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Is it time to take a second look at the cash method for income tax purposes?

By: Dave Herbe, CPA, MAcc- Tax Manager

The new tax law has changed the tax landscape significantly. There are changes to depreciation, tax rates, credits, deductions, you name it. One of the biggest changes that came with the Tax Cuts and Jobs Act (TCJA) was the threshold for small businesses that qualify for the cash method of accounting for income tax purposes. Under the old tax laws, for a small business to qualify for the cash method of accounting their gross receipts over the three previous tax years had to average $5 million or less. However, under the TCJA the threshold is average gross receipts of $25 million or less. Let’s look at an example below to help illustrate:

XYZ Corporation has had gross receipts of $8, $10, & $12 million over the last three calendar years. When they file their 2017 tax return, their average gross receipts for the previous three years totals $10 million. Under the old tax laws they would not be eligible to elect the cash method of accounting for income tax purposes. However, under the new law they would be eligible because their average gross receipts are under $25 million.

This allows small businesses who didn’t previously qualify to now make this election as their accounting method for tax purposes.

There are also some other advantages that come with choosing the cash method over the accrual method when eligible. It allows for more tax planning flexibility, as the business can control if they want to delay invoices to defer income to next year or escalate expenses before the end of the year to increase the deductions taken on the tax return. It also allows for potential cash flow benefits as it allows the business to pay tax on the actual cash it received v what has been earned but not into the bank account yet.  The business can also keep accrual financials for internal record keeping, but with the help of a tax accountant an easy accrual to cash adjustment can be made to convert the financials to a true cash basis. These are just some of the advantages that the cash method offers small businesses.

Although there are many benefits, it may not be the best option for every business that is eligible. There are some limitations besides the gross receipts test that can disallow a certain type of business from being allowed to convert to the cash method. It also might make sense to use the accrual method based on the type of business you are and how income is recognized. Before you switch from accrual to cash be sure to consult with your tax adviser to ensure it makes sense and is done properly.  Holbrook & Manter would be happy to assist you, please contact us today.

Department of Labor Increases Scrutiny of Defined Benefit Plans

Sponsors of defined benefit plans — commonly known as pensions — might be facing tighter scrutiny from the U.S. Department of Labor. Just last year, at an ERISA Advisory Council meeting, the agency’s Employee Benefits Security Administration (EBSA) announced that it had ramped up pension audit operations in its Philadelphia office and later decided to do so elsewhere. If your organization offers its employees a defined benefit plan, here’s what you should know.

Required statement

The focus of the audits is on pension plan sponsors’ efforts to deliver benefits to terminated vested participants. According to EBSA’s Reporting and Disclosure Guide for Employee Benefit Plans, plan administrators must provide a “Statement of Accrued and Nonforfeitable Benefits” to participants on request, on termination of service with the employer or after the participant has a one-year break in service. However, only one statement is required in any 12-month period for statements provided on request.

Best practices

Timothy Hauser, EBSA’s Deputy Assistant Secretary for Program Operations, offered some best practices for satisfying the agency’s notification requirements. He advised, first and foremost, that plan sponsors keep good records on how to reach plan participants and relay those records to other corporate entities in a merger or acquisition.

A good starting point, according to Hauser, is for plan sponsors to send participants a certified letter using the participant’s last known address. If mail is returned from the former employee’s last known address, he suggested trying to contact the participant by phone. It’s possible the phone number on record is a mobile phone that wouldn’t be pinned to a previous mailing address.

When other methods fail, Hauser recommended reaching out to former co-workers of the separated participant who might have remained in contact. With so much information available through social media, employers should also consider using the Internet to help find terminated missing participants.

Further concerns

In October 2017, the American Benefits Council submitted a letter to EBSA, requesting more detailed guidance because some of its members had been harshly penalized for failing to find missing participants. From EBSA’s perspective, a plan sponsor’s failure to track down separated vested participants represents a fiduciary breach — not an accusation that any plan’s sponsor would want to face in an audit.

In addition, EBSA continues to focus attention on the quality of audits of defined benefit plans’ financial records by “independent qualified public accountants.” This is in response to a 2015 EBSA report after it “audited” a sampling of plan audits. The review found “major deficiencies” with 39% of the audits it reviewed.

Up to speed

Pension plans may not be as widely used as they used to be, but the compliance rules related to them remain strict. Make sure you stay up to speed on everything that’s required. Contact Holbrook & Manter today for assistance. 

