Have you made substantial gifts of wealth to family members? Or are you the executor of the estate of a loved one who died recently? If so, you need to know whether you must file a gift or estate tax return.
Filing a gift tax return
Generally, a federal gift tax return (Form 709) is required if you make gifts to or for someone during the year (with certain exceptions, such as gifts to U.S. citizen spouses) that exceed the annual gift tax exclusion ($15,000 for 2018 and 2019); there’s a separate exclusion for gifts to a noncitizen spouse ($152,000 for 2018 and $155,000 for 2019).
Also, if you make gifts of future interests, even if they’re less than the annual exclusion amount, a gift tax return is required. Finally, if you split gifts with your spouse, regardless of amount, you must file a gift tax return.
The return is due by April 15 of the year after you make the gift, so the deadline for 2018 gifts is coming up soon. But the deadline can be extended to October 15.
Being required to file a form doesn’t necessarily mean you owe gift tax. You’ll owe tax only if you’ve already exhausted your lifetime gift and estate tax exemption ($11.18 million for 2018 and $11.40 million for 2019).
Filing an estate tax return
If required, a federal estate tax return (Form 706) is due nine months after the date of death. Executors can seek an extension of the filing deadline, an extension of the time to pay, or both, by filing Form 4768. Keep in mind that the form provides for an automatic six-month extension of the filing deadline, but that extending the time to pay (up to one year at a time) is at the IRS’s discretion. Executors can file additional requests to extend the filing deadline “for cause” or to obtain additional one-year extensions of time to pay.
Generally, Form 706 is required only if the deceased’s gross estate plus adjusted taxable gifts exceeds the exemption. But a return is required even if there’s no estate tax liability after taking all applicable deductions and credits.
Even if an estate tax return isn’t required, executors may need to file one to preserve a surviving spouse’s portability election. Portability allows a surviving spouse to take advantage of a deceased spouse’s unused estate tax exemption amount, but it’s not automatic. To take advantage of portability, the deceased’s executor must make an election on a timely filed estate tax return that computes the unused exemption amount.
Preparing an estate tax return can be a time consuming, costly undertaking, so executors should analyze the relative costs and benefits of a portability election. Generally, filing an estate tax return is advisable only if there’s a reasonable probability that the surviving spouse will exhaust his or her own exemption amount.
Seek professional help
Estate tax rules and regulations can be complicated. If you need help determining whether a gift or estate tax return needs to be filed, contact us.
Depreciation-related breaks on business real estate: What you need to know when you file your 2018 return
Commercial buildings and improvements generally are depreciated over 39 years, which essentially means you can deduct a portion of the cost every year over the depreciation period. (Land isn’t depreciable.) But special tax breaks that allow deductions to be taken more quickly are available for certain real estate investments.
Some of these were enhanced by the Tax Cuts and Jobs Act (TCJA) and may provide a bigger benefit when you file your 2018 tax return. But there’s one break you might not be able to enjoy due to a drafting error in the TCJA.
Section 179 expensing
This allows you to deduct (rather than depreciate over a number of years) qualified improvement property — a definition expanded by the TCJA from qualified leasehold-improvement, restaurant and retail-improvement property. The TCJA also allows Sec. 179 expensing for certain depreciable tangible personal property used predominantly to furnish lodging and for the following improvements to nonresidential real property: roofs, HVAC equipment, fire protection and alarm systems, and security systems.
Under the TCJA, for qualifying property placed in service in tax years starting in 2018, the expensing limit increases to $1 million (from $510,000 for 2017), subject to a phaseout if your qualified asset purchases for the year exceed $2.5 million (compared to $2.03 million for 2017). These amounts will be adjusted annually for inflation, and for 2019 they’re $1.02 million and $2.55 million, respectively.
This break historically allowed a shortened recovery period of 15 years for property that qualified. Before the TCJA, the break was available for qualified leasehold-improvement, restaurant and retail-improvement property. Again, the TCJA expanded the definition to “qualified improvement property.”
But, due to a drafting error, no recovery period was given to such property, so it defaults to 39-year property. For accelerated depreciation to be available for qualified improvement property, a technical correction must be issued.
