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California Announces Change to Independent Contractor Test

By Closely Held BusinessesNo Comments

Does your business receive any labor or services through the work of independent contractors? Earlier this year, the California Supreme Court passed a ruling which completely changed the standards for qualifying as an independent contractor vs an employee. The new rules make this classification much more clear-cut, however, this simplicity has made it substantially more difficult to qualify as an independent contractor. This means that many of those workers that you currently classify as independent contractors, may now need to be treated as employees. This article will help to explain these changes in more depth.

In the landmark decision of Dynamex Operations West, Inc. v. Superior Court of Los Angeles, No. S222732 (Cal. Sup. Ct. Apr. 30, 2018), the California Supreme Court unanimously announced a new test for determining whether a worker is an employee or an independent contractor. This newly simplified test is a 3-part standard in which the worker must meet all 3 requirements in order to qualify as an independent contract. The test is as follows:

  • The worker is free from the control and direction of the hiring entity in connection with the performance of the work.
    This piece of the test is most similar to the previous standards that were in effect. This means that if a business exercises the same amount of control over a worker as it does over it’s employees, that worker must also be considered an employee. In addition, it is now the responsibility of the business to prove these standards were met.
  • The worker performs work that is outside the usual course of the hiring entity’s business.
    This test is what may cause many workers now categorized as independent contractors to be converted to employees. If the services that the worker provides are thought to be under the ordinary course of business and seem to be typical for that particular business, the worker must now be considered an employee. The court gave an example in order to further clarify: “If a retailer hires a plumber or electrician to perform maintenance at their establishment, an independent contractor relationship is created. If a bakery hires a cake decorator or a clothing manufacturer hires a seamstress that works at home, these workers are employees”.
  • The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity.
    This does not mean the worker must have an official business entity through licensing, however, they must’ve taken steps on their own to establish an independent business for himself or herself.

If your business currently receives services through independent contractors and you think these rules may affect you, please feel free to contact your L&B professional at 858-558-9200 to further discuss these details and any potential consequences.

Considering Consolidation

By Closely Held BusinessesNo Comments

As companies diversify and restructure to achieve tax and operational goals, the complexities of consolidation remain at the forefront of financial reporting. Determining if your company meets the requirements for consolidation on a regular basis can lead to a smoother financial reporting process.

Complex business and ownership structures require the need for continual evaluation of the consolidation requirements for financial reporting. Under the accounting principles generally accepted in the United States (“U.S. GAAP”), there are two main relationships between entities that require consolidation: a controlling financial interest and the existence of a variable interest entity.

A controlling financial interest exists when an acquiring company, shareholder, or group of shareholders directly or indirectly obtains greater than 50% of the voting stock of another company. Under this scenario, the acquiring company would effectively be in control of the operating activities of the acquired company, which would require the entities to be reported as a single economic unit.

The second scenario requiring consolidation is when an acquiring company is the primary beneficiary of an acquiree that is considered to be a variable interest entity. An entity is considered a variable interest entity if any of the below conditions are met:

  • The entity needs additional financial support other than the amount of invested equity.
  • The equity investors lack the power to exert controlling interest.
  • The equity investors cannot absorb losses or receive residual returns from the entity.

It should be noted that the acquirer does not necessarily have to be an equity investor to hold a controlling interest or be the primary beneficiary of a variable interest entity. Other types of capital providers such as debt providers and guarantors can also meet this requirement.

Lastly, it is typical for business structures with common ownership to be engaged in lease arrangements. Accounting Standard Update 2014-07 allows for consolidation to be avoided if three conditions are met in a private company lease arrangement with common control:

  • The lessor and lessee are under common control.
  • A lease arrangement exists between the lessor and lessee.
  • Substantially all activities between the two entities relate to the lease arrangement.

Evaluating the need for consolidation can be comprehensive and difficult. For assistance in determining if your entity meets the consolidation requirements, please feel free to contact your L&B professional at (858) 558-9200.

What Have We Learned From the Tax Cuts and Jobs Act in the Last 6 Months?

