Tax Reform Session 2 Presented by Brendan Mc
Tax Reform Session 2 Presented by: Brendan Mc. Auliffe, CPA Chris Julien, CPA Berntson Porter & Company, PLLC in Bellevue, WA (Greater Seattle area) 11/3/2020 Berntson Porter & Company, PLLC © 2018 1
Outline • 179 Expensing • Section 199 A – The 20% Deduction • Section 163(j) – Interest Expense Limitation • Section 461(l) – Excess Business Loss Limitation • Section 1400 Z-1 & -2 – Opportunity Zones 11/3/2020 Berntson Porter & Company, PLLC © 2018 2
Section 179 Expensing • Section 179 is increased to $1 million. • Phase-out of qualified assets starts at $2, 500, 000 • Qualified real property is eligible with an election – QIP – Property Below • Can also now take Section 179 on: – Roofs – HVAC – Fire protection and alarm systems, – Security systems 11/3/2020 Berntson Porter & Company, PLLC © 2018 3
Section 179 Expensing • • • This will be important for QIP expensing, as 179 is the only avenue to avoid 39 year straight line treatment Don’t forget about trusts – No 179 allowed. (Some grantor, QSST, and ESBTs can) 179 cannot reduce income below zero, but can carry forward at the entity level at worst, possibly creating a 2 year depreciation life Operating company may be able to support the taxable income limitation of 179, but consider that all property eligible to take 179 is factored into the $2. 5 M acquisition limit, which would include elected QIP since now eligible for 179 and amounts expensed using bonus depreciation. 179 will have limited applicability due to income limitations, bonus depreciation, and potential recapture. Bonus is Better! 11/3/2020 Berntson Porter & Company, PLLC © 2018 4
Section 179 Expensing • Taxpayer with an existing building places in service $300, 000 of exterior renovations, $350, 000 of HVAC, and $30, 000 of personal property. • Taxpayer’s income before Sec. 179 expense is $400, 000. – No bonus/Sec. 179 on exterior. Full Sec. 179 on HVAC. Full bonus/Sec. 179 on personal property. • Taxpayer’s income before Sec. 179 expense is ($100, 000). – No bonus/Sec. 179 on exterior. No Sec. 179 on HVAC. Full bonus on personal property. • Taxpayer’s income before Sec. 179 expense $100, 000. – No bonus/Sec. 179 on exterior. Partial Sec. 179 on HVAC. Full bonus on personal property. 11/3/2020 Berntson Porter & Company, PLLC © 2018 5
Section 179 Expensing • What if we add another zero? • Taxpayer with an existing building places in service $3, 000 of exterior renovations, $3, 500, 000 of HVAC, and $300, 000 of personal property. • Now the election to treat qualifying real property as Sec. 179 property pushes the taxpayer above the phase-out limit. No Sec. 179 would be available for any property. 11/3/2020 Berntson Porter & Company, PLLC © 2018 6
Overview: Section 199 A Deduction • For tax years beginning after December 31, 2017 and before January 1, 2026, Section 199 A grants a deduction of up to 20% of the Qualified Business Income (QBI) for each of the taxpayer’s qualified trades or businesses (subject to limitations). • This applies to income from sole props, partnerships, S corps, trusts, and estates • Applies in full to a taxpayer’s qualified REIT dividends and qualified PTP income. • The deduction cannot exceed 20% of taxable income (reduced by net capital gain) of the taxpayer for the taxable year. – This serves to only give a 20% deduction to income not taxed at a preferential tax rate. 11/3/2020 Berntson Porter & Company, PLLC © 2018 7
Overview: Section 199 A Deduction • When taxable income exceeds the threshold amount (next slide), two additional limitations apply. – 1) Limitation on specified service businesses (SSBs) – 2) Limitation on W-2 wages paid and/or qualified property held by the business 11/3/2020 Berntson Porter & Company, PLLC © 2018 8
Overview: Section 199 A Deduction • Threshold amount: No limitations apply when taxable income (before 199 A) is less than $315 K for MFJ and $157. 5 K for all others. • Phase in range: The prohibition on SSBs and the wage/property limits are phased in over the next $100 k for MFJ, 50 k for all others. • Limits apply in full at $415 k for MFJ, $207. 5 k for all others. • The threshold is adjusted for inflation annually 11/3/2020 Berntson Porter & Company, PLLC © 2018 9
Overview: Limitations of 199 A • For taxpayers with taxable income above the phase-in range: – QBI for each qualifying trade or business is limited to the greater of: • 50% of the trade or business’ W-2 wages attributable to QBI; or • 25% of the trade or business’ W-2 wages attributable to QBI plus 2. 5% of the unadjusted basis immediately after acquisition (UBIA) of the trade or business’ qualified property for each qualified trade or business – QBI does not include income from a specified service trade or business (SSTB) • QBI is limited to income that is effectively connected with the conduct of a US trade or business. 11/3/2020 Berntson Porter & Company, PLLC © 2018 10
199 A Loss Carryovers • If total QBI is below zero, no deduction will be allowed, and the loss is treated as negative QBI from a separate activity in the next year. • This does not affect whether the loss is allowable for income tax purposes. • Example: S allocates a 20 k loss to A in 2018. A has no other QBI. A materially participates in S, has basis and at risk. The loss is allowable against A’s other taxable income. The 20 k QBI loss carries forward to 2019 and would offset any QBI generated by S in 2019 by as much as 20 k, which would eliminate the carryforward if 20 k of income or more was generated. 11/3/2020 Berntson Porter & Company, PLLC © 2018 11
What is Qualified Business Income (QBI)? • What is “qualified business income (QBI)? ” – Income taxed at ordinary rates from a qualifying sole proprietorship, rental property, LLC, S corporation, or partnership – Does not include: • Interest income • Dividend income • Other portfolio income & other portfolio deductions (e. g. 212 real estate taxes) • Long-term/short term capital gain/1231 gain characterized as capital 11/3/2020 Berntson Porter & Company, PLLC © 2018 12
What is Qualified Business Income (QBI)? • Special items: – 751 ordinary income on sale of hot assets is QBI – 1245 or 1250 ordinary income recapture is QBI – 481 adjustments related to the business that extend into 2018 are QBI – Does not include guaranteed payments or reasonable compensation received by a shareholder in an S corp – Planning note w/ guaranteed payments: No requirement to pay these to partners, unlike S corporation requirement for reasonable comp. Since partnership and LLC agreements are flexible, consider other ways to compensate those partners for services via special distributions to increase QBI to all partners and eliminate income that cannot receive the deduction. 11/3/2020 Berntson Porter & Company, PLLC © 2018 13
