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.

Kiddie Tax No Longer Based on Parents’ Tax Rate

Some years back, it was not uncommon for parents to put their investments in their dependent children’s names to take advantage of their children’s lower tax rates. Although the Uniform Gift to Minors Act legally made a child the owner of money put into his or her name, this didn’t stop parents from routinely putting their child’s name and social security number on the accounts so that the tax would be determined at the child’s lower marginal rate.

The IRS had no easy way to combat parents taking advantage of their children’s lower tax rates, so Congress came up with a unique way of taxing children’s investment income (unearned income) such as interest, dividends and capital gains. When this law was originally passed over 30 years ago, it only applied to children under age 14, but Congress expanded it over time to include children with unearned income under the age of 19 and full-time students under the age of 24 who aren’t self-supporting.

The way it worked prior to the 2017 tax reform, the first $1,050 of a child’s income was tax-free, the next $1,050 was taxed at just 10% and any unearned income above $2,100 was taxed at his or her parents’ higher tax rate. A child’s earned income (generally income from wages) was taxed at the single rate, and the child could use the regular standard deduction for single individuals ($6,350 in 2017) to reduce his or her taxable earned income. The computation got more complicated when the child’s siblings also had unearned income.

With tax reform, for years 2018 through 2025, the first $2,100 of the child’s unearned income is being taxed as before, with the first $1,050 being tax-free and the next $1,050 being taxed at 10%. However, instead of the balance being taxed at the parents’ tax rate, the balance is taxed at the income tax rates for estates and trusts, which for 2018 hits 37% when the balance of the unearned income reaches $12,500. The income tax rates for trusts and estates are illustrated below.

2018 Federal Tax Rate Schedule – Estates & Trusts
If the taxable income is: The tax is:
Over But not over Of the amount over
$0
$2,550
10%
$0
2,550
9,150
$255.00 + 24%
2,550
9,150
12,500
1,839.00 + 35%
9,150
12,500
3,011.50 + 37%
12,500

On the bright side, tax reform increased the standard deduction for singles to $12,000 (2018), meaning that a child can make up to $12,000 of earned income tax-free. The standard deduction is inflation adjusted for future years.

Uncoupling the child’s return from the parents’ return also solved another problem. If a child had taxable unearned income, they previously would have to wait for the parents’ return to be prepared to know what the parents’ top tax rate was before the child’s return could be prepared. It was not uncommon for young adults, in a rush for their tax refund, to jump the gun and file their own return while ignoring the kiddie tax rules, only to have to amend their returns. That is no longer the case.

If you have questions, please give us a call.

After Tax Reform, Which Is Right for You: S Corp or C Corp?

The Tax Cuts and Jobs Act has left many of today’s businesses with big questions. Incorporation remains a hot topic, but this law is shaking things up. It’s quick to assume your company should be one or the other, but without careful consideration of the facts, your organization may end up facing financial loss, hefty tax penalties or missed tax savings.

The goal of this type of incorporation is to minimize tax burdens, but the wrong decision can be costly. In a C Corp, the company pays corporate taxes to the Internal Revenue Service. But, in an S Corp, there’s no entity tax. Rather, taxes are paid through an individual return.

The New Law Changes
The new law, which went into effect for the 2018 tax year, brought changes to both S Corp and C Corp businesses. In fact, both types of corporations benefited here. For C Corps, the tax rate was dropped from 35 percent down to just 21 percent. For an S Corp the new law provides a deduction equal to 20% of the pass-through income from the corp subject to limitations for higher-income taxpayers. At best, this reduces the effective tax rate to 29.6 percent from 37 percent. In both cases, there are specific restrictions here to know.

One thing to remember about these tax changes is that there are many components to determining which method is right for your business. Don’t make a quick judgment here. Rather, invest in some one-on-one time with your tax professional to determine the best possible scenario for your individual company. To help, consider these key areas.

