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May 2018 Client Newsletter – “Tax Saving Tips”

Tax Reform: Planning for Your New 20 Percent Deduction

As you likely know by now, the Tax Cuts and Jobs Act created a 20 percent tax deduction under new tax code Section 199A.

The question for you: Will you reap any benefits from this new deduction? And the second question: If your chance of qualifying for the 20 percent tax deduction looks bleak, what can you do now to create some hope that you’ll get the deduction?

If your defined taxable income is $315,000 or less (joint return) or $157,500 or less (single), you can relax. You don’t need any strategies to realize your Section 199A deduction. It is simply the lesser of 20 percent of your taxable income (less net capital gains) or 20 percent of your qualified business income.

Example. John is single, a lawyer, with $125,000 in qualified business income and $150,000 in taxable income (excluding net capital gains). John’s Section 199A tax deduction is $25,000 (20 percent x $125,000).

Once you exceed $315,000 (married) or $157,500 (single), we should spend at least a few minutes reviewing your deduction.

Here’s an example of why this is important. We just reviewed a return that would have had $315,001 in taxable income and $350,000 in qualified business income. With that income, the 199A deduction was zero

for this individual, but with $1 less in taxable income, this individual’s deduction is $63,000. We are helping this individual avoid that highly troubling $1 so he can realize his $63,000 deduction.

If you expect to exceed the thresholds, we should talk, because some planning ideas require that you have time on your side. Also, once the year is over, you have very few, if any, Section 199A planning opportunities.

Divorce? Alimony? Tax Reform Says Get Divorced Now—Don’t Wait

Tax reform changes the alimony game. This may or may not have any relevance to you, but if it does, you will want to move quickly.

The Tax Cuts and Jobs Act (TCJA) eliminates tax deductions for alimony payments that are required under post-2018 divorce agreements. More specifically, the TCJA’s new denial of alimony tax deductions applies to payments required by divorce or separation instruments

• executed after December 31, 2018, or

• modified after that date, if the modification specifically states that the new TCJA treatment of alimony payments now applies.

Example. Betsy is divorcing Tim, and Betsy will pay $120,000 a year in alimony. If Betsy can deduct the $120,000 in her 50 percent combined federal and state income tax bracket, her net cost is $60,000 ($120,000 x 50 percent).

To look at the alimony in another light, with no tax deduction, Betsy has to earn $240,000, then pay taxes of $120,000 in her 50 percent bracket, before she can give Tim the $120,000. Regardless of how you look at the cost of alimony, the loss of the alimony tax deduction is huge.

Note: You deal with a judge (court) to finalize the divorce. This could take some time, so don’t procrastinate, or you’ll surely miss the deadline.

Avoid Being an IRS Target When Your Business Loses Money

If you operate what you think is a business, but that business loses money, it may not be a business at all under the tax code. Such a money-losing activity can look like a tax shelter to the IRS, and that substantially increases your chances of an IRS audit.

The tax code contains a business loss safe harbor that’s known as a presumption of profit. You meet this safe harbor when your activity produces a profit in three of five years (two of seven for breeding, training, showing, or racing horses). When you meet the safe harbor, you are presumed a business unless the IRS establishes to the contrary.

We know this for-profit tax code section as the hobby loss section. But you can see that this tax code section creates trouble for much more than what you would consider a simple hobby. Here’s an example of how badly the recent tax reform under the Tax Cuts and Jobs Act can treat a business that loses money.

Example. Henry has an activity that fails the business test and loses money. Last year, he had $70,000 of income and $100,000 of expenses. Under pre-tax-reform law, Henry could claim the hobby-related business deductions up to the amount of his income. So Henry deducted $70,000 (subject to some minor adjustments) and reported close to zero taxable income.

Not this year. Tax reform is going to make Henry suffer. With the same facts, Henry’s business deductions are zero. His taxable income is $70,000. Think about that. Henry lost $30,000 ($70,000 – $100,000) in real money. He now pays taxes on $70,000 of phantom income.

What can Henry do to make this problem go away? He has two choices.

• First, he could create a “for profit” business defense in the hope that he would defeat the IRS in an audit.

• Alternatively, he could stop the taxation on his phantom income by operating his activity as a C corporation.

Tax Reform Update on Business Meals with Clients and Prospects

Here’s the updated strategy: deduct your client and business meals as if tax reform never took place.

Wow. Is this aggressive? Not if

• the IRS comes out with regulations that follow a model set by the American Institute of CPAs, or

• the Joint Committee on Taxation in its explanation of the Tax Cuts and Jobs Act states that client and business meals continue as deductions, or

• lawmakers enact a new tax code section that authorizes client and business meal deductions.

