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The Pass-through Deduction: Things every business owner needs to know

Sep 21, 2018 12:16 PM

By Dan Packard, CPA, CFE, CVA

Tim Anderson, CPA

Scott Nielson, CPA

 

Recent tax changes have dramatically impacted the opportunities available to small business owners.  One of the largest opportunities now available is the pass-through deduction (Section 199A deduction), by which a taxpayer can deduct up to 20 percent of income from partnerships, s corporations, or sole proprietorships.  The availability of the deduction is influenced by your industry, the nature of your income, the structure under which you operate your business, and whether you’ve adequately prepared before year end.  Simply put, the deduction isn’t simple.  However, your ability to understand the deduction and properly plan can result in substantial tax savings.

The Basics

Effective for tax years beginning after December 31, 2017 and before January 1, 2026, a taxpayer is entitled to a deduction equal to 20% of the taxpayer’s “qualified business income” earned in a “qualified trade or business.” The deduction is limited, however, to the greater of:

  • 50% of the W-2 wages with respect to the qualified trade or business, or
  • The sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property.

The resulting deduction is then subject to a second limitation equal to 20% of the excess of:

  • The taxable income for the year, over
  • The sum of net capital gains

The purpose of this overall limitation is to ensure that the 20% deduction is not taken against income that is taxed at preferential rates.

“Qualified Business Income” is the net amount of qualified items of income, gain, deduction, and loss with respect to a qualified trade or business that are effectively connected with the conduct of a business in the United States. However, some types of income, including certain investment-related income, reasonable compensation paid to the taxpayer for services to the trade or business, and guaranteed payments, are excluded from qualified business income.

“Qualified trades and businesses” include all trades and businesses EXCEPT the trade or business of performing services as an employee and "specified service" trades or businesses: those involving the performance of services in law, accounting, financial services, and several other enumerated fields, or where the business's principal asset is the reputation or skill of one or more owners or employees.

The W-2 wage limitation does not apply to taxpayers with taxable income of less than $157,500 for the year ($315,000 for married filing jointly) and is phased in for taxpayers with taxable income above those thresholds. Income from specified service businesses is not excluded from qualified business income for taxpayers with taxable income under the same threshold amounts.  Consequently, taxpayers, regardless of the industry wherein they operate, can achieve the pass-through deduction if taxable income is $315,000 or less.

 2018 Passthrough Deduction Flow Chart

 

Maximizing the Pass-through Deduction

Given that the pass-through deduction is primarily designed to benefit qualified trades or businesses and those with taxable income less than $315,000 (MFJ), taxpayers should engage early in tax planning to ensure they maximize the benefit.  Below are several ideas you should consider and discuss with your CPA during tax planning:  

