Here are some of the most significant changes, with suggested year-end tax planning moves for 2020, assuming the proposals are enacted.
Tax tips and developments relating to real estate
The Joint Committee on Taxation has issued a description of the tax provisions in the CARES Act.
Here is a URL to download the report. https://www.jct.gov/publications.html?func=startdown&id=5256
Congress passed and President Trump signed the Coronavirus Aid, Relief and Economic Security (CARES) Act (P.L. 116-136) on March 27, 2020.
Here is a URL to see the text of the Act. https://www.congress.gov/116/bills/hr748/BILLS-116hr748enr.pdf
Here is a URL to the Franchise Tax Board’s FAQs relating to COVID-19 issues. https://www.ftb.ca.gov/about-ftb/newsroom/covid-19/help-with-covid-19.html
Here are some highlights of tax provisions of the Act.
Advance tax rebates
The provision that has received the most publicity is advance tax rebates of $1,200 for single persons and $2,400 for married couples who file joint income tax returns. In addition to these amounts, $500 will be included in the advance tax rebate for each dependent child claimed by the taxpayer(s) who qualifies for the child tax credit under Internal Revenue Code Section 24.
The rebates will be mailed or electronically deposited as soon as possible by the IRS to provide relief to Americans who are suffering from the shutdown of our society to fight the coronavirus pandemic.
Not everyone will qualify. The rebates are reduced to not below zero by 5% of the taxpayer’s adjusted gross income above $150,000 for married couples filing joint returns, $112,500 for heads of households, and $75,000 for other taxpayers.
Nonresident aliens, anyone who is claimed as a dependent, estates and trusts don’t qualify for the rebate.
The IRS will make a preliminary determination based on the last income tax return filed for 2018 or 2019, or for seniors who do not file an income tax return, their social security record.
Since the IRS doesn’t have spouse and dependent information for social security recipients who don’t file a tax return, they might want to file income tax returns for 2018 or 2019 if it increase their rebate.
When the taxpayer prepares his or her 2020 federal individual income tax return, the rebate will be recomputed based on the current year facts. Any additional rebate will be allowed as a credit on the income tax return. The taxpayer gets to keep any excess of the amount received over the computed amount.
The rebate reduces the federal income tax and any amount already received by the taxpayer and is treated as an refund received in amount. The rebate isn’t taxable income. The rebate can be more than the tax before the rebate and is refundable.
Waived early withdrawal penalty for certain retirement plan distributions
Taxpayers who receive a distribution from a qualified retirement plan or an IRA before they reach age 59 1/2 are normally subject to a 10% federal early distribution penalty.
The penalty will be waived for up to $100,000 of distributions during 2020 to an individual (1) who is diagnosed with coronavirus, (2) whose spouse or dependent is diagnosed with coronavirus, or (3) who experiences financial consequences as a result of being quarantined, being furloughed or laid off or having work hours reduced due to the coronavirus crisis, being unable to work due to lack of child care due to the virus, closing or reducing hours of a business owned or operated by the individual due to the virus, or other factors as determined by the IRS.
Unless the taxpayer elects out, the income from a coronavirus-related distribution will be spread ratably over a 3-taxable year period, beginning with with the distribution year (2020.)
Although these distributions won’t be eligible under the usual rules for rollovers or trustee-to-trustee transfers, corona virus-related distributions from a qualified plan or an IRA may be repaid to the qualified plan or an IRA within 3 years beginning the day after the date the distribution was received. The amount repaid will be treated as a direct trustee-to-trustee transfer within 60 days of the distribution.
Since these distributions aren’t considered to be rollovers, you can have as many distributions as you want during 2020 treated as trustee-to-trustee transfers or have them taxed over three years, provided they qualify as coronavirus-related.
Roth conversions can also be taxed over three years under the rule, provided the distribution was coronavirus related, such as if the account owner was diagnosed with a mild case of the virus.
It appears claiming the recharacterization of the distribution for any repayments will be reported on the 2020 income tax return, and the return will be amended if the distribution isn’t restored in time.
Distributions from inherited IRAs with a nonspouse beneficiary don’t qualify for rollover treatment. (IRC § 402(c)(4), (9), § 408(d)(3)(C).) (Once a distribution is received by a nonspouse beneficiary from an inherited IRA, it can’t be redeposited.)
