Check out the latest episode!! “WHAT IF I CAN’T FILE OR PAY MY INCOME TAX RETURN BY APRIL 15^TH, WHAT DO I DO NOW?”

By: Jeff Skolnick, CPA, M.S. Taxation

As most people know the filing deadline for income tax returns is April 15^th however not everyone always files by the deadline.  This article will focus on what happens when a taxpayer does not file on time or if the taxpayer filed but did not pay their liability in full. I will focus on federal returns in the article, although many of the same principles apply to state income tax liabilities as well.

Tax return was not filed on time, what’s next?

There are some taxpayers that do not file their returns on time but have a valid extension. These taxpayers have no problem at all. The IRS recognizes that it is not always possible to gather all of your information and file by April 15^th.  Typically, taxpayers that are involved in partnerships, LLCs, S corporations, Estates or Trusts may need additional time to obtain information pertinent to file their income tax returns.  Filing an extension, however, does not extend your time to pay therefore if you are unable to file by April 15^th you are still required to estimate the amount of tax you owe and pay it by April 15^th.  The main reasoning behind making people estimate their balance due is that if this was not done then any taxpayer with a balance due would automatically go on extension and wait until October 15^th (the due date of extended returns) to pay their balance due. 

Some taxpayers that do not file on time also do not file an extension form.  This is a little more complicated.  There are late filing penalties of 5% of the amount due each month or part of a month that your return is late. The maximum penalty is 25%. 

Individuals without a valid extension should file as soon as possible to at least stop the late filing penalties and pay as much as possible to reduce or eliminate the late payment penalties (which are explained below).

What happens if I did not pay may tax in full by April 15^th?

The IRS imposes a late payment penalty of ½ of 1% of any tax not paid by April 15^th. It is charged monthly and the maximum penalty is 25%.

What if I can’t pay my entire balance due?

For those taxpayers that cannot afford to pay their balance in full I would advise paying in as much as possible.  Penalties and interest are charged on outstanding balances and therefore the more that you can reduce the outstanding balance, the more you can reduce your penalties and interest.

The IRS does have a number of different options available to those without the means to pay their bills all at once:

Once again, I want to mention even if you do not have the money to pay your balance due file your return as this will eliminate any late filing penalties.  You will still be subject to late payment penalties.

Full payment Agreements – The IRS will give you up to 120 days to pay your balance in full. There is no fee to set this up, however, you will be subject to penalty and interest until you are paid in full.  This may be setup through the IRS Online Payment Agreement (OPA) application found at www.irs.gov or by calling the IRS at 800.829.1040.

Installment Agreements – If you cannot fully pay your liability within 120 you have the option of signing up for an installment agreement. There is a fee for this service unless you are considered to be a low income taxpayer. Taxpayers may either signup online at www.irs.gov, filing Form 9465 or by calling the IRS at 800.829.1040.  The IRS offers a number of different payment options:

• Direct debit form your bank account
• Payroll deduction from your employer
• Payments by Electronic Federal Tax Payment System (EFTPS)
• Payment by credit card
• Payment by check or money order or
• Payment with cash at certain retail locations

I must admit I have never had a client pay cash at a retail location but since the IRS lists it as an option, I wanted to mention it.

In order to sign up for an installment agreement you will be required to choose a monthly payment and a monthly payment due date. I always advise taxpayers to pick a number they can absolutely pay every month and a date they can pay by. You do not want to set up a payment and then miss a payment.  You can always pay the balance off early if you are in a position to do so.

Offer in Compromise – This option, while available, is much more complicated for taxpayers to qualify for. An offer in compromise will actually reduce your tax bill based on your ability to pay.  First of all, taxpayers must be up to date with all filings, including estimated tax payments for the current year.  This requirement alone often knocks taxpayers out of the box as many do not have the money to gave paid current estimated tax payments.  The IRS will then look at all of the taxpayer’s assets, liabilities, income and expenses to determine eligibility.  Again, this is a very complicated process generally to be used by taxpayers with substantial balances due and virtually no way to pay it.

Conclusion

This article focuses on taxpayers that either file or pay their taxes late.  Although the article explains the general rules you would be well advised to speak to a tax professional as there are sometimes circumstances which may make a taxpayer’s situation unique.

TAXATION OF ALIMONY AND CHILD SUPPORT

In today’s environment of divorce rate in excess of 50% coupled with changes in the taxability and deductibility of alimony, alimony, child support payments and filing status options have become even more of a hot topic then in the past. This article will attempt to clarify some of the rules.

What is alimony and what are the tax implications?

