THE NEW TAX PLANNING LANDSCAPE
In general, we believe a major aspect of the new Tax Cuts and Jobs Act will be to make tax planning more and more mathematical. By such a statement, we emphasize that the taxpayer’s choices are more likely to involve projections and ranges.
The choices also look to be more numerous. ((See generally, Tax Cuts and Jobs Act, Conference Report to Accompany H.R. 1, 115 th Cong., 1 st Sess., House Report 115-466, December 15, 2017, which includes the text of the Act, the legislative histories of the House, Senate and Conference. This is referred to hereinafter as the Conf. Rep. Note that for pagination one has to choose the PDF version at this site:
Enacted in December, the new law introduced major changes taking effect mostly after 2017, but there are some effects in 2017. Not all the changes are permanent which adds to the complexity.The general context is the repeal or cut back of numerous deductions, enhanced, targeted deductions that may significantly benefit some taxpayers, mostly businesses, along with some reduction in income tax rates generally for individuals. There is also the much-publicized major reduction in corporate tax rates. The tax on the first $50,000 of corporate income actually went up.
Long-term capital gain breaks are still with us, as is the 3.8% tax on net investment income enacted as part of Obamacare. ((Re the 3.8% tax and its computation, see IRS Form 8960 and its instructions at irs.gov.)) For high-income taxpayers who reach the 20% maximum federal rate on qualifying dividends1and long-term capital gains, the actual tax rate may be 23.8% because both qualifying dividends and1long-term capital gains are subject to the 3.8% tax. Part of the planning that can arise with projections is1understanding whether accelerated deductions offset income taxed at a lesser rate. ((Note that the13.8% tax that is inclusive generally of non-business gains also reaches short-term capital gains. Note1that California does not give a tax advantage to long-term capital gains so the California tax, at the1highest individual tax rates, reaches 13.3%.))
In planning generally, keep in mind the income tax isn’t the only tax. For example, in making decisions that may affect 2017 versus later years, keep in mind that carrying losses from one year to another is an income tax concept that doesn’t apply for purposes of the self-employment tax, which is the payroll tax for the self-employed. Accordingly, one of the factors to evaluate in accelerating deductions to the point of creating losses is whether such steps waste deductions that would otherwise reduce the self-employment tax.
For example, Form 1040, Schedule C business income of zero in each of two years translates into no self-employment tax in either year, whereas a $100,000 loss in one year and $100,000 of income in another year triggers self-employment tax on $100,000 of income. While it is generally beyond our scope, there are also self-employment tax savings potential when one incorporates, relative to the wage/payroll tax scenario that generally applies in a corporate context.
Accelerating Business Deductions
We believe the prospects for many taxpayers to call assets deductible business expenses has never in recent times been at such a scale as was introduced in the 2017 Act. In support of such statement, we have in mind primarily the following.
The depreciation particulars are quite complex but we note that first-year “bonus depreciation” under Section 168(k) was increased from 50% to 100% after September 27, 2017 through December 31, 2022, with some phase-down from 100% to 20% through 2026. ((See Conf. Rep. p. 346-372, especially p. 357.)) “A transition rule provides that for a taxpayer’s first taxable year ending after September 27, 2017, the taxpayer may elect to apply a 50-percent allowance instead of the 100-percent allowance.” ((Conf. Rep., p. 357.))
“Qualified improvement property” is eligible for bonus depreciation. “Generally, this is any improvement to an interior part of a building that is nonresidential real property. The improvement is placed in service after the date the building is first placed in service and is section 1250 property.” ((IRS Pub. 946, “How to Depreciate Property,” 2016, p. 26.)) This doesn’t apply to an enlargement of a building, an elevator or escalator, or the internal structural framework of the building.
The maximum amount of qualifying property the taxpayer may elect to expense under Section 179 was increased from $500,000 per year to $1 million. The benefit of this provision doesn’t begin to phase out until capital expenditures exceed $2 ½ million for the year with respect to property placed in service during the year. With indexing, the phase out begins at $2,530,000 in 2017, and the 2017 maximum is $510,000. The enhanced ability to expense qualifying property applies in tax years beginning after December 31, 2017. ((See generally the Conf. Rep. p. 372-375.)) In general, tangible personal property and off-the- shelf computer software qualify. For example, a large manufacturing press would qualify. A building would not qualify for this special expensing provision.
There is provision for carryover but this provision cannot be used to create a net operating loss to carryback to pre-2017 years in which the tax rates may be higher. However, if the capital expenditures were in place by year-end, one might use the expense election to offset higher tax rates of 2017.
There is another relief provision that generally allows expensing building improvements to the extent of the lesser of 2% of the unadjusted basis of the property or $10,000. ((Regs. 1.263(a)-3(h).))
Basis write-offs generally mean reduced deductions in future years, but we also note that for inherited assets, there is still step-up (or down) to fair market value at death, such that maximizing deductions for the older taxpayer doesn’t necessarily translate into reduced basis for heirs. In California, for example, both halves of community property generally step-up to fair market value upon the death of the predeceasing spouse.
The legislative history of another series of provisions aimed at helping small to mid-size businesses summarizes them as follows: “The provisions to expand the universe of taxpayers eligible to use the cash method, exempt certain taxpayers from the requirement to keep inventories, and expand the exception from the uniform capitalization rules applies to taxable years beginning after December 31, 2017.” ((Conf. Rep. p. 381, quoting from the House’s legislative history. Conference following the House provision. See generally p. 375-381, citing Sections 263A, 448, 460, and 471.))
Other Changes May Increase Your Tax
The general context of the new legislation purports to be pro-business, reduced corporate tax rates, etc., yet the general context is also the repeal or modification of many tax deductions One is generally surprised at some of the “less friendly” business provisions.
We argued it was unfair to consider denying some level of net operating loss carryback. See rojascpa.com, “Articles,” “Net Operating Loss Carryback Repeal Isn’t Getting the Attention It Deserves.” Inherent in the repeal of the NOL carryback provision was the anomaly that the taxpayer who loses $1 million and then makes $1 million in the following year roughly breaks even because the NOL deduction can be carried forward. Yet the taxpayer who makes $1 million and then loses $1 million in the following year is in a radically different position of paying tax on about $1 million given the repeal of the NOL carryback concept. The Supreme Court has noted that the strict application of the annual accounting concept can yield results that are “unduly drastic.” ((Libson Shops, Inc., 353 U.S. 382, 386 (1957).)) The repeal of the NOL carryback with certain modifications of the loss deduction rules is part of the new tax law. The repeal of the NOL carryback is effective for losses arising in tax years ending after December 31, 2017. In general, post-2017 losses are deductible to the extent of 80% of taxable income for losses arising in taxable years beginning after December 31, 2017. ((Amendments to Section 172, Conf. Rep. p. 70-72, 393-394.)) There is an exception that allows carryback relief for farming losses.