This additional first-year depreciation allowance is available for qualified assets, which before the TCJA included qualified improvement property. But due to the drafting error noted above, qualified improvement property will be eligible for bonus depreciation only if a technical correction is issued.
When available, bonus depreciation is increased to 100% (up from 50%) for qualified property placed in service after Sept. 27, 2017, but before Jan. 1, 2023. For 2023 through 2026, bonus depreciation is scheduled to be gradually reduced. Warning: Under the TCJA, real estate businesses that elect to deduct 100% of their business interest will be ineligible for bonus depreciation starting in 2018.
Can you benefit?
Although the enhanced depreciation-related breaks may offer substantial savings on your 2018 tax bill, it’s possible they won’t prove beneficial over the long term. Taking these deductions now means forgoing deductions that could otherwise be taken later, over a period of years under normal depreciation schedules. In some situations — such as if in the future your business could be in a higher tax bracket or tax rates go up — the normal depreciation deductions could be more valuable long-term.
For more information on these breaks or advice on whether you should take advantage of them, please contact us.
A refresher on major tax law changes for small-business owners
The dawning of 2019 means the 2018 income tax filing season will soon be upon us. After year end, it’s generally too late to take action to reduce 2018 taxes. Business owners may, therefore, want to shift their focus to assessing whether they’ll likely owe taxes or get a refund when they file their returns this spring, so they can plan accordingly.
With the biggest tax law changes in decades — under the Tax Cuts and Jobs Act (TCJA) — generally going into effect beginning in 2018, most businesses and their owners will be significantly impacted. So, refreshing yourself on the major changes is a good idea.
Taxation of pass-through entities
These changes generally affect owners of S corporations, partnerships and limited liability companies (LLCs) treated as partnerships, as well as sole proprietors:
Drops of individual income tax rates ranging from 0 to 4 percentage points (depending on the bracket) to 10%, 12%, 22%, 24%, 32%, 35% and 37%
A new 20% qualified business income deduction for eligible owners (the Section 199A deduction)
Changes to many other tax breaks for individuals that will impact owners’ overall tax liability
Taxation of corporations
These changes generally affect C corporations, personal service corporations (PSCs) and LLCs treated as C corporations:
Replacement of graduated corporate rates ranging from 15% to 35% with a flat corporate rate of 21%
Replacement of the flat PSC rate of 35% with a flat rate of 21%
Repeal of the 20% corporate alternative minimum tax (AMT)
Tax break positives
These changes generally apply to both pass-through entities and corporations:
Doubling of bonus depreciation to 100% and expansion of qualified assets to include used assets
Doubling of the Section 179 expensing limit to $1 million and an increase of the expensing phaseout threshold to $2.5 million
A new tax credit for employer-paid family and medical leave
Tax break negatives
These changes generally also apply to both pass-through entities and corporations:
A new disallowance of deductions for net interest expense in excess of 30% of the business’s adjusted taxable income (exceptions apply)
New limits on net operating loss (NOL) deductions
Elimination of the Section 199 deduction (not to be confused with the new Sec.199A deduction), which was for qualified domestic production activities and commonly referred to as the “manufacturers’ deduction”
A new rule limiting like-kind exchanges to real property that is not held primarily for sale (generally no more like-kind exchanges for personal property)
New limitations on deductions for certain employee fringe benefits, such as entertainment and, in certain circumstances, meals and transportation
Preparing for 2018 filing
Keep in mind that additional rules and limits apply to the rates and breaks covered here. Also, these are only some of the most significant and widely applicable TCJA changes; you and your business could be affected by other changes as well. Contact us to learn precisely how you might be affected and for help preparing for your 2018 tax return filing — and beginning to plan for 2019, too.
Consider an intrafamily loan to cover estate taxes
Sometimes estates that are large enough for estate taxes to be a concern are asset rich but cash poor, without the liquidity needed to pay those taxes. An intrafamily loan is one option. While a life insurance policy can be used to cover taxes and other estate expenses, a benefit of using an intrafamily loan is that, if it’s properly structured, the estate can deduct the full amount of interest upfront. Doing so reduces the estate’s size and, thus, its estate tax liability.