How big is the “if” in the if? We have some insights that say business meals will be deductible for all of 2018. Of course, nothing is certain except the current uncertainty.

Let’s put it this way: If you do what you need to do to deduct the meals, then you are in a position to claim the business meals deduction when one of the above happens. So, make sure you have your 2018 business meals documented as follows:

• The name of the person you had the meal with.

• The name of the restaurant where you had the meal.

• A short description of the business discussed.

• If the meal costs $75 or more, keep the receipt that shows the name of the restaurant, number of people at the table, and itemized list of food and drink consumed.

How to Deduct Your Legal Fees after Tax Reform

The Tax Cuts and Jobs Act (TCJA), known as tax reform, made it more difficult for you to deduct your legal fees. The new tax reform law suspended (killed is a better word) your legal fees as 2 percent miscellaneous itemized deductions for tax years 2018 through 2025.

This means you need to look for other possible ways to deduct legal fees, such as claiming them as business or rental property expenses. Here are some examples:

• You incur legal fees to sue a client for nonpayment of your invoices. You deduct those legal fees as a business expense.

• You incur legal fees to sue a vendor that did not perform the services you paid them to perform. You deduct those legal fees as a business expense.

• You incur legal fees to sue a vendor that damaged your rental property. You deduct those legal fees as a rental expense.

• You incur legal fees to evict a tenant who stopped paying rent. You deduct those legal fees as a rental expense.

New tax reform exception. The TCJA disallowed all business deductions for settlements or payments and the related legal fees for sexual harassment or abuse claims if the settlement or payment is subject to a nondisclosure agreement.

If you incur legal fees related to the ownership or protection of your property, then you generally capitalize the legal fees and add them to the tax basis of your property.

Reduce Self-Employment Taxes by Renting from Your Spouse

As a sole proprietor, you know that the 15.3 percent self-employment tax can eat up your profits in a hurry. You may be able to use a simple strategy to ease this tax burden.

If you own an office building or other assets, you can set up a rental arrangement with your spouse that could significantly cut your self-employment taxes. Here’s an example of how this strategy works:

Example. Wendy operates a sole proprietorship and earns $100,000 of net income. This income creates
a self-employment tax liability of $14,129.55.

Wendy gives the office building to Jim, her spouse, who then rents the office space back to Wendy. Wendy pays Jim $2,000 rent each month (the fair rental value of the building), which moves $24,000 off Schedule C and onto Schedule E. Schedule E, unlike Schedule C, does not give rise to self-employment taxes.

The rent-from-my-spouse strategy cuts Wendy’s self-employment income by $24,000, which puts an extra $3,391.09 of cash in her pocket at the end of the year. And she plans on doing this for at least 10 years, which means she’ll pocket $33,910.90 before considering her investment earnings on this money.

Your Personal Home Is Not Your Tax Home

The fact that your personal home is not your tax home is one income tax issue. Here’s another: Business travel is different from business transportation. Your tax deductions, tax strategies, and tax records hinge on the following federal income tax–defined terms:

1. Personal home

2. Tax home

3. Business travel

4. Business transportation

We know you don’t have an issue with your work deductions at the moment, but we want to make sure you are aware of what could happen if you moved your business location or personal home.

Meanings

Personal home This is where you live.
Tax home This is where you maintain your principal place of work.
Business travel You are in tax-deductible travel status when you travel away from your tax home overnight or long enough to require sleep.
Business Transporation You deduct business transportation as a cost of going to and from tax-deductible business destinations, whether in town or out of town.

Five Good Things to Know

1. Have your personal home within 50 miles of your tax home.
2. When you have your personal home within 50 miles of your tax home, claim the home-office deduction under the administrative office rules so you can eliminate commuting to your outside-the-home office.
3. Deduct overnight business travel when you travel on business outside the area of your tax home.
4. If you have more than one business, the business on which you spend the most time and make the most money is the principal business. It’s the location of your tax home. Overnight travel outside the tax-home area of the principal business to a secondary business is deductible. For example, if you have your principal office in Worcester, Massachusetts, you can deduct your overnight travel to your second business in New York City.
5. If you have one business with multiple offices in different cities, the office where you spend the most time, do the most important things, and make the most money is your tax home. When you travel away from this office overnight to a secondary office, you are in business travel status.

Hiring Your Children to Work on Your Rental Properties

Have you considered hiring your children to work on your rental properties? If so, were you concerned when you did not see a line item for wages on Schedule E of your Form 1040?

