Category: Tax Reform With Tax Cuts

President Trump and Republicans in Congress are working on tax reform and tax cuts in 2017.

Investment Fees Are Not Deductible But Borrow Fees Are

July 12, 2018 | By: Robert A. Green, CPA | Read it on

The Tax Cuts and Jobs Act suspended “certain miscellaneous itemized deductions subject to the two-percent floor,” which includes “investment fees and expenses.” However, the new law retained “other miscellaneous deductions” not subject to the two-percent floor, including short-selling expenses like stock borrow fees.

While individual taxpayers may no longer deduct investment fees and expenses on Schedule A starting in 2018, they are still entitled to deduct investment interest expenses, up to net investment income, as calculated on Form 4952.

The new law (page 95) has a complete list of suspended miscellaneous itemized deductions including “expenses for the production or collection of income.” That list does not include short-selling expenses. Section 67(b) excludes certain deductions from the “2-percent floor on miscellaneous itemized deductions;” including (8) “any deduction allowable in connection with personal property used in a short sale.”

Carrying charges vs. itemized deductions
Because investment fees and expenses are no longer deductible, some accountants might consider a Section 266 election to capitalize investment management fees as “carrying charges” to deduct them from capital gains and losses. But that won’t work: The IRS said taxpayers could not capitalize investment management fees under Section 266 because they are managerial rather than transactional.

Short-sellers probably could capitalize borrow fees under Section 266 because they are transactional. However, it’s safer to deduct these short-sale costs as “Other Miscellaneous Deductions” on Schedule A (Itemized Deductions) line 28. The new tax law suspended the Pease itemized deduction limitation, so the deduction has full effect on lowering taxable income. One concern: The IRS lists all Section 67(b) exclusion items in the instructions for Schedule A line 28, but it left out (8) for short-sale expenses. The code has substantial authority, and it’s reasonable to conclude that Schedule A instructions for other miscellaneous deductions on line 28 are not an exhaustive list.

Stock borrow fees
Short selling is not free; a trader needs the broker to arrange a loan of stock.

Brokers charge short sellers “stock borrow fees” or “loan premiums.” Tax research indicates these payments are “fees for the temporary use of property.” Watch out: Some brokers refer to stock borrow fees as “interest expense,” which confuses short sellers.

For tax purposes, stock borrow fees are “other miscellaneous deductions” on Schedule A line 28 for investors. Borrow fees are business expenses for traders qualifying for trader tax status (TTS). Borrow fees are not interest expense, so investors should not include them in investment interest expense deductions on Schedule A line 14.

It’s a significant distinction that has a profound impact on tax returns because investment expenses face greater limitations in 2017, and suspension in 2018 vs. investment interest expenses which are deductible up to investment income. Other miscellaneous deductions, including borrow fees, reported on Schedule A line 28 remain fully deductible for regular and alternative minimum tax (AMT).

Investment management fees cannot be capitalized
In a 2007 IRC Chief Counsel Memorandum, the IRS denied investors from capitalizing investment management fees paid to a broker as carrying charges under Section 266. Investors wanted to avoid alternative minimum tax (AMT) and other limitations on miscellaneous itemized deductions, the rules in effect before 2018. The problem is worse in 2018 with investment expenses entirely suspended.

The memo stated:

  • “Consulting and advisory fees are not carrying charges because they are not incurred independent of a taxpayer’s acquiring property and because they are not a necessary expense of holding property.
  • Stated differently, consulting and advisory fees are not strictly analogous to common carrying costs, such as insurance, storage, and transportation.”

Borrow fees might be able to be capitalized
Borrow fees seem to meet the requirements raised in the 2007 IRS Chief Counsel Memorandum for capitalization as carrying charges under Section 266. (It’s safer to deduct them as “other misc. deductions” on Schedule A line 28.)

Treasury Regulations under 1.266-1(b)(1) highlight several types of expenses that qualify as carrying charges, including taxes on various types of property, loan interest for financing property, costs to construct or improve the property, and expenses to store personal property.

A short seller cannot execute a short sale without borrowing securities and incurring borrow fees; they are a “necessary expense of holding” the position open, and “not independent” of the short-sale transaction. Borrow fees are not for the “management of property,” they are for the “acquisition, financing, and holding” of property.

Investment fees vs. brokerage commissions
Investors engage outside investment advisors and pay them advisory fees including management fees and/or incentive fees. Other investors may pay a broker a flat or fixed fee. These costs are managerial and not transactional, based on how many trades the manager makes. They cannot be capitalized under Section 266 according to the above IRS memorandum.

Brokerage commissions are transaction costs deducted from sales proceeds and added to cost basis on brokers’ trade confirmations and Form 1099-Bs. This tax reporting for brokerage commissions resembles a carrying charge.

Short-seller payments in lieu of dividends
When traders borrow shares to sell short, they receive dividends that belong to the lender — the rightful owner of the shares. After the short seller gets these dividends, the broker uses collateral in the short seller’s account to remit a “payment in lieu of dividend” to the rightful owner to make the lender square in an economic sense.

