Michael Gray, CPA's Blog

Tax and financial advice from the Silicon Valley expert.

How to make a retroactive small business accounting election for California

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  • mike   

The Franchise Tax Board has released preliminary guidance about how to make a small business accounting election on a 2018 income tax return.  California recently passed legislation, the “Loophole Closure and Small Business and Working Families Tax Relief Act of 2019”, adopting some of the provisions of the federal Tax Cuts and Jobs Act of 2017, including elections for certain small businesses that were previously required to use the accrual method of accounting to use the cash method and other accounting simplification measures.  The effective date for these accounting changes is for years beginning on or after January 1, 2019, but taxpayers may elect to apply the changes for years beginning on or after January 1, 2018.

Until formal procedures are issued, taxpayers may make the election by providing the following information to the Franchise Tax Board:

  1. A statement with the original or amended California income tax return stating the taxpayer’s intent to make a small business accounting election and which election(s) the taxpayer is making;
  2. On the top of the first page of the original or amended tax return, write “AB 91 – Small Business Accounting Election” in BLUE INK; and
  3. Mail the return to:

Franchise Tax Board

PO Box 942857

Sacramento, CA  94257-0500

Note:  These returns must be PAPER-FILED.

(Spidell’s Flash E-mail: How to make a retroactive small business accounting election, July 31, 2019.)

Heterosexual couples under age 62 can now be registered domestic partners in California

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  • mike   

Governor Newsom approved Senate Bill No. 30 on July 30, 2019.  The bill was authored by Senator Scott Weiner (Democrat state senator from San Francisco).  Under the new law, California’s Family Code is amended to allow heterosexual couples (a man and a woman) under age 62 to be registered domestic partners.

Before the change, only same-sex couples and heterosexual couples age 62 and greater could be registered domestic partners in California.

This change is important because registered domestic partners have essentially the same legal rights as married couples in California (including community property rights), and the relationship is not recognized as being married by the federal government.  THEREFORE, HETEROSEXUAL COUPLES WHO ARE CALIFORNIA REGISTERED DOMESTIC PARTNERS CAN AVOID THE FEDERAL INCOME TAX MARRIAGE PENALTY.

The federal marriage penalty means that a couple that files their income tax returns as married persons generally pays more income taxes than they would as unmarried persons.  The federal marriage penalty was increased under the Trump tax legislation, the Tax Cuts and Jobs Act of 2017.

Registered domestic partners are treated the same as married persons for California income tax reporting.

Be aware that registered domestic partners don’t qualify for some federal tax benefits that married couples do qualify for.  For example, gifts to a spouse who is a U.S. citizen qualifies for an unlimited marital deduction.  A bequest to a spouse who is a U.S. citizen also qualifies for an unlimited marital deduction.  The executor of a deceased spouse can elect on an estate tax return to give any unused lifetime exemption of the deceased spouse to a surviving spouse.  Only married persons are allowed to treat property settlements incident to a divorce as tax-free.

Heterosexual couples who are California residents and are planning to be married should consider being registered domestic partners, instead.

Heterosexual married couples who are California residents and who are paying a substantial federal marriage penalty should consider terminating their marriages and becoming registered domestic partners.  (Consult with your tax advisor to find out if you actually have a marriage penalty.)

I recommend consulting with a lawyer that specializes in family law and estate planning before making your decision.

(California S.B. 30, July 30, 2019.)

California sales tax relief for small businesses

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  • mike   

Thanks to the Supreme Court’s Wayfair decision, retailers that sell tangible personal property to customers located in states where they don’t have a physical presence may be required to collect sales and use tax.  For example, a company located in Nevada that sells furniture to a California customer may be required to collect California sales and use tax and report the sale and pay the tax to California.

The same concept can require a retailer located in one sales tax district, say Santa Clara County, that sells property to a customer located in another district, say Los Angeles County, to collect and remit the sales and use tax to the district where the customer is a resident (in this example, Los Angeles County.)  (This requirement has long applied to sales of motor vehicles.)

Initially, California’s Department of Tax and Fee Administration (CDTFA) issued rules imposing this collection requirement when a taxpayer had in either the preceding or current calendar year either (1) sales into the state or district exceeding $100,000 or (2) 200 or more separate transactions.

The new requirements were proposed to be effective on April 1, 2019.

Smaller retailers complained that the requirements were too burdensome — especially because they might have 200 separate transactions with a small dollar amount.

On April 25, 2019, Governor Newsom approved Assembly Bill No. 147, which provides relief to smaller retailers.

The new threshold for the requirement to collect California state and district sales and use taxes is more than $500,000 of sales of tangible personal property to customers located in California.  (Sales of motor vehicles are still subject to the use tax reporting requirement, regardless of the amount.)

The second threshold of 200 or more separate transactions has been repealed and is disregarded.

The new $500,000 of sales threshold is retroactively effective on April 1, 2019.

A change in the new law this isn’t favorable to small businesses doing business in California is that district sales and use taxes for all districts must be collected and reported when a business reaches the $500,000 threshold for all of California.  Under the previous guidelines, reporting and collection was only required when the $100,000 or 200 transactions threshold was reached for the district.  To help get the rates that apply, the CDTFA has on online lookup tool, Find a Sales and Use Tax Rate by Address.  Here is a link to the tool. https://gis.cdtfa.ca.gov/public/maps/taxrates/  (Spidell’s California Taxletter, May, 2019, p. 3, California adopts $500,000 economic nexus threshold for use taxes.)

Retailers with a physical presence in California are still required to report and collect California sales and use tax and local district sales and use tax.  They only need to be concerned about the $500,000 threshold as it relates to sales to customers located in another district.

