Category Archives: Blog

Kiddie Tax: New Hazards, New Opportunities

March 15, 2020

Despite its name, the “kiddie tax” is far from child’s play. And a change made by the Tax Cuts and Jobs Act (TCJA) puts some adult teeth into the tax. Now, children with unearned income may find themselves in a tax bracket higher than that of their parents. At the same time, the TCJA creates new opportunities for family income shifting.

Income Shifting Discouraged

At one time, parents could substantially reduce their families’ tax bills by transferring investments or other income-producing assets to their children in lower tax brackets. To discourage this strategy, Congress established the kiddie tax in 1986. The tax essentially eliminated the advantages of income shifting by taxing all but a small portion of a child’s unearned income at his or her parents’ marginal rate.

When the kiddie tax was first enacted, it applied only to children under 14, but in 2007 Congress raised the age threshold to 19 (24 for full-time students). Note that the kiddie tax doesn’t apply to children who reach 19 (or 24, if applicable) by the last day of the tax year. In addition, the tax doesn’t apply to children who either 1) are married and file joint returns, or 2) are 18 or older and have earned income that exceeds half of their living expenses.

Tax Bite Bigger

Now the kiddie tax applies according to the tax brackets for trusts and estates, rather than at the parents’ marginal rate. In previous years, the kiddie tax essentially undid the benefits of shifting investment income to one’s children. By applying the parents’ marginal rate to that income, the tax result was about the same as if the parents had retained ownership of the assets.

But the TCJA’s approach can push children into a tax bracket higher than that of their parents in many cases. That’s because, for 2019, the highest marginal tax rate for trusts and estates — currently, 37% — kicks in when taxable income exceeds $12,750. For individuals, that rate doesn’t apply until taxable income reaches $510,300 ($612,350 for joint filers).

Planning Opportunity

Although the new kiddie tax rules can lead to harsh consequences for many families, they may create tax-saving opportunities for higher-income taxpayers. Because the tax is now applied using the progressive rate structure for trusts and estates, rather than the parents’ marginal rate, parents can shift a limited amount of investment income to their children at lower tax rates. For example, parents in the 37% tax bracket can shift income up to $14,950 (the $2,200 unearned income threshold plus $12,750) before the 37% rate applies.

There are also several ways to shift income to your kids without triggering kiddie tax issues. For example, you can:

• Transfer investments that emphasize capital appreciation over current income, allowing the child to defer income until the kiddie tax no longer applies,
• Transfer tax-deferred savings bonds,
• Transfer tax-exempt municipal bonds,
• Contribute to 529 college savings plans, and
• Hire your kids.

Employing your children can be beneficial because earned income isn’t subject to kiddie tax; plus, your business can deduct the expense.

Look Before Leaping

Depending on your circumstances, shifting income to your children may reduce your tax bill. But given the risk that income-shifting may increase it, look closely at the kiddie tax before you attempt this strategy.

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Meals and Entertainment: Which Expenses are Still Deductible?

February 18, 2020

The Tax Cuts and Jobs Act of 2017 (TCJA) slashed many common deductions for business meals and entertainment. Yet a great deal of confusion remains about what is, and is not, deductible. Although most entertainment expenses no longer qualify (with some exceptions), many expenses for business meals continue to be deductible, at least in part. Here’s a quick review.

Entertainment

The TCJA generally ended the practice of deducting expenses for activities deemed “entertainment, amusement, or recreation.” Also eliminated are club memberships, regardless of how much business may be deducted there. And businesses can no longer deduct the cost of facilities related to entertainment, amusement, or recreation.

Meals

Businesses can still deduct 50 percent of the cost of business meals, so long as business is conducted during these meals, they’re not lavish or extravagant, and certain other requirements are met. With the elimination of most entertainment deductions, however, many businesses were uncertain about the tax treatment of meals provided during an entertainment activity.

Fortunately, the IRS provided some guidance: You can deduct 50 percent of food and beverage expenses provided during an entertainment activity as long as they are purchased separately or itemized on an invoice or receipt. So, for example, if you take customers to a baseball game and buy them hot dogs and beer — and the other requirements for deducting business meals are satisfied — then you can deduct the cost if it’s separately stated on an invoice or receipt. On the other hand, you can’t deduct the cost of a corporate suite or box that includes food and drinks, unless the meal costs are separately stated on the invoice.