TCJA draws a silver lining around the individual AMT

The Tax Cuts and Jobs Act (TCJA) didn’t eliminate the individual alternative minimum tax (AMT). But the law did draw a silver lining around it. Revised rules now lessen the likelihood that many taxpayers will owe substantial taxes under the AMT for 2018 through 2025.

Parallel universe

Think of the AMT as a parallel universe to the regular federal income tax system. The difference: The AMT system taxes certain types of income that are tax-free under the regular tax system and disallows some regular tax deductions and credits.

The maximum AMT rate is 28%. By comparison, the maximum regular tax rate for individuals has been reduced to 37% for 2018 through 2025 thanks to the TCJA. For 2018, that 28% AMT rate starts when AMT income exceeds $191,100 for married joint-filing couples and $95,550 for others (as adjusted by Revenue Procedure 2018-18).

Exemption available

Under the AMT rules, you’re allowed a relatively large inflation-adjusted AMT exemption. This amount is deducted when calculating your AMT income. The TCJA significantly increases the exemption for 2018 through 2025. The exemption is phased out when your AMT income surpasses the applicable threshold, but the TCJA greatly increases those thresholds for 2018 through 2025.

If your AMT bill for the year exceeds your regular tax bill, you must pay the higher AMT amount. Originally, the AMT was enacted to ensure that very wealthy people didn’t avoid paying tax by taking advantage of “too many” tax breaks. Unfortunately, the AMT also hit some unintended targets. The new AMT rules are better aligned with Congress’s original intent.

Under both old and new law, the exemption is reduced by 25% of the excess of AMT income over the applicable exemption amount. But under the TCJA, only those with high incomes will see their exemptions phased out, while others — particularly middle-income taxpayers — will benefit from full exemptions.

A Note for High-Income Earners

Before the Tax Cuts and Jobs Act (TCJA), many high-income taxpayers weren’t affected by the alternative minimum tax (AMT). That’s because, after multiple legislative changes, many of their tax breaks were already cut back or eliminated under the regular income tax rules. So, there was no need to address the AMT.

If one’s income exceeds certain levels, phaseout rules chip away or eliminate other tax breaks. As a result, higher-income taxpayers had little or nothing left to lose by the time they got to the AMT calculation, while many upper-middle-income folks still had plenty left to lose. Also, the highest earners were in the 39.6% regular federal income tax bracket under prior law, which made it less likely that the AMT — with its maximum 28% rate — would hit them.

In addition, the AMT exemption is phased out as income goes up. This amount is deducted in calculating AMT income. Under previous law, this exemption had little or no impact on individuals in the top bracket, because the exemption was completely phased out. But the exemption phaseout rule made upper-middle-income taxpayers more likely to owe AMT under previous law. Suffice it to say that, under the TCJA, high-income earners are back in the AMT spotlight. So, proper planning is essential.

Need to plan

For many taxpayers, the AMT rules are less worrisome than they used to be. Let Holbrook & Manter assess your liability and help you plan accordingly.

The Pitfalls of DIY Estate Planning

There’s no law that says you can’t prepare your own estate plan. And with an abundance of online services that automate the creation of wills and other documents, it’s easy to do. But unless your estate is small and your plan is exceedingly simple, the pitfalls of do-it-yourself (DIY) estate planning can be many.

Dotting the i’s and crossing the t’s

A common mistake people make with DIY estate planning is to neglect the formalities associated with the execution of wills and other documents. Rules vary from state to state regarding the number and type of witnesses who must attest to a will and what, specifically, they must attest to.

Also, states have different rules about interested parties (that is, beneficiaries) serving as witnesses to a will or trust. In many states, interested parties are ineligible to serve as witnesses. In others, an interested-party witness triggers an increase in the required number of witnesses (from two to three, for example).

Keeping abreast of tax law changes

Legislative developments during the last several years demonstrate how changes in the tax laws from one year to the next can have a dramatic impact on your estate planning strategies. DIY service providers don’t offer legal or tax advice — and provide lengthy disclaimers to prove it. Thus, they cannot be expected to warn users that tax law changes may adversely affect their plans.

Consider this example: A decade ago, in 2008, George used an online service to generate estate planning documents. At the time, his estate was worth $4 million and the federal estate tax exemption was $2 million.

George’s plan provided for the creation of a trust for the benefit of his children, funded with the maximum amount that could be transferred free of federal estate tax, with the remainder going to his wife, Ann. If George died in 2008, for example, $2 million would have gone into the trust and the remaining $2 million would have gone to Ann.

Suppose, however, that George dies in 2018, when the federal estate tax exemption has increased to $11.18 million and his estate has grown to $10 million. Under the terms of his plan, the entire $10 million — all of which can be transferred free of federal estate tax — will pass to the trust, leaving nothing for Ann.

