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12.06.18

A Quick Overview of the New Section 199A – 20% Deduction

By Steven E. Howell, CPA, DABFA – Client Service Partner, and Davide DiGenova, CPA – Tax Partner
RBT CPAs, LLP, a Council of Industry Associate Member

“A provision of the TCJA might benefit Council of Industry member firms organized as pass through entities.  This provision “199A,” provides for a deduction of as much as 20% for business activates conducted by these firms.”

On December 22, 2017, the Tax Cuts and Jobs Act (TCJA) was signed into law by the President of the United States.  Many of these tax law changes will apply to individual and business taxpayers commencing with their 2018 federal income tax filings.  One of the key provisions of the TCJA provides the ability for taxpayers to receive a deduction for Qualified Business Income, which for simplicity purposes can be referred to as “net income”, generated by a trade or business that is conducted within a partnership, S corporation, or sole proprietorship. One might refer to this deduction as the 20% deduction or, more technically, the 199A deduction.

The amount of the 20% deduction allowed will be based on the taxpayer’s individual taxable income less income which has a preferred federal tax rate such as preferred dividends.  This amount will be referred to as “adjusted taxable income”.  The 20% deduction allowed in a given year will be limited to the lesser of 20% of the adjusted taxable income or 20% of the qualified business income that flows through to the taxpayer.

Determining whether a taxpayer will qualify for the 20% deduction and to what extent this deduction will be allowed is more complicated than its name may suggest.  In order to understand this 20% deduction, one must first understand what types of businesses and income thresholds will disqualify a taxpayer from taking this deduction.  The first threshold that must be reviewed is whether the trade or business being conducted is considered a specified service trade or business (SSTB) or if such trade or business is a business of providing services as an employee (generally, referred to as changing from an employee to an independent contractor in order to benefit from this deduction when the taxpayer is truly an employee).  A SSTB is any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial or brokerage services, investing and investment management, trading, dealing in securities, and where the principal asset is the reputation or skill of one or more employees or owners (generally referred to as an endorsement).  The second threshold that must be met is that the trade or business being operated is conducted within a partnership, S corporation, or sole proprietorship.  This deduction will not apply to trades or business conducted within a C corporation.  The third threshold is whether taxable income exceeds $157,500 for a single income tax filer ($315,000 married filing joint).

Once the three basic thresholds have been analyzed, one can begin to determine the amount of the 20% deduction that will be allowed.  If a taxpayer conducts a trade or business which generates net income and a taxpayer’s taxable income does not exceed $157,500 ($315,000 married filing joint), regardless as to whether such trade or business is a SSTB, the taxpayer will be allowed a 20% deduction for that specific trade or business.

If a taxpayer’s taxable income exceeds the $157,500 ($315,000 married filing joint) but doesn’t exceed $207,500 ($415,000 married filing joint), then there needs to be an analysis done as to the type of trade or business that the taxpayer is operating.  A taxpayer who operates a SSTB and exceeds the lower threshold but not the higher threshold, will begin to lose the 20% deduction based on an income limitation and a wage limitation phase-in.  If the taxpayer doesn’t operate a SSTB, the 20% deduction will be reduced by a wage limitation phase-in only.

When a taxpayer’s taxable income exceeds the $207,500 ($415,000 married filing joint), the taxpayer will be disqualified from taking a 20% deduction on the net income generated by a specific trade or business that is considered a SSTB.  However, if a taxpayer doesn’t operate a SSTB, the 20% deduction will equal the lesser of 20% of the net income generated by the trade or business or the greater of 50% of wages paid by the trade or business or 25% of wages paid plus 2.5% of the unadjusted basis of assets held by the trade or business (excluding land).

As was mentioned earlier, the 20% deduction is a complex area of the TCJA.  It would be worthwhile to consult with your tax advisor as to whether you will qualify for this deduction.  The Internal Revenue Service issued proposed regulations during mid-August of 2018 which has provided additional guidance and has answered many questions for tax practitioners, but there are still areas which need additional clarification.

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R & D Tax Credit for Manufacturers

From Engineered Tax Services

The Research and Development (R&D) Tax Credit is a permanent federal tax incentive meant to stimulate innovation, technical design and manufacturing within the U.S. Most states have a similar tax incentive as well. While the R&D Tax Credit was available since 1981, tax regulations that were finalized in December 2003 significantly increased the types of activities that qualify for the credit.

Manufacturers often do not realize that they are eligible for the Research and Development tax credit. The R&D tax credit allows companies to realize tax savings, increase cash flow and stay competitive in the marketplace. Many of the qualifying activities are considered day-to-day operations for these companies. Manufacturers who develop new or improved products or processes qualify for this incentive. Less than one-third of eligible companies realize they qualify for the R&D tax credit. Also, many of the companies that are taking the credit are not claiming all of the credits to which they are entitled.

The Research Tax Credit can provide a hidden but immediate source of cash for manufacturers from prior years, plus a significant reduction to current and future years’ federal and state tax liabilities.

