Small Business Taxes & ManagementTM--Copyright 2017, A/N Group, Inc.
This the second part of our analysis of the House proposal, Tax Cuts and Jobs Act. Keep in mind that this is just the House proposal. The Senate Finance Committee will be writing its own version and there's a chance there could be floor amendments before voting. And passage by both the House and Senate is far from assured. There are many provisions that are controversial.
This is the second of several parts.
The proposed new law eliminates most of education benefits under current law and modifies the American Opportunity credit. While some of the programs were not as popular as the American Opportunity Tax Credit, the repeal of all of them will have an impact on a large number of taxpayers.
American Opportunity Tax Credit Current law provides for a credit of 100 percent of the first $2,000 of qualified tuition and related expensts and 25 percent on the next $2,000 for a maximum credit of $2,500. The credit is available to the first four years of a student's post-secondary education in a degree or certificate program and is phased out for higher income taxpayers. The proposal would continue the existing rules and extend the credit to a fifth year, but at a maximum of $1,250.
Lifetime Learning credit Under current law the Lifetime Learning credit is equal to 20 percent of qualified tuition and related expenses up to $10,000 in expenses. This credit can be taken for an unlimited number of years, but the $2,000 maximum credit is based on family size. In contrast to the American Opportunity credit it is available to students taking less than half-time course load. Under the proposal this credit would be eliminated. The credit is phased out based on income.
Student loan interest. The proposal would repeal the above-the-line deduction for student loan interest. The current deduction is capped at $2,500.
Deduction for qualified tuition and related expenses The current law allows a deduction for up to $4,000 per year for tuition. This benefit generates less benefits but is the easiest to qualify for. It is phased out for higher income taxpayers. The proposal would repeal this provision.
Educational assistance program. Under current law an employer can provide up to $5,250 annually of educational assistance to an employee. Nondiscrimination rules apply, but the assistance is available for both graduate and undergraduate courses. Only courses taken by the employee (not his dependents) qualifies. The benefits are excludable from the employee's gross income. These courses do not have to be job related to qualify for the benefit. The proposed law would repeal this provision.
Exclusion for interest on U.S. savings bonds Currently, interest earned on U.S. Seriess EE savings bonds issued after 1989 is excludable from gross income if the proceeds do not exceed higher education expenses for the year. This provision would be repealed.Repeal of exclusion for qualified tuition reductions. Qualified tuition reductions for certain education provided to employees (and their spouses and dependents) of certain educational organizations are excludible from gross income. The tuition reduction is subject to nondiscrimination rules. The exclusion generally applies below the graduate level, The proposed law would repeal this provision.
Coverdell savings accounts Under current law contributions to these plans are limited to $2,000 per beneficiary annually. Earnings accumulate tax deferred and earnings are excludable from the income of the distributee (student). Distributions can be used for both elementary and secondard expenses and qualified higher education expenses. The new law would eliminate this provision.
Section 529 qualified tuition programs These plans allow earnings of amounts contributed by parents, grandparents, etc. to grow tax free and the distributions are not taxable if used for qualified education expenses. The proposal modifies section 529 plans to allow such plans to distribute not more than $10,000 in expenses for tuition incurred during the taxable year in connection with the enrollment or attendance of the designated beneficiary at a public, private or religious elementary or secondary school. This limitation applies on a per-student basis, rather than a per-account basis. Thus, under the proposal, although an individual may be the designated beneficiary of multiple accounts, that individual may receive a maximum of $10,000 in distributions free of tax regardless of whether the funds are distributed from multiple accounts. Any excess distributions received by the individual would be treated as a distribution subject to tax under the general rules of section 529. The proposal also modifies section 529 plans to allow such plan distributions to be used for certain expenses, including books, supplies, and equipment, required for attendance in a registered apprenticeship program.
Discharge of student loan debt The forgiveness of debt is usually income to the debtor. There are exceptions for student loans. The proposal modifies the exclusion of student loan discharges from gross income, by including within the exclusion certain discharges on account of death or disability. Loans eligible for the exclusion under the proposal are loans made by (1) the United States (or an instrumentality or agency thereof), (2) a State (or any political subdivision thereof), (3) certain tax-exempt public benefit corporations that control a State, county, or municipal hospital and whose employees have been deemed to be public employees under State law, (4) an educational organization that originally received the funds from which the loan was made from the United States, a State, or a tax-exempt public benefit corporation, or (5) private education loans (for this purpose, private education loan is defined in section 140(7) of the Consumer Protection Act).
