Our Office will be closed Nov.21 – Nov.25 in observance of Thanksgiving. We will return to regular business hours on Monday, Nov. 28.
Our Office will be closed Nov.21 – Nov.25 in observance of Thanksgiving. We will return to regular business hours on Monday, Nov. 28.
When President Trump signed into law the Tax Cuts and Jobs Act (TCJA) in December 2017, much was made of the dramatic cut in corporate tax rates. But the TCJA also includes a generous 20% qualified business income (QBI) deduction for smaller businesses that operate as pass-through entities, with income that is “passed through” to owners and taxed as individual income.
The IRS issued proposed regulations for the qualified business income (QBI), or Section 199A, deduction in August 2018. Now, it has released final regulations and additional guidance, just in time for the first tax season in which taxpayers can claim the deduction. Among other things, the guidance provides clarity on who qualifies for the QBI deduction and how to calculate the deduction amount.
Rental real estate owners – proposed safe harbor
One of the lingering questions related to the QBI deduction was whether it was available for owners of rental real estate. The latest guidance (found in IRS Notice 2019-07) includes a proposed safe harbor that allows certain real estate enterprises to qualify as a business for purposes of the deduction. Taxpayers can rely on the safe harbor until a final rule is issued.
Generally, individuals and entities that own rental real estate directly or through disregarded entities (entities that are not considered separate from their owners for income tax purposes, such as single-member LLCs) can claim the deduction if:
The 250 hours of services may be performed by owners, employees or contractors. Time spent on maintenance, repairs, rent collection, expense payment, provision of services to tenants and rental efforts counts toward the 250 hours.
Investment-related activities, such as arranging financing, procuring property and reviewing financial statements, do not.
Be aware that rental real estate used by a taxpayer as a residence for any part of the year is not eligible for the safe harbor.
This safe harbor also is not available for property leased under a triple net lease that requires the tenant to pay all or some of the real estate taxes, maintenance and building insurance and fees, or for property used by the taxpayer as a residence for any part of the year.
Aggregation of multiple businesses
It is not unusual for small business owners to operate more than one business. The proposed regs include rules allowing an individual to aggregate multiple businesses that are owned and operated as part of a larger, integrated business for purposes of the W-2 wages and unadjusted basis immediately after acquisition (UBIA) of qualified business property (QBP) limitation, thereby maximizing the deduction. The final regs retain these rules with some modifications.
For example, the proposed rules allow a taxpayer to aggregate trades or businesses based on a 50% ownership test, which must be maintained for a majority of the taxable year. The final regulations clarify that the majority of the taxable year must include the last day of the taxable year.
The final regs also allow a “relevant pass-through entity” — such as a partnership or S corporation — to aggregate businesses it operates directly or through lower-tier pass-through entities to calculate its QBI deduction, assuming it meets the ownership test and other tests. (The proposed regs allow these entities to aggregate only at the individual-owner level.) Where aggregation is chosen, the entity and its owners must report the combined QBI, wages and UBIA of qualified property figures.
A taxpayer who doesn’t aggregate in one year can still choose to do so in a future year. Once aggregation is chosen, though, the taxpayer must continue to aggregate in future years unless there’s a significant change in circumstances.
The final regs generally don’t allow an initial aggregation of businesses to be done on an amended return, but the IRS recognizes that many taxpayers may be unaware of the aggregation rules when filing their 2018 tax returns. Therefore, it will permit taxpayers to make initial aggregations on amended returns for 2018.
UBIA in qualified property
The final regs also make some changes regarding the determination of UBIA in qualified property. The proposed regs adjust UBIA for nonrecognition transactions (where the entity doesn’t recognize a gain or loss on a contribution in exchange for an interest or share), like-kind exchanges and involuntary conversions.
