Understanding the Impacts of the Tax Cuts and Jobs Act on Retail, Franchise and Hospitality
Retail, Franchise & Hospitality
A couple of housekeeping items; you do have the ability to ask questions as we go. I believe you can type your questions in, and I encourage you to do so. We would rather ask questions as we go through the presentation versus waiting until the end. Some of the questions will normally spur other questions. We have somebody monitoring the questions here so we’ll answer them as they come in and as appropriate.
This is our normal disclosure. I think there’s a lawyer out there that makes us put this at the front of all of our presentations. So that’s what this is for. Hopefully everybody has access to the slides and can see what we’re going through. If you don’t, please let us know.
Before I get into the technical aspects of these slides, I want to run through what has happened, and maybe what hasn’t happened. Normally, when we have tax legislation, it starts in the House of Representatives. Which it did in this case. I actually think it may be a requirement. The House of Representatives comes up with a set of tax rules and laws that they argue about and they come to consensus that they eventually vote on it.
Once that vote is complete, that legislation is then sent over to the Senate. The Senate takes that into consideration, but they don’t necessarily have to agree or disagree with a specific legislation that the House has proposed and voted on. The Senate can simply say that they agree with the House, they can say that they disagree with the House, or they can say that they’re not even going to comment on what the House has said.
That process also took place in early to mid-December. After that, once the Senate votes on their legislation then it goes to a Joint Committee. The Joint Committee normally has a series of hearings, and actually the House and the Senate during their processes normally have a series of hearings as well. There’s a series of hearings that takes place, and the Joint Committee is going to put together the package to be voted on by the House and Senate, to eventually be sent to the President for signature.
In this case all of that happened, with the exception of all of the hearings. This was a relatively quick process. Some people would say that it was rammed through. I’m not sure that it was completely rammed through, but this process didn’t necessarily take the normal course. It was probably necessary to get it passed to not take the normal course, but the importance of the fact that they didn’t have the hearings is going to come into play because once the President signs the law, then the responsibility of the service is to start commenting and eventually writing regulations as it relates to the legislation. Normally, in the process of writing those regulations, the IRS will look to the hearings to get the intent of Congress as to what they were trying to accomplish in writing the law.
That’s going to be complicated in this situation. I have full faith that the IRS will eventually write regulations, and they will continue to try to write regulations over the next couple of years. But, normally where they had a series of hearings in order to go back and judge intent, they’re not going to have some of that information. We will be operating for probably quite a number of years under having just law, and in some cases having regulations that come out from time to time. Some experts and some of the people that we’ve talked to feel that it could be a dozen years, or 10 years before all the regulations are written on this law.
That will make this interesting. It’ll make my job interesting, and all my colleagues’ jobs interesting, and hopefully now we can help you navigate through these laws.
For the agenda today we’re going to go through this relatively quickly. Once again, please ask questions, because it’s a lot of information. I think we have an hour an hour and a half, so I want to make sure we get through all the information. We’re going to start with corporate taxes, we’re going to then go to depreciation, federal tax credits, and tax reform items. Finally, we’ll go to the 199A Qualified Business Income Deduction.
As it relates to corporate taxes, one of the things that you’ve seen in the news probably more than others is that this law has reduced the corporate tax rate from what used to be a graduated rate with a top rate of 35%, to a flat rate of now 21%. There are some other changes that we’re not really going to get into the details of that are displayed on this slide, as it relates to the Dividends Received Deduction, etc.
This next slide is going through the thought process that we are still going through. We started on the 24th of December, as we started getting phone calls about if our clients should remain pass-through entities, or now that the corporate tax rate is low, should they be switching. I wanted to explain at least the initial basis of our thought process.
In the old rules, the old 2007 prior, if you were to make $1 million dollars and take all of the cash out of the C-Corporation, your top rate would be somewhere around 50.5%. If you were to have the exact same function, you made $1 million dollars and you took all of the money out of the pass-through entity, our flow-through rate was approximately 40.8%. There’s always been about a 10% differential benefit as it relates to operating in a flow-through company versus a C-Corp.
In the new the law, if we were to make $1 million dollars and bring it through the C-Corp and take all of the money out via dividend, our C-Corp top rate would be about 39.8%. If we were to have the exact same action through a flow-through company, whether it’s an S-Corp, LLC, Limited Partnership, our top rate is right a 37%.
As you can see, we still have a benefit to operating through a flow-through entity versus a C-Corp, in the instance that we’re going to take all the money that we make out. That benefit has been reduced from 10% to about 2%, and that’s before the application of the 199A Deduction, which is the last topic that we’ll talk about today. The 199A Deduction, in many regards, is getting us back from our current state of a 2% benefit from using the pass-through versus a C-corp, closer to our 10% advantage from using a pass-through versus a C-corp.
One thing that this slide doesn’t take into account in the analysis of going from pass-Through to C-corp is the consideration state tax. It’s a big deal now because in a flow-through entity, state tax is normally paid at the individual level, and this deduction is grossly limited to about $10,000 in state taxes in total. In a C-corp environment, you’re able to take state tax deductions, just like any other deduction. So depending on the states in which you’re operating in, this slide does not take into account state tax deductions and your analysis absolutely has to.
Does anybody has any questions on that? I think the question is should I be a C-corporation versus a flow-through? In order to answer that question there’s a much longer process that has to be undertaken. There absolutely has to be planning and modeling, but if you have any questions let us know and we’ll come back to that and answer those questions.
The next section that we’re going to go through is on the new depreciation rules. I think these are really significant for any business owner, and they’re definitely significant for small business owners as well. The first change in the depreciation laws is simply this: there used to be three different types of qualified improvements. One was qualified leasehold improvements, one was restaurant improvements, and one was retail improvements. They have simply taken these and merged them together and called them all Qualified Leasehold Improvements.