The first thing to keep in mind is you must separate couples that divorced before 2019 from those divorcing after 2018. The rules have changed beginning in 2019 but I will get to that. The first thing I would like to do is to explain alimony and child support.

Alimony is clearly defined by the Internal Revenue Code and payments which meet the definition of alimony are allowable as deductions (whether or not the individual itemizes) on the return of the payor and includible as income on the return of the payee spouse. This holds true for anybody divorced prior to 2019.

In order for payments to be considered alimony the following tests must be met:

• Payments must be made under a divorce or separation agreement
• The divorce or separation agreement does not designate the payments as child support or a property settlement
• Payments must be in cash
• Divorced or legally separated couples must live in separate households
• The obligation to make payments must end upon the death of the payee spouse

Although the definition of alimony has not changed, in the past decade there have been more couples living together until they can sell their home. It is important to keep in mind that as long as they live in the same home, the payments being made, even if under a divorce or separation agreement are not alimony.

What is considered child support and what are the tax implications?

Child support payments are simply what they say, payments to support the children. There is no deduction to the payor spouse, nor any income to be reported by the payee spouse.

What if not all alimony and child support payments are made during the year?

Unfortunately, sometimes there are individuals who simply cannot keep up with their alimony and child support payments. The tax treatment in such a situation is simply to apply all payments to child support first and then the remainder is considered alimony.

This methodology can be very good or very bad depending on whose perspective you are looking at it from. If you are the paying spouse struggling to pay whatever you can and you still do not receive a deduction for the payments, it can be painful. If, on the other hand, you are the payee spouse, you will have no taxable income to report.

What is a property settlement and are there tax implications?

Property settlements incident to a divorce are defined as transfers from one spouse to another within 1 year of the date which the marriage ceases. Generally, these are not taxable although there are some special rules relating to retirement plans and IRAs. The basis of the property transferred is the same basis that the transferor had in the property, usually its original cost.

Law change for those divorced after 2018

As I mentioned there is a change in the law effective for anyone who was divorced after 2018. If a couple was divorced after December 31, 2018 then, while the definition of alimony is the same, it will no longer be deductible by the payor or income to the recipient. Please keep in mind if you were divorced before 2019 alimony continues to be deductible to the payor and income to the recipient.

FILING STATUS ISSUES THAT OFTEN ACCOMPANY DIVORCE

There are five filing statuses available to taxpayers. These are single, married filing jointly, married filing separately, head of household and qualifying widower. Qualifying widower has nothing to do with divorce but has to do with an individual whose spouse passed away within the last two calendar years before the tax year in question and a household was maintained for a dependent child or stepchild.

Single – In order to file as single, you must be unmarried or separated from a spouse by divorce or a separate maintenance decree. 

Married taxpayers can choose to file either a joint income tax return or separate tax returns.

Married filing jointly – You may file a joint return if:

You are married and living together

Married and living apart but not legally separated or divorced

Separated but not by a final divorce decree

Living in a common law state

Married filing separately – If you are married you can always choose to file separately however often times you will pay a higher income tax and will either lose out on or have a reduced benefit of these various credits:

Earned income credit

Credit for elderly or the disabled – unless you lived apart the entire year

Child and dependent care credit – unless you lived apart for the last six months of the year

Adoption credit – Unless you lived apart for the last six months of the year

Ineligible for education credits

Traditional IRA contributions if yours spouse was covered by a retirement plan and Roth IRA contribution limits both start to phase out at $0 of Adjusted Gross Income and are totally phased out by the time you reach $10,000 of adjusted Gross Income.

Head of household – You may be able to file as head of household if you meet all the following requirements.

You are unmarried or considered unmarried on the last day of the year or lived apart from your spouse for the last six months of the year.

You paid more than half the cost of keeping up a home for the year.

A qualifying person lived with you in the home for more than half the year (except for temporary absences, such as school). However, if the qualifying person is your dependent parent, he or she doesn’t have to live with you.

Head of household has a preferred tax rate to that of filing single.

Conclusion

This article discusses very general questions relating to alimony, child support and property settlements. Each situation is unique and as always if you’re not sure of the rules, then check with a tax professional.

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LATE S ELECTIONS

Under certain circumstances a taxpayer may want to change their sole proprietorship, partnership or LLC into an S corporation. This may be done in order to minimize self-employment taxes or to take advantage of the new 20% deduction allowed for Qualified Business Income.

