Wonder What a Tax Deduction Is Worth?

Individuals are always looking for tax deductions that can reduce their tax liability. But what is the actual tax benefit derived from a tax deduction? There is no straightforward answer because some deductions are above the line, others must be itemized, some must exceed a threshold amount before being deductible, and certain ones are not deductible for alternative minimum tax purposes, while business deductions can offset both income and self-employment tax. In other words, there are many factors to consider, and the tax benefits differ for each individual, depending on his or her particular situation and tax bracket.

For most non-business deductions, the savings are based upon your tax bracket. For example, if you are in the 12% tax bracket, a $1,000 deduction would save you $120 in taxes. On the other hand, if you are in the 32% tax bracket, the $1,000 deduction will save you $320 in taxes. Even so, if your taxable income is close to transitioning into the next-lower tax bracket, the benefit will be lower. You also need to consider whether the particular deduction is allowed on your state return and what your state tax bracket is to determine the total tax savings. Currently, the maximum federal tax bracket is 37%, meaning the most benefit that can be derived from a $1,000 income tax deduction is $370. Some individuals justify making discretionary purchases just because they are tax-deductible. Even in the highest tax bracket, you are still paying $630 out of pocket ($1,000 − $370), so it does not make sense to incur a tax-deductible expense just for the tax deduction.

Some deductions, such as IRA and self-employed retirement plan contributions, alimony, and student loan interest, are adjustments to income or what we call above-the-line deductions. These deductions, to the extent permitted by law, provide a dollar deduction for every dollar claimed. Deductions that fall into the itemized category must exceed the standard deduction for your filing status before any benefit can be derived. In addition, medical deductions are reduced by 7.5% of your adjusted gross income (AGI) in 2018, and most cash charitable deductions are limited to a maximum of 60% of your AGI. Under the tax reform, the deduction for state and local taxes has been capped at $10,000.

The most beneficial deductions are business deductions that offset both income tax and, depending upon the circumstances, self-employment tax. For 2018, the self-employment tax rate is 12.4% of the first $128,400 of net self-employment income plus 2.9% for the Medicare tax, with no cap. Some high-income taxpayers may pay an additional 0.9% Medicare tax. For self-employed businesses with less than $128,400 of net income, the self-employment tax rate is 15.3%. Thus, for small businesses with profits of less than $128,400, the benefit derived from deductions generally will include the taxpayer’s tax bracket plus 15.3%. For example, for a taxpayer in the 24% tax bracket, the benefit could be as much as 39.3% (24% + 15.3%) of the deduction. If the deduction were $2,000, the tax savings could be as much as $806 or more, when the taxpayer’s state income tax bracket is included.

If you are planning an expenditure and expect the tax deduction to help cover the cost, please consult with us in advance to ensure that the tax benefit will be what you anticipate.

Expecting Your Taxable Income to Be Low This Year? Take Advantage of It

If your taxable income is exceptionally low this year, or even if you expect not to be required to file a tax return this year, a number of tax opportunities may be available to you. But time is running short, since these opportunities will require action on your part before year’s end.

However, before we consider actual strategies, let’s look at key elements that govern tax rates and taxable income.

Adjusted Gross Income (AGI) – This is the sum of all of your income that’s subject to tax, such as wages, interest, dividends, gains from sales, net self-employment income, retirement income, minus items that are specifically deductible without having to itemize your deductions, including contributions to traditional IRAs and self-employed retirement plans, interest paid on student loans, contributions to health savings plans, and a limited number of others.

Taxable Income – To be simplistic, taxable income is your AGI less the greater of the standard deduction for your filing status or your itemized deductions:

AGI
XXXX
Deductions – XXXX
Taxable Income
XXXX

If the deductions exceed your AGI, then you can end up with a negative taxable income, which means that to the extent it is negative, you can actually add income or reduce your deductions without incurring any tax.

Graduated Individual Tax Rates – Ordinary individual tax rates are graduated. So as your taxable income increases, so does your tax rate. Thus, the lower your taxable income, the lower your tax rate will be. Your income tax is the result of multiplying your tax rate by your taxable income (but to simplify the computation for those with taxable income up to $100,000, the IRS figures the tax by income range and provides look-up tables, so for most taxpayers, their tax rate is not apparent). Individual ordinary tax rates range from 10% to as high as 37%. For 2018, the taxable income amounts for the three lowest tax rates – 10%, 12%, and 22% – are:

Filing Status
Single
Married Filing Jointly
Head of Household
Married Filing Separate
10%
$0–9,525
$0–19,050
$0–13,600
$0–9,525
12%
$9,526–38,700
$19,051–77,400
$13,601–51,800
$9,526–38,700
22%
$38,701–82,500
$77,401–165,000
$51,801–82,500
$38,701–82,500

So for instance, if you are single, your first $9,525 of taxable income is taxed at 10%. The next $29,174 ($9,526 to $38,700) is taxed at 12%, and the next $43,799 ($38,701 to $82,500) is taxed at 22%.

