Tax Cuts and Jobs Act Q&A: Understanding the New Tax Law

The Tax Cuts and Jobs Act (TCJA) was signed into law on Dec. 22, 2017, and created the most comprehensive reform to the US tax code in over 30 years. We posted key law highlights shortly after the passage, and now after receiving multiple questions from clients, we created a helpful guide.

We expect additional guidance from the IRS in the near future, and as the guidance is issued, we will continue with communications.

Q. I read that the new tax law is effective in 2018. Are there any parts of the law to consider for 2017?

A. Only a few provisions of the law take effect in 2017 including the following:

For Individuals:

  • Medical expenses were previously deductible but only to the extent they exceeded 10% Adjusted Gross Income (AGI) unless they were over 65 years old. The TCJA changed the limitation to 7.5% of AGI for all individuals for 2017 and 2018.
  • An exception to getting a contemporaneous written acknowledgment of charitable contributions of $250 was repealed. For 2017, contemporaneous written acknowledgment of all charitable contributions of $250 or more is needed.
  • The Conference report to the law said prepayments of 2018 state income taxes would not be allowed. Prepaying real estate taxes in 2017 became a contentious issue. The IRS issued an advisory addressing circumstances where they would allow real estate tax payments for taxes that were assessed in 2017. We expect further guidance on the treatment of tax prepayments.

For Businesses:

  • Expensing for equipment purchases after Sept. 27, 2017, has been expanded to include more types of property and now is 100% deductible (before the change it was 50% deductible)

Businesses

Q. The meals and entertainment rules have caused a lot of question for my business. Can you give me an overview of the changes and some examples of what I can or cannot deduct?

A. This is one of the most difficult changes to fully explain, and we expect further guidance to be issued by the IRS. Here is our take on the changes at this point:

Prior to the TCJA, entertainment, amusement or recreation (EAR) was deductible if it was directly related to the active conduct of your trade or business. In addition, if the EAR was directly preceding or following a substantial and bona fide business discussion, including business meetings, it was also deductible. The TCJA eliminated all the above language effectively taking away all EAR deductions after Dec. 31, 2017.

The TCJA also changed the definition of club dues that are non-deductible. Previously, club dues for social, athletic, and sporting clubs or organizations were not deductible (i.e. country club dues). The TCJA now says no deduction shall be allowed for amounts paid or incurred for membership in any club organized for business, pleasure, recreation, or another social purpose.

Deductions for meals need a deeper dive. In general, meals that are substantiated by amount, time and place, business purpose, and business relationship remain 50% deductible with exceptions. For example, the following meals are 100% deductible:

  • Expenses for employees. These expenses most likely will be the most common type you encounter. You can deduct 100% of expenses for recreational, social, or similar activities (including facilities) for the benefit of employees. The expenses for office holiday parties, for example, remain 100% deductible. We suggest isolating these types of expenses in your accounting records to more easily identify them.
  • The following are also 100% deductible, but not likely to be incurred by many of you:
    • Expenses that are treated as compensation
    • Expenses that are reimbursed by another person
    • Expenses that are available to the public
    • Entertainment sold to customers
    • Expenses included in the income of persons who are not employees

Other frequently asked questions related to meals and entertainment:

Are sports tickets deductible? No, they fall in the EAR definition
Are sports tickets given to employees or customers when we do not attend the event deductible? These will be classified as gifts limited to $25/employee or customer per year.
Are expenses peripheral to the entertainment deductible? These will be classified as entertainment and not deductible.
When employees are traveling for business purposes are meals deductible? Yes, subject to 50% and being adequately substantiated.
Are other meals with customers deductible? Yes, subject to 50% and substantiation.
Are meals provided for the convenience of the employer deductible? Yes, subject to 50% limitation and not deductible after 2025. It is possible a “de minimis” rule will be added to cover small expenses.

 

Q. I have read a lot about certain business income qualifying for a 20% deduction. What types of income qualifies? How do we claim the deduction? Are there limitations?

A. The TCJA created a new deduction for owners of S Corporations, Partnerships, and LLCs, and Schedule C, E and F activities. The deduction is based on having “Qualified Business Income (QBI).” QBI is your income from the above entities including a deduction for reasonable owner compensation.The deduction is 20% of the combined income from the activities and is then subject to other limitations.

Your deduction cannot be greater than one or two limitations, whichever is larger. First, the deduction cannot be greater than 50% of the activity’s wages. Wages are defined as the total W-2 wages from employees, not including shareholders multiplied by your ownership interest.

Second, the deduction cannot be larger than 25% of wages plus 2.5% of the unadjusted basis of property (meaning its original cost before any depreciation) within 10 years or its depreciation recovery period, if longer.In simpler terms, owners of retail, wholesale, distribution, or manufacturing businesses, will generally deduct 20% of the activity’s income. We suspect most owners of these business industries will have a deduction of 20% of their QBI because that will likely be larger than 50% of wages.

