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Tax Reform

Tax Reform Resource Guide

The Tax Cuts and Jobs Act (TCJA) which became a law in December 2017 contains some of the most extensive changes to corporate income tax and individual income and transfer taxes in over 30 years. Navigating these changes can be overwhelming and confusing to say the least.

Our professionals at Wegner CPAs have put together this Tax Reform Resource Guide to help you understand how the TCJA affects you and your business.  Keep in mind the impact will vary for every business.  This resource guide includes helpful tips on changes you can make to take advantage of tax savings strategies and more.

Our tax reform guide is organized into the following sections:

  • Accounting Method
  • Section 199A
  • Interest Expense
  • Choice of Entity
  • Partnership Audit
  • Wayfair

Please look through these sections by using the tabs at the top of the page, and feel free to contact us with any questions you may have about these or other tax matters.

 

Accounting Method Changes Allowed by the Tax Cuts and Jobs Act

The Tax Cuts and Jobs Act (TCJA) provides relief to small businesses by allowing changes to their tax methods of accounting for certain items.  The changes may simplify record-keeping and provide a tax benefit to these businesses.  Under the TCJA, taxpayers with average annual gross receipts are $25 million or less (based on the three prior tax years) qualify for these changes.  The four most common changes allowed under the TCJA are as follows:

1. Method of Accounting – from accrual to cash basis

Businesses often prefer the cash method because it permits more flexibility in managing the amount of taxable income reported in a tax year. For example, under the cash method, cash basis taxpayers don’t report accounts receivable as revenue until received, and expenses are deducted in the tax year actually paid.  Near the end of a tax year, cash method taxpayers can defer the receipt of income and accelerate the payment of expenses to minimize taxable income for that year.

Advantages of Cash Method of Accounting

  • Easier and cheaper to maintain
  • Matches cash flow better
  • Permits more flexibility in managing the amount of taxable income reported in a tax year.

Advantages of Accrual Method of Accounting

  • Matches income and expenses better for a more accurate picture of financial performance
  • Permits certain tax planning strategies, such as accrued expenses paid within 2 ½ months (e.g. bonus) and deferring certain advance payments

2. Exception to Require the Use of Inventory Accounting

Under the TCJA, taxpayers with average annual gross receipts of $25 million or less are no longer required to maintain inventories.  This is the case even if the production or purchase and sale of merchandise is a material income producing factor. The term inventory includes all finished or work-in-process goods as well as raw materials and supplies that have been acquired for sale or that will become part of merchandise for sale.

Under the TCJA small business exception, taxpayers can either (1) treat inventory as non-incidental materials and supplies or (2) account for inventory using a method that conforms to their Applicable Financial Statement, which is generally an audited financial statement.  If they don’t have an Applicable Financial Statement, the accounting method used in their books and records prepared in accordance with their accounting procedures is considered.

The cost of non-incidental materials and supplies are typically deducted as they are used and consumed (or when the taxpayer pays for the items, if later, under the cash basis of accounting).  This change to avoid maintaining inventories will simplify recordkeeping and may reduce the amount of labor and overhead capitalized.

3. UNICAP Exception for Small Resellers

Businesses that produce real or tangible personal property or acquire property for resale generally must use the uniform capitalization (UNICAP) rules under IRC Code Section 263A and include the direct costs and a portion of the allocable indirect costs of producing or acquiring property in their inventory costs.  The expanded exception to the UNICAP rules applies to any producer or reseller that meets the $25 million gross receipts test.  This change to avoid capitalizing such costs under the UNICAP rules will both simply tax filing for small businesses and will also provide accelerated deductions for items previously capitalized.

4. Accounting for Construction Contracts

Taxpayers generally must account for long-term contracts using the percentage of completion method of accounting under IRC Code Sec. 460. Under the percentage of completion method, taxable income from the contract is recognized as the contract progresses. The net income for the year is equal to the percentage of the contract that was completed multiplied by the total estimated gross profit. The percentage of the contract completed during the tax year is determined by comparing costs allocated to the contract and incurred before the end of the tax year with the estimated total contract costs.

