It goes without saying that the Tax Cuts and Jobs Act ("TCJA"), which passed into law on December 22, 2017 (Pub. L. 115–97), was a sea change in the Internal Revenue Code. It benefitted many taxpayers, disadvantaged many others, and handed tax professionals a steep learning curve to become proficient with its provisions.
This article is not intended to be a technical review of the TCJA, although we will touch on some technical points. Rather, it highlights what we see as areas that seem likely to generate errors and, in turn, claims against tax professionals. Our goal is to sharpen our scan when working in these areas so we minimize our risk in what will be an inherently uncertain endeavor for a few years.
We have also highlighted "Planning Considerations" and other key points in boldface in the following text to assist tax professionals and their clients in the planning process and management of risk.
More Fees Due to ComplexityWhile not a matter of substantive tax law, the fees we bill to our clients for tax planning and consulting are likely to be higher this year than in the past, and that may create some tension with clients. These additional fees to advise and assist them in TCJA compliance may be unavoidable for many clients, and those who are fee-averse to begin with could be especially unhappy. We are of course expected to know the tax law as changed by the TCJA, but in applying it to individual clients it will be, for many, a case of first impression. That requires some thought and some time. If we try to work with one eye on the clock, it can lead to errors.
Planning ConsiderationsAs a first step, we should inform our clients who may require additional planning and consulting related to TCJA of the likelihood of higher fees for 2018, and perhaps for a while thereafter, and why higher fees may be necessary. This information can accompany the annual tax questionnaire — a good place to start. The point can be followed up at the next opportunity to communicate with the client. Engagement letters should be used now more than ever for all tax clients to clarify terms and conditions of the services to be performed, and the fees associated with the services being rendered.
AlimonyAlimony comes from an unhappy place called divorce. The new alimony rules won’t make divorcing couples any happier. As we know, alimony payments required under divorce or separation instruments that are executed after December 31, 2018, are not deductible under the new law. Recipients of affected alimony payments will no longer have to include them in taxable income. Clients who are in divorce proceedings and want deductible alimony treatment for some or all of the payments that will be made to the other party must get their divorce agreement completed and signed by December 31, 2018. However, the recipients of those payments have a big incentive to put off finalizing the agreement until after 2018 because the payments would be tax-free to the recipient. Thus, there is significant risk from involvement with clients who fail to formalize their divorce/separation before the December 31, 2018, deadline. The damages could be substantial.
That divergence of interests between the people getting the divorce is yet another conflict of interest "red flag" in the collection of "red flags" related to doing work for divorcing couples. Don’t count on conflict waivers to save the day. We should also not count on divorce attorneys to know the ins and outs and intricacies of the new tax law as it applies to divorce — even though they should. So, if we have clients who have announced a divorce, we have a choice to stay engaged or disengage; if we stay engaged, we must be mindful of the risk, have signed conflict of interest waivers in place, and try to control events that involve us.
IRC §199AThe TCJA enacted IRC §199A, which made individuals, trusts, and estates eligible for a 20% deduction from their allocable domestic qualified business income (QBI) from each partnership, as well as LLCs, S Corporations, sole proprietorships, disregarded entities, real estate investment trusts (REITs), qualifying cooperatives, and qualifying publicly traded partnerships. In other words, a wide swath of our clients may be able to benefit from the provisions of §199A.
This new deduction is unfortunately complicated, and based on prior tax law changes it will take some time before the IRS can issue meaningful guidance. However, client pressure to exploit the planning opportunities is likely, and tax professionals will be asked how they can reduce their clients’ tax burdens through creative strategies centered around the QBI deduction. This dynamic may lead to planning based on judgment, guesswork, and tax instincts.
To begin with, there are definition issues and limitations that make §199A a complex law to apply:
Income from many service businesses may not qualify. There is an adjusted gross income (AGI) threshold below which the taxpayer can be exempted from this, and another above which the deduction phases out.
Section 199A impacts cooperatives, REITS, publicly traded partnerships, and their related dividends and distributions, and creates planning issues. For instance, farmers may find it beneficial to form cooperatives but may not know of the benefits or if the opportunity applies to their situation unless their tax professional mentions it.
There are limitations on the amount of the deduction based on the level of W-2 wages and tangible depreciable property in the business; however, this is not applicable below certain AGI thresholds.
