By now many of us are familiar with the various provisions of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. We have attended or taught continuing professional education on the changes, but we might not be aware of the full import of the changes. Here is a list of changes together with (perhaps) unexpected nuances.
Suspension of the 2% miscellaneous itemized deduction
Pre-TCJA, the following deductions were itemized deductions limited to the amount in excess of 2% of adjusted gross income (AGI) for individual taxpayers:
- Employee business expenses;
- Investment expenses;
- Professional dues;
- Union dues;
- Educator expenses in excess of the amount deductible above the line;
- Tax preparation fees;
- Employees' home office expenses;
- Rural mail carrier vehicle expense;
- Expenses limited to hobby income; and
These expenses provided no benefit pre-TCJA unless the individual taxpayer itemized. In some cases, the benefit from deducting the expenses was limited because the individual taxpayer became subject to the alternative minimum tax (AMT). Although the AMT exemption has been increased and the exemption phaseout point has been raised to $1 million for married taxpayers who file jointly, deductions for the above categories of expenses are now suspended through 2025. Many taxpayers may find the standard deduction is larger than itemizing deductions. Employees who incur out-of-pocket expenses expected to deduct the above expenses, which provided a tax benefit. For 2018 through 2025, there is no tax benefit for either income tax or net investment income tax. However, these expenses may continue to be deductible for state income tax purposes.
State and local taxes limited to $10,000
The sum of deductible state and local income tax (or, alternatively, state and local sales taxes) plus personal and real property taxes is limited to $10,000. Property tax imposed directly on investment and business property remains deductible. Property tax on investment property, outside of the $10,000 limitation, is reported on Line 6 of Schedule A, Itemized Deductions, (Form 1040, U.S. Individual Income Tax Return). Property taxes from activities reported on Schedule C, Profit or Loss From Business, or Schedule E, Supplemental Income and Loss, are reported on those schedules as in past years.
Hobby losses, which are defined as expenses in excess of income from an activity that the taxpayer cannot prove he or she intended to make a profit, are not deductible. Hobby expenses (limited to income) previously were limited in deductibility, but classified as miscellaneous itemized deductions subject to the 2% of AGI limitation (see above). Because that category of expenses is not deductible for 2018 through 2025, taxpayers who have income, but the activity does not rise to the level of a trade or business, are taxed on their gross profit. Operating expenses are denied. The income does not qualify for Sec. 199A (qualified business income (QBI) deduction), because the activity is not a trade or business.
Individual alternative minimum tax (AMT)
The individual AMT was not repealed, but the exemption amount was increased and the exemption phaseout point begins for taxpayers with much higher income levels than previously. Several sources estimate that 5 million taxpayers were subject to AMT in 2017. Because of the changes, the estimate for 2018 is 250,000 taxpayers will be subject to AMT. Although the TCJA simplified accounting methods for taxpayers with average annual gross receipts no more than $25 million (except tax shelters), AMT adjustments continue to apply to construction contractors. For AMT purposes, they are required to compute long-term contracting income using AMT methods. The other major category of taxpayers subject to AMT are those who exercise incentive stock options.
The deduction for moving expenses is suspended for years 2018 through 2025, except for members of the U.S. military on active duty who move pursuant to a military order and incident to a permanent change of station. Likewise, the reimbursement by the employer of employee moving expenses is taxable for 2018 through 2025, although a reimbursement in 2018 for a moving expense incurred in 2017 remains nontaxable.
Employers providing transportation fringe benefits
Qualified transportation fringe benefits include qualified parking (parking on or near the employer's business premises or on or near a location from which the employee commutes to work by public transit), transit passes, vanpool benefits, and qualified bicycle reimbursements. Employers are disallowed deductions for expenses associated with providing qualified transportation fringes to employees, except as necessary to ensure their safety. Under transitional guidance in Notice 2018-99, most employer-provided parking (including on surface lots next to the office) has an element of nondeductible expense if the primary use of the lot is by employees. This newly nondeductible item creates a new Schedule M-1, Reconciliation of Income (Loss) per Books With Income per Return, adjustment for employers required to file this form. Many Schedules M-1 will have a nondeductible expense for qualified transportation fringes, but the IRS did not modify the form to provide a designated line for this addition. Final guidance may differ from the transitional guidance.
The bicycle-commuting fringe benefit is now taxable to the employee.
No deduction is allowed for membership dues of any club organized for business, pleasure, recreation, or other social purposes.
Excess business loss
Under Sec. 461(l), business losses are limited to the sum of business income plus $250,000 ($500,000 for married filing jointly). Losses suspended in pre-2017 years due to tax basis, at-risk, and passive activities, allowed in 2018 and later years, appear to be subject to this limitation. According to the IRS, wage income is considered business income; the Blue Book says otherwise (Joint Committee on Taxation, General Explanation of P.L. 115-97 (JCS-1-18) (December 2018); see also AICPA Letter to Treasury and the IRS (2/28/19) and Hesse, "Questions Remain About the Excess Business Loss Rule," Tax Insider (March 7, 2019)). Proposed technical corrections submitted on Jan. 2, 2019 would have eliminated the treatment of wage income as business income for this purpose.
Net operating loss (NOL) limitation
Startup businesses often incur NOLs, which previously were fully deductible against future year taxable income. For NOLs created for years beginning after 2017, the NOL may offset up to 80% of taxable income. Generating large NOLs earlier (rather than deferring expenses to offset taxable income) will be detrimental for a business.
