Category: Taxes

President Trump and 2018 Tax

Your 2018 Taxes After Reform – A Quick Look

Now that the tax reform bill has passed and people have had a chance to read it, here is a quick look at how it will affect you and how to adjust your tax planning with the new scheme.

Although there are a lot of benefits in this bill for businesses and corporations, they tend to be across-the-board cuts and specific giveaways to particular businesses. Only two things really stand out from a planning perspective – the reduced penalty on repatriating overseas profits and the increased standard deduction for pass-through entities. The first affects only the biggest corporations. Most businesses do not have hoards of overseas cash to bring home.

As for the pass-through entities (partnerships, LLC’s and S Corporations), the increased deduction is across-the-board. It may make a difference for those businessmen that both draw a salary and profits from their business and they should speak to a tax professional about how this change affects them, as there are specific provisions in the bill to avoid recharacterizing income to take advantage of the change.

Your personal taxes are where the biggest changes will land. If you took the standard deduction in 2017, all the news is good – you’ll be paying less taxes overall. If you itemized, the news is not so good.

In the past, everybody had two options on their taxes – either take the “standard deduction” to reduce your income by a set amount to represent the various exempted expenses from your day-to-day life or itemize – list your specific exempted expenses. As a tax professional, we always compared the possible itemized expenses to the standard deduction to see which one made the most sense to use. The new tax bill reduces the amount of exempted expenses while also raising the standard deduction.

If you itemized your deductions (that would be on Schedule A of your 1040), and it was not that much larger than the standard deduction, you will now have the benefit of the larger standard deduction. Fewer receipts to keep track of. But if you had significant Schedule A deductions, you will very likely see an increase in your taxable income as your deductions are reduced, perhaps down to the standard deduction amount.

A few people were able to take advantage of the changes to move certain expenses into 2017 to take advantage of the old rules. However, most people were not in a good position to do that. Moving forward, plan on fewer tax advantages to loans. In particular, mortgage interest, home equity lines of credit and student loans will provide less tax value, mainly because they will no longer eclipse the standard deduction. Recalculate your plans for long-term financing to account for this.

C-Corporation or LLC

C-Corporation or LLC?

            Most advisors, particularly those not familiar with both the law and tax sides of the incorporation decision, tend to advise using an LLC over a C Corporation. And, it’s true, often an LLC is preferable for tax reasons. However, this is not always true and any businessperson should pay attention to the differences before making a final decision.

            The Limited Liability Company, or “LLC,” is considered to have better tax treatment, because it avoids the “double taxation” problem of traditional C Corporations. For example, a C corporation with a profit of $1 million would pay about $340,000 in federal taxes on the profit, leaving $660,000 of profit. When distributed as dividends, this would get taxed again at 20% (sometimes 15%), for an additional $132,000 in tax, leaving an after-tax amount of $528,000. The same $1 million in an LLC would get taxed as direct income to the members, who are probably at the 40% (rounding up a tiny bit to make the math easy), so the after-tax profits are $600,000, a difference of $72,000 in favor of the LLC.

That’s the standard example explaining why the LLC is the better option. But not all businesses are alike. A C Corporation offers advantages, including tax advantages, in certain situations.

For example, most states charge a yearly “fee” on each LLC. This fee is not large, but it is mandatory and must be paid whether or not the LLC makes a profit. In California and some other states, it is also based on revenues, not profits. An LLC with high revenues, but not yet making much in profit would be charged thousands of dollars that are not charged to a C corporation. Also, assuming you are in the highest tax bracket, C corporations have low tax rates on lower levels of profit, often significantly lower than the 40% rate most LLC members would pay on same profit, regardless of double taxation.

Another benefit of the C corporation is that it pays the taxes itself. Let’s look at the $1 million profit scenario above. In a C corp, if the company needs to keep the profit in the company as a reserve or to expand or some other reason, it has the $660,000 in the bank, ready to go. The shareholders have no additional tax. Although, when the money does come out, there is more tax – that only happens when and if the shareholders actually receive any money. If this were an LLC, the members would have to pay the $400,000 in taxes, reported on their personal tax returns, regardless of how much money actually made it into their hands. In this situation, the C corporation has $60,000 more in the bank than the LLC after taxes.