What is Qualified Business Income (QBI)? • Special items: – Previously suspended losses under 704(d), 1366(d) (basis), 465 (at risk), 469 (passive) do reduce QBI when allowable in 2018 -2025 but only if generated post 2017. – Problem here is that suspended losses do not have ordering rules in terms of the year generated and the IRS will presumably have to create them. – Example: On 12/31/18, A has $200 k of suspended losses from S Corp. $100 k of the loss is from 2017, $100 k is from 2018. In 2019, S gives A a K-1 with 100 k of income. A uses the $100 k of suspended loss against the $100 k of income to report $0. Which year is the $100 k loss from? If 2017, A still has QBI of $100 k. If 2018, QBI is $0. – 1231 gain that ends up taxed as capital gain will NOT receive a 199 A deduction. 1231 losses or gain that is ordinary due to nonrecaptured 1231 losses over prior 5 years will be QBI. 11/3/2020 Berntson Porter & Company, PLLC © 2018 14
What is Qualified Business Income (QBI)? • Special items: – 1231 gains are not QBI because they are taxed at preferential rates, but there is growing support to include 1231 gains based on multiple comments in the recent public IRS hearing on the proposed 199 A regulations. – Because 1231 is “business income”, it stands to reason it should be QBI in all cases, which would create simplification at a minimum. 11/3/2020 Berntson Porter & Company, PLLC © 2018 15
Trade or Business of being an Employee • No 199 A deduction will be allowed regardless of taxable income if service provider is performing services as an employee even if receiving a 1099. • For 199 A only, if an individual who was an employee is subsequently treated as an independent contractor, but continues to perform substantially the same services, the individual is presumed to be an employee and no 199 A deduction allowed. • Presumption can be rebutted by showing that under federal law the individual is no longer an employee. • Becoming a partner in a firm should not have this problem, but depending on type of firm, could end up in the specified service limitations. 11/3/2020 Berntson Porter & Company, PLLC © 2018 16
Specified Service Trade or Businesses • Specified Service Trade or Business (SSTB) – any trade or business involving the performance of services in the fields of: – Health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners – A trade or business that involves the performance of services that consists of investing and investment management, trading, or dealing in securities, partnership interests, or commodities – Excludes architecture and engineering from definition meaning those businesses should be eligible for 199 A deduction. 11/3/2020 Berntson Porter & Company, PLLC © 2018 17
Specified Service Trade or Businesses • The determination of whether a business is an SSTB is made at the business level. Reg. 1. 199 A. 6(b)(3): a relevant business entity must separately identify and report on the Schedule K-1 issued to its owners whether any business engaged in directly by the relevant business entity is an SSTB. • Example: – Billy is a CPA. Billy is an owner in an engineering firm S-corporation, but performs all accounting functions, which is an SSTB. The determination of the nature of the business is done at the S-corporation level (business level). Because engineering is not an SSTB, on the K-1 the S-corporation provides Billy will not designate the business as an SSTB. Thus, Billy would not be prohibited from claiming the S 199 A deduction. 11/3/2020 Berntson Porter & Company, PLLC © 2018 18
Field of Consulting • • Disqualified: – Those who provide professional advice to assist their client achieve goals and solve problems. Includes lobbyists. Not disqualified: – Does not include consulting that is embedded into the sale of goods/services that are not separately billed for Example: D is in the business of licensing software to customers. D discusses and evaluates the customer's software needs with the customer. The taxpayer advises the customer on the particular software product it licenses. D is paid a flat price for the software license. After the software is sold, D helps to implement the software for no extra fee. D is engaged in the trade or business of licensing software; not consulting. This is not an SSTB. 11/3/2020 Berntson Porter & Company, PLLC © 2018 19
Field of Health • • Disqualified: – Doctors, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologist, and other similar healthcare professionals who provide medical services “directly to a patient”. Not disqualified: – Health clubs, spas, trainers, instructors, pharmaceutical research, manufacturing, sales 11/3/2020 Berntson Porter & Company, PLLC © 2018 20
Fields of Law and Accounting • • Disqualified: – Everyone Not disqualified: – No one 11/3/2020 Berntson Porter & Company, PLLC © 2018 21
Field of Financial Services and Investment Management • • Disqualified: – Financial advisors, investment bankers, wealth planners, retirement advisors. Not disqualified: – Banks! Disqualified: – Receipt of fees for providing investing, asset management, or investment management services, including providing advice with respect to buying and selling investments. Not disqualified: – Property management! 11/3/2020 Berntson Porter & Company, PLLC © 2018 22
The Catch-All • An SSTB includes: "Any trade or business where the principal assets of such trade or business is the reputation or skill of one or more of its employees or owners. " • This was very concerning prior to the proposed regulations. • The proposed regulations, however, interpret this VERY narrowly. 11/3/2020 Berntson Porter & Company, PLLC © 2018 23
The Catch-All Example: H is a well known chef and the sole owner of many restaurants. H is so well known, H receives $500, 000 in endorsement income for the use of his name on a line of cookware. • Proposed regs: The business of endorsements is an SSTB. The restaurants, however, are not an SSTB, even though the chef is extremely skilled and famous. This is great news. • What if the endorsement income is collected by an entity that owns one of the restaurants? Is the endorsement treated as a separate business, so that only it is treated as SSTB income, and the income from the restaurant is preserved as non-SSTB income? Can we use the de minimis rule (discussed shortly) to make the endorsement income non-SSTB income? 11/3/2020 Berntson Porter & Company, PLLC © 2018 24