Planning ConsiderationsA sampling of the planning issues we may confront, and this is hardly an exclusive list, includes:
- Reducing income to stay below income thresholds
- “Changing” specified service income into non-specified service income
- Changing salaried employees to independent contractors
- Changing independent contractors to salaried employees
- Getting out of C Corporation entities
- Increasing wages (adding payroll tax expense) to gain more of QBI deduction
- If the client owns multiple businesses, exactly what is meant by qualified business income, is it aggregated, or should it be?
- If the client operates several businesses out of the same entity, should they be redeployed to other entities?
- Is the 21% C Corporation rate better than the available QBI deduction?
Global Intangible Low Tax Income (GILTI)The TCJA adds IRC §951A effective for taxable years of foreign corporations beginning after December 31, 2017. It provides that a U.S. shareholder of a controlled foreign corporation (CFC) must currently include a certain type of income called Global Intangible Low Tax Income (GILTI) whether or not distributions are received. GILTI is for some taxpayers1 subject to a 50% deduction resulting in a base rate on GILTI of 10.5%.
The perceived risks here are that this new law has many unanswered questions in its application and raises risks on tax advice or its omission.
The GILTI calculation itself is challenging and primed for errors. Also, questions remain on how it is applied. Among the many questions about the application of GILTI are whether GILTI losses, income, and foreign tax credits can or cannot be netted, and whether GILTI will be calculated at the U.S. shareholder level, or jointly among a consolidated group or sub-group.
Another risk is tax advice given or omitted on how a given business structure may incur higher tax rates. The GILTI rules apply a higher tax rate (37%) to GILTI attributed to individuals and trusts who own Controlled Foreign Corporation (CFC) stock directly or indirectly through LLCs or S Corporations as compared to C Corporation shareholders.
Planning ConsiderationsThis is where tax advice risk exists. Clients who own shares in a CFC either directly or through an LLC or S Corporation expose themselves to a higher tax rate than if they held those same shares through a C Corporation. Of course, getting the income out of the C Corporation may be a taxable dividend. The tax planner may also have to consider a §962 election.2
Also, because the effective GILTI tax rate is half of the domestic corporate income tax rate, corporate taxpayers could reduce overall tax by reporting losses in the U.S. and accepting the 10.5% GILTI rate on overseas income.
CFCs have been frequent flyers in the claims arena. The GILTI overlay on the CFC’s rules won’t decrease complexity of the risk to tax professionals who have clients with CFCs. This is clearly a “heads up” area.
Interest LimitationsThe newly amended §163(j) of the Tax Code provides the ability to deduct interest expense paid or accrued for many businesses — not just corporations. Business interest deductions generally will not be permitted to the extent net interest expense exceeds an adjusted earnings–based threshold. The limitation on interest deductions may result in an increased tax liability to corporations and investors in flow-through businesses that finance acquisitions with debt such as, for example, businesses that have undergone private equity–sponsored leveraged buy-outs (LBOs) or similar transactions.
Planning ConsiderationsCPAs and business clients planning transactions involving debt may be unaware of the new limitations on interest deductions. If we actively through an error or inadvertently through passivity don’t correct this lack of awareness and out-of-date belief, our clients may look to us if they get a tax surprise after the transaction is done.
Net Operating Loss ChangesThe law prior to the TCJA, generally, required net operating losses (NOLs) to be carried back two tax years, with the remaining NOL carried ahead to the 20 succeeding tax years, after which it expired. For regular tax purposes, the NOL was eligible to offset up to 100% of taxable income of a tax year (90% for Alternative Minimum Tax purposes) within the carryback and carryforward periods.
For NOLs arising in tax years beginning after December 31, 2017, the TCJA limits the NOL deduction to 80% of taxable income and eliminated the two-year carryback period but now provides an indefinite carryforward. For NOLs generated in tax years ending on or prior to December 31, 2017, prior tax law still applies — the 80% limitation on NOLs won’t apply, and the NOLs can be carried forward 20 years.
The legislation makes NOLs less valuable than they were in the past, which could require tax plans made prior to the TCJA to be re-examined if the use of NOLs was a material part of the plan.
Seeing that adequate records exist to classify NOLs as pre- or post-December 31, 2017, may fall on tax professionals, which makes it a risk. That also means educating clients and perhaps having an independent means of breaking the data out.
Limitations of Itemized DeductionsThe TCJA law gave a substantial increase to the standard deduction, but it took away or limited many common itemized deductions. Starting with 2018, individuals are permitted to deduct up to $10,000 ($5,000 married filing separately) in state and local taxes (SALT). In states that have high real property taxes or high income taxes or both, these limits will make many taxpayers face higher federal tax bills, and in some instances, substantially higher.