Here are some strategies you can employ for your tax benefit. However, these strategies may be interdependent on one another and your particular tax circumstances.

Take IRA Distributions – Depending upon your projected taxable income, you might consider taking an IRA distribution to add income for the year. For instance, if your projected taxable income is negative, then you can actually take a withdrawal of up to the negative amount without incurring any tax. Even if your projected taxable income is not negative and your normal taxable income would put you in the 22% or higher bracket, you might want to take out just enough to be taxed at the 10% or even the 12% tax rate. Of course, those are retirement dollars; consider moving them into a regular financial account set aside for your retirement. Also, be aware that distributions before age 59½ are subject to a 10% early-withdrawal penalty even if there is no tax liability, so this strategy isn’t recommended for those younger than 59½.

Redeem Government Bonds – If you have invested in U.S. government bonds, such as Series EE or I bonds, and you’ve been deferring paying tax on the interest from these bonds until they mature, you may want to cash in the bonds prior to the year when they mature, if that maturity date is within the next few years and to the extent that adding the bond interest to your other income for the year won’t push you out of the zero or 10% tax bracket and into a higher bracket. This strategy isn’t advisable if the interest you would earn on the bonds if you held them to maturity would be more than the tax you can save by cashing in the bonds during a low-income year.

Defer Deductions – When you itemize your deductions, you may claim only the deductions you actually pay during the tax year (the calendar year, for most folks). If your projected taxable income will be negative and you are planning on itemizing your deductions, you might consider putting off some of those year-end deductible payments until after the first of the year and preserving the deductions for next year. Such payments might include house of worship tithing, year-end charitable giving, tax payments (but not those incurring late payment penalties), estimated state income tax payments, and medical expenses.

Convert Traditional IRA Funds into a Roth IRA – Roth IRAs provide tax-free accumulation and tax-free retirement distributions. So to the extent of any negative taxable income or even just for the lower tax rates, you may wish to consider converting some or all of your traditional IRA into a Roth IRA. The lower income results in a lower tax rate, which will provide you with an opportunity to convert to a Roth IRA at a lower tax amount.

Zero Capital Gains Rate – There are three capital gains rates depending upon your taxable income. When your taxable income is in the lowest range, as shown in the table below, you will actually pay no tax on your long-term capital gains. Thus, if your taxable income is within the zero percent long-term capital gains rate bracket, this is an opportunity for you to sell some appreciated securities that you have owned for more than a year and pay no tax on the gains.

Long-Term Capital Gains Rates (2018)
Filing Status
0%
15%
20%
Single
$0–38,600
$38,601–425,800
$425,801 & Above
Head of Household
$0–51,700
$51,701–452,400
$452,401 & Above
Married Joint
$0–77,200
$77,201–479,000
$479,001 & Above
Married Separate
$0–38,600
$38,601–239,500
$239,501 & Above

Business Expenses – The tax code has some very liberal provisions that allow a business to currently expense, rather than capitalize and slowly depreciate, the purchase costs of certain property. In a low-income year, it may be appropriate to capitalize rather than expense these current-year purchases and preserve the depreciation deduction for higher-income years. This is especially true when taxable income is negative in the current year.

Affordable Care Act – On the negative side, if you have obtained your medical insurance through a government marketplace, employing any of the strategies mentioned above will increase your taxable income and could impact the amount of your allowable premium tax credit. As a result, you would likely have to repay some or all of any advance premium tax credit that was used to reduce your health insurance premiums; the credit is reconciled on your tax return.

If you would like to discuss how these strategies might provide you with tax benefits based upon your particular tax circumstances or would like to schedule a tax-planning appointment, please give us a call.

Legitimate Tax-Deductible Charity or Scam?

With the holiday season approaching, and with the great need for aid in the wake of the recent hurricanes and wildfires, you no doubt are being solicited for donations. However, do not be fooled by the scammers who come out from hiding whenever there is a disaster and during the holiday season. The last thing you want to do is get ripped off; not only will your charitable dollars go to waste, but you will also lose your tax deduction, as contributions are only tax-deductible if they are to qualified charities.

Soon, your physical and electronic mailboxes – not to mention your voicemail box – will be filled with charitable solicitations. Before you break out your checkbook, however, be sure to do your homework, especially if you are contemplating a donation to an organization that you are not already familiar with. The Federal Trade Commission suggests avoiding any charity or fundraiser that:

  • refuses to provide detailed information about its identity, mission, and costs, as well as how your donation will be used;
  • will not provide proof that your contribution would be tax-deductible;
  • uses a name that closely resembles that of a better-known (more reputable) organization;
  • thanks you for a pledge that you do not remember making;
  • uses high-pressure tactics to get you to donate immediately;
  • asks for donations in cash or asks you to wire money; or
  • offers to send a courier or overnight delivery service to collect a donation immediately.