By Closely Held BusinessesNo Comments

The Tax Cuts and Jobs Act became law on December 22, 2017, with most provisions taking effect January 1, 2018. The last six months has seen an unparalleled amount of interpretations of the new law with many issues still awaiting guidance to provide clarity. This article will update you on what we know to be true for 2018 and where we expect to receive more guidance before the end of the year.

Choice of Entity After Tax Rate Change

The new law eliminated the graduated rate structure and significantly decreased the top income tax rate for corporations from 35% to 21%. With the qualified dividend rate at 15%, under certain income thresholds, you could be looking at a 36% combined tax rate for corporate owners in comparison to pass-through entities such as S corporations and partnerships that would be subject to the top individual ordinary income rate of 37%. There are a number of factors to discuss including but not limited to the new pass-through income deduction, deductibility of state taxes, increase in dividend rates over certain income thresholds and the 3.8% net investment income tax.

Depreciation

Bonus depreciation is a valuable tax-saving tool for businesses as it allows for an immediate first-year deduction on the purchase of new equipment with no phase out restrictions. The new law increases bonus depreciation to 100% for property acquired and placed in service after September 27, 2017 and before 2023, after which it will be phased out to zero. Bonus depreciation has also been expanded to include purchases of used equipment.

In addition to bonus depreciation, Section 179 allows for the full expensing of new and used equipment, as well as purchased “off-the-shelf” software. The new law increases the limit significantly from $500,000 to $1 million and raises the phase out threshold from $2 million to $2.5 million, making this deduction available to more businesses. Businesses who exclusively used bonus depreciation in the past might now be eligible to expense under Section 179.

Pass-Through Income Deduction Update

As we mentioned earlier, pass-through income is generally taxed at the individual owner’s ordinary income tax rate. While the new law did not create a preferential rate for pass through income, it does provide for up to a 20% deduction of qualified business income. We have learned from interpretations of the law that this will include self-employed individuals as well as rental properties that are not held through an entity. With that said we are still waiting for guidance on what qualifies as a service industry and how to calculate the qualified business income deduction. This guidance is expected to be published by the end of June.

Net Operating Losses (NOLs)

When a business finishes a tax year with negative income for the year it generates a net operating loss that, under prior law, could be carried back two years and carried forward 20 years to be used against income. Under the new law, NOLs can no longer be carried back but will now have an indefinite carry forward life. The use of NOLs in any future year will be limited to 80% of taxable income.

Deduction for Net Interest Expense

There had not previously been a limit to the amount of interest expense that a business could deduct. The new law limits the deduction for interest expense to 30% of adjusted taxable income, with an indefinite carryover of disallowed amounts. Small businesses with average gross receipts of $25 million or less are not subject to this restriction.

Entertainment Expenses

The new law eliminates the 50% deduction for most entertainment expenses. There is a lack of clarity as to what qualifies as entertainment expenses under the new law, but legislators are expected to provide more details on the deductibility of these expenses at the end of June.

As you can see, the Tax Cuts and Jobs Act introduces many changes to how a business is taxed, and provides tax planning opportunities. It is important to consult your tax advisor before making decisions that will likely have a significant tax impact on your business. If you need assistance interpreting the new tax law changes and analyzing how they will impact your business, please contact your L&B Professional at (858) 558-9200.

Don’t Convert Your Garage, Convert Your Business!

By Closely Held BusinessesNo Comments

Are you using the most advantageous business entity? There are many things to consider when choosing a business entity type but choosing the right one for your situation can save you a lot in tax and may be able to limit your personal liability.

Thinking about converting from a C-Corporation to an S-Corporation or vice versa?

The primary reason for changing from a C-Corporation to an S-Corporation is to avoid double taxation without the need to liquidate the corporation. A C-Corporation’s income is taxed at the corporate level when the income is earned and then again when shareholders receive distributions which are considered dividend income. S-Corporation’s earnings are taxed once at the individual shareholder level. Recent tax reform decreased the corporate tax rate from 35% to 21%. Every business owner should consider if they are using the most appropriate entity type.