The new law also includes a new requirement that requires “marketplace facilitators” that sell goods for other companies on their web sites, like Amazon and EBay, to treat those sales as made by the marketplace facilitator.  The marketplace facilitator will report the sales and collect and remit the sales and use taxes when it exceeds the $500,000 of sales threshold for the State of California and the various districts.

If the marketplace facilitator reports the sale and collects and remits the sales and use tax, the retailer isn’t required to do so.

The marketplace facilitator rules won’t be effective until October 1, 2019.

Some retailers might have to report sales made through a marketplace facilitator from April 1 through September 30, 2019 and their reporting burden may be shifted to marketplace facilitators thereafter.

There may be audit issues with the new marketplace facilitator reporting requirement, because the sales reported on the sales tax report won’t agree to the books and records of the retailer and the marketplace facilitator.

Despite the complexity of the new reporting requirements, many smaller retailers will find a lot to be thankful for in this relief legislation.

IRS issues more proposed regulations for Qualified Opportunity Funds

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  • mike   

A great tax benefit enacted as part of the Tax Cuts and Jobs Act of 2017 is the Qualified Opportunity Fund (QOF).

Taxpayers who reinvest capital gains into one of these funds can defer federal income taxes on the reinvested capital gains, including Section 1231 gains from selling business assets that are taxable as capital gains, for up to eight years until the earlier of the date on which the qualified investment is sold or exchanged or December 31, 2026.  In addition, the additional gain relating to the appreciation of the Qualified Opportunity Fund may be tax free, provided an election is made and the investment is held for more than 10 years.

If the QOF is held at least 5 years, 10% of the reinvested deferred gain will be tax free.  If the QOF is held at least 7 years, an additional 5% of the reinvested deferred gain will be tax free.  These adjustments are accounted for as tax basis adjustments — adding the tax free amounts to the taxpayer’s cost of the investment in the QOF.

The IRS issued proposed regulations for these funds during October, 2018.  Now they have issued additional proposed regulations (REG-120186-18 to be published shortly in the Federal Register) and are asking for more feedback from the tax return preparation and consulting community.   Another public hearing is scheduled for July 9, 2019 at 10 a.m.

The new proposed regulations provide answers to many questions relating to Qualified Opportunity Funds, and are mostly favorable to taxpayers.  I can only cover a few highlights.  My printout of the regulations and preamble is about 168 pages.  Here are a few key points.

  1.  The ownership and operation (including leasing) of real estate is the active conduct of a trade or business.  A triple-net lease is not the active conduct of a trade or business.  This broad acceptance of real estate leases as a trade or business only applies for applying the rules for Qualified Opportunity Funds.

2.  Only net capital gains and net Section 1231 gains (from sales of business assets) that are taxed as capital gains qualify for deferral by reinvestment.  Since net Section 1231 losses are taxed as ordinary losses, the 180-day reinvestment period for net Section 1231 gains begins at the end of the taxable year when the sale of Section 1231 property was closed.

3.  If there is an “inclusion event”, any remaining reinvested deferred capital gains and Section 1231 gains will become taxable if the investment hasn’t already been held until December 31. 2026.

4.  If an S corporation that invests in a QOF has aggregate change of ownership of capital interests of more than 25%, there is an inclusion event.

5.  A conversion of an S corporation to a partnership or disregarded entity or a C corporation is an inclusion event.

6.  A taxpayer’s transfer of a qualifying investment by gift, whether outright or in trust, is an inclusion event.

7.  A taxpayer’s transfer of a qualifying investment to a revocable living trust (grantor trust) is not an inclusion event, because the trust is disregarded for income tax reporting and the taxpayer is considered to continue to own the investment.  The trust becoming irrevocable can be an inclusion event, but see item 8.

8.  The transfer of a qualifying investment to a beneficiary of an estate or trust as an inheritance is not an inclusion event.  Remaining reinvested deferred income is potentially income with respect of a decedent.  The beneficiary steps into the shoes of the decedent relating to when the income will be taxable.

9.  A corporate subsidiary that is a QOF is not eligible to be included in a consolidated income tax return.

10.  A corporate parent that is a QOF is eligible to be included in a consolidate income tax return.

11.  A taxpayer may invest amounts exceeding capital gains and Section 1231 gains that are eligible for deferral in a QOF.  The excess investment will be separately accounted for as a separate interest that is not eligible for QOF tax benefits.  (Any gain relating to that share will be taxable.)

12.  Distributions by QOFs can be inclusion events.  For example, if a QOF partnership or S corporation borrows money and distributes funds exceeding their tax basis to its partners (remember most QOF interests will start with a basis of zero, because there is no tax basis for the deferred gains that are reinvested in the fund), the distributions will be an inclusion event.  (Distributions of operating income should be handled carefully.  Remember you can have positive cash flow when you don’t have taxable income because of noncash deductions, like depreciation.)

13.  Special rules are provided for mergers, recapitalizations and reorganizations.  They are beyond the scope of this summary.  See your tax advisor.

14.  Used property leased tangible property that was previously not used for a depreciable purpose for at least five years can be eligible “original use” QEF property.

15.  The proposed regulations include fairly liberal “substantially all” definitions for various limitations.  They are beyond the scope of this summary.  See your tax advisor.

16.  Leases shouldn’t include prepayments for more than a year.

17.  The proposed regulations include valuation guidelines for tangible property when applying the test requiring 90% of the property of the QOF to be used in the Qualified Opportunity Zone.  The QOF may either use the value for a qualified (audited) financial statement or cost and present value of lease payments as of the inception of the lease.  The property doesn’t have to be revalued each year.

18.  QOFs are required to annually pass a 50% of gross receipts test.  A least 50% of the QOF’s gross income must be earned in a Qualified Opportunity Zone.  Under the regulations, the gross receipts aren’t tested based on where the customer is located, but on where the work is done to produce the products or services.  That means sales from reselling products produced overseas won’t be qualified income.  Just having a post office box located in a Qualified Opportunity Zone doesn’t mean the business is considered to be located there.