Typical Qualifying Research and Development Tax Credit Activities:

  • Product development using computer aided designing
  • Prototyping and 3D modeling
  • Designing manufacturing equipment
  • Alternative material testing
  • Improve manufacturing and production
  • Developing new or improved products or processes
  • Developing tooling and assembly design solutions
  • Designing and developing cost-effective business activities or tasks
  • Value engineering
  • Improve product performance and manufacturing practices
  • Evaluate material or substance flows
  • Designing and evaluating process alternatives
  • Product design processes – prototype design, development, and testing

 

Two Significant Enhancements to the R&D Tax Credit Began in 2016

  • Companies with less than $50 million in gross receipts (prior 3-year average) can use R&D credits to reduce Alternative Minimum Tax (AMT). This is very significant, especially for flow-thru entities, whose owners are in or close to AMT every year.
  • “Start-up companies” (companies with less than $5 million of gross receipts for the year and no gross receipts more than five years ago) can use R&D credits to reduce a portion of their federal payroll taxes going forward – specifically the employer’s Social Security portion of FICA taxes (6.2% of wages up to $127,200 per employee in 2017).

The R&D Tax Credit is one of the most significant tax incentives remaining under current tax law – a substantial tool for maximizing a company’s cash flow and bottom line.

 

Our R&D Tax Credit practice consists of engineers, CPAs, and attorneys who have extensive experience conducting R&D Tax Credit Studies at both the federal and state level. Our process begins with a free assessment to ensure that the company qualifies for the credit and would be able to utilize them. Each of our studies includes a site visit to help facilitate the study process. We also include audit support for all of our studies. This is a conservative federal and state incentive that was just made permanent by Congress as part of the 2015 PATH Act. Contact ETS for more information at 609-915-1607 or email gkimmel@engineeredtaxservices.com

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State $hortfalls shrinking

By E.J. McMahon,  Founder and Research Director, The Empire Center for Public Policy

New York State’s budget outlook for fiscal 2020 is improving, according to the FY 2019 Mid-Year Update issued today by Governor Cuomo’s Division of the Budget (DOB).

The Mid-Year Update—released 10 days past the Oct. 30 statutory deadline—pegs the budget gap at $3.070 billion for the fiscal year that starts next April 1. That’s down from $4.027 billion as of the end of the first fiscal quarter.

Assuming Cuomo sticks by his pledge to hold annual State Operating Funds budget growth to 2 percent, the state’s projected net revenue shortfall has been cut nearly in half, to $402 million from the previously projected $780 million. And if the 2 percent limit is maintained through FY 2022, the remaining gaps for the following two years would fall to $998 million and $316 million, respectively.

The significant partial gap-closing since the First Quarter Update can be traced primarily to two factors: a $303 million increase in projected miscellaneous receipts and federal grants, and a $579 million decrease in projected disbursements, which in turn stems mainly from reduction in projected debt service.

Notably, DOB hasn’t changed any of its first-quarter projections of state tax receipts—although state Comptroller Thomas DiNapoli’s office this week estimated that taxes will fall short of Cuomo’s previous projections by $116 million in fiscal 2019 and $383 million in fiscal 2020. If DiNapoli turns out to be correct, the gaps will be larger than Cuomo now expects.

An embarrassment of riches

The new numbers cast more doubt on the need to fully extend the state’s temporary higher “millionaire tax” rate, which now raises about $4.5 billion a year.

That tax, boosting the state’s top personal income tax rate from its permanent-law level of 6.85 percent to 8.82 percent, is Cuomo’s twice-extended version of a slightly higher set of temporary surtaxes first enacted under Governor David Paterson to help close budget shortfalls in 2009-10.

The Mid-Year Update, like all DOB financial plans, assumes no change to current state law—which would mean the higher millionaire tax rate expires as scheduled on Dec. 31, 2019, three-quarters of the way through the 2020 fiscal year.

Based on current revenues, this means the gaps projected on the “Adherence to 2% Spending Benchmark” bottom line of the financial plan could be closed with extended millionaire tax rates of roughly 7 percent to 7.5 percent through Dec. 31, 2021. The natural next step in such a phase-down would be to eliminate the tax entirely and revert to the permanent law top rate of 6.85 percent in 2022.

Balancing the budget with no millionaire tax after 2019 would require holding spending growth to 1.6 percent in FY 2020, and slightly below 2 percent in the following two years.

The only way Cuomo could actually spend the entire $4.5 billion raised by the millionaire tax would be to (a) invent a new category of off-budget disbursement, or (b) cut some other tax. In previous years, he’s chosen “b”—other temporary tax cuts, most recently in the form of a temporary “property tax relief credit.”

Then again, New York City Mayor Bill de Blasio, Assembly Democrats, and—last but not least—leading members of the newly elected state Senate Democratic Majority favor raising the millionaire tax even higher, in part to to generate more money for the Metropolitan Transportation Authority (MTA) and city subways.

Proponents of boosting the millionaire tax ignore the impact of the new federal tax law capping state and local tax (SALT) deductions, which has boosted New York’s effective marginal income tax rate to an all-time high.

Cuomo’s next financial update is due with the first Executive Budget of his third term, next February 1. In the meantime, he’s approaching another deadline that he has gotten into the habit of casually ignoring: Nov. 15, when representatives of the governor, comptroller and legislative leaders are required to meet publicly “for the purpose of jointly reviewing available financial information to facilitate timely adoption of a budget for the next fiscal year.”