The potential for an NOL carryback still exists as to an NOL incurred in 2017, and one aspect to a decision to carryback an NOL incurred in 2017 rather than to elect to carry such loss forward is the potential impact of an NOL carryover from 2017 on the benefits otherwise available to the taxpayer after 2017 under Section 199A – the new 20% deduction based on business income or adjusted taxable income, if less. See the following discussion of this new provision. Among the considerations here are contemplated rates of realization as a carryback and projected realization as a carryover, including AMT issues.
Potentially costly to certain business taxpayers is the new Act’s amendment limiting “excess business losses” of non-corporate taxpayers. ((Conf. Rep. p. 19, 238-239, amending Sec. 461(l) for losses in tax years beginning after December 31, 2017.)) This provision limits the ability of the taxpayer to offset non-business income with the current year’s business losses when such losses exceed $250,000, or $500,000 in a joint return. The disallowed business expenses are considered net operating loss carryovers, and thus of potential benefit in the future. The passive loss rules apply prior to these rules. In general, one need not have extremely high income to run into new limitations on deducting ordinary business losses. This new rule can be another consideration in the analysis of whether to incorporate and what assets to incorporate.
While the research and development credit was preserved, there were introduced some significant, down-the-road lengthening of R&D amortization periods. ((Sec. 13206 amending Sec. 45C and Sec. 274, Conf. Rep., p. 60-62, 423-425. The Senate version of these provisions was followed in Conference.))
Business-related membership dues in certain organizations will no longer be deductible, or at least be less deductible:
“The provision provides that no deduction is allowed with respect to (1) an activity generally considered to be entertainment, amusement or recreation, (2) membership dues with respect to any club organized for business, pleasure, recreation or other social purposes, or (3) a facility or portion thereof used in connection with any of the above items. Thus, the provision repeals the present-law exception to the deduction disallowance for entertainment, amusement, or recreation that is directly related to (or, in certain cases, associated with) the active conduct of the taxpayer’s trade or business (and the related rule applying a 50 percent limit to such deductions).” ((Senate amendment followed in Conference amending Sec. 274; Conf. Rep. p. 406; IRS Pub. 463.))
There is generally a 50% limit on deducting meals of employees traveling on business. After 2017 and until 2025, the new law “expands the 50 percent limitation to expenses of the employer associated with providing food and beverages to employees through an eating facility that meets requirements for de minimis fringes and for the convenience of the employer. Such amounts incurred and paid after December 31, 2025 are not deductible.” ((Senate amendment followed in Conference amending Sec. 274, Conf. Rep. p. 407.))
Accrual method taxpayers may have to accrue more income under a new tax rule that focuses on financial statement conformity. ((Conf. Rep., p. 62 reporting Section 13221 of the 2017 Tax Act amending Section 451. The legislative history is found at Conf. Rep. p. 425-429.)
Amidst the much-publicized benefits and tax reductions aimed at businesses, there are a number of less-publicized provisions aimed at increasing the taxes on business income.
INDIVIDUAL TAX PLANNING – THE RATES
2017 Year-End Planning
Just because of the time-value of money, income deferral and accelerating deductions are generally advantageous. This was generally true even more so in 2017 year-end planning because of the reduced tax rates coming in 2018.
Note that there is a constructive receipt concept in the tax rules that can limit one’s ability to shift income to future years. For example, if you receive a client fee in late 2017, it is taxable in 2017 even if you hold off taking the deposit to the bank until 2018.
The taxpayer’s particular circumstances and detailed calculations, goals and projections are most important. The facts that count are your facts. Keep in mind that our generalities may not hold true in your particular circumstances.
The 2017 Tax Rate Schedules
We’re coming off of the following 2017 tax rate structure:
Single: 10% of first $9,325, 15% from $9,325 to $37,950; 25% from $37,950 to $91,900; 28% from $91,900 to $191,650; 33% from $191,650 to $416,700; 35% from $416,700 to $418,400; 39.6% over $418,400.
Married filing joint: 10% of first $18,650, 15% from $18,650 to $75,900; 25% from $75,900 to $153,100; 28% from $153,100 to $233,350; 33% from $233,350 to $416,700; 35% from $416,700 to $470,700; 39.6% over $470,700.
We’re not discussing at this time the married, filing separately tax rates or head of household schedule.
The 2018 Tax Rate Schedules
The 2018 tax rate structure is as follows:
Single: 10% of first $9,525, 12% from $9,525 to $38,700, 22% from $38,700 to $82,500, 24% from $82,500 to $157,500, 32% from $157,500 to $200,000, 35% from $200,000 to $500,000, 37% over $500,000.
Married filing joint: 10% of first $19,050, 12% from $19,050 to $77,400, 22% from $77,400 to $165,000, 24% from $165,000 to $315,000, 32% from $315,000 to $400,000, 35% from $400,000 to $600,000, 37% over $600,000.
The standard deduction of $6,350 for singles and $12,700 for joint returns in 2017 increased in 2018 to $12,000 for singles, $24,000 in joint returns. The increased standard deduction for the elderly and blind is still with us. ((Conf. Rep. p. 201.)) Personal exemptions are no longer with us from 2018 to 2025. ((Conf. Rep. p. 204.)) Personal exemptions in 2017 are $4,050 albeit they are subject to phase-out at higher income levels that vary with filing status. Some taxpayers itemize in alternating years, a strategy that may be less accessible given the higher levels of standard deduction and the cut-back in many itemized deductions, the most significant of which may be limiting the 2018 deduction to $10,000 for the sum of state income tax and property tax on the residence. This new rule, which applies after 2017 and before 2026, places a limit on an aggregate figure, but it may matter the degree to which the federal return seems to expressly deduct state income tax rather than property tax, since the state return would disallow that state’s income tax deduction. Large gains that trigger large state tax in one’s home state or another state, such as gain on realty outside one’s state of residency, are more problematic given the limited deductibility of state income tax. Like-kind exchanges are more restricted with the 2017 Act but taxfree exchanges of non-dealer realty may still be possible. ((Conf. Rep., p. 394-397.))
The new rules also introduced a prohibition on deducting property taxes on foreign realty as an itemized deduction. ((Conf. Rep. p. 34.))
A highly successful business that flows significant taxable income through the Form 1040 may also trigger significant amounts of state income tax, amounts well in excess of the $10,000 deductible as an itemized deduction after 2017, which can be a significant incentive to consider C corporation status. A C corporation can normally deduct on its federal return the state income tax pertaining to its operations. The incremental deduction for state income tax on the Form 1040 is effectively zero if an individual or couple already pay property taxes that would use the new $10,000 maximum for state income taxes and property taxes combined.
The key is individual, tailored calculations and projections, but we add some general observations with a focus on whether incorporating makes sense. Post-2017, the federal corporate tax rate is a flat 21%, even for personal service companies. The 21% rate applies to business and investment income inside the corporation. More on corporate rates below but the basic perspective is the much-publicized reduction in the corporate tax rate to 21% effective January 1, 2018. The corporate tax rate applies to ordinary income and long-term capital gains; i.e., corporations don’t get a lesser rate on long-term capital gains but they are generally limited in so far as deducting capital losses. Incorporating involves some added complexities, costs and valuable owner time.
