The permanent reduction of the corporate income tax rate from a maximum of 35 percent to a flat 21 percent has led many businesses to reevaluate their current tax positions and reconsider their entity choice. The decision to convert from a pass-through entity to a C corporation, however, should not be based solely on how the IRS will tax business earnings in the short-term. Instead, business owners should consider a broader range of short- and long-term factors unique to their specific circumstances, including, but not limited to, their stage of development, the industry in which they operate, the makeup of their investors, their plans for distributing earnings, and their exit strategies.
Over the last few decades, pass-through structures have been the entity of choice for most closely-held domestic businesses. Owners of S corporations, LLCs and partnerships, could avoid both the U.S.’s corporate tax rate, which was among the highest in the world, and the imposition of a second level of tax on dividends distributed to their owners or the sale of corporate stock. On the contrary, owners of these businesses pay taxes just once, at their individual income tax rates, on their share of the entities’ profits. With tax reform and the reduced corporate tax rate changes, C corporations are now a more attractive structure for tax purposes. This is especially true when entities meet the requirements for issuing qualified small business stock (QSBS) and there is a likelihood of selling those shares as part of an exit strategy five years or more down the road.
Under Section 1202 of the tax code, individuals who acquired stock after Sept. 27, 2010, in a qualifying small business structured as a C corporation may exclude up to 100 percent of the gain they incur from selling those shares after Dec. 31, 2017. The amount of the gain eligible for exclusion can be as much as the greater of $10 million or 10 times the shareholder’s basis in the stock, which could translate to hundreds of millions of dollars in tax savings for qualifying C corporation shareholders. In other words, business owners and investors can realize a 0 percent tax rate on the profits they reap from selling stock in qualified small business corporations, provided they meet a long list of requirements. For example, they must have acquired the stock directly from the issuing entity or by gift or inheritance and held onto it for a minimum of five years before the sale. Special care should be taken to document any tangible or intangible property shareholders contribute to the corporation in exchange for the QSBS.
Electing to be a C corporation that issues QSBS is especially beneficial to start-up businesses that seek to raise as much capital as possible, in as many rounds as needed, from private investors and/or the public equity markets. Unlike S corporations that are limited to a maximum of 100 shareholders, C corporations can issue stock to an unlimited number of investors, including private equity funds.
On the downside, C corporations will continue to pass a second level of tax at a rate of 23.8 percent onto their shareholders when they pay dividends to them. However, the slashing of the corporate rate to 21 percent lessens this blow as does a business’s ability to control the timing of the dividend distributions and related tax liabilities they pass on to their owners.
In general, businesses in start-up and early stages are more likely to retain and reinvest earnings, building up ample working capital to finance their operations and continuous growth, rather than distributing profits to shareholders. In fact, owners of C corporations may limit their tax burden to only 21 percent of corporate earnings and avoid additional tax exposure for many years as long as they plan carefully and refrain from paying out dividends or becoming subject to an accumulated earnings tax. Conversely, owners of S corporations will pay taxes on all of their businesses’ earnings at a rate as high as 37 percent as well as a potential 3.8 percent Net Investment Income Tax (NIIT) regardless of whether or not they receive dividend distributions. The only saving grace for these pass-through entities, if they qualify based on such factors as their lines of business, their income, the wages they pay to employees and the cost of their fixed assets, is a new deduction of up to 20 percent on certain items of business income. Yet, even with the full benefit of this qualified business income (QBI) deduction, S corporation owners will still be subject to a top effective income tax rate of 29.6 percent plus potential Net Investment Income Tax of 3.8%, as opposed to C corporations which can limit their tax liabilities to a flat 21 percent rate, plus state income taxes, if any.
In order for shareholders to be issued QSBS, entities must have gross assets of less than $50 million on the date they issue stock to investors and immediately thereafter, taking into account the amount they raised through the stock issuance. In addition, they must use at least 80 percent of their assets to actively conduct non-service-oriented business activities, which specifically excludes those businesses that provide services in the fields of banking, finance, insurance, investing, hospitality, farming, mining and owning, dealing in, or renting real estate. In fact, no more than 10 percent of the value of the issuing company’s net assets may consist of real estate or stock and securities of unrelated corporations.
While the reduction of the corporate income tax rate may increase interest in C corporation status, there is little doubt that such an election will yield even more favorable tax savings for owners of start-up, early stage and smaller companies that intend to go public or be sold for a profit in the future. QSBS investors can enjoy tax-free income from the sale of the corporation’s stock or even roll over their gains free of taxes into shares of another qualified small business corporation without losing the benefit of the gain exclusion upon the sale of the replacement QSBS. With the new tax law, businesses and their owners should plan even more carefully than ever with the guidance of experienced advisors and accountants in order to maximize the potential benefits of a C corporation.
