The Tax Cuts and Jobs Act (TCJA) – Part 5

Hello again everyone and welcome to the fifth installment of our discussion about how the new Tax Cuts and Jobs Act can affect you. I hope that you find these articles enlightening.

To start off, if you haven’t read my introduction to the new law, please go to → Tax Cuts and Jobs Act–Part 1.

In this fifth installment I will be continue the discussion about items affecting individuals but with a business slant. There are a number of changes to the provisions applicable to business. Many are straight-forward, some are complex and will require regulations by the IRS to fully implement. I’ll start this discussion with some of the easier ones.

Immediate (Section 179) Expensing of Depreciable Assets

There are a number of ways of treating depreciable tangible personal property and certain other qualifying real property. Taxpayers can expense an asset with a cost of no more than $2,500 ($5,000 for certain taxpayers) under a safe harbor rule. That works well for small items such as laptops, calculators, small tools, etc. largely because it involves less paperwork and follows financial accounting rules. But there are some restrictions. For larger assets Section 179 allows an immediate deduction, but you must make an election to do so. In addition, there’s an income limitation. But it’s still simpler than taking annual depreciation.

Under prior law the Section 179 election was limited to $510,000 (adjusted for inflation) of assets in any one year and that amount was decreased for taxpayers who put more than $2,030,000 of tangible personal property in service during the year. There was a $25,000 restriction on SUVs (not adjusted for inflation) and for property used in connection with certain lodging facilities.

Increased Expensing Limits The new law increases the amount of property that can be expensed in any one year to $1 million and the investment limitation is increased to $2.5 million from $2 million. The higher $1 million limit on qualifying property means many small businesses won’t have to worry about depreciation of most assets. By combining the $2,500 safe harbor for lower-cost assets and the Section 179 option, over $1 million can be written off in any one year.

Tax TipTaxpayers doing business as a pass-through entity (S corporations, partnerships, etc.) may not want to use the full available amount. That’s because of the graduated rates for individuals where the pass-through income is taxed. Taking a large deduction in one year that drops your income into a low bracket only to push yourself into a high bracket in the following year will result in overall higher taxes. You do have some options and you don’t have to decide to depreciate or expense an asset until you file your return.

Qualified Real Property Definition The provision expands the definition of qualified real property eligible for expensing to include certain improvements to non-residential real property placed in service after the date such property was first placed in service. The improvements include roofs, heating, ventilation, and air-conditioning property, fire protection and alarm systems and security systems. This change not only allows a direct deduction for such improvements that are often encountered several times during the life of a building and that frequently generated controversy. Qualified improvement property continues to include certain leasehold improvement property, retail improvement property, and restaurant improvements and buildings. As under prior law, qualified improvement property is an improvement on the interior of a building. Modifications that enlarge the building do not qualify. The new law repeals the requirement that the improvement qualifies only if placed in service more than three years after the building is placed in service.

Property Used in Connection with Lodging The provision also expands the definition of Section 179 property to include certain depreciable tangible personal property used predominantly to furnish lodging or in connection with the furnishing of lodging. In the past longer-term lodging such as an apartment was distinguished from lodging such as a hotel, motel, inn, etc. Property used predominantly to furnish lodging or in connection with the furnishing of lodging generally includes beds and other furniture, refrigerators, ranges, and other equipment used in the living quarters of a lodging facility such as an apartment house, dormitory, or any other facility where sleeping accommodations are provided.

Sport Utility Vehicle Limitation The new law changes the rule with respect to the $25,000 limitation on sport utility vehicles such that this amount will be adjusted for inflation. The sport utility rule applies not only to the general definition of a sport utility vehicle but also a vehicle not subject to Section 280F and which is rated at not more than 14,000 pounds gross vehicle weight and has a seating capacity of less than 10 persons or truck with an interior cargo bed shorter than six feet.

 

Bonus Depreciation

Background For a number of years the law has contained a “bonus depreciation” provision, the intent of which has generally been to increase capital investment. Under normal rules, the first years’ depreciation is one-half of double the straight-line rate. The one-half is to account for the fact the property is in service for only a portion of the year. (Property placed in service in January gets 1/2 year of depreciation; so does property placed in service in December.) Bonus depreciation front loads the depreciation deduction even more. Under 50% bonus depreciation you can deduct half the asset’s value in the first year, plus you can take the regular depreciation on the other half. That was the rule in effect prior to the new law.

New Law The new law allows 100% bonus depreciation rather than 50% on property placed in service after September 27, 2017 and before January 1, 2023. Bonus depreciation drops to 80% for property placed in service after December 31, 2022 and before January 1, 2024; 60% in the following year then 40% in the following year and 20% for property placed in service after December 31, 2025 and before January 1, 2027. No bonus depreciation is allowed for subsequent years. Property subject to a written binding contract for its acquisition entered into before September 28, 2017 does not qualify. The placed in service dates for property with a longer production period and noncommercial aircraft are extended by one year. Bonus depreciation applies to both new and used property. (Under prior law it only applied to new property.) Special rules apply to prevent abuse. They include:

  • the property can not have been used by the taxpayer before purchase,
  • the taxpayer must have acquired the property by purchase,
  • the property can’t have been acquired from a related party if loss would be barred under Sec. 267 of the Internal Revenue
    Code.

Qualified leasehold improvement, restaurant property and qualified retail property retains a 15-year depreciation life, but now can be depreciated using MACRS (a faster method) rather than straight-line depreciation and the bonus depreciation rules apply.

The 100-percent bonus depreciation rules do not apply to assets used in a trade or business where the property has had floor plan financing indebtedness.

Bonus depreciation can be taken on qualified film, theatrical productions, or television shows placed in service after September 27, 2017.

Luxury Auto Limits Under Sec. 280F depreciation deductions for vehicles are capped on an annual basis. Under the old law it could take nine years to depreciate a $30,000 auto. The new law changes the limits for vehicles placed in service after December 31, 2017 and for which 100-percent bonus depreciation is taken. The new amounts are:

$10,000 for the first year,
$16,000 for the second year,
$9,600 for the third year,
$5,760 for the fourth and subsequent years.

These amounts will be adjusted annually for inflation.

Farm Assets The new law shortens the recovery period from 7 to 5 years for any machinery or equipment (other than any grain bin, cotton ginning asset, fence, or other land improvement) used in a farming business if the original use of the property commences with the taxpayer and is placed in service after December 31, 2017. The provision also repeals the required use of the 150-percent declining balance method for property used in a farming business (3-, 5-, 7-, and 10-year property only). The 150-percent method will continue to apply to 15- and 20-year property. A farming business electing out of the limitation on the deduction for interest (see later) must use the ADS method of depreciation any property with a recovery period of 10 years or more (e.g., single purpose agricultural or horticultural structures).

Computers Listed property is property of a type that could be used for recreational purposes such as autos, computers, cameras, audio equipment, etc. Computers used in an office environment aren’t included, but those used at home are. In order to secure a deduction for listed property special record keeping requirements apply. That generally means keeping a log. Cellphones were removed from this list a number of years ago. The new law removes this computers and peripheral equipment from the definition of listed property (and the stricter substantiation requirements) effective for property placed in service after December 31, 2017.

Tax TipBeing able to write off the full value of an asset in the first year will maximize cash flow for that year, but it could result in higher taxes down the road. You can elect out of the bonus depreciation for any class of asset for the year. If you do business as a pass-through entity (e.g., S corporation, LLC, partnership, etc.) the income or loss is passed through to the shareholders, partners, etc. and subject to the progressive tax rates. Moreover, you can generally no longer carry back losses to an earlier year. That means you could be getting a current deduction and saving taxes only to put yourself in a higher bracket in a subsequent year. There’s no easy rule of thumb–you’ve got to work through the numbers. You should be looking at making an election if you’re in a lower bracket and the depreciation deduction will be a substantial percentage of your before depreciation income.

Tax TipBuy or lease? It’s a frequent question when it comes to vehicles. Depreciation deductions are capped. Deductions for lease payments are restricted through the lease inclusion amount. But that restriction on lease payments appears to be less than those on depreciation under the old law. The new law may favor purchase and depreciation of an auto, at least for less expensive vehicles. While it’s a point for consideration, the IRS has yet to release the lease inclusion tables for 2018 and there are other factors to take into account when leasing a vehicle for business purposes.

Tax TipWhile the new law removes the stringent record keeping requirements for computers, the IRS can still challenge the business use of any property. You should be able to show that the computer is used regularly in your business. In many cases it’s obvious. Let’s say that you’re an independent salesperson on the road and take and place orders with your office using the computer. That probably won’t be questioned. On the other hand if you have a landscaping business and keep all your records using a paper ledger, you may want to be able to prove the business use in some way.

Solid Tax Solutions is available to help you with preparing your tax return as well as show you how the new tax laws will affect you.

Just give us a call at (845) 344-1040.

☛(845) 344-1040☚

_______________________________________________________________________________________________________________________________________

Bruce – Your Host at The Tax Nook

Our Firm’s Website: SolidTaxSolutions.com.

Other Social Media Outlets: Facebook.com/SolidTaxSolutions.

Twitter: Twitter.com/@SolidTax1040 (BTW, We Follow-Back).

The Tax Cuts and Jobs Act (TCJA) – Part 4

If you haven’t yet read the introduction to my first article on the new law 😟 (or you would like a refresher), please go and have a look at: → Tax Cuts and Jobs Act–Part 1.

In this 4th installment I am going to continue discussing items affecting individuals.

Recharacterization of IRA Contributions

If you make a contribution to an IRA (Traditional or Roth) for a taxable year, you’re permitted to recharacterize the contribution as a contribution to the other type (Roth or Traditional) by making a trustee-to-trustee transfer to the other type of IRA before the due date for your income tax return of that year. In a recharacterization, the contribution is treated as having been made to the transferee IRA (and not the original, transferor IRA) as of the date of the original contribution. Both regular contributions and conversion contributions to a Roth IRA can be recharacterized as having been made to a traditional IRA. In both cases, the recharacterization essentially undoes the conversion.

The new law repeals the special rule allowing a conversion contribution to a Roth IRA to be recharacterized as a contribution to a traditional IRA, but still allows an original contribution from a traditional or Roth IRA to be recharacterized as a contribution to the other type. That is, recharacterization can no longer be used to unwind a Roth conversion. For example, Ted makes a $5,000 contribution to his traditional IRA in 2018. He can recharacterize that as a contribution to Roth as late as October 15, 2019 (the extended due date of his return). Barbara makes a $5,000 contribution to a Roth IRA in 2018. She can recharacterize it as a contribution to a traditional IRA as late as October 15, 2019. In 2018 Suzanne converts $20,000 of her traditional IRA into a Roth, paying tax on the $20,000 of income. In June 2019 the value of the converted shares declines substantially under the new law she can’t recharacterize (undo) the conversion and is stuck with the consequences.

While not done all that frequently, this change will require taxpayers making a conversion contribution to a Roth to consider their actions carefully since they can no longer be undone. This provision applies to tax years beginning after December 31, 2017.