In comparing old law with new law tax rates below, we may discuss a range of income that doesn’t exactly correspond to the brackets under either the old rate schedules or new rate schedules.
The 2018 individual tax rates are 15% or less up to taxable income of $38,700, and they begin to exceed the corporate tax rate at this fairly low income level. The individual rates are 22% to 24% from $38,700 up to $157,500 of taxable income but the difference in 21% versus these individual tax rates would not likely justify the added expense and complexity of introducing a C corporation into one’s affairs.
For single taxpayers, comparing old law and new law rates gets a bit complicated above the level of $157,500 of taxable income. But we note generally the taxpayer with $200,000 to $418,400 in taxable income under the new rate schedule actually pays more tax than under the 2017 single taxpayer rate schedule. Because the individual tax rates reach their maximum of 37% under the new law versus 39.6% under the old law, there is a point at higher levels of income where the single taxpayer pays less tax under the new rate schedule.
In general, the single taxpayer might give thought to incorporating to shift income exceeding $157,500 where the rates vary from 32% to 37% relative to the 21% corporate tax rate under the new law.
Taxable income figures aren’t comparable if for no other reasons than personal exemptions went away in 2018 and the standard deduction increased, but our calculations indicate the single taxpayer with taxable income of $600,000 saves about $5,700 (less than 1% of income) compared to prior law, whereas the taxpayers filing jointly and making income of $600,000 save almost $21,500 (over 3% of income).
The single taxpayer is taxed at higher rates and somewhat more likely to have an incentive to incorporate given the new lower corporate rates.
Taxpayers filing jointly:
The 2018 individual tax rates are 12% or less up to taxable income of $77,400, and they begin to exceed the corporate tax rate at this moderate income level. The individual rates are 22% to 24% from $77,400 up to $315,000 of taxable income but the difference in 21% versus these individual tax rates would not likely justify the added expense and complexity and time commitment (e.g., Board meetings) of introducing a C corporation into one’s affairs.
For married taxpayers filing jointly, the savings comparing 2018 individual rates to 2017 individual rates tends to progress rather steadily, but there are particularly improved tax savings between these levels of income – $233,350 to $315,000 (24% rate versus the old 33%), and between $470,700 and $600,000 (35% rate versus the old 39.6%).
ESTATES AND TRUSTS – THE RATES
We note that estates and trusts are generally taxed as flow-through entities; taxable income may flow-through to the beneficiaries or be taxed at the entity level. Historically, trusts and estates reach their highest tax bracket quickly, and this continues to be true under the 2017 Act, although there was some modest reduction in tax rates so that their maximum is now 37%. ((Conf. Rep. p. 3.)).
Trusts and estates are also eligible for the new 20% of business income deduction under Section 199A. ((Conf. Rep. p. 224.)) The fact that an elderly person’s estate may continue to get the Section 199A deduction could be a factor in the considerations of whether to incorporate an elderly person’s business activities because of the major reduction in corporate tax rates.
If income is retained within the estate or trust, the income tends to be taxed at a relatively high rate, but whether one would want to consider incorporating any assets of an estate or trust would turn on its own unique set of circumstances, including the contemplated longevity of the estate or trust.
CORPORATE TAX PLANNING – THE RATES AND MORE
Corporate Rate Structure and Planning Basics
Corporate rates 2017: 15% of first $50,000; 25% from $50,000 to $75,000; 34% from $75,000 to $100,000; 39% from $100,000 to $335,000; 34% from $335,000 to $10,000,000; 35% from $10,000,000 to $15,000,000; 38% from $15,000,000 to $18,333,333; 35% above $18,333,333.
The new Sec. 199A deduction giving a percentage of business income deduction to many sole proprietors, partners and shareholders of S corporations is not available to C corporations – taxpaying entities where the shareholders do not elect flow-through treatment as an S corporation. ((A C corporation with accumulated earnings and profits converting to an S corporation and earning more than 25% of gross receipts from passive sources may lose the S election after three years. See instructions to the Form 1120S, page 2.))
One basically looks to the flow-through amounts and applies the percentage of business income rules at the partner or Subchapter S shareholder level. ((Conf. Rep., p. 224.))
The new corporate tax rate is a flat 21% after 2017. The tax rate change for corporations was made permanent whereas the individual tax rate reductions beginning in 2018 are temporary.
If an S corporation converts to a C corporation and there is also accounting method change to the accrual method, it may be possible to report the net method change adjustments (the “accounting method spread”) as an increase to taxable income in years where the adjustment is taxed at the new C corporation rates. ((See Conf. Rep., p. 104, 382-384. These special rules involve additions of Sections 481(d) and 1371(f) to the Code.))
If the shareholders of an S corporation believe it is advantageous to convert to a C corporation, they would need to act to revoke the S election by March 15, 2018, if all of 2018 is to be reported as C corporation income. In general, if the S election is revoked, reverting back to S corporation status in the near term would require IRS consent. ((See page two of the instructions to the Form 1120S, “Termination of Election.”))
Personal service corporations have been subject to a flat 35% rather than graduated rate structure. ((Sec. 11(b)(2); Sec. 448(d)(2).)) After 2017, they have become subject to the regular 21% corporate tax rate.
The corporate alternative minimum tax was permanently repealed for taxable years beginning after 2017. ((Conf. Rep. p. 40-42, 323. See Conf. Rep. p. 46 indicating Sec. 1374(b) is amended by striking paragraph (4) which dealt with AMT in the context of the built-in gains tax that can apply to a former C corporation that is now an S corporation.))
The alternative minimum tax for individuals is still with us, albeit for a period of years with increased exemption amounts. The AMT is a significant aspect of planning for many and needs to be part of the taxpayer’s projections. ((See Form 6251.))
We initially focus on the worst case scenario for incorporating. The double-taxation effect of incorporation, at its maximum, looking only to the federal tax, can be demonstrated by the following extreme example.
An individual earns an incremental $100,000 in 2018 which is subject only to the federal income tax. We assume no self-employment tax and the maximum individual tax rate of 37% applying to all of the income. So the taxpayer would have $100,000 less $37,000, or $63,000. If in 2018 the individual owned a C corporation that earned the $100,000, paid a 21% tax on it and distributed the $79,000 balance as a qualified dividend in 2018, the tax borne by our presumed sole shareholder would be $21,000 plus 23.8% of the $79,000 dividend – the 20% tax on a qualified dividend plus presumably the 3.8% tax under Section 1411 on net investment income. So we presume a total tax of $39,802. ((If you hold the stock more than sixty days, the tax on a “qualified dividend” is generally the same as long-term capital gain. See 2017 instructions to the Form 1040, p. 23.)) So the shareholder has $60,198 rather than $63,000. The shareholder is worse off but only by about $2,800 under our assumptions even with “double taxation.”