We would debate around the office what the differences are, and there are absolutely some new nuanced differences. One of the differences that existed, and one of the clarifications that was made in this law, was the fact that these Qualified Leasehold Improvements all exist inside the building envelope. There used to be some debate whether you could have Qualified Improvements that existed outside of the building envelope, and this law has clarified that fact.
They have also clarified, or I guess kept, the 15 year recovery period, using the straight-line and the half-year conventions. This is hugely important because as many of us know, any asset that has a less than a 20 year recovery period is eligible for Section 179 Expensing. One item to note here is that this law also removes Qualified Leasehold Improvements from bonus depreciation, and that’s a big deal. It seems that it’s relatively straightforward that this was the intent of the law.
Just yesterday, Jessica and I were on a call with one of our asset experts that helps us with our cost segregation practice, and he mentioned to us that his colleagues actually feel that this may have been a mistake. They may have mistakenly excluded these Qualified Leasehold Improvements from the 168K or the bonus depreciation.
I’m here to tell you that if we were filing a 2018 tax return today, we would exclude these Qualified Leasehold Improvements from bonus depreciation until we get further guidance, or until somebody clarifies that. The law itself states it pretty clearly that it excludes it from the 168K, or the bonus depreciation, so that’s one item that we’ll be looking to the service for clarification on.
Secondly, I included this slide in case any of you guys and gals have foreign assets. If you have foreign assets you’re not able to use the makers depreciation schedules. You have to use the ADS depreciation schedules, and they changed some of the useful lines within ADS. That’s why we’ve included this slide.
Next, this is a pretty big deal, is the Expansion of Section 179. The takeaway here is that Section 179 has been expanded from $500,000 to $1,000,000. The phase-out threshold has also been expanded from $2,000,000 to $2.5 million. The thing to remember about Section 179 Expensing is that we have to have income in order to take advantage of it, but the increase is absolutely something that’s going to be good for the business owner. It’s going to allow us to write-off our capital improvements quicker.
Jessica Hussain: For the leaseholds that were not eligible for bonus, we can get them here with Section 179.
Tommy Lee: That’s right.
Jessica Hussain: As long as you have income.
Tommy Lee: That’s right.
Next is bonus depreciation, which we’ve already kind of hit on. This is a 100% bonus starting on September 27, 2017, so that is going to affect your 2017 filing. One little quirk to this rule is that, as it relates to Qualified Leasehold Improvements, you can actually pick in 2017 which rule you would like to go with between September 27th and December 31st. If you deployed or put into service Qualified Leasehold Improvements, subsequent of September 27, 2017, you can use the old rules and expense 50% of those Qualified Leasehold Improvements.
Normally in retail and hospitality, we’re talking about five year assets, maybe a little bit of seven year. As long as you have purchased them and deployed them, or put them in service subsequent of September 27, 2017, you will have 100% bonus depreciation at your disposal. We’ve noted here at the bottom of this slide that Qualified Improvement Property does not qualify.
This slide I’ve included, we’re not going to really go into this side very much but the purpose of this slide is that if you have purchased an asset prior to September 27, 2017, and you deploy it after December 27, 2017, this shows you the bonus depreciation that you’re eligible for. That’s all we have on depreciation. There are no questions, everybody seems to get Corporate Tax Rates and depreciation. That’s great. Onto Federal Tax Credits.
The Federal Tax Credits that we included here were obviously the ones that were applicable to our retail, franchise, and hospitality clients. In the House version of the bill there was a proposal that the 515 base in which the Federal Tip Credit is calculated on was going to be raised to reflect federal minimum wage. I’m here to tell you that by the time it made it to the Senate, and absolutely by the time it made it to the President’s desk, the FICA tip credit was not touched.
Same thing with the Work Opportunity Tax Credit. This tax credit in the House version was going to be eliminated. I think in the Senate version they put it back fully. By the time the Joint Committee got together and sent this bill to the President, the Work Opportunity Tax Credit was also no longer touched.
The Empowerment Zone Employment Credit. This is a credit that developers will apply for. I think this credit has been cancelled, right?
Jessica Hussain: Yes. It expired now.
Tommy Lee: Okay.
Jessica Hussain: Yeah.
Tommy Lee: I put this in here because we have a lot of restaurateurs, especially in our growing markets such as Atlanta, that have been able to use this in years past. The credit has expired currently, but hopefully it’ll get back onto the tax rolls. This is a pretty good credit when it exists. Developers use it as some enticement to get their tenants. Ponce City Market is a really good example of where this credit exists. That’s here in Atlanta, and also at the Macy’s building downtown where they’re trying to spur some development.
Lastly for credits is a new credit for FMLA. Basically, you get a credit that’s equal to 12.5% of the wages paid to qualified employees, if you pay your employees during their FMLA leave. If you pay your employees during maternity leave, paternity leave, any other kind of sick leave, then that is considered FMLA leave. You will now get a new tax credit. This is, I believe, the only new tax credit in the legislation.
Okay, that’s it for tax credits. No questions, hopefully everybody’s still awake on the other side of this. Oh wait, we got a question.
So the question is, what about the new markets tax credit? I didn’t put that in this slide because I don’t think that there was ever any change to the new markets tax credit slated in this legislation. Maybe I will add it to the slide of tax credits because it’s certainly one that we utilize, but I don’t think that there was ever any change to the tax credit. Thank you for your question.
Okay, so we’re going to move on to some other relevant tax items. There’s some heavy hitters here. Business interest limitations, business loss limitations and net operating losses, taxation of carried interest, and taxation of self-created intangibles, which is actually my favorite.