While even a qualified professional couldn’t have predicted in 2008 what the estate tax exemption would be at George’s death, he or she could have structured a plan that would provide the flexibility needed to respond to tax law changes.

Don’t try this at home

These are just a few examples of the many pitfalls associated with DIY estate planning. To help ensure that you achieve your estate planning objectives, contact Holbrook & Manter to review your existing plan.

Addressing long-term care costs with a tax-qualified LTC insurance policy

No matter how diligently you prepare, your estate plan can quickly be derailed if you or a loved one requires long-term home health care or an extended stay at a nursing home or assisted living facility.

The annual cost of long-term care (LTC) can reach as high as six figures, and this expense isn’t covered by traditional health insurance policies, Social Security or Medicare. So it’s important to have a plan to finance these costs, either by setting aside some of your savings or purchasing insurance.

LTC insurance

An LTC insurance policy supplements your traditional health insurance by covering services that assist you or a loved one with one or more activities of daily living (ADLs). Generally, ADLs include eating, bathing and dressing.

LTC coverage is relatively expensive, but it may be possible to reduce the cost by purchasing a tax-qualified policy. Generally, benefits paid in accordance with an LTC policy are tax-free. In addition, if a policy is tax-qualified, your premiums are deductible (as medical expenses) up to a specified limit.

To qualify, a policy must:

  • Be guaranteed renewable and noncancelable regardless of health,
  • Not delay coverage of pre-existing conditions more than six months,
  • Not condition eligibility on prior hospitalization,
  • Not exclude coverage based on a diagnosis of Alzheimer’s disease, dementia, or similar conditions or illnesses, and
  • Require a physician’s certification that you’re either unable to perform at least two of six ADLs or you have a severe cognitive impairment and that this condition has lasted or is expected to last at least 90 days.

It’s important to weigh the pros and cons of tax-qualified policies. The primary advantage is the premium deduction. But keep in mind that medical expenses, including LTC insurance premiums, are deductible only if you itemize and only to the extent they exceed 7.5% of your adjusted gross income (AGI) in 2018 or 10% of AGI in future years (unless Congress extends the lower threshold). So some people may not have enough medical expenses to benefit from this advantage. It’s also important to weigh any potential tax benefits against the advantages of nonqualified policies, which may have less stringent eligibility requirements.

Think long term

Given the potential magnitude of long-term care expenses, the earlier you begin planning, the better. Holbrook & Manter can help you review your options and analyze the relative benefits and risks.

H&M Team Members Hold Art Supply Drive for Nationwide Children’s Hospital

Our team members are passionate about supporting a number of causes. Collectively, we continue to support Nationwide Children’s Hospital. Our team was asked to bring in art supplies over part of the summer that could then be donated to the patients at the hospital.  From markers and crayons… to coloring books and scissors… we covered all of the artistic bases. We had so much fun gathering up all of these colorful items in the hopes to brighten the day of those at Nationwide Children’s. As always, the process to drop off our donation was an easy one. It was our pleasure to deliver all that we collected to the friendly staff at the hospital. Happy art-creating to all of the patients! 

Looking to learn more about Nationwide Children’s Hospital? They share this write-up on their website:

Nationwide Children’s Hospital is a destination academic pediatric medical center designed to manage the most complex of diseases. We treat the sickest of patients from across the country and around the world. We build research programs to assure tomorrow’s breakthroughs help children everywhere. And we train the next generation of physicians, scientists and health care professionals.

Beyond our walls, we invest in building social equity in our communities, address the social determinants of health, and develop payment models to better serve unique populations of children. Our unparalleled investment in Behavioral Health services and research further cements our role as an ambitious champion for the well-being of children everywhere.

Turning these Common Business Expenses into Deductions

By: Grant Trudel, MBA- Senior Assistant Accountant  

Common expenses taken as deductions for businesses are travel, mileage reimbursement, and de minimis office expenses.  These have been areas of IRS scrutiny and have strict documentation guidelines that need to be followed for the deductions to be allowed. When your business has significant expenses related to the ordinary and necessary conduct of business operations, the tax consequences can be significant when the expenses are disallowed under an IRS audit.

