Since taking office in January, President Trump has called for comprehensive tax reform. The President’s recently released fiscal year (FY) 2018 outlines some of his key tax reform principles. At the same time, White House officials said that more tax reform details will be released in coming weeks. These details are expected to describe rate cuts for individuals and businesses, new incentives for child and elder care, elimination of certain deductions and credits, and more.
Since taking office in January, President Trump has called for comprehensive tax reform. The President’s recently released fiscal year (FY) 2018 outlines some of his key tax reform principles. At the same time, White House officials said that more tax reform details will be released in coming weeks. These details are expected to describe rate cuts for individuals and businesses, new incentives for child and elder care, elimination of certain deductions and credits, and more.
Note. The President’s budget is a blueprint for Congressional action. “This is the message from the President to the Congress and says, look, here are my priorities in terms of where I want to spend more; here's what I think should be spent; here's where the big-ticket items are,” White House Budget Director Mick Mulvaney told reporters in Washington, D.C. at a news conference unveiling the FY 2018 budget proposals.
Tax measures
The President’s FY 2018 budget highlights a number of tax reform proposals, leaving details for later. The President called for tax reform that lowers individual tax rates, expands the standard deduction, and protects homeownership, charitable giving and retirement saving. The FY 2018 budget also urges Congress to repeal the alternative minimum tax (AMT), the federal estate tax and the net investment income (NII) tax.
The President’s FY 2018 also highlights some business tax proposals, including lower rates for corporations and other business entities. To offset the cost of lower rates, unspecified business tax expenditures would be repealed.
Note. Federal law requires that every budget list all tax expenditures. Generally, a tax expenditure is any item that causes a loss of revenue due to a special exclusion, exemption, or deduction from gross income or which a special credit, a preferential rate of tax, or a deferral of tax liability. The FY 2018 budget lists more than 160 tax expenditures.
Health care and taxes
The Affordable Care Act (ACA) created the NII tax and a number of other new taxes. The President’s budget assumes the ACA will be repealed and replaced with the American Health Care Act (AHCA). As passed by the House in April, the ACHA repeals the NII tax, the additional Medicare tax, the excise tax on medical devices, and more. The Senate is currently debating the AHCA.
Funding the IRS
Earlier this year, President Trump proposed to reduce the IRS’s funding and his FY 2018 budget reflects that. However, in past years, Congress has restored some of the proposed funding cuts to the IRS. Last year, Congress gave the IRS an additional $290 million with instructions to use the funds for taxpayer services and to curb tax-related identity theft.
Additionally, President Trump proposed giving the IRS more authority to correct errors on taxpayer returns. The FY 2018 budget also urges Congress to expressly grant the IRS authority to regulate return preparers.
Family leave
President Trump also proposed to create a new benefit within the Unemployment Insurance (UI) program. This new benefit would provide up to six weeks paid leave to mothers, fathers, and adoptive parents.
If you have any questions about the President’s FY 2018 budget, please contact our office. Our office will keep you posted of developments as Congress begins to debate the President’s proposals and more details are released by the White House.
The future of the Affordable Care Act and its associated taxes has moved to the Senate following passage of the American Health Care Act (AHCA) in the House in April. Traditionally, legislation moves more slowly in the Senate than in the House, which means that any ACA repeal and replacement bill may be weeks if not months away.
The future of the Affordable Care Act and its associated taxes has moved to the Senate following passage of the American Health Care Act (AHCA) in the House in April. Traditionally, legislation moves more slowly in the Senate than in the House, which means that any ACA repeal and replacement bill may be weeks if not months away.
Note. At the time this article was prepared, few details have emerged about discussions in the Senate on the ACA’s taxes. Some senators have predicted that the Senate will write its own ACA repeal and replacement bill. A Congressional Budget Office (CBO) report, issued in late May, scored the House-passed AHCA as eventually causing 23 million fewer individuals to be covered, a number that may prompt the Senate to move further away from the House bill. It is also unclear if a Senate bill would repeal all or some of the ACA’s taxes. A Senate bill could also make other changes to the ACA, such as changes to the individual and employer shared responsibility requirements and the Code Sec. 36B premium assistance tax credit.