Under the final regs, UBIA of qualified property generally remains unadjusted as a result of these transactions. Property contributed to a partnership or S corporation in a nonrecognition transaction usually will retain its UBIA on the date it was first placed in service by the contributing partner or shareholder. The UBIA of property received in a like-kind exchange is generally the same as the UBIA of the relinquished property. The same rule applies for property acquired as part of an involuntary conversion.
Specified Service Trade or Business (SSTB) limitations
Many of the comments the IRS received after publishing the proposed regs sought further guidance on whether specific types of businesses are SSTBs. The IRS, however, found such analysis beyond the scope of the new guidance. It pointed out that the determination of whether a particular business is an SSTB often depends on its individual facts and circumstances.
Nonetheless, the IRS did establish rules regarding certain kinds of businesses. For example, it states that veterinarians provide health services (which means that they’re subject to the SSTB limits), but real estate and insurance agents and brokers do not provide brokerage services (so they aren’t subject to the limits).
The final regs retain the proposed rule limiting the meaning of the “reputation or skill” clause, also known as the “catch-all.” The clause applies only to cases where an individual or a relevant pass-through entity is engaged in the business of receiving income from endorsements, the licensing of an individual’s likeness or features, or appearance fees.
The IRS also uses the final regs to put a lid on the so-called “crack and pack” strategy, which has been floated as a way to minimize the negative impact of the SSTB limit. The strategy would have allowed entities to split their non-SSTB components into separate entities that charged the SSTBs fees.
The proposed regs generally treat a business that provides more than 80% of its property or services to an SSTB as an SSTB if the businesses share more than 50% common ownership. The final regs eliminate the 80% rule. As a result, when a business provides property or services to an SSTB with 50% or more common ownership, the portion of that business providing property or services to the SSTB will be treated as a separate SSTB.
The final regs also remove the “incidental to an SSTB” rule. The proposed rule requires businesses with at least 50% common ownership and shared expenses with an SSTB to be considered part of the same business for purposes of the deduction if the business’s gross receipts represent 5% or less of the total combined receipts of the business and the SSTB.
Note, though, that businesses with some income that qualifies for the deduction and some that does not can still separate the different activities by keeping separate books to claim the deduction on the eligible income. For example, banking activities (taking deposits, making loans) qualify for the deduction, but wealth management and similar advisory services do not, so a financial services business could separate the bookkeeping for these functions and claim the deduction on the qualifying income.
The TCJA allows individuals a deduction of up to 20% of their combined qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income, including dividends and income earned through pass-through entities. The new guidance clarifies that shareholders of mutual funds with REIT investments can apply the deduction. The IRS is still considering whether PTP investments held via mutual funds qualify.
QBI deduction in action
The QBI deduction generally allows partnerships, limited liability companies, S corporations and sole proprietorships to deduct up to 20% of QBI received. QBI is the net amount of income, gains, deductions and losses (excluding reasonable compensation, certain investment items and payments to partners) for services rendered. The calculation is performed for each qualified business and aggregated. (If the net amount is below zero, it’s treated as a loss for the following year, reducing that year’s QBI deduction.)
If a taxpayer’s taxable income exceeds $157,500 for single filers or $315,000 for joint filers, a wage limit begins phasing in. Under the limit, the deduction can’t exceed the greater of 1) 50% of the business’s W-2 wages or 2) 25% of the W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of qualified business property (QBP).
For a partnership or S corporation, each partner or shareholder is treated as having paid W-2 wages for the tax year in an amount equal to his or her allocable share of the W-2 wages paid by the entity for the tax year. The UBIA of qualified property generally is the purchase price of tangible depreciable property held at the end of the tax year.
The application of the limit is phased in for individuals with taxable income exceeding the threshold amount, over the next $100,000 of taxable income for married individuals filing jointly or the next $50,000 for single filers. The limit phases in completely when taxable income exceeds $415,000 for joint filers and $207,500 for single filers.
The amount of the deduction generally can’t exceed 20% of the taxable income less any net capital gains. So, for example, let’s say a married couple owns a business. If their QBI with no net capital gains is $400,000 and their taxable income is $300,000, the deduction is limited to 20% of $300,000, or $60,000.
