December 2017

The Tax Cut Suspended Many Deductions For Individuals

December 29, 2017 | By: Robert A. Green, CPA | Read it on

The Tax Cuts and Jobs Act suspended or trimmed several cherished tax deductions that individuals count on for savings. So, exactly how bad is it and what can you do about it?

The lion’s share of the $1.5-trillion tax cut goes to corporations (C-Corps). The Act lowered the corporate rate from 34% to 21%, a flat rate starting in 2018 and switched from a global income-tax regime to a territorial tax system. The Act made most C-Corp tax cuts permanent, giving multinational corporations confidence in long-term planning.

Democrats lambaste the Act because most of the individual tax cuts expire at the end of 2025. Republicans probably expect Democrats to cooperate in making the individual tax cuts permanent before the 2026 mid-term elections.

Individual changes take effect in 2018
The Act brings forth a mix of negative and positive changes for individuals. The highlights include:

  • Lower tax rates in all seven brackets to 10%, 12%, 22%, 24%, 32%, 35%, and 37%; Four tax brackets for estates and trusts: 10%, 24%, 35%, and 37%;
  • Standard deduction raised to $24,000 married, $18,000 head-of-household, and $12,000 for all other taxpayers, adjusted for inflation;
  • An expanded AMT exemption to $109,400 married and $70,300 single.
  • Many itemized deductions and AGI deductions suspended or trimmed (more on this below);
  • Personal exemptions suspended;
  • Child tax credit increased;
  • New 20% deduction for pass-through income with many limitations;
  • Pease itemized deduction limitation suspended;
  • Obamacare shared responsibility payment lowered to zero for non-compliance with the individual mandate starting in 2019;
  • Children’s income no longer taxed at the parent’s rate; kids must file tax returns to report earned income, and unearned income is subject to tax using the tax brackets for trusts and estates.

State and local taxes capped at $10,000 per year
The most contentious deduction modification is to state and local taxes (SALT). After intense deliberations, conferees capped the SALT itemized deduction at $10,000 per year. The Act allows any combination of state and local income, sales or domestic property tax. SALT may not include foreign real property taxes.

The Act prohibited a 2017 itemized deduction for the prepayment of 2018 estimated state and local income taxes. Individuals are entitled to pay and deduct 2017 state and local income taxes by year-end 2017.

The Act permits a 2017 itemized deduction for the advance payment of 2018 real property taxes, providing the city or town assessed the taxes before 2018. For example, a taxpayer could pay real property taxes before Dec. 31, 2017, and deduct it in 2017, on an assessment for the fiscal year July 1, 2017, to June 30, 2018. These IRS rules are similar for all prepaid items for cash basis taxpayers. (See IRS Advisory: Prepaid Real Property Taxes May Be Deductible in 2017 if Assessed and Paid in 2017.)

Consider that SALT is an AMT preference item; it’s not deductible for AMT taxable income.  Many upper-income and middle-income individuals fall into the AMT zone, so they don’t get a full SALT deduction. The Pease itemized deduction limitation also trimmed the SALT deduction for 2017 and prior years.

Many business owners deduct home-office expenses (HO), which include a portion of real property taxes and that allocation is not subject to the $10,000 SALT limit, and the home office deduction is not an AMT preference item. Here’s a tip: Report 100% of real property taxes on home office form 8829, to maximize the HO deduction. Deduct state and local income taxes, and the remainder of real property taxes, to reach the $10,000 SALT limit on Schedule A. When you factor in a more substantial standard deduction for 2018, many individuals may not lose as much of their SALT deduction as they fear. With lower individual tax rates, they might still end up with an overall tax cut.

The Act does not permit a pass-through business owner to allocate SALT to the business tax return. For example, an S-Corp cannot reimburse its owner for his or her individual state and local income taxes paid in connection with that pass-through income.

SALT is still allowed as a deduction from net investment income for calculating the 3.8% Obamacare net investment tax.

High-tax states are fighting back against the SALT cap. State and local jurisdictions are setting up 501(c)(3) charitable organizations to fund state and local social costs, including public schools. Residents would make charitable contributions to the state 501(c)(3) and receive credit for real property and or state income taxes. This type of restructuring would convert non-deductible SALT payments into tax-deductible charitable contributions. It will be difficult to arrange, and the IRS may object, so don’t hold your breath. High-tax states have significant transfer payments to people in need, and it seems appropriate to consider it charity.

Medical expenses modified
The Act retained the medical-expense itemized deduction, which is allowed if it’s more than the AGI threshold. In 2017, the AGI threshold was 10% for taxpayers under age 65, and 7.5% for age 65 or older. The Act uses a 7.5% AGI threshold for all taxpayers in 2018, and a 10% threshold for all taxpayers starting in 2019. Medical expenses are an AMT preference item.

Mortgage debt lowered on new loans
As of Dec. 15, 2017, new acquisition indebtedness is limited to $750,000 ($375,000 in the case of married taxpayers filing separately), down from $1 million, on a primary residence and second home. Mortgage debt incurred before Dec. 15, 2017 is subject to the grandfathered $1 million limit ($500,000 in the case of married taxpayers filing separately). If a taxpayer has a binding written contract to purchase a home before Dec. 15, 2017 and to close by Jan. 1, 2018, he or she is grandfathered under the previous limit. Refinancing debt from before Dec. 15, 2017 keeps the grandfathered limit providing the mortgage is not increased.

The conference report “suspends the deduction for interest on home equity indebtedness” starting in 2018. (IRS news release IR-2018-32, Feb. 21, 2018, Interest on Home Equity Loans Often Still Deductible Under New Law. If you stay within the $750,000 new acquisition indebtedness, and home equity loan funds are used to improve the home it’s borrowed on, then the home equity interest is deductible. Conversely, if you use the HELOC funds for other purposes, it’s not deductible.)