Qualified 2016 Disaster Distribution

Distributions from qualified retirement plans that occur before the participant reaches age 59-1/2 and don’t qualify for any other exception are generally subject to a 10% early withdrawal tax. Under the new law, an exception to the 10% tax applies in the case of a qualified 2016 disaster distribution from a qualified retirement plan, a Sec. 403(b) plan, or an IRA. In addition, income attributable to such a distribution may be included in income ratably over three years, and the amount of a qualified 2016 disaster distribution may be recontributed to an eligible retirement plan within three years. A qualified 2016 disaster distribution is a distribution from an eligible retirement plan made on or after January 1, 2016 and before January 1, 2018, to an individual whose principal place of abode at any time durng calendar 2016 was located in a 20-16 disaster area and who sustained an economic loss by reason of the events giving rise to the Presidential disaster declaration. Only the first $100,000 of distributions qualify for such treatment.

Rollovers of Plan Loan Offset Amounts

If you take a loan from a defined contribution plan and fail to repay the amount or default on the loan the outstanding balance is income and subject to the 10% early withdrawal tax. If an employee terminates employment their obligation to repay a loan is accelerated and, if the loan is not repaid, it’s canceled and the amount in employee’s account balance is offset by the amount of the unpaid loan balance. The loan offset is treated as an actual distribution from the plan and the amount of the distribution is eligible for tax-free rollover to another eligible retirement plan within 60 days. However, the plan is not required to offer a direct rollover. The new law extends the period during which a qualified plan loan offset may be contributed as a rollover contribution is extended from 60 days to to the due date (including extensions) for filing the Federal income tax return for the taxable year in which the plan loan offset occurs.

Qualified Tuition Program Distributions

The income on contributions made to a Section 529 Qualified Tuition Plan (QTP) are not taxable on distribution if made to pay qualified higher education expenses. Under the new law qualified higher education expenses also include tuition in connection with enrollment or attendance of the beneficiary at a public, private or religious elementary or secondary school. Qualified distributions under this provision is limited to $10,000 per tax year. The $10,000 limitation applies on a per-student, rather than a per-account basis.

The provision also modifies the definition of higher education expenses to include certain expenses incurred in connection with a home school. Those expenses are curriculum and curricular materials; books or other instruction materials; online educational materials; tuition for tutoring or educational classes outside of the home (but only if the tutor or instructor is not related to the student; dual enrollment in an institution of higher education; and educational therapies for students with disabilities.

Rollovers Between Qualified Tuition Programs and Qualified ABLE Programs

A qualified ABLE program is a tax-favored savings program intended to benefit disabled individuals. The program is established and maintained by a State agency or instrumentality. The new law allows for amounts from qualified tuition programs (Section 529) to be rolled over to an ABLE account without penalty, provided that the ABLE account is owned by the designated beneficiary of the 529 account, or a member of such designated beneficiary’s family. Such rolled over amounts count towards the overall limitation on amounts that can be contributed to an ABLE account for a taxable year. Any amount rolled over that is in excess of this limitation shall be includible in the gross income of the distributee.

Filing Thresholds

The requirement to file an income tax return for a citizen or a resident alien is based on a certain income level. The thresholds vary by filing status and age (65 or older) and whether or not a taxpayer is legally blind. The thresholds are adjusted for inflation every year. Because of the increased standard deduction, the filing thresholds are higher for every filing status. The new thresholds (assuming no inflation) for 2018 are:

Single $12,000
for 65 or older or blind add $1,600
for 65 or older and blind add $3,200

Married, filing separate $12,000

Married, filing joint $24,000
one spouse 65 or older or blind add $1,300
one spouse 65 or older and blind add $1,300
both spouses 65 or older or blind add $2,600
both spouses 65 or older and blind add $5,200

Head of Household $18,000
for 65 or older or blind add $1,600
for 65 or older and blind add $3,200

Qualifying Widow(er) (surviving spouse) $24,000
for 65 or older or blind add $1,300
for 65 or older and blind add $2,600

The new law also adds to the due diligence requirement of tax preparers to ensure clients qualify for the education and earned income tax credits the requirement a client qualifies to file as head of household. The penalty for failure to do so is $500.

Estate and Gift Tax

The new law increases the federal estate, gift, and generation-skipping transfer tax exemption to $10 million for the estates of decedents dying and gifts and transfers made after 2017. This provision expires at the end of 2025. Before the adjustments for inflation in the old law, the exemption is doubled. The $10 million amount is also adjusted for inflation. The $10 million amount is essentially doubled for a married couple because of the availability of the Deceased Spousal Unused Exclusion (DSUE). The obvious result is that far fewer taxpayers will have to worry about the estate tax in their financial planning. In 2016 only 4,142 returns were filed with a gross estate that exceeded $10 million and only 2,204 of those contained a tax liability. (Those returns represent decedents who died in earlier years, but the return was filed in 2016.) The step-up in basis rule remains in effect.

A new concern is that the exemption will revert to the lower amount when the new law expires at the end of 2025. Taxpayers who could exceed that lower amount should seriously consider careful estate planning. While making gifts may make sense for estate tax purposes, the basis rules for gifts dictate a carry-over basis rather than a step-up basis. That’s an important consideration. Making gifts to lower generations can make sense with the larger exemption, but the portability exemption does not apply to the generation skipping tax exemption amount of $10 million.

Rollover of Gain on Publicly Traded Securities

Under the prior law, a taxpayer could elect to roll over tax-free any capital gain realized on the sale of publicly-traded securities to the extent of the funds used to purchase common stock or a partnership interest in a specialized small business investment company within 60 days of the sale. There were dollar limits on the amount of the gain that could be rolled over. That provision has been repealed under the new law, effective for sales after December 31, 2017.

Self-Created Property not Capital Asset

Also under the prior law, property created by a taxpayer (whether or not associated with his trade or business) was considered a capital asset and would qualify for long-term capital gain treatment on a sale. Certain items were specifically excluded from favorable treatment such as inventory property, certain self-created intangibles, and property subject to depreciation. Self-created intangibles subject to the exception are copyrights, literary, musical or artistic compositions, letters or memoranda, or similar property which is held either by the taxpayer who created the property, or for whom the property was produced. A taxpayer could elect to treat musical compositions and copyrights in musical works as capital assets.

The new law amends Section 1221(a)(3) of the tax code, resulting in the exclusion of a patent, invention, model or design (whether or not patented), and a secret formula or process which is either held by the taxpayer who created the property or a taxpayer with a substituted or transferred basis from the taxpayer who created the property (or for whom the property was created) from the definition of a capital asset. Thus, gains or losses on such assets will not receive capital gain treatment. The provision applies to dispositions after December 31, 2017.

Whew, that is a lot of information.

What do you think about the new tax law and how it will affect you?

And business owners, I didn’t forget about you. In the next post (i.e., Part 5), I will talk a bit about some of the new tax provisions and how they will affect your business. You can find it right here.  👓

Remember, Solid Tax Solutions is available to help you with preparing your tax return as well as show you how the new tax laws will affect you.

Just give us a call at (845) 344-1040.

☛(845) 344-1040☚

 

_________________________________________________________________________________________________________________

Bruce – Your Host at The Tax Nook

Our Firm’s Website: SolidTaxSolutions.com.

Other Social Media Outlets: Facebook.com/SolidTaxSolutions.

Twitter: Twitter.com/@SolidTax1040 (BTW, We Follow-Back).

The Tax Cuts and Jobs Act (TCJA) – Part 3

So, welcome back boys and girls for Part – 3 of how the The Tax Cut and Jobs Act can affect you.

If you haven’t read the introduction to my first article on the new tax law, please go to Tax Cuts and Jobs Act (TCJA) – Part 1. In this third installment I will continue the discussion of itemized deductions that I started in Part 2 (and you can find Part 2 right here).

 

Gambling Losses

This change is a positive one. The new law makes it clear that losses from wagering transactions includes both the costs of the wagers and other expenses related to the activity of gambling. That could include travel to and from the casino.

 

Charitable Contributions

Charitable contributions that may be deducted in any one year are limited to a percentage of Adjusted Gross Income (AGI). The percentage depends on the type of contribution and the organization receiving the contribution. For cash or property that has not appreciated in value, contributions to public charities under the old law were limited to 50% of AGI. Lower percentages apply to capital gain property and contributions to non-operating private foundations. Under the new law, the 50% limit on contributions to public charities is increased to 60%. Under both prior and new law, charitable contributions deductions disallowed because of the 60% limitation in any year may be carried forward five years.

The new law repeals the deduction for payments made to a college or university in exchange for which the payor receives the right to purchase tickets or seating at an athletic event.

Under prior law you did not have to have a contemporaneous written acknowledgment from a charitable organization for contributions of $250 or more if the donee organization reports the contribution to the IRS. This exception to the general rule has been repealed, effective for the 2017 tax year. Thus, if you made a contribution in 2017 of $250 or more, you’ll need a statement from the charity in order to secure a deduction. This provision does not expire.

 

Casualty and Theft Losses

This change could be particularly difficult for taxpayers in the position of having a casualty loss. Under prior law such net losses were deductible if they exceeded 10% of a taxpayer’s Adjusted Gross Income (AGI) plus $100. The same rules apply to casualty losses sustained in a federally declared disaster. Taxpayers in the later situation could deduct the loss on their current year’s return or the prior year. Any net casualty gains (for example, your insurance reimbursement exceeds your tax loss) are taxable. A deduction for such losses could be taken only if you itemized.

Under the new law any personal casualty losses are not deductible unless attributable to federally declared disaster. This provision applies to tax years beginning after December 31, 2017. Personal casualty gains can still be used to offset losses.

The new law changes other rules for 2016 and 2017. Taxpayers who incur a net casualty loss as a result of a federally declared disaster in 2016 or 2017 are subject to a $500 per casualty threshold, but not to the 10% of AGI rule. In addition, a taxpayer can use the loss to increase their standard deduction. That is, they need not itemize to take the deduction.

Because of the 10% of AGI limitation, most taxpayers wouldn’t be able to deduct small casualty losses such as $2,500 in auto damage not covered by insurance because of a deductible. And even under prior law, a $50,000 deductible loss (after the 10% threshold) as a result of a house fire would only result in $12,500 in tax savings for a taxpayer in the 25% bracket, that’s still a significant saving. You may want to check your insurance policies to make sure you’re adequately covered. You should also check your policy for exclusions.

These changes don’t apply to business property.

 

Moving Expenses

Moving expenses were not deductible as an itemized deduction, but toward Adjusted Gross Income. In order to qualify as a deduction, the expenses had to be business related and there was a distance requirement associated with the move. Moving expenses were limited to the cost of transporting household goods and personal effects and to travel to the new residence.

The new law repeals the deduction for these expenses, with the exception of qualified moving expenses of members of the Armed Forces. And they may continue to exclude from income in-kind expenses and exclude from income any reimbursement for the expenses. The move must be related to a military order and a permanent change of station.