Numerous websites can help you to check the validity of a charity. The IRS provides one, but it is rather cumbersome to use. Charity Navigator allows you to search for a charity name and provides details about that charity’s function. When in doubt, take the time to verify a charity’s legitimacy.

If you plan to itemize your deductions – after you have determined that you are not contributing to a scam operation – ensure that your charitable donations meet the requirements for being tax-deductible. The recipient organization must be one or more of the following:

  • a church, synagogue, mosque, or other place of worship;
  • a tax-exempt educational institution or hospital;
  • a federal, state, or local governmental unit, if the contribution is used for public purposes;
  • a publicly supported corporation, trust, fund, foundation, or community chest that is organized and operated only for charitable, religious, educational, scientific, or literary purposes; to prevent cruelty to children or animals; or to foster certain national or international amateur sports competitions; or
  • a certain type of private operating foundation or agricultural research organization.

Substantiation – First and foremost, you must receive substantiation of your cash gift in order to deduct it on your tax return; you also must itemize your deductions rather than use the standard deduction. Cash contributions include those paid by cash, check, electronic fund transfer, and credit card. However, you cannot deduct a cash contribution, regardless of the amount, unless you can document the contribution in one of the following ways:

  1. A bank record that shows the qualified organization’s name, as well as the date and amount of the contribution. Eligible bank records include a. a canceled check, b. a bank or credit union statement, or c. a credit card statement.
  2. A receipt (or a letter or other written communication) from the qualified organization showing the organization’s name, as well as the date and amount of the contribution.

Cash contributions of $250 or more – To claim a deduction for a contribution of $250 or more, you must provide a written acknowledgment of the contribution from the qualified organization. This acknowledgment must include the following details:

  1. The amount of cash contributed
  2. Whether the qualified organization gave the taxpayer goods or services (other than certain token items and membership benefits) as a result of the contribution, including a description and good-faith estimate of the value of those goods or services (not counting intangible religious benefits)
  3. A statement that you received no benefit (other than an intangible religious benefit)

The value of any goods or services received in exchange for a donation must be subtracted from the amount claimed as a contribution. If the acknowledgment does not show the date of the contribution, then you must also supply one of the bank records described above to verify the contribution date. If this acknowledgement includes the contribution date and meets the other requirements, it is not necessary to provide other records.

The acknowledgment must be in your hands before the date you file your tax return but not later than the April due date for return (or the extended due date of October if you filed an extension).

Christmas Kettles – It is quite common for charitable organizations to collect cash donations at malls during the holiday shopping season. Consider writing a check to place in these kettles rather than using cash so that you will have the substantiation required for a tax-deductible contribution.

Needy Individuals – You may wish to help out a needy family; although that is a very kind thing to do, no charitable deduction is allowed for such gifts to private individuals (either directly or as through a charitable organization).

GoFundMe – Through this website (and others like it), people raise funds for good causes such as starting a business, paying medical bills or funeral costs, replacing damaged or destroyed homes. However, these websites are not qualified charities for the purposes of claiming a charitable contribution on your tax return.

Special Contribution Rule for Taxpayers Age 70½ and Over – The tax code includes a special provision that allows taxpayers who are at least 70½ years old to directly transfer up to $100,000 from an IRA account to a qualified charity. Instead of receiving a charitable deduction, that person instead gets the benefit of the IRA distribution being nontaxable and counting toward the required minimum distribution for the year. This is especially beneficial for people who receive Social Security benefits and those who take the standard deduction. Although this is generally considered a good tax-saving strategy for those who can afford to make large donations, there is actually no minimum for this rule, so it will likely even benefit individuals in lower tax brackets.

Bunching – When taxpayers’ itemized deductions are only marginally different from the standard deduction, they can consider the method known as bunching. In this technique, the taxpayer make two years’ worth of donations in a single year and then skips making donations in the next year. For example, if you annually contribute $5,000 to a house of worship but have total itemized deductions that are consistently a few hundred dollars less than the standard deduction, you can instead double up by donating $10,000 in a single year. That way, you will be able to claim itemized deductions for the year when you make the donation and can then take the standard deduction in the following year.

For large donations, there are limitations based on adjusted gross income, and there are other available techniques, such as donor-advised funds. This article also did not covered donations of noncash items, such as used furniture or household goods; these have additional substantiation requirements. Please call us if you have questions, or if you would like to set up an appointment to strategize about maximizing the tax benefits of your charitable contributions.

Rejoice — Business Meals Are Still Deductible

f you are a business owner who is accustomed to treating clients to sporting events, golf getaways, concerts and the like, you were no doubt saddened by part of the tax reform that passed last December. A part of the tax reform did away with the business-related deductions for entertainment, amusement or recreation expenses, beginning in 2018. You can still entertain your clients; you just can’t deduct the costs of doing so as a business expense.

