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NEWS

NEWS

House Ways and Means Committee Release Tax Reform Bill

On November 2, Kevin Brady (R-TX), Chairman of the US House of Representatives' Ways and Means Committee, released the Tax Cuts and Jobs Act, a comprehensive tax reform proposal consisting of legislative language and a detailed explanation. He also announced that the Ways and Means Committee would begin consideration, or "markup," of the proposal on November 6. House Republican leaders' goal is to have the tax reform bill passed by the full House of Representatives and sent to the US Senate prior to the Thanksgiving holiday. 

Business Provisions

  • The corporate tax rate would be a flat 20%.  Personal service corporations would be subject to a flat 25% rate. 
  • The corporate alternative minimum tax would be repealed.
  • A portion of net income distributed by a pass-through entity (i.e., sole proprietorship, partnership, limited liability company (LLC) taxed as a partnership or S corporation) to an owner or shareholder may be treated as “business income” subject to a maximum rate of 25%, instead of ordinary individual income tax rates.  The remaining portion of net business income would be treated as compensation and continue to be subject to ordinary individual income tax rates.  Rules are provided to determine the proportion of business income and to prevent the re-characterization of actual wages paid as business income.  Net income derived from a passive business activity would be treated as business income and fully eligible for the 25% maximum rate.  Under certain default rules, owners or shareholders receiving net income derived from an active business activity (including wages received) would treat 70% of business income as ordinary income and 30% as business income eligible for the 25% rate; alternatively, such owners or shareholders may elect to apply a specified formula based on the business’s capital investments to determine an allocation greater than 30%.  Certain personal services businesses, such as law firms and accounting firms, would generally not be eligible for the reduced 25% rate on business income with respect to such personal services business, though they would be allowed to use the alternative formula based on the business’s capital investments, subject to certain limitations.
  • Businesses would be allowed to fully and immediately expense the cost of qualified property (not including structures) acquired and placed in service after September 27, 2017 and before January 1, 2023. 
  • “Section 179” small business expensing limitations would be increased to $5 million and the phase-out amount would be increased to $20 million, effective for tax years beginning after 2017 and before 2023.  These amounts would be indexed for inflation.  The definition of qualifying property would be expanded, effective for certain property acquired and placed in service after November 2, 2017. 
  • Businesses would have greater access to the cash method of accounting, including certain circumstances where a business has inventories. 
  • Every business, regardless of form, would be subject to a disallowance of a deduction for net interest expense in excess of 30% of the business’s adjusted taxable income.  The net interest expense disallowance would be determined at the tax filer level, e.g., at the partnership level rather than the partner level.  An exemption from this rule would be provided for small business with average gross receipts of $25 million or less.  Also, this provision would not apply to a real property trade or business.
  • The special rule under existing law allowing deferral of gain on like-kind exchanges would be modified to allow for like-kind exchanges only with respect to real property.
  • Numerous corporate deductions and credits would be repealed.  For example, the deduction for income attributable to domestic production activities would be repealed.  However, the research and development tax credit and the low-income housing credit would be retained.