In addition, prior law allowed employers to reimburse qualified moving expenses and exclude them from the employee’s income. Under the new law any moving expense reimbursement must be included in the employee’s income–that is included on his or her W-2. Again, the exclusion for members of the Armed Forces continues to apply.

This change could make some employees think twice about switching jobs and moving to another area of the country. It could also make it less attractive to relocate an employee. Of course, an employer can still reimburse for the moving expense, but it would be taxable income. Thus, reimbursing an employee $4,000 for his moving expenses would increase his income by that amount and result in additional taxes. For example, for an employee in the 24% bracket that would result in additional $960 for just federal income taxes. An employer could “gross up” the payment, in effect paying the taxes (that creates more income for the employee, but makes him whole for his taxes). But, of course, that increases the cost to the employer.

 

Alimony and Separate Maintenance Payments

For many years the rule was that alimony and separate maintenance payments were deductible by the payor and income to the recipient. However, in order to qualify as alimony, the payments had to meet certain requirements. Many taxpayers tried to deduct property settlements or child support as alimony. A poorly worded divorce decree could cloud the issue and often resulted in tax litigation.

Under the new law alimony and separate maintenance payments are no longer deductible by the payor or income to the payee. The new rules don’t apply to existing agreements, but only to ones executed or modified after December 31, 2018. Changes made in the agreement after 2018 are considered modifications only if the modification expressly provides that the amendments made apply to such modification.

Tax professionals and attorneys crafting divorce agreements and taxpayers need to take the new rules into account. The new law will change the calculus of computing settlements. It won’t be possible to create a situation where a payor in a high bracket secures a substantial deduction while a spouse in a lower bracket has the income. In short, there’s less of a chance the government will be helping to finance a divorce.

 

Qualified Bicycle Commuting Reimbursements

Under prior law up to $20 per month of employer reimbursements for qualifying bicycle commuting expenses were excludable from the employee’s income. The reimbursements applied to a 15-month period. Qualifying expenses included the purchase of a bicycle, repair and storage. The new law repeals the exclusion for these reimbursements beginning with taxable years after December 31, 2017.

 

Like-Kind Exchanges

Generally, and an exchange of property for other property is, just like a sale for cash, a taxable event. However, for many years Section 1031 has allowed like-kind exchanges. In a like-kind exchange no gain is recognized on the exchange unless you receive unlike property in return. For example, Hector exchanges a two-family rental property for a strip mall. He receives no other property in return. He reports no gain (or loss) on the exchange. Now assume Fred receives both the strip mall and a backhoe used to maintain the property. At least some of the gain will be taxable. Gain isn’t avoided; it’s just deferred until the property received in the exchange is finally sold. In order to qualify the two properties must be of like-kind and the property must be held for productive use in a trade or business or for investment. (In addition, Sec. 1031 does not apply to stocks, bonds, notes, interests in partnerships, certain exchanges of livestock or foreign property). In addition, there are strict time requirements for identifying the replacement property and consummating the transaction. In the case of tangible property the definition of like-kind has been strictly interpreted. Thus, a car for a car is a like-kind exchange; a truck for a car is not. That’s generally not true for real estate. You can exchange vacant land for an office building and secure Sec. 1031 treatment.

Under the new law, like-kind exchange treatment will only apply to real property. The old law continues to apply to property relinquished or the replacement property is received on or before December 31, 2017. The 45-day identification period and requirement that receipt of the property must occur within 180 days applies.

While the most of the big dollar amounts in like-kind exchanges involve real estate, far more transactions probably involve tangible personal property. Every time you trade in a business vehicle, machinery, or other equipment you’re most likely doing a like-kind exchange. That means you’re deferring any gain on the exchange of the equipment; you’re also deferring any loss. Under the new law you’ll have to recognize gain, or loss, each time you “trade in” equipment. Because of changes in the depreciation rules, that may not make any difference, at least for federal tax purposes.

Example–Oak Inc. purchases a backhoe for $40,000 in 2018 and writes off the entire purchase price. In 2020 Oak Inc. trades in the backhoe for a small bulldozer costing $45,000 paying an additional $10,000 (it’s equivalent to selling the old backhoe for the amount allowed on the trade in, $35,000). The backhoe has been fully depreciated so the trade in produces a gain of $35,000 ($45,000 for the new unit less the $10,000 additional payment). Oak Inc. should be able to write off the full cost of the bulldozer offsetting the $35,000 gain with a $45,000 deduction.

Certain problems can arise. First, the depreciation allowed for state purposes may not be the same as for federal. Second, if the sale and purchase of the two machines occur in different years, there will be no “offset” and Oak Inc. could have a significant a gain in one year and a big deduction in the next.

Having to recognize any loss on a trade in may be advantageous, but not always.

You should talk to your tax adviser —> Solid Tax Solutions before engaging in significant trade ins or other activities that can be affected by the Tax Cut and Jobs Act.

BTW, you can find the next installment of this highly informative series – Part 4 right here.

__________________________________________________________________________________________________________________

Bruce – Your Host at The Tax Nook

Our Firm’s Website: SolidTaxSolutions.com.

Other Social Media Outlets: Facebook.com/SolidTaxSolutions.

Twitter: Twitter.com/@SolidTax1040 (BTW, We Follow-Back).

The Tax Cuts and Jobs Act (TCJA) – Part 2

In this second blog post I’ll be discussing individual itemized tax deductions that are taken on Schedule A (And, If by chance you missed Part 1 of this article about the Tax Cuts and Jobs Act you can read it here).

Everyone has been talking about the limit on state and local taxes, but there are additional cutbacks. As under prior law you want to take the larger of the standard deduction or your itemized deductions. The big increase in the standard deduction reduces your chances of your itemized deductions exceeding the standard. That’s made even more difficult by the new restrictions on state and local taxes, mortgage interest, and the elimination of miscellaneous itemized deductions. (Note: There are sometimes reasons to itemize even when you’d come out ahead with the standard deduction.)

For example, Fred and Wilma had state and local income taxes in 2017 $14,000; mortgage interest of $13,000 and charitable contributions of $1,000. Thus, instead of taking the standard deduction of $12,700 they itemized and deducted $28,000. Assuming the same expenses for 2018, because of the $10,000 limit on state and local taxes, their itemized deductions will only total $24,000, the same as the standard deduction.

Clearly, fewer taxpayers are likely to itemize for federal purposes. But that may prove disadvantageous for state purposes. For example, New York (and many other states) uses your federal itemized deductions and disallows the deduction for state income taxes. If, in 2018, Fred and Wilma lived in New York and had real estate taxes of $9,000, interest of $13,000 and $1,000 in charitable contributions they could take itemized deductions of $23,000 for state purposes. Their standard deduction for state purposes would be a bit above $16,050 substantially less (Side note: As of the date of this post the New York State Department of Taxation and Finance has not released their standard deduction amount for 2018, therefore I used the 2017 NYS standard deduction amount of $16,050 for a married couple filing jointly for illustration. Based on history, I do not expect the 2018 NYS standard deduction amount to be significantly higher than the 2017 NYS standard deduction amount). They may have to compute their itemized deductions just for state purposes. But there’s another hitch. Many states don’t allow you to itemize for state purposes if you didn’t itemize for federal. More than likely, a number of states will revise their rules to accommodate the federal changes.

There is some offsetting good news. First, the new law removes the limitation on itemized deductions (the Pease limitation) that’s based on Adjusted Gross Income (AGI). Under the old law taxpayers with AGI of more than $320,000 (married, joint; $266,700 for single individuals) would see their itemized deductions phased out.

Second, state and local taxes, certain interest deductions, etc. were not deductible for Alternative Minimum Tax (AMT) purposes. So many higher-income taxpayers ended up receiving little or no benefit from some of their deductions. The changes in the Alternative Minimum Tax make that much less likely.

 

State and Local Taxes

This change may be the one most talked about, and it’s also one of the most straightforward. Your deduction for state and local income, property, and sales taxes (if you use that option), combined, is limited to $10,000 ($5,000 married filing separate). No deduction is allowed for foreign real property taxes paid in the years 2018 through 2025; foreign income taxes are still deductible, subject to the restrictions on all taxes. If you prepaid state and local income taxes for 2018 in 2017, they’re not deductible until 2018. Real property taxes that are assessed in 2017 are deductible if paid in 2017, if you’re allowed to do so under local law.

There is an exception for state and local real or personal property taxes paid or accrued in carrying on a trade or business or income-producing activity. So let’s say that you have an auto repair business operated as a sole proprietorship. You own the building that is used by the business. The real property taxes would be fully deductible, but on Schedule C. Property taxes related to rental property should be taken on Schedule E as part of the rental expenses.

There are some issues here that will probably be addressed in guidance from the IRS.

If you have a vacation home that’s not being used, you might consider renting it to secure a deduction on Schedule E.

If you are self-employed and use a portion of your home for business, the business portion of the taxes (and other expenses) are deducted on Schedule C (or Schedule F for farm income). For example, you use 20% of your home for business. Your real estate taxes are $10,000 for the year. Of the total $2,000 (20%) would be deductible on Schedule C, the remaining $8,000 would be deductible on Schedule A, subject to the overall$10,000 limit rule.

 

Home Mortgage Interest Deduction

This change, too, is pretty simple. Mortgage interest on acquisition indebtedness on a qualified residence incurred on or after December 15, 2017 is deductible, but only to the extent of the interest on the first $750,000 ($375,000 if married filing separate) of debt, not the $1 million limit under the old law. No deduction is allowed for home equity debt, regardless of when incurred.

A qualified residence is your principal residence plus one other residence. That includes a vacation home, or a boat or recreational vehicle with living accommodations. The old rules continue to apply as well to other definitions. For example, the debt must be secured by the residence and acquisition indebtedness includes refinanced debt not in excess of the original debt. Acquisition debt includes debt incurred in the purchase, construction, or substantial improvement of the residence. There are other rules with respect to refinanced debt including that the refinancing cannot extend the term of the original loan. The qualifying debt on a mortgage refinanced that was taken out before December 15, 2017 can be as much as the old limitation, $1 million.

The two changes here are the loss of a deduction for home equity interest and the lower maximum indebtedness. Like other provisions in the new law, both of these restrictions expire after 2025.

While there are no “loopholes” there are steps you can take to make sure you don’t give away an interest deduction. For example, many taxpayers use their home equity line to add a room, redo a kitchen, finish the basement, etc. Under the prior law the first $100,000 of home equity interest was deductible, so it really didn’t make much difference if the amount was incurred for a addition to the home or a new foreign sports car. But for home improvements the home equity loan is really acquisition debt and the interest on the portion of the total debt used for these purposes should still be deductible, subject to the overall limits. Interest on home equity debt incurred to purchase a new car would not be. If you do use the home equity line for this purpose you need to keep accurate records of the date and amount spent and be able to tie it to the amount withdrawn from the home equity line. Talk to Solid Tax Solutions about the fine points of record keeping here.

