Category Archive: Blog

May/June Dates to Remember

May 10   

Employers. For Social Security, Medicare, and withheld income tax, file Form 941 for the first quarter of 2018. This due date applies only if you deposited the tax for the quarter in full and on time.

May 15

Employers. For Social Security, Medicare, withheld income tax, and nonpayroll withholding, deposit the tax for payments in April if the monthly rule applies.

 

June 15

Individuals. If you are not paying your 2018 income tax through withholding (or will not pay enough tax during the year that way), pay the second installment of your 2018 estimated tax.

If you are a U.S. citizen or resident alien living and working (or on military duty) outside the United States and Puerto Rico, file Form 1040 and pay any tax, interest, and penalties due for 2017. If you want additional time to file your return, file Form 4868 to obtain four additional months to file. Then, file Form 1040 by October 15.

Corporations. Deposit the second installment of estimated tax for 2018.

Employers. For Social Security, Medicare, withheld income tax, and nonpayroll withholding, deposit the tax for payments in May if the monthly rule applies.

Many Business Expenses are No Longer Deductible

 

The good news is that the TCJA of 2017 lowered corporate tax rates from a graduated schedule that reached 35% to a 21% flat rate. The bad news? Many business expenses are no longer tax deductible. That list includes all outlays that might be considered entertainment or recreation.

As of 2018, tickets to sports events can’t be deducted, even if you walk away from the game with a new client or a lucrative contract. The same is true if you treat a prospect to seats at a Broadway play or take a valued vendor out for a round of golf. Those outlays will be true costs for business owners without any tax relief.

Drilling down

Does that mean that you should drop all your season tickets supporting local teams? Cancel club memberships? Pack away your putter and your tennis racquet? Before taking any actions in this area, take a breath and crunch some numbers.

Example: In recent years, Luke Watson spent about $20,000 a year on various forms of entertainment, which his company claimed as a business expense. Indeed, these were valid expenses and helped his LW Corp. grow rapidly.

Assume that LW Corp. paid income tax at a 34% rate. In 2017 and prior years, business entertaining was only 50% deductible. Thus, LW Corp. deducted $10,000 (half of Luke’s expenses) and saved $3,400 (34% of $10,000). With $3,400 of tax savings and $20,000 of out-of-pocket costs, Luke’s net cost for entertaining was $16,600 under the law in effect during 2017.

Now suppose that Luke has the same $20,000 of entertainment costs in 2018 and that those costs would have still been 50% tax deductible at the new 21% tax rate. His tax savings would have been only $2,100, so the net entertainment cost would have been $17,900. As it is, under the new law his actual entertainment cost would be the full $20,000 with no tax benefit.

This example assumes that LW Corp. pays the corporate income tax on its profits. If Luke operates his business as an LLC or an S corporation, with business income passed through to his personal tax return, the calculation would be different, but the principle would be the same.

Business entertainment has been done mainly with after-tax dollars. Under the new TCJA, you’ll entertain clients and prospects solely with after-tax dollars. You should be careful about how this money is spent and judge the expected benefit. Nevertheless, if business entertaining has paid off for your company in the past, it may still prove to be valuable even without tax breaks.

Fine points

Meal expenses associated with operating a trade or business, including employee travel meals, generally continue to be 50% tax deductible. However, keep in mind that the rules have changed for meals provided for the employer’s convenience. Previously, these were 100% deductible if they were excludible from employees’ gross income as de minimis fringe benefits. That might have been the cost of providing free drinks and snacks to employees at the workplace. Now outlays for such meals are only 50% deductible and they’re scheduled to become nondeductible after 2025.

On the bright side, the new law doesn’t affect expenses for recreation, social, or similar activities primarily for the benefit of a company’s employees, other than highly compensated employees. So, your business likely can still pay for holiday office parties with pre-tax dollars.

