Tax Reforms Impact on Depend On Corporations, Our People - PDF document

Tax Reform’s Impact on Depend On Corporations, Our People S-Corporations, LLC’s Count On and Partnerships Our Advice Olsen Thielen Presenters: Matthew Klein, CPA Joe Mayer, CPA, MST 952-829-3415 651-621-8334 mklein@otcpas.com jmayer@otcpas.com Topics • Policy • Corporate Tax Implications • Pass-through Tax Implications • New Fringe Benefit Rules • Updated Depreciation Rules • Individual Income Tax & Alternative Minimum Tax • Accounting Method Changes for Small Taxpayers • Interest Expense Limitation • Miscellaneous Provisions 1

Policy • $1.5 Trillion in tax cuts over 10 years • According to the Joint Committee on Taxation (JCT) • Individuals get 56 percent of the tax cuts • Business get 44 percent of the tax cuts • If tax cuts were distributed in proportion to the distribution of individual and corporate income taxes paid • Individuals would get 86% of tax cuts • Corporations would get 14% of tax cuts • Common theme: Benefits for business, grow entire tax base Statistics from RSM Corporate Tax Implications 2

Background • Prior to Tax Reform, the U.S. had highest corporate rate among the Organization of Economically Developed Countries (OEDC) topping out at 35% • The 35% rate forced many multinational corporations to focus on sourcing income outside the U.S. • The rate also discouraged bringing profit earned overseas back to the U.S. (repatriation). • This trend has forced Congress to address the corporate tax rate to make it more competitive with other industrialized countries. Corporate Rates • Effective for years beginning 1/1/2018, C Corporations are taxed at a 21% flat rate • Previous system was a bracketed system topping out at 35% • Corporate alternative minimum tax has been eliminated • This helps ensure the effective tax rate of corporations do not rise above the 21% statutory rate. 3

Dividends Received Deductions (DRD) • To avoid potential for three layers of taxation, C corporations receive a deduction for dividends received from other corporations in which it holds an equity interest in • Amount of deduction depends on the stock ownership percentage in the other corporation Stock Ownership Old Law DRD % New Law DRD% <20% 70% 50% Between 20% and <80% 80% 65% >80% 100% 100% International Taxation Implications • Historically, the U.S. was a ”Worldwide” income taxing regime. • Foreign Tax Credit for taxes paid to other countries • Forced corporations to shift income to lower taxing jurisdictions and claim domicile outside of the U.S. • The Act adopts a ”Territorial” income tax system • Only the income earned in the U.S. taxed at 21% • Repatriation tax on assets currently sitting overseas • Immediate tax of 15.5% for liquid assets and 8% for illiquid assets • Paid over installment period: 8% in years 1-5; 15% in year 6; 20% in year 7, and 25% in year 8 4

Pass-through Tax Implications Background • Majority of privately-owned businesses are organized as pass-through entities and sole proprietorships • S Corporations • Partnerships • LLC’s taxed as partnerships • LLC’s with a single owner • Generally, more favorable due to one layer of taxation and taxed at the owner’s individual rate on his/her return • Since Congress reduced the C corporation tax rate, pass-through entities must be addressed 5

Qualified Business Income Deduction – In General • Section 199 (DPAD) vs. New Section 199A(Qualified Business Income Deduction) • Rather than cut the rate, Congress enacted a 20% deduction at the owner level for Qualified Business Income (QBI) from partnerships, S corporations, and sole proprietorships • Deduction is limited to 20% of taxable income adjusted for capital gain income/loss of the individual shareholder • QBI deduction reduces the effective top marginal tax rate on pass-through income to about 29.6% vs. 39.6% previously. • QBI is defined as taxable income from a U.S. trade or business excluding investment income/expenses (STCG, STCL, LTCG, LTCL, Dividends, Interest) • Earned income (wages, guaranteed payments) excluded from QBI Qualified Business Income Deduction – Limitations • Generally, 20% QBI Deduction is limited to the greater of: • 50% of W-2 compensation paid by the entity or; • 25% of W-2 compensation paid by the entity plus 2.5% unadjusted basis of assets (Alternative Method) – Real Estate • Taxpayers who are below a threshold amount of $315,000 for MFJ or $157,500 for all others are not subject to above limits • Deduction begins phasing out at $315,000 (MFJ) and entirely phased out at $415,000 (MFJ) • W-2 limitation greatly devalues the 20% deduction and raises effective tax rate closer to ordinary individual rates 6

