December 27th update: On December 22nd, the IRS published a helpful FAQ available here, which among other things clarified that the $2,000 credit for heat pumps is in addition to the $1,200 credit for building envelope improvements, for a maximum possible credit of $3,200. Huzzah!

On Friday, the House passed the Inflation Reduction Act; it now goes to President Biden for his signature. There are three new tax credits in this law every homeowner should know about: the Energy Efficient Home Improvement Credit, the Residential Clean Energy Credit, and the Alternative Fuel Vehicle Refueling Property Credit (for electric vehicle chargers).

Note: These credits are nonrefundable—in other words, you need to have at least $500 of tax liability to claim a $500 credit.

The Energy Efficient Home Improvement Credit (IRC § 25C)

Section 13301 of the Inflation Reduction Act rebrands the Nonbusiness Energy Property credit as the “Energy Efficient Home Improvement Credit.” The bill extends the credit to December 31, 2032, and significantly expands the credit to be more generous. These new rules apply to property placed in service after December 31, 2022.

What qualifies for the tax credit?

In general, the credit is equal to 30% of what you spent on qualified energy efficiency improvements, residential energy property, and home energy audits during the year (though there are annual limits, which I describe later).

Qualified energy efficiency improvements

Qualified energy efficiency improvements are building envelope improvements. This includes insulation, energy-efficient windows, and energy-efficient exterior doors.

To qualify for the credit, these improvements to the building envelope need to meet certain criteria:

• Windows – must meet Energy Star most efficient certification requirements.
• Exterior doors – must meet applicable Energy Star requirements.
• Insulation – must meet prescriptive criteria from a recent International Energy Conservation Code.

In addition to these component-specific rules, there are some general rules the improvements must follow, too. The improvement must be installed in the United States, you must be the original user of the improvement, you must reasonably expect to use the improvement for at least 5 years, and the improvement must be to your principal residence (as that term is defined by Section 121 of the Internal Revenue Code).

Residential energy property

Residential energy property is, in a nutshell, energy-efficient versions of appliances that heat or cool the air inside of your home, or heat water in your home. The term includes:

• Heat pumps, central air conditioners, water heaters, furnaces, and boilers as long as the appliance meets the highest efficiency tier (not including advanced tiers) established by the Consortium for Energy Efficiency;
• Biomass stoves and boilers with a thermal efficiency rating of at least 75 percent;
• Certain energy-efficient oil furnaces and hot water boilers; and
• Cost to upgrade a panel to at least 200 amps if the panel upgrade was installed in conjunction with, and enabled the installation and use of, any qualified energy efficiency improvements or other residential energy property (e.g., your home needed a panel upgrade to install an electric heat pump).

You can include labor costs in the total cost of residential energy property when calculating your credit.

As is the case for building envelope improvements, there are some additional rules you’ll need to follow to get a credit for purchasing one of these energy efficient appliances. The property must be installed in the United States, you must be the original user of the property, and the property must be installed on or in connection with a dwelling unit you use as a residence (not necessarily your principal residence).

Home energy audits

A home energy audit is exactly what you’d expect: a home energy auditor comes to your home and identifies the most significant and cost-effective energy improvements you could make. Predictably, the audit must be for a home in the United States and it must be for your principal residence. The Treasury will explain certification requirements for home energy auditors in future regulations.

How will I know if the improvement I purchased qualifies for the credit?

Starting in 2025, the Treasury will have a new system of product identification numbers to verify if property is eligible for the credit. Before then, you’ll have to rely on the definitions in the statute (explained in the previous section).

How to calculate the credit

As mentioned above, the general formula is that the credit is equal to 30% of what you spent on “qualified energy efficiency improvements,” “residential energy property,” and “home energy audits” during the year. But there are limits to the credit.

Annual limits

In my opinion, these caps are too complicated. But we’re stuck with the complexity, so here we go:

Component-specific limits

Windows. Limited to $600 per taxpayer per year. So, you could spend up to $2,000 on new energy-efficient windows in a given year and still get the full credit, since 30% × $2,000 = $600.

Exterior doors. Limited to $250 per door, and $500 for all doors, per taxpayer per year. So, you could spend up to $833 on an energy-efficient door—and $1,667 on multiple energy-efficient doors—in a given year and still get the full credit, since 30% × $833 = $250 and 30% × $1,667 = $500.

Residential energy property. Limited to $600 per taxpayer per year, just like windows.

Home energy audits. Limited to $150 per taxpayer per year.

Total annual limit

The total annual cap to the credit is $1,200 per year. This $1,200 cap applies to almost every type of improvement that qualifies for the credit: e.g., windows, doors, insulation, air conditioners, furnaces, panel upgrades, home energy audits.

Example 1: In 2023, a homeowner spends $2,500 on Energy Star most-efficient windows, $700 on one Energy Star door, $900 on another Energy Star door,  and $5,000 to upgrade their home’s insulation. They calculate their tax credit as follows:

Because it’s an annual limit, you can sometimes get a larger credit if you break a project up over multiple years.

Example 2: Assume the same facts as before, except the homeowner installs the windows and doors in 2023 and the insulation in 2024. In this case, the total credit for the project is $2,260, while in Example 1 it was only $1,200:

The heat pump exception

The $1,200 annual limit and the $600 residential energy property limit don’t apply to heat pumps; instead, heat pumps get their own annual credit cap of $2,000. So, you could spend up to $6,667 on a new heat pump in a given year and still get the full credit, since 30% × $6,667 = $2,000. (This exception applies to biomass stoves and boilers, too.)

Example 3: In 2023, a homeowner spends $6,000 to install a new heat pump. They calculate their tax credit as follows:

One final comment about these credit limits: I suspect the IRS will issue an updated version of Form 5695 within the next several months. (That’s the form you’ll use to claim these credits.) Once that’s available, you can use the form and its instructions as you plan your home improvements to confirm you understand the credit formulas correctly.

How utility rebates interact with the credit

I mentioned this in our blog post on the Inflation Reduction Act for real estate investors, but it’s worth repeating here: there’s a bit of tax law, Section 136, that exempts some utility rebates from taxable income.

More specifically, Section 136 says a taxpayer’s gross income doesn’t include “any subsidy provided (directly or indirectly) by a public utility to a customer for the purchase or installation of any energy conservation measure.” This section also says, “no deduction or credit shall be allowed for, or by reason of, any expenditure to the extent of the amount excluded under subsection (a) for any subsidy which was provided with respect to such expenditure.”

That’s potentially relevant for all tax credits I’ll mention in this article, but it’s particularly relevant to the Energy Efficient Home Improvement Credit. It means that when you calculate your tax credit for something like new windows or a new heat pump, you’ll need to first subtract any utility rebates from the cost of the improvement, and then multiply the cost by 30%.

The Residential Clean Energy Credit (IRC § 25D)

Section 13302 of the Inflation Reduction Act rebrands the residential energy efficient property credit as the “Residential Clean Energy Credit”—a fitting name, since this credit is most commonly used for residential solar panels.

The bill extends the credit to December 31, 2034, alters the phase-out schedule, and slightly modifies which property qualifies for the credit. For the most part, the new rules apply to property placed in service after December 31, 2021. Starting in 2023, biomass stoves no longer qualify for a credit under Section 25D, but battery storage technology does.

The new phase-out schedule is:

Example 4: You install a $20,000 solar panel system on your home in 2022. Your credit is 30% of the cost of the system—so, $6,000.

Example 5: You install a $20,000 solar panel system on your home in 2033. Your credit is 26% of the cost of the system—so, $5,200.

A final comment about the Residential Clean Energy Credit: while this credit isn’t refundable, you can carry it forward to reduce your tax liability in future years.

Applying the credits to condominiums and cooperative housing associations

If a cooperative housing association installs property or improvements that qualify for a credit under Sections 25C or 25D, the tenant-stockholders of the corporation claim the credit in much the same way they claim an itemized deduction for property taxes. In other words, the expenditure is allocated to the tenant-stockholder on their “proportionate share” of the expenditure. The tax law uses similar, albeit less detailed, language to explain how to allocate expenditures of a condominium management association.

For example, in my housing cooperative I own 55 shares, which is 2.8947% of the total outstanding stock in the corporation (1,900 shares). If my building spends, say, $60,000 in 2025 to replace some of our windows with Energy Star most efficient windows, I can report on my 2025 personal tax return that I spent $1,737 on those windows (because, well, through the co-op dues I did) and claim a $521 credit for that year.

One final comment about energy credits and housing cooperatives: in 2010, the Office of Chief Counsel noted in IRS Information Letter 2010-0244 that when a tenant-stockholder arranges for and purchases the improvement themselves, they are entitled to a credit based on the entire expenditure (as one would expect).