The waiver of penalty and extended rollover provisions apply to distributions on or after January 1 and before December 31, 2020. (Evidently, distributions ON December 31, 2020 won’t qualify.)
Required minimum distributions aren’t required for 2020
The required minimum distributions that apply to defined contribution qualified retirement plans (401(k)s and profit sharing plans) and IRAs after a participant reaches age 72 (age 70 1/2 before the SECURE Act was enacted) is waived for 2020.
If an employee reached age 70 1/2 during 2019, so the employee has a required beginning date on April 1, 2020, the penalty is also waived for that payment.
For years after 2020, the required minimum distributions will be computed by the regular procedure (beginning balance divided by life expectancy) without regard to the 2020 required minimum distribution and the required beginning date will be unchanged for other income tax determination purposes.
Charitable contributions limits for individuals increased
Individuals who don’t itemize deductions on their federal income tax returns will be able to deduct on their 2020 federal income tax returns up to $300 of charitable contributions that would otherwise qualify, except for donations to a donor advised fund or a private foundation.
The limitation for itemized deductions of cash charitable contributions to public charities by individuals, normally 60% of adjusted gross income, is eliminated for 2020.
Charitable contributions limit for corporations increased
The limit for charitable contributions for C corporations is increased for charitable contributions paid in cash during calendar year 2020 to public charities from 10% of modified taxable income to 25% of modified taxable income.
Charitable contributions limit for food inventory
For noncorporate taxpayers, the limit for charitable contributions of food inventory is increased from 15% to 25% of the taxpayer’s aggregate net income for 2020 from all trades or businesses from which such contributions were made.
For C corporations, the limit for charitable contributions of food inventory is increased from 15% to 25% of modified taxable income.
Exclusion for employer payments on student loans
Effective for payments made after March 28, 2020 and before January 1, 2021, payments by an employer, whether paid to the employee or to a lender, of principal or interest on any qualified education loan incurred by the employee for education of the employee are excluded from the employee’s taxable income. The employee won’t be eligible to claim an interest deduction for the excluded amount.
Payroll tax credit for certain employers
Employers who have their business operations fully or partially suspended during a calendar quarter due to orders from a government authority due to the coronavirus during the period beginning with the first calendar quarter beginning after December 31, 2019 for which gross receipts are less than 50% of gross receipts for the same calendar quarter in the prior year and ending with the calendar quarter for which gross receipts are greater than 80% of the gross receipts for the prior year and all tax-exempt organization during 2020 are eligible for an employee retention tax credit of 50% of qualified wages of up to $10,000 for each employee for all calendar quarters.
Note that employers who receive a small business interruption loan aren’t eligible for this credit. (The loan may be eligible for forgiveness, and that would be double-dipping.) If the employer claims the credit and receives a loan in a subsequent quarter, the credit will be recaptured.
The credit is effective for wages paid after March 12, 2020 and before January 1, 2021.
The credit is limited to the 6.2% employer share of social security taxes for all employees during the calendar quarter, but any credit in excess of that amount is treated as an overpayment and is refundable to the employer. (Note that medicare taxes and federal unemployment taxes aren’t eligible to be offset by the credit.)
The credit is reduced for credits allowed for employment of qualified veterans, research expenditures of qualified small businesses, and payroll tax credits for paid sick and paid family and medical leave provided in the Families First Coronavirus Response Act.
For employers having an average of more than 100 full-time employees during 2019, qualified wages means wages paid with respect to which an employee is not providing services due to a government-ordered suspension or a period of significant decline in gross receipts, but not in excess of the amount the employee would have been paid for working an equivalent duration during the 30 days immediately preceding the period.
For employers with an average of 100 or fewer full-time employees in 2019, qualified wages means wages paid with respect to an employee during any period of a government-ordered suspension or during a quarter that is within a period of significant decline in gross receipts.
Qualified wages don’t include any amounts taken in account for payroll tax credits provided in the Families First Coronavirus Response Act.
Qualified wages includes the employer’s qualified health plan expenses properly allocable to the wages that are excluded from the gross income of employees.
Wages of employees for which a work opportunity credit is claimed aren’t eligible for the credit.
Governmental employers aren’t eligible for the credit.
