THE TAXATION OF LAWYERS AND THEIR PRACTICES POST TAX REFORM

Transcription

1 THE TAXATION OF LAWYERS AND THEIR PRACTICES POST TAX REFORM PREPARED AND PRESENTED BY: JAMES M. MCCARTEN BURR & FORMAN, LLP TH STREET, NW, SUITE 1100 ATLANTA, GA TELEPHONE: (404) FACSIMILE: (404) PREPARED FOR: STETSON LAW'S 2018 NATIONAL CONFERENCE ON SPECIAL NEEDS PLANNING AND SPECIAL NEEDS TRUSTS PRE-CONFERENCE: TAX INTENSIVE PROGRAM ST. PETERSBURG, FLORIDA WEDNESDAY, OCTOBER 17, 2018

2 THE TAXATION OF LAWYERS AND THEIR PRACTICES POST TAX REFORM Prepared By: James M. McCarten Burr & Forman, LLP Atlanta, Georgia TABLE OF CONTENTS I. Introduction: Do The Cobbler's Children Have Shoes?...1 II. Reductions in Most All Tax Rates...1 A. The Corporate Tax Rate... 1 B. Individual Income Tax Rates... 1 C. Other Taxes... 2 D. The Loss of Deductions and Other Tax Benefits... 2 E. The Important Changes to Business Deductions... 2 F. Other Individual Tax Changes... 3 G. Choice of Entity After Tax Reform... 3 III. The Most Important Change for Small Businesses: the Qualified Business Income ("QBI") Deduction...6 A. Income Tax Equity For All Forms of Business Income... 6 B. The Proposed Regulations... 7 C. What is Qualified Business Income?... 7 D. The Language of the QBI Deduction... 8 E. The Initial Steps in Calculating the QBI Deduction... 8 F. The QBI Deduction for Individuals Below the Threshold Amounts G. The QBI Deduction for High Income Taxpayers H. How Much of the QBI of Each Trade or Business Can Be Used I. Determining the UBIA Limitation J. Trusts, Estates and the QBI Deduction K. QBI Planning for Professional Practices L. Significantly Increased Accounting Fees M. QBI Specific Penalties IV. Tax Changes Impacting Businesses...15 A. Corporate AMT B. Deemed Terminations of Partnerships C. Entertainment Expenses Are No Longer Deductible D. The Deduction of Business Interest is Now Limited E. Increases in Section 179 and Additional First-Year Depreciation i

3 V. Individual Income Tax Changes About Which All Practitioners Should Be Aware.17 A. The Sunset Provision B. The Alternative Minimum Tax C. The Kiddie Tax Provisions D. Home Mortgage Interest E. Medical Expenses F. Alimony G. The State and Local Tax Deduction H. Miscellaneous Itemized Deductions VI. Decision Points for Post-TCJA Choice of Entity Planning...19 A. Individual Income Tax Rates B. Applicable Individual Capital Gains and Qualified Dividend Tax Rates C. The 3.8% Net Investment Income Tax D. The 3.8% Medicare Tax on Wages and Self-Employment Income E. Corporate Tax Rates, Including the Repeal of the Corporate AMT F. The Two Layers of Tax on Income From C Corporations Versus Pass-thru Entities G. Deferral of the Second Layer of Tax by C Corporations H. The Ability of Owners to Utilize Business Losses on Personal Returns I. The QBI Deduction J. The Limitation on Individual Deductions for State and Local Taxes K. Passive Activity Losses L. A Realistic Exit Strategy: Asset Sale or Sale of Equity M. The Potential Benefit of Providing Services as a Sole Proprietor, through a Disregarded Entity or as the Sole Owner of an S Corporation ii

4 THE TAXATION OF LAWYERS AND THEIR PRACTICES POST TAX REFORM Prepared By: James M. McCarten Burr & Forman, LLP Atlanta, Georgia I. INTRODUCTION: DO THE COBBLER'S CHILDREN HAVE SHOES? As lawyers with a passion for helping our clients, clients who often are among the most vulnerable segments of our society; e.g., persons with a disability(ies) and seniors, we often bemoan the fact that it is difficult to find/make enough time for our spouses and children, maybe even grandchildren, much less ourselves. Given that it is difficult to find enough time for our families and ourselves, many lawyers save the non-billing part of their practice, the non-malpractice and the non-"let-me-keep-my-license" parts, for whatever time is left available. This program is focused on helping those of you who have not yet considered the impact which the provisions of the Tax Cuts and Jobs Act of 2017 (sometimes "Tax Reform," sometimes the "TCJA" and other times the "Tax Act") will have on you and your practice. I hope it will allow you to more easily identify the provisions of Tax Reform most relevant to you and what planning options you might decide to explore in order to minimize the amount of annual tribute you and/or your practice pay to the tax man. II. REDUCTIONS IN MOST ALL TAX RATES. A. The Corporate Tax Rate. One of the most important of the TCJA's tax changes is the permanent reduction in the corporate tax rate from 35% to 21%. B. Individual Income Tax Rates. Tax Reform also reduced the individual income tax rates applicable in all brackets from the highest rate down to the 15% rate; the lowest bracket remains unchanged at 2018, James M. McCarten and Burr & Forman, LLP P a g e 1