The EV Charger Credit (IRC § 30C)

I discussed the new EV charger credit in a previous blog post for real estate investors, so I won’t go into too much detail here. But know that a smaller version of the EV charger credit is available for homeowners located in a low-income community or rural area. That credit is 30% of the cost of the charger up to a $1,000 limit. And if you’re a homeowner, you don’t need to worry about the prevailing wage and apprenticeship rules that apply to businesses and real estate investors.

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Tax increases in the bill

Here’s some good news: if you’re a small business owner or real estate investor, the Inflation Reduction Act probably doesn’t raise your taxes.

The major revenue raisers in this bill are:

• A new book minimum tax for large ($1 billion+ average book income) C corporations
• A new excise tax on stock buybacks (only applies to publicly-traded corporations)
• Extension of excess business loss limitation rules from 2026 to 2028
• Increased money for IRS enforcement

The extension of the excess business loss limitation rules will hit some real estate investors. But for most folks in this category, we think the increased money for the IRS will be the most visible and meaningful change to our tax system due to this law. As we’ve frequently noted on this blog, keeping good records and staying on top of your bookkeeping are the two most important ways to protect yourself in an audit.

Tax increases not in the bill

Back in the autumn of 2021, Democrats had proposed significant changes to the federal income tax code. In response to these proposals we wrote a blog post last September on the slow death of the S corporation, had the ideas become law.

Well, it turns out reports of the S corporation’s death were greatly exaggerated; the Inflation Reduction Act contains no changes to the net investment income tax, or NIIT. It also contains no changes to the basis step-up rules for inherited assets, no change to the unified gift/estate tax credit, and no changes to IRA contribution or distribution rules. In fact, we could write a whole laundry list of proposed changes that never found their way into the Inflation Reduction Act—and we have:

• No change to top marginal rate for individuals
• No changes to capital gains tax rates
• No “billionaire tax”
• No changes to SALT
• No changes to 199A
• No change to carried interest loophole
• No change to 21% C corporation rate
• No new limits on deductibility of interest expense for C corporations
• No changes to limit 1202 exclusions
• No changes to expand wash sale rules
• No changes to foreign tax credit
• No changes to GILTI, FDII, or BEAT

So, what else is in this bill? Well, a lot of climate change-related stuff.

Green tax incentives for real estate investors

Real estate investors may be interested in the bill’s tax incentives for green retrofits—especially if your building is in Washington State and subject to the Clean Buildings law.

For multifamily and commercial buildings: a 179D revamp

Section 13303 of the Inflation Reduction Act dusts the cobwebs off Section 179D of the tax code. The 179D deduction is, in essence, a depreciation acceleration trick similar to the Section 179 deduction small business owners are familiar with. The basic idea is if a real estate investor either (1) purchases a new energy efficient building or (2) makes a deep energy retrofit to an existing building, the investor can deduct a large chunk of the cost of that asset in the first year instead of waiting several years to deduct the cost as “depreciation expense.”

The amount a taxpayer can deduct up front is the lesser of either (1) the cost of the retrofit or (2) the result of a complex formula built around an efficiency engineering standard, ASHRAE Standard 90.1. Predictably, then, one of the rules for claiming a 179D deduction is that an independent licensed engineer (or in some cases, an architect) must certify the energy savings targets before the taxpayer can claim the deduction.

We’re not going to go into the nuts and bolts of the formula here, because really the way to claim this deduction is to hire a consulting firm staffed with tax professionals and engineers to design the retrofit to maximize the deduction for you. They’ll calculate your deduction and prepare a report for your regular tax accountant as part of that process. But here are a few key things to understand about Section 179D if you’re interested in this tax savings opportunity.

First, know that this deduction is for larger buildings: think commercial buildings, 4+ story apartment buildings, schools, hospitals, etc.

Second, know that a 179D deduction isn’t something to start thinking about when it’s time to prepare your tax return for the year. You need to decide whether you’ll claim this deduction before you begin the project. That’s because you’ll want to choose a design firm that really knows Section 179D and the ASHRAE standard it rests on, to make sure their design meets the tax law’s requirements. And if you want to claim the full deduction, not just part of it, you’ll need to be sure the building contractor you select for the construction work understands and complies with the Inflation Reduction Act’s new prevailing wage and apprenticeship rules.

Third, for the sake of my own conscience, I feel I ought to point out that the consulting fees for calculating 179D deductions can be very expensive. And some big players have gotten into hot water after being fairly aggressive with this stuff.

Finally, this may be an odd thing for a tax accountant to admit, but there are options for funding deep energy retrofits that go beyond tax deductions and credits. For example, some sophisticated real estate investors in Seattle are experimenting with a novel transaction structure called the “metered energy efficiency transaction structure,” or “MEETS” for short. And King County recently launched a PACE loan program. Of course, we can’t endorse any particular financing idea for you if we don’t know your situation. But we want to acknowledge that there are many options to consider.

For buildings with a sunny roof: the commercial solar panel credit

Section 13102 of the Inflation Reduction Act extends the commercial tax credit for solar panels (in Section 48 of the IRC) to 2034, with a phase-out beginning in 2032. Starting January 1, 2022, your maximum tax savings will be 30% of whatever the panels cost your business or real estate activity.

Example: You install a $20,000 solar panel system on a duplex you own and lease to tenants. If you qualify for the credit and meet the wage and apprenticeship rules, the IRS will pay for 30% of the cost of the system—so, $6,000.

That probably already sounds pretty good. But here’s where the numbers get silly. In addition to getting a (usually 30%) tax credit, Section 48 “energy property” also gets a 5-year asset life under MACRS. What’s more, the section 48 credit reduces the basis for depreciation by only half the credit amount. And while you can’t use the Section 179 deduction on any property you’ve claimed the Section 48 energy credit on, for the next few years you can likely use bonus depreciation to achieve a similar result.

So, just to put this all together: if a landlord installs a solar energy system on a building it owns and rents to tenants, or a small business installs a solar energy system on a building it owns and uses for business, not only will the IRS pay for up to 30% of the cost of the solar panels, but the panels get depreciated over just 5 years (even though in reality the panels will likely last for 25-30 years). What’s more, even though you might think the depreciable basis would be the 70% of the cost of the panel the landlord or business owner paid themselves, really the basis for depreciation is 85% of the total cost of the panels (because only ½ of the credit is subtracted from the depreciable basis). And remember, just like any other 5-year property, the depreciable basis can be (at least partially) expensed using the bonus depreciation rules, depending on what year you install and start using the property.

Now, of course Congress has attached some strings to all of this free money. The panel system must be new, not used, and it needs to be located in the United States. You’ll also need to comply with the Inflation Reduction Act’s new prevailing wage and apprenticeship rules, or the credit is only 6%. And you must hold the property at least 5 years or the IRS will recapture the credit.

One final comment: the Inflation Reduction Act adds 10% to your solar panel credit if you install the panels in a low-income community, and 20% if you install the panels on a qualified low-income residential building project. There are also bonus credits for using domestic content and for installing panels in an “energy community” (think West Virginia coal country).

For parking lots in low income or rural areas: the EV charger credit

Section 13404 of the Inflation Reduction Act extends and modifies the Alternative Fuel Refueling Property Credit. “Alternative refueling property” includes electric vehicle charging stations, so this credit is relevant for any building owner who would like to install EV chargers in their parking garage or parking lot.

The new EV charger credit rules apply to property placed in service after December 31, 2022, and the credit expires December 31, 2032. One notable difference between the Senate Finance Committee proposal and what passed the Senate last Sunday: this credit is now only available to EV chargers installed in low income communities and rural areas. It’s also worth noting that the Inflation Reduction Act modifies section 30C to make bidirectional charging equipment and charging equipment for 2- and 3-wheelers eligible for the credit.

Example: You own a small office building in a low-income community and install 10 level 2 EV chargers in the building’s parking lot for $3,500 each (including parts and labor). If you qualify for the credit and meet the wage and apprenticeship rules, the IRS will pay for 30% of the cost of the chargers—so, $10,500.

Predictably, there are some strings attached. The charger must be new, not used, and it needs to be located in the United States. To get the full 30% credit, you’ll need to comply with the Inflation Reduction Act’s new prevailing wage and apprenticeship rules; otherwise, the credit is only 6%. And the credit is limited to $100,000 per item of property (that limit used to be $30,000 and it used to apply per location, not per item).

The Inflation Reduction Act keeps language in the old statute which says recapture rules “similar to” the rules of 179A apply to the credit. Section 179A has since been repealed, and the IRS never actually put out formal guidance on how the recapture rules work. All we have is an 11-page notice, IRS Notice 2007-43.