While the ban on deducting business entertainment was quite clear in the revised law, a lingering question among tax experts has been whether the tax reform’s definition of entertainment also applied to business meals, such as when you take a customer or business contact to lunch. Some were saying yes, and others no. Either way, both sides recommended keeping the required receipts and documentation until the issue was clarified.

The IRS recently issued some very business-friendly guidance, pending the release of more detailed regulations. In a notice, the IRS has announced that taxpayers generally may continue to deduct 50 percent of the food and beverage expenses associated with operating their trade or business, including business meals, provided:

  1. The expense is an ordinary and necessary expense paid or incurred during the taxable year in carrying out any trade or business;
  2. The expense is not lavish or extravagant under the circumstances;
  3. The taxpayer, or an employee of the taxpayer, is present at the furnishing of the food or beverages;
  4. The food and beverages are provided to a current or potential business customer, client, consultant or similar business contact; and
  5. Food and beverages provided during or at an entertainment activity are purchased separately from the entertainment, or the cost of the food and beverages is stated separately from the cost of the entertainment on one or more bills, invoices or receipts.

The IRS notice also included the following interesting examples related to #5: The taxpayer invites a business contact to a baseball game. The tickets to the game are entertainment and not deductible. However, the taxpayer also purchased hot dogs and a beverage for himself and the business contact. Because the food and drinks were purchased separately, they are not disallowed as entertainment and are deductible if they otherwise qualify as an ordinary and necessary business expense. Had the ticket price included the hot dogs and beverages, they would be treated as non-deductible entertainment. If the ticket price separately stated the ticket price and the food and beverage price, then the food and beverage portion would not be disallowed as entertainment.

Of course, the substantiation requirements still apply. You must be able to establish the amount spent, the time and place, the business purpose and the business relationship and names of the individuals involved. You should keep a diary, an account book, digital files or similar records with this information and record the details within a short time of incurring the expenses. If the meal expense is $75 or more, documentary proof (receipts, etc.) is also required.

If you are an employee, starting in tax year 2018, you will not be able to deduct your unreimbursed employee business expenses, including the cost of client meals. These expenses have been deductible as miscellaneous itemized deductions when you itemized deductions and when your total deductions in that category exceeded 2% of your adjusted gross income. Under the tax reform, this category of deductions is not deductible for years 2018 through 2025. So, unfortunately, the IRS’s expansive definition of meal expenses will not benefit you.

If you have questions related to business meals, substantiation, or the ban on entertainment expenses, please give us a call.

States Sue U.S. to Void $10,000 Cap on State and Local Tax Deduction

Four states – New York, Connecticut, Maryland and New Jersey – have sued the federal government to void the tax-reform cap on the federal itemized deduction for state and local taxes, contending that limiting the deduction is unconstitutional. The taxes at issue include state and local income taxes, real property (real estate) taxes and personal property taxes.

These states – all Democratic (blue states), with some of the highest state and local tax rates in the nation – saw this deduction limitation as political retribution from the Republican-controlled Congress and have passed state legislation attempting to circumvent the tax reform provision limiting the federal itemized deduction for state and local taxes (SALT) to $10,000.

Both NY and NJ have created charitable funds that their state constituents can contribute to and allows them to receive a credit against their state and local taxes. NY’s legislation allows 85% of the amount contributed to the fund as a credit against taxes, while NJ allows 90%. The Connecticut law allows municipalities to create charitable organizations that taxpayers can contribute to in support of town services, from which they then receive a corresponding credit on their local property taxes. Each of these measures essentially circumvents the $10,000 limitation on SALT deductions.

However, two big questions are whether a donation for which a donor receives personal benefit is really a deductible charitable contribution and whether the state legislatures really thought this through. These work-arounds overlook one of the long-standing definitions of a deductible charitable contribution: the donor cannot receive any personal benefit from the donation.

Recently, the IRS waded into the issue with Notice 2018-54 and an accompanying news release, informing taxpayers that it intends to propose regulations addressing the federal income tax treatment of certain payments made by taxpayers to state-established “charitable funds,” for which the contributors receive a credit against their state and local taxes – essentially, the work-arounds adopted or proposed by the states noted above and others. In general, the IRS indicated that the characterization of these payments would be determined under the Code, informed by substance-over-form principles and not the label assigned by the state.

The proposed regulations will:

  1. “Make clear” that the requirements of the Code, informed by substance-over-form principles (see below), govern the federal income tax treatment of such transfers; and
  2. Assist taxpayers in “understanding the relationship between the federal charitable contribution deduction and the new statutory limitation” on the SALT deduction.

Substance over form is a judicial doctrine in which a court looks to the objective economic realities of a transaction, rather than to the particular form the parties employed. In essence, the formalisms of a transaction are disregarded, and the substance is examined to determine its true nature.