About the Author: Barry M. Brant, CPA, is director of Tax, Consulting and International Services with Berkowitz Pollack Brant, where he leads the firm’s private client group and provides guidance on complex tax matters, including multi-national holdings, cross-border treaties and wealth preservation and protection. He can be reached at the CPA firm’s Miami office at (305) 379-7000, or via email at info@bpbcpa.com.
Families with children preparing to attend college for the 2019-2020 academic year may have an easier time applying for loans, grants and scholarships from federal and state sources thanks to a redesigned Free Application for Federal Student Aid (FAFSA) website and the introduction of a new mobile app called MyStudentAid, which is available for Apple and Android phones.
The FAFSA application period for next fall officially began on Oct. 1, 2018. It is recommended that families begin the application process as soon as possible for two important reasons. First, some aid is awarded on a first-come-first-served basis, and the earlier families file the FAFSA, the more time they will have to review their Student Aid Reports, make corrections to their forms, if needed, and compare the offers for aid dollars that they receive. In addition, families should recognize that completing the FAFSA, whether online or on a mobile device, is no walk in the park. The form includes more than 100 questions, many of which applicants will not know the answers to without first doing some research into their finances and other personal information. The sooner families begin the process, the more time they will have to locate requested information and complete the form without significant delay.
Following are some of the steps that families can take to prepare in advance and make the FAFSA application process go as smoothly as possible:
- Know the social security numbers, drivers’ license numbers and birthdates for the student and his or her parent(s);
- Have a hard copy of the family’s tax returns from the most recent tax year and/or access the IRS’s Data Retrieval Tool on the FAFSA website or by visiting https://ww.irs.gov in order to have your tax information automatically transferred from the IRS to the FAFSA;
- Gather the most recent statements of bank and brokerage accounts, 529 college savings plans and the current value of other assets (excluding the family home), and be prepared to identify whether the owner of those accounts are the parent(s) or the student; and
- Be prepared to list at least one college that the student hopes to attend. Students can change this information or add the names of additional schools at a later date.
Finally, families should not assume that their students will not qualify for financial aid, perhaps because the parents’ income is too high. In fact, only a small portion of parents’ income and assets figures into a students’ potential aid calculation. Instead, a student’s eligibility for financial aid will be more affected by assets held in his or her own name. This is something that families should consider and plan for under the guidance of professional accountants and financial advisors far in advance of a child’s entry into a higher education institution.
About the Author: Joanie B. Stein, CPA, is a senior manager with Berkowitz Pollack Brant’s Tax Services practice, where she works with individuals and closely held businesses to implement sound strategies that are intended to preserve wealth and improve tax-efficiency. She can be reached at the CPA firm’s Miami office at (305) 379-7000 or via email at info@bpbcpa.com.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.
The rehabilitation tax credit that provides an incentive for real estate owners to renovate and restore old or historic buildings has been modified under the Tax Cuts and Jobs Act (TCJA) signed into law in December 2017.
Under the new law, taxpayers claiming a 20 percent credit for the qualifying costs they incur to substantially rehabilitate a building must spread out that credit over a five-year period beginning in the year they placed the building into service, which is the date on which construction is completed and all or a portion of the building can be occupied. Excluded from the credit are any expenses that taxpayers incurred to buy the structure.
In addition, the law specifically eliminates the availability of a reduced 10 percent rehabilitation credit for pre-1936 buildings. However, owners of certified historic structures or pre-1936 buildings may qualify for temporary relief under a transition rule when they meet the following conditions:
- The taxpayer owned or leased the building on Jan. 1, 2018, and he or she continues to own or lease the building after that date.
- The 24- or 60-month period selected by the taxpayer for the substantial rehabilitation test begins by June 20, 2018.
Qualifying for and claiming the rehabilitation tax credit can be a complicated process for which taxpayers should seek the counsel of professional tax advisors and accountants.
About the Author: Joshua P. Heberling is a senior manager with Berkowitz Pollack Brant’s Tax Services practice, where he focuses on tax planning and compliance services for high-net-worth individuals and businesses in the commercial real estate, land development and office market industries. He can be reached at the firm’s Boca Raton, Fla., office at (561) 361-2000 or via email at info@bpbcpa.com.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.
There’s no question that the Tax Cuts and Jobs Act (TCJA) provides a big win for real estate businesses and investors. However, realizing the full benefit of these provisions will require careful evaluation, strategic planning and flexibility, as the IRS and U.S. Treasury continue to trickle out guidance that taxpayers may apply to their unique circumstances. Here’s a brief overview of some of the new regulations that taxpayers should be addressing with their accountants and advisors.