For housing developers: the Energy Efficient Home Credit

If you’re a housing developer who specializes in building energy efficient homes, you’ve probably been watching this provision in Build Ba—er, the Inflation Reduction Act—for months. But for the sake of thoroughness, we’ll note that section 13304 extended the Energy Efficient Home Credit (in section 45L of the Internal Revenue Code) to 2032, increased the credit’s size, and modified the eligibility requirements.

The old version of the credit provided $2,000 to eligible contractors for each newly constructed or “substantially reconstructed” home if the home consumed 50% less energy than a comparable dwelling unit and had a building envelope that accounted for at least 1/5 of the energy reductions. The Inflation Reduction Act increases this amount to $2,500 for homes meeting Energy Star requirements and $5,000 for zero energy ready homes, assuming the project meets new prevailing wage and apprenticeship requirements.

The new credit rules apply to dwelling units acquired after December 31, 2022.

How the credits interact with utility rebates

One final thing I’ll mention is how the tax code treats utility rebates, and how those rebates interact with the tax credits I’ve described in this blog post.

In general, utility rebates are taxable income. But section 136 of the Internal Revenue Code says a taxpayer’s gross income doesn’t include “any subsidy provided (directly or indirectly) by a public utility to a customer for the purchase or installation of any energy conservation measure.” This section also says taxpayers can’t claim a tax credit or deduction for any amount paid for with this sort of utility rebate.

So, if you claim a rebate from your local utility for a purchase that meets the statute’s definition of an “energy conservation measure,” you won’t need to pay income tax on the amount, which is good. But you’ll also need to subtract that amount from the purchase price first before calculating any tax deductions or credits. For example, if you install solar panels on an apartment building you own and claim a utility rebate for the panels, and the rebate counts as an “energy conservation measure” under Section 136, you’ll need to subtract the rebate from the cost of the panels before calculating the credit.

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The Strategy in a Nutshell

To explain the tax benefit of accelerated depreciation, it’s important to first understand what accountants mean when we use the word “depreciation”—because it’s probably not what you think.

What is “depreciation”?

So, here’s a weird thing: when accountants talk about “depreciation,” we’re talking about a number that has nothing to do with an asset losing value. I know, this sounds like nonsense. But let me explain.

If a taxpayer purchases an expensive asset that they’ll (1) use over several years to (2) generate revenue (such as a building purchased to rent to tenants), accountants don’t subtract the cost of the asset from income the year the purchase is made. Instead, we break up the cost of that asset into pieces and subtract a piece from income each year over the several years the taxpayer uses the asset to generate revenue.

The number of pieces the cost gets broken into depends on the type of asset the taxpayer invested in and how long the IRS thinks the asset is likely to last. For example, residential real estate is broken up over 27.5 years. Nonresidential real estate is broken up over 39 years. And the cost of other assets (e.g., appliances, cars, computers) is broken up into larger pieces over fewer years.

For reasons that aren’t really clear (at least to me), the convention is to label this expense as “depreciation” on the profit and loss statement. But that’s not really right—the accounting department did nothing to determine whether the asset in question lost value. Instead, this expense should really be labelled something like, “this year’s fraction of the cost of assets we bought some number of years ago.” It’s clunky, but it would be a much less confusing label.

Why Accelerate Depreciation?

So, why would a taxpayer want to accelerate depreciation deductions? Well, two reasons.

First, you can sometimes time an accelerated depreciation deduction to occur in a year with a big spike in ordinary income, thus avoiding a higher-than-normal tax rate.

Example: A high-income taxpayer has nonqualified employee stock options he wants to exercise before they expire. But he’s leery of recognizing so much ordinary income in one year due to the progressive rate structure of the U.S. income tax code. What’s more, he may predict that tax rates on ordinary income will be lower in the future than they are now. One idea for this taxpayer? Invest in a new real estate activity or small business and use a depreciation acceleration strategy to add a large deduction to his tax return in a year when his income and tax rate are otherwise very high.

A second, more abstract, but similarly lucrative benefit? If you can get out of having to wait several years to subtract the full cost of your investment from your income—in other words, if you can subtract the entire cost in the first year, or first few years, you use the asset—you end up with more money in your pocket than you would have otherwise.

Why? Because of the time value of money.

Assuming your tax rate stays constant over the life of your real estate investment, accelerating when you claim the deduction for the cost of the investment won’t lower your lifetime tax bill on paper. But remember that for the years you delay paying the tax, you can instead keep the money that would have gone to the IRS in an investment that earns you a return. Maybe you reinvest that money into your business, and so support additional growth in your firm. Maybe you invest it in an index fund. Or perhaps you just pay down a loan more quickly than you would have otherwise.

Possible Tax Savings

Taxpayers see an immediate reduction in income taxes in the year they deduct depreciation.

For example, if a taxpayer’s return includes a $100,000 deduction and her marginal tax rate equals 40 percent, the depreciation deduction likely lowers that year’s tax bill by $40,000.

Calculating the true savings of the accelerated depreciation, however, requires more work. The calculations also require additional information.

To keep the numbers simple, however, if a taxpayer saves $40,000 in taxes all at once rather than, say, $4,000 a year over ten years, that might deliver a time value of money benefit somewhere between $15,000 and $20,000. (I use a 15 percent annual discount rate to make this calculation.)

And then if a taxpayer can use a $100,000 deduction when the tax rate equals 40% rather than 20%, that obviously saves a large amount, too. In this simple example, it saves $20,000.

Turbocharging the Strategy

For much of the property a taxpayer depreciates, tax laws already allow for accelerated depreciation that frontloads depreciation in the early years of an investment.

Often taxpayers, for example, can use a Section 179 election to expense as much as roughly $1,000,000 of the cost of the personal property in the year the asset goes into service. (That million-dollar limit adjusts annually for inflation. In 2021, for example, the Section 179 limit is $1,050,000. Also note that a taxpayer’s income and other asset purchases factor into the maximum Section 179 deduction.)

Most taxpayers can also use bonus depreciation to immediately expense 100 percent of the cost of assets placed into service in 2021 or 2022 if the assets’ recovery period equals 20 years or less.

Finally, for situations where Section 179 and bonus depreciation don’t give a taxpayer a highly accelerated depreciation deduction? No problem. Three other big tricks exist for turbocharging depreciation deductions. One is to take advantage of the qualified improvement property rules, which relax the rules for when someone can use bonus depreciation. Another is to do something called a “cost segregation study,” which essentially transforms real property into personal property. And a third strategy is to use something called the “179D deduction,” a green building incentive that might be revamped in the Build Back Better bill (i.e., the reconciliation bill).

You’ll want to confer with your tax accountant. You likely need their help to assemble the right depreciation choices that save you taxes and generate time value of money benefits.

But know that these tricks all achieve the same fundamental thing: more of an asset’s cost is subtracted from taxable income earlier in the asset’s life. And possibly more of the asset’s cost is deducted in higher-income years.

Limits to the Strategy

The big caution taxpayers need to be aware of is that Congress has put complex rules into the tax code that limit taxpayers’ ability to deduct large losses from real estate and similar investments. Specifically, four loss limitation regimes to be aware of are the outside basis limitation rules (relevant for investors in partnerships and S corporations), the at-risk rules, the passive activity rules, and the excess business loss rules.

One can often sidestep these rules, but most taxpayers need the help of a skilled tax adviser to do so. And the taxpayer will need to have good recordkeeping to support claiming the loss. For example, if a taxpayer’s ability to claim a large loss rests on meeting the definition of a “real estate professional,” she ought to keep a detailed log of the hours she spends on the activity to prove she really meets that definition.

Another thing to keep in mind? A taxpayer should exercise caution when using accelerated depreciation for cars, boats, and planes or for property that is of a type often used for entertainment, recreation, or amusement. The reason? This property, called “listed property,” creates trouble for taxpayers if they happen to later convert the property from business use to personal use.

Which Taxpayers the Strategy Works Best For

Accelerated depreciation works best as a tax saving strategy for landlords and small businesses considering a large investment in real estate or significant capital assets (like vehicles, equipment, and machinery) and for taxpayers with an unusually high-income year.

Accelerated depreciation works best as a time-value-of-money strategy for investors and entrepreneurs able to invest tax savings in a venture that delivers a high rate of return. So small business. Or a leveraged real estate investment.

Other Information Sources

The IRS provides a great publication about how current depreciation rules work here: Publication 946: How to Depreciate Property.

If you’re interested in an example of how to avoid the loss limitation rules I mentioned earlier, we published an earlier post about the vacation rental strategy in November. We also have a post on the real estate professional rules, another strategy to allow losses.

