Update on the 20% pass-through/qualified business income deduction

The IRS recently released proposed regulations aimed at setting out the rules and regulations for the new Section 199A 20% business deduction; https://www.irs.gov/newsroom/irs-issues-proposed-regulations-on-new-20-percent-deduction-for-passthrough-businesses , all 184 pages of them.

The new laws and regulations pertain to domestic businesses operated as sole proprietorships, partnerships, S corporations, trusts, and estates; corporations do not qualify. The rules are effective for tax years after 2017 and before 2026. One reason for pressing ahead on the release was to set out procedures for taxpayers who need to aggregate separate business activities for the calculation. There are a great number of specific rules and ownership percentage tests, so meet with your tax professional for guidance that is appropriate for your business structure as you plan.

The deduction is for the lesser of the “Combined qualified business income amount” of the taxpayer, or 20% of the excess of taxable income for the tax year over the sum of net capital gains and aggregated amounts of qualified cooperative dividends. Again, there are a number of qualifications, especially for the trusts and estates, and you will want to consult with your licensed tax professional when making planning decisions.

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2018 Long-term capital gains rates

The TCJA keeps the 0%, 15%, and 20% LTCG rates for capital gains and qualified dividends but these rates now have their own brackets that you need to be aware of. The LTCG rates used to be tied to the tax bracket for your taxable income. Now the LTCG rates have their very own brackets. The new LTCG brackets are:

The columns are for      1. Single,   2. Joint, and  3. Head of household

0% bracket                          $0-$38,600      $0-$77,200      $0-$51,700

15% bracket begins at        $38,601              $77,201             $51,701

20% bracket begins at        $425,801            $479,001           $452,401

Trusts, estates and kiddie tax computations are different and you should contact your tax practitioner for guidance as these calculations have their own peculiarities. Those brackets are:

0% bracket covers $0-$2,600

15% bracket starts at $2,600

20% bracket starts at $12,701

Short-term capital gains are taxed at ordinary income rates just like wages or interest income. If you are an investor, understanding your average level of income and remembering the LTCG brackets above will keep you abreast of your estimates of the related tax liabilities. Contact your licensed tax practitioner for further guidance.

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Your business needs its own bank account

If you have a business then that business needs its own bank account. Often times, when I meet a new business owner, I have to explain the importance of having a separate bank account. Not only does it make your bookkeeping easier, it creates a legal distinction between you and the operations of the business. Once you have separate accounts you need to insure that they are never co-mingled. What belongs to the business stays in the business and only legal distributions and wages end up in your personal account. If you have your own corporation, which is an individual person in the eyes of the law, don’t you thing that person would want their own bank account?

In a recent tax court memo an S corporation with one owner was skewered by the IRS because they co-mingled business income with personal funds by making deposits of gross receipts into their corporate account as well as their two personal bank accounts. That is called co-mingling and is not allowed. The IRS takes a very dim view of co-mingling because it is a tactic used by people who are trying to hide nefarious activities.

To make things worse, the owner substantially omitted greater than 25% of his corporate gross earnings from his business return. This omission gave the IRS the legal authority to use the six year look-back period for audits instead of the usual three years. Normally the IRS has three years after a tax return has been filed to open up the books for an audit, but if you break certain rules, they can go back an additional three, which is what they did in this case.

The owner gave three separate sets of bank statements to their accountant; the corporate account and two personal accounts. The owner had deposited business income to all three accounts effectively co-mingling gross receipts. The accountant only reported the gross receipts from the business bank account in their bookkeeping calculations. One might deduce that willful blindness played a part but the IRS tends to focus on facts it can prove; that the business owner failed to report the correct amount of gross income to his corporation. Chasing a charge of fraud is difficult because proving intent is an uphill battle. So the IRS appears to have taken the bird in the hand and ignored what may have been lurking in the bush.

Keep your business activities separate from your personal dealings and never co-mingle the two. A first step for any new businesses is to get a separate bank account. If you do not fully understand these concepts then seek out a consultation from your friendly licensed tax practitioner. Using a licensed practitioner is important as it is unlawful for an unlicensed tax preparer to advise in any matter that is not directly connected to the tax returns they work on.

