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Banking and Financial Services

Giving Some Insight

By Terri Judycki

Terri Judycki, CPA, MST

Terri Judycki, CPA, MST

The Tax Cuts and Jobs Act (TCJA) has resulted in many changes for taxpayers. One area in particular is charitable giving.

For those who regularly make charitable contributions, changing philanthropic giving habits may result in greater tax benefits. This article will explore various strategies for maximizing the tax benefit of charitable giving under the new law.

The TCJA increases the standard deduction to $12,000 for a single taxpayer and $24,000 for a married couple filing a joint tax return. In addition, the itemized deduction for taxes has been capped at $10,000 for all combined state and local tax payments. The Congressional Budget Office estimates that these changes will reduce the number of taxpayers who itemize deductions by more than half.

To maximize the benefit of the higher standard deduction, consider bunching charitable contributions in alternating years. For example, if a married couple with no mortgage ordinarily gives $12,000 to charity each year, they will likely take advantage of the $24,000 standard deduction ($12,000 to charity plus $10,000 in state and local states is less than the $24,000 standard deduction). If, instead, they give $24,000 every other year, they will use the $24,000 standard deduction in the ‘off’ year and $34,000 in itemized deductions in the year with the gifts ($24,000 charitable contributions plus $10,000 state and local taxes), resulting in lower taxable income without any increase in cash expenditures.

From the charity’s perspective, though, this could leave some budget challenges.

Another way to bunch deductions without bunching the charities’ income is through the use of a donor-advised fund (DAF). DAFs are funds controlled by 501(c)(3) organizations in which the person establishing the fund has advisory privileges as to the ultimate distribution to charities.

In our example above, the married couple might establish a DAF with $24,000 in one year and direct or ‘advise’ that donations be made to specific charities over time. Amounts used to establish the DAF are deductible charitable contributions when transferred to the sponsoring organization.

“For those who regularly make charitable contributions, changing philanthropic giving habits may result in greater tax benefits.”

Whether the idea of bunching appeals to you or not, don’t overlook the benefits of gifting appreciated stock to charity. The stock must have been held for more than a year to take advantage of this planning opportunity. The charitable deduction is the fair market value on the date gifted. Gifting the stock instead of cash avoids income tax on the appreciation.

For example, if a taxpayer wants to make a gift of $10,000 to a charity and sells stock worth $10,000 for which he paid $7,000, he would have a $10,000 deduction and $3,000 taxable gain. If, instead, he directs his broker to transfer the stock to the charity, he is still entitled to a $10,000 deduction, but does not report the $3,000 gain.

Finally, taxpayers age 70½ or older have another option available. An individual who is 70½ or older on the transfer date can direct the trustee of his IRA to distribute directly to a qualified public charity. The distribution is called a qualified charitable distribution (QCD). The amount transferred counts as a distribution for purposes of meeting the minimum distribution requirement but is not included in the taxpayer’s income.

There are a few requirements. The charity cannot be a private foundation or a donor-advised fund. No more than $100,000 can be donated by an account owner each year. The gift to the charity must be one that would have been entirely deductible if made from the taxpayer’s other assets — for example, the donor should obtain adequate substantiation from the charity, and the donation should not be one that entitles the donor to attend a dinner, play golf, or receive any other benefit.

In our example above, the couple who makes a QCD from IRAs for the $12,000 each year reduces taxable income by $12,000 and still uses the standard deduction.

Another possible advantage is the effect the reduction may have on other taxable items. Depending on the taxpayer’s total income, reducing adjusted gross income could result in reduction of the amount of Social Security benefits that are taxed, an allowed loss from certain real-estate rentals, or a reduction in the net investment income tax (if the amount of excess AGI exceeds the net investment income).

Reducing income may also result in lower Medicare premiums that are based on income for higher-income taxpayers. In addition, some states do not provide deductions for charitable donations, but do follow the federal treatment of excluding the QCD from income.

These changes may result in tax savings that could be used to make an even larger donation to a favorite charity.

Terri Judycki is a senior tax manager with the Holyoke-based public accounting firm Meyers Brothers Kalicka, P.C.; (413) 322-3510; [email protected]

Banking and Financial Services

Take Caution with Section 199A

By Kristina Drzal Houghton, CPA, MST

Kristina Drzal Houghton

Kristina Drzal Houghton

On Dec. 22, 2017, the Tax Cuts and Jobs Act was signed into law, bringing the biggest changes to both corporations and individuals in the past 30 years. Having spoken before groups of medical professionals on this issue, I have found that many believe limitations in the law will prohibit physicians from benefiting from these tax reductions.

This article will focus on medical practices and highlight some techniques available to benefit from the 20% deduction which might otherwise be limited. Additionally, there will be detailed examples of said techniques that will help to provide perspective and clarity to practice owners and shareholders on this very complicated tax issue.

Over the past few decades, many practices have been formed as pass-through entities. In contrast to C-corporations, income earned by a sole proprietorship, S-corporation, or partnership is subject to only a single level of tax. There is generally no tax at the entity level; instead, owners of these businesses report their share of the business’ income directly on their tax return and pay the corresponding tax at ordinary rates.

The Tax Cuts and Jobs Act, signed into law this past December, reduced the top rate on ordinary income of individuals from 39.6% to 37%, and Section 199A further reduced the effective top rate on qualified business income earned by owners of sole proprietorships, S-corporations, and partnerships to 29.6%. Section 199A allows taxpayers other than corporations a deduction of 20% of qualified business income (QBI) earned in a qualified trade or business, subject to certain limitations.

