Understanding the Impacts of the Tax Cuts and Jobs Act on Professional Services
Bob Greenberger: Thank you, Kayla. I appreciate everyone taking the time for the webinar, and as you have questions, please feel free to submit them. You should be seeing on your screen the agenda, just that overview of what we’re going to be discussing. We’ll be talking about some individual changes. We’ll be spending some time on some changes in the business area. Miscellaneous changes cover a whole wealth of areas, except for international; it’s probably one of the areas we won’t get into. Then we’ll talk about the 20% business deduction under the new code section 199A. It’s also called “qualified business income deduction.” Lastly we’ll leave some time for some questions.
Before we dive in, though, I wanted to give you a little flashback and overview. The law was passed December 22, and there’s a few themes that you’ll see throughout the bill. One of them was supposed to be simplification. You will find by the end of the webinar that, for the most part, there was not tax simplification. This is one of the most significant tax laws that’s been passed since 1986, and we expect a lot of clarification, regulations, and guidance to be coming out in the next several months, or in the case of the IRS, in the next several years.
The tax law, you’ll find, affects each person drastically differently. Not only will it affect you much differently than your neighbor or than your partner that you work with, but it might affect you drastically differently one year from the next.
Some common themes throughout the tax law are, “Debt is bad, and capital expenditures is good.” You’ll see some provisions that Angela will talk about, both in business and individual provisions, where the interest deductions take somewhat of a haircut, but capital expenditures are favorable, and there’s favorable tax benefits to them.
The other driving force behind the tax law was the need to make the United States’ corporate rates the same or lower than the rest of the world, so the biggest provision that had the largest impact was a reduction of the 35% top corporate rate down to 21%. You’re going to hear several examples where the new law greatly discourages debt, and like I said, we’ll go into that throughout the webinar.
The Budget Reconciliation Act is a guiding principle that does not allow Congress to add tax provisions that increase the debt. If that happens, there has to be approval of 60% of the Senate. To get around this provision of 60% of the Senate, if there’s a provision that’s considered temporary, then you only need a majority vote, or 50%. There were a lot of provisions on the individual side that you’ll find are temporary, and effective for less than 10 years. In fact, most of them expire 2025, or they sunset in 2025.
Lower tax rates on the corporate side are big, but the other large thing that we see happening is corporations are now able to bring earnings in from overseas. They had planned on paying 30% or 35% to bring earnings back over, and now there’s an immediate tax, but only at about half that rate: 15.5% to bring dollars back from overseas, and in some cases, only 8%.
You can’t pick up the paper these days without seeing a lot of examples where companies are already taking advantage of kind of a windfall. JP Morgan just reported last Wednesday they’ve got a five-year plan to invest $20 billion. I think they’re expanding into 15 or 20 new markets, adding 3,000 employees. They expect their effective rate to drop from 35% down to 19% in 2018, and then starting in 2019, it’ll be about 20%. They plan to have more mortgages for low income communities, and they plan to also boost wages for about 22,000 employees.
Bank of America, US Bancorp announced 1,000 one-time bonuses. I picked up USA Today last Friday, and their researchers estimated that there would be 1.3 million workers that were going to receive cash or stock bonuses totaling about $1.7 billion. We are going to see this trickle down to many companies.
The analysts expect about a 7% or 8% boost to the aggregate per share profits for companies in the S&P 500, but there’s been plenty of examples that everyone’s seen with Disney, Home Depot, Apple, Verizon and Boeing, all making announcements. There’s definitely been an immediate impact already. We’ll get into the specifics. Now I’m going to turn it over to Angela Dotson to talk about some of the individual provisions.
Angela Dotson: Thanks, Bob. As Bob mentioned, there are a lot of temporary changes for individuals. Just keep that in mind as we go forward over the next few minutes. Of these changes, 99% of them will sunset at the end of 2025. The main thing that has been in the press related to individual tax was related to the rate reduction. Everything else was related to temporary changes for various expenses, or itemized deductions, and so forth. But that hasn’t gotten a lot of press. Our goal today is to give you an overview of some of the changes that you might not have heard so much news about.
There actually are several provisions that affect individuals. The ones that we will discuss today are the ones that we thought would be most relevant to a professional services-based crowd. There are plenty of other provisions that we will not cover, but the point is that this tax reform was very comprehensive. There are a lot of changes, and you need to be in contact with your CPAs to make sure that you’re doing planning to know how it will affect you. There are so many changes that people can’t really share common tax planning anymore. Everything really will be specific to the individual, and each line item that appears on their tax return.
The backdrop, again, for this is for individuals, we have temporary changes, but the corporate tax rate was made permanent. Just keep that in mind. The corporations don’t have to go back and re-up at the end of 2025. The Congress will have to do something for these individual changes to stay in place, or they revert back to the 2017 tax rates.
Let’s take a look at the tax rate schedule in 2017, compared to 2018. This is a slide where you can see side by side what the rates were before, and what they will be going forward. As Bob mentioned, in September of 2017, the administration released a framework for the new tax reform act. Part of it was simplicity. The president was expecting the vast majority of Americans to be able to file their taxes on a postcard. Well, as you can see, based on all of these rates, that will not be happening.
There were four principles that were laid out in September. The first one was related to making the tax code simple, fair and easy to understand. All the CPAs who’ve looked at this and all the people who’ve done some research and reading on this can agree that they did not make it simpler. They actually added several hundred pages to the existing code. The second principle was to give American workers a pay raise by helping them have more money immediately when they get their paychecks. With the reduced rates, the federal holding rates changed, so that changed their withholding table, so anybody that’s an employee should have seen their paychecks go up in 2018.
The third principle related to putting America on the same playing field with other countries. We had one of the highest corporate tax rates in the world, and so hopefully the 21% rate will give us a boost to our economy and help us to compete on a global playing field. The fourth principle was to bring back the trillions of dollars that have been sitting offshore, so the hope is to have that money, or at least some of that money, reinvested back into American businesses.
For the first two, you’ll see some of these themes throughout my part of the presentation, where there are a few things that were made simpler, and there are some ways that Americans will see more money in their paycheck or get more money back when they file their taxes.
Bob Greenberger: Angela, we already have a question from somebody. Their question is, “You mentioned that you can do planning and projections for people. Is there software available now that already incorporates the new tax act?”
Angela Dotson: That’s a great question, Bob. Thanks for fielding that for me. Actually, we do have software that is updated to incorporate the new tax reform act. We’ve been running projections and doing tax reform analysis for clients already, so we do have that capability available, and we do highly encourage people to start that planning sooner rather than later. I know right now, some people are still completing their 2016 tax returns that are due tomorrow. If anybody was affected by Hurricane Irma, you have until tomorrow to file that 2016 return.