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Veteran’s disability severance refunds

If you are a veteran who received disability severance payments after January 17, 1991, the DOD withheld taxes on those payments, and you reported the payments on your tax return, you are due a refund. You are supposed to receive detailed information from the DOD as to how to file for the refund.

If you have not received your information packet and believe that this situation pertains to you, you need to contact DFAS to obtain the necessary proof. You can file without the DOD letter but there will be some extra hoops to jump through. You can find more information from the IRS here: https://www.irs.gov/newsroom/veterans-owed-refunds-for-overpayments-attributable-to-disability-severance-payments-should-file-amended-returns-to-claim-tax-refunds

You only have one year from the date of your DOD letter to claim your refund. This time period is critical so do not put off filing. Follow all instructions and you should get your refund.

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Summertime child care credits

If your kids are under the age of 13 and they go to day camp during the summer, you can get a credit on your tax return for your costs. The Child and Dependent Care Credit is for the care of your child or qualifying person so you can work or look for work, so if you want to claim these expenses the kids absolutely can not stay at camp overnight. Save your receipts because the credit can max out at $2,100 for two or more children depending on the amount of your adjusted gross income.

Contact your licensed tax professional for advice.

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Three Tax Takeaways for Friday, July 06, 2018

First: consider that taxes are levied in three general categories; taxes on wages, taxes on spending, and taxes on income. All of your taxes touch one or two of these categories.

Second: the TCJA eliminates the alimony deduction for divorces that are finalized after December 31, 2018. This can be a sizable adjustment to income for those paying out large alimonies. On the other hand, alimony received is no longer included in the income of the recipient.

Third: an individual owner of an S Corporation was found to be liable for the Tax Preparer penalty. The owner prepared and signed their own S Corporation tax returns and as the result of an audit, they were found guilty of Tax Preparer infractions, in addition to the other penalties. The court noted that, “Congress intended the definition of tax return preparer to encompass those contributing to the material decisions regarding tax returns.” They were guilty of disregarding reasonable and appropriate review procedures through willfulness, recklessness, and gross indifference.

Don’t make the mistake of thinking S Corporations have special insulation from being audited by the IRS. The pass-through nature of the S Corporation ties it to where it is passing through to: the shareholder’s form 1040. The IRS algorithms follow the trail from the S Corporation right onto the personal tax returns of the shareholders. The last two S Corporation audits I worked examined both the S Corporation tax returns as well as the associated personal tax returns; for two consecutive years.

Separation of duties should compel any informed business person to seek out an independent and licensed tax return preparer to review your books and prepare the tax return.

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Three tax takeaways

1. South Dakota v. Wayfair

On-line sellers no longer have to have a physical presence within a state to be required to pay sales taxes for on-line sales within those states. On June 21, 2018 the Supreme Court overturned the physical presence standards used in the past as an “unsound and incorrect,” interpretation of the Commerce Clause that has created unfair and unjust marketplace distortions favoring remote sellers and causing states to lose out on enormous amounts of sales tax revenue.

Larger on-line sellers have mostly started charging sales taxes on their sales but it remains to be seen how the smaller retailers will comply with the changes. If you buy items over the internet and are not charged sales tax you are supposed to claim those purchases and pay a Use Tax, but most buyers are either not aware of what a Use Tax is, or simply ignore the law. This ruling gives the states more leverage in going after end users who fail to pay over Use Tax.

2. The 2018 draft of Form 1040 might be postcard size, but it will require more schedules

In our business we like to say, “Uncle Sam giveth with one hand and taketh away with the other.” Save money yes, as far as simplicity though – not so much. The TCJA reminds me of a certain bookkeeping program that sells basically the same product every year, but moves the bells and whistles around so you think you’re getting something new.