5 Tax Rates Before Tax Reform Tax Rates After Tax Reform Single Married Filed Joint Single Married Filed Joint Rate Taxable Income Rate Taxable Income Rate Taxable Income Rate Taxable Income 10% Under 10% Under 10% Under 10% Under $9,325 $18,650 $9,525 $19,050 15% 25% 28% 33% 35% 39.6% To $37,950 To $91,900 To $191,650 To 416,000 To $418,400 Over $418,400 15% To $75,900 25% To $153,100 28% To $233,350 33% To $416,700 35% To $470, % Over $470,000 12% Under $38,700 22% Under $82,500 24% Under $157,500 32% Under $200,000 35% Under $500,000 37% Over $500,001 12% To $77,400 22% To $165,000 24% To $315,000 32% To $400,000 35% To $600,000 37% Over $600,001 C. Other Taxes. While income tax rates changed, the self-employment, Medicare, and net investment income tax rates were not touched by the 2017 Tax Act. D. The Loss of Deductions and Other Tax Benefits. The trade-off made by Congress for the reductions in both the corporate and individual tax rates was to limit certain deductions available to taxpayers. 1. The individuals who will be affected the most by the "deduction reduction" will be those individuals who itemize deductions rather than claiming the standard deduction. 2. For those individuals in the mid to lower tax brackets who might have itemized in prior years, the increase in the standard deduction, which jumped from $12,700 for 2017 to $24,000 in 2018 for married couples filing jointly, this "deduction reduction" makes it more likely that they will utilize the standard deduction. 3. Also worth noting is that the deduction for personal exemptions has been repealed. E. The Important Changes to Business Deductions. Separate from the changes in tax rates imposed upon income earned in a trade or business, but very important for income 2018, James M. McCarten and Burr & Forman, LLP P a g e 2

6 planning are the new limitations on the amount of certain deductions allowed in calculating the net income earned from a trade or business. The most relevant of those TCJA changes are detailed in Section IV of these materials below. F. Other Individual Tax Changes. Because the other changes on how individuals are taxed under the TCJA are also important, but seem generally viewed with less enthusiasm by lawyers than getting the planning right for the primary source of their income, their professional practice and other closely-held trade(s) or business(es), the other important individual income tax changes are detailed in Section V of these materials below. G. Choice of Entity After Tax Reform. 1. A primary concern expressed by most business owners, including professionals, when the subject of tax planning is raised is what impact the new tax law will have on choice of entity and minimizing the tax bite on the cash generated by the business which is then distributed to the business owner. Equally important when comparing business entity choices is to not only examine the impact which the tax changes will have on individuals in the top tax brackets, but also the impact it will have on those in more modest tax brackets. The following comparisons assume that the business will distribute all of, some of or none of the net income earned by the business after income tax on the business' net income has been paid, whether the tax burden occurs at the entity level, the individual level or some burden at both levels. Type of Entity and Income Distributed* A corporation distributing 100% of its after-tax net income A corporation distributing 50% of its after-tax net Total Tax Rate If Individual in Top Bracket Total Tax Rate If Individual in Modest Tax Bracket 47.3% 40.8% 36.7% 33.4% income No corporate earnings distributed 26.0% 26.0% S corporations, partnerships or sole proprietorships (all pass-thru entities) 34.6% to 45.8% 27.4% to 46.2% *This chart, its tax rate calculations and the immediately following observations are reproduced here with permission from Steve Gorin's PowerPoint prepared and presented at the 2018 American College of Trust and Estate Counsel Southeast Regional Meeting (Sept. 6-9, 2018) and were culled by Mr. Gorin from his on-going thoughts on tax planning found in Gorin, II.E.1.a and b, "Structuring Ownership of Privately-Owned Businesses: Tax and Estate Planning Implications" (8/21/2018). These excellent, very detailed materials are available from Mr. Gorin at 2018, James M. McCarten and Burr & Forman, LLP P a g e 3