Bond Funds are not Without Risk – Holdings Diversity is Key

 

Typically, bond funds with low yields have relatively low risk. That doesn’t mean that these funds are without risk, though. With interest rates expected to rise this year, all types of bond values could drop, leading to an overall pullback in the prices of bond fund shares.

One way to respond to this unwelcome outlook is to diversify your fixed income holdings.

Example: Jane Miller has a target asset allocation of 60% in stocks and 40% in bonds. Working with her financial adviser, Jane puts half of that fixed income allocation (20% of her entire portfolio) into bond funds that mainly hold short-term issues from government entities and financially sound corporations. Such funds are likely to have low yields, but they probably will hold most or all of their value in the coming months and years.

These lower risk funds may be considered core fixed income investments.

Beyond the norm

Assume that Jane can tolerate some volatility in her portfolio. If so, she might put the other half of her fixed income allocation into these types of bond funds:

  • High-yield funds. These funds typically invest in corporate bonds that are unrated or low rated by specialized agencies, perhaps because the issuers are not in excellent financial condition. Fund holdings may be known as junk bonds. Yields are relatively high, but bond prices might drop in times of economic weakness, which can raise doubts about the companies’ ability to meet interest and redemption promises. This danger, known as credit risk, may be reduced if the fund holds many issues because most of a professionally chosen portfolio is likely to avoid defaults.
  • Emerging markets bond funds. Holdings include bonds from governments and companies based in areas considered to be developing economically. For example, such places could range from Brazil to Russia to South Africa. Currency movements may affect returns positively or negatively, but there might be little influence from U.S. interest rate moves.
  • Bank loan funds. As the name indicates, such funds purchase loans made by banks. The borrowers are usually companies; frequently, the loans are used to finance acquisitions. Questions about the borrowers’ ability to repay the debt make these funds vulnerable to recessions and low growth periods. On the other hand, bank loan funds generally invest in variable rate debt, so borrowers’ payment obligations (and the dividends to investors) can go up when interest rates rise.
  • Preferred stock funds. Whereas familiar stock funds own common stock of issuers, these funds buy preferred The name indicates that investors will be paid before common stock holders, in case the issuer can’t meet all its obligations. Preferred stock payouts come before dividends on common shares. In practice, preferred shares tend to pay fixed bond-like yields, and trading prices may have low volatility. Preferred stock funds can be considered more like bond funds than stock funds.
  • Municipal high yield funds. These funds hold tax-exempt municipal bonds from issuers that do not have a sterling credit rating. In essence, these funds are the tax-exempt cousin of the high-yield funds mentioned previously in this article, which pay taxable interest.

As is the case with all municipal bonds and muni bond funds, they should be held in taxable accounts to use their exemption. The other types of funds covered here may be favored for tax-deferred accounts such as IRAs, for which the high dividend payments can compound without a current tax haircut.

Staying put

All of the fund categories mentioned in this article have numerous entrants, so yields will vary from fund to fund. You may be able to find yields around 5% in some funds, whereas core bond funds might be yielding 3% or 2% or even less. Over a lengthy holding period, the difference between compounding a 5% yield and compounding a 2% or 3% yield can be sizable.

Moreover, bond funds tend to buy new bonds because of bond sales, bond redemptions, and new money from investors. If interest rates are rising, fund purchases will bring higher yields, whereas lower yielding bonds are replaced. Again, investors should plan on holding for the long term in order to maximize the value of using bond funds with relatively high yields.

Proceed with caution

High yields generally mean substantial risks, so you may want to mix such bond funds with lower yielding but less volatile bond funds. You could hold funds from every category mentioned here, or you could select only one or two categories to perhaps improve fixed income returns.

If you already hold mutual funds and you’re pleased with the results, you might want to see if the fund company has a high-yield fund, an emerging markets bond fund, and so on. Look at the fund’s past performance, manager tenure, and investment philosophy before making decisions. The same criteria apply if you’re choosing among funds from other companies on your own or if you’re working with an adviser.