Also, foreigners will see big benefits from using a United States C corporation over an LLC. Because the US has a worldwide tax policy, an LLC member who is attributed LLC earnings will have to file US taxes, including information on their worldwide income. Although, depending on the circumstances, the additional US tax, if any, will often be small, the reporting and additional work will have to be done. This is not true of a C corporation, even if it actually distributes dividends. This difference alone can make a C corporation more attractive, even if it results in higher taxes.

rental real estate

Rental real estate and your taxes

One of the most common questions that people ask me is how renting out property affects their taxes.  The rules are actually quite complex, and you should definitely seek the advice of a professional, but here is a simple overview.

Generally speaking, renting out real estate is considered “passive income.”  This is the worst type of income to have (for tax purposes).  Passive income counts as regular income and is taxed at the higher rate, but the losses you can take are limited and provide no relief from taxes.  Unlike an “active” business, where losses can be deducted from your income, rental business simply sets those losses aside to be used later, and that later day never comes for all too many taxpayers.

The most important thing to remember about a rental is that, for tax purposes, they often lose money.  This is because you have to take a depreciation deduction on top of your other costs for the building or property.  On the one hand, that will mean your rental income is rarely taxed.  On the other hand, it means that your losses will not save you any tax dollars.

There is some good news.  People making less than $100,000 per year in other income can deduct up to $25,000 of passive losses.  Over that amount, the amount deductible phases out until it is $0 at $150,000 of income (for married couples).  What this means for you is that you should understand that your decision to buy a rental property should not be influenced by the idea that it will generate tax savings.

However, there is an important opportunity.  “Real estate professionals” do not have the passive activity loss limitations on real estate.  To qualify as such a professional for tax purposes, you have to spend at least 750 hours per year actively working on your rental business.  But that is not the only requirement.  If you believe you spend enough time on your rentals, you should ask your tax professional about the other requirements.  It could mean big savings.

foreign bank accounts and fines

Foreign bank accounts now in danger of huge fines

Many people do not realize that the United States has a unique taxation philosophy – all of any United States resident or citizen’s income, earned anywhere in the world, is taxable here in the United States.  It bears repeating – if you are an immigrant or citizen and you have money in an account in your home country, not only is that interest income taxable here, but you must report that foreign account to the IRS on your yearly tax returns, if the balances on your foreign accounts exceed $10,000 at any point during the year.  When we tell our clients about this policy, they often don’t believe us.  It does not make sense to them, but it is the way that the United States tax system works.

As a result, those who have foreign bank accounts and investments have often not reported these accounts and the income derived from them.  Although this was illegal, the United States government did not have the ability to discover what was in these accounts automatically, the way they would with domestic financial institutions, so non-reporters often faced no consequences.

But, as of July 1, 2014, that has all changed.  The United States has begun seriously going after overseas bank accounts.  The Foreign Account Tax Compliance Act (“FATCA”) has mobilized the State Department to actively seek treaties that require foreign financial institutions to report account information of US residents and citizens to the IRS.  Over 100 nations have signed such treaties.  In fact, since the banks, investment houses and financial institutions of those nations are obligated to report, even for accounts in non-signatory countries, your account may not be safe, even if it is located in a “safe” country.  Furthermore, the State Department is actively pursuing all nations around the world, and is getting more countries signed up each month.  For example, Switzerland, one of the most famous bank havens in the world, was signed up well over a year ago.  Already, foreign institutions are now sharing their account information with the IRS.

At the end of this post, there is a list of websites with more information, including a list of countries that have agreed to share information with the United States.

What Does FATCA Mean for You?

FATCA means that your overseas financial institution will now report your account balance and earnings to the IRS.  Just as the IRS knows how much income you had from your employer’s W-2 form or 1099 form, it now knows how much money is held in foreign banks, investments and other financial instruments.  If you have not previously voluntarily reported on the account, you will be liable for a penalty.

These laws and reporting apply to any United States resident or citizen.  Permanent residents (holders of “green cards”) and anyone that has lived in the United States for more than 180 days of the year are included, as well as citizens.  In fact, US citizens or permanent residents that live and work overseas must also file US tax returns, including reporting on their foreign bank accounts.

The penalty comes in two tiers.  For those that innocently, through lack of knowledge, did not report on these accounts, the penalty is $10,000 per account per year, for up to 6 years.  Thus, someone with two overseas accounts for the past 5 years would owe $50,000 per account ($10,000 for 5 years) for a total of $100,000.  This penalty is not related to the amount of taxes you owe on the income or on the bank balance.  You could owe this penalty even if the total amount of money overseas was as little as $40,000.

