Michael Gray, CPA's Blog

Tax and financial advice from the Silicon Valley expert.

Opportunity Zones – A new “secret” tax benefit

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  • mike   

Capital gains deferral for up to eight years?  Tax free investment growth?  Sounds too good to be true?

The Tax Cuts and Jobs Act of 2017, enacted on December 22, 2017 and mostly effective for individuals for 2018 through 2026, includes a tax benefit that hasn’t been widely discussed, yet.

The tax benefit is for investing in Opportunity Zones.  The reason it hasn’t been widely discussed is the investment community has been waiting for guidelines on how to implement the rules.  On October 19, 2018, the IRS issued proposed regulations for investing in Opportunity Zones (REG-115420-18.)  The proposed regulations answer many, but not all, of the questions relating to the new rules.

A summary of the tax benefits are as follows:

  1. Effective January 1, 2018 through December 31, 2026, if an individual reinvests short- or long-term capital gains from a transaction with an unrelated party within 180 days in Qualified Opportunity Zone (QOZ) property, the reinvested gain won’t be subject to current taxation, but will be deferred until the earlier of the date the QOZ property is sold or liquidated, or December 31, 2026. When it is taxed on December 31, 2026, the gain will retain its character as short-term or long-term capital gain.
  2. If the investment is held for at least five years, the potential tax on 10% of the reinvested gain will be forgiven by a basis adjustment to the QOZ property.
  3. If the investment is held for at least seven years, the potential tax on 5% of the reinvested gain will be forgiven by a basis adjustment to the QOZ property.
  4. This means that, provided the holding period requirements are met and the property is held through December 31, 2026, 85% of the reinvested gain will be taxable on December 31, 2026.
  5. If the QOZ property is held for at least 10 years and the taxpayer makes an election to do so, any additional gain from the ultimate sale or liquidation of the property will be tax free!

Note that only the gain is reinvested, and not the total proceeds like for a Section 1031 exchange.

The investor should keep a side account of cash or liquid investments to provide for paying the tax on the reinvested gain for 2026.  The source of the cash could be the capital recovery for the sale generating the reinvested gains.

The property will usually be acquired by an individual investing in a qualified opportunity fund, and not by a direct investment in the property.

The fund will be organized as a qualified opportunity zone business, conducting a trade or business within a qualified opportunity zone.  The assets of the fund, on average, must consist of at least 90% qualified opportunity zone property.  The proposed regulations include a safe harbor rule permitting the fund up to 31 months to invest the cash received in qualified property, provided the fund has a written plan for the investment.  A major question that hasn’t been answered is whether a rental real estate activity qualifies as a trade or business.  There is an example of converting a factory building to residential rental property in Revenue Ruling 2018-29 that indicates rental real estate should qualify.  (A real estate based business, such as a hotel, certainly does qualify.)

Qualified opportunity zones are designated by the governor for each state.  For example, the governor of California can designate up to 879 tracts, and a list of them are listed on a California Department of Finance web site.  The zones are economically depressed and primarily commercial.  However, many of them are located close enough to more economically advantaged areas to still offer good potential for economic returns.

Remember California has not conformed to this federal tax law.  The federal deferral and exclusions from taxable income don’t apply to California taxpayers and California source income for nonresidents of California.

There are a few aggressive fund managers who are already offering Qualified Opportunity Funds that invest in real estate, with the representation that they can’t guarantee the tax benefits, because of unanswered questions for the rules.

With the release of the proposed regulations, investors can have more confidence investing in qualified opportunity zone funds, but should still use due diligence and consult with their tax advisors before going ahead.  Investors should also consider how the investment fits in their total investment portfolios.

IRS issues proposed regulations for the 20% of domestic trade or business income deduction

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  • mike   

The tax deduction of 20% of qualified business income under Internal Revenue Code Section 199A is one of the most complex provisions of the Tax Cuts and Jobs Act enacted on December 22, 2017.

The requirements for qualifying for and computing this deduction add a layer of complexity to our tax laws for owners of unincorporated businesses and S corporations similar to the complexity of the alternative minimum tax, the passive activity loss rules and the net investment income tax.

There are many questions about the details of how to apply the new rules.  On August 8, 2018, the Internal Revenue Service issued proposed regulations (REG-107892-181) as its initial guidance.  The IRS has asked for comments from the tax preparation and planning industry about the proposals and how to resolve some questions that are still unclear.  The IRS wants to receive the comments by September 22, 2018 and has scheduled a public hearing on October 16, 2018.  Taxpayers can rely on the proposed regulations until final regulations are issued.  The regulations won’t be binding until final regulations are issued, except for the anti-abuse rule for multiple trusts, which is effective for taxable years ending after December 22, 2017.

I expect this deduction will be a huge area of litigation from disagreements between the IRS and taxpayers about Congress’s intent in enacting this tax benefit.

My printout of the IRS summary and text of the proposed regulations is 183 pages.  I will only give some highlights here.  I recommend that any individual, trust, partnership, LLC or S corporation with a trade or business (including rental real estate) should have its income tax returns prepared by a professional income tax return preparer for 2018 and be prepared to pay higher income tax return preparation fees than in the past.  I also recommend that business owners should consult with their tax advisors well before the end of the year to find out how the tax law changes in the Tax Cuts and Jobs Act will affect them.

I apologize in advance if my explanation is confusing.  Please get professional advice.  Tax professionals should read the proposed regulations and get more detailed information in training courses and textbooks.

