Tax Reform

S Corp considerations for 2018 owners’ compensation resulting from the TCJA

 
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Posted by John Boykas, CPA

Owners of certain flow-through entities may qualify for reduced tax rates on qualified business income earned by the entities via the newly enacted Section 199A, part of the Tax Cuts and Jobs Act (TCJA).  If you operate as an S Corp, you may be able to take better advantage of these reduced tax rates simply by reviewing the compensation structure of payments to owners.  This planning technique must be considered during 2018 and will be relevant as long as Section 199A remains in effect (this provision sunsets in 2026).

Simply put                      

Section 199A allows for a 20% reduction in pass-through income to certain qualified shareholders (see below).  This is an easy way to save money.  Simply put, reducing the salary of owners will increase the net income flowing through to the shareholders, thereby lowering the tax rate; for example, if you are currently paying the top rate of 37%, you may qualify for a reduction of that percentage by 20%, resulting in a tax rate of only 29.6%.  Furthermore, the profits may not be subject to Medicare tax, resulting in an additional 2.9% savings.  As in the past, shareholders should be paid “reasonable compensation,” but this concept is not specifically defined.  Your trusted advisor should be able to determine whether you are in the lowest end of the reasonable compensation range in order to achieve the maximum tax benefit.  Of course, most people do not want to take home less money, but this can be solved by paying the reduction in salary as S Corp distributions, taking care to ensure that appropriate estimates are paid so that underpayment penalties are not incurred.

Example:  A small distributor where the owner historically receives a $400,000 salary that results in $100,000 net corporate income.  Without any planning, the owner will pay tax on the salary at normal rates but will receive a 20% reduction in the $100,000 corporate income, resulting in tax being paid on $480,000 ($400,000 salary plus 80% of $100,000).  With careful planning, we can reduce the salary to a reasonable $200,000, resulting in a net corporate income of $300,000.  The owner now pays tax on $440,000 ($200,000 salary plus 80% of $300,000).  This is a significant tax savings.

Now the details

For 2018, if the owner’s taxable income is less than the threshold amount ($315,000 for married filing jointly and $157,500 for other individuals), there are very few limitations.

However, two major limitations will be phased in once taxable income exceeds the threshold amounts, and will be fully applicable once taxable income is above $415,000 for married filing jointly and $207,500 for other individuals.  Specifically:

  • the deduction will not apply to “specified businesses,” e.g., doctors, lawyers, brokers, accountants, etc. (Architects and engineers are exempt from this limitation because they have better lobbyists); and
  • the 20% reduction will be limited to 50% of W-2 wages (or in the alternative 25% of W-2 wages plus 2.5% of certain property and equipment cost).  So, in certain situations, it may actually be beneficial to increase wages.

The takeaway             

There are many nuances and uncertainties regarding the application of Section 199A. And while the Treasury will eventually be issuing guidance, diligent business owners and their trusted tax professionals need to become familiar with them now.  Speak to your advisor sooner than later to discuss an optimal compensation target for 2018.

Navigating the Tax Cuts and Jobs Act: Volume 3 – Depreciation

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Patience is not a virtue in the world of tax and accounting.  Taxpayers generally prefer to recover the cost of investments in capital property as rapidly as possible.  Thanks to recent changes made by the Tax Cuts and Jobs Act (TCJA) in 2017, there is less waiting and more deducting.

For tax purposes, most taxpayers depreciate fixed assets under the Modified Accelerated Cost Recovery System (MACRS), which, as the name suggests, already offers accelerated tax deductions as compared to the de facto default method (straight-line).  A certain method under MACRS front-loads the magnitude of the tax deduction to the beginning of the useful life of the asset.  We also have even quicker options (if available) that provide even more up-front expensing: Section 179 and bonus depreciation.  Both of these options have been enhanced by the TCJA.

Section 179              

Under this section of the code, 100% of the cost of an asset can be written off as a tax deduction.  The amount of Section 179 (Sec. 179) benefit a taxpayer can receive in a given year is limited to taxable income; the excess carries over to future years.  The TCJA has expanded the assets that are eligible to this type of expensing.  In the past, Sec. 179 was not available for most real property, but under the new law, “Qualified Improvement Property” is now eligible (things like the roof of a building and components of A/C systems), as well as furnishings used predominantly in lodging activities. Be aware that qualified improvement properties are nonresidential only.

In addition, the limit on Sec. 179 expensing was increased from $500k to $1M per year, subject to a phase-out threshold increase from $2M to $2.5M (indexed for inflation).  The phase-out threshold decreases your expense by costs of fixed asset additions in a given year that exceed the phase-out threshold, dollar-for-dollar.  I always stress that the limit ($1M) is an absolute limit for any taxpayer.  One must be very careful when using Sec. 179 on pass-through entities, because if an individual receives more than $1M in Sec. 179, the excess deduction is lost permanently.

These changes became effective January 1, 2018.