There are risks here. Several states have proposed passing laws that would allow taxpayers to make a contribution to a state charity and for which they would receive up to a dollar-for-dollar credit against their state tax obligation. The taxpayer could then deduct the “contribution” as a charitable gift on the federal return. There have also been some published tax plans for getting around the SALT deduction limits using LLCs and Alaska trusts to own portions of one’s home. Whatever the plan may be, tax professionals know that this is a controversial area.
The IRS hasn’t been asleep on the charitable deductions/state tax credit issue and has issued Proposed Regulations for IRC §170 (I.R. 2018-172), which rejects the state charitable deduction/state tax credit plan. However that fight turns out, which may be many years in the future, tax professionals are dealing with the immediate issue of clients’ requests to use these devices to get around the TCJA limits. Proposed Regulations are of course just the Service's "position." They aren’t yet law, but they are a pretty good indication that action taken in contravention of that “position” will likely elicit a fight.
If your client wants to take a position that appears to be contrary to a "position" of the IRS, assuming professional standards are met (AICPA Statement on Standards for Tax Services (SSTS) and IRS Circular 230), steps should be taken to make the client, rather than you, responsible for the consequences. DOCUMENT, DOCUMENT, DOCUMENT!
Commercial Real Estate DepreciationOne of the winners in the TCJA was commercial real estate. Qualifying property placed in service after September 27, 2017, is eligible for 100% bonus depreciation, which drops 20% a year starting in 2023 and is gone by 2027. Used property3 is now able to be completely expensed.
The TCJA also changed IRC §179 by increasing the annual §179 limitation from $500,000 to $1 million, with a phase-out beginning at $2.5 million for qualifying assets placed in service. IRC §179 property now includes fire protection systems, alarm systems, security systems, HVAC, and roof structure.
Planning ConsiderationsTax professionals who have clients with commercial real estate will need to address the changes. TCJA limited business interest deductions, and some businesses may not want to maximize depreciation deductions in order to preserve more of the interest deduction. Also, cost segregation studies may become more useful. There will be planning challenges here.
Estate and Trust Limitations on Miscellaneous Itemized DeductionsThe TCJA included IRC §67(g), which disallows itemized miscellaneous deductions exceeding the 2% floor. Estates and non-grantor trusts calculate their adjusted gross income the same way as do individuals and thus would seem subject to the same §67(g) limitation.
The IRS issued Notice 2018-61, which confirms that §67(e) expenses remain deductible in determining the adjusted gross income of a non-grantor trust or estate during the taxable years to which §67(g) applies. The Notice also addresses if a beneficiary may deduct §67(e) expenses on the termination of a non-grantor trust or estate pursuant to IRC §642(h)(2). The Notice announces that Regulations will be issued to bring clarity to this area.
ConclusionThe changes in the body of tax law generated by the TCJA will, like tax law changes in the past, take a long time to digest, as we clarify the ambiguities, coverage gaps, and questions that always follow new law. Tax professionals have clients who want answers now. That dichotomy can put pressure on us to provide advice that may be based more on experience and intuition than on clear authoritative guidance. In such situations, applying appropriate risk management techniques will be critical to minimize exposure on the CPA.
Appropriate risk management includes at a minimum keeping the client part of the process to manage expectations. CAMICO’s claims experience continues to show that CPAs who successfully manage client expectations, which includes informing clients of opportunities and advising clients of risks, in addition to just following professional standards, are more likely to “get it right” and avoid becoming victims of potential liability exposures.
And of course, DOCUMENT, DOCUMENT, DOCUMENT!
By highlighting some areas in TCJA for which we should sharpen our scan, we can better manage and reduce our risk of an engagement failure.
Arthur V. Pearson, J.D., L.L.M., is a principal of the law firm of Murphy, Pearson, Bradley & Feeney, which has offices in San Francisco, Sacramento and Los Angeles. Art has worked with CAMICO policyholders for more than 25 years and can be reached at: email@example.com
1 The 10.5% GILTI tax rate only applies to international businesses that do not engage in U.S. trade or business.
2 Making a §962 election permits an individual to be taxed as a corporation, lowering the tax rate to 21%, not to 10.5%.
3 Eligible assets are those with a depreciable life of 20 years or less — personal property and “qualified improvement property,” which is defined as work done to the interior of a commercial building, excluding costs related to the enlargement of a building, an elevator or escalator, or the internal framework of the building.