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NEWS

NEWS

Business Provisions of the Proposed Tax Reform Bill

The following is a more in-depth discussion of thebusiness provisions of the comprehensive tax reform bill released by the House Republicans on November 2.  At the present time, the House Ways and Means Committee is marking up this bill, for anticipated votes by the Committee and then by the full House prior to Thanksgiving bill’s business provisions.

Tax Rate Structure for Corporations. The corporate tax rate would be reduced to a flat 20%.  Currently, corporate tax rates are graduated and start at 15%, with a maximum rate of 35%.  Between $335,000 and $10 million of income, corporations effectively pay a flat 34% because the lower brackets are phased out.  The 35% bracket currently applies at $10 million of taxable income.

Alternative Minimum Tax.  The corporate alternative minimum tax (“AMT”) would be eliminated.  Taxpayers that have AMT credit carryforwards will be able to use them against their regular tax liability and would also be able to claim a refundable credit equal to 50% of the remaining AMT credit carryforward in years beginning in 2019, 2020 and 2021 and the remainder in 2022.

Expensing of Capital Investments.   Businesses would be allowed to immediately write off (expense) the cost of new investments in depreciable assets made after September 27, 2017 and before January 1, 2023.  Property that is “first-used” by the taxpayer would qualify, so the property would no longer have to be new. 

Interest Expense.  The deduction for net interest expense incurred by any business, regardless of form, would be subject to a disallowance of a deduction in excess of 30% of the business’s “adjusted taxable income.”  Adjusted taxable income is the equivalent of EBIDTA and is computed without regard to business interest income and expense, net operating losses, depreciation, amortization and depletion. The amount of disallowed interest would be carried forward for five years.  Exempt from these rules would be businesses with average gross receipts of $25 million or less, regulated public utility companies and real property trade or businesses. The rules would apply at the entity level for pass-through entities and special rules would apply to the pass-through entities’ unused interest limitation for the year. 

Net Operating Loss Rules.  The net operating loss (“NOL”) deduction would be limited to 90% of taxable income (determined without regard to the NOL deduction). The 90% limitation is currently the limitation on AMT NOL usage and it will create a 2% of taxable income minimum tax on all corporations.   Carrybacks of NOLs would no longer be allowed except for one-year carrybacks for small businesses and farms with casualty or disaster losses.  The provision would apply to losses arising in years beginning after 2017.  For year beginning in 2017, the current NOL carryback rules would apply but NOLs created from the increased expensing discussed above would not be available for carryback.   NOLs arising in tax years beginning after 2017 that are carried forward would be increased by an interest factor.

Like-Kind Exchanges of Real Property.  The like-kind exchange rules would only be available for real property.  The rule would be effective for transfers after 2017 but a transition rule would apply to personal property transfers started but not completed by December 31, 2017.

Repeal of Other Business Expenses.  The following business deductions would be repealed:

  • The IRC Sec. 199 domestic production activity deduction (“DPAD”).
  • The deduction for local lobbying expenses.
  • The deduction for entertainment expenses other than business meals.

Gain Rollover to Special Small Business Investment Companies (“SSBIC”).  The rollover of capital gain on publically traded securities into an SSBIC would no longer be allowed.

Accounting Simplification for Small Businesses.  For certain businesses with less than $25 million in average annual gross receipts, the following accounting simplifications would apply:

  • Cash Method of Accounting.  C corporations and partnerships with C corporation partners would be able to use the cash method of accounting.  Currently, the gross receipts limitation is $5 million.  The new threshold would be indexed for inflation.
  • Accounting for Inventories.  Businesses would be able to use the cash method of accounting even though it had inventory.  The business would have to treat the inventory as a non-incidental material or supply.
  • Capitalization and Inclusion of Certain Expenses in Inventory Costs. Businesses would be fully exempt from the UNICAP rules for real and personal property, acquired or manufactured.
  • Long-Term Contract Accounting.  Businesses that meet the threshold would be able to use a non-percentage of completion method including the completed contract method.  

Business Credits.  The research and development (“R&D”) and low-income housing credits would remain.  The following credits would be repealed: orphan drug credit, employer-provided child care credit, rehabilitation credit, work opportunity work credit, new markets tax credit and disabled access credit. The deduction for unused credits would be repealed. 

Employer Credit for Social Security Taxes Paid with Respect to Tips. This credit would be modified to reflect the current minimum wage so that it is available with regard to tips reported only above the current minimum wage.  Additional reporting requirements would also be required.

Energy Credits

  • Production Tax Credit.  The inflation adjustment would be repealed, effective for electricity and refined coal produced at a facility the construction of which begins after November 2, 2017. Accordingly, the credit amount would revert to 1.5 cents per kilowatt-hour for the remaining portion of the ten-year period.
  • Investment Tax Credit (ITC).  The expiration dates and phase-out schedules for different properties would be synchronized. The 30% ITC for solar energy, fiber-optic solar energy, qualified fuel cell, and qualified small wind energy property would be available for property when the construction begins before 2020 and is then phased out for property when the construction begins before 2022.  No ITC would be available for property when the construction begins after 2021. Additionally, the 10% ITC for qualified microturbine, combined heat and power system and thermal energy property would be available for property when the construction begins before 2022. Finally, the permanent 10% ITC available for solar energy and geothermal energy property would be eliminated for property when the construction begins after 2027.
  • Residential Energy Efficient Property. The credit for residential energy efficient property would be extended for all qualified property placed in service prior to 2022, subject to a reduced rate of 26% for property placed in service during 2020 and 22% for property placed in service during 2021. The provision would be effective for property placed in service after 2016.
  • The enhanced oil recovery credit and the credit for producing oil and gas from marginal wells would be repealed.

Executive Compensation

  • Modification of the Limitation of Excessive Executive Compensation.  The exception to the $1 million deduction limitation for performance-based compensation would be repealed.  The definition of covered employee would also be amended to include the CEO, CFO and the three other highest paid employees.  Additionally, once an employee qualifies as a covered employee, his/her compensation would be subject to the $1 million limitation as long as the executive (or beneficiary) receives compensation from the company. 
  • Nonqualified Deferred Compensation. An employee would be taxed on compensation as soon as there is no substantial risk of forfeiture (i.e., the compensation is not subject to future performance of substantial services).  A condition would not be treated as constituting a substantial risk of forfeiture solely because it consists of a covenant not to compete or because the condition relates (nominally or otherwise) to a purpose of the compensation other than the future performance of services – regardless of whether such condition is intended to advance a purpose of the compensation or is solely intended to defer taxation of the compensation.  The provision would be effective for amounts attributable to services performed after 2017. For existing non-qualified deferred compensation plans, the current-law rules would continue to apply until the last tax year beginning before 2026.  At that time, the arrangements would become subject to the provision.
  • Excise Tax on Excess Tax-Exempt Organization Executive Compensation. The bill proposes a 20% excise tax on compensation in excess of $1 million paid to a tax-exempt organization’s five highest-paid executives. The provision would apply to all remuneration paid to such executives, including cash and the cash value of all remuneration (including benefits) paid in a medium other than cash, and excluding payments to a tax-qualified retirement plan and amounts otherwise excludable from the executive’s gross income. The excise tax also would apply to “excess parachute payments” by the organization to such individuals.  An excess parachute payment generally would include a payment contingent on the executive’s separation from employment with an aggregate present value of three times the executive’s base compensation or more. The provision would be effective for tax years beginning after 2017.

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.