Health care taxes
As approved by the House, the AHCA repeals nearly all of the ACA’s taxes and delays the ones it does not repeal immediately. The House-passed version of the AHCA repeals the net investment income (NII) tax, the excise tax on medical devices, and the health insurance provider fee, among others, retroactively to the start of 2017. Further, the House-passed version of the AHCA delays the ACA’s excise tax on high-dollar health plans.
Whether the Senate will go along with repealing all or some of the ACA’s taxes is unclear. Some GOP members of the Senate Finance Committee had previously called for immediate repeal of the additional Medicare tax. Other Republican senators called for immediate repeal of the medical device excise tax. Our office will keep you posted of developments.
Code Sec. 36B credit
Individuals who obtain health insurance through the ACA Marketplace may qualify for a tax credit to help offset the cost of coverage. The House-passed version of the AHCA also revises the Code Sec. 36B premium assistance tax credit. The amount of the credit would vary depending on the taxpayer’s age, among other modifications. Again, it is unclear if the Senate will adopt these changes to the credit or make its own revisions.
Other provisions
An ACA repeal and replacement bill in the Senate also is expected to address, among other things,
- Individual and employer shared responsibility requirements
- Health savings accounts
- Code Sec. 45R small employer health insurance credit
- Branded prescription drug fee
- Medical expense deduction
- Minimum essential health benefits
Other health care bills
Just before Congress’ Memorial Day recess, the House Ways and Means Committee approved several bills related to the House version of the AHCA. One bill would allow individuals who have certain types of COBRA coverage to claim the revised Code Sec. 36B credit. Another bill would disallow advance payments of the credit unless the recipient is a citizen or national of the U.S. or an alien lawfully present in the U.S.
Administrative actions
The U.S. Department of Health and Human Services (HHS), the Department of Labor (DOL) and the IRS administer different parts of the ACA. In May, HHS announced that changes to the direct enrollment process for the ACA Marketplace. HHS also announced that online enrollment for the Small Business Health Options Program (SHOP) would be through an agent or broker.
Please contact our office if you have any questions about health care and taxes.
Many businesses consider the occasional wining and dining of customers and clients just to stay in touch with them to be a necessary cost of doing business. The same goes for taking business associates or even employees out to lunch once in a while after an especially tough assignment has been completed successfully. It's easy to think of these entertainment costs as deductible business expenses, but they may not be. As a general rule, meals and entertainment are deductible as a business expense only if specific conditions are met. What's more, the deduction for either type of expense generally is limited to 50 percent of the cost.
Many businesses consider the occasional wining and dining of customers and clients just to stay in touch with them to be a necessary cost of doing business. The same goes for taking business associates or even employees out to lunch once in a while after an especially tough assignment has been completed successfully. It's easy to think of these entertainment costs as deductible business expenses, but they may not be. As a general rule, meals and entertainment are deductible as a business expense only if specific conditions are met. What's more, the deduction for either type of expense generally is limited to 50 percent of the cost.
Meals and entertainment directly connected to business. To be considered directly connected to business, the meal or entertainment event must meet three conditions:
- It must have been scheduled with more than a general expectation of deriving future income or a specific business benefit from the event. In other words, a meal or dinner date arranged for general goodwill purposes does not qualify.
- A business meeting, negotiation, or transaction must actually occur during the meal or entertainment, or immediately preceding and following it. In other words, business actually must be discussed.
- The main character of the event, considering the facts and circumstances, is the active conduct of your company's trade or business.
For example, an executive employee who treats a client to a golf game in order to discuss the general parameters of a business deal in an informal atmosphere is engaged in entertainment that is directly connected to business. So is a manager who discusses sensitive business plans with a subordinate over lunch at an off-premises restaurant.