Okay. We’re not going to spend nearly the time on this deductibility of business interest that we would if we were having a real estate seminar, because in the real estate world this is a really big deal. Everything is leveraged a little bit higher than they are in the hospitality world. The other thing is that this limitation doesn’t kick in unless you have revenues of $25 million or more.
I will warn that, in the spirit of this law, they are going to aggregate in some way, shape, or form, your different businesses. What isn’t in the law, and what will eventually be in the regulations is the tool in which they use to aggregate them. We see aggregation in the real estate world, and there’s some elections that we can make in order to aggregate our properties for active use. We see aggregation in the retirement plan world, in the ARISA law environment, that we will use in order to make sure that your employees are covered under the umbrella of retirement plans.
I don’t know that they’re going to use either of those two formats to get aggregation here but, I think that everybody feels that you’re not going to be able to split every piece of real estate you have into another entity so that you get under the $25 million limit. There is going to be some kind of aggregation rule here, and we’ll be looking for either comments from the service or maybe even regulations if we’re lucky.
Generally, what’s going on here is that they are going to limit your ability to deduct interest to 30% of your earnings before income taxes and interest income. After 2022, they’re going to expand that earnings definition to include amortization. If you’re not able to take interest in the current year, it will be added to your NOL’s or it’s going to be carried forward.
Jessica Hussain: Yeah. [crosstalk 00:22:37]
Tommy Lee: Excuse me, it’s going to be carried forward to the next year and be available for you to use the next year. However, you’re going to have the same limitations. Unless something is materially changed and you’re making a lot more money and have a lot less debt and corresponding interest, you may still have the same problem. Once again, I don’t know that this is going to be huge issue in the profitable restaurants, retail spaces. It may be problematic for our hotel clients, and I think that’s where we’ll probably do a lot of planning around this.
There is one thing, and I don’t know that we included it in here, but car dealerships must of had a really good lobby because one of the interest items that they did leave out of here is your show floor financing. So for car dealerships, they don’t pay cash for all the cars that you see in the lots. That interest is excluded from this definition. We didn’t add it in here because we don’t do a lot of car dealership work, but that is one exclusion.
The next slide is really talking about when you take that deduction and carry it over. I think we get a five year carry forward on the interest deduction. There’s a difference in your basis. That carry forward will come through you at the partner level in a pass-through entity, so this slide is kind of going into that. It shows how you get your basis right in case you dispose of that business unit with that carry over interest in your pocket, if you will.
Individual Limitation on Excess Business Losses. This one’s interesting. We had to read this probably five times the first day that we were looking at it to make sure that we understood exactly how this worked and exactly what they were trying to accomplish. We had to read it another five times to figure out exactly when we thought our clients would be affected by this.
You’ve always had some limitations on how you could take losses, and they usually have to do with basis or at risk. But even when you have sufficient basis or sufficient at risk to take a loss, if you’re filing single you can no longer take a business loss that’s greater than $250,000. If you’re married filing jointly, you can no longer take a business loss that’s greater than a half a million dollars.
When your business losses are limited in this way, it’s going to be added to your net operating loss. As we’ll get into in the next slide, your net operating loss has changed some too. So net operating losses will only be carried forward now in the future. Any losses that go above the $250,000 filing single or $500,000 married filing joint, will be added to your NOL.
We’ve put an example down here at the bottom of the slide. We also went through our clients and some of the 2016 and 2017 transactions that we dealt with because I thought that generally that was going to be when this came into play. We did have a client that sold a series of restaurants in 2017, and in that instance they had a pretty large capital gain, let’s call it $10 million for example purposes. They sold their restaurants in Q1. Because of that, they had some trailing expenses through the rest of the year, and so, in this instance they had a $10 million capital gain and $750,000 ordinary loss from business operations. In that case, that client would be affected here.
If they were single, they would have lost out on basically a $500,000 worth of deductions for that year. It would not have offset any of the capital gain in that current year, and it would have been carried forward. Fortunately these rules weren’t in place then, so they were able to net their gains and losses. But that was the instance in which I thought that we would probably see this most. The year of disposition you’ve got plenty of income, but for some reason you have some trailing losses without the corresponding revenue that we’re used to. We may have some ordinary losses with some other income that’s flowing through to our tax return, and that may be an issue.
The other thing that I thought about where this may be an issue is in some of our restaurant groups, as we’re growing, we will have some years in which we may build out one or two or three restaurants. In the past we would always ask ourselves, does it make sense to use our depreciation up this year to accelerate our depreciation?
In the past, we may accelerate that depreciation where we would have pretty large losses depending on the size of operation. We would need to take this limitation into account now to make sure that if we took those losses that we were going to be able to utilize them this year. Furthermore, as the next slide will tell us, we would also need to take in these new net operating loss carryback rules, because a lot of times we would take those losses anyways if we could carryback to recover tax.
Not to get ahead of myself, these new Net Operating Loss rules are simply this. We used to have a two year carryback and a 20 year carry-forward. We used to also be able to offset 100% of income with our net operating loss. The new Net Operating Loss Rules removed the two year carryback, and they give us an indefinite carry-forward. But, they only allow us to offset 80% of the income when applied to net operating loss. That’s a pretty major difference.
In talking with my colleagues around the country on some of these new laws, this is also one of the laws if we see a downturn in the economy over the next couple of years, they think this change, the net operating losses, may be on the chopping block.
I think I still have clients going through net operating losses from the downturn from 2008, 2009, and 2010. But, in those years we were able to carryback into sometimes 2006-2007, depending on when we had our losses, in order to recover some of our tax. We think if we see any kind of significant downturn in the economy that this elimination of the two year carryback may be on the chopping block, and it may come back.