Section 263(h) “Payments in lieu of dividends in connection with short sales” require the mandatory capitalization of these payments if a short seller holds the short position open for 45 days or less (one year in the case of an extraordinary dividend).

If a short seller holds the short sale open for more than 45 days, payments in lieu of dividends are deductible as investment interest expense.

Investment interest expenses
Section 163(d)(3)(c) states, “For purposes of this paragraph, the term ‘interest’ includes any amount allowable as a deduction in connection with personal property used in a short sale.” A broad reading of “any amount” could be construed as opening the door to borrow fees, but I doubt that. “Any amount” refers to dividends in lieu of dividends held more than 45 days.

Under certain conditions, Section 266 allows capitalization of interest to finance a property.  Short sellers and others might want to consider the possibility of a Section 266 election on investment interest expense, too — especially if they plan a standard deduction or don’t have sufficient investment income. Excess interest is a carryover to subsequent tax years.

Transactional vs. managerial expenses
The following investment expenses seem transactional, and therefore eligible for capitalization in Section 266: Storage of precious metals or cryptocurrency, borrow fees on short sales, excess risk fees on short sales, and margin interest expenses.

The following investment expenses seem to be managerial rather than transactional, and therefore cannot be treated as carrying charges under Section 266: Investment management fees, fixed or flat fees paid to brokers, computers, equipment, software, charting, education, mentors, coaching, monthly data feed fees, market information, subscriptions, travel, meals, supplies, chatrooms, office rent, staff salaries and employee benefits, accounting, tax and legal services, and most other trading-related expenses.

Section 266 election statement and tax reporting

Consider filing a Section 266 election statement with your tax return, including on an extension.

  • “For tax-year 2018, taxpayer herewith elects under Code Section 266 and IRS Regulations 1.266-1 to capitalize short-selling expenses as carrying costs applied to capital gains and losses.”

Explain the election and tax treatment in a tax return footnote.

Report short-selling expenses for realized (closed) short sales as “expenses of sale or exchange” on Form 8949 (Sales and Other Dispositions of Capital Assets) in column (g) “adjustment to gain or loss.” Defer borrow fees paid on unrealized (open) short sales until realized (closed) in the subsequent year.

Consult a trader tax expert on using this potential alternative solution. If you get full deductibility on Schedule A, it’s safer to skip Section 266 capitalization, which the IRS might scrutinize.

Trader tax status
If a short-seller qualifies for trader tax status, then stock borrow fees and other short-selling expenses are deductible as business expenses from gross income.

If a TTS trader engages an outside investment manager, then investment advisory fees remain investment expenses.

Darren L. Neuschwander, CPA and Roger Lorence, JD contributed to this blog post.

Webinar July 19, 2018: Investment Fees Are Not Deductible But Borrow Fees Are. Recording available afterward. Click here.

Related blog posts: Short Selling: How To Deduct Stock Borrow Fees and Short Selling: IRS Tax Rules Are Unique.

 


How Traders Can Get The 20% QBI Deduction Under New Law

January 12, 2018 | By: Robert A. Green, CPA | Read it on

Like many small business owners, traders eligible for trader tax status (TTS) are considering to restructure their business for 2018 to take maximum advantage of the “Tax Cuts and Jobs Act” (Act). Two tax benefits catch their eye: The 20% deduction on pass-through qualified business income (QBI), and the C-Corp 21% flat tax rate.

The 20% QBI deduction
There are two components for obtaining a 20% deduction on QBI in a pass-through business.

1. QBI: I’ve made some excellent arguments over the past few months in my blog posts for including Section 475 ordinary income for TTS traders in QBI, but the Act did not expressly confirm that position. I am confident that Section 475 is part of QBI, so consider that election for 2018. The law only counts QBI from domestic sources, which may mean trading activity in U.S. markets, but not foreign markets and exchanges.

I’ve also suggested that TTS “business-related” capital gains should be includible in QBI since the Act excludes “investment-related” short-term and long-term capital gains. For now, I assume the IRS may reject all capital gains.

2. SSA vs. non-SSA: Assuming a TTS trader has QBI on Section 475 MTM ordinary income, the calculation depends on whether the business is a specified service activity (SSA) or not. I’ve made some arguments on why a trading business could be a non-SSA but based on the new tax law, TTS traders should assume their business is an SSA.

For example, if a TTS trader has 2018 taxable income under the SSA threshold of $157,500 single and $315,000 married, and assuming the trader has Section 475 ordinary income, then the trader would get a 20% deduction on either QBI or taxable income less net capital gains (whichever is lower). The 20% deduction is phased out above the SSA threshold by $50,000 single and $100,000 married. If taxable income is $416,000, above the phase-out range, the married couple gets no QBI deduction at all.

A QBI deduction is on page two of the Form 1040; it’s not an adjusted gross income (AGI) deduction or a business expense from gross income.

