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The Basics of the New Section 199A and How It Affects the Self-Employed

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Affectionately being referred to as the Pass-Through Deduction, the new tax law will allow partnerships, LLCs, S corporations and sole proprietorships (in other words, pass-throughs) to deduct up to 20% of their Qualified Business Income under revised provisions of IRC § 199A.

How is the Pass-Through Deduction Calculated?

The Pass-Through Deduction usually will be whichever is smaller between 20% of the household’s Qualified Business Income or 20% of the household’s taxable ordinary income. For example, assume a self-employed plumber has $50,000 of Qualified Business Income in 2018, with no other sources of income. If the plumber is a single filer he may claim a $12,000 standard deduction, resulting in $38,000 in taxable income. Therefore, 20% of the plumber’s Qualified Business Income is $10,000 ($50,000 x 20%), while 20% of his taxable income is $7,600 ($38,000 x 20%). The plumber may claim a $7,600 Pass-Through Deduction, the smaller of the two amounts.

What is Qualified Business Income?

In general, Qualified Business Income is net income that is received from a Qualified Trade or Business. However, there are some exclusions, the most common of which are capital gains, dividend and interest income. Additionally, any guaranteed payments or “reasonable compensation” paid to owners must be excluded.

What is a Qualified Trade or Business?

In general, a Qualified Trade or Business is any trade or business that is not a “Specified Service Trade or Business” or the trade or business of performing services as an employee.

The IRS Defines a Specified Service Trade or Business as:

  • any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, 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 1 or more of its employees or owners,
  • any banking, insurance, financing, leasing, investing, or similar business,
  • any farming business (including the business of raising or harvesting trees),
  • any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A,
  • any business of operating a hotel, motel, restaurant, or similar business, and
  • any business which involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.

Income Based Exception for Specified Service Trade or Business Owners

An income-based exception exists for owners of a Specified Service Trade or Business which will allow them to take the Pass-Through Deduction as long as their income is below a certain amount. For 2018, that amount is $207,500 (or $415,000, for MFJ) to be eligible for a partial deduction and $157,500 (or $315,000, for MFJ) to be eligible for the full deduction. Therefore, even if a taxpayer owns a Specified Service Trade or Business if her income is below $157,500 (or $315,000, for MFJ) for the year she may still take the full 20% pass-through deduction. While, if her income is greater than $157,500 (or $315,000, for MFJ) but below $207,500 (or $415,000, for MFJ), she may take a partial deduction.

Phase Out Provisions and other Requirements for Certain Taxpayers

The New Pass-Through Deduction is very complex. While we have discussed the basics here, the new law contains numerous nuances. For example, for taxpayers who have income greater than $207,500 (or $415,000 for MFJ) the deduction must be calculated in a different manner. It is advised that you speak with a tax professional to determine your specific eligibility for the new Pass-Through Deduction.

Business Start-Up Costs – What’s Deductible?

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Launching a new business takes hard work — and money. Costs for market surveys, travel to line up potential distributors and suppliers, advertising, hiring employees, training, and other expenses incurred before a business is officially launched can add up to a substantial amount.

The tax law places certain limitations on tax deductions for start-up expenses.

  • No deduction is available until the business becomes active.
  • Up to $5,000 of accumulated start-up expenses may be deducted in the tax year in which the active business begins. This $5,000 limit is reduced (but not below zero) by the excess of total start-up costs over $50,000.
  • Any remaining start-up expenses may be deducted ratably over the 180-month period beginning with the month in which the active business begins.

Example: Gina spent $20,000 on start-up costs before her new business began on July 1, 2018. In 2018, she may deduct $5,000 and the portion of the remaining $15,000 allocable to July through December of 2018 ($15,000/180 × 6 = $500), a total of $5,500. The remaining $14,500 may be deducted ratably over the remaining 174 months.

Instead of deducting start-up costs, a business may elect to capitalize them (treat them as an asset on the balance sheet). Deductions for “organization expenses” — such as legal and accounting fees for services related to forming a corporation or partnership — are subject to similar rules.