De Minimis Rule • A business will not be an SSTB if: – Gross receipts are less than $25 M for the year and, – Less than 10% of the gross receipts are attributable to the performance of services in one of the disqualified fields. • Ex. S Co. , an S corporation, has $20 M in sales in 2018 from the sales of computer software. It also sold $2 M from separately- billed consulting revenue from helping the clients implement the software. While the consulting work is an SSTB, because the revenue from the work is less than 10% of the total revenue, it is ignored and none of the business is from an SSTB. (2 M/22 M = 9. 09%) 11/3/2020 Berntson Porter & Company, PLLC © 2018 25
De Minimis Rule • A business will also not be an SSTB if: – Gross receipts are greater than $25 M for the year, – Less than 5% of the gross receipts are attributable to the performance of services in one of the disqualified fields. • Ex. S Co. , an S corporation, earns $50 M in 2018 from the sales of computer software. It also earns $2 M from separately- billed consulting revenue from helping the clients implement the software. While the consulting work is an SSTB, because the revenue from the work is less than 5% of the total revenue, it is ignored and none of the business is from an SSTB. (2/52 = 3. 8%) 11/3/2020 Berntson Porter & Company, PLLC © 2018 26
De Minimis Rule • Uncertainty remains around what happens when de minimis scale is tipped • Does this mean you have a separate TOB activity to report and one activity is non SSTB and another SSTB? • Or does it mean the entire business in not qualified? • For now, we have to assume no income would qualify for a deduction unless owners’ income is below the threshold. 11/3/2020 Berntson Porter & Company, PLLC © 2018 27
Commonly Controlled Businesses • • • An SSTB includes any business that provides 80% or more of its services or property to a commonly controlled business. Common control: the same owners own 50% or more of both businesses, using the relationship rules of Sections 267(b) and 707(b). Example: LLC provides legal services. To maximize 199 A benefits, the owners form P 2 to own the office building that will be rented entirely to LLC, and P 3, which will provide administrative services to LLC. Because P 2 rents all of its property to LLC, and because P 3 provides all of its services to LLC, and because LLC, P 2 ad P 3 are commonly controlled, ALL THREE BUSINESSES ARE TREATED AS SSTBs. 11/3/2020 Berntson Porter & Company, PLLC © 2018 28
Commonly Controlled Businesses • Is there a planning idea here? Ex. A and B own 100% of Law Firm. C and D own 100% of Accounting Firm. A, B, C, D and E buy a building in a new LLC: A and B own a combined 48%, C and D own a combined 48%, and E owns 2%. The LLC rents the building 50/50 to Law Firm and Accounting Firm. • Law Firm and LLC are not commonly controlled because no group of owners own more than 50% of both. Same goes for Accounting Firm and LLC. Does this now allow the rental income paid from Law Firm and Accounting Firm to C to escape recharacterization as SSTB income? 11/3/2020 Berntson Porter & Company, PLLC © 2018 29
Commonly Controlled Businesses • The point of these rules is to kill the "cracking" idea. And there is one more way the regulations do that: • If a non-SSTB is commonly controlled with a SSTB, shares expenses with the SSTB, and has gross receipts of 5% or less of the total combined gross receipts, it is treated as an SSTB, even if it otherwise would not have been. Example: A, a dermatologist, earns $600, 000 in 2018 from seeing patients. A also owns a business that sells skin care, and that shares employees and office space with the dermatology clinic. Total revenue from the skin care line is $20, 000. The skin care line is treated as an SSTB, because the businesses are commonly controlled, share expenses, and the revenue of the skin care line is less than 5% of the total combined receipts of $31, 000. 11/3/2020 Berntson Porter & Company, PLLC © 2018 30
Qualified Business • Qualified Trade or Business – 199 A requires the business to rise to the level of a § 162 trade or business, other than the trade or business of performing services as an employee. – In addition, renting or licensing tangible or intangible property to a commonly controlled business will be treated as a § 162 trade or business. • Common Control: same person or persons own 50% or more of both businesses • Commonly controlled business can be a relevant passthrough entity or a CCorporation • Good for self-rentals; rental income from self-renting will rise to the level of a TOB for 199 A 11/3/2020 Berntson Porter & Company, PLLC © 2018 31
Qualified Business • 162 TOB not defined in the Code. Definition per Groetzinger v Comm. : – “We accept the fact that to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement diversion does not qualify. ” Prior to now, this only mattered with respect to 1231 losses and NOL creation since deductions against rental income allowable under 62(a)(1) when business and 62(a)(4) when merely a for profit activity not rising to the level of a TOB. 11/3/2020 Berntson Porter & Company, PLLC © 2018 32
Rental Trade or Business • In most instances, the courts have not asked much for a rental to rise to the level of a trade or business • Good news: Gilford – the rental of multiple properties, in one entity, in which the owner was not hands on, was a trade or business, The court focused on the amount of work required by the management agent, saying: “If such management was a trade or business, the taxpayer was so engaged although she acted only through an agent. ” 11/3/2020 Berntson Porter & Company, PLLC © 2018 33
Rental Trade or Business • Really good news: Fackler – the rental of a single commercial building was a trade or business, the court said: “Where the owner of depreciable property devotes it to rental purposes and exclusively to the production of income, the property is used by him in a trade or business. ” 11/3/2020 Berntson Porter & Company, PLLC © 2018 34
