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Also see: CPA Year-End Tax Planning Guide for Individuals.
An In-Depth Look: Practitioner's Year-End Tax Planning Guide for BUSINESSES Post TCJA
(Includes Links to Year-End Client Letters)
(Parker Tax Publishing December 2018)
The second installment of Parker's annual two-part series on year-end tax planning recaps 2018's major changes affecting businesses, as well as the strategies clients can use to minimize a business's 2018 tax bill.
CLIENT LETTERS for both individuals and businesses are available online now -
Practice Aid: Use Parker's CPA Sample Client Letters as a template or just sign your name at the bottom. See Our Sample Client Letter for BUSINESSES. and INDIVIDUALS
Introduction
As a result of the enactment late last year of the Tax Cuts and Jobs Act of 2017 (TCJA), many significant changes took effect in 2018 that will affect a business's 2018 federal tax return and should significantly reduce a business's tax bill. As the year draws to a close, practitioners will want to review these changes with their clients, as well as get an estimate of projected taxable income or loss to see what actions might be appropriate before year end. It's also important to ascertain that enough estimated taxes have been paid to avoid any penalties on underpayments.
Here's a quick recap of the new rules, followed by some year-end strategies that practitioners may want to discuss with their clients.
I. New Business-Related Tax Rules for 2018
The business-related provisions in the TCJA are generally permanent and generally take effect beginning with 2018 tax years. For businesses, highlights of the new law include: (1) an increase in amounts that may be expensed under Code Sec. 179 and an increase in the bonus depreciation deduction; (2) a 21 percent flat corporate tax rate; (3) for years beginning after 2017 and before 2026, a new 20 percent business deduction for sole proprietorships and pass-through entities; (4) the elimination of the corporate alternative minimum tax; (5) modifications of rules relating to accounting methods; and (6) several changes involving partnerships and S corporations.
Section 179 Deduction. For 2018, businesses can write off up to $1,000,000 of qualifying property under Code Sec. 179. This change is aimed at boosting a businesses' tax deductions so that the money saved on taxes can be plowed back into the business. Additionally, writing off an asset in the year it is purchased reduces recordkeeping requirements. The $1,000,000 amount is reduced (but not below zero) by the amount by which the cost of the qualifying property placed in service during the tax year exceeds $2,500,000.
In addition, the definition of property that qualifies for the Code Sec. 179 deduction was expanded to include certain depreciable tangible personal property used predominantly to furnish lodging, or in connection with furnishing lodging, as well as any of the following improvements to nonresidential real property: roofs; heating, ventilation, and air-conditioning property; fire protection and alarm systems; and security systems.
Bonus Depreciation Deduction. The new tax law extended and modified the additional first-year (i.e., "bonus") depreciation deduction, which had generally been scheduled to end in 2019. An enhanced bonus depreciation deduction is now available, generally, through 2026. Under the new rules, the 50-percent additional depreciation allowance that was previously allowed has been increased to 100 percent for property placed in service after September 27, 2017, and before January 1, 2023, as well as for specified plants planted or grafted after September 27, 2017, and before January 1, 2023. These deadlines are extended for certain longer production period property and certain aircraft.
The 100-percent allowance is phased down by 20 percent per calendar year in tax years beginning after 2022 (after 2023 for longer production period property and certain aircraft).
Another new provision removes the requirement that, in order to qualify for bonus depreciation, the original use of qualified property must begin with the taxpayer. Thus, the bonus depreciation deduction applies to purchases of used as well as new items.
TCJA also expands the definition of qualified property eligible for bonus depreciation to include qualified film, television and live theatrical productions, effective for productions placed in service before January 1, 2027.