The earnings within the corporation may eventually be converted to long-term capital gains upon the shareholder’s sale of stock. Such gains would normally be taxed at the same rate as qualified dividends. There are some circumstances where the gain on sale of the “small business stock” held more than five years may be excluded from income. ((See Sec. 1202.))
There are obviously other aspects to consider. The primary goal may be reduced current taxation to maximize capital within the business because the entrepreneur projects major earnings on additional capital. The earnings inside the corporation may be delayed a long time before any second income tax at the shareholder level is incurred.
If the shareholder dies and the stock steps up to fair market value at death, which would reflect accumulated earnings within the corporation, it may even be possible to get the earnings to the family without a second tax via sale of the stock or liquidation of the corporation. It may also be possible to avoid tax at the shareholder level via a charitable donation of the C corporation stock. Charitable donations of closely-held private company stock may yield deductions at fair market value, but donations of privately held stock also involve complexities, including appraisals.
The long established tax rule that most assets step-up (or down) to value at death also plays a role in deciding whether to operate as a corporation. With a C corporation, if the sole shareholder passes away, the shareholder’s stock usually steps up to value at death but the assets inside the corporation do not step up (or down) due to the death of the shareholder. These issues may be particularly important to the older businessperson contemplating incorporation.
It is also worthwhile to consider keeping certain assets outside of the corporation, such as realty that might step-up at the death of the owner. ((See also “Why Real Estate Inside the Closely Held C Corporation Should Generally be Avoided,” J. Michael Pusey, Main Street Practitioner, National Society of Accountants, June 2017, p. 18; nsacct.org.))
These arrangements raise issues of reasonable rents when ownership is not with the corporation but the assets are used by the corporation.
Part of the analysis of whether to incorporate includes whether to incorporate one business and not another, or certain assets, such as a division in one state but not another.
Even when the shareholder passes and the basis in the stock (presumably) steps up, any appreciation of assets within the corporation normally will incur a corporate tax if distributed out of the corporation. It is very difficult to get appreciated property out of corporate solution without incurring a corporate tax. The shareholder’s death wouldn’t step-up the basis of assets inside the corporation.
There are two basic corporate structures when related corporations proliferate; parent-subsidiary and brother-sister. There may be business reasons to create multiple corporations, but there are also rules dealing with the tax aspects of an individual or related group forming multiple corporations.
The proliferation of corporations to gain access to lower tax rates within a corporate structure is generally a non-federal tax issue after 2017 given that there is now only one federal corporate tax rate. Under the prior corporate rate schedule, if certain related party rules could be avoided, there was an incentive to form a new corporation if the income could start at the bottom of the rate schedule.
Corporations with certain qualifying levels of inter-connected ownership (parent-subsidiary groups with relatively little minority ownership) qualify for what is called consolidated tax return reporting whereby losses within the group can offset income of other members. The consolidated return provisions are still with us following the new legislation.
The other basic corporate structure is usually termed “brother-sister” where, e.g., individuals or partnerships own the predominant interests in the corporations that normally file stand-alone tax returns, although these may be affected by myriad related-party rules.
One of the problems with incorporating, particularly when multiple corporations are involved, is having pockets of losses that lodge at the corporate level. Generally such losses cannot be used until that corporation has income unless the ownership arrangement is such that consolidated reporting is permissible, consolidated reporting is elected and other corporations have income.
In a tax-planning-as-an-art-form vein, keep in mind one of the brushstrokes in planning an incorporation includes the impact on the individual return and what strategies might be suggested beyond the basics of comparing corporate and individual tax rates.
Considering the higher standard deduction, it may be that the individual would be less likely to itemize, in which case the individual would no longer save tax from donations. Shifting income to a corporation (net of wages or other income to the shareholder that is a corporate deduction) may materially affect adjusted gross income on the Form 1040. While the individual limits for charitable donations of cash are generally 50% of adjusted gross income in 2017, they are generally limited to 60% of adjusted gross income in years beginning after December 31, 2017 and before January 1, 2026. ((Conf. Rep., p. 22, 263.)) The limits on charitable donations in a corporate income tax return are generally 10% of taxable income with certain adjustments. ((See instructions to Form 1120.)) The concept of itemized versus deductions in arriving at adjusted gross income doesn’t apply in a corporate income tax return, which is to say donations are generally incrementally deductible in a corporate return if they don’t exceed the annual percentage of income limit. With exceptions, the general rule is five year carryover of above-the-limit charitable donations whether the taxpayer is a corporation or an individual.
Also, a major brushstroke here is the deduction for state income taxes. The corporation having significant income may shift the state tax to a corporate return where it would generally be deductible, whereas after 2017, the combination of state income taxes and residential property taxes in the individual return cannot exceed $10,000. We may see more incorporations in states such as California that have high state income tax rates, but a factor here is the difference in individual and corporate rates in the state. .
State reporting rules also have to be consulted when it comes to multiple corporations owned by the same individual or related parties.
More Planning Issues with a Corporate Structure
An early-growth-stage business with pressing capital needs may emphasize the short-term and consider the tax on future dividends as a distant problem. Down-the-road, there is the contingency of double-taxation in that dividend distributions out of “earnings and profits” will trigger a second tax despite the initial income tax at the corporate level.
Start-up businesses may also incur initial losses, such that it may be advantageous to consider incorporating after an initial operating period. With C corporations, losses do not flow through to the shareholders, such that if tax losses arise within the corporation they may translate into corporate NOL carryovers rather than deductible losses outside of the corporation. On the other hand, there are contemplation of death scenarios in which losses within a corporate structure may be preferable to loss carryovers that expire unused upon the death of the owner.
Wages are important with S corporations due to payroll taxes. ((See Rev. Rul. 59-221, 1959-1 C.B. 225, Rev. Rul. 74-44, 1974-1 C.B. 287, Ding, 200 F. 3d 587 (1999), CA-9, http://caselaw.findlaw.com/us-9th-circuit/1435681.html, PLR 20030026, 3/31/03.))
Wages for services by the owners and related parties are usually a significant planning issue with C corporations. Wages are taxable but also deductible to the corporation to the extent they represent reasonable compensation, and there is no prohibition per se on compensating owners. There are many, many cases involving the basic issue of distinguishing whether corporate payments to shareholders under the circumstances are reasonable compensation for services to the corporation rather than dividends. ((Public corporations may encounter compensation deduction limits. See Section 162(m) as amended by the 2017 Act.))
One of the planning issues with C corporations is taking steps to document the value of services to the corporation by insiders; e.g., time reports, accomplishments, comparable salaries in the industry, etc.
We noted above that loans because of interest deductions at the corporate level reduce corporate level income, and thus avoid the double taxation effect. There are tax rules that focus on the reasonableness of interest (and other) charges in related-party situations. ((See Sec. 482, Sec. 7872.)) One of the planning issues with respect to a corporation or partnership involves the complex rules governing the extent to which business interest expense may not be deductible. In general, these limitations may not apply in a context where average gross receipts are $25 million or less. ((Sec. 163(j); Conf. Rep. p. 66, 385-392.))