S Corp and C Corp Ownership
A key component in deciding how to incorporate your business relates to ownership. In the S Corp, there is a limit of 100 shareholders within the company. These must be domestic organizations operated in the United States where all of the company’s shareholders are also living in the United States. Additionally, this structure allows for a single stock classification. As a business, you cannot offer common stocks as well as preferred shares, for example.

Comparatively, C Corps allow for fewer restrictions. There is no limit on ownership at all. There is no limit on the number of shareholders the company can have. Any small- to a medium-sized company planning an IPO or simply obtain investors outside of the traditional domestic structure will find C Corps offer far more flexibility.

Another key factor about C Corps relates to the differences within your shareholders. These corporations can issue several types of stock. As a result, it is not uncommon for some shareholder votes to be more important than others. This, too, can influence the decision you make in choosing one or the other model.

Corporation Taxation – Choosing the Best Taxation Structure
Most companies will focus most of their decision on S Corp or C Corp options based on ownership as a starting point. However, every company also wants to keep costs low. Taxation is one of the most expensive hurdles any organization must manage. And, each type of structure offers a different look.

For example, consider how a C Corp is taxed. It is commonly referred to as a “double taxation structure.” This is because the company (the entity itself) will pay a corporate tax. Then, the stockholders pay taxes on their income from the business. While this has long been a concern for any business owner using the C Corp structure (paying taxes twice on income is very costly), the new tax law changes this a bit. As noted previously, the tax rate for C Corp has changed from 35 percent to just 21 percent. However, the dividends will still be faced with double taxation.

The slashing to 21 percent means every company is paying the same rate, neither the size of the company nor the type of organization matters. That’s an important consideration when choosing which type of structure is right for your company.

With the help of a tax professional, it is also important to consider other tax strategies available. For example, an S Corp shareholder pays taxes every year on the money the company earns during that year. This is a simpler, straightforward scenario. But, in a C Corp, the taxes are only paid when the company decides to distribute dividends. It can also occur if a shareholder realizes capital gains (such as when selling ownership). This provides the C Corp with an ability to minimize taxes just by timing dividends properly.

Making the Right Decision for Your Needs
This is only the very top edge of considerations for which is best for your company. However, there are a few things that can influence your decision.

Stable Small Businesses
If you own a smaller company, you’ll benefit from an S Corporation for various reasons. First, the income passes through and is taxable to the stockholders on their 1040s, thereby eliminating double taxation. Plus the lower tax rate and the 20% pass-through deduction are very beneficial to an S-Corporation structure.

Growing Small Businesses
If your company is growing – or you plan to go public and take on new ownership, the C Corporation offers the opportunity to do so. It allows for a larger number of investors, and international investments are possible. Additionally, as a smaller business, you may not be likely to issue dividends any time soon. As a result, this can reduce the amount of income reported to the IRS on an annual basis.

Larger Companies
For larger organizations, the C Corp tends to offer the best structure overall. Other options limit investor access and may create scenarios where the company cannot grow. The effective tax rate is significantly lower – competitive to any company no matter the size. The new tax reform provides the most advantages to this buyer in particular.

Making the Decision for Your Needs
Many organizations today have jumped on the new tax reform as an opportunity to incorporate more tax savings. However, a clear picture is important and we recommend slowing down before making any type of drastic decisions like this. They have far-reaching implications and can create a financial burden or limitations on an organization if the wrong decision occurs. With the assistance of a tax professional or attorney, it is possible to make better decisions based specifically on the type of business structure you have, the business’s short-term and long-term goals, as well as new laws and taxation rates. Before you make a change as an entrepreneur, know what you are really getting. Please contact us with any questions.

Tax Reform Eases the Alternative Minimum Tax – But It’s Still There

Although Congress has been promising to repeal the alternative minimum tax (AMT), they failed to do that when they passed tax reform in 2017. Instead, they lessened the effects of the AMT by increasing AMT exemptions (an amount of income exempt from AMT taxation) and raising the income thresholds for when the exemptions are phased out. These two steps and some other changes covered in this article lessen your chances of being hit by the AMT, but it is still there. It is wise to be aware of how the AMT is determined and the potential triggers.

