Update on Tax Reform Act
May 15, 2018 | BY Michael Rabinowitsch
1- Reduced Corporate Tax Rate
Under the new tax law, the tax rate for C corporations has been reduced to 21%. This rate does not apply to Sub-Chapter S corporations, LLCs or self proprietorships. Some financial advisors – unknowledgeable of the intricacies in tax law – may have advised S corporations to revoke its S election status and convert to a C corporation in order to benefit from the reduced tax rate. However, we urge caution. In converting a company to a C Corporation, factors other than only the tax rates have to be evaluated. Ignoring other factors, among which are the built-in gains tax and the difficulties involved in transferring assets, may result in a huge tax liability.
2- Section 199A Deduction
Much confusion surrounds the 199A deduction. Section 199A provides for a 20% deduction to owners of flow-through businesses. This deduction is calculated on the individual level and there are many factors that determine whether it can be applied. These factors include wages paid by the business, capital investment made by the owner and whether the business itself fulfills eligibility requirements. Many advisors suggest that companies split apart, creating management companies and sub-companies in order to utilize this deduction. We urge caution as the definition of what is considered a “Qualified Trade of Business” remains to be determined. Molding one’s business to fit into categories that may be ultimately be ineligible for the deduction is imprudent and exposes the company to risk.
3. State and Local Tax Deduction Limitation
Deductions for state and local income, sales, and property taxes are now subject to a combined cap of $10,000. Individuals living in states with higher tax rates (for example, California and New York) will feel the impact of this change to the greatest extent, and some may even consider relocating to states with lower or no income tax. Note, however, that state and local income and property taxes are generally not subject to this new $10,000 cap if they are paid or accrued in carrying on a trade or business or for the production of income.
To address this change New York created a charitable deduction program for the ostensible purpose of assisting New York residents and nonresident individuals address the SALT deduction limitation. Even though this change has the governor’s stamp of approval, it remains to be seen whether the federal government will actually recognize this as a charitable contribution and allow for a deduction. Recently, we saw taxpayers race to prepay taxes that ultimately were not recognized by the IRS. With this in mind, we do not recommend trying to utilize this deduction but to wait for definite government recognition of SALT as a charitable deduction.
4. Section 529 – Qualified Education Deductions
The law expanded the definition of “qualified education expenses” to include primary and secondary school expenses. The distributions from section 529 plans used to pay qualified education expenses are tax-free. Families as well as organizations were excited about this tax modification and rushed to participate in Section 529 plans. We urged caution and communicated a warning to our clients that New York State may not honor the change in the law. Ultimately, New York State disallowed this pay-in as a qualified distribution and those who relied on it will not enjoy this deduction. Our recommendation for the majority of our clients is that there is no purpose in participating in a Section 529 plan on a short-term basis.
5. Section 163J Interest Limitations
The newly enacted version of section 163(j) limits deductions for business interest expense and it applies to all taxpayers, including partnerships and their partners. Under the newly crafted law a taxpayer’s deduction for business interest expense is limited to, among other factors, the taxpayer’s business interest income. The business must generate $25 million in revenue.
This has motivated many businesses to split into several entities in order to take advantage of this deduction. However, as with many new amendments to the law, certain factors remain undefined. Without knowing the definition of ‘business’ we cannot consider what course of action to apply. We do not recommend making precipitous measures in regard to an entities structure until the tax law is clarified.