Year-end Tax Planning Is Not Business as Usual: Things You Need to Know

This has been a tumultuous year for taxes, with the tax reform that passed in late 2017 generally becoming effective in 2018, often with significant changes for both individuals and businesses. This is the first major tax reform legislation in more than 30 years. To implement it, the IRS will have to create or revise approximately 450 forms, publications and instructions and modify around 140 information technology systems. All of these changes are to ensure it can accommodate the newly revised or created tax forms, not to mention writing tax regulations for all of these changes – a daunting task for sure. The following issues could affect you and you may need to plan ahead.

Refund or Tax Due? – Most taxpayers are equating the recent tax reform to a larger refund when their 2018 tax return is prepared. However, that may not be the case because your tax refund is the difference between what you prepaid through payroll withholding and estimated tax payments and what you owe. Even if your tax bill is lower, if your prepayments were also lower, then your refund may not be as expected.

The passage of tax reform came on December 20, 2017, just days before employers needed Form W-4 – the Employee’s Withholding Allowance Certificate – for 2018 withholding information from their employees, which did not give the IRS time to adjust the form and withholding tables for the new law. It was not until late February that the IRS published revised withholding tables and an updated Form W-4. Even then, there was concern that some employers might be using the old W-4 with the new tables. On top of that, many taxpayers and tax professionals were finding that the revised W-4 and withholding tables did not produce an accurate result. The bottom line is that there is a real concern that many taxpayers are in for an unpleasant surprise at tax time – so much so that the IRS has been issuing almost daily notices warning taxpayers that they may be under-withheld. This is a real concern for 2018 returns, and you may wish to fine-tune your withholding before year’s end.

Underpayment of Taxes: Should your liability be greater than your prepayments by $1,000 or more, you may also be subject to underpayment penalties. This could simply be the result of under-withholding on your wages or underpaying estimated tax if you are self-employed, or of out-of-the-ordinary income, such as stock gains, sale of a business or rental or even winning big from the lottery. There are safe harbor prepayments to avoid a penalty, which require prepaying:

  • 90% of the current year’s tax liability,
  • 100% of the prior year’s tax liability, or
  • 110% of the prior year’s tax liability, if the prior year’s AGI was over $150,000.

If you are underpaid, there is still time to make adjustments and avoid or mitigate the penalty. Adjusting your payroll withholding is the best option, since withholding is treated as being paid ratably throughout the year, and the penalty is computed on a quarterly basis based on the prepayments through that quarter. However, as the end of the year gets closer, there is less and less time for revised withholding to kick in, so don’t delay in notifying your employer if you need to increase your withholding.

Alternative Minimum Tax (AMT): Although Congress had promised to repeal both individual and corporate AMT, they only repealed the corporate AMT. However, even though they didn’t repeal it for individuals, the tax reform act did increase the exemption amounts and phase-out thresholds, and it eliminated certain deductions that triggered the AMT, so that the AMT will impact fewer taxpayers, giving rise to these possible strategies:

Exercise Incentive Stock Options – These changes to the AMT may allow larger blocks of incentive stock options to be exercised, and the stock that’s issued can be held long-term and thus enjoy the lower capital gains tax rates without triggering the AMT. Some tax planning may be required, which may be a multi-year endeavor.

Recapture AMT – The higher exemptions and phase-outs provide a greater opportunity for taxpayers with AMT tax credit carryover to recapture AMT paid in prior years. If the current year’s regular tax exceeds the AMT, a taxpayer can claim the AMT credit carryover for the difference.

Avoid the Minimum Required Distribution Penalties: Once taxpayers reach the age of 70.5, they are required to take what is known as a “required minimum distribution” from their qualified retirement plan or IRA every year. If this is the first year that this rule applies to you and you haven’t taken your money out yet, there’s no need to panic – you don’t have to do so until some time during the first quarter of next year. Of course, if you wait until 2019 to take your 2018 distribution, you’re going to end up having to take two distributions in one year: one for 2018 and one for 2019. For those who fell into this category before 2018, you only have until December 31st to withdraw your 2018 distribution to avoid penalties.