There are two ways to determine your tax: the regular way, which most everyone is familiar with, and the alternative method. Your tax will be the higher of the two.

So, what is the alternative tax and why might you get hit with it? Well, many, many years ago, Congress, in an effort to curb tax shelters and tax preferences of wealthy taxpayers, created an alternative method for computing tax that disallows certain deductions and adds preference income and called it the AMT. Although originally intended to apply to the wealthy, years of inflation caused more than just wealthy taxpayers to be caught up in the tax.

What Triggers the AMT? The list of tax deductions and preferences not allowed when computing the AMT is substantial and, at times, complicated. However, the typical taxpayer does not encounter most of them. In the past, the seven following items routinely caused taxpayers to be hit by the AMT. As you will note, tax reform has lessened or eliminated the impact of some of these.

  1. Medical Deductions – For many years, medical deductions were allowed to the extent they exceeded 7.5% of a taxpayer’s income for regular tax purposes and 10% for the AMT computation. The 2.5% difference was one of the items that added to the AMT tax. (For 2013 through 2016, the percentage for taxpayers under age 65 was 10% for both regular tax and AMT, and they had no AMT adjustment.) For 2017 and 2018, tax reform made the medical limit 7.5% for both regular and AMT purposes. After 2018, the percentage of income that reduces medical expenses will be 10% for both regular tax and AMT. Therefore medical expenses also will not impact the AMT in 2019 and later years.
  2. Deduction for Taxes Paid – When itemizing deductions on a federal return, a taxpayer is allowed to deduct a variety of state and local taxes, including real property, personal property, and state income or sales tax. But, for AMT purposes, none of these taxes is deductible, thus creating an AMT adjustment. However, tax reform imposed a $10,000 limit on state and local tax deductions, lessening the difference in the regular tax and AMT adjustment, especially for higher income taxpayers and those living in states with high taxes. However, when combined with other triggering items, the state and local taxes deducted for regular tax can still create an AMT.
  3. Home Mortgage Interest – For both the regular tax and AMT computations, interest paid on a debt to acquire or substantially improve a main home or second home is deductible as long as the $1 million debt limit ($750,000 for loans incurred after 2017) isn’t exceeded. Prior to 2018, for regular tax purposes, the interest on up to $100,000 of equity debt on first and second homes was also deductible, creating a difference between the regular tax and AMT deduction, as equity debt interest is not allowed for AMT purposes. Additionally, interest on debt to acquire a motor home or boat that is used as a taxpayer’s home or second home is deductible for regular tax purposes but not for AMT purposes. Starting in 2018, tax reform no longer allows homeowners to deduct the interest on equity debt, which eliminates another difference between what is deductible for regular tax and the AMT and reduces the chances of being saddled with the AMT.
  4. Miscellaneous Itemized Deductions – The category of miscellaneous deductions, which includes employee business expenses and investment expenses, is not deductible for AMT purposes. For certain taxpayers with deductible employee business expenses or high investment advisor fees, this has created a significant AMT. Here again, tax reform has eliminated these same miscellaneous deductions for regular tax beginning in 2018, thus eliminating another difference between the AMT and the regular tax computation.
  5. Personal Exemptions – Through 2017, a deduction for personal exemptions was allowed for regular tax but not for the AMT, creating a difference in the computation and adding to the chance of being subject to the AMT. As of 2018, exemptions are no longer allowed for regular tax, which eliminates yet another difference.
  6. Standard Deduction – For regular tax purposes, a taxpayer can choose to itemize their deductions or use the standard deduction. However, for the AMT, only itemized deductions are allowed. Tax reform substantially increased the standard deduction used to figure regular tax, and this can increase chances of being affected by the AMT. There is a strategy that can be used to mitigate the AMT for taxpayers who would normally use the standard deduction, which is forcing itemized deductions even if they total an amount that is less than the standard deduction amount. Even the smallest of charitable deductions will benefit at a minimum of 26% (the lowest bracket for the AMT). This strategy is tricky and best left to a tax professional to figure out.
  7. Exercising Incentive Stock Options and Holding the Stock – Many employers offer stock options to their employees. One type of option is called a qualified or incentive stock option. The taxpayer does not recognize income when the options are exercised and becomes qualified for long-term capital gain treatment upon sale of the stock acquired from the option if the stock is held more than a year after the option was exercised and two years after the option was granted. However, for AMT purposes, the difference between the option price and the exercise price is AMT income in the year the option is exercised, which frequently triggers an AMT tax when large blocks of stock are exercised. Tax reform did not change this provision.