Deducting the interest
An estate can deduct interest if it’s a permitted expense under local probate law, actually and necessarily incurred in the administration of the estate, ascertainable with reasonable certainty, and will be paid. Under probate law in most jurisdictions, interest is a permitted expense. And, generally, interest on a loan used to avoid a forced sale or liquidation is considered “actually and necessarily incurred.”
To ensure that interest is “ascertainable with reasonable certainty,” the loan terms shouldn’t allow prepayment and should provide that, in the event of default, all interest for the remainder of the loan’s term will be accelerated. Without these provisions, the IRS or a court would likely conclude that future interest isn’t ascertainable with reasonable certainty and would disallow the upfront deduction. Instead, the estate would deduct interest as it’s accrued and recalculate its estate tax liability in future years.
The requirement that interest “will be paid” generally isn’t an issue, unless there’s some reason to believe that the estate won’t be able to generate sufficient income to cover the interest payments.
Ensuring the loan is bona fide
For the interest to be deductible, the loan also must be bona fide. A loan from a bank or other financial institution shouldn’t have any trouble meeting this standard.
But if the loan is from a related party, such as a family-controlled trust or corporation, the IRS may question whether the transaction is bona fide. So the parties should take steps to demonstrate that the transaction is a true loan.
Among other things, they should:
Set a reasonable interest rate (based on current IRS rates),
Execute a promissory note,
Provide for collateral or other security to ensure the loan is repaid,
Pay the interest payments in a timely manner, and
Otherwise treat the loan as an arm’s-length transaction.
It’s critical that the loan’s terms be reasonable and that the parties be able to demonstrate a “genuine intention to create a debt with a reasonable expectation of repayment.”
If you’re considering making an intrafamily loan, contact us. We’d be pleased to answer any questions you may have.
When holiday gifts and parties are deductible or taxable
The holiday season is a great time for businesses to show their appreciation for employees and customers by giving them gifts or hosting holiday parties. Before you begin shopping or sending out invitations, though, it’s a good idea to find out whether the expense is tax deductible and whether it’s taxable to the recipient. Here’s a brief review of the rules.
Gifts to customers
When you make gifts to customers, the gifts are deductible up to $25 per recipient per year. For purposes of the $25 limit, you need not include “incidental” costs that don’t substantially add to the gift’s value, such as engraving, gift-wrapping, packaging or shipping. Also excluded from the $25 limit is branded marketing collateral — such as pens or stress balls imprinted with your company’s name and logo — provided they’re widely distributed and cost less than $4.
The $25 limit is for gifts to individuals. There’s no set limit on gifts to a company (a gift basket for all to share, for example) as long as they’re “reasonable.”
Gifts to employees
Generally anything of value that you transfer to an employee is included in the employee’s taxable income (and, therefore, subject to income and payroll taxes) and deductible by you. But there’s an exception for noncash gifts that constitute “de minimis fringe benefits.”
These are items so small in value and given so infrequently that it would be administratively impracticable to account for them. Common examples include holiday turkeys or hams, gift baskets, occasional sports or theater tickets (but not season tickets), and other low-cost merchandise.
De minimis fringe benefits are not included in an employee’s taxable income yet are still deductible by you. Unlike gifts to customers, there’s no specific dollar threshold for de minimis gifts. However, many businesses use an informal cutoff of $75.
Keep in mind that cash gifts — as well as cash equivalents, such as gift cards — are included in an employee’s income and subject to payroll tax withholding regardless of how small and infrequent.
The Tax Cuts and Jobs Act reduced certain deductions for business-related meals and eliminated the deduction for business entertainment altogether. There’s an exception, however, for certain recreational activities, including holiday parties.
Holiday parties are fully deductible (and excludible from recipients’ income) provided they’re primarily for the benefit of non-highly-compensated employees and their families. If customers also attend, holiday parties may be partially deductible.
Gifts that give back
If you’re thinking about giving holiday gifts to employees or customers or throwing a holiday party, contact us. With a little tax planning, you may receive a gift of your own from Uncle Sam.