Finally, taxpayers likely need a tax accountant’s help to maximize the benefits of accelerating depreciation. So do ask your tax advisor to consider these issues. And do give them both the time and the information they need to come up with smart recommendations. Finally, this plug for our accounting firm: If you don’t have a tax advisor who can help with this sort of stuff? You can contact us here: Nelson CPA.

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B&O Basics

Washington’s B&O tax recognizes three main categories of businesses, which it treats differently and subjects to different tax rates:

• Retailers
• Wholesalers
• Service businesses

That last category is often referred to as “apportionable activities,” and in addition to service businesses, it also includes royalty income and a hodgepodge of other seemingly-random industries. [See RCW 82.04.460(4)(a) for more on apportionable activities.]

When Do I Have B&O Nexus in Washington?

For wholesalers and apportionable activities, Washington defines nexus for B&O tax purposes in RCW 82.04.067(1):

1. A person engaging in business is deemed to have substantial nexus with this state if, in the current or immediately preceding calendar year, the person is:
   1. An individual and is a resident or domiciliary of this state;
   2. A business entity and is organized or commercially domiciled in this state; or
   3. A nonresident individual or a business entity that is organized or commercially domiciled outside this state, and the person had:
      1. More than fifty-three thousand dollars of property in this state;
      2. More than fifty-three thousand dollars of payroll in this state;
      3. More than two hundred sixty-seven thousand dollars of receipts from this state; or
      4. At least twenty-five percent of the person’s total property, total payroll, or total receipts in this state.

For all other types of business activities, mainly retail, a business has nexus if its physically present in the state, or if it meets the gross receipts part of the nexus test described above [RCW 82.04.067(6)].

And one final note: those specific dollar amounts listed in (1)(c) are adjusted every year for inflation. As of this writing, the current thresholds, for both apportionable sales and wholesale sales, are:

• $57,000 of property
• $57,000 of payroll
• $285,000 of gross receipts

Finally, note that WAC 458-20-194(2) contains a more detailed explanation of the Washington Department of Revenue’s interpretation of nexus rules, including several examples.

What Counts as “Engaging Within the State”?

Per RCW 82.04.066:

“Engaging within this state” and “engaging within the state,” when used in connection with any apportionable activity as defined in RCW 82.04.460 or selling activity taxable under RCW 82.04.250(1), 82.04.257(1), or 82.04.270, means that a person generates gross income of the business from sources within this state, such as customers or intangible property located in this state, regardless of whether the person is physically present in this state.

What Counts as “Property in the State”?

The definition of “property” for the purpose of determining nexus is from RCW 82.04.067(2):

Property counting toward the thresholds in subsection (1)(c)(i) and (iv) of this section is the average value of the taxpayer’s property, including intangible property, owned or rented and used in this state during the current or immediately preceding calendar year.

In most cases, you determine the value of property you own by simply using the original price you bought it for [RCW 82.04.067(2)(b)(i)]. For property you rent, you determine the value by multiplying your annual rent by eight [RCW 82.04.067(2)(b)(ii)]. If your business makes loans, there are special rules for determining the value of those assets. And computer software and other digital goods get a special loophole in RCW 82.04.067(2)(e).

What Counts as “Payroll in the State”?

The definition of “payroll” for the purpose of determining nexus is from RCW 82.04.067(3):

Payroll counting toward the thresholds in subsection (1)(c)(ii) and (iv) of this section is the total amount paid by the taxpayer for compensation in this state during the current or immediately preceding calendar year plus nonemployee compensation paid to representative third parties in this state. Nonemployee compensation paid to representative third parties includes the gross amount paid to nonemployees who represent the taxpayer in interactions with the taxpayer’s clients and includes sales commissions.

That point the law makes about “representative third parties” exists to close a potential loophole for determining nexus. One trick that some businesses tried in the past was to call all of their workers in a state “independent contractors,” not “employees.” The idea was that without any employees in the state, the business didn’t have nexus in the state.

However, in Scripto, Inc. v. Carson (362 U.S. 207, 1960) the Supreme Court determined that this trick didn’t work. Scripto, Inc. was an Atlanta-based business that hired 10 salesmen as independent contractors to regularly solicit sales in Florida. In response to Scripto’s argument that it had no nexus in Florida because it had no employees, the Court had this to say:

True, the “salesmen” are not regular employees of appellant devoting full time to its service, but we conclude that such a fine distinction is without constitutional significance. The formal shift in the contractual tagging of the salesman as “independent” neither results in changing his local function of solicitation nor bears upon its effectiveness in securing a substantial flow of goods into Florida… To permit such formal “contractual shifts” to make a constitutional difference would open the gates to a stampede of tax avoidance.

What Counts as “Receipts from the State”?

The definition of “receipts from the state” for the purpose of determining nexus is from RCW 82.04.067(4). Generally speaking the rules for sourcing sales of tangible property, whether retail or wholesale, are the same for B&O tax purposes as for sales tax purposes—i.e., it’s destination based.

For apportionable activities, you use the same value for “receipts attributable to Washington” as you would use in Washington’s apportionment formula, described later in this article. Washington uses a tiered system, but for now it’s enough to know that for a service business you generally attribute receipts based on the location where the customer received the benefit of the service your business provided.

What About Public Law 86-272?

So, here’s the awkward thing about P.L. 86-272. It only applies to income taxes. And the tax base for Washington’s B&O tax isn’t income, it’s gross receipts. So multistate businesses can’t use Pub. Law 86-272 to claim they don’t have nexus for B&O tax purposes.

How Does B&O Allocation and Apportionment Work?

If your business doesn’t have B&O tax nexus in Washington, then you don’t need to worry about paying Washington B&O tax on any of your business’ revenues. But if your business does have nexus in Washington, your next step is to figure out how much of your business’ revenue is Washington’s “share” to tax.

For sales of tangible personal property, you calculate Washington’s “share” of your business’ gross receipts using the destination-based sourcing rules in RCW 82.32.730. For examples of the application of these rules, see WAC 458-20-193. You’ll notice that these tangible property sourcing rules for B&O are the same sourcing rules as apply for retail sales tax, as we described in our last blog post.

On the other hand, for apportionable activities (e.g. service businesses and royalty income), you calculate these “shares” using Washington’s apportionment formula, described below.

What’s the Apportionment Formula?

Per RCW 82.04.462, the apportionment formula for determining what portion of gross receipts are subject to Washington B&O is:

WA Receipts = Apportionable Receipts × (Receipts Attributable to WA)/(Total Receipts – Receipts Attributable to a State Business Doesn’t Pay Tax To)

One significant thing to note about this formula is that if a business only has nexus in Washington State, and no other state, then 100% of the business’ gross receipts will be subject to Washington B&O, even if the business has out-of-state customers. This is because, in such a situation, the denominator of the “receipts factor” will equal the numerator.

What Does it Mean for Apportionable Income to be Attributable to Washington?

Under Washington’s tax laws, apportionable income—which again, is mostly service income and royalty income—is attributed to states under a tiered system. Essentially you apply the first rule in the list if you can, and if applying that rule is impossible, you move on down the list until you get to a rule that’s decently workable.

What Does it Mean for Income to be “Taxable in Another State”?

Per RCW 82.04.460(4)(b):

“Taxable in another state” means that the taxpayer is subject to a business activities tax by another state on its income received from engaging in apportionable activities; or the taxpayer is not subject to a business activities tax by another state on its income received from engaging in apportionable activities, but any other state has jurisdiction to subject the taxpayer to a business activities tax on such income under the substantial nexus standards in RCW 82.04.067(1).

How Do I Know My B&O Tax Rate?

Once you know whether or not you have Washington B&O tax nexus, and which receipts count as Washington receipts, you’re largely past the difficult part. Your last step is to simply multiply your Washington gross receipts for the taxing period (usually a month) by your B&O tax rate.

The general rates for the major categories of businesses are:

However, note that many industries in Washington State have successfully lobbied for special, lower tax rates. The Washington Department of Revenue has a helpful list of such rates here.

When it’s time to file your tax return and pay your B&O tax, you’ll take care of it on the same tax return you use to file and pay sales tax. You file this combined excise tax return using the Washington Department of Revenue’s online portal, MyDOR (this is the same account you used when you applied for a Washington business license). If you use QuickBooks, this can make accounting for B&O payments a bit tricky, but we provided some ideas on how to deal with that issue in this prior blog post.

The post B&O Tax Nexus in Washington appeared first on Evergreen Small Business.

This blog post is the first in a two-part series. This post explains how Washington State sales tax works for multi-state businesses. Another blog post next week will explain how Washington’s B&O tax works for multi-state businesses.

Introduction to the Concept of “Nexus”

Steve discussed the concept of nexus in more detail in this older blog post. But the short version is, states can impose rules on businesses and collect taxes from those businesses if the business has enough of a connection to the state. This connection is referred to as “nexus,” and frustratingly, the case law on nexus is different for different types of taxes.

