IRS DRAFT 2018 FORMS

We have already seen the IRS draft of the stupid new 2018 Form 1040 “postcard” andits 6 new supplemental statements.  The IRS has now also issued draft copies of the 2018 Schedule A and Form K-1s for partnerships and S-corps and the instructions for the 2018 Form 1040.

The 2018 Schedule A section for “Taxes You Paid” begins with “State and local taxes”.  There are lines for income taxes or general sales taxes, real estate taxes and personal property taxes.  The wording and format for indicating if you are claiming state and local sales tax instead of state and local income tax has changed, but the option still exists.  After entering amounts for these three items and coming up with a total there is a line that says “Enter the smaller of line 5d {total taxes claimed – rdf} and $10,000 ($5,000 if married filing separately).”  Here is where the new limitation is applied.   

This section also contains a line for “Other taxes” that is after the application of the $10,000 limit, which indicates that these taxes are deductible in addition to the $10,000.  I am curious to read the instructions to find out what “other taxes” they are talking about.   In the past I have put employee withholding for state unemployment, disability and family leave contributions, but these taxes are really part of state and local income taxes and are included in the $10,000 limit.

The “Interest You Paid” section includes a new box to check under the line for “Home mortgage interest and points” if “you didn’t use all of your home mortgage loan(s) to buy, build, or improve your home”, referring the taxpayer to the instructions.  Here is where you must indicate if you have any home equity debt.  I cannot stress enough how the elimination of the deduction for home equity interest affects the preparation of the Schedule A. 

There is also a line identified as “Reserved”, which has been suggested exists because the IRS thinks the idiots in Congress may reinstate the inappropriate deduction for mortgage insurance premiums for 2018 before the end of the year.

The “Casualty and Theft Losses” category line identifies the new limitation of the deduction to “casualty and theft loss(es) from a federally declared disaster”.

The entire “Job Expenses and Certain Miscellaneous Deductions” section is gone, as these items are no longer deductible.  And the “Total Itemized Deductions” section no longer asks if your AGI is over the former Pease threshold, as the phase-out of itemized deductions no longer exists.

I am truly eager to see the draft of the instructions for Schedule A for many reasons, including the explanation of what is deductible as gambling losses.  There has been conflicting advice and information provided by tax preparation CPE providers.

All the discussions of the unnecessary new Section 199a deduction mention that the K-1s from partnerships and sub-S corporations will be reporting important information related to this deduction.  But the draft K-1s for 2018 do not look any different than those of past years.  Perhaps the information will be included in “See attached statement for additional information”.  I certainly hoped, and had assumed from what I had been taught at GOP Tax Act CPE sessions, that the front page of the K-1 would specifically address the Section 199a deduction requirements.

I have very briefly skimmed the 1040 instructions, but have not reviewed it in any detail yet.  I did, however, check to see and found that it does include a "Simplified Worksheet" for calculating the Section 199a deduction.  

I will let you know as more draft forms with GOP Tax Act changes are released.

TTFN

THE SECTION 199a DEDUCTION MAKES NO SENSE

The new “Section 199a” deduction – 20% of pass-through business income - created by the GOP Tax Act makes absolutely no sense.

Why does it exist?  The Act reduces the tax rate on regular “C” corporations to 21%. Pass-through businesses – sole proprietors filing Schedule C, partnerships and sub-S corporations – had paid tax on net business income at “ordinary income” rates, as much as 37% under the new rate schedule.  So to make the reduced C corporation rate more palatable Congress felt it had to throw pass-through businesses a bone.

But are C corporation net profits really taxed at only 21%.  A corporation will pay 21% tax on its profits.  When the profits are paid out to shareholders as dividends the individual shareholders include these dividends as income on their personal tax returns.  This is the classic “double-taxation” of corporate dividends.  Qualified dividends are taxed at a lower rate – 0%, 15% or 20%.  Plus, dividends, being investment income, can also be subject to the Obamacare 3.8% surtax.

A taxpayer in the 22% bracket will pay 15% tax on the qualified dividends received.  So, the corporate income represented by the dividend distribution is actually taxed at 36% - 21% and 15%.  If the same taxpayer received the dividend income as a pass-through from a sub-S corporation the tax on $100 would be $18 ($100 - $20 = $80 x 22% = $17.60), or only 18% - half the effective tax on C corporation income.

A person in the top tax bracket would pay 23.8% tax on the dividends – the 20% capital gain rate and the 3.8% Obamacare surtax.  So, the corporate profit would be effectively taxed at 44.8%.  Sub-s pass through income could be taxed at as much as 40.8% (the 20% deduction may not be available).   