Applicable limitations. In general, only 50 percent of expenses incurred for entertainment and meal expenses is deductible. A limited exception applies to entertainment or on-premise meals provided to employees.
Expenses with respect to entertainment facilities generally are not deductible at all. A facility includes any item of personal or real property owned, rented, or used by a taxpayer if it is used during the tax year for or in connection with entertainment. They include yachts, hunting lodges, fishing camps, swimming pools, tennis courts, bowling alleys, automobiles, airplanes, apartments, hotel suites and homes in vacation resorts.
Country club dues are not deductible (although the meals purchased with business clients at the club are, up to the 50 percent limit). Deductions for skyboxes or other private luxury boxes at sporting events are limited to the face value of a nonluxury box seat ticket multiplied by the number of seats in the box.
Record-keeping requirements. Even if a meal or entertainment expense qualifies as a business expense, none of the cost is deductible unless strict and detailed substantiation and recordkeeping requirements are met to the letter.
Please contact our offices for assistance on how to comply with these requirements at minimum cost and expense, and how your business’s typical meal and entertainment expenses fare under the deduction rules.
As “hurricane season” officially begins, the IRS has released a number a tax tips, reminders and other advice to help taxpayers weather the storm of natural disasters and similar emergencies. The underlying theme for all IRS "tax tips" is that recordkeeping has generally become easier in the digital age. However, it remains the primary responsibility of the taxpayer to preserve adequate records whether or not caused by a disaster.
As “hurricane season” officially begins, the IRS has released a number a tax tips, reminders and other advice to help taxpayers weather the storm of natural disasters and similar emergencies. The underlying theme for all IRS "tax tips" is that recordkeeping has generally become easier in the digital age. However, it remains the primary responsibility of the taxpayer to preserve adequate records whether or not caused by a disaster.
Bottom line: Although the IRS will often extend filing deadlines and generally offer "hot line" accessibility, the "burden of proof" on substantiation and other requirements found within the tax laws is ultimately placed upon the taxpayer’s shoulders.
Preparation Checklist
The IRS advises taxpayers to consider taking the following steps, among others, to better prepare for hurricanes and other emergencies:
Emergency plans. Personal and business situations change over time, as do preparedness needs. An emergency plan, both at home and in business, whether for safety or to prepare for insurance claims and tax contingencies, should be updated annually.
Digital copies of key documents. The IRS advises that taxpayers should keep a duplicate set of key documents including bank statements, tax returns, identifications and insurance policies in a safe place, away from the original set. The IRS observes that maintaining an additional set of records should be easier these days, with many financial institutions providing statements and documents electronically and on secure internet sites. Even if the original records are only provided on paper, the IRS suggests scanning them into an electronic format.
Taxpayers should also photograph or videotape the contents of their residences, especially items of higher value. The IRS disaster loss workbooks and Publication 584 can help taxpayers compile a room-by-room list of belongings. A photographic record can help taxpayers prove the fair market value of items for insurance and casualty loss claims. Ideally, photos should be stored outside the area of the home or office.
Payroll providers. The IRS suggests that employers who use payroll service providers should ask the provider if it has a fiduciary bond in place. It notes that the bond could protect the employer in the event of default by the payroll service provider.
IRS data storage. Back copies of previously-filed tax returns and all attachments, including Forms W-2, can be requested by filing Form 4506, Request for Copy of Tax Return. Alternatively, transcripts showing most line items on these returns can be ordered through the Get Transcript tool available on the IRS website, or by calling 1-800-908-9946 or by using Form 4506T-EZ, "Short Form Request for Individual Tax Return Transcript" or Form 4506-T, " Request for Transcript of Tax Return."
Individuals, trusts, estates, personal service corporations and closely held C corporations may only deduct passive activities losses from passive activity income. The rules do not apply to S corporations and partnerships but do apply to their respective shareholders and partners. In general, limited partners are not deemed to materially participate in partnership activities. Thus, a limited partner's share of partnership income is passive income. However, general partners or acting general partners may hold limited partnership interests and materially participate in the partnership.