If your business has any amount of activity in Washington State (such as customers in Washington State, inventory located in Washington State, an office in Washington State, or people working in Washington State on your behalf), then you want to get up to speed on the nexus rules for both Washington sales tax and Washington B&O tax. And if your business is primarily based in Washington, but also does business in other states, you’ll want to know how Washington’s tax laws deal with that out-of-state activity.

How Washington’s Sales Tax Works in a Nutshell

You’re probably familiar to some degree with how sales tax works because you’ve seen it on sales receipts as an ordinary consumer.

A consumer who makes a taxable purchase in Washington pays the tax, and the business that makes the taxable sale collects the tax on the state’s behalf. Then, periodically, the business remits the tax to the Washington Department of Revenue.

The sales tax a consumer pays has both a state-level component, which is always 6.5%, and a local component, which can be as high as 3.6%, depending on what the voters in the locality have chosen. For example, the City of Seattle sales tax rate is currently 3.6%. Thus, when you purchase goods in Seattle, you pay a total sales tax rate of 10.1% (6.5 + 3.6). On the other hand, the City of Snohomish only has a local rate of 2.6%, so when you purchase goods in Snohomish, you pay a total sales tax rate of 9.1% (6.5 + 2.6). The Washington Department of Revenue has a comprehensive list of both current and historical local sales tax rates available here.

Bookkeeping for Sales Tax

When a business collects on a sale to a customer, it collects both the sale price for itself, and the sales tax for the government. However, the business only has to count the sales price portion as income in its books. The sales tax portion is instead described as an increase to a current liability account (often this account is called something like “Sales Tax Payable”). Then, when the business remits the sales tax to the state, in the books that payment decreases the liability account for sales tax.

Even though a business may owe sales tax for many local governments, the business remits the entirety of the sales tax it’s collected for Washington State jurisdictions to the Washington Department of Revenue. It reports this sales tax payment on a Washington Excise Tax Return. On this return, the business needs to do a careful job at noting which localities get which portion of the sales tax payment that’s being made with the return. Businesses file this combined return using the Washington Department of Revenue’s MyDOR portal. (It’s the same account your business uses to track its Washington business license.)

Therefore, a business needs to do the following in order to get sales tax right in Washington State:

• Identify when a sale is subject to sales tax in Washington
• Identify which local jurisdiction gets to tax the sale in Washington, if the sale is taxable
• Have an accounting system that can effectively track sales tax liabilities (not just the amount of the liability, but also which jurisdiction the tax is for)

I discuss these three issues later in this article.

One Quick Aside: Understanding Use Tax

I want to take the time to mention use tax in this article because it is an important loophole-closing provision in Washington State’s sales tax regime, and understanding it is essential for understanding the tax obligations both of your customers, and of your own business.

We all know the “trick” for getting out of paying Washington sales tax, right? Take a day trip to Portland, OR, where there is no sales tax, and take care of your major purchases there. Clever, no?

Well, you probably won’t be surprised to hear that, like any other state that collects sales tax, Washington knows this trick. And it’s closed this loophole with a response that’s pretty standard for states that charge sales tax: use tax.

Here’s how it works. Washington State says, “sure, Seattle resident, you can go buy your nice new TV in Portland. And no, the Portland business that sold it to you doesn’t need to collect Washington sales tax on the sale. But when you bring that TV back to use in your Seattle apartment, you need to pay use tax on the TV. What’s use tax? It’s 10.1% of what you paid for the TV in Portland, same as the amount of sales tax you would have paid if you had purchased the TV in Seattle.” (Consumers pay use tax using the Washington Department of Revenue’s MyDOR portal.)

This issue of use tax replacing sales tax explains why Justice Kennedy spoke about Wayfair rather scathingly in the Supreme Court’s recent South Dakota v. Wayfair decision:

Wayfair offers to sell a vast selection of furnishings.  Its advertising seeks to create an image of beautiful, peaceful homes, but it also says that “‘[o]ne of the best things about buying through Wayfair is that we do not have to charge sales tax.’”… What Wayfair ignores in its subtle offer to assist in tax evasion is that creating a dream home assumes solvent state and local governments.

It makes you wonder how the former justice would feel about the headline to this ad campaign from Portland’s tourism department.

When Do I Have Sales Tax Nexus in Washington?

If one or more of these four criteria apply to your business, then your business needs to collect and remit Washington State sales tax:

• Your business has a physical presence in Washington State, however slight [WAC 458-20-193]
• Your business has $100,000 or more in annual gross sales, or 200 or more annual transactions, in Washington State [emergency ruling] (this is essentially a copy of the South Dakota law upheld in the Wayfair case, linked above)
• Your business has a referral agreement with one or more Washington State residents, and your total referrals from all Washington residents exceeds $10,000 [RCW 82.08.052] (this is essentially a copy of New York’s Amazon law).

However, it’s important to note that Washington has a use tax reporting law, in addition to its regular sales tax laws. (These use tax reporting laws are sometimes referred to as “Colorado laws” because Colorado was the first state to use the trick.)

Washington’s use tax reporting law says that if your business has $10,000 or more in annual gross sales in Washington State, then your business needs to file a report with the Washington Department of Revenue detailing who each one of your Washington customers was and how much those customers bought (RCW 82.13.020). This is so the Department of Revenue has the information it needs to collect use tax from those customers. In addition, your business would also have to notify Washington customers with a detailed explanation of their use tax obligations, and how to pay that use tax.

If a business doesn’t want to provide this information to the Department of Revenue or its customers, it can opt out by voluntarily collecting sales tax. (In other words, if a business collects sales tax even when it doesn’t have to, it gets out of the use tax reporting requirement.)

What Counts as “Physical Presence”?

The Washington Department of Revenue lists on its website some examples of what it considers physical presence. The most obvious ways to have physical presence in Washington are to own property in the state, lease property in the state, or have employees working for you in the state. Note that owning property in the state includes stuff like storing your inventory in an Amazon warehouse in Washington State.

What Counts as a “Washington Sale”?

The sourcing rules for sales and use tax are in RCW 82.32.730, if you want to get into the nitty-gritty of it. But the short version is that Washington uses destination-based sales tax for sourcing retail sales. So, if you deliver goods to customers in Washington State who will presumably use those goods in Washington, then it’s a Washington sale.

What Types of Sales Are Subject to Sales Tax?

If you know your business has sales tax nexus in Washington State, your next step is to determine whether the sale is of a type subject to sales tax.

In general, any transaction that’s considered a “retail sale” of tangible personal property under state law is subject to sales tax [RCW 82.08.020]. Washington’s sales tax laws define “retail sale” as “any sale, lease, or rental for any purpose other than for resale, sublease, or subrent” [RCW 82.08.010(11)]. The definition of “retail sale” for sales tax also includes any sale that counts as a “retail sale” for B&O tax [RCW 82.08.020(1)(e)].

Among accountants, the common definition of “tangible property” is property that exists in the physical world, as opposed to “intangible property” like patents, copyrights, and trademarks. And “personal property” is any property that isn’t real estate. These are the definitions you’ll see on sites like Investopedia.

However, state laws have gotten more creative in the recent past about how they define “tangible property” as a way of expanding their sales tax base.

For example, Washington State’s sales tax laws define “tangible personal property” to include electricity, water, gas, steam, and prewritten computer software [RCW 82.08.010(7)]. And the state takes special care to clarify that personal property includes digital goods, digital codes, and digital automated services unless the context clearly indicates otherwise [RCW 82.08.010(10) and 82.08.020(1)(b)].

Businesses subject to Washington sales tax rules must charge customers sales tax on the full sales price. Washington’s sales tax laws define “sales price” to include things like delivery and installation charges, even if those charges are separately itemized [see RCW 82.08.010(1) and 82.08.145].

Exceptions to the General Rule

Know that Washington’s sales tax laws contain numerous exemptions. Many of these exemptions are pretty random, and are surely the result of successful industry lobbying efforts. But the most common exemptions fall into four major categories:

• Wholesale sales
• Non-Washington sales
• Sales handled by what’s called a “marketplace facilitator”
• Sales of basic needs like prescriptions and groceries

Note: it may be worth taking a brief skim though RCW 82.08 to see if there’s an exemption listed that applies to your business.

Exemption for Wholesale Sales

If your business sells items wholesale, then you don’t need to collect sales tax on the sale as long as you can prove that the sale wasn’t a retail sale. But note that under state law, the burden of demonstrating that a sale is a wholesale sale rather than a retail sale falls on the seller (see RCW 82.08.050, 82.04.470, and 82.08.140). So how does a business prove that its sales are wholesale? By collecting and saving reseller permits.

