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The Tax Cuts and Jobs Act: How It Still Affects You

The Tax Cuts and Jobs Act: How It Still Affects You

Editor’s Note: This article is a follow-up to The Tax Cuts and Jobs Act – How Will It Affect YOU? published in the Winter 2018 issue.

On Aug. 8, the IRS issued proposed regulations for the newly created Section 199A 20 Percent Qualified Business Income (QBI) deduction. 199A has been one of the most talked about aspects of the Tax Cuts and Jobs Act since its passage last December. This provision of the act was included in the tax reform bill in an attempt to give pass-through entities (such as partnerships, LLCs and S corporations) and sole proprietorships similar tax savings that were provided to C Corporations (C Corp tax rates were reduced from a high of 35 percent to a flat 21 percent). The new 20 percent QBI deduction is effective for the 2018 tax year through 2025.

Although the new tax deduction is generous, the structure of the deduction is complicated with many limits, phase-ins, and phase-outs. Whether or not you will be able to take the deduction depends upon many factors, the key being your personal taxable income. Other factors include wages paid by the practice, the value of business property, nature of income, etc.

Physicians are especially impacted by limits on the deduction since the income is earned from what the law labels as a “Specified Service Trade or Business” (SSTB).

What is a Specified Service Trade or Business (SSTB)?

Most unincorporated business owners, partners and S Corporation shareholders benefit from the 199A deduction. However, Congress precludes some higher-income business owners from taking the deduction if the income is earned from an SSTB.

An SSTB is a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees. Per IRS regulations:

The term “performance of services in the field of health” means the provision of medical services by physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists and other similar health care professionals who provide medical services directly to a patient. The performance of services in the field of health does not include the provision of services not directly related to a medical field, even though the services may purportedly relate to the health of the service recipient. For example, the performance of services in the field of health does not include the operation of health clubs or health spas that provide physical exercise or conditioning to their customers, payment processing, or research, testing and manufacture and/or sales of pharmaceuticals or medical devices.

Based on this definition, physician practices are considered SSTBs, and therefore, limits apply on the available deduction.

How does the deduction work?

The QBI deduction is based off “pass-through income,” income reported on a Schedule K-1 earned from partnerships, LLCs and S Corporations or if a sole proprietor, what is reported on Schedule C of Form 1040 individual income tax return. Wages reported on a W2 or guaranteed payments paid to partners do not qualify as QBI. It excludes any investment-related items, such as interest, dividends or capital gains or losses from the sale of property. The maximum deduction available is 20 percent of QBI.

Although the deduction is calculated based on income earned from a trade or business (i.e. – the physician practice), the actual amount of the deduction is dependent on the taxable income of the individual. Most physicians with taxable income over $415,000 filing a joint return will be hard-pressed to qualify for the deduction. As such, it is possible for a large group practice to have some physicians qualify for a QBI deduction and some not qualify when there is a large variation in income among the owners.

The deduction itself is claimed on Form 1040 individual income tax return. Form 1040 will include a new line for the deduction in arriving at taxable income.

How do I know if I qualify to take the deduction?

The deduction is fairly simple and straightforward for individuals with married filing joint taxable income of $315,000 or less ($157,500 or less if filing single). Those taxpayers receive the full 20 percent QBI deduction. Above those taxable income amounts, the 20 percent QBI deduction becomes subject to a tangled web of limitations, phase-ins, and phase-outs. Individuals with income from SSTBs (i.e. physician practices) are subject to even more limitations that, depending on the individual’s taxable income, quickly eliminate the 20 percent deduction altogether.

Let’s first examine the limits applicable to both service and non-service businesses alike once taxable income exceeds the limits noted above. The 20 percent qualified business income deduction is limited by the greater of:

  • 50 percent of W2 wages paid by the qualifying business or
  • 25 percent of W2 wages paid plus 2.5 percent of unadjusted basis of all qualified property.

These limits are phased in for joint filers with taxable income greater than $315,000 but less than $415,000 ($157,500 / $207,500 for non-joint filers) and result in a reduced 1991A QBI deduction.