Future Divorce Tactics Impacted by Tax Reform

 

When couples divorce, financial negotiations often involve alimony. The tax rules regarding alimony were dramatically changed by the Tax Cuts and Jobs Act (TCJA) of 2017, but existing agreements have been grandfathered. In addition, the old rules remain in effect for divorce and separation agreements executed during 2018. Next year, the rules will change, and the roles will be reversed.

Under divorce or separation agreements executed in 2018, and for many years in the past, alimony payments have been tax deductible. Moreover, these deductions reduce adjusted gross income, so they may have benefits elsewhere on a tax return. While the spouse or former spouse paying the alimony gets a tax deduction, the recipient reports alimony as taxable income.

Shifting into reverse

Beginning with agreements executed in 2019, there will be no tax deduction for alimony. As an offset, alimony recipients won’t include the payments in income.

Example 1: Joe and Kim Alexander get divorced in 2018. Joe expects to be in a 35% tax bracket in the future, whereas Kim anticipates being in a 22% bracket. Suppose that the proposed agreement has Joe paying $3,500 a month ($42,000 a year) in alimony.

Joe will save $14,700 in tax (35% times $42,000), but Kim will owe $9,240 (22% times $42,000). Net, the couple will save over $5,000 per year in taxes. This type of calculation will affect the negotiations, as it has in the past. Assuming the relevant rules are followed, it may make sense to tip the agreement toward Joe paying alimony to Kim, perhaps in return for other considerations.

Example 2: Assume that the Alexanders’ neighbors, Len and Marie Baker, have identical finances. They divorce in 2019. If Len pays $42,000 a year in alimony, he will get no deduction and won’t get the $14,700 in annual tax savings that Joe did in example 1. Marie, on the other hand, will pocket $42,000, tax-free, without the $9,240 tax bill faced by Kim in example 1.

Moving things along

Just as people shouldn’t “let the tax tail wag the investment dog,” so taxes shouldn’t dominate divorce or separation proceedings. However, it’s also true that taxes shouldn’t be ignored. If you are in such a situation, our office can help explain to both parties the possible savings available from executing an agreement during 2018, rather than in a future year.

The new rules will be in effect beginning in 2019. With no alimony deduction and a tax exemption for alimony income, it may be desirable to consider after-tax, rather than pre-tax, income when making decisions. Speaking very generally, there may be less cash for the couple to use after-tax.

Keep in mind that, as of 2019, not all states will have alimony tax laws that conform to the new federal rule. Your state may still offer tax deductions for alimony payments and impose income tax on alimony received. That’s all the more reason to look at after-tax results when calculating a divorce or separation agreement.

Getting personal

The impact of the new TCJA on spousal negotiations may go beyond the taxation of alimony. Among other provisions to consider, the TCJA abolishes personal exemptions. As a tradeoff, the standard deduction was almost doubled.

In some past instances, divorcing spouses would agree that the high bracket party would claim the children’s personal exemptions, which effectively were tax deductions, in return for some other consideration. Now those exemptions don’t exist, so they shouldn’t be part of divorce negotiations. If you previously entered into an agreement that included the treatment of children’s personal exemptions, you may want to consult with counsel to see about possible revisions.

 

Defining alimony

Payments to a spouse or former spouse must meet several requirements to be treated as alimony for tax purposes. The following are some key tests.

  • The payments are made under a divorce or separation agreement.
  • There is no liability to continue the payments after the recipient’s death.
  • The payments aren’t treated as child support or a property settlement.
  • The payments are made in cash (including checks or money orders).

New Tax Benefit for Pass-Through Entities

 

Many small businesses are pass-through entities, including S corporations, partnerships, sole proprietorships, LLCs, and LLPs. The label indicates that all business earnings are passed through to the owners’ personal income tax returns. Thus, they avoid the corporate income tax.

