Since President Trump’s inauguration, tax reform has been a moving target. There has been talk ranging from reducing the number of tax brackets to completely repealing various items such as the alternative minimum tax and the estate tax. At this point in time, there is an official bill that has been proposed, but it is still unknown when or if this bill will become law. The current bill generally leaves 2017 taxes alone but does have significant changes for tax law in 2018 and beyond. Your Aldrich advisor would be happy to talk through your specific circumstances to determine how these potential tax changes will affect you or your business.
Obamacare Repeal? American Health Care Act Proposed Changes
H.R. 1628, otherwise known as the American Health Care Act (AHCA), was introduced on March 20, 2017 and passed the House of Representatives on May 4, 2017. Currently, the bill awaits Senate approval. At this point, however, Obamacare has not been repealed.
Two Big Changes on the Horizon: New Partnership Audit Rules
IRS Audit Assessments – Who is liable for the tax?
Currently, only partners are liable for any tax assessments resulting from an IRS audit of a partnership. Effective for partnership tax years starting on or after January 1, 2018, the partnership itself will be liable for any assessments levied on past years’ returns, thus eliminating the need to proceed against individual partners. This means new partners would be liable for assessments that would otherwise be assigned to past partners who may no longer be owners.
The assessment would generally be computed based on the highest individual tax rate. However, a couple of elections may be made during the audit that would affect these tax calculations. Some partnerships may be eligible to opt out of the new audit rules, but this exception is very narrow. Talk to your advisor if you would like to explore this possible option.
Partnership Representative (Formerly the Tax Matters Partner)
Little emphasis has been placed on tax matters partners up until now. This was because the tax matters partner was only relevant in certain types of audit proceedings and individual partners still had the right to participate. Starting with the new rules for 2018, partners should take a vested interest in the partnership representative. Here’s why:
- This person will have complete authority to act on behalf of the partnership (and therefore the partners) when dealing with the IRS.
- This person has the authority to make various elections during the audit proceeding as noted above.
- Perhaps most importantly, the partnership representative does not need to be a partner in the partnership.
These changes might not seem like big issues now since a company cannot predict when there will be an IRS audit. However, formulating a plan ahead of time will prevent a potential headache in the future. It’s in your best interest to discuss these changes with your tax advisor well in advance of any IRS audit or any change in ownership of the partnership. Amending the partnership agreement is the recommended course of action to remedy these concerns.
Tax Saving Opportunities
The Research and Development (R&D) Tax Credit
In 2015, Congress made the R&D Tax Credit permanent as part of the Protecting Americans from Tax Hikes Act. The tax credit’s incentives encourage U.S. companies to maintain their competitive advantages through continued innovation and improvements. Basic guidelines to qualify for the credit are as follows:
- The project must be intended for the development of a new or improved business component, such as a product, process, technique, formula, invention or software.
- The project‘s purpose must be to discover information that is technical in nature. Thus, the activity must rely on the principles of physical sciences, such as engineering, biology or computer science.
- The project must aim to eliminate uncertainty related to the development or improvement of a business component. Uncertainty can include the capability, development method or optimal design of the business component.
- The project must evaluate one or more alternative solutions through the development, refinement and testing of different options.
Interest-Charge Domestic International Sales Corporation (IC-DISC)
Businesses who export products should consider the use of an interest charge domestic international sales corporation (IC-DISC) to reduce their tax burden.
An IC-DISC is a separate entity that earns a commission on the operating company’s export sales based on the greater of either 50 percent of net income on sales of qualified export property or four percent of gross receipts from sales of qualified export property. A properly executed IC-DISC isn’t taxable at the entity level. The operating company receives a deduction for the commission paid at ordinary tax rates, and the IC-DISC pays no tax.
The IC-DISC distributes all its profits as qualified dividends, and the owners pay tax on the dividends at more favorable capital gains tax rates. Depending on the owners’ personal income levels, federal capital gains tax rates could be as low as zero or 15 percent — or as high as 23.8 percent (the highest federal capital gains rate of 20 percent plus an additional 3.8 percent of net investment income tax).
To illustrate, let’s assume Widgets, Inc. (a fictional S corporation) ships $2 million of product internationally and pays $80,000 in commissions to its IC-DISC. Assuming the owners qualify for the highest capital gains tax rate of 23.8 percent, they’ll owe federal tax of $19,040 on qualified distributions from the IC-DISC. However, the owners also owe less tax on their S corporation earnings. Widgets, Inc can deduct $80,000 in commissions paid to the IC-DISC, resulting in a tax savings of $31,680, assuming the owners are in the highest federal tax bracket of 39.6 percent.
The net savings is $12,640 ($31,680 – $19,040), or 15.8 percent of the commission charge. However, it is often possible to pay a higher commission using the 50 percent of net export income calculation.
If your business has large amounts of foreign sales, this strategy might be one worth considering. Talk to your Aldrich advisor to determine whether the potential benefit outweighs the setup costs incurred.
