Planning to Live Beyond 2025? How You Can Still Enjoy Estate Tax Reform’s Sunset Special

The just-enacted Tax Cuts and Jobs Act doubles the federal estate, gift, and generation-skipping transfer lifetime tax exemptions through 2025. The exemptions revert to their pre-Act levels on January 1, 2026. Ignoring inflation adjustments, the combined exemptions for a married couple will then fall from over $22 million to $11 million. At the 40% Federal transfer tax rate, a 2026 sunset will increase a married couple’s estate tax by $4.4 million.

Do you want to avoid $4.4 million of estate tax, even if you plan to celebrate the 2026 New Year amongst the living?

A married couple can permanently harvest the increased exemptions by gifting assets with value up to the full $22 million exemption amount before 2026. If you gift into a generation-skipping trust, the exempted assets can pass through many generations free of transfer tax. With valuation discounts for lack of control and lack of marketability still fully available, family business assets are particularly attractive for gifting.

A taxpayer can not use the increased exemption until he or she first make gifts exhausting his or her pre-Act exemption. An individual does not create an additional tax benefit until he or she first gifts about $5.5 million worth of property. A couple does not capture the full additional benefit until they give away property worth over $22 million.

These ordering rules create an obstacle for many, who can not afford to give away that much property. Married taxpayers in that situation may consider funding “Spousal Lifetime Access Trusts.” Each spouse gifts assets to a trust for the other spouse, leaving the gifted assets available to the beneficiary spouse for his or her lifetime. When the beneficiary spouse dies, the remaining trust assets pass to children or other beneficiaries free of estate tax. Persons who created such trusts shortly before 2013, when another legislative sunset almost reduced the lifetime exemptions, can fund their existing trusts with additional gifts.

Many families will wait until 2026 is closer before taking action. Families with sufficient wealth to afford substantial gifting, who also expect estate tax liability even with the increased exemptions, should consider gifting sooner, to remove appreciation in the gifted assets before 2026 from their future taxable estates.

For more information regarding the Tax Cuts and Jobs Act, follow these links:

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

Rethinking Large 2017 Year-End Charitable Gifts

With the standard exemption increasing and federal income tax rates generally falling in 2018, accelerating charitable gifts into 2017 may seem like a no-brainer. You might want to think twice if you plan a large charitable gift.

Under current law, the income tax charitable deduction and many other itemized deductions gradually phase out as income increases above $313,800 for married jointly filing taxpayers. The phase out continues until the deductions are reduced by 80%.

The just-enacted Tax Cuts and Jobs Act suspends this limitation, allowing charitable and other itemized deductions without the income-based phase out.  This could cause a 2018 charitable gift to produce a more valuable tax benefit than a 2017 gift, particularly for large gifts.

If you are unsure how to proceed, ask your CPA to run the numbers in both scenarios.  Better to wait a year for the deduction, than to receive a much smaller benefit than you expected.

For more information regarding the Tax Cuts and Jobs Act, follow these LINKS:

http://blog.williamsparker.com/businessandtax/2017/12/18/whats-tax-reform-bill/

http://blog.williamsparker.com/businessandtax/2017/12/18/reform-business-tax-reform/

http://blog.williamsparker.com/businessandtax/2017/12/19/2017-year-end-planning-art-equipment-non-real-estate-1031-exchanges/

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

 

2017 Year-End Planning for Art, Equipment, and Other Non-Real Estate 1031 Exchanges

The Tax Cuts and Jobs Act eliminates Section 1031 Exchanges for non-real estate transactions effective January 1, 2018.  But you still have time to plan If you anticipated executing an early-2018 1031 Exchange with art, equipment, or other non-real estate investment assets.

The Act includes a transition rule that allows a taxpayer to complete a non-real estate 1031 Exchange during 2018 if the taxpayer either acquires replacement property for a “reverse” exchange or disposes of relinquished property for a “forward” exchange before January 1, 2018.

