February Tax Saving Tips
Tax-Saving
Tips
February 2019
IRS Issues Final Section 199A
Regulations and Defines QBI
Your
ownership of a pass-through trade or business can generate a Section 199A tax
deduction of up to 20 percent of your qualified business income (QBI). The C corporation
does not generate this deduction, but the proprietorship, partnership, S
corporation, and certain trusts, estates, and rental properties do.
The tax
code says QBI includes the net dollar amount of qualified items of income,
gain, deduction, and loss with respect to any qualified trade or business of
the taxpayer.
Sole Proprietorship QBI
·
Subtract
the deduction for self-employed health insurance.
·
Subtract
the deduction for one-half of the self-employment tax.
·
Subtract
qualified retirement plan deductions.
·
Subtract
Section 1231 net losses (ignore gains).
Example. You have $120,000 of net income on
Schedule C. You deducted $10,000 for self-employed health insurance, $8,478 for
one-half of your self-employment taxes, and $10,000 for a SEP-IRA contribution.
Your QBI is $91,522 ($120,000 - $10,000 - $8,478 - $10,000).
Rental Property QBI
If you
own rental property as an individual or through a single-member LLC for which
you did not elect corporate taxation, you report your rental activity on
Schedule E of your Form 1040. If you can claim the property is a trade or business,
your QBI begins with the net income from your Schedule E.
Partner’s QBI from the Partnership
A
partner may obtain income from the partnership in two ways: (1) as a payout of
profits and/or (2) as a Section 707 payment (generally referred to as a “guaranteed
payment”). The profits qualify as QBI, and the partnership profits are adjusted
for the same items as with the sole proprietorship. The Section 707 payments
reduce the net income of the partnership. They do not count as QBI.
S Corporation Shareholder QBI
The
more than 2 percent shareholder in an S corporation ends with QBI calculated in
the same manner as for the sole proprietor. For example, the S corporation
treats the health insurance as wages to the shareholder which reduces the
profits of the S corporation and that reduces the shareholder’s QBI.
Wages
paid to the shareholder-employee reduce the net income of the S corporation but
do not count as QBI.
Trusts and Estates
The
rules above apply to trusts and estates. The tricky part is where to apply the
rules—to the trust, to the estate, or to the beneficiary?
IRS Clarifies Net Capital Gains in
Final 199A Regulations
New tax
code Section 199A can give you a tax deduction of up to 20 percent of your
taxable income reduced by net capital gains. In new final regulations, the IRS
has provided clarity on the capital gains component of the Section 199A tax
deduction.
The Section
199A tax deduction applies to your trade or business income from a pass-through
entity such as a proprietorship, a rental property, a trust, an estate, a partnership,
or an S corporation. When taxable income is equal to or less than the threshold
of $315,000 (married, filing jointly) or $157,500 (filing as single or head of
household), you apply the 20 percent to the lesser of your
·
taxable
income reduced by net capital gains, or
·
QBI.
For the
Section 199A calculation, your net capital gains are
·
all
net capital gains taxed at a preferred tax rate, plus
·
dividends
that are taxed at preferred capital gains rates.
Example. You have $200,000 of taxable
income, $12,000 of unrecaptured Section 1250 capital gain from the sale of a
rental property, and $13,000 of long-term capital gain from the sale of that
rental. For Section 199A purposes, you apply the 20 percent deduction to a
taxable income ceiling of $175,000 ($200,000 - $12,000 - $13,000).
IRS Creates a New “Safe Harbor” for
Section 199A Rental Properties
The
Section 199A 20 percent tax deduction is a gift from lawmakers—literally. You
don’t earn this deduction; it’s simply there for you if you qualify.
Under
the trade or business rule, your rental property profits can create the
deduction. And now, under an alternative rule, you can use the newly created
IRS safe harbor to make your rentals qualify for the deduction.
When
you meet the new safe-harbor rules, the IRS deems your rental a trade or
business with net rental profits that are QBI for the Section 199A tax
deduction. But you may not want to use the safe-harbor rules, because they
contain some onerous provisions. Also, you may not qualify to use the safe
harbor. No problem. You can simply use the second method and win your 199A tax
deduction using the existing trade or business tax law rules.
Under
the new Section 199A rental real estate safe harbor (and only for this Section
199A safe harbor), each of your rental real estate properties individually or
as a group (if you so choose) falls into one of the following categories:
1.
Residential
real estate enterprise
2.
Commercial
real estate enterprise
3.
Triple
net lease real estate
Grouping rule. You (or your pass-through entity)
must either
·
treat
each rental property as a separate enterprise, or
·
treat
all similar properties as a single enterprise.