Tenancy-in-common: A versatile estate planning tool
If you hold significant real estate investments, tenancy-in-common (TIC) ownership can be a powerful, versatile estate planning tool. A TIC interest is an undivided fractional interest in property. The property isn’t split into separate parcels. Rather, each TIC owner has the right to use and enjoy the entire property.
TIC in action
An individual TIC can’t sell or lease the underlying property, or take other actions with respect to the property as a whole, without the other owners’ consent. But each owner has the right to sell, mortgage or transfer his or her TIC interest. This includes the right to transfer the interest, either directly or in trust, to his or her heirs or other beneficiaries.
Someone who buys or inherits a TIC interest takes over the original owner’s undivided fractional interest in the property, sharing ownership with the other tenants in common. Each TIC interest holder has a right of “partition.” That is, in the event of a dispute among the co-owners over management of the property, an owner can petition a court to divide the property into separate parcels or to force a sale and divide the proceeds among the co-owners.
TIC and estate planning
Here are a couple of the ways TIC interests can be used to accomplish your estate planning goals:
Distributing your wealth. Dividing real estate among your heirs — your children, for example — can be a challenge. If you transfer real estate to them as joint tenants, their options for dealing with the property individually will be limited. What if one child wants to hold on to the real estate, but the other two want to cash out? Transferring TIC interests can avoid disputes by giving each heir the power to dispose of his or her interest without forcing a sale of the underlying property.
Reducing gift and estate taxes. Fractional interests generally are less marketable than whole interests. Plus, because an owner must share management with several co-owners, fractional interests provide less control. As a result, TIC interests may enjoy valuation discounts for gift and estate tax purposes.
Get an appraisal
If you’re considering using TIC interests in your estate plan, it’s critical to obtain an appraisal to support your valuation of these interests. Keep in mind that appraising a TIC interest is a two-step process. It begins with an appraisal of the real estate as a whole. Then an appraisal of the fractional interests follows. In some cases, it may be desirable to use two appraisers: a real estate appraiser for the underlying property and a business valuation expert to quantify and support any valuation discounts you claim. Contact us with questions.
Now’s the time to review your business expenses
As we approach the end of the year, it’s a good idea to review your business’s expenses for deductibility. At the same time, consider whether your business would benefit from accelerating certain expenses into this year.
Be sure to evaluate the impact of the Tax Cuts and Jobs Act (TCJA), which reduces or eliminates many deductions. In some cases, it may be necessary or desirable to change your expense and reimbursement policies.
What’s deductible, anyway?
There’s no master list of deductible business expenses in the Internal Revenue Code (IRC). Although some deductions are expressly authorized or excluded, most are governed by the general rule of IRC Sec. 162, which permits businesses to deduct their “ordinary and necessary” expenses.
An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your business. (It need not be indispensable.) Even if an expense is ordinary and necessary, it may not be deductible if the IRS considers it lavish or extravagant.
What did the TCJA change?
The TCJA contains many provisions that affect the deductibility of business expenses. Significant changes include these deductions:
Meals and entertainment. The act eliminates most deductions for entertainment expenses, but retains the 50% deduction for business meals. What about business meals provided in connection with nondeductible entertainment? In a recent notice, the IRS clarified that such meals continue to be 50% deductible, provided they’re purchased separately from the entertainment or their cost is separately stated on invoices or receipts.
Transportation. The act eliminates most deductions for qualified transportation fringe benefits, such as parking, vanpooling and transit passes. This change may lead some employers to discontinue these benefits, although others will continue to provide them because 1) they’re a valuable employee benefit (they’re still tax-free to employees) or 2) they’re required by local law.
Employee expenses. The act suspends employee deductions for unreimbursed job expenses — previously treated as miscellaneous itemized deductions — through 2025. Some businesses may want to implement a reimbursement plan for these expenses. So long as the plan meets IRS requirements, reimbursements are deductible by the business and tax-free to employees.
The deductibility of certain expenses, such as employee wages or office supplies, is obvious. In other cases, it may be necessary to consult IRS rulings or court cases for guidance. For assistance, please contact us.
Businesses aren’t immune to tax identity theft
Tax identity theft may seem like a problem only for individual taxpayers. But, according to the IRS, increasingly businesses are also becoming victims. And identity thieves have become more sophisticated, knowing filing practices, the tax code and the best ways to get valuable data.
