The IRS on Jan. 11, 2018, released new guidelines to help businesses and payroll-service providers adjust employees’ withholding calculations to reflect the new income tax rates and provisions of the Tax Cuts and Jobs Act. Businesses must apply the new withholding tables to workers’ paychecks by Feb. 15, 2018.
The new tables rely on the information that workers have already provided to their employers in existing Forms W-4, including the number of withholding allowance they claims. As a result, employees will not be required to complete new W-4s in 2018. However, it is recommended that workers check their withholding status on paychecks they receive after February 15 to ensure that the appropriate amount of income taxes are taken out of their pay each pay period.
While the payroll withholding adjustments under the new tax law will result in an increase in workers’ take-home pay, it does not mean that workers will owe less in taxes at the end of 2018. It is advisable that businesses and individual taxpayers meet with experienced accountants to guide them through the provisions of the new tax law.
The advisors and accountants with Berkowitz Pollack Brant work closely with businesses of all sizes and across virtually all industries to implement strategies intended to minimize tax liabilities, maintain regulatory compliance, improve efficiencies and achieve long-term growth goals.
About the Author: Cherry Laufenberg, CPA, is an associate director of Tax Services with Berkowitz Pollack Brant, where she works with corporations, pass-through entities, trusts and foreign entities. She can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or via email at firstname.lastname@example.org.
While the Tax Cuts and Jobs Act (TCJA) reduces the corporate tax rate significantly from 35 percent to a flat 21 percent, the tax rate on income earned by many pass-through entities organized as LLCs, partnerships, S corporations, or sole proprietorships is also reduced albeit in a more complicated manner. According to the Brookings Institute, approximately 95 percent of small businesses are organized as pass-through entities, so the impact of the new pass-through tax rate reduction is important.
Under the TCJA, for tax years beginning on Jan. 1, 2018, and before Jan. 1, 2026, owners of qualifying pass-through entities may, subject to certain limitations, deduct at the individual owner level, up to 20 percent of the U.S.-source qualified business income (QBI) that passes from their businesses through to their personal income tax returns. QBI is a new tax term defined as ordinary passive or active income earned from a trade or business less ordinary deductions. QBI also includes qualified dividends received from REITs, qualified cooperative dividends, qualified income from publicly traded partnerships, and income generated from rental property or from trusts and estates with interests in qualifying pass-through entities. Excluded from the QBI deduction is foreign income, investment income, and wages that owners/partners earn as employees of those businesses.
When individual taxpayers qualify to claim the full 20 percent deduction on QBI, the remaining pass-through income they report on their individual income tax returns will be subject to a top effective tax rate of 29.6 percent. This cap is based on the TCJA’s new top individual income tax rate of 37 percent applied to 80 percent of an entity’s QBI. While this is quite an improvement from the top rate of 39.6 percent that was in effect prior to the TCJA, the new reduced rate for pass-through income is subject to a myriad of complex calculations and phase-out rules that taxpayers must plan for carefully.
Limitations Based on Income and Wage Thresholds
To qualify for the full 20 percent QBI deduction, business owners’ total taxable income (before the QBI deduction) must be at or below $157,500 for individual taxpayers or $315,000 for married taxpayers filing joint returns. When a business owner’s taxable income exceeds these thresholds and the pass-through entity is not a specified service business, the QBI deduction will be limited, based on the business’s W-2 wages and capital investments.
More specifically, the QBI deduction for individuals with taxable incomes above these thresholds is limited to:
- The lesser of 20 percent of QBI, or
- The greater of:
- 50 percent of the business’s W-2 wages; or
- 25% percent of W-2 wages plus an additional 2.5 percent of the unadjusted basis (purchase price) of qualifying tangible depreciable property that generates trade or business income, including buildings, furniture, fixtures and equipment.
With this in mind, owners of pass-through businesses that pay large sums of employee W-2 wages may be able to take a larger QBI deduction than owners of businesses that pay less wages or have fewer W-2 employees. The same is true for owners of businesses with significant investment in tangible assets, such as real estate and equipment, who may be in a better position to maximize their QBI deduction than entities that are not as capital intensive.
