Deduction

Article Dean Dorton

In the first two parts of this Tax Cuts and Jobs Act QBI deduction series, we discussed the computation of the deduction and the businesses and income that qualified for the deduction. In Part 3, we will discuss special rules applicable to specified service businesses and other provisions. (Please note that the discussion below is based on the statute and committee explanations and is subject to change with additional guidance.)

As noted in Part 2, the qualified business income deduction generally does not apply to the specified service businesses listed in the article. However, there is an exception for otherwise nonqualifying businesses if the owner’s taxable income is below a certain amount. The owner of a specified service business can claim the full deduction otherwise available for a qualified trade or business if the owner’s taxable income does not exceed $315,000 on a joint return and $157,500 on all other returns. If the owner’s taxable income is between $315,000 and $415,000 on a joint return, or between $157,500 and $207,500 on all other returns, then the owner can claim a reduced deduction. The deduction is equal to the deduction otherwise available for a qualified trade or business multiplied by the applicable percentage. If the owner’s taxable income exceeds the upper amount, no deduction is allowed.

As an example, assume that joint filers operate a specified service business and have taxable income of $375,000 for 2018, which is $60,000 over the threshold. Also assume that the deduction allowable for a qualified trade or business with the same business income, wages, and property is $50,000. Since this is a specified service business the otherwise allowable deduction is 40% (the applicable percentage) of this amount or $20,000 (100% – $60,000 / $100,000 = 40%). As one may note from the computation in Part 1 and this computation, between the threshold amounts and the threshold amounts plus $100,000 or $50,000, depending on the filing status, the wage and property limitations are phased in and the specified service business deduction is phased out. The final deductible amount, after combining all separate business deductions and 20% of REIT and publicly-traded partnership income, is then subject to the taxable income limitation.

As noted in Part 2, there is some uncertainty as to how broadly the definition of specified service trade or business will be implemented. Additionally, if a sole proprietorship or other pass-through entity conducts both a qualified trade or business and a specified service business, there is currently no guidance on how to determine the business income, wages, and property allocable to each. If a taxpayer has both types of businesses in separate entities but there are transactions among the entities, such as rent, interest, or management fees, will this require adjustments in determining business income subject to the deduction?

The qualified business income deduction does not reduce the amount of income subject to self-employment tax, nor would it appear to reduce the net income for purposes of calculating contributions to self-employed retirement plans, although no guidance in this area has been issued. The deduction reduces the taxpayer’s taxable income, not the taxpayer’s adjusted gross income, and the deduction is not included in itemized deductions. The deduction is not adjusted in arriving at alternative minimum taxable income.

One area of uncertainty is the interaction of this deduction with the passive activity limitations. The passive activity regulations permit a taxpayer to treat certain activities as separate activities or to group activities based on regulatory criteria. Since the qualified business income provisions do not reference the passive activity rules and do not permit the grouping of businesses, guidance will be needed to determine the relationship between these provisions, and planning for individuals with multiple activities and businesses may need to be reconsidered.

The qualified business deduction is also impacted by other provisions of the Tax Cuts and Jobs Act. The Act created a new limitation on the deductibility of business interest expense by individual taxpayers conducting business as sole proprietors, partners, or S corporation shareholders. Although the qualified business income deduction does not reduce the deduction for interest, the interest limitation will impact the amount of business income subject to the qualified business income deduction. We will discuss the interest limitation in an upcoming article.

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Article Dean Dorton

In our fourth installment, we will discuss the new expansion of the limitation on the deduction of interest expense. For tax periods beginning after December 31, 2017, the limitation has been expanded to include individuals (and businesses owned by individuals). One major consideration, however, is that taxpayers who have gross receipts under $25 million are exempt from this limitation. Real estate businesses that otherwise would have to apply this limitation can elect out by using the alternative depreciation system (ADS), rather than MACRS. ADS lives are longer than MACRS lives (although the residential real estate life has been reduced to 30 years), and assets using ADS lives are not qualified for the 100% bonus depreciation or Section 179 expensing. As such, if the business interest limitation applies to a taxpayer, they need to consider the financing terms and interest expense relative to net income, as well as the implications of cost recovery/expensing of assets, and the QBI deduction.

If the taxpayer is not exempt and does not elect out of the limitation, business interest expense will be limited to the sum of:

  1. Business interest income and
  2. 30% of adjusted taxable income.

Adjusted taxable income is taxable income adjusted for income and expenses not related to a trade or business, net business interest, NOLs, QBI deduction, and depreciation. The depreciation addback only applies until January 1, 2022.