How it works
In tax identity theft, a taxpayer’s identifying information (such as Social Security number) is used to fraudulently obtain a refund or commit other crimes. Business tax identity theft occurs when a criminal uses the identifying information of a business to obtain tax benefits or to enable individual tax identity theft schemes.
For example, a thief could use an Employer Identification Number (EIN) to file a fraudulent business tax return and claim a refund. Or a fraudster may report income and withholding for fake employees on false W-2 forms. Then, he or she can file fraudulent individual tax returns for these “employees” to claim refunds.
The consequences can include significant dollar amounts, lost time sorting out the mess and damage to your reputation.
There are some red flags that indicate possible tax identity theft. For example, your business’s identity may have been compromised if:
Your business doesn’t receive expected or routine mailings from the IRS,
You receive an IRS notice that doesn’t relate to anything your business submitted, that’s about fictitious employees or that’s related to a defunct, closed or dormant business after all account balances have been paid,
The IRS rejects an e-filed return or an extension-to-file request, saying it already has a return with that identification number — or the IRS accepts it as an amended return,
You receive an IRS letter stating that more than one tax return has been filed in your business’s name, or
You receive a notice from the IRS that you have a balance due when you haven’t yet filed a return.
Keep in mind, though, that some of these could be the result of a simple error, such as an inadvertent transposition of numbers. Nevertheless, you should contact the IRS immediately if you receive any notices or letters from the agency that you believe might indicate that someone has fraudulently used your Employer Identification Number.
Businesses should take steps such as the following to protect their own information as well as that of their employees:
Provide training to accounting, human resources and other employees to educate them on the latest tax fraud schemes and how to spot phishing emails.
Use secure methods to send W-2 forms to employees.
Implement risk management strategies designed to flag suspicious communications.
Of course identity theft can go beyond tax identity theft, so be sure to have a comprehensive plan in place to protect the data of your business, your employees and your customers. If you’re concerned your business has become a victim, or you have questions about prevention, please contact us.
Selling your business? Defer — and possibly reduce — tax with an installment sale
You’ve spent years building your company and now are ready to move on to something else, whether launching a new business, taking advantage of another career opportunity or retiring. Whatever your plans, you want to get the return from your business that you’ve earned from all of the time and money you’ve put into it.
That means not only getting a good price, but also minimizing the tax hit on the proceeds. One option that can help you defer tax and perhaps even reduce it is an installment sale.
With an installment sale, you don’t receive a lump sum payment when the deal closes. Instead, you receive installment payments over a period of time, spreading the gain over a number of years.
This generally defers tax, because you pay most of the tax liability as you receive the payments. Usually tax deferral is beneficial, but it could be especially beneficial if it would allow you to stay under the thresholds for triggering the 3.8% net investment income tax (NIIT) or the 20% long-term capital gains rate.
For 2018, taxpayers with modified adjusted gross income (MAGI) over $200,000 per year ($250,000 for married filing jointly and $125,000 for married filing separately) will owe NIIT on some or all of their investment income. And the 20% long-term capital gains rate kicks in when 2018 taxable income exceeds $425,800 for singles, $452,400 for heads of households and $479,000 for joint filers (half that for separate filers).
An installment sale also might help you close a deal or get a better price for your business. For instance, an installment sale might appeal to a buyer that lacks sufficient cash to pay the price you’re looking for in a lump sum.
Or a buyer might be concerned about the ongoing success of your business without you at the helm or because of changing market or other economic factors. An installment sale that includes a contingent amount based on the business’s performance might be the solution.
An installment sale isn’t without tax risk for sellers. For example, depreciation recapture must be reported as gain in the year of sale, no matter how much cash you receive. So you could owe tax that year without receiving enough cash proceeds from the sale to pay the tax. If depreciation recapture is an issue, be sure you have cash from another source to pay the tax.
It’s also important to keep in mind that, if tax rates increase, the overall tax could end up being more. With tax rates currently quite low historically, there might be a greater chance that they could rise in the future. Weigh this risk carefully against the potential benefits of an installment sale.
Pluses and minuses
As you can see, installment sales have both pluses and minuses. To determine whether one is right for you and your business — and find out about other tax-smart options — please contact us.