Bonus depreciation

Bonus depreciation was introduced as a “special” option for taxpayers to incentivize investing in capital property back in 2002 for a limited time.  For obvious reasons, bonus depreciation was very popular and was reintroduced several times since in subsequent legislation.  The deduction has varied from 30% - 100% over that period and was eligible for qualifying property, which had to be “new” and have a useful life of 20 years or less.  Bonus expense is figured after Section 179, if applicable.  Under the TCJA, taxpayers can enjoy 100% bonus depreciation and the “new” property requisite has been lifted.

These changes became effective September 27, 2017, so be aware that certain property may be eligible for 100% bonus on your 2017 tax return.

Other issues

There is a slight snag in the TCJA where “Qualified Improvement Property” isn’t granted the intended 15-year life, thus making it ineligible for bonus depreciation, but it is widely believed that this will be fixed in a technical correction bill.  Your move, Congress.

Many states do not recognize bonus depreciation and have different limits for Sec. 179.  Failing to recognize and plan for those differences might result in an unwanted (and unintended) surprise state tax bill.

The Alternative Depreciation System (ADS) must be used for certain assets or certain taxpayers and uses a straight-line method (slow).  Additionally, ADS has a longer recovery period and may not use accelerated expensing methods described above (even slower).  ADS has increased relevance in the world of the TCJA for reasons we will explore when we discuss the business interest deduction limitation in a future post.  Under ADS, the useful life for residential real property was shortened from 40 years to 30 years, which puts it more in line with the MACRS life of 27.5 years.

Every change highlighted above is a boon to taxpayers seeking to accelerate tax deductions on the cost of capital investment property.  These changes apply to more than just rental properties; all businesses with tangible property additions are impacted. In some cases, these changes can also be applied to residential properties, but that’s a longer and more in-depth conversation we can parse out at a later date.

Care must be taken when dealing with Sec. 179, and we can’t forget to consider the state differences.  Taxpayers need to understand the nuance in the new law (and impending technical corrections) and how to maximize the benefit.  Reach out to your advisor, or give me a call to discuss.

The IRS is not amused with states' attempts to circumvent federal tax changes

 
 

The recently enacted Tax Cuts and Jobs Act (TCJA) makes some potentially detrimental changes to state and local tax (SaLT) deductions, namely a limitation on the tax deduction of $10k for married filers and $5k for single filers for state taxes.  Prior to the TCJA, there was no such limitation (even though some taxpayers were hit with the Alternative Minimum Tax, but that is a different discussion).  This presents a problem for taxpayers in “high-tax” states: any jurisdiction that imposes a high income tax, a high property tax, or both, such as New York, New Jersey, California, and Connecticut.  The TCJA did not cap the deduction on charitable contributions; in fact, they increased the limit from 50% to 60% of adjusted gross income for certain types of gifts, and even then excess contributions are allowed to be carried over into subsequent years.

If only there was some way to decrease the amount of state taxes paid to say, less than $10K, while at the same time increasing charitable gifts!  State legislators in these high-tax states were quick to cook up a work-around to this change and came up with a doozy.  States will establish state-run charitable trust funds.  Taxpayers would be allowed a state tax credit of some percent (New York provides 85%; New Jersey, 90%) of their contribution to these funds, and in theory, also get a deduction on their federal tax return for a charitable contribution.  Thus, states would shift the character of payment from one category to the other and there will be much rejoicing (and tax deductions).

 
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The IRS wasted little time responding and announced that they will release proposed regulations to provide guidance to taxpayers on how the IRS is the authority on the characterization of charitable contribution and it doesn’t matter what the states say.  The central factors in determining if a charitable contribution is deductible is that it 1) is paid to a qualified organization (which the states’ trust funds can meet) and 2) the deduction must be reduced by any benefit the taxpayer receives.  If you have been paying attention, you will have noticed that, in this arrangement, the taxpayer would receive a benefit for their contribution in the form of a tax credit, and therefore they would have to reduce their charitable contribution deduction by the state tax credit they received.  This results in a net zero benefit to taxpayers.

More than anything, this is posturing by politicians in state and federal positions.  Unfortunately for those of us in high-tax states, we will have to deal with paying taxes to our state and not getting the benefit we were used to getting in the past.  There are other important issues that states will have to address in the wake of the TCJA which we will discuss in future posts.  If you would like to complain about this or other topics, reach out to your trusted advisor, or give me a call.

Navigating the Tax Cuts and Jobs Act: Volume 2 – Rate reductions

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Posted by Evan Piccirillo, CPA

The most straightforward and significant change of the Tax Cuts and Jobs Act (TCJA) is the reduction in income tax rate to corporations and individuals.  This is the “giveth” of the TCJA, and while there are many “taketh aways,” which we will discuss later on, all things being equal, most entities and people will consequently pay less tax.

Corporations

Corporations pay a flat 21% tax on income, and this provision is permanent (meaning there is no language in the law that builds in an expiration of this provision).  Prior to 2018, corporations would pay tax based on graduated rates as determined by their taxable income for the year (taking into account the dreaded alternative minimum tax (AMT)).

Here are the rates for 2017:

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You may have noticed that this table contains a rate that is lower than 21%, namely the lowest bracket for corporations with taxable income of less than $50k.  Those corporations will be paying more tax under the new regime.  That aside, the 21% rate will result in a much lighter tax burden for most corporations.  I stress here again that this is under an “all things being equal” scenario.  There are other provisions of the TCJA (which we will address in future posts) that will add to these corporations’ tax burdens, given certain circumstances.

