Sweeping changes in the federal and state tax codes that took effect in 2018 virtually guarantee lower taxes for most businesses that will file returns this year.
Now it may be time for accountants, tax attorneys, financial advisors and other tax professionals to scrutinize what transpired over the last year or so to determine if anything needs to be tweaked so that lower taxes can become the lowest possible taxes that don’t run afoul of new IRS regulations.
People who know their way around IRS form 1120S and the masses of other Internal Revenue documents make it clear there’s no assembly-line strategy for business owners who want to maximize the impact of the federal Tax Cuts and Jobs Act and the stem-to-stern overhaul of the Kentucky tax code that was approved last April.
“As with any tax question, it depends…,” said Melissa Mattox, driving home the point that no two clients who walk through the door at Lexington’s Kinkaid & Stilz law firm have identical tax issues.
“With many of our clients we had to take a ‘wait and see’ approach regarding the QBI (the federal Qualified Business Income) deduction because there was a lot of uncertainty around what was a ‘service’ business and what wasn’t,” said Mattox, referring to a critically important element of the new federal tax law that pertains to thousands of smaller businesses throughout Kentucky and elsewhere in the country.
“Now that the regulations are out, clarifying which businesses are able to take advantage of the QBI deduction, we can do more in-depth planning.”
“There is no one-size-fits-all recommendation (on the QBI) anymore because your strategy changes with your industry, your level of business and nonbusiness income, the amount of assets owned by the business and your payroll,” said Mattox, a CPA, the tax manager for the law firm and a member of the executive committee of the Kentucky Society of CPAs.
Cindy Hockenberry, director of tax research and government relations for the National Association of Tax Professionals, agreed that tax questions can’t be answered with a cookie-cutter approach.
“The answer depends on so many factors, including the type of business, what services they offer, what the income projections are, and how they are currently organized. It is not a one (tax) tip fits all situation,” said Hockenberry, whose association is based in Appleton, Wis.
“Business owners in any state with an income tax (such as Kentucky) should seek the advice of a tax professional to ensure they are claiming all the proper deductions and paying the least amount of tax allowed by law,” she said.
Hockenberry’s comments about hiring a professional echoed those of other accountants, attorneys and financial advisors who focus on tax issues. And while remarks from people who get paid to do tax work may seem to be self-serving, it’s clear that the first major rewrite of the federal code since 1986, combined with controversial tax reform in Kentucky, have layers of intricacy that might baffle most taxpayers.
“Of course, we will adjust our advice as we see the (ongoing) results of the tax law changes. Our advice to our clients will change year to year, regardless of tax law changes, based on their particular circumstances,” said Miranda Aavatsmark, a CPA and tax manager for Blue & Co., an accounting and consulting firm that has an office in Lexington and nine others in Kentucky, Ohio and Indiana.
“However, there is still a lot of guidance (from the IRS) to be issued in regards to the new tax law,” Aavatsmark said. “As this guidance is released, it will help us to better understand how the changes affect our clients. In 2019, clients may have more opportunity to make changes and realize greater savings once we have computed their actual 2018 tax liability.”
“The upcoming tax season should provide better insights as to which businesses may not receive benefits. It will be interesting to learn who did not benefit and the reasons, so that we can adjust our advice in 2019,” Aavatsmark said.
Erica Horn, a CPA and attorney and associate director of tax services for Dean Dorton, a Lexington-headquartered accounting firm, agreed it may be too early to make any ironclad conclusions about the impact of the state and federal changes. “I think it’s a little too soon to know how this is all going to play out,” Horn said.
Business returns taking longer
Although some individual taxpayers may find that federal tax filing is less complicated now, that may not be the case for business owners. Several tax professionals who commented for this story said business returns might take longer this year because new regulations could prompt plenty of new questions from business owners.
“We think we’re going to be real busy, and we’re estimating that we’re probably going to be spending 10 to 20 percent more time on returns this year,” said CPA Kevin L. Fuqua, a partner in MCM (Mountjoy Chilton Medley) CPAs and Advisors in Louisville.
Tax cuts at the federal level made national and international headlines, touched off a flurry of presidential tweets and clearly overshadowed Kentucky’s effort last spring to duplicate at the state level many of the changes in President Trump’s Tax Cuts and Jobs Act.
“For Kentucky business owners it’s important to reiterate that there were big changes at the federal level, but you have to remember that there were also big changes in Kentucky,” said Rachael High Chamberlain, an attorney in the Lexington office of Frost Brown Todd and the vice chair and secretary of the Kentucky Bar Association’s taxation committee.
Chamberlain, Horn, Fuqua and others who commented for this story emphasized that there are a couple of major differences between the federal and state codes for businesses.
At one level the federal legislation that was designed to stimulate American business growth took a chainsaw to the tax rate for “C corporations” – the structure typically adopted by larger companies – and trimmed the maximum rate of nearly 40 percent to a flat 21 percent.
But sole proprietorships, partnerships, LLCs and S corporations – which are common business structures in Kentucky – received their stimulus in a different form. At the federal level, business owners can deduct 20 percent of what is known as “qualified business income” in a tax cut that approximates what C corporations received.
“To individual taxpayers who have LLCs or taxpayers who are sole proprietors or some taxpayers who are members of partnerships, they’ll benefit by a 20 percent deduction of pass-through income from gross income,” said Dennis Repenning, a Covington attorney who handles taxes for a variety of business clients.
