Late week's Republican tax plan appears to have the support of the President, but passing a bill through the Senate will be a more difficult task as the GOP holds a slim majority in the House. The plan will likely go through some changes before becoming law - if it becomes a law at all. Here are some of the key current provisions impacting our clients
1. Corporate Tax Rate
The current corporate tax rate of 35% would be lowered to 20% and there would be a one-time tax break allowing corporations to repatriate overseas profits to the United States.
Very few of our clients are C-Corporations and most are “pass-through” corporations. There may be relief as the proposal would allow 30% of a pass-through entity’s profits to be taxed at a preferred rate of 25%. Unfortunately, it appears that companies that perform services like medical, dental, legal, accounting etc., will not be eligible for these rates. More than any other provision in this plan we feel that this one will need further clarification of how exactly it will work.
Individual Tax Changes
2. Tax Brackets
The proposed plan reduced the current 7 brackets down to 4. In a surprising move, the top rate will remain at 39.6%, which is the higher rate that was passed during the Obama administration. The new rates would be 12%, 25%, 35% and 39.6%.
3. Standard Deduction
The standard deduction would be nearly doubled for a married couple to $24,000. It is thought that this change would eliminate the need for many to itemize deductions like mortgage interest, charitable contributions, and taxes.
Exemptions for taxpayers and their dependents would be eliminated in this plan.
5. State and Local Taxes
State and local taxes would no longer be a deduction.
6. Real Estate Taxes
The real estate tax deduction would be capped at $10,000 each year.
7. Mortgage Interest
The deduction would remain unchanged on current homes, which allows interest related to the first $1,000,000 of debt on a primary residence as a deduction. The new tax plan does lower the limit the deduction on new home purchases to interest on the first $500,000.
8. Alternative Minimum Tax (AMT)
The AMT would be eliminated in this plan.
9. Estate Tax
The Estate Tax would be eliminated in this plan. Of all the pieces of this proposal, we expect this one to face the most scrutiny as the current law allows a married couple to protect nearly $11,000,000 of assets from the Estate Tax. This shelters a significant amount of wealth, so the removal of the Estate Tax all together is seen as an aggressive move that provides a tax break only to the uber-wealthy.
10. Child Credit
This would increase to $1,600 per child versus the current $1,000. It would also allow a small credit for college-aged children and for people providing care to their parents.
So How Does this Impact You
We’ve recalculated several tax returns across the income spectrum and found a lower tax bill in every case - particularly for the lower-middle class to middle class. While some deductions are lost, the impact is mitigated by a flatter and more gradual tax rate. The repeal of the AMT will also have a net positive effect. In previous years, many of our clients lost the real estate tax deduction, exemptions, and state tax deductions with the levying of AMT, so the elimination of these deductions doesn’t necessarily have a material impact.
On balance, this plan does accomplish what Republicans set out to do. It makes tax compliance easier for many people and it does remove some special interest deductions. Whether it goes far enough (or too far) is a matter of opinion, and no doubt the opinion makers will cloud the debate that is about to ensue.
The Downside of Controversial Tax Strategies
As a CPA firm, we often get suggestions from clients on tax deductions they feel eligible for based on articles read or seminars attended. There exists a cottage industry of consultants who promise to lower your taxes if you engage them, but, oddly, these consultants will typically avoid actually preparing returns. Why? Signing a tax return as a preparer puts the CPA at risk too. If an audit were to be done, the preparer must provide the support documents and rationale for all deductions applied. If deductions were wrongly applied, yes, the taxpayer will owe taxes, penalties, etc but the preparer will suffer too. Penalties, and even loss of licensure, can reign down. This is why we find it ironic that the consultants will call your CPA “timid,” but then will sit on the sideline when it comes to tax preparation.
Below are some of the most common "strategies" from consultants along with our take on the applicability and legality:
STRATEGY: Create a Management Company to Leverage C-Corporation Tax Rates
Their Recommendation: If you have a small business, you can create an additional management company and register it as a C-Corp. Your small business will pay the management company $50,000 for "managing" or "marketing" of your legitimate small business.
One of the advantages to the C-Corporation structure is that the first $50,000 of income is taxed at 15%, which is usually lower than a business owner’s individual tax rate. There are also certain deductions that a C-Corporation can take that are not eligible to the flow through entities that many businesses use.
On the surface this sounds like a great strategy. The problem we see is that the IRS taxes C-Corps that are Personal Service Corporations at a flat 35%, not the flat 15% as advertised by consultants. They IRS defines a personal service company as “any activity performed in the fields of accounting, actuarial science, architecture, consulting, engineering, health, law and the performing arts.” So, the question is, how comfortable do you feel that the IRS would not consider management services to fall under the broad definition of consulting services? I’m not sure I’d bet on it. Furthermore, the IRS has an important “substance over form” doctrine, which means you can technically follow the law, but if the substance is to avoid taxes, then they can override your position. So, how comfortable do you feel that they would allow the deduction if you were magically performing management services only for companies that you own and the result was this was saving you taxes?
STRATEGY: Rent out Your Home to Your Business
Their Recommendation: Have your small business rent your personal home out for 14 days a year at $1,000 a day for "officer's meetings" or "company retreats."