Example–In 2017 Bill and Carol drew down $30,000 on a $100,000 home equity line to purchase a car. On July 1, 2018 they take $60,000 from their home equity line to pay for a new kitchen and an additional bathroom. The interest on the $60,000 home improvement debt would be deductible in 2018. But that amount was outstanding for only half the year. Bill and Carol would have to determine the amount of interest on that $60,000 for the last six months of 2018.

Business owners can encounter the situation where they borrow on their home to finance their business or for the purchase of a rental property. In both of these situations the loan and the interest really belongs on the business or the rental property and should be deducted on that business. Debt related to these types of loans is not subject to the $750,000 restriction. For example, John and Susan have a home worth $2.3 million. They borrow $1.25 million to finance their business. Interest on the entire debt would be deductible, but not as an itemized deduction on Schedule A. Again, talk to Solid Tax Solutions about the record keeping and mechanics, both of which can be critical.

Investors can still deduct investment interest. Amounts borrowed through a home equity line should be allocated to the investment interest deduction.

While the interest isn’t deductible, that doesn’t mean taking out a home equity loan no longer makes sense. If you got into financial difficulty and ran up your credit cards, using a home equity loan at 4% or a similar interest rate to pay off 22% credit card balances makes sense. On the other hand, car loans currently carry a low rate. It may make more sense to finance a new car with an auto loan rather than use home equity money. A home equity line can still prove useful in many situations, but you shouldn’t use it indiscriminately.

 

Medical Expense Deduction

Here, the change is a positive one. Under prior law only unreimbursed medical expenses that exceeded 10% of AGI were deductible for regular or AMT purposes. The new law lowers the percentage threshold to 7.5% for both regular and AMT purposes, but only for 2017 and 2018. (It had been 7.5% some years ago.) For example, under the 10% threshold a taxpayer with AGI of $50,000 would be able to deduct only the amount of unreimbursed medical expenses that exceeded $5,000 (10% of $50,000). Under the new law, that same taxpayer would get a deduction for expenses that exceeded $3,750 (7.5% of $50,000). Medical expenses includes health insurance, long-term care insurance (subject to restrictions), unreimbursed doctor and hospital bills, tests, prescriptions, etc.

This change applies to tax years beginning after December 31, 2016. That means it applies to 2017 tax returns, one of the few changes that does.

There’s a downside here though. The lowered threshold only applies to tax years beginning before January 1, 2019. For almost all taxpayers that means it only applies to tax years 2017 and 2018.

 

Miscellaneous Itemized Deductions

Unfortunately, here we will see another cut courtesy of the Tax Cut and Jobs Act. These miscellaneous itemized deductions (subject to a 2% of AGI threshold) include a broad range of expenditures from job hunting expenses, union dues, professional uniforms, an employee’s home office, unreimbursed employee business expenses (e.g., travel, lodging, meals and entertainment), continuing education expenses, to professional subscriptions and dues. The expenses deductible under this category also include expenses for the production and collection of income such as the cost of preparing your tax return, investment advisory publications and advisory fees. They may also include attorney’s fees for the collection of income a safety deposit box, and appraisal fees. Finally, expenses related to “hobby losses” are deductible here.

Many taxpayers don’t break the 2% threshold required to deduct any of these expenses, or do so only sporadically, but the category is such a catchall that more than a few taxpayers, particularly professionals who are employees will feel the pinch on a regular basis.

Taxpayers who are self-employed (that includes partners in a partnership and LLC members) or do business through a regular corporation or ‘S’ corporation should be particularly careful who the expenses belong to and who pays them. For example, you may have been deducting unreimbursed business expenses on Schedule A where you could be deducting them on your S corporation. Talk to Solid Tax Solutions about the correct treatment.

Business owners may have to reconsider their reimbursement policies. If the business had a policy of not reimbursing employees for meals that were business related, the employee will now be forced to absorb the entire bill. In order to placate and retain employees you may have to start reimbursing for items you didn’t in the past.

Please feel free to share this post and any other of our blog posts with your friends and family.

Also, Part 3 is soon to follow. The wait is over 😃. Part 3 is ready and you can read it here.

Call and talk to your tax adviser at Solid Tax Solutions (Web: SolidTaxSolutions.com) about these and other ways the Tax Cut and Jobs Act will affect your 2018 AND 2017 taxes.

→(845) 344-1040←

 

__________________________________________________________________________________________________________________

Bruce – Your Host at The Tax Nook

Our Firm’s Website: SolidTaxSolutions.com.

Other Social Media Outlets: Facebook.com/SolidTaxSolutions.

Twitter: Twitter.com/@SolidTax1040 (BTW, We Follow-Back).

The Tax Cuts and Jobs Act (TCJA) – Part 1

Lately I’ve received a lot of calls as well, as impromptu questions when I am moving around town, of people wanting to know what the heck is the ‘new tax law’ all about and how these changes will affect them.

So, I thought the best and most efficient way to get preliminary information out to everyone is through this blog with a “brief” (Lol) overview.

And, off to the races we go……

Soooo, there have been many claims on both sides of the political aisle about the Tax Cuts and Jobs Act which is also referred to as the TCJA (and as a side note the TCJA is over 500 pages). Will your taxes go down? By how much? For middle class taxpayers it will ultimately depend on your particular situation. There’s no doubt that some taxpayers in states with high income and/or real estate taxes could see their taxes go up. And it can also depend on what other deductions you’re losing. But higher-income taxpayers won’t feel the pinch as much. That’s because their deductions under the old law may be phased out or lost because of the Alternative Minimum Tax (AMT). Most taxpayers will see a decline in their taxes, a few will see an increase. The higher your income the bigger the benefit, both in absolute and percentage amounts. The increase in the exemption for the Alternative Minimum Tax will mean far fewer taxpayers will be caught in the trap. In fact the estimate is that only about 200,000 taxpayers will pay the tax, down from 4.4 million. For many taxpayers that can be a big saving.

Home ownership will not be as attractive as it was, particularly in high tax states. And that could depress home prices. On the other hand, new benefits for landlords will make owning a rental more profitable. That could be enhanced because more people may be renting.

Business owners should fare well under the new rules. While owners of business in certain services (medicine, accounting, legal, etc.) may not do as well as others, everyone will get a benefit. For C corporations (otherwise known as a regular corporation) tax rates will be materially lower; for owners of S corporations and other pass-through entities, the benefits are less clear, but should be significant. But there are some changes that could reduce the benefits. For example, an employee who is asked to move to another location may want more of an incentive since his moving expenses are no longer deductible.

One issue that I haven’t heard mentioned more than once is the effect on state income taxes. Most states tie their computation of taxable income to the federal rules. Some do it automatically (when the fed makes a change, the state automatically does), some have to pass a legislation to follow the change. Most states have modifications to federal taxable (or adjusted gross) income. For example, New York State excludes state and federal pensions and allows an exclusion for up to $20,000 in other pension income. It also exempts all of Social Security income. But it doesn’t follow some of the federal depreciation rules.

Some deductions were eliminated in total. For example, moving expenses are no longer deductible (with an exception for the armed forces). But unless a provision of existing law was mentioned, it’s still in effect. The 0.9% medicare tax on wages of higher income individuals as well as the 3.8% tax on net investment income. The special benefits for capital gains and dividends were largely untouched.

Most amounts in the new law are adjusted for inflation using the chained CPI approach (for your reference, a quick read primer about the chained CPI is here), a method that results in smaller annual increases in tax brackets, thresholds, etc.

Finally, keep in mind that most of the provisions take effect January 1, 2018. (Technically, they apply to tax years beginning after December 31, 2017; I’ll point out any that don’t). Most of the provisions that apply to individuals expire on December 31, 2025.

Beginning with this article you and I will take a look at all the important changes in the law and how it will affect taxpayers.

 

Individual Tax Rates

 

Tax Rates Based on Filing Status

 

There’s no question that income tax rates are lower across the board (with the exception of estates and trusts). But how much varies with your situation. Of course, you could still pay higher taxes if your taxable income is higher because you can’t deduct some of your state and local taxes, can’t claim a credit, etc. That’s why it’s important to work through your numbers. Unless you take the standard deduction and never have any unusual circumstances, trying to make them arrive at generic examples is very difficult =>(Solid Tax Solutions can work the numbers for you).

Tax Rates: Single Taxpayers–>2018
      Taxable income:                   Tax:
  Over     But not over         Tax       +%   On amount over            

$      0     $  9,525        $    0.00   10       $      0
   9,525       38,700           952.50   12          9,525
  38,700       82,500         4,453.50   22         38,700
  82,500      157,500        14,089.50   24         82,500
 157,500      200,000        32,089.50   32        157,500
 200,000      500,000        45,689.50   35        200,000
 500,000      .......       150,689.50   37        500,000
 

Tax Rates: Married Individuals Filing Joint and Surviving Spouses–>2018
      Taxable income:                   Tax:
  Over     But not over         Tax       +%   On amount over            

$      0     $ 19,050        $     0.00  10       $      0
  19,050       77,400          1,905.00  12         19,050
  77,400      165,000          8,907.00  22         77,400
 165,000      315,000         28,179.00  24        165,000
 315,000      400,000         64,179.00  32        315,000
 400,000      600,000         91,379.00  35        400,000
 600,000      .......        161,379.00  37        600,000 
 
Tax Rates–Head of Household–>2018
      Taxable income:                   Tax:
  Over     But not over         Tax       +%   On amount over            

$      0     $ 13,600        $     0.00  10       $      0
  13,600       51,800          1,360.00  12         13,600
  51,800       82,500          5,944.00  22         51,800
  82,500      157,500         12,698.00  24         82,500
 157,500      200,000         30,698.00  32        200,000
 200,000      500,000         44,298.00  35        200,000
 500,000      .......        149,298.00  37        500,000 
 
Tax Rates: Married Filing Separate–>2018
      Taxable income:                   Tax:
  Over     But not over         Tax       +%   On amount over            

$      0     $  9,525        $     0.00  10       $      0
   9,525       38,700            952.50  12          9,525
  38,700       82,500          4,453.50  22         38,700
  82,500      157,500         14,089.50  24         82,500
 157,500      200,000         32,089.50  32        157.500
 200,000      300,000         45,689.50  35        200,000
 300,000      .......         80,689.50  37        300,000 
 
Tax Rates: Estates and Trusts–>2018
      Taxable income:                   Tax:
  Over     But not over         Tax       +%   On amount over            

$      0     $  2,550        $     0.00  10       $      0
   2,550        9,150            255.00  24          2,550
   9,150       12,500          1,839.00  35          9,150
  12,500      .......          3,011.50  37         12,500 
 

So what are the savings? I computed the tax using several levels of taxable income. I didn’t take into account different situations such as the loss of tax deductions or the higher standard deductions or the Alternative Minimum Tax. I used 2017 rates for the “old” rates because many taxpayers want to compare last year to the new rates. If the law hadn’t been enacted, 2018 rates would be slightly lower after accounting for the annual cost-of-living adjustment.