“Thin capitalization” issues and structuring the level of debt versus equity is an on-going planning aspect of operating a business through a corporation. The loan from a related party to a corporation enables repayments to the shareholder to be made without the monies being taxable as dividends, and the interest factor basically shifts income from the corporation to the lender (or creates losses inside the corporation) which may be less desirable under the reduced corporate tax rate.
One of the major planning issues with corporations is structuring ownership of assets. For example, the owners may retain ownership of key corporate assets, including realty, outside of the corporation.
Another major planning issue with corporations is planning the number of entities. We noted above the overall structures with multiple entities are basically parent-subsidiary approaches versus brother-sister arrangements. The proliferation of many brother-sister C corporations can be problematic in that it increases the potential for pockets of losses that would not be used currently but rather translate into contingent benefits as loss carryforwards.
There is an accumulated earnings tax of 20% for basically not paying dividends and letting earnings accumulate beyond the needs of the business. ((Sec. 531.)) In general, there is a relief under the accumulated earnings tax rules for accumulations of $250,000 or $150,000 for personal service corporations. ((Sec. 535(c)’(2).)) There are certain deductions under the accumulated earnings tax in arriving at accumulated taxable income, and such rules sometimes distinguish “mere holding or investment companies.” ((Sec. 535(b)(8).)) The most significant deduction is often the one focused on what is retained to meet the reasonable needs of the business, a concept that introduces the importance of documenting needs for capital improvements, employee benefit plans, contingencies, etc. ((Sec. 535(c)(2).)) The accumulated earnings tax is not ordinarily a problem from “day one,” but it is an important long-term planning issue in many closely-held corporation situations.
Another potential problem when an individual or related group forms a C corporation is the personal holding company tax. This is basically focused on closely-held corporations with quite a lot of passive income. ((Sec. 542.)) The personal holding tax rules are still with us, as are the foreign personal holding company rules aimed at persons forming foreign entities to hold passive investments in an effort to avoid U.S. tax.
While an S corporation is not subject to the passive activity loss rules, it is possible that such rules and the at-risk rules apply to a C corporation. “The passive activity rules apply to personal service corporations and closely held corporations other than S corporations.” ((See IRS Publication 542, Rev. December 2016, Corporations, p. 15, 16. See also IRS Form 8810 and its instructions, and “Understanding the Problems of PHC Status, Ed. Al Ellentuck, The Tax Adviser, September 1, 2016, https://www.thetaxadviser.com/issues/2016/sep/understanding-problems-of-phc-status.html. See also p. 6-3 to 6-5, and p. 8-3 of Passive Activity Loss, IRS Audit Technique Guide, https://www.bradfordtaxinstitute.com/endnotes/audit_technique_guide_3149-115.pdf.))
Another significant issue is planning with respect to employee benefit plans, e.g., non-corporate retirement plans versus corporate benefit plans, and whether the owners participate in such plans. This topic is generally beyond our immediate scope.
There are certain potential benefits within the corporate tax structure but there are also potential benefits outside of the corporate tax structure.
Does one incorporate given the potential benefit of the new 20% deduction for non-corporate business income? One aspect of this decision is the reduction in corporate tax rates (rate) is permanent whereas the 20% deduction is scheduled to expire in tax years beginning after 2025.
This major new business deduction provision, which is tantamount to a significant tax rate reduction in some circumstances, is not available to C corporations. The decision to incorporate foregoes this new, potential deduction barring an S election.
NEW 20% DEDUCTION FOR CERTAIN BUSINESS INCOME
This complex, dynamic new provision is discussed in more detail in the authors’ “A Planning Introduction to the 20% of Business Income Deduction.”
The basic concept is non-corporate taxpayers get a deduction measured by 20% of net business income beginning after December 31, 2017 and before January 1, 2026. ((See generally Conf. Rep., p. 10-18 for text of new Sec. 199A, and p. 205-224 for the legislative history.))
There are some scenarios in which a taxpayer needs wages or wages and capital expenditures to qualify for a deduction, and particular categories of service providers may not qualify depending on the level of taxable income. The rules may limit the 20% of net business income deduction depending on the taxpayer’s overall taxable income and the components of the income. The rules sometimes make it necessary to distinguish each trade or business.
The application of the new rules may get complicated and require new recordkeeping.
What Qualifies as Business Income for Purposes of the 20% Deduction?
The focus is on an active business, not the activity level of the sole proprietor, partner or S shareholder. For this purpose, business income, combined net business income, may qualify regardless of whether the partner or S shareholder is active.
Whether a partnership or S corporation, the computations focus on the individual taxpayer; i.e., the computations don’t begin and end at the partnership or S corporation level under this new concept.
The basic definition of a “trade or business” is “any trade or business” with two exceptions: wages of an employee and in certain cases a “specified service trade or business.” ((Sec. 199A(d).))
Planning point: Earnings as an independent contractor may qualify, so this is one more area of the Code where employee vs. contractor distinctions are important, possibly even placing new strategic emphasis on minimizing employee characterization.
Planning point: Subchapter S flow-through of business income generally qualifies as being eligible for the 20% of business income deduction but the new context suggests possible disputes with the IRS over whether payouts are nondeductible dividends or wages that should reduce the level of Subchapter S flow-through of business income. Whether payouts from S corporations are dividends or wages triggering payroll taxes and withholding is a traditional area of dispute between the IRS and owners of S corporations, and this issue is still with us. ((See Rev. Rul. 59-221, 1959-1 C.B. 225, Rev. Rul. 74-44, 1974-1 C.B. 287, Ding, 200 F. 3d 587 (1999), CA-9, http://caselaw.findlaw.com/us-9th-circuit/1435681.html, PLR 20030026, 3/31/03.))
Planning point: Keep in mind that reducing the historic level of wages to shareholder-employees of an S corporation may be justified in some circumstances (age, health, other responsibilities, etc.) and may be particularly advantageous under the new 20% of business income rules.
Guaranteed Payments to a Partner
A partner receiving guaranteed payments from the partnership is not receiving qualifying business income for this purpose. ((Sec. 199A(c’)(4).))
Planning point: Reviewing the level of guaranteed payments, which do affect the actual economics in a partnership context, is important because it reduces the flow-through partnership income that may otherwise qualify for the 20% of business income deduction.
The new environment of Section 199A may cause the IRS to argue that payments to partners characterized as distributions are really disguised guaranteed payments. Such an argument may be even more likely in a family partnership context.
Qualifying business income must be effectively connected with the conduct of a trade or business within the United States. ((Sec. 199A(c’)(3)(A).)) Foreign earned income doesn’t qualify for the deduction but may qualify for limited exclusion under another rule.
In general, such items as dividends and interest income don’t qualify. ((Sec. 199A(c)’(3)(B).)) Typical capital gains and losses in an investment, rather than business context, do not qualify. ((Conf. Rep., p. 215.))