Some people are still concerned about their 2017 return that’s just getting started, but with so many changes in the tax reform bill, I don’t think it can be too early to start this analysis, because you will need to run many different scenarios and engage in some conversation to see what you can do to maximize the benefits that are available to you in the bill.
Standard deductions: Now, many people will not have to itemize deductions going forward, because the standard deduction almost doubled for each category, as you can see here on the screen. For some taxpayers, they will have a simpler tax preparation process, and may be able to file their tax return on their own, without the help of a preparer, if they fall into this category, because the standard deduction will be more than the combination of all their itemized deductions. For most taxpayers that we work with, this won’t be the case, so there’s still a lot of planning that will be involved to determine the timing of when you take certain deductions, and that will reveal itself more as we go on in the presentation.
The personal exemption was repealed for 2018, so you can’t take the exemption for yourself or your children. But there is a give back a little bit later, and it may be on the next slide, related to the child tax credit. But the personal exemption won’t really have a huge impact, because they did try to make up for it in a later section, but those are gone for 2018 through 2025.
The child tax credit: This one is a big win, I think, for parents and for families. The child tax credit actually doubled from $1,000 per child to $2,000 per child. The threshold for taking the credit also increased greatly. In 2017, an individual started to phase out at $75,000, while a couple, married filing jointly, started to phase out at $110,000.
Under the new laws, those phase outs start at $240,000 and $400,000 related to those single and married filing joint couples, respectively. This one is a very big win for families. There’s also a refundable portion. $1,400 per child is available to be refunded. That means if you have no tax, that you can still receive a refund of up to $1,400 per child with your tax refund.
They also added a new credit that’s brand new for 2018, related to dependents who are not your children. Many people are in the sandwich generation where they are taking care of their parents or other non-child dependents. There’s a $500 credit available. It’s not a lot of money, but it is a credit, so it reduces your tax liability dollar for dollar. I think that was a big win for the taxpayers, and people who are taking care of others in their household.
Bob Greenberger: Angela, we have another question that someone sent in. It says, “Are LLCs also eligible for the 21% corporate tax rate?” The answer is, if the LLC is a pass-through entity, and taxed as a partnership, then it doesn’t pay taxes at all. Rather, the income flows through to the individuals on a form K-1 and the individuals report that income on their tax return. LLCs can make an election to be taxed as a C corporation, and if they do that, they would be taxed at 21%.
One further point is that if the LLC is a pass-through entity that’s not paying taxes, when that income flows through to the individuals, the individuals might be able to get a deduction (we’re going to cover that towards the end of this webinar) where they get what’s called a qualified business income deduction. They may be able to get a 20% deduction on that income, but that hopefully answers your question. Thanks.
Angela Dotson: That’s a great question, and there is a lot of confusion surrounding who qualifies for the corporate tax rate. In addition to what Bob just said, if you’re incorporated, that does not necessarily mean you qualify for the 21% corporate tax rate. The corporate tax rate is for those companies that are filing a C corporation tax return. Most of our clients are pass-through entities and don’t qualify under the 21% corporate tax structure. There are a few C corporations that we have as clients that will have the benefits, but by and large, the corporations that will see the most benefit are bigger corporations like Apple, Google and JP Morgan, and some of those businesses that Bob referred to just a second ago. Let’s get my slide moving here. There we go.
The kiddie tax rate actually went up. This is one of the few places that I saw where tax rates went up. As we saw on a previous slide, all of the individual rates went down, but kiddie taxes will be taxed based on trust and estate tax rates for 2018 and going forward. Previously, they fell under the same individual tax rates as everyone else, but now they use the trust and estate tax rate, and as you can see based on this slide, there are four tax rates with the maximum rate being at 37%.
This is definitely an area where parents who have kids with investment income want to pay attention. That 37% tax rate kicks in when they reach $12,500 of taxable income, and the taxable income is made up of interest, dividends, rental income and things of that nature. This is not their wage income, that if they were to go out and have a part-time job. This is for their investment income.
One of the other things that happened with the tax reform is that since the kiddie tax is now based on trust and estate rates, it’s not interdependent on the parents’ tax return. You don’t have to hold up the kid’s return to finish it along with the parents’ return. The kids no longer have to file for an extension just because the parents are doing so.
But again, this is an area that has not gotten a lot of coverage, and if you don’t pay attention, your children, or you, on behalf of your children, could be paying a 37% rate if this is not monitored. As a planning note, you want to make sure that your CPA, financial advisor, and the parents are having conversations about what’s inside those investment accounts, and what transactions will be happening or won’t be happening going forward.
As a point of contrast, the single taxpayers don’t reach the 37% tax bracket until their income is over $500,000. This is a big hit on the kiddie tax, just an area to be aware of, because again, like I said, it has not gotten much press.
Bob Greenberger: Angela, good point, and before you go to the next slide, just for those parents that have $100,000 in their kid’s account, and suddenly want to pull that money back, because maybe the parents are only in a 24% or a 32% bracket, and the kids are in a 37% bracket, be sure to talk to your CPA before you have your kids give you $100,000, because that transaction could be subject to gift tax.
Angela Dotson: Great point.
Bob Greenberger: Right.
Angela Dotson: There are changes to gift tax rules that we’re not covering in this presentation, but just be aware that there are several changes related to tax reform that may come into play, so communication with your CPA over the next year is going to be very important.
For capital gains, there’s no news as far as changes. Everything remains the same. The rates are the same. The thresholds change slightly, but they’re pretty much in line with where they were for 2017. No news is good news here. Nothing new for you to learn related to capital gains tax rates, so they survive the reform.
Let’s move on now to itemized deductions. This is where a lot of taxpayers will see their schedule A’s decrease significantly based on the things that were either slashed or repealed altogether. Let’s start with the repeal of the disallowance of 3% of your itemized deductions.
Some taxpayers, who had adjusted gross income over certain thresholds, were limited in their itemized deductions. This essentially represented a 1.18% increased tax for these taxpayers. Their marginal tax rate was 39.6%, but after the disallowance of certain itemized deductions, it effectively pushed them to a 40.71% rate.
You must pay attention to your marginal rate, but also the effective rate that you’re paying. One thing to note that I didn’t mention before, the tax rates went down. Based on the itemized deductions also going down, it is very possible that your income may have gone up. The tax rate is not the only indicator of whether you will be paying a higher or lower tax amount.
The home mortgage interest: The amount of acquisition debt that you may use to deduct interest was changed. The previous amount was $1 million. The new amount is $750,000. This is a partial win for the taxpayer. When the Senate and the House were contemplating this change, the proposed number was $500,000. I believe they thought about the effect this might have on the housing market, and pushed it back up to $750,000.
