Tax Cuts and Jobs Act Thoughts

February 22, 2018

By Damien B.M. English

Are you prepared for the new tax bill recently passed by Congress? The Tax Cuts and Jobs Act (TCJA) joins a long line of new legislation CPAs will have to educate themselves on before this administration is done in the White House. CalCPA and CalCPA Education Foundation instructors have updated top tax courses and added new topics directly addressing the issues and implications for your clients to keep you informed. You can check out updates and course listings online.

We also decided to field reactions to the TCJA from a variety of CalCPA members for an idea of some of the top things CPAs should be aware of during the beginning days of this new tax law. 

Mark F. Seid, CPA, EA, USTCP
Seid & Company, CPAs
Here are my top three things CPAs should know right off the bat:
  1. The TCJA made fundamental changes in the structure of tax returns and 2018 will be the year of education—not only for tax practitioners, but also for our clients. We need to understand how to plan with the new law and then effectively communicate tax-advantaged strategies to our clients.
  2. The TCJA gave us the new Sec. 199A deduction of 20 percent of qualified business income. For taxpayers above the threshold amounts, failure to plan could result in losing out on this deduction entirely. We need to encourage our clients to engage us for mid-year and year-end tax planning—2018 tax planning will pay off more than ever before.
  3. The TCJA is a federal law. California does not conform to most of the changes in the TCJA. While federal income tax returns may have become easier to prepare for some, their California income tax returns will still follow the rules in place prior to TCJA. As a profession, we should be encouraging our Legislature to keep pace with changes in federal laws to ease the tax compliance burden on California taxpayers.
Scott Hoppe, CPA 
Partner, Why Blu
The major thing we can do is let clients know it is not straightforward. The 2018 tax law is poised to benefit small businesses across the board. Those benefits, however, are not so straightforward. The Wall Street Journal eloquently captured the complexity: 

“The owner of a successful chain of tanning salons should qualify for a new tax deduction, but someone who makes the same amount from a group of dermatology clinics won’t. A high-earning architect can generally claim that same tax break, but the designer who collects a big fee for working on the building’s interior probably can’t. A chef who owns her restaurant can also expect to pay less, but that may not be true if she is a celebrity chef. … doctors, lawyers and others in service businesses can’t claim the break if they earn too much money.”

The law is as clear as mud.

Gary R. McBride, CPA, JD, LLM, 
Professor Emeritus, California State University, East Bay
The new law forces tax professionals to re-think certain long-held assumptions about the federal tax law. 

Choice of Entity
Under prior law, C corps were generally regarded as inferior from an income tax standpoint relative to sole proprietorships, partnerships and S corps. For tax years beginning after 2017, the total C corp federal tax (at the entity and owner level) on $100 of C corp earnings is $39.8—only 2.8 percent higher than the top individual marginal rate. First the corporation is taxed at 21 percent, and when the remaining $79 of earnings and profits is subsequently distributed, the shareholder pays $18.80 (23.8% x $79). The individual level tax on dividend distributions is deferred, and corporations that can plow the earnings back into growing the company—thus deferring the shareholder level tax—have more money to invest than they would without the C corp. 

Regarding the impact of state of California taxes, C corps can fully deduct their 8.84 percent state income tax liability. Granted, S corp shareholders also continue to deduct the 1.5 percent entity level tax above AGI, but the general state individual income tax is, at best, an itemized deduction of $10,000 (when aggregated with sales tax and property taxes) on a joint return.

Conversely, taxpayers with high marginal rates (above 21 percent) may be fooled into believing that a C corp is the better choice, while the opposite may be true. Due to the progressive rate structure, when a married couple on a joint return reaches the 37 percent marginal bracket at $600,000 of taxable income, their total federal income tax is $161,379. That individual is paying federal tax at an average rate of 26.9 percent, which is a full 12.9 percent below the total federal taxes of 39.8 percent (entity plus owner) that a C corp shareholder may face. 

Each client’s unique facts must be considered, including other factors such as the need to extract funds from the corporation for personal use. Employment tax, which can be minimized by S corp shareholders and eliminated by limited partners, must also be considered. In addition, C corps must be prepared to justify the retention of earnings. They remain subject to the accumulated earnings penalty tax and the personal holding company tax. In addition, appreciated C corp assets are taxed twice upon liquidation: Once at the corporate level on the deemed sale gain and again to the shareholder as stock sales proceeds. C corp rates could creep upward in future legislation, but the same can be said about all tax rates.