The second tier is for those who have willfully avoided reporting their accounts.  In other words, those that knew of the requirement, but purposefully failed to comply.  This penalty is 50% of the account balance for each year it was unreported, up to 6 years.  That means up to 300% of the balance.  For example, if you had $100,000 in an unreported overseas account for six years, then you could be liable for a $300,000 fine.  In addition, this tier may involve criminal charges, with penalties that could include jail time.  This is easily the harshest penalty for any tax matter.

How Can You Protect Yourself?

Fortunately for those with overseas accounts, there is a much cheaper alternative.  The IRS has an amnesty program for those that voluntarily and truthfully disclose their foreign bank accounts.  Until recently, the voluntary disclosure program carried a cost of 27.5% of the balance in the foreign account.  But, as of July 1, 2014, they have reduced that to 5% for most taxpayers (the ones that would qualify for the first tier penalty described above), depending upon circumstances.  As long as you or your overseas financial institution is not currently under IRS scrutiny, you may qualify for a voluntary disclosure program with just a fraction of the penalties for non-disclosure.

What is the Risk of Non-Disclosure?

The difference between voluntary disclosure and non-disclosure is stark. Non-disclosers may owe up to 300% of the bank balance.  For some, that is more money than they currently own.  Even those that qualify for the first tier penalty could easily owe over $100,000, even on relatively small accounts.  Compared to that, 5% of the bank balance for voluntarily disclosure is a negligible amount.

Let’s consider an example – a person with two accounts overseas, a checking account of $20,000 and a savings account with $30,000 for a total of $50,000 and a simple domestic tax return without complex issues.  The first tier penalty on this money would be $120,000.  The second tier penalty would be $150,000 and possible criminal prosecution.  However, if they qualify as not willful, and voluntarily disclose, they would owe an estimated $1,000 of back taxes and penalties (this depends on many factors, including which country, the interest rate and past exchange rates), $2,500 for the 5% penalty and estimated attorney’s fees of $3,000 (this also depends on many factors and is made assuming a simple tax return and simple interest income from overseas) for a total of $6,500.

The difference is striking – $6,500 compared to $120,000 or even $150,000.  Moreover, the longer you delay disclosure, the more willful it will look in the IRS’ eyes and the more likely that you will be assessed at the second tier penalty.

Also a word of warning to those that have recently or will soon close those overseas accounts – the information gathering and reporting requirements go back up to 6 years, so you could still be on the hook for large fines.  Simply closing the accounts and moving the money back to the United States may not protect you.

How Do I Take Advantage?

Unless your overseas accounts are small, the best route is to hire a professional.  Unlike some other tax matters, a Report of Foreign Bank and Financial Accounts (“FBAR”) is a complicated matter that requires professional help.  Not only will you have to properly report several years of records and accounts, but you will have to amend your past tax returns to account for the changes.  Not to mention protecting you from any further consequences and minimizing your new tax liability.

If possible, find a firm like ours where the entire FBAR process is in-house, to reduce your overall costs, since there won’t be any extra bills for the exchanges between the accountants and your lawyer.  Although it may be tempting to use a CPA instead of a lawyer for this process, only a lawyer offers attorney-client privilege protection that could become critical if you are judged to have willfully failed to report your accounts.

If you have any questions regarding your foreign accounts or would like to learn more about your liability, please contact us at 949-287-6901 to make an appointment.


Resources

List of nations that are currently reporting to the US:

http://www.treasury.gov/resource-center/tax-policy/treaties/Pages/FATCA-Archive.aspx

Foreign assets reportable on your US tax return:

http://www.irs.gov/Businesses/TypesofForeignAssetsandWhetherTheyareReportableonForm-8938

IRS FAQ on the voluntary disclosure program (some of this information is outdated as of 7/1/2014)”

http://www.irs.gov/Individuals/International-Taxpayers/Offshore-Voluntary-Disclosure-Program-Frequently-Asked-Questions-and-Answers

 Comparison between Form 8938 and Form 114 reporting requirements:

http://www.irs.gov/Businesses/Comparison-of-Form-8938-and-FBAR-Requirements