In addition to the above limits, the ability to take the 199A QBI deduction for individuals with pass-through income from a SSTB is completely lost once individual taxable income exceeds $207,500 if filing single or $415,000 if filing joint. Phase out begins at $157,500 filing single and $315,000 filing joint.

The chart at the bottom of this section summarizes the various limitations, phase-ins and phase-outs for both SSTBs and non-SSTBs.

To illustrate, assume Dr. A is a sole practitioner who files a joint return. Her practice is organized as a single-member LLC. The qualified business income as reported on Schedule C of Dr. A’s 1040 is $240,000 after wages paid to staff of $195,000. Dr. A and her husband’s taxable income for the year is $295,000.

In this example, Dr. A’s tentative 20 percent deduction is $48,000 ($240,000 QBI* 20 percent). Since Dr. A’s overall taxable income is less than $315,000, she is able to take the full deduction of $48,000 since neither the W2 phase-in limit nor the SSTB phase-out limit applies.

But what if Dr. A’s taxable income is over the $415,000 limit noted above? Since the medical practice is considered a SSTB and income is over the allowed threshold, Dr. A is not allowed to take any amount as a QBI deduction.

It is important to note 199A generally requires taxpayers to identify QBI on a business-by-business basis. Physicians who own interests in other non-SSTB pass-through entities may still qualify for a 199A deduction for that trade or business.

IRS Anti-Abuse Regulations

Various planning strategies have been considered by physicians and their advisors on how to avoid the SSTB limitation. Some of these strategies became known as “crack and pack,” which involved splitting a practice into separate legal entities to isolate non-medical activities to qualify for some amount of deduction. One of the entities would provide the medical services and the other entity would lease office space, provide billing services, or various other administrative functions.

However, the regulations issued by the IRS contain various anti-abuse provisions – one of which significantly limits the ability to segregate activities among various entities when there is common ownership among the entities solely to qualify for the 199A QBI deduction. The proposed regulations state if any trade or business provides 80 percent or more of its property or services to an SSTB, and if that other trade or business and the SSTB share 50 percent or more common ownership, then that other business is considered an SSTB too. For purposes of this anti-abuse rule, ownership is both direct and indirect ownership by related parties.

It is a common practice for various components of a physician practice to be held in separate entities, often for legal protection and tax planning. One such example is real-estate held in a separate entity and rented to the practice. This is still acceptable; the anti-abuse regulations just prohibit taking a 199A QBI deduction in such circumstances.

The regs contain various other anti-abuse provisions, such as treating non-SSTB’s as an SSTB if they share expenses/overhead with a 50 percent commonly owned SSTB. In addition, there will be increased scrutiny over changes in classification between employee versus independent contractor or partner/shareholder status due to the impact on qualifying for the 199A QBI deductions. Physicians should consult with their attorney/tax advisor prior to making any such changes in an attempt to take a 199A QBI deduction.

Planning Opportunities

Although not every physician will be able to take advantage of the new 20 percent QBI deduction, the Tax Reform and Jobs Act still provides numerous other tax breaks, such as an overall reduction in individual income tax rates, elimination of some itemized deduction limitations, increased depreciation deductions, etc. For those physicians under the SSTB thresholds noted above, now is the time to time to consult with your tax advisor to ensure optimization of the 199A QBI deduction.

  • Physicians under the SSTB threshold should review and evaluate the following items and discuss with their tax advisor and attorney:
  • Whether he or she is operating the practice in the most appropriate entity form to qualify/maximize the 20 percent QBI deduction.
  • Partners in a partnership currently receiving guaranteed payments should consider revising their partnership agreements and taking draws instead to increase QBI and the corresponding 20 percent deduction.
  • For S Corporations, review compensation agreements and ensure a reasonable compensation is paid for services provided (not QBI), and pay the remainder of income as a distribution (does qualify for QBI).

In Summary

This summary merely scratches the surface of the 199A 20 percent QBI deduction and was written in the context of physician practices. Although the regulations are still in proposed form and not expected to be finalized until later this year, the Department of the Treasury has provided sufficient insight and interpretation of the law to plan for its implementation.