Individuals, trusts, estates, personal service corporations and closely held C corporations may only deduct passive activities losses from passive activity income. The rules do not apply to S corporations and partnerships but do apply to their respective shareholders and partners. In general, limited partners are not deemed to materially participate in partnership activities. Thus, a limited partner's share of partnership income is passive income. However, general partners or acting general partners may hold limited partnership interests and materially participate in the partnership.
Closely held C corporations and personal service corporations are treated as materially participating in an activity if shareholders owning 50 percent or more by value of the outstanding stock materially participate in the activity. Closely held C corporations can also satisfy the material participation standard under an alternative rule based on the participation of full-time employees in the activity.
A passive activity is trade or business activity in which the taxpayer does not materially participate. A passive activity is any activity that involves the conduct of a trade or business in which the taxpayer does not materially participate. Passive activities generally include rental activities, regardless of whether the taxpayer materially participates in the activity. A taxpayer's rental real estate activity is not a passive activity, however, if the taxpayer (1) materially participates in the activity, and (2) performs qualifying services in real property trades or businesses. A facts and circumstances test applies in determining whether other activities are combined or treated as separate for purposes of the passive loss rules.
Individuals who own and actively participate in the management of rental real estate may offset up to $25,000 of passive activity loss from rental real estate against active income in any tax year. The offset amount is reduced by 50 percent of the amount by which the taxpayer's adjusted gross income exceeds $100,000, phasing out completely at $150,000 of adjusted gross income. More liberal rules apply to the offset of rehabilitation and low income housing credits.
Deductions and credits that are disallowed under passive activity rules may be carried forward and used as passive activity deductions and credits in succeeding years. Remaining passive activity deductions are deductible against nonpassive income when taxpayer disposes of the passive activity. Passive activity credits may only be applied to taxes on passive income.
A major exception to the definition of a passive activity is a working interest in any oil and gas property that the taxpayer holds directly or through an entity that does not limit the taxpayer's liability for the interest, regardless of whether the taxpayer materially participates in the activity.
A taxpayer's passive activity loss for the tax year is disallowed and is carried forward until the taxpayer has available passive activity income. Passive activity loss is the amount by which passive activity deductions from all passive activities exceed passive activity gross income from all passive activities for the tax year.
For more on passive activity losses, please contact our office.
As an individual or business, it is your responsibility to be aware of and to meet your tax filing/reporting deadlines. This calendar summarizes important federal tax reporting and filing data for individuals, businesses and other taxpayers for the month of June 2017.
As an individual or business, it is your responsibility to be aware of and to meet your tax filing/reporting deadlines. This calendar summarizes important federal tax reporting and filing data for individuals, businesses and other taxpayers for the month of June 2017.
June 1
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 24–26.
June 2
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 27–30.
June 7
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 31–June 2.
June 9
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates June 3-6.
June 12
Employees who work for tips. Employees who received $20 or more in tips during May must report them to their employer using Form 4070.
June 15
Individuals. Individuals, partnerships, passthrough entities and corporations make the second installment of 2017 estimated quarterly tax payments.
Individuals. U.S. citizens or resident aliens living and working (or on military duty) outside the United States and Puerto Rico must file Form 1040 (or apply for an automatic extension to file 4-months on Form 4668) and pay any tax due.
C corporations. Make the second installment of 2017 estimated tax.
Employers. Deposit payroll tax for May if monthly deposit rule applies.
June 16
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates June 10–13.
June 21
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates June 14–16.
June 23
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates June 17–20.
June 28
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates June 21–23.
June 30
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates June 24–27.
Starting in 2010, the $100,000 adjusted gross income cap for converting a traditional IRA into a Roth IRA is eliminated. All other rules continue to apply, which means that the amount converted to a Roth IRA still will be taxed as income at the individual's marginal tax rate. One exception for 2010 only: you will have a choice of recognizing the conversion income in 2010 or averaging it over 2011 and 2012.