The implication of the IRS’s reference to the substance-over-form doctrine is likely that the formal mechanisms for implementing the state work-arounds – e.g., charitable contributions to “charitable gifts trust funds” – will not dictate their tax treatment. That is to say, the IRS will not recognize a charitable contribution deduction that is a disguised SALT deduction.

While the notice only mentions work-arounds involving transfers to state-controlled funds, another type of work-around has been enacted, and others have been proposed. In addition to the “charitable gifts trust funds” described above, New York also created a new “employer compensation expense tax” that essentially converts employee income taxes into employer payroll taxes. The IRS stated in Information Release 2018-122 that it is “continuing to monitor other legislative proposals” to “ensure that federal law controls the characterization of deductions for federal income tax filings.”

Allowing these work-arounds to stand would open Pandora’s Box to other schemes to circumvent the charitable contribution rules. For example, a church could take donations and then give the parishioner credit for the parishioner’s children’s tuition at the church’s school – something that is not currently allowed.

Have these states set their citizens up for IRS troubles if they utilize these work-arounds? Are these states now concerned that their work-arounds might not pass muster and will be ruled invalid after several years in the courts, so they are now pre-emptively suing the federal government?

Taxpayers in states with work-arounds should carefully consider all potential ramifications when deciding whether to get involved with something that could drag through the courts for years, with potential interest and penalties on taxes owed if (more likely, when) the IRS prevails. If you have any questions, please do not hesitate to contact us.

Big Changes for Vehicle Tax Deductions

In the past, the business use of a vehicle was determined either by using the standard mileage rate for business or using actual expenses plus vehicle depreciation limited by the luxury auto caps. That continues to be the case, except the luxury auto depreciation limit has been substantially increased. In addition, there are other changes as detailed in this article.

Standard Mileage Rates – The standard mileage rates for the business use of a car (or a van, pickup, or panel truck) are:

STANDARD MILEAGE RATES FOR BUSINESS
2017
2018
53.5 Cents Per Mile
54.5 Cents Per Mile

However, the standard mileage rates cannot be used if you have used the actual expense method (using Sec. 179, bonus depreciation and/or MACRS depreciation) in previous years. This rule is applied on a vehicle-by-vehicle basis. In addition, the business standard mileage rate cannot be used for any vehicle used for hire or for more than four vehicles simultaneously.

Actual Expense Method – Taxpayers always have the option of calculating the actual costs of using their vehicle for business rather than using the standard mileage rates. In addition to the potential for higher fuel prices, the extension and expansion of the bonus depreciation, as well as increased depreciation limitations for passenger autos in the Tax Cuts and Jobs Act, may make using the actual expense method worthwhile during the first year a vehicle is placed in business service. Actual expenses include:

  • Gasoline
  • Oil
  • Lubrication
  • Repairs
  • Vehicle registration fees
  • Insurance
  • Depreciation (or lease payments).

However, these expenses must be allocated between deductible business use and nondeductible personal use, making it necessary to keep records of business miles and total miles in order to document the allocation between business and personal use.

Vehicle Depreciation – The so-called “luxury auto” rules limit the annual deduction for depreciation. Tax reform substantially increased these limits providing much larger first and second-year deductions for more expensive vehicles. The table below displays the limits that apply to vehicles placed in service in 2017 and 2018 and shows the substantial increase for 2018. These rates are inflation adjusted in subsequent years.

Tax reform also included 100% bonus depreciation, which, at the election of the taxpayer, can be added to the first-year luxury auto rates (see the amounts for “First Year with Bonus” in the table below). However, instead of an $8,000 increase, if the vehicle was purchased before September 28, 2017, but not put into service until 2018 or 2019, the increase to the first year depreciation cap is only $6,400 or $4,800, respectively, rather than $8,000.

LUXURY AUTO DEPRECIATION LIMITS
Trucks & Vans
Automobiles
2017
2018
2017
2018
First Year
3,560
10,000
3,160
10,000
First Year with Bonus
11,560
18,000
11,160
18,000
Second Year
5,700
16,000
5,100
16,000
Third Year
3,450
9,600
3,050
9,600
Thereafter
2,075
5,760
1,875
5,760

Vehicle Interest Expenses – Regardless of whether the standard mileage rate or actual expense method is used, a self-employed taxpayer may also deduct the business use portion of interest paid on an auto loan on their Schedule C. However, employees may not deduct interest paid on a consumer car loan.

Sale or Trade-in of a Business Vehicle – Under prior law, it was good tax strategy to trade-in a vehicle that would result in a gain, thus deferring the gain into the replacement vehicle and avoiding the tax on the gain. On the other hand, it was good practice to sell a vehicle for a loss and take advantage of the tax loss. Unfortunately tax reform no longer allows tax-deferred exchanges for anything but real estate. This does away with the aforementioned strategies, and now all sales and trade-ins are treated as sales, with any gain being taxable and any loss being deductible. However, a loss on the sale of a vehicle used solely for personal purposes is not deductible, and if the vehicle was used both for business and personal reasons, only the business portion of the loss is deductible.