When is a Service Trade or Business Excluded from the New Pass-Through Deduction?

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The new Section 199A pass-through deduction identifies certain business fields that may not utilize the deduction if the owner’s income is above certain thresholds or phase-outs. These businesses are identified in the new law as Specified Service Trade or Businesses.

What is a Specified Service Trade or Business?

The new Section 199A defines a Specified Service Trade or Business as:

  • any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, 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 1 or more of its employees or owners,

  • any banking, insurance, financing, leasing, investing, or similar business,
  • any farming business (including the business of raising or harvesting trees),
  • any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A,
  • any business of operating a hotel, motel, restaurant, or similar business, and
  • any business which involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.

It is important to note that the new law specifically excludes architecture and engineering from being classified as a Specified Service Trade or Business. Therefore, business owners in those fields are eligible for the pass-through deduction regardless of the income thresholds discussed below.

What are the Income Thresholds and Phase-Outs?

For 2018, specified service taxpayers with income below $157,500 (or $315,000 if married filing joint) will be eligible to claim the full 20% deduction. Specified service taxpayers that are above that threshold, but still have income below $207,500 (or $415,000 if married filing joint) will be eligible for a partial deduction. These figures will be adjusted for inflation moving forward in future years.

Confused by the Specified Service Trade or Business Definition?

If you are confused by the new law’s definition of a Specified Service Trade or Business you are not alone. These definitions are very vague and many service fields do not perfectly fit the definition as it is currently written. For example, is the hair stylist for a famous musician in the field of performing arts? Congress has tasked the Tax Commissioner with drafting regulations for the new Section 199A, which will hopefully bring clarity to this issue. Be sure to consult with a qualified tax advisor when determining your eligibility for this new deduction, especially if you are unsure if you qualify.

Individual Tax Deductions – A Look at What’s Changing in 2018

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The recently enacted tax reform law made some significant changes to the system of income tax deductions used by consumers. Here are highlights of the changes.

The standard deduction is increased.

For the 2018 tax year, the standard deduction has grown to as much as $24,000. Because of the significant increases, many taxpayers who formerly itemized their deductions may now benefit from the standard deduction instead.

Changes in Standard Deductions

Filing Status

Old Law

New Law

Single

$6,500

$12,000

Married filing jointly

$13,000

$24,000

Head of household

$9,550

$18,000

Married filing separately

$6,500

$12,000

These 2018 standard deduction amounts will be indexed for inflation after 2018. The additional standard deduction for the elderly and the blind is unchanged.

The deduction for state and local taxes is reduced.

For those who itemize their deductions, the maximum amount permitted for all state and local taxes (SALT) combined is $10,000 per year ($5,000 for married individuals filing separately). How the new limit affects you will depend on your specific situation. If you live in a high-tax state, you may see much of your SALT deduction reduced, and that could mean that itemizing deductions is no longer the better option.

The mortgage interest deduction has a lower cap.

For mortgage debt incurred after December 15, 2017, you may only deduct interest on debt value up to $750,000 ($375,000 for married individuals filing separately). Previously, the limit was $1 million. For home equity debt, the deduction for interest is suspended through 2025, unless the proceeds are used to buy, build, or substantially improve the home that secures the loan.

Casualty and theft losses are not now generally deductible.

Beginning this year, only losses that occur as the result of a federally-declared disaster may be deducted. Formerly, casualty and theft losses had generally been deductible to the extent they exceeded 10% of adjusted gross income (AGI).

Miscellaneous itemized deductions are suspended.

Various miscellaneous expenses, such as unreimbursed employee business expenses and tax preparation expenses, were formerly deductible as an itemized deduction to the extent they totaled more than 2% of the taxpayer’s AGI. The new law suspends the deduction for these expenses.

Charitable contributions are still deductible if you itemize.

Cash contributions will now be allowed up to 60% of the taxpayer’s “contribution base,” up from 50%. A taxpayer’s contribution base is generally equal to AGI exclusive of any net operating loss carryback for the year. This change will affect only those taxpayers who contribute a significant proportion of their income to charity.