Don’t let that bother you. The IRS in its instructions explains that wages and other ordinary and necessary business expenses of the rental that are not named on Schedule E go on line 19.

Because you own more than one rental property, your children may work on more than one. No problem. You need to allocate the wages and associated expenses to the properties on a reasonable basis.
The most apparent allocation basis for the money you are paying the children being time spent by the children at each property.

2017 Tax Bill – “Tax Cuts and Jobs Act”

By the time you read this the President will have signed the most significant tax legislation since 1986. The following is a brief summary of those areas that we think will impact most of our clients in 2018 and in some cases, 2017.

Most of the changes that impact individuals will expire at the end of 2025 while the changes that impact corporations and business are made permanent. We expect there will be Technical Correction bills next year to adjust for flaws that are identified in this legislation. In the future we do think that some of the provisions in this bill will change and/or be repealed as political control changes through our normal election swings.

The following changes include the primary items related to individuals and most small businesses. The tax bill contains numerous other provisions that impact foreign income taxation as well as changes to the insurance industry taxation.

Individual Provisions

The tax brackets for individuals, trusts and estates are all changing and almost all individual taxpayers will see a lower federal tax liability.

Standard Deduction & Personal Exemptions

The standard deduction is increasing substantially but taxpayers are losing their personal exemption deduction. The winners are those taxpayers that have 3 or fewer dependents and the losers are those taxpayers that have more than 4 dependents.

This change will supposedly reduce the taxpayers that itemize from approximately 30%+ of all returns filed down to something in the 10%+ range according to Congress.

Kiddie Tax Modified

Under the current law the net unearned income of a child (i.e. interest & dividends) was taxed at the parent’s tax rate (if higher) with the exception of the first $2,100 which was taxed at the child’s rates. This created complexity to the return and resulted in delays in filing the child’s return until the parent’s return was completed.

Under the new law this rule goes away but the unearned income of the child is taxes according to the brackets for estates and trusts. This change is an improvement!

Capital Gains

Under current law, net capital gains are taxed at a maximum rate of 0%, 15%, or 20% depending on the level of taxpayer income.

The new law retains the provisions for favorable tax treatment for capital gains and qualified dividends and indexes the brackets for inflation.

Income from Pass-Through Entities

This is one of the most significant changes in the tax law and is an attempt to level the playing field with those businesses that are paying taxes at a corporate level whom are the benefactors of a significant tax cut with the reduction of the corporate tax rate to 21%.

A complete explanation would take several pages and any examples we use to explain this provision has exceptions that may limit the deductions. With that said, a brief summary with qualifiers follows:

What is the deduction?

For most small businesses, where the owners have a combined taxable income of less than $315,000 (joint) or $157,500 (single), they will be allowed a deduction equal to 20% of the “Qualified Business Income”. If you have a business that is operated as a sole proprietor and have a net profit for the year of $100,000 your deduction would be $20,000.

Who does it apply to?

All operating and passive businesses that are operating as sole proprietorships, partnerships, or S Corporations whose income is taxed at the individual level

What is “Qualified Business Income” (QBI)?

Generally speaking it is the net profit from any business discussed above. However, it excludes salaries (W-2 income) from S Corporation owners and “guaranteed payments” to partners paid from partnerships. It also includes income flowing from passive activities, MLP’s, and REITS.

The original Senate bill allowed the S Corporation W-2 and guaranteed payments from partnerships to be included as QBI. However, the final compromise bill specifically exempts this income from receiving the benefit of the 20% deduction. This change will certainly create planning opportunities to maximize the deduction without compromising the integrity of returns being filed.

Are there any businesses that do not qualify for this deduction?

The short answer is yes. If the activity is from a professional service such as an accounting firm, law firm, or healthcare they cannot take advantage of this provision if their income is over the thresholds discussed above. Surprisingly, architects and engineers were specifically excluded from the definition of professional services.

What happens if I am over the thresholds of $157,500 and $315,000 of taxable income

The rules change significantly and the computation changes.

You start with taking 20% of the QBI. However, the deduction cannot exceed 50% of your share of the W-2 wages paid by the business. For example:

The taxpayer is a 30% owner of a manufacturing S Corporation. Her share of income is $700,000, and her share of the W-2 wages of the S Corporation are $200,000. She is entitled to a deduction equal to the LESSER OF:

  1. 20% of $700,000, or $140,000, or
  2. 50% of her share of the W-2 wages of the S Corporation or $100,000

Thus, she can take a deduction of $100,000 on her return.