There are varying rules and tax consequences regarding the deductibility of de minimis office expenses, travel, and vehicle/mileage reimbursement expenses, but one thing is constant: proper documentation is critical for deducting expenses. Keeping receipts, canceled checks, bills, or other like kind documentation of expense is the first step in creating proper documentation for the expenses. If mileage is being reimbursed, a mileage log that includes the date of travel, mileage, the destination of travel, the business purpose of the trip, and other supporting information should be kept as support for the expense. For de minimis office expenses, business purchases of tangible property that are below the $2,500 threshold,  you will only need to keep record of the business usage if the property is kept at a location other than the company’s place of business (such as a home office). If the property is kept at the company, all use is assumed to be for business purposes.

If travel is a frequent part of the business operations, timely record keeping is considered more reliable than re-creating mileage logs after the fact. There are various mobile phone applications that can be used to track mileage, allowing annotation on the trip to be undertaken promptly. When purchasing travel expense such as hotels, car rentals, or flights, it is best practice to use a company credit card as travel is often looked at for personal travel expenses. Keeping copies of the reason of travel such as a business conference or meeting along with notation of business purpose will aid in properly documenting the expense. One thing to keep in the fore front is the requirement to track the business purpose of any expense. Too often, business expenses appear to be personal in nature and are disallowed without proper documentation. When it comes to proper documentation, there is no such thing as too much proof if the IRS has any doubt regarding the business purpose.

If the company is reimbursing employees, requiring monthly expense reports with the proper documentation is best practice and each report should be kept with the correlated expenses. Having an Accountable Plan that is in compliance with the IRS guidelines as part of the company policies and procedures will allow for the expenses to be deducted by the company without being considered taxable income to the employee. Any reimbursements deemed to be paid without an Accountable Plan are required to be reported on the employee’s W-2 and are taxed on by the employee’s personal return.

Aspects the Accountable Plan needs to include in order to pass IRS scrutiny include:

1) The expense(s) must have a business purpose and were incurred while an employee was performing services in the ordinary course of business for the company; 2) The employee must adequately account to the company by providing detailed information on the expense(s) including the date, time, place, amount of the expense, and the business purpose; 3) Any excess reimbursements paid to an employee must be returned to the company within a reasonable and specified period of time.

Please contact us for more information on the deductibility, how to properly document expenses, and Accountable Plans.

Important Information about the Qualified Business Deduction

By: Linda Fargo, CPA, CGMA- Manager

The 2017 Tax Act, officially named “An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018” but often referred to as the “Tax Cuts and Jobs Act”, introduced the “Qualified Business Income Deduction” or “QBI Deduction” contained in Internal Revenue Code (IRC) §199A .  The actual name is, however, more symbolic of the complicated and even convoluted way this extremely favorable deduction is calculated. (Fortunately, some of the complications were eliminated in the Consolidated Appropriations Act, 2018 enacted March 23, 2018.)  Recently released proposed regulations add clarity but also raise additional questions.

Since the QBI deduction introduces a whole new set of acronyms, let’s start with a glossary to assist in understanding what they all mean and, hopefully, keeping them straight.

Individual Individual An individual, trust (other than a grantor trust), estate or other person eligible to claim the Code Section 199A deduction.
QTB Qualified Trade or Business A very broad category of business activities, but subject to numerous highly technical requirements and limitations.
TI Taxable Income Defined for QBID only, as TI determined after all above and below the line deductions but without regard to Section 199A.
QBI Qualified Business Income Items of income, gain, deduction and loss from domestic business activities connected with the conduct of a trade or business within the United States. It is not necessary to actively participate.
QBID Qualified Business Income Deduction Generally 20% of QBI subject to certain limitations and thresholds.
SSTB Specified Service Trade or Business Any trade or business involving the performance of services except engineering and architectural services.
IT Initial Threshold TI of $157,500 for single filers and $315,000 for joint filers
MT Maximum Threshold TI of $207,500 for single filers and $415,000 for joint filers
SSTB Limitation Specified Service Trade or Business Limitation Taxpayers with a SSTB can enjoy the QBID only if their TI is less than certain thresholds.  Phases out between the IT and the MT.  Once the MT is reached no QBID is allowed. “Poor Lawyer Exception”
UBIA Unadjusted Basis Immediately After Acquisition Original basis of assets for which the depreciable period is the later of (1) 10 years from the placed-in-service date or (2) the last day of the last full year in the MACRS recovery period, determined without considering the alternative depreciation system (ADS)
W&P Limitation Wage and Property Limitation The greater of 50% of the W-2 wages or the sum of 25% of the W-2 wages plus 2.5% of the UBIA of all qualified property. Phases in between the IT and the MT for non-SSTB. “Good Planner Exception”
CQBIA Combined Qualified Business Income Amount The sum of the QBI for each QTB plus 20% of the aggregate amount of the qualified REIT dividends and qualified publicly traded partnerships (PTP) income of the taxpayer for the taxable year
TIL Taxable Income Limit The QBID is limited the 20% of TI minus capital gains