To take advantage with property you haven’t sold, consider causing a related-party taxpayer—such as a corporation you control—to purchase the property before year-end, and escrowing the proceeds with a qualified intermediary. The related party can sell the property to an unrelated party with a stepped-up tax basis a few years later.  You can complete the 1031 Exchange in 2018 using the escrowed proceeds in the usual 1031 Exchange time frames.

For a reverse exchange, you can park replacement property purchased before year end with an accommodation titleholder, and complete the exchange by selling the relinquished property in 2018 within the usual 1031 Exchange time frames, with the same result.

These strategies are not risk-less.  For example, in the forward exchange scenario, you will recognize gain and pay tax if you can’t complete the exchange within 180 days, even though you initially “sold” property to a related party.  But in the right situation, some taxpayers might nevertheless use the transition rules to make something out of nothing.

To read the transition rules, see page 192 of the Act.

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

 

Should You Reform Your Business for Tax Reform?

If you own a closely-held business, it likely utilizes a “pass-through” S corporation or partnership tax classification.  The owners pay income tax individually on pass-through entity income, whether or not the business distributes the income.

C corporations are different.  C corporations pay tax on their own income.  The shareholders pay an additional dividend tax only when the C corporation distributes dividends.

Under the Tax Cuts and Jobs Act that Congress likely will pass Tuesday, the federal tax rate on retained C corporation income will drop from 35% to 21%.  The top individual tax rate, which also applies to pass-through entities, will equal 37%.  The Act makes C corporation tax status more attractive than in the past.

Should you convert your pass-through business to a C corporation?  

Should you change the tax classification of your business?

The short-answer: Probably not, unless you plan to own the business a long time and indefinitely reinvest profits.

A longer answer:

Under the Act, converting your business into a C corporation creates a trade-off between:

  1. a lower tax rate on operating income, leaving more cash to reinvest in the business; and
  2. paying more tax (or getting a lower purchase price) when you sell the company, and having less flexibility taking profits out of the business in the meantime.

If you convert your Florida-based pass-through business to a C corporation, the business will pay state income taxes that pass-through entities avoid. The C corporation’s combined federal and state tax rate will reach just over 25% on reinvested income.

The problems? You will pay a higher or equivalent tax rate, as compared to the pass-through tax rate, if you take the profits out of the corporation.  If you sell the business as a C corporation you will (1) pay about a 43% combined corporate-level and shareholder-level tax rate on the sale gain (versus a likely 20% or 23.8% rate as a pass-through), or (2) receive a lower purchase price to compensate a buyer willing to purchase the corporation stock for forgoing a tax basis step up in the corporate assets.  And if laws or circumstances change, you cannot always readily convert back to pass-through status without negative tax consequences.

What’s in the Act for Pass-Through S Corporations and Partnerships?

The Act includes a new deduction of up-to-20% of income for pass-through businesses.  If your business earns $10 million of income, you might qualify to deduct $2 million.  The deduction would save $740,000 in federal income tax and reduce the business’ effective income tax rate from about 36% to approximately 29%.

The catch?  For taxpayers with income over about $400,000 (or a lower threshold for persons other than married, joint filers), the Act limits the deduction to (1) 50% of the wages paid to employees, or (2) the sum of 25% of wages, plus 2.5% of the value of owned depreciable property.  If the business earns a $10 million profit, but its payroll is $3 million, you may only qualify to deduct $1.5 million, not $2 million. Unless the business has a lot of payroll or owns substantial depreciable property, its tax rate may remain in the mid-to-high 30% range.

Despite the new deduction, the Act leaves most pass-through entity owners paying a higher tax rate than C corporations pay on reinvested business profits.  But most pass-through entities retain the advantages of a lower tax rate on profits distributed to owners and on the sale of the business.

What to Do?

If you can predict future payroll and equipment purchases, the price and timing of a business sale, and Congress’ whims, you can perform a present value calculation to decide whether pass-through or C corporation tax status is best for your business.  The calculation would compare the pre-business-sale tax savings from the reduced C corporation tax rate on reinvested profits, against the increased tax on distributed profits and from a future business sale.