  • Retirement Plan Contributions: Increasing retirement plan contributions, especially for the business owner, is a great idea irrespective of the pass-through deduction.  Safe harbor 401(k) profit-sharing plans can provide significant benefits to a business owner and their spouses, and also allow staff to contribute to the 401(k) plan at a relatively low cost to the business.  Furthermore, the business owner can adopt a defined benefit or cash balance plan that can provide for extreme contributions for the owner, subject to some limitations.  Implementation of a pre-tax retirement plan will reduce your taxable income and help you achieve the income thresholds that yield the largest pass-through deduction. 
  • Employment of Your Children in your Business: Paying your children the highest reasonable amount for the services they render will further reduce taxable income.  Thanks to the increased standard deduction, each child can now earn up to $12,000 annually that is free of federal income tax. 
  • Be Cautious with Capital Gains and Investment Income: Interest, dividends, and capital gains all serve to increase taxable income.  Consequently, it is wise to review investment portfolios to ensure capital gains are not needlessly being recognized as assets are moved.  Furthermore, when selling real property, 1031 exchanges should be considered whenever possible to defer gains and reduce taxable income.  As a reminder, Section 1031 allows a taxpayer who owns real property held for investment or used in a business to exchange property and defer paying taxes if the taxpayer acquires a like-kind replacement property to be held for investment or used in a business.  This allows taxpayers to potentially use all of the proceeds from the sale of the relinquished property to leverage into more valuable property, increase cash flow, diversify into other properties, expand business operations, reduce management or consolidate into one larger replacement property.  When considering replacement properties, be sure to consider Opportunities Zones and the tax benefits associated with investment in these types of properties. 
  • Charitable Contributions: Charitable contributions present a highly effective way to reduce taxable income.  Charitable contributions can take many different forms: cash contributions to qualified 501(c)3 organizations, non-cash contributions of household items, and contribution of highly appreciated property, such as stock, art, or real property.  Taxpayers can specifically take a charitable deduction for qualified conservation contributions, which are contributions of a qualified real property interest to a qualified organization exclusively for conservation purposes. A qualified real property interest for this purpose can be the taxpayer’s entire interest in the property, a remainder interest or an easement that restricts the use of the property in perpetuity. Conservation purposes include (1) preserving land for outdoor recreational use by, or education of, the general public; (2) protecting relatively natural habitats of fish, wildlife or plants; (3) preserving open space (including farmland or forest space) for scenic enjoyment of the general public or under a governmental conservation policy yielding significant public benefit; and (4) preserving a historically important land area or a certified historic structure.  This type of donation can be facilitated in many different ways. 
  • A Dilemma: Real Estate and Business Management Entities: Administrative and management companies provide billing, collection, human resource, and other ancillary services.  Intrinsically, administrative and management companies are qualified trades or businesses.  Business owners that do not generate qualified business income have been incentivized to establish these types of entities to create intercompany service agreements and generate qualified business income.  These separate management companies are commonly owned by the business order, the business owner’s spouse, or the business owner’s children.  If your business is utilizing an administrative or management company, the services provided should equate to the fees that are paid.  Minutes should be prepared annually to document the services that were performed.  Before adding an administrative or management company to your business structure, be aware of the published guidance from the Treasury Department.  The Treasury regulations include an anti-abuse rule designed to prevent taxpayers from separating out parts of what otherwise would be integrated with the non-qualified trade or business, such as administrative functions, in an attempt to qualify those separated parts for the pass-through deduction. 

If a business owner owns business real estate in a separate entity, he or she may be inclined to increase the rent paid from a non-qualifying business activity to the rental entity to create qualified business income.  Unfortunately, if the real estate entity leases only one property (the business real estate), there is authority that the real estate entity isn’t a qualified trade or business.  Additionally, paying too high a rent risks having it recharacterized if rent exceeds the fair market value of facilities in the geographic area.  In an effort to combat this, the real estate entity may consider hiring maintenance and janitorial staff and require the operating entity to reimburse for those costs.  

The new tax bill has created many questions that have yet to be answered.  Consequently, it is difficult to know which strategies will provide the most meaningful benefit moving forward.  Strategizing with CPAs at Cooper Norman can help you find the best route forward.  We encourage you to start tax planning as soon as possible. 

 

Tax
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Tommy Gwinn Quoted on Bitcoin filings

Brooke Eppa
Mar 22, 2018 06:01 PM

Tommy Gwinn of our Pocatello office quoted in the Idaho Business Review.

Make sure you file your Bitcoin and other cryptocurrency gains and losses correctly on your taxes!
 
 
Learn more about Tommy Gwinn here.
 
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Tax Reform Summary

Dec 7, 2017 02:14 PM

If you are feeling confused by the recent tax reform proposals, you are not alone. With the Senate narrowly passing their version of tax reform early Saturday morning, both the House of Representatives and the Senate have now each passed their own versions of a tax legislation bill, but the two versions include many technical differences.

We have been closely monitoring the progress of these bills. Although the final details of the bill are yet to be determined, it is clear that it will have a dramatic impact on your 2018 tax return (filed in 2019).

House and Senate Republicans are set to reconcile differences between the two tax bills.  Here are a few highlights of things that may affect you.