This limitation is calculated at the partner level as well as the partnership level, so the partner’s share of income from a partnership will be excluded at the partner level (since the limitation would already have been calculated at the partnership level). Currently, there is little guidance on the potential that a partner might elect out and the partnership might not (or vice versa), and the interplay with the calculation at the partner level.

There is a concept that any “excess taxable income” generated by the partnership can be used to calculate the partner’s individual limitation. Conversely, if the partnership passes through excess business interest expense in a tax year which could not be deducted, the interest will be retained at the partner level and deducted if there is excess taxable income from the partnership in a future tax year.

Due to the fact that this will be considered at the entity as well as owner level, there will be more reporting requirements for the partnership to ensure all the information that is needed to calculate the applicability of this limitation is passed through to owners.

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Article Dean Dorton

The Tax Cuts and Jobs Act includes a new deduction for individual business owners who conduct their activities through a sole proprietorship, partnership, or S corporation. Trusts and estates are also eligible to claim the deduction. The deduction is effective for taxable years beginning after December 31, 2017, but continues only through taxable years beginning prior to December 31, 2025. In a series of three articles, we will discuss the new deduction, its complexities, and its uncertainties. (Please note that the discussion below is based on the statute and committee explanations and is subject to change with additional guidance.)

The qualified business income (QBI) deduction is a 20% deduction from the net taxable business income of each separate qualified trade or business of the taxpayer, regardless of whether the business is conducted as a sole proprietorship or through a pass-through entity, such as a partnership or S corporation. The deduction is applicable regardless of whether the taxpayer has an active or passive role (for example, as a limited partner) in the operation of the business. Additionally, the new law provides for a 20% deduction with respect to certain qualified income from real estate investment trusts (REITs) and publicly-traded partnerships (PTPs).

The 20% deduction for each separate trade or business is subject to certain limitations related to wages paid and depreciable property owned and used by the business. There is an additional limitation for the combined business income deduction for each separate trade or business and the deductions related to REIT and PTP income based on the taxable income of the individual taxpayer. After this limitation is applied, the deduction is increased if the taxpayer has qualified cooperative dividends.

Although the next article will cover in more detail the definition of a qualified trade or business and type of business income that qualifies for the deduction, it should be noted that based on the statutory language, most retail, manufacturing, and real estate businesses, and many service businesses, should qualify. However, certain service businesses will not qualify for the deduction if the owner’s taxable income exceeds a certain amount.

As noted above, the qualified business income deduction is calculated separately for each qualified trade or business and then the combined amount is subject to the taxable income limitation. In determining the deduction for each separate business, the calculation begins with 20% of the net taxable business income of the business. This is the maximum deduction applicable to that business. There are special rules applicable to businesses with losses, which we will address later.

The next step is to determine the limitation based on the wages paid by the business and the depreciable property owned and used by the business. This limitation is only applicable if the owner’s taxable income for the year exceeds a certain “threshold amount” for the taxable year. The threshold amount for 2018 is $315,000 for taxpayers filing joint returns and $157,500 for all other taxpayers. These amounts will be adjusted for inflation. The limitation is “phased-in” after taxable income exceeds these amounts and is fully applicable when taxable income exceeds $415,000 and $207,500, respectively.

Generally, the deduction for each separate business is limited to the greater of two amounts.

The first amount is 50% of the “W-2 wages” of the business. W-2 wages include wages paid by the business that are subject to withholding plus certain deferred wages, such as Section 401(k) contributions. So, for example, if a business had $200,000 of wages paid including deferrals, this limitation amount would be $100,000.

The second limitation amount is the sum of 25% of W-2 wages plus 2.5% of qualifying depreciable property owned and used by the business. The property generally must be real property or personal property that was acquired within the last 10 years. The 2.5% is applied to the original cost or basis of the property, rather than the remaining undepreciated cost. Assuming the business in the above example had $1 million of qualifying property at the end of the tax year, this second limitation would be the sum of 25% of $200,000 for the wage component plus 2.5% of $1 million for the property component, or $50,000 + $25,000 = $75,000.

Accordingly, the higher of the two limitation amounts is $100,000, so the qualified business income deduction for this separate business would be limited to $100,000, regardless of the whether the 20% of business income was a higher amount. However, if the 20% amount is less than the limitation, say $50,000 in this example, then the deduction is limited to the 20%, or $50,000 in this example.

As noted above, the sum of the deductions for each separate trade or business, plus 20% of qualified REIT and PTP income, is limited by the taxable income of the owner (or owner and spouse if filing jointly). The combined deduction is limited to 20% of the taxable income in excess of capital gains and certain cooperative dividends. Although guidance has not been published, capital gains as defined in the legislation include capital gains from the sale of assets used in a business. The lower of these two amounts, plus 20% of certain cooperative income, is the final deductible amount on the tax return. The deduction cannot exceed taxable income for the year.