As with SALT, the home office mortgage interest deduction is not subject to Schedule A limits. IRS instructions for home office Form 8829 state, “If the amount of home mortgage interest or qualified mortgage insurance premiums you deduct on Schedule A is limited, enter the part of the excess that qualifies as a direct or indirect expense. Do not include mortgage interest on a loan that did not benefit your home (explained earlier).”

Investment expenses suspended
The Act has many provisions impacting investors, including suspension of miscellaneous itemized deductions, which include investment expenses, starting in 2018. The Act did not repeal investment interest expense. (See The Tax Cut Impacts Investors In Negative And Positive Ways.)

Investment expenses are still allowed as a deduction from net investment income for calculating the 3.8% Obamacare net investment tax. Retirement plans, including IRAs, are also entitled to deduct investment expenses, although it may be difficult to arrange with the custodian.

Unreimbursed employee business expenses suspended
The Act suspends unreimbursed employee business expenses deducted on Form 2106. Speak with your employer about implementing an accountable reimbursement plan and “use it or lose it” before year-end 2018. See a list of these items below.

Tax preparation and planning fees suspended
Miscellaneous itemized deductions include tax compliance (planning and preparation) fees. If you operate a business, ask your accountant to break down their invoices into individual vs. business costs. The business portion is allowed as a business expense.

Miscellaneous itemized deductions suspended
See the complete list of suspended miscellaneous itemized deductions in the Joint Explanatory Statement p. 95-98. Here are the highlights.

Expenses for the production or collection of income:

  • Clerical help and office rent in caring for investments;
  • Depreciation on home computers used for investments;
  • Fees to collect interest and dividends;
  • Indirect miscellaneous deductions from pass-through entities;
  • Investment fees and expenses;
  • Loss on deposits in an insolvent or bankrupt financial institution;
  • Loss on traditional IRAs or Roth IRAs, when all amounts have been distributed;
  • Trustee’s fees for an IRA, if separately billed and paid.

Unreimbursed expenses attributable to the trade or business of being an employee:

  • Business bad debt of an employee;
  • Business liability insurance premiums;
  • Damages paid to a former employer for breach of an employment contract;
  • Depreciation on a computer a taxpayer’s employer requires him to use in his work;
  • Dues to professional societies;
  • Educator expenses;
  • Home office or part of a taxpayer’s home used regularly and exclusively in the taxpayer’s work;
  • Job search expenses in the taxpayer’s present occupation;
  • Legal fees related to the taxpayer’s job;
  • Licenses and regulatory fees;
  • Malpractice insurance premiums;
  • Medical examinations required by an employer;

Occupational taxes;

  • Research expenses of a college professor;
  • Subscriptions to professional journals and trade magazines related to the taxpayer’s work;
  • Tools and supplies used in the taxpayer’s work;
  • Purchase of travel, transportation, meals, entertainment, gifts, and local lodging related to the taxpayer’s work;
  • Union dues and expenses;
  • Work clothes and uniforms if required and not suitable for everyday use; and
  • Work-related education.

Other miscellaneous itemized deductions subject to the 2% floor include:

  • The share of deductible investment expenses from pass-through entities.

Personal casualty and theft losses suspended
The Act suspends the personal casualty and theft loss itemized deduction, except for losses incurred in a federally declared disaster. If a taxpayer has a personal casualty gains, he or she may apply the loss against the gain.

Gambling loss limitation modified
The Act added professional gambling expenses to gambling losses in applying the limit against gambling winnings. Professional gamblers may no longer deduct expenses more than net winnings.

Charitable contribution deduction limitation increased
The Act raised the 50% limitation for cash contributions to public charities, and certain private foundations to 60%. Excess contributions can be carried forward for five years.

The Act retained charitable contributions as an itemized deduction. But, with the suspension of SALT over the $10,000 cap, and all miscellaneous itemized deductions, many taxpayers are expected not to itemize. Some taxpayers won’t feel the deduction effect from making charitable contributions. Consider a bunching strategy, to double up on charity one year to itemize, and contribute less the next year to use the standard deduction. Another bunching strategy is to set up a charitable trust like at Fidelity.

Alimony deduction suspended
The Act suspends alimony deductions for divorce or separation agreements executed in 2019, and the recipient does not have taxable income.

Moving expenses suspended
The Act suspends the AGI deduction for moving expenses, and employees may no longer exclude moving expense reimbursements, either. “Except for members of the Armed Forces on active duty who move pursuant to a military order and incident to a permanent change of station.”

Expanded use of 529 account funds
The Act significantly expands the permitted use of Section 529 education savings account funds. “Qualified higher education expenses” include tuition at an elementary or secondary public, private, or religious school.

There are many other changes, but they are not in the mainstream.

Consider a consultation with Green Trader Tax to discuss the impact of the “Tax Cut And Jobs Act” on your investment activities.

Learn more about the new law and tax strategies for investors, traders and investment managers in Green’s 2018 Trader Tax Guide.


The Tax Cut Impacts Investors In Negative And Positive Ways

December 27, 2017 | By: Robert A. Green, CPA | Read it on

The Tax Cut and Jobs Act impacts investors in many ways, some negative and others positive. Investors with significant investment expenses will decry the suspension of that miscellaneous itemized deduction. Investors in pass-through entities may be surprised they might be entitled to a 20% deduction on qualified business income. These changes under the new law take effect in 2018.

Investment expenses suspended
The new law suspends “all miscellaneous itemized deductions that are subject to the two-percent floor under present law.” These include investment expenses, unreimbursed employee business expenses and tax compliance fees for non-business taxpayers. Miscellaneous itemized deductions are an AMT preference for 2017.

Investment expenses include trading expenses when the trader is not eligible for trader tax status (TTS), stock borrow fees and related costs for short sellers without TTS, and investment advisory fees and expenses paid to investment managers. TTS traders have business expense treatment, so qualification for that status is essential in 2018.

Investment expenses are still allowed as a deduction from net investment income for calculating the 3.8% Obamacare net investment tax. Retirement plans, including IRAs, are also entitled to deduct investment expenses, although it may be difficult to arrange with the custodian.