The following examples are a simplified illustration of the tax consequences under each entity type and assume income tax is paid at the highest marginal tax rate.

Example 1: A C-corporation earns $1,000 in income before taxes in year 1, it pays $210 ($1,000 x 21%) in federal income taxes in year 1. When the corporation distributes the remaining $790 ($1,000 income -$210 taxes) the shareholder(s) who receive the distribution would pay $188 of income tax ($790 x 23.8%). The resulting total income tax paid on the $1,000 of income is $398.

Example 2: If the corporation had elected S status and earned the same $1,000 as in example 1 the S-corporation would pay $0 in Federal entity level tax. The $1,000 would be reported on the shareholder(s)’ return. This income might be eligible for the 20% pass-through income deduction enacted as part of the recent tax reform bill. If the income is eligible, the tax would be calculated on $800 [$1,000 income – $200 ($1,000 x 20%)]. The resulting federal income tax liability on the $1,000 of income would be $296 (800 x 37%).

Read more about the pass-through income tax deduction in our article “Tax Reform: Pass-Through Income Deduction Edition”

Other important tax consequences exist, such as Built-In Gains Tax. S-Corporations that were previously C-Corporations may also pay taxes on accumulated, untaxed income that resulted from when the corporation operated as a C-Corporation. The company needs to measure the fair market value at the effective date of the S-election as compared to the tax basis to measure the amount of unrecognized appreciation. The amount of unrecognized gain is determined for each asset separately then the net of unrecognized built-in gains and built-in losses is the corporation’s total unrecognized built-in gain. It must track the disposition of these assets for the next 10 years, at which time any built-in gains are taxed at a rate of 21%.

It should also be noted that, if the C-Corporation has net operating losses that are not used, those losses cannot be used to offset its income generated as an S-Corporation and in turn cannot be passed through to its shareholders. If the unused losses cannot be carried back to a previous tax year then those losses will be forfeited upon the conversion.

Should your business be an LLC?

If you are operating a sole proprietorship, you may want to consider converting it to an LLC. The benefit of operating as an LLC is that it offers limited liability protection. In the case of a sole proprietorship there would be no federal tax impact of forming an LLC.

LLCs that operate in California are required to file a separate LLC return and are subject to an annual tax of $800 plus an LLC fee. The LLC fees is calculated on the total California sourced gross receipts.

Owners of LLCs are referred to as members. If you decided to add a member to your LLC, both members would have limited liability protection. One of the benefits of using an LLC vs. a C-Corporation is that you are not subject to double taxation.

It is easy to convert from an LLC to a C-Corporation if you later decide the business needs to be incorporated. This could be the case if you are planning on getting venture capital funding, as many venture capital firms require a corporate form. Another benefit on using a C-corporation is the ability to qualify for the 100% gain exclusion on Qualified Small Business Stock (“QSBS”). There are several criteria that must be met including holding the stock for 5 years in order to qualify for this tax savings.

If you have any questions about this topic, or any other tax matters, please feel free to contact your L&B professional at 858-558-9200.

Show Me the Money: How to Pull Cash Out of Your Business

By Closely Held BusinessesNo Comments

Do you have a successful business with cash reserves that you want to transfer to your personal account? It seems like it should be easy enough, but unfortunately nothing related to taxes is ever easy. Depending on the business structure, prior year earnings, and what you have personally contributed to the business, there could be a significant tax impact from transferring the money. This article goes through the common strategies used to get money out of a business and compares how they relate to the different business structures.

Strategies to Transfer Money from a Business

There are several strategies that are used to get money out of a business. Below is a general discussion of these strategies:

Distributions – A distribution is the transfer of money or property from the business to the owner. Depending on the entity type, a distribution may be treated as a return of capital, a capital gain or a dividend. A return of capital is the most tax advantageous method of taking money from a business. This treatment is reserved for sole proprietorships and passthrough entities that have basis (cash, property or recourse debt) in excess of the distribution amount. Distributions from sole proprietorships and general partnerships are always considered a return of capital whereas distributions made from a Limited Partnership, LLC or S-Corporation to an owner without basis are treated as a capital gain. Distributions made to the owners of a C-corporation are taxed as dividends, which are one of the most inefficient tax methods for getting money out of an entity. The dividends are taxed to the individual, often at a preferred rate, but the entity does not receive a deduction for the amount paid, resulting in double taxation.