 

Brief Overview:

The qualified business income deduction (QBID) is potentially available to all taxpayers with qualified trade or business (QTB) income other than C corporations, including estates and trusts with qualified business income (QBI). Generally, except for non-grantor estates and trusts, the QBID is taken at the individual taxpayer level.  The eligibility list includes individuals operating a QTB through a sole proprietorship (including through a single member LLC), as well as individuals who are owners of pass-through entities, including S corporations, partnerships and grantor trusts.  Basically, any individuals who operate a Schedule C or F business, or who report income from a business activity on Schedule E, may be eligible to claim the to claim the QBI deduction.  The QBI deduction specifically does NOT apply to W-2 wages.

Subject to limitations based on the type of business involved, the amount of wages paid and/or the original purchase price of property placed in service in connection with the business, the QBI deduction is equal to 20% of QBI.

The deduction provided in Code Section 199A(a) is the lesser of: (a) the combined qualified business income amount (CQBIA) (which in many or most cases will be equal or approximately equal to 20% of QBI), or (b) 20% of the excess of taxable income over net capital gains (the “taxable income limitation”).

The basic concept seems deceptively simple.  Unfortunately, as with most tax law, the exceptions, thresholds and limitations can result in some very complex calculations.  Let’s take it step by step.

Step One: Calculate TI

The QBI deduction starts with taxable income (TI).  A taxpayer must first run all his/her tax information through the complex structure of the Internal Revenue Code before beginning to calculate the deduction.  This would include all calculations for passive activity, basis, at risk, bonus depreciation, itemized deductions, etc.

Step Two: Identifying QBI

The first step in computing QBID is identifying qualified business income (QBI) from each of the taxpayer’s Section 162 trades or businesses.  Generally, QBI includes Items of income, gain, deduction and loss from domestic business activities connected with the conduct of a trade or business within the United States. In addition, according to proposed regs, rental or licensing of tangible or intangible property (ex. rental activity) that does not rise to the level of a Code Sec. 162 trade or business is nevertheless treated as a trade or business for purposes of QBID, if the property is rented or licensed to a trade or business which is commonly controlled (self-charged rent).  QBI doesn’t include investment income such as capital gains and losses, dividends, interest income (unless properly allocable to a trade or business), and commodity and foreign currency gains.  QBI specifically excludes reasonable compensation paid to the taxpayer, guaranteed payments and payments to partners acting outside their capacity as a partner.  It also does not include any qualified REIT dividends or qualified publicly traded partnership income come.

A qualified trade or business (QTB) is generally defined as any trade or business other than the business of performing services as an employee or a specified service trade or business (SSTB).

A SSTB is one that involves the performance of services in the in the fields of health, law, 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.  Engineering and architectural services are specifically excluded. Some commentaries question whether the “reputation or skill” clause might pull engineering and architectural services back into the definition of SSTB.  However, based on the proposed regs, it appears the IRS interprets the “reputation or skill” clause narrowly to apply to endorsements; license of an individual’s image, likeness, voice and the like; and appearance fees.

There is an exception that allows taxpayers with lower income to treat SSTB income as a nonservice business for Section 199A purposes.  However, this exception is only fully available for taxpayers with 2018 taxable income below the initial threshold (IT) of $315,000 if married filing jointly ($157,500 for all others).  The exception is fully phased out when 2018 taxable income is $415,000 or more if married filing jointly ($207,500 for all others).  Taxpayers with income above the maximum threshold (MT) can’t treat any income from a SSTB as QBI.

New proposed regulations provide for a de minimis rule.  If less than 10% (5% for entities with receipt of more than $25 million) of QBI is from an SSTB, it can be ignored, and the entire business is treated as eligible for QBID.  It is unclear if specified service income in excess of 10%/5% taints the whole business or only the specified service income.

QBI losses can be carried forward and treated as a loss from QTB in the next year.  This functions much like the passive activity loss limitation.  According to proposed regs, losses or deductions that were disallowed for tax years beginning before January 1, 2018 are not taken into account for purposes of computing QBI in future years. Code Sec. 199A carryover rules do not affect the deductibility of the losses for purposes of other provisions of the Code.

If a taxpayer has an overall loss after qualified REIT dividends and qualified PTP income are combines, the portion of the individuals QBID related to the qualified REIT dividends and qualified PTP income is zero for the year.  This overall loss does not affect the taxpayer’s QBI but is instead carried forward and used to offset combined REIT dividends and qualified PTP income in the succeeding year(s).  Yet another new tracking requirement!