An owner of a non-SSA business, like a manufacturer, is entitled to the 20% deduction without a taxable income limitation, although there is a 50% wage limitation, or alternative 25% wage limitation with 2.5% qualified property factor, above the SSA income threshold. (See Traders Should Be Entitled To The Pass-Through Tax Deduction.)

TTS trading with Section 475 ordinary income
TTS is a hybrid concept: It gives “ordinary and necessary” business expenses (Section 162). A trader in securities and or commodities (Section 1256 contracts) eligible for TTS may elect Section 475(f) mark-to-market (MTM)) accounting, which converts capital gains and losses into ordinary gains and losses.

Steven Rosenthal, Senior Fellow, Urban-Brookings Tax Policy Center, weighed in for my prior blog post and again recently: “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 new tax law for this reason and “because it’s not on the QBI exclusion list.” Rosenthal pointed out there is no statutory definition of “business income.”

In the new law, QBI excludes a list of investment items including short- and long-term capital gains and losses. I don’t see how an IRS agent could construe Section 475 ordinary income as capital gains.

I look forward to the Congressional analysis in the”Blue Book” for the General Explanation of the Act — hopefully, this will shed further light on my questions. Some traders may prefer to wait for IRS regulations on these Act provisions and other types of IRS guidance. Hopefully, big law firms will form a consensus opinion on this issue for their hedge fund clients, soon.

Congress may not have envisioned the pass-through deduction for hedge funds and TTS trading companies, and they may fix things through interpretation or technical correction to prevent that outcome.

Trading in a C-Corp could be costly
Don’t only focus on the federal 21% flat tax rate on the C-Corp level; there are plenty of other taxes, including capital gains taxes on qualified dividends, potential accumulated earnings tax, a possible personal holding company tax penalty, and state corporate taxes in 44 states.

If you pay qualified dividends, there will be double taxation with capital gains taxes on the individual level — capital gains rates are 0%, 15% or 20%. If you avoid paying dividends, the IRS might assess a 20% accumulated earnings tax (AET). If you have trading losses, significant passive income, interest, and dividends, it could trigger personal holding company status with a 20% tax penalty. (See my blog post How To Decide If A C-Corp Is Right For Your Trading Business.)

How to proceed
For 2018, 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 these deductions. Consider this the cake.It puts you in position to potentially qualify for a 20% QBI deduction on Section 475 or Section 988 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 should get the 20% QBI deduction in partnerships or S-Corps. Within the phase-out range above the threshold, $100,000 (married) and $50,000 (other taxpayers), a partial deduction. QBI likely includes Section 475 and Section 988 ordinary income and excludes capital gains (Section 1256 contracts and cryptocurrencies). It might be a challenge for a TTS sole proprietor to claim the pass-through deduction because Schedule C has trading expenses only; trading gains are on other tax forms.

I suggest you consult with me about these issues soon.

Darren Neuschwander, CPA, and Roger Lorence, Esq., contributed to this post. 


How To Decide If A C-Corp Is Right For Your Trading Business

January 9, 2018 | By: Robert A. Green, CPA | Read it on

When taking into account the Tax Cuts and Jobs Act for 2018, don’t focus solely on the federal 21% flat tax rate on the C-Corp level. There are plenty of other taxes, including capital gains taxes on qualified dividends, state corporate taxes in 44 states, and accumulated earnings tax assessed on excess retained earnings.

When a C-Corp pays qualified dividends to the owner, double taxation occurs with capital gains taxes on the individual level (capital gains rates are 0%, 15% or 20%). If an owner avoids paying sufficient qualified dividends, the IRS is entitled to assess a 20% accumulated earnings tax (AET). It’s a fallacy that owners can retain all earnings inside the C-Corp.

C-Corp vs. individual tax rates
Starting in 2018 under the new tax law, C-Corps may benefit from a 21% flat tax rate vs. individual graduated rates of 10% to 37%. Don’t confuse your tax bracket with your tax rate, which is less. For example, the average individual tax rate is 27% for a married couple entering the top 37% tax bracket of $600,000 and 30% for a single filer approaching the top bracket of $500,000; so the actual rate difference is 6% and 9% in these two examples.

Upper-income traders may also have individual 3.8% net investment tax (NIT) on net investment income (NII). NIT applies on NII over the modified AGI threshold of $250,000 (married) and $200,000 (single). Adding this in, the difference between the flat rate could be 9.8% and 12.8% in our example.

Traders don’t owe self-employment (SE) tax, so I don’t factor that into the equation. Other small business owners have SE or payroll tax in pass-throughs but can avoid it with a C-Corp. Let say the C-Corp has a 10% rate advantage for high-income traders and a lower or no benefit for middle- to lower-income traders.

Now come all the haircuts that can lead to adverse taxes and make the C-Corp a costlier choice for a trader. Double taxation on the federal level can wipe out that savings with a 15% or 20% capital gains tax on “qualified dividends.” Double taxation on the state level can lead to a C-Corp owner paying higher taxes than with a pass-through entity. There are potential 20% accumulated earnings taxes and personal holding company tax penalties. Look before you leap into a C-Corp and consult a trader tax expert.