The TCJA expands the exception for the required use of the percentage of completion method by increasing the gross receipts test from $10 million to $25 million for contracts entered into after December 31, 2017, in tax years ending after that date.  Taxpayers who qualify may account for long-term contracts using the completed-contract method or any other permissible exempt contract method.  However, contractors are still required to use the percentage of completion method for Alternative Minimum Tax (AMT) purposes regardless of their tax accounting method for regular tax purposes.  The TCJA’s repeal of corporate AMT and changes made to the AMT rules for individuals diminish the harmful impact of this AMT adjustment.

Manner of Making a Change in Accounting Method

Taxpayers who wish to change their method of accounting for tax purposes for any of the above items must timely file IRS Form 3115, Application for Change in Accounting Method. Form 3115 generally is attached to the income tax return for the year of change. In addition, a copy of the Form 3115 must be filed with the appropriate IRS office no later than the date the tax return is filed.

The TCJA provides significant tax planning opportunities for small businesses.  We strongly encourage you to consult with your Wegner CPAs tax advisor to see if any of these changes make sense for your business.

Pass-Through Deduction for Qualified Business Income (QBI)

The Tax Cuts and Jobs Act brought in a new deduction for qualified business income (sometimes referred to as Section 199A).  In general, business owners and real estate investors may receive a 20% tax deduction on their individual 1040 tax return in tax years 2018 thru 2025.  But there are limitations based on taxable income and type of income.

If Taxable income is below $315,000 married filing joint (MFJ) or $157,500 all others then the 20% deduction is received on ALL qualified business income. No limitations apply.

What is qualified business income (QBI)?

Generally QBI is business income from your flow-thru Partnership, S Corporation, trust or business income that is reported on your individual tax return on a Schedule C, F or E.  In addition, net income from active rental real estate activity is also eligible for the 20% deduction.

What does not qualify for the deduction?

It does not include any wages, guaranteed payments from a partnership, capital gain or loss, dividend income, interest income, income from foreign currency transactions, commodities, or annuities.

If Taxable income is greater than $315,000 MFJ or $157,000 all others, but less than $415,000 MFJ or $207,500 all others: Taxpayer is eligible for a reduced deduction subject to the limitation.

If Taxable income is greater than $415,000 MFJ or $207,500 all others: Most “Service” businesses are ineligible if the income threshold is exceeded.  However, the 20% deduction is still available for non-specified service trade or business income.

What is Specified Service Trade or Business Income (SSTB)?

SSTB is any business involving the performance of services in the fields of:

  • Health
  • Law
  • Accounting
  • Actuarial Science
  • Performing Arts
  • Consulting
  • Athletics
  • Financial Services/Brokerage Services
  • 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
  • A trade of business that involves the performance of services that consist of investing and investment management, trading or dealing in securities, partnership interests or commodities.

What is the limitation?

Once taxable income exceeds the levels previously mentioned, the deduction can be limited by the larger of 50% of wages or 25% of wages plus 2.5% of unadjusted basis of qualified property.

  • Wages: Wages are determined by each business.  They are the wages reported on Forms W-2 and W-3 for the calendar year.  Accrued wages cannot be part of this amount.  There are also some anti-abuse rules.
  • Unadjusted Basis of Qualified Property: Generally this means tangible property of a character subject to the allowance for depreciation under code section 167(a), which is held for use at the close of the year and which is used during the year, and the depreciable period has not ended.  The Depreciable period is the longer of 10 years or the applicable recovery period.  So a piece of equipment  might have a depreciable life of 5 years, then we are able to consider that piece of equipment for 10 years in this calculation while a building with a 39 or 27.5 year life is considered for the full 39 or 27.5 years.  Taking a Section 179 deduction in the first year or taking bonus depreciation does not affect the unadjusted basis.  However, a business expensing policy does affect this calculation.  If a piece of equipment is expensed instead of capitalized and depreciated, it is not part of this calculation.

How does this really work?

Below are a couple of examples with some basic fact patterns.

