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The Tax and Cuts and Jobs Act is set to slash $1.4 trillion from the federal budget — but not everyone will be cashing in on its changes. Hollywood’s elite, along with countless other California residents, will find themselves without deductions that used to be a financial failsafe.
“When you lower tax rates you theoretically create a disincentive to hire fancy lawyers and accountants to figure it out,” says tax and estate attorney to the stars Bradford Cohen. “However, this law is by no means simplification. It is infinitely more complex, and there are tremendous opportunities for planning here.”
While the maximum individual tax rate is dropping from 39.6 to 37 percent, Cohen says the benefits of the new law are illusory and temporary, and many people will find themselves paying more taxes than they are now when individual benefits expire in 2025.
Hollywood business manager Rick Shephard estimates that for every client who earns more than a million dollars a year, his or her taxes will increase by $30,000 for each additional million earned. “They all know that their taxes will go up as a consequence of this law,” he says. “This is not a tax reduction act. It’s a reallocation act.”
Here are the areas in which entertainment’s top experts say the changes in the law will most affect their clients:
Most actors filing as corporations won’t qualify for a 20 percent deduction of business income, and other talent may also miss out.
Stars often receive income from multiple employers, which makes them eligible to file their taxes through a loan-out corporation, which offers a variety of liability and tax benefits. Shephard says any actor who routinely earns $500,000 a year is most likely incorporated, and 90 percent of those who are use pass-through S corporations.
Starting in January, there’s a 20 percent deduction on an individual’s qualified business income from an S corporation, partnership, limited liability corporation or sole proprietorship. But all those incorporated actors likely won’t be able to take advantage of the new deduction. To the IRS, there’s a big difference between income earned by personal service workers and everyone else. “If you’re paid for doing services with a special skill you don’t qualify for this deduction,” says Shephard. In Hollywood, that specifically includes actors, athletes, lawyers and accountants — and may also extend to behind-the-scenes folks like writers and producers.
Actors whose household income is less than $315,000 a year are still eligible, Cohen notes, and those with diversified sources of income may be able to bifurcate their earnings to take advantage of the deduction. “I met with a client who’s making a lot of money, and we’re going to set up a separate company for their non-acting revenue,” he says.
The total deduction for state and local income taxes and property taxes is capped at $10,000.
For California residents who pay higher than average property and state income taxes, being able to deduct those payments on their federal tax returns was a financial godsend. Now the total deduction is limited to $10,000.
“If you own a house and have a job, your combined state income and property tax is going to be way over $10,000,” says Hollywood tax and estate attorney Jeffrey Eisen, adding that one of his clients called upset because he pays more than half a million each year in property taxes on two homes. “This hurts the bluest states the most, New York, New Jersey, Connecticut, California and Illinois. There’s no question about it.”
The government estimates this change will bring in $668 billion in revenue over the next decade.
“The dramatic reduction of the property tax deduction and state and local tax deductions will likely significantly raise the effective tax rate for individuals in Hollywood — the higher their California source income and the more valuable their home, the bigger the impact of the loss of those deductions,” says Laura Zwicker, an attorney to ultra-high-net-worth individuals. “Readers should be aware that while they can pre-pay their 2018 property taxes before year-end and claim a deduction for that payment on their 2017 income tax return, the new law contains a provision that specifically disallows a deduction for any state income tax for 2018 pre-paid in 2017.”
Shephard says many clients are thinking of moving to a lower-tax state. “The problem is if you work in California, you’re still going to pay tax at the California rates,” he says.
The estate and gift tax exemption is doubled but only through 2025.
When a high-net worth individual dies, those entrusted to handle his or her estate are immediately confronted with a nine-month tax deadline — at which time up to 40 percent of the estate’s value has to be paid to the IRS. Currently, an individual can transfer to an estate, or give to another person, $5.6 million without paying tax on it. Beginning Jan. 1, that exemption will double to $11.2 million per person or $22.4 million per couple — but there’s a catch. The new cap expires Dec. 31, 2025. So if a person doesn’t die or give their money away before that date, the higher limit doesn’t benefit them.
“If a client has sufficient assets that they can afford to make a gift of their full credit amount, we would recommend making the gift as soon as possible,” says Zwicker, noting there are two primary reasons for this move. First, it’s possible the law could change again before 2025. Second, if money or an asset is transferred and it appreciates there’s no extra tax on the added value.
But Eisen, whose firm created a primer on the new law for clients, says it’s not always easy to convince entertainers to part with their money. “People who are in front of the camera, no matter how A-list or prominent they might be, are always afraid they won’t get another job,” he says. “What if I never work again? It’s in the back of their minds.”
The change is estimated to save taxpayers $83 million over the next decade.
Alimony payments aren’t deductible on federal taxes for couples splitting after Dec. 31, 2018.
Under the prior law, if John and Jane Doe divorced, the higher earner could deduct spousal support payments. So if John makes $1 million a year and pays Jane $300,000 in alimony, he’d essentially lower his taxable income to $700,000 — and Jane would have to add $300,000 to her annual earnings on her tax return.
For couples who split after Jan. 1, 2019, John can’t deduct the payments and Jane doesn’t have to claim the income. So John still pays Jane $300,000 but has to pay taxes on his full $1 million in earnings, and Jane pays no taxes on the spousal support income. Assuming Jane is in a lower tax bracket, that means more money will be paid to the federal government. (The most recent budgetary analysis from the Joint Committee on Taxation estimates it will bring in $6.9 billion over the next decade.)
“Congress just saw a loophole and a source of lost tax revenue,” says top Hollywood divorce lawyer Laura Wasser. “They didn’t see the economic substance of the payment of support. It’s a transfer of wealth. The paying spouse is giving income to the recipient spouse.”
The ability to deduct those payments lessened the blow of having to make them, she says, and having to factor in taxes will likely complicate divorce settlement negotiations.
“We will now have different classes of divorce tax payers, those before the implementation of the new tax law and those after,” says Wasser. “It appears the law will grandfather pre-existing agreements under old law.”
That, she says, raises several issues for splitting couples and their attorneys. “Are modifications of prior orders new orders or old,” she wonders. “Are prenuptial agreements orders for purposes of this law?”
Larry Ginsberg, another divorce attorney to the stars, adds that clients will likely be revising their prenups in light of the new law. “Many of those agreements contemplate that any spousal support payable upon separation will be deductible to the payor and taxable to the payee,” he says. “These issues should be revisited, which is not necessarily a comfortable conversation to have during an intact marriage.”
Couples could also choose to fast-track divorces during the next 12 months if the deductibility of spousal support significantly impacts tax or financial planning.
“Since spousal support may be integral to resolving other issues in the case as well, parties may be hesitant to resolve that issue before being fully aware of how all other financial issues are going to go,” he says. “It makes an already complicated analysis more complex.”
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