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The Tax Cuts and Jobs Act (TCJA) added a new tax deduction for owners of pass-through entities – a 20% deduction of qualified business income (QBI) from a qualified trade or business.

This new provision may potentially lower the maximum individual tax rate of 37% on pass-through income to 29.8%, which makes it more comparable to the new C corporation tax rate of 21%.  However, the new law contains limitations that may reduce or eliminate the deduction for some business owners.

What Is the 20% QBI Deduction?

For tax years beginning after December 31, 2017 through 2025, the QBI deduction is 20% of QBI from an S corporation, partnership, sole proprietorship, trust or estate at the owner level.  The definition of QBI includes only income associated with business activity conducted in the United States.  It does not include reasonable owner compensation, guaranteed payments to a partner, or investment income (including capital gains).

The 20% QBI deduction is computed separately for each business. Once combined, the 20% QBI deductions are limited to 20% of the individual’s taxable income in excess of any capital gains.

Who Qualifies for the Deduction?

Qualified trades or businesses include all trades or businesses except those classified as a “specified service trade or business” (SSTB).  An SSTB is a business that provides services in any one of the following business types:  health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any business where the principal asset is the reputation or skill of one or more employees or owners.

Engineering and architecture services are specifically excluded from the definition of an SSTB and are considered qualified businesses.  However, even income from an SSTB can generate a potential deduction if the taxpayer’s taxable income is under the threshold amounts discussed below.

What Are the Limitations?

Several limitations may apply to limit the potential deduction, depending on the owner’s taxable income level.  First, the QBI deduction can’t exceed 20% of “modified” taxable income.  For this purpose, taxable income is reduced by net capital gain (including qualified dividend income).

Threshold Amounts

If the owner’s taxable income before the deduction is under $315,000 (married filing jointly) and $157,500 (all other filers), no additional limitations apply. This is true for any type of trade or business, including SSTBs.

If the owner’s taxable income before the deduction is between $315,000 and $415,000 (married filing jointly) and $157,500 and $207,500 (all other filers), a limitation phase-in calculation is required.  The limitation phase-in rules reduce or eliminate the 20% QBI deduction, depending on the owner’s taxable income level.

Owners of SSTBs get no deduction if their taxable income exceeds these thresholds.

The amount of the deduction is limited to the greater of 50% of the owner’s allocated share of W-2 wages, or 25% of W-2 wages plus 2.5% of the owner’s allocated share of qualified property used in the business.  The definition of qualified property is generally based on the original cost of the property.

Note that the passive activity loss and the at-risk limitations should also be considered in applying the new deduction rules.

The new law also includes special penalties for taxpayers who understate their income through the misapplication of the new QBI rules.

Owners of Multiple QBIs

If the taxpayer owns multiple QBIs and the total combined amount of QBI for all qualified businesses is a net loss for the year, the taxpayer gets no deduction for the current year. Instead, the loss is carried forward as a loss to offset total combined QBI in the next tax year.  Otherwise, the limitation provisions apply separately to each qualified business, and the potential deduction is combined.

Additional Guidance Needed

At this time (August 2018), many unanswered questions remain regarding the application of the 20% QBI deduction rules.  The federal government has announced that it expects to publish more guidance in the near future.

Next Steps

While the potential for tax benefit associated with the new 20% deduction rules may be substantial, the existing provisions are complex, and can be ambiguous.  For assistance, please contact your Clark Nuber professional or Rene Schaefer to determine if your business qualifies for the new 20% QBI deduction and what limitations may apply.

© Clark Nuber PS and Developing News, 2018. Unauthorized use and/or duplication of this material without express and written permission from this blog’s author and/or owner is strictly prohibited. Excerpts and links may be used, provided that full and clear credit is given to Clark Nuber PS and Developing News with appropriate and specific direction to the original content.

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Do the New Mortgage Interest Rules Affect You?

Though the mortgage interest deduction is not gone, there is confusion about the new rules and who it applies to. If you can still itemize deductions under the TCJA, you need to be aware of these new tax provisions.

What mortgage interest is deductible?

In the past, mortgage interest was deductible for home acquisition debt up to $1 million or less ($500,000 for married filing separate) on one or two homes plus home equity interest debt of up to $100,000. Under TCJA, mortgage interest is deductible if the home acquisition debt is $750,000 or less ($375,000 for married filing separate) on one or two homes for 2018 through 2025. Debt incurred on or before December 15, 2017 is grandfathered in under the old rules for home acquisition debt of $1 million or less. Debt will also be grandfathered in if there was a written binding contract before December 15, 2017 to close on the purchase of a principal residence before January 1, 2018, and purchase the residence before April 1, 2018. Home equity interest is generally no longer deductible for 2018 through 2025. There’s an exception to deduct home equity interest if the proceeds were used to buy, build or substantially improve the taxpayer’s home that secures the loan. It is still subject to the overall debt limits. Documentation and tracing will be important to determine the amount of deductible home equity interest.