Rental Trade or Business • Better news: Hazzard and Stratton - rental of a single family residence is a trade or business. "The court has repeatedly held that the renting of improved real estate constitutes the carrying on of a trade or business, regardless of whether or not the taxpayer engaged in any other trade or business. " • But see Grier. Much higher standard required by the 2 nd Circuit. 11/3/2020 Berntson Porter & Company, PLLC © 2018 35
Rental Trade or Business • Bad news: Neill, Rev. Rul. 75 -322 - Triple net lease is not a trade or business. • Triple-net lease is akin to owning stock? • Factors to consider: – Nature of property; number of tenants, length of lease – How was the property acquired? – Level of involvement by owner 11/3/2020 Berntson Porter & Company, PLLC © 2018 36
1. 199 A-4 Aggregation • Aggregation – allows taxpayers to treat multiple trades or businesses as a single trade or business for purposes of applying the wage and qualified property limitations (Proposed Regulation Section 1. 199 A-4 provides rules for aggregation) • To aggregate multiple trades or businesses: – Each trade or business must independently qualify as a trade or business – There must be majority ownership by the same person or group of persons – No trade or business may be a Specified Trade or Business – Trades or businesses must be integrated 11/3/2020 Berntson Porter & Company, PLLC © 2018 37
1. 199 A-4 Aggregation • The same group of persons, directly or indirectly, owns 50% or more of each TOB to be aggregated. For S corps, this means issued and outstanding shares. For a partnership, means capital or profits. • 50% majority needs to be in place for the majority of the year • All items of QBI must be reported in the same taxable year (i. e. all calendar year). • Must be able to answer 2 of the 3 questions below yes: – 1) Do the TOBs provide products or deliver services that are either the same or “customarily delivered together”? – 2) Do the TOBs share facilities, personnel, accounting, legal, manufacturing, purchasing, HR, or IT resources? – 3) Do the TOBs coordinate operations or rely on each because they create part of a supply chain? 11/3/2020 Berntson Porter & Company, PLLC © 2018 38
1. 199 A-4 Aggregation • To make the aggregation election, a statement will be attached to the return identifying the aggregated TOBs, a short description, and the EIN. • Statement will appear on each year’s return and omitting the stmt gives the IRS the right to disaggregate. • Consistency is required. Changes can occur if a new business is started or acquired or if facts and circumstances warrant a change. • Aggregation means that the QBI, W 2 wages, and depreciable property (UBIA) are combined to compute the 199 A deduction and potential limitations. 11/3/2020 Berntson Porter & Company, PLLC © 2018 39
Determination of Wages • The W-2 wage rules and UBIA of qualified property are relevant for taxpayers that have taxable income in excess of the taxable income threshold, as W-2 wages or the UBIA of qualified property are limitations to the deductible amount of trade or business QBI – Taxpayers with taxable income at or below the taxable income threshold do not apply wage and qualified property limitations to determine the QBI of a trade or business ($157, 500 for single, $315, 000 for MFJ) – Limitations phase in over next $50 k of income for single, 100 k for MFJ 11/3/2020 Berntson Porter & Company, PLLC © 2018 40
Determination of Wages • “W-2 wages” are the total wages subject to wage withholding, elective deferrals, and deferred compensation paid by the qualified trade or business with respect to its employees during the calendar year ending during the tax year of the taxpayer • Proposed regulations allow for wages to be allocated under 1. 199 A-2 if wages were paid to “common law employees or officers” of the business • This extends to professional employer organizations • Notice 2018 -64 provides guidance on allocations • 1. 199 A-2 is a backup plan for businesses that aren’t aggregated under the 1. 199 A-4 regulations 11/3/2020 Berntson Porter & Company, PLLC © 2018 41
Determination of Wages • 3 methods for reporting wages: • 1) Unmodified box method – pick box 1 or box 5 wages from W-3. Note: Box 1 shows wages subject to FIT including S corp SH medical. Doesn’t include elective deferrals or employee contributions to 401 k plans. Box 5 not always > Box 1 due to SH medical, but in general box 5 should be higher. • 2) Modified Box 1 method – box 1 plus elective deferrals reported in box 12 of W 2 and properly coded D, E, F, G, and S. This method should be used with S corps since it would include SH medical and elective deferrals unlike option 1. • 3) Tracking wages method – Track W 2 wages subject to FIT WH making appropriate modifications. Required for short years. 11/3/2020 Berntson Porter & Company, PLLC © 2018 42
Determination of UBIA • UBIA is “unadjusted basis immediately after acquisition” related to qualified property. In general, this is original cost under Section 1012. • Qualified property: – Tangible property subject to deprecation – Held at the end of the tax year and used in the business – Depreciable period (10 years or class life, whichever is longer) cannot have ended before end of tax year – Basis adjustments under 734 and 743 are not qualified property. – Does NOT include property acquired within 60 days of year end and disposed within 120 days unless used for 45 days. 11/3/2020 Berntson Porter & Company, PLLC © 2018 43
Determination of UBIA • Depreciable property contributed to a partnership or corporation comes in at its adjusted basis, not original cost. • Example: A acquires machinery in 2016 for $10 k in her Schedule C. As of 12. 31. 18, the UBIA is $10 k and the AB is $0 due to 100% bonus. On 1. 1. 19, A contributes this machinery to S corp in a Sec. 351 transfer in exchange for stock of the S corporation. In the 2019 return, the UBIA on this piece of property is now $0. • Some Schedule Cs will benefit from conversion to S corps for 199 A purposes (and SE tax), but this issue needs to be considered. • If A was an LLC, a F 2553 only conversion to S status would prevent the $0 UBIA result, but this approach is not recommended in most cases due to potential S corporation election problems contained in many LLC agreements. 11/3/2020 Berntson Porter & Company, PLLC © 2018 44
