The Tax Cuts and Jobs Act that President Trump signed last December promises to give small business owners a tax reduction of up to 20 percent for 2018, but there has been a lot of confusion about which businesses will qualify for the deduction and other tax breaks. The IRS has issued some guidance and proposed regulations that can be used to help determine which companies and individuals can benefit from the pass-through tax deduction and how it can be calculated.
William Norwalk, a tax partner at Sensiba San Filippo, a Bay Area-based accounting firm that works with many small and midsized businesses across a variety of industries, has been giving his clients advice on the new deduction.
“One client had done a lot of investing in tax-advantaged type of investments over the last couple of years, sold his business, and received a large sum of money,” he said. “Ultimately we had encouraged him to recognize the income on that in 2017 instead of 2018 because the California state tax was a huge deduction that was going to go away. In his case, to minimize the overall tax on the gain, it was smarter for him to time that sale in 2018 and have the income happen that way. This year we’re dealing with the fact that he had all that money coming in, but the business that was generating the money was no longer in his portfolio, so the character of his income changed a lot and he got tax-advantaged investments that are going to create losses early on. We were looking at the fact that he may have an opportunity to take money out of a retirement account and we would accelerate the withdrawal of money out of the retirement account because he could absorb that amount of income this year without generating significant tax. So in his case it was the combination of last year knowing how the law was going to change, implementing it to benefit last year, but then as things developed this year, it actually switched and we’re trying to jam income into this year to offset those losses.”
The pass-through deduction phases out for small businesses in fields such as law firms and accounting firms. “The ones that are earning over the threshold limits, which for married filing jointly is $315,000, they would have that limitation come into play, but there may be in some cases things they can do to bring their income down to the threshold, so if they end up, even if they’re a professional, if they’re below that $315,000 as a married filing joint taxpayer, they’d still be able to get the full benefits of that deduction,” said Norwalk. “It’s fact specific. If you’ve got an attorney who is earning a million dollars a year, it’s going to be pretty hard to get them down below that amount, but maybe if someone is earning say $450,000 and they’re just running their own practice, if they were to set up a defined benefit retirement plan, potentially if they were an older person, they may be able to offset a large amount of income, almost enough to get them below that limit. With that, and maybe looking at what other deductions they could generate.”
Tax reform is not necessarily turning out to be tax simplification for many clients. “When you heard about the possibility of tax reform and simplification of the taxes, where they always start out in conversation, but by the time they get done they’ve usually added enough complexity to create confusion and have people wonder what they can do,” said Norwalk. “Based on the fact that there are so many rules and different thresholds, clients who think they can just do it themselves and are higher-income people are the ones that are really going to lose an opportunity to benefit from the skills of the practitioners who have been studying this and planning with clients over the course of the year. At least among our clients, they don’t feel like things have been simplified in any shape or form, and feel our services are as valuable as ever.”
The Section 199A deduction for pass-through businesses has been generating a lot of questions among both tax practitioners and clients. “Along with the international stuff, it’s probably the most complicated thing in the new tax law,” said Mark Luscombe, principal federal tax analyst for Wolters Kluwer Tax & Accounting. “Unlike the international that involve multinational corporations that can afford to hire the very best to figure it all out, this is applying to Schedule C filers, sole proprietorships, who have to figure it out on their own, or hire trusted advisors to figure it out for them. We’re basically suggesting they look for trusted advisors.”