7 (a) Each of the above combined tax rates include a presumed five percent (5%) state income tax on earnings from the business. (b) The above comparison does not truly account for all differences associated with state income taxes. Many states require withholding on non-resident owners of businesses and/or require all owners of the business to file in those states. Because the income is taxed to the individual and not a separate legal entity (except for states which, like Tennessee and Florida, among others, have no personal income tax), individuals and trusts which own passthru businesses will likely be unable to deduct the full amount of state income tax assessed against their business income and/or state property taxes, while C corporations have no such limitation. (c) Another factor which should considered in the choice of entity decision is that C corporations are better vehicles for providing fringe benefits on a tax favorable basis. 2. Compare the total federal income tax due for the income of a C corporation which is fully distributed to its owners. Type of Entity and Income Distributed* Corporate Taxable Income Individual in Top Bracket Individual in Modest Tax Bracket $100,000 $100,000 Federal and State Income Taxes Net Income After Income Tax Income Taxes at 28.8% or 20% rate when distributed Cash to Owners -$26,000 -$26,000 $74,000 $74,000 -$21,312 -$14,800 $52,688 $59,200 *This chart, its tax rate calculations and the immediately following observations are reproduced here with permission from Steve Gorin's PowerPoint prepared and presented at the 2018 American College of Trust and Estate Counsel Southeast Regional Meeting (Sept. 6-9, 2018) and were culled by Mr. Gorin from his on-going thoughts on tax planning found in Gorin, II.E.1.a and b, "Structuring Ownership of Privately-Owned Businesses: Tax and Estate Planning Implications" (8/21/2018). These excellent, very detailed materials are available from Mr. Gorin at 2018, James M. McCarten and Burr & Forman, LLP P a g e 4

8 (a) This calculation assumes that 100% of the corporation's net income is distributed and that a state tax will be imposed upon the distribution to the owners at 5%, with a 5% tax also being imposed for corporate state income taxes. (b) Because the amount distributed should be treated as a dividend (the chart above ignores any requirement that reasonable compensation be paid to owners who work in the business), the rates applied with regard to the individual in the highest bracket will be the 20% qualified dividend income tax rate, the 3.8% net investment income tax ("NIIT") and the 5% state income tax for a total tax rate of 28.8%. 3. Compare the tax bite if only 50% of corporate after-tax income is distributed: Distributing 50% of Corporate After- Tax Income* Individual in Top Bracket Individual in Modest Tax Bracket Corporate Taxable Income Federal and State Income Taxes Net Income After Income Taxes Distribution to Owner Income Taxes at 28.8% or 20% as above Net Cash to Owner Corporate Cash Plus Shareholder Cash $100,000 $100,000 -$26,000 -$26,000 $74,000 $74,000 $37,000 $37,000 -$10,656 -$7,400 $26,344 $29,600 $63,344 $66,600 *This chart, its tax rate calculations and the immediately following observations are reproduced here with permission from Steve Gorin's PowerPoint prepared and presented at the 2018 American College of Trust and Estate Counsel Southeast Regional Meeting (Sept. 6-9, 2018) and were culled by Mr. Gorin from his on-going thoughts on tax planning found in Gorin, II.E.1.a and b, "Structuring Ownership of Privately-Owned Businesses: Tax and Estate Planning Implications" (8/21/2018). These excellent, very detailed materials are available from Mr. Gorin at 2018, James M. McCarten and Burr & Forman, LLP P a g e 5

9 4. If none of a C corporation's after tax income is distributed, the total tax burden is limited to $26,000 (at least for the foreseeable future until the difference is later distributed) which leaves the total cash available to the C corporation and perhaps the owners of $74, However, two of the taxes which the owners of C corporations historically had to consider in their planning and, with the rise in popularity of pass-thru entities, have generally not been in play for the last 20 years or so must again be considered. (a) The personal holding company tax. (b) The accumulated earnings tax. III. THE MOST IMPORTANT CHANGE FOR SMALL BUSINESSES: THE QUALIFIED BUSINESS INCOME ("QBI") DEDUCTION. A. Income Tax Equity For All Forms of Business Income. During the early part of the legislative process, it became clear to members of the House Ways and Means Committee that when the corporate income tax rate was reduced, small businesses organized as pass-thru entities would be placed at a significant business disadvantage due to the difference in tax rates which would apply to business income. In order to even the playing field between C corporations and pass-thru entities, the concept of a deduction which would only apply to active business income taxed at the owner level was conceived. As the Committee and its staff continued to work on the TCJA, the shape of the QBI deduction solidified and was eventually included in the Act in its current form. 1. Designated as Code Section 199A, the Qualified Business Income ("QBI") deduction is only available to non-corporate owner(s) of pass-thru businesses (specifically, individuals, estates and trusts). 2. The amount of the deduction is calculated on the owner's personal income tax return or trust/estate income tax return, and is subject to a number of exceptions and limitations, including the following: (a) The amount of a taxpayer's taxable income and threshold amounts which apply when the income is earned by a specified service trade or business; and (b) The deduction is limited to the amount of wages paid by the business or the W-2 wages paid plus the pass-thru' s basis in its property (the unadjusted basis immediately after 2018, James M. McCarten and Burr & Forman, LLP P a g e 6