Executive Summary

  • The new 20 percent QBI deduction is based on pass-through income earned from partnerships, S-Corps, LLC’s or sole proprietorships.
  • W2 wages/guaranteed payments do not qualify as QBI.
  • Deduction will be claimed on Form 1040 individual tax return.
  • Claiming the deduction will be difficult, if not impossible to claim for physicians with taxable income over $207,500 if filing single or $415,000 if married filing joint unless there are sources of income from other non-SSTB pass-through entities.
  • Newly issued IRS anti-abuse regulations limit the ability to split apart practice into various entities to isolate non-medical activities in order to take the deduction.
  • Physicians earning under the above thresholds should meet with their tax advisor and attorney now to maximize potential deductions for 2018.

Mark Baker is a Principal with Jackson Thornton CPA’s and Consultants in Montgomery, Ala. He may be reached by calling (334) 834-7660 or email Mark.Baker@JacksonThornton.com. Jackson Thornton is an official partner with the Medical Association.

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The Tax Cuts and Jobs Act: How Will It Affect YOU?

The Tax Cuts and Jobs Act: How Will It Affect YOU?

The new tax reform law — commonly referred to as the “Tax Cuts and Jobs Act” (TCJA) — is the most significant tax legislation in decades. Although the law was passed only a few weeks ago, the impact on the economy and business outlook seems undeniable as the stock market rally continues and both individuals and businesses appear the most optimistic in quite some time.

Tax reform was originally sold to us as simplification. In fact, you would be able to file your taxes on a postcard, right? Although some aspects of tax law have been simplified, other new provisions such as the 20 percent Qualified Business Income Deduction are very complex, despite appearing straightforward at first glance.

The law significantly impacts both individuals and businesses. Let’s start with a basic overview of what’s covered in the new law. (Except where noted, these changes are effective for tax years beginning after Dec. 31, 2017.)

INDIVIDUAL PROVISIONS

The new law makes small reductions to income tax rates for most individual tax brackets, and it significantly increases individual AMT and estate tax exemptions. But there’s also some bad news for individuals: the TCJA eliminates or limits many tax breaks. In addition, much of the tax relief for individual taxpayers will be available only temporarily.

Here are some of the key changes. Except where noted, these changes will sunset after 2025:

Individual Tax Rates

The majority of physicians will notice tax savings due to an overall reduction in tax rates. Please see the summary comparing tax rates and income brackets pre- and post-TCJA later in this section.

Physicians will notice not only have the tax rates been reduced, but the upper thresholds of most income brackets have also increased, resulting in more of your income being taxed at lesser rates.

For instance, under the new brackets, the 24 percent bracket extends all the way up to taxable income of $315,000, whereas under the old law, the 25 percent bracket only went up to taxable income of $156,150. For a married filing joint taxpayer with taxable income of $315,000, this results in tax savings of almost $15,000.

Standard vs. Itemized Deductions / Personal Exemptions / Limitations

Every taxpayer has the choice whether to itemize deductions on Schedule A of their 1040 (mortgage interest, charitable contributions, property taxes, state and local taxes, etc.) or take the allowable standard deduction.

Under the new law, the standard deduction nearly doubles as follows:

  • $24,000 for married individuals filing a joint return
  • $18,000 for head-of-household
  • $12,000 for all other individuals

Even with the increased standard deduction, I anticipate it will still be advantageous for most physicians to continue itemizing their deductions as most will exceed the increased thresholds above.

Prior limitations on itemized deductions, known as the Pease limitation (named after Rep. Donald Pease), have now been repealed. Under the Pease limitation, many physicians found their itemized deductions limited because their taxable income exceeded the amount allowed for full deductions. As a result of tax reform, these limitations no longer apply.