Your interest is related to your acquisition debt. That means debt that you use to acquire your home, construct it or substantially improve it. That’s the good news. The bad news is if you have a home equity loan, that interest is no longer deductible, starting with 2018. If you have a home equity loan that was in place prior to 2018, you can no longer deduct that interest. No grandfathering in for this one. Home equity interest is gone. The debt limit is reduced, but not so drastically.
State and local taxes, the SALT deduction: This is one you probably heard about. It’s limited to $10,000 per taxpayer. The combination of your real estate taxes and income taxes for itemized deductions purposes is limited to a cap of $10,000. This is going to be a major hit for many taxpayers. Most people have a state income tax deduction that’s one of the higher numbers on their schedule A.
The IRS has also disallowed any prepayments of real estate taxes or income taxes. If you prepay any property tax that has not been assessed to you, that does not qualify for a deduction in the current year. The property tax must be assessed by the county before you can take that as a deduction on your schedule A. If you have real property taxes in a foreign jurisdiction, those are not allowed as well.
Casualty and theft losses: Personal casualty losses have been repealed, unless there’s a federally declared disaster area. Many taxpayers have personal casualty and theft losses when their insurance company doesn’t make them whole, and they’re able to take a tax deduction on schedule A to make up for the lack of cash they received back. But that’s no longer available unless it is a federally declared disaster. Another law for the taxpayer.
A little bit of a win here when we move down the slide to charitable contributions. The limit has increased from 50% to 60% of charitable contributions that you can deduct from your adjusted gross income, and some private charities or private foundations qualify as well. For private foundations, that’s doubling. The old limit was 30%. Some private foundations now qualify for 60%.
This is an inducement for you to continue to give to charity, even though you’re losing some of your itemized deductions. Some people are planning on bunching their charitable contributions into one year, so for 2018, some people may choose not to donate anything to charity, and hold that cash over to 2019 to combine the 2018 and 2019 amount to increase their overall charitable contributions. Now that the standard deductions have gone up, people are figuring out ways to maximize the tax benefit of their charitable contributions.
There may be an unintended consequence here related to nonprofit organizations. Their dollars might decrease, which will put them at a disadvantage for their operations. I know there’s some lobbying going on to change the rules related to this one, but we’ll just have to see how it plays out over time.
Medical expenses are not on this slide, but I wanted to mention it. It is one of the areas where the tax reform is retroactive, back to 2017. The threshold to deduct your medical expenses is seven and a half percent of AGI starting with 2017, going forward to 2025. The old limitation was 10% of AGI, so 7.5% was the rate up until … Two or three years ago, they increased it to 10%.
Angela Dotson: They took it back to 7.5%, so that’s a retroactive tax surprise for some people who may be able to take advantage of that for 2017. Just make sure that when you’re gathering all your tax documents for 2017, keep that in mind, that this piece of the tax reform applies to 2017.
Bob Greenberger: Angela, two questions, and it looks like you’ve answered one. The first one is someone who’s married, and said they have $20,000 worth of itemized deductions every year. They didn’t really say what they had, so if it’s mortgage interest, you can’t just decide when you want to pay your mortgage interest, or the bank won’t be happy with you. But Angela kind of hit the answer by saying if it was just charitable contributions, you could so choose to, instead of paying $20,000 a year, and then if you’re married filing joint, you would get a $24,000 standard deduction two years in a row while giving $20,000 to the same charity two years in a row.
Instead, what you could do, and Angela called it “bunching,” she could have said to the charity, “Hey, charity. I’m going to give you $40,000 this year, and don’t expect a check from me next year.” Instead of having $24,000 deducted two years in a row, they would have $40,000 deducted the first year, and $24,000 the next year, so the bunching aspect could be a major plan for those that are near the standard deduction amount.
The second question came from someone that said, “I am over 70 and a half years old. Can we still make qualified distributions from my IRA to a charity?” The answer is yes. For those of you that don’t know, maybe if you don’t even itemize, or there was other benefits to doing this, but what you could do is you could instruct whoever is holding your IRA to make a charitable donation directly from your IRA to the charity, and it would count as your required minimum distribution. For example, if you’re required to take a $10,000 required minimum distribution, instead of having $10,000 taxed on your tax return and receiving $10,000 and then deducting $10,000 as a charitable contribution that might not be deductible, because you might be below the standard deduction amount, instead you could instruct the IRA holder to pay the $10,000 directly to the charity, and that $10,000 would not be included on your tax return as income, nor would the $10,000 show up as a charitable contribution deduction.
The net effect usually was somewhat beneficial. If you go back one page, Angela, you’ll see it mentioned at the top there the repeal of that 3%. There were some people that were losing some of their itemized deductions, so that taking the $10,000 charitable contribution, you might not have gotten the full tax benefit, and so there was somewhat of a benefit to do that before. That benefit has somewhat lessened for those that were getting this benefit of the 3% disallowance that’s at the top of the page, but for others it might be a big windfall, for those that don’t get to itemize their deductions at all.
Angela Dotson: Great point, Bob. The last point I wanted to make on itemized deductions was miscellaneous itemized deductions are completely disallowed for 2018 going forward to 2025. If you were taking a deduction for your tax preparation fees, that’s gone. If you were taking a deduction for your investment advisory fee, that’s gone. If you had un-reimbursed expenses from your employer, that’s also gone.
The point is, all your miscellaneous itemized deductions are immediately disallowed without any warning. The un-reimbursed employee business expenses I believe will have the most impact for taxpayers who have been in the habit of covering some expenses and taking that itemized deduction on their personal return in excess of what their employer was willing to reimburse for.
Alright, let’s move on now to talk about some of the business changes that are taking effect under the tax reform. Let’s start with net operating losses, or NOLs. Under the old law, you could carry back an NOL two years and forward for 20 years. You could also use 100% of your NOL to reduce your taxable income down to zero. That’s the old law.
Things are changing a little bit with the new law. Carry backs are completely eliminated. You can no longer carry back your NOL to make a refund claim for taxes paid in an earlier year. Part of this reason is because the old rates now are higher than they are currently, so they don’t want you to carry back to a higher tax year, which makes sense.
Going forward, you won’t be able to deduct 100% of your NOL against all of your taxable income. You can only deduct 80%, so you always have tax, even though you have an NOL, which is completely foreign in the world that I’ve been living in for the past 20 or so years. Most people who have a NOL don’t even come in to discuss planning, because they know they have a huge NOL and don’t have to worry about it, but going forward, they do, because 20% of their income will still be taxable, and that NOL will be carried forward indefinitely.
There’s no 20-year time period where it will expire. It will go forward indefinitely, but that is something new that people will have to get used to and make sure that they plan for the tax they will have, because it can eliminate your taxable income on a go forward basis.
