Year-End Tax Planning under the New Tax Act

By December 13, 2018 Tax
The Tax Cuts and Jobs Act (TCJA) created many changes to the tax code. As a result, tax planning for 2018 will be different. Here is what you need to know as we approach the end of the year. In most cases, you will want to take action in one or more areas before 12/31/18, so it will be important to work with your tax advisor in December to maximize tax savings. Please remember that California has not conformed to any of the changes in the TCJA.

 

BUSINESS INCOME

The maximum individual federal tax bracket for both 2018 and 2019 will be 37%. Therefore, it will generally make sense to defer income until 2019, unless you expect to be in a higher tax bracket in 2019.

Cash basis businesses can control taxable income by accelerating expenses or deferring revenue based on when disbursements are made or revenue is received. Use of credit cards to pay expenses creates a deduction when charged on credit card, even for a cash basis taxpayer. Prepaid expenses are generally deductible when paid, as long as the economic benefit related to such expense doesn’t extend beyond 12 months.

Section 199A Deduction

The special 20% deduction on qualified business income (QBI) is a great tax planning opportunity, but has hurdles to overcome in order to obtain the full benefit. There are many limitations which must be navigated. The deduction generally applies to income from pass-through entities, like S Corporations and LLCs, as well as sole proprietorships (Schedule C). However, personal service businesses will not qualify unless an individual’s taxable income is below certain thresholds discussed below. The definition of personal service income is hazy in some regards and has resulted in some uncertainty.

Individuals with taxable income below certain thresholds ($157,500 for singles and $315,000 for married filing joint) will not be subject to the personal service income limitation or the wage and/or depreciable property limitation. Thus, a personal service business would be eligible for the 20% QBI deduction in this circumstance. A new tax planning strategy will be to keep taxable income below these thresholds, at least every other year, by shifting income and expenses between years. The requirement to have a certain level of wages and/or a certain level of depreciable property makes it difficult to maximize the 20% deduction once an individual’s income is above the threshold amount. For those who are managing the pass-through entity, this requires planning and analysis prior to year-end to maximize the income eligible for the deduction. Generally, each pass-through business entity flowing into your individual return must be analyzed separately. This will drive up the cost of preparing tax returns. Another benefit of the Section 199A deduction is that QBI generally includes passive investments in real estate (watch out for NNN leases), REIT’s and PTP’s. However, QBI does not include capital gains from these investments.

Tax planning to optimize the 199A deduction will be challenging. If you achieve a full 20% deduction on QBI, your effective federal tax rate on business income will be reduced to no more than 29.6%. It will be important to discuss planning with your tax advisor before year-end so as to maximize qualified business income and the 20% deduction. The issues that need to be addressed are significant! One example is that you will want to minimize wages paid to you by your qualified business entity, but not so much as to trigger a reduction in the 199A deduction for insufficient wages.

Also, be aware that moves designed to reduce this year’s taxable income (such as postponing revenue or accelerating expenses) can inadvertently reduce your QBI deduction. Work with your tax advisor to anticipate any adverse side effects of other tax planning strategies and optimize your results on this year’s return.

100% bonus depreciation and more generous Section 179 deductions

Thanks to the TCJA, 100% first-year bonus depreciation is available for qualified new and used property that’s acquired and placed in service in calendar year 2018. That means your business might be able to write off the entirecost of some (or all) of your 2018 asset additions on this year’s return. A year-end purchase of equipment could substantially reduce your taxable income. This may be a good tool to reduce your taxable income below the $315,000/$157,500 threshold so as to maximize the 199A deduction.

Bonus depreciation isn’t subject to any spending limits or income-based phase-out thresholds, but the programs will be gradually phased out, starting in 2023, unless Congress extends it. Consider buying some extra equipment, furniture, computers or other fixed assets before year-end. Your tax advisor can explain what types of assets qualify for this break.

Heavy SUV’s, pickups and vans that are used over 50% for business are treated for tax purposes as transportation equipment. So, they generally qualify for 100% bonus depreciation.

For qualifying property placed in service in tax years beginning in 2018, the TCJA increased the maximum Sec. 179 deduction to $1 million. (Under prior law, the limit was $510,000 for tax years beginning in 2017.)

The Section 179 deduction has also been expanded to include personal property used to furnish lodging and certain real property, including improvements to an interior portion of a nonresidential building placed in service after the building was first placed in service.