  1. Facts: Taxable income is $200,000 MFJ. The business income from pass thru S Corp is $100,000. The taxpayer is below the taxable income limitations and their QBI is less than the taxable income so the full 20% deduction is received.  $100,000 x 20%= $20,000 deduction.
  2. Facts: Taxable income is $300,000 MFJ. The business income from pass thru S Corp is $400,000. Other losses and deductions have reduced taxable income, however, the taxable income is below the $315,000 limitation.  In this case, the 20% QBI deduction is limited to 20% of taxable income or $300,000 x 20% = $15,000 deduction.
  3. Facts: Taxable income is $500,000 MFJ. The business income from pass thru S Corp is $400,000 and the business is not from a SSTB so taxpayer qualifies for the QBI deduction subject to limitations.  Wages are $110,000 and qualified property is $400,000. The taxable income is over $415,000 so the 20% QBI deduction is subject to the limitation.   20% of QBI income is $80,000 ($400,000 x 20% = $80,000).  The deduction is limited to the larger of 50% of wages or 25% of wages plus 2.5% of qualified property.    The limitation is $55,000.  This is computed by taking the larger of 50% of wages, $55,000 ($110,000 x 50%), or 25% of wages, $27,500 plus $10,000 (2.5% x $400,000) = $37,500.  In this case, the taxpayer would only qualify for a $55,000 deduction instead of the full 20% of $80,000.
  4. Facts: Taxable income is $500,000 MFJ. The business income is from a specified service business, i.e. law partnership, self-employed financial planner.  The taxpayer receives NO deduction because the taxable income is over $415,000 and it’s from a Specified Service Trade of Business.

This is a general overview of this deduction.  Section 199A is one of the more complex new rules included in the Tax Cuts and Jobs Act.  There are many factors to plan for and opportunities to maximize the deduction on your 2018 tax return.   We strongly encourage you to consult with your Wegner CPAs tax advisor to determine if you qualify for the deduction and how to plan to maximize the deduction beginning in 2018.

Interest Expense Limitation

The classic response you’ll get from most CPAs when you ask them a seemingly straight forward question is “well it depends”. So if you’re planning to ask your CPA about the new interest expense limitation, there is a good chance their response will still be “well it depends…”. Luckily after going through a few questions, you and your CPA should be able to sort through this fun new aspect of tax reform. Here is why:

Prior to tax reform there was little to no limitations on the deductibility of business interest in a given tax year. Post tax reform there are some new rules on when a business can deduct business interest.

How is the limitation calculated?

In general, the business interest expense in a given year is limited to the sum of the following:

  • Business interest income, plus
  • 30% of adjusted taxable income, plus
  • Interest from floor plan financing

Does this impact all businesses?

No, the good news is there are some broad exceptions to the new limitation which will exclude many small businesses. The following are the exceptions:

  • The first, and most significant, exception applies to any organization whose gross receipts are $25,000,000 or less. If you are under this threshold, you can continue deducting business interest as you always have. No limitation applies to the business.
  • Real estate trade or businesses as defined in §469 (c)(7)(C) and Farming business as defined by §263A(e)(4) may file an irrevocable election to be excluded from the interest expense limitation. The one caveat to making this election is it requires real estate trade or business to compute depreciation of real property using MACRS ADS and farming is required to compute depreciation using MACRS ADS for assets with lives of 10 years or more.
  • Certain regulated public utilities and certain electric cooperatives are also excluded from the limitation rules.

If my interest expense is limited, what happens to the excess?

This is an important item to note. The limitation is simply a limitation which defers the deduction, rather than recharacterizing it into a non-deductible. What this means is that interest expense limited in a given year may be carried forward and used in future years as the limitation calculation allows.

Are the rules the same between Corporations, S Corporations, and Partnerships?

The initial calculation of the limitation is the same for all entities, however the application of the limitation is considerably more complex for pass-through-entities (partnerships and S corporations). This complexity is due to the nature of how these entities are taxed at the individual level. Both partnerships and S corporations calculate the limitation at the entity level and pass the limitation to the partner or shareholder as a separate item on their K-1s.

So what’s next if my business may be subject to the new interest deductibility rules?

The business interest limitation can have a significant effect on your tax liability and can apply even to conservatively financed businesses. For example, because the limitation is based on a percentage of adjusted taxable income, the limitation can apply in years of low profitability.

Businesses should consider the following steps now to understand, strategize and hopefully minimize the effects of the business interest limitation.

  1. Run some scenarios of your 2018 tax liability taking into account the new business interest limitation.
  2. Review the costs and benefits of electing out of the interest rules (for real estate or farming businesses). This will include factoring in longer depreciation lives for certain assets and no bonus depreciation.
  3. Consider the potential effect of the interest limitation on your capital structure since the limitation will increase the after-tax cost of debt financing. For example, some businesses may decide to use preferred equity vs. subordinated debt if the interest deduction is limited.