Real Estate Income
How these new rules apply within the real estate industry is not entirely clear. We would generally anticipate that home builders and hotel/motel owners would qualify but would caveat that, e.g., the executive with a single rent house may not qualify as having a trade or business under these rules. There may be a question of whether or when the real estate professional with apartment buildings will qualify.
Some General Rules and Issues
This deduction is available in arriving at taxable income but not adjusted gross income. This new deduction doesn’t depend on whether the taxpayer itemizes. ((Conf. Report, p. 224.))
The deduction is available to trusts and estates with provision for apportioning of the deduction between the entity and beneficiaries. ((Conf. Rep. p. 224.))
There is no provision to carry over the Section 199A deduction itself. There is some possibility of carryover within the Section 199A rules for unused business losses, a concept that can limit but not enhance benefits in future years. ((Conf. Rep. p. 214.
This deduction isn’t available in computing the self-employment tax. ((Conf. Rep. p. 220 reporting the Senate Report.))
The Basic 20% Math and the “If Less Rule”
As discussed below, special rules may apply to certain service providers.
The computation measures the deduction looking to “combined qualified business income amount” or if less, 20 percent of any excess of taxable income over any net capital gain as defined in Section 1(h) which includes qualified dividends. ((Sec. 199A(a).)) The latter might be termed the “if less rule,” and it may apply relatively often, for example, if the taxpayer has only business income, the deduction for part of the self-employment tax, and the standard deduction.
Itemized deductions, such as charitable donations, as well as business expenses may materially impact the deduction under the “if less rule.” For example, charitable donations can reduce the 20% of business income deduction by reducing taxable income and increasing the impact of the “if less rule.” There are certain situations where the rules limit the 20% of business income deduction unless there are levels of wages or wages and capital but those limitations can be mitigated by reduced taxable income. In those scenarios, by removing or lessening the wage or wage and capital requirements, charitable donations, for example, may be deductible under the normal rules and also increase the 20% of business income deduction.
There are portions of the calculations within these rules where increased taxable income helps, and other portions of the calculations where reduced taxable income helps. The level of taxable income can impact whether certain types of service providers are even included in the benefits of the new 20% of business income concept.
Nonbusiness income may even enhance the 20% of business income deduction by reducing the impact of the “if less rule” but the results may vary depending on whether such income is from qualified dividends.
The rules can be quite complex and math here can sometimes be downright surprising.
The concept of “combined” qualified business income nets income and losses. For example, in a joint return, one spouse’s business loss is subtracted from the other spouse’s business income.
The statute focuses on business income but expressly encompasses “gains” and “losses. Conspicuous by its absence is any rule distinguishing the portion of gain that may relate to appreciation in years prior to enactment of the new statute. There are complex general tax rules encompassing Section 1231 and other provisions that can result in the sale of a single piece of business real estate being taxed as ordinary income (depreciation recapture), long-term gain taxed at a rate of 25%, and long-term gain taxed at a rate of 20% or less. We only have the statute and legislative history for guidance at this point, but we believe this new statute may reach such gains, even when taxed at a more favorable rate than ordinary income. On the other hand, such gains could also bring more into play the “if less rule” that focuses on 20% of taxable income as reduced for certain gains and qualified dividends. However, if the IRS agrees such gains may generally qualify as business income for this purpose, there may also be some scenarios in which net capital gains would yield an incremental 20% of business income deduction.
The impact of a net operating loss carryover in the 20% of business income calculations may not be entirely clear but we would argue it should not reduce the base. It would presumably reduce taxable income under the “if less rule.”
Planning point: In deciding whether to carryback an NOL from 2017, consider that as an NOL carryover, it may have a detrimental effect in so far as accessing the new 20% of business income deduction.))
We would caveat that there are complexities and possible issues as to how the IRS will interpret the new rules.
What issues arise within these rules when there are multiple businesses?
A multitude of different businesses, including a partnership flow-through of business income, is not an issue until one gets to the wage or wage and property acquisitions limitations, which may not even apply. But when they apply, one has to measure those limitations looking to each trade or business. Under the statute as written, an excess of, say, wages for purposes for one trade or business would not help another trade or business where there is a limitation based on the wages or wages and capital rule.
Planning point: Early in the process of dealing with these new rules, give thought to what may be construed as a different trade or business. Plan to capture the relevant information, such as wages and capital expenditures by each trade or business beginning in 2018, if the wage or wage and capital limitation rules may apply. Consider changing the facts in a manner that may avoid multiple businesses.
Planning point: Part of the math here involves decisions about whether to have deductions, business or non-business deductions, in a particular year that reduce taxable income to a level such that the wage or wage and capital limitations don’t apply.
Each industry, including the real estate industry, may present its own issues as to when activities may constitute a single business or multiple businesses.
The Basic Math Gets More Complicated with Higher Levels of Taxable Income
Our focus here is on the special limitations requiring in some circumstances wages or wages and capital.
The added limitation basically looks to the higher of (a) 50 % of W-2 wages, or (b) 25% of W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property. The higher of (a) or (b) is the one figure compared to 20% of net business income. There is a 20% of business income rule, which is combined business income net of losses, and it is this rule which involves the wage or wages and capital limitation. We may refer to this as Rule #1.
There is another limit based on 20% of taxable income not counting the Section 199A deduction. This second, very important, often applicable limitation, also contains a reduction for gains under Section (h) which appears to encompass net long-term capital gains over short-term capital losses plus qualified dividends. We may refer to this as Rule #2.
There is a third rule saying the deduction can never exceed taxable income. ((Sec. 199A(a), last sentence.))
The concept which introduces computations based on wages and property applies only for purposes of Rule #1, the basic rule looking to 20% of net business income. When the computation applies the “if less” approach of Rule #2 which looks to taxable income as reduced by the sum of net long-term capital gains over net short-term capital losses plus qualified dividends, the level of wages or wages and capital improvements doesn’t enter into the computation.
The taxpayer can totally or partially disregard the rules requiring wages or wages and capital improvements depending on the level of taxable income for the year.
We will at times distinguish the moderate-income taxpayer, the middle-income taxpayer, and the higher-income taxpayer. The distinctions focus on taxable income, not gross sales or business income. One of the complications here is that there are some scenarios where one has to capture information on wages or wages and capital broken down by each trade or business.
A key concept here is “threshold amount,” defined in 2018 as $157,500 except it is $315,000 with a joint return. ((Sec. 199A(e’)(2). These are for 2018 or the taxable year beginning after December 31, 2017.)) The focus is on taxable income being less than the threshold amount; taxable income is prior to the 20% of business income deduction under Sec. 199A.
Moderate-Income Taxpayers: The basic math we described so far prevails if the taxable income prior to the Section 199A deduction is less than the threshold amount – $157,500 for other than joint returns and $315,000 for joint returns. Smaller taxpayers, or big taxpayers with lesser levels of taxable income, don’t have to contend with the wages or wages and capital rules in a year of such levels of taxable income.