Guaranteed Payment/1099 – Typically passthrough entities use this strategy. The payment is given to the owner in exchange for performing services and is treated as self-employment income, and subject to the 15.3% self-employment tax. However, the entity does receive a deduction for the amount paid to the owner, so double taxation is avoided.

Rent – If the taxpayer has a property, or room, available that can be used by the business, then the owner may be able to rent the space to the business at the fair market rate. This method can be used for any entity type other than a sole proprietorship. Rental income is taxable to the recipient, but the recipient can recognize rental expenses, including depreciation, to offset the income. The business also gets a deduction for rent expense paid.

Wages – Generally only S-Corporation and C-Corporation owners receive wages from their business, which are tax deductible for the business. The income is subject to employment taxes, which are paid by both the recipient and the business. Since S-Corporation earnings are not subject to self-employment tax, owners are required to pay themselves fair wages for any services performed for the business.

Relationship between Strategies and Business Structures

Below is a table showing the relationship between business structures and entity type:

Strategy Sole Proprietorship General Partnership LLC/LLP/LP S-Corporation C-Corporation
Distribution Tax Free, No Limitation Tax Free, No Limitation Tax Free, Up to Basis Tax Free, Up to Basis Taxable as dividends
Guaranteed Payment/1099 N/A Subject to Self-Employment Tax Subject to Self-Employment Tax Subject to Self-Employment Tax N/A
Rent N/A Taxable Taxable Taxable Taxable
Wages N/A N/A N/A Subject to Employment Tax Subject to Employment Tax

Special Situations and Other Considerations

If there are basis problems or income tax considerations preventing the use of the above strategies, here are a couple more ideas worth considering:

1. Short term financing – The business entity can loan the money to the individual. While the money will have to be repaid in some way, the loan can be done at favorable interest rates and give the taxpayer immediate access to the funds.

2. Retirement Options – An alternative method is to create a retirement account for the business owner and have the business make contributions. While this does not give immediate access to the funds, it does transfer them out of the business to the owner.

What works best for you?

There are many different variables in play when determining which strategy works best for your specific situation. If you have any question about which strategy would be the best to get money out of your business, please feel free to contact your L&B professional at (858) 558-9200.

Choosing a Retirement Plan for Your Business

By Closely Held BusinessesNo Comments

When deciding on a retirement plan for your business, the number of available options can be overwhelming. Each plan has its benefits, but it is important to understand which is most suitable for your particular situation. The retirement plans detailed within can help you determine which plan is most appropriate for your business and its employees.

401(k) Plans

A 401(k) plan is a retirement plan under which an employee can elect to have their employer contribute a portion of their wages to a retirement account. The wages contributed are known as “elective deferrals” and are not subject to federal income tax at the time of deferral.

The main tax advantages of sponsoring a 401(k) plan are:

  • Employer contributions are deductible on the employer’s federal income tax return to the extent that the contributions do not exceed certain limitations.
  • 401(k) contributions and investment gains are tax deferred until distribution in retirement.

The maximum employee contribution that can be made to the plan is $18,500 for 2018. For those employees over 50 years of age, a $6,000 additional catch-up contribution can be made. Employee elective deferrals must be made by the end of the year to be included on that tax year’s W-2. Employer nonelective matching contributions can be made up to 25% of compensation or for self-employed individuals net earnings from self-employment after deducting one-half of your self-employment tax and can be made until the extended due date of the employer’s tax return.

There are several types of 401(k) plans available to employers including traditional 401(k) plans, safe harbor 401(k) plans, and SIMPLE 401(k) plans. Below is a brief description of each type.