The basics

Effective for tax years beginning after December 31, 2017 and before January 1, 2026, noncorporate taxpayers, including individuals, estates and trusts, are eligible for a federal income tax deduction of 20% of qualified domestic trade or business income.  (For this explanation, I will refer to the deduction as the 20% deduction for business income as shorthand.)  The business income may be from an entity that is a sole proprietorship, a partnership (including most LLCs taxed as partnerships) or an S corporation.  Income from a trade or business that is a specified service trade or business (SSTB) does not qualify for the deduction unless the taxpayer has taxable income of up to $415,000 for taxpayers filing a joint return ($315,000 threshold + $100,000 phaseout) or $207,500 for other taxpayers ($157,500 threshold + $50,000 phaseout.)  The deduction for a trade or business that is not a SSTB may be subject to certain limitations, explained below.

In general, the deduction is limited to the greater of (a) 50% of the W-2 wages of the trade or business; or (b) the sum 25% of the W-2 wages of the trade or business plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property of the trade or business (generally, depreciable property).

The wage and qualified property limitations don’t apply if the taxpayer has taxable income of not more than $157,500, or $315,000 for a joint return.  The limitation is phased in for the next $50,000 of taxable income, or $100,000 for a joint return.

A 20% of business income deduction is also available for a partner’s share of income from a publicly traded partnership and for distributed income from an agricultural or horticultural cooperative or a REIT (real estate investment trust).  This part of the 20% deduction for business income is not subject to the wages and property limitations that apply to other qualified business income.

See below for special rules relating to agricultural and horticultural cooperatives.

The total of the 20% deductions for business income plus the cooperative deduction can’t exceed the taxable income less net capital gains for the tax year.  For the purpose of computing this limitation, the 20% deduction is disregarded.

The 20% deduction for business income is a separate deduction after determining adjusted gross income and before itemized deductions or the standard deduction.

The 20% deduction for business income that is allowed when computing regular taxable income is also allowed for the alternative minimum tax.  No separate computation is required.

Under the proposed regulations, a relevant passthrough entity (RPE) is a partnership, LLC taxed as a partnership or S corporation, S corporation or an estate or trust required to file an income tax return and issue Schedule K-1 to its owners or beneficiaries.  A PTP is a publicly traded partnership.

Domestic trade or business income (Qualified Business Income)

The IRS states in the proposed regulations that it will follow the rules under Internal Revenue Code Section 162 to determine whether the entity is a trade or business.  This provides a resource of past litigation for determining whether or not it is a trade or business.

There is an exception for the rental or licensing of tangible or intangible property to an entity that is commonly controlled (explained below).  If the entity the property is rented or licensed to qualifies as a trade or business, the rental or licensing income will also be trade or business income, even if the entities don’t qualify to be aggregated (also explained below).  It’s not clear that this exception applies if the controlled business that the property is rented or licensed to is a C corporation, since C corporations aren’t eligible for the 20% deduction for business income.

Other than this exception, the proposed regulations do not go into detail about rental real estate income.  There is an example in the proposed regulations where rental real estate income other than to a commonly-controlled entity qualifies for the deduction.  There are court cases where rental from a triple-net lease is considered investment income and not trade or business income.  Some, but not all, rental real estate operations should qualify for the deduction.  I recommend that rental real estate operations that claim the deduction should issue Form 1099 to noncorporate payees to whom payments for services and interest expenses are paid.

The income must be effectively connected with the conduct of a trade or business within the United States.  A determination might have to be made whether income and related deductions have a foreign source and not qualify for the deduction.  A trade or business conducted in Puerto Rico is considered to be conducted within the United States.

Interest income is trade or business income only if it relates to a trade or business.  That would usually be interest income of a bank for business loans or interest received for late payments of accounts receivable.  Interest income for investment of working capital, reserves or similar accounts isn’t related to a trade or business.

Dividends income does not relate to a trade or business.

Short and long-term capital gains are not trade or business income.

W-2 income, compensation for services received other than in the capacity as a partner and guaranteed payments received for services rendered to the trade or business are not trade or business income.  (Profitable partnerships and LLCs taxed as partnerships might want to restructure their compensation for partners from guaranteed payments to special allocations of income.)

Guaranteed payments from a partnership or an LLC taxed as a partnership in lieu of interest for the use of capital are not trade or business income.  (Again, profitable partnerships might want to restructure these arrangements to special allocations of income.)

S corporations that pay dividends to their shareholders and pay them low or no W-2 income will find the IRS is even more aggressive recharacterizing dividends as reasonable compensation, not qualifying for the 20% of business income deduction.  The proposed regulations clarify that the reasonable compensation issue will only apply to S corporations in the context of this deduction.

Ordinary income from the disposition of business assets, such as depreciation recapture, is trade or business income.

Unadjusted basis immediately after acquisition (UBIA) of qualified property

Congress enabled trades and businesses that don’t have significant payrolls to get some benefit from the 20% deduction for business income by incorporating an alternative limitation based on investment in depreciable property.

Qualified property is depreciable property that meets three conditions:

  • It’s held by and available for use in the trade or business at the close of the taxable year;
  • It’s used to produce qualified business income during the taxable year; and
  • The depreciable period for the property hasn’t ended before the close of the taxable year of the individual or the passthrough entity.

Any depreciable addition to or improvement to qualified property is treated as separate qualified property first placed in service on the date the addition or improvement is placed in service.

Property is not qualified property if it is acquired within 60 days of the end of the taxable year and disposed of within 120 days without having been used in the trade or business for at least 45 days before disposition, unless the taxpayer demonstrates that the principal purpose of the acquisition and disposition was a purpose other than increasing the 20% of business income deduction.

Depreciable basis adjustments relating to changes in partnership ownership under Internal Revenue Code Sections 734(b) and 743(b) are not qualified property.

The depreciable period is the period beginning on the date the property was first placed in service by the individual or passthrough entity and ending on the later of (1) the date 10 years after that date, or (2) the last day of the last full year in the Modified ACRS recovery period of the property.  For most personal property, this will be 10 years; for residential real estate, 27.5 years; and for commercial real estate, 39 years.  There is no change in the depreciable period when the taxpayer elects to expense the property or claims bonus depreciation.