Alternatively, you have another calculation to make that might provide benefit. That formula is:

  • 25% of the wages paid by the business PLUS,
  • 5% of the original cost of property used in the production of income

The alternative option is pointed directly at taxpayers that own commercial and residential real estate either individually or through a flow through entity. To illustrate, let’s assume the commercial real estate was purchased for $2,000,000 10 years ago, the net rental income from this property is $300,000, and there are no wages paid to manage the property. The computation looks like this:

  • 20% of net rental income is $60,000
  • 50% of wages is $0
  • The lesser of the two computations is $0

Based on this calculation no deduction would be allowed. However, we get another crack at the deduction. The alternative calculation looks like this:

  • 25% of the wage is still $0
  • 5 % of $2,000,000 is $50,000
  • The deduction is a combination of the two or in this case, $50,000 which is lesser than 20% of the QBI of $60,000

Itemized Deductions

There are significant changes made to itemized deductions including the elimination of deductions that are common on many tax returns.

With the changes made to itemized deductions the standard deduction will come into play. If you are going to be on the “bubble” of itemizing a planning idea is to bunch deductions every other year to take advantage of your deductions and to maximize the standard deduction from year to year.

Child Tax Credit

Under current law a taxpayer can claim a child tax credit up to $1,000 per qualifying child under the age of 17.  The credit starts to phase out once taxable income hits $75,000 for single filers and $110,000 for joint returns. To the extent the credit exceeded the federal tax liability a portion of the credit was refundable.

For taxable years starting next year the credit is increased to $2,000 with the phase-out limits increased to $200,000 for single filers and $400,000 for joint returns. The amount refundable is increased to $1,400 per qualifying child if the credits exceed the federal tax liability. To qualify, each child must have a valid social security number. A Taxpayer Identification Number is no longer acceptable.

Alimony Deductions

Under the current law alimony is deductible by the payor, and includible in income of the payee.

For divorce or separation instruments executed after December 21, 2018, alimony will no longer be deductible by the payor, nor will it be taxable to the payee. For agreements entered into prior to this date the current tax rules will apply.

Education Incentives & 529 Plans

The House bill would have eliminated most of the current education incentives but all have been retained in the final bill.

Section 529 Plans can now be used to pay for qualified tuition for children in K-12 as well as post-secondary. This includes elementary and secondary public schools as well as private and religious schools.

Exclusion of Gain on the Sale of a Primary Residence

The old rules still apply and a taxpayer may exclude up to $250,000 of gain ($500,000 if married filing jointly), provided the taxpayer has owned and used the home as his or her primary residence for two of the previous five years.  Both the House and Senate bill would have changed the use period to five out of eight years.

Estate Taxes

Under the current rules, a taxpayer is entitled to an exclusion of nearly $5,500,000 which translates to an $11,000,000 exemption for married couples before an estate tax is imposed.

The final bill would immediately double the estate exemption to $11,000,000 for a single taxpayer and $22,000,000 for a married couple.

Alternative Minimum Tax (AMT)

Each taxpayer must calculate their tax twice. If the AMT is higher than the regular tax calculation you pay the higher of the two taxes. Unfortunately, if a taxpayer has significant real estate and state income taxes it is a tax that is quite common because of the low exclusions that are currently available.

The AMT is retained under the current bill but the exemption amount is increased to $109,400 from $86,200 for joint returns and surviving spouses and $70,300 from $55,400, for single taxpayers. In addition the phase-out provisions were significantly expanded. As a result we would expect to see a significant decline in the number of taxpayers that are subject to the AMT.

Individual Insurance Mandate

Under current law any individual who doesn’t maintain “minimum essential health care coverage” must pay a penalty to the IRS. The bill repeals this penalty starting in 2019.

 

Corporate Tax Rate

Under current law the top corporate tax rate is 35%. The final bill drops the corporate rate to 21%.

Cash Method of Accounting

Under current law you must use the accrual method of accounting if average gross receipts is in excess of $5,000,000. The final bill changes that to $25,000,000 of average gross receipts.

 

Bonus Depreciation

Under current law taxpayers can expense 50% of new qualifying property with phase-outs in future years.

The final bill allows 100% expensing of new and used qualifying property purchased and placed in service after September 27, 2017 and before January 1, 2023. Subsequent to 2022 the bonus depreciation is phases down and goes away starting in 2027.

