Michael Gray, CPA's Blog

Tax and financial advice from the Silicon Valley expert.

Tax tips and developments relating to individuals

IRS proposed regulations will keep more in retirement accounts

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  • mike   

The IRS has issued proposed regulations relating to required minimum distributions from retirement accounts, including, 401(k), IRA and Roth IRA accounts.  (Proposed Regulations REG-132210-18, Proposed Regulations Section 1.401(a)(9)-9.)

The required minimum distribution is generally computed using a life expectancy table issued by the IRS, called the lifetime distribution table.  The life expectancy tables haven’t been updated for many years.

(If a taxpayer fails to take a required minimum distribution, the federal penalty is 50% of the undistributed amount.)

Since life expectancies have been increasing, required minimum distributions will be smaller using the proposed tables, potentially leaving larger balances to accumulate future earnings.  Bigger distributions can optionally be taken at the risk of exhausting the account before the employee or plan owner’s death.

The proposed regulations are proposed to be effective for retirement plan distributions for tax years beginning on or after January 1, 2021, provided they are adopted as final regulations by that date.

Required minimum distributions for a non-spouse beneficiary of a deceased employee or a deceased plan owner are based on the life expectancy determined using the Single Life Table of the beneficiary as of the date of death of the employee or plan owner, minus one for each subsequent year.  Under the proposed regulations, the beneficiary will be able to recompute his or her life expectancy as of the date of death of the employee or deceased plan owner using the new lifetime distribution table starting January 1, 2021.

 

IRS gives more guidance for virtual currency transactions

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  • mike   

The IRS is very concerned that taxpayers aren’t properly reporting their transactions for Bitcoin and other virtual currencies.  Previously, guidance was issued in Notice 2014-21.  Now it has released additional guidance about this subject.

In Revenue Ruling 2019-24, the IRS discusses “hard forks”.  A hard fork is like a spinoff for a stock.  New cryptocurrency is created on a new distributed ledger.  According to the Revenue Ruling, if the new currency is “airdropped” to a distributed ledger address owned by the taxpayer, it is an accession to wealth that is taxable as ordinary income equal to the fair market value of the currency received.  If the new ledger isn’t owned by the owner of the base currency, no taxable income results for that individual.

The IRS has also issued additional Frequently Asked Questions about virtual currency at its website.  Here is a link to the FAQ.  https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions

One of the FAQ items relates to virtual currency received in exchange for performing services.  The answer provided is that virtual currency received in exchange for performing services is taxable as ordinary compensation income, based on the fair market value of the currency received.

Another FAQ makes it clear that virtual currency transactions can be reported using the specific identification method.  The taxpayer must specifically identify the batch of units sold and when they were acquired.  A unit of virtual currency can be identified by documenting the specific unit’s unique digital identifier such as a private key, public key, and address or by records showing the transaction information for all units of a specific virtual currency, such as Bitcoin, held in a single account, wallet or address.  The information must show.

1. The date and time each unit was acquired,

2. The taxpayer’s basis and the fair market value of each unit at the time it was acquired,

3. The date and time each unit was sold, exchanged, or otherwise disposed of, and

4. The fair market value of each unit when sold, exchanged or disposed of, and the amount of money or the value of property received for each unit.

Taxpayers who don’t specifically identify units of virtual currency that are sold, exchanged or otherwise disposed of are deemed to have sold the units on a first-in, first-out basis.

Transactions other than ordinary income transactions should be reported on Schedule D and Form 8949.

I recommend that taxpayers who participate in virtual currency transactions should get professional help when preparing their income tax returns.

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.)

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.

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.

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.

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.

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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Michael Gray, CPA's Blog

Tax and financial advice from the Silicon Valley expert.