19.  Unimproved land won’t be considered qualifying property unless plans are in place to substantially improve the land within 30 months.

The IRS says they will be issuing more proposed regulations for QOFs soon.

These proposed regulations are critically important for taxpayers to realize the tax benefits that they are counting on when making investments in QOFs.

Increased standard deduction means increased net investment income tax

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  • mike   

The Tax Cuts and Jobs Act of 2017 increased the standard deduction for 2018 to $24,000 for married taxpayers filing joint returns, $18,000 for heads of households, and $12,000 for other taxpayers.  This means most taxpayers will now be using the standard deduction to compute their federal income tax.

In the past, taxpayers who itemized their deductions could deduct part of their state income tax deduction when computing their 3.8% tax on net investment income (net investment income tax, or NIIT.)

Since they will not be claiming the state income tax deduction for regular tax purposes when they claim the standard deduction, they will “lose” that deduction when they compute their NIIT for 2018.

Here is the rationale for my conclusion that taxpayers who claim the standard deduction aren’t eligible to claim a deduction for state income taxes for the NIIT.

Reg. Sec. 1.1411-1(a) gives the general rule that, unless otherwise detailed in the regulations, the regular tax rules apply for the computation of the net investment income tax. (So, unless there is a defined exception, an election to claim the standard deduction will also apply for the NIIT.)

Reg. Sec. 1.1411-4(a) defines net investment income as the excess of investment income (as defined) over deductions properly allocated to the income.

Reg. Sec. 1.1411-4(f)(3)(iii) explains the deduction for state income taxes. It is based on the amount claimed for regular tax purposes, with no exception defined when a taxpayer elects to claim the standard deduction.

In most cases, taxpayers (especially married filing joint returns) will pay a lower overall tax when they claim the standard deduction compared to itemizing, even considering the net investment income tax. You are right that people haven’t been talking about the additional NIIT many taxpayers will pay when they claim the standard deduction.

For every $100 of deduction “lost”, the tax increase is $3.80.

This is a rather sneaky increase in the new tax law.

IRS issues final regulations for the 20% of qualified domestic business income deduction

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  • mike   

The 20% of qualified domestic business income (QDBI or called QBI in the regulations) deduction 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.

Even professional tax return preparers will be challenged when computing the deduction for higher-income taxpayers.  Any taxpayer who owns an unincorporated business or an S corporation should get professional help for preparing their 2018 income tax returns.

The IRS issued final regulations on January 18, 2019, and a corrected version of the final regulations on February 1, 2019.  The final regulations were published in the Federal Register on February 8, 2019, after a delay because of the federal shutdown.  The IRS incorporated many of the suggestions that they received in response to proposed regulations that were issued on August 8, 2018, so the final regulations are “new and improved.”

The deduction is effective for taxable years beginning after December 31, 2017.  For 2018, taxpayers may elect to use the final regulations in their entirety, the proposed regulations in their entirety, or to only follow the Internal Revenue Code.  No cherry-picking!  In most cases, taxpayers should follow the final regulations, so they can use benefits like aggregation of businesses.

My printed copy of the final regulations, including the preamble, is 249 pages.  I can only cover some highlights here.  Professional tax return preparers should study the final regulations and attend the continuing education updates that are widely available.

The computation of the deduction is much simpler and more favorable for taxpayers below the income thresholds.  The deduction is computed for individuals and for the undistributed income of trusts and estates.

The basics.  The basic computation is 20% of qualified domestic business income.  The total deduction under Section 199A is 20% of qualified domestic business income + 20% of qualified REIT dividends + 20% of qualified income from a publicly traded partnership + 9% of qualified production activity income from an agricultural cooperative.  The total deduction is limited to 20% of taxable income in excess of net capital gain (including qualified dividends.)

If a taxpayer’s taxable income exceeds a threshold amount, things become more complicated.

The threshold amounts for 2018 are $315,000 for married, filing joint returns and $157,500 for other taxpayers.  The threshold limitations are phased in from $315,000 to $415,000 for married, filing joint returns and $157,500 to $207,500 for other taxpayers.  The threshold amounts will be indexed for inflation after 2018.

Once the thresholds are reached, the income of specified service trade and businesses (SSTBs) will be phased out and eliminated for the computation of the deduction.

In addition for taxpayers over the thresholds, for income other than from qualified REIT dividends, publicly-traded partnerships or agricultural cooperatives, the deduction will be limited to the greater of (1) 50% of W-2 wages paid, or (2) 25% of W-2 wages + 2.5% of unadjusted basis immediately after acquisition (UBIA.)  The limitation is applied for each trade or business or aggregated trades or businesses.

The 20% deduction for QDBI is the same amount for the alternative minimum tax as for the regular tax.

Qualified domestic business income (QDBI, or called QBI in the regulations).  Qualified domestic business income means the net amount of qualified items of income, gain, deduction and loss with respect to any trade or business (or aggregated trade or business) as determined under the rules for Internal Revenue Code Section 199A.  Only income for business conducted in the United States (including Puerto Rico) qualifies for the deduction.  The trade or business must be conducted as a passthrough entity, including sole proprietorships, partnerships, S corporations, and LLCs taxed as sole proprietorships, partnerships or S corporations.

The income of S corporations must be reduced by reasonable compensation paid to shareholders.  If an S corporation doesn’t pay reasonable compensation, the IRS can reclassify part of the income as wages.  This rule doesn’t apply to partnerships or LLCs taxed as partnerships, because partnerships don’t have a reasonable compensation requirement as corporations do.

Any income taxed as capital gains, including some net gains from the sale of business assets called net Section 1231 gains, are excluded from QDBI.  Other investment income such as most interest income and qualified dividends income are also excluded from QDBI.