Example. You have 10 rentals; eight are
residential, and two are commercial. None are triple net lease. With grouping, you
have two enterprises: one residential and one commercial.
With
grouping of the residential and no grouping of the commercial, you have three
enterprises: residential, commercial 1, and commercial 2. (Reminder: You don’t
have to use the safe-harbor rules for your rental properties. You can use the
historical trade or business rules.)
Safe-Harbor Requirements
Solely
for Section 199A purposes, the IRS will treat your rental real estate
enterprise as a trade or business if you (or your pass-through entity) can satisfy
the following requirements:
1.
You
maintain separate books and records that reflect the income and expenses of
each rental real estate enterprise.
2.
You
perform 250 or more hours of “rental services” during the tax year.
3.
You
maintain contemporaneous records, including time reports, logs, or similar
documents, regarding the following: (i) hours of all services performed, (ii)
description of all services performed, (iii) dates on which such services were
performed, and (iv) who performed the services. (Note: The contemporaneous
records rule does not apply to tax years beginning before January 1, 2019—but
don’t let this give you false hope; you still need proof.)
Rental Services
Qualifying
defined “rental services” can be done by you, your employees, your agents,
and/or your independent contractors. Such services include
1.
advertising
to rent or lease the real estate;
2.
negotiating
and executing leases;
3.
verifying
information contained in prospective tenant applications;
4.
collecting
rent;
5.
operating,
maintaining, and repairing the property;
6.
managing
the real estate;
7.
purchasing
materials; and
8.
supervising
employees and independent contractors.
Rental
services that do not qualify for the safe harbor include
·
financial
or investment management activities, such as arranging financing, procuring
property, or studying and reviewing financial statements or reports on
operations;
·
planning,
managing, or constructing long-term capital improvements; and
·
hours
spent traveling to and from the real estate.
Reminder. The safe-harbor rules above are
solely for Section 199A purposes.
Beware. The passive-activity rules for
material participation and status as a real estate professional contain many
differences from what you see for the Section 199A tax deduction.
Time log. Your number-one important record
for obtaining hassle-free tax deductions on your rental real estate is an
accurate and provable time log. If you are using the new Section 199A safe
harbor, you now have one additional reason to track time spent.
Nonqualifying Real Estate
Triple
net lease property does not qualify for the safe harbor. Remember, the safe
harbor is not the only method you can use to qualify your rental real estate
for the Section 199A tax deduction.
Also,
you may not use the safe harbor on real estate that you use as a residence. If
you have a vacation home, Section 280A makes that vacation home either a rental
property or a residence.
Safe Harbor—No 1099 Issues
If you
use the safe harbor, your rental is a business regardless of whether you send
1099s to service providers. In its preamble to the final Section 199A
regulations, the IRS notes that the law requires a trade or business to send
1099s to certain service providers.
Final Thoughts
You may
not find it easy getting to the safe harbor. But remember, once you are inside
the safe harbor, you have the comfort of knowing that your rental properties
are business properties for the possible 20 percent tax deduction under Section
199A. Now, because of the safe harbor, you have a choice:
·
use
the safe harbor, or
·
use
the existing tax code trade or business rules to prove that your rental is a
trade or business.
And
remember, once you are inside the safe harbor, the fact that you did or did not
issue 1099s to your service providers is moot for purposes of the Section 199A
tax deduction.
IRS Section 199A Final Regs Shed
New Light on Service Businesses
Remember,
new tax code Section 199A offers you a 20 percent tax deduction gift if you
have
·
pass-through
business income (such as from a proprietorship, a partnership, or an S
corporation), and
·
2018
taxable income of $315,000 or less (married, filing jointly) or $157,500 or
less (filing as single or head of household).
But
once your taxable income is greater than the relevant amount listed above
(which Section 199A calls a “threshold”), your Section 199A tax deduction
becomes more complicated. Under the rules that apply to this new Section 199A
tax deduction, the tax code creates two types of businesses:
1.
Business
that are in favor and can realize the
new deduction regardless of taxable income.
2.
Business
that are out of favor. The tax code calls the out-of-favor business a
“specified service trade or business.”
If you
own an out-of-favor specified service trade or business, you suffer a zero
Section 199A tax deduction on that business’s out-of-favor income when you have
1040 taxable income greater than $415,000 (married, filing jointly) or $207,500
(filing as single or head of household).
With
taxable income greater than the $315,000/$157,500 threshold and less than the
$415,000/$207,500 upper limit, Section 199A reduces the tax deduction available
to your out-of-favor specified service trade or business.