3 reasons you should continue making lifetime gifts
Now that the gift and estate tax exemption has reached a record high of $11.18 million (for 2018), it may seem that gifting assets to loved ones is less important than it was in previous years. However, lifetime gifts continue to provide significant benefits, whether your estate is taxable or not.
Let’s examine three reasons why making gifts remains an important part of estate planning:
1. Lifetime gifts reduce estate taxes. If your estate exceeds the exemption amount — or you believe it will in the future — regular lifetime gifts can substantially reduce your estate tax bill.
The annual gift tax exclusion allows you to give up to $15,000 per recipient ($30,000 if you “split” gifts with your spouse) tax-free without using up any of your gift and estate tax exemption. In addition, direct payments of tuition or medical expenses on behalf of your loved ones are excluded from gift tax.
Taxable gifts — that is, gifts beyond the annual exclusion amount and not eligible for the tuition and medical expense exclusion — can also reduce estate tax liability by removing future appreciation from your taxable estate. You may be better off paying gift tax on an asset’s current value rather than estate tax on its appreciated value down the road.
When gifting appreciable assets, however, be sure to consider the potential income tax implications. Property transferred at death receives a “stepped-up basis” equal to its date-of-death fair market value, which means the recipient can turn around and sell the property free of capital gains taxes. Property transferred during life retains your tax basis, so it’s important to weigh the estate tax savings against the potential income tax costs.
2. Tax laws aren’t permanent. Even if your estate is within the exemption amount now, it pays to make regular gifts. Why? Because even though the Tax Cuts and Jobs Act doubled the exemption amount, and that amount will be adjusted annually for inflation, the doubling expires after 2025. Without further legislation, the exemption will return to an inflation-adjusted $5 million in 2026.
Thus, taxpayers with estates in roughly the $6 million to $11 million range (twice that for married couples), whose estates would escape estate taxes if they were to die while the doubled exemption is in effect, still need to keep potential post-2025 estate tax liability in mind in their estate planning.
3. Gifts provide nontax benefits. Tax planning aside, there are other reasons to make lifetime gifts. For example, perhaps you wish to use gifting to shape your family members’ behavior — for example, by providing gifts to those who attend college. And if you own a business, gifts of interests in the business may be a key component of your ownership and management succession plan. Or you might simply wish to see your loved ones enjoy the gifts.
Regardless of the amount of your wealth, consider a program of regular lifetime giving. We can help you devise and incorporate a gifting program as part of your estate plan.
Choosing the right accounting method for tax purposes
The Tax Cuts and Jobs Act (TCJA) liberalized the eligibility rules for using the cash method of accounting, making this method — which is simpler than the accrual method — available to more businesses. Now the IRS has provided procedures a small business taxpayer can use to obtain automatic consent to change its method of accounting under the TCJA. If you have the option to use either accounting method, it pays to consider whether switching methods would be beneficial.
Cash vs. accrual
Generally, cash-basis businesses recognize income when it’s received and deduct expenses when they’re paid. Accrual-basis businesses, on the other hand, recognize income when it’s earned and deduct expenses when they’re incurred, without regard to the timing of cash receipts or payments.
In most cases, a business is permitted to use the cash method of accounting for tax purposes unless it’s:
- Expressly prohibited from using the cash method, or
- Expressly required to use the accrual method.
Cash method advantages
The cash method offers several advantages, including:
Simplicity. It’s easier and cheaper to implement and maintain.
Tax-planning flexibility. It offers greater flexibility to control the timing of income and deductible expenses. For example, it allows you to defer income to next year by delaying invoices or to shift deductions into this year by accelerating the payment of expenses. An accrual-basis business doesn’t enjoy this flexibility. For example, to defer income, delaying invoices wouldn’t be enough; the business would have to put off shipping products or performing services.
Cash flow benefits. Because income is taxed in the year it’s received, the cash method does a better job of ensuring that a business has the funds it needs to pay its tax bill.
Accrual method advantages
In some cases, the accrual method may offer tax advantages. For example, accrual-basis businesses may be able to use certain tax-planning strategies that aren’t available to cash-basis businesses, such as deducting year-end bonuses that are paid within the first 2½ months of the following year and deferring income on certain advance payments.
