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NEWS

NEWS

Key Business Provisions of The Tax Cuts and Jobs Act

The following summarizes the key provisions of the Tax Cuts and Jobs Act (the Act) as it relates to businesses. 

Corporate Tax Rate Reduction.  For taxable years beginning after December 2017, the corporate tax rate is a flat 21%. The 21% tax rate also applies to personal service corporations. It appears that the rate will be pro-rated for fiscal year filers if the taxable year includes January 1, 2018.

Dividend Received Deductions.  The 80% dividends received deduction is reduced to 65% and the 70% dividends received deduction to 50%.

Corporate Alternative Minimum Tax.  The corporate AMT is eliminated.  Taxpayers that have AMT credit carryforwards will be able to use them against their regular tax liability and will also be able to claim a refundable credit equal to 50% of the remaining AMT credit carryforward in years beginning in 2018 through 2020 and 100% for years beginning in 2021.

Pass Through Entities.  The Act generally allows a non-corporate taxpayer (including a trust or estate) who has qualified business income (“QBI”) from a partnership, S corporation or sole proprietorship (pass-through entities) to deduct the lesser of:

  • The combined QBI amount of the taxpayer; or
  • 20% of the excess, if any, of the taxpayer’s taxable income for the tax year, less net capital gain.

QBI is defined as all domestic (U.S.- source, including Puerto Rico) business income other than investment income.  QBI does not include any amount that is treated as reasonable compensation of the taxpayer for services rendered to the business (W-2 salary for S corporation) or any amount paid by a partnership that is a guaranteed payment for services performed. The 20% deduction is not allowed in computing adjusted gross income, but rather is allowed as a deduction reducing taxable income.

Limitations

For pass-through entities, the deduction cannot exceed the greater of:

  • 50% of the W-2 wages attributable to QBI paid to the taxpayer; or
  • The sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis of all qualified property.

Qualified property is generally defined as tangible, depreciable property that is held by, available for use, and used in the qualified trade or business at the close of the taxable year.

For a partnership or S corporation, each partner or shareholder is treated as having W-2 wages for the taxable year in an amount equal to his or her allocable share of the entity’s W-2 wages for the tax year.

The W-2 wage limit does not apply in the case of a taxpayer with taxable income not exceeding $315,000 for married individuals filing jointly ($157,500 for other individuals). This limitation is phased-in for individuals with taxable income exceeding these thresholds over the next $100,000 of taxable income for married taxpayers filing jointly ($50,000 for other individuals).

Thresholds and Exclusions

The deduction does not apply to “specified service businesses,” which means any trade or business that involves the performance of services for any trade or business where the principal asset of such trade or business is the reputation or skill of one or more employees or owners.  These include the areas of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services.

The Act specifically excludes engineering and architecture services from the definition of specified service business.  This exclusion does not apply for a taxpayer whose taxable income does not exceed $315,000 for married individuals filing jointly ($157,500 for other individuals). The deduction for service businesses is phased out over the next $100,000 of taxable income for joint filers ($50,000 for other individuals).

Excess Business Losses of Taxpayers Other than Corporations.  The Act implements a new rule, which states that “excess business losses” of a taxpayer other than a corporation are not allowed for the taxable year but are instead carried forward and treated as part of the taxpayer's net operating loss (“NOL”) carryforward in subsequent tax years. This limitation applies after the application of the passive activity loss rules.  NOL carryovers generally are allowed for a taxable year up to the lesser of the carryover amount or 80% of taxable income.

An excess business loss for the taxable year is the excess of the taxpayer’s aggregate deductions attributable to his/her trade and businesses over the sum of aggregate gross income or gain of the taxpayer, plus a threshold amount. The threshold amount for a taxable year is $500,000 for married taxpayers filing jointly and $250,000 for other individuals, with both amounts indexed for inflation.

Increased Bonus Depreciation.  Businesses are generally allowed to write off (expense) a percentage of the cost of depreciable assets that are acquired and placed in service from September 28, 2017 to December 31, 2026.  The write-off percentages are as follows:

9/28/17 to 12/31/22 100%
2023 80%
2024 60%
2025 40%
2026 20%

Depreciation Limitation for Luxury Automobiles and Personal Use Property.  For passenger automobiles placed in service after December 31, 2017 and for which bonus depreciation is not claimed, the luxury automobile depreciation limitation is increased to a maximum of $10,000 for the year in which the vehicle is placed in service, $16,000 for the second year, $9,600 for the third year and $5,760 for the fourth and later years.  The limitations are indexed for inflation for automobiles placed in service after 2018.
Section 179 Expensing.  The “Section 179” small business expensing limitation is increased to $1,000,000, and the phase-out threshold is increased to $2,500,000, effective for property placed in service in taxable years beginning after December 31, 2017.  These amounts are indexed for inflation.  The definition of qualifying property is expanded to include certain improvements to real property.

Recovery Period for Real Property.  The provision eliminates the separate definitions of qualified leasehold improvement, qualified restaurant and qualified retail improvement property and provides a straight-line, 15-year recovery period for qualified improvement property and a 20-year “alternative depreciation system” (“ADS”) recovery period for such property.  The ADS recovery period for residential rental property is reduced from 40 to 30 years. Both of these rules are effective for property placed in service after December 31, 2017. The recovery period for nonresidential real and residential rental property remains at 39 and 27.5 years, respectively. 

Computers and Peripheral Equipment Removed from Listed Property.  Deductions for such property are no longer subject to the heighted substantiation requirements.