This means taxpayers will often have depreciable property still on their books and records that won’t qualify for this limit.

If property is acquired in a Section 1031 tax-deferred exchange or in an involuntary conversion under Internal Revenue Code Section 1033, the depreciable period of the disposed property will continue to apply for the carryover basis portion of the basis, and the depreciable period will start on the replacement date for any additional basis for the replacement property.  There is an exception when the taxpayer makes an election under Treasury Regulations § 1.168(i)-6 to treat the property as first placed in service by the taxpayer on the date the replacement property is placed in service.

Property acquired in a nonrecognition transaction, such as a contribution to a partnership, will continue to have the depreciable period of the contributor.

Inherited property is acquired on the date of death.

The unadjusted tax basis is the cost that would be eligible for depreciation.  The tax basis is determined disregarding basis adjustments for tax credits claimed or for expensing the property under Internal Revenue Code Section 179.  However, any tax basis adjustment for the personal use of the property does apply and that part isn’t included as qualified property for the limitation.

If a passthrough entity doesn’t determine and report the UBIA for each trade or business conducted by the entity, UBIA is presumed to be zero.

W-2 wages

W-2 wages is not necessarily the same as the amount claimed as the deduction for wages on the taxpayer’s federal income tax return.

For example, wages could be capitalized to manufactured property.  Also, the business might report using the accrual method of accounting, but W-2 wages are always reported using the cash method.  A trade or business could have a fiscal year.  The W-2 wages are determined using a calendar year.

W-2 wages for the limitation computation are the wages reported on Form W-2 paid by the person/business during the calendar year ending during the taxable year.  For example, if a trade or business has a taxable year ending June 30, 2019, it would use W-2 wages reported for calendar year 2018.

In determining W-2 wages for the limitation computation, an individual or passthrough entity may include W-2 wages paid by another person/business and reported by the other person/business on Forms W-2 with the other person/business listed as the employer on Box c of Forms W-2 when the W-2 wages were paid to common law employees or officers of the individual or passthrough entity for their employment by the individual or passthrough entity.  In such cases, the individual/business that reported the wages on Form W-2 may not include those wages to compute its limitation.

Each individual or passthrough entity that directly conducts more than one trade or business must allocate those wages among its various trades or businesses, according to the trade or business that generated those wages.  Then the wages must be allocated to the qualified business income of the trade or business.  (This may be more difficult than it sounds, and arguments with the IRS about it are likely.)

A passthrough entity must determine and report W-2 wages for each trade or business conducted by the entity.  If a passthrough entity doesn’t determine and report W-2 wages for each trade or business conducted by the entity, W-2 wages are presumed to be zero.

W-2 wages do not include any amount which is not properly allocable to qualified business income.  For example if a taxpayer reports wages paid to a household employee on Form W-2, those wages are not included for this limitation.

W-2 wages includes the amount reported as wages in Box 1 of Form W-2 for an employee, plus amounts the employee has elected to defer, such as contributions to a 401(k) plan.  These amounts are reported in box 12 of Form W-2.  Elective Roth contributions are already included in taxable wages and are not added.

The IRS has issued a proposed revenue procedure relating to alternative methods for computing W-2 wages.  (Notice 2018-64, August 8, 2018.)  According to the proposed revenue ruling, wages reported on Form W-2 should be reduced by wages that aren’t subject to income tax withholding, including supplemental unemployment compensation benefits.

Forms W-2 provided to statutory employees (the “Statutory Employee” box in Box 13 should be checked) are not included in W-2 wages for the limitation computation.

The wages must be reported on Form W-2 to the Social Security Administration.  W-2 wages don’t include any amounts not properly included in a W-2 Form filed with the SSA on or before the 60th day after the due date, including extensions, for Form W-2.  So, be diligent about filing Forms W-2 and the transmittal Form W-3 on time.  (The due date of Form W-2 is January 31 of the year following the calendar year to which it relates.  Corrected Forms W-2 are due on or before January 31 of the year following the year in which the correction is made.)  Each Form W-2 together with its accompanying Form W-3 will be considered a separate information return and each Form W-2c (corrected W-2) and its accompanying Form W-3c will be considered a separate information return.

If a corrected Form W-2 is filed with the SSA before the 60th day after the original due date (including extensions), the corrected Form W-2 wages are used as W-2 wages for the limitation computation.  According to the proposed regulations, corrected W-2 wages for corrected Forms W-2 filed 60 days or later after the original due date (including extensions) are only used as W-2 wages for the limitation computation if the wages are decreased on a Form W-2c.

The proposed regulations include methods of determining W-2 wages when there is a change of ownership for a business and for short taxable years.  Those rules are beyond the scope of this summary.

Common control

Trade or businesses are under common control if the same person or group of persons, directly or indirectly, owns 50% or more of each trade or business.  For an S corporation, ownership is determined based on the issued and outstanding shares.  For a partnership (including an LLC taxed as a partnership), ownership is determined for the capital or profits of the partnership.  The test applies to the ownership for the majority of the tax year at issue.

When determining control, an individual is considered to own the interest owned, directly or indirectly, by the individual’s spouse (unless legally separated under a decree of divorce or separate maintenance) and the individual’s children, grandchildren, and parents.

Note that common control applies based on the facts even when a taxpayer owns a minority interest in a trade or business.   For example, that individual might own a minority interest in a trade or business and also in a rental property leased to the trade or business.  If the trade or business and the rental property are 50% or more owned by the same individuals, minority owners still treat them as under common control and can treat the rental income as trade or business income under the safe harbor.