This slide just contains an example. You guys will have these slides available to you, so I’ll just continue on.
Excess business losses: These go hand-in-hand with the NOL, so in any given year, there’s now a limitation of $500,000 of how much of a business loss that you can take in one year, if you’re married filing jointly. Before, you could take up to $1 million of a loss with married filing joint taxpayers, but now you’re limited to $500,000.
Anything in excess of that $500,000 becomes the NOL that you can’t carry back, that you have to carry forward, and like I said before, you can’t eliminate all of your tax on a go forward basis, even though you have a large NOL amount. I think this is going to be a shock to the small and mid-sized business community, who have been used to using up their NOLs to carry back, or using their losses to offset non-business income. If they have other income in excess of what their business loss was, that was able to reduce that down.
Now, there’s a limit on that. That might shrink some investments from small business, but we will just see over time that taxpayers just need to be aware that this limit is in effect, and for single taxpayers, the limit is $250,000. Everything else will have to be carried forward.
Then here is an example, and we won’t get into that for the purpose of this session.
Other things that are changing: One of the most popular items that was talked about before the law was passed was alimony. There were several taxpayers who had agreed to their alimony settlement because they knew they could deduct their payments, and that the spouse or the ex-spouse would have to take it into taxable income.
Beginning for agreements executed after December 31 of 2018, the payee no longer has to take the alimony into income, and the payer won’t have to deduct it, or won’t be able to deduct it. This might be a point of planning for attorneys or people who are entering into divorce settlements. You don’t have to consider the after-tax impact any longer, so your divorce settlement payments might be reduced.
The Affordable Care Act: The individual mandate was repealed. This is a permanent part of tax reform. This won’t expire at the end of 2025. This is the penalty that showed up on your tax return if you did not have health insurance coverage for each month during the year. This is completely repealed, and you won’t see it starting with 2018. The taxes associated with the Affordable Care Act did remain in place.
The net investment income tax remains at 3.8%, and the Medicare tax remains at 0.9%. Those are the same rates that we had last year. The only thing that is removed related to the Affordable Care Act is the penalty. People are free to choose not to have health insurance, and not be penalized on their tax return for not doing so.
Some other miscellaneous changes that I wanted to cover, just because I thought they were very relevant, and they also have not received a lot of press. This one could really be in the business section, but entertainment expenses are no longer deductible. That’s right. Entertainment expenses are no longer deductible.
You may not have heard this before, but it’s true that they are not deductible. Meals are deductible up to 50%, but the entertainment is gone, so the box seats, the concert tickets, all those things, you’re still free to entertain your clients, but there’s no longer a taxable deduction related to it.
There’s also a change in how meals are treated for the convenience of the employer, or on-premises meals. Under the old rule, you could deduct 100% of those meals. Now, under the current rules, you can only deduct 50%. Beginning after 2025, those meals will be non-deductible as well. They are sending us a signal here that meals and entertainment are coming off the table, slowly but surely.
Part of this is to take the pressure off of the IRS to determine what’s really entertainment, what was personal, what was business. This takes away some of the fuzzy math and the playing around that people were doing with their personal entertainment that they may have called business. This one is one to definitely keep an eye on.
Now that we’re at the end of January, some people have incurred entertainment expenses that are not deductible. At this point, people need to look at their reimbursement policies and determine from an HR and operations perspective, what is your plan going to be around entertainment expenses?
Bob Greenberger: Angela, we just had another question come in. This one is someone that runs a business, and they were just asking, do they need to do anything differently with how they track meals and entertainment? “Because in the past, we always kept those together.”
Angela Dotson: That is a great question. All the accounting people will be glad that question was asked, because you do need to track that differently. Going forward, you need to carve out a separate general ledger account for your entertainment, and have a different account for your meals. Otherwise, when you get to the end of the year, and it’s time to prepare your tax return, it will be a burden to go back and break that out, and to determine what was entertainment versus what was meals. Thanks for that question.
Fringe benefits related to transportation: Many of those have been eliminated. Under the old rules, if employers were to subsidize or pay for transportation fringe benefits, they would receive a deduction and the employees would not have to take the fair market value of that into income. Under the new rules, employers can no longer deduct transportation fringe benefits except as it relates to bicycle reimbursement programs or subsidies. Going forward, again, the transportation fringe benefits are not allowed as a deduction for the employer, but if you do go ahead and continue to provide that benefit at a no deduction basis for you, it is still not includible in income for the employee.
This is a new code section related to maternity and paternity leave. This one is a win, I think, for families and for businesses. Many small businesses have been adding or enhancing their maternity and paternity leave policies over the last several years, and this new code section allows you to take a credit of 12.5% if you pay your employee at least 50% of the wages that they normally earn when they’re not on FMLA. The credit can go up to 25%, but not over that amount. For the percentage you pay over their 50% of salary, you get an increased benefit.
This is a big win for companies that have already been allowing their employees to have a maternity and paternity leave policy, and for those that have not, this has been encouragement for them to do so. The maximum amount of time that the employee can be off related to this credit is 12 weeks, so the calculation, if your plan allows more than 12 weeks of maternity or paternity leave, the calculation is only based on 12 weeks. That is the amount that will qualify for the credit. I think this, again, is a win for employers and for the family. Again, this is a credit, so it’s a dollar for dollar reduction of your tax liability, which is always better than a deduction. This one is a major win, I think.
We do have another question here. We had a question related to the business entertainment. The question is, “Does this non-deduction, the business entertainment for all meals, or only for the owner for the S Corp?” This is for all meals regardless of your entity type. This is related to any business meals, or business entertainment, the non-deduction part.
The next slide I get really excited about, because it’s ripped from the headlines, so to speak. Sexual harassment: Under the old law, and just in general, you can deduct any expense that’s considered ordinary and necessary for you to carry on your trade or business. If you were sued or had a legal situation going on, that would fall under the old law.
Under the new law, if there is a settlement related to sexual harassment or sexual abuse, you no longer have a deduction if there is a non-disclosure agreement associated with that case. The legal fees would not be deductible, and the settlement itself would not be deductible. This one is ripped straight from the headlines of what we have seen happen over the past year with 2017.
Something happened, and there’s a tipping point with the disclosure and punishment related to sexual harassment, so that quickly found itself into the tax reform. This is one of my favorite ones, because it’s definitely the tax reform keeping up with what’s going on in the everyday culture.
The domestic production activities deduction, also known as DPAD, was repealed for tax years going forward. For professional services companies, this was available to certain businesses such as dentists. If you were a dentist and you were making inlays and certain crowns that qualified for the DPAD deduction, that was available for you, and architects and engineers were receiving credit for constructing, or being a part of the construction of new homes or buildings, so they received the DPAD deduction. That’s repealed.