The TCJA contains a new tax benefit for pass-throughs. This provision is complex, but it is relatively straightforward for taxpayers with taxable income below $157,500 in 2018, or $315,000 on a joint return. Such business owners may qualify for a tax deduction that equals 20% of their qualified business income (QBI).

Example: Melanie Foster runs her business as an LLC. In 2018, her QBI (the net of her company’s domestic business taxable income, gain, deduction, and loss) is $140,000. On the joint tax return that Melanie files with her husband, the taxable income is $235,000. This taxable income is before the QBI deduction.

Here, Melanie can deduct $28,000 (20% of $140,000) from their taxable income. Note that this deduction doesn’t reduce the Fosters’ adjusted gross income, which can impact many areas on their tax return.

Over the limits

For taxpayers over $157,500 or $315,000 in taxable income, other factors come into play, which can reduce the QBI deduction. Moreover, some service businesses, such as medical practices and law firms, don’t merit the Q (for qualified) in QBI if their income is over certain limits. HLB Gross Collins, P.C. can illustrate the value of the deduction for your pass-through business income.

TCJA Trims Some Itemized Deductions

 

A key component of the TCJA is the expansion of the standard deduction. The numbers for 2018 are $24,000 (married couples filing jointly), $18,000 (heads of household), and $12,000 (all others). These amounts are almost double the respective standard deductions in 2017. However, personal exemptions were eliminated.

As a give-and-take, the new tax law trims some itemized deductions. Taxpayers can either itemize or use the standard deduction, so some shift to the standard deduction is likely.

Down with debt deductions

Among the trimmed itemized deductions are those for mortgage interest. The new law caps deductions to interest on $750,000 worth of debt used to buy, build, or substantially improve a main or second home. For loans incurred before December 15, 2017, the old rules remain in place, so interest on up to $1 million of such debt is still deductible.

These rule changes affect only newer home loans in the $750,000–$1 million range. Of broader impact, interest on any home equity loans or lines of credit cannot be deducted, starting in 2018. Previously, interest on home equity debt up to $100,000 generally could be deducted. (All of these home loan interest tax changes are scheduled to end after 2025, reverting to 2017 law.)

Therefore, home equity debt now looks like many other types of loans: the interest is nondeductible. Should you keep the one you have? That depends on your situation. If you wish to reduce your debt load, paying down home equity debt has become more attractive. Prepaying a nondeductible loan at, say, 5% is the equivalent of earning 5% on your money, after tax, with no market risk.

Another option is to update your existing home debt. A so-called cash out refinance might provide you with spending money, although the full interest deduction may not be available. Our office can help you crunch the numbers to see if the expense involved would make it worthwhile, and how it will impact the after-tax cost of residence related debt.

Yet another alternative is to use a personal loan to pay off the home equity debt. An unsecured personal loan might be preferable to a loan or line of credit that places your home at risk.

Positive Prognosis for Medical Deductions

 

Many miscellaneous itemized deductions, including unreimbursed employee business expenses no longer can be used to reduce your income, starting with 2018 tax returns. Some observers predicted a similar demise for medical and dental expenses. As it turned out, these deductions not only were retained, the tax benefit was enhanced.

Playing the percentages

Under the law in effect during 2017, unreimbursed medical and dental expenses could be deducted only to the extent they exceeded 10% of adjusted gross income (AGI).

Example: Ivan Larson had $100,000 of AGI in 2017 and $9,100 of unreimbursed medical or dental expenses. Because 10% of his AGI was $10,000, Ivan’s outlays were under the threshold, so he wasn’t expecting a tax deduction for them.

Surprisingly, the TCJA lowered the threshold to 7.5% of AGI, effective for 2017 and 2018. For Ivan, that was $7,500 of expenses (7.5% of his $100,000 AGI), so his deduction for last year was $1,600 (his $9,100 of costs minus the $7,500 threshold).