Here is what I say should be done.

C corporations should be allowed to claim a tax deduction for “dividends paid” and only pay corporate income tax on the actual “retained” earnings.  Dividends would continue to be taxed on the income tax returns of shareholders.  But since there is no longer any “double taxation” there would no longer be a need for a special tax rate on dividends.  There would be no 20% Section 199a deduction.  So, monies passed through to business owners – either as corporate dividends or pass through business income – would all be taxed at ordinary income rates. 

The inequity in the treatment of corporate income and self-employment income from sole proprietorships and partnerships exists not in the income tax treatment but with the application of the FICA-equivalent “self-employment tax”.  A person who owns a corporation pays himself/herself a salary, subject to FICA tax. The employee pays half the tax and the employer pays half the tax.  The net profits distributed to the owner is in the form of dividends, or sub-S pass through income, which is not subject to self-employment tax.  Employee benefits, such as health insurance premiums and employer pension plan contributions, are not subject to FICA tax.

A sole proprietor and general partner pays self-employment tax – the equivalent of both halves of the FICA tax – on the total amount of “net earnings from self-employment” which is the total net profit reported on Schedule C or the total business income pass through for the general partner, adjusted for half the s-e tax, before any deductions for health insurance premiums or pension contributions.  A large portion of the net earnings from self-employment for sole proprietors and general partners is “wage-equivalent”, but a portion is also “dividend-equivalent”.  

First, health insurance premiums and pension contributions (with the possible exception of the equivalent of 401(k) deferrals) for the self-employed person should be allowed as a deduction in determining net earnings from self-employment.  And only a percentage of the net earnings from self-employment, the percentage representing wage-equivalent earnings, should be subject to the self-employment tax.  It is truly difficult to determine the appropriate allocation of net income to wage earnings and return on investment dividends.  Perhaps using an arbitrary allocation, like 70% wage-equivalent and 30% dividend-equivalent, is the simplest way to go. 

FYI I would also do away with ALL industry-specific loopholes, deductions and credits for ALL business activities, basically taxing ALL business entities on net book profit.  

What do you think?

TTFN

THE NEW TAX CODE - INVESTMENT INCOME

Here is how investment interest would be taxed in my new simple, fair and consistent Tax Code.

(1) When it comes to the question of taxing municipal bond interest I am “bi” – I could go either way. I am not against taxing the interest earned on municipal bonds, and the dividends paid by mutual funds that invest in mutual bonds. But I would also be willing to continue to exempt this income from federal taxation. Or I could tax only the earnings of “private activity” bonds, which are currently taxed under the dreaded AMT.

However, I think at this point I would tend toward taxing municipal bond interest the same as any other kind of interest.

(2) My new Tax Code would do away with “qualified” dividends. All dividends would once again be taxed as ordinary income.

The reason certain dividends were allowed “qualified” status and as such taxed at lower rates was to somewhat alleviate the “double-taxation” of corporate dividends. Corporate profits are taxed on the corporate return, and dividends, which are a distribution of corporate profits, are also taxed on the individual tax return of the shareholder. My new Tax Code would do away with the double taxation of corporate dividends by allowing corporations to claim a tax deduction for “dividends paid”.

If a corporation had a net profit of $100,000, and paid $90,000 out to shareholders in dividends, it would pay federal corporate income tax on only $10,000. The shareholders would pay tax on the dividends received at ordinary income rates.

Coupled with this new “dividends paid” deduction for corporations would be the total abolition of all current special interest corporate deductions, credits and loopholes. A corporation would simply report gross income and deduct “ordinary and necessary” business expenses and come up with a net profit or loss. Dividends paid to shareholders would be deducted from any gain to determine taxable income.

There would be no “special deduction” for dividend income, and charitable contributions would be 100% deductible as a business expense on the Form 1120, regardless of the amount of profit or loss.

One side benefit to doing away with the category of “qualified” dividends on the Form 1040 is that brokerage and mutual fund houses will no longer need until the middle of March to properly prepare year-end Consolidated 1099 reports. The 1099 information can be prepared and sent to taxpayers by January 31st, as was done before qualified dividends were created, and there will be no more need for one or more “corrected” copies.

(3) When it comes to the taxation of long-term capital gains, and capital gain distributions, I would return to my early days in “the business”. I would not have a separate, lower tax rate for long term capital gains (as I would not have a separate, lower tax rate for qualified dividends) – instead my new Tax Code would bring back the 50% “capital gain exclusion”.