The math is more complicated for businesses qualifying for other tax breaks, such as the Section 1202 small business stock gain exclusion.  It grows even more complicated if the model considers the tax effects of an owner’s death.

If your crystal ball isn’t clear, you are stuck making best guesses about the future of politics and your business.  But if you frequently take profits out of your business or imagine selling it in the foreseeable future, you probably will stick with the pass-through  tax status your business already uses.

For more comprehensive information regarding the Tax Cuts and Jobs Act, follow this link to our previous post.

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

What’s in the Tax Reform Bill?

Congress is set to pass the Tax Cuts and Jobs Act, which includes the most comprehensive changes to the federal tax law in over thirty years.

We will provide insight regarding the new law in the coming days and weeks.

In the meantime, here is a chart summarizing salient provisions in the Act.

Here is a link to the Act (including Congress’ explanation of the law beginning on page 510).

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

The U.S.-Japan Income Tax Treaty

Japan has long been one of the United States’ largest trading partners.  Japan is also one of the United States’ longest-standing tax treaty partners.  The first U.S.-Japan income tax treaty was concluded in 1954.  Updated treaties were signed in 1971 and 2003, and a protocol in 2013 further modernized the treaty.  The U.S.-Japan income tax treaty largely follows the model tax convention published by the Organisation for Economic Co-operation and Development (OECD), of which both countries are members.

The U.S.-Japan income tax treaty helps reduce the incidence of double taxation and encourages the cross-border movement of people and goods.  In general, the tax treaty allocates or restricts taxing rights between the two countries so that a resident of either the United States or Japan does not pay tax in both countries with respect to the same income (or pays reduced rates of tax in one of the countries).

For example, dividends paid by a company which is a resident of the United States to a resident of Japan may generally be taxed in both Japan and the U.S., but the rate of tax imposed by the United States with respect to such dividends is limited to either 5% or 10% (or, in some circumstances, such tax may be eliminated).  In the case of interest and royalties paid by a resident of one of the countries, only the country in which the recipient of the interest or royalty payment resides may tax such payments.  Similarly, capital gains derived by a resident of the United States or Japan from the sale of property other than real estate are generally taxable only by the country in which the seller of the property resides.  Gains from the sale of real estate and certain real estate holding companies, however, remain taxable in both countries under the tax treaty.

The tax treaty also provides for tie-breaker rules so that the same person is not considered a resident of both countries and provides a limited safe harbor for wages and salaries paid to residents of one country who perform employment services in the other country.  Other provisions relate to the taxation of diplomats, athletes, and branches or “permanent establishments” of multinational businesses, among other special situations.  Where disputes regarding the taxation of cross-border activities arise, notwithstanding the provisions of the treaty, the treaty provides a dispute resolution mechanism whereby the U.S. and Japanese governments can come to a mutual agreement to reduce or eliminate the additional taxation.

Recent U.S.-Japan income tax treaty documents and Treasury Department technical explanations are available at treasury.gov.

Nicholas A. Gard
ngard@williamsparker.com
(941) 552-2563

Williams Parker Convinces IRS to Waive $224,640 Penalty Asserted Against Client

An LLC taxed as a partnership with 128 partners failed to file its partnership tax return electronically, resulting in the IRS asserting a penalty of $224,640 under IRC section 6698(a)(1). Partnerships with more than 100 partners are required to file their tax returns electronically under IRC section 6011(e). Williams Parker represented the partnership in connection with a penalty waiver request pursuant to IRS Announcement 2002-3, 2002-1 CB 305 (Jan. 14, 2002). Shareholder Mike Wilson at Williams Parker convinced the IRS that the partnership was entitled to a penalty waiver under the criteria of the Announcement, and therefore the IRS withdrew the entire $226,640 penalty. Information regarding the Announcement criteria and related guidance can be found at irs.gov.

