Tax and financial advice from the Silicon Valley expert.

Tax tips and developments relating to S corporations

Expenses paid with forgiven PPP loans aren’t tax deductible

The IRS has issued guidance relating to the tax deductibility of expenses paid with a Paycheck Protection Loan that is forgiven.  (Notice 2020-32.  https://www.irs.gov/pub/irs-drop/n-20-32.pdf)

According to the CARES Act, the forgiveness of indebtedness is not taxable income.  (CARES Act Section 1106(i).)

The CARES Act doesn’t specify whether the expenses are tax deductible.

A Paycheck Protection Loan is eligible for forgiveness when the proceeds are used for the following expenses during the 8-week “covered period” beginning on the the loan’s origination date (CARES Act Section 1106(b)):

  1. Payroll costs
  2. A payment of interest on a covered mortgage obligation
  3. A payment on a covered rent obligation
  4. A covered utility payment

The IRS reminds taxpayers that, according to Internal Revenue Code Section 265(a)(1), no deduction is allowed for any item that is allocable to tax-exempt income.

To receive tax-exempt income from the federal government and to be allowed a tax deduction paid using the income would be a double benefit.

Taxpayers and their tax return preparers should note that these items won’t be tax-deductible on their 2020 income tax returns.

 

Joint Committee on Taxation explains Tax Provisions in CARES Act

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

Which employees qualify for employer leave payments under the Families First Coronavirus Response Act?

Congress enacted and President Trump signed legislation requiring employers to make employee leave payments as a coronavirus relief measure on March 18, 2020.  The title of the legislation is the Families First Coronavirus Reponse Act (P.L. 116-127)  (the Family First Act, FFA or the Act.)  Employers are reimbursed for these payments through tax credits that they can apply against their payroll tax liabilities.

Here is a URL to the text of the Act. https://www.congress.gov/116/plaws/publ127/PLAW-116publ127.pdf

The Department of Labor recently published questions and answers that provide important information about which employees are covered and the amounts that employers are required to pay those employees.  Here is a URL to the questions and answers.  https://www.dol.gov/agencies/whd/pandemic/ffcra-questions

The Department of Labor has also issued a poster that employers are required to use to notify employees of their rights.  Here is a URL to the poster.  https://www.dol.gov/sites/dolgov/files/WHD/posters/FFCRA_Poster_WH1422_Federal.pdf

According to the Department of Labor Questions and Answers, the FFA’s paid leave provisions are effective on April 1, 2020 and apply to leave taken between April 1, 2020 and December 31, 2020.

The IRS has published FAQs about the payroll tax credits for required employee leave under the FFA.  Here is a URL to the FAQs. https://www.irs.gov/newsroom/covid-19-related-tax-credits-for-required-paid-leave-provided-by-small-and-midsize-businesses-faqs

The employee leave requirements of the FFA do not apply to private sector employers that have 500 or more employees.

Employers with fewer than 50 employees and compliance with the requirements would threaten the viability of the business as a going concern may qualify for a small business exemption.  These businesses should document the reason the business viability is threatened.  There currently isn’t a form or application procedure for the exemption.

According to guidance issued by the Department of Labor, employees who take paid leave under the Act are required to provide the employer with documentation supporting the reason for leave.  The employer should keep copies of federal and local quarantine orders.  The employee should give a statement with the employee’s name, qualifying reason for requesting leave, a statement that the employee is unable to work, including telework, for that reason, and the date(s) for which leave is requested.  If leave is requested under a doctor’s orders, a letter from the doctor should be kept by the employer.

If expanded family leave is requested because a child’s school is closed, documentation should be kept for that event.

According to guidance issued by the Department of Labor, you are unable to work if your employer has work for you and one of the reasons listed below for the Emergency Paid Sick Leave Act prevents you from being able to perform that work, either under normal circumstances at your normal worksite or by teleworking.

According the Department of Labor guidance, if an employer closed its worksite before April 1, 2020, the employee isn’t entitled to paid sick leave because there isn’t any work for the employee to do.  This is true whether the employer closes the worksite for lack of business or because it’s required to close because of a Federal, state or local directive.  In this case, the employee should apply for state unemployment insurance benefits.