The IRS is expected to release guidance to clarify the application of the rules, so stay tuned for more information.  Contact your Wegner CPAs tax advisor with questions about how the rules affect your business.

Benefits of C Corporation vs. S Corporation Structure

One of the highlights with the passage of the Tax Cuts and Jobs Act (TCJA) is the flat tax rate of 21% for C corporations.  This was a significant change from the previous law where C corporations were subject to graduated tax rates with the top corporate tax rate of 35%.

For businesses operating as a pass-through entity (such as an S corporation, partnership, or sole proprietorship), income is taxed at the owner’s marginal tax rate which after the individual tax rate reduction in the TCJA, this can still be as high as 37%.  This change to the corporate tax rates has led many business owners to consider converting to corporate status.  While the new 21% tax rate may at first look attractive, there are many factors that should be considered.

First, the C corporation rate applies only to income left in the company to be taxed.  The TCJA did not change the tax rate on corporate dividends.  Dividends are generally subject to tax at 15% qualified capital gains rates plus an additional 3.8% net investment income tax.  If the corporation pays out all of its earnings as dividends the combined effective tax rate is 39.8%.  This ‘double tax’ on corporate profits may be avoided if the corporation retains the profits to finance growth or other bona fide business purpose.  However, retaining all profit can lead to other tax issues such as the accumulated earnings tax or personal holding company tax.

The TCJA did provide a tax break for businesses structured as a pass-through entity.  For certain businesses, the TCJA created a new 20% deduction on “qualified business income”.  This deduction may reduce the marginal tax rate for individuals from 37% to as low as 29.6% on qualified business income.  However, keep in mind that this deduction is only available through 2025 unless Congress extends it.

C corporations generally benefit from more generous rules regarding the deductibility of owner/officer fringe benefits.  C corporations can also fully deduct state and local taxes while individual owners of pass-through entities are subject to an overall limitation of $10,000.

Losses by the C corporations are trapped at the corporate level.  Losses incurred by pass-through entities flow through to the individual owner tax returns and may offset other income and reduce tax (subject to special loss limitation provisions).

Some C corporation shareholders may benefit from a special rule that excludes up to 100% of the gain from the sale of stock if certain requirements have been met.  This gain exclusion is not available to pass-through entities.

The reduction in the corporate tax rate and other tax law changes have made it important to revisit your business entity structure.  However, there are many reasons why converting to a C corporation may not make sense until the individual taxpayer’s unique situation is reviewed. The professionals at Wegner CPAs can help you through the decision-making process.

Partnership Audit Procedures

Beginning in 2018, new partnership IRS audit procedures apply to new and existing partnerships. The IRS manual requires the audit of partnerships at the entity level. Under prior rules, any partnership URS examination adjustments were pushed down to each partner and the tax/penalty/interest was paid at the partner level, accordingly. However, under the post-2017 partnership audit procedures, the adjustments are ordinarily imposed and a tax is calculated at the partnership level and partners may now have the opportunity to “opt out” of these new partnership procedures.

Included in these new rules, partnerships must designate a “partnership representative” who will have the authority to bind the partnership with respect to IRS audit results.  If no partnership representative is appointed, the IRS will designate one.  In general, it makes sense for new partnerships (including LLCs) to designate a partnership representatives when they are formed.

A partnership may elect out of the partnership audit procedures if:

  • the partnership is required to furnish 100 or fewer statements (K-1s) to its partners, and
  • each statement (K-1) the partnership is required to furnish for the year is furnished to an individual, a C corporation, a foreign entity that would be treated as a C corporation if it were a domestic entity, an S corporation, or an estate of a deceased partner.

NOTE: if K-1s are furnished to partnerships, trusts, foreign entities not described above, disregarded entities, estates of individuals other than a deceased partner and any person that holds an interest on behalf of another person, the partnership is ineligible to make this “opt out” election.

Eligible partnership must make the election on its timely filed return for the tax year to which the election applies and must notify its partners of the election within 30 days of the day it makes the election.

Under the partnership audit procedures, the IRS may make adjustments to (i) any item or amount relating to the partnership that is relevant in determining the income tax liability of any person and (ii) any partner’s distributive share of any such item or amount. In general, an imputed underpayment will be determined (a) by netting all partnership adjustments for the reviewed year and (b) applying the highest individual or corporate tax rate to the adjustments. Special rules apply so that items of different characters aren’t netted against each other.

