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 firstname.lastname@example.org.
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 email@example.com.
Due to the passage of the Tax Cuts and Jobs Act that President Trump signed into law in late 2017, business and payroll service providers will need to adjust employees withholding calculations for the 2018 tax year. However, as the IRS works to apply the new law, it asks businesses to continue to use the existing 2017 withholding tables during the month of January. The agency expects to issue guidance on this matter in the coming weeks to enable businesses to make payroll changes based on employees’ existing W-4 information.
Workers should expect to see an increase in their take-home pay, with less taxes withheld from their paychecks, beginning in February 2018.
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 current administration failed in its attempts to fully repeal the Affordable Care Act (also known as Obamacare), it did secure under a package of tax reform the elimination of the health care law’s individual mandate beginning in 2019. Regardless of how all of this will play out, one consistent trend that continues to emerge from the administration is an increased reliance on Health Savings Accounts (HSAs).
Currently, HSAs are available only to workers with high-deductible health insurance plans, which for 2017 were defined as those with an annual deductible of $1,300 for self-only coverage and $2,600 for family coverage. These amounts are indexed annually for inflation.
According to the most recent information from the Kaiser Family Foundation, only 19 percent of workers were enrolled in HSAs in 2016. However, this is expected to change, especially as more and more employers opt for high-deductible health plans.
HSA Tax Benefits
In the most basic terms, an HSA can be compared to a bank account for which eligible workers can set aside money to use solely for paying current and future health care expenses. Contributions to the account may be made by the individual, perhaps via automatic deferral from earnings, a family member or even one’s employer. However, unlike a typical savings account, HSAs allow individuals to contribute pre-tax dollars and earn interest on their investments free of taxes. In addition, annual contributions roll over from year to year, rather than following the use-it-or-lose-it rules of a traditional health reimbursement account (HRA) or health care flexible savings account (FSA).
Another tax benefit of HSAs is that qualifying participants may deduct from their taxable income not only their own HSA contributions but also those made by their employers. For 2017, the IRS allowed qualifying employees and their employers to contribute to an HSA up to $3,400 in pre-tax dollars for themselves, or $6,750 for a family plan, plus a $1,000 catch-up contribution for individuals age 55 and older. Because workers own their individual accounts, rather than their employers, they may continue to keep and contribute to their HSAs long after they switch jobs and even into retirement since there are no age-based distribution requirements. As account owners accumulate savings, they may choose to put these funds in an investment vehicle, such as stocks and bonds, which can allow their money to grow along with their retirement savings.
When HSA participants do take distributions to pay for qualifying medical expenses, including doctor visits and prescription medications, they may exclude those amounts from their taxable income in the year of the distributions. Additionally, workers may withdraw funds from their HSAs to pay for certain health insurance premium payments, including payments for COBRA coverage and for the health insurance of individuals receiving unemployment income. As an added plus, under the current Affordable Care Act, payments for preventative services, including annual visits to primary care physicians, are exempt from the HSA deductible.
Potential Pitfalls of HSAs
Despite all of the tax-advantaged benefits that HSAs provide, they do come with potential risks, especially when consumers fail to follow the rules.
For example, under current law, all withdrawals from an HSA that an individual 65 and younger uses for non-qualifying medical expenses will be subject to tax as well as a 20 percent penalty. In addition, account owners cannot use HSA savings to cover the eligible medical expenses of a dependent child who is older than 24 years of age.
With the future of health care unknown, taxpayers should take the time to understand all of their options relating to what will surely be rising health care costs in the future. The professional advisors and accountants with Berkowitz Pollack Brant have deep knowledge and experience helping taxpayers understand and comply with evolving laws while maintaining tax efficiency and wealth preservation.
About the Author: Adam Cohen, CPA, is an associate director in the Tax Services practice of Berkowitz Pollack Brant, where he works with closely held businesses and non-profit charities, hospitals and family foundations to maintain tax efficiency and comply with federal and state regulations. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or via e-mail email@example.com.
Effective Jan. 1, 2018, Florida’s sales tax on the total rental payments that commercial real estate owners receive for leasing their properties decreases from 6 percent to 5.8 percent. The reduced rate applies to the rental, leasing, letting and granting of a license to use certain commercial property for occupancy periods that begin on or after the first of the New Year. When a tenant occupies or has a right to occupy a covered property before Jan. 1, 2018, the 6 percent sales tax will apply.
Under a bill signed into law by Gov. Rick Scott, the .2 percent sales-tax reduction applies to leases and rentals of commercial property, including office and retail space, warehouses and self-storage units, when the tenant occupied or was entitled to occupy a property prior to Jan. 1, 2018. Excluded from the lower sales tax rate are rentals for parking or storing automobiles or towed vehicles in lots or garages, docking or storing boats at docks or marinas, or the rental of tie-down or storage space for aircraft at airports, all of which will be subject to a rate of 6 percent on the total rental charged.
As a result of the sales tax reduction, commercial property owners and managers should review their lease arrangements and update their systems and invoice software to reflect the change.
About the Author: Karen A. Lake, CPA, is State and Local Use Tax (SALT) specialist and an associate director of Tax Services with Berkowitz Pollack Brant, where she helps individuals and businesses navigate complex federal, state and local tax laws, credits and incentives. She can be reached at the firm’s Miami office at (305) 379-7000 or via email at firstname.lastname@example.org.