Lower Income Taxes for Individuals and Businesses
For starters, the new law reduces the top marginal income tax rate for high-income earners from 39.6 percent to 37.0 percent and more than doubles the estate tax exemption, which allows individual taxpayers to exclude from estate tax up to $11.2 million in assets, or $22.4 million for married couples filing jointly. At the same time, the TCJA establishes a corporate tax rate of 21 percent, down from 35 percent, while also eliminating the corporate Alternative Minimum Tax (AMT).
Potential Deduction for Pass-Through Entities, Trusts and Estates
Businesses that are structured as pass-through entities, such as partnerships, LLCs, S corporations and sole proprietorships, may qualify to deduct annually as much as 20 percent of U.S.-sourced “qualified business income” (QBI) that flows through to their owners’ personal tax returns. While the deduction is subject to a myriad of restrictions, based on taxpayers’ lines of business and their taxable income, the consensus is that investors and professionals involved in the real estate industry can reap significant tax savings. Realizing these benefits may require taxpayers to reassess and perhaps restructure their existing operations, including how they pay employees and independent contractors, and evaluate more closely how the new law will treat specific items of income, such as triple net leases or ground lease real estate rentals.
First-Year Bonus Depreciation
The TCJA allows businesses to immediately write-off 100 percent of the costs they incur for an expanded list of qualifying tangible personal property, including previously used assets that they purchased or financed during the tax year. Under prior law, bonus depreciation was limited to 50 percent and applied only to new property. As a result, qualifying businesses may now immediately recover the full costs of more investments they make to grow their operations. Yet, because additional guidance is still forthcoming from the IRS, taxpayers should plan carefully.
Section 179 Expensing
Eligible businesses may take an immediate deduction of up to $1 million per year for the costs they incur to acquire qualifying improvement property and business assets. The amount of the deduction is reduced dollar-for-dollar when acquisition costs exceed $2.5 million. Previously, the Section 179 deduction was limited to $500,000, and it began to phase out at $2 million.
As an added benefit, the TCJA also expands the definition of Section 179 property to include other improvements made to nonresidential real property, including roofs; heating, ventilation, and air-conditioning; fire protection; and alarm and security systems.
Net Operating Losses
Prior to the TCJA, businesses were permitted to carry back net operating losses (NOLs) two years or carry them forward 20 years to offset table income. Effective for the 2018 tax year, however, NOLs can longer be carried backward. NOL carryforwards, which are now limited to 80 percent of a business’s taxable income, may be applied against taxable income indefinitely. As a result of the tax reform law, businesses will need to adjust 2018 carryovers from prior tax years to account for the 80 percent limitation.
Business Interest Deduction
The TCJA generally limits the interest payments that businesses may deduct to 30 percent of “adjusted” gross taxable beginning in 2018 and further limits the deduction beginning in 2022. However, the law does provide real estate businesses and investors with a number of exceptions to this limit. For example, eligible taxpayers may elect to fully deduct (after any required capitalization) interest accrued in the development, construction, acquisition, operation, management, leasing or brokerage of real property. In addition, there is an exemption for certain taxpayers considered “small business” with average annual gross receipts of $25 million or less for the three most recent prior tax-year periods.
Carried Interest
Congress spent the past several years debating the preferential tax treatment of management fees and other forms of compensation (in excess of salaries) paid to partners, managers and developers for a share of a business or a project’s future profits. This concept of carried interest treatment survived Congressional wrangling over tax reform and will continue to be taxed at the favorable long-term, capital gains rate of 20 percent rather than the maximum ordinary income rate, which under the TCJA is 37 percent. However, the new law does limit the tax treatment of these gains to apply only to assets held for more than three years or sold after three years.
Section 1031 Like-Kind Exchanges
Thanks, in large part, to the lobbying efforts of the National Association of Realtors and National Association of Real Estate Investment Trusts, Section 1031 exchanges of like-kind real estate property will continue to receive tax-deferred treatment under the TCJA. Nevertheless, the law eliminates the availability of tax-deferred exchanges of personal property, including items such as artwork, coins and other collectibles.
About the Author: John G. Ebenger, CPA, is a director of Real Estate Tax Services with Berkowitz Pollack Brant, where he works closely with developers, landholders, investment funds and other real estate professionals, as well as high-net-worth entrepreneurs with complex holdings. He can be reached at the CPA firm’s Boca Raton, Fla., office at (561) 361-2000 or via email at info@bpbcpa.com.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.
