Category: Corporate Governance

Small Business End-Of-Year Checklist

The end of year is a busy time for many reasons. Travel plans, holiday hosting, and family visits tend to keep your calendar packed. But as a small business owner you have additional obligations that need to be addressed. The end of year is a perfect time to assess your current business, make some decisions, and set some overall goals to ensure you start the New Year off right. When 2019 rolls around be sure you took the time to self-assess with this Checklist:

(    )   December is not too late to make a number of moves that can lower your income tax bill. Consult with your advisor team about important income and deduction items as well as new structures that you may want in place for 2019.

(    )   Take the time to express gratitude to the folks who made positive differences for you this past year.

(    )   As you review your financial results for 2018, it’s a great time to set goals for 2019 and make an actionable plan that will help you start achieving these objectives right away.

 

* Intended as general guidance only and not as legal advice.

Navigating Business Tax Classifications In 2018

The Tax Cuts and Jobs Act of 2017 (the “Act”) has dramatically changed the tax landscape this year.  Two important changes include the new 20% deduction for pass-through entities, such as S-corporations and partnerships, and the 21% flat tax rate for C-corporations.  Where conventional wisdom once dictated that most small business owners elect S-corporation tax status for their companies (a “pass-through” option), these new rules should have owners re-considering whether C-corporation tax status might offer better tax results.

In this post, we will compare S-corporation (pass-through taxation) and C-corporation (corporate taxation) tax classifications for business owners at two different income levels. One example covers an owner with taxable income just below the $315,000 taxable income phase-out threshold for married filing jointly status (“Income Level I”) and one shows an owner with total income of $1 Million (“Income Level II”) when factoring in both her personal income (from W-2 wages) and business net income. The detailed examples can be found here.

As for our conclusions, at incomes around Income Level I, there is an advantage to using pass-through taxation because much of the income is taxed on the individual’s return at rates below the 21% rate applicable to C-corporations. However, at higher personal income levels, such as Income Level II, if there is a desire to re-invest significant funds in the business, using C-corporation taxation may enable a business owner to pay lower income taxes and therefore have more funds for business growth.

Should you choose S-corporation or C-corporation income tax classification?

As with many tax questions, the answer ultimately is: it depends. Specifically, the owner’s goals for the business profits should be a driving force in determining the appropriate tax classification in each situation. Pass-through entities expose business income to individual brackets which include rates below 21%. If this amounts to a major portion of the income, it can be a very important factor and favors pass-through entities such as S-corporations and partnerships. As personal incomes increase, more individual income will be exposed to brackets above 21% and, if the intention is to leave it in the corporation anyway, then the C-corporation classification can result in lower income taxation. Business owners should consult with their CPAs, attorneys, and financial advisors to take full advantage of these new tax laws.

 

* Intended as general guidance only and not as legal advice.

Three Practical Tax Steps

In our last post, we detailed many of the new individual and corporate tax laws. Here we’ll take a closer look at three practical steps you should consider taking in light of these.

1. Revisit the income tax classification of your corporation or LLC.

For decades now, the S corporation has been the income tax classification of choice for most non-real estate businesses. The fact that it offers a single level of tax versus “double taxation” in C corporations has mostly been the deciding factor. Now, while C corporations still expose their owners to double tax (first on corporate income and second on dividends to shareholders), the combined tax rate is comparable to the single rate that S corporation owners incur. On top of this, C corporations offer their owners much more flexibility in the timing for payment of taxes. We believe the bottom line will be that closely-held businesses will be formed as C corporations much more often than they have been in recent memory. Note, however, there can be a number of tax costs associated with transitioning from one classification to another, so be sure to do so with the help of your tax advisors.