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.

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 C-Corp stock for 60 days, it’s a “qualified dividend,” subject to lower long-term capital gains rates of 0%, 15%, and 20%. The 0% capital gains bracket applies to taxable income up to $77,200 (married) and $38,600 (single). A 15% dividends tax offsets the difference in individual vs. corporate tax rates.

State double taxation can ruin the C-Corp strategy
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 your state on the Tax Foundation map, State Corporate Income Tax Rates and Brackets for 2017.) States don’t use lower capital gains rates for taxing individuals; they treat qualified dividends as ordinary income.

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 if he or she retains earnings and can successfully avoid IRS 20% accumulated earnings tax (more on this to come). 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.

The new tax law capped state and local income, sales, and property taxes (SALT) itemized deductions at $10,000 per year. It does not suspend SALT deductions paid by C-Corps, but that expense is only the double-taxed portion; the individual SALT on qualified dividends is still limited.

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. (See Section 533.)

If the IRS treats a trader tax status (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 with Section 475 ordinary income is an investment company. A TTS trading C-Corp needs to demonstrate a business need for E&P above the $250,000 threshold.

“AET requires the corporation to have adopted a plan for business expansion that will require substantial additional capital,” says Roger Lorence, a tax attorney in the New York City area who specializes in hedge fund tax. “The plan must be in writing and adopted by the Board; it must refer to the analysis of the business, the need for expansion, the need for more capital, and include a timeline for implementation.”

Arguing the C-Corp needs more trading capital for growing profits is likely not an acceptable reason for avoiding dividends. Sufficient reasons might include buying exchange seats, hiring traders and back office staff, and purchasing more equipment and automated trading systems. Over a period, the C-Corp must implement its formal plan. Otherwise, the IRS won’t respect the policy. Many one-person TTS trading companies don’t have these types of expansion plans, and they likely won’t succeed in defending against an AET assessment. Previously, I pointed out a C-Corp might be suitable for a high-income trader, but they would probably exceed the AET threshold in the first year.

Personal holding company tax penalty
“Personal holding company” (PHC) status is triggered when a closely held C-Corp has at least 60% of gross income coming from certain passive income (including interest, dividends, rents, and royalties), and has not made sufficient distributions to shareholders. The IRS is entitled to assess a 20% PHC tax penalty. The new tax law did not revise the PHC rules, and some tax experts think Congress should have tightened them.

Capital gains and Section 475 ordinary income are not passive income, so a successful TTS trader C-Corp will likely not meet the definition. However, if a trader incurs a net trading loss for a given year, then passive income might exceed 60% of gross income and trigger a PHC penalty. If a trader has substantial passive income, don’t hold those positions in a C-Corp.

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 21% C-Corp tax rate over the individual tax rates up to 37% on wage income instead.

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 new law has an excess business loss limitation of $500,000 (married) and $250,000 (single), and it repealed the NOL carryback, only allowing carryforwards.
3. A C-Corp investment company without TTS may not deduct investment expenses. The Act suspends miscellaneous itemized deductions for individuals, which includes investment expenses. Don’t try to house investments in a C-Corp; it might be deemed a PHC.
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 $100,000 (married) or $50,000 (single), with the remainder of the loss treated as a capital loss. Therefore, 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.” Conversely, with a pass-through entity and Section 475 ordinary loss treatment, the trader would have all ordinary loss treatment.

There are a few good things about C-Corps: A more extensive assortment of fringe benefit plans for owners, and charitable contributions, which some individuals may limit due to the higher standard deduction.

Example: Profitable trader in a tax-free state
Nancy Green, 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 company 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 $207,500 taxable income threshold for a specified service activity, so she does not qualify for the Act’s 20% deduction on qualified business income (QBI) in a pass-through. Her 2018 federal income tax is $195,460. Her marginal tax bracket is the top 37% rate, and her average tax rate is 31% — 10% above the C-Corp flat rate of 21%. She also owes 3.8% NIT on $300,000 ($500,000 K-1 income less the modified AGI threshold of $200,000), which equals $11,400. Nancy’s total federal tax liability using an S-Corp is $206,860.

With a C-Corp, Nancy’s individual tax return gross income is $146,000 from wages, and she takes a $25,000 itemized deduction, which lowers her taxable income to $121,000. Her individual federal income tax is $23,330, which is 19.3% 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 $105,000 ($500,000 times 21%). With her individual tax paid using the C-Corp, her total federal tax is $128,330.

The C-Corp structure delivers 2018 federal tax savings of $78,530 vs. the S-Corp. There is no corporate or individual income tax in Texas, and she did not exceed the franchise tax threshold, so the savings with the C-Corp can be significant. It also depends on whether or not she 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%, reducing C-Corp net income at a 21% rate, and subjecting her to more individual tax at 24% and 32% marginal rates. (This might be the more attractive option.)
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 $24,182.