When I first started preparing 1040s back in the early 1970s the Schedule D allowed for a 50% deduction for net long-term capital gain – only half of such gains were included in taxable income. So if net long-term capital gain was $10,000, only $5,000 was carried over to Form 1040 as income. There was only one set of tax rates for all income – no special lower rates for capital gains. This 50% exclusion was later increased to 60%.

The result would be that capital gains, and capital gain distributions, would be taxed at a rate half that of the rate for “ordinary income”, without having to create a separate set of tax rates and a separate tax calculation. If net long-term capital gain on Schedule D was $10,000, and the taxpayer was in the 25% tax bracket, the effective tax on the net capital gain would be 12.5% - calculated at 25% tax on $5,000 of income.

I would also increase the maximum net capital loss deduction from $3,000 to $5,000 and index it for inflation. And I would allow taxpayers net capital losses to elect to “carryback” losses for three years to apply against capital gains reported in prior years.

I first proposed this idea in a letter to Dubya back in 2002. Here was my thinking at the time (see my post Dear George) –

“During the late 1990s and into 2000, when the stock market was flourishing, many taxpayers realized, and were taxed on, large capital gains, including excessive capital gain distributions from mutual funds. In most cases these capital gains were reinvested in the market and in additional mutual fund shares. In 2001 and 2002 the bear market provided these same investors with substantial capital losses.”

I had clients who had 6-figure gains in one year and 6-figure losses in the next. The net effect of 24 months of investing was basically 0 gains or an actual net loss. However the clients paid tons of tax to Sam on the gains in the first year, but were limited to deducting $3,000 in losses in the next year and a loss carryover that will last for decades and, unless they have a big score in the future, may never be fully deducted.

It seems only fair in such a situation that investors be allowed to carry back the losses to apply against the earlier gains of a bull market and get a refund of the taxes paid on these gains.

FYI, in response to my letter I received a brief form “thank-you for sharing your views and concerns” letter from the “Director of Presidential Correspondence”.

(4) Since the new Tax Code will not allow a deduction for depreciation of real property, I would remove the income and deduction limitations on claiming losses from rental real estate with active participation.

Business, including rental, losses passed through to “limited” partner investors on a Form K-1 would be treated similar to investment interest, with the deduction limited to net K-1 income from all passive activity K-1s. Suspended losses could be deducted in the year the investment is sold or terminates. The “at risk” rules would remain as currently written.

As mentioned above under my discussion of corporations, all current special interest deductions, credits and loopholes for partnerships, limited or otherwise, would be abolished. A partnership would simply report gross income and deduct “ordinary and necessary” business expenses and come up with a net profit or loss to be allocated on the K-1s.

So what do you think about these proposals?

TTFN

SUMMER RERUN - THE K-1 BLUES

While I am working away on the GD extensions - here is the first in a series of summer reruns, originally published July 11, 2007 - rdf.

The Form K-1 for a limited partnership investment is the scourge of the tax preparer!

Over the years I have had many clients who, in addition to shares of stock or mutual funds, also owned “units” of a limited partnership venture. If you own stock or mutual funds you report on your Form 1040 any dividends received. While investors in a limited partnership may receive distributions similar to dividends, they do not report what they have received from the partnership but instead their “distributive share” of the entity’s individual sources of income, losses, deductions and credits. A limited partner receives a Form K-1 to report his/her distributive share of the income, losses, deductions and credits.

The first problem with K-1s from the point of view of a tax preparer is that they always arrive late. Unlike other tax information reporting forms, like 1099s and 1098s which are required to be sent to taxpayers by January 31st, investors do not receive their Form K-1s until the middle or end of March. Some do not come until April. The due date of the federal partnership tax return, Form 1065, is generally the same as the due date for the Form 1040. Because I do not want to work on 1040s in “installments” I cannot begin the tax return of a client with limited partnership investments until late in the season, when I am usually already backed up.

The second problem is that because limited partnerships invest in real estate, oil and gas, timber, commodities and futures, and the like they often generate unique deductions and credits that must be reported on any number of obscure supplemental tax forms and schedules. Each form and schedule takes time to complete. In most cases it seems to me that I am spending an hour or more to complete all the required supplemental forms and schedules to provide the client with a minimum effective tax savings. It costs more to prepare the multitude of forms and schedules than any ultimate tax benefits provided!