The accrual method also does a better job of matching income and expenses, so it provides a more accurate picture of a business’s financial performance. That’s why it’s required under Generally Accepted Accounting Principles (GAAP).
If your business prepares GAAP-compliant financial statements, you can still use the cash method for tax purposes. But weigh the cost of maintaining two sets of books against the potential tax benefits.
Making a change
Keep in mind that cash and accrual are the two primary tax accounting methods, but they’re not the only ones. Some businesses may qualify for a different method, such as a hybrid of the cash and accrual methods.
If your business is eligible for more than one method, we can help you determine whether switching methods would make sense and can execute the change for you if appropriate.
Close-up on the new QBI deduction’s wage limit
The Tax Cuts and Jobs Act (TCJA) provides a valuable new tax break to noncorporate owners of pass-through entities: a deduction for a portion of qualified business income (QBI). The deduction generally applies to income from sole proprietorships, partnerships, S corporations and, typically, limited liability companies (LLCs). It can equal as much as 20% of QBI. But once taxable income exceeds $315,000 for married couples filing jointly or $157,500 for other filers, a wage limit begins to phase in.
Full vs. partial phase-in
When the wage limit is fully phased in, at $415,000 for joint filers and $207,500 for other filers, the QBI deduction generally can’t exceed the greater of the owner’s share of:
- 50% of the amount of W-2 wages paid to employees during the tax year, or
- The sum of 25% of W-2 wages plus 2.5% of the cost of qualified business property (QBP).
When the wage limit applies but isn’t yet fully phased in, the amount of the limit is reduced and the final deduction is calculated as follows:
- The difference between taxable income and the applicable threshold is divided by $100,000 for joint filers or $50,000 for other filers.
- The resulting percentage is multiplied by the difference between the gross deduction and the fully wage-limited deduction.
- The result is subtracted from the gross deduction to determine the final deduction.
Let’s say Chris and Leslie have taxable income of $600,000. This includes $300,000 of QBI from Chris’s pass-through business, which pays $100,000 in wages and has $200,000 of QBP. The gross deduction would be $60,000 (20% of $300,000), but the wage limit applies in full because the married couple’s taxable income exceeds the $415,000 top of the phase-in range for joint filers. Computing the deduction is fairly straightforward in this situation.
The first option for the wage limit calculation is $50,000 (50% of $100,000). The second option is $30,000 (25% of $100,000 + 2.5% of $200,000). So the wage limit — and the deduction — is $50,000.
What if Chris and Leslie’s taxable income falls within the phase-in range? The calculation is a bit more complicated. Let’s say their taxable income is $400,000. The full wage limit is still $50,000, but only 85% of the full limit applies:
($400,000 taxable income - $315,000 threshold)/$100,000 = 85%
To calculate the amount of their deduction, the couple must first calculate 85% of the difference between the gross deduction of $60,000 and the fully wage-limited deduction of $50,000:
($60,000 - $50,000) × 85% = $8,500
That amount is subtracted from the $60,000 gross deduction for a final deduction of $51,500.
That’s not all
Be aware that another restriction may apply: For income from “specified service businesses,” the QBI deduction is reduced if an owner’s taxable income falls within the applicable income range and eliminated if income exceeds it. Please contact us to learn whether your business is a specified service business or if you have other questions about the QBI deduction.
Does your business have to begin collecting sales tax on all out-of-state online sales?
You’ve probably heard about the recent U.S. Supreme Court decision allowing state and local governments to impose sales taxes on more out-of-state online sales. The ruling in South Dakota v. Wayfair, Inc. is welcome news for brick-and-mortar retailers, who felt previous rulings gave an unfair advantage to their online competitors. And state and local governments are pleased to potentially be able to collect more sales tax.
But for businesses with out-of-state online sales that haven’t had to collect sales tax from out-of-state customers in the past, the decision brings many questions and concerns.
What the requirements used to be
Even before Wayfair, a state could require an out-of-state business to collect sales tax from its residents on online sales if the business had a “substantial nexus” — or connection — with the state. The nexus requirement is part of the Commerce Clause of the U.S. Constitution.