Remember, if you have any questions let us know, or I’ll just keep talking.
This slide is giving an example of the application of the Net Operating Losses, and your ability to only offset only 80% of income instead of 100% as we were in the past.
Okay, next is the change in carried interest. I included this slide because carried interest is sometimes a part of our world. Sometimes not. We see that larger restaurant groups will sometimes give carried interest as they’re growing. As they’re looking for operators, they’ll give some carried interest to their new operators. We absolutely see this in our restaurant funds, as our funds come in and gobble up different restaurants. Maybe a franchise group is purchasing restaurants from other franchisees, and we’ll see the private equity funds absolutely take a carried interest position.
The biggest change here, really the only change here, is that the carried interest holding period has always been a year. Now, they’ve moved it to three years. This can be a big deal. Honestly, if you read some of the commentary around carried interest and around these new carried interest provisions, the general thought was that Congress felt that they needed to do something with carried interest because it’s been in the news over the past 10 years.
Honestly though, I don’t know how much of a revenue raiser this is really going to be. Most of the private equity firms and private equity groups usually have a plan that extends greater than three years in order to hold their restaurants before they plan on disposing of them, or hold their hotels before they plan on disposing of them. I don’t know how effective this increase in holding period is really going to be to raise revenue. But, I think it was Congress’s way to say, especially in the paper, “Yeah, we dealt with carried interest and we made it not quite as beneficial as it was before.” There’s not really anything more to this, it’s just simply the increase in holding period from one years to three.
Okay. So this is probably my favorite slide because it’s probably given me the most heartache of most of anything in this new tax law. The new law is simply changing the type of asset class for certain self-created and tangible assets.
In the five lines, if you go back and you read the Committee Report, you’re going to see that it absolutely says that this is meant for self-created and tangible assets. It mentions patentable assets, and not only assets that have been patented, but assets that could be patented. It also mentions copyrights. None of that really gave me the heartache that I had. What gave me the heartache was this: what it didn’t exclude, specifically, was business and personal good-will. And business and personal good-will, in my brain is absolutely a self-created and tangible asset.
Probably on the 26th of December, the day after Christmas, I was on the phone with our [Cardel 00:34:51] and M&A tax group, a number of lawyers around the country, IP lawyers, business lawyers, anybody that I thought may have made it all the way through to page 460 something and had read this provision and had even the slightest amount of heartache that I had.
I’m not sure that, at least on my first set of phone calls, anybody else had made it to that part. But I certainly did create some heartache for some lawyers out there, and some investment bankers, when I showed them this and I asked my simple question of, “Hey, does this include personal or business good-will?” So fortunately, we’ve had a couple of weeks to go through this and to cool off. The general consensus is this that what they’re targeting here is not personal and business good-will.
Why does that matter to you? As a restaurant owner, as a hotel owner, as a retail shop owner, when we put a deal together and we sell your assets, we normally do it in an asset deal that’s normally most advantageous for us. Even if it’s not most advantageous to us, it’s absolutely most advantageous for the buyer. The reason that we don’t normally care is because we put a lot of the purchase price allocation right to good-will, and its one big bucket.
So we come up with some fair market value of the personal property assets that we have on our books. We allocate part of the purchase price to that personal property asset. That’s normally very low, and we’re pushing for it to be low while the buyer’s pushing for it to be a little bit higher. But, we all agree that the purchase price, over and above that allocation to personal assets, is good-will.
What does this change? With the assumption that the intent behind this law doesn’t include personal and business good-will, I still think that there’s something that we need to take into consideration. The IRS now has a tool in order to change certain tangible property that is identified from a capital asset to an ordinary asset. If you’re a franchisor, if you’re a multi-unit restaurant group, if you’re a multi-unit hotel group- maybe not in the franchisee hotel space, but a multi-unit, privately labeled group- you have a name. And that name is value. That name’s probably been copyrighted, and that copyright now has value.
If you’re in the restaurant business, or maybe in the hotel or the retail business, you might have some kind of secret sauce. Whether it’s some kind of distribution channel or some kind of sales channel which I don’t think is normally patentable, it is something that the IRS could deem as be patentable. Think about if somebody has a better barbecue sauce than somebody else. The IRS now has a tool to come in and put a value, or at least require you to put a value on and allocate sales price to that asset and for that asset be ordinary.
Our recommendation to our clients that are sitting in that space is to think about valuing those assets way before we’re having the conversation with the IRS, and even before we have a deal on the table to sell our business. We can go out to a third-party valuation firm, Aprio has a third-party valuation firm, and we can help you value these copyrights and these intangible assets. If you’re a GAP filer you’re already in tune to this. We’re normally already placing some kind of value on certain intangible assets on our GAP books. Usually copyright and patentable assets are sitting on our GAP books.
Furthermore, during the audit process we’re testing those for impairment. Some of our GAP filers already may have these kinds of assets on their books. They already may have a process that they’re deploying in order to test impairment. But for a large majority of our privately held restaurant, hotel, and retail groups, many of them aren’t GAP filers because, why would you be if you didn’t have to be? They’re not testing for impairment. It’s the first time they’ve even heard about testing for impairment.
Those are the folks that I really want to make sure realize that this is maybe an opportunity to value that asset, and to get it on the books at a lower value than you may get when the IRS makes you do it after a sale. Because after a sale, we all know what you sold it for. The IRS can come in and say, “Hey, the value of the intangible assets are X. They’re the difference between your purchase price and the book value or the fair market value that we’ve assigned to the assets.” That valuation may look a whole lot different with that set of facts than it would today.