Convert into a Roth IRA: If you have a traditional IRA and your income for 2018 has been very low, you may want to consider converting your traditional IRA into a Roth IRA and taking advantage of the tax-free distribution benefits of a Roth IRA in the future, especially if you can do so with little or no tax on the conversions. This will probably require a tax projection to determine an amount to convert and the tax cost, if any, of the conversion. However, the tax reform made conversions permanent, and once made, the conversion cannot be undone.

Review Portfolio for Losses: The conventional strategy is to offset as much of your gains as possible with losses from selling other assets in your portfolio. If you have an overall loss, the loss that can be used to offset income other than capital gains is limited to $3,000 ($1,500 for married taxpayers filing separately), and any excess loss carries over to the next year. Keep in mind that losses from the sale of business assets are generally separately allowed in full in the year of sale and are not mixed with the losses from the sale of capital assets.

Assets that are sold and not held long-term, referred to as short-term capital gains, do not receive the benefit of the special rates afforded to long-term capital gains. Taxpayers achieve a better overall tax benefit if they can arrange their transactions to offset short-term capital gains with long-term capital losses.

Make the Most of Higher Education Tax Credits: Both the Lifetime Learning education credit and the American Opportunity Credit allow qualified taxpayers who prepaid tuition bills in 2018 for an academic period that begins by the end of March 2019 to use the prepayments when claiming the 2018 credit. That means that if you are eligible to take the credit and you have not yet reached the 2018 maximum credit for qualified tuition and related expenses paid, you can bump up your credits by paying early for 2019 now. This may not apply to you if you’ve been paying tuition expenses for the entire 2018 tax year, but it will probably provide you with some additional help if your student just started college this fall.

Optimize Health Savings Account Contributions: Did you become eligible to make contributions to a Health Savings Account this year? If so, then you can make deductible contributions into that account up to its maximum amount, no matter when you became eligible. For 2018, the maximum deduction for self-only coverage is $3,450; for family coverage, it is $6,900. Empty Flexible Spending Accounts: If you have a flexible spending account, double-check to see if any remaining account balance can be used for medical expenses, including eyeglasses and/or other health care items covered by the FSA. Remember: funds not used by the account deadline will be forfeited.

Bunch Charitable Deductions: Many people who itemize take advantage of the ability to take a deduction for their donation to their favorite charity or house of worship. Did you know that you can choose to pay all or part of your 2019 planned giving in 2018 to increase the amount you deduct in 2018? Though this may not be appealing to those who itemize every year, you may find this to be an effective strategy if you only marginally itemize every year. Implementing this strategy means you will alternate between taking the standard deduction one year and itemizing the next, giving you a big boost in deductions on the year when you itemize.

Additionally, those who are required to take a required minimum distribution from their IRA because they are 70.5 or older can have their RMD paid directly to a qualified charity, and instead of getting a charitable deduction, the distribution is tax-free, which in turn might reduce the amount of your taxable Social Security income. If this strategy appeals to you, don’t wait until the last minute to implement it, as your IRA trustee or custodian will need time to process the paperwork and make the distribution to the charity or charities you designate.

Deductions – Although the tax reform increased the standard deduction, possibly making it a better choice for the federal return for some, most states did not conform to the federal changes, making it business as usual for itemizing on the state return.

Remember the Annual Gift Tax Exemption: One of the best ways to ultimately reduce your estate taxes and at the same time give to those you love is to take advantage of the annual gift tax exemption. Although the gifts are not tax-deductible, for tax year 2018, you are able to give $15,000 to each of as many people as you want without having to report the transfer to the government or pay any gift tax. If this is something that you want to do, make sure that you do so by the end of the year, as you are not able to carry the $15,000 over into 2019.

Home Equity Debt: The interest on home equity debt is not allowed as an itemized deduction for years 2018 through 2025. (Note: the term equity debt has a different meaning for tax purposes than for lenders. For tax purposes what lenders refer to as equity debt can actually be acquisition debt and may still be deductible if used to purchase or substantially improve a taxpayers home or second home.) But that doesn’t mean equity interest can’t be deducted somewhere else on your return as investment interest or business interest, if you can trace the use of the loan funds to a deductible use.

Retirement Savings: Be sure to maximize your retirement plan contributions before year-end. Once the year is gone, you have forever lost an opportunity to make this year’s annual tax-advantaged addition to your savings for future retirement, which won’t be all that pleasant without a substantial retirement nest egg. If your employer matches some of the amount you contribute to your 401(k) or another eligible retirement plan, be sure to contribute as much as you can to take full advantage of this perk. If the contributions are tax-deductible, such as to a traditional IRA, or made with pre-tax income, maximizing the contributions may also cut your tax bill.