Employees – Tax reform also eliminates the itemized deduction for employee business expenses; this is the place on the tax return where employees could deduct the business use of their vehicle for their employer. Thus, business vehicle expenses are no longer deductible by employees.

Please call us if you have questions related to the business use of your vehicle.

How Some High-Income Taxpayers Can Maximize the New 20% Pass-through Business Deduction

Taxpayers with higher 1040 taxable incomes who are self-employed but are not “specified service businesses” may find it beneficial to structure new businesses, or restructure an existing business, as an S corporation to avoid taxable income limitations that apply to the new 20% Sec. 199A pass-through deduction.

To make up for the tax reform’s reduction of the C corporation tax rate to 21%, from which other forms of business activities do not benefit, Congress created a new deduction and code section: 199A. The 199A deduction is for taxpayers with other business activities – such as sole proprietorships, rentals, partnerships and S corporations – since, unlike C corporations, which are directly taxed on their profits, the income from the other business activities flows through to the owner’s tax return and is taxed at the individual level, i.e., at the individual’s tax rate, which can be as high as 37%.

This new Sec. 199A deduction is 20% of the pass-through income from these business activities. But not every owner of these flow-through businesses will benefit from this deduction because, as in all things tax, there are limitations.

Whether or not a taxpayer will benefit from the deduction will depend in great part upon the taxpayer’s 1040 taxable income figured without the Sec. 199A deduction. Married taxpayers with a taxable income below $315,000 (or below $157,500, for others) will benefit from the full 20% deduction.

However, limitations begin to apply when a taxpayer’s 1040 taxable income exceeds those amounts. The most restrictive limitation is the one placed on “specified service businesses.” Once married taxpayers filing jointly have a 1040 taxable income exceeding $415,000 (or above $207,500, for others), they receive no Sec 199A deduction benefit from any pass-through income derived from a specified service business. Specified service businesses include trades or businesses involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services or any trade or business in which the principal asset of the trade or business is the reputation or skill of one or more of its employees or owners. Note that an engineering or architecture business is not a specified service business for this deduction.

On the other hand, a taxpayer can still benefit from pass-through income from other business activities, even when the taxpayer’s 1040 taxable income exceeds the $415,000/$207,500 limits, provided the business activity pays wages and/or has qualified business property, the combination of which make up what is referred to as the wage limitation. Without getting too complicated, the Sec. 199A deduction is the lesser of 20% of one’s pass-through income or the wage limitation. If the wage limit is zero, then the Sec. 199A deduction would also be zero for these high-income taxpayers. The wage limitation itself is the greater of 50% of the wages paid by the business activity or 25% of the wages paid plus 2.5% of the cost of qualified business property. Perhaps this is best explained by example.

Example #1: Peter and his wife have a 1040 taxable income of $475,000. Peter has a self-employed business (not a specified service business), from which he has a net profit of $300,000, and his tentative 199A deduction is $60,000 (20% of $300,000). However, because his taxable income exceeds $415,000, his Sec. 199A deduction is the lesser of $60,000 or the wage limit. Peter has no employees or qualified business property, so his wage limitation is zero; thus, his Sec. 199A deduction is also zero.

Example #2: Same as example #1, except Peter’s business is organized as an S corporation. Of his net profit of $300,000, it is determined that a reasonable compensation (wage) for the services Peter provides to the S corporation is $150,000, which the S Corporation pays as a salary to Peter. The other $150,000 is pass-through income. Now, Peter’s Sec. 199A deduction is the lesser of 20% of the pass-through income – $30,000 (20% of $150,000) – or the wage limitation, which is 50% of the wages paid by the S Corporation or $75,000 (50% of $150,000).

This demonstrates how a business activity can benefit from being organized as an S corporation, since S corporations are required to pay working shareholders a reasonable wage for their services provided in operating the business. They are able to divide the pass-through income between reasonable wages and pass-through income to enable a 199A deduction for a higher-income taxpayer. Other business entities do not provide this option, which is the reason why high-taxable-income taxpayers might explore the benefits of organizing new businesses as, or reorganizing their existing businesses into, an S corporation.

Of course, there are other issues involved as well, and some sole proprietors may not find it worth the expense or effort to switch to a different type of business entity. However, the higher the taxpayer’s income, the more beneficial it becomes. The same issues also apply to partnerships. To see if organizing or reorganizing your business activity into an S corporation can reduce your tax liability, call us for an appointment.


Has Tax Reform Taken Away Your Home Mortgage Interest Deduction?

The Tax Cuts and Jobs Act of 2017, more commonly referred to as tax reform, substantially altered the itemized deduction for home mortgage interest. It affects just about everyone who has been deducting their home mortgage interest as an itemized deduction on their tax returns.