Year-End Tax Planning Moves for Individuals
The following are strategies individuals may implement before the end of the year to potentially save money on their 2017 taxes:
Realize capital losses on stock while substantially preserving your investment position. If an individual is expecting capital gains, realizing any losses in their portfolio could be beneficial. There are several ways this can be done. For example, you can sell the original holding and then buy back the same securities at least 31 days later. It may be advisable to meet with an advisor to discuss the kinds of year-end trades you might be considering.
Postpone income until 2018 and accelerate deductions into 2017. This strategy may be especially valuable if Congress succeeds in lowering tax rates next year in exchange for slimmed-down deductions. However, regardless of what happens in Congress, this strategy could enable you to claim larger deductions, credits and other tax breaks for 2017 that are phased out over varying levels of adjusted gross income (AGI). These include child tax credits, higher education tax credits and deductions for student loan interest.
Postponing income is also desirable for taxpayers who anticipate being in a lower tax bracket next year due to changing financial circumstances. Alternatively, in some cases, it may pay to actually accelerate income into 2017. For example, this may be the case if you will have a more favorable filing status this year than next year (e.g., head of household versus individual filing status).
Consider Roth IRA conversions. Depending on your financial circumstances and tax bracket, a Roth IRA may be a more valuable retirement saving vehicle compared to a traditional IRA. A Roth conversion would allow an investor to convert money in a traditional IRA to a Roth IRA.
Completing a Roth conversion will increase your tax liability in the year of the conversion. It is important to ask yourself, “Where will I get the money to pay tax on the conversion?” Using additional funds from a traditional IRA would delete your retirement account and require additional market appreciation to recoup the value of the traditional IRA. Lastly, if you anticipate your tax rate will be lower when you plan to utilize the Roth IRA, you may want to reconsider a conversion. Paying tax today at a higher rate to convert traditional IRA assets would provide no benefit if future distributions from the account would be taxed at a lower rate.
There are a number of advantages to initiating a Roth conversion. However, there are also a number of considerations to discuss with your tax and/or financial advisor prior to completing a conversion. If you are contemplating a Roth conversion this year, we recommend you fully review all the future benefits and drawbacks before making a decision.
Defer bonuses. It may be advantageous to try to arrange with your employer to defer year-end bonuses until early 2018. This could potentially reduce your tax bill if Congress reduces tax rates beginning in 2018. Consider using a credit card to pay deductible expenses before the end of the year. Doing so will increase your 2017 deductions even if you don’t pay your credit card bill until after the end of the year.
Strategize state and local income tax payments. If you expect to owe state and local income taxes when you file your return next year, consider asking your employer to increase withholding of state and local taxes (or make estimated payments of state and local taxes) before year-end to pull the deduction into 2017. This applies if you won’t be subject to alternative minimum tax (AMT) in 2017. This strategy would be especially beneficial if Congress eliminates such deductions beginning next year.
Estimate the effect of any year-end planning moves on your AMT liability for 2017. Keep in mind that many tax breaks allowed for purposes of calculating regular taxes are disallowed for AMT purposes. These include the deduction for state property taxes on your residence, state income taxes, miscellaneous itemized deductions and personal exemption deductions. If you are subject to the AMT for 2017 or suspect you might be, these types of deductions should not be accelerated.
Consider bunching itemized deductions. You may be able to save taxes by applying a bunching strategy to pull miscellaneous itemized deductions, medical expenses and other itemized deductions into this year. This strategy would be especially beneficial if Congress eliminates such deductions beginning in 2018.
Settle insurance claims. You may want to settle an insurance or damage claim in order to maximize your casualty loss deduction this year.
Take required minimum distributions (RMDs) from your IRA, 401(k) or other employer-sponsored retirement plan. RMDs from IRAs must begin by April 1 of the year after you reach age 70½. This start date also applies to company plans, but non-five-percent company owners who continue working may defer RMDs until April 1 following the year they retire. Failure to take RMDs can result in a penalty of 50 percent of the amount of the RMD not withdrawn.
Although RMDs must begin no later than April 1 following the year in which the IRA owner attains age 70½, the first calendar year distribution is in the year in which the IRA owner reaches age 70½. Thus, if you turned age 70½ in 2017, you can delay the first RMD until 2018. If you do defer the first distribution, you will have to take a double distribution in 2018 — the amount required for 2017 plus the amount required for 2018. Think twice before delaying 2017 RMDs to 2018, as bunching income into 2018 might push you into a higher tax bracket or have a detrimental impact on various income tax deductions that are reduced at higher income levels. However, if you will be in a substantially lower bracket next year, it could be beneficial to take both distributions in 2018.
Strategize FSA contributions. Increase the amount you set aside for next year in your employer’s health flexible spending account (FSA) if you set aside too little for this year.
Strategize HSA contributions. If you become eligible in December of 2017 to make health savings account (HSA) contributions, you can make a full year’s worth of deductible HSA contributions for 2017 in December.