As a result of these new rules, qualifying pass-through businesses should plan and project their future taxable incomes at both the entity and individual owner levels while considering the pros and cons of their entity choice. In some instances, it may make sense for a pass-through business to convert to a C corporation and take advantage of the new 21 percent corporate tax rate. Alternatively, business owners may maximize their QBI deductions when they increase their capital investments and buy depreciable property that they previously leased, or when they hire more employees to increase their W-2 wage base, rather than relying on independent contractors.
Treatment of Professional Service Businesses
The law limits the preferential treatment of pass-through business income when it is earned through 1) a “specified service trade or business” in which the principal business assets are the skills and/or reputation of one or more of the owners or employees, or 2) the trade or business of performing services as an employee. More specifically, the law references businesses that involve the delivery of services in the fields of medical care (i.e., physicians, dentists, nurses), legal counsel, accounting and tax counsel, actuarial sciences, performing arts, consulting, athletics, financial services, and financial brokerage services. Due to some last-minute law changes, architectural and engineering services were eliminated from the “specified service trade or business” treatment.
In general, the full 20 percent QBI deduction is available when an owner’s taxable income, including specified service business income but excluding the QBI deduction, is less than $157,500 for individuals or less than $315,000 for married couples filing joint tax returns. When the owner’s taxable income exceeds these ceilings, the 20 percent deduction is gradually phased out, and the owner may receive a reduced QBI deduction. Once taxable income reaches $207,000 for single filers, or $415,000 for joint filers, the QBI deduction for specified service business pass-through income is fully phased out, and the business owner receives no QBI deduction for that pass-through business. To the extent the QBI deduction is limited or eliminated, pass-through business owners will be taxed at their individual rates on their pass-through income, which the TCJA maxes out at 37 percent for individual taxpayers with taxable income of $500,000 or more, or $600,000 or more for married couples filing jointly.
As a result of these specified service businesses restrictions, medical and dental practices, law firms, accounting firms, and other entities whose services include “consulting” or whose primary assets are the skills and reputation of one or more owners or employees, should carefully consider their current structures and project future tax liabilities and potential savings they may yield by restructuring as C corporations. For some entities, such as those that reinvest profits back into the businesses rather than paying dividends to their owners, a timely conversion to a C corporation may allow them to take advantage of the preferable 21 percent tax rate on corporate profits.
Alternatively, specified service business owners may consider separating out each income-generating aspect of their business operations under different structures. For example, a doctor may form a separate legal entity to hold his or her ownership of an office building or surgical center. This will effectively remove revenue generated from real estate assets from the physician’s service income and keep service income below the legislative limits. In addition, owners of specified service business who file joint tax returns with their spouses may instead consider whether electing married filing separately status might increase their QBI deduction.
The new flow-through deduction rules and QBI calculations incorporate other less common income and loss sources, such as the carryover of qualified business losses, income from qualified REIT dividends, publicly traded partnerships income and losses, and capital gains. While not addressed in this article, taxpayers with flow-through businesses should comprehensively address all QBI factors to ensure an accurate QBI deduction.
Unlike many of the business-related provisions contained in the Tax Cuts and Jobs Act, the deduction of pass-through business income is temporary. Moreover, the future political climate, including the 2020 elections, may shift the power in Washington, D.C., away from the Republicans and result in a repeal of all or some parts of the TCJA before the Dec. 31, 2025 expiration date.
In light of these facts and the complexity of interpreting the QBI rules for pass-through businesses, it is critical that entrepreneurs meet with their accountants and tax advisors during the first half of 2018 to properly plan for these new laws and optimize their tax savings without incurring undue risks or derailing their business and financial goals. The best course of action will depend on each taxpayer’s unique facts and circumstances.
About the Author: Thomas L. Smitha, JD, CPA, is an associate director of Tax Services with Berkowitz Pollack Brant, where he provides accounting and consulting services, as well as tax planning and tax structuring counsel to private and publicly held companies. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or via email at email@example.com.
In today’s sharing economy, individuals need little more than an Internet connection to become self-made entrepreneurs. Thanks to platforms such as Uber, Airbnb, TaskRabbit and Upwork, there are countless opportunities for individuals to make money driving cars, renting out rooms or providing on-demand services, either as their primary source of income or as a side gig. However, it is important that participants in the gig economy understand how their services affect their tax liabilities. Here are some quick points to keep in mind.