Determination of UBIA • UBIA is not reduced by any depreciation expense, bonus, 179, or credits taken that otherwise reduce basis (e. g. electric car credit) • Depreciable period is the later of: • 10 years or the last day of the last full year of the recovery period. • Example: A buys a 10 k machine on 11/18/2014 that has a 5 year recovery period. This UBIA will be 10 k from 2014 -2023 because the qualifying period is the longer of 5 years or 10 years. • Example: A buys a $1 M nonresidential bldg. where $800 k is allocated to the bldg. ; 200 k to land. The 800 k is UBIA from 2014 -2052, the last full year of depreciation. 11/3/2020 Berntson Porter & Company, PLLC © 2018 45
Determination of UBIA • 1031 (like kind exchange) & 1033 (involuntary conversion) transactions: Date replacement property is PIS is split and the UBIA can be reduced. • Substituted basis is deemed PIS when original asset was PIS. • Excess basis is deemed PIS on day replacement property PIS. • Example: In 2014, S acquires a nonresidential bldg. for $1 M. In 2018, when basis in $600 k, S exchanges its building plus $250 k for another building in a 1031 exchange. • 600 K is UBIA from 2014 -2052 and 250 K is UBIA from 2018 -2056 11/3/2020 Berntson Porter & Company, PLLC © 2018 46
Determination of UBIA • Lack of disclosure of UBIA info on return/K-1 s means IRS presumes a $0 for UBIA. • Special rules exist for allocating qualifying property to partners and shareholders • Partner/shareholder share of tax depreciation/total depreciation * UBIA • This doesn’t account for basis of property with no tax depreciation, so for those properties, UBIA is allocated to partners the way gain would be allocated under 704(c). – First, to contributing partner up to pre contribution gain – Then, in accordance with nonrecourse deductions – Then, profit ratios 11/3/2020 Berntson Porter & Company, PLLC © 2018 47
Example: Above Threshold • TI = 880 K (assume no capital gain included) • QBI = 900 K • W 2 wages = 300 k UBIA = 30 k • Tentative deduction = 900 k * 20% = 180 k • Wage limit = 300 k * 50% = 150 K • Wage & property limit = (300 k * 25%) + (30 k * 2. 5%) = 75, 750 • Deduction = 150 k 11/3/2020 Berntson Porter & Company, PLLC © 2018 48
Example: Within Threshold • TI = 375 K (assume no capital gain included) • QBI = 300 K • W 2 wages = 40 k UBIA = 0 • Tentative deduction = 300 k * 20% = 60 k • Wage limit = 40 k * 50% = 20 k • Wage & property limit = (40 k * 25%) + (0 * 2. 5%) = 10 k • Deduction = 36 k (375 k-315 k=60 k/100 k = 60% * tentative deduction 60 k = 36 k) 11/3/2020 Berntson Porter & Company, PLLC © 2018 49
Example: Multiple TOBs, No Aggregation • Deduction determined at each business if no aggregation • Example: F, single, owns 100% of A, B, and C. None have UBIA. • A – QBI $1 M, wages $500 k, Deduction = 200 k (limited to 250 k, so use 200 k) • B – QBI $1 M, wages $0, Deduction = 0 k (50% * $0 = $0) • C- QBI - $20 k, wages $500 k Deduction = 4 k • F’s taxable income before 199 A is $2, 500, 000 • 199 A deduction = 200 k + 4 k = $204 k 11/3/2020 Berntson Porter & Company, PLLC © 2018 50
Example: Multiple TOBs, With Aggregation • Now you sum the three businesses together • QBI = $1 M + 20 k = $2, 020, 000 • Wages = $1 M • Deduction = $404, 000 ($2. 02 M * 20%) • Full deduction achieved by aggregation 11/3/2020 Berntson Porter & Company, PLLC © 2018 51
Example: Multiple TOBs, With Aggregation • Aggregating a business where one has high wages and low property and another the opposite could end up costing deductions. • F, single, has two wholly owned businesses • A – QBI $1 M w/ 400 k wages, no UBIA • B – QBI $1 M w/ no wages, $4 M UBIA • Aggregating results in deduction of: • 400 k limited to greater of: – 400 k * 50% = 200 k or (400 k * 25%) + (4 M * 2. 5%) = 200 k 11/3/2020 Berntson Porter & Company, PLLC © 2018 52
Example: Multiple TOBs, With Aggregation • Not aggregating would have produced 100 k additional deduction. • A – $1 M * 20% = 200 k limited to 200 k (400 k wages * 50%) • B - $1 M * 20% = 200 k limited to 100 k ($4 M UBIA * 2. 5%) • Total deduction = 200 k + 100 k = $300 k 11/3/2020 Berntson Porter & Company, PLLC © 2018 53
SSTB Example Within Phase Out • A & B are married • TI = 375 K • A is 50% owner of S corp that is an SSTB • QBI 300 k • Since 375 K of TI is 60% into the phase out range, 60% of benefit is lost. The remaining Wages 40 k UBIA 0 40% is applied to share of income to determine your 199 A deduction. • Going through the many, many steps generates a $14, 400 199 A deduction 11/3/2020 Berntson Porter & Company, PLLC © 2018 54
Treatment of Fiscal Year Businesses • If an individual receives a K-1 from a relevant passthrough entity with a tax year that straddles 12/31/2017, all of the QBI, W-2 wages, and UBIA are treated as being generated in the tax year in which the relevant passthrough entity’s tax year ends. • Example: – Jimmy, an individual, is a shareholder in an S-corporation with a FYE of June 30 th. On Jimmy’s 2018 Form 1040, Jimmy may claim the Section 199 A deduction for the QBI earned by the S-corporation for its tax year beginning July 1, 2017 and ended June 30, 2018. 11/3/2020 Berntson Porter & Company, PLLC © 2018 55
199 A Interplay with the 1040 • 199 A will not affect net earnings from self employment • It will not affect the net investment income tax • It will not have an AMT adjustment • It will also not reduce a partner or shareholder’s basis in their partnership interest or stock 11/3/2020 Berntson Porter & Company, PLLC © 2018 56
Penalty Regime if 199 A Taken • § 6662 imposes a 20% accuracy-related penalty on an underpayment of tax due to a substantial understatement of tax. Generally, for taxpayers other than C-corporations, the understatement is substantial if its amount for tax year exceeds the greater of: • 10% of the tax required to be shown or • $5, 000 11/3/2020 Berntson Porter & Company, PLLC © 2018 57
Penalty Regime if 199 A Taken • The TCJA amended § 6662 to provide that any taxpayer who claims a § 199 A deduction is subject to a lower threshold before a substantial understatement penalty is applied, equal to the greater of: – 5% of the tax required to be shown or $5, 000 • The § 6662 changes do not require substantial understatement to be attributable to the § 199 A deduction. • This means that any taxpayer who claims the deduction will be subject to the lower threshold, even if the understatement on the return is unrelated to the § 199 A deduction. 11/3/2020 Berntson Porter & Company, PLLC © 2018 58
State Conformity to 199 A • As of right now Colorado, Idaho, and North Dakota are the only states that conform to the new 199 A deduction. • Most state individual income tax returns start with Federal AGI, which will not be affected by the 199 A deduction. 11/3/2020 Berntson Porter & Company, PLLC © 2018 59