1)  Traditional 401(k) Plan

A traditional 401(k) plan allows eligible employees to make pre-tax contributions through payroll. In a traditional 401(k) plan, employers have the choice to make contributions on behalf of all participants, make matching contributions based on employees’ contributions, or both.

  2)   Safe Harbor 401(k) Plan

A safe harbor 401(k) plan is similar to a traditional 401(k) plan, however, employer contributions must be fully vested when made. The safe harbor 401(k) plan is not subject to the complex annual nondiscrimination tests that apply to traditional 401(k) plans. In addition, safe harbor 401(k) plans that do not provide any additional contributions in a year are exempted from the top-heavy rules of section 416 of the Internal Revenue Code. Both the safe harbor and traditional 401(k) plans are for employers of any size and can be combined with other retirement plans.

 3)   SIMPLE 401(k) Plan

 The SIMPLE 401(k) plan was formed so that small businesses could have an efficient, cost-effective way to offer retirement benefits to their employees. This type of 401(k) plan is available to employers with 100 or fewer employees who received at least $5,000 in compensation from the employer for the previous calendar year. Employees who are eligible to participate may not receive any contributions or benefit accruals under any alternative plans of the employer and are limited to a $12,500 elective deferral with a $3,000 catch up contribution.

4)   Solo 401(k) Plan

 The Solo-k plan is just a traditional 401(k) plan covering a business with no employees which can include the business owner’s spouse. One advantage to this plan is the employee elective deferral can be made dollar for dollar with compensation or earned income up to the deferral limitations allowing for a larger contribution with smaller amounts of income.  Additionally, this plan is not required to file a Form 5500 until assets exceed $250,000 and even then it files a shorter Form 5500-SF.

SEP

Simplified Employee Pension (SEP) plans are easy to set up and maintain, as they do not have the start-up and operating costs of a conventional retirement plan.  Any employer with one or more employees is eligible to provide them, and it is commonly seen with sole proprietorships for its flexibility and simplicity.

In 2017 and 2018, the maximum contribution to a SEP is the lesser of $54,000 or 25% of the employee’s salary. Contributions for each year must be made no later than the extended due date of the employer’s tax return. Annual contributions can be flexible, making this a good plan if cash flow is an issue from one year to the next. If the employer plans to contribute anything to an employee’s SEP, they must contribute equally for all employees that are eligible.

 Simple IRA

SIMPLE IRA plans can offer a substantial source of income for retirement by permitting both employers and employees to set aside money in retirement accounts. An advantage of a SIMPLE IRA is that it does not have the start-up and operating costs of a conventional retirement plan.  It is available to any small business with 100 or fewer employees.  Under a SIMPLE IRA, an employer is required to annually contribute either a matching contribution of up to 3% of compensation or a 2% nonelective contribution for each eligible employee.

In 2018, the maximum that can be contributed to a SIMPLE IRA is $12,500, with an additional $3,000 allowed for those employees over 50 years of age. SIMPLE IRA employee contributions can be made no later than 30 days after the close of a month for which the contributions are made and employer match contributions are required by the extended due date of the employer’s tax return.

Choosing the best type of retirement plan for your business can be very complex. Please contact your L&B professional at 858-558-9200 to further discuss the best option for your business.

Are you prepared to sell your company?

By Closely Held BusinessesNo Comments

It may be time for you to sell your business, but what do you need to do to prepare for that to happen? Whether you are selling now or in the future, there are many steps that you can take as a business owner to ensure that the sale of your company goes smoothly.

