Tax Reform – What We Know and What We Want to Know
Recent tax reform has made significant tax changes for financial institutions, for both C and
S corporations. As with anything new, there were many questions. The Internal Revenue Service (IRS) has been gradually rolling out much needed guidance as it relates to the Tax Cuts and Jobs Act (TCJA) but still has a long list of topics to address. The uncertainty has created challenges of knowing how and when to take action to improve taxpayers’ overall tax picture. Let’s look at what we think we know.
Tax rate changes seemed to be relatively straightforward at first glance. For C corporations, the tax rate changed from a graduated scale ranging from 15% to 35% to a flat 21% and also repealed AMT tax. However, the reduction to individual tax rates paled in comparison. To help balance the scales, TCJA created a Section 199A deduction of 20% of qualified business income for S corporations and other pass-through entities. On August 8, 2018, the IRS issued preliminary guidance that contained the definition of qualified business income. The proposed regulations clarified that banking income (taking deposits and making loans) will qualify for the 20% deduction on the shareholders’ individual tax returns, but the guidance also generated more questions on whether all income at the bank would qualify; specifically, income derived from wealth management and retirement planning services. Refer to Wipfli’s 8/30/18 article at https://www.wipfli.com/insights/articles/fi-new-guidance-on-the-20-percent for a more in-depth discussion on the 20% deduction for S-corporation shareholders and the issues for the financial institution industry.
Tax reform also brought changes in employee benefits. Effective January 1, 2018, no business deduction is allowed for the cost of providing transportation to employees, including the cost of employee parking if that cost is more than $260 per month. This could include costs of providing free parking to employees and also costs when the parking lot is shared by employees and customers. Temporary guidance issued by the IRS as recently as December 10, 2018, stated that costs to consider include repairs, maintenance, utility costs, insurance, property taxes, interest, removal of snow, ice, leaves and trash, cleaning, landscape costs, parking lot attendant expenses, security and rent. These costs would be allocated by the percent of spaces reserved for employees to those available to customers and the general public. One thing to consider is that there is a special rule allowing “employers to retroactively reduce the amount of their nondeductible parking expenses” if they make changes to their parking arrangements or reduce the number of reserved parking spots by March 31, 2019. If a business pays a third party for the employee to park in a lot or garage, allocation of these costs is not necessary; the cost would be the amount paid to the third party. As an alternative to treating the costs as nondeductible, an employer can include the costs in excess of the $260 limit in the taxable income of the employees and then include these costs as a reduction to taxable income.
Changes to meals and entertainment deductions have been less than clear as well. The TCJA repealed the rule that allowed a deduction for entertainment, amusement, or recreation expenses even if it is directly related to business activities. This includes membership fees, green fees, sporting events and performance tickets. It also limited the deduction for most meal expenses (beverages, snacks, staff lunches) to 50%, which were previously all deductible. The exception for holiday parties and social activities for the benefit of employees was not changed. And the cost of cookies and coffee in the lobby is all deductible also.
One of the seemingly unintended consequences of the new tax law relates to bank-owned life insurance (BOLI). Under the new law, BOLI policies that are “transferred for value” may lose their tax-exempt status and therefore produce taxable death benefits. This could come into play when there is an acquisition of an entity that holds an interest in a life insurance contract. The IRS announced that the Treasury intends to issue detail regulations on the application of this new rule.
An opportunity that requires further guidance would enable taxable capital gains to be deferred and perhaps partially exempted from taxation if they are reinvested in qualified opportunity zones. In October 2018, the IRS released some proposed regulations and identified the low-income tracts that were nominated. For additional information, please go to Wipfli’s 10/29/18 article “First Guidance on New Opportunity Zones Issued” at https://www.wipfli.com/insights/articles/tax-first-guidance-on-new-opportunity-zones-released which includes a link to a map of the qualified opportunity zones. Additional guidance is expected to come in the spring.
While we wait anxiously for more guidance from the IRS, there is still a list of other potential opportunities to be evaluated that could have a significant impact on 2018’s taxable income.
Let’s look at the accounting methods used to report taxable income. The accounting method that taxpayers choose determines when income and expenses are recognized. There is a diverse array of accounting method change options to consider, but there are IRS regulations for each that determine eligibility which need to be reviewed as well.