Also, if you’re anticipating a sale in 2018 or 2019, you’re under the gun to box up and value these assets. I think that is my general advice, especially if you’re a franchisor, multi-unit restaurant, or hotel group that’s holding some kind of name that could be associated with value. I think now’s probably a pretty good time to box that up, get some value on that copyright, and get it on our books in anticipation of some kind of sale transaction in the future. We don’t want to scramble and do this at the end. We certainly don’t want to scramble and do this with some kind of deal on the table.
I’m looking for questions on this. I think this is the most riveting part of the new tax law. It certainly kept me up at night for many a nights. Poor Jessica was getting texts from me saying, “Have you read this? What do you think about this?” Please let me know if you have any questions.
Okay, we will move on to some miscellaneous other tax reform items. Let’s talk about accounting methods, sexual harassment/abuse settlements, meals and entertainment. I’m going to run through these really quickly. There used to be a $10 million limit for all three of these items. That $10 million limit has now been increased to $25 million dollars. That’s really the takeaway here.
As it relates to the restaurant businesses, especially our multi-unit guys, would find that they would get over this $10 million test. Then we would have to do what we call a 263A calculation where we add some costs to your inventory. Some of the ancillary costs, utilities, etc., were added to your inventory holdings. They’ve increased the limit in which you have to do that from $10 million to $25 million. That really makes life easier.
I think in every business this is probably pertinent. It’s absolutely pertinent in the news. What this is doing is limiting your ability to deduct settlement payments and costs around settling sexual harassment settlements. I did this same presentation for a law firm, with a room half full with lawyers, and they definitely came in and said that in the case that you had some kind of severance agreement already in place, and then you accelerated your severance agreement because of some sexual harassment issue, you would have to bifurcate the severance agreement that was already in place versus the severance agreement. I’m sure they’re right. I’m not sure that I really thought about this other than what I put into the slide until the conversation the other day. But I thought it was pertinent.
Lastly, which happen to be one of my most popular slides a couple of days ago, is a change in the meals and entertainment deductions. I think that on the face this sounds a whole lot worse than it may be. I think that there’s a lot of regulations and a lot of guidance that needs to come out around this. There’s absolutely ambiguity around what is and what isn’t deductible.
Here at Aprio, there’s a woman in our office that is focused on providing guidance to our clients on what used to be deductible and what is no longer deductible. I’m assuming that everybody on this call is on our mailing list. We’re going to be putting some information and some further guidance on there. I’m sure it’ll be updated once we get some clarification and regulations, but the reason that I included this in the retail and hospitality slide was because this could affect our top line.
A general statement here is that what they’re going after is the entertainment section, not necessarily the meal section. For instance, if I was to take one of my clients out to play golf and then we ate lunch afterwards. Not only the golf, but also the meals associated with the golf would not be deductible. When we were giving this presentation on Tuesday, we had a number of questions that came up that were pretty restaurant specific.
One of them was shift meals. In most restaurants there’s always a shift meal before the lunch shift, and definitely a shift meal before the dinner shift. The question was, “Is that deductible now?” In that specific case of shift meals, I think that we all agree that it’s a normal business expense, and it would fall under the 162 100% deduction. What are we doing? We’re teaching our staff what we’re serving, the presentation, what’s in it, what it looks like, so that they can be more descriptive to our customers. That’s an example of an ordinary business expense.
Another example of an ordinary business expense is here at the firm, during what we call filing season, we supply meals to our staff. I think three days or four days a week, we have meals that we supply in the evening, or on a Saturday at lunch. I’ve always known that those, at least in the past, were 100% deductible. I thought that they would now be 50% deductible because the convenience of employer meals. But here’s where I was corrected.
This convenience of employer acception, or this convenience of employer meals, is when an employer actually has a facility on site. Some of the major law firms, there’s one in particular I know here in Atlanta, actually have their own facility on site to feed their attorneys and their clients. That’s where convenience of employer meals kind of comes into place. Actually, the guidance that I got was that those meals that we supply our employees would be 100% deductible. Really, it’s because it’s a de minimis fringe benefit, and that’s the acception that it’s used.
The other question that we got the other day pertained to the hotel business as well. We’ll sometimes order food from a restaurant for our hotel staff. That’s still 100% deductible. This, once again, this is really targeting entertainment. We’re going to come out with some more guidance and some more commentary around this. My point of including this slide was just making sure that you were aware of this, and thinking about it from a top line perspective if you are one of our entertainment clients.
Okay, 199A is going to be a lot of fun. I think it’s probably at least one of the reasons that you’re on this webinar today. I will give it a second and see if any questions come in. I got a ton of questions about meals and entertainment the other day, so, eventually there’s going to be a question that comes in about it that has some specific example that will probably stump me. But, we’ll give it a couple more seconds and we will move on to 199A.
Okay. 199A, Qualified Business Income Deduction. Before I get into the details of this, I’ve put all the information that you’re going to need to go through and slice and dice regarding the 199A Qualified Business Income definitions and deductions here. We’ve put a map in here that you can use to walk your way through the law.
What I’m going to do however, is I’m going to be a little bit more specific to the retail and hospitality space because I think it’s really a whole lot easier in the retail and hospitality space. We’ll talk about hotels, because hotels always have a bit of a real estate component, so that’s a little bit more complicated. But I’m going to try to simplify this. I guarantee you if I read you the rules of this law nobody, including myself, would make any sense of it, and our heads would be spinning. So I’m going to try to simplify this.
I will start with reminding you that the old rules gave us a 10% benefit by utilizing pass-through entities versus utilizing the C-corp. The new rules reduce that benefit before the application of 199A to just 2%. 199A is really what I think the writers of this law are using to restore our benefit from that 2% back to the 10%. So, to restore the benefit of utilizing a pass-through entity versus a C-corp entity back to that 10% differential. 199A is the tool that they’re using.