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. Like many other states, California treats all income as ordinary income; it does not distinguish qualified dividends or long-term capital gains. In Nancy’s case, California’s corporate tax would be $44,200 ($500,000 x 8.84% rate), plus individual taxes on $300,000 qualified dividends would be approximately $28,000. A C-Corp in California would lead to much 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.

The 800-pound gorilla in the room is the 20% accumulated earnings tax (AET), and under what conditions the IRS may assess it on a trading business C-Corp. Nancy can tell the IRS she is a TTS trader entitled to retain earnings up to $250,000. Her C-Corp made $500,000 and paid qualified dividends of $300,000, so she kept $200,000 of profits inside the C-Corp. The IRS allows up to $250,000, so she should be fine for 2018, but what about 2019? Does Nancy have a written plan that is feasible for keeping a war chest of earnings over the $250,000 threshold? Probably not, and that could render the C-Corp tax advantage a mirage for her and others in a similar boat.

I suggest traders consult with me to discuss their 2018 projections and see which shoe fits best: a partnership, S-Corp or C-Corp, or some combination, thereof.

 

 


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. 

 


Senate’s Five Haircuts On The Tax Deduction For Pass-Through Entities

November 24, 2017 | By: Robert A. Green, CPA

shutterstockTaxReforms

Forbes

Read it on Forbes.

Update Dec. 16: As expected, the Conference Agreement (CA) adopted the Senate Amendment on the pass-through deduction, and 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 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 Finance Committee posted the legislative text for the “Tax Cuts and Jobs Act” bill. There are five haircuts on calculating the deduction on qualified business income (QBI) for pass-through entities.

It’s a bit of a maze, but it could be a significant deduction and will take plenty of tax compliance work to determine and support it. Trader tax status traders using Section 475 are service businesses, which may use the QBI deduction providing their taxable income is under the upper-income limitation.

Haircut No. 1: 50% of wages limitation
On each separate pass-through entity (PTE), the 17.4% QBI deduction may not exceed 50% of employees’ W-2 wages in that PTE. One PTE may have a wage limitation and another may not. Look for wage amounts on 2018 Schedule K-1s from partnerships and S-Corps.

Exception from wage limit: The 50% wage limitation does not apply to taxpayers with taxable income under $500,000 married and $250,000 for others. There is an annual inflation adjustment on the threshold. Per the modified mark, “the application of the W-2 wage limit is phased in for individuals with taxable income exceeding this $500,000 (or $250,000) amount over the next $100,000 of taxable income for married individuals filing jointly or $50,000 for other individuals.” The phase-in calculations are even more complicated and beyond the scope of this article.

Haircut No. 2: Service businesses limited to upper-income threshold
The bill excludes “specified service activities” from taking a QBI deduction unless the taxpayer has taxable income under $500,000 married and $250,000 for others. There is an annual inflation adjustment on the threshold. The modified mark states, “the benefit of the deduction for service businesses is phased out over the next $100,000 of taxable income for married individuals filing jointly or $50,000 for other individuals.” The phase-out calculations are also quite complicated and beyond the scope of this article.

The bill states, “The term ‘specified service trade or business’ means any trade or business involving the performance of services described in section 1202(e)(3)(A), including 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)).”

In Section 475 Traders May Be Eligible For Pass-Through Tax Cuts, I expected the Senate legislation text would mirror the House bill’s definition.

Haircut No. 3: Deduction on QBI or modified taxable income
Calculate the 17.4% QBI deduction based on total QBI or modified taxable income — whichever amount is lower.

First, calculate the 17.4% deduction on domestic QBI per PTE, after applying the wage limitation, and total it up. Next, figure modified taxable income: Take taxable income and exclude long-term capital gains and qualified dividend income (capital gains preferences). Calculate 17.4% of modified taxable income. Finally, take the lower of those two amounts.

Here’s an example: An S-Corp consulting service business has net income of $150,000 after deducting officer compensation of $50,000 (reasonable compensation of 25% of net income), business expenses and employee benefits (health insurance and retirement plan). The 50%-wage limitation doesn’t apply since the taxpayer is under the upper-income threshold. There are no investment-related items to exclude from QBI. The taxpayer has itemized deductions of $30,000 due to charitable contributions. Therefore, taxable income is $170,000, comprised of $50,000 wages, $150,000 S-Corp net income, and less $30,000 itemized deductions. This single taxpayer should calculate the 17.4% QBI deduction on taxable income of $170,000 since it’s lower than total QBI of $200,000. The QBI deduction is $29,580.

Haircut No. 4: Exclude capital gain preferences
Assume the same taxpayer also has $40,000 of long-term capital gains and $5,000 of qualified dividends. Gross income is $245,000 and taxable income is $215,000. Modified taxable income is $170,000 after excluding the capital gains preferences. The result is the same as above: Use the 17.4% QBI deduction based on modified taxable income since it’s less than the QBI deduction based on QBI of $200,000.