Architects and engineers get it back, because they receive a special carve out or special treatment related to the 20% deduction that Bob will talk about in a few minutes, but dentists did not get any special treatment. Any other professional service company that was receiving the DPAD deduction for producing things here domestically loses out on the benefit of that deduction, and there wasn’t really anything else that was a substitute or makeup for it.
Bob Greenberger: Angela, before you jump into depreciation, we had another question about “What are the states doing?” I think what that question means is, “Are the states adopting the federal rules?” For those listeners in Georgia, the answer is, “I don’t know.” And for those in the other states, we don’t know. There was an interesting quote from the Tax Foundation in Washington that said, “All we’ve done is move from one capital to 50 capitals.”
What’s happened with this new law, as Angela’s going through it, you see that it curtailed a lot of tax breaks, like the deductions for mortgage interest and tax preparation fees, business deductions for interest and entertainment expenses. A lot of those cuts in provisions were offset by the federal rates that were reduced, and it more than offset those changes.
The problem is, state tax rates haven’t changed, so if states simply adopt everything that is done with the federal, then you’re going to see people paying more state taxes. For example, last week, the New York Department of Taxation issued a report estimating that the federal government’s limit on business interest deductions would yield $45 million in tax revenues for New York. Wonderful for New York, but not wonderful for the people living in New York that are paying those extra taxes in.
There’s actually a quirk in New York for individuals. The way the personal exemption is written for single filers in New York is actually going to mean about an $840 million tax increase. Every state, it has to look at this and decide which parts of the law they want to accept or not accept, so we expect to see some guidance on all the states coming out in the next several months.
Angela Dotson: Great point, Bob, and I also expect to see some of these states keep as much of that money as possible while trying to add in some amount of relief to keep people in their state. One of the questions I have is how many people might seek out states like Florida that don’t have a state income tax, based on these drastic changes, depending on what various states might end up doing. It’s going to be interesting to see what the states do going forward, especially in some of those high tax states, like you mentioned, like New York and California.
I feel like I’ve been the bearer of a lot of bad news up until this point in the presentation. Now I’m moving on to bonus depreciation. Here’s some good news. The bonus depreciation going forward is 100%, and it will start to phase out in year 2023, but from now until then, you have 100% bonus depreciation.
One caveat is that qualified improvement property no longer qualifies for bonus depreciation treatment. It will qualify for section 179 expensing, but not for the bonus depreciation. This is a big win for taxpayers related to buying equipment and knowing what the treatment will be. Over the past few years, bonus depreciation has been up and down, and very sporadic, and has made it difficult for businesses to really plan for the equipment, and the tax deduction was kind of chasing and making the decision in a lot of cases.
Now that we’re at 100%, there won’t be as much anxiety regarding, “Do I buy this piece of equipment this year, or do I wait until next year?” This is good news for businesses, with this 100% bonus. Then again, this starts to phase down, and will be fully phased out by 2027. We have a good, consistent period with the bonus going forward.
Section 179, the limitation goes up from $500,000 to $1 million for years beginning after 2017. The threshold for that starts to phase out once you purchase assets over $2.5 million. That threshold was increased by $500,000 compared to prior year. The SUV limitation remains at $25,000, but one of the new interesting things is, you can now take bonus depreciation on the rest of the amount of those vehicles. Anybody that waited to purchase a car or an SUV in 2018 made a great decision, because the benefit will be greater than it would have been in 2017.
With the 179 deduction and bonus depreciation threshold being so high, the main reason that you would use this 179 expense outside of the SUV deduction would be for the qualified improvement property that doesn’t qualify for bonus. Between the two, you should be able to basically expense any capital expenditures fully over the next several years.
There are some definition changes related to section 179. Under the old rules, qualifying residential rental property didn’t qualify for 179 expensing. Now it does. There are some additional things that qualify under qualified real properties, such as HVAC units, fire suppression systems and roofs. Those were not included in the past, so there’s an expansion of things that qualify for 179 going forward as a result of the tax act.
There’s also a simplification of the improvement property categories. Under the old system, we had three separate categories and three separate definitions under these categories, with the qualified leasehold improvement, qualified restaurant improvement, and qualified retail improvement. Under the new law going forward, we’re just going to have qualified improvement property. This will make it a little simpler for your CPAs to work with your operations managers to determine what qualifies for 179 versus what will qualify for your bonus depreciation.
The luxury vehicle depreciation has increased going forward. This next slide shows tax rates where if you have luxury vehicles, the limit went from $3,000 in first year depreciation, up to $10,000. This is a major change for automobile depreciation on the luxury auto, and again, this section of the tax reform act is a win for businesses. You’re getting more in enhanced deductions at a faster rate than you would under the old tax law.
Like kind exchanges: This is the concept where you have non-recognition of gain and loss on the sale or exchange of like kind property. Under the old law, you could exchange real property and personal property. Under the new law, only real property qualifies. This will be a hit to some organizations that have used the like kind rules to exchange equipment, cars or different things. Going forward, there’s only going to be a like kind exchange available for real property, and only for those that are not holding real property primarily for sale.
This is just an example of what that looked like under the old laws. If you traded in some equipment, and if you received a $20,000 trade-in, then your net cost of that equipment was $60,000. That was the basis that you had on your tax return, and you recognized no gain on that $20,000 trade-in. Under the new law, you have to pay tax on that $20,000.
The good news is that capital gains tax rate, but the bad news is that the value of your new asset is now at $80,000 versus $20,000, so once the bonus depreciation phases out, you will run up against this limitation with the amount of property that you placed in service during the year. This is a slide that basically kind of just summarizes the positive impact of this, and the negative impact.
Now we’re getting to the section that everybody wants to know about, the 20% business deduction. I will turn it over to Bob, and I will monitor the questions.
Bob Greenberger: Thank you, Angela. Go ahead and have another cup of coffee as we get into this new business deduction section, 199A. Just as an overview, before we dive in, this is a deduction that you can take even if you don’t have any itemized deductions. You can still get what’s called qualified business income deduction.
The other point that I want you to take away is that it really depends what your specific situation is. We’ve had a lot of questions about, “Should I change my type of entity? Should I spin off something from my company into another?” And it all depends specifically on your own situation. In fact, this is one of the areas that you have to almost figure out someone’s entire tax return and know what their taxable income is before you can determine what the effect of this qualified business income deduction is.
I’m going to go through the first five slides quickly, not to drill down into the numbers, but just to give you an idea of what the 20% deduction might look like. The deduction was working its way through the House before it ended up with the Senate, and through the White House, and being tax law. It originally was a credit. It ended up as a deduction, and it’s a 20% deduction against certain income. I’m going to get into all the definitions, but I just want everyone to be aware that it may or may not be 20%.