Specified service trades or businesses (SSTB)

Specified service trades or businesses are involved in performing services in one or more of the following fields: health (care), law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, (securities) brokerage services, (securities and commodities) trading, dealing in securities, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.

The proposed regulations elaborate on the fields and state that it is the nature of the work done and not licensure that determines whether a trade or business is a SSTB.  For example, an unlicensed bookkeeping service is considered an accounting business so it is a SSTB.

Businesses involved in the research, testing and manufacture of pharmaceuticals or medical devices are not considered “health” businesses, and neither are health clubs/gymnasiums.

Banks are not considered financial services businesses.

Consulting means the provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems.  Consulting provided incidental to selling products or software at no additional fee for the service is not “counted” as consulting services.

The biggest concern of the tax planning and preparation of the community is the last field.  Almost any businesses could be considered have as its principal asset the reputation or skill of its employees or owners.  The IRS laid this concern to rest by only including the following types of trades and businesses:

  • A trade or business in which a person receives fees, compensation, or other income for endorsing products or services,
  • A trade or business in which a person licenses or receives fees, compensation or other income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity, or
  • Receiving fees, compensation, or other income for appearing at an event or on radio, television or another media format.

The term fees, compensation or other income includes the receipt of a partnership interest or S corporation stock with their corresponding distributive shares of income, deduction, gain or loss.

For a trade or business with gross receipts of $25 million or less for a taxable year, a trade or business is not a SSTB if less than 10% of the gross receipts of the trade or business are attributable to the performance of services in a specified field.

For a trade or business with gross receipts of more than $25 million, the threshold is 5% of gross receipts.

Any trade or business that provides 80% or more of its property or services to a SSTB and there is 50% or more common ownership, directly or indirectly, in the trades or businesses, will be treated as a SSTB.

If a trade or business provides less than 80% of its property or services to a SSTB and there is 50% or more common ownership, directly or indirectly, in the trades or businesses, that portion of the trade or business of providing property or services to the commonly-owned SSTB is treated as part of the SSTB.

For this purpose, indirect common ownership is determined under Internal Revenue Code Sections 267(b) and 707(b).

If a trade or business that otherwise would not be treated as a SSTB has 50% or more common ownership, directly or indirectly, with a SSTB, and has shared expenses with the SSTB, then that trade or business will be treated as incidental to and part of the SSTB if the gross receipts of the trade or business represents no more than 5% of the combined gross receipts of the trade or business and the SSTB in a taxable year.

Trade or business of performing services as an employee

Income of a trade or business performing services as an employee doesn’t qualify for the 20% deduction for business income.

The determination of whether a trade or business is performing services as an employee is not solely determined based on whether the individual performing the services is treated as an employee for federal employment tax purposes.

For this purpose, an individual who was properly treated as an employee for Federal employment tax purposes by the person or business to who he or she provided services and who subsequently is treated as other than an employee by such person for providing substantially the same services to that person/business or a related person/business, is presumed to be in the trade or business of performing services as an employee with regard to those services.  The presumption also applies if the individual provides services directly or indirectly through an entity or entities.

The presumption may be rebutted if the individual shows that, under Federal tax law, regulations and principles, including common-law employee classification rules, the individual is performing services in a capacity other than as an employee.

Aggregation

Electing to aggregate different trades and businesses and treat them as one for computing the 20% deduction is one of the most important elections for the 20% deduction for business income.

For example, business A has taxable income of zero, W-2 wages of $100,000 and no depreciable assets.  Business B has taxable income of $100,000, no W-2 wages and no depreciable assets.  If these businesses are reported separately, there is no 20% deduction for their operations.  If they are aggregated, the 20% deduction before the overall taxable income limitation would be $20,000, which is the lesser of 20% of $100,000 (income) = $20,000 or 50% of $100,000 (W-2 wages) = $50,000.

Aggregation is not required.  Different taxpayers that own the same trades and businesses can make different aggregation elections; some might choose not aggregate while others will choose to aggregate.

Taxpayers that elect to aggregate two or more trades or businesses must continue to do so in future taxable years, unless one or more of the businesses becomes ineligible, such as when there no longer is common control.

Taxpayers may elect to aggregate a new trade or business with a previously existing group.

This election is separate from the passive activity loss grouping rules.  Qualification as a real estate professional and electing to combine all real estate activities has no effect for aggregation under these rules.

A trade or business that is a specified service trade or business (SSTB) can’t be aggregated with another trade or business.

In order to otherwise qualify for aggregation, the trades or businesses must be commonly controlled (see above explanation) and satisfy at least two of the following factors:

  • The trades or businesses provide products and services that are the same or customarily offered together.
  • The trades or businesses share facilities or share significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources.
  • The trades or businesses are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group (such as supply chain interdependencies).

For each taxable year, individuals must attach a statement to their federal income tax returns identifying each trade or business that is aggregated. The statement must include:

  • A description of each trade or business;
  • The name and employer identification number for each entity in which a trade or business is operated;
  • Information identifying any trade or business that was formed, ceased operations, was acquired, or was disposed of during the taxable year; and
  • Such other information that the IRS requires in forms, instructions or published guidance.

If the individual fails to attach the required statement, the IRS may disaggregate the individual’s trades or businesses.

Pass-through entity reporting

Passthrough entities, including partnerships, LLCs taxed as partnerships, S corporations, estates and trusts, must report to their owners and beneficiaries the information required for the owners and beneficiaries to compute their 20% deduction for business income.  The information will be included on Schedule K-1 or a statement attached to Schedule K-1 that is issued to its owners or beneficiaries.

That information will include, for any trade or business engaged in directly by the entity:

  • Each owner’s allocable share of qualified business income (QBI), W-2 wages, and unadjusted basis immediately after acquisition (UBIA) of qualified property; and
  • Whether any of the trades or businesses is a specified service trade or business (SSTB.)

