Tax Cuts and Jobs Act alert: Today, the IRS has issued Notice 2018-76 providing guidance on the business expense deduction for meals and entertainment. For more information, contact your Dean Dorton advisor or Melissa Hicks.
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Tax
The Tax Cuts and Jobs Act includes a new section of the tax code that allows taxpayers to take advantage of a new investment vehicle called a qualified opportunity fund. This fund is organized as a corporation or partnership that holds at least 90% of its assets in qualified opportunity zone property.
An opportunity zone, per the IRS, is an economically-distressed community where new investments (under certain conditions) may be eligible for preferential tax treatment. These zones are designed to spur economic development and job creation in distressed communities.
The IRS has issued Notice 2018-48, which lists the qualified opportunity zones that were previously nominated by the states and certified by the Treasury Department.
This means taxpayers who have capital gains from other projects or securities can roll those funds into a newly created qualified opportunity fund, and defer paying taxes on those gains for a period of time, and possibly exclude a portion of the gains from taxation. If there are gains created while invested in the opportunity fund and the investment is maintained for 10 years, there may be an opportunity to permanently exclude payment of tax on those gains in excess of the original deferred gain.
You do not have to live or work in a qualified opportunity zone in order to invest in a qualified opportunity fund. You can self-certify by attaching a form to your timely filed tax return.
On April 9, 2018, the Treasury Department certified 144 Kentucky census tracts and 156 Indiana census tracts as opportunity zones.
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For more information, contact your Dean Dorton advisor or: Faith Crump, fcrump@deandorton.com |
You are probably aware that late last year, The Tax Cuts and Jobs Act (TCJA) made substantial alterations to the tax laws, resulting in sweeping changes to individuals and businesses. Although not specifically addressing the energy sector, many of these modifications will have a positive impact on energy companies.
One of the changes effectively lowered the cost of capital equipment acquisitions by changing the rules for bonus depreciation. Under previous tax rules, 50% bonus depreciation was available for certain “new” eligible property used in a business or in an income producing activity. By accelerating the deduction for machinery, most software, and real property, 50% bonus depreciation was able to lower the true economic cost of these assets. Under TCJA the bonus depreciation is now 100%, generally only applying to property that is acquired and placed in service after September 27, 2017.
Bonus depreciation is available for new and the majority of previously used property, as opposed to before the Act, where property was required to be new. However, the used property will now qualify unless the taxpayer both (1) previously used the property and (2) acquired the property in certain forbidden and tax free transactions, or through a related person or entity. Similar to before, taxpayers should sometimes make the election to turn down bonus depreciation (an “election-out”). Sole proprietorships and entities taxed under the rules for partnerships and S corporations still want to make sure that they don’t “waste” these deductions by applying them against lower-bracket incomes in the year property was placed in service when given an opportunity to apply them against higher bracket income in later years. Under the Act, entities taxed as “regular” corporations are taxed at a flat rate.
While these are the major aspects of bonus depreciation, the TCJA made several smaller significant changes. Even without amendment, TCJA bonus depreciation is a complicated area with tax implications for transactions that are not simple asset acquisitions. There are phase-outs away from 100% over the next few years until bonus deprecation is generally no longer available under current law, beginning after December 31, 2026.
The multitude of changes brought by TCJA can impact your business, with bonus depreciation being only one. Consult with your tax advisor when considering asset acquisitions to get the most benefit from tax savings from these changes in the law.
For more information, contact your Dean Dorton advisor or Bert Layne, CPA at blayne@deandorton.com.
After vigorous debate on the floors of both the Kentucky Senate and House of Representatives, on Monday, April 2, the General Assembly passed the Free Conference Committee Substitute for HB 366. The bill, which might be called “Tax Reform Lite,” makes significant changes to Kentucky’s tax code, but many argue there is much reform left to be done.
The bill raises Kentucky’s cigarette tax by 50 cents to $1.10 per pack and includes changes to Kentucky’s individual and corporation income taxes, sales and use tax, and one small, but important change, to the state’s property taxes. Additionally, the bill limits and suspends some existing tax credits and incentives. Here is a brief look at a few of the more significant provisions of the bill.
Individual income tax
- In large part, changes made in December to the federal tax code are incorporated into the state tax code. The primary exception is Kentucky will not adopt the increased expensing and depreciation provisions for capital improvements.
- The current graduated tax system, with rates ranging from 2% to 6%, is converted to a flat rate of 5% for all taxpayers effective for tax years beginning on or after January 1, 2018.
- The personal credit of $10 per person is repealed.
- For taxpayers that itemize deductions, the only itemized deductions that will be allowed are deductions for mortgage interest and charitable contributions. All other itemized deductions, that is, deductions for the cost of medical insurance, medical expenses, local occupational taxes and property taxes paid, interest expense on investments, casualty and theft losses, and other miscellaneous deductions are eliminated.
- Long-term care and health insurance premiums allowed previously as a deduction from Kentucky adjusted gross income are no longer allowed.
- Historically, Kentucky has permitted $41,110 per person of pension income to be excluded from taxable income. With this bill, that exclusion is reduced to $31,110 per person. Social Security continues to be fully exempted from Kentucky income tax.
Corporation income tax
- As with the individual income tax, the corporation income tax is conformed to the federal tax code as amended in December. Again, the primary exception is Kentucky will not adopt the increased expensing and depreciation deductions for capital improvements.
- Similar to the recent federal changes, the deduction for domestic production activities is eliminated.
- The current graduated tax system, with a top rate of 6%, is converted to a flat rate of 5% for all taxpayers effective for tax years beginning on or after January 1, 2018.