Fiscal year taxpayers (that is, corporations with year-ends other than 12/31) will pay tax on a blended rate.  The blended rate is the sum of the ratios of the old tax rate for the number of days in 2017 and the new tax rate for the number of days in 2018.  For example a June 30 year-end will have a blended rate of about 28%.

Also, the corporate AMT is eliminated!  Certain AMT credits will be recoverable as well, which mean those benefits will not be lost.

Individuals

Individuals will pay a 7-bracket, progressive tax.  The rates for most of the brackets drops from 1-3% and most brackets will begin at a higher dollar amount of income as compared to prior years.  This rate reduction will be in effect for only 8 years and then revert to the pre-2018 structure, so remember this “giveth” has an expiration date, unless our legislators decide to extend it.  Prior to 2018, the tax methodology was similar, but at less favorable rates.

In spite of many of the itemized deductions that are suspended while these individual rate reductions are in effect (which we will discuss in later posts), many individual taxpayers will be pay less tax under this regime.  It may vary on a case-by-case basis (as individual tax always does), but for the most part, this is a clear benefit to individuals.

The (kind of) bad news is that the individual AMT has not been eliminated in fact, but I do believe that it has been eliminated in effect.  The thresholds and exemptions have been increased and the primary culprit in determining AMT applicability for most taxpayers (the itemized state tax deduction) is severely limited.  It will be a very rare instance that AMT will apply.

The TCJA has many “giveths" and “takeths", but the rate reductions are a clear “giveth” on the corporate side and individual side alike.  Don’t get too excited yet, because our legislators have found many, often very complex, ways to recover some of this lost tax revenue.

If you have any questions or would like to better understand this, reach out to your trusted advisor, or email me.  Stay tuned for our next post, where we will explore a significant “taketh” provision!

Self-employment tax: the other tax reform

 
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Posted by Courtney Kopec, CPA

While the headlines parsed the effects of the Tax Cuts and Jobs Act of 2017, other important tax issues affecting the owners of pass-through entities were being scrutinized. Over the past year, the U.S. Tax Court modified self-employment (“SE”) tax guidelines to firm up the limited partner and LLC pass-through rules previously used to avoid self-employment tax on income earned by certain taxpayers.

S corporation ordinary income is not subject to SE tax

In Fleischer v Commissioner (TC Memo 2016-238), the taxpayer created an S corp entity to report non-employee compensation from a service provider contract he entered into with MassMutual as a financial services provider. The intended result was to exclude self-employment income tax because S-corp pass-through income is not subject to SE tax. The Court determined the income should have been reported on Schedule C and subject to SE tax. The Court applied two tests to determine whether the corporation was the controller of the income: first, the individual providing the services must be an employee of the corporation; and second, a contract must exist recognizing the corporation’s controlling position. The Court determined that the taxpayer, not his S corporation, had earned all the income.

A partner’s power is either general or limited, but not both

In Castigliola v Commissioner (TC Memo 2017-62), a law practice that was incorporated as a professional limited liability company by three attorneys had a compensation agreement that was reasonable based on average salaries in their area. The partners reported the guaranteed payments they received as subject to self-employment tax. However, the net profits distributed in excess of the guaranteed payments were reported as not subject to SE tax. The taxpayers argued that the guaranteed payments reflected reasonable compensation for their services and the earnings in excess were attributable to the partner’s investment and were akin to the items of income or loss of a limited partner. The Court determined that in the absence of a written operating agreement that identified a general partner, all three attorneys had equal management power that was in no way limited. None of the partners could be considered as limited and classify their additional income as limited partner income. Therefore, all three attorneys were general partners and all income was subject to SE tax.

A surgeon successfully separates out his passive activities

In Hardy v Commissioner (TC Memo 2017-16), a surgeon (Hardy) performed surgeries at a facility in which he held a 12.5% minority interest and so considered himself a limited partner. He held no management authority at the facility and his distributions were not related to his performance. Hardy reported the income as passive and, at first, also paid self-employment tax on the income. The core issue was whether Hardy properly reported the income as passive and the activities should treated as a single activity and “constitute an appropriate economic unit for the measurement of gain or loss for the purposes of Section 469.” The IRS argued that Hardy’s payment of SE tax implied that the activities were non-passive and should be grouped as a single activity. The Court rejected the IRS argument and held that Section 1.469-4(c)(2) permits a taxpayer to use any reasonable method of “applying the relevant facts and circumstances” to group activities and, therefore, the taxpayer was not liable for the SE tax. He would have been liable for SE tax and could not use the passive losses if the Court determined the activities were to be grouped as a single activity.

Tax planning considerations

The implications of the three cases presented are clear: the IRS wants to subject pass-through entity income to self-employment tax, where appropriate. The owners of S corps who do not take reasonable compensation are easy prey for IRS auditors. If you are an entrepreneurial owner of an S corporation and are not taking salary, or if you are a managing partner in a partnership entity, you should consult your CPA tax advisor to review your tax exposure under these types of situations.

Further reading