If an employer closes its worksite after April 1, 2020 but before the employee goes on leave, the employee isn’t entitled to paid leave under the Act and should apply for unemployment insurance benefits.

If an employer closes its worksite after April 1, 2020 when an employee is on paid sick leave under the Act, the employee is no longer eligible for paid leave under the Act and should apply for unemployment insurance benefits.

If an employer remains open and furloughs an employee after April 1, 2020 because there isn’t work for the employee, the employee isn’t eligible for paid leave under the Act and should apply for unemployment insurance benefits.

If an employer remains open and reduces an employee’s scheduled work hours because of a reduced workload, the employee isn’t entitled to paid leave under the Act, even if the reduced hours are a result of the coronavirus shutdown.  The reason is the employee isn’t prevented from working those hours because of a coronavirus-related reason.

An employee may take paid sick leave or expanded family and medical leave intermittently while teleworking.

Unless you are teleworking, paid sick leave for qualifying reasons related to coronavirus must be taken in full-day increments.

Unless you are teleworking, once you begin taking paid sick leave for one or more of the qualifying reasons, you must continue to take paid sick leave each day until you either (1) use the full amount of paid sick leave or (2) no longer have a qualifying reason for taking paid sick leave.  This requirement is imposed to avoid having other employees be exposed to the coronavirus.

The rules are different when a parent is taking sick leave to care for a child whose school or place of care is closed.  In that case, the employer and employee can agree for the employee to take paid sick leave intermittently, such as taking leave on Mondays, Wednesdays and Fridays and working on Tuesdays and Thursdays.

Employees may not receive unemployment benefits when they are receiving paid sick leave.

According to Department of Labor guidance, employers aren’t allowed to require employees to supplement or adjust the pay mandated under the Act with paid leave under the employer’s paid leave policy.  The employee must choose one or the other.

Wages paid for employee leave under the FFA are taxable wages for employees, but aren’t subject to the employer shares of Social Security tax (6.2%).

There are two sections of the FFA relating to employee leave:  The Emergency Family And Medical Leave Act and The Emergency Paid Sick Leave Act.

The Emergency Family And Medical Leave Expansion Act

The Emergency Family And Medical Leave Act relates to employees who are unable to work or telework due to a need to take leave to care for a son or daughter under 18 years of age of such employee if the school or place of care has been closed, or the child care provider of the son or daughter is unavailable due to a public health emergency (the coronavirus shutdown declared by a Federal, state or local authority.)

In order to be eligible, the employee must have been employed for at least 30 calendar days by the employer from whom leave is being requested.

The first 10 days for which an employee takes leave may be unpaid leave.  An employee may elect to substitute accrued vacation leave, personal leave, or medical or sick leave for unpaid leave.  According to guidance issued by the Department of Labor, the employee may be entitled to paid leave under the Emergency Paid Sick Leave Act for the initial 10 days, which is a higher rate of pay.  (See below.)

After the first 10 days, the employer is required to pay the employee not less than two-thirds of the employee’s regular rate of pay, based on the number of hours the employee would normally be scheduled to work.  The maximum required paid leave is $200 per day, or $10,000 total for the ten-week period.

According to guidance issued by the Department of Labor, the employee initially uses up to 10 days under the Emergency Medical Leave Act, and then may use up to ten weeks expanded leave after that under the Emergency Family And Medical Leave Expansion Act.

If the employee has an irregular schedule, the employer should determine an average of hours worked per week and average rate of pay per hour over a six-month period ending on the date the employee starts taking leave.  If the employee worked less the six months, the employer may estimate the hours expected the employee to be scheduled to work.  According to guidance issued by the Department of Labor, if the employee hasn’t been employed for at least six months, use the number of hours that the employer and the employee agreed the employee would work when the employee was hired.  If there wasn’t such an agreement, calculate the appropriate number of hours of leave based on the average hours per day the employee was scheduled to work over the entire term of his or her employment.

According to Department of Labor guidance, overtime hours are included when computing the hours the employee would normally work in a week when computing expanded leave.  Pay does not include a premium for overtime hours.