Applicability to Cost Segregation • As any tax rate reduction does, 199 A would decrease the value of the deduction for entities with depreciable real estate. The new effective top rate with 199 A is 29. 6% vs. 39. 6% (in 2017). 11/3/2020 Berntson Porter & Company, PLLC © 2018 60
Applicability to Cost Segregation • Many real estate rentals may not qualify for 199 A under the current proposed regulations based on the TOB Section 162 standard. Leases that are triple net could make it risky to take the 199 A deduction since grouping under 1. 199 A-4 requires each activity to be a TOB on its own. 199 A grouping is not similar to the Section 469 regime which take multiple activities that would be passive if not for the grouping. 11/3/2020 Berntson Porter & Company, PLLC © 2018 61
Applicability to Cost Segregation • In year of sale, 199 A is likely not going to apply to the real property owner absent W-2 wages due to the requirement that UBIA exist on the last day of the tax year. • This means that recapture is taxed at a HIGHER rate than the original deduction. • If aggregated with other businesses with significant wages or UBIA this could alleviate that problem. 11/3/2020 Berntson Porter & Company, PLLC © 2018 62
Interest Deduction Limitation • New Interest Deduction Limitation (Section 163(j)): – Applies to business interest expense. Limited to 30% of “Adjusted Taxable Income” – Notice 2018 -28 issued, still no regulations issued – Adjusted Taxable Income (ATI) – Taxable Income before: • Income, gain, loss, or deduction not allocable to business • Interest income or expense • NOL • Section 199 A deduction • Depreciation, Amortization, Depletion (until 1/1/2022) 63
Interest Deduction Limitation – Investment interest expense is NOT included for limitation – Floor plan financing interest does not apply (cars, trucks, boats, farm equipment for sale or lease) – Floor plan financing means indebtedness used to finance acquisition of motor vehicles (defined as self propelled vehicle designed for transporting persons or property on a public street, road, or highway, a boat, farm machinery or equipment) and is secured by the inventory so acquired. (Sec. 163(j)(9)) 64
Interest Deduction Limitation • Businesses not affected by the limitation: – Businesses with average gross receipts less than $25 million over the prior three years – The business of furnishing or selling certain types of energy – Electing farming business – Electing real property trade or business • Have to use ADS on residential, non-residential rental, and qualified improvement property if they elect to be exempt from limitation – Change effective on 1/1/2018 65
Interest Deduction Limitation • Can you crack apart your business to avoid the $25 M rule? No • Aggregated by 448(c) which generally indicates a more than 50% common control/ownership test. – Many nuances in Section 414 on affiliated service companies, but in general, more than 50% common control means those entities are pulled together as one for the purposes of the $25 M gross receipts test. 66
Interest Deduction Limitation • Rental real estate typically has low receipts and many investment real estate entities would lack the common control issue • $25 M test not permanent, if you dip below and are under the threshold, disallowed interest from prior years is presumably deductible in first year where prior 3 year average is below $25 M • This $25 M “small business exception” will be adjusted for inflation (expected to be $26 M for 2019) • Exception cannot be used for tax shelters prohibited from using cash method (Sec. 448(a)(3)). 67
Interest Deduction Limitation • Changes were also made to ADS depreciation: – Residential rental: From 40 to 30 years – Nonresidential rental: No change – still 40 years – Qualified improvement property: From 15 years to 20 years • Note the shorter life on QIP using ADS (20 years) vs. regular tax (39 years) • Absent the technical correction we are hoping for making QIP 15 year and eligible for bonus, ADS elections on QIP could be beneficial 68
Interest Deduction Limitation • Doesn’t apply to electing “real property trades or businesses” • Absent a technical correction to the QIP rule, this would be an immaterial difference in depreciation and with QIP, it is more rapid depreciation • Qualifying businesses are “real property trades or businesses” defined in Sec 469(c)(7): – Real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. – At the taxpayer's election pursuant to Sec. 163(j)(7)(B), the business interest limitation doesn't apply to such trades or businesses. 69
Interest Deduction Limitation • What to do with disallowed interest expense? – C-corps and S-corps • Carries forward at entity level. Can be used in subsequent year as additional interest expense if there is enough ATI. No reduction in stock basis for S corp owners. – Partnerships • Carries forward at partner level. Immediately reduces basis in partnership. Added back to basis in the event of sale. Can be used in a subsequent year if enough ATI passes through to the partner. • Only ATI from the SAME PARTNERSHIP can be used in future years to deduct disallowed interest expense 70
Interest Deduction Limitation • What to do with excess ATI? – Excess ATI is also passed to the partner level. • The amount passed to partners is allocated in same manner as non-separately stated income per partnership agreement. • Excess ATI can be used for the partner’s other business interest expense (if applicable), but it must first be used against the prior disallowed interest expense from the partnership. – Excess ATI over interest expense/Total ATI x taxable income x partnership ownership % = Excess ATI passed through to partner 71
Interest Deduction Limitation • Example 1: Revenue test X Co. , a calendar year corporation, had gross receipts of: o 2015: $24 million o 2016: $25 million o 2017: $30 million o 2018: $18 million Ø Rule applied for 2018: Average of revenue of 2015, 2016, and 2017 = (24 + 25 + 30)/3 = $26. 33 million. Therefore, X. Co is subject to interest limitation rule in 2018. Ø Rule applied for 2019: Average of revenue of 2016, 2017, and 2018 = (25 + 30+18)/3 = $24. 33 million. Therefore, X. Co is NOT subject to interest limitation rule in 2018. 72
• Interest Deduction Limitation Example 2: Aggregation rule A 45% B 45% C 40% Ø Conclusion: The A-B-C group is NOT a parent-subsidiary controlled group, because for the group to exist, A must own at least 50% DIRECTLY in one subsidiary corporation; here, A owns only 45% of B and 40% of C. In addition, B and C are not a controlled group because B owns only 45% of C. 73