 Individual tax rates

  • The House bill collapses the current seven brackets into four and keeps the top tax rate of 39.6%, although it raises the income level at which that applies. The changes would take effect in 2018.
  • The Senate bill has seven brackets, but reduces the top rate to 38.5% (currently 39.6%) for income over $500,000 for single filers and $1 million for couples filing jointly. The Senate bill also reduces income levels on other brackets compared with the current levels.

 Obamacare individual mandate

  • While the House bill makes no changes to the Affordable Care Act, the Senate bill would repeal the individual mandate that requires Americans to purchase health insurance or face a tax penalty.

 Mortgage interest deduction

  • The House bill would reduce the mortgage interest deduction for future home purchases.  Homeowners would be limited to deducting interest on up to $500,000 in mortgage debt. Deductions for second homes would no longer be allowed. Existing mortgages would not be affected.
  • The Senate bill does not change any of those provisions.

 Estate tax

  • The House and Senate bills would double the exemption next year for assets subject to the estate tax, a levy of as much as 40% that hits heirs of large estates.
  • The current exemption levels are $5.49 million for an individual and about $11 million for a couple.

 Alternative minimum tax

  • The House bill eliminates the alternative minimum taxes for individuals and corporations.
  • The Senate bill also repeals the tax, but AMT would return in 2026 as part of the expiration of the changes to that part of the tax code.

 Corporate rate reduction

  • The House and Senate bills permanently cut the corporate tax rate to 20% from 35%. The House cut would take effect next year, but the Senate bill delays it until 2019.

 Tax rate on pass-through businesses

  • The House and Senate bills also reduce taxes on pass-through businesses — sole proprietorships, partnerships, limited liability companies, and S corporations.
  • The changes are complicated and the bills take different approaches to those taxes.
  • The House bill would cap the top tax rate for pass-throughs at 25%, down from 39.6% individual rate.
  • The Senate plan would continue taxing pass-through businesses at the individual rate that would apply to the owner, with a top proposed rate of 38.5%. But the Senate bill would allow most pass-throughs to deduct about 23% of their business income from their taxes. 
  • This would likely exclude many service-based companies.

 State income tax

  • If you itemize your deductions, you can deduct state and local income taxes or sales taxes. Both proposals would eliminate the state and local income tax or sales tax deduction for individual taxpayers.
 
 
Dan Packard, CPA, Cooper Norman
You can read more about the author Dan Packard, MAcc, CPA, CFE, CVA here. 
 
Tax
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2017 AgKnowledge Seminar

Brooke Eppa
Dec 16, 2016 05:05 PM
AGKnowledge Seminar Logo
 
 
AgKnowledge agriculture seminar image
 
You can register through Eventbrite or call Malinda in our Idaho Falls office at 208.523.0862 for questions or to register over the phone.
$25 per person or $50 per farm (lunch is included)
 
All locations listed below will be in the state of Idaho:
 
 
Pocatello - Tuesday, January 31, 2017
 
Twin Falls - Wednesday, February 2, 2017
 
Idaho Falls - Thursday, February 3, 2017
AgKnowledge future planning
 
 
 
AgKnowledge Agriculture seminar header image
 
 
 
Itinerary posted here soon
 
 
 
 
 
AgKnowledge agriculture business seminar
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American Opportunity Tax Credit

Ryan Stone
Dec 14, 2016 11:21 AM

As a recent university graduate, the American Opportunity Tax Credit is something that has directly benefitted me and something that I have been very grateful for. If you or one of your dependents is a university student, this might be something that could help you lower the amount of federal income tax that you pay. The credit can be taken on 100% of the first $2,000 spent on qualified tuition and related expenses, and then 25% on the next $2,000 spent on qualified tuition and expenses. The total maximum credit is $2,500 per student, per year, and can be used for the student’s first four years of post-secondary education. Not only can this reduce your tax liability, but up to 40% of the credit amount is refundable which could generate a refund if your tax liability is reduced to zero before using up the entire credit.

In order for this credit to be applicable, you or your dependent needs to be a qualifying student. A qualifying student is a student who is pursuing a degree or other recognized credential from a college or university and is enrolled at least half-time. Additionally the student must not have been convicted of a controlled substance felony.