“That’s right off the top, and it’s a big deal,” Repenning said. “There may be limitations on the deduction for some, but it’s still huge. And corporations will pay a lower rate of income tax than before. Kentucky corporations benefit twice: The federal tax rate drops, and the state income tax drops.”
When the Kentucky tax code was revamped last year, the state scrapped a graduated rate that ranged from 2 to 6 percent and imposed a flat rate of 5 percent on all taxpayers, including businesses that may have been paying
6 percent.
“Kentucky wants to be more business friendly, and a lot of the changes that were made will help businesses,” Chamberlain said.
“Kentucky rushed through its tax-reform legislation, and there wasn’t much public debate on the theory behind it,” she said, explaining that one underlying principle seems to be that the tax base has been broadened so that more people are paying at a rate that has been lowered.
Chamberlain, Horn, Repenning and others point out that the 20 percent deduction on pass-through income – that which passes through a business — wasn’t adopted by the state.
Horn said Kentucky “decoupled” from that 20 percent provision.
Chamberlain put it differently: “Kentucky for 2018 and going forward has just decided to pretend that it doesn’t exist.”
For example, a tax filer with $100,000 in qualified business income can deduct up to $20,000 on their federal filings and pay tax on the $80,000 balance. With no Kentucky deduction, however, the entire $100,000 is taxable, Chamberlain said.
Scott W. Dolson, an attorney in the Louisville office of Frost Brown Todd, said he’s fielding more questions from clients about C corporation business structure because of the huge reduction in the tax rate and an obscure tax benefit predating the recent tax cut that pertains to the sale of “qualified small business stock.”
Despite this, Dolson stresses that he believes most of his business clients still receive more tax benefit structured as S corporations, partnerships, sole proprietorships or LLCs.
“The code says you have a 20 percent deduction, but there are 100 rules that you have to be aware of. People hire us to make sure they are taking advantage of the full 20 percent deduction. There are nooks and crannies,” said Dolson, whose law practice includes tax planning and structuring for closely held businesses such as partnerships and LLCs.
Horn said state tax code also departs from the federal legislation by declining to adopt new rules on how a business can “expense” or depreciate the purchase of, for example, new equipment.
MCM’s Fuqua said new federal rules may require some tough decisions by business owners on whether they “expense” (deduct) the cost of new equipment immediately in one year under so-called “bonus depreciation” provisions or depreciate it over a period of years.
Under bonus depreciation, most business owners can deduct 100 percent of the cost of machinery, equipment, computers, appliances and other business essentials in the year in which they are “placed in service,” the IRS said. But the IRS has made clear that this bonus depreciation won’t be available forever and only covers items placed in service between late September 2017 up to Jan. 1, 2023.
The alternative is to depreciate that purchase over a period of years; for example, taking a 20 percent deduction for five years, Fuqua said.
The business owner would deduct equivalent amounts using either method, he said, but the deduction’s impact on a tax bill can vary depending on whether the taxpayer’s income increased or decreased in the year(s) in which depreciation is claimed.
“Some people will say, ‘Let’s expense everything now and get the (maximum) deduction.’ There are short-term and long-term approaches,” Fuqua said.
“We as a state couldn’t afford to conform to the depreciation and expensing provisions,” Horn said, explaining why Kentucky didn’t follow the federal government’s lead on those deductions.
At Hilliard Lyons, a wealth management firm that opened its doors in Louisville in 1854, Chairman and CEO James R. Allen, Vice President of Financial Planning Greg King and Chris Staples, senior vice president and a managing director of the Hilliard Lyons Trust Co., made it clear that they look well into the future for their clients.
In a detailed email, King and Staples point out that it’s “…important for us to emphasize that many of the new tax provisions are only in place through Dec. 31, 2025 … so there is a window during which they (clients) can take advantage of the benefits of the new tax act before the tax law is set to change again. This sunset of the provisions makes tax planning more difficult for the long-term, but we don’t want to let this opportunity to potentially save some taxes go by simply because the rules may change in the future.
“Many businesses will consider making changes to their structure to pursue the new lower corporate tax rates,” King and Staples said. “Others will consider adjustments to take advantage of pass-through deductions provided in the new tax law as well.
“Many business owners expect to benefit long-term from the changes in the tax act, but since Treasury (the U.S. Treasury Department) only recently issued the bulk of the important regulations related to the tax act in late 2018, most owners postponed making sweeping changes to their business structure until we knew more about the specific rules applied to the tax act provisions,” they said.
Regarding general advice he might have for Kentucky business owners for 2019, Repenning takes a philosophical stance.
“There’s something called tax policy. It addresses both short-term financial needs and long-term goals,” Repenning said. “Kentucky taxpayers will pay less tax on the whole than they did last year. But both the Congress and the Kentucky legislature chose immediate tax savings over the long-term health of the national economy and Kentucky’s future. When you have an economy that is shrinking and money is tight, it can provide a modest shot in the arm to business. But we were in an expansion economy when these federal and state changes were enacted. So we have to ask if we’re going to be better off next year or the year after, especially when budget issues are being ignored.”
Greg Paeth is a correspondent for The Lane Report. He can be reached at [email protected].
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