In contrast, the deduction for real estate rental operations may be limited to the second test because they generally have little or no W-2 wages. Their deduction may be limited to 2.5% of unadjusted basis of their property if they have no wages. It is not possible to say how many real estate rental activities will have the limit applied. We do have software to calculate the QBI using a variety of inputs to assist us with your specific fact patterns.

The law also limits the QBI deduction and includes an income phase out if you are in a specified service business. A specified service business is defined as performing services in the fields of health, law, consulting, athletics, financial services, and brokerage services (where the principal asset is the reputation or skill of one or more of its employees), owners or investing and investment management trading, dealing in securities, partnership interests, or commodities. We think additional guidance will be issued to help us decide what businesses fall within this definition, although many businesses clearly are within its meaning.

Owners of specified service businesses with taxable income above thresholds begin to lose the deduction. For those married and filing jointly, the deduction phases out as taxable income exceed $315,000 and is fully lost when taxable income exceeds $415,000.

Q. My business is currently an S Corporation. With the C Corporation tax rate being reduced should I consider terminating the S election and converting to C status?

A. The Federal tax rate for C Corporations is now 21% for all taxable income. If you compare tax rates in a vacuum, the C Corporation rate is lower than the highest individual rate on S Corporation income by 8.6% points. The highest effective individual rate for S Corporation income is 29.6% (37% X 80% is 29.6%). The spread also exists for the 32% and 35% individual rates.However, changing from S to C Corporation includes other considerations.

For example, as S Corporation income flows through to its shareholders their stock basis increases whereas similar C Corporation income does not increase stock basis. An increase in stock basis will ultimately lead to smaller individual level taxes on the sale of the entity. Along the same lines, if you sell your assets of the business the tax cost of an S Corporation will be far less than a similarly situated C Corporation.Since each business circumstance has specific facts, we think terminations of S Corporation elections need to be carefully analyzed.

Q. Has the new law made changes to deducting payments for parking?

A. Qualified transportation fringes include qualified parking (parking on or near the employer’s business premises or on or near a location from which the employee commutes to work by public transit), transit passes, vanpool benefits, and qualified bicycle commuting reimbursements. The new law disallows a deduction for expenses associated with providing any qualified transportation fringe to employees, and except as necessary for ensuring the safety of an employee, any expense incurred for providing transportation (or any payment or reimbursement) for commuting between the employee’s residence and place of employment. Although the fringe benefit is not deductible, it remains tax-free to the employee after application of some dollar limitations.

Individuals

Q. I have read a lot about my deduction for state and local taxes being limited to $10,000. Can you explain what this means, and does it affect other itemized deductions?

A. Beginning in 2018, the total deduction an individual can take for itemized taxes is $10,000. The $10,000 limitation includes all state and local income taxes plus your real estate taxes. Some clients residing in non-income tax states (i.e., Florida) would substitute sales tax for state and local taxes. Add up all your state, local income taxes (or for some their sales tax), and real estate taxes, and if they exceed $10,000, you get to deduct only $10,000. You are still able to deduct charitable contributions and mortgage interest in 2018.

Q. Is interest on home equity loans still deductible under new law?

A. The Internal Revenue Service advises taxpayers that in many cases they can continue to deduct interest paid on home equity loans. Responding to many questions received from taxpayers and tax professionals, the IRS said that despite newly-enacted restrictions on home mortgages, taxpayers can often still deduct interest on a home equity loan, home equity line of credit (HELOC) or second mortgage, regardless of how the loan is labelled.

TCJA suspends from 2018 until 2026 the deduction for interest paid on home equity loans and lines of credit, unless they are used to buy, build or substantially improve the taxpayer’s home that secures the loan.Under the new law, for example, interest on a home equity loan used to build an addition to an existing home is typically deductible, while interest on the same loan used to pay personal living expenses, such as credit card debts, is not. As under prior law, the loan must be secured by the taxpayer’s main home or second home (known as a qualified residence), not exceed the cost of the home and meet other requirements.

Additionally, there is also a new dollar limit on total qualified residence loan balance. For anyone considering taking out a mortgage, the new law imposes a lower dollar limit on mortgages qualifying for the home mortgage interest deduction. Beginning in 2018, taxpayers may only deduct interest on $750,000 of qualified residence loans. The limit is $375,000 for a married taxpayer filing a separate return. These are down from the prior limits of $1 million, or $500,000 for a married taxpayer filing a separate return.

The limits apply to the combined amount of loans used to buy, build or substantially improve the taxpayer’s main home and second home.For further information on this topic, read our latest update.

While the answers to these frequently asked questions reflect our views at this time, our answers are subject to change on the basis of additional guidance, input received, or further developments in practice. Please continue to follow our blog for further updates. If you have further questions, please contact us at info@barneswendling.com.

 

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