Eligibility for the new Sec. 199A deduction (20 percent of qualified business income) also must factor into the choice of entity analysis. C corps are not entitled to that deduction. If an individual taxpayer in the 37 percent marginal bracket is eligible for the Sec. 199A deduction, her qualified business income is taxed at 29.6 percent (80% x 37%). A good candidate for C corp status is an individual whose other income pushes her entire Form 1040 business profit into the 37 percent bracket and who owns a service business (such as an accounting practice) that’s disqualified from the new Sec. 199A deduction due to her high taxable income. If the client is generating foreign source income, the new contains several major tax benefits that strictly apply to U.S. C corps.

C Corp Shareholder W-2 Wage Strategy
Under prior and new law, S shareholders remain incentivized to pay low W-2 wages to shareholders to reduce shareholder employment tax. Under prior law, C corp shareholders normally preferred to pay high W-2 wages as a means of avoiding double taxation. With the new lower corporate rate, C corp shareholders will, like S shareholders, also be motivated to receive low W-2 wages from their closely held C corps. C corp shareholders will more often prefer to retain and reinvest the earnings in the corporation to defer the tax on dividends (and W-2 wages) as long as possible. 

The new law provides S shareholders with an added motivation to pay low W-2 wages—such wages will reduce shareholders qualified business income eligible for the new Sec. 199A deduction. Conversely, if the S corp is not paying W-2 wages to non-owner employees (and has little unadjusted basis in its assets), the payment of W-2 wages to S shareholders may help the shareholder qualify for Sec. 199A deduction.

Small Business Accounting Methods
The cash method of accounting is available to many more “small” businesses, given that the accrual method mandate in Sec. 448—applicable to C corps, partnerships with C corp partners and tax shelters—disappears if gross receipts do not exceed $25 million (up from $5 million) for the prior three-year taxable period (previously for all prior tax years beginning after 1985).

In addition, if certain conditions are met, businesses below the $25 million threshold can avoid accounting for inventories and use the cash method for sales and purchases [Sec. 471(c)(1)(B)(i) and (ii)]. Prior law generally required all businesses to account for inventories when the purchase or sale of merchandise was an income-producing factor and mandated the accrual method for sales and purchases when inventories were required. Under prior law, the IRS allowed limited exceptions in Rev. Proc. 2001-10 if gross receipts are under $1 million, and Rev. Proc. 2002-28 for certain industries, an exception if gross receipts were under $10 million.

Finally, under the new law any producer or reseller that meets the $25 million gross receipts test is exempt from Sec. 263A.

Annette Nellen, CPA
Director, MS Taxation Program at San Jose State University
Chair, AICPA Tax Executive Committee
  1. There are a lot of changes in the TCJA that will affect all clients: individuals, businesses, tax-exempt entities, estates and trusts.
  2. Some clients will see their taxes reduced and others will see higher taxes. It really depends on a mix of factors, such as how much they lose in deductions (such as for state taxes), whether they qualify for the new deduction for qualified business income, the age of their children and more. To know the effect, you need to run the numbers for the client.
  3. Some of the provisions, such as the deduction for qualified business income (Sec. 199A), interest expense limitations and even new depreciation and meals and entertainment rules, are complex. Don’t delay spending time with the IRC language and thinking about how it applies to clients. You may want to designate folks in your firm to become the firm expert in key change areas.
Derek White
Tax supervisor, OUM & Co. LLP
While there are many areas that can be focused on, here are three areas of focus for tax advisers to consider:

Things May Not Be What They Appear 
On the surface, many of the updates sound straightforward. Reading further into the committee reports and the updated law reveals the potential for complex transactions/calculations, additional business disclosures and a lot of uncertainty in the short term. The Sec. 199A pass-through deduction of 20 percent of business income sounds fantastic, but the details of the law suggest there could be a potential for limitations that may not benefit clients to the extent many are expecting. Tax preparers should consider internal policies for disclosing pertinent information related to the 199A deduction on Schedule K-1s they prepare when the 199A deduction is in effect.