Although the benefits noted above are positive, there are some “take-aways” that should be noted, such as:

  • Personal exemptions of $4,050 have been eliminated;
  • Elimination of the deduction for interest on home equity debt;
  • Mortgage interest deduction limited to interest on debt up to $750,000 for new loans (previously $1,000,000). Taxpayers can continue to deduct interest on primary and secondary/vacation home;
  • New $10,000 limit ($5,000 if single) on the deduction for state and local income/property taxes; and
  • Elimination of moving expense deduction.

Since passage of the law, I have had several phone calls and emails from individuals worried that they are losing the ability to deduct charitable contributions. Please note that charitable deductions remain fully deductible under the new law. In fact, taxpayers are able to contribute more under the new law – up to 60 percent of their adjusted gross income as opposed to 50 percent previously. There is one exception, an admittedly BIG exception. Donors are no longer able to deduct 80 percent of the amount paid for the right to purchase tickets for athletic events (i.e. Tide Pride, Tigers Unlimited).

Estate Tax

Although the Estate Tax was not repealed under the TCJA, its impact was significantly reduced through increased gift and estate exemption amounts. Previously, the estate and gift tax exclusion was $5,490,000 in 2017, but under the new law will double to $11,200,000 in 2018 (including inflation). The increased exemption amounts are set to expire Jan. 1, 2026. This creates significant planning opportunities for physicians to transfer wealth using the increased exemption.

Alternative Minimum Tax (AMT)

AMT is a “supplemental” tax that hits many physicians. It essentially taxes those whom the IRS believes are taking too many deductions under the standard income tax system. For instance, under AMT, no deductions are allowed for state and local taxes, real estate and personal taxes, etc.

Many were hopeful AMT would be repealed in its entirety, but that did not happen. Instead, the exemption amount was raised significantly, thereby subjecting fewer individuals to AMT. It’s very likely that if you were subject to AMT tax in the past, you may not be going forward in 2018.

Affordable Care Act

During the final days of the bill’s negotiation process between the House and the Senate, a provision was added for the repeal of the individual mandate called for under the healthcare reform bill. Many took this to mean that the Patient Protection and Affordable Care Act was gone; however, that is not the case. The tax reform bill merely removed the penalty associated with the mandate for individuals to obtain health insurance. PPACA is still very much in play.

There was no change to the 3.8 percent net investment income nor the additional .9 percent payroll tax on high-wage earners. In addition, large employers (generally those with 50 or more FTE’s) are still required to provide affordable minimum essential health care coverage to full-time employees. Those employers are also still required to complete Form’s 1094 and 1095 annually to report the details of healthcare coverage provided to employees.

Alimony

Under the TCJA, individuals will no longer be allowed to deduct payments for alimony or separate maintenance payments. Likewise, the recipient of those payments will no longer include payments in their income. This is generally effective for divorce or separation agreements executed after Dec. 31, 2018. Current rules (i.e. alimony deduction) continue to apply to already-existing divorces and separations, as well as divorces and separations that are executed before 2019.

BUSINESS PROVISIONS

In addition to the individual provisions noted above, the TCJA also has many provisions which will impact businesses both large and small. In general, the law significantly reduces the income tax rate for corporations and eliminates the corporate alternative minimum tax (AMT). It also provides a large new tax deduction for owners of pass-through entities and makes major changes related to the taxation of foreign income. But it also reduces or eliminates many business tax breaks.

Following are some of the key business-related changes:

Corporate Tax Rate Reduction

Under the old law, corporations were subject to graduated tax rates that topped out at 35 percent. Personal service corporations, which include physician practices, were taxed at a flat 35 percent. The TCJA reduced the corporate tax rate to a flat 21 percent rate. Although the tax rate reduction is a positive, most physician practices organized as C Corporations bonus out income at year-end to avoid paying corporate tax at all, making this somewhat irrelevant.

20 Percent Qualified Business Income Pass-Through Deduction

But what if your practice isn’t organized as a C Corporation? It doesn’t seem fair that one entity type receives a reduction in tax rates while others do not. To compensate for this, Congress created an entirely new 20 percent qualified business income (QBI) deduction for owners of flow-through entities (such as partnerships, LLCs and S corporations) and sole proprietorships through 2025. This new deduction is commonly referred to as the “pass-through deduction,” as income from these entities passes through to owners and is included on the individual 1040 income tax return.