The third is that because of the nature of limited partnership investments you cannot simply take the individual items of income, deduction and credit reported on the many lines of the Form K-1 and directly transfer them to the 1040 as is – not that that is a simple process. Limited partnerships fall under the rules of a “passive investment” and as a result are limited in the amount of losses, deductions or credits that can be claimed.

An investor in a limited partnership is a “limited” partner. A “general partner” manages the business and is personally liable for the debts of the partnership. A “limited partner” is liable only to the extent of his/her dollar investment in the partnership. If a person invests $1,000.00 as a limited partner the most he can lose is the $1,000.00. The deduction of losses from a limited partnership is first limited to the investor’s “at risk” basis. Generally a limited partner with an investment of $1,000.00 can only deduct up to $1,000.00 in losses from the entity.

Limited partnership losses are also subject to the passive loss limitation rules. As a general rule passive losses are only deductible to the extent of passive income. In the acronyms of the tax world, a PAL (passive activity loss) needs a PIG (passive income generator). Losses that cannot be deducted on the current year Form 1040 are “suspended” until the investment is disposed of (you sell your units or the partnership terminates) or passive income is generated. And who do you think is going to be the one to keep track of all these suspended losses – certainly not the client!

Generally losses from one limited partnership can be deducted against income from another limited partnership. However, there is a special type of limited partnership called a Publicly Traded Partnership (PTP). You can offset losses from a PTP only against income or gain from the same PTP. You cannot apply losses from a PTP against excess gain from another limited partnership. Income and losses from a PTP are not reported on Form 8582 (Passive Activity Loss Limitations). Any net income from current year activity less prior year unallowed losses is reported as “nonpassive income” directly on Schedule E. So PTPs require even more detailed recordkeeping.

Why do individuals invest in limited partnerships? I doubt any of my clients that have owned a limited partnership investment over the years actually called up his/her broker and said, “I want to buy some units of XYZ Timber LP.” Individuals invest in limited partnerships because their brokers tell them to!

While I cannot say this with certainty, it is my belief that brokers receive a higher commission from selling limited partnership units than from selling traditional shares of stock. Similar to the fact that a broker will receive a higher commission from selling an annuity. In many cases the brokerage house will “encourage” their brokers to push a certain limited partnership in which the house has some kind of vested interest. I remember years ago when almost all my clients with accounts at Shearson (a name that has disappeared due to multiple subsequent mergers) owned a Balcor limited partnership.

As I do not own any limited partnership units myself (the only time I was tempted was when I received an offering from Broadway produced Alexander Cohen to invest in a Peter Cooke and Dudley Moore review back in the 1970s – instead I invested in my own local production of Stephen Sondheim’s COMPANY which did not show a profit, unlike the Cooke and Moore show) and I do not follow the market, I cannot say whether a limited partnership investment has the potential to return a greater profit than a stock or bond investment. I do know that several limited partnerships offer the pas through to investors of specialized tax credits – although often these credits must eventually be “recaptured”, which causes more tax preparation nightmares.

As a point of information - for a great while the IRS was not able to properly match K-1 information to 1040s, as it has been able to do with 1099 information returns for just about all of my years in “the business”. However that appears to no longer be true. Already this year I have seen IRS notices regarding income from 2006 K-1s not reported on the corresponding Form 1040.

I would certainly welcome hearing from brokers on the merits of investing in a limited partnership, and would also be interested in knowing if brokers do indeed receive a greater commission or incentive to sell such investments (you can make your comments anonymously). I want to know if the necessary additional tax preparation fees charged to clients for all the extra work and agita that comes with limited partnership Form K-1s is worth it. I also welcome comments from taxpayers who have invested in a limited partnership and from fellow tax preparers.

DO IT YOURSELF!

Earlier this week I pointed out that telling all Schedule C filers to incorporate, and telling a one-person business to incorporate solely for the purpose of reducing his/her audit profile, is truly bad advice (click here for post).

But I did add that there are times when it may indeed be cost effective for a closely-held business to incorporate.

If, after careful consideration of all the facts and circumstances and a detailed cost benefit analysis, and after consulting with a competent tax professional, you decide that it would be appropriate to incorporate your one-person business you certainly do not need a lawyer to do so.

While I am not familiar with all the states procedures, I expect that you can incorporate easily online via the website of your State. Last year I formed a NJ corporation online in about half an hour.

FYI, registering your business as an LLC is equally as easy and can generally be done online.

You can also very easily get an Employer Identification Number from the IRS at the Service’s website.