Here’s how a married couple would fare under four different taxable income assumptions.

Taxable Income of $40,000– Jack and Jill have taxable income of $40,000. Under the new law they’ll pay tax of $4,419 versus $5,068 under the old law. That’s a savings of $649.

Taxable Income of $100,000– Assume taxable income of $100,000. They’ll pay $13,879 under the new law versus $16,478 under the old. A savings of $2,599.

Taxable Income of $375,000– With taxable income of $375,000 they’ll pay $83,379 versus $98,967 for a $15,588 savings.

Taxable Income of $600,000– Taxable income of $600,000 will result in $161,379 under the new law, down from $182,831 under the old law. A savings of $21,452.

I also computed the saving at taxable income of $75,000. That was $1,699, in between the $40,000 and $100,000 savings amounts.

For single individuals, I computed the differences at taxable income of $100,000 and $500,000. At $100,000 there’s a savings of $2,692; at $500,000 the savings rise to $3,129.

There’s no question that the tax rates are lower, and higher-income taxpayers will see the biggest savings, both in absolute and percentage amounts. But all taxpayers should benefit. The question is how will this be offset by the loss of deductions? That depends on your particular situation. Both the rates and brackets generally combine to lower taxes. For example, in 2017 the 25% rate for a married couple filing joint started at $75,901; under the new law, the rate is 22% and the bracket starts at $77,401. But there are some anomalies, such as the 35% bracket for married, filing joint starts at $416,701 under the old law and $400,001 under the new.

Capital Gain Rates and Related Taxes

The tax rate on long-term capital gains follows the old rules updated for the new rates. For example, under the old rules, you’d pay no tax on qualified dividends or long-term capital gains if you’re in the 10% or 15% bracket. There is no 15% bracket under the new law. The 12% bracket is substituted. Thus, if you’re in the 10% or 12% bracket, you pay no tax on qualified dividends or long-term capital gains. Above that, qualified dividends and long-term capital gains are taxed at 15% until you reach the top bracket. If you’re in the top bracket, they’re taxed at 20%.

The maximum tax rate on unrecaptured Section 1250 gains remains at 25%; the maximum tax on collectibles is 28%, as under prior law.

The Net Investment Income Tax (NIIT) of 3.8% remains in effect. This tax generally applies to dividends, capital gains, and passive income. The additional medicare tax of 0.9% continues to apply to Medicare wages in excess of the threshold amounts.

 

Alternative Minimum Tax

Congress did not eliminate the alternative minimum tax for individuals, but by making two strategic changes it slashed its impact.

The first change is the exemptions. Under prior law the exemption was $84,500 for a married couple filing joint. That’s increased to $109,400. For single individuals or head of household, the exemption increases from $54,300 to $70,300; for married filing separate it goes from $42,500 to $54,700. Under both prior and new law the exemption is phased out 25 cents for each $1 that the Alternative Minimum Taxable Income (AMTI) exceeds the thresholds. That was a big trap for many taxpayers. Under prior law the phaseouts began AMTI of $160,900 (married, joint), $120,700 (single, head of household), and $90,450 for a married couple filing separately. Under the new law, phaseout of the exemption begins at $1 million for a married couple filing joint and $500,000 for all other filers. That, coupled with the fact that only the first $10,000 of state and local taxes are deductible for regular tax purposes (state and local taxes are not deductible for AMT purposes) significantly reduces a major add-back.

The rates for the AMT are unchanged from prior law (after adjustment for inflation). The 26% rate applies to AMTI up to $191,500 ($95,750 if married, filing separate) for 2018; the 28% rate applies to income above those amounts.

For many taxpayers who either paid or had to consider the AMT in the past, they should discuss the tax with their advisor. There’s a good chance a few rules of thumb may provide them with relief from having to consider the tax.

 

Standard Deduction, Personal Exemption and Child Tax Credit

This is where things start to get more complicated. Under prior law, the standard deduction for a single taxpayer was $6,500 and $13,000 for a married couple filing jointly. Each individual was entitled to a personal exemption of $4,150. These were the amounts released by the IRS in November that would have taken effect for 2018. Thus, a single taxpayer, taking the standard deduction would have been entitled to deduct $10,650 from their adjusted gross income to arrive at taxable income. A married couple with no children could deduct $21,300 ($13,000 standard deduction plus two $4,150 exemptions). They could deduct another $4,150 for each dependent child. In addition, a single individual or married couple with children could take a tax credit of $1,000 for each child under the age of 17. The personal exemption and child credit were phased out for higher-income individuals.

Under the new law the standard deduction is increased to $12,000 for a single individual; $24,000 for a married couple filing jointly and $18,000 for head of households. The amounts are adjusted annually for inflation. That seems generous, but the new law also eliminates the personal exemption. That would be $4,150 per person. Thus, the standard deduction isn’t going from $13,000 to $24,000 for a married couple with no children, in effect it’s going from $21,300 to $24,000. For a single individual the deduction is going from $10,650 to $12,000. It’s an increase, but a more modest one than appears on the surface.

A bigger issue is the exemptions for dependent children. These are also eliminated. In their place is a higher child tax credit.

Under prior law taxpayers could claim a tax credit of $1,000 for each child under the age of 17 at the end of the year. The credit is phased out ($50 for every $1000) for taxpayers with Modified Adjusted Gross Income (MAGI) above $110,000 (married, joint) $75,000 (single). Part of the credit may be refundable. There are other restrictions.

Under the new law the credit is increased to $2,000 per qualifying child. Phaseout begins at $400,000 (married, joint); $200,000 for any other filing status. The phaseout is the same as under the old law. In addition, a $500 credit can be claimed for each dependent who doesn’t qualify for the child credit. The maximum refundable portion is $1,400 per qualifying child. The refundable portion is equal to 15% of a taxpayer’s earned income in excess of $2,500 to the amount the tax credit exceeds the taxpayer’s tax liability. In addition, there are new requirements for a proper taxpayer identification number. A social security number will be valid only for a person who is a U.S citizen or is authorized to work in the U.S. Without this, the refundable credit is limited to $500.

So, are you better or worse off under the new law? Here it depends on your tax rate. A credit is a direct reduction in taxes. The tax savings doesn’t depend on your tax rate. With a deduction, the value depends on your tax rate. For example, Bob and Susan can get a $1,000 tax credit or a $4,150 deduction (the amount of the personal exemption for a child). They’re in the 10% bracket. The tax credit will save them $1,000 in taxes, but a $4,150 deduction will only reduce their taxes by $415 (10% of $4,150). Jack and Jill can also choose between a $1,000 credit or a $4,150 deduction, but they’re in the 35% bracket. The $4,150 deduction will reduce their taxes by $1,452.50. They’re better off with a deduction.

Under the old law a qualifying child would give you a $1,000 credit and a $4,150 deduction. Continuing the example above, under the new law Bob and Susan now have $2,000, much better than the $1,000 credit and a personal exemption which would save $415 in taxes. Jack and Jill get a $1,000 credit (which they would not have gotten under prior law because of the phaseout of the credit). But they also get another $1,000 credit instead of a $4,150 deduction which would have been worth $1,452.

There’s another important difference here. Under prior law a qualifying child for the dependency exemption had to be either under age 19 or, if a full-time student, under age 24 at the end of the calendar year. For the $2,000 credit the child must be under the age of 17. For a dependent older than that you’re only entitled to a $500 credit. Offsetting this is the phaseout of the child credit under the new law which occurs at a much higher income level.

Stay tuned ladies and gentlemen there is more TCJA fun to follow, you can find Part 2 of this article here.

You can reach Solid Tax Solutions by ☎ at: (845)344-1040.

You can also visit us on the web at: SolidTaxSolutions.com.

_______________________________________________________________________________________________________________

Bruce – Your Host at The Tax Nook

Our Firm’s Website: SolidTaxSolutions.com.

Other Social Media Outlets: Facebook.com/SolidTaxSolutions.

Twitter: Twitter.com/@SolidTax1040 (BTW, We Follow-Back).

You and Your Spouse Own a Business Together. What are the Tax Issues?

Ahhhhh……….The Husband and Wife owned business.

Love, love, love……….

A man and a women holding hands.

No one knows for sure how many businesses in the U.S. are co-owned by spouses.

A professor from Oklahoma State University estimated in 2000 that there were 3 million such businesses, so the number today likely is much higher.

Some giant corporations — Fiji Water, Forever 21, Panda Express, and Houzz — were founded by husband-wife teams.

There are many personal issues that couples face when co-owning a business.

Here are some of the tax issues that spouses co-owning a business should think about.

Tax Filing for Spousalpreneurs

A couple who co-owns and operates a business that is unincorporated and shares in the profits and losses are in a partnership, whether or not they have a formal partnership agreement. Usually they must file a partnership tax return, Form 1065, as well as report the income, losses, etc. on their personal return. However, they can elect to file Schedule Cs along with their Form 1040 instead of Form 1065, saving them from the complexities of the partnership return. To make this election:

  • Both spouses must materially participate in the business, which essentially means working on a day-to-day basis. (Material participation tests can be found at the IRS.) Neither spouse can be merely an investor.
  • Each spouse must file a Schedule C to report his or her share of income, gain, loss, deduction, and credit attributive to the respective interests in the business. If they split things equally, then both Schedule Cs will look the same.
  • Each spouse must file a Schedule SE to pay self-employment tax on his/her share of the net income from the business. This is the same action that would occur if the couple had filed a partnership return.

Divorce

It’s not uncommon for spouses who co-own a business to get divorced. What happens in the property settlement? Some spouses continue to co-own the business after divorce. Others may transfer interests to the other so that only one spouse owns and runs the business after the couple splits up.  How the business interests are addressed all depends on the couples involved.

From a tax perspective, the transfer of property incident to divorce is tax free. This means the transferring spouse does not recognize any gain or loss on the transfer to the other spouse. The spouse who now owns the business steps into the shoes of the other spouse when it comes to tax basis, so that if the business is later sold, the recipient-spouse recognizes the gain on any appreciation the transferor-spouse had but did not recognize at the time of the property settlement.

If spouses try to co-own and run a business after the divorce but it doesn’t work out, they can still part ways tax free. That’s what happened recently to one couple who had co-owned three dance-related businesses. After 17 months following the divorce, one party bought out the other for $1.6 million, and the Tax Court said this wasn’t a sale but rather part of the property settlement.

Innocent Spouse Relief

Spouses who co-own businesses typically file joint tax returns. These tax returns include the couple’s business income. By filing jointly, each spouse is jointly and severally liable for the tax due on the return, plus any interest and penalties. Can an owner obtain innocent spouse relief for the actions of the other spouse? Seems so.

In another recent case, one spouse was the sole owner of the business; the other handled the books and all other back-office operations. This spouse routinely had the tax return prepared and, after obtaining the other’s signature, filed it. The problem: She didn’t file it one year and he was assessed interest and penalties (she had died by this time). While he owed the tax, the Tax Court gave him innocent spouse relief for the interest and penalties.