Save reseller permits for at least five years after the date of sale. If you aren’t careful about saving reseller permits and you get audited by the Washington Department of Revenue, they’ll charge you sales tax on the sales to any customers who you didn’t save a permit for.

Exemption for Non-Washington Sales

If you sell and deliver a product to a customer outside of Washington State, then you don’t need to collect sales tax as long as you document it properly. Note that non-Washington sales include sales to customers in other U.S. states, Native American tribes, and foreign countries (WAC 458-20-192, 458-20-193, and 458-20-193C).

In addition, non-residents of certain states are exempt from Washington sales tax if the property they purchase will be used outside of Washington (RCW 82.08.0273), even if you don’t deliver the sale out of state. These are called “qualified nonresident sales,” and you can read more about them on the Washington Department of Revenue’s website.

Sales Handled by a Marketplace Facilitator

Note that if you have what the law calls a “marketplace facilitator” collecting and remitting sales tax for you, then you don’t need to worry about collecting and remitting sales tax yourself on those sales (see RCW 82.08.0531(4) and 82.13.020). A marketplace facilitator would be a company like Amazon.com or the Apple App Store.

Exemptions for Basic Needs

The most common exemptions are for things like food and prescriptions; things that are clearly necessities, and thus have been exempted from sales tax to make the tax less regressive. The Washington legislature will sometimes change the rules on borderline cases: things that you’d probably find in a grocery bag, but aren’t really necessities, such as bottled water or candy.

The Washington Department of Revenue has a page that explains a bit about various exemptions and tax breaks here.

How Do I Determine the Correct Local Sales Tax Rate to Use on a Receipt?

Once you’ve determined that a sale is subject to sales tax in Washington State, your next question to answer is, what local rate do I need to add on top of the 6.5% state tax rate for this sale?

Remember that Washington State uses destination-based sales tax. That means the answer to this question usually depends not on where your business is located, but where your customer is located. Say you operate a furniture store in Duvall. A customer makes a purchase in your Duvall store location, but needs you to deliver the furniture to their residence in Bellevue. What’s the correct local rate?

You (and your customer) might hope that you only need to charge Duvall’s 2.1% local rate. But because the destination of the furniture is Bellevue, you actually need to charge Bellevue’s 3.5% local rate. And, accordingly, your furniture business needs to have an accounting system that can track customer destinations and is capable of applying the correct sales tax rate for every possible destination (i.e., every local jurisdiction your business is willing to deliver to).

How Do I Even Begin to Comply with This?

If you’re a traditional brick-and-mortar retailer with only one or two shops, then complying with sales tax is easy. This is because as long as you don’t deliver products to your customers, and only transfer goods you sell in your store, you only ever charge the sales tax rate for the physical location your store is in. Your customers, if they take the items purchased to a jurisdiction with a higher sales tax rate, may need to pay use tax on the difference. But dealing with the complexity of that falls onto the consumer, not you.

On the other hand, if your business does deliver products to consumers (say, because you’re an online retailer), complying with Washington’s sales tax laws is a real headache. The sales tax rate you charge is based on where you deliver the product and where the customer will use it, and Washington has hundreds of sales tax jurisdictions. There’s no way around it: you need to spend money on sales tax software that your brick-and-mortar competitors don’t need to spend. In this situation, your major options for dealing with sales tax include AvaTax, TaxJar, and QuickBooks Online’s new Automated Sales Tax.

QuickBooks Desktop Sales Tax Tracking

If your business is a traditional brick-and-mortar shop that only makes sales and transfers goods to customers at a handful of store locations, then your sales tax solution can probably be cheap and simple. Desktop versions of QuickBooks have had sales tax tracking for a long time, though the system requires some manual effort from the bookkeeper.

To use this solution, you’ll need to enter sales tax rates yourself, update them yourself each time the rate changes, and identify for yourself which rate applies to each sale. However, if you only have a few rates to keep track of because you don’t deliver products to your customers, those drawbacks aren’t too bad. Note, also, that the Washington Department of Revenue has files with sales tax rates in them which you can import into desktop versions of QuickBooks.

Automated Sales Tax Solutions

E-commerce businesses and other shops that deliver goods to customers probably need a sales tax solution that’s more automated than the sales tax tracking available in QuickBooks desktop. We know of three automated sales tax options that are designed to work for these types of small businesses:

• AvaTax
• TaxJar
• QuickBooks Online Automated Sales Tax

The common thread among all of these programs is that they try to automate several aspects of tracking sales tax that would otherwise leave the typical small business owner overwhelmed.

For example, one common feature among such programs is keeping track of which jurisdictions use destination-based sales tax (e.g. Washington), which use origin-based sales tax (e.g. Illinois), and which use their own odd system (e.g. California). Then, the program will use information like the customer’s shipping address to automatically look up the correct sales tax rate for the relevant jurisdiction (out of a database containing the approximately 10,000 different sales tax jurisdictions across the U.S.)

Often these programs will also try to help small business owners identify when they have physical presence in a state—and thus sales tax nexus (even under pre-Wayfair rules)—because the business stores inventory in that state. (This is a common scenario for business who participate in Amazon’s FBA program; such a business might have nexus in 40 or so states under the physical presence standard.)

These programs will also typically offer help with preparing sales tax returns, so the business can file all of their sales tax reports through one software program using one user login, rather than needing to create and keep track of dozens of different logins for all of the jurisdictions the business has nexus in.

The post Sales Tax Nexus in Washington appeared first on Evergreen Small Business.

But let me explain what’s what and then walk you through the steps for doing the bookkeeping.

What’s the issue with Washington state sales tax?

Sales tax isn’t the only type of excise tax Washington State levies on businesses. It also levies a tax on gross receipts, often referred to as “B&O”.

To minimize the administrative burden of these taxes, Washington’s Department of Revenue doesn’t make businesses file a separate tax return and make a separate payment for each type of tax. Instead, it has businesses calculate each type of tax owed on one return, and has the business submit all the taxes owed as a single payment. (Experienced QuickBooks users can already see the problem…)

What Intuit has done in QuickBooks—again, to try and make things easy for small business owners—is it’s come up with a system for how it can take care of most the bookkeeping for sales tax behind the scenes.

The QuickBooks Excise Tax Approach

The QuickBooks system is to have a special feature, called “sales tax tracking,” to automatically calculate correct sales tax on invoices and sales receipts, as long as sales tax jurisdictions have already been set up, and as long as the person recording the invoice can identify which sales tax jurisdiction to use when recording the transaction. Then, when a business remits sales tax to the proper taxing agency, the bookkeeper records this event with a special type of transaction. QuickBooks calls this transaction a “sales tax payment.” In order for QuickBooks sales tax tracking to work properly, the business must record every sales tax payment as, well, a “sales tax payment,” and it must record only sales tax payments as sales tax payments.

You can see how this approach collides with how Washington State collects sales tax. Two systems that were supposed to make things easier have come together to make things much more complicated and difficult for Washington small business owners.

Luckily, there are two workarounds to this conundrum.

Workaround #1: Record Sales Tax and B&O as Two Separate Payments in QuickBooks

The upside: this is easy to record, and easy to make accrual vs. cash basis accounting work correctly in QuickBooks (assuming your version of QuickBooks allows you to track Accounts Payable).

The downside: it makes working in the bank feed and reconciling the bank account more complicated, because the single payment that posts to the bank’s ledger won’t match the two separate payments you recorded in QuickBooks.

Workaround #2: Record the B&O Portion of Sales Tax as a “Sales Tax Adjustment”

The upside: this method won’t complicate working in the bank feed or reconciling the bank account

The downside: this method is more complex to enter, and WA B&O payments won’t show up properly on accrual-basis financial statements.

The tutorial at the end of this article will show you how to use this second workaround, and it will also illustrate the limitations of this workaround.

A quick clarification: Which sales tax system are we talking about?

QuickBooks Online has two different sales tax systems: old and new.

The old system is like what’s available in QB desktop, where the user manages their own sales tax rates. This system works just fine for brick-and-mortar shops that don’t deliver their goods to customers and only have a handful of locations.

The new system, called “Automatic Sales Tax,” appears to be Intuit’s answer to AvaTax and TaxJar, but it doesn’t cover as many jurisdictions yet. This system is designed to work better for stores (whether online or brick and mortar) that deliver goods to their customers, and thus have hundreds, or maybe even thousands, of sales tax jurisdictions to keep track of.

As of this writing, new QuickBooks Online accounts start off using the new, more-automated sales tax system. Accordingly, the images in this article illustrate the new system (because that’s what we had to work with when we created a demo account for this tutorial). If you use the old system, stuff will conceptually work much the same way, but the interface will look a little different and fewer tasks will be automated.

