How High Net Worth Individuals Are Affected By The New Tax Law

Updated: Aug 21, 2018

On Be Secure Financially we cover a lot of information regarding how to take control of your finances, fom beginners who are just starting their financial journey, to those who have achieved complete financial freedom. Then, there are those individuals that have not only achieved financial freedom, but also reached the dream for many: High Net Worth.

The most commonly quoted figure for membership in the high net worth club is $1 million in liquid financial assets. "Very-HNWI" (VHNWI) can refer to someone with a net worth of at least US$5 million. In this personal finance article we explain "How High Net Worth Individuals Are Affected By The New Tax Law".

1. Elimination of Form 2106 Deduction for Unreimbursed Employee Business Expenses.

Prior to January 1, 2018, if a company failed to reimburse employees for such business expenses (known as “unreimbursed employee business expenses”), the employees could claim the deductions themselves on their personal tax returns on IRS Form 2106. The new tax law has eliminated these unreimbursed employee business expense deductions for employees.

This change has been the most talked about new tax item affecting professional athletes—they’re required to be W-2 employees in their capacity as professional team players and have historically claimed Form 2106 deductions for such expenses as agent fees, marketing, public relations, business management, accounting, legal, clubhouse dues, training and conditioning, union dues and travel.

Entertainers who are W-2 employees include crew members, writers, directors, film and TV actors and musicians who, in addition to freelancing and fronting their own groups, tour with major-label artists or Broadway productions and are classified as employees within that context.

The tax law will no longer allow deductions (including many of those listed above) for grooming, audition travel, music, voice or acting lessons, wardrobe and personal assistants.

2) Gift Planning

The act doubles the amounts that a U.S. person can transfer free of the federal estate and gift tax. In 2017, each individual had an estate and gift tax exemption exemption of $5.49 million. Beginning on January 1, 2018, these exemptions were increased to approximately $11.2 million, indexed for inflation in future years.

The higher exemption amounts are scheduled to return to their lower pre-act levels after December 31, 2025. Accordingly, high net worth individuals should consider making gifts equal to their increased exemption amounts prior to this date. And because any appreciation in gifted assets should be protected from future wealth transfer taxes, a gift of property in 2018 may be a better use of an individual’s exemption than a gift in 2025.

The act does not change the federal income tax treatment of assets owned by a decedent at the time of his or her death. This means that unrealized appreciation in an asset held by an individual during his or her lifetime will never be subject to income tax if the individual holds the asset at the time of death. Conversely, assets that are given away during a donor’s lifetime generally will have a basis in the hands of the recipient equal to the basis of the donor.

3. A significant 20 percent deduction for individuals, trusts and estates that receive income from a “qualified trade or business” held in pass-through form, such as a partnership or an S corporation.

There are, however, limitations on the ability of individuals and trusts with income in excess of certain thresholds to benefit from this deduction. The new 20 percent deduction may generate planning opportunities for family offices and investment entities.

As one example, families with holdings that are likely to qualify for the new deduction might consider compensating family office executives with a profits interest in a family investment partnership rather than W-2 wage income. The profits interest arrangement may enable executives to enjoy the lower tax rate resulting from the deduction while further aligning the interests of the family office and the executive.

For owners of real estate, the business must be considered a “qualified trade or business”.

Presumably, this definition includes owners of rental apartment buildings and multiple rental properties. In that case the Rental Income, subject to certain limitations will be eligible for the 20% deduction.

4. Prior to January 1 of this year, taxpayers who lived in states with high individual income tax rates or had high real estate property tax bills could claim those taxes as an itemized deduction (often a substantial one) on their federal tax returns.

Unfortunately, these write-offs are now limited to $10,000 in total, and the unavailability of these deductions will significantly affect various groups of High Net Worth Individuals living in highly taxed states and those who own expensive personal residences.

5. For divorce agreements executed in 2019 and beyond, payments between former spouses will be treated in much the same way as shared income during their marriage.

This means that alimony/maintenance and support payments will no longer be tax deductible by the payor nor taxable income to the recipient – akin to how child support has always been. Without the tax deduction as an incentive, 2019 alimony payments will likely drop so the payor is out-of-pocket for the same amount as they would have been under the old rules, where the Alimony payments had been Tax Deductible. Even accounting for the recipient’s tax savings (typically the recipients have had a lower tax rate), this means they will almost certainly be receiving less than they would have in 2018. It’s a lose-lose proposition for both payor and recipient.

Existing divorced couples and those who execute the agreement in 2018 will be able to maintain the current deductibility of alimony/maintenance after for as long as they pay it.

However, a benefit to the recipient is that the spouse receiving alimony and unallocated support will now qualify for the Child Tax Credit, recently doubled from $1,000 to $2,000 for children under the age of 17. The adjusted gross income threshold for this credit has now increased to $200,000 for a single filer and phases out at $240,000. To qualify, the parent must have the dependency exemption. While the exemption amount is $0 through 2025, it still is important to negotiate who is entitled to it. In addition, there are credits available to the “custodial parent” as defined by the IRS, including the credit for child and dependent care expenses and education credits.