Background: To fully understand the impact of the law changes, we need to compare the prior tax law to the new tax reform. Under prior law, a taxpayer could deduct the interest he or she paid on up to $1 million of acquisition debt and $100,000 of equity debt secured by the taxpayer’s primary home and/or designated second home.

Qualified home acquisition debt is debt incurred to purchase, construct, or substantially improve a taxpayer’s primary home or second home and is secured by the home. The interest paid on up to $1 million of acquisition debt has been deductible as part of itemized deductions on Schedule A.

Home equity debt is debt that is not acquisition debt and is secured by the taxpayer’s primary home or second home, but only the interest paid on up to $100,000 of equity debt had been deductible as home mortgage interest. Often, home equity debt is used to purchase a new car, finance a vacation, or pay off credit card debt or other personal loans – all situations in which the interest on a consumer loan obtained for these purposes wouldn’t have been deductible.

The old law continues to apply to home acquisition debts by grandfathering the home acquisition debts incurred before December 16, 2017, to the limits that applied prior to the changes made by tax reform. As explained later in this article, equity debt interest didn’t survive in the tax reform’s legal changes.

New Acquisition Debt Limits: Under the new law, which took effect for home acquisition loans obtained after December 15, 2017, the acquisition debt limit has been reduced to $750,000. Thus, if a taxpayer is buying a home for the first time, the deductible amount of acquisition debt interest will now be limited to the interest paid on up to $750,000 of the debt. If the home acquisition debt exceeds the $750,000 limit, a prorated amount of the interest is still deductible.

If a taxpayer already has a home with grandfathered acquisition debt and wishes to finance a substantial improvement on the home or acquire a second home, the new acquisition debt, for which the interest would be deductible, would be limited to $750,000 less the grandfathered acquisition debt existing at the time of the new loan. This may be a tough pill to swallow for many future homebuyers, since the cost of housing is on the rise while Congress has seen fit to reduce the cap on acquisition debt, on which interest is deductible.

Equity Debt: Under the new law, equity debt interest is no longer deductible after 2017, and this even applies to interest on existing equity debt, essentially pulling the rug out from underneath taxpayers who had previously taken equity out of their homes for other purposes and who were benefiting from the itemized deduction.

Tracing Equity Debt Interest: Because home mortgage interest rates are generally lower than business or investment loan rates and easier to qualify for, many taxpayers have used the equity in their home to start businesses, acquire rental property, or make investments, or on other uses for which the interest would be deductible. With the demise of the Schedule A home equity debt interest deduction, taxpayers can now trace interest on equity debt to other deductible uses. However, if the debt cannot be traced to a deductible purpose, unfortunately, the equity interest will no longer be deductible.

Refinancing: Under prior law, a taxpayer could refinance existing acquisition debt and the allowable interest would be deductible for the full term of the new loan. Under tax reform, the allowable interest will only be deductible for the remaining term of the debt that was refinanced. For example, under the old rules, if you refinanced a 30-year term loan after 15 years into a new 25-year loan, the interest would have been deductible for the entire 25-year term of the new loan. However, under tax reform, the interest on the refinanced loan would only be deductible for 15 years – the remaining term of the refinanced debt.

Determining when home mortgage interest is deductible and how much was deductible was frequently complicated under the prior tax law, and the new rules have added a whole new level of complexity. Please call us if you have questions about your particular home loan interest, refinancing, or equity debt interest tracing circumstances.

Good and Bad News About The Home Office Tax Deduction

“Home office” is a type of tax deduction that applies to the business use of a home; the space itself may not actually be an office. This category also includes using part of a home for storing inventory (e.g., for a wholesale or retail business for which the home is the only fixed location); as a day care center; as a physical meeting place for interacting with customers, patients, or clients; or the principal place of business for any trade or business.

Generally, except when used to store inventory, an office area must be used on a regular and continuing basis and exclusively restricted to the trade or business (i.e., no personal use). Two methods can be used to determine a home-office deduction: the actual-expense method and the simplified method.

Actual-Expense Method – The actual-expense method prorates home expenses based on the portion of the home that qualifies as a home office; this is generally based on square footage. These prorated expenses include mortgage interest, real property taxes, insurance, heating, electricity, maintenance, and depreciation. In the case of a rented home, rent replaces the interest, tax, and depreciation expenses. Aside from prorated expenses, 100% of directly related costs, such as painting and repair expenses specific to the office, can be deducted.

Simplified Method – The simplified method allows for a deduction equal to $5 per square footage of the home that is used for business, up to a maximum of 300 square feet, resulting in a maximum simplified deduction of $1,500.

Even if you qualify for a home-office deduction, your deduction is limited to the business activity’s gross income—not, as many people mistakenly believe, its net income. The gross-income limitation is equal to the gross sales minus the cost of goods sold. This amount is deducted on a self-employed individual’s business schedule.