They had to do 199A because when they dropped the C-corp rate from 35% to a flat 21%, they had to do something to the pass-through rate or everybody was going to jump ship. Everybody was going to go operate in the C-corp. It was going to be great for law firms and it was going to be great for accounting firms. But, fortunately for the small business owner and our clients, they’re utilizing 199A to restore that 10% differential.
How they crafted this rule was actually pretty smart. They’re giving preference to income derived from capital versus income derived from personal services. What do I mean by that? The 199A has a certain set of limitations that we’re going to go through. Some of them are absolutely pertinent. I think they’re probably less impactful to the retail and hospitality group folks, but they exist.
One of the major limitations has to do with personal service income. What’s personal service income? I guess the easiest definition would be income derived from a personal service, so an accountant, a lawyer, or a consultant. Somehow, it is not an architect or an engineer. I don’t know if they just had a brilliant lobby that came in; I don’t know how they got that passed. Normally the lawyers get stuff passed like that for themselves, but somehow the architects and engineers got themselves excluded from the original definition of personal services.
I’ve had a number of conversations with lawyers and accountants around town that are now calling themselves legal engineers and tax architects. I don’t know that that’s really going to fly. I feel fortunate that I’m not having to do this for our professional services group, because our professional services group really had to get into the nuances of this rule.
We are going to have the professional services group webinar, which I believe has already happened. It will be up on our website at some point in time, so if you are an attorney that’s listening to this, and you have a lot of questions about how you can get around this, then you can certainly try me and stump me. But one of the first places to go is probably to listen to that webinar, and specifically their discussion about 199A.
199A is basically creating a deduction that is going to be 20% of your qualified business income. Once again, I put in this slide that it’s creating an effective top marginal rate. The point of the 199A deduction is driving down that effective top marginal rate for pass-through entities or individuals with Qualified Business Income to 29.6%.
Something important about this deduction is it actually reduces taxable income. It’s not a deduction before the AGI limit, like a retirement plan or moving expenses, because there different story there since they got rid of those. It’s not a deduction above AGI, and it’s also not an itemized deduction, which have been limited quite a bit. We’re not going to touch on itemized deductions and some of the individual provisions in this seminar. Once again, we did have an individual webinar that we’ll be putting up on our website.
This actually reduces taxable income. I don’t know that there’s ever been a deduction that reduces taxable income this way. We haven’t seen the IRS do this. I think the whole point was that if you went through the gauntlet of qualifying for the Qualified Business Income Deduction, that you were going to be able to take it, and there wasn’t another set of limitations that were going to apply. So they went straight to reduced taxable income. I promise you we have an example of this later on in this presentation, so we’ll go over that.
The limitations to qualified business income deductions do not apply to individuals that are filing single that have less than $157,500 of taxable income. They also do not apply married filing joint at $315,000 of taxable income. There is a phase out for single at $50,000. It starts at the $157,000, and you’re completely phased out at $207,500. For married filing joint, it’s at $415,000. I promise you we’re going to get into the calculation of this deduction, but I’m somewhat setting the stage for it.
This is our simplified map of how you go through and determine whether you qualify for the qualified business income deduction, and how you determine which one of the limitations are applicable to you. I am not going to go through this map. This is for you to go back and check my examples. This is for you to read and maybe ask questions about. It took a lot for somebody to create this map because this is probably eight or nine pages of tax law.
It’s relatively complicated. However, when you back up it’s relatively straightforward, and we’re going to go through a straightforward example as it relates to retail and hospitality clients. My example’s a restaurant client. So I’m going to try to simplify this, but if we do get some more involved questions maybe we’ll come back to this map in order to answer your questions. But this is really there for your reference.
The deduction is simply this. The deduction is 20% of your qualified business income. That’s the maximum deduction you can get on your qualified business income. If you have a qualified business income of $1 million, the maximum deduction you can get for that $1 million of qualified business income is $200,000. 20% is the maximum.
The limitations that we’re going to talk about will reduce that maximum amount. So just remember, the first thing you have to do is figure out your qualified business income. Then you use the 20% in order to calculate your maximum qualified business income deduction. We call that a QBID around here. I’ll try to not use acronyms too much, but that is the maximum qualified business income deduction, the qualified business income times 20%.
There are some other nuances in here. I’ve put them in this slide in case they apply to you. Once again, I’m trying not to get into the weeds and the minute details of this. I’m trying to keep it at a high level, but I’ve included them in this slide. The qualified cooperative dividends, the taxable income minus net capital gains, etc.
So what’s qualified business income? Qualified business income for a restaurateur is all of your income that’s derived from the restaurant. From a hotel perspective it’s all of your income. If you’re a retailer, it’s all of your income. Once again, where we start knocking away and chipping away at qualified business income is when we start talking about the trades. Section 2012e3A specifies what items are excluded, and even there there’s some ambiguity.
We gave this presentation on Tuesday and I was approached by a woman after the presentation. She owned a salon, and her and her husband were not the people cutting hair, but they owned the salon. All of the hairdressers were her employees. The income from that business is derived from professional services. However, the income that’s passed through to her is arguably derived from her capital deployment. That’s where some of this ambiguity fits.
I don’t have the answer. I didn’t have the answer for her then, and I don’t necessarily have the answer for her now. I would probably say, based on what I’ve read so far, that the income is derived from professional services. It would probably be excluded. When and if we file that tax return, we’re going to have to really look at that.
