New Section 199A - Planners, Sharpen Your Pencil

New Section 199A - Planners, Sharpen Your Pencil

Article posted in Income Tax, Regulations on 9 February 2018| 3 comments
audience: National Publication, Dennis Walsh, CPA | last updated: 23 February 2018
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Summary

New code section 199A is confusing and complex and offers many planning opportunities once it is understood. Dennis Walsh helps clarify with great insight into some of the many considerations we face.
 

By: Dennis R. Walsh, CPA

 

Sometimes me sits and thinks. Sometimes me just sits.

Perhaps this captures the feelings of many tax practitioners and gift planners faced with the daunting task of optimizing business and personal income taxes under the CPA Full Employment Act, also known as the Tax Cuts and Jobs Act of 2017. 

Most small businesses need to re-examine flow-through versus C corporation taxation, in particular the extent to which to utilize the 20% of qualified business income deduction under new Section 199A applicable to income from flow-through entities, or the 21% flat tax rate applicable to C corporations, both effective with the 2018 tax year. And the implications go beyond operating effects.

Given (1) the statutory ink is barely dry, (2) current absence of implementing guidance for Section 199A, (3) time compression for tax practitioners in their busy season, and (4) client expectations to make the best recommendations, the analysis amounts to a formidable task. 

It would therefore seem justifiable to defer recommendations until a future date. Looking ahead, tax year 2017 may be remembered as the year of the tax filing extension.

Projections regarding the combined 2017 and 2018 effects of elections such as the Section 179 and 168(k) writeoffs, or whether to carryback a 2017 net operating loss will help inform the tax entity evaluation. Assumptions regarding the amount and timing of charitable gifts and other non-business deductions will also play an important role in managing the taxable income based limitations of the 20% deduction from year to year.

Thus, the study goes beyond tax rate differentials under the old and new law. Given the nuances of the 20% deduction, , The calculations will often yield surprising results and will require running pro forma numbers in most cases.

Taxpayers operating more than one trade or business have greater possibilities, but the analysis is compounded. In addition, Section 199A guidance for defining separate trade or business activities is not yet available.

This is important because the limitation of the 20% deduction to the greater of 50% of wages paid or 25% of wages paid plus 2.5% of qualified property, applicable to high-income taxpayers, is not applied by comparison of aggregate totals but separately applied to each qualifying trade or business of the taxpayer. see “Planning for the UBTI Changes” for a discussion of other Code provisions on this issue.

Accordingly, accounting systems of pass-through entities operating multiple trades or businesses must be able to capture this data for each separate activity for Schedule K-1 reporting to shareholders, partners, and trust or estate beneficiaries.

The evaluation also poses a timing challenge for businesses operating as a corporation or LLC with the option of electing or revoking S corporation status. For such entities using the calendar year, representing most S corporations, the due date for either election to be effective for 2018 is March 15, 2018. In the case of termination, a new election cannot be made for 5 years without obtaining IRS consent.  

Yet, there may be situations where perceived tax differences between C and S corporation status for 2018 under the new law are so dramatic that the assumption of risks associated with acting on less than a fully ripe analysis is warranted. That’s for advisors and their clients to decide on a case by case basis.

Here are some bite-size planning points gleaned from reflecting on immediate and long-term implications of the 20% deduction and related tax entity choices:

·       The new 21% corporation tax rate is permanent, while the Section 199A deduction sunsets after 2025 unless extended at some point.

·       Personal service corporations are taxed at the new 21% corporation rate versus the former 35% rate, creating a potential to divide income that for most taxpayers in affected occupations did not exist under prior law.

·       The built-in gains tax still applies in the case of a C corporation with appreciated assets and converting to S corporation.

·       C corporation status comes without the limitations associated with employee benefits for 2% S corporation shareholders.

·       State corporation income and franchise taxes, where applicable, should be considered in evaluating corporate versus pass-through taxation of business earnings.

·       The 20% accumulated earnings tax applicable to a C corporation remains a potential long-term threat, but the $250,000 exemption and the reasonable needs of the business exception still apply under the new law.

·       If a decision is made to shift trade or business activities away from a tax entity also having income from passive sources, consideration should be given to potential exposure to the passive income tax in the case of an S corporation and the personal holding company tax in the case of a C corporation.

·       State taxes attributable to business income are generally deductible by a C corporation, which may provide a partial offset to a loss of personal itemized deductions due to the new $10,000 cap on the sum of residential property taxes and state income taxes.

·       Qualified business income under Section 199A does not include any amounts treated as reasonable compensation paid to an S corporation shareholder/employee. The IRS now has twice the incentive to attack dividends as constructive wages (i.e. reasonable compensation). Accordingly, the basis for reasonable compensation as well as any factors supporting reduced wages, such as decreased involvement due to health, age, or other activities should be documented.

·       It is not yet certain how a net operating loss carryover will affect computation of the 20% deduction, but it appears that while not reducing qualified business income arising in the carryover year it will nevertheless come into play with the taxable income based limitations.

·       The lower capital gain rates generally apply to gain on stock arising from corporate liquidation, but there may still be a corporate level tax if any appreciated assets are held by a C corporation upon liquidation or if such property is disposed of within the built-in gains recognition period in the case of an S corporation.

As with other property, the estate of a deceased shareholder receives a fair market value adjustment to the basis of stock acquired from the decedent, generally eliminating shareholder tax on subsequent liquidation of the corporation.

Due to the myriad of planning possibilities and sensitivity of the 20%of business income calculation, the introduction of Section 199A may result in the most computational approach to tax planning yet. Bottom line – do the math.

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Comments

Re: New Section 199A - Planners, Sharpen Your Pencil

Dennis, someone at the Heckerling brought up the question whether charitable income tax deductions would help to reduce a high income taxpayers AGI so their income may get under the 199A phaseout. In order for that to be true 199A would have to also be a below the line deduction. Does that logic make sense? thanks for the article.

Re: New Section 199A - Planners, Sharpen Your Pencil

Paul,
The Section 199A deduction is taken “below the line” (i.e. adjusted gross income) in arriving at taxable income. Taxable income is the starting point for the phaseout calculations. So, yes, optimizing contributions may be important in managing the deduction phaseouts applicable to high-income taxpayers and those in specified service trades. But there are numerous moving parts to the calculation and no assumptions should be made. Remember that this is a “lesser of” computation. Increasing contributions may help with one of the limitations while at the same time working against the taxpayer in another. Run the numbers in every case.

Re: New Section 199A - Planners, Sharpen Your Pencil

thank you Dennis. that's great

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