Interest income that is business income, such as the income of banks from making loans or late charges for accounts receivable, is included in QDBI.

Ordinary income or losses relating to the sale of business assets, including depreciation recapture and net Section 1231 losses, are included in QDBI.

Income from the trade or business of being an employee is excluded from QDBI.

Guaranteed payments to partners are also excluded from QDBI because they are considered similar to wage and interest income.

QDBI is reduced for deductions relating to the income, including the deduction for self-employment taxes, self-employed retirement contributions and the self-employed medical insurance deductions for adjusted gross income.

A controversial matter is whether net rental income from a real estate operation qualifies as a trade or business.  The IRS has separately issued Notice 2019-07, a proposed revenue procedure for a safe harbor for real estate operations to qualify as trades or businesses qualifying for the deduction.  I have written a separate blog post about Notice 2019-07.  http://www.michaelgraycpa.com/posts/irs-issues-safe-harbor-for-rental-real-estate-qualification-for-20-qualified-business-income-deduction/

Loss considerations.  The final regulations make it clear that loss limitation rules, such as the passive activity loss rules, at-risk rules and losses limited by basis, are applied before the rules to compute the 20% QDBI deduction.  Any loss carryovers from taxable years beginning before January 1, 2018 are disregarded when making the 20% QDBI computations.  According to other proposed regulations, REG-134652-18, any future carryovers of those losses are treated as coming from a separate trade or business and are not aggregated with the current-year income of the entity that generated the loss.

Grouping under the passive activity loss rules and the election to be a real estate professional are disregarded for the 20% of QDBI deduction computations.

The negative qualified business income of any entity is allocated and applied to the positive qualified business income of any other entities.  Any losses in excess of the total positive business income of the other entities is disregarded and carried forward to the next taxable year.  The total loss carryforward will be considered to come from a separate entity in the subsequent taxable year.

The loss limitation is applied separately for publicly traded partnerships and any excess loss is carried forward separately as a loss from a publicly traded partnership.

Passthrough entities (RPEs).  The income from a relevant passthrough entity (RPE) (partnership, S corporation, estate or trust) with a taxable year ending in 2018 will be used to compute the 20% of QDBI deduction computations for 2018.  These entities might have already issued Schedule K-1s omitting the necessary information.  They should consider amending their income tax returns and issuing amended Schedule K-1s including the required information.  (The final regulations provide that amended returns can be filed for this purpose.)  Otherwise, the W-2 wages and QBIA for the entity will be considered to be zero!

W-2 wages.  W-2 wages will generally be determined based on W-2s issued by the entity during the calendar year ending within the taxable year of the entity.  A taxpayer may include W-2 wages paid by an employee leasing company on its behalf.  In that case, the employee leasing company can’t include those wages for its computation of the 20% of QDBI deduction.  (No double counting!)  Payments to common law employees who report their income as self-employed aren’t included in W-2 wages.  W-2 wages do not include any amount that is not properly included in a return filed with the Social Security Administration on or before the 60th day after the due date (including extensions) for W-2s.  File Forms W-2 for your employees on time!

A taxpayer must allocate W-2 wages to the trades or businesses that they relate to.  Wages paid for nondeductible items like household workers are disregarded.

The IRS has issued Revenue Procedure 2019-11 with methods for computing W-2 wages.

Unadjusted basis when initially acquired (UBIA).  Unadjusted basis when initially acquired (UBIA) is the tax basis of depreciable property before applying accumulated depreciation, including bonus depreciation and the Section 179 expense election.  The property must be held by and available for use in the trade or business at the close of the taxable year and must have been used at any point during the taxable year in the trade or business’s production of QDBI.

The depreciable period for the property must have not ended before the close of the individual’s or reporting passthrough entity’s taxable year for it to be included in UBIA.  The depreciable period is the lesser of (1) 10 years after the property was placed in service, or (2) the last day of the depreciable life of the property.  This means the depreciable period for most personal property is 10 years, the depreciable period for most residential real estate is 27.5 years and the depreciable period for most commercial real estate is 39 years.

There is an anti-abuse provision that property acquired within 60 days of the end of the taxable year and disposed of within 120 days of acquisition without having been used in a trade or business for at least 45 days prior to disposition will be excluded from UBIA.

Basis information for property aquired in tax years ending before 2018 will have to be determined relating to property contributed in a tax-free transaction by a partner or shareholder with a partnership (including most LLCs) or an S corporation.  Carryover information also applies for qualified property received in a Section 1031 exchange or a Section 1033 involuntary conversion.  Additional amounts invested in property received in a Section 1031 exchange or a Section 1033 involuntary conversion will be treated as the acquisition of another piece of property with an acquisition date when placed in service and its own depreciable period.

The UBIA of inherited property will generally be the fair market value on the date of death.  The acquisition date for inherited property will generally be the date of death.

The final regulations allow a Section 743(b) adjustment relating to a transfer of a partner’s interest of depreciable property to be included in UBIA.  A Section 734(b) adjustment relating to the liquidation of a partner’s interest is not included in UBIA.

Aggregation.  A significant change in the final regulations is allowing aggregation by a relevant passthrough entity.  Under the proposed regulations, only the individual taxpayer, estate or trust that claimed the 20% of QDBI deduction could make the aggregation election.  This is a simplification measure that will make reporting on Schedule K-1 easier for some passthrough entities.  The election by the passthrough entity should be done thoughtfully, because it is irrevocable and may negatively affect some partners who might have chosen different aggregation.

Aggregation, or combining two or more trade or business operations, can be helpful to make limitation amounts for W-2 wages and UBIA from one operation available for income in another operation.