New proposed regulations state that only losses suspended (suspended basis/at risk/passive activity losses) after 2017 reduce QBI in the future.  Since there is currently no “ordering” to suspended losses, additional tracking will be required.

Step Three: Computing QBID 

Once QBI is identified for each QTB, the next step is computing the deductible for each trade or business.  Generally, the deductible amount is 20% of QBI for each QTB. However additional limits apply for taxpayers with TI above the IT and are phased in completely at the MT.

For taxpayers with TI above the MT, the QBID is limited to the greater of (1) 50% of the W-2 wages paid by the business or (2) 25% of the W-2 wages paid by the business plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of the business’s qualified property. These limitations, commonly referred to as the wage & property limitation (W&P Limitation), phase in between the same initial and maximum thresholds that apply to the SSTB.

For those taxpayers with TI between the IT and the MT, the phase-in is computed by determining the amount by which 20% of QBI exceeds the W&P Limitation (the excess amount).  The taxpayer’s phased in limit equals the excess amount multiplied by the percentage obtained when dividing the amount of taxable income that exceeds the threshold by $100,000 ($50,000 for non-joint filers).

W-2 Wages. For purposes of the limitation, these are total wages subject to withholding, elective deferrals, and deferred compensation paid by the QTB during its calendar year ending in the taxpayer’s taxable year, provided such compensation is properly allocable to QBI. Additionally, the business must file Form W-2 reporting such wages.

Proposed regs state that, in the case of W-2 wages that are allocable to more than one trade or business (Ex. leased employees or common paymaster), the portion of the W-2 wages allocable to each trade or business is determined in the same proportion to total wages as the deductions associated with those wages are allocated amount the particular trades or businesses.

Notice 2018-64, 2018-35 IRB contains a proposed revenue procedure that sets out 3 methods for calculating W-2 wages.

Also, the proposed regs indicate that there is a W-2 wages-paid limitation for high-income individuals that applies even if the person isn’t engaged in a specified service business.  It caps the deduction at the basic 20% of QBI from the business or, if lower, a figure that looks at W-2 wages paid by the business and the unadjusted basis of tangible, depreciable property used in the business and not fully depreciated.

Qualified Property. For purposes of the limitation, this is depreciable property held by the business and available for use at the end of the year that is used in the production of QBI.  The depreciable period is the later of (1) 10 years from the placed-in-service date or (2) the last day of the last full year in the MACRS recovery period, determined without considering the alternative depreciation system (ADS).  The depreciable period for purposes of QBID is not the same as the depreciation (or recovery) period for income tax purposes. Let’s hope our depreciation software will calculate this for us. If not, this provision could be a logistical nightmare.

In the case of a pass-through entity, each owner is allocated their proportionate share of the W-2 wages and qualified property of the entity.  It has been suggested that partnerships might have the flexibility to cause specific partners to be allocated W-2 wages and unadjusted basis, by making special allocations of wage expenses and depreciation deductions. When preparing pass-through entity tax returns, it will be necessary to gather this information, determine the allocations and to report it on the owners’ K-1s.

The proposed regs clarify that Section 179 and the additional first-year depreciation doesn’t affect the applicable recovery period for QBID purposes.  However, UBIA does reflect the reduction in basis for the percentage of the taxpayer’s use of the property for other than trade in the taxpayer’s trade or business (non-business use).

Proposed regs also explain that if a taxpayer has QBI of less than zero from one trade or business, but has overall QBI greater than zero when all of the taxpayer’s trades or businesses are taken together, then the taxpayer must offset the net income in each trade or business that produced net income with the net loss form each trade or business that produced net loss before the taxpayer applies the W&P limits. The taxpayer must apportion the net loss amount the trade or businesses with positive QBI in proportion to the relative amounts of QBI in such trades or businesses.  Then, for purposes of applying the W&P limitation, the gain or income in respect to each trade or business (as offset by apportioned losses) is the taxpayer’s QBI with respect to that trade or business. The W-2 wages and UBIA of qualified property from the trades or businesses which produced negative QBI are not taken into account for purposes of QBID and are not carried over into subsequent years.

In addition, proposed provide for an elective aggregation regime.  If certain requirements are met, taxpayers who engage in more than one trade or business may – but are not required to – aggregate trades and businesses, treating them as a single trade or business for purposes of applying the W&P limitation.  Once aggregation is chosen, it must be consistently reported in all subsequent years. Annual reporting is required.