10 3. Like many of 2017's Tax Reform provisions, the QBI deduction is scheduled to expire on December 31, B. The Proposed Regulations. On August 8, 2018, the IRS issued its first set of regulations with respect to the QBI deduction (a 104 page preamble, plus 184 pages explaining very technical issues associated with the deduction). In addition, regulations relevant to the QBI deduction were simultaneously issued under Code Section 643 which set forth an anti-avoidance provision dealing with the misuse of multiple trusts. Where relevant and practical, the provisions of the Proposed Regulations are covered below. C. What is Qualified Business Income? 1. Pursuant to Prop. Reg. Section 1.199A-1(b)(4), QBI means "the net amount of qualified items of income, gain, deduction and loss with respect to any trade or business as determined" pursuant to the rules found in Prop. Reg. Section 1.199A-3(b). 2. The proposed regulation continues by defining the term "trade or business" in the same manner as that term is used in Code Section 162, but at the same time excludes the trade or business of performing services as an employee as well as any rental activity which does not rise to the level of a trade or business. (a) Rental activities will, however, be treated as a "trade or business" for QBI purposes so long as the property is rented to or licensed to a commonly owned trade or business. Prop. Reg. Section 1.199A-4(b)(1)(i). (b) Two businesses are "commonly owned" where the same persons own, directly or indirectly, 50% or more of each business (and the attribution rules apply). (c) The new regulations further provide that if a service provider was treated as an employee, the presumption under the QBI rules is that the individual remains an employee. This rule is designed to prevent employees from deciding to become independent contractors in hopes of qualifying for the QBI deduction even though nothing in the relationship has changed. (d) The focus of the QBI deduction is on the trade or business-related items of income, gain, deduction or loss which results in the exclusion of most types of investment income from the QBI 2018, James M. McCarten and Burr & Forman, LLP P a g e 7

11 D. The Language of the QBI Deduction. Before delving into the details of how the QBI deduction is calculated and to whom it is available, it is important to learn the new acronyms adopted under Code Section 199A and Prop. Reg. Section 1.199A-1(b). 1. Those acronyms include the following: QBI - qualified business income; RPE - relevant pass-thru entity; SSTB - specified service trade or business UBIA - unadjusted basis immediately after acquisition; PTP - publicly traded partnerships; REIT - real estate investment trust. 2. Another defined term used in the Section 199A analysis is "Threshold Amount," the amount for any taxable year in which the QBI deduction can be claimed which exceeds the dollar amount(s) of taxable income described in Prop. Reg. Section 1.199A-1(b)(11). E. The Initial Steps in Calculating the QBI Deduction. 1. Has the Applicable Threshold Amount Been Reached? One of the first steps in determining the amount of the QBI deduction with which practitioners and business owners must become accustomed is the "threshold amount," a term defined in the statute. (a) For individuals, trusts and estates, the threshold amount is $157,500. (b) Where qualified business income is received by one or both spouses who have chosen to file jointly, the threshold amount increases to $315,000. (c) The threshold amounts are based upon the taxpayer's "taxable income" not the traditional "adjusted net income." (d) A brief review of the 2017 version of IRS Form 1040 makes it clear that the deduction is not part of calculating adjusted gross income (e.g., the QBI deduction is not used to reduce a taxpayer's "total income," Line 22 on Form 1040); (i) Therefore, the QBI will not be entered on the first page of the 2018 Form (ii) Neither is the QBI deduction an itemized 2018, James M. McCarten and Burr & Forman, LLP P a g e 8

12 (iii) Accordingly, the QBI deduction should be a line item following Line 43, Taxable Income, on Page 2 of next year's Form (e) The statute specifically provides that the QBI deduction is only available for income tax purposes. Code Section 199A(f)(3). The deduction will have no application to the self-employment tax calculation, net investment income tax calculation or similar separate taxes. (f) It is further worth noting that the QBI deduction (at least an estimated amount of the deduction) can be used by business owners who are employees of the business or another company entirely in determining the amount of withholding necessary to avoid estimated penalties. Code Section 3402(m)(1). The QBI deduction should also be taken into account for estimated tax purposes. 2. Specified Service Trades or Businesses. The availability of the QBI deduction for individuals engaged in an SSTB when their taxable income is at or below the appropriate threshold amount is the full amount of that taxpayer's QBI deduction. This anomaly is sure to generate planning by professional practices whose profession or business is included as an SSTB under Section 199A. (a) Only when a taxpayer's taxable income is at or below the applicable threshold amount does the calculation of QBI deduction include trade or business income from professional service entities in the fields of health, law, accounting, actuarial sciences, performing arts, consulting, athletics, financial services, brokerage, or where the principal asset is the reputation or skill of one or more of the organization's employees. (b) For non-corporate taxpayers whose taxable income exceeds the applicable threshold amount, the QBI deduction excludes net business income from an SSTB. 3. Multiple Trades or Businesses. Where multiple businesses are owned by the same non-corporate taxpayer, the amount of QBI must be determined for each separate business and if any business has a negative QBI, that loss is netted against the positive QBI earned through other from businesses. (a) Once the QBI for each separate trade or business has been determined, the applicable W-2 wage and/or QBIA of qualified property limitation for each trade or business is 2018, James M. McCarten and Burr & Forman, LLP P a g e 9