This first example, you’ll see someone’s W-2 salary of $100,000. That is not income that you can take a qualified business income deduction on. The second line says QBI, or qualified business income deduction. We’ll get into a definition a little bit more in a minute, but basically it’s any business income that flows through to your tax return. It doesn’t matter where it hits on your tax return, as long as it goes on your personal tax return.
It could be a sole proprietorship on a schedule C. It could be a farm on schedule F. It could be a rental property on schedule E. It doesn’t matter if you own the sole proprietorship, or the farm, or the rental property through a single member LLC, as long as it hits your personal tax return. If you get a K-1 from a business, that might be eligible for qualified business income as well. You can see the second line, qualified business income was $250,000. $250,000 times 20% is $50,000, and a couple lines down, you’ll see the $50,000 that they’re getting. They’re getting the full 20% deduction.
This applies in general. Anyone that has taxable income, if you’re married filing joint, below $315,000, or you’re in a different category, married filing separate, or single, or head of household, below $157,500. In this case, it’s a married couple. Their taxable income was below $315,000. No matter what kind of business they’re in, they’re going to get a full 20% deduction.
If we go on the next slide, you’ll see that here’s someone that is a part-owner in a widget company. They have the same $250,000 of qualified business income, but because their income’s a little bit higher, $350,000, they’re above $315,000, and again, we’ll get into why that’s happening, but they’re not getting a full 20% deduction. They’re only getting 18.6%. We’ll get into the weeds of these numbers a little bit later, but I’m just trying to illustrate the deduction amount right now. Here’s a third example. The same widget company. They even have a little bit more taxable income. Instead of $350,000, they have $500,000. Now, their 20% deduction is down to 16.9%.
Let’s look at an example if you’re a doctor, or an attorney, or a CPA, which we’ll define a little bit later as specified service businesses. You’ll see in this case, their taxable income is $350,000. They’re only getting a 13% deduction, and if their income is over $415,000 in this last example, they get no deduction at all.
Some of you may have thought, “If I’m an attorney, I don’t get a deduction at all, period.” The answer is, no, you might, depending on the amount of your taxable income.
Let’s go through some of the definitions, now that you’ve seen just an overview, and hopefully I’ve convinced you that it’s not always 20%. Let me tell you also that if you get a K-1, and your partner attorney in the office next to you gets the K-1 for the exact same amount, you might not get the same qualified business income deduction.
In fact, it’s probably more likely than not you’ll get a different deduction, because each person’s situation is a little bit different. In fact, if you get the same K-1 or the same qualified business income two years in a row, you might not have the same deduction on your own tax return two years in a row. It’s very fact-specific to several things on your tax return.
Let’s go to the next slide. We’re going to define, “What’s qualified business income?” In general, it’s income, as I mentioned before, that’s from a trade or business, and it flows through to your tax return. It can’t be something from a W-2. It can’t be investment income, like dividends, or interest, or capital gains and losses. It can’t be from W-2 wages, or even a guaranteed payment that comes through on a K-1 from a partnership or an LLC.
Anything that’s connected to a trade or business, if you’re getting a form K-1, it’s probably going to be the first line on the top of that form K-1. Now that we know what qualified business income is, what’s a qualified trade or business? Well, it has to be in the United States, and of course Puerto Rico is okay, too.
Let’s talk a little bit about special rules for service businesses. I mentioned a minute ago about specified service businesses. It’s defined in part from section 1202, a different part of the code, but the Congress then took that part of the code and shaved part of it off, and said, “Engineers and architects, we’re going to give them exemption, and they’re not going to be considered a specified service business. But if you’re in health, or law, if you’re in accounting, performing arts, then you’re going to be what’s called a specified service business.”
If you look at the last sentence of that first bullet, where it says, “The principal asset of the trade or business is the reputation or skill of one or more of its employees,” that’s really the key. Every type of industry and job is not defined, and every type of service isn’t defined, but you really have to ask yourself, “Is it really the reputation or skill of just me?”
Although it doesn’t specifically say “insurance broker,” again, they’re not selling goods and products. They’re not the widget factory. They probably have a trade or business on the reputation or skill of just their own employees, and they’re going to be considered a service business.
Qualified business income deduction: Here’s where the math starts a little bit. On item A it says, “20% of the combined qualified business income.” Unfortunately, if you get 20 K-1s, you’re going to have to do some math on all 20 K-1s, and some of them might be a specialized service business. Some of them might not. You’re going to get a different qualified business income deduction for every single one of your K-1s. You’re going to add all of those up on line A, and then you’re going to compare that to 20% of your taxable income.
Wait a minute. I can’t just look at taxable income, because what if I have long-term capital gains? Well, if you have long-term capital gains, you already had a preferential 15% or 20% rate, or maybe 0%, if you were in that lowest bracket. Because you already had a preferential rate on the long-term capital gains, Congress has said, “We’re not going to allow you to include long-term capital gains when you compute taxable income.”
Let me give you an example. For item A, let’s say that your combined qualified business income was $500,000. 20% of $500,000 would be $100,000. Let’s look at B. Let’s say that B, the taxable income is $600,000. 20% of $600,000 is $120,000. It’s the lesser of A, $100,000, or B, $120,000. You would get a deduction of A, $100,000.
But wait a minute, I forgot to subtract my long-term capital gains on B. Of my $600,000, I had $300,000 of long-term capital gains, so I’m left with $300,000 that weren’t at the preferential rate. I multiply 20% times $300,000, and get $60,000, which is less than my answer on A, so my deduction on my tax return is going to be limited to $60,000 in this situation. The deduction, again, is not an itemized deduction, and it there will be a new line on page two of the 1040. It’s going to be after your adjusted gross income.
A says “qualified business income,” so let me go to the next slide and talk about where that number came from. For each one of the separate businesses, whether it’s your farm or rental property on a schedule E, or your K-1 from your business, you’re going to take 20% of your qualified business income. If you’re above a certain threshold, and I’ll get into that in a minute, you can’t just take 20% of your income. You have to compare that to 50% of the W-2 wages that are allocable to the business.
Let me give you an example before I move to the bottom right-hand corner of the slide. When you get your K-1s for 2018, you’re going to take a look at that, and on line one, it’s going to say, “My trade or business income from my business was $500,000.” There’s going to be a new line on your form K-1 that says, “What’s the allocable share of all the W-2 wages of the entire business?”