For example, an opportunity to change from the accrual basis to the cash method of accounting has been created by TCJA for some taxpayers. Cash-method taxpayers report income when cash is received and generally deduct expenses when paid. Accrual-method taxpayers report income in the year their right to it becomes fixed and the income amount can be determined with reasonable accuracy. Deductions are taken when all events have occurred that create the liability and the amounts can be determined with reasonable accuracy. Switching from the accrual to cash method can create a deferral of income and/or the acceleration of deductions for some taxpayers, thereby reducing taxable income for the year.
Before tax reform, several restrictions on the use of the cash method applied, preventing many businesses from using it. C corporations could only use the cash method of accounting if their average annual gross receipts were less than $5 million. The TCJA increased the threshold to $25 million.
S corporation limitations were much more relaxed prior to TCJA, such as gross receipts less than $50 million. This created an opportunity in many cases to make the election to use the cash method of reporting for tax in 2017 and potentially create a permanent tax savings for the individual shareholders who report the taxable income on their personal returns, assuming 2017 tax rates were higher than in 2018. If the bank is reporting 2018 taxable income on the accrual basis, switching to the cash method may be a good option to consider.
If reporting taxable income on the cash basis is not a good choice, making an election to deduct some prepaid expenses could be an option. Back in 2003, the IRS began to allow certain prepaid expenses to be deducted for tax purposes if the benefit would be used by the end of the following taxable year. The decision to accelerate this deduction can be made on an annual basis, which provides flexibility each year but requires a one-time change in accounting method to be filed.
There are additional accounting method change options that may help create a more favorable tax position in 2018 depending on facts and circumstances, such as depreciation to claim previous year’s missed depreciation or amortization (see discussion below on cost segregation studies) and/or the conformity election to provide a safe harbor for bad debt deductions.
Keep in mind that the IRS must be notified of any changes to accounting methods. Since this application must be included with the tax return, this must be done by the tax return due date, including extensions.
Outside of accounting method changes, current year depreciation and expensing can also be tailored to fit different tax situations (within certain rules and limitations).
The Section 179 limit for expensing capital assets was increased to $1 million for 2018 (with some limitations). In addition, certain improvements to nonresidential real property, such as roofs, heating, air conditioners, fire protection, among others, now qualify for Section 179 expensing. Note: S-corporation shareholders who are “passive” (and certain trusts) may lose out on the Section 179 deduction, so caution should be taken in considering expensing purchases under Section 179. For example, if a passive shareholder does not have any other "ordinary trade or business" income on their personal return, they would lose the Section 179 deduction (which could be the case for shareholders who are retired). The deduction would not carry over like a passive loss does; it would just go away.
Bonus depreciation was also increased to 100% and applies to a broader base of assets in 2018 than it has in the past. This means that most purchases of tangible personal property can be written off immediately for tax purposes.
Another change brought by the TCJA includes transactions previously considered to be like-kind exchanges. Personal property and other intangibles are no longer eligible for a gain deferral. This means that a trade of a bank-owned vehicle may result in a taxable gain.
And don’t forget about cost segregation studies. An in-depth analysis of buildings, remodeling projects, etc., can increase current depreciation expense by identifying property that can be considered as personal property instead of real property. Personal property can often be deducted immediately under either Section 179 or bonus depreciation while real property may be required to be depreciated over 39 years.
How about a new tax credit? The Employer Credit for Paid Family & Medical Leave is available to some employers who pay wages to employees who are on family and medical leave (FMLA) in 2018 and 2019.
If this isn’t enough, there may be more to come. Tax reform 2.0 is on the table (or it was when this article was written). We are also hoping to see several technical corrections, renewal of tax break “extenders,” and further guidance from the IRS to answer our many questions.
Please recognize that tax strategies are never a “one size fits all”; each taxpayer’s set of facts and circumstances is different. The tax laws are complex, and care must be taken to avoid unintended consequences.
Let us help you implement a tax strategy to maximize the available opportunities (or minimize the impact, as the case may be) created by the recent sweeping tax reform.