Although your chances of being affected by the AMT have significantly diminished, there is still a possibility you can be affected by it. Your chances increase if you have investment or business interests that are subject to AMT adjustments not encountered by the average taxpayer (and not discussed in this article). The AMT is an extremely complicated area of tax law that requires careful planning to minimize its effects. If you have any questions, please contact us for further assistance.

Tax Reform 2.0 Is in the Works

The dust has not yet settled from the Tax Cuts and Jobs Act (TCJA), passed into law in December 2017, and the House Ways and Means Committee is already considering another round of tax changes. The committee chair, Kevin Brady, Republican from Texas, wants to include input from stakeholders such as business groups, think tanks and other relevant organizations. Historically, major tax reforms have been decades apart, so the committee chair is looking for another approach to the way Washington deals with tax policy.

As with all tax legislation, it begins with talking points. From what we can gather, it appears the focus of Tax Reform 2.0 will include:

  • Making the first round of individual and pass-through business deductions permanent.
  • Focusing on retirement savings and creating a flexible universal savings account so individuals are accustomed to saving for retirement earlier in life.
  • Making it easier for small businesses to participate in multi-employer retirement plans.
  • Looking for ways to help the Treasury implement the TCJA.
  • Providing new business start-ups with greater expensing options for start-up costs.
  • Identifying technical corrections needed for the TCJA.

Commentators believe that making the selected TCJA changes permanent will be a tough sell in Congress at this time, as there is little to no support from the Democratic side of the aisle. However, the retirement savings ideas will probably have a favorable reception and have a good chance of passing.

Stay tuned for further developments and if you have any questions or concerns in the interim, please do not hesitate to contact us.

Clergy Tax Benefits Under Fire

Section 107 of the Internal Revenue Code provides that a minister of the gospel’s gross income doesn’t include the rental value of a home (parsonage) provided; if the home itself isn’t provided, a rental allowance paid as part of compensation for ministerial services is excludable. The benefit is generally referred to as a parsonage allowance. Thus, a minister can exclude the fair rental value (FRV) of the parsonage from income under IRC Sec. 107(1), or the rental allowance under Sec. 107(2), for income tax purposes. The Sec. 107(2) rental allowance is excludable only to the extent that it is for expenses such as rent, mortgage payments, utilities, repairs, etc., used in providing the minister’s main home, and only up to the amount of the FRV of the home.

However, either type of parsonage allowance is only excludable for income tax purposes and is subject to self-employment taxes, although for years before 2018 and after 2025, the amount subject to self-employment tax can be reduced by the minister of the gospel’s employee business expenses.

Back in October 6, 2017, in the US District Court for the Western District of Wisconsin, Judge Barbara B. Crabb, in Gaylor v. Mnuchin (the treasury secretary), concluded that Section 107(2) of the Internal Revenue Code is unconstitutional. Specifically, she concluded that this code section violates the Establishment Clause of the First Amendment because it does not have a secular purpose or effect and because a reasonable observer would view the statute as being an endorsement of religion.

The code section under judicial fire is the part of code Sec. 107 allowing churches and other religious organizations the ability to provide tax-free housing to their ordained ministers, even though the housing is not provided in kind by the church or the religious organization. This provision of the code was envisioned to provide ministers of the gospel with modest tax-free housing. However, it contains no limitations on its application and, as a result, also applies to:

  • Televangelists like Joel Osteen, who uses this tax provision to live tax-free in his multi-million dollar mansion.
  • Other ordained ministers working in church-affiliated schools as teachers and administrators who also benefit from the provision.