Family offices
A family office (FO) refers to a wealthy family with substantial investments, across multiple asset classes. The FO hires staff, leases office space, and purchases computers and other fixed assets for its investment operations. An FO produces investment income, and the majority of its operating costs are investment expenses. Losing the investment expense deduction comes as a shock to them. Some FOs are evaluating which activities might qualify for business expense treatment to convert non-deductible investment expenses into business deductions from gross income. Some FOs investing in securities and Section 1256 contracts might ring-fence an active trading program into a separate TTS entity for business expenses. Some of them are not natural TTS traders so that it will be a challenge. Other FOs invest in rental real estate and venture capital, which might have business expense treatment. The goal is to allocate general and administrative expenses to business expenses.

Investment interest expenses retained
The present law remains in effect for itemizing investment interest expense. Investment interest expense is deductible up to the extent of investment income. The excess is carried over to the subsequent tax year. (See Form 4952 and instructions.)

Short sellers
If a short seller does not qualify for TTS, the stock borrow fees are considered investment expenses. (Some brokers use the term “interest charges” — in reality,  these expenses are stock borrow fees. See Short Selling: How To Deduct Stock Borrow Fees.)

Interest expense modified
TTS traders have business interest deductions for margin interest on TTS trading positions. According to the new law, “The conference agreement follows the House in exempting from the limitation taxpayers with average annual gross receipts for the three-taxable year period ending with the prior taxable year that do not exceed $25 million.” A TTS trading company will likely not trigger the 30% income limitation on business interest expenses.

Carried interest modified
The new law changed the carried interest tax break for investment managers in investment partnerships, lengthening their holding period on profit allocation of long-term capital gains (LTCG) to three years from one year. If the manager also invests capital in the investment partnership, he or she has LTCG after one year on that interest. The three-year rule only applies to the investment manager’s profit allocation — carried interest. Investors still have LTCG based on one year. Investment partnerships include hedge funds, commodity pools, private equity funds and real estate partnerships. Many hedge funds don’t hold securities more than three years, whereas, private equity, real estate partnerships and venture capital funds do.

Investors also benefit from carried interest in investment partnerships. Had the new tax law repealed carried interest outright, investment partnerships without TTS would be stuck passing investment advisory fees (incentive fees) through on Schedule K-1 as non-deductible investment expenses. Carried interest fixes that: The partnership allocates capital gains to the investment manager instead of paying incentive fees. The investor winds up with a lower capital gain amount vs. a higher capital gain coupled with a non-deductible expense. For example, if the investor’s share of net income is $8,000, he or she is happy to report $8,000 as a net capital gain. Without carried interest, the investor would have a $10,000 capital gain and have a $2,000 (20%) non-deductible investment expense.

FIFO is not required
Senate and House conferees canceled the last minute and controversial proposal to require investors to use First-In-First-Out (FIFO) accounting on the sale of securities. FIFO is the default method, but sellers of securities may also use “specific identification.” Investors are entitled to cherry-pick securities positions they sell for capital gains. For example, if an investor sells a portion of Apple shares, he or she may select lots with higher cost basis to realize a lower capital gain. The specific identification method requires a contemporaneously written instruction to the broker and a written confirmation of that execution by the broker. Many taxpayers don’t comply with these rules. For sales of financial products other than securities (such as cryptocurrency), specific identification may not be possible.

Long-term capital gains rates retained
The new tax law maintains the LTCG rates of 0%, 15%, and 20%, and the capital gains brackets are the same for 2017 and 2018. LTCG rates apply if an investor holds a security for more than12 months before sale or exchange. The new law did not change the small $3,000 capital loss limitation against other income, or capital loss carryovers to subsequent tax years. The new law also retains LTCG rates on qualified dividends.

Section 1256 60/40 capital gains rates retained
The 60/40 capital gains rates on Section 1256 contracts are intact, and the new law did not mention any changes to the Section 1256 loss carryback election. At the maximum tax bracket for 2018, the blended 60/40 rate is 26.8% — 10.2% lower than the top ordinary rate of 37%. 

Wash sale loss rules and Section 475
The new law did not fix wash sale loss rules for securities in Section 1091. For more on this lingering issue, see Don’t Solely Rely On 1099-Bs For Wash Sale Loss Adjustments.

The new law does not make any changes to Section 475 MTM ordinary income or loss. It does not change tax treatment for various financial products including spot forex in Section 988, ETFs, ETNs, volatility options, precious metals, swap contracts, foreign futures and more.

Section 1031 like-kind exchanges restricted to real property
The new law limits Section 1031 like-kind exchanges to real property, not for sale. Investors may no longer use Section 1031 to defer income recognition on exchanges in artwork, collectibles, and other tangible and intangible property. Cryptocurrency (coin) is intangible property.

Before 2018, some tax experts indicated it might be possible to defer capital gains and losses on coin-to-coin exchanges as Section 1031 like-kind exchanges. The IRS never said Section 1031 could be used on coin-to-coin trades, and I don’t think it applied to coin-to-coin trading on coin exchanges. I don’t think coin exchanges meet the Section 1031 requirement to act as a qualified intermediary in a multi-party exchange. (See Cryptocurrency Traders Owe Massive Taxes For 2017.)

20% QBI deduction on pass-through entities
The new tax law states, “An individual taxpayer generally may deduct 20 percent of qualified business income from a partnership, S-corporation, or sole proprietorship, as well as 20 percent of aggregate qualified REIT dividends, qualified cooperative dividends, and qualified publicly traded partnership income. Special rules apply to specified agricultural or horticultural cooperatives. A limitation based on W-2 wages paid is phased in above a threshold amount of taxable income. A disallowance of the deduction with respect to specified service trades or businesses is also phased-in above the threshold amount of taxable income.”

The threshold is $315,000 (married) and $157,500 (other taxpayers), and the phase-out range is $100,000 (married) and $50,000 (other taxpayers).