Employers with less than 25 employees are not required to pay leave provided:

  1. The employee takes leave to care for the employee’s child.
  2. The position held by the employee does not exist due to economic conditions or other operating conditions of the employer (a) that affect employment; and (b) are caused by a public health emergency during the period of leave.
  3. The employer makes reasonable efforts to restore the employee to a similar position, with equivalent pay and benefits.
  4. If the employer is unable to restore the employee to a similar position, the employer makes a reasonable effort to contact the employee during the 1-year period beginning on the earlier of (a) the date on which the qualifying need from a public health emergency concludes, or (b) the date 12 weeks after the date on which the employee’s leave commences.

The Emergency Paid Sick Leave Act

An employer is required to provide to each employee employed by the employer paid sick time to the extent that the employee is unable to work (or telework) and takes leave because:

  1. The employee is subject to a Federal, State or local quarantine order relating to the coronavirus.
  2. The employee has been advised by a health care provider to self-quarantine due to concerns relating to the coronavirus.
  3. The employee is experiencing symptoms of the coronavirus and seeking a medical diagnosis.
  4. The employee is caring for an individual who is subject to an order described at item 1 or has been advised as described at item 2.
  5. The employee is caring for a son or daughter of the employee if the school or place of care of the son or daughter has been closed, or the child care provider of the son or daughter is unavailable due to coronavirus precautions.
  6. The employee is experiencing any other substantially similar condition specified by the Secretary of Health and Human Services in consultation with the Secretary of the Treasury and the Secretary of Labor.

An employer of an employee who is a health care provider or an emergency responder may elect to exclude the employee from eligibility from paid sick leave under this Act.

An employee that meets requirements 1, 2, or 3 above is entitled to paid sick time at the employee’s regular rate of pay for up to 80 hours for a full time employee or, for a part-time employee, the average number of hours the employee works during a two-week period.  According to guidance issued by the Department of Labor, the amount received will be based on the greater of (a) the employee’s regular rate of pay, (2) the federal minimum wage, or (3) the applicable state or local minimum wage, up to a maximum of $511 per day, or $5,110 for the entire sick leave period.

(According to guidance issued by the Department of Labor, once the employee takes 80 hours, the employee won’t qualify for additional sick leave under the Act for 2020.  Only sick leave received for the period on or after April 1, 2020 counts.)

According to guidance issued by the Department of Labor, commissions, tips, and piece rates must be included in the employee’s regular rate of pay.

An employee that meets requirements 4, 5, or 6 above is entitled to compensation based on 2/3 of the amounts for requirements 1, 2, or 3 to a maximum of $200 per day, or $2,000 for the two-week period.

The sick time under the Act isn’t eligible for carryover to a subsequent year.

Paid sick time under the Act ceases beginning with employee’s next workshift following the termination of the need described at items 1 – 6 above.

An employer may not require that an employee search for or find a replacement employee as a condition to receive sick pay under the Act.

If the employee is eligible for accrued sick pay from the employer, the employee uses sick pay under the Act first.

Employers are prohibited from discharging, disciplining, or in any other way discriminating against an employee who takes leave in accordance with the Act and files a complaint relating to the Act.

Tax Credits For Paid Sick and Paid Family and Medical Leave

Certain employers are eligible for a tax credit against the employer share of social security tax (6.2%.)  The credit is 100% of qualified sick leave wages paid by the employer for the calendar quarter.

The maximum sick leave wages for an individual is $200 per day, or $511 per day in the case of sick leave wages paid under the Emergency Paid Sick Leave Act.

In addition to the sick leave wages, the credit is increased for the employer’s qualified health plan expenses that are properly allocable to the qualified sick leave wages for which the credit is allowed.  The IRS is to define a procedure to prorate the qualified health plan expenses on the basis of period of coverage to to time periods of leave that the wages relate to.

The maximum days for an individual for a calendar quarter is 10 minus the total days taken in preceding calendar quarters during 2020.

The credit is limited to the total employer portion of social security taxes and medicare taxes for the quarter, but any excess credit over that limit is treated as a refundable overpayment.

Qualified sick leave wages for the credit means compensation required to be paid under the Emergency Paid Sick Leave Act.

