Business Taxes, Part II of III on year-end tax planning

This is Part II of three parts on year-end tax planning under the Tax Cut and Jobs Act. In our first part, we discussed the impact of the new law on personal taxes. In this part, we focus on small businesses.

Choice of Entity for Small Businesses

One of the biggest changes from the new tax law is the massive reduction in the tax rate for regular or “C” corporations. That may sound very appealing, but does this mean you should convert your S Corp. or LLC into a C Corp.? It could, if you expect to keep net income in your business.

If that is not your plan, i.e., if you want to take out money for yourself and other members, then use a pass-through entity instead of a C Corp. While a C Corp. may only pay taxes of 21% on its income, the amount the C Corp. distributes, via dividends or otherwise, will be taxed again to shareholders. If the shareholders are in the highest bracket, then income that started in the corporation had to pay over 52% in total taxes before getting into shareholders pockets. If you are a pass-through such as an LLC or partnership, then no tax is imposed at the entity level and entity members may qualify for the QBID on their personal returns – see below.

Be clear on your goals: do you want to leave net income in to grow the business for sale or an IPO? Or do you want to distribute net income to business members?  Deciding makes the choice clear.

Section 199A QBID

In our first part, we discussed the qualified business income deduction of 20% for certain pass-entities.. The deduction is complicated and subject to limitation. One such limitation is the total income of the taxpayer reported on her individual or joint tax return. The deduction phases out for high income taxpayers, starting at $157,500 of income for single taxpayers and $315,000 for married taxpayers, and phasing out when income exceeds $207,500 for single taxpayers and $415,000 for married taxpayers. There are wage and capital limits that can bring back a deduction when the phase out is exceeded, but that does not help service businesses as discussed below.

The deduction is “below the line,” so it does not reduce self-employment taxes or any items that are keyed to adjusted gross income (“AGI”). It also does not affect net operating losses.

Another limit is on income from a service business. This is defined as income from the following:

Health, law, accounting, consulting, financial services, performing arts, actuarial science, athletics, brokerage services, investing or trading in securities, or any business where the principal asset is the reputation or skill of its employees (there are now regulations on this last type, but those do not answer all questions).

Architects and engineers were excluded from the list in the final bill.

For those within the definition of service business, QBID drops to zero when the phase out is exceeded.

If you are bumping up against any limits for 2018, you will want to review ways to defer income to 2019 or reduce taxable income in 2018 by increasing your deductions.

Businesses use of Home

The new tax law imposes limits on Schedule A deductions, including state and local income and real estate taxes. If some of your real estate taxes otherwise subject this limit are for a home office or other business use, then the business portion is not limited and can be used to shelter business income.

New Rules on Entity-level Audits

Under the new tax law, LLCs and partnerships face substantial changes for the IRS audit procedures:

  1. Beginning in 2018, the IRS can audit such entities at the partnership or LLC level under the Centralized Partnership Audit Rules or “CPAR.” This gives the IRS new powers, one of which is the ability to impose a tax at the entity level and let the partners sort it all out, rather than the pre-2018 requirement to audit each partner; and
  2. The IRS would contact the Partnership Representative for the entity. If no PR has been designated, then the entity loses by default.

This means (a) updating your operating agreement to designate the PR in place of the tax matters partner and (b) electing out of the CPAR rules on your 2018 tax filing to avoid application of these unfavorable rules.

What is a WISP?

You have probably received e-mails and other notices asking you to review updated privacy policies from various vendors. Many of these were generated in response to adoption of the GDPR (General Data Protection Regulation) by the European Union in May of 2018.

What too few companies know is that there are laws in the US that require implementation of privacy safeguarding. One affecting companies doing business in Massachusetts is the Standards for the Protection of Personal Information of Residents of the Commonwealth in force since 2010.

If you are affected and have not either established or reviewed your company’s WISP (written information security program), please act right away to avoid liability for any potential breach.  Also, check the laws of any other state in which your do business to see what laws apply to your use of personal information.

Conclusion

If any of this raises questions for your year-end planning, let me know. I will be glad to see if can help.

Impact of New Tax Law, Part I of III on year-end tax planning

New Tax Law

The Tax Cut and Jobs Act made substantial changes to tax rates, deductions and credits for individuals, corporations and other entities. It also affected changes to estate taxes. For a summary of all changes, please see our post from December in 2017 year-end tax planning – a year of uncertainty.  Please also see the other parts of this series:  in the second part, we discussed planning for small businesses; in the third part, we provided a practical guide for year-end action; and in Tax Planning Hacks, we discussed planning ideas for your Itemized Deductions and more.

The purpose of this post is to get you started on year-end planning to take advantage of the TCJA changes.

What is the Impact of New Tax Law?

We have been reviewing the impact of the new law with projections in our CCH ProSystem Fx tax software. While many individuals lose deductions in 2018 that they were previously allowed, that does not mean that their taxes increase as much they feared. Here are some reasons why:

  • They probably do not owe the AMT as they have in the past.
  • The change in rates lowers total taxes for many.
  • The passthrough deduction discussed below can make a big change.

If you want us to review the impact on your taxes, please let me know.

Clarifications on New Tax Law

Mortgage interest remains deductible even on an equity line of credit (ELOC), provided proceeds from the ELOC were used to purchase or substantially improve your home. However, if the proceeds were used for consumption, then the interest is not deductible.