International Provisions

  • The bill proposes significant changes to the taxation of business income earned outside the U.S. – including moving away from a deferral system to a “territorial” system.
  • It introduces a “participation exemption” system to the U.S. for the taxation of foreign income (similar to many European countries) whereby 100% of the foreign-sourced portion of dividends received from 10% or more owned foreign corporations would be exempt from U.S. tax.  No foreign tax credit would be allowed on any dividend qualifying for the participation exemption.
  • As a transition to this new system, the bill would deem a repatriation of previously deferred foreign earnings.
  • A current U.S. tax would be imposed on deferred earnings and profits of foreign corporations owned by 10% or greater U.S. shareholders. The rate would be 12% on earnings and profits (E&P) comprising cash or cash equivalents and 5% on the remaining E&P that has been reinvested in a foreign corporation’s business (e.g., property, plant and equipment).  An election is available to pay the tax in equal installments over a period of up to eight years.  Foreign tax credits would be partially available to offset the tax. 
  • If foreign E&P is taxed on transition to the participation exemption, the E&P can then be repatriated tax-free to the U.S. – subject to possible foreign withholding tax.
  • To address “base erosion,” a U.S. parent of one or more foreign subsidiaries would be subject to the 20% U.S. corporate tax rate on 50% of the U.S. parent’s “foreign high returns” (i.e., a 10% tax).  High returns would be measured as the excess of the subsidiaries’ income over a routine return (7% plus the federal short-term rate) on the subsidiaries’ bases in tangible property, adjusted downward for interest expense.
  • The deductible net interest expense of a U.S. corporation that is a member of an international financial reporting group would be limited to the extent the U.S. corporation’s share of the group’s global net interest expense exceeds 110% of the U.S. corporation’s share of the group’s global earnings before interest, taxes, depreciation and amortization (EBIDTA).
  • Payments (other than interest) made by a U.S. corporation to a related foreign corporation that are deductible, includible in costs of goods sold, or includible in the basis of a depreciable or amortizable asset would be subject to a 20% excise tax, unless the related foreign corporation elected to treat the payments as income effectively connected with the conduct of a U.S. trade or business.
  • There are also a number of other potentially impactful international tax provisions included in the bill that we will discuss in more detail in future commentary. 

Individual Provisions

  • The current seven tax brackets would be consolidated into four brackets of 12%, 25%, 35% and 39.6%.  For married taxpayers filing jointly, the 39.6% bracket threshold would be $1,000,000; in the case of unmarried individuals, it would be $500,000.
  • Personal exemptions would be eliminated and consolidated into a larger standard deduction --$24,000 for married taxpayers filing jointly and $12,000 for single filers. 
  • Most itemized deductions would be repealed, except for charitable contributions, up to $10,000 of state and local real property taxes and certain mortgage interest.  The deduction for interest on existing mortgages would continue, but for debt incurred after November 2, 2017, interest paid on only $500,000 of principal residence mortgage debt would be deductible.  Amongst the deductions repealed would be: state and local income or sales taxes, personal casualty losses, wagering losses, tax preparation expenses, medical expenses, alimony payments, moving expenses, contributions to medical savings accounts and expenses attributable to the trade or business of being an employee.
  • The bill would not change the current treatment of “carried interests.”
  • Pre-tax contribution levels for retirement accounts, such as a tax-deferred 401(k) account, would be retained.  
  • The individual alternative minimum tax would be repealed. 
  • The child care credit would be increased to $1,600 per child under 17; alternatively, a credit of $300 would be allowed for non-child dependents.  A family flexibility credit of $300 would be allowed with respect to a taxpayer (each spouse in the case of a joint return) who is neither a child nor a non-child dependent.  The refundable portion of the child credit would be limited to $1,000.  The family flexibility credit and the non-child dependent credit would be effective for taxable years ending before January 1, 2023.
  • The many existing provisions on education incentives would be consolidated and simplified.  Certain deductions and exclusions would be repealed.
  • The estate tax would be phased out over six years.  The “basic exclusion amount” would be doubled from $5 million (as of 2011) to $10 million, which is indexed for inflation ($10.98 million for 2017).  Beginning after 2023, the estate and generation-skipping tax would be repealed while maintaining a beneficiary’s step-up basis in estate property. 
  • Beginning in 2024, the gift tax is lowered to a top rate of 35% and retains a basic exclusion amount of $10 million and an annual exclusion of $14,000 (as of 2017), indexed for inflation.

IRS to Target Specific S Corporation Areas as Part of New Compliance Campaign

The Internal Revenue Service’s Large Business and International Division has approved five new compliance campaigns in several areas including specific areas related to S corporations. The LB&I Division has been moving toward issue-based examinations and a compliance campaign process in which it decides which compliance issues present enough of a risk to require a response in the form of one or multiple treatment streams to achieve tax compliance objectives. The five new campaigns were identified through data analysis and suggestions from IRS employees. The goal is to improve return selection, identify issues representing a risk of non-compliance, and make the best use of the division’s limited resources.