Any credit allowed increases taxable income and no credit is allowed for wages when another tax credit is based on them.

An employer may elect out of claiming the credit.

The credit is not available for employees of Federal, state, or local governments.

Tax credit for sick leave of self-employed individuals

Self-employed individuals may claim a credit for the qualified sick leave equivalent amount for the individual against the individual’s self-employment tax.

An eligible self-employed individual is covered if he or she would be entitled to receive benefits under the Emergency Paid Sick Leave Act if the individual was an employee of an employer (other than himself or herself.)

The “qualified sick leave equivalent amount” is an amount equal to the number of days during the taxable year (up to the applicable number of days) that the individual is unable to perform services in any trade or business referred to in IRC Section 1402 for a reason that individual would be entitled to receive sick leave under the Emergency Paid Sick Leave Act multiplied by the lesser of (a) $200 ($511 for any day of sick time for reasons 1, 2, or 3 above) or (b) 67% (100% for any day of paid sick time for reasons 1, 2, or 3 above) of the average daily self-employment income of the individual for the taxable year.

The average daily self-employment income is the net earnings from self-employment of the individual for the taxable year divided by 260.

The applicable number of days is the excess of 10 days over the number of days taken into account in all preceding taxable years.

Any credit in excess of the self-employment tax is treated as a refundable payment.

The taxpayer is required to document the reason why he or she is entitled to the credit.

If the individual also receives wages from an employer that are required to be paid under the Emergency Paid Sick Leave Act, the qualified sick leave equivalent amount is reduced by any paid leave amount received.

Payroll credit for Required Paid Family Leave

An employer may claim a tax credit to apply against the employer portion of social security taxes (6.2%) for each calendar quarter an amount equal to 100% of the qualified family leave wages paid by the employer with respect to the calendar quarter.

The qualified family leave wages for an individual are up to $200 per day, to a maximum of $10,000 for a calendar year.

Any credit in excess of the employment taxes is treated as a refundable overpayment.

In addition, qualified health plan expenses attributable to the wages are added to the credit, under rules similar to those described for Paid Sick and Paid Family Leave, above.

This credit also increases taxable income and any expenses for which another tax credit is allowed are disallowed for computing this credit.

Credit for Family Leave for Self-Employed Individuals

Self-employed individuals who would have been eligible for leave under the Emergency Family and Medical Leave Expansion Act if they were employees may claim a tax credit against their self-employment tax for amounts equivalent to Family Leave.

The individual may claim up to 50 days times the lesser of (a) 67% of the average daily self-employment income, or (2) $200.

The self-employed person is required to be able to document being entitled to the credit.

If the self-employed person receives leave compensation as an employee for another employer, the eligible self-employment income is reduced for any leave payments received.

The credit is refundable.

If any benefit is allowed for the income under another Code section, the credit is disallowed for that amount.

Expediting getting payroll tax credits

The employer can expedite getting the cash benefit of payroll tax credits under the FFA or the CARES Act by either

  1. Retaining these employment taxes instead of depositing them: (a) Federal income tax withheld for all employees; (b) The employee’s share of social security and medicare taxes (for employees who received paid leave benefits); and (c) the employer’s share of social security and medicare taxes for all employees or
  2. Employers may file Form 7200, Advance Payment of Employer Credits Due To COVID-19.  The IRS says it will try to issue refunds within two weeks for this form.  It can be filed several times during a quarter.

Here is a URL for Form 7200 with instructions.  https://www.irs.gov/forms-pubs/about-form-7200

Congress enacts advance tax rebates and other tax breaks in the CARES Act

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.

Unemployment insurance

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 mgray@taxtrimmers.com.

 

 

What does the Federal tax due date change to July 15, 2020 cover?

The IRS has issued Notice 2020-18 and posted FAQs at the IRS web site explaining what the Federal tax due date extension to July 15, 2020 covers.  The IRS has also issued Notice 2020-23, applying the extension to more tax returns and tax payments.