This
brings us to the question: What if your taxable income is above the limit, but
your pass-through business has one part that’s out of favor and another part
that’s in favor? You will like what the rules have done for you if you are in
this situation. The new regulations make it clear that it is possible for you
to benefit from the de minimis rule.
The rule. If the trade or business has
annual gross receipts of $25 million or less, it is an in-favor business if it
gets less than 10 percent of its gross receipts from an out-of-favor specified
service trade or business, such as (among others) law, consulting, accounting,
and health care. If gross receipts are greater than $25 million, substitute 5
percent for the 10 percent.
De Minimis Example 1
Green
Lawn LLC sells lawn care and landscaping equipment and also provides advice and
counsel on landscape design for large office parks and residential buildings.
The
landscape design services include advice on the selection and placement of
trees, shrubs, and flowers and are considered under Section 199A an
out-of-favor consulting business.
Green
Lawn LLC separately invoices for its landscape design services and does not
sell the trees, shrubs, or flowers it recommends for use in the landscape
design. Green Lawn LLC maintains one set of books and records and treats the
equipment sales and design services as a single trade or business.
Green
Lawn LLC has gross receipts of $2 million, of which $250,000 is attributable to
the landscape design services, a consulting business. Because consulting
services are 10 percent or more of total gross receipts, the entirety of Green
Lawn LLC’s trade or business is an out-of-favor specified service trade or
business.
De Minimis Example 2
Veterinarian
LLC provides veterinarian services performed by licensed staff and also
develops and sells its own line of organic dog food at its veterinarian clinic
and online. The veterinarian services are in the out-of-favor specified service
trade or business of health care.
Veterinarian
LLC separately invoices for its veterinarian services and the sale of its
organic dog food. It maintains separate books and records for its veterinarian
clinic and its development and sale of dog food. Veterinarian LLC also has
separate employees who are unaffiliated with the veterinary clinic and work
only on the formulation, marketing, sales, and distribution of the organic dog
food products.
Veterinarian
LLC treats its veterinary practice and the dog food development and sales as
separate trades or businesses for purposes of Sections 162 and 199A. It has
gross receipts of $3 million. Of the gross receipts, $1 million is attributable
to the out-of-favor veterinary services.
Although
the gross receipts from the services in the field of health care exceed 10
percent of Veterinarian LLC’s total gross receipts, the dog food business is a
separate, in-favor business.
Note
that Animal Care wins because it has two trades or businesses, which it proves
with its financial books and its separation of its employees.
Green
Lawn LLC, in the previous example, failed because it had one business only,
which it also proved by the way it kept its books.
IRS Updates Defined Wages for New
Section 199A Tax Deductions
Your
Section 199A tax deduction will benefit from your business’s W-2 wages paid to
you and your employees if you
·
are
married and filing jointly and your taxable income is over $315,000 and less
than $415,000;
·
are
filing as single or head of household and your taxable income is over $157,500
and less than $207,500; or
·
have
an in-favor business and your taxable
income is greater than $415,000 (married, filing jointly) or $207,500 (filing
as single or head of household).
If you
are above the $415,000/$207,500 threshold with no wages and no property, your
Section 199A tax deduction is zero regardless of your type of business.
Example 1. You have an in-favor business with
$400,000 of QBI with no wages or property. Your Form 1040 shows $500,000 of
taxable income. Your Section 199A tax deduction is zero.
Note. Your $500,000 in taxable income is
above the threshold. Without wages or property, the deduction is zero
regardless of the type of business.
Example 2. Your in-favor business has
$400,000 of QBI after wages of $300,000. Your Form 1040 shows $500,000 of
taxable income. Your Section 199A tax deduction is $80,000. For Section 199A
purposes, W-2 wages include
·
cash
wages and benefits,
·
elective
deferrals,
·
deferred
compensation, and
·
designated
Roth contributions.
For
Section 199A purposes, you must use one of the three following IRS-created
methods to find your Section 199A wages:
1.
Unmodified box method. Under this effortless method, your
W-2 wages are the lesser of Box 1 or Box 5.
2.
Modified Box 1 method. Under this more accurate method,
your W-2 wages are the total of Box 1 plus amounts in Box 12 that are coded D,
E, F, G, and S minus amounts in Box 1 that are not wages for federal income tax
withholding purposes.
3.
Tracking wages method. Under this most accurate method,
you track the W-2 wages subject to federal income tax withholding and add the
amounts in Box 12 that are coded D, E, F, G, and S.
If you
operate as an S corporation, you should use the modified Box 1 method (method
2) or the tracking wages method (method 3) to ensure your S corporation
includes your elected deferrals and health insurance in its W-2 wage
calculation.
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