Strategize year-end gifting. Make gifts sheltered by the annual gift tax exclusion before the end of the year to save gift and estate taxes. The exclusion applies to gifts of up to $14,000 made in 2017 to each of an unlimited number of individuals. You can’t carry over unused exclusions from one year to the next. Such transfers may save family income taxes when an income-earning property is given to family members in lower income tax brackets who are not subject to the kiddie tax.
Be aware of hurricane relief provisions. If you were affected by Hurricanes Harvey, Irma or Maria, keep in mind that you may be entitled to special tax relief under recently passed legislation. This includes relaxed casualty loss rules and eased access to your retirement funds. In addition, qualifying charitable contributions related to relief efforts in the Hurricane Harvey, Irma or Maria disaster areas aren’t subject to the usual charitable deduction limitations.
Year-End Tax-Planning Moves for Businesses and Business Owners
Make expenditures that qualify for the business property expensing option. For tax years beginning in 2017, the expensing limit is $510,000 and the investment ceiling limit is $2,030,000. Expensing is generally available for most depreciable property (other than buildings), off-the-shelf computer software, air-conditioning and heating units, and qualified real property (which includes qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property).
This year’s generous ceiling limits make it possible for small and medium-sized businesses to deduct most, if not all, of their outlays for machinery and equipment purchases. What’s more, the expensing deduction is not prorated for the time the asset is in service during the year. The fact that the expensing deduction may be claimed in full (if you are otherwise eligible to take it), regardless of how long the property is held during the year can be a potent tool for year-end tax planning. Thus, property acquired and placed in service in the last days of 2017, rather than at the beginning of 2018, can result in a full expensing deduction for 2017.
Make expenditures that qualify for 50 percent bonus first-year depreciation. Consider buying property that qualifies for this tax break and placing it in service this year since the bonus percentage declines to 40 percent in 2018. Although potential new tax rules call for 100 percent bonus starting with purchases after September 27, 2017 through 2023. The bonus depreciation deduction is permitted without any proration based on the length of time an asset is in service during the tax year. As a result, the 50 percent first-year bonus write-off is available even if qualifying assets are in service for only a few days in 2017.
Take advantage of the “de minimis safe harbor election.” Also known as the book-tax conformity election, this enables businesses to expense the costs of lower-cost assets and materials and supplies. To qualify for the election, the cost of a unit of property can’t exceed $5,000 if the taxpayer has an applicable financial statement, or AFS (e.g., a certified audited financial statement along with an independent CPA’s report). If there’s no AFS, the cost of a unit of property can’t exceed $2,500.
Keep a close eye on tax reform. If you’re contemplating large equipment purchases, be sure to keep a close eye on the tax reform plan being considered by Congress. The current version contemplates the increased bonus depreciation for five years and a much higher yearly expensing limit. This would be a major incentive for some businesses to make large purchases of equipment in late 2017. However, in some cases, it may be worth it to wait for 2018.
Be aware of hurricane relief provisions. If your business was affected by Hurricanes Harvey, Irma or Maria, you may be entitled to an employee retention credit for eligible employees.
Defer income until 2018. A corporation should consider deferring income until 2018 if it will be in a higher tax bracket this year. This could certainly be the case if Congress succeeds in dramatically reducing the corporate tax rate beginning next year.
A corporation should also consider deferring income if doing so will preserve the corporation’s qualification for the small corporation AMT exemption for 2017. Note that there is never a reason to accelerate income for purposes of the small corporation AMT exemption. This is because if a corporation doesn’t qualify for the exemption for a given tax year, it won’t qualify for the exemption for a later tax year either.
Strategize net operating losses (NOLs). A corporation (other than a “large” corporation) that anticipates a small NOL for 2017 (and substantial net income in 2018) may find it worthwhile to accelerate just enough 2018 income (or to defer just enough 2017 deductions) to create a small amount of net income for 2017. This will permit the corporation to base its 2018 estimated tax installments on the relatively small amount of income shown on its 2017 return, rather than having to pay estimated taxes based on its much larger 2018 taxable income.
Strategize for the domestic production activities deduction (DPAD). If your business qualifies for the DPAD for the 2017 tax year, consider whether the 50 percent of W-2 wages limitation on this deduction applies. If it does, consider ways to increase 2017 W-2 income, such as paying bonuses to owner-shareholders whose compensation is allocable to domestic production gross receipts. Note that the limitation applies to amounts paid with respect to employment in the calendar year 2017, even if the business has a fiscal year. Keep in mind that the DPAD wouldn’t be available next year under the tax reform plan currently before Congress.
Tax deductible retirement plan contributions. Business owners should review their retirement plan to see if they are taking full advantage of available tax deductible contributions. Changes to improve existing retirement plans, or adopting a new plan before year end can significantly decrease taxable income.
Here are some sample maximum tax deductible contribution amounts by age:
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If specific legislation may affect you or your business and you would like to discuss, please don’t hesitate to call your Aldrich advisor. They can help you decide whether action is needed before year-end and beyond.