• Interest Deduction Limitation Example 3: Aggregation rule D 55% E 100% 25% F 30% G Ø Conclusion: The D-E-F-G group is a parent-subsidiary controlled group, because - E is owned 55% by D - F is owned 100% by E - G is owned by 25% + 30% = 55% by E and F For purposes of determining whether D, E, F, G are subject to the interest limitation rules, the revenue of all 4 corporations must be aggregated together. 74
Interest Deduction Limitation • Example 4: Employee Wages A is an employee of X Co. , and earns $800, 000 in wages annually. In addition, A borrowed money to purchase a partnership interest that passes through income. Under the interest tracing rules, the interest expense on the borrowing is considered "business interest expense. " In computing A's 30% of adjusted taxable income limitation for purposes of determining the deductibility of the interest, A cannot include the $800, 000 of wages he received from X Co. , because A's role as an employee in X Co. is not a "trade or business" for purposes of Section 163(j). 75
Interest Deduction Limitation • Example 5: Electing real property trade or business You have a group of commercial rental buildings that when aggregated together, have more than $25 million annually in gross receipts. You have a ton of interest expense. Ø You can elect out of the limitation rules once you prove that you are a real estate professional. Ø However, you will have to take a slower depreciation on your buildings and improvements using ADS depreciation method and no 100% bonus on those improvements. Ø Absent a technical correction to QIP that would allow for 100% bonus, this might not be important 76
Interest Deduction Limitation • Example 6: Floor-Plan Financing Interest Retail floor planning (also referred to as floor planning or inventory financing) is a type of short term loan used by retailers to purchase high-cost inventory such as automobiles. These loans are often secured by the inventory purchased as collateral. Floor planning is commonly used in new and used car dealerships. Ø A business can ALWAYS fully deduct its floor plan financing. Ø Any taxpayer who fully deducts floor plan financing interest CANNOT claim 100% bonus deprecation on ANY of its assets. 77
Interest Deduction Limitation • Example 6: How to calculate Interest Deduction – Scenario 1 X Co. has taxable income of $300, 000. Included in that amount are: o $40, 000 of interest income, $150, 000 of interest expense, $200, 000 of depreciation, $20, 000 of amortization Ø Step 1: X Co. computes its "adjusted taxable income" as follows: $300, 000 - $40, 000 + $150, 000 + $20, 000 = $630, 000. Ø Step 2: Interest deduction limitation = $630, 000 * 30% + 40, 000 interest income = $229, 000. Ø Step 3: Because the interest expense of $150, 000 is less than the limitation of $229, 000, the interest is deductible in full. 78
Interest Deduction Limitation • Example 7: How to calculate Interest Deduction – Scenario 2 X Co. has taxable income of $10, 000. Included in that amount are: o $40, 000 of interest income, $150, 000 of interest expense, $200, 000 of depreciation, $20, 000 of amortization Ø Step 1: X Co. computes its "adjusted taxable income" as follows: $100, 000 - $40, 000 + $150, 000 + $20, 000 = $340, 000. Ø Step 2: Interest deduction limitation = $630, 000 * 30% + 40, 000 = $142, 000. Ø Step 3: X Co. can deduct $142, 000 of the $150, 000 of interest expense. 79
Interest Deduction Limitation • Example 7: How to calculate Interest Deduction – Scenario 2 (continued) The $8, 000 nondeductible interest expense in Scenario 3 can be carried forward indefinitely. - If it's a C or S corporation, the excess interest simply gets carried forward at the entity level and is treated as additional interest expense in the next year. - If it's a partnership, the entity does not carryforward the excess. The excess interest expense is allocated among the partners, and the partners carry it forward. 80
163(j) Limitation & Cost Segregation • Unlike 199 A, this is a revenue raising provision of the TCJA. Pre 2022, depreciation is an addback to the 30% limitation’s base • This means additional depreciation taken will not limit the deductibility of interest until returns filed for years beginning in 2022 when depreciation and amortization are removed from the base • The lack of a QIP technical correction allowing for 100% bonus on TIs is making the drawback of the election to be a real property trade or business less painful today, but it is an irrevocable election and a QIP technical correction or law change could be painful in the future because of this. 81
Limitation on Excess Losses & NOLs • “Excess business losses” of a taxpayer other than a corporation are not allowed • Loss limitation is $500, 000 if MFJ ($250, 000 if single) (expected to be $510 k/$255 k in 2018) • Losses from pass-through entities have to get through these limitations in the following order: – The basis limitation rules of Sections 1366 or Section 704, – The at-risk limitation rules of Section 465, and – The passive activity rules of Section 469, and NOW – The new Section 461(l) Excess Business Loss (EBL) rules 11/3/2020 Berntson Porter & Company, PLLC © 2018 82
Limitation on Excess Losses & NOLs • Trade or business income and losses flowing through to the individual (both passive and nonpassive) must first get through the first 3 hoops, and then, after netting all income and loss - if the loss exceeds $500, 000 for MFJ (or $250, 000 for anyone less), the excess loss is not allowed in the current year • It becomes part of your NOL, which as we’ll discuss later, is only allowable to the extent of 80% of taxable income in future years • It will become NOL even for a taxpayer with positive overall taxable income. This NOL cannot be carried back since the new rules prevent NOL carrybacks 11/3/2020 Berntson Porter & Company, PLLC © 2018 83
Limitation on Excess Losses & NOLs • Example: Joe hits it big in 2017, selling a business for $50 million. He invests some of the proceeds, generating $1 million in investment income in 2018. He gets restless, and invests another chunk of money into a new partnership that he materially participates in, which kicks off a loss of $800, 000 to him in 2018 • Before Section 461(l) was added to the Code, Joe would have been entitled to deduct the full $800, 000 loss against his $1, 000 of investment income • In 2018, however, only $500, 000 of the loss will be available to reduce Joe’s $1, 000 of investment income. As a result, Joe has taxable income of $500, 000, and the $300, 000 “excess loss” becomes a net operating loss that Joe carries forward to 2019. 11/3/2020 Berntson Porter & Company, PLLC © 2018 84