Every client I have run a projection for is going to pay a lower income tax but there are bound to be exceptions. For the simplest filers; a single person with a W-2 and nothing else, the new filing system will definitely result in lower taxes and be as simple and easy to file as we can imagine. Those with complex tax structures can expect the same amount of effort, and folks who have pass-through income have some additional work if they want to take advantage of the §199A deduction (up to 20%).

3. The Tax Court recently ruled that the property manager of an apartment complex was an employee and not an independent contractor

The Tax Court has enumerated the following factors in determining whether and employee-employer relationship exists (abridged):

  1. The degree of control exercised by the principal over the details of the work.
  2. Which party invests in the facilities used in the work.
  3. The opportunity of the taxpayer for profit or loss.
  4. Whether the principal has the right to discharge the taxpayer.
  5. Whether the work is part of the principal’s regular business.
  6. The permanency of the relationship.
  7. The relationship the parties believe they are creating.
  8. Whether the principal provided the worker employee benefits.

The Manager was the only person who preformed work regularly at he apartment complex. The Manager performed the usual routine duties of any property manager.

The Court’s conclusion ruled in favor of the IRS:

While it did not issue the Manager a Form 1099-MISC or any other Form 1099, the Apartment Complex treated the Manager as an independent contractor and neither withheld or paid employment taxes with respect to his services.

On audit, the IRS determined that the Manager should have been classified as an employee. The IRS also assessed additions to tax, and penalties for the Apartment Complex for failure to file a return (payroll tax forms 941 and 940), and related penalties for failure to pay payroll taxes.

Our conclusion:

If your business pays any individual (has an SSN only) for services, they need to receive either a W-2 or form 1099-MISC. If you simply pay them, then you are paying a worker under the table. The only payees you do not need to issue a 1099 to are corporations (has an EIN and not a SSN).

Although all worldwide income is required to be reported, this payment arrangement leaves the reporting up to the discretion of the payee. The employer also gives the impression that they were attempting to escape paying the employer portion of Social Security and Medicare taxes. Under-funding the Social Security and Medicare funds is a big problem in this country and a side of the equation the powers-that-be seem willing to ignore.

It will be interesting to see the reaction of Black Market Operators when they reach the age of collecting Social Security benefits and they scream bloody murder because their checks are so small. A number of them probably do not even realize that the size of their payments relies on the amounts they have invested into those funds.

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Some tips for building credit

Start by saving money now, because you are going to need it. Brian Tracy, the business guru and author of many best-selling business books, teaches us that unless you can save 10% of your earnings, your measure of being financially successful is not good. Another of his tips to remember is that the laws of attraction will compel a savings account to attract even more savings. The bigger it gets, the more you will want to put in there.

Avoid the financial pitfalls of spending too much on wants. Good savers are able to differentiate between needs and wants. Wants always cost a premium and you can always live without them. You need to learn the difference between needs and wants to save money.

Two of the fastest ways to build credit are to have a credit card, car loan, or both. If you have applied for a credit card and been denied, your banker can set aside a portion of your savings in a separate savings account; say $2,000. Then you can use your own money as collateral for a small secured loan. Because the loan is coming from your reputable bank, the interest rate is probably the best you are going to get. Use the loan for something that you need, and that you already have enough cash to pay for if you had to. Examples are things like a new washer and dryer, computer, or car repairs. Your small, secured loan should have a term of just over one year, fourteen months is ideal. Car loans are good because they typically offer a reasonable interest rate, and the regularity of repayment demonstrates your ability to manage a credit balance.

Remember to never, ever use credit to finance your fun. Never borrow to buy toys, lavish vacations, or go out to restaurants. If you do not have the surplus cash then you don’t get to have those things. Starting now, you are to think of borrowing as “Financing.” Don’t pay attention to commercials that try to brainwash you into thinking that it is normal to carry a high-interest balance all your life; “Credit check lets you always know your credit score – so you can be the one in control,” sort of things. Paying interest at 24% should never be considered normal. You won’t be the smart one for knowing what’s in your wallet, what you’ll be is broke.