Aggregation of gross receipts
Businesses that are not tax shelters are provided exceptions from certain accounting method requirements and are allowed to deduct business interest expense without limitation. Become familiar with the aggregation rules under Sec. 448(c).
Tax shelter determination
The cash method accounting exceptions provided businesses with no more than $25 million of average annual gross receipts (determined on an aggregated basis with certain related parties) do not allow tax shelters to qualify. Tax shelters are defined in Sec. 448(d)(3), referring to Sec. 461(i)(3). This is a daisy-chain of Code section provisions. The unwary may be surprised of the broad application of the tax shelter definition. A limited liability company (LLC) that allocates (or perhaps might allocate, if it had a loss) losses to members more than 35% of which are not active in the management is a tax shelter. There are exceptions.
Qualified trade or business
The Code does not define the term "trade or business." Although the final Sec. 199A regulations provide rules for determining how to compute the 20% QBI deduction, and they provide guidance on the determination of specified service trades or businesses (SSTBs), they provide little guidance on whether the taxpayer has a trade or business (T.D. 9847). Taxpayers may be surprised that certain rental real estate activities do not rise to the level of a trade or business, although the IRS has created a safe harbor (Notice 2019-07). Most other rental activities rise to the level of a trade or business, but triple net lease activities might not.
Consistent treatment of business activities
A trade or business is subject to all information reporting. In previous years, a rental activity may have asserted information reporting (filing Forms 1099) did not apply because it was not a trade or business. Activities rising to the level of a trade or business generate QBI and are subject to information reporting. Likewise, taxpayers holding property as tenants in common must file a partnership tax return if the activity rises to the level of a trade or business.
Details for Sec. 199A
Partnerships, S corporations, trusts, and estates must separately report the amount of QBI for Sec. 199A. The regulations provide that if these passthrough entities fail to report the QBI separately, the taxpayer is to assume the positive QBI (and other QBI components) is zero. Line 1 of Schedule K-1 is not necessarily QBI. Taxpayers receiving a Schedule K-1 without disclosure of the QBI components should contact the preparer of the passthrough entity tax return. This also applies for fiscal year entities beginning in 2017, ending in 2018.
Partnership and S corporation details
Schedule K-1 (for both entity types) contains new codes, some changed codes, and much more supporting schedule information. Output from tax preparation software should be reviewed for accuracy; prior-year default settings for pro forma returns are no longer appropriate in many cases.
Centralized partnership audit regime
The partnership should decide on the appropriate partnership representative unless the partnership is able to, and does, elect out of the centralized partnership audit regime. This partnership representative carries much more authority than the prior tax matters partner. As to the election out of the regime, confirm that no partner makes the partnership ineligible for the election. Preparers may not be aware of partnership interests held by grantor trusts or other disregarded entities.
Trust (and estate) administrative expenses
There is a distinction between tax preparation expenses and other administrative expenses allowable to trusts and estates on Form 1041, U.S. Income Tax Return for Estates and Trusts. The de minimis rule for "unbundling" treats all expenses as subject to the 2%-of-AGI limitation. Any trust or estate using the de minimis unbundling rule should be aware that expenses subject to 2%-of-AGI limitation are no longer deductible. In addition, trusts and estates may want to take a fresh look at the "reasonable method" used to unbundle trustee fees in light of the tax law change.
Charitable contributions passing through to an ESBT shareholder
Charitable contributions passing through to an electing small business trust (ESBT) shareholder are no longer deductible under the rules applicable to trusts; the deductible amount is now subject to the charitable deduction rules applicable to individual taxpayers. Individuals are allowed charitable contribution deductions limited to certain percentages of AGI with a five-year carryforward of amounts that exceed the AGI limits. Prior to the law change, an ESBT was allowed a charitable contribution deduction for amounts up to gross income with no carryforward option.
A business' North American Industry Classification System (NAICS) code may designate an incorrect business category, especially important now that specific codes may imply incorrectly that the business is an SSTB. Preparers should review the displayed NAICS code to determine if the code appropriately describes the taxpayer's principal business.
Lowered understatement threshold under Sec. 6662
Individual taxpayers are generally subject to a substantial understatement of income tax penalty of 20% on the amount of an understatement of income tax if the taxpayer's understatement is the greater of 10% of the tax required to be shown on the tax return or $5,000. However, under Sec. 6662(d)(1)(C), for tax years 2018–2025, taxpayers who claim a QBI deduction of any amount will lower their understatement threshold on their entire tax return from 10% to 5%. Many taxpayers who claim QBI deductions for small amounts of qualified real estate investment trust dividends or small business income could unknowingly subject themselves to a higher risk of an understatement penalty on their tax return.
Some provisions of the TCJA are on a list for technical corrections. If Congress passes technical corrections legislation and the president signs it, amended returns may be necessary. Extending the filing date by requesting an extension of time to file may reduce the need for filing an amended income tax return.
Christopher W. Hesse, CPA, is a principal in the National Tax Office of CLA (CliftonLarsonAllen LLP). He is the vice-chair of the AICPA Tax Executive Committee. To comment on this article or to suggest an idea for another article, contact senior editor Sally Schreiber at Sally.Schreiber@aicpa-cima.com.