Haircut No. 5: Carryover of losses
The Senate bill requires a carryover of total qualified business losses (QBL) to the subsequent tax year. For example, assume total QBL in 2018 is $50,000, and QBI in 2019 is $300,000. The 2018 QBL is carried over to 2019, which reduces 2019 QBI to $250,000. It’s important to note that this QBL carryover does not change taxable income; it only affects the QBI deduction in the subsequent tax year.

The Senate bill has a separate provision (Limitation On Excess Business Losses For Noncorporate Taxpayers) limiting losses, which does change taxable income for the current and subsequent tax years. (See How The Senate Tax Bill Disallows Excess Business Losses In Pass-Throughs.)

Reason for the haircuts on the QBI deduction
The Senate provides the 17.4% QBI deduction to incentivize small businesses to create jobs and increase wages. It targets non-service activities, like manufacturing for “Made in America.” The Senate includes all pass-throughs, including service businesses and passive-activity owners, in waiving the wage limitation and using the upper-income threshold.

The tax code is voluminous because Congress adds complicated anti-abuse provisions to block taxpayers and tax advisers from gaming their tax regime. Several haircuts for this deduction prevent “double-dipping” of tax loopholes. The Senate Finance Committee felt it would be inappropriate to provide a QBI deduction that leads to a net operating loss (NOL) carryover, on income already taxed at lower capital gains tax rates, or on itemized deductions. It also did not want to leave out service businesses and passive-activity owners. It had to meld this code with existing code. Slaying the tax code beast is nearly impossible.

These haircuts make the tax code more complicated and will lead to confusing tax compliance, which is contrary to the goals of tax reform.  These provisions are significantly different from the House’s bill, too. There could be changes to the Senate bill this week when it’s subject to floor debate and amendments. Stay tuned to our blog as we continue to cover this fluid situation.

Darren Neuschwander CPA contributed to this blog post.


Section 475 Traders May Be Eligible For Pass-Through Tax Cuts

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

shutterstockTaxReform

Forbes

Read it on Forbes.com

 

Update Nov. 24: The Senate Finance Committee posted the legislative text for the “Tax Cuts and Jobs Act” bill on Nov. 22. There are five haircuts on calculating the deduction on qualified business income for pass-through entities. The Senate bill’s definition of a “specified service activity” includes a trading business. (See my next blog post, Five Haircuts On The Tax Deduction For Pass-Through Entities.)

Owners of a trading business are anxious to learn if they will qualify for tax cuts with the House’s 25% pass-through rate or the Senate’s 17.4% pass-through tax deduction. While the two bills have a few things in common, they are vastly different, and both contain nuances for a trading business.

The House bill provides little relief for active owners of a service business, which likely includes a trading business. The Senate bill has a more generous provision for service companies.

Last week, the House passed its bill, the “Tax Cut & Jobs Act” (H.R.-1), and the Senate Finance Committee approved its modified mark. The Senate expects the Joint Committee on Taxation (JCT) to complete drafting its bill this week and release it for floor debate the week after Thanksgiving. Republican Senator Ron Johnson came out in opposition to tax reform proposals, saying they don’t go far enough to help small-business pass-throughs vs. big corporations. He’s right. In current form, the Senate’s modified mark is better than the House bill for active owners of pass-throughs, and I hope GOP leaders choose the Senate’s pass-through proposals, with further improvement, for final legislation.

Here are the steps required for a trading business to achieve tax relief under the House vs. Senate proposals. (Spoiler alert: It’s much easier in the Senate.)

The first requirement is business income
Because the House and Senate bills limit pass-through tax cuts to business income, a big question remains: Does income in a pass-through entity meet the definition of “qualified business income”? A trading business, eligible for trader tax status (TTS), with capital gains income, is likely not included in the definition of business income. But a trading business with Section 475 MTM ordinary income might be included.

Here’s my rationale. The House bill’s summary states, “Certain other investment income that is subject to ordinary rates such as short-term capital gains, dividends, and foreign currency gains and hedges not related to the business needs, would also not be eligible to be recharacterized as business income.”

The House bill goes on to state, “Net business income or loss shall be determined with respect to any business activity by appropriately netting items of income, gain, deduction, and loss with respect to such business activity.” The bill notes “certain investment-related” exceptions, a list that includes short-term and long-term capital gains, dividend income, any interest income other than interest income that is properly allocable to a trade or business, and annuities.

Section 475 ordinary income and rental income are not on the exceptions list. A TTS futures trader has lower Section 1256 contract 60/40 capital gains tax rates (60% is a long-term capital gain), so it’s doubtful he or she could qualify for the more moderate pass-through rates.

The Senate mark (JCX-51-17, Nov. 9) states, “Qualified business income or loss does not include certain investment-related income, gain, deductions, or loss.” This language is similar to the House summary.