2. Consider Trusts to deal with taxable income limits and limitations on deductions.

For example, taxpayers filing a joint tax return avoid some significant limitations and get the maximum 20% Qualified Business Income (QBI) deduction on their business income with taxable income of $315,000 or less. However, in some cases it will make sense for taxpayers with higher income to transfer some ownership to a trust, which would often have lower taxable income and be able to utilize the full 20% QBI deduction. Likewise, if a taxpayer has property taxes of $50,000, only $10,000 of this amount can be used to offset taxable income under the new rules. A full $40,000 of this former deduction is wasted. However, if four trusts also each owned a fifth of the home and had $10,000 of income, they could each utilize the available $10,000 state and local income tax deduction.

3. Income Taxes in Estate Planning.

For those planning their estates and passing wealth to family and others, there’s always been a need to balance income tax and estate tax concerns. Now, however, until the expiration date under the new tax act (at the end of 2025), fewer estates will be directly impacted by estate taxes. This is true because there is a $10 Million exclusion, indexed for inflation to amount to approximately $11.18 Million in 2018.

Thus, planning for income taxes will become the biggest tax factor for most estates. The question is how to pass assets to heirs with minimum taxes due on a subsequent sale. Since the basis of an asset (in many cases this is what you paid for it) can be subtracted from the sale proceeds in the calculation of gain, one important theme here is strategies to generate basis. A technique to consider is transferring assets to a person before their death. Then, when that person dies and the asset passes through their estate, it can be given a basis equal to its fair market value at the date of the decedent’s death (i.e., the basis is “stepped up” to fair market value). For example, you may know of a trust with assets that are valued higher than their basis. If so, note that in many cases there are mechanisms to “swap” them back into the estate of the person who set up the trust. This will leave the trust with assets of an equal value and will help ensure heirs have maximum basis and the least amount of income taxes due related to sales out of the estate.

 

* Intended as general guidance only and not as legal advice.

Big Tax Changes

We plan to address the new 2017 Tax Act changes in a couple of ways. Below is a summary of many of the major provisions, both for businesses and individuals. Later, we’ll take a closer look at some practical steps you should consider in light of the new tax law.

First, the corporate rate cuts are significant. The 2017 tax act provides for a 21% flat corporate tax rate. Businesses conducted as sole proprietorships, partnerships, or S corporations are subject to a special deduction under the 2017 tax act beginning in 2018.

Business Deductions and Credits

  • Section 179 Expensing:
    • The expensing limitation is increased to $1 million and the phase out amount to $2.5 million. The new limitations are to be adjusted for inflation. The act further expands the definition of §179 property and the definition of qualified real property for improvements made to nonresidential real property.
  • Research and Development Credit:
    • The research and development credit is preserved.
  • Deductions for Income Attributable to Domestic Production Activities:
    • Beginning in 2018, the deduction for income attributable to domestic production activities is repealed.
  • Entertainment Expenses Deductions:
    • Beginning in 2018, no deduction is allowed generally for entertainment, amusement, or recreation; membership dues for a club organized for business, pleasure, recreation, or other social purposes; or a facility used in connection with any of the above.
  • NOL Deduction:
    • Beginning in 2018, the limit on the NOL deduction is 80% of the taxpayer’s taxable income and provides that amounts carried to other years be adjusted to account for the limitation. Amounts are to be carried forward indefinitely.

Corporations

  • Corporate Tax Rate:
    • Beginning in 2018, there is a 21% flat corporate tax rate; there is no special tax rate for personal service corporations.
  • Alternative Minimum Tax:
    • Beginning in 2018, the alternative minimum tax is repealed. In 2018, 2019 and 2020, if taxpayer has AMT credit carryforward, taxpayer is able to claim a refund of 50% of remaining credits (to extent credits exceed regular tax for year). For 2021, taxpayer is able to claim a refund of all remaining credits.

Pass-Through Entities

  • Pass-Through Tax Rate:
    • Beginning in 2018, generally a 20% deduction for qualified business income is provided in lieu of tax rate changes. Special rules apply when computing the deduction. The deduction expires after December 31, 2025.