As a business owner, you should take steps every day to prepare for the sale of your company. Whether you are selling within the next year or five years, you should run your company with a sale in mind. Preparing your business for sale early on will help your company run smoother, and will make your business more appealing to buyers in the event that you do decide to sell. Here are some steps you can take:

  • Make yourself Redundant – You are selling a business, not yourself. Buyers want a business that can be successful after you exit, should you choose to do so. Find people you can trust to put in management positions and create internal controls that foster success within your company.
  • Recognize and Identify Strategic Buyers – Know your audience. There are certain buyers who are not seeking your profits, but rather your customer base, intellectual property, or other assets. There are certain steps you need to take to secure that property and make it easy to sell, so be sure you are aware of what buyers are after.
  • Settle any lawsuits – A business with unresolved legal issues looks less attractive to buyers. Cleaning up these issues ahead of time can increase your value at time of sale.
  • Offer a realistic and supportable forecast – Buyers will want insight into expected future earnings of your company. Providing a reliable forecast will demonstrate the strength of your management team and the overall quality of your company.
  • Focus on Profitability – Although certain deductions may be great for tax purposes, they won’t be as beneficial on your financial statements. Potential buyers are attracted to profits; consider managing your expenses in order to maintain a profitable position on your financial statements.
  • Protect the Positions of your Key Staff Members – The key employees of your company can provide a lot of value to the business you are selling. Make sure to take steps to retain them at your company or find a replacement for those positions should they leave before the sale is complete.
  • Get Out of the Office (get to know your clients) – Your clients can provide the best references as to the successful operations of your business. Ensure you have good relationships with them so when it comes time for the sale, they can provide a great reference.
  • Reach out to the Business Broker or Investment Banker – Although not necessary, a broker can be a valuable tool for the sale of your business. They can maintain a pool of potential buyers and can connect you with buyers who are looking to acquire exactly what you plan to sell.
  • Play Hard to Get – Create a demand for your company by speaking with multiple buyers. Competition among buyers usually means a higher sale price.
  • Keep it on the Down Low – Maintain a level of secrecy around the sale of your company. You risk losing key customers and employees if word about the sale of your business comes out too quickly.

A business merger or sale is a complex situation with many factors that may affect your tax situation. If you are considering one of these options, we advise that you contact an experienced tax advisor.  If you have any questions about this topic, or any other tax matters, please feel free to contact your L&B Professional at (858) 558-9200.

Cost Segregation – A Celebration of Accelerated Depreciation

By Closely Held BusinessesNo Comments

Have you recently purchased a building or are you currently in the market to?  If you are looking to take advantage of all the tax deductions a building can provide whether its residential or commercial property, participating in a cost segregation study might be a realistic course of action for you to achieve this goal.  This increasingly popular tax strategy offers facility owners the opportunity to defer taxes, reduce their overall current tax burden, and free up capital by improving their current cash flow.  Virtually every taxpayer who owns, constructs, renovates, or acquires a commercial real estate structure stands to benefit from a cost segregation analysis.

What is Cost Segregation?

Cost segregation is a practice in which tangible personal property or land improvements are identified and segregated from the building’s structural components and depreciated separately. This allows for the depreciable life of these assets, which otherwise would have been lumped together with building costs depreciated over a 39-year or 27.5-year life, to be depreciated over 5, 7 or 15 years, dramatically accelerating depreciation expense. You are then able to front-load your depreciation deductions and reduce your current income tax obligations. Take a look at this simple example.

Before Cost Segregation After Cost Segregation Benefits
5-year property $500,000
7-year property $500,000
15-year property $500,000
39-year property $5,000,000 $3,500,000
$5,000,000 $5,000,000
First-year Depreciation Deduction $128,205 $893,685 $765,480
Accelerated Cash Flows, Years 1-5 $348,343
Total Net Present Value of Accelerated Cash Flow $137,997

Source: https://www.naiop.org/en/Magazine/2015/Summer-2015/Finance/The-Benefits-of-Cost-Segregation-Studies.aspx

Cost segregation studies must be performed by an accredited engineering firm who specializes in this practice. Licensed engineers are needed to schematically reverse engineer the building and break it up into its separate depreciable parts. A cost segregation study can be costly, but a present value calculation of the benefits of the study will help in determining whether the benefits out weight the cost.

If you feel like you’ve already missed out on this great opportunity, don’t worry! You can still choose to participate in a cost segregation study even if your building has already been depreciated over a number of years. If you complete a cost segregation study, you are allowed to take a deduction in the year of the study to “catch up” on the allowable accelerated depreciation.