Previous Supreme Court rulings had found that a physical presence in a state (such as retail outlets, employees or property) was necessary to establish substantial nexus. As a result, some online retailers have already been collecting tax from out-of-state customers, while others have not had to.
What has changed
In Wayfair, South Dakota had enacted a law requiring out-of-state retailers that made at least 200 sales or sales totaling at least $100,000 in the state to collect and remit sales tax. The Supreme Court found that the physical presence rule is “unsound and incorrect,” and that the South Dakota tax satisfies the substantial nexus requirement.
The Court said that the physical presence rule puts businesses with a physical presence at a competitive disadvantage compared with remote sellers that needn’t charge customers for taxes.
In addition, the Court found that the physical presence rule treats sellers differently for arbitrary reasons. A business with a few items of inventory in a small warehouse in a state is subject to sales tax on all of its sales in the state, while a business with a pervasive online presence but no physical presence isn’t subject to the same tax for the sales of the same items.
What the decision means
Wayfair doesn’t necessarily mean that you must immediately begin collecting sales tax on online sales to all of your out-of-state customers. You’ll be required to collect such taxes only if the particular state requires it. Some states already have laws on the books similar to South Dakota’s, but many states will need to revise or enact legislation.
Also keep in mind that the substantial nexus requirement isn’t the only principle in the Commerce Clause doctrine that can invalidate a state tax. The others weren’t argued in Wayfair, but the Court observed that South Dakota’s tax system included several features that seem designed to prevent discrimination against or undue burdens on interstate commerce, such as a prohibition against retroactive application and a safe harbor for taxpayers who do only limited business in the state.
Please contact us with any questions you have about sales tax collection requirements.
The TCJA changes some rules for deducting pass-through business losses
It’s not uncommon for businesses to sometimes generate tax losses. But the losses that can be deducted are limited by tax law in some situations. The Tax Cuts and Jobs Act (TCJA) further restricts the amount of losses that sole proprietors, partners, S corporation shareholders and, typically, limited liability company (LLC) members can currently deduct — beginning in 2018. This could negatively impact owners of start-ups and businesses facing adverse conditions.
Before the TCJA
Under pre-TCJA law, an individual taxpayer’s business losses could usually be fully deducted in the tax year when they arose unless:
- The passive activity loss (PAL) rules or some other provision of tax law limited that favorable outcome, or
- The business loss was so large that it exceeded taxable income from other sources, creating a net operating loss (NOL).
After the TCJA
The TCJA temporarily changes the rules for deducting an individual taxpayer’s business losses. If your pass-through business generates a tax loss for a tax year beginning in 2018 through 2025, you can’t deduct an “excess business loss” in the current year. An excess business loss is the excess of your aggregate business deductions for the tax year over the sum of:
- Your aggregate business income and gains for the tax year, and
- $250,000 ($500,000 if you’re a married taxpayer filing jointly).
The excess business loss is carried over to the following tax year and can be deducted under the rules for NOLs.
For business losses passed through to individuals from S corporations, partnerships and LLCs treated as partnerships for tax purposes, the new excess business loss limitation rules apply at the owner level. In other words, each owner’s allocable share of business income, gain, deduction or loss is passed through to the owner and reported on the owner’s personal federal income tax return for the owner’s tax year that includes the end of the entity’s tax year.
Keep in mind that the new loss limitation rules apply after applying the PAL rules. So, if the PAL rules disallow your business or rental activity loss, you don’t get to the new loss limitation rules.
Expecting a business loss?
The rationale underlying the new loss limitation rules is to restrict the ability of individual taxpayers to use current-year business losses to offset income from other sources, such as salary, self-employment income, interest, dividends and capital gains.
The practical impact is that your allowable current-year business losses can’t offset more than $250,000 of income from such other sources (or more than $500,000 for joint filers). The requirement that excess business losses be carried forward as an NOL forces you to wait at least one year to get any tax benefit from those excess losses.
If you’re expecting your business to generate a tax loss in 2018, contact us to determine whether you’ll be affected by the new loss limitation rules. We can also provide more information about the PAL and NOL rules.