As an example, a securities hedge fund eligible for TTS with Section 475 ordinary income may have qualified business income (QBI), and the hedge fund is likely a specified service activity (SSA). If a non-active limited partner has taxable income under $315,000 (married) or $157,500 (other taxpayers), he or she might get a 20% deduction on the partnership share of QBI or taxable income less net capital gains (whichever is lower). In the $100,000/$50,000 phase-out range above the income threshold, the QBI deduction phase-out. Some investors may exceed the phase-out, and not qualify for the deduction, but others may have lower income and be eligible for the deduction.

A passive investor in a non-SSA might be eligible for the 20% deduction above the income threshold, subject to a 50% wage limitation, or alternative 25% wage limitation plus 2.5% of the qualified property. The 20% deduction on pass-through entities applies to active, non-active and passive owners without distinction. (Learn more about the 20% pass-through deduction on my blog post How Traders Can Get The 20% QBI Deduction Under New Law.)

Obamacare net investment tax retained
The new law retained the Obamacare net investment tax (NIT) of 3.8% on net investment income (NII) over modified AGI of $200,000 single and $250,000 married, not indexed for inflation.

The Act suspends investment expenses as a miscellaneous itemized deduction on Schedule A, but it does not interrupt investment expenses for NII. Form 8960 Part II “Investment Expenses Allocable to Investment Income and Modifications” includes miscellaneous investment expenses, investment interest expenses, and state, local and foreign income taxes. The new law capped state and local income taxes on Schedule A at $10,000 per year, but there is no cap for these expenses on Form 8960. Continue to keep track of these costs.

Ordinary tax rates reduced
The new law lowered tax rates on ordinary income for individuals for almost all tax brackets and filing status. It decreased the top rate to 37% in 2018 from 39.6% in 2017. Short-term capital gains are taxed at ordinary rates, so investors receive this benefit.

Repeal of the recharacterization option for Roth IRA conversions
If a 2017 converted Roth account drops significantly in value in 2018, a taxpayer can reverse the Roth conversion with a “recharacterization” by the due date of the tax return including extensions (Oct. 15, 2018). That’s the last year to do a reversal. The new law repeals this recharacterization option starting in 2018.

Temporary tax cuts for individuals
The individual tax cuts are temporary through 2025, which applies to most provisions, including the suspension of investment expenses. Republicans probably expect Democrats to extend, or make permanent, the individual tax cuts before the 2026 midterm election year. President Barrack Obama made the President George W. Bush’s 10-year tax cuts permanent for all individuals, other than the upper 2%, in the fiscal cliff at the end of 2012. In 2010, Obama extended all Bush tax cuts to 2012.

Republicans in Congress forged the new tax law in haste. A technical corrections bill is already in the works, and Republicans may need Democrats to pass it through regular order. There will be surprises from the IRS in their regulations and guidance, too. Tax planning is difficult until all these issues become settled.

Consider a consultation with Green Trader Tax to discuss the impact of the “Tax Cut And Jobs Act” on your investment activities.

Learn more about the new law and tax strategies for investors, traders and investment managers in Green’s 2018 Trader Tax Guide.

 


Traders Should Be Entitled To The Pass-Through Tax Deduction

December 20, 2017 | By: Robert A. Green, CPA

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Congress passed the “Tax Cut and Jobs Act” (Act) on Dec. 20, and the President signed it into law on Dec. 22, 2017. The new law adopted the Senate Amendment for the 20% pass-through deduction, but it’s not clear how a trading company can use it. Traders should consider other smart moves as the Act suspended investment expenses, retained investment interest expense, and repealed NOL carrybacks.

Changes to pass through rules
The Conference Report (CR) decided on a 20% pass-through deduction vs. the Senate Amendment’s 23%. To meet the House halfway, the CR lowered the Senate’s taxable income (TI) threshold for “specified service activities” (SSA) to $157,500 single and $315,000 married. The CR retained the Senate phase-out range of $50,000 single and $100,000 married, above the TI threshold. For example, if an individual’s TI is over $207,500 single or $415,000 married, he or she won’t get any pass-through deduction on domestic “qualified business income” (QBI) in an SSA. But, individuals are entitled to a 20% deduction for QBI in a non-SSA at higher income levels, subject to the 50%-wage limitation above the threshold. (See examples in the Joint Explanatory Statement, p. 28-37.) The CR added an alternative wage limitation: 25% of wages plus 2.5% of “unadjusted basis, immediately after acquisition, of all qualified property,” which includes real estate and other tangible property. The House bill had a capital factor, which recognized investment in equipment.

I still have a few critical questions about the new law’s impact on TTS trading companies and TTS hedge funds.

1. Are TTS trading companies and TTS hedge funds an SSA?

In earlier posts, I thought a trading company was likely an SSA because “trading” is mentioned in the SSA definition.

The Joint Explanatory Statement definition of an SSA: “A specified service trade or business means any trade or business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities. For this purpose a security and a commodity have the meanings provided in the rules for the mark-to-market accounting method for dealers in securities (sections 475(c)(2) and 475(e)(2), respectively).”

I wonder if the following part of the SSA definition applies to a hedge fund: “the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.” A one-person TTS trading company does not market to investors, so they don’t have a reputation or brand intangible asset, and this part of the definition should not apply to them.

A management company provides the performance of investing, investment management and trading services to a hedge fund. The hedge fund is the customer in receipt of those services. A management company is a general partner of the hedge fund organized as a limited partnership, and the general partner can bring TTS to the hedge fund level. An outside manager would not suffice for the hedge fund achieving TTS.

The Act’s definition of SSA is a bit different, p. 33-34 states: ‘‘(2) SPECIFIED SERVICE TRADE OR BUSINESS.—The term ‘specified service trade or business’ means any trade or business— (A) which is described in section 1202(e)(3)(A) (applied without regard to the words ‘engineering, architecture,’) or which would be so described if the term ‘employees or owners’ were substituted for ‘employees’ there in, or (B) which involves the performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)).”