The IRS and U.S. Treasury last week issued long-awaited guidance on a new tax break introduced by the Tax Cuts and Jobs Act (TCJA) that may provide real estate and other investors with significant tax savings. While the proposed regulations provide some clarity about the Opportunity Zone program and how it will be administered, many questions remain unanswered and will require further guidance from the IRS and the Treasury. As a result, it is critical that taxpayers tread very carefully with the counsel of experienced advisors and accountants.
What is the Opportunity Zone Program?
Congress created the Opportunity Zones program as an incentive to help revitalize distressed neighborhoods with private investment rather than federal spending dollars. Under the hurriedly drafted tax reform bill passed into law at the end of 2017, taxpayers may defer and potentially eliminate capital gains tax liabilities from the sale of certain assets when they reinvest those gains into predominantly low-income areas certified by the U.S. Treasury as Opportunity Zones (OZs).
The law makes it clear that taxpayers may not invest directly into businesses or development projects in OZs. Rather, they must direct their capital into Qualified Opportunity Funds (QOFs) organized as corporations and partnerships, which in turn must invest at least 90 percent of their assets, directly or indirectly, into qualified businesses and real estate assets located in designated OZs. The QOFs, which are already being created by developers, private equity firms and even nonprofits, are made up of a portfolio of buildings and businesses located in more than 8,700 census tracts across the country that the Treasury has certified as Opportunity Zones.
How can I Reap Tax Savings?
The tax benefits that come with investments in OZs are impressive and become even more significant the longer investors keep their interests in QOFs. Here’s generally how it works. An individual or business that incurs a capital gain from the sale of real estate, stock or any other property to an unrelated person may reinvest or “roll over” the proceeds from the sale (in an amount equal to the gain to be deferred) in a QOF within 180 days from the date of the initial sale, and receive the following benefits:
- Defer tax on the original capital gain until Dec. 31, 2026, or the date the taxpayer sells his or her interest in the QOF, whichever occurs first;
- Exclude from taxation up to 15 percent of the rolled-over capital gain by receiving a 10 percent step-up in the basis of the investment after holding the QOF investment for at least five years, and an additional 5 percent step-up after holding the QOF investment for at least seven years; and
- Avoid capital gains tax on the appreciation of QOF investments held for a minimum of 10 years by making an election to increase the basis of the QOF investment to the fair market value of the investment on the date they sell their interest in the QOF.
For example, consider an investor who sells a property and incurs a $1 million capital gain. If the investor rolls that gain into a QOF, he or she can defer paying taxes on that gain until 2026. If the investor holds the interest in QOF for seven years, he or she will be taxed on only 85 percent of the original gain, or $850,000, instead of $1 million. If the investor sells his or her interest in the QOF after 10 years, his or her basis increases, and he or she pays no tax on the appreciation of the QOF investment.
From an investor’s standpoint, qualified opportunity funds can be good alternatives to 1031 like-kind exchanges, especially if taxpayers have challenges satisfying the 1031 requirements to identify suitable replacement property within 45 days and close within 180 days. Also, because the new tax law limits the use of 1031 exchanges solely to real estate beginning in 2018, investing in QOFs may be the only way for some investors to defer paying tax on their capital gains until 2026.
Nevertheless, investors should recognize that QOFs are illiquid investments that yield the most rewards the longer investors hold onto them. Moreover, there is no guarantee that investments in distressed Opportunity Zones will appreciate in value. Therefore, investors seeking to capitalize on the tax-deferred treatment of gains invested into QOFs should be prepared to hold onto their QOF investments for a long-term and have other sources of liquidity available to them (e.g., to cover tax payments on the capital gains they will recognize in 2026).
What’s New?
The guidance issued by the Treasury and IRS on Oct. 19, 2018, is not a comprehensive list of rules that answer all of taxpayers’ questions concerning the Opportunity Zones program. In fact, the Treasury and the IRS are still working on additional guidance that is expected to address a number of other issues and questions posed by tax practitioners. Nonetheless, these proposed regulations provide some much-needed clarity regarding the requirements that taxpayers must meet in order to properly defer the recognition of gains by investing in QOFs, as well as certain requirements that corporations or partnerships must meet in order to qualify as a QOF. Taxpayers may now rely on these proposed regulations to help them implement tax-efficient planning strategies for the remainder of 2018 and into 2019. Following are some of the issues that the most recent government guidance addresses.
What Gains are Eligible for Tax Deferral?