Here is a URL for IRS FAQs on the Employee Retention Credit. https://www.irs.gov/newsroom/faqs-employee-retention-credit-under-the-cares-act
Deferred payment of employer payroll taxes
Deposits of the employer portion of payroll taxes due from March 28, 2020 through December 31, 2020 are deferred and payable 50% on December 31, 2021 and the balance on December 31, 2022.
Payments for one half of self-employment tax (the “employer” portion) for 2020 are also deferred and payable 50% on December 31, 2021 and the balance on December 31, 2022.
Employers that have a loan forgiven under Section 1106 of the CARES Act for a loan under Section 7(a)(36) of the Small Business Act aren’t eligible for deferring payment of employer payroll taxes.
Net operating loss deduction and carrybacks
The 80% of taxable income limitation for deducting net operating losses has retroactively been suspended for taxable years beginning after December 31, 2017 and before January 1, 2021. For taxable years beginning after December 31, 2020, the 80% of taxable income limitation for deducting net operating losses will be restored.
For losses arising in a taxable year beginning after December 31, 2017 and before January 1, 2021, net operating losses may be carried back 5 taxable years. Previously, net operating loss carrybacks weren’t allowed for these years.
Taxpayers may elect to waive the carryback. There is also a special election available to exclude carrybacks to one or more years that have income exclusion of offshore income under Internal Revenue Code Section 965.
Taxpayers may revoke a previous election to waive a net operating loss carryback by July 25, 2020.
Note many taxpayers should consider filing amended returns to claim net operating loss carrybacks from 2017, 2018. and 2019.
Excess business loss limitations suspended
The limitations on deductions for business losses in excess of business income have been suspended for taxable years beginning after December 31, 2017 and before January 1, 2021.
Since these losses will now be allowed, taxpayers who are entitled to them should file amended income tax returns to claim them.
Tax credit for prior year minimum tax liability of C corporations
The alternative minimum tax was repealed for C corporations by the Tax Cuts and Jobs Act of 2017. Unused minimum tax credits were scheduled to be refundable with an annual 50% limitation for taxable years beginning in 2018, 2019, and 2020 until a 100% limitation would be applied for taxable years beginning in 2021.
Under the CARES Act, taxpayers may elect to claim a refundable credit for 100% of the balance for taxable years beginning in 2018 or 2019.
The election to claim the 100% limit for 2018 can be made using an application of tentative refund form (Form 1139.) The form should be filed by December 31, 2020. The IRS should issue the refund within 90 days after receiving the form.
Increased limit on deduction for business interest
Certain taxpayers that have more than $25 million of business income or are “tax shelters” are subject to a limitation for deducting business interest expenses.
Under the Tax Cuts and Jobs Act of 2017, the limit is the sum of (1) business interest income of the taxpayer for the tax year; (2) 30% of the taxpayer’s adjusted taxable income for the year; and (3) floor plan financing interest of the taxpayer for tax year.
Under the CARES Act, the limitation of item (2) is increased to 50% for taxable years beginning in 2019 and 2020.
Technical correction for Qualified Improvement Property
Qualified improvement property is an improvement to an interior portion of a building that is nonresidential real property provided the improvement is placed in service after the date the building was first placed in service. Improvements relating to the enlargement of a building, an elevator or escalator, or the internal structural framework of the building aren’t qualified improvement property.
This is the expanded definition of qualified improvement property adopted in the Tax Cuts and Jobs Act of 2017.
A drafting error in the Tax Cuts and Jobs Act of 2017 made the property subject to a 39 year depreciable life and not eligible for 100% bonus depreciation.
The CARES Act includes a technical correction defining qualified improvement property as 15 year property, qualifying for bonus depreciation. This correction is retroactive to the date of enactment of the Tax Cuts and Jobs Act of 2017, which was December 20, 2017.
Even with this technical correction, some taxpayers won’t qualify for bonus depreciation for this property. Taxpayers that are otherwise subject to the limitation for business interest deductions under Internal Revenue Code Section 163(j) (generally they have average annual gross receipts for the three prior years of $26 million for tax years beginning in 2020) and make elections to be excluded from the limitations, notably electing real property trade or businesses, electing farming businesses, and certain infrastructure trades or businesses, must used the alternative depreciation system instead of the modified accelerated depreciation system. For these businesses, depreciable real estate has a useful life of 39 years, so they don’t qualify for bonus depreciation on qualified improvement property.