Bottom Line

Spouses who co-own businesses should have very good lawyers and tax professionals so that each spouse’s interests are protected.

Solid Tax Solutions (SolidTaxSolutions.com) is skilled in such matters and can be reached year-round at: (845) 344-1040.

__________________________________________________________________________________________________

Bruce – Your Host at The Tax Nook

Our Firm’s Website: SolidTaxSolutions.com.

Other Social Media Outlets: Facebook.com/SolidTaxSolutions.

Twitter: Twitter.com/@SolidTax1040 (BTW, We Follow-Back).

A Sole Proprietorship May Be The Easiest Route to Travel for SOME Businesses!

A lot of people think that the first step to starting a business is incorporating or organizing a Limited Liability Company (LLC). While both types of entities can provide your business with additional protection, they’re not the answer for everyone. And that protection comes at a cost. I’ve created a list of some factors that should be reviewed before deciding on an LLC, a corporation, or a sole proprietorship. For the sake of this post, I will assume that your business, at least in the beginning is a one-person show with no partners and no employees. While that leaves out many startups, it encompasses many more.

The Words 'Sole Proprietorship'.

Here Are Some Points to Consider:

Potential Liability. If you’re designing and importing a children’s toys, you will need all the protection you can get. On the other hand, if you’re a carpenter your insurance should be able to handle most liability issues. Many professionals are likely to be sued personally even if the business is incorporated. Things quickly change if you have employees. If that’s the case a corporation or LLC can protect you personally.

Business Debts. In earlier times the corporate form was used mostly to protect owners from being personally liable for corporate debts. Today, it’s used for personal protection from a range of lawsuits. But for most small businesses, owners will be required to personally guarantee any bank, etc. loans. The only advantage to a corporation or LLC may be avoiding accounts payable on a default. And even a corporation or LLC won’t protect you if don’t respect the formalities of the entity.

Cost. If you do it yourself, the cost of setting up (and dissolving if it doesn’t work out) a corporation or LLC may be relatively small (generally between $125 and $800). Using an attorney will add to the cost. There may be annual fees such as filing fees and franchise taxes. These vary widely. Not much of an issue if the business is nicely profitable, but a burden if you’re suffering losses. If you do business as a corporation (S or C) you’ll have a separate return to file. That is a consideration if you have a professional prepare it.

LLC vs. S Corporation. While you could do business as a regular C corporation, you could find yourself subject to double taxes. Most small businesses elect S corporation status where profits and losses are passed through to the shareholders. An LLC with only one member is a separate entity for legal purposes, but is disregarded for federal tax purposes. That is, instead of filing a partnership return (the normal return for an LLC with more than one member (owner)), a single-member LLC reports its income and expenses on the owner’s Schedule C. That, plus the fact no balance sheet is required, can save some preparation costs at tax time.

DBA. If you’re doing business as a corporation or LLC you will decide on a name when filing with the state. While you could use your own name (e.g., Ralph Kramden, Inc.) that’s usually not the case. As a sole proprietorship, the default is to use your own name. That’s fine if you’re Ralph Kramden, Attorney-at-Law, but not so attractive if you want to brand the business. The solution is filing with your state for a Doing Business As (DBA) to do business under an assumed name (e.g., Ralph Kramden doing business as Brooklyn Auto Body). You have to decide if you want the extra work of a DBA.

Transactions Between You and Entity. If you’re doing business as a separate entity, you’ve got to respect the formalities. Business assets are purchased and titled in the name of the entity. Assets transferred to shareholders or LLC members should be accounted for on the books and for tax purposes. Loans are taken out in the name of the entity. Not in your name personally. Paying a corporate loan (or other expense) with a personal check won’t get you a deduction. The proper approach is either to make a loan or equity contribution to the business so the business can pay the expense and get the deduction. Alternatively you can submit an expense report and have the business reimburse you. Paying personal expenses with a business check as well as not respecting other formalities such as making customers, creditors, etc. aware that you’re doing business as an LLC or corporation can allow outsiders to challenge the existence of the corporation or LLC. It sounds simple enough, but most small business owners don’t follow through. A sole proprietorship doesn’t have these problems.

Switching Entities. If you start a business as a sole proprietorship and later decide to incorporate or change to an LLC, doing so is relatively straightforward and there are generally no tax consequences. Going in the other direction can be more complicated, particularly if you have fixed assets. In some cases there may be tax consequences.

The Best Approach? If you have or will have shortly, owners in addition to yourself, you might as well use a corporation or LLC from the businesses inception. If additional owners are unlikely (at least for some time) a sole proprietorship should be considered if the liability protection of an LLC or corporation isn’t needed. You should discuss the issue with your attorney and with your tax advisor.

Keep in mind that this discussion is in no way inclusive of all factors to be considered in starting a business.

If you found this information to be helpful drop us a line to let us know and feel free to pass this article along to your friends and family.

If you are considering starting a business (or already have a business) give us a call for a consultation. Your business will thank you.

We can be reached at: (845) 344-1040. You can also learn more about us at our website:
SolidTaxSolutions.com.

__________________________________________________________________________________________________

Bruce – Your Host at The Tax Nook

Our Firm’s Website: SolidTaxSolutions.com.

Other Social Media Outlets: Facebook.com/SolidTaxSolutions.

Twitter: Twitter.com/@SolidTax1040 (BTW, We Follow-Back).

HERE IS WHAT YOU SHOULD KNOW ABOUT YOUR SIDE GIG AND TAXES.

Ahh…the ‘Side-Gig’, the ‘Side-Project’, ‘Moonlighting’, or the ‘Side-Hustle’ (NO not this Hustle). From Uber to Dogwalker.com, there are tons of ways to make some money on the side while pursuing your dream job – or just digging out of debt. If you’re hoping to pick up some extra cash with a side gig this year, here’s what you need to keep in mind on the tax side.

1) Income is Income. It doesn’t matter if your extra income is from driving a car or trading stocks, income is reportable unless it’s otherwise excluded.

2) Understand the Difference Between a Real Business and Just a Fun Way to Make Some Money. Income may be income but how and where it’s reported can vary depending on whether you’re engaged in a business or making money with a hobby.

Hobbies and businesses are reported on different spots on your federal income tax return (line 21 for hobby income versus Schedule C for business income), and they are treated differently for purposes of self-employment tax (business income is subject to self-employment tax while hobby income is not). When it comes to deductions, if you earn income in the pursuit of a hobby, you can offset the income with deductions but you cannot claim deductions that exceed your income: if you spend more than you make, you’re unfortunately out of luck.

If, however, you earn income in the pursuit of a business, you can offset the income with deductions, and you can carry losses forward or backward to other years. These are sometimes referred to as the “hobby loss rules,” and they’re important.To distinguish a real business from a hobby, the IRS looks at a lot of factors including whether you expect to make money (if so, you’re typically a business) as well as whether you are actually making money (again, typically a business)—so how seriously you treat your new pursuit will matter.

3) Keep Good Records. It may seem like all good fun when you’re renting out your apartment on the weekends, but you want to be able to verify your income and your expenses. The best way to do this is contemporaneously.

If you’re working by the hour, keep a log of your time. Save your invoices and document income: if you can stash it in a separate account, even better. When it comes to expenses, keep receipts and annotate the nature of the expense (you can write this right on the receipt, or use a scanner and upload the image with an explanation). And please don’t ditch those receipts immediately after Tax Day (click here to find out how long to hold onto your tax records).

4) You May Need to Prorate Some Expenses. Typically, you can only deduct expenses primarily for business use. Sometimes, you may have items like your cell phone or your car that are used for business and personal reasons. When it comes to those expenses, all is not lost: you can typically deduct the business portion of the expense.

To figure that out, you’ll want to document your use and note when it’s for business. The easiest way to do this is to keep a log of your time and mileage (there are also apps that can help you do this). If at the end of the year, you find, for example, that 40% of the use was for business, then you can typically deduct 40% of the expense. Some exceptions apply (for example, the IRS always considers a primary home landline as personal {not business}, even if you swear it’s used solely for business).

5) You May Need to Make Estimated Tax Payments.The extra few hundred dollars you earn from ads on your blog might not drastically affect your tax bill, but if you’re making a significant amount of money, you’ll want to plan ahead.

If you expect to owe more than $1,000 at tax time, you’ll want to make estimated tax payments. To make estimated tax payments, you’ll use federal form 1040ES, Estimated Tax for Individuals (downloads as a pdf). Estimated taxes must be paid quarterly: if you skip a payment or pay late, you may be subject to a penalty.

6) Consider Hiring a Tax Pro. If your tax situation becomes more complicated from your side hustle—especially since all of your income will not be reported by your employer on a W-2, you may need help. Don’t hire just on cost.

If you have a Side-Gig or are just thinking about starting that Side Hustle, don’t get caught up in the IRS tax net.

Solid Tax Solutions (SolidTaxSolutions.com) Can Help You!

Give Us a Call At: (845) 344-1040.

We Are Open Year-Round!

Sometimes, a side hustle is just that. But if it turns out to be something more, don’t ignore the business and tax side of things.

_________________________________________________________________________________________________

Bruce – Your Host at The Tax Nook

Our Firm’s Website: SolidTaxSolutions.com (or just click on the icon on right sidebar of this page).

Other Social Media Outlets: Facebook.com/SolidTaxSolutions (or just click on the icon on right sidebar of this page).

Twitter: Twitter.com/@SolidTax1040 (BTW, We Follow-Back).

Categories: Business, Income Tax

HOW THE TAX LAWS AFFECT HOME RENTALS!

It’s common practice for people to rent out their vacation homes when they are not being used for personal Rest and Relaxation. That rental income can cut the costs of owning and maintaining a second home. But these days, some of you may be cashing in on short-term rentals of your primary homes. Those of you who live in or near vacation destinations or who live in the vicinity of major events can now connect with renters through advertising sites like Craigslist or rental sites like Airbnb. So for example, back in 2015 many Philadelphia residents jumped into the short-term rental market when Pope Francis visited that city.

House with the words For Rent
A Short-Term Rental Can Affect Your Taxes!

Unlike typical vacation home landlords, some taxpayers may be unfamiliar with the tax law rules on rentals of a residence.

Rule #1:

Short Term Rentals. Under a longstanding tax rule, many short-term home rentals are essentially tax-free. The IRS says that when a home is rented for less than 15 days during a year, there’s no need to report the rental income or expenses. The rental income and rental expenses are simply ignored for tax purposes. Home-related expenses, such as mortgage interest and property taxes, are deducted as usual if the homeowner itemizes deductions.

Once rentals hit the 15-day mark, two other rules come into play depending on whether the property qualifies as a personal residence or as investment property.