The entity must also report on an attachment to Schedule K-1 the QBI, W-2 wages, UBIA and SSTB determinations for any other passthrough entity in which the reporting passthrough entity owns a direct or indirect interest.

This information must be reported despite aggregation by the owners of the passthrough entities, because the aggregation election is made by the individual owner.

If the required information isn’t reported by the passthrough entity, the owner’s share of the QBI, W-2 wages and UBIA of qualified property will be presumed to be zero.

Trusts and estates will allocate the reportable items to the trust or estate and the beneficiaries of the trust or estate in proportion of the allocation of the trust’s or estate’s distributable net income.  If the trust or estate makes no distributions and none of its income is required to be distributed, all of the reportable items will be allocated to the trust or estate.  If the trust or estate has no distributable net income, all of the reportable items will be allocated to the trust or estate.

Losses

Trade or business losses for computing the 20% of business income deduction will be separately accounted for.  Losses that are tax deductible for computing taxable income might not be deductible when computing the 20% of business income deduction.

Regular tax net operating losses are not allowed when computing qualified business income for the 20% of business income deduction.

Losses or deductions that were disallowed, suspended, limited or carried over from taxable years ending before January 1, 2018 will be disallowed when computing qualified business income for the 20% of business income deduction.

Previously disallowed losses or deductions from taxable years ending after December 31, 2017 under the passive activity loss rules, at risk rules or from insufficient basis that are subsequently allowed when computing taxable income will be taken into account when computing qualified business income for the 20% of business income deduction.

Passthrough entities report the income or loss for each trade or business that they conduct to the owners of the entity.  The loss limitations are applied at the level of the individual owner, estate or trust.

When any trade or business has a loss for a taxable year, that loss is allocated pro-rata according to the taxable income before the loss of any other trades or businesses of the taxpayer who is the owner or beneficiary computing taxable income.  The net income amount will be considered to be zero.  The W-2 wages and UBIA limitations for that trade or business are disregarded.  The W-2 wages and UBIA limitations only apply for trades or businesses with positive taxable income after reduction from the losses of any trades or business that have losses.

If the total of the taxable income for the trades or businesses of the taxpayer is a loss, that loss is disallowed for the taxable year and the 20% of business income deduction is zero.  The loss is carried forward to the next taxable year and is considered to be the loss of a separate trade or business when making the 20% of business income deduction computation.

For example, Jane Taxpayer has three trades or businesses to report on her 2018 income tax returns, A, B and C.  None of these businesses have depreciable property since Jane leases the equipment.  For 2018, A has $25,000 of taxable income, B has $75,000 of taxable income, and C has a taxable loss of ($50,000).  The W-2 wages for 2018 are $25,000 for A, $20,000 for B and $10,000 for C.  To compute the 20% of business income deduction, C’s taxable loss is allocated 25% to A, or ($12,500) and 75% to B, or ($37,500).  After subtracting the allocated losses, the 20% deduction for A’s income is $12,500 X 20%, or $2,500, limited to 50% of A’s W-2 wages, $12,500, or $2,500.  The 20% deduction for B’s income is $37,500 X 20%, or $7,500, limited to 50% of B’s W-2 wages, $10,000, or $7,500.  The W-2 wages for C are disregarded for this computation.

If the taxable loss for C in the previous example was ($120,000), the total loss for all of the trades or businesses would be ($20,000).  There would be no 20% deduction for business income for 2018 and the $20,000 loss would be carried over to 2019, and would be treated as a loss from a separate trade or business other than A, B or C.

When computing the 20% of business income deduction for REIT dividends and qualified publicly traded partnership income, any losses from publicly traded partnerships are combined with the income of other publicly traded partnerships and REIT dividends.  The deduction is 20% of any positive total.  If the total is a loss, the 20% deduction for REIT dividends and qualified publicly traded partnership income is zero.  The loss is carried forward to combine with REIT dividends and qualified publicly traded partnership income for the next taxable year.

Multiple trusts

Since each trust has its own threshold for applying the W-2 wages and UBIA limitations and for the phaseout of the deduction relating to SSTB income, there is a potential for abuse by individuals creating multiple trusts to hold ownership interests in family trades and businesses.

There is an anti-abuse provision in Internal Revenue Code Section 643 which aggregates two or more trusts and treats them as a single trust if such trusts have substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries, and if a principal purpose for establishing such trusts is the avoidance of Federal income tax.  When applying this rule, spouses are treated as one person.

Under the proposed regulations, it is presumed that multiple trusts with the same grantor or grantors and substantially the same primary beneficiary or beneficiaries that hold trade or business interests are established to avoid Federal income tax.  Therefore, the trusts will be aggregated and treated as a single trust, unless there is a significant non-tax (or non-income tax) purpose that could not have been achieved without the creation of these separate trusts.

Agricultural or horticultural cooperatives

Special rules apply for income from an agricultural or horticultural cooperative.

The 20% of business income deduction attributable to income from an agricultural or horticultural cooperative is reduced by the lesser of:

  • 9% of the QBI with respect to the trade or business as is properly allocble to qualified payments received from the cooperative;
  • 50% of the W-2 wages with respect to the trade or business allocable to the income, determined under Prop. Reg. 1.199A-2.

In addition to the reduced 20% of business income deduction (net 11%), an agricultural or horticultural cooperative can take an additional tax deduction of 9% of the lesser of (1) the qualified production activities income (QPAI) of the taxpayer for the taxable year, or (2) the taxable income of the taxpayer for the taxable year.  The deduction is limited to 50% of the W-2 wages of the taxpayer for the taxable year.  The deduction is computed without regard to the deductions for patronage dividends, per-unit retain allocations and nonpartronage distributions.