Medical expense rules become more generous.

Taxpayers with substantial medical expenses who also itemize can now deduct unreimbursed medical expenses in excess of 7.5% of their AGI, down from the deductibility threshold of 10% previously. Note that the reduced threshold was made retroactive to January 1, 2017, but will apply only for 2017 and 2018.

Moving expenses lose their tax advantage.

The deduction for qualified moving expenses, which can be claimed even if a taxpayer doesn’t itemize, has been suspended, except for members of the Armed Forces on active duty (provided certain conditions are met).

The alimony deduction for payers is eliminated.

The tax treatment of alimony payments will change significantly under the new law. Such payments will no longer deductible by the payer (and the recipient will no longer be required to include the alimony in income). The change applies to alimony paid under any divorce or separation agreement executed after December 31, 2018.

Note that some of these provisions are scheduled to sunset in 2019 or 2026 unless Congress acts to extend them. Talk to your tax advisor to see how the law may ultimately impact your situation.

Source/Disclaimer:

This communication is not intended to be tax advice and should not be treated as such. Each individual’s tax circumstances are different. You should contact your tax professional to discuss your personal situation.

Michigan Updates Sales Tax Requirements after Wayfair Decision

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The State of Michigan recently issued guidance in response to the Wayfair decision.  In this decision, the Supreme Court held that a business’ physical presence in a state is no longer required before a state can impose a sales or use tax collection requirement on that business.  Even though a physical presence is no longer required, states must meet the Constitution’s Commerce Clause requirements before imposing a tax collection requirement on the business.

The Commerce Clause requires that a tax:

  • is applied to an activity with substantial nexus with the taxing state. (prior to Wayfair, the Supreme Court held that a physical presence was required to establish nexus.)
  • is fairly apportioned in and out of the state
  • does not discriminate against interstate commerce
  • is fairly related to services provided by the state

In Wayfair, the Supreme Court held that a seller has substantial nexus in a state if it “avails itself of the substantial privilege of carrying on a business in that [state].”  In the Wayfair case, South Dakota required remote sellers to remit sales tax for sales sourced to South Dakota if the seller’s sales exceeded $100,000 or the seller had 200 or more separate transactions with customers in the state.

The Court found three factors important in finding South Dakota’s law constitutional:

  • the law had a safe harbor for smaller sellers (those with under $100,000 in sales or under 200 transactions per year)
  • the law only applied on a prospective basis—there was no retroactive tax remittance requirement
  • South Dakota is a member of the Streamlined Sales and Use Tax Agreement that standardizes its sales tax rules to reduce administrative and compliance costs. Michigan is also a member of this body.

Sales and Use Tax Nexus in Michigan

A seller has substantial nexus in Michigan (and therefore has a sales/use tax remittance obligation) under three rules:

  • The seller has a physical presence in Michigan
  • The seller can have representational , attributional, or “click-through” presence. See a prior post explaining these rules.
  • The seller has economic nexus as described in Wayfair

After September 30, 2018, a seller that has sales (both taxable and non-taxable) into Michigan exceeding $100,000, or a seller that has 200 or more separate transactions of sales (both taxable and non-taxable) into Michigan in the previous calendar year has nexus in Michigan and is required to remit sales or use tax on all of its taxable sales into Michigan and file all required returns.

Remote sellers must review their 2017 calendar year sales (January to December) to determine if they meet either of the two economic nexus thresholds.  If they meet either threshold, they must begin filing and paying sales tax in Michigan beginning October 1, 2018 forward.

Remote sellers that only have nexus due to exceeding either of the economic nexus standards are not liable for any tax, penalty, or interest for any transactions occurring before September 30, 2018.

Example:  Glamazon.com has no physical or representational presence in Michigan.  However, it had $150,000 of sales into Michigan between January 1, 2018 and December 31, 2018.  It has economic nexus in Michigan effective after September 30, 2018.  It must begin reporting and paying sales tax on all taxable sales from October 1, 2018 forward.

Once a seller has nexus due to its economic presence, it must remit tax until a calendar year passes in which it does not meet either of the economic nexus standards.