A TTS forex trader has foreign currency ordinary income (Section 988) that is business-related. Without TTS, that forex trader’s ordinary income is investment-related. Forex traders may want to consider a capital gains election to be eligible for Section 1256(g) 60/40 tax rates on “major” pairs, but that may disqualify them from pass-through benefits. They can consider which is better for them.

Section 475 ordinary income is also considered business-related for TTS traders.  Steven Rosenthal, Senior Fellow, Urban-Brookings Tax Policy Center, weighs in: “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 income is business income under the House bill and Senate mark. (Section 475(f)(1)(D) excludes Section 475 ordinary income from self-employment income and self-employment tax.)

The next requirements for receiving pass-through tax cuts vary significantly in the House vs. Senate bills.

Does the House bill consider a trading business a service activity?
It’s essential because active owners of service businesses may receive a tiny pass-through tax cut in the House bill. The bill states, “The term ‘specified service activity’ means any activity involving the performance of services described in section 1202(e)(3)(A), including investing, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)).” When my partner Darren Neuschwander, CPA, and I read this definition two weeks ago, we thought it expressly included a trading business.

The House summary that accompanies the bill is different from the actual bill, it states, “certain personal services businesses (e.g., businesses involving the performance of services in the fields of law, accounting, consulting, engineering, financial services, or performing arts) would be zero percent.” Notice the summary version dropped the second part, “including investing, trading, or dealing in securities.” Section 1202(e)(3)(A) lists the personal service fields.

The thousand dollar question is: Does the House consider a trading business a specified service activity, or not? Rosenthal believes a hedge fund with Section 475 ordinary income does not meet the House definition of specified service activity. His interpretation is that an investment manager offers trading services to a hedge fund and the fund receives those services. The manager is a service activity; the hedge fund is not. It’s about how Rosenthal interprets the comma placement in the definition, which he knows well because he used to be a legislation counsel at JCT.

I pointed out to Rosenthal that a management company is the general partner of a hedge fund limited partnership, to bring trader tax status to the fund level, which is a requirement for the hedge fund using Section 475. For this blog post, I assume a trading business is a service company based on how I read the House bill’s definition.

The House gives little benefit to active owners of service companies
An active owner of a non-service activity receives a 70% labor percentage and a 30% capital percentage. Calculate the pass-through benefit as “distributed” business income, multiplied by the capital percentage, multiplied by the maximum pass-through rate (25% for the 35% and 39.6% ordinary brackets and 9% for 12% ordinary bracket).

Active owners of a service business get a 100% labor percentage and 0% capital percentage. If they have a significant investment in business equipment and other fixed assets, they may have an “alternative capital percentage,” providing it’s at least 10%. Most TTS trading businesses won’t have an alternative capital percentage and therefore won’t get any relief in the House bill, except for the preferential 9% rate.

The House bill’s summary states, “Under the provision, the first $75,000 of an active owner or shareholder’s net business taxable income would be subject to a 9-percent rate in lieu of the ordinary 12-percent rate. Owners or shareholders in personal service businesses would be eligible for the preferential 9-percent rate.” This provision gives a small tax benefit to a service business.

The House bill favors passive business activities
The bill summary states, “Net income derived from a passive business activity would be treated entirely as business income and fully eligible for the 25-percent maximum rate.”

The original House bill had a sneaky proposal to expand self-employment tax on the labor percentage of active owners and for all limited partner income. After blowback, the House scrapped the self-employment tax provisions, yet it retained the significant tax break on limited partners. Active owners of non-service businesses get 30% of the benefits vs. limited partners. Many active-owners of service companies will get very few benefits.

I think Congress and the IRS will object to active owners restructuring their interests into general partner vs. limited partner ownership stakes to cash in on the House bill provisions favoring limited partners.

Will hedge fund limited partners get the 25% pass-through rate?
The House bill’s summary states, “The determination of whether a taxpayer is active or passive with respect to a particular business activity would rely on current law material participation and activity rules within regulations governing the limitation on passive activity losses under Code section 469. Under these rules, the determination of whether a taxpayer is active generally is based on the number of hours the taxpayer spends each year participating in the activities of the business.”

Some tax advisers suggest limited partners in hedge funds with TTS and Section 475 income can get the 25% House rate. I think there is likely a problem with that position. Under the “trading rule” exception to Section 469, a hedge fund investment is not a passive activity. Hedge fund investors are “non-active” owners, rather than passive-activity owners so that the House bill may treat them as an active owner of a service business with 0% capital percentage.

The Senate proposal is better for TTS Section 475 traders and funds
The Senate mark’s definition of a “specified service activity” does not include a trading company, but it has not yet released the final bill. It’s conceivable that the Senate could render a trading company a service activity. But, service companies fare much better in the Senate modified mark vs. the House bill.

Active owners of non-service businesses get the full benefit of the Senate pass-through proposals. The Senate’s original mark allows a 17.4% pass-through deduction on net business income, limited to 50% of owner wages.

The Senate’s original mark excluded service activities unless the owner had taxable income under $150,000 married and $75,000 for other individuals. (See How The Pass-Through Tax Cut Is Better In The Senate.)