Business owners below the applicable threshold amount — which is $157,500 of taxable income for all filers except joint filers, and $315,000 for those filing jointly —— can enjoy a QBI deduction for the lesser of 20% of their qualified business income or 20% of their taxable income. It does not matter what type of business is generating the income, nor is there a need to analyze W-2 wages paid by the business or depreciable assets owned by the business. The QBI deduction is what it is.

Business owners over their applicable threshold who derive their income from a business that is not a specialized trade or service business may also have their QBI deduction at least partially phased out, but the full deduction may be ‘saved’ based on how much they pay in W-2 wages and/or how much depreciable property they have in the business.

Business owners over their applicable threshold who derive their income from a ‘specified service’ business — which includes doctors, lawyers, CPAs, financial advisors, athletes, musicians, and any business in which the principal asset of the business is the skill or reputation of one or more of its employees — will have their QBI deduction phased out.

The phaseout range is $50,000 for all filers except joint filers, and $100,000 for those filing jointly. Once a business owner’s taxable income exceeds the upper range of their phase-out threshold ($207,500 for individuals and $415,000 for married filing jointly), they cannot claim a QBI deduction for income generated from a specialized trade or service business.

Examine your practice to determine if all your income is from a specified trade or business. A careful analysis of your practice could identify that it consists of multiple different trades or businesses. For example, an orthopedic practice might sell medical equipment. Breaking this portion of the practice off into its own LLC will decrease the specified service trade or business income and could potentially qualify for a QBI deduction with proper planning.

Shifting Business-owned Real Estate to New Entities and Paying Rent

Many practices own the real estate out of which they operate. If this is the case for a higher-earning business owner, there is an obvious way of converting some of the specified service-business income into income from a business that may qualify for a QBI deduction. In short, the business owner can create a new entity, transfer the real estate into that entity — provided the transfer is not tax prohibitive — and then lease that real estate back to the original business.

The original business’s profits, which are not eligible for the QBI deduction (assuming the business owner’s taxable income exceeds their applicable threshold), will decrease, and profits can be shifted to the new real-estate company, which could potentially qualify for at least a partial QBI deduction.

Example: John is a dentist and is the sole owner of an oral-surgery practice organized as an LLC. His income from the practice — which falls under the specified service business umbrella — is $900,000 per year. Thus, John is currently ineligible for any QBI deduction. Several years ago, the LLC purchased the medical offices out of which the practice operates for $2 million. The upkeep on the office space, the depreciation on the property, and other expenses currently reduce the net profit of the LLC by about $100,000 per year, but the property provides little else in the way of tax benefit for John.

One option to consider in a case like this would be to spin off the medical office building into a separate LLC, or other business structure, and have the dental practice rent space in the building. Those rent payments would be deductible for the medical practice, and taxable income for the new business … except the profit in the new business may be eligible for the QBI deduction.

For instance, suppose that, after spinning the medical office off into its own entity, the dental practice leases the office space at the rate of $220,000 per year. The net result of such a transaction would be reducing the dental practice’s net income $120,000 ($220,000 rental expense minus $100,000 prior expenses ‘lost’ = $120,000). The real-estate entity, on the other hand, would now have a profit of $120,000 — a net shift of zero — but the real estate’s income could qualify for the QBI deduction. Thus, the result is an equivalent amount of business income, but a $24,000 QBI deduction for John on his personal return that, at his tax rate, would save him nearly $9,000 in federal income taxes annually.

Shifting Other Business-owned Assets to Other Entities and Leasing Them Back

For some business owners, there’s the potential to continue to push the boundary even further on shifting depreciable property out of a business, and then leasing it back to the original business entity.

Example: Continuing the earlier example of John and the dental practice above, suppose the practice also owns X-ray machines and a variety of other depreciable medical equipment as well, with an unadjusted basis of $750,000. This equipment could be spun off into yet another business, and the dental practice could lease back the equipment.

The mechanics and potential tax benefits of this move are essentially the same as when real estate is moved into a separate entity. When it comes to the QBI deduction, depreciable business property is depreciable business property. The 2.5% limitation is not impacted by the type of depreciable property or the length of time over which it will be depreciated.

Of course, the limitation to this strategy is that not all small businesses have substantial (or much, or any) depreciable property to spin off into other entities in the first place … and at some point, any and all depreciable property that could be spun off will have been. So that’s it, right? Maybe not.

If You Can’t Lease Equipment, Lease People with an Employee-leasing Company

Many specified service businesses are labor intensive but may not necessarily require a great deal of depreciable property. Anesthesia and radiology practices are both good examples of this. Outside of some office furniture and some computers, these businesses can generate substantial profits without ever owning any significant amount of depreciable property since they operate out of hospital-owned facilities. They do, however, often employ a great number of people, and spend substantial amounts on human capital.

To that end, the language in Section 199A leaves the door open to the possibility of creating an employee-leasing company and leasing back one’s employees from that company. Some practitioners believe this to be a gaping hole in the rules, while other practitioners are a little more cautious at this time. Even on the conservative side, the billing and administrative employees could defensibly be split off into a separate LLC if it can be demonstrated that it is not a specified trade or business because it is not dependent on the skill or reputation of one or more of its employees.

Notwithstanding the benefits of the above strategy, some caution is merited. Tax advisers are understandably eager for answers, but unfortunately, Section 199A is just one small piece of the most significant overhaul of the tax law in 31 years. The IRS is now charged with the herculean task of providing guidance for a host of new and changed statutory provisions, and, as a result, it may be some time before tax advisers have certainty related to some of the strategies posed in this article.

Until that guidance arrives, Section 199A will best be approached cautiously, particularly considering the potential substantial-understatement penalty that comes with claiming a deduction under this provision.

Kristina Drzal Houghton, CPA, MST is a partner with the Holyoke-based accounting firm Meyers Brothers Kalicka, P.C. and director of the firm’s Taxation Division; [email protected]