These are the requirements for aggregation:

  1. The same person or group of persons must own 50% or more of each trade or business to be aggregated;
  2. The common ownership must be in place for the majority of the taxable year, including the last day of the taxable year (change from the proposed regulations), in which the items attributable to each trade or business to be aggregated are included in income;
  3. All of the trades or businesses must report on returns with the same taxable year (watch fiscal year passthrough entities!);
  4. A specified service trade or business isn’t eligible to be aggregated;
  5. The trades or businesses to be aggregated must satisfy at least two of the following factors:
  6. The trades or businesses provide products, property or services that are the same or customarily offered together.
  7. 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.
  8. The trades or businesses are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group (for example, supply chain interdependencies.)

A rental of equipment or real estate to a commonly-controlled trade or business should qualify for aggregation.  They share significant centralized business elements (B) and rely upon one another (C).

According to the final regulations, the rental or licensing of tangible or intangible property that does not rise to the level of a Section 162 trade or business is nevertheless treated as a trade or business for purposes of Section 199A, if the property is rented or licensed to a trade or business conducted by the individual or an RPE which is commonly controlled.

Once a taxpayer chooses to aggregate two or more businesses, the same aggregation must be followed in all subsequent taxable years, unless there is a change in facts such as the liquidation of a business.

The taxpayer (including RPEs) must make certain disclosures or the IRS can disallow the aggregation.

Specified service trade or business (SSTB).  Once a taxpayer exceeds the thresholds, the 20% deduction for QDBI relating to a specified service trade or business (SSTB) is phased out and eliminated.

The listed SSTBs are health, law, accounting, actuarial science, performing arts, consulting (excluding architecture and engineering), athletics, financial services, brokerage services, investing and investment management, trading, dealing in securities, partnership interests or commodities, and 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 final regulations generally are the same as the proposed regulations relating to the SSTBs, with some clarification and additional examples.

Health includes medical services provided by physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals.  Services by health spas that provide physical exercise or conditioning, payment processing, or the research, testing and manufacture and/or sales of pharmaceuticals or medical devices are not considered healthcare services.

Legal services include services provided by attorneys, paralegals, legal arbitrator, mediators and similar professionals.  Services to law firms by printers, delivery services or stenography services are not legal services.

Accounting services are not determined by certification.  Accountants, enrolled agents, tax return preparers, financial auditors and professionals providing similar services are considered to be providing accounting services.

Services in the performing arts includes individuals who participate in the creation of performing arts, including actors, singers, musicians, entertainers, directors, and similar professionals.  The maintenance and operation of equipment or facilities for use in the performing arts and broadcasting services are excluded.

Consulting involves providing professional advice and counsel to clients to help achieve clients’ goals and solving problems.  Consulting embedded in or ancillary to the sale of goods or performance of services on behalf of a trade or business that is otherwise not an SSTB is not included, provided there is no separate payment for the consulting services.

Athletics service includes the performance of services who participate in athletic competition, such as athletes, coaches, and team managers.  The maintenances and operation of equipment or facilities for use in athletic events or broadcasting or distributing video of athletic events are excluded.  Schools for teaching amateur sports skills should be excluded.

Sales of commodities relating to property that is stock in trade of a trade or business or that otherwise would be included in the inventory of a trade or business are excluded.

The most favorable provision relates to the last category.  A trade or business where the principal asset of such trade or business is the reputation or skill of one or more employees or owner includes any of the following.

  1. A trade or business in which a person receives fees, compensation or other income for endorsing products or services,
  2. 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 other symbols associated with the individual’s identity,
  3. Receiving fees, compensation, or other income for appearing at an event or on radio, television or another media format.

Receiving a partnership interest or the receipt of stock of an S corporation is included in fees, compensation or other income.

For a trade or business with gross receipts of $25 million or less for a taxable year, the trade or business is not an SSTB if less than 10% of the gross receipts of the trade or business are attributable to SSTB items.  (If 10% or more of the gross receipts are attributable to SSTB items, the entire entity is treated as a SSTB.)

For a trade or business with gross receipts exceeding $25 million, the threshold will be 5% instead of 10%.

Taxpayers that have trades or businesses that include SSTB income and other income should consider splitting them into separate entities, including having separate books and records, to avoid recharacterizing what would otherwise be qualifying income to SSTB income under the above rule.  Having a separate S corporation would clearly be a separate trade or business.

If a trade or business provides property or services to an SSTB that has 50% or more common ownership, that trade or business will also be treated as a separate SSTB with respect to the related parties.  (For example, rental income from a building leased to a medical S corporation that has the same ownership will be SSTB income.)  Common ownership can be direct or indirect through family members or related entities under Internal Revenue Code Sections 267(b) or 707(b).

Trade or business of performing services as an employee.  Income from a trade or business of performing services as an employee is not QDBI.  Reporting income on Form W-2 does not determine whether an individual is an employee.  Whether an individual is an employee is a trade or business is determined by facts and circumstances.

An individual who was properly treated as an employee for Federal employment tax purposes and is later treated as not an employee while providing the same services to the trade or business will be presumed to be an employee for three years after ceasing the be treated as an employee for Federal Employment Services.  This is a rebuttable presumption that can be disputed by providing records, such as contracts or partnership agreements, that corroborate the individual’s status as a non-employee.

Disclosure for relevant passthrough entities (RPEs).  The final regulations include disclosure rules for RPEs.  If an RPE fails to properly report any item, it is considered to be zero.

Estates and trusts.  Information relating to income that is taxable to a beneficiary of an estate or trust should be reported on Schedule K-1s issued to the beneficiaries, including QDBI, W-2 wages, and UBIA for each trade or business (or aggregated trades and businesses.)

Income that isn’t distributed or distributable to the beneficiaries will be taxed to the estate or trust and the estate or trust will be eligible to claim the 20% of QDBI deduction relating to that income.  This will require allocation of the QDBI, W-2 wages and UBIA between the estate or trust and the beneficiaries of the estate or trust.