Note: these images come from QuickBooks Simple Start. If you use a different version of QuickBooks Online, or if Intuit has just updated the user interface since we published this article, then what you see in the software might be a little different then what we show below.

How to set up sales tax and WA B&O in QBO

If you’ve already set up sales tax in QBO, skip ahead to the next section. But if you’re just getting started, this section is for you.

As I mentioned earlier, if you’re setting up sales tax in a brand-new account from scratch, QuickBooks Online will guide you through the process of setting up Automatic Sales Tax.

First, navigate to Taxes in the left navigation menu (between Reports and Accounting). You’ll see this screen, or something close to it:

Perhaps obviously, click the green “Set up sales tax” button. The next few screens you’ll see will look something like this:

The address you use for this step is important, because it tells QuickBooks what taxing jurisdiction you’re in. For example, our hypothetical coffee shop is located in Redmond, WA. That means that, as of this writing (and for the purposes of this example), its sales are subject to a state sales tax rate of 6.5% and a local sales tax rate of 3.5%.

Note that if you’re using QuickBooks’ old sales tax system, or if you’re using sales tax tracking in QuickBooks desktop, you’ll need to look up these rates yourself and add them to the program manually. You’ll also need to update the rates manually any time they change. But if you’re using Automatic Sales Tax in QuickBooks Online, QuickBooks will use the address of the sale location as the jurisdiction for the sale.

Three other quick points before I move on.

First, in Washington State, we have what’s called “destination-based sales tax.” That means if your business operates in, say, Duvall, but you sell a product to a customer in Redmond and deliver the product to the customer, you need to use the Redmond sales tax rate for the sale. If, on the other hand, you have a bricks-and-mortar shop in Duvall, and you don’t deliver to customers (i.e. you only sell and transfer title to your goods at the Duvall location), then you use the Duvall rate.

Second, note that even if two jurisdictions use the same local rate (for example, both the City of Redmond and the City of Bellevue have a local rate of 3.5%), you can’t just use the same sales tax item for Bellevue sales and Redmond sales. This is because when you go to file your sales tax return with the Washington Department of Revenue, the form is going to ask how much of the sales tax you’re remitting is Washington State’s share, how much is Bellevue’s share, how much is Redmond’s share, and so on. So, you’ll need your accounting system to provide you data not just on how much sales tax to collect, but which jurisdictions you’re collecting it for. The Washington Department of Revenue keeps a list of current and historical local sales tax rates here. It even has a file you can use to import tax rate information if you’re using a desktop version of QuickBooks.

This isn’t an issue to worry about if you’re using Automatic Sales Tax in QBO (or a similar product like AvaTax or TaxJar), but if you’re using an older, less-automated version of sales tax tracking in QuickBooks, it’s a mistake that novice small business owners can sometimes make.

Finally, if you’re in a business where you sell tangible goods and deliver them to out of state customers, you want to get up to speed on the recent Supreme Court case South Dakota v. Wayfair. You may have an obligation to collect sales tax not just in Washington, but in other states as well.

After this initial setup, QuickBooks will ask you how frequently you file sales tax in Washington State (see below). Your business’ filing frequency is based on your estimated sales tax liability. In our example, the combined state and local sales tax rate is about 10%. So, a business with about 48,000 or more in monthly taxable sales would need to file monthly, whereas a business with smaller sales volume might be able to file quarterly or even annually.

Once you’ve finished setup, here’s what the Sales Tax Center looks like in QuickBooks Online:

Note that you can edit your sales tax settings after the fact from this screen by clicking “Sales tax settings” in the upper right corner. That will bring up a page that looks something like the image below; just click the “Edit” button for the particular agency you want to edit settings for:

All right, that’s sales tax set up. But for Washington State businesses, there’s one final step you’ll need to take to get things really working right for recording payments, and that’s creating an account in the chart of accounts for Washington B&O (see below).

How to Record a Sales Receipt with WA Sales Tax in QBO

Once you’ve set up sales tax in QuickBooks Online, you’re ready to start recording sales receipts that include sales tax.

To do so, first, click the Plus icon, then click Sales Receipt.

The next screen you’ll see will look something like this:

As illustrated in the above image, what’s nifty about automated sales tax tracking is that it will take the location of the sale (see in upper right corner) and use it to calculate sales tax on the sale, assuming you’ve checked the checkbox under the “Tax” column to indicate that the sale is subject to sales tax. (Sales of tangible property are generally subject to sales tax, while sales of services generally aren’t.)

If you’re curious about where QuickBooks is getting its calculation from, you can click the blue Sales tax label and it will bring up an overlay of the details, as shown below:

How to Record Paying Sales Tax and WA B&O Using the Sales Tax Adjustment Method

Okay, we’ve set up sales tax and we’ve been recording our sales receipts in QuickBooks to automatically calculate sales tax. And now a month has gone by, and we have to record the tax payment made to the Washington DOR. How do we do that?

Well, here’s what it will look like when you use the sales tax adjustment method in QuickBooks Online.

When a sales tax return is fileable, you’ll see a button in the sales tax center that lets you record the payment. Click this button and you should see a screen that looks something like the image below.

What you’ll do to get WA B&O working right is click the “+ Add an adjustment” button. That will bring up the overlay shown below. For the reason, indicate “Other”, and for the account, choose B&O. Then, enter the amount of B&O you owe for the tax period. (For most retailers, B&O is 0.471% of gross receipts.)

Once you’ve added the adjustment, the amount QuickBooks indicates for Tax Due should be the same as the amount you actually paid with your Washington Excise tax return when you filed it using MyDOR. (We have more information on MyDOR accounts in this article on our blog.) If the amount looks correct, click the green “Select filing method” button.

As of this writing, QBO’s automatic sales tax doesn’t support e-filing for WA sales tax (and if they did, this workaround probably wouldn’t be necessary). So, choose “File manually” as your filing method. Then, be sure to scroll down far enough so you can see where to enter information about when you paid sales tax. Enter the date paid and which bank account you paid it out of, then click “Record Payment.”

This is the last screen you’ll see, and it just confirms you recorded the sales tax as paid in QuickBooks.

Limitations of the Sales Tax Adjustment Method

There’s a lot to like about the sales tax adjustment method as a workaround for dealing with Washington B&O. It’s not too much work, it gets the right number in the right account, and because it records a single payment in the register for your business bank account, it keeps bank account reconciliations and working in the bank feed easy.

The one major drawback to be aware of is that, using this method, Washington B&O expense will only show up as an expense as of the date the expense was paid, regardless of whether or not you’re generating reports on cash or accrual basis. In other words, you won’t be able to track B&O accrual’s properly with this method (as shown below).

And there you have it, that’s how you deal with Washington sales and B&O tax in QuickBooks Online.

The post How to Record Washington State Sales Tax in QuickBooks Online appeared first on Evergreen Small Business.

Step 1: Make sure you have a SecureAccess Washington account

One of your first steps as a new business owner is to create a SecureAccess Washington account if you don’t already have one.

SecureAccess Washington is a login system that many Washington State agencies use. So, if you already have an account with, for example, the Washington Department of Licensing, you may already have a SecureAccess Washington account.

If you’re not sure whether or not you have a SecureAccess Washington account, you can check using this link. If you know you don’t have a SecureAccess Washington account, you can use this link to sign up for one.

Step 2: Sign in to MyDOR

Once you have a SecureAccess Washington login, you can sign in to MyDOR here.

MyDOR is the Washington Department of Revenue’s online portal. This account is what you’ll use to file your initial business license application. You’ll also use this account in the future to file Washington excise tax returns.

After you’ve successfully signed into MyDOR, you’ll see a page that looks something like what’s in Figure 1, above. To continue to the new business license application, click the “Apply for a new business license” link, under “Business Licensing” in the upper left corner.

Step 3: Complete the Washington Online Business License Application

There’s a fair amount of information to have ready for this step, but other than that the application is quite easy.

Business Information

On the first page of the online business license application, select the purpose of your application. In this tutorial we’ll assume that this is an application for a new business that won’t hire employees and doesn’t require any special licenses (e.g. liquor, cannabis, cigarettes).

In later pages of the application you’ll need to enter the following information about the new business:

• The business’ name
• The type of ownership (for example, “LLC”)
• The country and state of formation (for example, “United States” and “Washington”)
• The Washington UBI number (assuming the business already has one)
• The formation date (assuming the business is operating as an LLC or corporation, not a sole proprietorship)
• The federal EIN

All of the information above but the last bullet point comes from filing articles of formation with the Washington Secretary of State’s office. The last bullet point comes from filing an online EIN application with the IRS.