13 (b) If the entire amount of QBI for all businesses in a single year is negative, that loss is treated as a separate business itself and carried over to subsequent years where it is used to offset the positive QBI of the taxpayer's other businesses. Prop. Reg. Section 1.199A-1(d)(2)(iii)(A). 4. Aggregating Trades or Businesses. Somewhat akin to the concept of "grouping" under the passive loss rules, taxpayers may aggregate separate trades or businesses where the trades or businesses meet certain criteria. This taxpayer favorable rule allows the W-2 wages and/or the UBIA of one business to apply to another business which might not have sufficient wages or own sufficient property which would mean that no QBI deduction related to that second business would be available. (a) The separate owners of a business entity are not required to make the same election regarding aggregation. And while aggregation is not allowed at the entity level, each entity must account for and report the relevant QBI factors for each and every separate trade or business operated. (b) Non-corporate taxpayers are allowed aggregate businesses where a single person or a group of persons, directly or indirectly, owns 50% or more of each business being aggregated. (c) The 50% ownership requirement must be met for a majority of the tax year. (d) All the aggregated businesses must use the same tax year. (e) The businesses cannot be specified service trades or businesses. (f) The aggregated businesses meet at least two of the following tests: (i) the same products or services are offered by each business; (ii) the businesses share facilities or certain core business elements; and (iii) the businesses are "operated in coordination with, one or more businesses in the aggregated group." Prop. Reg. Section 1.199A-4(b). (g) Aggregation choices must be applied consistently by the taxpayer in future years. Additionally, the taxpayer's aggregation choices must be disclosed when filing annual tax 2018, James M. McCarten and Burr & Forman, LLP P a g e 10

14 F. The QBI Deduction for Individuals Below the Threshold Amounts. For individual taxpayers and married couples filing jointly who have $157,500 or $315,000 or less, respectively, of taxable income, the amount of the deduction will be 20% of the QBI received by the taxpayer plus 20% of qualified REIT dividends and qualified PTP income received by the taxpayer. If the QBI deduction exceeds the taxpayer's taxable income reduced by net capital gain for the year, the deduction will be limited to 20% of the difference from that subtraction exercise. G. The QBI Deduction for High Income Taxpayers. For individual taxpayers whose taxable income exceeds the threshold amounts, the QBI deduction is calculated in a twostep process. 1. First, the qualified business income for each separate trade or business must be calculated. (a) For trades or businesses other than SSTBs or the trade or business of performing services as an employee, the determination of a taxpayer's qualified trades or businesses will be determined under rules already developed pursuant to Code Section 162. Prop Reg. Section 1.199A-1(d)(4). (b) An exception provided in the Proposed Regulations allows a trade or business which rents property to a related trade or business is automatically treated as a separate trade or business (the Code Section 162 analysis is unnecessary). However, as a separate trade or business, the limitations discussed in the following paragraph will still apply. H. How Much of the QBI of Each Trade or Business Can Be Used? As noted earlier, the amount of the QBI deduction for each separate trade or business will be the lesser of: 1. 20% of the QBI for that trade or business or, if a smaller amount, capped at 50% of the W-2 wages "allocable to" that trade or business. If a greater deduction is produced, the cap applied is 25% of the W-2 wages allocated to the trade or business plus 2.5% of the UBIA of qualified property associated with that trade or business. 2. Under Prop. Reg. Section 199A-1(d), the actual amount of the QBI deduction is then the lesser of: (a) the sum of the QBI calculation for each trade or business plus 20% of qualified REIT dividends plus 20% of qualified PTP income; or (b) 20% of (the taxpayer's taxable income - net capital 2018, James M. McCarten and Burr & Forman, LLP P a g e 11