These rules are complex and depend on several variables.  The table below summarizes the computation for each of the taxpayer’s QTBs.

Nonservice Business Specified Service Business
Taxable income of $315,000 ($157,500 for non-joint) or less 20% of QBI 20% of QBI
Taxable income greater than $315,000 but less than $415,000 ($157,500/$207,500 for non-joint) Same as above, W&P limitation phase in Amount of income that is QBI is phased out: W&P limitation is phased in
Taxable income of $415,000 ($207,500 for non-joint) or more 20% of QBI subject to the W&P limitation No deductible amount

 

Step Four: Determining the CQBIA

Once calculated, the QBID for all QTBs are combined with 20% of qualified real estate investment trust (REIT) dividends and qualified PTP income. The W&P limitation does not apply to the REIT and PTP component of the deduction. The result is the combined qualified business income amount (CQBIA).

A qualified REIT dividend is any dividend from a REIT received during the tax year that isn’t a Section 857(b)(3) capital gain dividend income under IRC Sec. 1(h)(11).

Qualified PTP income is the sum of (1) the net amount of the taxpayer’s allocable share of each qualified item of income, gain, deduction, and loss from a Section 7704 PTP that isn’t treated as a corporation for tax purposes and (2) any gain recognized by the taxpayer upon the disposition of a PTP interest to the extent it’s treated as an amount realized from the sale or exchange of property other than a capital gain.

Step Five: Calculating the Final Deduction

The final QBID is the lesser of (1) the CQBIA amount or (2) 20% of the excess, if any, of the TI over the sum of net capital gains and the aggregate amount of qualified cooperative dividends; plus, the lesser of (1) 20% of the aggregate amount of the qualified cooperative dividends for the taxable year, or (2) taxable income reduced by the net capital gain. This is known as the taxable income limit (TIL).

Other Considerations:

Entity Considerations. In the case of an S corporation, the IRS requires that a shareholder receive reasonable compensation from the S corporation for his services.  Neither these wages nor guaranteed payments to partners qualify for QBI.  In contrast, in the case of a business conducted by a sole proprietor or a single member LLC that is treated as a disregarded entity, all the business’s income can be QBI. Also, because of the exclusion of SSTB, it might be beneficial to break down income streams into multiple entities.  However, it appears this can only be done as long as the businesses aren’t under “common control.”

In addition, when you combine a 21% corporate rate, a 100% Section 1202 exclusion for owners of a C corporation, and the uncertainty of a Section 199A deductions for owners of a pass-through entity, business owners might want to take a close look at forming or convert to a C Corporation.

Deduction for Specified Agricultural or Horticultural Cooperatives.  A specified agricultural or horticultural cooperative is entitled to a deduction equal to 9% of the lesser of (1) the “qualified production activities income” of the cooperative for the taxable year or (2) the taxable income of the cooperative for the taxable year (calculated without regard to certain patronage dividends, per-unit retains, and non-patronage distributions.)  Basically, this cooperative-level deduction is very similar to the domestic production deduction (DPAD).  The cooperative will be able to either pass the deduction through to its patrons or retain the deduction for its own use.  As a result, patrons will be unable to definitively calculate their QBID until notified by the cooperative about whether or not the cooperative elected to pass the deductions through to the patrons.

Substantial Understatement Penalty. For a taxpayer claiming the QBID, the 20% accuracy penalty for substantial understatements of income tax applies if the understatement exceeds the lesser of (1) 5% (instead of the usual 10%) of the tax required to be shown on the return, or (2) $5,000.

Filing Status Optimization. The interplay between QBI and TI in a joint versus separately filed return may result in a substantial tax savings to file separately, especially if one of the spouses has high income and the other owns a SSTB.

Planning Opportunities. Given the complexity of the new deduction as well as some other tax law changes, it’s a good idea to get a head start on determining the affects on each individual tax situation in 2018.  We would love to schedule a planning meeting with you.

Your Financial Gatekeeper

How to Obtain Peace of Mind with a Trust Protector

An irrevocable trust makes for a smooth transfer of wealth to family members – with the an additional tax-advantage bonus. However, you must relinquish control of the assets placed within the irrevocable trust while setting it up. What you control from there is who will eventually manage the distribution of wealth and assets after your passing. You appoint the trustee. And if you’re not completely confident that a single trustee will carry out your wishes in full, you can establish a trust protector, as well.

What Does a Trust Protector Do?