I got this question earlier today from a gentlemen that provided something that would amount to legal services. But once again, there was a number of employees that were providing the business services. There was income that was coming from that. They were not attorney’s, they were not accountants, and they certainly weren’t engineers and architects. There’s still ambiguity here, and we expect to get some guidance. We expect to get some regulations from the Feds on kind of nailing down exactly who is in this exception.
The other thing that I would think about is, even in the restaurant and hospitality practice, we represent some consultants. To me they’re providing professional services. I think even more clearly within Section 1202, in that definition, their income would not qualify as qualified business income. With all of that said, let me tell you when that matters.
As an accountant, if I am filing single and my income is less than $157,500, I still get the benefit of the qualified business income deduction. It’s once I get over the $157,500 and I make it through the $50,000 phase out, at $207,500. Once I get above the $207,500, if I’m in a qualifying trade or business I no longer get the qualified business income deduction. The same rule applies if I’m married filing joint, just different limitations apply. It starts at $315,000 and I’ve got a $100,000 of phase out, so at taxable income of $415,000 I’m no longer getting any benefit for the qualified business income deduction.
I want to make a couple of points here real quick. First of all, the $157,500 and the $315,000 limitation is not on your gross salary, it’s on your taxable income. Right. So a lot of times when we have pass-through income from professional services, there’s items that reduce our taxable income. We have retirement plans, and it’s one of our best planning tools that reduces taxable income. Depending on what kind or retirement plan we get into, we can very easily we can reduce it by a 401K amount. With not that much more preparation and heartache, we can get up to about $50,000. If we get into cash balance plans, we can get into the hundreds of thousands of dollars.
There are definitely items that can and will reduce your taxable income number from your base salary or your base guaranteed payments. So there’s some planning opportunities there. We definitely have seen one case so far where we came across a consultant and they were making approximately $400,000, and we saw an opportunity to put a retirement plan in place. We put the retirement plan in place for him and his wife, and I think we were able to defer about $100,000 into that retirement plan. Not only did this save them the tax, but it brought him below the threshold. When it brought him below the threshold, they were eligible for the qualified business income deduction.
Just because you’re a lawyer or accountant, and we don’t have as good of a lobby as the architects and engineers, there is still hope. There are some planning opportunities. Also, I will mention, this qualified business income is ordinary income. This isn’t capital gains, this isn’t dividends, it’s ordinary income. So those are some of the other items that are excluded. Interest is excluded out of there, etc.
So we talked about the calculation. We get the qualified business income, and I think we did that ad nauseam. Then we take the 20% and that gives us our maximum deduction. Two of the thresholds that I think are applicable, once we get over the income limits, are the $157,500 and the $315,000 that we discussed. Those are two applicable kind of limitations that we have.
The first one is 50% of our allocable share of the W2 wages. So if I own 100% of the restaurant, and I have $500,000 in wages, then 50% of that is $250,000. So no matter how much income I have, and no matter how much 20% of that income is, my qualified business income deduction cannot exceed that $250,000. So for this limitation, this is not how you calculate it, this is not your deduction. It just means that your deduction cannot be greater than this.
For the folks in restaurant and retail, I’m going to show you an example. I don’t think we’re going to run up against this limitation. If we do, we have a really, really well run restaurant or store. For our hotel folks, sometimes our wages aren’t nearly as significant percentage wise as they are in the restaurant and the retail space. Also, for our real estate folks, I realize that there’s many of my clients that have restaurant or retail holdings that also own the underlying real estate in those holdings, or may just have real estate in their portfolio.
Since wages don’t come into play as much in real estate, Congress provided another limitation, and it’s 2.5% of the unadjusted basis of the property. What is unadjusted basis mean? The cost. So if I paid $10 million for a building, my limitation’s going to be 25% of W2 wages plus 2.5% of that $10 million. So something above $250,000. Okay. When we’re talking to our clients that are real estate holders, that’s how this gets a little bit more complicated. We have to run our limitations through this gauntlet versus what I think is easier.
The other thing to take into account here is that it’s your applicable share. So if you own 50% of the business, and your business has $1 million in wages, you’re only going to get 50% of those wages allocable to you. Then you can only take half of that. So 50% of $1 million in wages, because you own 50% of the business, is at $500,000. Then we apply this limit of 50% of those allocable wages at $250,000 and so that is the limitation that you’re going to have.
Jessica Hussain: And that calculation is done per business.
Tommy Lee: That’s right. We have to do this calculation per business, per holding.
K1’s will look a little bit different. K1’s are going to have this information on them. There’s going to be some more calculations in order to get that information on the K1’s. We could probably have another hour long conversation about some ambiguity on exactly how we’re going to do that, but we’re waiting for some more guidance.
When I started thinking about this, I wanted to understand how good of a restaurant or how good of a retail location I was going to have before I started running up on these limitations. I’ve given two examples here, Restaurant A and Restaurant B. With Restaurant A, you can kind of read through the cost structure that I put in each of the examples. Restaurant A is a fairly well run restaurant. I think most of us would take 14% margins and we’d be okay with that. If you look at the net profit on a $2 million restaurant with a 14% margin, we come to $270,000. We take our $270,000 times 20%. Our maximum qualified business income deduction would be $54,000. We apply our W2 wage limit, and I’m assuming we own 100%, so it’s $300,000. Our $54,000 is way under our $300,000, so we get the whole deduction.
Even in the most well run restaurant, that I have made up here for example B, I put our food costs around 30%. I put our labor costs at 20%, which brings me to a 40% margin. If anybody has a restaurant like this, we would like to speak with you after this call, and so would probably all the bankers on this call as well. We would certainly lend you money. We have a 40% margined restaurant, and we have $800,000 of net profit. We apply our 20% calculation, and our deduction comes to $160,000. But even in this really well run restaurant, probably not reality, we still get the full QBID.