Divorce in the Future: If you or someone you know is contemplating divorce, you should be aware of a big tax change related to alimony. For divorces finalized by the end of 2018, alimony payments are deductible by the one paying them and considered income to the one receiving them. However, for divorces finalized after 2018, alimony is no longer deductible by the payer and is no longer taxable for the recipient. This can have a significant impact on the terms negotiated during a divorce.

Maximize Business Expenses: Beginning in 2018, business owners are able to write off most business purchases using the very liberal 100% bonus depreciation and the Sec. 179 expensing allowance. But to benefit, the business asset must not only be purchased before year’s end, it must also be placed into service by year’s end.

New Flow-Through Deduction: Individuals with taxable incomes (net of capital gains) less than $157,500 and married couples filing jointly with taxable incomes less than $315,000 will enjoy the benefits of the new 20% pass-through deduction from business entities other than C-corporations. Taxpayers with higher incomes will want to determine if any change in compensation structure might increase the deduction.

Additionally, S-corporation employee-stockholders will need to make sure their salary meets the “reasonable compensation” requirements, since the wages are a critical factor in determining the flow-through deduction from an S-corporation.

Every taxpayer’s situation is unique, not all of the suggestions offered here may apply to you, and by no means does the list include all the changes brought about by tax reform. However, they cover many of the major issues for taxpayers and small businesses. If you had any major business, income, or family changes or if any of the issues discussed affect you, a year-end tax planning appointment may be appropriate. The best way to ensure that you are putting yourself into the best tax-advantaged position is to consider all of your tax options. Please call us with questions or to schedule an appointment.

Hardship Exemption Rules

The Affordable Care Act (Obamacare) included a “shared responsibility payment,” which in reality is a penalty for not having health insurance. Along with this penalty came a whole slew of exemptions from the penalty, including some that were designated as “hardship” exemptions. However, the hardship relief from the penalty required pre-approval from the government health insurance marketplace, which required the applicant to provide documentary evidence of the hardship. Once approved, the applicant was issued an exemption certificate number (ECN) that needed to be included on the individual’s tax return to avoid the penalty.

Hours after being sworn in, President Trump signed an executive order aimed at reversing the Affordable Care Act. The executive order states that the Trump administration will “seek prompt repeal” of the law. To minimize the “economic burden” of Obamacare, the order instructs the secretary of the Department of Health and Human Services and other agency heads to “waive, defer, grant exemptions from, or delay the implementation” of any part of the law that places a fiscal burden on the government, businesses or individuals.

As a result of President Trump’s executive order, the Centers for Medicare & Medicaid Services (CMS) announced on September 12, 2018, that consumers can claim a hardship exemption for not purchasing insurance and avoid the penalty for not being insured for 2018, either by:

  • Obtaining an ECN through the existing application process or
  • Simply entering the hardship code on their federal income tax return (a form of self-certification).

However, the CMS cautioned that consumers should keep any documentation that demonstrates qualification for the hardship exemption with their other tax records.

The following are the more common hardship exemptions affected by this change. For a complete list and additional details related to qualifying for these hardships, visit the CMS website.

  • Homelessness
  • Being evicted or facing eviction or foreclosure
  • Receiving a shut-off notice from a utility company
  • Experiencing domestic violence
  • Death of family member
  • Fire, flood or other disaster that caused substantial damage
  • Bankruptcy
  • Medical expenses that can’t be paid, resulting in substantial debt
  • Increased medical expenses to care for a member of the family
  • Claiming a child who has been denied Medicaid or CHIP coverage
  • Ineligibility for coverage because the state didn’t expand Medicaid

The shared responsibility payment and exemptions are determined on a monthly basis, and a person is eligible for a hardship exemption for at least the month before, the month(s) during and the month after the specific event or circumstance that creates the hardship.

There are a variety of other exemptions in addition to the hardship exemptions, and 2018 is the final year the shared responsibility payment will be assessed. The Tax Cuts and Jobs Act (tax reform) has eliminated the penalty beginning in 2019.

If you have any questions related to the penalty for not having health insurance and the the penalty exemptions, please contact us.