As part of the S corporation campaign, the IRS noted that S corporations and their shareholders are supposed to properly report the tax consequences of distributions. The service has targeted three issues as part of this campaign:

  • When an S corporation fails to report gain upon the distribution of appreciated property to a shareholder.
  • When an S corporation fails to determine that a distribution, whether in cash or property, is properly taxable as a dividend; and,
  • When a shareholder fails to report non-dividend distributions in excess of their stock basis that are subject to taxation.

For this campaign, the IRS plans to conduct issue-based examinations, suggest changes to tax forms, and conduct stakeholder outreach.

As part of the campaign, any examinations that result from this campaign will probably touch upon other S corporation related issues including the methods S corporations use to determine reasonable compensation and its impact on potential under-reported FICA taxes.

Taxation of Cryptocurrency Mining Activities

There are new rules which the US Congress passed in December 2017 that change the way the IRS treats cryptocurrency. Before the US Congress put forth a clearer ruling in 2017, the classification category of cryptocurrency assets was up for interpretation according to many tax experts. That’s because many cryptocurrency miners and traders treated cryptocurrency similar to real-estate for tax purposes by citing the like-kind exchange rules of IRS Code Section 1031.

Following this ruling a miner could theoretically trade a mined cryptocurrency for another cryptocurrency without having to pay taxes. With 1031 exchanges limited to real estate transactions under the recent tax act this treatment is now out the window. Now anyone with cryptocurrency mining operations in 2018 will have to pay taxes beginning in 2019.

There are a couple of things to consider when paying taxes for cryptocurrency mining. You have two different income streams to consider. The first taxable event occurs whenever a miner mines a new coin. The IRS considers this to be income even if the miner decides to only hold the coins as “inventory”. When you mine the coins, you have income on the day the coin is "created" in your account at that day's exchange value. If you are reporting activity as an individual taxpayer, you can report the income as a hobby or as self-employment. If you report as a hobby, you include the value of the coins as "other income" on line 21 of form 1040. Your ability to deduct any expenses is limited -- expenses are itemized deductions subject to the 2% rule.

If you report as self-employment income (you are doing work with the intent of earning a profit) then you report the income on schedule C. You can fully deduct your expenses. The net profit is subject to income tax and self-employment tax. Similar treatment occurs if you operate as a multi-member LLC except that the transactions are reported on the LLC’s tax return with the individual members having their shares of the net profits or losses reported on individual K-1s.

Your second income stream comes when you actually sell the coins to someone else for dollars or other currency. Then you have a capital gain or a capital loss.

Finally, if you immediately sell the coins for cash, then you only have income from the creation and you don't also have a capital gain or loss.

Now, as far as expenses are concerned, if you are doing this as a business, you can take an expense deduction for computer equipment you buy (as depreciation) and your other expenses (for example electricity and other business expenses). But if you are doing this as a home-based business you need to be able to prove those expenses, such as with a separate electric meter or at least having your computer equipment plugged into a portable electric meter so you can tell how much of your electric bill was used in your business. Unless your expenses are very high, they won't offset the extra self-employment tax, so you will probably pay less tax if you report the income as hobby income and forget about the expenses.

Supreme Court Rules States Have Authority To Require Online Retailers To Collect Sales Taxes

The U.S. Supreme Court, in a 5-4 decision, has held that states can assert nexus for sales and use tax purposes without requiring a seller’s physical presence in the state, thereby granting states greater power to require out-of-state retailers to collect sales tax on sales to in-state residents. The decision in South Dakota v. Wayfair, Inc., et al overturns prior Supreme Court precedent in the 1992 decision Quill Corp. v. North Dakota which had required retailers to have a physical presence in a state beyond merely shipping goods into a state after an order from an in-state resident before a state could require the seller to collect sales taxes from in-state customers. That was before the surge of online sales, and states have been trying since then to find constitutional ways to collect tax revenue from remote sellers into their state.

The Court noted: “When the day-to-day functions of marketing and distribution in the modern economy are considered, it is all the more evident that the physical presence rule is artificial in its entirety”. The Court also rejected arguments that the physical presence test aids interstate commerce by preventing states from imposing burdensome taxes or tax collection obligations on small or startup businesses. The Court concluded that South Dakota’s tax collection plan was designed to avoid burdening small businesses and that there would be other means of protecting these businesses than upholding Quill.