Tax Reform Swings a Hand Ax at Carried Interests; What Does it Mean and How Can I Plan Around It?

While tax reform has a long march before becoming law, the amended House of Representatives bill passed yesterday swings an ax at lower-tax-rate-capital-gain-eligible “carried” partnership interests, though it swings a smaller ax—like a hand ax rather than a full-sized ax—than proposals in years past.

This latest proposal focuses on limited industries and allows an escape hatch for interests held more than three years. Here are the details:

How Do I Know if I Have a Carried Interest, and Why are Carried Interests Special?

The phrase “carried interest” applies to a partnership interest granted to a partner for services.  The idea is that the capital-investing partners “carry” the service partner, who does not make a capital contribution in proportion to the service partner’s interest.

Partnerships often structure carried interests to have little or no value at grant, causing the recipient to recognize little or no wage or other compensation income at that time.  Later, if the partnership recognizes long-term capital gain, the partnership allocates part of that gain to the service-providing partner.  This results in the service partner paying tax at a tax rate as little as half the rate on wage or compensation income (approximately 20%, as compared to approximately 40%, depending on the circumstances).

Why Change the Tax Treatment of Carried Interests?

Critics complain that carried interest partnership allocations amount to a bonus that should be taxed at the higher ordinary rates, like wage income and other incentive compensation.  The most vocal criticism focuses on hedge funds, private equity firms, and real estate investment firms, where critics see carried interest allocations as the equivalent of management fees.  Past Congressional proposals would have recharacterized a percentage or all partnership allocations to carried interests as compensation income, without regard to industry.

Carried interest advocates respond that many carried interest holders invest years of effort before receiving an allocation to their partnership interests, and therefore make the equivalent of an investment associated with a capital contribution.

Proposed Changes in the House Bill

The amended House bill takes a middle ground between the current law and prior Congressional proposals to curb the eligibility of carried interests for long-term-capital gain allocations. The bill focuses on carried interests in hedge funds, private equity firms, and real estate investment firms, not traditional operating businesses.

In targeted firms, the bill allows a partnership to allocate long-term capital gain to a carried interest partner who has held his or her partnership interest more than three years. If the partner has held the interest for three years or less, the proposal recharacterizes the allocation as short-term capital gain. In most cases, short-term capital gain characterization results in income taxation at the same rate as wage or other compensation income, but still allows the partner to avoid employment taxes.

It remains uncertain whether this proposal will survive reconciliation with a to-be-passed Senate tax reform bill.

Future Planning

Even if the proposal becomes law, look for motivated taxpayers to form “shelf” entities to begin the running of the three-year holding period while undertaking limited business activity. The taxpayers will then have such partnerships ready to use in the future, when a more substantial opportunity arises. Others will design hybrid debt-equity capital structures such that even service-providing partners’ interests qualify as capital interests rather than carried interests.

Read the carried interest proposal (see Section 3314 of the House amendment to the Tax Cuts and Jobs Act).

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

What’s Not to Like About the Proposed Tax Rate Reductions for Small Businesses?

If you run a small business (or even a large closely-held business) taxed as an S corporation or partnership, don’t get too excited about the tax rate reduction headlines in Congress’ latest tax reform proposals.

The House bill touts a 25% tax rate for business income from these entities. Passive investors would enjoy the 25% rate on all business income, which may encourage more investment and lower equity financing costs.  But for an entrepreneur actively involved in the business, the lower rate only applies to 30% of annual income from the business, or to annual business income up to approximately eight percent of adjusted tax basis (roughly, the un-deducted investment amount) in the business assets.  So the House bill is friendly to passive investors, and offers only limited benefits to traditional entrepreneurial small business operators.

The Senate proposal touts a 17.4% deduction against S corporation and partnership business income, but limits that deduction to 50% of the amount the individual taxpayer business owner receives in wages.  In other words, you have to pick up a dollar of income tax at the full individual tax rate and pay employment taxes on that amount, to enjoy the reduced tax rate on fifty cents of non-wage income.  This mix is not much different than the House’s 70% wage income-to-reduced-tax-rate business income ratio.