As noted above, there are special rules regarding losses at businesses that qualify for the new deduction. Generally, if a taxpayer has multiple businesses, a loss at one business will reduce the combined deduction for all other separate businesses with positive income for the tax year. Additionally, an overall loss for all businesses for the tax year will be carried over to the next tax year and reduce the deduction in the succeeding tax year.

In the next article, we will discuss the types of trades or businesses and the income that qualifies for the new deduction.

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Article Dean Dorton

Previously, we discussed changes to and expansion of existing tax law. In this installment, we will be addressing tax law that is entirely new. As such, there are still areas that will require further clarification from the IRS. We will discuss the law as passed on December 22, 2017 and our interpretation of the newly created Section 199A deduction, otherwise known as the “qualified business income deduction” or “20% business deduction.” The calculations as outlined in the Tax Cuts and Jobs Act are quite elaborate and involve a number of new definitions.

One of the most important new terms is “qualified business income” (QBI), which is defined as the income, gain, loss, or deduction from a qualified trade or business (defined below), in the U.S., and excludes investment income (short-term and long-term capital gains, dividends and interest, and a variety of other items).

Another new term is “qualified trade or business” (QTB). To be eligible for the QBI deduction, the income must be generated by a qualified trade or business. This is any trade or business other than “specified service trades or businesses,” which include the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financials services, brokerage services, any services related to investment management, and any trade or business where the principal asset is the skills and reputation of the employees or owners.

One important item to note: Even specified service trades or business are eligible for the deduction if the taxpayer’s income does not exceed certain thresholds. There is a phase-out for the specified service trades, so once taxable income exceeds $415,000 for joint returns, income generated from the specified service trades will not be considered QTB and therefore will not be considered for the QBI deduction.

There are two limitations on the deduction at the QTB level: the W-2 wage limitation and the W-2 wage and qualified property limitation. These limitations only apply if taxable income exceeds $315,000 for a joint return, or $157,500 for all other returns. If your income is less than this threshold, then none of the limitations apply, so the deduction calculation becomes less complicated.

The QBI deduction must be calculated separately for each QTB, then combined at the taxpayer level. Each QTB will calculate their QBI deduction as:

  1. The lesser of 20% of the QTB’s qualifying business income, or
  2. The greater of either
    1. 50% of W-2 wages of the QTB, or
    2. the sum of 25% of the W-2 wages plus 2.5% of the unadjusted basis of qualified property.

The unadjusted basis limitation will likely be of significant importance to the real estate industry. There will be additional tracking needed for assets placed in service, as there are limitations on the life for this deduction (which may differ from MACRS depreciation lives).

Once qualified business income is calculated at each QTB, it is then combined into one amount, the “qualified business income amount” (QBIA). The final QBI deduction is calculated as the lesser of the combined deduction for all QTBs or 20% of taxable income in excess of net capital gain.

If the net QBI is a loss, then it is carried forward to the next tax year to offset QBI. There is little guidance on how the carryover loss is applied to the separate QTBs, or the interaction with the other limitations.

This new 20% deduction from QBI is effective for taxable years beginning after December 31, 2017 through December 31, 2025. It applies to taxpayers other than C corporations, including trusts and estates, and is calculated at the owner level.

It does not reduce self-employment income, and is not modified for alternative minimum tax purposes. It also cannot increase a net operating loss.

One of the biggest unknowns at this time is how this QBI deduction will interact with the passive activity loss rules. This interplay will likely have significant impact to many involved in real estate. Another aspect, which has not been clarified at this point, is the impact of the aggregation rules for real estate, since the QBI deduction must be calculated for each separate trade or business.

While the word “simplification” was continuously mentioned during the negotiations and creation of the Tax Cuts and Jobs Act, it was definitely not considered with this new Internal Revenue Code section.

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Article Dean Dorton

By: Mike Shepherd

Is the recent Tax Cuts and Jobs Act a simplification or complication?

The short answer is yes. But how can it be both simplification and complication you ask? Congress works in mysterious ways.

The flagship change of the Tax Cuts and Jobs Act (TCJA) is that it cuts corporate rates from 35 percent to 21 percent in order to bring the United States more in line with corporate rates in the rest of the world. This is supposed to stimulate the economy and increase job growth, which in turn is supposed to increase the individual income tax base to help pay for the corporate rate decrease. At the same time the TCJA is supposed to simplify the tax code for most Americans.Simplification

Depending on where you pull the statistics, approximately 40 percent of U.S. taxpayers will itemize when filing their 2017 income tax returns. The TCJA implements changes that should drop that number to approximately 10 percent.