It has been estimated that the government foregoes in excess of $800 million in tax revenues because of the provision.

Judge Crabb, in issuing her decision, directed the parties to file supplemental materials regarding what additional remedies are appropriate, if any. The judge subsequently stayed injunctive relief until 180 days after the final resolution of all appeals. The additional time will allow Congress, the IRS and affected individuals and organizations to adjust to the substantial change. This case will certainly be appealed to the circuit court and eventually to the Supreme Court. So, we will need to keep our eyes on this case and see how it plays out in the long run.

It should be emphasized that Sec. 107(1), which permits an amount equal to the rental value of a parsonage furnished to a minister as part of his or her compensation to be excluded from income, is not affected by Judge Crabb’s ruling; thus, this benefit continues to be income-tax free.

Ministers of the gospel will also feel one of the negative aspects of the Tax Cuts & Jobs Act of 2017 (aka tax reform), which suspended the deduction for employee business expenses. Thus, beginning in 2018 and through 2025, ministers of the gospel will no longer be able to reduce the amount of their housing allowance by their employee business expenses when computing their self-employment taxes.

If you have questions related to taxation issues for ministers of the gospel, please call 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.

A Mid-Year Tax Checkup May Be Appropriate

Taxes are similar to vehicles, in that they sometimes need a check-up to make sure they are performing as expected. That is especially true for 2018, with all of the changes brought about by tax reform.

One area of major concern is the amount of taxes individuals are withholding from their wages. Tax reform was passed late in 2017, and there was a considerable amount of confusion among employers related to the amount of taxes to withhold in 2018. It took the IRS a couple of months to come out with a revised Form W-4 (Employee’s Withholding Allowance Certificate) and withholding tables, and even then, there were concerns about whether the revised and more complicated W-4s were being filled out correctly by employees and whether the revised W-4s were actually being submitted to employers at all. The IRS has even been issuing notices cautioning taxpayers to be sure they are withholding enough.

While most people will see an overall tax reduction as a result of the tax reforms, the amount of their refund or tax due hinges on the amount of pre-payments, which include withholding and estimated tax payments. All this confusion related to withholding can lead to unpleasant surprises at tax time. If you count on a refund each year, it might be appropriate to have this office run a mid-year tax projection to ensure that the projected refund will be as expected.

This is also true for retirees receiving pensions and Social Security benefits and for self-employed taxpayers who are making pre-payments via estimated taxes. You obviously do not want to pay too much and generally don’t want to end up with a huge tax liability. A mid-year check-up will allow adjustments to the 3rd- and 4th-quarter estimated tax payments so that the end result will be as desired.

Married couples with two working spouses, individuals with multiple jobs and situations in which taxpayers are both wage earners and self-employed cause the most difficulty in getting the prepayments correct. If you would like a mid-year projection and withholding check-up, please call for an appointment.

There are a number of other circumstances that can impact your taxes, and you probably should not wait until tax time to see the results. You could even be missing opportunities to decrease your prepayments and obtain more cash flow. With mid-year tax planning, you may be able to take steps to mitigate the tax impact of certain events and thus avoid unpleasant surprises before it is too late to address them. Here are some events that can significantly impact your tax liability:

  • Getting married or divorced, or becoming widowed
  • Changing jobs or your spouse starting to work
  • Having a substantial increase or decrease in income
  • Having a substantial gain from the sale of stocks or bonds
  • Buying or selling a rental
  • Starting, acquiring, or selling a business
  • Buying or selling a main or vacation home
  • Retiring or going to retire this year
  • Being the beneficiary of an inheritance
  • Giving birth to or adopting a child
  • Making significant business purchases
  • Having substantial investment income or gains from the sale of investment assets
  • Making unplanned withdrawals from an IRA or pension plan

If you anticipate or have already encountered any of the above events or conditions, it may be appropriate to consult with us—preferably before the event and definitely before the end of the year.