Since the trust threshold for 2018 is $157,500, the final regulations include an anti-abuse rule requiring two or more trusts to be aggregated and treated as one trust if the trusts have substantially the same grantor or grantors and substantially the same beneficiary or beneficiaries.  Spouses are treated as one person when applying this rule.  This anti-abuse rule is effective for taxable years ending after December 22, 2017.

Conclusion.  I hope this summary persuades many who are eligible for the 20% of QDBI deduction to get help with structuring their operations to maximize this tax benefit and to properly compute the deduction.

The software providers are scrambling to incorporate the requirements in their tax return preparation software.

You might not be able to correctly compute the deduction using the carryover information in the system.  The output should be carefully reviewed to be sure it is complete, especially for desireable elections.  If the information isn’t properly reported, the deduction could be lost entirely.

IRS issues Safe Harbor for rental real estate qualification for 20% qualified business income deduction

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  • mike   

One of the most controversial items in the Tax Cuts and Jobs Act of 2017, enacted during December, 2017, is whether rental real estate qualifies as a trade or business, and therefore qualifies for the 20% deduction for qualified domestic business income under Internal Revenue Code Section 199A.

Late January, 2019, the IRS issued Notice 2019-07.  The Notice is a proposed Revenue Procedure that outlines a safe harbor for rental real estate operations to qualify as a trade or business and qualification for the 20% of qualified domestic business income deduction under Internal Revenue Code Section 199A.

The Revenue Procedure is proposed to be effective for taxable years ending after December 31, 2017.

The advantage of following the Revenue Procedure is avoiding a dispute and possible litigation with the IRS about whether a rental real estate operation qualifies for the deduction.

Under the Revenue Procedure, a rental real estate enterprise must meet a series of requirements.

Taxpayers must either treat each property held for the production of rents as a separate enterprise or treat all similar properties held for the production of rents as a single enterprise.  Commercial and residential real estate may not be part of the same enterprise.  Taxpayers must report their real estate operations consistently from year-to-year unless there has been a significant change in facts and circumstances, such as acquiring another property.

Here are the requirements to be met.

  1. Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise.
  2. For taxable years beginning before January 1, 2023, 250 or more hours of rental services are performed each year with respect to the rental enterprise.  For taxable years beginning after December 31, 2022, the test must be met in any three of the five consecutive taxable years that end with the taxable year.
  3. The taxpayer must maintain contemporaneous records, including time reports, logs, or similar documents regarding (i) hours of all services performed; (ii) description of services performed; (iii) dates on which such services were performed; and (iv) who performed the services.  The records are to be made available for inspection at the request of the IRS.  This requirement doesn’t apply for taxable years beginning before January 1, 2019.

Rental services include (i) advertising to rent or lease the real estate; (ii) negotiating and executing leases; (iii) verifying information contained in prospective tenant applications; (iv) collection of rent; (v) daily operation, maintenance and repair of the property; (vi) management of the real estate; (vii) purchase of materials; and (viii) supervision of employees and independent contractors.

Rental services may be performed by owners or by employees, agents, and/or independent contractors of the owners.

The term “rental services” does not include financial or investment management activities, such as arranging financing, buying property, studying and reviewing financial statements or operations reports, or planning, managing or constructing long-term capital improvements, or hours spent traveling to and from the real estate.

Rental real estate rented or leased under a triple-net lease requiring the tenant or lessee to pay taxes, fees and insurance and to be responsible for maintenance activities for a property in addition to rent and utilities.

(Remember that, under the final Section 199A regulations, property rented to a commonly-controlled entity is considered to be the same type of business income as the entity it is rented to, even for a triple-net lease.)

Real estate used by the taxpayer (including an owner or beneficiary of a relevant passthrough entity relying on the safe harbor) also doesn’t qualify for the safe harbor.

The taxpayer or relevant passthrough entity must attach a statement to the tax return on which it claims the Section 199A deduction or passes through Section 199A information that the requirements of the Revenue Procedure are satisfied.  The statement must be signed by the taxpayer or an authorized representative of an eligible taxpayer or relevant passthrough entity.  Here is the required wording of the statement. “Under penalties of perjury, I (we) declare that I (we) have examined the statement, and, to the best of my (our) knowledge and belief, the statement contains all the relevant facts relating to the revenue procedure, and such facts are true, correct, and complete.”  The individual or individuals who sign must have personal knowledge of the facts and circumstances related to the statement.

The Revenue Procedure only gives a safe harbor to qualify for the 20% of qualified domestic business income deduction.  Taxpayers may still claim they qualify under a different standard.  (These are excerpts of an analysis by Gary McBride, CPA and attorney.)

The IRS is generously applying a service-based standard in the Revenue Procedure.  Another standard has also been applied to determine that rental real estate operations are a trade or business.

The IRS’s position is based on a decision of the Second Circuit Court of Appeals, Grier v. U.S., 218 F. 2d 603, 2nd Cir., 1955.)  This position is only followed by the Tax Court in the Second Circuit.  Under the Grier decision, it is highly unlikely the rental of one single family residence can be a trade or business for taxpayers located in the Second Circuit Court of Appeals territory.

In other cases, the courts have looked to whether the taxpayer was responsible for the maintenance of the property.  (Hazard v. Commissioner, 7 TC 372 (1946) acq. 1946-2 CB 3; Reiner v. US, 22 Fd. 2nd. 770 7th Circ., 1955).)  In GCM 38779 (7/27/81), the IRS Chief Counsel rejected an IRS national office audit group request to remove the acquiescence to Hazard.

If it is practical, I recommend that you follow the safe harbor in the Revenue Procedure to avoid having an IRS controversy.