The “specified service activity” term and definition stress the “performance of services” listing various types of service providers. A one-person TTS S-Corp trades for its account; it does not perform trading services for customers.

Even if a hedge fund is considered a non-SSA, an active or non-active owner is unlikely to achieve a 20% pass-through deduction due to the 50% wage limitation, or the alternative 25% wage limitation plus 2.5% of the unadjusted qualified property. Hedge funds don’t pay wages, and they don’t own significant qualified property. The management company pays compensation and has business equipment; not the hedge fund.

If the IRS considers a TTS S-Corp a non-SSA, there would likely be a 20% pass-through deduction above the SSA income threshold. The TTS S-Corp pays officer compensation of $146,000 to maximize a Solo 401(k) contribution of $55,000 (under age 50, 2018 limit). The 50% wage limitation would be $73,000 (50% of $146,000). $73,000 divided by the 20% deduction is net income of $365,000 in the TTS S-Corp. A spouse might also receive compensation. The Act requires a taxpayer to calculate QBI and the wage limitations on each interest in a pass-through entity, separately.

2. Can TTS trading income, including Section 475 ordinary income, be treated as “qualified business income” (QBI)?

The pass-through deduction formula is very complicated. In rough summary, it’s a 20% pass-through deduction calculated on the lower of combined QBI from domestic sources or taxable income less net capital gains. (See the Joint Explanatory Statement, p. 28-40.)

The QBI exclusion list does not mention Section 475 ordinary income, so it seems appropriate to include it in QBI. Only a TTS trader may elect Section 475. I covered this issue in my blog post Section 475 Traders May Be Eligible For Pass-Through Tax CutsSteven Rosenthal, Senior Fellow, Urban-Brookings Tax Policy Center, weighed in then, and I confirmed this with him again after enactment of the Act: “Section 475 treats the gain as ordinary income,” he says. “Section 64 provides that gain that is ordinary income shall not be treated as gain from the sale of a capital asset.” Mr. Rosenthal thinks Section 475 ordinary income is QBI under the Act for this reason and “because it’s not on the QBI exclusion list.”

QBI should also include ordinary income on a rental real estate activity. The media quoted several tax experts saying rental companies should benefit from the pass-through deduction, which means they consider rental income to be QBI. Those tax experts implied rental real estate companies are likely non-SSA and the 2.5% qualified property factor will lead to more active and passive owners being eligible for the 20% pass-through deduction.

If investors in the rental real estate activity can achieve the pass-through deduction on a non-SSA, then TTS traders with Section 475 should have non-SSA with QBI treatment, too. One company invests in real estate, the other in securities, and both have ordinary income. Neither entity performs services for clients.

The CR used the Senate Amendment’s definition of “Treatment of investment income” — the QBI exclusion list (full list included below). The Senate Amendment and CR deleted “short-term capital gains” (STCG) from (1), but left “long-term capital gains and losses.” Oddly, the Act itself left in STCG to (1). Rushing may have led to errors.

The CR states an exclusion of “investment-related” items.  A TTS trader or TTS hedge fund has “business-related” activity. I wonder if this could open the door to a TTS trader or TTS hedge fund having QBI on short-term capital gains that are business related. Perhaps, business-related Section 1256 capital gains with 60/40 rates should be included in QBI, too. There is a 60% long-term capital gain portion, but it’s not “long-term capital gains” that are “investment-related.”

The 20% deduction is on the lower of QBI or modified taxable income less net capital gains. For example, if a trader has QBI consisting of all business-related capital gains, and it’s his only TI, then he won’t get a deduction since modified TI less net capital gains might be zero. If the trader has significant other income, it could be different.

It’s much better for a TTS trader to elect Section 475 to have ordinary income: It’s safer to assume QBI includes Section 475 and that modified TI does not subtract Section 475 ordinary income.

See the definition (5) below. Forex trading is “directly related to the business needs of the business activity.” Some forex traders might want to retain Section 988 ordinary income treatment rather than file a contemporaneous capital gains election.

CR “Treatment of investment income: Qualified items do not include specified investment-related income, deductions, or loss. Specifically, qualified items of income, gain, deduction and loss do not include (1) any item taken into account in determining net long-term capital gain or net long-term capital loss, (2) dividends, income equivalent to a dividend, or payments in lieu of dividends, (3) interest income other than that which is properly allocable to a trade or business, (4) the excess of gain over loss from commodities transactions, other than those entered into in the normal course of the trade or business or with respect to stock in trade or property held primarily for sale to customers in the ordinary course of the trade or business, property used in the trade or business, or supplies regularly used or consumed in the trade or business, (5) the excess of foreign currency gains over foreign currency losses from section 988 transactions, other than transactions directly related to the business needs of the business activity, (6) net income from notional principal contracts, other than clearly identified hedging transactions that are treated as ordinary (i.e., not treated as capital assets), and (7) any amount received from an annuity that is not used in the trade or business of the business activity. Qualified items under this provision do not include any item of deduction or loss properly allocable to such income.” 

How to proceed
For 2018, trader tax status (TTS) traders should consider a partnership or S-Corp for business expenses, and a Section 475 election on securities for exemption from wash sale losses and ordinary loss treatment (tax loss insurance). Consider a TTS S-Corp for employee benefit plan deductions including health insurance and a high-deductible retirement plan, since a TTS spousal partnership or TTS sole proprietor cannot achieve employee benefit deductions. Consider this the cake. It puts you in position for potentially qualifying for a 20% QBI-deduction on Section 475 ordinary income in a TTS trading pass-through entity – icing on the cake. If a TTS trader’s taxable income is under the specified service activity (SSA) threshold of $315,000 married, and $157,500 other taxpayers, he or she might get the 20% QBI-deduction in partnerships or S-Corps. QBI includes Section 475 ordinary income, and it excludes capital gains. It might be a challenge for a TTS sole proprietor to claim the pass-through deduction, because Schedule C has trading expenses, only, and trading gains are on other tax forms. Trading in a C-Corp could be costly.