As previously mentioned, qualified tuition and expenses are used to calculate the amount of the credit. Tuition and fees along with course materials (required books, supplies, etc.) are all qualified expenses and can be used to calculate the credit. However, things like insurance, room and board, and transportation are not considered qualified expenses. Another factor in calculating the credit is the amount of financial aid received. The college or university that you or your dependent is attending will send you a tuition statement (1098-T) which will report qualified expenses as well as financial aid received. The amount of qualified expenses reported on the tuition statement might just be the amount of tuition and fees paid/billed and therefore you might be able to tack on things like books and supplies that you were required to purchase for your courses. The total qualified educational expenses will be reduced by financial aid you receive like scholarships, fellowships, or grants, but will not be reduced by borrowed funds like student loans.

Form 8863 is used to calculate the credit and must be attached to your Form 1040 when you file your individual tax return. The form instructs you to start on Part III where you will calculate the amount of the credit. Then it will take you to Part I and then to finish up on Part II. Part I will calculate any phase-out of the credit that might take place based on your AGI (Adjusted Gross Income). Taxpayers that are married and filing jointly will begin to lose some of the credit if their AGI is above $160,000 and will completely miss out on the credit if their AGI reaches $180,000 or above. For taxpayers using the other filing statuses the credit will be limited if AGI reaches $80,000 and completely eliminated with an AGI of $90,000 or above.  After the phase-out calculation, the refundable portion of the credit is calculated in Part I and then the nonrefundable portion is calculated in Part II.

In conclusion, it can be very advantageous to use education credits and deductions when preparing your tax return. Most of the time the American Opportunity Tax Credit will be the optimal credit to use, but if you don’t qualify, you can check to see if you qualify for the Lifetime Learning Credit or the Tuition and Fees Deduction. Education expenses are already high enough, you might as well use them to get some relief on your taxes and hopefully this post shed some light on how to do so.

-Ryan Stone

Email Ryan 

Tax
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December 1st Federal Overtime Rule Delayed

Dec 14, 2016 11:00 AM

A preliminary injunction was filed in a November 22 ruling that has put a hold on the implementation of the new federal overtime rule. 

The case was filed in the District court in Texas by 21 states, the U.S. Chamber of Commerce, and other business groups. 

“A preliminary injunction preserves the status quo while the court determines the Department of Labor’s authority to make the final rule as well as the final rule’s validity,” said Judge Amos Mazzant of the U.S. District Court for the Eastern District of Texas. 

The Department of Labor will appeal the decision, but until the courts make a final ruling, employers may continue to follow the existing overtime rule.

Cooper Norman News, Tax
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Thinking about giving this #GivingTuesday?

Nov 29, 2016 11:17 AM

If you’re thinking in participating in #GivingTuesday, keep in mind that certain charitable contributions are deductible if you itemize on your 2016 tax return. IRS Select Check on IRS.gov is a searchable online tool that lists most eligible charitable organizations. Donations to  religious organizations and government agencies are eligible to be deductible donations even if they are not listed in this database. In some states, Idaho for example, there is also a special deduction for contributions made to state educational entities or youth rehabilitation services. Property donations (items like clothing, household items, and other like items) are normally limited to the item’s fair market value or the value at which the thrift store can sell it. If any benefit is received in result of the donation (merchandise, meals, tickets or services), donors may have to reduce the value of their charitable contribution. Bank records (canceled checks, bank statements, etc.) or a written statement from the organization is needed to prove the amount of any donation made so be sure to keep track of these items. For more details on Charitable Contributions and possible tax deductions, visit the IRS website

 

IRS giving tuesday graphic

 

 IRS press release on Gifts to Charities

Tax
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New Nevada Business Tax Quick Overview

Aug 29, 2016 06:25 PM

Nevada has adopted a tax on businesses that generate more than $4,000,000 in revenues from within the state. Some of the notable features of the tax include:

 

1-      This is set up to be more of a franchise tax rather than an income tax. The standard nexus rules of P.L. 86-272 don’t apply here.