- Companies that do business in Kentucky and other states will apportion their income to Kentucky using a single-factor apportionment formula, as opposed to the current three-factor apportionment formula. The sales factor for service entities will now be computed based on market-sourcing as opposed to the current cost of performance methodology.
Property taxKentucky is one of only a handful of states that imposes a property tax on business inventory. The bill attempts to “phase-out” this tax by allowing a non-refundable income tax credit of 25% for taxes paid in 2018 and increasing the credit by 25% each year until there is a 100% credit for taxes paid on business inventory for years beginning on or after January 1, 2021. Stated otherwise, the property tax will remain, because of its importance to local governments, but taxpayers will receive a non-refundable credit against their state income tax for the inventory tax they pay.Sales and use tax
Effective for transactions occurring on or after July 1, 2018, the bill imposes sales and use tax for the first time on the following:
- Labor and services associated with the repair, installation, and maintenance of taxable tangible personal property;
- Extended warranties;
- Landscaping and lawn care services;
- Janitorial services;
- Pet care (small animal) veterinarian services;
- Industrial laundry services;
- Dry cleaning and laundry services;
- Linen supply services;
- Pet grooming and boarding services;
- Diet and weight-reducing services;
- Tanning services;
- Limousine services; and
- Admissions to campsites, campgrounds, recreational vehicle parks, bowling centers, skating rinks, health spas, swimming pools, tennis courts, weight training facilities, fitness and recreational sports centers, golf courses, and country clubs.
The bill repeals the sales tax exemption for pollution control facilities for transactions occurring on or after July 1, 2018.
Credits and incentivesThe Kentucky Industrial Revitalization Tax Credit, Kentucky Investment Fund Tax Credit, and Kentucky Angel Investor Tax Credit are suspended for four years to provide time for the General Assembly to study the impact of the credits. Also, the film tax credit, which has been subject to negative press, is retained but limited by the bill.Revenue estimatesThe tax bill is estimated to provide additional revenue of $234.1M in fiscal year 2019 and $244.1M in fiscal year 2020. Much debate took place in the House as to the accuracy of these estimates.ConclusionThe Tax Foundation, a leading independent tax policy research organization, has stated the changes instituted by HB 366 will move Kentucky from 33rd to 18th on the State Business Tax Climate Index published by the Foundation.
In that case, a constitutional majority (51 votes in the House and 20 votes in the Senate) could override the Governor’s veto.
If you have any questions, please contact your Dean Dorton advisor or Erica Horn at ehorn@deandorton.com.
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.
In Part 1 of this Tax Cuts and Jobs Act QBI deduction series, we discussed the computation of the deduction and the limitations on the deduction based on wages, property, and taxable income. In Part 2, we will discuss the businesses that qualify for the deduction and the types of income that qualify. (Please note that the discussion below is based on the statute and committee explanations and is subject to change with additional guidance.)
The legislation describes which trades or businesses are eligible for the deduction by defining those that are not eligible for the deduction. These ineligible businesses are defined as “specified service” trades or businesses. The statute provides that the specified service trades or businesses below do not qualify for the deduction:
- Services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage
- Any trade or business where the principal asset is the reputation and skill of one or more employees or owners
- Services involving investing, investment management, trading, or dealing in securities, partnership interests, or commodities
Additionally, performing services as an employee does not qualify. Even though these businesses do not qualify for the deduction, there is an exception to this disallowance, if the taxable income of the taxpayer is below a certain amount, which will be discussed in Part 3 of this series.
The listing of the various disqualified businesses above raises several questions since the businesses are very broad. For example, performing arts and athletics are not eligible, but is operating a theatre or athletic facility, or leasing the facility to the operator, also ineligible? Do consulting services include management services? Additionally, the application to businesses where the principal asset of the business is the reputation or skill of the employees or owners is uncertain. Does this apply only to pure service businesses, or does it apply to such businesses as restaurants, home improvement, and so forth?
Additionally, no guidance has been issued with respect to multiple businesses owned by the same taxpayer. For example, a taxpayer may own three businesses—a manufacturing business, a sales business, and a management company that manages both businesses. The deduction may be significantly different depending on whether these businesses are grouped as one or treated as separate for the calculation of the deduction. However, at this time, there is no guidance on how to treat these related businesses.
The deduction applies to qualified business income from a business that is conducted in the United States. Accordingly, businesses operated outside the United States do not qualify. Guidance is needed for businesses with operations within and outside the United States.
Qualified business income is the sum of all income, gain, deduction, and loss from the business that is reportable or allowable in determining taxable income. This does not include nonbusiness and investment income in the form of short-term and long-term capital gains, dividends, interest, commodity, and foreign currency gains and losses, and other investment income, and the deductions related to nonbusiness and investment income. Additionally, it does not include wages paid to an S corporation shareholder or certain guaranteed and other payments to partners for services.
One item of business income where the application is unclear is capital gains and losses from a business. For example, the gain on the sale of a building used in a business or rented to a tenant may already be taxed at 20%. The additional deduction could lower the effective rate of tax on this gain to 16%.
As noted in Part 1 of this series, income from partnerships and S corporations qualify for the deduction at the partner or shareholder level. This pass-through entity will be required to provide the required information related to business income, wages, and property to its partners or shareholders to permit them to calculate their deduction for each separate business. The pass-through entities may need to provide this information for multiple businesses if the entity has more than one business. Guidance is needed to determine the number of qualified businesses in these circumstances and the allocation of income, gains, deductions, and losses to each separate business.
Additionally, trusts and estates may both claim the deduction at the trust or estate level and distribute business income, wages, and property amounts to beneficiaries based on distributable net income so that they can claim a deduction. The rules related to trusts, estates and beneficiaries are complex and beyond the scope of this article.