Income is Taxable.
The IRS considers gig workers to be independent contractors who must report and pay taxes on the income they earn, including cash payments. Income is generally taxable regardless of the amount of time individuals engage in a specific activity or whether or not they receive an income statement, such as Forms W-2 Wage and Tax Treatment, 1099-MISC for Miscellaneous Income, or 1099-K for Payment Card and Third Party Network Transactions.
In many instances, the IRS requires online platforms that facilitate transactions between consumers and gig workers to report to the IRS workers’ income when it exceeds $20,000 and/or when workers conduct more than 200 transactions in a given year. In contrast, freelance workers who do not use sharing platforms to secure work can expect to receive Form 1099-MISC, a copy of which is also provided to the IRS, when they receive income of $600 or more in a tax year.
Pay Taxes as You Go so You Don’t Owe.
Independent contractors must pay self-employment taxes in addition to federal income taxes. Gig workers can make estimated tax payments to the IRS throughout the year to cover these tax obligations rather than waiting to pay a significant tax bill when they file their tax returns.
Alternatively, freelancers who are considered to be employees of either an online platform or another business have the option to withhold more taxes from their paychecks by adjusting their exemptions on IRS Form W-4, Employee Withholding Allowance Certificate. It is beneficial for workers to meet with tax advisors to ensure that the correct amount is withheld from their income. When workers do not withhold enough tax, they may owe a significant tax bill at the end of the year and also be liable for estimated tax underpayment penalties. If they withhold too much tax, workers may unintentionally reduce their cash flow, give the IRS an interest-free loan, and lose out on opportunities to invest those extra dollars or benefit from compounding interest.
Take Qualifying Deductions to Lower Taxable Income.
The Tax Code allows individuals to deduct certain “ordinary and necessary” costs of doing business from their gross income. These deductible business expenses may include the costs of cell phones; wireless and Internet service plans; certain auto expenses, such as gas, oil, insurance, tune-ups and repairs; fees for parking and tools; and food and drinks. However, because freelance workers use their phones, cars and other items for both personal and business use, it is important that they carefully separate out and claim as a deduction only the business portion of these expenses. The IRS has very strict rules regarding what satisfies the business-use substantiation standards, including a requirement to maintain contemporaneous records, which can be very difficult for workers to implement when their gig is a side job. Alternatively, gig workers who use their cars for companies like Uber or Lyft can instead claim a standard mileage rate deduction or 53.3 cents per mile when they use their car for business purposes.
Similarly, taxpayers who earn income from renting out a house or an apartment must divide their use of the home between personal and business purposes in order to calculate the appropriate deductions of mortgage interest, real estate taxes, casualty losses, maintenance, utilities, insurance and depreciation, they may claim in a given year. It is important to note, however, that the IRS will generally not allow a taxpayer to deduct rental expenses that exceed the gross rental income limitation.
Independent contracts and freelancers represent a growing segment of the U.S. workforce who face unique tax compliance challenges. Engaging the services of professional tax accountants can help these workers meet their tax obligations and take advantage of potential tax benefits.
About the Author: Richard Cabrera, JD, LLM, CPA, is a senior manager with Berkowitz Pollack Brant’s Tax Services practice, where he provides tax planning, consulting, and mergers and acquisition services to businesses located in the U.S. and abroad. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or via email at firstname.lastname@example.org.
Following the passage of the Tax Cuts and Jobs Act (TCJA), the IRS issued preliminary guidance to help multi-national businesses comply with the new law’s “deemed repatriation tax” on foreign profits that U.S. companies and their overseas subsidiaries hold offshore.
Effective for the last tax year beginning prior to Jan. 1, 2018, U.S. businesses will be subject to a one-time “deemed repatriation tax” of 15.5 percent on certain earnings they made since 1987 and invested in liquid assets held overseas and an 8 percent tax on foreign earnings invested in illiquid, fixed assets, such as plants and equipment. The tax due may be spread over an eight-year period and is due regardless of whether or not businesses actually bring foreign profits back to the U.S.