The QBI deduction is further limited for SSTBs. SSTBs include, among others, businesses involving law, financial, health, brokerage and consulting services, as well as any business (other than engineering and architecture) where the principal asset is the reputation or skill of an employee or owner. The QBI deduction for SSTBs begins to phase in at $315,000 in taxable income for married taxpayers filing jointly and $157,500 for single filers, and phasing in completely at $415,000 and $207,500, respectively (the same thresholds at which the wage limit phases in).
The QBI deduction applies to taxable income and doesn’t come into play when computing adjusted gross income (AGI). It’s available to taxpayers who itemize deductions, as well as those who don’t itemize, and to those paying the alternative minimum tax.
Proceed with caution
The tax code imposes a penalty for underpayments of income tax that exceed the greater of 10% of the correct amount of tax or $5,000. But the TCJA leaves less room for error by taxpayers claiming the QBI deduction: It lowers the threshold for the underpayment penalty for such taxpayers to 5%.
Please contact your tax advisor to avoid such penalties and review your specific facts and circumstances regarding the QBI deduction.
Review our QBI Flow Chart using your facts and circumstances to answer the question, “Am I eligible for the new 20% Qualified Business Income (QBI) Deduction?”
The Colorado Department of Revenue issued the following statement regarding proposed sales tax rules to implement the U.S. Supreme Court’s South Dakota v. Wayfair decision and destination sourcing:
“As part of our rulemaking process to implement sales tax rules for in-state and out-of-state retailers, we have heard from legislators and the business community, and the Department of Revenue agrees it is important for the state to take the time to get this right.
“As such, the Department is extending the automatic reprieve for Colorado businesses and out-of-state retailers to comply with the emergency rules from the current March 31, 2019 deadline to May 31, 2019. We will evaluate the need for another extension as May 31 nears. This additional time will give the state legislature an opportunity to find innovative solutions to streamline and simplify our sales tax collection laws in accordance with the wishes of the residents of Colorado.
“This is an opportunity to simplify sales tax for all parties: for businesses that collect and remit sales tax, for customers who pay it, and for those of us in state government whose obligation it is to carry out the tax laws passed by the state legislature. No one desires a streamlined and simplified sales tax collection and compliance system more than the Department of Revenue.”
If you have questions about sales tax in Colorado or in other states, please contact your tax advisor.
Tax reform included major changes to gift and estate taxes. The new laws significantly reduces the number of taxpayers who will be subject to gift and estate taxes, at least for the next several years, but factoring taxes into your estate planning is still important if you live in a state with an estate tax.
The Tax Cuts and Jobs Act (TCJA) more than doubles the combined gift and estate tax exemption and the generation-skipping transfer (GST) tax exemption, from $5.49 million for 2017 to $11.18 million for 2018.
This amount will continue to be annually adjusted for inflation through 2025. Absent further congressional action, however, the exemptions will revert to their 2017 levels (adjusted for inflation) for 2026 and beyond.
The rate for all three taxes remains at 40% — only three percentage points higher than the top income tax rate.
Even before the TCJA, the majority of taxpayers did not have to worry about federal gift and estate taxes. While the TCJA protects even more taxpayers from these taxes, those with estates in the roughly $6 million to $11 million range (twice that for married couples) still need to keep potential post-2025 estate tax liability in mind in their estate planning. Although their estates would escape estate taxes if they were to die while the doubled exemption is in effect, they could face such taxes if they live beyond 2025.
Taxpayers who could be subject to gift and estate taxes after 2025 may want to consider making gifts now to take advantage of the higher exemptions while they’re available.
Income tax planning, which became more important than estate planning back when exemptions rose to $5 million more than 8 years ago, is now an even more important part of estate planning.