The deduction for state and local income taxes (SALT) and property taxes is capped at $10,000. However, property taxes for rental properties are still fully deductible against rental income on Schedule E. And farmers and self-employed taxpayers can still deduct the business portion of the taxes on Schedules F and C. Finally, you may be able to use a trust to share ownership of a property with beneficiaries so that they can deduct a portion of the property taxes.

Change for Small Businesses

One of the biggest changes is the qualified business income deduction (“QBID”) under section 199A, also know as the pass-through deduction. This deduction reduces taxable income from qualifying businesses by 20% for taxpayers under the income limitations. This is, net profits form the business after any W-2 salary paid to the owners is reduced.

Pass through businesses include sole proprietors, S corporations, LLCs and partnerships. They also include real estate investment trusts (“REITs”) and certain publicly traded partnerships (“PTP”). But there are income limits and thresholds that eliminate the QBID service companies. Here is a good chart on that may help you see if you qualify for the 20% deduction. Also, watch for more in our next post.

Planning under 199A for QBID

If you have a pass-through business and your year-end planning shows that you may hit the income limits that reduce or eliminate the deduction, you can move income and deductions for Schedule A to change that. Push income into next year and bring any deductions from next year into this year. If you succeed in getting back under the income the limitation, you get a 120% benefit for the right offs – that is, 100% deduction value on Schedule A and 20% QBID value.

The income limits are toughest on service companies. If your small business is a service company, you may want to break out any non-service business to get the benefit of QBID. A professional office that does billing, debt collection or operates a professional building may be able to put those activities in separate entities that qualify for QBID. Furthermore, if your small business is considering buying an office, keep that in a separate entity from the business.

Conclusion

Watch for Part II coming soon. In the meantime, please contact us if you have any questions.

7 things to do when starting a business to avoid nasty surprises

(also seen online at IRIS.xyz)

The only thing that hurts more than paying an income tax is not having to pay an income tax. Thomas Dewar

When you decide to start a business, taxes may be the last thing you think about. However, not realizing that you owe the self-employment tax as well as income taxes can lead to a nasty surprise when you file your taxes. This post is aimed at avoiding that costly surprise.

But, before we discuss the self-employment tax, there are other important steps to take when you become self-employed. Here are the 7 things to do after you start your own business to avoid nasty surprises:

Avoid nasty surprises – set up bookkeeping, form your entity, get licensed, buy insurance, and pay taxes

Bookkeeping – set up bookkeeping using software like QuickBooks (either online or on your laptop). You don’t want to be scrambling to find receipts at tax time or not be able to tell somebody if you are making money or not.

You can save time by downloading from your bank and credit card companies. If you set up things well, all income and every expense will be properly categorized for your profit and loss statement, or P&L. The P&L and balance sheet help you monitor your business to see how well you are doing and are essential for preparing your tax returns. The balance sheet will also come in handy if you need to apply for financing.

For all these steps, you may want to hire an accountant or speak to an attorney.

Entity – for many small businesses, being a sole proprietor is appropriate. You avoid paying corporate excise taxes and filing annual reports. However, if you have partners, you may want to form a partnership, corporation or LLC (details on choosing are beyond the scope of this post).

If your business involves risks that could lead to law suits, form a corporation or LLC to shelter your personal assets from liabilities of the business that insurance may not cover. Make sure that any actions you take for the business are in your capacity as an officer or manager – i.e., never sign personally.

Remember, you may want to consult with an attorney.

Get licenses, file annual reports and pay local taxes – certain businesses require a license to operate. Most entities are required to file annual reports. And, your city may impose taxes on the personal property in your business. Be sure to find out so you don’t owe penalties for failing to file and pay.

Buy health and other insurance – in addition to liability insurance, you will want to obtain health insurance if you are no longer working for another employer. You may get favorable treatment for this expense on your income taxes. You can also purchase insurance to cover damage to equipment, loss of data, identity theft and so on.

File payroll taxes – if you hire people to work for you and pay them over $600 per quarter in any year, you need to report the compensation. If they are independent contractors, you file a form 1099 with the IRS. If they are employees, you file a W-2 with the Social Security Administration. You also provide these forms to your people for the income tax filings.

You may need to withhold and remit FICA and Medicare taxes. Also, your employees may request that you withhold and remit federal and state income taxes (unless you live in a state that does not impose income taxes). Failure to withhold and pay to the IRS and state can lead to serious penalties.

Pay your income tax – one big shock for many who start a business is how much they owe in taxes. When you received a paycheck, you probably did not focus much on the fact that your employer withholds federal and state income taxes and FICA and Medicare taxes. And, you never had a chance to spend what was withheld.

However, when you run your own business, you have full access to the pre-tax income, so you must diligently allocate funds ahead of time so that you don’t come up short at text time. To avoid owing interest on the taxes due, you make estimated tax payments each quarter to the IRS and state.

Pay the self-employment tax – when you were an employee, your employer withheld FICA and Medicare taxes from your paychecks. The employer also contributed FICA and Medicare taxes on your behalf

When you become self-employed, you are responsible for both the employee and employer amounts. This tax is based on your net self-employment income

A lot to remember, right?

Maybe, but knowing and planning is far better than trying to scrape together money in April to cover taxes you did not expect.

Good luck with your new business!

In future posts, we will examine partnering with others, assessing your profitability, rules on deducting expenses, and entry into the real estate market.