This tax season, we have seen significant tax methods of accounting changes being made for small businesses. Many of our clients with $25 million or less in gross receipts are moving from an accrual-based to a cash-based method of accounting. This involves additional forms, notably form 3115, which requires additional information and can bog down the tax filing process.
If a cash-based method of accounting is selected, it also generally involves stopping the tracking of inventory for tax purposes and instead tracking inventory as a non-incidental supplies and expenses. That has allowed our clients, if they have a high amount of receivables outstanding, to be able to delay recognizing income related to those receivables in the current year. As a result, they are able to generate a large deferral for the tax year, creating a favorable tax adjustment.
One notable complication to changing the method of accounting used by a small-business taxpayer relates to the aggregation rules. If a person or entity owns a variety of different entities, they may not fall under that $25 million gross receipts test depending on whether the various entities’ income has to be aggregated. Identifying this can be time-consuming, as one needs to fully understand the client’s entire ownership structure to determine whether the $25 million gross receipts test is met.
Flow-through entity deductions are on the rise
Another hot topic for the 2018 tax filing season is a new deduction related to flow-through entities, also known as the 199A deduction or the 20% deduction. The deduction applies at the individual level for flow-through income from a partnership or S corporation and, if applicable, can allow an individual to decrease their effective tax rate up to 6%.
One of the sticking points about that deduction is that depending on an individual’s taxable income, if the flow-through income is derived from a specified service trade or business (SSTB), then the individual could lose the ability to take the 20% deduction. If a married filing jointly individual has taxable income over $415,000 and has flow-through income derived from an SSTB, then a 20% deduction will not be allowed. SSTBs include professions such as lawyers, accountants, medical practices, financial dealers and consultants. The Bonadio Group has to spend a significant amount of time with our clients understanding if their entire business would be deemed an SSTB or if they have certain lines of activity in their business that could be carved out.
As an example—look at an optometrist’s business. The eye exams they give are considered a medical practice and deemed an SSTB. However, the part of the business that sells frames and lenses could be eligible for the 199A deduction. We would need to discuss how to track that income appropriately for tax purposes, including the requirement to have separate books and records.
Interest expense limitations
Another significant change for taxpayers is the new interest expense limitation rules. A highly leveraged individual or business or a business with a taxable loss can now be subject to these new limitation rules, where in the past they were not. Many people and businesses glossed over this change and have been surprised to find that the new limitations apply to them.
The law only allows for an interest expense deduction to the extent it doesn’t exceed 30% of adjusted taxable income. In general, adjusted taxable income for 2018 starts with taxable income and requires adjustments for net interest expense, depreciation and amortization. Applying the interest expense limitation rules becomes even more complicated because the regulations issued by the Treasury Department have not yet been finalized. The Bonadio Group was active during the public hearing portion regarding the temporary regulations, and submitted a variety of comments based on our client base. We are finding the vast majority of our clients who think they have an interest expense limitation are choosing to delay their filings.
There are two ways to avoid the interest expense limitation rules. The first is if you choose to make an irrevocable real estate trader business election. The second is if business gross receipts are under $25 million. The point of this rule is not to hinder small business. However, as previously mentioned, the aggregation rules can cause many businesses to not fall under the $25 million exception.
One item that is being missed is that even if a small business qualifies for the $25 million exception, if they are considered a syndicate, they cannot avoid the interest expense limitation rules. A syndicate is generally defined as an entity that allocates greater than 35% of losses to limited partners or members. This is pretty clear cut for partnerships, but more of a gray area for limited-liability companies.
Waiting for final forms
Besides having to fully understand the ramifications of all the new tax laws, this was an unusually challenging tax season because not all tax forms have been finalized. You can imagine that when the IRS is issuing guidance during compliance season (January through April) while people are trying to prepare returns, it complicates things.
In a typical year, the vast majority of forms would be finalized by January. But because there’s so much new information, the federal and state governments are still working on adjusting and finalizing forms. This poses a challenge to all tax software companies tasked with updating software to reflect the latest tax law changes.
Because there are so many changes and nuances coming through every week it is even more important that the public enlist the help of a tax accountant to ensure proper understanding of the new tax laws and ensure proper review of tax filings. While all the major changes are certainly addressed in the various tax software platforms, there’s a chance some of the software may not yet reflect the smaller nuances. From a consulting perspective, with regard to the 199A deduction, final regulations have been issued, but there’s still some portions that are unclear. This leaves tax accountants responsible for interpreting the new law and taking a defendable position for their clients. For anything that’s unclear, we are encouraging our clients to extend their returns until further guidance can be provided.