About half way through your second secured small loan your bank should be ready to issue you a credit card. This is worth waiting for. A rule of business is that if someone approaches you, it is never for your benefit. When you receive credit card offers in the mail you’ll see this theory at work because the interest rates will average 24% and higher. Many rates from reputable banks with which you regularly do business are 19.9%. That is the best you can hope for when building credit.

You are trying to build credit, not carry a balance. When you do use your credit card, always pay the balance before the monthly cycle ends. You can build credit without paying any interest at all. It is a myth that you need to carry your credit card balance beyond a month and pay interest in order to build credit. By paying the balance before the cycle ends, you will build credit a little slower, but you will still build credit. A banker friend of mine recently shared his cheat-sheet for which elements make up a credit score:

35% payment history – always pay on time

10% types of credit used – secured loans or unsecured credit cards

10% applications for new credit – each time you take out a loan or use a credit card

15% length of credit history – how long you have demonstrated good management

30% amounts owed – the balance you carry and pay interest on

By this logic, you can add at least 10% to your credit score for using credit while not paying interest. A good example is deferring an expense for a couple of weeks but paying the entire balance before the monthly interest cycle. Assume that you need new tires and a brake job and the store has a 40% off sale that ends tomorrow. You are not allowed to use your savings. You don’t have the surplus cash right now, but you will have the cash over the next two weeks. This is a perfect time to use your credit card to take advantage of the savings, and since you will be able to pay the balance within two weeks, you will also not pay any interest. You saved money, built up your credit and paid no interest.

Within the time it will take you to save enough for a down payment on a home, your credit score will be in great shape. The combination of your savings and a good credit score will afford you the bargaining power to negotiate a best interest rate on a new home loan.

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Withdrawals from your IRA

If you are older than 59 ½ years old and withdraw money from your regular IRA, the distributions are only subject to income tax. If you withdraw funds before you reach age 59 ½ those amounts are subject to both income tax and an early withdrawal penalty equal to 10% of the amount you took out.

Because you fund a Roth with after-tax dollars, you can take your contribution out at any time and for any reason. If you are over 59 ½ years old and have held your Roth for at least 5 years, you can withdraw earnings with no tax or penalty. To escape taxes and the 10% early withdrawal penalty on earnings, you need to hold the Roth IRA for at least 5 years and be over 59 ½ years old. If you’re over 59 ½ but held the account less than 5 years you’ll pay income tax on your earnings but there is no penalty.

There are a number of exceptions to the early withdrawal penalties and those all come with a multitude of conditions. The cost of early withdrawal penalties makes it cost-effective to consult with your tax professional BEFORE you make any early withdrawal. Some common exceptions to the penalty are: the distribution is used for unreimbursed medical expenses, payments of medical insurance when you are unemployed, disability, higher-education expenses, inherited IRA, first time home purchases, substantially equal periodic payments, IRS levy, and being called up to active duty for reservists.

You may qualify for more than one exception, there are conditions, and there are other arrangements that may affect your tax calculations. Contact your licensed tax professional for a consultation because unlicensed tax preparers are prohibited from advising clients in matters of tax planning, and for good reason.

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The TCJA changes for unreimbursed employee expenses

One of the most profound changes in the new tax law is that taxpayers who are used to taking a deduction for unreimbursed employee expenses subject to the 2% of AGI floor will loose those deductions effective from 2018 through 2025. Unreimbursed employee expenses are schedule A deductions. These changes to the tax laws do not affect sole proprietors who report their business activities on schedule C.

These are the expenses that you may incur during your W-2 job that are not reimbursed by your employer. Common deductions may include mileage for a salesperson, tools for a mechanic, uniforms, professional licenses, union or other professional dues, home office, home computer, travel expenses, or meal and entertainment expenses to name a few.

The largest impact in the clients I work with is going to be for salespeople because they can drive between 40,000 and in some cases as many as 70,000 miles each year. They are also required to entertain. Those are a lot of expense deductions that they are loosing. If you think 70,000 business miles is a lot, that is the same as driving from Naples, FL to Miami and back, five times a week, for one year. There are plenty of employees who make drives like that and more, and for them, and anyone else who relies on these deductions, the TCJA is going to hurt.

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