Generally S corporation elections must be filed (A) at any time during the preceding taxable year (in other words any time in 2018 if you are electing to be an S corporation beginning in 2019), or (B) at any time during the taxable year and on or before the 15th day of the 3rd month of the taxable year (March 15, 2019 for calendar year entities).  The election is made by filing Form 2553.

What if I apply after the 15^th day of the third month, is there any relief for late elections?

The good news is yes there is relief available if you’ve filed your S corporation election late and meet certain criteria.

Rev Proc 2013-30 outlines the criteria to be met and procedures to follow in case of a late S election.

The general rules of Rev Proc 2013-30 are as follows: (My comments on the rules in parentheses)

(1) The Requesting Entity intended to be classified as an S corporation as of the Effective Date of the election; (the company wants to become an S corporation)

(2) The Requesting Entity requests relief under this revenue procedure within 3 years and 75 days after the Effective Date (except in the case of certain corporations meeting additional criteria under this revenue procedure); (For a calendar year entity that wanted to be an S corporation beginning in 2019 this extended deadline would be March 15, 2022).

(3) The failure to qualify as an S corporation was solely because the Election Under Subchapter S was not timely filed by the Due Date of the Election Under Subchapter S; and

(4) In the case of a request for relief for a late S corporation election, the Requesting Entity has reasonable cause for its failure to make the timely Election Under Subchapter S and has acted diligently to correct the mistake upon its discovery.

If an entity meets all of the above criteria and follows the procedures outlined in the Revenue Procedure, then the S corporation election may be deemed as valid even though it is filed late.

Exception to the 3 Years and 75 Days Rule

Certain entities can qualify for the exception to the 3 years and 75 day rule when:

• The entity is a corporation (i.e., not a sole proprietorship, partnership or LLC seeking an entity classification election);
• The entity failed to qualify as an S corporation solely because the election was not timely field;
• The corporation and all its shareholders reported their income consistent with S corporation status for the year the S election should have been made and for every subsequent taxable year (if any);
• At least 6 months has elapsed since the date on which the corporation filed its tax return for the first year the corporation intended to be an S corporation;
• Neither the corporation nor any of its shareholders was notified by the IRS of any problems regarding the S corporation status within 6 months of the date on which the Form 1120S for the first year was timely filed; and
• The completed Election form includes the statements as described in the revenue procedure.  

Although this exception exists, it is unlikely many situations will qualify since the current system is set up to notify the corporation of the problem with its filing requirement when the return rejects in processing. It could apply to a case where it did not go through normal processing.

Conclusion

This article discusses procedures to allow entities to file S corporation election forms after the due date of day 15 of the 3^rd month after the effective date. Please keep in mind it is much easier to file the forms on time. This relief is to correct a situation in which that did not happen. The rules are very specific as are the procedures to be followed. I strongly suggest that if you are trying to take advantage of these provisions, then you should contact a tax professional familiar with these procedures.

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The 2018 Tax Cuts & Jobs Act

Article By: Jeff Skolnick, CPA, M.S. Taxation

The 2018 Tax Cuts & Jobs Act contains a very generous deduction for owners of Pass-Thru Entities.  There are a number of rules that limit this deduction based on various factors which include occupation, taxable income, entity structure and proper recordkeeping.  That being said, this is a deduction well worth understanding.  The remainder of this article will break this provision down and explain it.

New Code Section

The new tax law adds a new section to the Internal Revenue Code.  The new section is 199A. Qualified Business Income. This code section allows a 20% deduction for Qualified Business Income of a Pass-Thru Entity.  As I mentioned before there are a number of limitations that may apply.  Think of the 20% deduction on Qualified Business Income as the first hurdle.

Pass-Thru Entity

The new code section applies to pass-thru entities; therefore it makes sense to define the term pass-thru entity.  Pass-thru entities are generally sole proprietorships, partnerships and S corporations.  The reason I did not mention LLCs is that LLCs for tax purposes are considered disregarded entities meaning they have no tax standing on their own.  The default tax position of a single member LLC is a sole proprietorship, the default position of a multiple member LLC is a partnership.  The only real difference between a single member LLC and a sole proprietorship or between a multiple member LLC and a partnership is that the LLCs enjoy protection from legal liability in essentially the same manner as corporations.  Lastly LLCs can also choose to be taxed as S corporations.  While obviously 100% of a sole proprietorship’s income would be eligible for the deduction, partners and S corporation shareholders pick up their ratable share of the associated entities income and deductions.  For example a 50% shareholder in an S corporation that had qualified business income of $250,000, W-2 wages paid of $100,000 and qualified property of $1,000,000 would use $125,000, $50,000 and $500,000 respectively on his/her return.