Mandatory repatriation of foreign accumulated earnings and profits in a businesses’ foreign sub(s) offers a chance to benefit from low tax rates on foreign earnings. However, calculating foreign E&P may have been glossed over by many tax preparers (especially those with foreign losses). With the deemed repatriation of foreign earnings, there will be a renewed focus on ensuring accumulated E&P is calculated for these foreign entities correctly. The E&P calculation for the foreign earnings repatriation is long and potentially arduous. It may not be enough to just look at the foreign subsidiaries book retained earnings to indicate the presence of accumulated earnings. On top of that, many clients may be unwilling to pay extra fees to go through this calculation.

Tax Planning Opportunities
Often we hear that tax advisers are left out of clients’ decisions on structuring their business entities. The new tax law offers a unique opportunity to be a lot more proactive with clients, especially related to entity structure choices. Business entity owners have an opportunity to plan around the corporate tax rate reduction and 199A deduction to maximize tax savings. Consider analyzing the optimum wage-to-business income levels to maximize tax savings, especially with S corp owner-employees. Another key consideration is to analyze if a change in the business structure to utilize the reduced corporate structure or 199A deduction would benefit the taxpayer.

Individual taxpayers with the potential for mobility may see leaving California become increasingly tempting given the removal of many key tax provisions that California taxpayers have come to rely on. State income and property tax deduction limitations could have a significant tax effect on individuals that make moving out of state more desirable. Taxpayers considering leaving the state should ensure their fact pattern would show they’re not a resident of California in the eyes of the FTB.
Manufacturing clients and other businesses with high capital asset needs may be able to take advantage of the changes in accelerated depreciation provisions, especially the updated bonus depreciation rules that allow for used assets to qualify.

Businesses that rely on debt financing may need to consider the effects of the interest expense limitation. Interest deduction for entities with aggregated gross receipts over $25 million may be limited to an amount not to exceed 30 percent of adjusted taxable income. However, an exception to this rule does exist for certain real estate entities.

Uncovering Hidden Gems/Traps
There are a few items in the new law that have slipped under the radar that could have a significant impact on many taxpayers. 

Bonus depreciation provisions previously stipulated that the asset must be an original use asset: The asset couldn’t be “new to the taxpayer,” but must have been the original use of that asset to qualify. The new rules stipulate used assets qualify for this provision. Restaurants and manufacturing clients may benefit from this provision.

Corporate net operating losses previously expired after 20 years. Federal losses generated in 2018 and beyond now have an unlimited life. However, it does come at a cost with only 80 percent of a corporate taxpayer’s income in a year can be offset by a net operating loss. Be prepared to potentially pay some tax if utilizing NOLs.
Meals and entertainment previously had a 50 percent limitation depending on the type of expense. Many of these expenses will now see a 100 percent limitation on any deduction for tax purposes.

Technical terminations have been removed, which would simplify the tax compliance by eliminating the need for the previously required short-period return.
Interest expense limitation could cause some taxpayers to rethink debt financing. While there are some exceptions to this limitation, some taxpayers may find themselves with higher taxable income due to this provision. This effect of this limitation may be somewhat lessened given the lower tax rate of 21 percent.

Bill Norwalk, CPA
Tax partner-in-charge, Sensiba San Filippo LLP
  1. The increase in the estate tax exemption amount to approximately $11 million per person should stimulate a conversation with high net worth clients to review their estate plan.
  2. There’s still time to give guidance to fiscal year entities with years ending in months other than December to possibly shift taxable income to a future tax year and have it taxed at a lower rate.
  3. Do not make a hasty decision to revoke the S corp election because of the reduced C corp income tax rate. Thorough analysis of federal and state income tax implications for each case is suggested, and it may be wise to see how the client’s state reacts to the federal reforms in 2018 and target timing of conversion to 2019 or later.

Mark Harrison, CPA
Tax Partner, Moss Adams (Sacramento)
With the Tax Cuts and Jobs Act marking the most sweeping change to tax law since 1986, now is a good time to reassess your current situation—everything from entity structure to international operations to credits and incentives—to avoid unnecessary compliance penalties and take advantage of the tax savings opportunities you may not have been eligible for in the past.

John Clausen, CPA
State and Local Tax Director, Moss Adams (Silicon Valley)
Taxpayers will need to understand the three principal ways in which states adopt federal tax laws—rolling, fixed date and selective—as well as the dates on which states plan to conform to federal law, to determine the impact the federal tax changes will have on their state tax liabilities.

Damien B.M. English is CalCPA’s managing editor. 
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