Accounting Simplification for Small Businesses.  For certain businesses with not more than $25 million in average annual gross receipts (indexed for inflation), the following accounting simplifications apply:

  • Cash Method of Accounting.  C corporations and partnerships with C corporation partners will be able to use the cash method of accounting.  Currently, the gross receipts limitation is $5 million. 
  • Accounting for Inventories.  A business will be able to use the cash method of accounting even though it has inventory.  The business will have to treat the inventory as non-incidental materials and supplies or conform to the taxpayer’s financial accounting treatment of inventories. 
  • Capitalization and Inclusion of Certain Expenses in Inventory Costs.  Businesses will be fully exempt from the UNICAP rules for real and personal property, acquired or manufactured.
  • Long-Term Contract Accounting.  Businesses that meet the threshold will be able to use a non-percentage of completion method including the completed contract method.

Accounting Methods/Special Rules for Taxable Year of Inclusion.  This provision revises the rules associated with the recognition of income.  For taxable years beginning after December 31, 2017, it requires a taxpayer to recognize income no later than the taxable year in which such income is taken into account as income on an applicable financial statement, subject to an exception for certain long-term contract income.

Deferral Method for Advanced Receipts.  This codifies the current deferral method of accounting for advance receipts for goods and services under an IRS revenue procedure; i.e., taxpayers will be allowed to defer the inclusion of income associated with certain advance receipts to the end of the taxable year following the tax year of receipt if such income also is deferred for financial statement purposes.

Interest Expense Deduction.  For taxable years beginning after December 31, 2017, the deduction for business interest is limited to the sum of business interest income, floor plan financing interest, and 30% of the “adjusted taxable income” of the taxpayer for the taxable year.  The adjusted taxable income is the taxable income of the taxpayer computed without regard to (i) any item of income, gain, deduction or loss which is not properly allocable to a trade or business; (ii) any business interest or business interest income; (iii) the 20% deduction for certain pass-through income; (iv) for taxable years beginning after December 31, 2017 and before January 1, 2022 -- depreciation, amortization, or depletion; and (iv) the amount of any net operating loss deduction.  The amount of disallowed interest is carried forward indefinitely.  Exempt from these are businesses with average gross receipts of $25 million or less, regulated public utility companies, electing real property trade or businesses, and electing farming businesses.

Net Operating Loss Deduction.  The NOL deduction is limited to 80% of taxable income (determined without regard to the NOL deduction), effective for losses arising in taxable years beginning after December 31, 2017. 

Carryovers to other years are adjusted to take account of this limitation and can be carried forward indefinitely.  The two-year carryback and certain special carryback provisions are repealed except for certain farming businesses and property and casualty insurance businesses.  The provisions to limit carrybacks and allow indefinite carryforwards applies to losses arising in taxable years beginning after December 31, 2017.

Like-Kind Exchanges of Real Property.  The like-kind exchange rules are only available for real property not held primarily for sale.  The rule is for transfers after 2017 but a transition rule applies to any exchange if either the property being exchanged or received is exchanged or received on or before December 31, 2017.

S Corporation Conversions to C Corporations.  In the case of an S corporation which revokes its S corporation election during the two-year period beginning on the enactment date (of this legislation) and has the same owners on both the enactment date and the revocation date, distributions from the terminated S corporation are treated as paid from its accumulated adjustments account and from its earnings and profits.  Adjustments attributable to the conversion from S corporation status to a C corporation (IRC Sec. 481(a)) are taken into account ratably over six years.

Repeal of Certain Business Expenses.  The following business deductions are repealed:

  • The IRC Sec. 199 domestic production activity deduction (“DPAD”) for taxable years beginning after December 31, 2017.
  • The deduction for entertainment expenses other than business meals. Taxpayers will still generally deduct 50% of the food and beverage expenses associated with operating their trade or business.  For amounts incurred and paid after December 31, 2017, and until December 31, 2025, the 50% limitation applies to expenses of the employer associated with meals provided for the convenience of the employer on the employer’s business premises, or provided on or near the employer’s business premises through an employer-operated facility that meets certain requirements: such amounts paid or incurred after December 31, 2025 are not deductible.

Local Lobbying Expenses.  Deductions for lobbying expenses with respect to legislation before local government bodies are disallowed, effective for amounts paid or incurred on or after the date of enactment.

Amortization of Research and Experimental Expenditures.  Specified research or experimental expenditures, including software development expenditures, are capitalized and amortized over a five-year period (15 years if attributable to research conducted outside of the United States).  This provision applies on a cut-off basis to expenditures paid or incurred in taxable years beginning after December 31, 2021. 

Research and Development Credit.  As indicated in Policy Highlights published by the Conference Committee, the credit is preserved.

Modification of Limitation on Excessive Employee Compensation.  Applicable to taxable years beginning after December 31, 2017, the exception to the $1 million deduction limitation for commissions and performance-based compensation in the case of publicly held corporations is repealed.  The definition of covered employee is amended to include the principal executive officer, the principal financial officer and the three other highest paid employees.  Once an employee qualifies as a covered employee, his/her compensation is subject to the $1 million limitation as long as the executive (or beneficiary) receives compensation from the company.  There is a transition rule for written binding contracts in effect as of November 2, 2017 not modified thereafter in any material respect.

Denial of Deduction for Settlements Subject to Nondisclosure Agreements Paid In Connection with Sexual Harassment or Sexual Abuse.  No deduction is allowed for any settlement or payment related to sexual harassment or sexual abuse if such settlement or payment is subject to a nondisclosure agreement, or for attorney’s fees related to such settlement or payment.  This provision applies to amounts paid or incurred after the date of enactment.

Deductibility of Fines and Penalties for Federal Income Tax Purpose.  No deduction is allowed for any amount paid or incurred to, or at the direction of, a government or governmental entity in relation to the violation of any law or the investigation or inquiry by that government or entity into the potential violation of any law. Certain exceptions apply.

 

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.