Maximize retirement plan contributions

Retirement plan contributions should be maximized every year. If you do not have a qualified retirement plan in place, consider establishing one before year-end. For a defined contribution plan, 2018 deductions can be as high was $55,000 per employee. Defined benefit plans have even higher limits. The plan must cover all employees and cannot discriminate in favor of the highly compensated executives.

If you are self-employed, consider a Solo 401(k) plan that has a $55,000 contribution limit ($61,000 if age 50 or older). A SEP-IRA may also make sense.

Converting to cash basis of accounting if your business has less than $25 million in revenue

Normally, businesses with inventory must use the accrual basis and account for inventory. The TCJA now allows businesses with less than $25 million in revenue for the 3 prior years to use the cash basis, meaning that inventory can be treated as non-incidental material and supplies. The conversion requires an application to change the method of accounting. Unfortunately, California has not conformed to this new provision, so the accrual method must be continued for California purposes.

Should an S Corporation convert to a C Corporation?

The TCJA reduces the maximum tax rate for C Corporations from 35% to 21%. That’s a 40% reduction in tax! Nevertheless, C Corporations are still subject to double taxation, one at the corporate level and one on the dividend to the owner. This will cause the total taxes to be higher than what S Corporations incur related to the single level of tax at the shareholder level (the extent of the variance depends on your state of residence). Nevertheless, if dividends can be deferred or if the profits must be retained in the corporation for growth or capital investments, it may make sense to convert to a C Corporation. There are other pros and cons of a C Corporation, so these should be explored with your tax advisor before deciding to convert.

Some bad news for businesses

The TCJA eliminates any deduction for entertainment expenses. Previously, such expenses were 50% deductible. Business meals remain 50% deductible.

Certain “excess business losses” cannot be used to shelter other sources of income. Generally, business losses of more than $500,000 from pass-through entities must be carried forward, rather than offset non-business sources of income.

Business interest expense is subject to new limitations. Generally, business interest expense is capped at 30% of EBITDA. The excess interest can be carried forward for 5 years.

Post- 2017 net operating losses (NOL’s) cannot be carried back and when carried forward can only offset 80% of future taxable income.

INDIVIDUALS

Individual tax rates have been reduced and the brackets have been increased, such that the maximum tax rate of 37% is not incurred until taxable income reaches $600,000 (MFJ). Previously, the maximum rate of 39.6% kicked in at taxable income of $470,000 (MFJ). As an example of a lower bracket, the 24% tax rate applies to taxable income between $165,001 and $315,000 (MFJ). Previously, income in this range was taxed at rates of 28% to 33%.

State income tax deduction

The repeal of the deduction for state taxes, except for a maximum of $10,000 for the sum of state income taxes and property taxes, is perhaps the biggest negative provision of TCJA. What is not well understood is that the alternative minimum tax (AMT) previously wiped out most of the tax benefit of state income/property taxes anyway. The silver lining is that AMT will rarely apply in the future.

Nevertheless, there is much talk about moving to states with lower state tax rates. Be aware that the California FTB may challenge individuals who claim that they have moved out of state based on factors indicating that they continue to spend time in California or that they “intend” to move back to California in the future, especially if they retain their California residence.

Higher standard deduction

The standard deduction has been increased to $12,000 for singles and $24,000 for MFJ. Thus, itemized deductions will be less common. Furthermore, some itemized deductions have been repealed, such as miscellaneous itemized deductions (broker fees, tax preparation fees, and unreimbursed business expenses).

Charitable contributions

Charitable contributions are still deductible, assuming itemized deductions exceed the standard deduction. Tax planning will continue as before, except that you may want to bunch charitable contribution every other year if your itemized deductions would otherwise be less than the standard deduction. Using a donor advised fund (DAF) is a good bunching tool because it allows you to continue to benefit your favorite charities every year. The DAF may also be useful to bunch deductions so as to cause taxable income to be less than the $315,000/$157,500 threshold that triggers loss of the 20% QBI deduction.

Donating appreciated securities to charity creates a tax deduction for the value of the securities donated, yet no taxes are due on the built-in gain. Other property can be donated to charity but an appraisal performed by a “qualified appraiser” will be needed if the fair market value is greater than $5,000. Gifting appreciated assets also avoids the NII tax on the gain that would otherwise be incurred on the sale of such assets.