Capital gains incurred from an actual or deemed sale or exchange of assets, or any other gains that are required to be included in a taxpayer’s computation of capital gain are eligible for deferral. Excluded are gains that arise from a sale or exchange of property with a related party (based on the 20 percent ownership rule).
Who Can Qualify for Tax Deferral?
Taxpayers that can elect tax-deferral benefits of the Opportunity Zone program include individual taxpayers, C corporations (including regulated investment companies (RICs) and real estate investment trusts (REITs)), partnerships and certain other pass-through entities (including S corporation, decedents’ estates, and trusts). Partnerships may elect to defer all or part of their capital gain to the extent they make an eligible investment in a QOF. If a partnership does not elect to defer capital gain, its partners may elect their own deferral with respect to their distributive share of capital gain to the extent they make an eligible investment in a QOF. Similar rules apply to other pass-through entities (including S corporations, estates and trusts) and their shareholders and beneficiaries.
When does the 180-day Period Begin?
Taxpayers generally must roll over capital gains into a QOF within 180 days from the date of sale or exchange giving rise to the capital gain. The proposed regulations provide that, in certain circumstances, the 180-day clock does not start running until the date the ultimate taxpayer would be deemed to have recognized the gain. For example, the 180-day period for partners in partnerships and shareholders of S corporations generally begins on the last day of the entity’s taxable year. The proposed regulations, however, provide an alternative for situations in which the partner knows (or receives information) regarding both the date of the partnership’s capital gain and the partnership’s decision not to elect deferral of the gain, in which case the partner may choose to begin its own 180-day period on the same date as the start of the partnership’s 180-day period. Similar rules apply to other pass-through entities (including S corporations, estates and trusts) and their shareholders and beneficiaries.
What Qualifies as an Eligible Interest Investment in a QOF?
In order to defer capital gains tax under the Opportunity Zones program, taxpayers must own an eligible interest in a QOF, which is an equity interest issued by the QOF, including preferred stock or a partnership interest with special allocations. Specifically excluded from the definition of eligible interest investment are debt instruments, such as bonds, loans or other evidence of indebtedness, as well as deemed contributions of money due to increase in partner’s allocable share of partnership’s liabilities.
What is included in the Definition of Qualified Opportunity Zone Business Property?
A QOF must be an investment vehicle legally structured as a corporation or partnership in any of the 50 states, D.C. or five U.S. territories. It must invest at least 90 percent of its assets in qualified opportunity zone property (QOZ Property), which includes qualified opportunity zone business property (QOZ Business Property) and certain equity interests in operating subsidiaries (either corporations or partnerships) that satisfy certain additional QOZ business requirements.
QOZ Business Property is generally tangible property that the QOF purchased from an unrelated party after Dec. 31, 2017, and used in the QOFs trade or business (substantially all of the use of such property must be in a qualified opportunity zone). The original use of such property must begin with the QOF (e.g., new construction), or the QOF must make substantial improvements to the property within 30 months of the date of its acquisition.
By and large, for the “substantial improvement” requirement to be satisfied, additions to the basis of the purchased tangible property in the hands of the QOF must exceed an amount equal to the QOF’s adjusted basis of such property at the beginning of the 30-month period. Based upon IRS guidance, if a QOF purchases a building located on land wholly within a QOZ, substantial improvement to the purchased tangible property is measured by the QOF’s additions to the adjusted basis of the building (thus, the “original use” requirement is not applicable to the land and the QOF is not required to separately substantially improve the land on which the building is located).
The proposed regulations also establish a helpful “working capital” safe harbor for QOF investments in QOZ businesses that acquire, construct, or rehabilitate tangible business property used in a business operating in an opportunity zone. Under this safe harbor, a qualified opportunity zone business may hold cash or cash equivalents for a period of up to 31 months, if there is a written plan that identifies these working capital assets as held for the acquisition, construction, or substantial improvement of tangible property in the opportunity zone, there is a written schedule showing that the working capital assets will be used within 31-months, and the business substantially complies with the schedule.
There’s no question that Opportunity Zones have the potential to yield immense tax benefits. However, since the regulations are complex and still evolving, investors and QOF sponsors will need to work closely with their tax and legal advisors to plan ahead and implement strategies that maintain compliance and maximize tax savings under application of the new law.
About the Author: Arkadiy (Eric) Green, CPA, is a director of Tax Services with Berkowitz Pollack Brant, where he works with real estate companies, commercial and residential developers, property management companies, real estate investors and high-net-worth individuals to structure investments and complex transactions for maximum tax efficiency. He can be reached at the CPA firm’s Boca Raton, Fla., office at (561) 361-2000 or via email at info@bpbcpa.com.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.
Posted on October 24, 2018