15 3. Under the Proposed Regulations, W-2 wages include not only wages as traditionally defined for W-2 purposes, it also includes any elective deferrals made by the employees as well as Roth contributions. Prop. Reg. Section 1.199A-2(b)(2)(i). 4. The Proposed Regulations next provide a taxpayer friendly rule allowing the allocation of W-2 wages among separate trades or businesses where employees of various of the separate businesses are employed by a central management company. Prop Reg. Section 1.199A-2(b)(2)(ii). 5. Where multiple trades or businesses are housed in a single entity, that entity is to allocate the amount of its W-2 wages between each separate business. Prop. Reg. Section 1.199A-2(b). 6. For reporting purposes, all pass-thru entities must identify, calculate and report the separate trades or businesses, the business income associated with each, and the wages and/or UBIA limitations associated with each. Prop. Reg. Section 1.199A-6(b) I. Determining the UBIA Limitation. 1. With respect to UBIA, calculating the limitation begins by determining the tangible depreciable property held by the trade or business as of the close of the tax year. Further, the property must have actually been used during the tax year for the production of QBI and the "depreciable period" for such property must not have ended before the close of the relevant tax year. Prop. Reg. Section 1.199A-2(c)(1). 2. The QBI deduction requires businesses to track yet another depreciation method in order to know if the "depreciable period" is still open. The QBI depreciable period begins when the property is placed in service and closes on the latter of: (a) 10 years after acquisition, or (b) the end of the last full year of the applicable recovery under traditional depreciation rules. 3. The term "unadjusted basis immediately after acquisition" means that acquisition cost, not the adjusted basis, is used for purposes of calculating the QBI deduction. (a) For purposes of the UBIA limitation, any addition or improvement to real property is treated as a separate item of qualified 2018, James M. McCarten and Burr & Forman, LLP P a g e 12

16 (b) The basis adjustments provided when a Section 754 election is in effect do not apply and cannot be treated as basis in property for QBI purposes. Prop. Reg. Section 1.199A-2(c)(1). J. Trusts, Estates and the QBI Deduction. Because the QBI deduction is available to non-corporate taxpayers, it can be claimed by trusts and estates. The threshold amount for an estate or trust will be the same as the threshold amount for a single individual, $157, As expected, the Proposed Regulations provide that QBI and the related elements involved in the deduction's calculation are to be allocated appropriately between the beneficiaries to whom DNI is distributed and the trust itself. Prop. Reg. Section 1.199A-6(d)(i). As a general proposition, the amount of QBI, W-2 wages, UBIA and other factors relevant in the calculation are allocated between the trust and its beneficiaries based on the relative portion of the DNI retained by the trust or distributed to a beneficiary. Id. 2. Up until the Proposed Regulations were issued, there had been discussion about whether the QBI deduction would even be available for electing small business trusts ("ESBTs") because of some unique statutory glitches unrelated to the QBI provisions. Thankfully, Prop. Reg. Section 1.199A-6(d)(v) makes it clear that the QBI deduction is available to ESBTs. 3. Similar to the discussions from some tax practitioners that it might be possible to use multiple trusts in order to avoid losing the deduction for any amount of state or local real estate taxes paid (e.g., structuring the ownership of investment property to include multiple trusts), the IRS apparently believed there was potential for abuse of the QBI deduction by using multiple trusts. Prop. Reg. Section 1.199A-6(d)(3)(v). (a) The Section 199A Proposed Regulations refer to Code Section 643(f) and the Proposed Regulations simultaneously issued thereunder in the anti-abuse rule so that when a principal purpose for creating and funding separate trusts is to obtain tax benefits, the separate trusts will not be recognized for tax purposes. (b) In fact, the Proposed Regulations under Section 643(f) specifically provide that a principal purpose will be presumed to be tax avoidance unless there is a significant non-tax (or non-income tax) purpose that could not have been achieved without the creation of separate 2018, James M. McCarten and Burr & Forman, LLP P a g e 13