Additional Depreciation on "Luxury" Automobiles and Certain Personal Use Property. Another benefit of the new tax law is that it increases the depreciation limitations that apply to certain "listed" property such as vehicles with a gross unloaded weight of 6,000 lbs or less (known as "luxury" automobiles). For luxury automobiles acquired after September 27, 2017, and placed in service after 2017, an additional $8,000 deduction is available, thus making the write-off for the first year $18,000. The deduction is $16,000 for the second year, $9,600 for the third year, and $5,760 for the fourth and later years in the recovery period. In addition, computer or peripheral equipment is no longer considered listed property which means that such property is not subject to the heightened substantiation requirements that previously applied.
New Deduction for Qualified Business Income. One of the biggest changes for 2018 is the new qualified business income (QBI) deduction. A sole proprietor, a partner in a partnership, a member in an LLC taxed as a partnership, or a shareholder in an S corporation, may be entitled to a deduction for QBI for tax years beginning after December 31, 2017, and before January 1, 2026. Trusts and estates are also eligible for this deduction.
While there are important restrictions to taking this deduction, the amount of the deduction is generally 20 percent of qualifying business income from a qualified trade or business. A qualified trade or business means any trade or business other than -
(1) a specified service trade or business; or
(2) the trade or business of being an employee.
A "specified service trade or business" is defined as any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, including investing and investment management, trading, or dealing in securities, partnership interests, or commodities, and 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. Engineering and architecture services are specifically excluded from the definition of a specified service trade or business.
However, there is a special rule which allows a taxpayer to take this deduction even if the taxpayer has a specified service trade or business. Under that rule, the provision disqualifying such businesses from being considered a qualified trade or business for purposes of the QBI deduction does not apply to individuals with taxable income of less than $157,500 ($315,000 for joint filers). After an individual reaches the threshold amount, the restriction is phased in over a range of $50,000 in taxable income ($100,000 for joint filers). Thus, clients with income that falls within this range are entitled to a partial deduction. Once the end of the range is reached, the deduction is completely disallowed.
For purposes of the deduction, items are treated as qualified items of income, gain, deduction, and loss only to the extent they are effectively connected with the conduct of a trade or business within the United States. In calculating the deduction, QBI refers to the net amount of qualified items of income, gain, deduction, and loss with respect to the qualified trade or business of the taxpayer.
QBI does not include any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer, or any guaranteed payment (or other payment) to a partner in a partnership for services rendered with respect to the trade or business. Qualified items do not include specified investment-related income, deductions, or losses, such as capital gains and losses, dividends and dividend equivalents, interest income other than that which is properly allocable to a trade or business, and similar items.
If the net amount of QBI from all qualified trades or businesses during the tax year is a loss, it is carried forward as a loss from a qualified trade or business to the next tax year (and reduces the QBI for that year).
W-2 Wage Limitation. The deductible amount for each qualified trade or business is the lesser of:
(1) 20 percent of the taxpayer's QBI with respect to the trade or business; or
(2) the greater of: (a) 50 percent of the W-2 wages with respect to the trade or business, or (b) the sum of 25 percent of the W-2 wages with respect to the trade or business and 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property (generally all depreciable property still within its depreciable period at the end of the tax year).
The W-2 wage limitation does not apply to individuals with taxable income of less than $157,500 ($315,000 for joint filers). After an individual reaches the threshold amount, the W-2 limitation is phased in over a range of $50,000 in taxable income ($100,000 for joint filers).
In the case of a partnership or S corporation, the business income deduction applies at the partner or shareholder level. Each partner in a partnership takes into account the partner's allocable share of each qualified item of income, gain, deduction, and loss, and is treated as having W-2 wages for the tax year equal to the partner's allocable share of W-2 wages of the partnership. Similarly, each shareholder in an S corporation takes into account the shareholder's pro rata share of each qualified item and W-2 wages.
The deduction for QBI is subject to some overriding limitations relating to taxable income, net capital gains, and other items and will not affect the amount of the deduction in most situations.