A pro-rata portion of the deduction for the cooperative is passed through to the owners who receive a qualified payment from the cooperative.  The amount will be identified by the cooperative in a written notice.  This is similar to the procedure for the old DPAD deduction.

The pass-through deduction from the cooperative to the owner is subject to the taxable income limitation.

The cooperative won’t be able to deduct any qualified payment up to the deduction allowable with respect to the payment.

When you add these two amounts together, you’re back to 20% of deductions attributable to the cooperative income.

(The IRS said in the explanation for the proposed regulations that it plans to issue separate proposed regulations for cooperatives later this year.  The IRS expects those proposed regulations will provide that only the patronage business of a relevant cooperative will qualify for the deduction for business income.)

Conclusion

After reading this report, I hope you will appreciate the complexity of this new deduction.  This is not a simple matter for reporting using consumer tax return preparation software.  Making errors in choices for elections and failure to report correctly can result in a smaller deduction or in losing the deduction altogether.  You have to get the right figures in the right boxes.  There are penalties from overstating the deduction that I haven’t discussed here.

Tax practitioners should study the details for computing the deduction seriously and business owners should seek professional help when planning for and reporting the deduction.

Equity compensation isn’t subject to Railroad Retirement Tax

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  • mike   

The U.S. Supreme Court resolved a conflict of interpretation about whether employee stock options are subject to Railroad Retirement Tax.

The Court ruled that equity compensation isn’t subject to the Railroad Retirement Tax.

The retirement system for the railroad industry was nationalized by the Railroad Retirement Act of 1937.  Railroad employers pay taxes on employee compensation, somewhat like the social security system.

Under the Railroad Retirement Act, the tax applies to “any form of money remuneration.”

The IRS claimed that stock options should be considered to be “money remuneration.”

The Supreme Court said that money is understood to be currency issued by a recognized authority as a medium of exchange.  While stock can be bought or sold for money, it isn’t usually considered to be a medium of exchange.

 

Supreme Court changes the game for sales tax on interstate sales

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  • mike   

For many years, companies that sold their goods in states where they had no physical presence (no assets or employees located in the state) haven’t collected sales tax.  They relied on U.S. Supreme Court rulings in National Bellas Hess (1967) and Quill Corp. (1992) that they weren’t obligated to collect the tax.

With the explosion of the internet and world wide web, a growing share of U.S. commerce is now conducted online.  The states have suffered declining sales tax revenue and “bricks and mortar” merchants have suffered a disadvantage from having to collect sales tax while online merchants don’t have to.

The Supreme Court, at the request of 41 states, two territories and the District of Columbia, reversed the National Bellas Hess and Quill decisions on June 21, 2018.  The Court basically said that making a sale creates sufficient nexus to be required to collect sales tax.

This decision will have a significant impact on businesses that make interstate sales.  They now need to determine the sales tax for a huge number of jurisdictions in the U.S.  Counties and cities have their own sales tax rates.  Businesses might be required to file hundreds of sales tax reports.

Some states have thresholds to eliminate the burden for smaller businesses.  For example, in South Dakota, only sellers that deliver more than $100,000 of goods or services into the state or engage in 200 or more separate transactions for the delivery of goods or services into the state are required to collect sales tax.

Hopefully Congress will develop legislation to ease the burden for collecting, reporting and paying state and local sales taxes.

 

What meals, entertainment and business gifts are 100% deductible?

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  • mike   

The deductibility for meals, entertainment and business gifts is a complex area of the federal tax laws that is worth studying.  I am going to highlight some areas where these items are 100% deductible to stimulate further conversation with your tax advisor.  This is not a complete explanation that you can rely on as authority for a tax position.

These rules were radically changed by the Tax Cuts and Jobs Act of 2017, effective for amounts paid or incurred after December 31, 2017 until December 31, 2025.  The tax deduction for entertainment expenses has been repealed.  These expenses include any item relating to (1) an activity generally considered to be entertainment, pleasure, recreation, (2) membership dues with respect to any club organized for business, pleasure or other social purposes, or (3) a facility or any portion thereof used in connection with any of the above items.

Under the Act, no deduction will be allowed for expenses associated with providing any qualified transportation fringe to employees of the taxpayer, except as necessary for ensuring the safety of an employee, any expense incurred for providing transportation (or any payment or reimbursement) for commuting between the employee’s residence and place of employment.

The basic rule is that certain business meals are 50% deductible.  Business gifts are deductible up to $25 to a person (spouses are counted as one person) per year.

Under the Act, food and beverages provided on the business premises of the employer for the convenience of the employer as a de minimus fringe benefit are only 50% tax deductible.   Such amounts incurred and paid after December 31, 2025 will not be tax deductible.  The “cafeteria exception” has been repealed.

Under the Act, recreational or social expenses (including facilities expenses) primarily for the benefit of employees other than certain owners and highly compensated employees, such as company picnics and holiday parties, are still tax deductible.  Meals relating to these activities are still 100% deductible.

There are important exceptions that should be separately accounted for on a business’s books and records.

For example,

When a taxpayer is in the business of providing meals and entertainment to customers, such as amusement parks, restaurants and nightclubs, the expenses of providing those goods and services are 100% tax deductible.  This is a form of providing “samples” as a promotional expense

An important exception that I want to focus on is expenses for goods, services and facilities made available by the taxpayer to the general public.  This article was inspired by private IRS letter ruling 9641005, which explains how the limitations apply for a casino.  IRS private letter rulings can’t be relied on as authority for tax positions, but indicate the thinking of the IRS for this situation.

In that ruling, the term “general public” is very broadly interpreted to include a customer or group of customers.  (It may be that casinos as a group have enough political “pull” to get a generous interpretation by the IRS.)