Starting in 2010, the $100,000 adjusted gross income cap for converting a traditional IRA into a Roth IRA is eliminated. All other rules continue to apply, which means that the amount converted to a Roth IRA still will be taxed as income at the individual's marginal tax rate. One exception for 2010 only: you will have a choice of recognizing the conversion income in 2010 or averaging it over 2011 and 2012.
The Tax Increase Prevention and Reconciliation Act of 2005 eliminated the $100,000 adjusted gross income (AGI) ceiling for converting a traditional IRA into a Roth IRA. While this provision does not apply until 2010, now may be a good time to make plans to maximize this opportunity.
The Roth IRA has benefits that are especially useful to high-income taxpayers, yet as a group they have been denied those advantages up until now. Currently, you are allowed to convert a traditional IRA to a Roth IRA only if your AGI does not exceed $100,000. A married taxpayer filing a separate return is prohibited from making a conversion. The amount converted is treated as distributed from the traditional IRA and, as a consequence, is included in the taxpayer's income, but the 10-percent additional tax for early withdrawals does not apply.
Significant benefits
While recognizing income sooner rather than later is usually not smart tax planning, in the case of this new opportunity to convert a traditional IRA to a Roth IRA, the math encourages it. The difference is twofold:
- All future earnings on the account are tax free; and
- The account can continue to grow tax free longer than a traditional IRA without being forced to be distributed gradually after reaching age 70 ½.
These can work out to be huge advantages, especially valuable to individuals with a degree of accumulated wealth who probably won't need the money in the Roth IRA account to live on during retirement.
Example. Mary's AGI in 2010 is $200,000 and she has traditional IRA balances that will have grown to $300,000. Assuming a marginal federal and local income tax of about 40 percent on the $300,000 balance, the $180,000 remaining in the account can grow tax free thereafter, with distributions tax free. Further assume that Mary is 45 years of age with a 90 year life expectancy and money conservatively doubles every 15 years. She will die with an account of $1.44 million, income tax free to her heirs. If the Roth IRA is bequeathed to someone in a younger generation with a long life expectancy, even factoring in eventual required minimum distributions, the amount that can continue to accumulate tax free in the Roth IRA can be staggering, eventually likely to reach over $10 million.
Planning strategies
Now is not too early to start planning to take advantage of the Roth IRA conversion opportunity starting in 2010. While planning to maximize the conversion will become more detailed as 2010 approaches and your assets and income for that year are more measurable, there are certain steps you can start taking now to maximize your savings.
Start a nondeductible IRA
The income limits on both kinds of IRAs have prevented higher income taxpayers from making deductible contributions to traditional IRAs or any contributions to Roth IRAs. They could always make nondeductible contributions to a traditional IRA, but such contributions have a limited pay-off (no current deduction, tax on account income is deferred rather than eliminated, required minimum distributions).
While a taxpayer could avoid these problems by making nondeductible contributions to a traditional IRA and then converting it to a Roth IRA, this option was not available for upper income taxpayers who would have the most to benefit from such a conversion. With the elimination of the income limit for tax years after December 31, 2009, higher income taxpayers can begin now to make nondeductible contributions to a traditional IRA and then convert them to a Roth IRA in 2010. In all likelihood, there will be little to tax on the converted amount.
What's more, taxpayers with $100,000-plus AGIs should consider continue making nondeductible IRA contributions in the future and roll them over into a Roth IRA periodically. As a result, the elimination of the income limit for converting to a Roth IRA also effectively eliminates the income limit for contributing to a Roth IRA.
Example. John and Mary are a married couple with $300,000 in income. They are not eligible to contribute to a Roth IRA because their AGI exceeds the $160,000 Roth IRA eligibility limit. Beginning in 2006, the couple makes the maximum allowed nondeductible IRA contribution ($8,000 in 2006 and 2007, and $10,000 in 2008, 2009, and 2010). In 2010, their account is worth $60,000, with $46,000 of that amount representing nondeductible contributions that are not taxed upon conversion. The couple rolls over the $60,000 in their traditional IRA into a Roth IRA. They must include $14,000 in income (the amount representing their deductible contributions), which they can recognize either in 2010, or ratably in 2011 and 2012.