This provision replaces the previous tax regime, under Section 965 of the Internal Revenue Code, for which U.S. businesses were able to defer paying a 35 percent tax on repatriated earnings by stockpiling profits offshore. It aims to move the U.S. to a more territorial system in which U.S. companies would pay taxes in the future solely to the foreign governments where they earn profits.
The end result of the new law would be an immediate tax hit on corporate profits with the benefit of avoiding U.S. taxes in the future, even on earnings that businesses bring back to the States. However, it is important to note that these benefits are afforded solely to C Corporations and not to S Corporations or individuals. This may be a surprising result for some because, while the future benefits of a territorial regime only apply to C Corporations, the deemed repatriation of foreign earnings does, indeed, apply to S Corporations that do not elect to defer the income pick-up as well as to individuals, for which no election to defer the income pick-up is available.
Under IRS Notice 2018-07, the agency has declared its plan to better define, in the near future, what constitutes liquid and illiquid assets held offshore for purposes of calculating the effective tax rate applicable to the deemed repatriation of foreign earnings. Furthermore, the Notice attempts to further explain and eliminate the double taxation issue that may arise when foreign corporations of a U.S. company have different tax years (e.g., one foreign corporation has a December 31 year-end and another has a November 30 year-end.)
About the Author: Andre Benayoun, JD, is an associate director of International Tax Services with Berkowitz Pollack Brant, where he works with inbound and outbound multinational businesses and nonresident aliens on a variety of matters, including structuring for mergers, acquisitions and liquidations; planning for profit repatriation; treaty analysis; tax-efficient debt financing; and pre-immigration tax planning. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or via email at email@example.com.
For more than three decades, IRS partnership audits have operated under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), which required individual partners to pay their share of a partnership’s tax underpayments identified in an IRS audit, unless the partnership elected to be taxed at the entity level. Since TEFRA’s enactment, partnerships have proliferated in number, size, and complexity, making it difficult for the IRS to audit and collect taxes from partners in larger and more complex entities. To solve this problem, Congress enacted sweeping changes to the IRS audit rules in the Bipartisan Budget Act of 2015 (BBA). Beginning in the 2018 tax year, the BBA will require partnerships, rather than individual partners, to be liable for income taxes on all adjustments of partnership income, gains, losses, deductions, credits, and related penalties and interest.
While early adoption of the new rules is permitted, partnerships should be prepared for how these changes will affect the valuation, taxation, and protection of their current and future partners’ interests.
The New Partnership Audit Rules
Under the new partnership audit rules, the burden to pay underreported taxes identified by an IRS audit shifts from individual partners to the partnership in the year the IRS makes the adjustment (the adjustment year), rather than in the year under audit (the audit year). With this change, a partnership will be responsible for correcting an “imputed underpayment” and remitting taxes at the highest individual rate (39.6 percent in 2017), plus penalties and interest in effect during the adjustment year, rather than the audit year. This change allows the IRS to collect unpaid taxes directly from a partnership rather than its partners. Consequently, under the BBA, a partnership’s current partners may be liable to pay for tax benefits former partners erroneously received in prior years.
To account for this discrepancy, the new rules allow a partnership to elect tax treatment at the partner level and transfer audit year tax liabilities back to audit year partners when the partnership takes one of the following actions:
- Within 45 days after receiving an IRS Notice of Proposed Adjustment, the partnership can make a Section 6226 election to issue to all partners during the audit year examination revised K-1s or similar statements, reflecting each partner’s share of items adjusted by the IRS. If the partnership elects out of the default rules, each partner would be required to pay taxes for the audit year when the revised K-1 is issued. Penalties and interest on the underpayment of tax will accrue from the audit year.
- Within 270 days after receiving an IRS Notice of Proposed Adjustment, the partnership can issue updated K-1s to all affected partners and convince those partners to file amended tax returns incorporating the IRS adjustments. All affected partners would be required to pay the additional taxes, penalties and interest for all directly and indirectly affected years.
Time constraints on these elections may cause difficulties for many partnerships, especially those filing an administrative appeal. Oftentimes, the appeal process may take more time to resolve than the 45- to 270-day timeframe partnerships have to make an election. Additionally, if a partner-level election is made, the interest rate on tax underpayments will be increased by two percentage points.