If you are interested in this 20% deduction for a trading or non-trading business, I suggest a  consultation with me soon.


How To Setup The Best Trading Entity For Tax Cuts

December 2, 2017 | By: Robert A. Green, CPA

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Forbes

Read it on Forbes.

Update Dec. 22, 2017: The “Tax Cut and Jobs Act” (Act) is law, and as expected, the Conference Agreement (CA) adopted the Senate Amendment on the QBI deduction on pass-throughs. It reduced the rate to 20% from 23%. To meet the House part-way, it lowered the taxable income threshold to $157,500 single and $315,000 married, for the “specified service activity” (SSA) and wages limitations.  The CA retained the Senate’s phase-out ranges above the threshold of $50,000 single and $100,000 married. If an individual’s taxable income is over $207,500 single or $415,000 married, he or she won’t get a pass-through deduction on an SSA. But, they might get a deduction on a non-SSA, subject to the wages limitations. The CA added an alternative to the 50% wage limitation: 25% of wages plus 2.5% of “unadjusted basis, immediately after acquisition, of all qualified property.” The House bill had a capital percentage, so contrary to media reports, a capital factor did not come from out of the blue. In the CA on pages 28 – 37, there are examples for how the phase-out range works. The CA raised the C-Corp flat tax rate to 21%, and it adopted the House commencement date in 2018.  

The Senate passed their “Tax Cuts And Jobs Act” bill on Dec. 2, after making last-minute concessions to holdout Republican senators. One significant change was increasing the pass-through deduction to 23% from 17.4%. Many service businesses, including traders, may qualify for the deduction if their taxable income is under an upper-income threshold. Conferencing the Senate and House bills should commence next week and that may be difficult for this provision since the House 25% pass-through rate is entirely different from the Senate 23% pass-through deduction. I hope the Senate provision prevails and the House accepts it. In this article, I’m offering preliminary advice — stay tuned for updates if and when Congress passes final legislation.

I envision most TTS traders continuing to use an S-Corp for 2018 to unlock employee-benefit plan deductions – it’s the cake. They may qualify for the 23% pass-through deduction if their taxable income is under the upper-income threshold, which would be icing on the cake. A high-income trader living in a corporate-tax-free state, who does not expect to qualify for the pass-through deduction, should consider a C-Corp when the 20% flat tax rate applies. The Senate bill delays the 20% corporate rate by one-year to 2019, whereas, the House bill commences its 20% corporate rate in 2018.

Form a single-member LLC and select entity type afterward
Traders planning to be eligible for trader tax status (TTS) in 2018, who want an entity, can form a single-member LLC this month and remain a “disregarded entity” for 2017, so there is no 2017 LLC tax return. On Jan. 1, 2018, admit a spouse for a partnership tax return, and/or file an S-Corp election by March 15, 2018, or choose to be taxed as a C-Corp. That plan provides time to make the best assessment of your tax situation and planning, and it facilitates account openings in time for trading on Jan. 1. If you commence trading in 2018 in an individual account, and later switch to a partnership, S-Corp or C-Corp, it will complicate 2018 tax compliance.

The C-Corp 20% rate
In the Senate’s bill, C-Corps benefit from a 20% flat tax rate vs. individual rates up to 38.5%, plus 3.8% Obamacare net investment tax (NIT). (The House bill’s top individual tax rate is 39.6%.) The maximum difference could be a whopping 22.3% in federal tax rates. Several tax pundits have suggested that many pass-through entities would likely switch to a C-Corp.

The 20% corporate flat tax rate is not as good as it seems at first look. The average individual tax rate is 30% for high-income taxpayers just entering the top tax bracket, and with the inclusion of the 3.8% NIT, the actual difference is 14%. Double taxation on the federal level can wipe out that savings with a 15% or 20% capital gains tax on “qualified dividends” plus 3.8% NIT. Double taxation on the state level can lead to a C-Corp owner paying higher taxes than with a pass-through entity. Forty-four states have a corporate income tax, and states treat qualified dividends as ordinary income. There are also potential 20% accumulated earnings taxes and 20% personal holding company tax penalties. Look before you leap into a C-Corp and consult a trader tax expert.

Pass-through tax cuts
The Senate bill provisions for pass-through entities have many limitations, especially for service businesses. The definition of a “specified service activity” includes trading. Qualified business income (QBI) includes Section 475 ordinary income, and it excludes capital gains from investments. It is questionable whether QBI excludes business-related capital gains for a TTS futures or securities trader, not electing Section 475 ordinary income. That answer may not be apparent until the IRS issues regulations. In the Senate bill, a pass-through service business owner is eligible for the 23% deduction on QBI, providing his or her taxable income is under the threshold of $500,000 married and $250,000 other taxpayers. It phases-out up to $600,000 married and $300,000 other taxpayers. Non-service businesses do not have the income threshold. (See Senate’s Five Haircuts On The Tax Deduction For Pass-Through Entities and Section 475 Traders May Be Eligible For Pass-Through Tax Cuts.)

The House bill also restricts specified service activities, including trading. It allows active owners of service businesses to use the 11% pass-through tax rate vs. the 12% ordinary bracket for 2018, on the first $75,000 of business income, for taxable income under $150,000 married and $75,000 other taxpayers. There is a phase-out range up to $225,000 married and $112,500 other taxpayers. Active owners of a service business can qualify for the maximum 25% pass-through tax rate if the business has an “alternative capital percentage” of 10% from a significant investment in business equipment (and perhaps “internal-use software”). Many traders won’t achieve a 10% alternative capital percentage, so they may not get any of the 25% rate benefit under the House bill.