Middle-Income Taxpayers: If taxable income before the Section 199A deduction is between $157,500 and $207,500, or $315,000 to $415,000 on joint returns, the wage or wage and capital requirements apply within limits. If the wage or wage and capital requirements aren’t satisfied, the Section 199A deduction is scaled back to some degree.
High-Income Taxpayers: If taxable income before the Section 199A deduction is more than $207,500, or $415,000 on joint returns, the wage or wage and capital requirements apply. If the wages or wages plus capital related to the trade or business are zero, the 20% of business income deduction is zero.
Planning point: Reducing taxable income can be particularly important given the limitation rules under Section 199A. Deductions with respect to capital expenditures under Section 168(k) and Section 179 may be helpful in controlling taxable income for this purpose of minimizing or doing away with this particular limitation, but they would also reduce the 20% of business income calculation unless, say, the deductions related to realty that for some reason wasn’t considered a trade or business.
As one reads Section 199A, there are references to determining the deducible amount with respect to “each trade or business” and measuring wages or wages and qualified property with respect to “the trade or business.”
The limitations look to “W-2 wages” with respect to a qualified trade or business, or a combination of “W-2 wages” and “the unadjusted basis immediately after acquisition of all qualified property.” ((Sec. 199A(b).))
W-2 wages don’t include amounts “not properly allocable to qualified business income..” ((Sec. 199A(b)(4)(B).))
Nor does it include amounts “not properly included in a return filed with the Social Security Administration on or before the 60th day after the due date (including extensions) for such return.” ((Sec. 199A(b)(4)(C).))
So the tax benefits here suggest being sure one’s payroll tax reports are not delinquent, or at least not very delinquent.
Qualified property for this purpose includes as part of the definition tangible property of a character subject to depreciation “which is held by, and available for use in, the qualified trade or business at the close of the taxable year…” ((Sec. 199A(a)(6).)) The 2.5% factor is applied to the unadjusted basis of the property immediately after acquisition. ((Sec. 199A(a)(2).))
The legislative history provides:
“For purposes of the provision, qualified property means tangible property of a character subject to depreciation that is held by, and available for use in, the qualified trade or business at the close of the taxable year, and which is used in the production of qualified business income, and for which the depreciable period has not ended before the close of the taxable year. The depreciable period with respect to qualified property of a taxpayer means the period beginning on the date the property is first placed in service by the taxpayer and ending on the later of (a) the date 10 years after that date, or (b) the last day of the last full year in the applicable recovery period that would apply to the property under section 168 (without regard to section 168(g)).” ((Conf. Rep. p. 222.))
Do decisions to, say, expense an item under Section 179 mean the costs do not qualify as “unadjusted basis” for this purpose? What about assets where there is a 100% deduction under the “bonus depreciation” rules of Section 168(k)?
Among the issues here is that the language of Section 179(a)(1) says the cost is treated “as an expense not chargeable to a capital account.” So do you have unadjusted basis for purposes of Section 199A if expenditures are treated as an expense? Yet the regulations would indicate there is basis, and presumably basis immediately after acquisition, because they provide basis has to be reduced by the Section 179 expense. ((Regs. 1.179-1(f).))
We are hopeful that the IRS will quickly address and concur with our belief that to accelerate the deductions for capital expenditures under either Sections 179 or 168(k) doesn’t rule out having “unadjusted basis immediately after acquisition” for purposes of avoiding cut-back of benefits under Section 199A.
The language doesn’t just focus on the capital expenditures of a particular year.
Allocations of lump-sum purchase price among assets may affect these calculations.
Because more liberal rules may apply under Section 199A with lower levels of taxable income, completely unrelated expenditures, if deductible, can increase this deduction.
Example: After all the talk of restricting charitable donations, the 2017 tax bill actually increased the limit from 50% of adjusted gross income to 60% of adjusted gross income. After 2017, the enhanced charitable deduction limit is generally 60% of adjusted gross income. Let’s assume the joint return taxpayer with $787,500 of business income and adjusted gross income also has a charitable donation of 60% of $787,500 or $472,500.
The return would not likely be this simple. For example, it would often include such deductions as 50% of self-employment tax. But at the risk of over-simplification, we assume only business income $787,500 and a charitable deduction of $472,500 (which exceeds the standard deduction), or taxable income of $315,000 before any Section 199A deduction. The taxpayers have now moved into the moderate-income category where wages and/or qualified property are not required to justify the 20% of business income deduction. Their deduction would not be 20% of business income, but the lesser 20% of taxable income, or $63,000, which is a major improvement over the zero deduction they would have under the high-income taxpayer calculations assuming no wages or qualified property.
So we see in this scenario that charitable donations (and other deductions) not only save tax in a normal fashion as deductions in their own right, they also yield a worthwhile increase in the Section 199A deduction by moving the taxpayer out of the higher levels of taxable income where the rules about wages or wages and capital can severely limit if not eliminate the deduction.
These rules emphasize “doing the math.”
The charitable deduction is limited to a percentage of adjusted gross income, so the fact that the Section 199A benefit is a deduction in arriving at taxable income but not adjusted gross income can at times have the effect of enhancing our results.
Special Rules Applying to Certain Service Providers
There are certain types of service income scenarios where the income may be phased out with higher levels of taxable income.
Architects and engineers were excepted, but many professions are denied access to the 20% of business income rule or attain limited access to it under rules naming: health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. ((Sec. 199A’s incorporating with exceptions Sec. 1202(e’)(3)(A).)) While “financial services” are referenced in one area of the list, there is also listed work where the trade or business consists of investing and investment management, trading or dealing in securities, etc.
There are certain types of service businesses, not all service businesses, where higher levels of taxable income phase one out of the benefit of the 20% of business income deduction regardless of having wages or wages and capital.
For those types of service providers, the phase out begins, using 2018 figures, when taxable income before the Section 199A deduction exceeds $157,500 or $315,000 in the case of joint returns. Those service providers with taxable incomes less than these amounts qualify even if they are, e.g., lawyers or CPAs.
There may also be an adjustment downward as to the factors – wages and qualified property. ((Sec. 199A(d)(3)(A)(ii).))
If one is in the ineligible group of service providers, the phase-out is complete and the 20% of business income deduction with respect to such service income drops to zero when taxable income before the Section 199A deduction exceeds, in 2018, $207,500, or $415,000 in joint returns.
Planning point: The scale-back focuses on taxable income which may encourage, e.g., Keogh contribution deductions. This particular type of deduction may not be available to older service providers. It may also be an issue whether or to what degree Keogh or other benefit programs may be considered as directly reducing the 20% of business income calculation, and whether, e.g., one
Planning point: The scale-back focuses on taxable income which may encourage, e.g., charitable contributions.