Other benefits By removing itemized deductions, employees who take courses to maintain or improve skills and deduct them as a miscellaneous itemized deduction would lose that benefit. While not as broad as some of the other repealed educational benefits (it can't be used by a CPA to take a physics course), it is still commonly used particularly by those individuals who must maintain job skills as professionals. The only benefit still available would be an employer reimbursement of tuition for job-related courses. Thus, an accountant working for Madison, Inc. could be reimbursed for an accounting course. Madison could deduct the amount and it would not be income to the employee. A course not work related would not qualify for such treatment.
Maximum Rate on Business Income of Individuals
S corporations, LLCs, partnerships, etc. are termed "pass-through" entities. Their income is taxed to the shareholders, members, or partners depending on the entity. Most LLCs are taxed as partnerships. A sole proprietorship is not treated as an entity distinct from its owner for Federal income tax purposes. Generally, all the income of a partnership where the partners are general partners is self-employment income, as is income from a sole proprietorship and subject to the self-employment tax (the equivalent of FICA and Medicare taxes). An S corporation shareholder who receives a salary pays the regular FICA taxes. The pass-through income is taxed like ordinary income to the shareholder, partner, etc.
Under the proposed law, to lower business taxes, qualified business income of an individual from a partnership, S corporation, sole proprietorship is subject to Federal income tax at no more than 25 percent. Qualified business income means, generally, all net business income from a passive business activity plus the capital percentage of net business income from an active business activity, reduced by carryover business losses and by certain net business losses from the current year.
Qualified business income is defined as the sum of 100 percent of any net business income derived from any passive business activity plus the capital percentage of net business income derived from any active business activity, reduced by the sum of 100 percent of any net business loss derived from any passive business activity, 30 percent (except as otherwise provided in the case of specified service activities or in the case of a taxpayer election to prove out a different percentage, below) of any net business loss derived from any active business activity, and any carryover business loss determined for the preceding taxable year. Qualified business income does not include income from a business activity that exceeds these percentages.
Example 1--Madison Inc., an S corporation, has one shareholder, Sue Swanson. The corporation operates a local bakery of breads, rolls, cakes, etc. Assume Sue takes no salary and the business earns $80,000 for the year. Sue's husband is an investment banker whose salary is $1.5 million for the year. Of the $80,000 from Sue's business, 30% ($24,000 of qualified business income) would be taxed at no more than a 25% rate; the remaining 70%, would be taxed at the couple's regular income tax rate, 39.6%.
Example 2--The facts are the same as in example 1, but now Sue takes a salary of $30,000, reducing Madison's profit to $50,000. The $30,000 is added to the $50,000 ($80,000 profit before wages less wages of $30,000) before applying the percentage allocation calculation. The 30% is applied to the total of $80,000 ($50,000 + $30,000) to yield $24,000. The same result as in the example above.
The additional wrinkle here involves the self-employment tax. The proposed law assumes that the qualified business income (the 70% portion) is subject to the self-employment tax.
Example 3--The facts are the same as in example 2. Sue pays her share of FICA and Madison pays its share of FICA on Sue's salary of $30,000. But, in addition, Sue will pay the self-employment tax (SECA) on the remaining labor portion of income. The labor portion is $56,000 (70% of $80,000). Subtracting her salary yields $26,000 of which is subject to SECA.
Currently, in the case of a general partners current rules provide that generally all distributive income of a partner is subject to SECA. That's not true for limited partners. Limited partners are not subject to SECA. The proposal changes that, making all partners subject to SECA, based on the 70%-30% rule. The proposal modifies the exceptions that apply in determining net earnings from self employment by providing that rentals from real estate and personal property leased with the real estate are not among the exceptions. The proposal retains the present-law exceptions for dividends and interest, and gains or loss from the sale or exchange of a capital asset, or gains or losses from other property that is neither inventory nor held primarily for sale to customers.
The proposal provides for special allocations for businesses that are more capital intensive, allowing a taxpayer to elect an increased percentage with respect to any active business activity other a specified activity. The election would apply to that year and the succeeding four taxable years. On the other hand, certain businesses such as the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, and any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees, or investing, trading, or dealing in securities, partnership interests, or commodities would have a capital percentage of zero. An election may be made to increase this percentage.
For purposes of the calculation, net business income would be determined separately for each business activity. Qualified business income for the 25% maximum rate includes any net business income derived from any passive business activity.
Comment--This is a big change in the rules and will affect virtually all businesses and business owners (other than C corporations). If the proposal is made law in substantially the same format, some taxpayers may want to consider doing business as a C corporation, but only after careful consideration. The exact impact will vary widely. Depending on several factors, shareholders of small S corporations could see higher taxes, some lower. Capital intensive businesses will have to consider electing a higher capital percentage. Service businesses in the health, consulting, etc. fields would receive no benefit from the proposal. Also keep in mind that this is one of the more complex provisions in the proposal and we've only discussed the highlights. Finally, there's a good chance this provision will be modified before the bill is passed.
Copyright 2017 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 11/08/17