If you are curious as to how cost segregation can benefit your business, please contact your L&B professional at (858)558-9200.

Tax Reform: Pass-Through Income Deduction Edition

By Closely Held BusinessesNo Comments

Currently, owners of partnerships, S corporations, and sole proprietorships – as “pass-through” entities – pay tax at the individual rates, with the highest rate at 39.6 percent. The highest rate is reduced to 37 percent under the Tax Cuts and Jobs Act starting in 2018. The Act also allows a temporary deduction in an amount equal to 20 percent of qualified income of pass-through entities, subject to a number of limitations and qualifications. Conversely, the Tax Cuts and Jobs Act limits the deduction for excess business losses from pass-through entities.  Let’s dive into the details and see how this effects your business.

Pass-through Income Deduction

Non-corporate taxpayers may deduct up to 20 percent of domestic qualified business income from a partnership, S corporation, or sole proprietorship (Code Sec. 199A deduction). A similar deduction is allowed for specified agricultural or horticultural cooperatives. Unfortunately there are limitations if you cross over the income thresholds for single filers with taxable income above $157,500 or for joint filers with taxable income above $315,000. Those limitations include a calculation of your deduction that may not exceed the greater of: 50% of the W-2 wages paid by the business or 25% of the W-2 wages paid by the business plus 2.5% of the unadjusted basis of depreciable property owned by the business. In addition, the deduction is not allowed for specialized trade or business income which includes income stemming from performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any business where the principal asset of the business is the reputation or skill of one or more of its employees. The deduction applies to tax years from 2018 through 2025.

For individual taxpayers, the Code Sec. 199A deduction is not allowed in determining adjusted gross income. Further, it is not an itemized deduction, but it is available to individuals who itemize deductions and to those who claim the standard deduction. However, the deduction amount cannot be more than the taxpayer’s taxable income (reduced by net capital gain) for the tax year.

The Code Sec. 199A deduction is similar to the domestic production activities deduction under Code Sec. 199, in that both allow taxpayers to deduct a portion of their “taxable income” if it is less than a portion of their relevant business income. Also, neither deduction can be claimed if the taxpayer has no relevant business income. It is anticipated that the IRS will provide a new worksheet or form for calculating the Code Sec. 199A deduction, similar to Form 8903, Domestic Production Activities Deduction.

 Example : Bob works as an executive with a large company and earns a W-2 salary of $500,000. In addition, he is the sole owner of an LLC that owns rental real estate. Bob reports net profit from the LLC of $300,000 and has total taxable income of $720,000 (before application of the pass-through deduction). The unadjusted basis of the LLC properties is $1,400,000, and the LLC pays W-2 wages to a property manager of $80,000.

Bob is well beyond the phase-out range, but since LLC is not a specialized service trade or business, he is not precluded from taking the 20% pass-through deduction. Rather, instead of simply applying the deduction to the lesser of eligible business income, or taxable income, less capital gains, we must now incorporate the third test noted above. As a result, Bob’s pass-through deduction will be $55,000, which is the lowest of the following amounts:

1) $60,000, which is 20% of Bob’s eligible business income of $300,000

2) $144,000, which is 20% of Bob’s taxable income of $720,000

3) The greater of:

      • $40,000, which is 50% of the LLC’s W-2 wages of $80,000
      • $55,000 which is 25% of the LLC’s W-2 wages of $80,000 plus 2.5% of the $1,400,000 unadjusted basis of the LLC property

Limit on Excess Business Losses for Non-corporate Taxpayers

 Under the Tax Cuts and Jobs Act, excess business losses of non-corporate taxpayers are not allowed for tax years beginning after December 31, 2017, and before January 1, 2026. Any excess business loss that is disallowed is treated as part of the taxpayer’s net operating loss (NOL) carryover to the following tax year.

Non-corporate taxpayers must apply this rule for excess business losses after applying the passive activity loss rules. For partnerships and S corporations, the limit on excess business losses is applied at the partner or shareholder level.

Comment: For losses arising in tax years beginning after December 31, 2017, an NOL may generally only reduce 80 percent of taxable income in a carryback or carryforward tax year.