Some General Planning Observations
There are limitations under these rules that can flow from higher levels of taxable income before the 20% of business income deduction and as adjusted for certain items. The level of wages or wages and capital is one such limitation except when taxable income is at reduced levels. The taxpayer may have to determine the business income of each separate trade or business, which could present a significant administrative and practical problem, and deal with pockets of limitations except when there are lower levels of taxable income. The rule that denies the benefit of the 20% of business income deduction to certain categories of service providers, such as lawyers and CPAs, goes away at lesser levels of taxable income.
Non-business deductions can sometimes do “double duty” – reduce taxable income and help the taxpayer avoid the limitations in the previous paragraph while at the same time not reducing the base for computing the 20% of business income deduction. Deductions related to realty may or may not be considered related to a trade or business for purposes of Section 199A depending on the facts and how the rules are interpreted.
Business deductions may similarly help avoid limitations but reduce he base for computing the 20% of business income deduction – while helping reduce the self-employment tax.
Among the possibilities for larger business deductions is a decision to maximize write offs of depreciable asset acquisitions under Section 179 and the “bonus depreciation” rules of Section 168(k). Capital additions may be a favorable factor at higher taxable income levels which require certain levels of wages or wages and capital.
These rules under Section 199A look to the basis in equipment immediately after the acquisition. We are hopeful that the IRS will quickly conclude that maximizing deductions under Sections 179 and 168(k) doesn’t reduce the “unadjusted basis” for purposes of avoiding reductions of benefits under the 20% of business income rules. We encourage “doing the math” in 2017 and 2018 with respect to whether or when to maximize deductions under Sections 179 and 168(k) considering that such business deductions in 2017 won’t reduce income in 2018 which may qualify for the 20% deduction.
Planning with respect to large gains on sales of business assets may encompass not only preferential rate treatment but incremental benefits under the 20% of business income rules. Planning with respect to such gains may be problematic in that the “if less” income limitation includes an adjustment for the sum of net long-term capital gains in excess of net short-term capital losses plus qualified dividends but there may nevertheless be planning possibilities with larger sales of business assets.
Buyer and seller issues in significant business transition transactions will include looking at the Section 199A issues for both parties.
Planning with respect to investments generally should consider the 20% of business income aspects. For example, the benefit of such deduction can arise from flow-through income from an active business in which the individual isn’t active whereas interest income doesn’t qualify. While “qualified dividends” are subject to beneficial tax treatment, they appear to not increase the “if less rule” looking to 20% of taxable income as reduced by the sum of net long-term capital gains net of short-term capital losses and qualified dividends. So for purposes of that computation, one may prefer interest income, if that limitation is even close to being a factor.
The range of planning issues is particularly broad, in significant part because the rules include a focus on “taxable income.”
MAINTAINING THE ESTATE PLANNING PERSPECTIVE
With all the talk of repeal of the estate tax, it is still with us, though more of a concern now for the top 1% of wealthy taxpayers – single taxpayers with estates of $11,210,000 and couples with estates of $22,420,000 ($10 million plus indexing). The increased exemption from estates and gift tax applies after December 31, 2017 and before January 1, 2026, so technically this benefit is temporary. ((Conf. Rep., p. 316. The exemption from generation-skipping tax also increased temporarily.)) The 2017 exemption was $5.49 million and $10.98 million for a married couple. ((Conf. Rep. 307-316.))
The basics of estate planning are still with us. One needs to have in place living trusts, wills, powers of attorney, medical directives, etc.
Large estates may still consider sundry techniques aimed at reducing valuations. Large estates may still consider major charitable dispositions. The estate tax charitable deduction is still unlimited. Lifetime charitable gifts have the advantage of reducing both income tax and estate tax, and yes, the income tax savings can be subject to estate which raises the issue of giving it away, etc. Estate planning is still very complicated with large estates. But even with small estates where income tax and efficient administration are the focus, in so far as testamentary gifts to charity, consider gifts of income in respect of a decedent.
The annual gift tax exclusion was just announced: it is $15,000 in 2018, up from $14,000 in 2017. Taking advantage of the annual gift tax exclusion is still good planning for many taxpayers.
The greatly increased estate tax exemption in the 2017 Act may play an important role in any major restructuring contemplated whether the motivation is primarily income tax or transfer taxes, or a combination thereof.
Long-term planning for ownership and succession management of a closely-held business is often a critical part of the estate plan.
Any focus on incorporating due to the reduction in corporate tax rates would need to include estate planning in the mix of considerations.
Its personality and emphasis changes with the law and the times but estate planning is still very important.
A key component of estate planning is overall, long-term income tax planning for the family, which may be dramatically impacted by the myriad changes in the 2017 Act.
THE ENHANCED PLANNING PERSPECTIVE
We said initially that planning has become more and more mathematical. There are many complications and broad ranges of choices.
We have in mind such areas as decisions to expense capital additions which, along with its benefits, may have a detrimental effect on the 20% of business income calculations, the Section 199A deduction.
We saw that within the new Section 199A rules, a deduction, even a charitable donation deduction, can have a detrimental aspect in that it can move the 20% of business income calculation into the area where the deduction is focused on 20% of taxable income as adjusted for net long-term capital gains in excess of short-term capital losses plus qualified dividends. Yet within the new Section 199A rules, even a charitable deduction could have a beneficial effect in moving the taxpayer into lower taxable income levels which can mitigate the limitation rules focused on wages and capital additions. Charitable donations and other deductions may mitigate the Section 199A rule limitations that would otherwise apply to certain service providers with higher levels of taxable income.
There are new issues of relationships between one tax deduction and another. It is important to understand the relationships among our goals.
There are reasons to act quickly and reasons to be cautious as we glean more and more of possible interpretations of the new law.
Some of the new provisions are brand new concepts with no history of interpretation. There are usually some surprises as the IRS writes regulations and rulings.
Much of the initial focus in more complex individual and business environments will be whether to make major structural changes given the degree of changes, particularly the major reduction in the corporate income tax and the introduction of the concept that up to 20% of business income of other than C corporations may translate into a new deduction.
The analysis should begin because some taxpayers may want to make significant structural changes early, if their scenario is one where the advantages of a particular approach are more dramatic.
Another major emphasis generally gives taxpayers more control over their taxes by allowing quicker deductions for capital expenditures. While it is generally good to postpone taxes by accelerating deductions, there are always issues of effective tax rates. Balanced planning is often a key to good tax planning. For example, expensing capital expenditures may adversely affect the new 20% of business income calculations.
There continue to be the multitude of taxes that require coordinated planning.
It remains to be seen when and the degree to which a particular state will follow the new federal changes.
In all fairness to the 2017 Tax Act, it does have simplifying aspects in the long term, primarily in that it repeals many deductions. But it has many aspects that are extraordinarily complex, not just in transitioning to the new rules but in the on-going application of the rules. We believe this to be true not only from a compliance standpoint but also from a planning and strategy perspective.
The information contained herein is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230, as the content of this document is issued for general informational purposes only, is intended to enhance the reader’s knowledge on the matters addressed therein, and is not intended to be applied to any specific reader’s particular set of facts. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. Applicability of the information to specific situations should be determined through consultation with your tax adviser.