Assuming they have sufficient earned income each year thereafter (until reaching age 70 1/2), John and Mary can continue to make the maximum nondeductible contributions to a traditional IRA and quickly roll over these funds into their Roth IRA, thereby avoiding significant taxable growth in the assets that would have to be recognized upon distribution from a traditional IRA.
Rollover 401(k) accounts
Contributions to a Section 401(k) plans cannot be rolled over directly into a Roth IRA. The lifting of the $100,000 AGI limit does not change this rule. However, they often can be rolled over into a traditional IRA and then, after 2009, converted into a Roth IRA.
Not everyone can just pull his or her balance out of a 401(k) plan. A plan amendment must permit it or, more likely, those who are changing jobs or are otherwise leaving employment can choose to roll over the balance into an IRA rather than elect to continue to have it managed in the 401(k) plan.
For money now being contributed to 401(k) plans by employees, an even better option would be for those contributions to be made to a Roth 401(k) plan. Starting in 2006, as long as the employer plan allows for it, Roth 401(k) accounts may receive employee contributions.
Gather those old IRA accounts
Many taxpayers opened IRA accounts when they were first starting out in the work world and their incomes were low enough to contribute. Over the years, many have seen those account balances grow. These accounts now may be converted into Roth IRAs starting in 2010, regardless of income.
Paying the tax
In spite of all the advantages of a Roth IRA, a conversion is advisable only if the taxpayer can readily pay the tax generated in the year of the conversion. If the tax is paid out of a distribution from the converted IRA, that amount is also taxed; and if the distribution counts as an early withdrawal, it is also subject to an additional 10-percent penalty. For those planning to convert who may not already have the funds available, saving now in a regular bank or brokerage account to cover the amount of the tax in 2010 can return an unusually high yield if it enables a Roth IRA conversion in 2010 that might not otherwise take place.
Careful planning is key
Transferring funds between retirement accounts can carry a high price tag if it is done incorrectly. For those who plan carefully, however, converting from a traditional IRA to a Roth IRA can yield very substantial after-tax rates of return. Please feel free to call our offices if you have any questions about how the 2010 conversion opportunity should fit into your overall tax and wealth-building strategy.
The AMT is difficult to apply and the exact computation is very complex. If you owed AMT last year and no unusual deduction or windfall had come your way that year, you're sufficiently at risk this year to apply a detailed set of computations to any AMT assessment. Ballpark estimates just won't work
The AMT is difficult to apply and the exact computation is very complex. If you owed AMT last year and no unusual deduction or windfall had come your way that year, you're sufficiently at risk this year to apply a detailed set of computations to any AMT assessment. Ballpark estimates just won't work.
If you did not owe AMT last year, you still may be at risk. The IRS estimates that half million more individuals will be subject to the AMT in 2006 because of rising deductions and exemptions. If Congress doesn't extend the same AMT exclusion amount given in 2005, an estimated 3 million more taxpayers will pay AMT.
For a system that was intended originally to target only the very rich, the AMT now hits many middle to upper-middle class taxpayers as well. Obviously something has to be done, and will be, eventually, through proposed tax reform measures. In the meantime, expect AMT to be around for at least another year.
Basic calculations. Whether you will be liable for the AMT depends on your combination of income, adjustments and preferences. After all the computations, if your AMT liability exceeds your income tax liability, you will be liable for the AMT. Here are the basic steps to take to determine in evaluating whether you will owe the AMT:
- Step #1: Calculate your regular taxable income. If your regular tax were to be determined by reference to an amount other than taxable income, that amount would need to be determined and used in the next steps.
- Step #2: Calculate your alternative minimum taxable income (AMTI) by increasing or reducing your regular taxable income (or other relevant amount) by applying the AMT adjustments or preferences. These include business depreciation adjustments and preferences, loss, timing and personal itemized deductions adjustments, and tax-exempt or excluded income preferences. This is the step with potentially many sub-computations in determining increases and reductions in tax liability.