2-      You will need to look to the state’s definition of “Nevada Income” to calculate the correct amount to report on the form.

3-      The form is based on a fiscal year- 7/1-6/30.

4-      The tax rate used is based on the business NAICS code of the business.

5-      The filing requirement applies to all businesses including sole proprietors (Sch C, E, and F).

 

Any business registered in Nevada or with operations there will need to file a return annually. Some additional references on the Nevada Business Tax can be found at the Tax Adviser and the Nevada Department of Taxation.

 

If you believe this applies to you and your business and would like assistance in preparation of this return, please contact us at any of our three locations in Idaho Falls (208.523.0862), Pocatello (208.232.6006), and Twin Falls (208.733.6581). Our tax experts can help you navigate the many nuances and requirements of filing.

 

Disclaimer: Any material appearing in communication or shared third party content from Cooper Norman is for informational purposes only and is not intended as legal, accounting, or tax advice provided by Cooper Norman. Opinions expressed in communications from Cooper Norman professionals or shared third party content do not necessarily reflect the opinion of Cooper Norman or its associates. These communications are not intended to create, and receipt does not constitute, a legal relationship, including, but not limited to, an accountant-client relationship. Often these materials have been prepared by professionals, but the user should not substitute these materials for professional services, and should seek advice from an independent advisor before acting on any information presented. Cooper Norman assumes no obligation to provide notification of changes in tax laws or other factors that could affect the information provided.

 

You can read more about the author, Tim Anderson, CPA, MAcc on his bio here.

Tim Anderson, CPA, MAcc, Idaho Falls, Cooper Norman, Business Advisor

Tax
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2016 AgKnowledge Ag Seminar

Brooke Eppa
Dec 1, 2015 06:10 PM
AGKnowledge Seminar Logo
 
 
AgKnowledge agriculture seminar image
 
You can register through Eventbrite or call Malinda in our Idaho Falls office at 208.523.0862 for questions or to register over the phone.
$25 per person or $50 per farm (lunch is included)
 
All locations listed below will be in the state of Idaho:
 
 
Pocatello - Tuesday, January 19, 2016
 
Twin Falls - Friday, January 22, 2016
 
Idaho Falls - Friday, January 29, 2016
AgKnowledge future planning
 
 
 
AgKnowledge Agriculture seminar header image
 
Itinerary
 
Sign in and registration
9:45am - 10:00am
 
Topic 1 - Tax Update
10:10am to 10:55am
 
Topic 2 - Strategic Planning and Retreats for Business
11:05am to 11:50am
 
Lunch
11:50am to 12:20pm
 
Topic 3 - Industry Panel Part 1: Commodity Leaders will give presentations, discuss, and answer questions regarding current opportunities and issues
12:20pm to 1:00pm
 
Break 1:00pm to 1:10pm
 
Topic 4 - Industry Panel Part 2: Commodity Leaders will give presentations, discuss, and answer questions regarding current opportunities and issues
1:10pm to 2:10pm
 
Question and Answer and Wrap Up 
2:10pm to 2:25pm
 
 
 
 
AgKnowledge agriculture business seminar
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2015 ISU Cooper Norman Tax Competition

Brooke Eppa
Jan 29, 2015 10:10 AM
Cooper Norman’s first annual collegiate tax competition took place yesterday, Wednesday, January 28th at Idaho state University.  We invite undergraduate students to participate in the two hour competition.  The participants are presented with 2 tax research topics and are asked to draft tax file memos addressing the issues.  Cash prizes were awarded to the three top teams.  We had over 40 participants.  
 
2015 ISU Tax Competition Sponsored by Cooper Norman
2015 ISU Tax Competition Sponsored by Cooper Norman 2

2015 ISU Tax Competition Sponsored by Cooper Norman 3
 
2015 ISU Tax Competition Sponsored by Cooper Norman 4  
2015 ISU Tax Competition Sponsored by Cooper Norman 5  
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