Taxpayers with commercial buildings that had qualified improvement property placed in service after 2017 should amend their 2017, 2018 and 2019 income tax returns to claim bonus depreciation for the year the property was placed in service.
Government loan guarantees for small businesses
In addition to the tax provisions discussed above and many other matters, the legislation includes a “Paycheck Protection Program.” The Federal government will 100% guarantee SBA administered loans to businesses with not more than 500 employees. Sole proprietors, independent contractors and other self-employed individuals are eligible for loans. The covered loan period begins February 15, 2020 and ends on June 30, 2020.
There is an issue about whether self-employment compensation for partners in partnerships and members of LLC taxed as partnerships can be included in wages for Paycheck Protection Program loans. They aren’t specifically listed.
Act Section 1102(a)(1)(viii)(I)(bb) includes income of a sole proprietor or independent contractor that is a wage, commission,income, net earnings from self-employment, or similar compensation and that is an amount that is not more than $100,000 in 1 year, as prorated for the covered person…”
The SBA “Interim Final Rules” II. 3. f. says payroll costs include “… for an independent contractor or sole proprietor, wage, commissions, income, or net earnings from self-employment or similar compensation.”
Based on these definitions, it seems that it was intended that compensation of self-employed persons, including LLC members, should be covered by the Paycheck Protection Program. In a recent CalCPA webinar, CPAs from Armanino suggested that guaranteed payments in lieu of wages should be included in payroll for the loan application. Since the definition in the Act is “self-employment income”, it seems to me that all self employment income should be included. Guaranteed payments in lieu of wages should be increased or decreased for the partner’s or member’s share of self-employment income or losses from the partnership or LLC.
When you include this item in wages, you should probably explain what you are doing and why.
This legislation was drafted in a hurry, and whoever wrote it wasn’t thinking about partnerships and LLCs.
The maximum loan amount is $10 million through December 31, 2020. The loan amount is based on payroll costs incurred by the business.
Uses of the loan include payroll support, such as employee salaries (subject to a $100,000 limitation for an employee’s wages), paid sick or medical leave, insurance premiums and mortgage interest, rent, and utility payments.
Only compensation of persons whose principal place of residence is in the United States are covered.
Federal employment taxes imposed or withheld between February 15, 2020 and June 30, 2020, including the employee’s and employer’s share of FICA and Railroad Retirement Act taxes and income taxes required to be withheld from employees, are excluded.
Qualified sick and family leave wages for which a credit allowed under the Families First Coronavirus Response Act (Public Law 116-126) are also excluded. (No double dipping!)
Eligibility is based on whether a business was operational on February 15, 2020 and had employees for whom it paid salaries and payroll taxes, or a paid independent contractor.
The Act waives borrower and lender fees for particpating in the Paycheck Protection Program, and waives collateral and personal guarantee requirements under the program.
The maximum interest rate for these loans is four percent.
No loan payments will be required for at least six months and not more than a year, and requires the SBA to issue guidance about the deferment process by April 27, 2020.
Although the stated maturity of the loans is 10 years, the principal amount of the loan is forgiven up to the amount of (1) payroll costs; (2) payments of interest on a covered mortgage obligation; (3) payments on any covered rent obligation; and (4) covered utility payments. No more than 25% of the forgiven amount can be for non-payroll costs.
The debt cancellation is tax free. (Act § 1106(i).)
Caution! I have heard that some businesses, such as registered investment advisors, may be subject to restrictions on having debt. Check with your compliance officer or attorney before going ahead with an application for an SBA loan.