Example:  Assume same facts as above example; however, between January 1, 2018 and December 31, 2018, Glamazon.com only has $80,000 of sales into Michigan and only has 150 separate transactions into Michigan.  Seller no longer has economic nexus beginning January 1, 2019 and may cease remitting and reporting tax after that date (i.e., it must continue to remit and report sales tax through December 31, 2018, but may cease remitting and reporting for sales on or after January 1, 2019).

Qualified Small Employer HRA Avoids $100 per Day Penalty

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Background

Over the past few years, there has been a $100 per day per employee penalty for employers who provided certain Health Reimbursement Accounts (HRAs) and/or Employer Payment Plans.

Under an HRA, an employer reimburses employees for the medical expenses up to a certain limit.  The reimbursement is deductible by the employer and tax-free to the employee.

Under an Employer Payment Plan, the employer either reimburses employees for the cost of health insurance premiums or directly pays the insurance company for the employees’ health insurance coverage.  Again, the payment is deductible by the employer and tax-free to the employee.

Under the market reform provisions of Obamacare, these plans became disfavored and subjected the employer to a $100 per day per employee (i.e., $36,500 per employee per year) penalty.  The primary reason for the penalty is because the market reform provisions eliminated any annual or lifetime cap on benefits.  HRAs are generally subject to an annual cap and Employer Payment Plans are deemed to be capped at the cost of the employee’s premium that is being paid.

Qualified HRAs No Longer Subject to $100 per Day per Employee Penalty

Qualified HRAs are exempt from the $100 penalty.  Employer Payment Plans remain subject to the penalty.

Eligible employers that do not offer group health insurance coverage to any employees can offer a Qualified Small Employer HRA (QSEHRA).  Eligible employers are employers that are not applicable large employers under Obamacare (applicable large employers have 50 or more employees).

The employer must offer a QSEHRA to each eligible employee.  An eligible employee is defined broadly as any employee; however, the employer can elect to exclude the following:

  • Employees who have not completed 90 days of service
  • Employees under age 25
  • Part-time or seasonal employees
  • Employees covered by a collective bargaining agreement covering accident and health benefits
  • Nonresident alien employees with no U.S. source income

A QSEHRA must be provided on the same terms to all eligible employees and funded entirely by the employer.  Payments and reimbursements are limited to $4,950 per year ($10,000 for family coverage) and are prorated if the employee is not covered for the whole year.  For example, if a single person starts employment on July 1, then the limit is reduced by 50%–$2,475 ($4,950 times 50%).  These amounts will be adjusted for inflation.

Payments/Reimbursements are Taxable If Employee Does Not Have Minimum Essential Coverage

Unlike a regular HRA, premiums for individual health insurance policies, as well as other medical expenses such as deductibles and copays, can be paid or reimbursed by a QSEHRA.  However, any payments or reimbursements from a QSEHRA for medical care (including insurance premiums) that are provided when an individual does not have minimum essential coverage are included in the employee’s income.  Generally, an individual health insurance policy qualifies as minimum essential coverage, but the employer must verify that the employee has minimum essential coverage.  Payments under a QSEHRA will affect the employee’s amount and qualification for the premium tax credit.

Employer Must Provide Notice to Employees

An employer funding a QSEHRA must provide written notice to each eligible employee no later than 90 days before the beginning of the year (or the date the employee first becomes eligible to participate).  The notice must state the amount that will be available for reimbursement or payment for the year.  Additionally, the notice must remind the employee that any benefits available under a QSEHRA must be disclosed to the health insurance marketplace if the employee applies for coverage through the marketplace and requests advance payment of the premium tax credit.  The notice must also include a statement that if the employee does not have minimum essential coverage for any month, he may be subject to a penalty for the month and that payments and reimbursements under the QSEHRA may be included in income.

Employers that do not provide proper notice to employees are subject to a penalty of $50 per employee.  The total penalty that can be assessed for one year cannot exceed $2,500.

Finally, amounts paid under a QSEHRA must be reported on the employee’s W2 (even though the payments are generally tax-free).

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.