So when you hear the politicians touting simplification, they are referring to this large drop in itemized filing. The TCJA accomplishes this with some of the following changes:

  • Increase the standard deduction from $6,500 to $12,000 for single filers and $13,000 to $24,000 for married filing jointly
  • Increase the child tax credit from $1,000 to $2,000 per qualifying child, and increase the phase-out of these credits from $75,000 for single filers and $110,000 for married filers to $200,000 for single filers and $400,000 for married filers
  • Personal exemptions are suspended
  • Home equity line interest deductions are suspended
  • Charitable contributions for amounts paid for college athletic seating rights are suspended
  • Miscellaneous itemized deductions are suspended
  • Alimony deductions are suspended
  • Itemized deduction limitation is suspended
  • Casualty and theft losses are suspended
  • Moving expense deductions are suspended

Complication

For those left in the 10 percent itemization bucket and those with small businesses (which is most likely a lot of the readership of this publication), things get more complex. The TCJA will be a tax cut for most; however, many taxpayers—particularly those with high wages—will end up with a tax increase. A few of the complex changes are as follows:

  • The state and local tax deduction (income and property) is capped at $10,000. This change is particularly tough on those in high income tax states. Many don’t think of Kentucky as a high income tax state, but when you add in the local tax, taxpayers in Kentucky’s two most populous counties of Jefferson and Fayette pay between 8 percent and 9 percent, which is not low in relation to many other states.
  • The top individual tax rate is reduced to 37 percent from 39.6 percent, but the cap on the state and local deduction may still cause tax increases for some highly compensated Kentuckians.
  • The complicated individual alternative minimum tax (AMT) is retained with higher exemption amounts.
  • A new limitation is placed on “excess business losses.” This complex calculation is likely to hurt some small business owners and those with equine businesses by limiting the amount of currently deductible losses from those businesses.
  • A new qualified business income (QBI) deduction is added which creates a potential 20 percent deduction for businesses that qualify. A recent Forbes article did a Q&A on how this deduction and the related limitations work. The printed article is 39 pages long.

Anytime the tax law is changed dramatically, there are “ripples” in the new law which cause unintended consequences. It’s likely to take years for a lot of those items to be completely sorted out which adds to the complication.

Many CPA firms will be running side-by-side 2018 versus 2017 comparisons with their 2017 tax preparation process to help taxpayers better understand the implications of the TCJA. Further, many taxpayers may want to make changes during 2018 to adjust to the new law.

Time will tell if the TCJA accomplishes its goals. However, one thing is for certain; the TCJA is the most sweeping tax legislation we’ve had in over 30 years.

As always, please consult with your tax adviser regarding the changes that might be applicable to your specific situation.

As originally featured in Louisville’s Business First

Article Dean Dorton

Currently, home ownership comes with many tax-saving opportunities. Consider both deductions and exclusions when you’re filing your 2016 return and tax planning for 2017:

Property tax deduction. Property tax is generally fully deductible — unless you’re subject to the alternative minimum tax (AMT).

Mortgage interest deduction. You generally can deduct interest on up to a combined total of $1 million of mortgage debt incurred to purchase, build or improve your principal residence and a second residence. Points paid related to your principal residence also may be deductible.

Home equity debt interest deduction. Interest on home equity debt used for any purpose (debt limit of $100,000) may be deductible. But keep in mind that, if home equity debt isn’t used for home improvements, the interest isn’t deductible for AMT purposes.

Mortgage insurance premium deduction. This break expired December 31, 2016, but Congress might extend it.

Home office deduction. If your home office use meets certain tests, you generally can deduct a portion of your mortgage interest, property taxes, insurance, utilities and certain other expenses, and the depreciation allocable to the space. Or you may be able to use a simplified method for claiming the deduction.

Rental income exclusion. If you rent out all or a portion of your principal residence or second home for less than 15 days, you don’t have to report the income. But expenses directly associated with the rental, such as advertising and cleaning, won’t be deductible.

Home sale gain exclusion. When you sell your principal residence, you can exclude up to $250,000 ($500,000 for married couples filing jointly) of gain if you meet certain tests. Be aware that gain allocable to a period of “non-qualified” use generally isn’t excludable.

Debt forgiveness exclusion. This break for homeowners who received debt forgiveness in a foreclosure, short sale or mortgage workout for a principal residence expired December 31, 2016, but Congress might extend it.

The debt forgiveness exclusion and mortgage insurance premium deduction aren’t the only home-related breaks that might not be available in the future. There have been proposals to eliminate other breaks, such as the property tax deduction, as part of tax reform.

Whether such changes will be signed into law and, if so, when they’d go into effect is uncertain. Also keep in mind that additional rules and limits apply to these breaks. So contact us for information on the latest tax reform developments or which home-related breaks you’re eligible to claim.