In his dissenting opinion, Chief Justice John Roberts argued that, although he agreed that the enormous growth in internet commerce in the interim years has changed the economy greatly, Congress was the correct branch of government to establish tax rules for this new economy. He also took issue with the majority’s conclusion that the burden on small businesses would be minimal.

Prior to the decision, many states had already begun planning for the possible overturn of Quill.

Congress may now decide to move ahead with legislation on this issue to provide a national standard for online sales and use tax collection, such as the Remote Transactions Parity Act or Marketplace Fairness Act, or a proposal by Rep. Bob Goodlatte, R-Va., that would make the sales tax a business obligation rather than a consumer obligation. Under that proposal, sales tax would be collected based on the tax rate where the company is located but would be remitted to the jurisdiction where the customer is located.

 

C Corp vs S Corp or LLC:
How The Tax Cuts and Jobs Act Impacts This Decision

The Qualified Business Income Deduction section of the Tax Cuts and Jobs Act included a new deduction meant for S corps, LLCs, partnerships and sole proprietorships (commonly referred to as pass-through entities). The deduction is calculated at 20% of the trade/business income of these entities. There are limitations based on owner’s taxable income, W-2 salaries of the business, assets in the business and whether or not the business is a service or non-service entity.

Accordingly, not all pass-through entities will qualify for the 20% deduction.

The Tax Cuts and Jobs Act has also dropped the C corporation tax rate to 21% and a lot of questions have arisen from closely held business owners about converting their limited liability company (LLC) or S corporation (S corp) to a C corporation (C corp) including questions from the owners of entities that don't qualify for the 20% deduction. Does it make sense to switch to or start a C corp? The answer is not that simple. Much depends on your business and the business model you operate under.

While the federal tax rate for C corps has dropped favorably to a flat 21%, there are still limitations to a C corp’s tax structure. C corps are subject to double tax. When a C corp issues dividends on their profits, the shareholders receiving the dividends are then taxed on their personal tax return, while the C corp receives no deductions for these payments. Whereas, if you are structured as an LLC or an S corp, you are taxed on the net taxable income that flows through to the owner’s individual tax return and you can distribute the funds out of your company, without double tax. If the goal of the business is to reinvest the earnings back into the company, C corps are a favorable option to take advantage of the lower tax rates.

As a practical matter, for current operations, closely held C corporations do not normally pay dividends. Owners in these entities are often active in the business and draw a salary. The corporation gets a deduction for the salaries, but owners receiving the salary pay federal tax on that salary at a rate as high as 37%.

Upon exiting a closely held business, the sale of the assets of the business are, normally, the only viable option. Very few buyers will want to buy the ownership interest in a closely held business. If you decide to sell your business as a C corp, income generated from the sale of assets is taxed at the corporate level first and then taxed again when the net cash is distributed out to the shareholders.

Also, consider the timing issues when switching to and from a C corporation. Let’s say your business is currently structured as an S corp. You and your shareholders deem your business is better suited as a C corp and you want to convert your organization. It is fairly easy to switch to a C corp. But there is a “buyer beware” with that enterprise. You must wait five years after the switch to a C corp to switch back to an S corp. Once you switch back to an S corp, you could be subject to double taxation on built-in gains (unrealized appreciation on assets held while the entity is a C corporation) for an additional five years after the switch. At a minimum, you will need to live with the possibility of some degree of double taxation for up to ten years.

So what is the bottom line on all of this?

If you have a business that you plan on keeping fairly small, with fewer than 100 shareholders and located in the U. S, you probably want to be an S corp or an LLC. But if your goal is to reinvest profits back into your business to finance future organic growth then the C corporation is probably a good fit. If you have big plans for growing your company to position it for future sale or to go public, you might want the flexibility to take on investors, raise capital, issue different kinds of stock, and invite foreign investors into your business as a C corp.

As always, it is best to consult your advisors before commencing any changes in business structure.