You also do not need a “Black Beauty” or other such corporate package with by-laws, corporate seal and personalized stock certificates, which lawyers are fond of selling at a nice mark-up, or pay an inflated fee for a lawyer to prepare corporate bylaws.

You can download free blank stock certificates and corporate by-laws and purchase an inexpensive corporate seal from a variety of online sources. I expect you can also find free pro-forma corporate resolutions online. Just do a “Google” or other search.

What do you think a lawyer will do when preparing your by-laws? He/she will have a secretary or paralegal clerk go to the firm’s work processing inventory, pull down pro-forma by-laws, and type in your name and information. And when a lawyer forms a basic corporation the same secretary or paralegal goes online and files the appropriate forms. Even when there was paper filing the secretary or clerk would do all the work. You can do this just as easily yourself for free.

Here are a few online resources (FYI I have no personal experience with or connection to these resources):

PRINTABLE STOCK CERTIFICATES

CORPORATE BY-LAWS

CORPORATE BY-LAWS

CORPORATE SEAL

Where you may need the assistance of a lawyer, experienced in tax matters, is if you are forming a partnership, to help with the writing of the Partnership Agreement. And, of course, you also may need to consult a lawyer when forming a more complex corporation, with multiple shareholders of differing inter-relationships.

You certainly should sit down with a competent tax professional, experienced in business taxes, and go over all of your options in detail, and perform the requisite cost benefit analyses, before making any moves.

TTFN

MY GETTING READY FOR FILING SUITE OF POSTS

As you start to receive your 2007 tax forms and reports in the mail, and begin to get your 2007 “stuff” together to turn over to your tax pro (possibly me), or before you start to prepare your own returns (are you sure you want to do that), I refer you to my getting ready for filing “suite” of January 2007 posts. The advice I provided in these posts for 2006 returns still applies to 2007.

As you would expect, the various amounts for exemptions, standard deductions, etc in these January 2007 posts apply to tax year 2006. You can find the appropriate 2007 amounts on the WHAT’S NEW FOR 2007 Page of my website.

GETTING READY TO PREPARE YOUR RETURN -

A reminder for taxpayers who have brokerage accounts - Because of the rules and rates for “qualified” dividends that have been in effect since 2004, you should again this year receive at least one “Corrected” 1099 statement. You should wait a few weeks after receiving the original 1099 information before giving your “stuff” to your preparer.

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A bank may issue one Form 1099-INT for all the accounts – savings, money market and CDs – that belong to the same name and Social Security number. There may be 6 or 7 accounts listed on a 1099-INT. It is important to verify each account listed on the form to make sure all of them belong to you. One of my clients received a 1099-INT last year with someone else’s account, that earned $300+ interest, included in the listing! Had he not carefully checked the form he would have paid close to $100.00 in unnecessary federal and state income tax. If you find an error on a Form 1099-INT go to the bank immediately and request a corrected form.

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Another reminder – According to Internal Revenue Service Revenue Ruling 69-184 you cannot be both a partner in and an employee of the same partnership. A partner cannot receive a salary from the partnership, and should not be given a W-2. If you are a partner who received “guaranteed payments” in 2007 but you receive a 2007 Form W-2 from the partnership you should go to the partnership’s accounting firm, tell them that they FU-ed. Check out my January 2006 post “EMPLOYEE OR PARTNER – THAT IS THE QUESTION”.

WHAT TO GIVE YOUR TAX PREPARER- PART I and PART II

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New for 2007 – Retired Policemen and Firefighters need to provide your tax pro with the amount withheld from your pension for the year for health insurance premiums.

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As you are gathering your “stuff” to hand over to your preparer it is a good time to review the new stricter documentation rules for cash contributions. Check out my post “NEW RULES FOR CASH CONTRIBUTIONS.”

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A final reminder - The upcoming tax-filing season will be full of delayed refunds.

As TAX GIRL Kelly Phillips Erb correctly points out “Congress is responsible for this mess, not IRS”. The employees of the IRS deserve kudos for being on top of the issue and putting in long hard hours to fix their system with the least possible amount of delay and inconvenience.

But there will be delays and inconvenience, and I expect more than the IRS has suggested in its information releases.

If you are a victim, do not take your anger out on the IRS. Instead write a chastising letter to your Congress-persons. Tell them to make abolishing the dreaded Alternative Minimum Tax a priority for early in 2008. And tell them to be damned sure that there is never again a repeat of the 2007 fiasco.

TTFN