Tax Reform Enables Deferral of Taxable Gains Into Investments in Opportunity Zones

Those who have a large capital gain from the sale of a stock, asset, or business and who would like to defer that gain with the possibility of excluding some of it from taxation should investigate a new investment called a qualified opportunity fund (QOF), which was created as part of the recent tax reform.

To help communities that have not recovered from the past decade’s economic downturn, lawmakers included in the Tax Cuts and Jobs Act of 2017 the new code Sections 1400Z-1 and 1400Z-2, which are intended to promote investments in certain economically distressed communities through QOFs. Investments in QOFs provide unique tax incentives that lawmakers designed to encourage taxpayers to participate in these funds.

Reinvesting Gains – TCJA of 2017 provides a taxpayer who has a capital gain from selling or exchanging any property to an unrelated party prior to January 1, 2027 may elect to defer that gain if it is reinvested in a QOF within 180 days of the sale or exchange. Only one election may be made with respect to a given sale or exchange. If the taxpayer reinvests less than the full amount of the gain in the QOF, the remainder is taxable in the sale year, as usual. The amount of the gain – not the amount of the sale’s proceeds, as in Sec 1031 deferrals – needs to be reinvested in order to defer the gain. There are special rules for capital gains from mutual fund dividends, REITs, and pass-through entities.

The gain income is deferred until the date when the QOF investment is sold or December 31, 2026 – whichever is earlier. At that time, the taxpayer includes the lesser of the following amounts as taxable income:

a. The deferred gain
b. The fair market value of the investment, as determined at the end of the deferral period, reduced by the taxpayer’s basis in the property. (Basis is explained below.) A taxpayer who holds a QOF investment for 10 years or more before selling it can permanently exclude the gain from the sale that is in excess of the originally deferred gain (i.e., the appreciation) by electing to treat the basis as being equal to the fair market value of the investment.

Qualified Opportunity Fund Basis – The basis of a QOF that is purchased with a deferred gain is $0 unless either of the following increases applies:

(a) If the investment is held for 5 years, the QOF’s basis increases from $0 to 10% of the deferred gain.

(b) If the investment is held for 7 years, the QOF’s basis increases from $0 to 15% of the deferred gain.

If on December 31, 2026 a taxpayer holds a QOF that was purchased with deferred gains, gain must be included in income on the 2026 tax return to the extent of the lesser of the deferred gain or the FMV on December 31, 2026 over the basis in the investment. The basis of the investment will then be increased by the amount of this included gain.

If the QOF investment is held for at least 10 years before being sold, the taxpayer can elect to increase the basis to the property’s fair market value. This adjustment means that the QOF’s appreciation is not taxable when it is sold.

Example 1: On June 30, 2018, Phil sold a rental apartment building for $3 million, resulting in a gain of $1 million. Within the statutory 180-day window, he invested that $1 million into a QOF and elected to take the temporary gain deferral exclusion. On July 1, 2026, he then sold the QOF for $1.5 million. Because Phil held the investment for over 7 years, its basis is enhanced by $150,000 (15% of $1 million). Because the investment’s fair market value is greater than the original deferred gain, he must include a taxable gain of $1.35 million ($1.5 million – $150,000) in his 2026 gross income.

Example 2: The facts here are the same as in Example 1, except Phil waited to sell the QOF until 2030, meaning that he held it for nearly 12 years. Because he had the investment on December 31, 2026, he was required to include $850,000 ($1 million – $150,000) of deferred gain on his 2026 return, and his basis in the QOF was increased by $850,000. After selling the QOF for $1.5 million, Phil elected to permanently exclude the gain by increasing his basis to $1.5 million (the fair market value on the date of the sale). Thus, he has no gain ($1.5 million – $1.5 million) in 2030.

Mixed Investments – If a taxpayer’s investment in a QOF consists of both deferred gains and additional investment funds, it is treated as two investments; this provides the tax benefits of both types. However, the temporary gain deferral and the permanent gain exclusion only apply to the deferred gain elected amount and not the additional investment funds.

