Tax Talk With Collins Hannafin
Small Business Planning Opportunities Under the 2017 Tax Cut and Jobs Act
Taxpayers started the year off with new Federal Tax legislation that offers individuals and businesses both opportunity and challenge. Taxpayers are beginning to see more clarity as the Internal Revenue Service has been busy issuing Treasury Regulations and Revenue Procedures that should enable taxpayers to better understand how to actually take advantage of the provisions this new legislation has to offer.
For the small business owner, the IRS recently issued Revenue Procedure 2018-40. This Rev Proc expands the number of small business taxpayers eligible to use the cash receipts and disbursements method of accounting as well as exempt small business taxpayers from the requirements to capitalize costs, including certain home construction contracts under §263A, to account for inventories under §460 as well as account for inventories included in long term contracts under §471. IRC §263A provides for the capitalization and inclusion in inventory of costs of certain expenses. In general costs of inventory as well as direct and indirect costs of holding inventory are expenses that would be subject to capitalization and not deductible until sold. If the small business taxpayer qualifies for the exemption noted above, these costs could be deductible immediately. IRC §471 provides for additional rules on accounting methods acceptable for the accrual-based accounting for inventory. Additionally, the accrued based small business taxpayer is subject to IRC §460 which prescribes the percentage of completion method of accounting method to be applied to long term contracts. Long term contracts are any revenue generating arrangement that extends beyond a current taxable year.
This new guidance now defines a small business taxpayer as one, other than a tax shelter, that demonstrates it has average gross receipts for the three prior taxable years of $25,000,000 or less. The expanded scope of this regulation provides small business flexibility in tax planning for 2018 and beyond. Please keep in mind that the current regulation requires that the small business taxpayer secure the consent of the Commissioner of the IRS before changing the method of accounting for federal income tax purposes. This can be accomplished by filing form 3115 with the IRS.
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Special Rules for Capital Gains Invested in Opportunity Zones
One aspect of the 2017 Tax Cuts and Jobs Act (or “TCJA”) that could provide investors with capital gains a tax planning opportunity is §1400Z-2, Special Rules for Capital Gains Invested in Opportunity Zones. On October 19, 2018 the IRS issued proposed regulations which clarify some of the points in the new code section. What this new code section provides is an opportunity for a taxpayer to defer capital gains through reinvesting capital gain proceeds in a Qualifying Opportunity Fund (or “QOF”). This new rule enables the taxpayer to defer capital gains for the period in which the taxpayer holds the reinvested amount in the QOF. Unlike other Federal incentives, this Code section does not provide a direct tax credit rather a deferral of eligible taxable capital gains. Therefore, those investors who might not have the tax capacity to utilize a direct tax credit can now enhance the internal rate of return of a qualifying investment with this tax deferral. The deferral, which ostensibly is an interest free loan, should not only enhance the internal rate of return of the qualifying investment but it should also increase the absolute dollar for dollar return. This can be seen in the following example which demonstrates a 200-basis point increase in yield by taking advantage of this tax incentive:
This new code section defines a QOF as any investment vehicle which is organized as a corporation or a partnership for the purpose of investing in qualified opportunity zone property. The Department of Treasury Community Development Institutions Fund provides a state by state map which highlights all of the qualifying opportunity zones. Surprisingly these Opportunity Zones are not limited to major cities. If a Western Connecticut resident wished to locally reinvest the proceeds of a capital gain from a 2018 or later transaction they could do so and potentially defer this gain from their current and near-term tax returns. In the Danbury, Connecticut area, any business whose asset base is located in an area surrounding Main Street from its’ southern point running north close to Interstate 84, would qualify.
The basis in the Qualifying Investment Fund, for tax purposes would be zero. This basis would increase over the holder’s period of the investment. Therefore, any sale of the QOF would result in a capital gains tax on 100% of the proceeds of the sale. Under §1400Z-2(B)(2)(b)(ii) the basis would increase by an amount equal to 10% of the deferred gain for investments held for at least five years and an additional 5% of the deferred gain for investments held for at least seven years. In the case of any investment held for at least ten years, the tax basis of such property shall be equal to the fair market value of such property the date that the investment is sold or exchanged.
The proposed regulations issued on October 19, 2018 further clarify that any post-acquisition gains recognized on QOF investment held for at least 10 years are excluded from gross income. This would be accomplished by the taxpayer electing to step up the basis in the investment to the current fair market value. The examples above presume that the ultimate sale of the QOF will meet the requirement set forth in the Internal Revenue Code for this class of asset and the regulations thereon.
The proposed regulation issued by the IRS on October 19, 2018 is subject to a period of review and public commentary with a public hearing scheduled for January 19, 2019. The definitions noted above and included in the proposed regulation and the numerous points that the proposed regulation considered and were not included in this discussion, could have an impact on the application of this new code section.