Under the TCJA, the threshold will move back to 10% of AGI next year. Therefore, you may want to accelerate elective medical expenses such as prescription sunglasses and tooth implants into 2018.

If you plan to incur such expenses this year, before they may be absolutely necessary, you should be confident that your total of unreimbursed medical and dental costs will exceed 7.5% of AGI in 2018. You also should believe that you won’t be taking the standard deduction: $12,000 this year for Ivan, a single taxpayer.

Unless you itemize deductions and your total of unreimbursed medical and dental costs will top 7.5% of AGI, accelerating elective outlays into 2018 will be a wasted effort. You’ll be better off waiting until 2019 to make such payments when they might be tax deductible under the law that will be in effect then.

Are State and Local Taxes a Reason To Move

 

As many people are all too aware, some states and localities impose higher income and property taxes than others. Residents of high tax areas may have taken some solace by itemizing deductions on their tax returns and reducing federal income tax obligations by deducting the taxes paid.

Example: Jennifer Knight deducted $25,000 worth of state income tax and local property tax on her 2017 tax return. Assuming Jennifer was in a 25% tax bracket, she reduced her net outlay for those taxes with $6,250 in tax savings (her 25% tax rate times the $25,000 tax deductions).

In this scenario, Jennifer’s actual tax cost was $18,750, not $25,000, because she cut her federal tax bill by $6,250.

New rules

Under the TCJA, there is still an itemized deduction for taxes paid, but it is now capped at $10,000 a year, starting in 2018. Some people refer to this as the SALT deduction for state and local taxes. It mainly covers property and income taxes, although taxpayers can choose to include sales tax instead of income tax towards the $10,000 cap. (The $10,000 limit is the same for single filers and couples filing jointly, so there is a true “marriage penalty” here.)

As might be expected, taxpayers and politicians in high tax states and localities have loudly protested the cutback in the deduction for taxes paid. Is this the final straw? The added burden that will drive people to move to areas where income and property tax (and perhaps estate tax) are less of a burden?

Relocation may make sense, but such a decision should be made with care. Calculate how much extra you’ll be paying in tax now, considering the loss of the taxes paid deduction and all the other features of the TCJA. Don’t forget to include the alternative minimum tax (AMT), which still impacts many individuals. People who owe the AMT get no tax benefit from deducting state or local taxes. Our office can help with this computation.

Then, find out how much you’d owe after a move to a different area. Include income taxes and, assuming you’ll be a homeowner, likely property tax. Find out if sales tax will be meaningful in the new area. Determine the state’s estate tax exemption and estate tax rates, if you expect to leave assets to loved ones.

Typically, you’ll discover that relocating is a puzzle with many different parts of varying sizes. Effectively paying more in state and local tax under the TCJA may be a key piece of that puzzle, but it’s just one thing to consider before calling the movers.

April/May Dates to Remember

April 17

Individuals. File a 2017 income tax return. If you want an automatic six-month extension of time to file the return, file Form 4868, “Application for Automatic Extension of Time To File U.S. Individual Income Tax Return.” Then, file Form 1040, 1040A, or 1040EZ by October 15.

If you are not paying your 2018 income tax through withholding (or will not pay in enough tax during the year that way), pay the first installment of your 2018 estimated tax. Use Form 1040-ES.

Employers. For Social Security, Medicare, withheld income tax, and nonpayroll withholding, deposit the tax for payments in March if the monthly rule applies.

Household employers. If you paid cash wages of $2,000 or more in 2017 to a household employee, file Schedule H (Form 1040) with your income tax return and report any household employment taxes. Report any federal unemployment (FUTA) tax on Schedule H if you paid total cash wages of $1,000 or more in any calendar quarter of 2016 or 2017 to household employees. Also, report any income tax you withheld for your household employees.

Corporations. File a 2017 calendar-year income tax return (Form 1120) and pay any tax due. If you want an automatic six-month extension of time to file the return, file Form 7004 and deposit what you estimate you owe.