Qualified Opportunity Funds – To defer capital gains-related taxes through the recently enacted opportunity-zone program, taxpayers must invest in a QOF – an investment vehicle that is organized as a corporation or a partnership for the purpose of investing in properties within qualified opportunity zones. These investments cannot be in another QOF, and the properties must have been acquired after December 31, 2017. The fund must hold at least 90% of its assets in the qualified-opportunity-zone property, as determined by averaging the percentage held in the fund on the last days of the two 6-month periods of the fund’s tax year. Taxpayers may not invest directly in qualified opportunity zone property.

Partnerships – Because a QOF that is purchased with deferred capital gains has a basis of zero, taxpayers who invest in QOFs that are organized as partnerships may be limited to deducting the losses that these partnerships generate.

Qualified Opportunity Zones – A low-income census tract can be specifically designated as a qualified opportunity zone after a nomination from the governor of that community’s state or territory. Once the qualified opportunity zone nomination is received in writing, the treasury secretary can certify the community as a qualified opportunity zone. Once certified, zones retain this designation for 10 years. At this point, most Opportunity Zones have been designated and certified. An example of where to find information can be found here.

Proposed Regulations have been issued, and the Department of the Treasury and the Internal Revenue Service will provide further details regarding this new incentive in the near future, including additional legal guidance and an outline of the procedure for electing to defer a gain. If you have questions, please give us a call.

Do You Own a Specified Service Trade or Business? If So, Your 20% Pass-Through Tax Deduction May Be Limited

As part of its recent tax reform, Congress included a new 20% deduction of pass-through income for trades or businesses other than C-corporations. This pass-through income is referred to as qualified business income (QBI); for trades or businesses, it generally includes bottom-line profits, and for S-corporations and partnerships, it includes K-1 flow-through income. This new law was added as tax code section 199A, so the deduction is often referred to as the 199A deduction.

Congress added this deduction to benefit sole proprietors, partners, and S-corporation shareholders (among others); the goal is to allow for benefits equivalent to the substantial tax-rate cut that the same reform provided to C-corporations. However, this new deduction is not applied uniformly to all types of trades and businesses, for which there are two categories:

  • qualified trades or businesses (QTBs) and
  • specified service trades or businesses (SSTBs).

This deduction is limited by the taxpayer’s filing status and 1040 taxable income, and it differs depending on whether the business is a QTB or a SSTB. Although the main purposes of this article are to define SSTBs and to describe how they are taxed differently from QTBs, if one is to understand why an SSTB may not qualify for the deduction, whereas a QTB might qualify, it is necessary to first understand the basic differences between the deductions for SSTBs and QTBs.

Apparently, Congress considered the income from service businesses to be akin to wages and didn’t want taxpayers who provide services to have the benefit of the 20% deduction instead of paying taxes on that income as ordinary wages. This change was primarily aimed at deterring high-income people from becoming independent contractors or setting up pass-through businesses so that they could turn their wages into business income and get the 20% deduction. The result is a phase-out of the deduction for high-income taxpayers who have income from SSTBs.

The table below provides an overview of the tax treatment for each type of business. As you will note, the SSTB deduction phases out for higher levels of 1040 taxable income, but the QTB deduction does not. This type of phase-out is called a wage limitation.

Example of How to Use the Table: Two married people who are filing jointly have 1040 taxable income (before the 199A deduction) of $469,000; they also have a SSTB. They would first select the box with their filing status (“Married Filing a Joint Return”), then move to the right to the correct range of 1040 taxable income (which is the adjusted gross income after removing either the standard deduction or the itemized deductions; in this case, “Greater than $415,000”), and finally follow that column down to the cell aligned with the correct type of business (“SSTB”). In this case, the trade or business does not qualify for the 199A deduction.

Taxpayer’s Filing Status

Taxable Income
(Before the 199A deduction)

Married Filing a Joint Return
Less Than $315,000
Between $315,000 and $415,000

Greater than $415,000

Other filing Statuses
Less Than $157,500
Between $157,500 and $207,500

Greater than $207,500

Type of Business
The 199A Deduction
SSTB
20% of QBI
Deduction phased out
No deduction allowed
QTB
20% of QBI
Wage limitation phased in
Deduction equal to the lesser of 20% of QBI or the wage limitation

Specified Service Trades or Businesses (SSTBs)
The IRS describes SSTBs as being in the following fields:

  • Health – The health category includes the provision of services by physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and similar health care professionals who provide medical services directly to patients. However, this excludes the provision of services that are not directly related to a medical field, even when those services purportedly relate to the health of the service recipient. For example, this category excludes the operation of health clubs or spas that provide physical exercise or conditioning; health-related payment processing; or the research, testing, manufacture, and/or sales of pharmaceuticals or medical devices.
  • Law – The law category refers to the provision of services by lawyers, paralegals, legal arbitrators, mediators, and similar professionals in their capacities as such. The category excludes the provision of services that do not require skills unique to the field of law, such as the printing, delivery, and stenography services provided to lawyers.
  • Accounting – The accounting category includes the provision of services by accountants, enrolled agents, tax-return preparers, financial auditors, and similar professionals in their capacities as such. This category is not limited to services that require state licensure as a certified public accountant. This category also excludes payment processing and billing analysis.
  • Actuarial Science – The actuarial science category refers to the provision of services by actuaries and similar professionals in their capacities as such. This category only includes the services provided by analysts, economists, mathematicians, and statisticians if they are engaged in analyzing or assessing financial costs due to risk or uncertainty.
  • Performing Arts – The performing arts category includes the performance of services by individuals who participate in the creation of the performing arts, including actors, singers, musicians, entertainers, directors, and similar professionals in their capacities as such. It excludes services that do not require skills that are unique to the creation of performing arts, such as the maintenance and operation of equipment or facilities. Similarly, the dissemination of video or audio of performing-arts events to the public is not considered to be a service in the performing arts.
  • Athletics – The athletics category refers to the performance of services by individuals who participate in athletic competitions, including athletes, coaches, and team managers in sports such as baseball, basketball, football, soccer, hockey, martial arts, boxing, bowling, tennis, golf, skiing, snowboarding, track and field, billiards, and racing. This category excludes the provision of services that do not require skills that are unique to athletic competition, such as the maintenance and operation of equipment or facilities for use in athletic events. It also excludes the provision of services by persons who disseminate video or audio of athletic events to the public.
  • Consulting – The consulting category refers to the provision of professional advice and counsel to clients to assist them in achieving goals and solving problems. Consulting professionals include lobbyists and similar professionals, but this category focuses on their capacities as such and excludes the minor consulting that accompanies the sale of a product. A trade or businesses cannot be an SSTP if less than 10% of its gross receipts are from consulting (or 5% if the company’s gross receipts are greater than $25 million).
  • Financial services – The category of financial services applies to services that are typically performed by financial advisors and investment bankers, including the following financial services: managing wealth; advising clients with respect to their finances; developing retirement and wealth-transition plans; providing advisory and other services regarding valuations, mergers, acquisitions, dispositions, and restructurings (including in title 11 bankruptcies and similar cases); and raising financial capital through underwriting or by acting as a client’s agent in the issuance of securities. This includes the services provided by financial advisors, investment bankers, wealth planners, retirement advisors, and similar professionals but excludes banking services such as deposit-taking or loan-making.
  • Brokerage Services – The brokerage services category includes services in which a person arranges transactions between a buyer and a seller with respect to securities and in exchange for a commission or fee. This includes services provided by stock brokers and similar professionals but excludes services provided by real estate or insurance agents and brokers.
  • Reputation or Skill – The original legislation’s list of SSTBs included trades or businesses for which the principal asset was the reputation or skill of one or more of employees or owners. However, it was unclear if this meant, for example, that a self-employed plumber who provided his skill to the business would be eligible for the 199A deduction. The taxpayer-friendly interpretation of these tax regulations has generally defined “reputation and skill” to mean:(1) The receipt of income in exchange for endorsing products or services for which the individual provides endorsement services;
    (2) The receipt of licensing income in exchange for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbol associated with that individual’s identity; or
    (3) The receipt of appearance fees or income (including fees or income paid to reality performers who appear as themselves on television, social media, or other forums; radio, television, and other media hosts; and video game players).

The amount of pass-through deduction that is ultimately available due to an SSTB is entirely dependent upon the taxpayer’s 1040 taxable income. Thus, in some cases, pension contributions and the expensing of business assets can lower a taxpayer’s taxable income enough that he or she benefits from an increase in the pass-through deduction. In this scenario, married couples who are not living in community-property states could benefit from filing separately rather than jointly.

If you have questions related to whether your business qualifies for this new deduction, whether it is classified as an SSTB, or how SSTB income fits into your overall tax picture, 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.

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.