This is my way of just showing you. I think for the folks in the restaurant and the retail business, because we’re so labor intensive, I don’t think we’re going to run up on these limitations.
Hopefully this provided a good example. Once again, I’m just making the point that, especially in our restaurant and our retail operations, we’re not going to run up on the limitations. I’m going to go through a real world example here real quick to show you the benefit of QBID. I think that’s really the question. It certainly was the question that I was asking. But, unfortunately we had to go through all of the other stuff first to realize how to calculate this before we could go to the benefit.
In my example we have a local restaurant and they’re in the pizza business. They have two locations, and both of them are successful. Both locations are owned 100% by the taxpayer who is married, I didn’t put that one the slide, through two separate S-Corporations. The owner pays himself $52,000 in salary from each location because that’s what he has deemed as reasonable.
In this case, these are the real numbers. For pizza one and pizza two everybody will kind of recognize the cost structure here. For pizza restaurant number one, the projected income for 2017 is about $225,000, which represents a 23% net margin. Excuse me, I’ll take it down a couple of lines. We have a taxable income of $217,000, which represents a 23% net margin. Not sure how both of these can be 23%.
Then for pizza restaurant number two, the taxable income is $322,000. Call it $600,000, has a 26% net margin. We take those QBI numbers, we multiply them by 20%, and we calculate our QBI deduction for restaurant number one, which is $43,500 approximately. We calculate our QBID, or our qualified business income deduction, for restaurant number two, and it’s $64,500, approximately. We look at our two W2 wage limitations, and both of these are well within the range so the bottom numbers, the QBID realized. So we’re able to take full deduction of the $43,500 and the $64,500.
This slide is exactly like the slides that I used a couple of slides back. I’ll remind you of them, just with real numbers. I’m just calculating the deduction, we’re not yet applying it. So the next thing that we’ll do is that we’ll apply the deduction. In our example here, we’re going to apply 2017 to 2018. A couple additional facts include that the spouse also has wages of about just under $68,000. They do have some interest and dividend income, and as we talked about, that income is not eligible for QBID or QBI. In this case, their taxable income does exceed the $315,000, so we can see how the limitations apply.
This is a client of ours that we are doing planning for. We took their 2017 numbers, and the only difference in the income to 2017 and 2018 is in the tax refunds, because I could not override my tax software. I couldn’t make it happen where it’s the same number, but I promise you that’s the only difference.
You will notice that our total income is the same for example purposes. You’ll notice that the itemized deductions are quite different, and that’s because of the new tax law. That’s because their state taxes aren’t as deductible as they were before. That’s really the driver in the itemized deductions. We have $10,000 limit in deductible taxes.
So you’ll see that in 2017, our income comes to $656,000. In 2018, our taxable income is actually higher, at $678,000. Once again, that’s driven by the reduction in itemized deductions. After taxable income, we apply the qualified business income deduction. That is the $108,000 number, and I promise you it is the two deduction numbers from the previous slide. We’ve added them together a number of times and checked them twice. So our qualified business income deduction, remember it wasn’t limited, is at $108,022. If you look at the difference in our federal tax, we have reduced our tax burden for this tax payer by almost $55,000.
This is where the rubber meets the road. This is the answer that I exhaustively went through regarding the qualified business income, or the 199A rules. This is why it matters. This is why generally I feel very comfortable saying that really from a business perspective in general, this is why this tax law is going to be good for the business owner. This is going to reduce your effective rate.
Remember, we’re trying to bring our effective rate closer to our corporate rate for our business income. It’s effectively taking it down closer to that 21%, or that differential to 29.6%. If you do the math here, these are probably in the top rate bracket. But remember, our taxes are graduated, so maybe our next dollar would have been at 37%. That doesn’t mean that our last dollar was, so their effective tax rate isn’t going to be 29.6% here.
But this is a big deal. This is where the savings are coming in. This is the money that these tax payers are going to be putting in their pocket just because of the next tax law.
One thing that I would like to mention is that anytime that we’re doing tax planning, we’re always looking at a span longer than a year. Generally the Federal Government and the State Government require us to file tax returns. People that are in my business are very appreciative of that, but this one year filing is simply just that.
When we really look at the effects of decisions that we make, we really need to look over a span of probably 5 or 10 years. We normally try to look at the profitable life of the business to determine how long we’re going to have to look at. But we need to look at a span longer than just filing years. So, the Federal Government knows that too.
One of the things that they put in this provision which really wouldn’t work without it is that they will not let people like us mess with depreciation and mess with expenses in order to take advantage of the filing years. For instance, if I have a qualified business income loss of $100,000 in year one, and I have a qualified business income of $150,000 in year two, they’re going to make me net those. My qualified business income is $50,000 in this case, and the maximum deduction that I can get on my qualified business income would be $10,000. I took the $50,000 and simply multiplied it by 20%.
So there will be some carry-forward schedules that people like me and Jessica will have to keep up with. Fortunately we have software for this. We’re going to have to keep up with it to make sure that if you have losses in the past that we’re adding them to gains in the future, and vice versa. Maybe not vice versa, but I think going forward we need to make sure that we’re not taking advantage of those limitations.
That’s our presentation. I guess we’ll give it a couple minutes to see if the questions come pouring in, or if I just did a really good job of explaining it all.
Okay, I guess I explained it well. We didn’t have a whole lot of questions. I appreciate your time. We have included our contact information. If you do have any questions later tonight, tomorrow, next week, please feel free to shoot us an email or shoot us a phone call and hopefully we can help you out.
Thanks for your time and have a great day.