Here is a URL for the application form for a Paycheck Protection Program loan. https://home.treasury.gov/system/files/136/Paycheck-Protection-Program-Application-3-30-2020-v3.pdf?j=268557&sfmc_sub=124882304&l=3151_HTML&u=8813281&mid=7306387&jb=592&utm_medium=email&SubscriberID=124882304&utm_source=NewsUp_A20Mar225&Site=aicpa&LinkID=8813281&utm_campaign=Newsupdate&cid=email:NewsUp_A20Mar225:Newsupdate:Share+the+application:aicpa&SendID=268557&utm_content=Special
Here is a URL for a borrower’s guide for Paycheck Protection Program loan. https://home.treasury.gov/system/files/136/PPP%20Borrower%20Information%20Fact%20Sheet.pdf?j=268557&sfmc_sub=124882304&l=3151_HTML&u=8813282&mid=7306387&jb=592&utm_medium=email&SubscriberID=124882304&utm_source=NewsUp_A20Mar225&Site=aicpa&LinkID=8813282&utm_campaign=Newsupdate&cid=email:NewsUp_A20Mar225:Newsupdate:accompanying+borrower+guide:aicpa&SendID=268557&utm_content=Special
Here is a URL for the Small Business Administration’s interim final rule for Paycheck Protection Program loans. https://www.sba.gov/sites/default/files/2020-04/PPP–IFRN%20FINAL_0.pdf
Disaster loss election available
Since President Trump invoked the Robert T. Stafford Disaster Relief and Emergency Assistance Act when he declared the coronavirus outbreak to be a national emergency, disaster losses are eligible to be carried back one year under Internal Revenue Code Section 165(i) . Taxpayers should consider which tax year the losses they incur relating to the COVID-19 crisis will have the best tax benefit.
The Act includes a temporary Pandemic Unemployment Assistance program through December 31, 2020 to provide payments to people who traditionally aren’t eligible for unemployment benefits, including self-employed persons, independent contractors and those with a limited work history, who are unable to work as a direct result of the coronavirus public health emergency.
Unemployment compensation benefits are increased an additional $600 per week to each recipient of unemployment insurance or Pandemic Unemployment Assistance for up to four months.
Unemployment benefits are extended an additional 13 weeks through December 31, 2020 when state unemployment benefits are no longer available.
Railroad unemployment benefits are also increased like other unemployment benefits explained above, and the 7-day waiting period for railroad unemployment insurance benefits is temporarily eliminated through December 31, 2020.
For details about how these changes affect your situation, consult with your tax advisor or write to me at firstname.lastname@example.org.
The IRS issued the final regulations for Qualified Opportunity Zones, TD 9889, on December 20, 2019 and they were published in the Federal Register on January 13, 2020. The final regulations are generally effective for taxable years beginning after March 13, 2020, but taxpayers may elect to apply them for taxable years beginning after December 31, 2017 (for most taxpayers, 2018 and 2019.) If taxpayers decide to rely on proposed regulations previously issued by the IRS, they must totally follow the proposed regulations — no cherry picking! Alternatively, if the final regulations are selected for 2018 and 2019, the taxpayer must solely rely on those.
Here’s a link to the regulations in the Federal Register: https://www.federalregister.gov/documents/2020/01/13/2019-27846/investing-in-qualified-opportunity-funds
The final regulations are generally more taxpayer-friendly than the proposed regulations, but there are some rules in the proposed regulations that are more favorable for some taxpayers.
My printout of the final regulations with the preamble is 543 pages. I won’t explain them in detail here, but hit a few highlights. If you are thinking of investing or have invested in a Qualified Opportunity Zone, I highly recommend that you work with a tax professional who has studied the rules.
When investing in a Qualified Opportunity Zone investment, due diligence is essential. This is the type of investment that will attract fraudsters as organizers. You won’t get the tax and investment benefits if the organizer steals your money.
Very briefly and over-simplified, the benefits of Qualified Opportunity Zone investments are: (1) Defer the taxation of capital gains until the earlier of an inclusion event (such as selling the investment) or December 31, 2026; (2) If the investment is held at least five years no later than December 31, 2026, 10% of the original gain becomes tax free; (3) If the investment is held at least seven years no later than December 31, 2026, 5% of the original gain becomes tax free; (4) If the investment is held more than 10 years, the appreciation of the investment becomes tax free. Note that (1) in order to get ALL of the tax benefits, the investment must have been made by December 31, 2019, (2) the tax on at least 85% of the deferred capital gain must be paid for the tax year that includes December 31, 2026.
Remember that states might not conform to the Qualified Opportunity Zone rules. For example, California hasn’t conformed at this time.
The Opportunity Zones are designated by the states. You can likely locate them by searching online for “Qualified Opportunity Zones” and the state. These investments are becoming available through investment advisors. Alternatively, married couples can set up their own Qualified Opportunity Zone fund, or taxpayers otherwise can join together to make these investments. (This is NOT a do-it-yourself project! Only do it with professional help!)
Here are a few comparisons of the proposed and final regulations.