Example A: No Limitation Joe, a married taxpayer filing joint, owns a wholly owned manufacturing business called Widget. Joe receives $200,000 in wage income, $500,000 of qualified business income from Widget, $50,000 of capital gain and $100,000 of itemized deductions. Widget pays a total W-2 wages of $1,000,000 and has $1,000,000 of unadjusted basis in its assets Example A: No Limitation (cont.) Joe’s Qualified Business Income Deduction of $100,000 would be calculated as follows: Step 1: 20 % of Qualified Business Income Step 4: Calculate 20% of adjusted taxable income net of capital gain 20% of QBI (500,000 * 20%) 100,000 A Wage Income 200,000 Step 2: Greater of 50% of W‐2s or 25% W‐2 and 2.5% asset unadjusted basis Qualified Business Income 500,000 Capital Gain 50,000 50% W‐2 wages Itemized Deductions 500,000 B (100,000) Taxable Income 650,000 25% W‐2 Wages and 2.5% asset unadjusted basis Less Capital Gain 275,000 C (50,000) Taxable Income adjusted for capital gain 600,000 F Greater of B or C 500,000 D 20% of F 120,000 G Step 3: Qualified Business Income Amount Lesser of Qualified Business Income Amount or 20% of adjusted taxable Lesser of A or D income net of capital gain (Lesser of G or E) Step 5: 100,000 E 100,000 7

Example B: W-2 Limitation Joe, a married taxpayer filing joint, owns a wholly owned manufacturing business called Widget. Joe receives $50,000 in wage income, $500,000 of qualified business income from Widget, $50,000 of capital gain and $100,000 of itemized deductions. Widget pays a total W-2 wages of $150,000 and has $300,000 of unadjusted basis in its assets. Example B: W-2 Limitation (cont.) Joe’s Qualified Business Income Deduction of $75,000 would be calculated as follows: Step 1: 20 % of Qualified Business Income Step 4: Calculate 20% of adjusted taxable income net of capital gain 20% of QBI (500,000 * 20%) 100,000 A Wage Income 50,000 Step 2: Greater of 50% of W‐2s or 25% W‐2 and 2.5% asset unadjusted basis Qualified Business Income 500,000 Capital Gain 50,000 50% W‐2 wages Itemized Deductions 75,000 B (100,000) Taxable Income 500,000 25% W‐2 Wages and 2.5% asset unadjusted basis Less Capital Gain 45,000 C (50,000) Taxable Income adjusted for capital gain 450,000 F Greater of B or C 75,000 D 20% of F 90,000 G Step 3: Qualified Business Income Amount Lesser of Qualified Business Income Amount or 20% of adjusted taxable Lesser of A or D Step 5: income net of capital gain (Lesser of G or E) 75,000 E 75,000 8

Example C: Alternative W-2 Limitation Ryan, a married taxpayer filing joint, owns a wholly owned real estate business called RE Biz. Ryan receives $500,000 of qualified business income from RE Biz, $50,000 of capital gain and $100,000 of itemized deductions. RE Biz pays a total W-2 wages of $0 and has $1,000,000 of unadjusted basis in its assets. : Example C: Alternative W-2 Limitation (cont.) Ryan’s Qualified Business Income Deduction of $25,000 would be calculated as follows: Step 1: 20 % of Qualified Business Income Step 4: Calculate 20% of adjusted taxable income net of capital gain 20% of QBI (500,000 * 20%) 100,000 A Wage Income ‐ Step 2: Greater of 50% of W‐2s or 25% W‐2 and 2.5% asset unadjusted basis Qualified Business Income 500,000 Capital Gain 50,000 50% W‐2 wages Itemized Deductions ‐ B (100,000) Taxable Income 450,000 25% W‐2 Wages and 2.5% asset unadjusted basis Less Capital Gain 25,000 C (50,000) Taxable Income adjusted for capital gain 400,000 F Greater of B or C 25,000 D 20% of F 80,000 G Step 3: Qualified Business Income Amount Lesser of Qualified Business Income Amount or 20% of adjusted taxable Lesser of A or D Step 5: income net of capital gain (Lesser of G or E) 25,000 E 25,000 9

Conversions to C Corporations • On the surface, 21% flat tax rate compared to 29.6% effective tax rate seems like an easy decision • HOWEVER, double taxation for C Corporations make this decision much less obvious. • Conversions need to be considered for each specific fact pattern and fit long-term strategy of the organization. • May make sense for high-growth business where all earnings are reinvested in the business Example D – C Corporation Conversion C Corp Passthrough Income 100.00 100.00 QBI Deduction (20.00) ‐ Taxable Income 80.00 100.00 Tax @ highest rate 29.60 21.00 Cash Remaining 70.40 79.00 Tax on Cash Distributed Out @ 15% ‐ 11.85 Cash Remaining 70.40 67.15 Effective Tax Rate 29.6% 32.9% 10