You might find it challenging to get the time accounting records from independent contractors who perform services for you.  You should have an understanding with them about the requirements before the work is done.

I hope it is apparent to our readers that you should get help with a professional tax advisor when applying these rules.

Remember Congress needs to pass a technical correction for bonus depreciation of Qualified Improvement Property

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  • mike   

Congress passed a tax simplification provision in the Tax Cuts and Jobs Act of 2017 to consolidate the eligibility of certain real estate improvements for tax favored treatment.  Specifically, Qualified Improvement Property is defined as an improvement to an interior portion of a building that is nonresidential real property provided the improvement is placed in service after the date that the building was first placed in service.  Improvements related to the enlargement of the building, an elevator or escalator, or the internal structureal framework of the building are not qualified improvement property.

Congress intended to a assign a 15-year depreciable life to Qualified Improvement Property, which would have qualified it for 100% bonus depreciation.  (Effective for property acquired and placed in service after September 27, 2017 and before January 1, 2023.   The rate phases down thereafter.)  In its hurry to pass the legislation, the 15-year life provision was missed.  That means, unless Congress passes a technical correction, Qualified Improvement Property has a 39-year depreciable life and doesn’t qualify for bonus depreciation.

Taxpayers who plan to use bonus depreciation for Qualified Improvement Property for 2018 should consider extending the due date for their income tax returns.  Consult with a tax professional about alternative ways to deal with the situation.  It’s likely, but not certain, that Congress will eventually pass a technical correction and permit amended income tax returns to claim bonus depreciation on tax returns where it should have been available.

Alternatively, taxpayers can claim the Section 179 expense election for Qualified Improvement Property.  The maximum amount that a taxpayer may elect to expense for 2018 is $1 million.  The maximum deduction is reduced when the taxpayer places more than $2.5 million of property qualifying for the Section 179 election in service during 2018.  The thresholds are indexed for inflation after 2018.  The Section 179 deduction also can’t reduce taxable income below zero.  Any excess is carried forward.

Amended 2017 returns required for fiscal year passthrough entities

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  • mike   

Since proposed regulations were not issued for owner/beneficiary information relating to the 20% of qualified business income deduction until August 8, 2018 and it wasn’t listed on the 2017 forms, that information was omitted on many passthrough entity income tax returns for fiscal years ending in 2018.  According to proposed regulations issued on August 8, 2018, that information should be included on the 2018 income tax returns for the owner.  (Proposed Regulations Sections 1.199A-1(f)(2) and 1.643(e)-(2)(ii).)  If that information is listed on the owner’s Schedule K-1, it’s presumed to be zero.  (Proposed Regulations Section 1.199A-6(b)(3)(iii).)

Lessons From Our Fire Recovery Experience

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  • mike   

Our family home was destroyed in a fire two days before Thanksgiving, 2015.  On November 29, 2018, we sent the final payment to the fire restoration company, three years after the destruction of our home.  (The restoration was finished during September, 2018 and we received the final payment from our home insurance claim late November, 2018.)  I thought readers might be interested in what our experience was like and the lessons that we learned that might help other victims of fires and to prepare for the possiblility of a fire or other disaster.

First, we had enough insurance to cover most of the cost of restoring our home and personal property.  The process of getting those benefits was rather horrific, but we got through it without the help of a public adjuster.  I’m not certain that “everyman” could.  Since I am a CPA with business management experience and my wife, Janet, understands home design, we were able to manage the process with a lot of help.

What is a public adjuster?  A public adjuster is a company that helps people who have suffered disaster losses to get the maximum recovery from their insurance company.  For this service, they receive a hefty fee.  I understand it’s 5 – 10% of the total recovery.  For some people, this is a worthwhile investment.  We were able to get the policy limits for our recovery, so we were fortunate to get through the process without a public adjuster.

It’s probably a good idea to review your policy benefits with your property insurance agent to really understand your coverage.  I understand some people have lost their coverage after making a claim like this.  So far, our property insurance company is continuing ours.

As I watched our home burn, a representative from a fire recovery company put his arm over my shoulder and reassured me, “Mike, I’m going to rebuild a beautiful new home for you.”

I asked him, “Can you have the rebuild done by next Christmas?”  He reassured me that he thought he could.  I might not have given them the job if I knew in advance that it would take almost three years!

We spent the night of the fire sleeping in my daughter’s front room.  It was one of the most miserable and uncomfortable nights of my life.  The next week or so our insurance company paid for our lodging at a Residence Inn, which was great.  The Residence Inn provided breakfast and a Happy Hour buffet on several nights, so we didn’t have to go out for dinner on most nights or for breakfast.

Our homeowner’s insurance policy provided living accomodations replacement for two years, so we shortly moved to a furnished rental home located close to my daughter’s family.  My granddaughters thought it was great that Grandma could walk and pick them up from school.  The insurance also covered additional living expenses, including some meals and additional mileage to commute to work compared to our regular residence, and duplicate expenses for utilities and garbage.

It’s very important to keep good records during this process to identify duplicate living expenses, including the utilities costs for both your regular residence and the rental residence, to get reimbursements for duplicate expenses.  (In Santa Clara County, garbage  pickup is included on the real estate tax bill.)

When our two years was over, the insurance company informed us they would no longer cover the rental for the home.  The rebuilding of our home was only about half done.  There wasn’t even a front door and no furnace for heat!  We moved into our unfinished home and slept on the (unfinished) floor using inflatable mattresses.  There was one working sink and one working toilet.  We lived in our home while the restoration company finished rebuilding it.

Your property insurance agent does not handle your fire loss claim.  The insurance company assigns adjusters to do that.  We had separate adjusters for the building and for personal property (furniture, clothing, etc.)  The adjuster might be an employee of the insurance company of an independent contractor.  A big irritation in this process is the insurance company routinely rotates adjusters off cases every few months.  This means your file is neglected for some time and you have to get another person up to speed.  We kept in touch with our insurance agent to act as our advocate with the company to keep the momentum going processing our claim and reduce the rotation of adjusters on our case.