A trust protector is essentially the “board of directors” to the designated trustee. The trustee handles the trust on a day-to-day basis, while the protector manages the trustee and helps make critical decisions moving forward, such as high-value investment transactions or the sale of closely held business interests.

There is almost no limit to the powers you can bestow on your designated trust protector. You can allow a trust protector to replace a trustee, to appoint a successor trustee or a successor trust protector, and to approve or veto investment or beneficiary distribution decisions. He or she can also resolve disputes between trustees and beneficiaries.

A Quick Word of Warning

While it may be tempting to provide a protector with a broad range of powers, this may hamper the original trustee’s ability to manage the trust efficiently. Keep in mind that the idea is to protect the integrity of the trust, not to appoint a co-trustee. You don’t want too many cooks in the estate planning kitchen.

Exercising Discretion to Reach Estate Planning Goals

Trust protectors offer a variety of added benefits:

  • A protector with the power to remove and replace the trustee can do so if the trustee develops a conflict of interest or fails to manage the trust assets in the beneficiaries’ best interests.
  • A protector with the power to modify the trust’s terms can correct mistakes in the trust document or clarify ambiguous language.
  • A protector with the power to change the way trust assets are distributed if necessary to achieve your original objectives can help ensure your loved ones are provided for in the way you would have desired.

*These are just a handful of examples showcasing how the appointment of a designated trust protector can help ensure you achieve your estate planning goals.

This Is Not a Light Decision

Picking the perfect trust protector is critical to your estate planning strategy. Given the potential power this person will have over your family’s wealth, you will want to choose someone you have immense trust and confidence in. This person should be qualified to make investment and other financial decisions on your behalf. Many individuals choose to appoint a trusted financial advisor — such as a long-term accountant, attorney or investment advisor — who may not be able or willing to serve as trustee, but can provide an extra layer of protection by monitoring the trustee’s performance.

Contact Holbrook & Manter today if you would like to learn more about incorporating a trust protector into your estate plan.

Grants vs. Contracts: Why it Matters

By: William Bauder, CPA, CGMA, CITP- Manager

Which would you prefer, a grant or a contract? To many, they are both equally good things to have.   Obtaining either a grant or a contract means that your organization has money!  They also both mean that someone recognizes your organization for the value it can provide with the proper funding.  For your accountant however, the difference between the two can be very complex even in a seemingly simple situation.  When the complexities of accounting for these funding sources are paired with the current complexity of the upcoming changes to the revenue recognition rules – the accounting can become nearly impossible to decipher.  However, a hopeful fix for these complexities was just made with the Financial Accounting Standards Board’s (FASB) recent release of Accounting Standard Update (ASU) (No. 2018-08)

The purpose of the release of ASU 2018-08 is to help clarify the difference between a grant and a contract for financial reporting purposes.  Using a decision tree, both parties must first determine if they both are receiving commensurate value (i.e. exchanging items or services of equivalent value).  If it’s determined that an exchange has in fact occurred, the organization should follow the standard revenue recognition guidance.  It should be noted that one item that has often led to inconsistency in practice is the consideration of societal benefits. Societal benefits include general benefits to society based upon the work you are performing. These benefits are specifically excluded from the decision tree and should not be considered as commensurate value for the transacting parties. 

The next step in determining if a transaction should be treated as a grant or contract is to determine whether or not the transaction is considered a contribution (i.e. nonreciprocal). If this is the case, you must then consider if there are any special conditions placed upon the contribution.  Conditions can affect the timing of revenue and expense recognition by the resource recipient and resource provider.  For a contribution to be conditional, the answer to both the following questions is expected to be “yes”:

1.       Does the contributor retain either a right of return to the resource provider or a right of release of promisor from its obligation to transfer resources?

2.       Is there a barrier the not-for-profit (NFP) organization must overcome to be entitled to the resources provided?

To help define a “barrier” the FASB has also provided the following indicators as part of ASU 2018-08:

“The NFP is required to achieve a measurable outcome (e.g., help a specific number of beneficiaries or produce a certain number of units).”

  “The NFP is required to overcome a barrier related to the primary purpose of the agreement. (Note: This excludes trivial or administrative requirements.)”

 “The NFP has limited discretion over how the resources are spent (e.g., a requirement to follow specific guidelines about incurring qualifying expenses).”

If a contribution is determined to be conditional, any funds transferred in advance are to be recognized as a liability and revenue is not to be recognized until all conditions have been substantially met.

If your organization’s accountant has been struggling to fully understand how to implement the new Accounting Standard, ASU 2018-08 should be a helpful tool in clarifying what it will mean to have a grant or contract on your books. Contact us today for more information and assistance.