Other Exemptions and Relief
The new audit rules apply to partnerships of all sizes for taxable years beginning after December 31, 2017. However, the law provides an opportunity for certain small partnerships to annually opt-out of the rules when they have 100 or less direct and indirect partners, all of whom are either individuals, C Corporations, foreign entities treated as U.S. C Corporations, S Corporations, or estates of deceased partners.
Taking advantage of this opt-out election requires qualifying partnerships to follow complex reporting and compliance requirements, which includes the obligation to provide the IRS with the names and taxpayer identification numbers of indirect partners who hold an interest in and may be liable for partnership tax liabilities. Also, when a partnership elects to opt-out, the pre-TEFRA audit rules will apply. This will typically mean that each partner will be audited separately.
Finally, partnerships that wish to avoid underpaid tax adjustments at the highest tax rate of 39.6 percent in 2017, can examine the effective tax rates of their individual partners. Partnerships may qualify for a lower tax rate when they can demonstrate within 270 days of receiving an IRS notice that certain partners qualified for a rate adjustment during the audit year because:
- Part of the identified underpayment was allocable to a partner that was a tax-exempt entity;
- Part of the identified underpayment was due to ordinary income allocable to a C Corporation partner or a capital gain or dividend allocable to an individual partner; or
- At least one partner files an amended return consistent with the final partnership adjustment and pays the tax in full.
Compliance with the new audit rules requires partnerships to appoint a person or entity “with a substantial presence in the U.S.” to serve as partnership representative (PR) to act on behalf of the partnership for all IRS matters. In contrast to the TEFRA rules, the PR does need not be a partner. Going forward, the IRS will only communicate with and issue notices to the sole PR who represents and binds the partnership and all of its partners in IRS audits and court proceedings. If the partnership does not appoint a PR, the IRS may appoint one for the partnership.
Regarding timing, a partnership may be able to apply the new rules retroactively to the 2016 or 2017 tax years only when it receives an IRS notice of examination or files a claim for refund for 2016 or 2017. To make this early opt-in election, the partners must timely file a signed statement conforming to the language and manner required by the IRS.
In 2017, the Treasury Department released proposed regulations on the new partnership audit rules. Additionally, a Tax Technical Corrections Act was introduced in Congress to address many of the issues arising from these new rules. While the rules may be modified in the future, partnerships should comply with the new law and understand how it will impact their operations. The following items should be addressed under the guidance of experienced tax professionals:
- How will the partnership select a PR to have sole authority in IRS matters?
- What processes will be employed to ensure the PR meets its reporting obligations to the partners and the IRS?
- Does the partnership qualify to opt-out of the new rules or lower its imputed tax?
- How should the partnership agreement be amended to address the new rules?
- Does the partnership have any exposure to imputed tax underpayments from prior tax years?
- How will the partnership handle tax liabilities incurred by prior partners?
- If the partnership issues financial statements, will it be required to accrue income taxes under GAAP or IFRS?
Tax Reform Impact
In December 2017, Congress passed a sweeping tax reform act, which includes several important changes involving partnerships. Beginning in the 2018 tax year, individual partners may deduct up to 20 percent of their share of their partnership’s “qualified business income.” The intended effect of this provision is to reduce the top tax rate on an individual partner’s share of qualified business income (QBI) to 29.6 percent, from the top individual rate of 37 percent that is effective under the new tax law. While a full discussion of this tax reform provision is beyond the scope of this article, its impact on partnerships will need to be addressed in future IRS examinations where the new partnership audit rules will apply. Depending on future regulations, IRS rulings, and other developments, the result of a partnership-level audit assessment could result in income adjustments from IRS partnership examinations of 2018 and future years to be taxed at 37 percent, versus an otherwise available 29.6 percent rate under new tax reform act. Proper planning and elections may mitigate these unfavorable results. Timely tax planning will be critical to ensure optimal tax results for partnerships and partners, given these major developments.
About the Author: Thomas L. Smitha, JD, CPA, is an associate director of Tax Services with Berkowitz Pollack Brant, where he provides accounting and consulting services as well as tax planning and tax structuring counsel to private and publicly held companies. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or via email at firstname.lastname@example.org.