The IRS has a “vacation home” rule that states so long as you rent a property for 14 days or less that you do not have to pay any income tax on those earnings. The purpose of this law is to let people occasionally rent a property without having to go through all the compliance hoops of documenting the income and expenses.
Many of these tax consultants will say you should rent your home to your business for 14 days and reduce your income by $14,000 or so. While we do feel, this can be a legitimate deduction the key thing here is to have great documentation to justify why your home was being used. What was the purpose of the rental? How did you determine your rental rate? Why was the home needed versus your existing place of business? Simply going, “mark me down for $14,000” doesn’t cut it.
STRATEGY: Deduct of Home Fitness Facility Including Your Pool
Their Recommendation: Build out that home gym, put in a pool and have your business pay for it. It counts as a exercise and wellness equipment for use of the business or practice.
Yes, businesses can deduct the cost of exercise and wellness equipment they place in the business. The question becomes, “does this count if I put it in my home?” Some of these advisors seem to think so stating that you “just need to make it available to your employees” and this will suffice as business use. If you legitimately open up your home to all of your employees and have them use the equipment, then yes, this would apply. But think about that for a second. Do you want your employees stopping by your home to use the gym? Do you have liability insurance that would cover any injuries that they might incur? Understandably, you could see the IRS denying this deduction.
STRATEGY: Kids on the Payroll
Their Recommendation: By paying your children (increasing employee wage expense), you can reduce the net income of your small business (reducing taxes) but still receive the benefit of the income in your family.
We have no issues with children on the payroll and think it’s not a bad idea to get them some exposure in the business. Where we take issue is paying your newborn baby $6,000 to be a model on your website. We get that your child is cute, but you can probably get a model for a fraction of the cost. We have had clients take this deduction and they have received letters from the Social Security Administration asking for detailed descriptions of these infant’s jobs. You think the IRS is getting wise to this? We do.
STRATEGY: Home Office
Their Recommendation: Claim a home office and therefore write-off a portion of your home expenses (mortgage, utilities, etc) against the business revenues.
This is a great deduction for self-employed people who have no principle place of business and it should be used. However, what if you already have a principle place of business outside your home? While the IRS will allow a deduction, there is this caveat:
"You use it exclusively and regularly for administrative or management activities of your trade or business. You have no other fixed location where you conduct substantial administrative or management activities of your trade or business."
We think this makes it tough to take that deduction, unless you essentially replicate what you are doing at your principal place of business at home.
In closing, we certainly don’t want clients overpaying on taxes, but we also want to give them realistic advice and prepare taxes in a manner that will sustain an audit. Some suggestions by consultants hinge on you never being audited. Sure, anything is deductible so long as your crazy enough to try it, but you better have the money reserved to pay the taxes, penalties, and interest down the road. This is not our recommended approach to taxes or life. When we sign off on our clients tax returns, we are putting our names, livelihoods, and reputation on the line and ensuring that we stand with you.
Curious as to what some of the recent tax terms and proposed changes actually are?
Below is a quick guide to the terms and concepts you'll be hearing over the next couple months as our country looks to understand and ratify some changes to the tax code. "Knowledge is power; information is liberating; education is the premise of progress." Kofi Annan
Corporate Tax Rate
The corporate tax is levied on the profits of C-Corporations and is essentially a 35% flat rate. The corporate tax rate in the United States is among the highest in the world and it is believed that companies are keeping profits overseas to avoid this tax. C-Corporations are non-pass-through entities which means they are subject to double-taxation. First, taxes are paid by the C-Corp at the corporate tax rate on profits. Second, shareholders and owners are taxed as they take those profits out as dividends.
President Trump recently unveiled some details of his tax plan and with this will come many articles purporting this solely as a plan with “tax cuts for the rich”. The problem with this view is that it over-simplifies a complex tax system and distracts from the true debate.
Take, for example, Bruce Murphy's recent piece Tax Handout For Rich Kids where he focuses on the tax deduction students at University School (the wealthiest school in our area) receive. Never mind that the deduction has been around for over 3 years or that it applies to all private school tuition, a writer needed some page views on a current issue, so he took the low hanging fruit. I mean, very few are sympathetic to those taxpayers who can afford in excess of $20,000/year, right? Easy target.
Most of our clients fear an audit by the Internal Revenue Service and wonder what “red flags” they may be raising on their personal tax returns. In reality, there is a higher chance of receiving a sales and use tax audit from the State, than a visit from the IRS.
Sales tax is generally charged on revenue from the sale of tangible property (items you can touch and see) and service revenues are (typically) exempt. As with most laws, the exceptions to these general rules provide confusion and often times lead to violations - albeit unintentional. For example, repair services are generally taxable (even though it’s a service) whereas construction of a home or building is generally exempt (even though the end result is tangible property).
Many of our clients provide a service and thus, sales tax is not a big issue. However, the Use tax can trip them up.
Use tax is supposed to be submitted on any purchase you make where sales tax is not charged at least at the rate of your local municipality. For example, if you purchase supplies for your office and live in Milwaukee County, you must make sure that you paid at least 5.6% in sales tax on that purchase. It sounds like a nit-picky rule, but we’ve actually seen auditors add the tax to purchases when the client was inadvertently charged the Waukesha County tax of 5.1% by the vendor.