Like the House plan, the Senate small business tax rate proposal limits benefits to entrepreneurs.  Unlike the House bill, the Senate does little for passive investors, who may have a hard time justifying high wages to bolster their deduction.

The proposed 20% tax rate for traditional C corporation income is more straightforward than the S corporation and partnership tax rate proposals.  This may cause some small businesses to consider converting to C corporation status (the tax status of many larger companies and the vast majority of publicly-traded companies).  But in so doing the businesses (including, especially, Florida businesses) may become subject to state income taxes they otherwise avoid.  Further, any cash removed from the business will either be subject to the full individual tax rates or to a 23.4% dividend tax.  Finally, when the business is sold, the seller may receive a lower price (because the buyer can’t depreciate the purchased assets) or pay tax at an effective tax rate significantly higher than received or paid by the seller of a business structured as a S corporation or partnership.  So while taking advantage of the 20% C corporation tax rate may seem desirable to a growing business that reinvests its profits, the business owner may suffer a significant detriment upon a business sale and pay a higher tax rate on cash removed from the business in the meantime.

Conceivably, if you operate a small business, some flavor of the House and Senate proposals could reduce your tax liability.  There are some clean wins.  For example, both bills would allow many small businesses to immediately deduct much larger volumes of annual asset purchases, rather than take depreciation deductions over time. But if enacted, the tax rate proposals will not make life more simple or reduce difficult choices.

Changes to business tax rates are just the tip of the tax reform iceberg. The bills would make significant changes to many other areas of the tax law.  More to come…

Here is a link to a summary of the House bill: https://waysandmeansforms.house.gov/uploadedfiles/tax_cuts_and_jobs_act_section_by_section_hr1.pdf

Here is link to a summary of the Senate bill: https://www.finance.senate.gov/imo/media/doc/11.9.17%20Chairman’s%20Mark.pdf

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

Section 1059A – A Trap for the Unwary?

Our community is near multiple major ports, including Port Manatee and the Port of Tampa.  Taxpayers that import goods through these ports should be aware of U.S. tax issues that can arise from their actions.  U.S. taxpayers that import goods from related parties outside the United States have several tax rules to consider in setting their transfer prices and reporting income, including the transfer pricing regimes in both the importing and exporting jurisdictions.  Among the U.S. tax rules that such importers must consider is a lesser-known Internal Revenue Code section, Section 1059A.

Section 1059A provides that the maximum amount a U.S. taxpayer may claim as basis in inventory goods imported from a related party is the amount that was determined for customs purposes when the goods were imported.  The statute is designed to prevent taxpayers from claiming low values for customs purposes (reducing the amount of U.S. customs duties owed) and high values for transfer pricing purposes (reducing the amount of U.S. taxable income).

A trap for the unwary can occur when related parties retroactively modify their intercompany pricing after goods are imported.  For example, a U.S. company may increase the amount paid for an imported good at the end of the year in order to satisfy the arm’s length standard for transfer pricing purposes.  This additional amount is generally be subject to customs duties, but reporting additional customs duties can fall through the cracks if a company’s personnel responsible for tax and customs compliance do not communicate regarding the adjustment.  In addition, even where additional amounts are reported for customs purposes, the timing of an upward adjustment in the customs price could prevent taxpayers from including the adjustment in the basis of the inventory for tax purposes if the adjustment is made after the customs value has been “finally-determined” (generally, 314 days after the date of entry).  These issues may frequently arise when taxpayers retroactively adjust transfer prices in accordance with Advance Pricing Agreements.

In recent years, practitioners have called for better coordination between the Internal Revenue Service and U.S. Customs and Border Protection along with reforms to eliminate the potential whipsaw of Section 1059A.  It remains to be seen whether current tax reform proposals will reach this issue.

Nicholas A. Gard
ngard@williamsparker.com
(941) 552-2563