Most of the gaming operations, shows, and restaurant facilities in the casino are providing meals, entertainment and lodging to the general public, and so the expenses of providing them are tax deductible as cost of goods and services sold.

Casinos provide a number of gifts to customers intended to stimulate additional business, called “comps.”

When a casino provides food, drinks and show tickets on its premises as comps to guests who are gambling or lodging on the premises, they are providing tax deductible “samples” to the public, which are 100% tax deductible.  (The same rule applies to restaurants providing complementary meals to customers or reviewers, as I described above.)

Some promotional gifts given to customers may be fully tax deductible.  An example from the Congressional Committee report is cited that if the owner of a hardware store advertises that tickets to a baseball game will be provided to the first 50 people who visit the store on a particular date, or who purchase an item from the store during a sale (gift with purchase), the total cost of the tickets is tax deductible as a business promotion expense.  Casinos commonly give coupon books to their guests and may deduct 100% of the expenses for the coupon items.

Items, such as promotional pens, that cost up to $4.00 with the taxpayer’s name imprinted for which multiple identical items are given are not considered to be business gifts, but simply fully tax-deductible promotional items.

Dinner meetings for groups of customers or prospective customers relating to a business presentation, as we commonly see for financial planners, are 100% tax deductible “public events.”  (Time will tell if the IRS changes its position in light of the Tax Cuts and Jobs Act of 2017.  I believe this exception still applies.)

Things become more involved for comps provided by casinos for activities off their business premises.

For example, sporting event tickets (unless relating to a business promotion) are only deductible for their face value, and under the Act only deductible as gifts subject to the $25 annual limit per customer.

Meals or other entertainment provided off the premises might be 50% deductible if a representative of the casino accompanies the customer for a business deduction.  Otherwise, reimbursements provided to the customer or direct payment by the casino aren’t tax deductible.

Some business expenses that would otherwise be entertainment are classified differently in certain situations.  For example, professional theater critics may fully deduct theater tickets for shows they review, and fashion shows by clothing manufacturers are fully deductible promotional events.

Note the $25 and $4 limitations above are very old, going back to 1954.  This is a good time to write your representatives in Congress that these limitations should be increased or eliminated.

Now is a great time to review your accounting procedures with your tax advisor to assure you are maximizing your tax deductions.  Your business should also segregate entertainment expenses from business meals on its books and records.  If you need assistance in that effort, please call Thi Nguyen, CPA at 408-286-7400, extension 206.

A Social Security benefit when both spouses were at least age 62 on 1/1/2016

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  • mike   

Under a grandfather rule, married couples who were both at least age 62 on January 1, 2016 are eligible for a procedure called a “restricted application” to increase their Social Security benefits.  The spouses must also meet other qualifications for spousal benefits to use the procedure, which I’m not going to explain here.

The Social Security benefit increases by 8% each year after the individual reaches “full retirement age” until reaching age 70, usually for a total potential 32% increase.  (For individuals born from 1945 to 1954, full retirement age is age 66.)

If you are trying to provide the highest possible survivor benefit, you will usually want to defer applying for benefits for the higher-earning spouse until age 70.

Lower-earning spouses can always apply for worker benefits under their own account and later apply for potentially higher spousal benefits after their higher-earning spouses apply for benefits under their own account.

When a restricted application is made, the higher-earning spouse initially applies only for spousal benefits under the lower-earning spouse’s account.  Retirement credits continue to accrue on the higher-earning spouse’s account and that spouse applies for worker benefits on his or her own account at age 70.

For example, John was born on April 8, 1953.  His full retirement age benefit at age 66 is $2,500 per month.  Jill was born on December 30, 1952.  Her full retirement age benefit at age 66 is $800 per month.

Jill applies for worker benefits at age 66 on December 30, 2018.  Her benefit is $800 per month.

John makes a restricted application for spousal benefits at age 66 on April 8, 2019, for a benefit of $400 per month (disregarding cost of living adjustments for all computations.)

John applies for worker benefits on his own account at age 70 on April 8, 2023, for a benefit of $3,300 per month.

Jill applies for spousal benefits during April 2023 for a benefit of $1,250 per month (one-half of John’s primary insurance amount of $2,500).

You can’t apply for spousal benefits until your spouse applies for worker benefits.

When the low-income spouse applies for spousal benefits after reaching full retirement age, that spouse receives one-half of the high-income spouse’s primary insurance amount (the worker benefit that spouse would receive at full retirement age without any increases for deferred retirement credits), even if the high-income spouse hasn’t reached full retirement age, and even when the high-income spouse applies for benefits later than full retirement age.

This explanation only covers the highlights.  You might want to go over your details with a financial planner who understands Social Security benefit planning.

Also, be extra careful when making a restricted application for benefits to avoid accidentally making a regular application.

I hope this information is helpful for you or somebody that you know.  Feel free to share a link for this blog post.

Are you a winner or loser under tax reform?

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  • mike   

Many Americans are probably wondering whether they will pay more or less taxes under proposals released by President Trump and the tax-writing committees of Congress.

If you listen to President Trump’s sales presentations for the plan, everyone will be better off, but it ain’t necessarily so.

The proposals are still rather sketchy.  The taxable income amounts for which the various tax brackets will apply haven’t even been announced.  Here is my speculation about who are some of the winners and who are some of the losers under the proposals.  Since a combination of factors may apply, each family will need their own computations of tax before and after the changes when the details of the plan are ultimately released if Congress is successful in passing tax reform legislation.