Qualified Business Income

Qualified business income is defined in the new law as the “net amount of qualified items of income, gain, deduction and loss with respect to qualified trades or businesses of the taxpayer”.  This is basically the net income line (income less all applicable expenses). There are, however, certain items that are not counted as qualified items.  The term qualified business income excludes short-term and long-term capital gains and losses as well as dividend income and interest income (unless earned in a trade or business).  The law also considers Real Estate Investment Trust (REIT) dividends, qualified publicly traded partnership income and qualified cooperative dividends as qualified business income but these are more specialized situations and this ebook will not focus on these items. I only wanted to mention them to provide information that rules do exist on these types of income.

Qualified business income does not include W-2 wages or guaranteed payments to partners.

How the deduction works

This new deduction, as I mentioned earlier, is calculated by first taking 20% of Qualified Business Income (the first hurdle) followed by a number of other hurdles which I will now cover.

Taxable Income Limitation

I have labeled the taxable income limitation as hurdle number 2.  The reason for this is that there are a couple of other provisions which kick in at certain taxable income levels. First of all while the 20% limitation on Qualified Business Income is hurdle number 1, if 20% of taxable income less capital gains and qualified cooperative dividends is less than Qualified Business Income than this lower limitation amount is used.  Again qualified cooperative dividends are a specialized area which I am not going to delve in to here. If you see the term you know this section applies. I also mention the term so people realize that qualified cooperative dividends are not the same as the qualified dividends everyone is used to seeing on Form 1099-Div. Qualified dividends are considered capital gains for this code section.

Example 1

Scott, a single taxpayer, has qualified business income of $100,000 and taxable income of $160,000 of which $10,000 is long term capital gain income.  Hurdle number 1 is 20% of qualified business income or in this case $20,000.  Hurdle number 2 is 20% of taxable income less long term capital gain income ($160,000 – $10,000 multiplied by 20%), or $30,000.  The deduction in this example is limited to $20,000 based on his qualified business income.

Example 2

Scott, a single taxpayer, has qualified business income of $150,000 and taxable income of $100,000, none of which is related to long term capital gains.  Hurdle number 1 is 20% of qualified business income or in this case $30,000.  Hurdle number 2 is 20% of taxable income, or $20,000.  The deduction in this example is also limited to $20,000 although this time based on taxable income.

Specified Service Trade or Business

What I consider to be hurdle number 3 is the exception for what the code section calls “specified service trades or businesses”.  Code section 199A defines these businesses based on the definition shown in another code section (1202(e)(3)(A)).  Code section 1202 defines these businesses as any “trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, 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 1 or more of its employees”. 

In order for the specified service trades and businesses to utilize the deduction of this new code section fully the taxable income of the taxpayer(s) must be at or below $315,000 for married taxpayers filing a joint return and one half or $157,500 for everyone else.  Once the taxpayer(s) exceeds the taxable income limitation the deduction phases out. In the case of taxpayers with a threshold of $315,000 the deduction phases out over the next $100,000 of taxable income.  In the case of a taxpayer with a threshold of $157,500 the deduction phases out ratably over the next $50,000 of taxable income.

In each of the examples that follow there were no capital gains. In addition when the taxpayer exceeds the applicable limits ($315,000 for married taxpayers filing jointly and $157,500 for everyone else) hurdle 4 (explained later) also kicks in. For purposes of examples 3 through 7 assume there is enough W-2 wages and/or Qualified property that hurdle 4 does not come into play.  Again I will explain hurdle 4 shortly, however I do not want to further complicate these examples at this time.

Example 3

Scott, a single taxpayer, has qualified business income of $100,000 from a specified service business and taxable income of $150,000.  Hurdle number 1 is 20% of qualified business income or in this case $20,000.  Hurdle number 2 is 20% of taxable income, or $30,000.  Hurdle number 3 is that Scott’s qualified business income was earned in a specified service business; therefore the third hurdle has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $20,000 and because Scott’s taxable income is below $157,500 he is allowed the full $20,000 deduction even though his qualified business income was earned in a specified service business.

Example 4

Kathy, a married taxpayer, has qualified business income of $250,000 from a specified service business and taxable income of $300,000 on her jointly filed income tax return.  Hurdle number 1 is 20% of qualified business income or in this case $50,000.  Hurdle number 2 is 20% of taxable income, or $60,000.  Hurdle number 3 is that Kathy’s qualified business income was earned in a specified service business; therefore the third hurdle has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $50,000 and because Kathy’s taxable income is below $315,000 she is allowed the full $50,000 deduction even though her qualified business income was earned in a specified service business.