Rule #2:

Personal Residence Rentals. If a personal residence is rented for 15 days or more during the year, all the rental income is included in income. Expenses are allocated between personal and rental use based on the number of days the home is used for each purpose. Otherwise deductible expenses attributable to personal use (mortgage interest, property taxes) can be written off if the homeowner itemizes deductions. All expenses attributable to rental use are deductible—but only up to the amount of gross rental income.

A home is treated as a personal residence for a tax year if it is used for personal purposes for more than the greater of (1) 14 days or (2) 10 percent of the total days it is rented at a fair rental price.

Days of personal use generally include any days the home is used by you or a family member or by anyone at less than a fair rental price. However, days the homeowner spends on repairs and maintenance are not personal use days, even if family members use the property for recreational purposes on the same day.

KEY POINT: This rule is not likely to come into play when a homeowner rents out their primary residence on a short-term basis. But it can crop up with vacation home rentals. For example, if a person uses a vacation home for a three-week vacation each year (21 days), the home will be treated as a personal residence only if rental use is limited to a total of 30 weeks (210 days).

Rule #3:

Investment Property Rentals. If a person’s property does not qualify as a personal residence, it’s considered an investment property. In that case, it is subject to the passive loss rules. Rental deductions are not limited to the amount of rental income, but any overall loss on the rental is deductible only to the extent of income from other passive investment sources. There is, however, an important exception: If a person has adjusted gross income of $100,000 or less and is actively involved in rental of the property (for example, by making repairs, approving tenants, and the like), the homeowner can write off up to $25,000 of the net rental loss against non-passive income, including his or her salary. The $25,000 exception is phased out a rate of 50 cents for each dollar of income between $100,000 and $150,000.

TAX TIP: By fine-tuning personal use of the home, homeowners can pick the rule that will yield biggest tax deductions.

Example: Bob and Carol Smith have adjusted gross income of about $95,000. The Smiths own a beach home that they use for three weeks each summer and rent for the remaining 12 weeks of the season. Their annual rental income is $18,000. Their total annual expenses for the home, including mortgage interest, taxes, maintenance and depreciation, come to $40,000. Of that amount, $8,000–including $4,000 of mortgage interest and $800 of property taxes—is allocable to personal use. The remaining $32,000 is allocable to the rental. The Smiths’ three weeks of personal use puts the vacation home in the personal residence category. Therefore, the Smiths can deduct the $4,800 of mortgage interest and taxes attributable to their personal use (the remaining expenses attributable to personal use are nondeductible). In addition, they can deduct their rental expenses—but only up to the amount of their rental income. Total deductions: $22,800. 

Change of Plans: The Smiths limit their annual vacation to just two weeks and rent the home for an additional week, increasing their rental income to $25,500. Based on their new mix of rental and personal use, they allocate $5,320 of expenses, including $2,660 of mortgage interest and $532 of property taxes, to their personal use. The remaining $34,680 of expenses are allocable to the rental.

Cutting back on vacationing makes the home an investment property. The Smiths lose some deductions on the personal side; they can deduct the $532 of property taxes attributable to personal use, but not the $2,660 of mortgage interest. (Mortgage interest attributable to personal use is deductible only if the home qualifies as a personal residence.) However, they pick up substantial deductions on the rental side. They can deduct their rental expenses up to the amount of their $25,500 of rental income. In addition, because the Smiths’ adjusted gross income is below $100,000, they can deduct their $9,180 loss on the rental ($34,680–$25,500) against other income. Total deductions: $35,212.

On The Flip Side: Assume the Smiths’ adjusted gross income exceeds $150,000. In that case, they may want to do more vacationing, rather than less. Reason: Whether the home is classified as a residence or an investment property, their rental deductions will be limited to their rental income. But by boosting their personal use, they can increase the amount of deductible mortgage interest and taxes attributable to personal use.

So, I hope that you have found this article to be helpful. Feel free to drop me a reply.

If you have a short-term (or even a long-term) rental you may be hurting yourself when it comes to taxes and the IRS.

So, give Solid Tax Solutions a call at (845) 344-1040 and let us get and keep you on the correct and profitable path.

And, don’t forget to check out our other informative articles on our blog: TheTaxNook.com.

Until the next time….
__________________________________________________________________________________________________

Bruce – Your Host at The Tax Nook

Our Firm’s Website: SolidTaxSolutions.com (or just click on the icon on right sidebar of this page).

Other Social Media Outlets: Facebook.com/SolidTaxSolutions (or just click on the icon on right sidebar of this page).

Twitter: Twitter.com/@SolidTax1040 (BTW, We Follow-Back).

LLCs, S-CORPORATIONS, AND PARTNERSHIPS – THE BASICS: PART 2

Hello again everyone!

With tax season now in motion, I wanted to take a bit of a break to complete Part 2 of this  blog post giving an overview of entity classification considerations for starting a new business (or looking at your ‘up and running’ business).

I hope that you found Part 1 to be insightful.
If, by chance, you missed Part 1 or simply would just like a refresher you can read that post here.

The second part will definitely continue the journey. So have a cup of coffee (or your favorite beverage) and let’s delve into Part 2 of LLCs, S-Corporations, And Partnerships – The Basics.

S Corporation Rules and Requirements

S corporations are just corporations that have elected to be taxed under special rules where the income and losses are passed through to the shareholders. Most, but not all, states recognize S corporations the same way the IRS does. There are a number of rules associated with S corporations. Violating them could result in a loss of S status. Should that occur, losses will be disallowed to the shareholders and profits will be taxed at the corporate level.

Making the S election is usually pretty straightforward. All of the shareholders must agree to make the election. In many states no separate election is necessary, filing the federal form automatically qualifies the corporation for S status in the state; in others you must file a separate state form.

Generally, the form must be filed within 2-1/2 months the corporation first has shareholders. Existing corporations can elect S status for a year by March 15 of that year (calendar-year corporations). There are exceptions to the rules, but this is not the place to make a mistake. You don’t want to find out some years down the road that you’ve been denied S-Corporation status. While the election is relatively simple, I would strongly recommend that you seek the services of a qualified professional to guide you through this process (this is not the time to be ‘penny wise and dollar foolish’).

There are several requirements associated with the shares of an S corporation:

  • The maximum number of shareholders is 100;
  • Shareholders can only be individuals, estates or certain trusts;
  • Shareholders must be citizens or residents of the U.S.; and
  • There can only be one class of stock.

The first requirement is unlikely to cause a problem for most corporations. All members of a family and their spouses are considered as a single shareholder for determining the 100-shareholder limit.

The second and third requirements can present pitfalls. Partnerships, corporations, and nonresidents cannot be shareholders. If an existing shareholder sells his or her shares to one of these persons, the S election will be terminated. An IRA cannot be a shareholder. (An inadvertent termination can often be remedied, but not without effort.)

The last requirement sounds innocent, but can often be a problem. While you’re unlikely to inadvertently issue preferred shares, the IRS has held that unequal distributions to shareholders can result in a second class of stock. For example, John Smith and Susan Jones each own 50% of SoapNSuds Inc. John takes a $50,000 salary; Susan takes only $10,000 annually. Neither takes any cash distributions. But SoapNSuds Inc. pays all the expenses of a car for Susan which Susan uses only 10 percent for business. The 90 percent of personal use is a distribution to Susan. Since Susan has gotten a preferential distribution, SoapNSuds Inc. may now have two classes of stock. Debt other than straight debt can be considered a second class of stock (e.g., convertible debt). Differences in voting rights generally won’t constitute a second class. Health or accident insurance premiums paid on behalf of a 2-percent plus shareholder aren’t considered distributions for the second class of stock requirement.

As always, the rules are far more complicated than discussed above. There are other requirements as well as exceptions.

 

Fringe Benefits

This is one of the drawbacks of partnerships and S corporations. Certain fringe benefits paid to any partners or more than 2-percent shareholders of an S corporation are not deductible. The fringe benefits generally include:

  • health and accident insurance,
  • qualified transportation fringes,
  • group term life insurance premiums on the first $50,000, and
  • meals and lodging furnished for the convenience of the employer.

Health insurance premiums are deductible, but only if included on the employee/shareholder’s W-2. The employee can then deduct the amount toward his or her adjusted gross income on their personal tax return. Meals and lodging furnished for the convenience of the employer include meals provided on company premises when employees can’t leave because of work requirements.

Most other fringe benefits, such as employee discounts, working condition fringes, no-additional cost services, and de minimis fringes should be deductible by the partnership or S corporation.

 

Attribution Rules

This is a technical area that’s beyond the scope of this blog post. However, you should be aware that stock ownership or an interest in a partnership can be attributable to a related party. For example, you own 50 percent of the stock of TicTak Inc. You pay the health insurance for your son who is an employee of TicTac Inc. Your son is deemed to be a more than 2-percent shareholder. In order for his health insurance to be deductible, you would have to include his health insurance premiums on his W-2.

 

Excessive Salary

Excessive salary issues have generally involved C corporations. Because dividends from a C corporation are not deductible by the corporation but income to the shareholder, the best tax way to take money out of a C corporation is generally by salary. But excessive salaries can be challenged by the IRS and deemed to be, in part, dividends.

With an S corporation, partnership, or similar entity, the IRS may take issue with excessive salaries paid to relatives, claiming you’re trying to shift income to a lower bracket taxpayer. So as an example, let’s say that you are the sole shareholder of MedBuzz Inc. a highly profitable medical electronics manufacturer. You’re in the top tax bracket (i.e., 39.6%). Your son works for the business on a part-time basis. He has a college degree but no special skills, but you pay him $275,000 per year. The IRS may decide he’s only worth $35,000 and disallow a deduction for the remainder.

If there is any question as to the salary paid to a relative, you should document hours worked and be able to show the salary is not excessive.

 

State Taxation

Most states tax S corporations the same as the Federal government does. (There are certain exceptions.) Of more concern are S corporations, partnerships and LLCs doing business in more than one state or where you have a nonresident shareholder. The partnership, S corporation, etc. must file in each state in which it does business. (This would be a good time to  check with a tax professional on the definition of doing business.) The shareholders or partners must file a personal tax return in those states or file a composite return. So, let me give a couple of examples to help clarify the above.

Example 1–Lobster Inc. is a Massachusetts corporation owned by two Massachusetts residents, Bob and Carol. Lobster Inc. is also doing business in New Yawk New York. Lobster Inc. has to file a New York state S corporation return. Both Bob and Carol have to file New York nonresident individual income tax returns reporting Lobster Inc.’s share of New York income on their nonresident returns.

Example 2–Clams Inc. is a Massachusetts corporation owned by Ted and Alice. Clams Inc. does business only in Massachusetts. Ted is a Massachusetts resident; Alice is a New York resident. Alice has to file a Massachusetts nonresident return reporting her share of Clams Inc.’s income.

That’s the general approach. Some states allow the use of a composite return. If that’s the case the corporation can file a return for the nonresidents and pay the tax directly. While the approach is simpler, the total tax should be about the same. Some states require composite returns; in some it is optional (if available). Many states now require making installment payments for nonresident shareholders.