If you’re a 10% owner, and the total earnings of the company was $5 million, you have $500,000 of income allocated to you on line one. If wages were, say, $1 million — again, I’m a 10% owner — your allocable share of wages for the whole company would be $100,000. In that example, you would take 50% of the W-2 wages that were allocated to you, $100,000 times 50% would be $50,000, and you would get the lesser of the $50,000, which is 50% of the W-2 wages, or 20% of the qualified business income, which would be $100,000. You would be limited to only having a $50,000 amount to deduct as qualified business income deduction.
Let’s say I’m a real estate company, and everyone that works for the real estate company isn’t in the entity that I own. The only thing I own is a bunch of real estate. There’s no W-2 wages in there, because they’re all working for the management company. In that case, you’d be in trouble, because 50% of W-2 wages would be zero.
That’s why at the 11th hour, Congress said, “Well, listen. If Trump or any of you have real estate, then we’re going to have a little exception for you, and we’re going to allow you to take your allocable share of all the qualified property and come up with a factor for that as well.” Let’s say there’s $10 million worth of qualified property, you’re a 10% owner, and you have $1 million allocated to you. 2.5% is $25,000, so although 50% of W-2 wages was zero, 2.5% of the property would be $25,000. You would compare that $25,000 to the item above it, 20% of your qualified business income, to see what your deduction is.
Again, it’s the greater of the two items on the bottom, 50% of W-2 wages, or 25% of W-2 wages and adding 2.5% of the property. You take the greater of those two items and then compare that to 20% of your qualified business income, and whichever is less is your answer.
After you’ve had all kinds of fun doing that computation, you’d pick up your other 19 form K-1s, and you do it 19 more times. That’s when you then get the combined, all your 20 K-1s, or all your businesses, and that’s when you, as a last step, compare that to your taxable income. That’s the math for everyone.
Let’s talk about qualified property just for a minute. It’s not property after you reduce it for depreciation expense. It’s really what the original basis was that you paid for it. There’s some other special rules that I’ll let you look at that on, but for most of you, you might not be as concerned about that, because it might just show up on your form K-1 you get from your business that you’re an owner in.
The W-2 limit that we talked about, that doesn’t apply if your taxable income is below $315,000 or $157,500 if you’re single. You don’t have to worry about that W-2 phase in. You basically would just get the full qualified business income deduction. There’s a phase out that starts if you’re married at $315,000, and ends at $415,000. Once you’re over $415,000, the previous slide applies, where you’re comparing the 50% of W-2 wages to 20% of qualified business income. If you’re in between the $315,000 and $415,000, basically you just get a pro rata reduction of the lower of the two amounts.
Angela Dotson: Bob, would you mind going back to the example with the numbers, to kind of drive these examples home a little bit? I think that if people are able to see that numbers now with a little more context, I think that might be helpful.
Bob Greenberger: Let’s go back to the numbers again. Now that we have somewhat of an understanding, here’s this first example. Let’s look at a couple things before we get our calculators out. What’s taxable income? Well, taxable income is below $315,000. I just told you a minute ago that we don’t have to worry about the W-2 wages, so we’re not even going to worry about that. In fact, we don’t even have, down below, where it says “limit one” and “limit two” on these wages, we didn’t even fill numbers out, because for this taxpayer, it didn’t matter.
They had $250,000 of qualified business income, times 20%, equals $50,000. I would then compare that to taxable income of $260,000 times 20%, which would be $52,000, and I get the lesser of $50,000 or $52,000. In this case, the last number shown, which is in the middle of the page, they get the full 20% qualified business income deduction of $50,000. This doesn’t matter if you’re a specified service business or not. Anyone below $315,000, if you’re married filing joint, this would apply.
Let’s take a look at the next page. Here’s a widget company. They’re above the $315,000. In this case, you can see when you multiply $250,000 times 20%, it would be $50,000, but you can see the fifth number down says “$46,500.” That’s because theirs is in between $315,000 and $415,000, so they’ve taken a little bit of a haircut from $50,000 down to $46,500. I’m not going to go through the math on that, but if you have questions, let me know. Now I’m looking at $46,500. I would then compare that to taxable income of $303,500 times 20%. That number is over $60,000, so I end up with $46,500.
My third example is the same person, but now instead of a $350,000 there, it’s $500,000 of taxable income. Their qualified business income was $400,000. $400,000 times 20% is $80,000. You can see, though, underneath the first orange line, the QBID, or qualified business income deduction, is only $67,500. Well, why is that? Well, let’s go down to the bottom of the page a little further.
You can see that the $80,000 deduction. That’s from 20% of the $400,000. Let’s go down to the limit. Number one doesn’t apply because I’m not a service company. Limit number two, the wages allocated to the taxpayer were $120,000. 50% of wages would be $60,000, but I’m going to get the greater of limit two or limit three.
Let’s look at limit three. Property allocated to the taxpayer was $1.5 million. If I take 25% of $120,000 in wages, which is $30,000, and 2.5% of my property, which is $37,500, and I add those two numbers up, under limit number three, I get $67,500. Now I get the greater of limit two or three, which is $67,500, and I compare the $67,500 to the $80,000, and I take the lesser of $67,500 or $80,000, and I end up with $67,500.
Angela Dotson: Bob, we do have a question.
Bob Greenberger: Sure.
Angela Dotson: Someone wants to know, should they consider changing their pass-through entity into a C corporation, because this seems complex, and are they better off with the 21% rate that the corporations are getting?
Bob Greenberger: That’s a great question, and it depends. A couple things to keep in mind. In general, forgetting about the tax rates, there are some other issues just being a C corporation anyway that you would want to consider, instead of a flow-through entity. But keep in mind you’re not just comparing the 21% corporate rate to the highest, 37% bracket for individuals. Why is that?
Well, let’s just say that I had $100,000 of income in my C corporation, and I pay $21,000. I’m now left in my corporate bank account with $79,000. But to pull that money out, I have to pay tax on it again. They call it double taxation, even though it’s really not double. They still call it double taxation.
To pull the extra $79,000 out, I’m going to have to pay tax on that as a dividend, not just at 20%, but there’s an extra 3.8% net investment income tax, so I’m paying 23.8% of the remaining $79,000. That’s roughly $16,000, $17,000 on top of the $21,000 I paid. I’m up to about $38,000, which is 38%. If I have a pass-through entity, I’m at 37% to start with, on the high end, but I might get a 20% deduction, and that would drive 37% rate down to 29.6%.
Yes, it’s less complicated, but sometimes you might be willing to pay for hundreds of thousands of dollars’ worth of savings for a little bit of complication. In this particular example, it’s not intuitively obvious what might be better, but you really have to look at each situation separately, because someone may or may not be getting the qualified business income deduction, and I think you really have to look at your situation, not only from a tax standpoint, but from a non-tax standpoint as well.
I stick with my original answer. It depends.
Angela Dotson: It depends.