Qualified business income is essentially the net income of the practice after physician salaries. It excludes any investment-related items, such as interest, dividends, or capital gains or losses from the sale of property. The deduction is 20 percent of the QBI and is a reduction in taxable income on Form 1040.

What appears rather straightforward at first, quickly becomes complex and illogical with a strict or literal reading of the law. In some cases, the amount calculated for the 20 percent deduction varies among entity types with all else being equal, which doesn’t appear the outcome Congress intended. These ambiguities will most likely be addressed in later regulations and technical corrections that will provide further details on interpretation and application of the law. This will be a key area to monitor for the remainder of 2018.

In addition, the 20 percent deduction is subject to a tangled web of limitations and phase-outs. Service-related entities (i.e. physician practices) are also subject to even more limitations that, depending on income level, quickly eliminate the 20 percent deduction.

Let’s first examine the limits applicable to both service and non-service businesses alike. The 20 percent qualified business income deduction is limited by the greater of:

  • 50 percent of W2 wages paid by the qualifying business, or
  • 25 percent of W2 wages paid plus 2.5 percent of unadjusted basis of all qualified property.

The 20 percent deduction is reduced if an individual’s taxable income as shown on their 1040 exceeds $157,500 if filing single or $315,000 if filing jointly. For service-related businesses such as a physician practice, the 20 percent deduction is completely lost once the physician’s individual taxable income exceeds $207,500 if filing single or $415,000 if filing jointly. Phase out begins at $157,500 filing single and $315,000 filing jointly.

To illustrate, assume Dr. A is a solo practitioner who files a joint return. Her practice is organized as a single-member LLC. The qualified business income as reported on Schedule C of Dr. A’s 1040 is $240,000 after $195,000 in wages paid to her staff. Dr. A and her husband’s taxable income for the year is $295,000.

In this example, Dr. A’s tentative 20 percent deduction is $48,000 ($240,000 QBI * 20 percent). Since this amount is less than 50 percent of wages ($195,000 * 50 percent = $97,500), the deduction is not reduced. Also, since Dr. A’s overall taxable income is less than $315,000, she is able to take the full deduction of $48,000.

This is perhaps the most complex area of the tax reform law. This is an area which will merit monitoring in the coming months as the IRS provides additional guidance on the implementation of this provision of the law.

Depreciation Deductions

For physician practices, several favorable changes were made to the existing rules regarding depreciation. Most notably, equipment purchased after Sept. 27, 2017, and before Jan. 1, 2023 (in most cases) can by fully expensed or deducted in the year of purchase rather than depreciating over the equipment’s useful life. Previously, this “bonus” depreciation was limited to 50 percent of the asset’s cost, but has now been increased to 100 percent. In addition, the equipment no longer has to be original use or new property — used property also qualifies for the deduction.

In addition to bonus depreciation, the provisions of Code Section 179 were also modified to allow for more property types to qualify for immediate write-off, including subsequent improvements to commercial property such as roofs, heating and A/C systems, fire protection, alarm and security systems.

Other Business Impacts

In addition to the major overhauls noted above, there were several other impacts to businesses, including but not limited to:

  • Repeal of the 20 percent corporate Alternative Minimum Tax
  • New limits on net operating loss deductions
  • Elimination of the Section 199 deduction
  • Like-kind exchanges now limited to real estate only
  • New tax credit for employer-paid family and medical leave — only through 2019
  • New limitations on excessive employee compensation
  • New limitations on deductions for employee fringe benefits, such as entertainment and, in certain circumstances, meals and transportation

Summary

The TCJA will have a significant impact on business and individuals. These items highlight the major provisions of the law that are most impactful to physicians. The new tax law is certainly broad-reaching and complicated.

Article contributed by Mark Baker, Principal, Jackson Thornton CPAs and Consultants. Jackson Thornton is a Preferred Partner of the Medical Association.

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