For example, holding assets until death may be advantageous if estate taxes are not a concern. When you give away an appreciated asset, the recipient takes over your tax basis in the asset, triggering capital gains tax should he or she turn around and sell it. When an appreciated asset is inherited, on the other hand, the recipient’s basis is “stepped up” to the asset’s fair market value on the date of death, erasing the built-in capital gain. In this scenario, retaining appreciating assets until death can save significant income tax.
Be aware that many states impose estate tax at a lower threshold than the federal government does.
Whether you need to be concerned about federal gift and estate taxes, having an estate plan in place and reviewing it regularly is important.
The Tax Cuts and Jobs Act (TCJA) initially seemed to eliminate the popular meal expense deduction for businesses in some situations. The IRS has since issued transitional guidance — while it works on proposed regulations — that confirms the deduction remains allowable in certain circumstances and clarifies when businesses can claim it.
The need for guidance
Before the TCJA, the tax code generally prohibited deductions for expenses related to entertainment, amusement or recreation (commonly referred to as entertainment expenses). It provided exceptions, though, for entertainment expenses “directly related” to or “associated” with conducting business.
The code further limited deductions for food and beverage expenses that satisfied one of the exceptions. A deduction was allowed only if 1) the expense was not lavish or extravagant under the circumstances, and 2) the taxpayer (or an employee of the taxpayer) was present when the food or beverages were furnished. The amount of the deduction was limited to 50%.
Tax reform revised the tax code to disallow a deduction for expenses related to entertainment expenses, regardless of whether they are directly related to or associated with conducting business. Some taxpayers interpreted the amendment to ban deductions for business meal expenses as though they were deemed to be entertainment expenses. According to the new guidance, though, the law does not specifically eliminate all of these expenses.
Rather, the law merely repeals the two exceptions and amends the 50% limitation to remove the reference to entertainment expenses. The TCJA does not address the circumstances in which providing food and beverages might constitute nondeductible entertainment, the IRS says, but its legislative history “clarifies that taxpayers generally may continue to deduct 50% of the food and beverage expenses associated with operating their trade or business.”
Until the IRS publishes its proposed regulations explaining when business meal expenses are nondeductible entertainment expenses and when they are 50% deductible expenses, businesses may deduct 50% of business meal amounts if:
The IRS recognized that the fifth criterion above could create some confusion. The guidance, therefore, includes illustrative examples.
In the first example, a taxpayer invites a business contact to a baseball game, paying for both tickets. While at the game, the taxpayer also pays for hot dogs and drinks. The game is entertainment, so the cost of the tickets is a nondeductible entertainment expense. However, the cost of the hot dogs and drinks, purchased separately from the tickets, isn’t an entertainment expense. Therefore, the taxpayer can deduct 50% of the cost as a meal expense.
The second example employs a similar scenario, with the taxpayer inviting a contact to a basketball game. This time, though, the taxpayer buys tickets to watch the game from a suite, with access to food and beverages included. The game again represents entertainment, and the cost of the tickets is nondeductible. The cost of the food and beverages is not stated separately on the invoice, rendering it a disallowed entertainment expense, as well.
The final example uses the scenario above, except that the cost of the food and beverages is stated separately on the invoice for the basketball game tickets. The cost of the tickets remains nondeductible, but the taxpayer can deduct 50% of the cost of the food and beverages.
TCJA does not change the definition of “entertainment.” Under the applicable regulations, the term continues to include, for example, entertaining at:
Entertainment also includes hunting, fishing, vacation and similar trips. It may include providing food and beverages, a hotel suite or an automobile to a customer or the customer’s family.
Be aware that the determination of whether an activity is entertainment considers the taxpayer’s business. For example, a ticket to a play normally would be deemed entertainment. If the taxpayer is a theater critic, however, it would not. Similarly, a fashion show would not be considered entertainment if conducted by an apparel manufacturer to introduce its new clothing line to a group of store buyers.