The partnership audit procedures do allow partnerships with the opportunity to suggest modifications to imputed underpayments. Thus, a partnership that receives a notice of proposed partnership adjustment (NOPPA) may request a modification of the imputed underpayment based on various grounds, including the character of its partners (e.g., a tax-exempt organizations). The IRS may file a notice of a final partnership adjustment (FPA) no earlier than 270 days after the NOPPA is filed. Thus, a partnership has at least 270 days to request a modification of an imputed underpayment.

Although imputed underpayments, and interest and penalties, are ordinarily imposed at the partnership level, the partnership may elect to have imputed underpayments taken into account at the partner level. If the election is made, the partnership must provide statements to each of its partners notifying the partner of its portion of the imputed underpayment and the partners would have to pay their portions of the imputed underpayment and the interest and penalties.

An FPA is the equivalent of a notice of a deficiency and gives the partnership the right to file a readjustment petition in Tax Court within 90 days of the FPA. The partnership may also file a readjustment petition in a district court or the Court of Federal Claims, but it must pay the tax before it files a petition in those courts. A partnership is also allowed to file an administrative adjustment request (AAR) to adjust partnership-related items unless it has received a notice of an administrative proceeding from the IRS.

This is a very brief introduction to the complex partnership audit procedures. If you have any additional questions, please do not hesitate to contact a Wegner CPAs tax professional.

The Wayfair Decision – The Other Shoe

On June 21, 2018, the “other shoe” finally dropped in the sales & use tax world when the U.S. Supreme Court issued its decision in South Dakota v. Wayfair, Inc.  Wayfair overturned our long standing position that an out-of-state seller cannot be required under the Commerce Clause to collect the use tax of the state where the customer is located unless the seller maintains a physical presence in the customer’s state. The majority opinion by the Supreme Court Justices replaced that “bright line” physical presence nexus standard with a facts and circumstances analysis of whether the out-of-state seller has substantial authority to do business in a state.  This is called economic nexus.  The majority opinion did not rule out the possibility that state taxing agencies can apply this new economic nexus standard retroactively to assess out-of-state sellers for years of sales & use taxes that they did not collect because they were relying on the Supreme Court’s long-standing physical presence nexus standard for sales & use tax nexus.

What do we do about this?

First, don’t panic.  Particularly now that physical presence is no longer a safe harbor, sales & use tax professionals are faced with the legal and practical challenges of learning many more states’ sales & use tax laws and regulations. No one could possibly learn all of the different state requirements and yet our jobs demand it (owners, accountants, bookkeepers, software developers-the list goes on). You will learn the secrets to working in a multistate environment if it’s new to you.  Because Revenue Department sales and use tax audits are inevitable, it’s best to prepare now to reduce your audit exposure.

Don’t kid yourself that the “other shoe” doesn’t apply to you.

Please don’t assume your business is ok without assessing whether you have created economic nexus or not.  Once you’ve determined the economic nexus states you’ve triggered, quantify any future (or retroactive) exposure.  Based on Wayfair, most states are adopting the South Dakota standard of $100,000 in sales or 200 transactions per calendar year.  Note that the standard is $100,000 in sales; not taxable sales.  So most business industries are affected.

Since sales taxes due on remote sales are a trust tax and collected from the end user, sellers should not wait.  After the decision was handed down in June, Kentucky and Hawaii quickly adopted guidance effective July 1st for economic nexus standards.   Other various states are on board effective October 1st through January 1st (2019).   As you might guess, once a sales transaction occurs, it’s very difficult to go back to a customer to collect tax on a past transaction.   However, it is illegal to collect a trust tax and fail to report it even for a month or so.  Be very careful that your registrations and collection procedures are in place before your organization collects sales taxes.

Once your team is educated on the intricacies of sales tax (definition of sales price, taxability of products and services, shipping & handling and other charges), your collection system is in place, your accountant gets a rhythm for filing the compliance returns, and some time goes by, it will be a routine part of your compliance procedures.

If you have questions about the Wayfair decision and how it impacts your business, please contact Cam Brawley, Director of SALT Services, with Wegner CPAs.