17 K. QBI Planning for Professional Practices. 1. As noted above, the QBI calculation does not include, except for individuals whose income is below the relevant Threshold Amount, the income from service businesses in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investment management, trading services, dealing in securities, partnership interests or commodities, or any business where the principal asset is the reputation or skill of one or more of its employees, but some potential exceptions exist. 2. Where a traditional business has a division producing income which is treated as from an SSTB, the entire business will not be treated as an SSTB provided that less than 10% of its gross receipts are from the SSTB. If the total gross receipts of the business exceed $25,000,000, the allowable amount of SSTB income is 5%. Prop. Reg. Section 1.199A- 5-(c)(i). 3. Somewhat conversely, when a separate trade or business would not be treated as an SSTB, but has more than 50% common ownership with an SSTB (calculated using the attribution rules), shares expenses with the SSTB and accounts for 5% or less of the combined gross receipts of the two trades or businesses, the business is treated as "incidental" to the SSTB. And, if a business is incidental to an SSTB, the two businesses are combined for purposes of the QBI deduction and treated as a single SSTB. Prop. Reg. Section A- 5(c)(3). 4. Conceptually similar to the incidental business rule identified above, the Proposed Regulations provide that any trade or business with 50% or more common ownership to an SSTB (attribution applies) and which provides 80% more or more of its property or service to an SST be will be treated as an SSTB. 5. Where a non-sstb business meets the 50% common ownership requirement, but does not provide 80% of its product or services to the related SSTB, the business is not treated as an SSTB in its entirety. However, the portion of the business providing property or services to the commonly-controlled SSTB (measured at the 50% level) is treated as part of the SSTB. L. Significantly Increased Accounting Fees. While the availability of the QBI deduction will benefit most owners of pass-thru entities, there is a non-tax cost to making 2018, James M. McCarten and Burr & Forman, LLP P a g e 14

18 benefit available. The pass-thru entity, known as an RPE in the language of the QBI deduction, is required to determine and report the information necessary for its direct and indirect owners to determine and claim the QBI deduction. This will mean that the RPE will have to determine the following: 1. All of the trades or businesses it engages in. 2. Whether any of those trades or businesses are SSTBs. 3. The relevant income and deduction components allocable to each trade or business; in other words, income and expenses will have to be allocated to the separate trades or businesses and should not be done on a straight pro-rata basis, expenses which are only relevant to one trade or business, must be allocated to that trade or business. 4. Similarly, the W-2 wage and UBIA limitations are to be separately determined. Prop. Reg. Section 1.199A-6(b)(3). 5. For any pass-thru entity which fails to identify and separately report the relative QBI-related information, the owner(s) of that RPE will not be allowed to claim any QBI deduction for a trade or business carried on by that RPE. M. QBI Specific Penalties. The substantial understatement penalty will be deemed to apply if an understatement of tax arises from use of the QBI deduction and the understatement is the greater of $5,000 or 5% of the tax required to be shown on the return. The change made to the substantial understatement penalty is that the level of understatement required has been reduced from 10% to 5%, but only for an understatement attributable to QBI. IV. TAX CHANGES IMPACTING BUSINESSES. For most professionals, the following changes with respect to business income and deductions will be the most important of such changes, but the list is not comprehensive. Remember, though, that the changes to business tax provisions are permanent. Unlike the individual income tax provisions of the Tax Act, they are not scheduled to sunset effective December 31, A. Corporate AMT. The corporate alternative minimum tax has been repealed effective as of January 1, B. Deemed Terminations of Partnerships. The TCJA repealed the rule that treated a sale or transfer of 50% or more of the capital and profits interests in a partnership as a "technical 2018, James M. McCarten and Burr & Forman, LLP P a g e 15

19 C. Entertainment Expenses Are No Longer Deductible. The deduction for business expenses related to entertainment, amusement or recreational activities or for membership dues to any club organized for business, pleasure, recreation or other social purpose has been repealed. D. The Deduction of Business Interest is Now Limited. Businesses whose average gross receipts exceed $25,000,000 for the three (3) prior years can only deduct interest equal to the sum of (1) business interest income, (2) 30% of the taxpayer's adjusted taxable income computed before interest, taxes, depreciation, amortization or depletion deductions ("EBITDA"), and (3) the taxpayer's floor plan financing. This limitation applies to all corporate and noncorporate business taxpayers. It even applies to non-profits with respect to the calculation of the unrelated business income tax. Any business interest disallowed can be carried forward indefinitely with certain restrictions imposed for partnerships. Code Section 163(j), as amended by the TCJA. The IRS provided guidance on the application of these limitations earlier this year in Notice E. Increases in Section 179 and Additional First-Year Depreciation. 1. Rather than the limit of $500,000 available under prior law, the ability of businesses to deduct the entire cost of depreciable tangible personal property and certain real property acquired during the tax year has increased to $1,000,000 per year. Further, the Section 179 deduction is not phased out until the total qualifying property which is placed in service during the year exceeds $2,500,000 (up from pre-tax Reform's $2 million limitation). 2. The pre-tcja limit on additional first-year depreciation was 50% of qualified property acquired during the year. For 2018, 100% expensing of qualified property, a term which generally includes depreciable assets other than real property improvements, is acquired and placed in service during the tax year is available. This business tax provision is one of the few which has a sunset date. The deduction is phased out by 20% per year for property placed in service during 2023 and before Other Miscellaneous Business Tax Changes. While unlikely to apply to most professional practices, additional business tax changes which are worth noting follow: (a) Like Kind Exchanges. Like kind exchanges are no longer permitted for property other than real property. Previously, like kind exchange treatment was available for automobile fleets, aircraft and other tangible personal 2018, James M. McCarten and Burr & Forman, LLP P a g e 16

