With the end of 2018 just around the corner, it’s time for both individuals and businesses taxed as pass-through entities to assess performance, to budget and, of course, our favorite topic, to plan tax opportunities.
While it’s been nearly a year since the passage of the tax law overhaul, it remains a hot topic, and the IRS continues to release guidance to allow taxpayers to more fully understand its broad implications. Year-end tax planning always is an important task, and now more than ever, it is imperative to consider year-end tax planning opportunities while ensuring compliance with the new rules.
Tax reform often was touted as a simplification to the tax code, but in reality, the law changes are proving to be anything but simple. Let’s walk through year-end planning under the new tax regime:
The tax overhaul increased the number of businesses that can use the overall cash method of accounting for federal income tax purposes. The gross receipts test associated with the limitation on whether or not entities can use the overall cash method has increased from $5 million to $25 million, which may allow some businesses in this range to convert to the overall cash method, potentially allowing for a temporary deferral of taxable income.
The gross receipts threshold also was raised for certain inventory methods, which may provide a favorable benefit to some taxpayers. Where appropriate, taxpayers should file an accounting method change with a timely filed tax return to take advantage of these changes.
For businesses taxed as pass-through entities and their non-C corporation owners, the new 20 percent deduction available on certain qualified income may reduce a pass-through owner’s maximum effective tax rate from 37 percent to 29.6 percent. Both the pass-through businesses and their owners will need to work through a complex analysis to maximize the benefits of this reduced effective tax rate.
While the changes to the tax code achieved simplification in certain areas such as itemized deductions, other areas such as the 20 percent pass-through deduction are certain to be tricky to navigate, but in many cases, the tax savings will be worth the cost of doing so.
The tax overhaul provides for increased “bonus” depreciation provisions, allowing for additional first-year depreciation deductions for qualified property acquired and placed in service after Sept. 27, 2017, and before 2023.
Bonus depreciation is now permitted for both new and used property, whereas previously, it was only permitted on new property. The Section 179 limits also have been expanded, currently with a $1-million deduction limitation for businesses with under $2.5 million of total purchases. It will be important to carefully assess the timing of capital expenditures to take the maximum benefit under these new provisions. A cost segregation study also could help maximize depreciation deductions.
For individuals, it will be important to project estimated income and deductions for the current and next calendar year. Part of the tax overhaul included material changes to itemized deductions and the standard deduction starting in the 2018 tax year, presumably intended to simplify and be favorable for the majority of individual taxpayers (though this really is good news only for those taxpayers who do not have itemized deductions in excess of the increased standard deduction).
For tax years 2018-25, a $10,000 cap is placed on the itemized deduction for state and local taxes. If you are mad about losing this for Michigan (4.25 percent), just imagine if you lived in New York (up to 8.82 percent) or California (13.3 percent). Most miscellaneous itemized deductions also have been suspended, including tax preparation fees (too bad!), deductions for employee business expenses, investment expenses and several other previously allowed deductions.
At the same time, the standard deduction was increased such that a taxpayer’s amount of total itemized deductions must generally be greater than $12,000 for single individuals and $24,000 for married couples filing jointly before there is any benefit for itemizing deductions.
Certain remaining deductible expenses, such as charitable contributions, should be carefully planned to determine if there is a benefit to bunching these deductions into one tax year versus spreading over multiple years.
Individuals also are impacted by modified net operating loss provisions. While the tax code changes include favorable provisions, such as increased first-year expensing of capital expenditures and increased applicability of the cash accounting method, the changes also modified several loss provisions that may not be taxpayer favorable, so it will be imperative to appropriately manage tax deduction benefits against the modified loss rules.
For example, a new provision effectively limits an individual taxpayer’s deductible net business loss to a certain threshold ($500,000 for married filing jointly taxpayers and $250,000 for all other taxpayers). This new limitation ultimately can force taxpayers to defer net business losses in excess of these thresholds to the following tax year as a net operating loss.
Additionally, starting in the 2018 tax year, individuals may no longer use net operating losses to offset all of their taxable income in a subsequent year. Net operating losses incurred in tax years after 2017 can now only be used to offset 80 percent of taxable income. As such, careful year-end planning may be desired in order to plan the timing of certain deductions due to the new net operating loss limitations.
Also included in the tax reform package is a new business interest expense limitation. Generally speaking, for taxpayers with receipts above a $25-million threshold, business interest expense will be limited to 30 percent of a taxpayer’s adjusted taxable income for tax years starting in 2018. For tax years 2018-21, adjusted taxable income is similar to an EBITDA calculation. For tax years after 2021, the adjusted taxable income will no longer exclude deductions allowable for depreciation and amortization. For many businesses that have material amounts of debt on the balance sheet, it will be crucial to analyze the impact of this new limitation before year-end to determine if there are any debt-restructuring opportunities available to help minimize the impact of this new limitation.
Proposed regulations were recently released by the IRS and the 439-plus pages of guidance prove to be both complex and at least initially perceived as more taxpayer unfriendly than some had anticipated.
Individual taxpayers and businesses of all sizes and across all industries have been impacted by the immense changes to the federal tax code, both favorably and unfavorably. Taxpayers should assess year-end tax planning opportunities to maximize some of the benefits provided for in the federal tax code overhaul.
Many of the changes to the tax code are extremely complex, and IRS guidance still is being released on some provisions, so it will be important to work with your tax adviser to obtain the maximum benefit while ensuring compliance. Now is the time to make sure that you do not have any surprises (at least any controllable ones) this year-end.
Kelli Olson is a tax managing director and Eric Fischer is a tax senior manager with the local office of accounting firm BDO USA, LLP. The views expressed above are those of the authors and not necessarily those of BDO USA, LLP. The comments expressed above are general in nature and are not to be considered as any specific tax or accounting advice and cannot be relied upon for the purpose of avoiding penalties. Readers are urged to consult with their professional advisers before acting on any items discussed herein.