Bob Greenberger: It depends. All right. We were on the widget company, and we’re going to go to the next page.
I’m on example D, so it’s an attorney, or a doctor, or a CPA, and they are what we called previously a specified service company. You can see in this particular situation, their taxable income is $350,000. Their qualified business income is $250,000, and their taxable income is $317,500. The qualified business income deduction would be $50,000, which is $250,000 times 20%, but it was limited to $32,500 because they were about $315,000. They were somewhat phased out.
We can go down to the bottom of the page, but those items didn’t reduce it further, because remember, limit two or three, you would look at the greater of those two, and in this case, I got $65,000 is greater than $48,750, but then when I take the lesser of $65,000 or the $32,500, and I’m stuck with my $32,500. Instead of 20% times $250,000, getting $50,000, I’m limited to $32,500 because I’m a service company and my taxable income as a married person is above $350,000.
Let’s go to the last example, and you’ll see that it’s the same attorney, or doctor, or CPA, or the specified service person that is above $415,000, married filing joint, or above $207,500 if I’m not married filing joint. I’m completely phased out. No deduction.
Angela, how did that work out?
Angela Dotson: That was good. We have another question here. The question is, “What if you have no W-2 employees, but you treat your personnel as non-equity partners and make guaranteed payments to them for the services they render to the partnership, reported to them on their K-1?”
Bob Greenberger: Good question. Interesting question. First of all, the guaranteed payment portion on that partner’s K-1 is not qualified business income. It’s just like a W-2. Now I’m just looking at their ordinary income for qualified business income. I think the question then was, “Do I include guaranteed payments as part of that W-2 computation?” And the answer is yes.
Angela Dotson: Okay. I think we have another question here. This person wants to go back to case E in just a second, and they want to know, “Is it better to change to a C Corp in the case of this example?”
Bob Greenberger: Your question is, “Do I switch to a C Corp?”
Angela Dotson: Right, because I think their question is, since they’re getting no deduction, is it better for this example to switch to a C Corp?
Bob Greenberger: In this case, let’s think about that. In this case, I’ve got $400,000, and you’re asking, “Should that be C Corp income?” Let’s just say under my math before, it wasn’t 21%. It was closer to roughly 30%. I’m paying tax of, say, $120,000 on the $400,000, all right?
Angela Dotson: Yes.
Bob Greenberger: In addition to that, I’ve got my own tax return that now has, instead of $500,000 of taxable income, it’s only $100,000 of taxable income. I would add the $120,000 of tax I paid at the corporate level to tax on the $100,000, and the $100,000 is going to be taxed somewhere in the 24% neighborhood, or at least that’s the bracket that you’re in. Let’s just say that the average rate is, say, 20%. I’m going to have roughly $20,000 of taxable income on my personal return, plus $120,000 on my corporate return, for $140,000.
I’m going to compare that to $500,000 of taxable income in the 35% bracket, although it’s not all at 35%. I don’t know the answer to that. Let’s see. I was at $140,000, so the question is, “Is my effective rate greater than 28%?” I don’t know the answer to that, because a lot of the dollars, without running the numbers, a lot of the dollars are being taxed at 10%, 12%, 22%, 24%, 32%. Some of the dollars are being taxed at 35%. The average or effective rate might be less than 28% without switching to a C corporation. My guess is, it’s not going to be significantly different one way or another.
Another point is, that’s just one year, and so you kind of have to think about what’s happening year after year.
Angela Dotson: That’s right.
Bob Greenberger: But that’s the way I would look at it, is you have to kind of run the numbers and say, “What would the individual tax be? And if I split out the C corporation, what would that do?”
Angela Dotson: Right. I totally agree with you, that you need to run the numbers. This is the type of calculation that it’s hard to just eyeball it and determine what your income is going to be on a year by year basis. I definitely recommend a more detailed planning analysis for every taxpayer.
I have another question here. “If an S Corp is a partner in a specified service partnership, and the S Corp gets guaranteed payments which are reported on the K-1. The S Corp then passes through as business income on a K-1 from an S Corp to the sole shareholder. Is it qualified income for the 199A deduction?” I think I bungled that up.
Bob Greenberger: Well, you’re reading it the way it’s written. It’s actually a trick question. I think one of our partners threw that in there, because if you’re in an S Corp, you can’t give guaranteed payments. But let’s just assume that what that person meant was it’s an S Corp, and you’re a shareholder. You’re not a partner, but you’re a shareholder in the S Corp, and you’re getting a W-2.
Angela Dotson: Right.
Bob Greenberger: If that’s what the person meant, the W-2 would not be reported on the K-1 if it’s an S Corp, so again, I don’t know if this person really meant S Corp, or they meant partnership, but the W-2 would be reported on a W-2, and then that amount would have been reduced from the S Corp income before their K-1 amount is shown. I’m not sure I understand what the question was.
The question was, “If it’s passed through as business income on the S Corp …” Let me just say that if you are an S Corp owner, then the amount of ordinary income shown on the line one of your K-1 is going to be what the qualified business income is. The W-2 wages that are reported are not part of that computation of qualified business income.
Let’s move on back to where I was, and we are almost done. Hopefully those examples helped clarify, but if any questions, please feel free to reach out to us, and there we are. I don’t know if there’s any other questions anyone has. We’ve got a few minutes left.
Here’s a question.
Angela Dotson: I think we have a clarification on the last question.
Bob Greenberger: The person clarified that what they mean is the S Corp is a partner, and then the sole shareholder of the S Corp is passed through. What he might be referring to, and thanks for that clarification, is sometimes we’ll see entities that are partnerships that an individual, instead of owning an interest in that partnership directly — in fact, some law firms do that — they might have an S corporation that they own solely that gets their pro rata share of income from the law firm.
Assuming that that’s the scenario, if the S Corp is a partner in the partnership, and you own the S corporation 100%, the S cCrp does get qualified business income from the entity, and that then flows through to the individual ultimately. It’s almost as if the S Corp doesn’t exist, and that the individual owned it themselves. If they had owned an interest in the partnership originally, it would have been qualified business income, and the fact that you put an S Corp in between you and that trade or business, it would retain the character of qualified business income. If there are guaranteed payments that go from the partnership through there, the guaranteed payments are not considered qualified business income.
The only other question was, “How easy is it to change from an S Corp to a C Corp?” We’ll take that as our last question, as we’re winding down. I don’t know the answer to that. I’m not an attorney. I don’t think it’s very difficult, but that would be a good question for an attorney. I think it’s shuffling some paperwork, and it can be done. There are some tax considerations when you switch from an S corporation to a C Corp, so you have to make sure that you take that into account.
Angela Dotson: There are certain assets that you generally don’t want to hold in a C Corp, so that would be considered as well.
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