Example 5

Kathy, a married taxpayer, has qualified business income of $250,000 from a specified service business and taxable income of $500,000 on her jointly filed income tax return.  Hurdle number 1 is 20% of qualified business income or in this case $50,000.  Hurdle number 2 is 20% of taxable income, or $100,000.  Hurdle number 3 is that Kathy’s qualified business income was earned in a specified service business; therefore the third hurdle has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $50,000 and because Kathy’s taxable income exceeds $415,000 ($315,000 plus the $100,000 phase-out) she is allowed no deduction.

Example 6

Kathy, a married taxpayer, has qualified business income of $250,000 from a specified service business and taxable income of $360,000 on her jointly filed income tax return.  Hurdle number 1 is 20% of qualified business income or in this case $50,000.  Hurdle number 2 is 20% of taxable income, or $72,000.  Hurdle number 3 is that Kathy’s qualified business income was earned in a specified service business; therefore the third hurdle has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $50,000 and because Kathy’s taxable income exceeds $315,000 but is below $415,000 part of her deduction will be phased out.  The phase-out is calculated by subtracting the threshold amount from the taxable income.  In this case $360,000 less $315,000 equals $45,000.  $45,000 is 45% of the $100,000 phase-out.  Kathy’s deduction is therefore limited to $50,000 multiplied by 55% (again she loses out on 45% of this deduction).  The allowable deduction is 55% of $50,000 or $27,500. Please keep in mind that in addition to the three hurdles listed here Kathy would also be subject to hurdle 4. For purposes of this example assume that hurdle 4 would not limit the deduction in any way.

Example 7

Scott, a single taxpayer, has qualified business income of $150,000 from a specified service business and taxable income of $190,000.  Hurdle number 1 is 20% of qualified business income or in this case $30,000.  Hurdle number 2 is 20% of taxable income, or $38,000.  Hurdle number 3 is that Scott’s qualified business income was earned in a specified service business; therefore the third hurdle has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $30,000 and because Scott’s taxable income exceeds $157,500 but is below $207,500 part of his deduction will be phased out.  The phase-out is calculated by subtracting the threshold amount from the taxable income.  In this case $190,000 less $157,500 equals $32,500.  $32,500 is 65% of the $50,000 phase-out.  Scott’s deduction is therefore limited to $30,000 multiplied by 35% (again he loses out on 65% of this deduction).  The allowable deduction is 35% of $30,000 or $10,500.  Please keep in mind that in addition to the three hurdles listed here Scott would also be subject to hurdle 4. For purposes of this example assume that hurdle 4 would not limit the deduction in any way.

Other limitations based on taxable income

The last hurdle (what I call hurdle number 4) applies to all businesses; remember hurdle 3 only applies to specified service trade or businesses. Once the threshold limits of $315,000 and $157,500 are reached the code section states that the deduction will be the “lesser of 20 percent of the taxpayer’s qualified income or the greater of 50 percent of the W-2 wages with respect to the qualified trade or business or 25 percent of the W-2 wages with respect to the qualified trade or business, plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property.”  That certainly is a mouthful and I will now explain it in English. 

The first part discussing 20% of qualified business income is the same number we’ve been using from earlier.  This is the calculated figure after leaping over hurdles 1 and 2.  The newly introduced complication is the greater of 50% of W-2 wages (a number very easily attained from the payroll tax filings of an entity) or 25% of W-2 wages plus 2.5 % of the unadjusted basis of qualified property.

Qualified Property

The code section defines qualified property as property held by, and available for use in the qualified trade or business. The unadjusted basis is used (original cost without any reduction for depreciation). The only other limiting factor on property is that property no longer qualifies as of the later of 10 years after the date it is placed in service or the last full year that the property is depreciated.

Example 8

Kathy, a married taxpayer, has qualified business income of $250,000 not from a specified service business and taxable income of $360,000 on her jointly filed income tax return.  Kathy’s business paid $60,000 in W-2 wages and has no qualified property. Hurdle number 1 is 20% of qualified business income or in this case $50,000.  Hurdle number 2 is 20% of taxable income, or $72,000.  There is no hurdle number 3 because Kathy’s qualified business income was not earned in a specified service business.  Hurdle 4 has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $50,000 and because Kathy’s taxable income exceeds $315,000 but is below $415,000 part of her deduction will be phased out.  Hurdle number 4 limits the deduction to the greater of 50% of W-2 wages (in this case $30,000) or 25% of W-2 wages plus 2.5% of the acquisition cost of qualified property (in this case $15,000 + $0).  Hurdle 4 therefore limits the deduction to $30,000.  The phase-out is calculated by subtracting the threshold amount from the taxable income.  In this case $360,000 less $315,000 equals $45,000.  $45,000 is 45% of the $100,000 phase-out.  The phase-out is 45% of the difference between the $50,000 deduction calculated by using the first 2 hurdles and the $30,000 calculated by hurdle 4.  $20,000 multiplied by 45% equals $9,000. Kathy’s deduction is therefore limited to $50,000 less the $9,000 phase-out or $41,000.