Under the proposed regulations, the taxpayer had to sell the investment (corporation, LLC or partnership interest) in order to get the 100% exclusion of appreciation within the fund after holding the investment (called a Qualified Opportunity Fund or QOF) for more than 10 years. Under the final regulations, the exclusion can be claimed when the QOF sells a Qualified Opportunity Zone asset (for example, a building.)
Under the proposed regulations, a property that was abandoned or otherwise left vacant for 5 years or longer could be treated as “originally used” for the purposed of the Original Use Test. Under the final regulations, the period is reduced to 3 years or longer, or only 1 year if the property was vacant before the designation of its location as a Qualified Opportunity Zone.
In order to defer the taxation of capital gains, the gain the taxpayer wishes to defer must be invested in the QOF within 180 days after the sale.
Under the proposed regulations, gains from the sale of Section 1231 assets (business assets) had to be netted for the taxable year and only Section 1231 gains in excess of losses could be deferred and invested in QOF. Because the net gain couldn’t be determined until the end of the year, the time for the 180 day reinvestment started as of the end of the year of the sale. Under the final regulations, gains from the sale of Section 1231 assets, without regard to Section 1231 losses, can be deferred and invested in a QOF. The time for the 180 day reinvestment starts on the date of the sale. When the gain becomes taxable, it will retain its status as a Section 1231 gain.
(Note that the proposed regulations and final regulations both provide that capital gains, not reduced by capital losses, are eligible for tax deferral by reinvesting them in a QOF. The measuring date for 180 day reinvestment of capital gains is the date of the sale.)
For investors in a partnership or S corporation and for beneficiaries of estates and non-grantor trusts, called pass-through entities, the proposed regulations provided the ratable share of the capital gain from the passthrough entity could be reinvested in a QOF (1) within 180 days of the actual date of a sale or exchange by the passthrough entity, or (2) within 180 days after December 31 of the taxable year in with the gain was incurred. Since it may be some time before the information is determined after the end of the taxable year, the final regulations add a third option, (3) within 180 days after the due date, WITHOUT EXTENSIONS, of the pass-through entity’s tax return for the taxable year in which the sale or exchange took place (generally, either March 15 or April 15 of the following year.)
The final regulations provide that taxpayers may elect to have the 180-day period begin on either the date an installment sale payment is received or on the last day of the taxable year in which the taxpayer would have recognized the gain under the installment method. If the payment date is selected, the taxpayer must continue to follow that method in future years. Also, installment sale gains from sales in years before January 1, 2018 are eligible for reinvestment in a QOF and tax deferral.
The final regulations clarify that nonresident aliens may defer the tax on capital gains that would otherwise be subject to U.S. tax by investing the gains in a QOF.
Under the proposed regulations, there was an inclusion event requiring the taxation of deferred gains for all of the shareholders if a QOF organized as an S corporation had a change of ownership exceeding 25% before the holding period requirements were met. Under the final regulations, this requirement has been eliminated. Only the shareholders who transfer their shares will have an inclusion event.
You can see from these changes that taxpayers will need to determine based on their own facts which set of regulations to choose. As I write this, there is still time to defer federal income taxes by investing in a QOF for sales made late in 2019.
There are many additional provisions, including operating rules for Qualified Opportunity Zone investments, that I haven’t discussed here. Once more, see your tax advisor for details.
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.
- 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.
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:
- The same person or group of persons must own 50% or more of each trade or business to be aggregated;
- 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;
- All of the trades or businesses must report on returns with the same taxable year (watch fiscal year passthrough entities!);
- A specified service trade or business isn’t eligible to be aggregated;
- The trades or businesses to be aggregated must satisfy at least two of the following factors:
- The trades or businesses provide products, property or 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 (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.
- 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 other symbols associated with the individual’s identity,
- 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.
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.
- Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise.
- 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.
- 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.
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.
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 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.
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.
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.
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.
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.)
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.
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.
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.
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
The interview on Financial Insider Weekly to be broadcast in San Jose and Campbell on Friday, July 28, is with G. Scott Haislet, CPA and attorney at law. Our interview subject is “Sale of a principal residence.” The interview will be broadcast at 9:30 p.m. Pacific Time on CreaTV, Comcast Channel 15 in San Jose and Campbell, and will be broadcast as streaming video at the same time at www.creatvsj.org. You can find broadcast times for other San Francisco Bay Area cities and past episodes at www.financialinsiderweekly.com.