6 highlights from tax reform
What to know heading into tax season
December/January 2018-19 Footnote
It's been a year since the Tax Cuts and Jobs Act was enacted and, while the IRS has issued sets of proposed regulations and notices to provide guidance, some provisions are far from clear. Nevertheless, as tax season approaches, it's time again to dig in and get another round of returns out the door.
Heading into the first tax season that includes the biggest tax law overhaul in 30 years, several key items should be on the minds of practitioners. The following are six provisions that have a broad impact on our middle-market business tax clients and on our middle-class individual tax clients.
1. Qualified business income deduction
The biggest news for middle-market business owners, co-op patrons, and holders of interests in real estate investment (REITs) and publicly-traded partnerships (PTPs) is the 20-percent qualified business income deduction.1
A four-step approach to calculating the deduction is:
- Classify a client's trade/business as qualified or specified service. Above certain thresholds of taxable income, the deduction may be reduced in any case, and for a specified service trade or business, ultimately eliminated altogether.
- Segregate qualified business income. This is important because wages, reasonable compensation and guaranteed payments are not eligible for the deduction.
- Apply thresholds. The deduction is allowed in full below certain thresholds of taxable income, and limited or eliminated above certain thresholds of taxable income.
- Calculate the deduction for a qualified or for a specified service trade or business. This is important because, above certain thresholds of taxable income, the calculation is made using only a fraction of the factors for a specified service trade or business.
It is surprising that no clarification was provided in proposed regulations on whether rental real estate income is eligible for the deduction, especially because purely passive investments in REITs qualify. The IRS has initially relied on the generic definition of a trade or business as an activity engaged in for income or profit that is carried on regularly and continuously.2
2. Various business expenses
No deduction is allowed for entertainment expenses.3 This will disallow greens fees, sporting event tickets and other items of client and customer entertainment.
The IRS issued transitional guidance on the deductibility of business meals, with proposed regulations to follow.4 A significant development is that, in the case of food and beverages provided during or at an entertainment event, 50 percent of the food and beverage costs is deductible only if purchased separately from the entertainment or stated separately from the cost of the nondeductible entertainment on a bill, invoice or receipt.
A real property trade or business can elect out of the limitation on interest expense deductibility, but then may not use 100-percent bonus depreciation.5
The definition of qualified real property has been expanded to include roofs, heating, ventilation and air conditioning (HVAC) property, fire protection and alarm systems, and security systems.6
Consideration may be appropriate of cost-segregation services, ongoing consulting on the repair regulations, and the IRS Audit Techniques Guide, "Capitalization of Tangible Property."
Expansion of 100-percent bonus depreciation to used property increases the present value of the tax advantage of an asset purchase versus a stock purchase to a buyer, and may expand the depreciation recapture potential to a seller when selling a business.
3. Fringe benefits
No deduction is allowed for transit passes or parking. This may result in a taxable fringe benefit to employees.7
Section 127, Educational Assistance Programs, is retained, but miscellaneous deductions are suspended. While many employers may use the $5,250 per year limit for budgeting purposes, they may not have adopted a separate written plan. Instead, they may have relied on Section 132(d), Working Condition Fringe Defined. The rationale for not including a working condition fringe benefit in income was that, if the employee paid the expense, the payment would have been allowable as a trade or business expense of the employee.
With unreimbursed employee expenses (such as job education listed on Schedule A, Itemized Deductions) suspended as a miscellaneous deduction, employer-provided graduate tuition is taxable in the absence of a written Section 127 plan.
4. Individual income tax rates
For 2017, the old top individual tax rate of 39.6 percent applied for joint taxable income exceeding $470,700. The new 2018 top individual tax rate of 37 percent applies for joint taxable income exceeding $600,000.8
Long-term capital gains and dividend tax rates remain virtually unchanged with a top rate of 20 percent.9
Remember that the 3.8-percent net investment income tax continues to apply when adjusted gross income exceeds $250,000.10 Disallowed itemized deductions will not offset investment income, potentially increasing the overall 3.8-percent tax on net investment income.
The exposure to alternative minimum tax (AMT) should be reduced because the main trigger of AMT, the addback of state and local taxes, has been minimized. With only $10,000 of deductions allowed for state and local taxes, the addback that often resulted in AMT has been significantly scaled back for many taxpayers.
Estate tax rates continue at a top bracket of 40 percent, but the unified credit has doubled to $10.98 million.11
5. Standard deduction
The standard deduction basically has doubled to $12,000 single and $24,000 filing joint.12 For federal income tax purposes, the number of taxpayers itemizing deductions has been estimated to drop from approximately one-third to less than 10 percent.
Unless a state tax filing allows itemized deductions below the federal levels (like Minnesota), a large group of taxpayers no longer will be required to track deductions that do not exceed the standard deduction threshold. Because the majority of your clients are likely Minnesotans, it's paramount to remind them to continue to track all likely deductions for their state returns.
Along with a higher standard deduction, personal exemptions of $4,050 each were suspended. A $500 tax credit for other dependents was added. Unlike personal exemptions, it does not apply to a taxpayer or spouse.13
Even if not itemizing, a client may benefit from a charitable contribution of appreciated stock to avoid the related capital gains tax. Clients older than 70 1/2 may benefit from charitable contributions of up to $100,000 per taxpayer per year from IRAs by not increasing AGI with a required minimum distribution, since AGI is used to measure various tax thresholds.14
6. Kiddie tax
While purportedly simplifying the kiddie tax, the new law increases taxes on many children by applying ordinary and capital gains rates applicable to trusts and estates to the net unearned income of a child, rather than referencing the parents' rate.15
Even though personal exemptions for dependents are suspended, the head of household filing status remains. A due diligence tax preparer requirement is added, beginning with 2018 returns, with an associated $500 penalty for each failure to be diligent in determining eligibility to file as head of household.
Final regulations issued on Nov. 5, 2018, clarify that even if a preparer has pre-existing knowledge of a taxpayer's situation in determining head of household status, that does not mean preparers can forgo their duty to make reasonable inquiries and contemporaneously document their work.
Most business provisions in the new tax law are permanent, while most individual provisions only apply from 2018 through 2025. But anything in the tax law is permanent only until it is changed. So, regardless of the time horizon of new tax law provisions, 2018 tax return preparation under the new tax law is enough to keep your attention for now.
Mark Sellner consults with other CPAs and their clients on business and executive tax matters, including partnership taxation and the tax consequences of buying and selling a business. He is a member of the Minnesota Society of CPAs, where he has received the Excellence in Teaching Award and the Distinguished Service Award, and the Florida Institute of CPAs. You may reach him at email@example.com or 612-508-4107.
1 New IRC Section 199A; taxable years 2018-2025
2 Prop. Reg. Sec. 1.199A-1(b)(13), Aug. 8, 2018
3 New IRC Section 274(n)(1); permanent
4 Notice 2018-76, Oct. 3, 2018
5 New IRC Section 168(k)(9); after Sept. 27, 2017, through 2022, then phased down to 20 percent by 2027, New IRC Section 163(j)(10)
6 New IRC Section 179(f)(2); permanent
7 New IRC Section 274(a)(4), New IRC Section 274(l)(1); permanent
8 New IRC Section 1(j); taxable years 2018--2025
9 IRC Section 1(h)
10 IRC Section 1411
11 IRC Section 2001, New IRC Section 2010(c)(3)(C); taxable years 2018--2025
12 New IRC Section 63(c)(7); taxable years 2018--2025
13 New IRC Section 24(h)(4); taxable years 2018--2025
14 IRC Section 408(d)(8)
15 New IRC Section 1(j)(4); taxable years 2018--2025