Request for comments
The IRS has requested comments on future guidance clarifying the treatment of business meal expenses and entertainment expenses, including input on whether and what additional guidance is required and the definition of “entertainment.” Businesses should submit comments to the IRS by December 2, 2018. If you have questions on how this guidance may affect your business, contact your tax professional.
Converting a traditional IRA to a Roth IRA can provide tax-free growth and tax-free withdrawals in retirement, but what if you convert your traditional IRA — subject to income taxes on all earnings and deductible contributions — and then discover you would have been better off if you left it as a traditional IRA?
Before the Tax Cuts and Jobs Act (TCJA), you could undo a Roth IRA conversion using a “recharacterization.” Effective with 2018 conversions, the TCJA prohibits recharacterizations. If you executed a conversion in 2017, you may still be able to undo it.
Reasons to recharacterize
Generally, if you converted to a Roth IRA in 2017, you have until October 15, 2018, to undo it and avoid the tax hit.
Here are some reasons you might want to recharacterize a 2017 Roth IRA conversion:
If you recharacterize your 2017 conversion but would still like to convert your traditional IRA to a Roth IRA, you must wait until the 31st day after the recharacterization. If you undo a conversion because your IRA’s value declined, there is a risk that your investments will bounce back during the waiting period, causing you to reconvert at a higher tax cost.
Recharacterization in action
Sally had a traditional IRA with a balance of $100,000 when she converted it to a Roth IRA in 2017. Her 2017 tax rate was 33%, so she owed $33,000 in federal income taxes on the conversion.
However, by August 1, 2018, the value of her account had dropped to $80,000. So Sally recharacterizes the account as a traditional IRA and amends her 2017 tax return to exclude the $100,000 in income.
On September 1, she reconverts the traditional IRA, whose value remains at $80,000, to a Roth IRA. She will report that amount when she files her 2018 tax return. The 33% rate has dropped to 32% under the TCJA. Assuming Sally is still in this bracket, this time she’ll owe $25,600 ($80,000 × 32%) — deferred for a year and resulting in a tax savings of $7,400.
(Be aware that the thresholds for the various brackets have changed for 2018, in some cases increasing but in others decreasing. This, combined with other TCJA provisions and changes in your income, could cause you to be in a higher or lower bracket in 2018.)
Know your options
If you converted a traditional IRA to a Roth IRA in 2017, it is worthwhile to see if you could save tax by undoing the conversion. If you are considering a Roth conversion in 2018, keep in mind that you will not have the option to recharacterize. See your financial adviser whether recharacterizing a 2017 conversion or executing a 2018 conversion makes sense for you.
For tax years beginning in 2018 and beyond, the Tax Cuts and Jobs Act (TCJA) created a flat 21% federal income tax rate for C corporations. Under prior law, C corporations were taxed at rates as high as 35%. The TCJA also reduced individual income tax rates, which apply to sole proprietorships and pass-through entities, including partnerships, S corporations, and, typically, limited liability companies (LLCs). The top rate, however, dropped only slightly, from 39.6% to 37%.
On the surface, that may make choosing C corporation structure seem like a no-brainer, but there are many other considerations involved.
Under prior tax law, conventional wisdom was that most small businesses should be set up as sole proprietorships or pass-through entities to avoid the double taxation of C corporations: C corporations pay entity-level income tax and then shareholders pay tax on dividends — and on capital gains when they sell the stock. For pass-through entities, there is no federal income tax at the entity level.
Although C corporations are still potentially subject to double taxation under the TCJA, their new 21% tax rate helps make up for it. This issue is further complicated, however, by another provision of the TCJA that allows noncorporate owners of pass-through entities to take a deduction equal to as much as 20% of qualified business income (QBI), subject to various limits. But, unless Congress extends it, the break is available only for tax years beginning in 2018 through 2025.
No one-size-fits-all answer applies when deciding how to structure a business. The best choice depends on your business’s unique situation and your situation as an owner. Your tax adviser can help you evaluate your options.