The good news is that, under the tax reform, the home-office deduction is still allowed for self-employed taxpayers. The bad news is that this deduction is no longer available for employees, at least for 2018 through 2025. The reason for this change is that, for an employee, a home office is considered an employee business expense (a type of itemized deduction); Congress suspended this deduction as part of the tax reform.

If you have concerns or questions about how the home-office deduction applies to your specific circumstances, please give us a call.

Preparing for Taxes for 2018 and Beyond

Tax reform has changed the way most taxpayers need to think about and plan for their taxes. It is no longer business as usual, and those who think it is are in for a rude awakening come tax time next year.

For most taxpayers, the most significant change is the increase in their standard deduction, which on the surface seems like a big benefit. But don’t overlook the fact that the same tax reform that nearly doubled the standard deduction took away the personal exemption as a deduction. So, for example, under old law, a married couple’s standard deduction would have been $13,000, and their two personal exemptions would have been $8,300 (2 x $4,150), for a total deduction of $21,300. Under the new law, they will be able to deduct $24,000, the new standard deduction for 2018. So, their total increase over what they would have gotten under prior law is only $2,700. If they have four children, their deductions for 2018 under prior law would have been $37,900 ($13,000 plus 6 x $4,150), as compared to the new law’s $24,000. However, for individuals with children under age 17, the child tax credit for 2018 was increased to $2,000 (with $1,400 being refundable) from the prior $1,000, in many cases making up for the loss in the exemption deduction. Note that a credit is a dollar-for-dollar reduction of the tax, while a deduction reduces the income that is taxable.

Tax reform also placed some limitations on itemized deductions by limiting the amount that can be claimed for state and local taxes as well as totally eliminating the deduction for employee business expenses along with some other commonly encountered deductions. Thus, the remaining allowable itemized deduction categories are medical (in excess of 7.5% of AGI), up to $10,000 of state and local taxes, home acquisition debt interest, investment interest, charitable contributions and gambling losses (limited to the amount of gambling income).

Some taxpayers may be able to employ what is referred to as the “bunching” strategy as a workaround. This strategy has the taxpayer taking the standard deduction one year and itemizing the next. This is accomplished by doubling up charitable contributions in one year and skipping donations the next year, deferring or pre-paying medical expenses where possible, and paying state estimates in advance for the year of itemizing and prepaying all assessed property taxes, while keeping in mind that the maximum deduction for taxes in any year is $10,000. This strategy should only be used if the shifting of deductions results in total itemized deductions being greater than the year’s standard deduction.

Another huge issue is the loss of employee business expenses. This means the likes of long-haul truckers, traveling salespeople and others with large employee business expenses should seek out accountable expense reimbursement plans with their employers, even if they have to reduce their pay to balance it out.

For taxpayers in business, tax reform offers 100% expensing of purchased tangible business assets other than structures. At the same time, it also offers a new 20% flow-through business deduction. The combination of these two deductions must be carefully considered because expensing rather than depreciating the cost of equipment, machinery, etc., will reduce the business’s profit, which will in turn reduce the flow-through deduction. On the flip side, the new 20% deduction is limited for certain higher-income individuals, and reducing income by expensing capital purchases may actually help one to qualify for the deduction.

Married couples contemplating divorce will have to understand how the law changes will affect their situation and whether they should finalize the divorce before the end of the year. Currently, alimony is deductible by the payer and taxable to the recipient. Tax reform has changed that long-standing rule for divorce agreements entered into after December 31, 2018, or pre-existing agreements that are modified after that date, to include a new provision saying that alimony is no longer deductible by the payer and is not income to the recipient. Of course, the treatment of alimony can be adversarial and can also be a planning issue for 2018.

Here are some additional issues of importance:

  • Business entertainment expenses are no longer deductible.
  • Up to $10,000 of Qualified Tuition Plan (Sec. 529) funds can be used for elementary and high school expenses, if permitted by the plan.
  • Taxpayers who convert their traditional IRA to a Roth IRA can no longer change their minds and undo the conversion.
  • Casualty losses, other than those incurred in a federally declared disaster area, are no longer deductible, so you should consider whether you have adequate insurance.
  • Moving expenses are no longer tax deductible, and employer reimbursement for moving costs is now taxable income. If an employer requires an employee to relocate, consider having the employer provide a tax gross-up reimbursement.
  • Taxpayers basing their ability to purchase a home on the tax deduction they will derive from the interest they’ll be paying need to be aware that for homes purchased after 2017, the home mortgage interest deduction is limited to the interest paid on the first $750,000 ($375,000) of home acquisition debt.
  • Taxpayers who have tapped their home’s equity in the past should be aware that they can no longer deduct home equity debt interest, even if the debt was acquired before 2018 and is $100,000 or less.
  • For taxpayers residing in a state that has a state income tax, some or all of the federal tax reform changes may not apply for state filing purposes, or they may apply only if the state legislature enacts conforming legislation.

As you can see, it is definitely not business as usual. If you have any questions about how tax reform may affect you, please contact us.