 

Converted C Corporations

Converting from a C (regular) corporation to an S corporation is generally easy and you can usually avoid any current tax consequences. But there are traps to watch out for.

The first is the built-in gains tax. It involves appreciated assets held by the corporation while it was a C corporation and sold by the S corporation. Because the sale of appreciated assets would be taxed twice to a C corporation, but not to an S corporation, were it not for the built-in gains tax, converting to an S corporation would provide a loophole.

Example–In 1996 Green Acres Inc., then a C corporation, purchased 100 acres of land for $100,000. In 2015 when the land is worth $400,000, Green Acres Inc. converts to S corporation status. Green Acres Inc. sells the land in 2017 for $650,000. Any appreciation in the land after Green Acres Inc. converted to S corporation isn’t subject to the built-in gains tax. But the $300,000 gain ($400,000 value at time of conversion less $100,000 purchase price) is subject to the special tax.

The tax rate is the highest tax rate applied to corporations. The tax does not apply to assets held by the S corporation longer than 5 years at the time of sale. Therefore, in the example above, if Green Acres Inc. had converted to S corporation status in 2010, the tax would not have applied.

As always, the rules are more complex and you may be able to avoid the tax by careful planning.

The second danger associated with a converted C corporation involves excess net passive investment income. The S corporation must first have accumulated earnings and profits as a C corporation (while the rules aren’t exactly the same, accumulated earnings and profits are similar to retained earnings). Then it must have more than 25 percent of its gross receipts from royalties, rents, dividends, interest, and annuities. An S corporation that meets these tests is subject to a separate tax at the highest corporate tax rate on the excess net passive income.

While the tax is unlikely to affect most operating corporations (an S corporation in the business of renting property enjoys a special exception to the rent rule), there is a real danger for corporations where operations have been terminated. For example, ABC Inc. has been in business for many years about half of them as a C corporation. It sells most of its operations for cash. Rather than distributing the cash, the corporation invests it and collects dividends and interest.

The third trap uses the same tests as in the second (excess net passive income and accumulated earnings and profits) but adds a third test–three years of excess passive income. Here the penalty is termination of S corporation status. Clearly something you want to avoid.

The fourth trap involves distributions. Generally, distributions of income from S corporations are nontaxable. The shareholders pay tax on all the income when earned, so they avoid a second tax on distributions. For converted C corporations with accumulated earnings and profits distributions out of the earnings while the entity was an S corporation are nontaxable. But once those earnings have been distributed, additional earnings will be from accumulated earnings and profits of the former C corporation and are taxed just like ordinary dividends.

There are several options to avoiding these problems, but they may depend on your specific situation.

 

Basis

I’ve discussed basis in other places, but a review is worthwhile. Generally, your basis in an S corporation, partnership or LLC is equal to:

Your original and any subsequent capital contributions, + your share of the income of the entity, + your share of the separately stated income (e.g., dividends, interest, etc.), – your share of the losses, – your share of the separately stated deductions (e.g., a Section 179 expense option), – your share of the distributions.

There are a number of items that can enter into the calculation (such as when property rather than cash is contributed to the entity), but the basic approach remains the same. In addition to your basis in equity capital, S corporation shareholders and partners have a basis in any money loaned to the entity. Partners can increase their basis in the partnership by partnership debts for which they are liable. Once your equity basis has been exhausted by losses, additional losses will reduce your loan basis.

Your basis is important for determining your amount at-risk, the amount up to which you’re allowed to deduct the losses of the entity. It also determines your gain or loss on the sale of the business.

Just because you can’t take the losses doesn’t mean they don’t reduce your basis. The Section 179 expense option can create a particular trap. Because of a limitation, you may not be able to use the deduction elected by the S corporation or partnership, but your share of the amount elected will reduce your basis.

Another trap arises from nondeductible expenses. Even though they don’t decrease your profit or increase your loss, they do reduce your basis. The most commonly encountered one is the 50 percent of meal and entertainment expenses that aren’t deductible.

 

Loss Limitations

I’ve said that income and losses of S corporations, partnerships, LLCs, etc. are passed through to the partners, shareholders, etc. That’s generally true, but in order to take the losses you have to pass some tests. The first I discussed in Part 1, material participation. (Actually the material participation test is applied first.) But you also have to have sufficient amount at-risk. That is, your economic investment in the entity must be at least as much as the losses.

What’s your amount at-risk in the entity? A complete discussion would be involved, but most taxpayers won’t get into the nuances. In most cases, your amount at-risk is very similar to your basis. And, in many cases, a shareholder or partner needs to go no further. But there can be substantial differences, particularly in the case of partnerships. Here are some points:

  • You are not at risk with respect to amounts protected by nonrecourse loans, guarantees or stop-loss agreements.
  • You are not at risk with respect to amounts borrowed from a person who has an interest (or than as a creditor) in the entity or a person related to a person with such an interest.
  • In some cases the at-risk rules can be applied separately to separate activities.

Two examples based on simple situations should help clarify.

Example 1–Vince invests $5,000 in XYZ Inc. to start the business (he’s the only shareholder). During year 1 XYZ Inc. has income of $30,000 and Vince takes a distribution of $9,000. Vince’s basis in XYZ Inc. at the end of year 1 is $26,000 ($5,000 + $30,000 – $9,000). In year 2 XYZ Inc. has a loss of $15,000 and Vince takes a distribution of $2,000. Vince’s basis at the end of the year is $9,000. In year 3 XYZ Inc. has a loss of $16,000; Vince takes no distribution. Vince can only deduct $9,000 of the $16,000 loss. The remaining $7,000 loss can be carried forward and used in a year when he has sufficient basis.

Example 2–The facts are the same as in example 1, but in year 3 Vince loans XYZ Inc. $10,000. The loan increases his total basis in XYZ Inc. to $19,000 (the $9,000 equity basis at the end of year 2 plus the $10,000 loan basis). Viince can take the full $16,000 loss, leaving him with no equity basis (you use equity first) and only $3,000 in loan basis ($10,000 original loan basis less $7,000 loss applied to loan basis).

Here comes a trap. Assume XYZ Inc. ceases operations (just to simplify the example) when XYZ Inc. starts repaying the loan to Vince, a portion of each principal payment will be income because Vince’s basis in the loan is only $3,000.

A second trap involves loans from a party who has an interest in the entity other than as a creditor. For example, Vince and Kathy are 40-60 shareholders in XYZ Inc. Vince wants to increase his interest to 50 percent and borrows $30,000 from Kathy to make an equity investment. Vince is not at risk for the $30,000 additional investment.

It sounds like I have spent a considerable amount of time explaining what may sound like a fine point. However, many small businesses are financed with only a minimal amount of equity and a large amount of debt.

Partnerships, LLCs and sole proprietorships can get more complicated. The basic rules are the same. But your amount at-risk in a partnership or sole proprietorship is increased by any loans for which you are personally liable and decreased by the relief of any debt for which you are liable. For example, Bonnie and Clyde are 50-percent partners in Green2Go Co., a general partnership. Each contributed $5,000 to start the business. Green2Go Co. borrows $20,000 from Ketchum Bank to purchase inventory. Bonnie and Clyde are considered to have increased their amount at risk by their share of the loan, $10,000 each.

But that increase is elusive. Assume Green2Go Co. has losses of $30,000 ($15,000 for each) in the first year. Bonnie and Clyde can deduct all the losses because their amount at risk is $15,000 each. That decreases the at risk amount to zero. Assume in year two Green2Go Co. has cash flow but no profit for the partners. Green2Go Co. uses $10,000 of the cash generated to pay off the bank loan. Bonnie and Clyde will have $5,000 of taxable gain because of the reduction in the bank loan. A similar situation could occur if the partner is no longer at-risk with respect to the loan or investment.

 

Sale of Interest

Selling your interest in an S corporation can be as simple as signing over the shares of stock. More than likely you’ll draft a purchase and sale agreement providing for a noncompete clause, payment terms, etc. Some of the proceeds will be outside the gain or loss on the business. For example, the noncompete agreement is usually between the owner of the business and the buyer. The corporation isn’t involved. It’s more complicated in the case of a partnership, since there are a number of special issues to be dealt with and that’s beyond the scope of this blog post. However, the starting point for computing gain or loss is similar.

Whether you have a gain or loss on the sale of an asset is determined by your selling price and the basis. That can be good news or bad news, depending on your basis. Keep in mind that your basis in an S corporation or partnership depends on your equity investment plus any income less losses and distributions. For example, Vince started XYZ Inc. with $5,000. Over the years XYZ Inc. has had income of $85,000; Vince takes no distributions. He sells his stock for $160,000; he has a $70,000 gain (selling price of $160,000 less $90,000 basis). Katlin started World Inc. with a $100,000 investment. World Inc. has losses of $90,000; her basis is $10,000 ($100,000 investment less $90,000 in losses). Katlin sells her stock for $160,000. She has a gain of $150,000 ($160,000 selling price less $10,000 basis).

As always, things can be more complicated. The point to remember here is that your gain or loss is based on more than just your original investment.

 

Distributions

In our Part 1 of this article I said it really doesn’t matter if you take a distribution or not, the income from an S corporation, partnership, etc. is taxable to you. But what about the distribution? Is that taxable? This is another time when the answer depends on your basis.

Generally, distributions up to your basis are nontaxable. Distributions in excess of your basis are taxed as a capital gain.

Example–Chris invested $5,000 to start LMN Inc. LMN Inc. has had earnings of $23,000. Chris takes a distribution from the company of $35,000. At the time of the distribution, Chris’ basis in LMN Inc. was $28,000. Of the $35,000 distribution, $28,000 is nontaxable, the remaining $7,000 is treated as a capital gain and, assuming the required holding period is met, taxed at long-term capital gain rates.

The rules for partnerships are similar. How can you distribute more money than you put in? Simple. If you financed the business with debt or even have accounts payable, you could have cash available for distribution.

In the discussion above I assumed that only cash is distributed. Distributing property (e.g., a truck used in the business given to your son) will complicate the issue. A distribution of appreciated property by an S corporation could result in a taxable gain. And the amount of the distribution will be the fair market value of the property. A distribution of property by a partnership won’t result in gain until it’s sold by the partner. But a distribution of property encumbered by a liability (a truck with a loan outstanding on it) can trigger an overall decrease in partnership liabilities. The reduction in the partners’ liability will result in a deemed distribution to the partners.

 

In Conclusion:

As I wrap up this two-part post I will say that I know that this post was a long read (in addition to Part 1) but the length just reflects how intricate choosing an entity classification can be for your business. The decision is not to be taken lightly.

But, keep in mind, what I covered in these two posts only scratched the surface. So, if you are starting a business or even if you are already ‘in business’, give Solid Tax Solutions
(SolidTaxSolutions.com) a call so that we can help you make informed and smart decisions for your business.

We can be reached at (845) 344-1040 year round.

__________________________________________________________________________________________________

Bruce – Your Host at The Tax Nook

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