By Miranda Aavatsmark
Make no mistake, Congress did not come together and pass any new tax laws or make other changes to the existing tax laws in 2019. Although there was much talk of “Tax Reform 2.0” and the need for a few technical corrections, it simply did not happen. However, some of the changes that were made with the Tax Cuts and Jobs Act of 2017 did not go into effect until 2019. Other changes became effective in 2018, but 2019 may be the first tax year accountants and business owners will fully understand and realize their effects. CPAs and other professionals in the community are likely still grappling with 2018 changes, software issues, and planning for their clients. But, as with ever-evolving tax laws, tax professionals certainly understand and live with the saying, “just when you think you know, you don’t.”
That being said, let’s highlight some of the changes to keep in mind as 2019 nears a close.
Individual Health Insurance Mandate
In late 2017, Republican lawmakers touted the penalty for not having health insurance around with a knife and chopping block in hand. When all was said and done though, the mandate sat on death row for an additional year. Starting with 2019 income tax filings, individuals will no longer pay a penalty for not having health insurance coverage for themselves and their family members.
Historically, alimony payments were deductible by the taxpayer paying the payments and included in income by the recipient taxpayer. Issues often arose between taxpayers and the IRS because the alimony rules were confusing, the wording of divorce agreements may have been ambiguous, and conflicts generally arose between the ex-spouses. In addition, at one point in time, the IRS was not even matching the alimony deductions on the payer’s return to the income on the recipient’s return. The problems and dramatic family dynamics of this particular tax law likely led to the changes effective for divorce agreements entered into after December 31, 2018. If the divorce or settlement agreement is after December 31, 2018, alimony paid is no longer deductible and alimony received is no longer included in income. Alimony payments pursuant to agreements entered into prior to January 1, 2019, are still treated the same under the old tax laws.
Note that many of the TCJA tax law changes are temporary and set to sunset after December 31, 2025. Nevertheless, the above changes to the individual health insurance mandate and alimony are both permanent.
Net Operating Loss Carryovers
Net operating losses (NOLs) that were created in a tax year ending after 2017 are no longer eligible to be carried back to claim a prior-year refund. NOLs can be carried forward indefinitely, but can only offset 80% of future taxable income on an annual basis. To illustrate this, suppose a taxpayer, Mr. X, incurs an NOL of $300,000 in 2018, which is carried to 2019. In 2019, Mr. X’s taxable income is $100,000 but he will only be able to offset $80,000 (80% of taxable income) of his income with his 2018 losses. Therefore, his 2019 taxable income will be reduced to $20,000 and he will carry the remaining $220,000 of losses to 2020.
Keep in mind, NOLs that were created in tax years prior to 2018 carry the old tax rules with them. These NOLs can be carried back two years and forward twenty years without any taxable income limitations. NOLs created under the old and new laws will need to be tracked and accounted for separately as they are created and used. Fiscal year taxpayers with a tax year beginning before December 31, 2017, may also need to track losses within the same tax year separately due to an error in the wording of the new law.
This permanent change to the tax law applies to corporations, individuals, estates, and trusts. Exceptions to the new rules are available for certain farming losses and farming businesses.
Excess Business Losses
Individual taxpayers were hit with another layer of loss limitations starting in 2018. Individuals are limited to $250,000 of net business losses ($500,000 for married filing joint) in excess of other items of income and gains in a tax year. For example, Ms. Y (a single taxpayer), has business losses of $400,000, and investment income of $100,000. Ms. Y can deduct $250,000 of business losses and will carryover $150,000 of excess business losses to the next tax year. Excess business losses that are suspended in the current year are carried over to the next year and take on the same characteristics of regular net operating losses. Therefore, Ms. Y’s $150,000 of excess business losses carries over to the next tax year and can only offset 80% of her taxable income.
It is important to note that all business income and losses are netted together first before applying the excess business loss rules. This means that if Ms. Y had two businesses, one with a loss of $1,000,000 and one with an income of $600,000, the net loss of $400,000 is what is used to determine excess business losses. Other loss limitations rules such as material participation and basis limitations would be determined first before calculating excess business losses.
Excess business loss rules limit the losses for all non-corporate taxpayers and is a temporary change set to sunset after December 31, 2025.
Pass-through Deduction Carryovers
The pass-through deduction (IRC Section 199A) is available to owners of pass-through businesses starting with tax years beginning after December 31, 2017. The deduction is equal to 20% of qualified business income with limitations based on taxable income, W2 wages paid, tangible property owned, and a classification of whether the activity is a specified service trade or business or not. Without rehashing many of the caveats and some of the more complicated calculations, for purposes of this article, we will try to keep it simple.
If a taxpayer has net losses from qualified business income (QBI), generated after December 31, 2017, then those losses will be carried over to the next tax year and offset future QBI. For example, Mr. Q has net QBI losses of $40,000 generated in the 2018 tax year and is unable to take any 199A deduction. In 2019, Mr. Q has QBI income of $50,000 that must be reduced by the prior losses of $40,000, resulting in net QBI of $10,000 and potentially a $2,000 199A deduction.
Generally, QBI is not reduced by pre-2018 suspended losses due to basis, passive, or at-risk loss limitations. For example, if Mr. Q had suspended losses of $5,000 incurred prior to 2018 that he is now able to take in 2019, the additional loss of $5,000 does not reduce net QBI in 2019. The losses will reduce his taxable income, but since they were not originally eligible for 199A treatment (pre-2018 losses) they will not reduce QBI in current or future years.
The pass-through deduction is a temporary tax deduction available to individuals, estates, and trusts, scheduled to sunset after December 31, 2025.
Business Interest Expense Carryovers
The business interest expense limitation, IRC Section 163j has been around a number of years, but the TCJA significantly changed how this law was applied. As a result, 163j impacted many large businesses whose average annual gross receipts exceed $25 million starting in 2018. The new rule generally imposes a 30% limitation on the deductibility of business interest expense. The rules and exceptions to this limitation are also very complex and beyond the scope of this article.
C-corporations generally carryover interest expense limited by 163j indefinitely, but cannot carry it back. The disallowed interest expense carryover is added to the succeeding year’s interest expense as if paid or accrued when computing that tax year’s limitation.
S-corporations treat disallowed business interest expense similar to a C-corporation in that the deduction is carried over to succeeding tax years at the corporate level. Disallowed interest expense is not passed out to the shareholders and does not affect their basis. An S-corporation does allocate excess taxable income and excess business interest income to shareholders on a pro-rata basis in order to help calculate any 163j limitations on an individual level.
Contrary to corporations, the disallowed portion of interest expense is not carried over at the partnership level, instead, it is distributed out to the partners as excess business interest in the year incurred. Excess business interest allocated to each partner can only be deducted by partners in future years when the allocating partnership distributes excess taxable income. Further, excess business interest expense allocated to each partner reduces their partnership basis in the year distributed, even though the expense is not deductible that year. If the partner disposes of their partnership interest before all of the excess business interest expense is used up, then the unused amount can be added back to their basis.
The business interest expense limitation is also a permanent change to the tax laws included in TCJA.
Although this is not an exhaustive list of all TCJA tax law changes that may impact 2019 differently than 2018, it attempts to highlight several significant issues. Closing up 2019 and heading into 2020, with a presidential election on the horizon, means that none of these changes are completely secure. CPAs and tax professionals know this better than most and consistently work hard to adapt quickly with each round of updates.
If you have questions or would like to discuss the impact of these changes on your organization, please contact your local Blue & Co. advisor.
This article was originally published in The Kentucky CPA Journal.