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Why Join a Group Captive for Insurance

A captive insurer is an insurance company that is wholly owned and controlled by its insureds; its primary purpose is to insure the risks of its owners, and its insureds benefit from the captive insurer’s underwriting profits. Single-parent captives have only one owner. Group captives, on the other hand, are formed when a group of individuals or entities comes together to jointly own a captive insurance company. Sometimes they are sponsored by industry associations for the benefit of their members, hence the alternative name “association captive.”

Why Join a Group Captive?

Like single-owner captive insurers, group captive insurers offer the key benefits of pricing stability, insurance coverage stability, and improved services. However, the use of group captives is feasible for organizations that do not have adequate capital resources to form their own single-parent captive. Other benefits of the group captive approach are examined below.

  • Improved Loss Forecasting and Greater Risk Retention Potential – Given the law of large numbers, overall claim experience can be predicted with a higher degree of confidence for a group captive insurer than if a single organization’s exposures were being covered.
  • Mass Purchasing Power – Group captives can obtain services and reinsurance more cost-effectively than if each member of the group attempted to obtain such services and reinsurance by itself.
  • Reduced Overhead – General management overhead is reduced in a group captive insurer due to economies of scale. The per-member cost of administering a group captive is decidedly lower than if the identical coverage is obtained in a single-owner arrangement.
  • Increased Loss Control Emphasis – The group captive structure imposes a sharing of losses on its members. This ultimately produces peer pressure and healthy competition among the members to enforce safety practices and control claims. No member wants to feel as if it is generating more than its “fair share” of claim expenses. Participants in a group captive might find themselves voted out, nonrenewed, or canceled if they cannot live up to the group’s loss control standards.
  • Retention and Return of Profits in a Cost-Effective Manner – The majority of group captive insurance companies pay dividends or otherwise distribute underwriting profits and interest to their owners or insureds. Depending upon how the captive program has been set up, the group captive can be financially advantageous, as compared to a noninsurance risk retention program or commercial insurance.

 

Problems Inherent in Group Captives

Because they have multiple owners, group captives are subject to a number of potential difficulties that do not plague their single-owner counterparts. These disadvantages are noted under the following headings.

  • Formation/Capitalization Delays – As the number of potential members of a group captive increases, the time required to form and capitalize the venture will increase proportionately.
  • Decision-Making Problems – Once a group captive has been established, the differing needs of its members may make it difficult to reach consensus on operational issues.
  • Rating and Cost Allocation Controversies – Honest differences of opinion may arise between members as respects the rating process. Depending on the rating plan that is devised, some members will fare significantly better or worse than others.
  • Potential Higher Costs – A group captive insurer’s initial costs are usually higher than traditional loss funding alternatives. Further, participation in a group captive might require an initial capital contribution from each member. Captive participants must keep the long-term goals of stable pricing and availability of coverage in mind. Their commitment should not be swayed by swings in the insurance market cycle.
  • Profits and Earnings Distribution Conflicts – Another major area of potential disagreement pertains to the distribution of underwriting profits and earnings that accumulate on those profits. Many problems are avoided when a predetermined earnings distribution plan is in place before the captive begins to operate.
  • Reduced Degree of Confidentiality – Potential group captive members are required to divulge a substantial amount of financial information. Most small business owners prefer to keep this information confidential.
  • Additional Management Time – Volunteer management on boards and committees is one of the reasons group captives’ costs can be kept low, but in exchange, this requires the volunteers to expend their time and effort to manage the captive.
  • Different Growth Rates of Owners When a group captive is initially created, the members/owners arrive at a consensus on the retention levels and amount of risks insured. Over time, different members may grow much larger and desire higher retentions and/or coverage amounts.
  • Potential Withdrawal of Participants – Group captives face the threat of potential large-scale capital withdrawal by their members. Of course, this could severely impair the captive’s continued financial well-being. Accordingly, when group captives are formed, clear and unambiguous procedures must be developed for dealing with these circumstances.
  • Potential Tax Problems – When comparing group captives to conventional loss funding programs, captives may appear to represent the better opportunity to deduct the premiums from federal income taxes. This is especially true when comparing a group captive to a typical large deductible plan. However, unless the captive is able to withstand the Internal Revenue Service’s test regarding risk shifting and distribution, premium tax deductibility could be in jeopardy. Group captives also present additional tax issues.

Is Participating in a Group Captive Right for You?

A number of crucial factors should be considered when deciding whether to participate in a group captive. If you are interested in learning what for factors are and learning more about the Group Captive endorsed by the Council of Industry contact Owen McKane at the Reis Group.

  • Who controls the facility, and are there any conflicts of interest?
  • Are there any provisions for the withdrawal of participants and the entry of new participants?
  • What is the minimum required participation time?
  • How are premiums determined?
  • What, if any, risk control efforts does the facility require of participants?

Once these and other questions are answered and the decision to participate in a captive is made, each member/owner must continue its commitment to ensure the captive remains truly workable.

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