The Senate modified mark significantly improved the provision for all owners of pass-throughs, including non-service and service businesses. It doesn’t mention passive activity owners or limited partners, so I presume they should be able to get the benefits since the Senate waived the wage limitation under the income threshold.

The modified mark states, “Under a special rule, the W-2 wage limit does not apply in the case of a taxpayer with taxable income not exceeding $500,000 for married individuals filing jointly or $250,000 for other individuals. The application of the W-2 wage limit is phased in for individuals with taxable income exceeding this $500,000 (or $250,000) amount over the next $100,000 of taxable income for married individuals filing jointly or $50,000 for other individuals.

“The modification further provides that the exception allowing the 17.4-percent deduction in the case of certain taxpayers with income from a specified service business applies to those whose taxable income does not exceed $500,000 for married individuals filing jointly or $250,000 for other individuals. The benefit of the deduction for service businesses is phased out over the next $100,000 of taxable income for married individuals filing jointly or $50,000 for other individuals.” (See Senate Juices Up Tax Cut For Pass-Throughs.)

The process is moving fast
I look forward to reading the Senate bill after Thanksgiving, and I will update this blog post accordingly. I hope GOP leaders agree to use the Senate bill as the vehicle for passage as they rush to pass tax reform legislation before year-end.

The timing is right for taxpayers and accountants. If Congress finalizes the legislation by mid-December, TTS traders will have time to consider a new tax plan for 2018, which might include a revised entity solution and a Section 475 election.

TTS traders with Section 475 should not count their tax chickens on pass-through tax breaks before they hatch. Stay tuned for updates.

Darren Neuschwander CPA contributed to this blog post.

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Senate Juices Up Tax Cut For Pass-Throughs

November 15, 2017 | By: Robert A. Green, CPA

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Forbes

Read it on Forbes.

Update Nov. 24: The Senate Finance Committee posted the legislative text for the “Tax Cuts and Jobs Act” bill on Nov. 22. There are five haircuts on calculating the deduction on qualified business income for pass-through entities. The Senate bill’s definition of a “specified service activity” includes a trading business. (See my blog post, Five Haircuts On The Tax Deduction For Pass-Through Entities.)

In the Nov. 14 modified mark of the tax cut bill prepared by the staff of the Joint Committee On Taxation for the Senate Finance Committee, there are two significant improvements in the 17.4% deduction for pass-through businesses for taxpayers with taxable income up to $500,000 (married) and $250,000 (other individuals). Under this upper-income threshold, the Senate committee removed the 50% wage limitation and allowed specified service businesses to use the 17.4% pass-through deduction. There are phase-out rules over the limit of $100,000 (married) and $50,000 (other individuals).

In the original mark, the specified service business income threshold was $150,000 (married) and $75,000 (other individuals). The 50% wage limitation is complicated for taxpayers over the income limit.

The House improved its pass-through provisions with modifications to HR-1 in 115–39, scrapping the original bill’s expansion of self-employment income (SEI). The modified House bill helps middle-income taxpayers by adding an 11% maximum pass-through tax rate, phasing down to 9%, on the first $75,000 of business income, which phases out between $150,000 and $225,000 for married filers.

I prefer the Senate’s modified markup to the House’ modified bill for pass-through provisions. Deciphering the House’s complicated rules is difficult. For many small business taxpayers, the Senate’s modified mark delivers more significant tax savings.

I look forward to seeing the Senate committee’s actual bill — I hear it should be the vehicle for the final legislation negotiated by conferees in the Senate and House.

The text of the Senate’s modified provision is as follows (download the entire document JCX-56-17.pdf here):

“The Chairman’s modification provides that in the case of a taxpayer who has qualified business income from a partnership, S corporation or sole proprietorship, the amount of the 17.4-percent deduction is generally limited to 50 percent of the taxpayer’s allocable or pro rata share of W-2 wages of the partnership or S corporation or 50 percent of the W-2 wages of the sole proprietorship.

“W-2 wages of a partnership, S corporation, or sole proprietorship is the sum of wages subject to wage withholding, elective deferrals, and deferred compensation paid by the partnership, S corporation, or sole proprietorship during the calendar year ending during the taxable year.

“Under a special rule, the W-2 wage limit does not apply in the case of a taxpayer with taxable income not exceeding $500,000 for married individuals filing jointly or $250,000 for other individuals. The application of the W-2 wage limit is phased in for individuals with taxable income exceeding this $500,000 (or $250,000) amount over the next $100,000 of taxable income for married individuals filing jointly or $50,000 for other individuals.

“The modification further provides that the exception allowing the 17.4-percent deduction in the case of certain taxpayers with income from a specified service business applies to those whose taxable income does not exceed $500,000 for married individuals filing jointly or $250,000 for other individuals. The benefit of the deduction for service businesses is phased out over the next $100,000 of taxable income for married individuals filing jointly or $50,000 for other individuals.”


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