Section 179 Depreciation

Under current law you can deduct up to $510,000 of qualifying property (both new and used) with the deduction phasing out starting once current year purchases exceed $2,000,000. The final bill moves this up to $1,000,000 with the phase-out starting with $2,500,000 of qualifying purchases.

The final bill also is expanded to include the hotel industry to be eligible for 179 expensing. In addition, improvements to non-residential real property for roofs, HVAC systems, fire and protection systems as well as security systems are all eligible for 179 expensing.

Interest Expense

Currently there is no limitation of the amount of interest that can be deducted against business income. Starting in 2018 business interest expense will be limited to 30% of “adjusted taxable income” which is a new term. Companies not subject to this limitation includes businesses with gross receipts of less than $25,000,000 and commercial real estate owners.

Net Operating Losses

Currently individuals and businesses that incur net operating losses can carryback the loss 2 years and then forward 20 years. The final bill changes this to not allow carrybacks and any carryforwards will be limited to 80% of taxable income.

Alternative Minimum Tax (AMT)

Starting in 2018 the 20% corporate AMT is repealed.

Recovery Periods for Real Property

The original House and Senate bills had provisions to reduce the depreciable recovery period of commercial and residential real estate down to 25-years from 49 and 27.5-years. This provision did not make the final cut.

However, the final bill cleans up several classification of depreciable property that we now have to deal with. Starting in 2018 the separate definitions of “qualified leasehold improvement”, “qualified restaurant”, and “qualified retail improvement” properties are now eliminated.

Starting in 2017, improvements that meet the definition of “Qualified Improvement” property are assigned a depreciable life of 15-years and depreciated using the straight line method. In addition, restaurant buildings placed in service after December 31, 2017 will have a depreciable life of 39-years as compared to the current life of 15-years.

Like-kind Exchanges

Under current law you can exchange real estate for a comparable asset without having to recognize gain assuming all criteria are met. In addition, a trade-in of personal property (vehicle or a piece of equipment) will generally be a tax-free exchange.

The final bill keeps the real estate 1031 exchange option available but all exchanges of personal property will no longer be eligible for tax-free treatment. For example if you have a piece of equipment that has been fully depreciated and you receive a trade-in value of $10,000 gain will be recognized on the transaction. However, you are also eligible for bonus depreciation or section 179 expensing which should allow you to offset the gain recognized.

Employer’s Deduction for Entertainment Expenses

Under current law an employer can deduct up to 50% of expense relating to meals and entertainment.

Under the final bill starting in 2018 all entertainment expenses are no longer deductible. This includes items such as sporting tickets, golf events, membership dues, facility use, and any other item that would be considered entertainment. This removes the subjective determination of whether such expenses are sufficiently business related.

However, the purchase of meals and related beverages will continue to be allowed at 50% of the expense assuming they are related to a business purpose.

Limitation on Excessive Employee Compensation

The deductions for certain employees working for a publicly traded company is limited to $1,000,000. Any compensation over that amount is not allowed. The final bill includes stock option value into this computation.

Deduction for Local Lobbying Expenses Eliminated

The final bill disallows a deduction for lobbying expenses with respect to legislation before local government bodies.

New Credit for Employer-Paid Family and Medical Leave

Starting in 2018 a credit can be claimed for wages paid to an employee who is on qualified family and medical leave subject to a plan and meeting certain requirements.

Planning Suggestions

Most of the provisions in the bill are effective for 2018 but as a general rule the following recommendations should be considered if you still have time for last minute planning.

  • You can still make a 4th quarter state tax estimate. There is wording in the final bill that appears to preclude or limit the amount that can be made. However, we have had conversations with a national tax leader that the language in the bill was put there to prevent someone from prepaying their entire 2018 tax state tax payment in 2017 thus, claiming the deduction in 2017 and avoiding the $10,000 bucket for the limitation for real estate taxes and state income taxes. A reasonable payment (even if it results in a refund on your 2017 state return) should be consider provided you are not in an AMT situation. If you are subject to AMT, the state tax payment will not reduce your federal tax liability
  • Defer income into 2018 if you expect the lower rates to benefit you.
  • Accelerate deductions into 2017 if you are going to be subject to the standard deduction.
  • If you are close to the standard deduction amount consider “bunching” your itemized deductions so that every other year you itemize and the off year you claim the standard deduction.
  • Call us with questions to see if there is anything we can do to help with some last minute planning.

Seminars

Due to the timing of the legislation we have not scheduled any client education seminars/webinars but are planning to do so in January. If you are interested in attending please call our office and give Beth your name, phone #, and e-mail address and we will make sure you have a spot reserved.