Changes in Accounting Method Rules. The new tax law has also expanded the number of businesses eligible to use the cash method of accounting as long as the business satisfies a gross receipts test. This test allows businesses with annual average gross receipts that do not exceed $25 million for the three prior tax-year period to use the cash method. A similar gross receipts threshold provides an exemption from the following accounting requirements/methods:
(1) uniform capitalization rules;
(2) the requirement to keep inventories; and
(3) the requirement to use the percentage-of-completion method for certain long-term contracts (thus allowing the use of the more favorable completed-contract method, or any other permissible exempt contract method).
Carryover of Business Losses Is Now Limited. Beginning in 2018, excess business losses of a taxpayer other than a corporation are not allowed for the tax year. Under this excess business loss limitation, a taxpayer's loss from a non-passive trade or business is limited to $500,000 (married filing jointly) or $250,000 (all other taxpayers). Thus, such losses cannot be used to offset other income. Instead, if a business incurs such excess losses, those losses are carried forward and treated as part of the business's net operating loss carryforward in subsequent tax years.
New Interest Deduction Limitations. Effective for 2018, the deduction for business interest is limited to the sum of business interest income plus 30 percent of adjusted taxable income for the tax year. However, there is an exception to this limitation for certain small taxpayers, certain real estate businesses that make an election to be exempt from this rule, businesses with floor plan financing (i.e., a specialized type of financing used by car dealerships), and for certain regulated utilities.
The new law exempts from the interest expense limitation taxpayers with average annual gross receipts for the three-taxable year period ending with the prior tax year that do not exceed $25 million. Further, at the taxpayer's election, any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business is not treated as a trade or business for purposes of the limitation, and therefore the limitation does not apply to such trades or businesses.
Elimination of Entertainment Deduction. The new tax law also eliminated business deductions for entertainment. As a result, 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.
Under prior law, there was an exception to this rule for entertainment, amusement, or recreation directly related to (or, in certain cases, associated with) the active conduct of a trade or business. This is no longer the case.
In addition, a business can no longer deduct expenses associated with providing any qualified transportation fringe benefits to employees, except as necessary for ensuring the safety of an employee, including any expense incurred for providing transportation (or any payment or reimbursement) for commuting between the employee's residence and place of employment.
A business may still generally deduct 50 percent of the food and beverage expenses associated with operating their trade or business (e.g., meals consumed by employees during work travel). If meals are combined with entertainment, the meal portion needs to be separately stated in order for the business to deduct the meal expense.
Employer Credit for Paid Family and Medical Leave. For 2018 and 2019, eligible employers can claim a general business credit equal to 12.5 percent of the amount of wages paid to qualifying employees during any period in which such employees are on family and medical leave if the rate of payment under the program is 50 percent of the wages normally paid to an employee. The credit is increased by 0.25 percentage points (but not above 25 percent) for each percentage point by which the rate of payment exceeds 50 percent.
Given the cost of implementing such a policy and complying with reporting requirements, the credit may be impractical for many employers to pursue during the short period it's available. For businesses that already have a qualifying family and medical leave plan in place, however, the credit may provide a nice windfall.
Changes to Partnership Rules. Several changes were made to the partnership tax rules. First, gain or loss from the sale or exchange of a partnership interest is treated as effectively connected with a U.S. trade or business to the extent that the transferor would have had effectively connected gain or loss had the partnership sold all of its assets at fair market value as of the date of the sale or exchange. Any gain or loss from the hypothetical asset sale by the partnership is allocated to interests in the partnership in the same manner as nonseparately stated income and loss.
Second, the transferee of a partnership interest must withhold 10 percent of the amount realized on the sale or exchange of the partnership interest unless the transferor certifies that the transferor is not a nonresident alien individual or foreign corporation.
Third, the definition of a substantial built-in loss has been modified so that a substantial built-in loss is considered to exist if the transferee of a partnership interest would be allocated a net loss in excess of $250,000 upon a hypothetical disposition by the partnership of all of the partnership's assets in a fully taxable transaction for cash equal to the assets' fair market value, immediately after the transfer of the partnership interest. This could necessitate the adjustment of the basis of partnership property.