C-Corp double taxation with qualified dividends
A C-Corp pays taxes first on the entity level, and the owners owe taxes a second time on the individual level on dividends and capital gains. The House bill has a 20% flat tax rate on C-Corps and a 25% flat tax rate on “personal service corporations.” The Senate just has one 20% flat tax rate.

When C-Corps make a cash or property distribution to owners, it’s a taxable dividend if there are “earnings and profits” (E&P). If the individual holds the stock for 60 days, it’s a “qualified dividend,” subject to lower long-term capital gains rates of 0%, 15%, and 20%. A high-income trader will likely pay the 15%, or 20% rates, plus Obamacare 3.8% NIT on unearned income over the modified AGI threshold. This dividends tax and NIT may offset the 14% difference in individual vs. corporate tax rates.

Accumulated earnings tax
If the C-Corp does not pay dividends from E&P, the IRS can assess a 20% “accumulated earnings tax” (AET) if the C-Corp E&P exceeds a threshold and company management cannot justify a business need for retaining E&P. The IRS is trying to incentivize C-Corps to pay dividends to owners. The IRS AET threshold is $250,000, or $150,000 for a personal service corporation.

As stated in Section 533 – Evidence of purpose to avoid income tax:
“(a) Unreasonable accumulation determinative of purpose
For purposes of section 532 (Corporations subject to accumulated earnings tax), the fact that the earnings and profits of a corporation are permitted to accumulate beyond the reasonable needs of the business shall be determinative of the purpose to avoid the income tax with respect to shareholders, unless the corporation by the preponderance of the evidence shall prove to the contrary.

“(b) Holding or investment company
The fact that any corporation is a mere holding or investment company shall be prima facie evidence of the purpose to avoid the income tax with respect to shareholders.”

If the IRS treats a TTS trading company as an “investment company,” then it may assess 20% AET on all E&P and therefore undermine the C-Corp strategy for traders. But I don’t think a TTS trading company is an investment company. Perhaps, a TTS trading C-Corp can demonstrate it has a business need for E&P above the threshold.

Officer compensation avoids double taxation
Historically, C-Corps paid higher officer compensation to avoid the 35% C-Corp tax rate. But now, C-Corps may want the 20% C-Corp tax rate over the individual tax rates of 35%, and 38.5% on wage income instead.

State double taxation can ruin the C-Corp strategy
If you live in a high tax state for corporate and individual taxes, the C-Corp may be the wrong choice of entity. According to Tax Foundation, “Forty-four states levy a corporate income tax. Rates range from 3 percent in North Carolina to 12 percent in Iowa.” (See the Tax Foundation map, State Corporate Income Tax Rates and Brackets for 2017.)

States don’t use lower capital gains rates; they treat qualified dividends as ordinary income. The Senate and House bills repeal state and local income tax deductions for individuals.

A C-Corp is a wrong choice for a trader entity in California with an 8.84% corporate tax rate, but it could be the right choice for a high-income trader in Texas without corporate taxes. The Texas 0.75% franchise tax applies to all types of companies with limited liability, including LLCs, and C-Corps, and the “No Tax Due Threshold” is $1.11 million. Most traders won’t trigger the Texas franchise tax.

Don’t try to avoid filing a C-Corp tax return in your resident state. You are entitled to form your entity in a tax-free state, like Delaware, but your home state probably requires registration of a “foreign entity,” if it operates in your state. Setting up a mail forwarding service in a tax-free state does not achieve nexus, whereas, conducting a trading business from your resident state does.

C-Corp Cons
1. No lower 60/40 capital gains tax rates on Section 1256 contracts.
2. Ordinary losses do not pass-through to the owner’s tax return, missing an opportunity for immediate tax savings against other income. The Senate bill has an excess business loss limitation of $250,000 single, and $500,000 married, and it repeals the NOL carryback. (See How The Senate Tax Bill Disallows Excess Business Losses In Pass-Throughs.)
3. A C-Corp investment company without trader tax status may not deduct investment expenses.
4. If you liquidate a C-Corp to realize the capital loss and ordinary loss trapped inside it, you might qualify for Section 1244 ordinary loss treatment up to $50,000 single, or $100,000 married, with the remainder of the loss treated as a capital loss. That means you could be stuck with a capital loss carryover. Per Section 1244, “a corporation shall be treated as a small business corporation if the aggregate amount of money and other property received by the corporation for stock, as a contribution to capital, and as paid-in surplus, does not exceed $1,000,000.”

S-Corps work well for TTS traders
For 2017 and subsequent years, TTS traders can arrange to deduct health insurance and retirement plan contributions in an S-Corp. The 2017 maximum Solo 401(k) retirement plan deduction is $54,000 or $60,000 if age 50 or older. For 2018, the IRS raised the limit by $1,000. Health insurance premiums for a family could easily be $20,000 per year. Sole proprietor traders and spousal-partnership traders cannot have these employee-benefit deductions.

The Senate and House bills bring potential additional benefits for TTS traders, starting in 2018. As a specified service activity, a TTS trader may qualify for the Senate’s pass-through deduction or the House’s pass-through tax rates.

There is no double-taxation with an S-Corp, except for minor S-Corp taxes in a few states: California has a 1.5% franchise tax, Illinois has a 1.5% replacement tax, and New York City treats S-Corps like a C-Corp. In those jurisdictions, high-income TTS traders use a dual entity solution: A trading partnership and S-Corp or C-Corp management company to limit S-Corp entity-level taxation.

If there are business losses from business expenses and Section 475 trading losses, using a pass-through structure will offset other income, and possibly generate a net operating loss (NOL) carry forward. (The Senate and House bills repeal NOL carrybacks.)

If the TTS trader does not need employee-benefit plan deductions, they may trade in an LLC filing a partnership return or a general partnership. A partnership return qualifies for pass-through tax cuts. Sole proprietor traders may have difficulty claiming tax cuts since it deducts business expenses on Schedule C and reports trading gains on other tax forms.