The tax reform legislation recently passed by Congress also significantly changes the landscape for individuals beginning January 1, 2018, and continuing for many years come. For many taxpayers, the changes made by the legislation present a host of tax planning challenges and opportunities going forward. Due to the elimination or limitation on itemized deductions, and the elimination of personal exemptions, a key consideration in planning for 2018 is to first look at ways to lower your taxable income. You should thus consider maximizing all pre-tax contribution opportunities such as your 401(k), maximizing deductible IRA contributions, and consider investing in state and municipal bonds (whose interest is exempt from federal tax).

Further, despite the headlines, it will remain important for you to keep track of your medical expenses, mortgage interest, property and state income or sales tax payments and charitable contributions made during 2018 due to new restrictions on itemized deductions.

Highlighted below are some of the more significant changes made by the reform legislation and possible challenges and opportunities to lower your tax bill for 2018 and beyond.

Lower Individual Tax Rates

The legislation creates lower individual income tax brackets of 10%, 12%, 22%, 24%, 32%, 35%, and lowers the top rate from 39.6% to 37%, respectively. (The current rates are to be restored in 2026, i.e., 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%, respectively).

Modification of the Alternative Minimum Tax (AMT)

The legislation retains the AMT for individuals but increases the exemption amount and phaseout thresholds so fewer people will pay it. From 2018 through 2025, a higher AMT exemption will apply to income, beginning with $109,400 for joint filers and $70,300 for other taxpayers in 2018. The exemption will phase out at $1 million for joint filers and $500,000 for other taxpayers. The thresholds will be adjusted for inflation.

Increase in the Standard Deduction

Beginning in 2018, the standard deduction increases significantly from $12,700 to $24,000 for joint filers, from $9,350 to $18,000 for heads of households, and from $6,350 to $12,000 for singles. Since you can claim the higher of the standard deduction or itemized deductions, you will want to closely compare the two methods as you may now benefit from a higher standard deduction given the many changes to itemized deductions.

Elimination of Personal Exemptions

In exchange for lower tax rates and increase in the standard deduction, personal exemptions no longer may be claimed beginning in 2018.

$10,000 Cap on State and Local Tax Deduction

In a significant departure from prior law, the legislation will allow individuals to deduct no more than $10,000 of any combination of the following taxes – state and local income taxes, state and local property taxes, and sales taxes.

Limits on Mortgage Interest Deduction

The tax reform act reduces the amount of mortgage indebtedness on which taxpayers may deduct interest to $750,000 for mortgages incurred after December 15, 2017. (The $1 million limitation remains for older debt). Interest on your principal residence and a second home are deductible. Importantly, however, beginning in 2018, interest on home equity indebtedness no longer is deductible, regardless of when it was incurred.

Medical Expense Deduction

Individuals may continue to deduct medical expenses in 2018 and 2019 if the expenses exceed 7.5% of adjusted gross income. The threshold returns to 10% of adjusted gross income in 2019. Again, you will need to review whether claiming such expenses, when combined with other allowable itemized deductions, yields a higher deduction than the standard deduction.

Elimination of Deduction for Unreimbursed Employee Business Expenses

The reform act eliminates the deduction for miscellaneous itemized deductions through 2025. Thus deductions (subject to the 2% floor of adjusted gross income) for costs related to the production or collection of income, such as appraisal fees, investment fees, and safety deposit box rent are now non-deductible, and, importantly, expenses related to employment, such as uniforms, professional society dues, computer used for work, and job-hunting expenses also are non-deductible. Employees who incur significant unreimbursed business expenses may want to ask their employer about adjusting their compensation or establish an accountable expense reimbursement plan that would allow the employer to reimburse the employee tax-free while also entitling them to a deduction against their business income.

Alimony Deduction

The tax legislation repeals the above-the-line deduction for alimony paid for divorces or separations executed after December 31, 2018. After that date, alimony payments will not be included in the recipient’s income and the payments no longer will be deductible by the payor. If you are currently contemplating divorce or separation, a careful review of the effects of the new law should be undertaken to determine the economic effect on your tax situation and timing of any agreements.

 

* Intended as general guidance only and not as legal advice.