The extension doesn’t apply to all federal taxes.  For example, it applies to federal income tax returns and gift tax returns and tax payments, including estimated income tax payments, due on April 15, 2020, and June 15, 2020,  but doesn’t apply for federal payroll tax returns,  or some excise taxes,

Notice 2020-23 says the extension to July 15, 2020 also applies to federal income tax returns and payments due on or after April 1, 2020 and before July 15, 2020, including calendar year or fiscal year corporate income tax returns, calendar or fiscal year partnership returns, calendar or fiscal year income tax returns for estates and trusts, estate and generation-skipping tax returns and estate tax installment payments under certain tax elections, exempt organization business tax returns, and quarterly estimated income tax payments.

The extension also doesn’t apply to the due date of filing amended income tax returns, corporate requests for quick refunds of estimated tax payments (Form 4466), the time for completing retirement account rollovers, or for taking excess deferrals contributed to a 401(k) plan out of the plan (due April 15.)

The extension does apply to contributions for 2019 to IRAs (including Roth IRAs) and Health Savings Accounts (HSAs).

Nothing needs to be done to get the due date extension to July 15, 2020.  The due date has simply been changed.

Penalties for late filing of income tax returns and penalties for late payment of income taxes won’t apply for income tax returns and income tax estimated tax payments otherwise due on April 15, 2020 that are filed and paid by July 15, 2020.

If a taxpayer needs additional time to file its 2019 income tax return beyond July 15, 2020, it can file an automatic extension to file form by July 15, 2020, showing the estimated tax due.  The due date for paying the tax isn’t extended beyond July 15, 2020, and late payment penalties plus interest will apply for 2019 income taxes not paid by July 15, 2020.

If a taxpayer has scheduled an automatic payment of income taxes on April 15, 2020 for an e-filed income tax return, the taxpayer may call IRS e-file payment services 24/7 at 888-353-4537 to cancel the payment.  The IRS recommends that you wait 7 to 10 days after your tax return has been accepted before calling and the request must be received no later than 11:59 p.m. ET two business days before the scheduled payment date.  The taxpayer should then go to www.irs.gov/payments/direct-pay to schedule a payment for July 15, 2020.

Estimated tax payments that were previously scheduled using Direct Pay can be cancelled and rescheduled at www.irs.gov/payments/direct-pay.  You will need the transaction number for the scheduled transaction.

The California Franchise Tax Board has announced it is conforming to the federal due date extension for income tax returns and for tax payments, including both the first and second estimated tax payment for 2020.

If you have a question about this matter, call the IRS, consult with your tax advisor or write to me at mgray@taxtrimmers.com.

Here’s a link to Notice 2020-18. https://www.irs.gov/pub/irs-drop/n-20-18.pdf

Here’s a URL to IRS Notice 2020-20, extending the due date for federal gift tax returns and generation skipping tax returns with respect to a gift. https://www.irs.gov/pub/irs-drop/n-20-20.pdf

Here’s a link to the FAQs. https://www.irs.gov/newsroom/filing-and-payment-deadlines-questions-and-answers

Here’s a URL to Notice 2020-23, applying the federal due date extension to more tax returns.  https://www.irs.gov/pub/irs-drop/n-20-23.pdf

Final Qualified Opportunity Zone regulations increase benefits

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.

 

How to make a retroactive small business accounting election for California

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

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

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

Franchise Tax Board

PO Box 942857

Sacramento, CA  94257-0500

Note:  These returns must be PAPER-FILED.

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

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

The 20% of qualified domestic business income (QDBI or called QBI in the regulations) deduction under Internal Revenue Code Section 199A is one of the most complex provisions of the Tax Cuts and Jobs Act, enacted on December 22, 2017.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

These are the requirements for aggregation:

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

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

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

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

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

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

The listed SSTBs are health, law, accounting, actuarial science, performing arts, consulting (excluding architecture and engineering), athletics, financial services, brokerage services, investing and investment management, trading, dealing in securities, partnership interests or commodities, and any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.  The final regulations generally are the same as the proposed regulations relating to the SSTBs, with some clarification and additional examples.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Amended 2017 returns required for fiscal year passthrough entities

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

Are you a winner or loser under tax reform?

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

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

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

Winners

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

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

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

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

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

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

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

Losers

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

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

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

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

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

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

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

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

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

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

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

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Tax and financial advice from the Silicon Valley expert.