Fourth, TCJA modifies the basis limitation on partner losses to provide that a partner's distributive share of items that are not deductible in computing the partnership's taxable income, and not properly chargeable to capital account, are allowed only to the extent of the partner's adjusted basis in the partner's partnership interest at the end of the partnership tax year in which an expenditure occurs. Thus, the basis limitation on partner losses applies to a partner's distributive share of charitable contributions and foreign taxes.
Lastly, the rule providing for technical terminations of partnerships has been repealed.
Changes to S Corporation Rules. Several changes were also made to the tax rules involving S corporations. First, income that must be taken into account when an S corporation revokes its S corporation election is taken into account ratably over six years, rather than the four years under prior law. Second, a nonresident alien individual can be a potential current beneficiary of an electing small business trust (ESBT). Third, the charitable contribution deduction of an ESBT is not determined by the rules generally applicable to trusts but rather by the rules applicable to individuals. Thus, the percentage limitations and carryforward provisions applicable to individuals apply to charitable contributions made by the portion of an ESBT holding S corporation stock.
International Tax Changes. TCJA made sweeping changes to the Unites States' international tax regime through a series of highly complex provisions that are beyond the scope of this article.
II. Year-End Planning Considerations
Increased Expensing and Bonus Depreciation. The increased Code Sec. 179 expensing deduction and the increased bonus depreciation deduction may create new opportunities to reduce current year tax liabilities through the acquisition of qualifying property - including property placed in service between now and the end of the year. However, if a client has expiring net operating losses, then holding off on such purchases until next year or later may be a more appropriate strategy.
Reduced Corporate Tax Rate and the Qualified Business Income Deduction. As a result of the change to the top corporate tax rate and the introduction of a new sole proprietorship and pass-thru entity deduction, businesses may want to rethink their choice of entity. A reduction in the corporate tax rate from 35 percent to 21 percent may appeal to some clients, while the 20 percent QBI deduction for sole proprietorships and pass-through entities may seem enticing to others. One point to remember is that the 21 percent tax rate is permanent, at least until Congress changes it again, while the 20 percent QBI deduction is scheduled to expire after 2025. Additionally, as previously noted, the 20-percent QBI deduction does not apply to many types of businesses, such as health, law, and accounting businesses just to name a few, unless the taxpayer's taxable income is below a certain threshold. Finally, the QBI deduction is quite complex and can affect, and be affected by, numerous other deductions and tax strategies.
As an example, if a client takes the Code Sec. 179 and bonus depreciation deduction, that deduction reduces QBI and thus decreases a client's Code Sec. 199A deduction in that year. However, taking the Code Sec. 179 and bonus depreciation in one year also reduces depreciation deductions in future years. While this increases the client's Code Sec. 199A income in the future, it may cause a client's taxable income to exceed the $157,500/$315,000 threshold which, absent the availability of the 2.5 percent of qualified property calculation or the availability of W-2 wages, would lead to the complete elimination of the QBI deduction.
Thus, for any particular business thinking about changing the form in which it conducts business as a result of these recent changes in the law, numerous projections and calculations will have to be done to see if this is the best move for a particular client.
Vehicle-Related Deductions and Substantiation of Deductions. Expenses relating to business vehicles can add up to major deductions. So, if a client's business might benefit from the purchase of a large passenger vehicle, consideration should be given to purchasing a sport utility vehicle weighing more than 6,000 pounds. Vehicles under that weight limit are considered listed property and deductions are more limited. However, if the vehicle is more than 6,000 pounds, up to $25,000 of the cost of the vehicle can be immediately expensed.