Clothing and household items donated to charity must be in “good condition” in order to be deductible. Thus, taxpayers must be ready to prove both the value and the condition of the property contributed. In addition, contributions made by check must be supported by bank records or receipt from the charity (contribution of more than $250 must always be supported by acknowledgement from the charity.)

Capital Gains

The TCJA does not alter the taxation of capital gains. As provided under prior law, the capital gain tax rate increases from 15% to 20% at the point where old tax rates reached 39.6%. For 2018, this would be $479,000 for married filing joint. The 3.8% NII tax still applies if your AGI is greater than $250,000 (MFJ).

As in the past, we recommend that you harvest capital losses before year-end. Remember not to reinvest in the same security for 31 days.

If you expect net short-term capital gains for 2018 (holding period less than 12 months), you may want to accelerate short-term capital losses in order to avoid ordinary tax rates on such gains.

The opportunity to have capital gains taxed at zero percent still applies if you are in the 10% or 12% tax bracket for ordinary income (taxable income of less than $77,400 if you are married filing joint.) Clearly, if you are eligible for the 0% tax on capital gains, you should not accelerate capital losses.

Contribute to Your Retirement Plan

Individuals with a traditional IRA or an employer sponsored retirement plan, such as a 401(k) plan, should consider making a contribution to the plan before year-end. Not all taxpayers will qualify for deductible IRA contributions.

For 2018, the IRA contribution limit is $5,500 ($6,500 for individuals older than 50 years of age who qualify for the catch-up provisions). The maximum amount of an employee can contribute to a 401(k) in 2018 is $18,000 ($24,000 for individuals older than 50 years of age who qualify for the catch-up provision). In certain circumstances, it may be advisable to convert an IRA into a Roth IRA.

In the case of a traditional 401(k) plan, consider making a $35,000 “after-tax” contribution in addition to the $18,000 pre-tax contribution. The employee may be able to later to roll any after-tax amounts into a Roth IRA, with the remainder to traditional IRA.

Gifting to your children

Back in the old days, we used to recommend annual gifting to children in amounts equal to the annual gift tax exclusion (today $15,000 or $30,000 for a married couple). Now that the TCJA has increased the lifetime gift and estate tax exemption to $11.2 million for single individuals ($22.4 million for couples), there is less need to limit your gifting to $15,000 per child per spouse, other than to avoid filing a gift tax return showing how much of your lifetime exemption you have used. Why make your heirs wait? Assuming you are comfortable financially and that you trust your children to spend your gifts wisely, transfer wealth to the next generation sooner rather than later.

Funding a 529 education savings plan for one or more children or grandchildren is now even more attractive. The $15,000 annual limit is less important as explained above, and income earned from investments in the plan is exempt from tax. Fund the 529 Plan while the kids are young in order to capitalize on the tax free growth.

Gifting appreciated securities to children may also make sense if the children are in the bottom two tax brackets (for singles, taxable income of less than $38,700). As indicated earlier, the tax rate on long-term capital gains and qualified dividends is 0% for taxpayers in the 10% or 12% tax bracket. If your child is under 24, watch out for the “kiddie tax” rules.

Deferring taxes on the sale of your business and certain other assets

The TCJA has introduced the Opportunity Fund which works something like a 1031 exchange to defer the capital gain tax. The good news is that it applies to any source of capital gain, including the sale of securities, and does not require parking sales proceeds with an accommodator while you search for an appropriate investment. It is restricted to investments in Opportunity Zones, such as a real estate development project in a depressed geographic area. The rules pertaining to an Opportunity Fund are complicated, so be sure to seek advice as to how they work.

There are several other techniques to defer taxes on the sale of your business, such as use of a charitable remainder trust. In addition, a sale of a C Corporation that meets the test of a qualified small business corporation (QSBC) can also avoid federal capital gains tax. If you are contemplating a major transaction, be sure to contact your tax advisor.

Foreign Investments

Make sure you disclose all foreign bank accounts and foreign investments to the IRS in order to avoid severe penalties. See your tax advisor for applicable forms and due dates.

If you own a foreign business, be sure to speak with your tax advisor regarding major changes in the US taxation of foreign business income.

Click the link to read the full 2018 Tax Planning Guide.