20 (b) Net Operating Losses. Under the new law, NOLs are only available to offset up to 80% of a business' taxable income and cannot be carried back to prior years. (c) Qualified Stock Options. The income which would otherwise be recognized by certain employees upon the exercise of a stock options or the vesting of restricted stock may now defer recognition of that income for up to five years from the recognition date. The deferral benefit is not available to any person who owns 1% or more of the company, a CEO, a CFO and any of the four (4) highest compensated officers during any of the preceding 10 years. Family members are also excluded from this benefit. (d) Carried Interests. Ignoring all other relevant rules, when a partnership interest is received in connection with the performance of services, that interest must be held for at least three (3) years in order for gain recognized to be treated as long-term capital gain. V. INDIVIDUAL INCOME TAX CHANGES ABOUT WHICH ALL PRACTITIONERS SHOULD BE AWARE. In addition to the changes in the tax rates identified earlier, the following changes applicable to individuals will also impact tax planning post A. The Sunset Provision. Almost all of the income tax changes impacting individuals, trusts and estate are set to expire on December 31, The sunset provision also applies to the QBI deduction. B. The Alternative Minimum Tax. The 2017 Tax Act increases the AMT exemption for individuals from $78,750 to $109,400 with a phase-out threshold beginning at $1,000,000 for married taxpayers filing jointly. These increased exemptions are also indexed for inflation. While the AMT that exemptions for individuals have increased, no similar benefit is provided to trusts and estates. C. The Kiddie Tax Provisions. No longer is the tax on the unearned income of a child required to be determined using the parents' tax rates. However, for many individuals who are dependents claimed on tax returns filed by others, while the change will make the calculation easier, the cost for simplification will often be a higher tax bill. As of 2018, the unearned income of children and certain adults claimed as a dependent will be calculated at the same rates applicable to trusts and 2018, James M. McCarten and Burr & Forman, LLP P a g e 17

21 D. Home Mortgage Interest. The deduction for home mortgage interest is limited to interest on $750,000 of debt used to acquire a personal residence after December 15, Further, no tax deduction will be available for interest paid on home equity indebtedness, etc. E. Medical Expenses. The TCJA retains the medical expense deduction, and even increases the potential amount of a deduction by reducing the threshold for expenses paid before the deduction can be claimed from 10% to 7.5% (of AGI), but only for F. Alimony. One of the TCJA provisions causing a lot of consternation among individual taxpayers is that alimony paid to an ex-spouse is no longer deductible to the payor, nor is it income to the recipient in divorce or separation instruments executed after December 31, Equally important in the context of divorce and separation tax planning is the repeal of Code Section 682(a) which provided that when a grantor trust is created by one spouse for the benefit of the other, the income generated by that grantor trust would not be taxed to the grantor, if the income was actually received by the donee-spouse (or which the donee-spouse was entitled to receive); now all the income tax is paid by the grantor while the ex-spouse can still receive distributions. G. The State and Local Tax Deduction. Effective beginning this year, the deduction for state and local income, sales and property taxes unrelated to a trade or business or an investment activity (as determined under Code Section 212) is limited to $10,000 for individuals filing jointly. Anti-abuse regulations were issued by the IRS on August 23 of this year which prevent most of the workarounds being considered by various states. Prop. Reg. Section 1.170A-1(h). H. Miscellaneous Itemized Deductions. The deduction previously allowed for certain miscellaneous itemized deductions is no longer available with the enactment of Code Section 2018, James M. McCarten and Burr & Forman, LLP P a g e 18

22 VI. DECISION POINTS FOR POST-TCJA CHOICE OF ENTITY PLANNING. A. Individual Income Tax Rates. B. Applicable Individual Capital Gains and Qualified Dividend Tax Rates. C. The 3.8% Net Investment Income Tax. D. The 3.8% Medicare Tax on Wages and Self-Employment Income. E. Corporate Tax Rates, Including the Repeal of the Corporate AMT. F. The Two Layers of Tax on Income From C Corporations Versus Pass-thru Entities. G. Deferral of the Second Layer of Tax by C Corporations. H. The Ability of Owners to Utilize Business Losses on Personal Returns. I. The QBI Deduction. J. The Limitation on Individual Deductions for State and Local Taxes. K. Passive Activity Losses. L. A Realistic Exit Strategy: Asset Sale or Sale of Equity. M. The Potential Benefit of Providing Services as a Sole Proprietor, through a Disregarded Entity or as the Sole Owner of an S 2018, James M. McCarten and Burr & Forman, LLP P a g e 19