Corporations. Deposit the first installment of estimated income tax for 2018

 

May 10        

Employers. For Social Security, Medicare, and withheld income tax, file Form 941 for the first quarter of 2018. This due date applies only if you deposited the tax for the quarter in full and on time.

 

May 15

Employers. For Social Security, Medicare, withheld income tax, and nonpayroll withholding, deposit the tax for payments in April if the monthly rule applies.

Regard Roth Conversion Carefully

The article “Rethinking retirement contributions” explains why the new TCJA devalues putting money into traditional tax-deferred plans and favors Roth versions. Does the same reasoning apply to conversions from Roth to traditional accounts? From a tax viewpoint, the answer may be yes, but other factors indicate you should be cautious about such moves.

Example 1: Fred and Glenda Polk would have had $220,000 in taxable income in 2017 without contributing to their employers’ traditional 401(k) plans. However, they contributed a total of $40,000 to the plan, bringing their income down to $180,000. The couple was in the 28% bracket last year, so the income deferral saved a total of $11,200 in tax: 28% times $40,000.

Assume they kept their $11,200 of tax savings in the bank. If their employers have a 401(k) plan that offers designated Roth accounts, they could convert the $40,000 they contributed in 2017 to the Roth side if the plans allow such moves. Alternatively, depending on the plan terms and the Polks’ circumstances, they might be able to rollover the $40,000 to a Roth IRA. Yet another possibility, the Polks might leave the $40,000 in their 401(k)s but convert $40,000 of pretax money in their traditional IRAs to Roth IRAs.

With any of these strategies, the couple would generate a $9,600 tax bill (24% of $40,000) on the Roth conversion, because their joint income falls into the 24% tax bracket in 2018, in this example. The Polks could pay that $9,600 from their $11,200 of tax savings in 2017 and wind up ahead by $1,600.

Therefore, people who move into a lower tax bracket this year might be able to come out ahead with Roth conversions of income that had been deferred at a higher tax rate. Going forward, the money transferred to the Roth side may generate tax free rather than taxable distributions.

One-way street

Nevertheless, there are reasons to be cautious about Roth conversions now. For instance, U.S. stocks are trading at lofty levels. Roth conversions could be highly taxed at today’s equity values.

Example 2: Heidi Morris has $300,000 in her traditional IRA, all of which is pre-tax. Investing heavily in stocks, Heidi has seen her contributions grow sharply over the years. With an estimated $100,000 in taxable income this year, Heidi calculates she can convert $50,000 of her traditional IRA to a Roth IRA in 2018 and still remain in the 24% tax bracket.

However, stocks could fall heavily, as they have in previous bear markets. The $50,000 that Heidi moves to a Roth IRA could drop to $40,000, $30,000, or even $25,000. Heidi would not want to owe tax on a $50,000 Roth conversion if she holds only $25,000 worth of assets in the account.

Under previous law, Heidi had a hedge against such pullbacks, at least for Roth IRA conversions. These conversions could be recharacterized (reversed) to her traditional IRA, in part or in full, until October 15 of the following calendar year. In our example, Heidi could have recharacterized after a market setback, avoided a tax bill, and subsequently re-converted at the lower value. (Timing restrictions applied.)

Such tactics are no longer possible because the TCJA has abolished recharacterizations of Roth IRA conversions. (Conversions to employer-sponsored Roth accounts could never be recharacterized.) Now moving pre-tax money to the Roth side is permanent, so the resulting tax bill is locked in.

In the new environment, it may make sense to take it slowly on Roth conversions in 2018. If stocks rise, boosting the value of your traditional retirement accounts that hold equities, you won’t be sorry about the increase in your net worth; you can convert late in the year at today’s lower tax rate. On the other hand, if periodic corrections occur, they could be an opportunity for executing a Roth conversion at a lower value and a lower tax cost.