Limitation on Excess Losses & NOLs • Net Operating Loss (NOL) carryback no longer allowed. – Prior law allowed loss to be carried back 2 years and forward 20 – New law prohibits carryback, but allows unlimited carryforward • NOL can no longer offset 100% of income – Prior law allowed 100% income offset – New law allows only 80% offset (90% for AMT) • Consider the following – $100 loss in year one, $50 income in year two, $50 income in year three – Business has made no money overall, but it still paying tax in years two and three 11/3/2020 Berntson Porter & Company, PLLC © 2018 85
Limitation on Excess Losses & NOLs • What this means for cost segregation – Large losses from depreciation are no longer as valuable as their utilization may be limited – Taxpayers may try to manage income to zero rather than create losses – If the economy goes south, NOL carrybacks will not be available to generate refunds from previously paid taxes 11/3/2020 Berntson Porter & Company, PLLC © 2018 86
What are Opportunity Zones? • Low income community census tract designated by the Governor of a state. It uses the same definition as the New Market Tax Credit, which means that the poverty rate is 20% or more, in the case of a tract not located within a metropolitan area, the median family income for such tract does not exceed 80 percent of statewide median family income, or the case of a tract located within a metropolitan area, the median family income for such tract does not exceed 80 percent of the greater of statewide median family income or the metropolitan area median family income. • A population census tract that is not a low-income community may be designated as a qualified opportunity zone under this section if the tract is contiguous with the low-income community that is designated as a qualified opportunity zone, and the median family income of the tract does not exceed 125 percent of the median family income of the low-income community with which the tract is contiguous. Berntson Porter & Company, PLLC © 2018
What are Opportunity Zones? (cont. ) • A designation as a qualified opportunity zone shall remain in effect for the period beginning on the date of the designation and ending at the close of the 10 th calendar year beginning on or after such date of designation. Berntson Porter & Company, PLLC © 2018
Why do we care? • 3 -fold ability to defer and eliminate capital gain taxes. Note that you *must be starting with a capital gain* for the Opportunity Zone provisions to apply. • Deferral of capital gains invested in Qualified Opportunity Fund within 180 days from sale date. Deferral until the earlier of the disposal of the replacement property or tax year including Dec. 31, 2026. • For the deferred capital gains, a permanent exclusion of 10% or 15% of the gain if the OZ investment is held for 5 or 7 years (before 2026). • For subsequent gain/appreciation in excess of amount invested, if the investment is held for 10 years or more, then the basis of the property is equal to the FMV when sold. Berntson Porter & Company, PLLC © 2018
What is a Qualified Opportunity Fund? • An investment vehicle organized as a corporation or partnership that holds at least 90% of its assets in Qualified Opportunity Zone Property, as measured by the average on the last day of the first six month period of the year and on the last day of the year. Berntson Porter & Company, PLLC © 2018
What is Qualified Zone Property? Qualified OZ Stock, Qualified OZ Partnership Interest or Qualified OZ Business Property • OZ Stock is stock (1) acquired at its original issuance, after 12/31/2017, (2) in exchange solely for cash from a qualified opportunity zone business, (3) and during "substantially all" of the OF's holding period of the stock, the corporation issuing the stock is a qualified opportunity zone business. • OZ Partnership interest has similar rules as stock above, for capital or profits interest in a partnership. Berntson Porter & Company, PLLC © 2018
What is Qualified Zone Property? (cont. ) • OZ Business Property is (1) tangible property used in a trade or business if such property was acquired by the fund by purchase after 12/31/2017, (2) the original use of the property begins with the QO fund or the QO fund substantially improves the property, (3) and during substantially all of the qualified opportunity fund's holding period for such property, substantially all of the use of such property was in a qualified opportunity zone. • Substantial improvement means during any 30 month period beginning after the acquisition of the property, the taxpayer doubles the basis in the property. Special rule for land buildings – only the basis of the building needs to be doubled within the 30 month period. Berntson Porter & Company, PLLC © 2018
What is Qualified Zone Property? (cont. ) • Qualified Opportunity Zone Business means trade or business in which ‘substantially all’ (70%) tangible property is qualified opportunity zone business property, 50% of the total gross income is derived from active conduct of T or B, substantial portion of the intangible property is used in the conduct of the T or B, less than 5 percent of the average of the aggregate unadjusted bases of the property of such entity is attributable to nonqualified financial property, no portion of the proceeds of such issue is to be used to provide (including the provision of land for) any private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises. Berntson Porter & Company, PLLC © 2018
What if a QO fund has money invested that is not a rollover of capital gain? • Treated as two separate investments, of which the provisions of this section only apply to the portion that is rolled over gain. Berntson Porter & Company, PLLC © 2018
Other Rules • Related person is same as Sec. 267(b) and 707(b)(1) except replace 50% with 20%. • Penalty for OF fund that does not maintain 90% requirement equal to the difference between 90% of the assets less the portion that is qualified property multiplied by the underpayment penalty rate. Berntson Porter & Company, PLLC © 2018
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