Vehicle expense deductions are generally calculated using one of two methods: the standard mileage rate method or the actual expense method. If the standard mileage rate is used, parking fees and tolls incurred for business purposes can be added to the total amount calculated. Since the IRS tends to focus on vehicle expenses in an audit and disallow them if they are not properly substantiated, clients should be counseled to maintain the following tax records with respect to each vehicle used in the business: (1) the amount of each separate expense with respect to the vehicle (e.g., the cost of purchase or lease, the cost of repairs and maintenance); (2) the amount of mileage for each business or investment use and the total miles for the tax period; (3) the date of the expenditure; and (4) the business purpose for the expenditure. The following are considered adequate for substantiating such expenses: (1) records such as a notebook, diary, log, statement of expense, or trip sheets; and (2) documentary evidence such as receipts, canceled checks, bills, or similar evidence. Records are considered adequate to substantiate the element of a vehicle expense only if they are prepared or maintained in such a manner that each recording of an element of the expense is made at or near the time the expense is incurred.
Retirement Plans and Other Fringe Benefits. Because benefits are very attractive to employees, clients might consider using benefits rather than higher wages to attract employees. While a business is not required to have a retirement plan, there are many advantages to having one. For example, by starting a retirement savings plan, an employer not only helps employees save for the future, the employer can also use such a plan to attract and retain qualified employees. Retaining employees longer can impact a business's bottom line by reducing training costs. In addition, a business owner can take advantage of the plan also, and so can the business owner's spouse. Where the business owner's spouse is not currently on the payroll, adding him or her to the payroll and paying a salary up to the maximum amount that can be deferred into a retirement plan is worth considering. For example, if a business owner's spouse is 50 years old or over and receives a salary of $24,500, all of it could go into a 401(k), leaving the spouse with a retirement account but no taxable income.
By offering a retirement plan, a business owner also generates tax savings to the business because employer contributions are tax deductible and the assets in the retirement plan grow tax free. Additionally, a tax credit is available to certain small employers for the costs of starting a retirement plan.
Also, as noted above, for 2018 and 2019, eligible employers can claim a general business credit equal to 12.5 percent of the amount of wages paid to qualifying employees during any period in which such employees are on family and medical leave under an employer's plan if the rate of payment under the program is 50 percent of the wages normally paid to an employee.
Increasing Basis in Pass-thru Entities. If an S corporation or partnership is going to pass through a loss to a client, it's advisable to double check that the client has enough basis in the loss-generating entity to deduct the loss. If not, then the client should be encouraged to increase his or her basis in that entity in order to deduct the loss for 2018 taxes if doing so is financially appropriate.
De Minimis Safe Harbor Election. If a client has not already done so, it may be advantageous to elect the annual de minimis safe harbor election in Reg. Sec. 1.263(a)-1(f)(1)(ii)(D) for amounts paid to acquire or produce tangible property. By making this election, and as long as the items purchased don't have to be capitalized under the uniform capitalization rules and are expensed for financial accounting purposes or in the client's books and records, the client can deduct up to $2,500 per invoice or item (or up to $5,000 if the client has an applicable financial statement).
Accounting Method Changes. If a client agrees that his or her business might benefit from a change to the cash method of accounting, then the appropriate tax forms will have to be filed to initiate the changes in addition to setting up the client's books and records to reflect the new method of accounting.
S Corporation Shareholder Salaries. For any business operating as an S corporation, it's important to ensure that shareholders involved in running the business are paid an amount that is commensurate with their workload. The IRS scrutinizes S corporations which distribute profits instead of paying compensation subject to employment taxes. Failing to pay arm's length salaries can lead not only to tax deficiencies, but penalties and interest on those deficiencies as well. The key to establishing reasonable compensation is being able to show that the compensation paid for the type of work an owner-employee does for the S corporation is similar to what other corporations would pay for similar work. If a client is in this situation, the tax return workpapers should include documentation of the factors that support the salary the client is being paid.
Centralized Partnership Audit Regime. Finally, the new centralized partnership audit regime took effect in 2018. The rules potentially change which partners may be responsible for additional taxes as a result of audit changes and, as a result, necessitate that partnerships update their partnership agreements to reflect the new regime. Some practitioners are going so far as to refuse to do partnership returns for any partnerships that have not revised their partnership agreement to make it clear which partners will be responsible for any tax deficiencies.
Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.
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