An “excess business loss” is the excess, if any, of

(1) the taxpayer’s aggregate deductions for the tax year from the taxpayer’s trades or businesses, determined without regard to whether or not such deductions are disallowed for such tax year under the excess business loss limitation; over

(2) the sum of

(a) the taxpayer’s aggregate gross income or gain for the tax year from such trades or businesses,      plus

(b) $250,000, adjusted for inflation (200 percent of the $250,000 amount in the case of a joint return).

The $250,000 amount is adjusted for inflation for tax years beginning after December 31, 2018.

If you are curious as to how the pass-through income deduction will impact your taxes, please contact your L&B professional at (858) 558-9200.

Tax Reform and What it Means for Your Business

By Closely Held BusinessesNo Comments

The Tax Cuts and Jobs Act became law on December 22, 2017, with most provisions taking effect on January 1, 2018.  While much of the discussion regarding the new tax law has focused on changes that impact individuals, there are many changes coming for businesses as well.  Some of these changes will be seen at the entity level, while others will be reflected on the personal returns of owners of pass through entities.

Tax Due Dates

Remember, with the passage of the “Surface Transportation and Veteran’s Health Care Choice Improvement Act of 2015,” tax return due dates have changed for certain types of entities:

  • Due March 15, 2018

o   Partnerships – filing calendar year Form 1065

o   S-Corporations – filing calendar year Form 1120S

  • Due April 17, 2018

o   C-Corporations – filing calendar year Form 1120

Tax Rate

The Tax Cuts and Jobs Act eliminated the graduated corporate rate structure and decreased the income tax rate for businesses significantly from 35% to 21%. Under the new tax legislation, corporate taxable income will be taxed at a flat rate of 21% for tax years beginning after December 31, 2017.

Depreciation

Section 179 allows for the full expensing of new and used equipment, as well as purchased “off-the-shelf” software. The deduction was previously aimed at small to mid-sized businesses as the deduction was capped at $500,000 (and phased out as total purchases exceed $2.0 million). The Tax Cuts and Jobs Act increases the limit significantly to $1 million and raises the phase out threshold from $2 million to $2.5 million, making this deduction available to more businesses. Businesses who exclusively used bonus depreciation in the past might now be eligible to expense under Section 179 and should consider this moving forward.

Bonus depreciation is a valuable tax-saving tool for businesses as it allows for an immediate first-year deduction on the purchase of new equipment with no phase out restrictions. Bonus depreciation was at 50% in 2017. The Tax Cuts and Jobs Act increases bonus depreciation to 100% for property acquired and placed in service after September 27, 2017 and before 2023 and will be gradually phased out to zero. Bonus depreciation was also expanded to include purchases of used equipment.

Pass Through Income Deduction

Under prior law, pass through income from a trade or business was generally taxed at the owner’s ordinary income tax rate.  While the Tax Cuts and Jobs Act did not create a preferential rate for pass through income, it does provide for up to a 20% deduction of qualified business income from pass through entities (partnership, S corporation, or sole proprietorship).

Net Operating Losses (NOLs)

Under prior law, NOLs could be carried back two years and carried forward 20 years.  Under the new law, NOLs can no longer be carried back.  However, NOLs will now have an indefinite carry forward period.  The NOL deduction in any year will be limited to 80% of taxable income.

Deduction for Net Interest Expense

There had not previously been a limit to the amount of interest expense that a business could deduct.  The Tax Cuts and Jobs Act limits the deduction for interest expense to 30% of adjusted taxable income, with an indefinite carryover of disallowed amounts.  Small businesses with average gross receipts of $25 million or less are not subject to this restriction.

Entertainment Expenses

Prior law allowed a 50% deduction for most entertainment expenses.  The Tax Cuts and Jobs Act eliminates this deduction.

There are significant changes coming in 2018 with the passing of the Tax Cuts and Jobs Act.  If you need assistance interpreting these changes and analyzing how they will impact your business, please contact your L&B Professional at (858) 558-9200.

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