- Step #3: If your AMTI exceeds the applicable AMT exemption amount, pay AMT on the excess.
While no single factor will automatically trigger the AMT, the cumulative result of several targeted tax benefits considered in Step #2, above, can be fatal. Common items that can cause an "ordinary" taxpayer to be subject to AMT are:
- All personal exemptions (especially of concern to large families);
- Itemized deductions for state and local income taxes and real estate taxes;
- Itemized deductions on home equity loan interest (except on loans used for improvements);
- Miscellaneous Itemized Deductions;
- Accelerated depreciation;
- Income from incentive stock options; and
- Changes in some passive activity loss deductions.
Starting for tax year 2005, businesses have been able to take a new deduction based on income from manufacturing and certain services. Congress defined manufacturing broadly, so many businesses -just not those with brick and mortar manufacturing plants-- will be able to claim the deduction. The deduction is 3 percent of net income from domestic production for 2005 and 2006. This percentage rises to 6 percent and then 9 percent in subsequent years.
Starting for tax year 2005, businesses have been able to take a new deduction based on income from manufacturing and certain services. Congress defined manufacturing broadly, so many businesses -just not those with brick and mortar manufacturing plants-- will be able to claim the deduction. The deduction is 3 percent of net income from domestic production for 2005 and 2006. This percentage rises to 6 percent and then 9 percent in subsequent years.
Domestic production includes the manufacture of tangible personal property and computer software in the U.S. It also includes construction activities and services from engineering and architecture. Income from these activities must be calculated on an item-by-item basis and cannot be determined by division, product line or transaction. Direct and indirect costs are subtracted to determine "qualified production income." Land does not qualify as domestic production property.
The 3 percent rate is applied to the lower of net income from domestic production and overall net income. That amount is then capped at 50 percent of wages paid out by the employer for all its business activities.
Example. In 2005, Company X has $300,000 of income from domestic production activities. The company's overall net income was $500,000. The 3 percent rate is applied to $300,000, yielding a potential deduction of $9,000.
Company X paid its employees $50,000 in wages and reported this amount on Forms W-2 for 2005. Since the deduction is limited to 50 percent of wages paid and reported, Company X's deduction for 2005 is capped at $25,000 (50 percent of $50,000 in wages). X is entitled to a $9,000 deduction.
W-2 wage limitation
In some cases, the W-2 wage limit can easily trip up taxpayers. A successful sole proprietor who earns income but has no employees would not have any W-2 wages and, therefore, could not take the deduction. Self-employment income is not treated as wages. Neither are payments made to independent contractors. A small business that is incorporated but has no employees would have the same problem. Because payments to partners are not W-2 wages, a partnership with two partners and no employees also would be unable to take the deduction. Sole proprietors and other small businesses may want to consider putting a family member on the payroll, so that they have W-2 wages to satisfy this requirement.
An incorporated business, such as an S corporation, could put an owner on the payroll and apply the W-2 limit to reasonable wages paid to the owner. Employees include officers of the corporation and common law employees, as defined in the Tax Code. The more labor-intensive the manufacturing process, the more likely that a deduction will not be reduced by the W-2 wage limitation. The more automated the manufacturing process, the more likely it is that the manufacturer will find itself restricted by the wage limitation and not be able to take the full manufacturing deduction.
Code Sec. 199 defines W-2 wages as the sum of the total W-2 wages reported on Forms W-2, "Wage and Tax Statement," for the calendar year ending during the employer's taxable year. W-2 wages are defined as wages and deferred salary that is included on Form W-2. Deferred salary includes elective deferrals for a 401(k) plan or tax-sheltered annuity; contributions to a plan of a state and local government or tax-exempt entity; and designated Roth IRA contributions. IRS guidance provides three methods for calculating W-2 wages.
Our office can help you determine your eligibility for the manufacturing deduction and the amount of the deduction. Give us a call today.