What about meals provided at or near the workplace? Previously, businesses could deduct 100 percent of meal costs — such as those provided for the employer’s convenience or to facilitate overtime work — that were excluded from employees’ income as “de minimis” fringe benefits. The TCJA reduced the deduction for such costs to 50 percent and eliminated most of these deductions beginning in 2026 (although the benefits will still be excludable from employees’ income).

Exceptions

There are a few exceptions to the rules outlined above. For example, businesses can still deduct 100 percent of meal and entertainment costs that are treated as employee compensation. And there’s a 100-percent deduction for recreational or social activities — such as holiday parties, picnics, or outings — that are primarily for the benefit of rank-and-file employees rather than owners or management. Businesses can also deduct meal and entertainment expenses for certain employee or stockholder meetings or conferences: Meal expenses are 50-percent deductible, but there’s some uncertainty over whether entertainment expenses are 50-percent or fully deductible.

If you have questions about the deductibility of your meal and entertainment expenses, please contact us. Note that the TCJA did not change the rules regarding deduction of business travel expenses.

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The TCJA Limit on Interest Expense Deductions

February 5, 2020

Does it Affect Your Business?

The Tax Cuts and Jobs Act (TCJA) introduced a variety of tax benefits for businesses. Among other things, it slashed corporate income tax rates, temporarily reduced individual rates and established a new 20% deduction for certain pass-through income. At the same time, the act placed limits on several tax breaks, including the amount of interest expense a business may deduct.

“Small” Businesses are Exempt

Before you worry about the mechanics of the business interest limit, you should determine whether you qualify for the small business exemption. Businesses whose average annual gross receipts for the preceding three years are $25 million or less aren’t subject to the limit and, with a few rare exceptions, may deduct all their business interest expense.

Keep in mind that some related businesses must combine their gross receipts for purposes of the $25 million test. So, you can’t avoid the limit by splitting a larger business into separate entities.

How it Works

If your gross receipts exceed the $25 million threshold, then under the TCJA your annual deduction for business interest expense is limited to the sum of:

1. Your business interest income,
2. 30% of your adjusted taxable income, and
3. Your floor-plan financing interest (for dealers in some motor vehicles, boats and farm equipment).

Put another way, aside from floor-plan financing, your net interest expense — that is, interest expense less interest income — is deductible up to 30% of adjusted taxable income. Note: The limit doesn’t apply to investment interest.

Your adjusted taxable income is your taxable income without regard to:

• Nonbusiness income,
• Business interest expense or income,
• The amount of any net operating loss deduction,
• The 20% pass-through deduction, and
• Depreciation, amortization or depletion.

The last adjustment expires at the end of 2021. In other words, beginning in 2022, adjusted taxable income will be reduced by the amount of depreciation, amortization and depletion, limiting business interest deductions even further.

Disallowed interest expense may be carried forward indefinitely and deducted in subsequent years, subject to the same limits.

Real Property and Farming Businesses May Opt Out

Some real property businesses — including development, construction, management, leasing and brokerage — may elect not to apply the business interest limit. The trade-off is that these businesses must forgo 100% bonus depreciation and depreciate specific assets over longer periods.

Once made, the election is irrevocable. A similar election is available for farming businesses.

What About Pass-Through Entities?

A complete discussion of the application of the business interest limit to pass-through entities is beyond the scope of this article. But in general, the limit applies at the entity level.
For a partnership, any interest above the limit is passed through to the partners and carried forward until it can be offset against “excess taxable income” allocated to the partners. Excess taxable income is essentially partnership income in each year that’s sufficient to support interest deductions beyond the partnership’s actual interest expense for that year.

For an S corporation, excess interest is carried over at the entity level until the corporation generates sufficient income to absorb it.

Next Steps to Take

If your average annual gross receipts exceed $25 million, estimate the impact of the business interest limit on your tax bill. If it’s significant, consider strategies for softening the blow, such as shifting from debt to equity financing. If you have a real property or farming business, weigh the costs and benefits of opting out of the interest limit.

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