How is refinancing treated?

For home acquisition debt to continue to be grandfathered under the old rules of $1 million, the refinanced debt can only be for the amount of the old mortgage debt and cannot exceed the remaining original debt term. There can be no cash taken out – even to cover closing costs –  and the term cannot be extended. Special rules apply if the original mortgage debt is not amortized over the life of the loan (i.e., has a balloon payment at the end). For example:  A home acquisition debt was taken out in 2010 for $1 million for 30 years and the outstanding balance of $850,000 is refinanced in 2018.  The refinanced debt term can be for 22 years or less for the mortgage interest to be fully deductible under the grandfather rules. After 2025, the old rules will apply – mortgage interest expense will be deductible for the home acquisition debt up to $1 million and home equity interest debt up to $100,000. The new mortgage interest rules will generally apply to new home acquisition debt after December 15, 2017. These new rules may affect the Seattle/Bellevue areas more than other areas, since the average home price is well over $750,000. It is important to know the rules before you purchase your next home or refinance your mortgage to avoid any surprises and higher taxes than expected. Please contact your Clark Nuber professional or Rene Schaefer to understand this new tax provision and how it may affect you. © Clark Nuber PS, 2018. All Rights Reserved  

Revenue Recognition for Privately Held Manufacturers

As a quick recap, the new revenue recognition standard (ASU 2014-09, also known as ASC 606) provides new requirements for recognition of revenue arising from contracts with customers, except in cases where contracts are within the scope of other U.S. GAAP requirements (such as the leasing standards). The standard impacts businesses in all industries and will become effective January 1, 2019 for non-public companies. Companies may elect one of two methods for implementation: (1) the modified retrospective approach or (2) a full restatement. Revenue amounts and timing may not ultimately change, but disclosure requirements likely will change. Furthermore, tax treatment will generally need to follow GAAP and considerations will need to be made relative to tax filings as well.

One Size Does Not Fit All

Each provision of ASU 2014-09 will not apply to every company. For example, two manufacturing companies competing in the same marketplace could face different issues, depending on what terms are negotiated in their customers’ contracts. It is important to understand the guidance as it relates specifically to each individual business. The following is a summary of the five-step process model that companies will need to work through to determine revenue recognition under the new standard. For the purposes of this article, I have added a few areas of interest for manufacturers.

Revenue Recognition Model – Five-Step Process

1. Identify the contract. All businesses have agreements with their customers. A contract is anything that creates enforceable rights or obligations (contract, purchase order or change order). Approval and commitment of a contract can be in writing, orally or in accordance with customary business practices. The contract needs to also have commercial substance, as defined, have identifiable payments terms, and collection needs to be probable.
Shipping and Handling - Shipping and handling that occurs before a customer obtains control of a product is considered a fulfillment activity.  Shipping and handling that occurs after a customer obtains control of a product is considered a promised service. An accounting policy election can be made to treat promised services as fulfillment.
2. Identify the performance obligations in the contract. Distinct goods or services that have their own value should be separately identifiable from other promises in the contract (that is, explicit and implicit).
Warranty -  If a warranty is not separately priced, revenue is recognized in full at the time of delivery and the related cost is accrued. Extended warranties and warranties that provide services other than assurance that a product complies with its specifications, are accounted for as separate performance obligations within a contract.
3. Determine the contract price. This includes fixed cash consideration, variable consideration, financing components, consideration payable to the customer, and non-cash consideration.
Variable Consideration - Can include bonuses, price concessions, refunds, milestone payments, penalties, discounts, returns, volume rebates, etc. Out-of-pocket costs may also potentially be viewed as variable consideration. The new standard tasks each business with valuing contracts based on a variety of methods, with further guidance included within the standard.
Returns - Revenue is not recorded for refunds expected to be paid to customers. Rather, a refund liability is recorded with a corresponding asset (adjustment to COGS) representing the right to recover products from customers of settling the refund liability.
Gross Versus Net Revenue - The transaction price is the amount of consideration for which the company expects to be entitled (net of discounts or rebates). Companies make an accounting policy election to exclude from the transaction price certain types of taxes collected from customers.
4. Allocate the contract price to performance obligations. First, allocate transaction price using standalone selling prices for identified performance obligations. If standalone selling prices are not available for certain performance obligations, a company may use available market data. A residual approach may be used for any remainder. 5. Recognize revenue as the performance obligation is satisfied. Each performance obligation is recognized at a point in time or over a period of time. Over time, recognition is only allowed if any of the following are met:
  • Customer simultaneously receives and consumes the benefit.
  • Services rendered create or enhance an asset that the customer controls.
  • Services do not create an asset with an alternative use to the service provider and the service provider has an enforceable right to payment at all times during the term of the contract.
Milestones - Contractual billing milestones may not be considered performance obligations and are not necessarily indicative of “point in time” recognition.
Short Cycle Manufacturing - Companies may have an enforceable right to payment and under the principal of the new standard would need to recognize revenue. The FASB is already deliberating on an exception for this one, so stay tuned.
Bill and Hold - The new standard provides explicit guidance that is essentially the same guidance in the SEC’s interpretive guidance. Many private companies were already following it; therefore, no change is likely. However, companies may want to revisit the four criteria that must be met for recognition:
  • The reason is substantive.
  • The product is separately identified.
  • The product is ready for physical transfer.
  • The company cannot be able to use or redirect the product.