The initial two people that we worked with at our restoration company were actually very helpful.  One of them had previous experience as an adjuster for a property insurance company.  They gave us some coaching about the process and how to deal with our property insurance company.  The other one actually wrote some software for us to make it easier to make the list of personal property lost in the fire.  This was enormously helpful.  With his software, we could look up items on the internet to give references for replacement costs and where they came from.  These people left the company, one about a year after our loss when we made the initial personal property loss report and the other a few months before our house rebuild was finished, requiring us to get another representative up to speed to finish the job.  This created more inconvenience because he wasn’t familiar with our case.

Recreating our personal property list was a huge job.  It required listing in detail all of the items in each room of the house.  I have a pretty good memory and can summon a picture of what was where.  Not everyone is so fortunate.  My wife, Janet, walked through stores looking at the shelves for items that we lost, taking picture of items and their prices with her smart phone.  Although the personal property adjusters said to focus on the high value items, small value items really add up.  Looking back, it would have been great to have photos or videos as a tour of the house showing everything.  We had CDs of our photos that weren’t kept outside the house in a safe deposit box, so they burned.  Now many people are putting photos and documents “in the cloud”.  A good idea!

Again, be sure to keep your receipts for replacement items, including clothing, towels, razors, toothbrushes, toothpaste, etc.  You also have to list in detail what the receipts are for.  (For example, state if out bought the Phantom of the Opera DVD.)  You might need to attach your receipt to a separate piece of paper with a list of items purchased with the amounts.

Initially, our policy paid for the depreciated value of items.  It paid for replacement cost when we provided copies of receipts and the items were purchased within two years after the fire.  Those receipts are the documentation of the cost of the replacement items.  They can also be important income tax records.  According to the rules for involuntary conversions (such as a fire), if there is any gain from the insurance recovery, it isn’t taxable provided the item is replaced for at least the amount recovered.

Since the rebuild of our home wasn’t done in two years, we ordered some furniture with delayed delivery and put appliances (dishwasher, refrigerator, washing machine, dryer, microwave oven, stove, trash compacter) in the garage.  We couldn’t delay the delivery of some furniture that we bought at a consignment store (a great source for antique/wood furniture!) so we just had them put it in our unfinished home.  As we approached the two year date, our personal property adjuster made an extra effort to come to our home and help us assemble the information so that we reached our policy limit.

We had to replace many documents, like vehicle pink slips, passports, social security cards and birth certificates.  The cost of replacing these items were included in our insurance claim.

Rebuilding our home was like a slapstick comedy.  There were many miscommunications leading to many false starts.

The restoration company was able to make an accurate model of our home, using laser equipment.  Too bad the architect ignored the model.  You’d think the plans might be on file with the City of San Jose.  Nobody got them.  Some of our neighbors have homes with the same exterior and floor plan as ours.  Nobody bothered to check them out.

There were several errors in the plans prepared by the architect.  The architect was not located near our home.  Each time the plans were changed, they had to be approved by the City of San Jose building department.  In some cases, it took months to get the approval for the changes.  Building would usually stop when waiting for the approval.  Finally, we got to the point of harassing our restoration company to get changes processed more quickly and to expedite getting approval by the City of San Jose.

Some examples of the plan corrections:

  • We have an open staircase, which gives a very open look when entering the house. The architect’s plan had an enclosed staircase.
  • We have a family room – kitchen, which is one large open room. The architect’s plan had a wall between the family room and kitchen.
  • We have vaulted ceilings in the master bedroom and the front room. The architect’s plan didn’t have vaulted ceilings.  (This required a major change in the “truss” plans for our roof and changes in the ventilation for the HVAC for the house.)
  • The architect’s plan omitted the linen cabinet for the upstairs hallway.
  • The architect’s plan didn’t include the furnace or air conditioning(!)

The architect and the builder didn’t know which codes applied for some items, such as the insulation for the vaulted ceilings, and how the frame for the house is attached to the foundation.  Items like this required rework and multiple inspections.

City inspections also became an issue.  Waiting between inspections resulted in more delays waiting to continue building.  Finally, I called my city council representative and got the direct telephone number for the inspector and was able to expedite having inspections done.

The builder was in a fog about ordering many items.  Janet and I regularly had to go to the hardware store to keep things moving by buying ceiling lamps, faucets, sinks, toilets, cabinet handles, fireplace mantle, etc.

We had turnover of the construction foreman for the restoration company.  The first foreman was great, but left after only a few weeks on the job.  The second foreman was congenial, but didn’t seem to actively manage the job.  There were several items that he said he would take care of, such as ordering floor tile, getting the gas fireplace, and the mantle for the fireplace, that we ended up taking care of ourselves.  More delays!

If we didn’t manage the reconstruction of our home and keep pressing to get the job done, it might have taken two more years to finish it!

I did quite a bit of research relating to the tax rules for an involuntary conversion (replacement after a disaster.)  I recommend that you consult with a tax expert if your home is destroyed by a fire.  One thing to be aware of is that you apply the exclusion for sale of a residence, $250,000 for an individual or $500,000 for a married couple, before applying the exclusion for replacement property, so you get a basis increase from the involuntary conversion of a principal residence.

In summary, you can’t passively rely on others to take care of the restoration of your home, replacing your property and getting the maximum insurance recovery.  You have to pay attention and be actively involved in the entire process, including watching insurance deadlines.  If someone else says they’ll handle it for you, be prepared to pay a hefty fee and be prepared to be disappointed and step in when necessary.

Michael Gray, CPA's Blog

Tax and financial advice from the Silicon Valley expert.