Example 9

Kathy, a married taxpayer, has qualified business income of $250,000 not from a specified service business and taxable income of $360,000 on her jointly filed income tax return.  Kathy’s business paid $60,000 in W-2 wages and has $1,000,000 of qualified property. Hurdle number 1 is 20% of qualified business income or in this case $50,000.  Hurdle number 2 is 20% of taxable income, or $72,000.  There is no hurdle number 3 because Kathy’s qualified business income was not earned in a specified service business.  Hurdle 4 has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $50,000 and because Kathy’s taxable income exceeds $315,000 but is below $415,000 part of her deduction will be phased out.  Hurdle number 4 limits the deduction to the greater of 50% of W-2 wages (in this case $30,000) or 25% of W-2 wages plus 2.5% of the acquisition cost of qualified property (in this case $15,000 + $25,000).  Hurdle 4 therefore limits the deduction to $40,000.  The phase-out is calculated by subtracting the threshold amount from the taxable income.  In this case $360,000 less $315,000 equals $45,000.  $45,000 is 45% of the $100,000 phase-out.  The phase-out is 45% of the difference between the $50,000 deduction calculated by using the first 2 hurdles and the $40,000 calculated by hurdle 4.  $10,000 multiplied by 45% equals $4,500. Kathy’s deduction is therefore limited to $50,000 less the $4,500 phase-out or $45,500.

Example 10

Scott, a single taxpayer, has qualified business income of $450,000 not from a specified service business and taxable income of $500,000 on his income tax return.  Scott’s business paid $800,000 in W-2 wages and has $1,000,000 of qualified property. Hurdle number 1 is 20% of qualified business income or in this case $90,000.  Hurdle number 2 is 20% of taxable income, or $100,000.  There is no hurdle number 3 because Scott’s qualified business income was not earned in a specified service business.  Hurdle 4 has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $90,000 and because Scott’s taxable income exceeds $207,500 he is limited by hurdle 4.  Hurdle number 4 limits the deduction to the greater of 50% of W-2 wages (in this case $400,000) or 25% of W-2 wages plus 2.5% of the acquisition cost of qualified property (in this case $200,000 + $25,000).  Hurdle 4 therefore limits the deduction to $400,000.  The deduction is calculated by using the first 2 hurdles ($90,000) and the $400,000 calculated by hurdle 4. Scott’s deduction is $90,000.  Notice there is no phase-out since Scott’s taxable income exceeds $207,500.

Example 11

Scott, a single taxpayer, has qualified business income of $450,000 not from a specified service business and taxable income of $500,000 on his income tax return.  Scott’s business paid $60,000 in W-2 wages and has $1,000,000 of qualified property. Hurdle number 1 is 20% of qualified business income or in this case $90,000.  Hurdle number 2 is 20% of taxable income, or $100,000.  There is no hurdle number 3 because Scott’s qualified business income was not earned in a specified service business.  Hurdle 4 has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $90,000 and because Scott’s taxable income exceeds $207,500 he is limited by hurdle 4.  Hurdle number 4 limits the deduction to the greater of 50% of W-2 wages (in this case $30,000) or 25% of W-2 wages plus 2.5% of the acquisition cost of qualified property (in this case $15,000 + $25,000).  Hurdle 4 therefore limits the deduction to $40,000.  The deduction is calculated by using the first 2 hurdles ($90,000) and the $40,000 calculated by hurdle 4. Scott’s deduction is $40,000.  Notice there is no phase-out since Scott’s taxable income exceeds $207,500.

How to take the deduction

Another great thing about this deduction is that it is available to both those who itemize and those who do not itemize their income tax deductions.

CONCLUSION

This is a deduction that will be very beneficial to many that own sole proprietorships, interests in partnerships, S corporations and LLCs.  There are a few limitations that must be followed and in some instances action such as restructuring your business type (for example from a sole proprietorship to an S corporation) may be required.  While this article is intended to provide a certain level of knowledge regarding this new provision it does not replace the expertise of a professional or further research if you are a professional.