Other Considerations for Manufacturers

In addition to the changes in ASC 606, there are other changes to costs (ASC 340) that are not covered in the five-step model. Those who are responsible for implementing revenue recognition should also take note of the following considerations.
  • Costs of obtaining the contract - These are incremental costs incurred as a result of a contract being obtained. Costs are deferred and amortized over the life of the contract (including considerations for renewal), as long as costs are expected to be covered. This includes sales commissions but does not include legal and credit evaluations.
  • Contract Fulfillment - The costs of fulfilling a contract should be accounted for under other GAAP standards. Any deferred costs are amortized over the life of the contract (including considerations for renewal) in the same pattern as revenue is recognized. Costs included are equipment recalibration and design costs required to fulfill a contract.
The new model focuses on recognition of revenue and not margin and costs. FASB did not include guidance for abnormal or wasted materials. Use your judgement to adjust for costs that do not contribute to contract progress.

Next Steps

The five-step revenue recognition model may appear straightforward, but it provides a simplified, high-level overview. Most companies will likely have more than one contract that needs to be evaluated. It will take time to capture the information needed to support compliance. If you don’t have one yet, create an implementation team and set up a road map to assess the impact of the new standard. Public companies were required to adopt the standard in 2018, so private companies will have a window into its impact. Implementation teams should consider evaluating the footnote disclosures of public companies as noted in their quarterly filings and compare to others in the industry as they begin to evaluate how the standard will affect their company. A CPA firm can help you with this process, and the time to start is now. For more information about implementing revenue recognition standards for manufacturers, please contact Hillary Parker. © Clark Nuber PS, 2018. All Rights Reserved

Uniform Guidance: Changes to the Micro-Purchase and Simplified Acquisition Thresholds

In the previous article, we discussed interim guidance that was provided in the 2018 OMB Compliance Supplement on both NDAA’s, but we were still waiting for more guidance from the OMB. The OMB has now issued OMB Memo M-18-18 (M-18-18). In this article, we provide an update on both the NDAA of 2017 and the NDAA of 2018.

Institutions of Higher Education, Nonprofit Research Organizations, and Independent Research Institutes

For these entity types, the NDAA of 2017, Section 217 (Pub. L. No. 114-328, 130 Stat. 6 (2051)) and 41 USC 1902(a)(2) contained the following provisions.
  • Raise the micro-purchase threshold to $10,000 for procurements under grants and cooperative agreements to institutions of higher education or related or affiliated nonprofit entities, nonprofit research organizations, and independent research institutes.
  • Allow a threshold higher than $10,000 as determined appropriate by the head of the relevant executive agency.
M-18-18 clarified that the provisions of the NDAA of 2017 were effective when signed into law on December 23, 2016. In addition, M-18-18 provides further instructions on the process for these entities to request a micro-purchase threshold of higher than $10,000 provided the entity meets the criteria for a low-risk auditee in accordance with 2 CFR Part 200.520. The entity must also have an acceptable internal institutional risk assessment. Several of these entity types have already been successful in obtaining approval for higher micro-purchase thresholds from their cognizant federal agency.

All Other Entities Except for States

For all other entities except states, the NDAA of 2018 increases the simplified acquisition threshold to $250,000 and the micro-purchase threshold to $10,000 for all auditees. The NDAA of 2018 was to update the definitions in the Federal Acquisition Regulations (FAR) at 48 CFR Part 2.1. The 2018 OMB Compliance Supplement made clear that entities were not to implement the higher thresholds until the FAR definitions were updated and became effective. M-18-18 changed this and allows for early adoption. By issuing M-18-18, the OMB is requiring all federal agencies to adopt exceptions to the FAR definitions, making the increases in both the micro-purchase and simplified acquisition thresholds effective as of the date of M-18-18, June 20, 2018. As such, there is no longer a need to wait until the FAR updates their definitions to make effective these higher thresholds. Entities are not required to increase the micro-purchase and simplified acquisition thresholds but, if they wish to do so, must update their procurement policies and procedures to reflect the change in thresholds. They cannot retroactively make these changes effective prior to June 20, 2018. The increase in these purchase thresholds is a welcome relief for many entities, especially as it relates to the increase in the micro-purchase threshold. If questions exist after reading M-18-18, entities are encouraged to send questions to the OMB contacts included in the memo. Please click here for a link to the OMB Memo M-18-18. © Clark Nuber PS, 2018. All Rights Reserved

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