When should a TTS trader consider a C-Corp?
If you are a high-income trader in a corporate-tax-free state and don’t qualify for pass-through tax cuts, the C-Corp’s 20% rate may be attractive. But, the Senate bill delayed the 20% rate until 2019. The House commences its 20% corporate rate in 2018. (See the Nancy White example below.)

New solutions
There will be opportunities for tax advisers to conceive other ideas based on final legislation and its anti-abuse provisions. For example, a trading company is a “specified service activity” with limits on pass-through tax cuts, but a second entity set-up to receive royalties for licensing trading systems may not be.

S-Corp example for a middle-income trader
Joe Smith is single, and he operates a TTS trading S-Corp in 2017 to maximize employee benefit deductions.

For 2018, the S-Corp net income is $200,000, including Section 475 ordinary income, and after it deducted business expenses and officer compensation. The S-Corp officer compensation is $25,000, including reimbursement of health insurance of $6,500, and a Solo 401(k) “elective deferral” of $18,500 (2018 maximum). Joe’s taxable income is $170,000 ($206,500 gross income, less a $6,500 health insurance AGI deduction, less $30,000 itemized deductions).

Taxable income is under the Senate bill’s $250,000 single threshold for a “specified service activity” so Joe is entitled to the lower of a 23% deduction on qualified business income (QBI), or 23% deduction on modified taxable income. The QBI deduction is $39,100 (23% of $170,000 modified taxable income). Taxable income after the pass-through deduction is $130,900.

Joe’s 2018 federal income tax is $25,956. Joe’s marginal tax bracket is 24%, and his average tax rate is 20%. A C-Corp has the same 20% rate, but Joe qualifies for a $39,100 pass-through deduction, whereas with a C-Corp, he does not.

If Joe used a C-Corp, then net income is $200,000 after deducting health insurance expenses and officer compensation of $18,500 for Joe’s Solo 401(k) elective deferral. A C-Corp can deduct the $6,500 health insurance premiums as a business expense. So far, Joe’s taxable income is zero, unless he executes additional officer compensation above the elective deferral and/or he pays a qualified dividend, before year-end. Joe wants to utilize the $12,000 standard deduction and the 0% capital gains bracket up to $38,700 single, so he pays a qualified dividend of $50,700. His individual tax bill is still zero on the federal level. Joe may take officer compensation, but that incurs 12.4% social security taxes up to the social security base amount of $128,400 (2018 limit) and 2.9% Medicare tax is unlimited. Traders don’t owe payroll or SE taxes on trading gains, so this additional social security tax is unwarranted and costly.

If Joe does not pay additional wages to reduce net income of $200,000, the C-Corp taxes are $40,000, assuming the new corporate rate applies in 2018. That’s $14,044 more tax than using the S-Corp entity strategy. Even before considering state taxes, it’s wise for Joe to use an S-Corp.

A C-Corp might be right for a highly profitable trader in a tax-free state
(Assume the low C-Corp tax rate applies for 2018). Nancy White, a resident of Texas, consistently makes well over $500,000 net income per year trading securities with Section 475 ordinary income. She has officer compensation of $146,000 to maximize her Solo 401(k) retirement plan contribution of $55,000 (under age 50).

With an S-Corp, her 2018 gross income is $646,000 ($500,000 K-1 income and $146,000 wages), she takes a $25,000 itemized deduction, which makes her taxable income $621,000. Nancy is over the $250,000 taxable income threshold, so she does not qualify for the Senate bill’s 23% deduction on pass-through business income. Her 2018 federal income tax is $197,325 using Senate rates. Her marginal tax bracket is the top 38.5% rate, and her average tax rate is 32% — 12% above the C-Corp flat rate of 20%. She also owes 3.8% NIT on the unearned net income of $500,000 K-1 income over the modified AGI threshold of $200,000. NIT is $11,400. Nancy’s total federal tax liability using an S-Corp is $208,725.

With a C-Corp, her individual tax return gross income is $146,000 from wages, and Nancy takes a $25,000 itemized deduction, which lowers her taxable income to $121,000. Her individual federal income tax is $23,580, which is 19.5% of taxable income. Nancy does not owe NIT in this case. (This assumes she has no qualified dividends from the C-Corp.)

The federal corporate tax is $100,000 ($500,000 times 20%). Total federal tax is $123,580.

The C-Corp structure delivers 2018 federal tax savings of $85,145 vs. the S-Corp. There is no corporate or individual income tax in Texas, so the savings with the C-Corp can be significant. It further depends on if Nancy pays qualified dividends or has an IRS 20% AET assessment.

If Nancy needs distributions for living expenses, she has two choices:

1. Pay additional wages, which only are subject to Medicare tax of 2.9%, which reduces C-Corp net income at a 20% rate, and subjects her to more individual tax at 24% and 32% marginal rates.

2. Pay qualified dividends taxed at 15%, plus some 3.8% NIT, which does not reduce C-Corp taxes. Her overall savings will decline, but it’s still substantially positive vs. the S-Corp. For example, a qualified dividend of $300,000 would cause $45,000 of capital gains taxes and $9,348 of NIT. Net federal tax savings from using the C-Corp vs. the S-Corp would be $30,797.

If Nancy moves to California, the C-Corp is not a good idea because California has an 8.84% corporate tax rate and with double taxation, the C-Corp savings disappears. Just like many other states, California treats all income as ordinary income; it does not distinguish qualified dividends or long-term capital gains. California’s corporate tax is $44,200 ($500,000 times 8.84% rate), plus individual taxes on $300,000 qualified dividends is approximately $28,000. A C-Corp in California would lead to $41,403 higher federal and state taxes vs. using a dual entity solution, where a trading partnership and S-Corp management company are used to avoid the state’s 1.5% franchise tax on S-Corps.

If you have any questions, please email me at info@greentradertax.com. Consider a consultation with me and our entity formation service after.

Webinar Dec. 6: How To Setup The Best Trading Entity For Tax Cuts.

Darren Neuschwander CPA contributed to this blog post. 

 


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