Tax reform has led to confusion over some of the changes to longstanding deductions, including the deduction for interest on home equity loans.
The IRS has since clarified that the interest on home equity loans, home equity lines of credit and second mortgages will, in many cases, remain deductible under the new laws, regardless of how the loan is labeled.
Under prior tax law, taxpayers could deduct “qualified residence interest” on a loan of up to $1 million secured by a qualified residence, plus interest on a home equity loan (other than debt used to acquire a home) up to $100,000. The home equity debt could not exceed the fair market value (FMV) of the home reduced by the debt used to acquire the home.
For tax purposes, a qualified residence is the taxpayer’s principal residence and a second residence, (e.g. house, condominium, cooperative, mobile home, house trailer or boat). The principal residence is where the taxpayer resides most of the time; the second residence is any other residence the taxpayer owns and treats as a second home. Taxpayers are not required to use the second home during the year to claim the deduction. If the second home is rented to others, though, the taxpayer also must use it as a home during the year for the greater of 14 days or 10% of the number of days it is rented.
In the past, interest on qualifying home equity debt was deductible regardless of how the loan proceeds were used. A taxpayer could, for example, use the proceeds to pay for medical bills, tuition, vacations, vehicles and other personal expenses and still claim the itemized interest deduction.
The new tax rules
The new rule under tax reform limits the amount of the mortgage interest deduction for taxpayers who itemize through 2025. Beginning in 2018, a taxpayer can deduct interest only on mortgage debt of $750,000. The congressional conference report on the law stated that it also suspends the deduction for interest on home equity debt. And the actual bill includes the section caption “DISALLOWANCE OF HOME EQUITY INDEBTEDNESS INTEREST.” As a result, many people believed tax reform eliminates the home equity loan interest deduction.
On February 21, the IRS issued a release explaining that the law suspends the deduction only for interest on home equity loans and lines of credit that are not used to buy, build or substantially improve the taxpayer’s home that secures the loan. In other words, the interest is not deductible if the loan proceeds are used for certain personal expenses, but it is if the proceeds go toward, for example, a new roof on the home that secures the loan. The IRS further stated that the deduction limits apply to the combined amount of mortgage and home equity acquisition loans — home equity debt is no longer capped at $100,000 for purposes of the deduction.
Some examples from the IRS help show how the new rules work:
The new IRS announcement highlights the fact that the nuances of tax reform will take some time to flesh out completely. We will keep you updated on the most significant new rules and guidance as they emerge.
The sweeping changes of recent tax reform may impact the choice of how business taxpayers maintain their financials, specifically regarding the cash vs accrual methods of accounting. In tax years beginning after December 31, 2017, taxpayers may select their accounting method according to the new limits and conditions, as applicable:
Tax reform permits taxpayers in certain circumstances to recognize income for tax purposes no later than the year in which it is recognized for financial reporting purposes:
Tax law changes may impact on a businesses’ accounting method choice, and warrant a company to review and, possibly, revise those choices.
In a like-kind exchange, a taxpayer doesn’t recognize gain or loss on an exchange of like-kind properties if both the relinquished property and the replacement property are held for productive use in a trade or business or for investment purposes. For exchanges completed after Dec. 31, 2017, the TCJA limits tax-free exchanges to exchanges of real property that is not held primarily for sale (real property limitation). Thus, exchanges of personal property and intangible property can’t qualify as tax-free like-kind exchanges.
Although the real property limitation applies to exchanges completed after Dec. 31, 2017, transition rules provide relief for certain exchanges. Specifically, the real property limitation doesn’t apply to an exchange if the relinquished property is disposed before Jan. 1, 2018, or the replacement property is received by the taxpayer before Jan. 1, 2018. If the transition rules apply and all other requirements for a tax-free exchange are satisfied, an exchange of personal property or intangible property that is completed after Dec. 31, 2017 can qualify as a tax-free like-kind exchange.