Winners

U.S. corporations with accumulated earnings “parked” offshore.  U.S. multinational corporations haven’t brought their cash from offshore subsidiaries to the U.S. to avoid having them taxed.  Under the tax proposal, they would be able to repatriate the cash at low tax rates, payable over up to five years.  This could make the cash available to pay as dividends to U.S. shareholders to make investments in the U.S.  It could also be just a transfer from a foreign bank to a U.S. bank.

U.S. multinational corporations.  Under the proposal, dividends paid to U.S. corporations from offshore subsidiaries that are at least 10% owned by the U.S. corporation would be tax exempt.  U.S. corporations would no longer be subject to tax on their worldwide income, but only their U.S. operations.

U.S. business owners.  The maximum corporate tax rate would be reduced from 38% to 20%.  The maximum tax rate for individuals on business income would be reduced from 39.6% to 25%.  Investments in depreciable assets (equipment) other than structures (buildings) would be currently deductible for at least five years.

Employees with incentive stock options.  The exercise of incentive stock options isn’t subject to the regular tax, but is currently taxable under the alternative minimum tax.  Since the alternative minimum tax would be repealed, the exercise of incentive stock options would be deferred until the stock is sold or there is another disqualified disposition.  The original tax benefit of incentive stock options would be restored.

Healthy retired empty nesters.  Many of these taxpayers already use the standard deduction.  Their standard deductions will increase under the tax proposals, likely resulting in a tax reduction.

Very wealthy families.  The federal estate tax would be repealed.  Very few Americans are currently subject to the federal estate tax at death.  The exemption equivalent for 2017 is $5.49 million per individual, or nearly $11 million for a married couple.  The federal estate tax rate is 40% for the excess.  (Note there is no proposal to repeal the federal gift tax!)

High income individuals.  The maximum income tax rate would be reduced from 39.6% to 35%.  The additional 3.8% tax on net investment income is also proposed to be repealed.

Losers

Very large families.  The personal exemption would be repealed.  The rationale is the larger standard deduction would cover the elimination of the personal exemption, but it is a flat amount.  The dependent exemption for 2017 is $4,050.  With the $12,700 standard deduction for married couples for 2017, a family of three would have a combined deduction of $24,850 — exceeding the proposed standard deduction for married couples of $24,000.

Single parent families.  It appears the head of household filing status, a very significant tax break for single parent families, would be eliminated.

People who live in states with high income taxes.  States with high income tax brackets include California, New York, New Jersey, Minnesota and others.  (Note many of them are “blue” states.)  The deduction for state income taxes would be repealed.

People who pay high real estate taxes.  The deduction for real estate taxes would be repealed, eliminating a significant tax benefit of home ownership.

People in nursing homes.  Since the medical deduction would be eliminated, people who are uninsured or underinsured and pay for long-term care will lose a signficant tax benefit.  (For many of them, their medical expenses eliminates most of their taxable income.)

Employees with employee business expenses.  Employee business expenses are an itemized deduction that would be repealed.

Corporations that issue bonds or borrow money.  The deduction for interest expense for C corporations would be partially limited.

People who pay high legal fees.  Some legal fees now qualify to be deducted as miscellaneous itemized deductions.  This deduction would be repealed.

People who have high investment management expenses.  Investment management expenses for taxable investments are miscellaneous itemized deductions.  This deduction would be repealed.

Tax return preparers.  Actually, pluses and minuses.  Taxpayers will be totally confused by the tax law changes and will seek help in sorting them out.  Many tax returns will be simpler to prepare, resulting in lower fees.  Tax professionals will need to approach planning more from a financial planning point of view.  Tax return preparers who serve high net worth clients will still have plenty of business.  These clients will still have complex tax issues to deal with

Let your representatives in Congress know what you think about these proposals.  Here is a web site with contact information:  https://www.usa.gov/elected-officials

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How can a business valuation specialist save taxes for your business or family?

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  • mike   

The interview on Financial Insider Weekly to be broadcast in San Jose and Campbell  on Thursday, August 24, is with James Brown, ASA, CFP(R) of Perisho, Tombor & Brown.   Our interview subject is “The role of the business valuation specialist.”  The interview will be broadcast at 6:30 p.m. Pacific Time on CreaTV, Comcast Channel 15 in San Jose and Campbell, and will be broadcast as streaming video at the same time at www.creatvsj.org. Note the change in day and time.  You can find broadcast times for other San Francisco Bay Area cities and past episodes at www.financialinsiderweekly.com.

After eight years of production, this is the final broadcast of a new interview for Financial Insider Weekly.  Thank you to the public access television stations that broadcast the show and to the viewers for watching it.  You will find a wealth of financial information under past episodes at www.financialinsiderweekly.com.

How should you prepare to sell a business?

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  • mike   

The interview on Financial Insider Weekly to be broadcast in San Jose and Campbell  on Friday, August 11, is with Greg Carpenter of BTI Group Mergers & Acquisitions.   Our interview subject is “Preparing to sell a  business.”  The interview will be broadcast at 9:30 p.m. Pacific Time on CreaTV, Comcast Channel 15 in San Jose and Campbell, and will be broadcast as streaming video at the same time at www.creatvsj.org. You can find broadcast times for other San Francisco Bay Area cities and past episodes at www.financialinsiderweekly.com.

What should you know when buying a business?

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  • mike   

The interview on Financial Insider Weekly to be broadcast in San Jose and Campbell  on Friday, August 4, is with Greg Carpenter of BTI Group Mergers & Acquisitions.   Our interview subject is “Buying a business.”  The interview will be broadcast at 9:30 p.m. Pacific Time on CreaTV, Comcast Channel 15 in San Jose and Campbell, and will be broadcast as streaming video at the same time at www.creatvsj.org. You can find broadcast times for other San Francisco Bay Area cities and past episodes at www.financialinsiderweekly.com.

Michael Gray, CPA's Blog

Tax and financial advice from the Silicon Valley expert.