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THINGS TO KEEP IN MIND FOR 2018 TAX FILINGS

Article by: Jeff Skolnick, CPA, M.S. Taxation

This article is a recap of the major provisions passed in the Tax Cuts and Jobs Act that relate to businesses.

Corporate rate is cut to 21% after 2017.  Prior to 2018 the corporate tax rates paid by “C” corporations ranged from 15% on the first $50,000 of taxable income to 25% for the next $25,000 of income and then the rates went to 34% and 35% thereafter. There is no longer a special tax rate on personal service corporations.  These were previously taxed at 35%. Personal service corporations were defined as C corporations that performed services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting.

Alternative Minimum Tax has been repealed for corporations after 2017. This applied to corporations with average annual gross receipts for a three-year period of over $7.5 million in most cases ($5 million if it was within the corporation’s first 3 years of existence).

New Code Section has been to the Internal Revenue Code.  The new section is 199A. Qualified Business Income. This code section allows a 20% deduction for Qualified Business Income of a Pass-Thru Entity.  There are a number of limitations that may apply.  Think of the 20% deduction on Qualified Business Income as the first hurdle.

Increased Section 179 Expensing. Section 179 is the Internal Revenue Code Section that allows fixed assets to be fully written off in the year of purchase rather than depreciated over a number of years. Beginning after 2017 the annual first year expensing amount will be $1,000,000 (up from  $500,000).  The phaseout which currently begins at $2,000,000 is raised to $2,500,000.  This deduction is available for new and used equipment.  Most assets with the exception of real property are eligible. Qualified real property is eligible. Qualified real property is certain improvements made by either a landlord or a tenant in a nonresidential property.

Bonus Depreciation. Beginning September 28, 2017 through December 31, 2022 eligible property may be expensed 100% in the year of acquisition.  Each year subsequent to 2022 the percentage will drop (80% in 2023, 60% in 2024, 40% in 2025, 20% in 2026 and 0% thereafter).  Bonus depreciation will now apply to both new and used property (previously it only applied to new property).  This provision applies to basically the same assets as discussed in the Section 179 expensing paragraph. One important exception is that Qualified Improvement Property, this is Leasehold Improvements made to a commercial building while they are eligible for Section 179 due to an error in the writing of the law are not eligible for bonus depreciation.

Increased Limits to Luxury Automobile Depreciation.  Certain automobiles considered to be “luxury” automobiles had limitations placed on the amount of depreciation that was allowed each year. TheLuxury automobile depreciation limitation has increased to $10,000 in year 1, $16,000 in year 2, $9,600 in year 3 and $5,760 each year thereafter beginning in 2018.  This yields a total depreciation deduction of $47,120 over five years. The limitations for automobiles placed in service in 2017 were $11,160 in year 1, $5,100 in year 2, $3,050 in year 3 and $1,875 each year thereafter. This yielded a depreciation deduction of only $23,060 over the first five years.

Limitation on Business Interest. For years after 2017 certain companies that average $25,000,000 or more in sales are limited in the amount of interest that may be deducted as an expense on their tax returns.  This number is limited to 30% of adjusted taxable income. Taxable income is adjusted by adding back certain deductions such as depreciation in years before 2022, net operating losses and the new Section 199A deduction for Qualified Business Income of Pass-Thru Entities.

Net Operating Losses. If a company incurred a net operating loss (expenses exceeded income) prior to 2018 then the rule was the loss would be carried back to the tax return filed 2 years ago and would reduce the income of that return. The return would be amended and the taxpayer would receive a refund or credit. If not all of the loss was absorbed by that tax year (for example there was not enough income in the earlier tax year to totally use the loss, then the loss would be carried forward to the tax year filed 1 year ago and then forward to the tax years for the next 20 years until it was used in it’s entirety).Beginning in 2018 net operating losses will no longer be carried back 2 years and forward for 20 years.  The new law repeals loss carrybacks and modifies carryforwards from 20 years to indefinite. This applies to all companies other than property and casualty insurance companies which remain bound by the old laws.  Additionally, upon utilization they are limited to 80% of the taxable income without regard to the NOL deduction.

Entertainment Expenses which were formerly allowed as deductions (although limited to 50% of cost) are no longer deductible in 2018.

Meals provided at or near business premises by an employer, beginning in 2018, are now only 50% deductible rather than the 100% that they have been.

Transportation Reimbursements made to employees for commuting to and from a place of employment from the employee’s residence are no longer deductible.

Domestic Production Activities Deduction has been repealed after 2017.  This deduction amounted to 9% of “Qualified Production Activities Income” limited by taxable income and W-2 wages paid.

Partnership Technical Terminations are repealed in 2018. Under prior law if there was a sale or exchange of 50 percent or more of the total interest in partnership capital and profits then the partnership would be terminated.

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Self-Employment Tax 2019

Article By: Jeff Skolnick, CPA, M.S. Taxation

With the number of self-employed people growing each year I wanted to address self-employment tax.  This is by far the biggest surprise that almost all encounter the first year that they are profitable.

WHAT IS SELF EMPLOYMENT TAX?

Self-employment tax is the way in which the government collects Social Security and Medicare taxes from self-employed people.  The average person that works for a company is paid a salary.  The employee’s paycheck is reduced by 6.2% for Social Security tax (also shown as FICA).  This 6.2% is deducted until the employee’s wages exceed the Social Security limit ($132,900 in 2019).  Also, the employee’s paycheck is reduced by 1.45% for Medicare tax. There is no wage limit on Medicare tax.

Example 1:

An employee receives a salary of $1,000 per week.  The employee will see a deduction of $62.00 for FICA and $14.50 for Medicare taxes resulting in a net check of $923.50.  This does not take in to account the federal and state withholding amounts or any other deduction such as state unemployment withholding.

In my example above, the employee has had a total of $76.50 withheld from his/her paycheck.  The employer is required to make a matching contribution of $76.50, and thus the government collects $153 of Social Security and Medicare tax on the $1,000 salary. 

Self-employed individuals do not receive a paycheck, and therefore the government needs another method of collecting Social Security and Medicare taxes.  The method used is as follows:

A taxpayer calculates his/her net self-employment income by taking all allowable deductions against the gross income earned by the individual.  The individual then pays both halves of the Social Security/Medicare tax.  The calculation of self-employment is slightly different than Social Security and Medicare taxes for employees and the rate is approximately 14.1% on income up to the Social Security limit and approximately 2.7% on income above the Social Security threshold.

Example 2:

A sole proprietor has a net income of $1,000.  According to the law, only 92.35% of self-employment income is subject to the tax. The self-employment tax is calculated by multiplying $1,000 by 92.35% and then by the 15.3%.  The resulting self-employment tax is $141.30 (notice this figure is approximately 14.1% of $1,000). 

Social Security and Medicare taxes levied against individuals and employers are never reduced by any deductions. Self-employment taxes are calculated based on net income of the associated business, and therefore a reduction in the net income not only produces an income tax savings but also serves to reduce self-employment tax.

Example 3:

A sole proprietor has a net income of $500.  According to the law, only 92.35% of self-employment income is subject to the tax. The self-employment tax is calculated by multiplying $500 by 92.35% and then by the 15.3%.  The resulting self-employment tax is $70.65.

Notice the reduction in self-employment income produced a reduction of self-employment tax.

Also there is no self-employment tax levied against self-employment income less than $400.

It is important to remember that this tax is separate from any other federal or state income taxes.  It is, therefore, possible that a taxpayer has $0 income tax because of the standard or itemized deductions but still has a self-employment tax liability.

WHAT INCOME IS SUBJECT TO SELF EMPLOYMENT TAX?

• Any income earned by a sole proprietor or the owner of a single member LLC would be considered self-employment income.

• Income earned by general partners of partnerships.

• Income earned by members of LLCs if they perform services for their business or participate in management activities.

WHAT INCOME IS NOT SUBJECT TO SELF EMPLOYMENT TAX?

• Income from rental real estate

• Capital gains

• Dividend and interest income

HOW DO WAGES AFFECT SELF EMPLOYMENT TAXES?

Wages are subject to Social Security and Medicare taxes and therefore are not subject to self-employment taxes; however, if you earn both wages and self-employment income, then your wage income may reduce your self-employment liability.  An example of this would be if you earned $140,000 of wages, then you have already surpassed the Social Security limit, and any self-employment income you have would be subject to only the Medicare tax, approximately 2.7% and not the full 14.1%.

HOW DO I PAY THE TAXES OWED ON SELF-EMPLOYMENT TAX?

Typically individuals with earnings that are not subject to withholding (such as income from a sole proprietorship, partnership or LLC) pay the government through quarterly estimated tax payments.  The taxpayer will pay their taxes in 4 installments due April 15^th, June 15^th, September 15^th and January 15^th.  The last payment occurs 15 days after the yearend.

CONCLUSION

This article gives only a basic overview of the self-employment tax.  This area can be quite complex and can amount to significant dollars therefore I encourage consultation with a competent tax professional.

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