Location Information

You should also be prepared to enter the date you’ll begin business operations in Washington State, a business phone number, an email address, an estimate of your annual gross receipts in Washington State, and a description of what your business does.

Be prepared to answer the following questions about your new business:

• Did you buy, lease, or acquire all or part of an existing business?
• Did you purchase/lease any fixtures or equipment on which you have not paid sales or use tax?
• Is this business owned by, controlled by, or affiliated with any other business entity?
• Are you changing your business structure (such as changing from sole proprietorship to corporation) and want to close the old account?
• Have you ever owned another business?

If you plan to use a trade name (i.e. a “doing business as” or “DBA” name), have that name ready, too. And have an address ready for where your business will be physically located in Washington State.

As part of the application, you’ll need to decide whether or not you want to opt in to workers’ compensation coverage as an owner. If you’re unsure whether you want to or not, then this would be a good question to ask a labor law attorney or a financial advisor.

Finally, have ready the first and last name of each governing person of the business. (For an LLC or a corporation, this information should match what’s been provided to the Washington Secretary of State about your business.)

City Licenses

Many local governments in Washington state require their own, additional business license. Some of these localities allow you to apply for their local business license as part of the same online application as your state-level license. Other local governments (such as the City of Redmond, where our CPA firm is located), have their own application system for business licenses.

If your city allows you to apply for their license through the state’s online business licensing system, you’ll add those licenses to your application in this step.

Specialty Endorsements

These are special licenses that most businesses don’t need to worry about. The Washington Department of Licensing has a comprehensive list of special business licenses available here.

Step 5: Pay the fee

The standard business license fee as of this writing is $19. If you have additional trade names or special licenses as part of the application, then the fee may be higher.

Step 6: Complete any additional local business licenses, if necessary

Like we mentioned above, many local governments use their own business licensing systems instead of the state Department of Revenue’s system. Check the licensing requirements for any city or town you plan to conduct business in and see if they require your business to be licensed.

What do I do after I’ve filed my state and local business license applications?

The Washington Department of Revenue might take up to 10 days to process your business license application. After they do, you’ll receive a letter in the mail that looks like this—save this letter for your records.

Depending on your situation, forming your entity, obtaining an EIN, and obtaining state and local business licenses might be all the paperwork you need to form your business. However, some businesses will want to take the following next steps:

Choose an Accounting System

Unless your business is very small scale, you’ll benefit from using a real accounting system sooner rather than later. We have some free articles on this blog on choosing an accounting system here:

• What Sort of Accounting System Does a Small Corporation Need?
• Accounting System Recommendations for Novice Bookkeepers
• Should You Use QuickBooks Self-employed?
• Tax Deduction Receipts

Make an S election

This is probably something you should do after consulting with a knowledgeable professional. However, we have some free articles on this blog explaining the benefits of S status. See, for example:

• C Corporation vs. S Corporation: A Short Primer
• What Are the Advantages of an S Corporation?
• The Million Dollar S Corporation Mistake
• Little Known Benefits of an S Corporation

Set up Payroll

Not every Washington State business has employees, but any business with employees (including shareholder-employees of an S corporation) needs to set up payroll. We have a blog post that explains how to do that here: Washington Small Business Payroll Setup Tips.

We also have this article explaining why we think full service payroll products are the best option for most small businesses: Why Small Businesses Should Outsource Payroll.

The post How to Apply for a Washington Business License appeared first on Evergreen Small Business.

For some small businesses and individuals, the new Section 951A GILTI tax creates a huge planning challenge and compliance burden.

And what’s worse? Many of these folks don’t even know yet that they have to deal with a new tax.

No kidding, this could get ugly. Fast.

Section 951A GILTI Tax in a Nutshell

The Section 951A GILTI tax—GILTI stands for “global intangible low-taxed income”—requires these U.S. taxpayers to pay taxes on a proportional share of all or some of the income earned inside a foreign corporation.

Example: A small business owns 100 percent of a small foreign corporate subsidiary making $100,000 a year. This small business needs to calculate the Section 951A GILTI tax on the $100,000, report those calculations on its 5471 form, and then pay any taxes owed.

Example: An individual invests in a foreign small family business earning $1,000,000 annually. If the individual’s ownership percentage equals 20 percent, she first needs to determine whether the Section 951A tax applies to the $200,000 “share” of income she indirectly earns (20 percent of the $1,000,000). If Section 951A does apply, she then needs to calculate the GILTI tax, report those calculations on her 5471 form, and finally pay any taxes owed.

GILTI for Small Businesses and Individuals

Large, sophisticated businesses served by big accounting firms already know (and surely have planned for) Section 951A. But we’re finding that scary numbers of smaller businesses and individual investors seem oblivious to the new law.

Any small business or individual with international investments, however, needs to deal with the GILTI tax issue.

Tax practitioners, therefore, can provide enormous value to clients by helping them either avoid the Section 951A tax completely or by minimizing the actual taxes paid. And fortunately, a rich set of planning tactics exist.

Trick #1: Reduce Ownership Percentage Below Threshold

A first tactic to look at? Can a taxpayer reduce shareholdings below the threshold that triggers the Section 951A tax?

The Section 951A GILTI tax hits U.S. taxpayers who own 10% or more of a controlled foreign corporation.

Accordingly, a taxpayer who owns just over that 10 percent threshold may want to look at dialing down her or his ownership percentage. Dropping from 10 percent to 9 percent, for example, “solves” the GILTI problem.

One important wrinkle to consider, however: In determining percentages, tax law requires taxpayers to include stock owned through foreign entities. And it also requires taxpayers to use the Section 318 constructive ownership rules. For Section 318, an individual counts shares owned by a spouse, children, grandchildren, and parents as her or his own shares. And an individual counts shares owned directly or indirectly through a corporation he controls, a partnership he owns an interest in, or a trust he’s a beneficiary of—and vice versa.

A taxpayer could not, therefore, get around the GILTI rules by giving or selling his stock to a spouse, his parents, children, or grandchildren. Nor could a taxpayer get around GILTI by splitting his interest in a foreign corporation among a bunch of different entities he controls. The constructive ownership rules count those shareholdings, too.

Trick #2: Fail the Controlled Foreign Corporation Test

The Section 957 controlled foreign corporation definition suggests another gambit for avoiding GILTI in some situations: A U.S. taxpayer may want to orchestrate failing the controlled foreign corporation test.

Tax law defines a controlled foreign corporation as a foreign corporation where U.S. shareholders owning at least 10 percent of the corporation collectively own more than 50 percent of the corporation. In some situations, failing this “test” may make sense.

Example: A foreign corporation with five unrelated U.S. taxpayer shareholders who each own 11 percent shares counts as a controlled foreign corporation. If the U.S. taxpayers reconfigure their ownership so these five shareholders each own 10 percent shares, that change should mean the foreign corporation no longer counts as “controlled.”

The one wrinkle with this gambit? Tax law is clever, and defines “control” as not just owning more than 50% of the shares by value, but also more than 50% of the shares by voting power. So a scheme where U.S. shareholders only own 50% or less of the corporation, but still get more than 50% of the votes on major shareholder decisions, almost certainly won’t work.

Trick #3: Elect Disregarded Entity or Partnership Status

Our office’s “favorite” trick for avoiding Section 951A GILTI tax? Elect to have the foreign entity treated as a disregarded entity or partnership.

Often, this choice is available to a taxpayer. (One needs to check the Section 301.7701-2 regulations for entity classification choices available to a particular entity.) And when the choice exists, making an election moots Section 951A.

Two reminders about this approach: First, if a taxpayer elects to treat a foreign corporation as a disregarded entity or partnership, the taxpayer reports the foreign entity’s income on the U.S. taxpayer’s U.S. tax return. (This is bad.) But if the taxpayer elects, then the taxpayer also reports the foreign income taxes as credits on the U.S. taxpayer’s U.S. tax return. (This is good.) In many cases, the taxes and the credits offset each other—or nearly so.

A second reminder: Electing disregarded entity or partnership status for a foreign entity previously treated as a corporation triggers a deemed liquidation of the foreign corporation. That deemed liquidation in turn triggers income taxes, potentially, on the taxpayer’s U.S. tax return. Accordingly, these taxes may need to be considered.

Trick #4: Make a Section 962 Election

An old statute, Section 962, provides a last-minute gambit for mostly avoiding the Section 951A GILTI tax: A taxpayer may elect to treat any interests in controlled foreign corporations as if they are owned not directly, but indirectly through a “virtual” U.S. corporation.

The Section 962 election results in two benefits for individuals. First, the Section 951A GILTI tax calculations use the taxpayer’s marginal tax rate on the GILTI income. Regular corporations, as compared to individuals, pay a pretty low 21 percent flat income tax rate. That means the taxpayer uses that 21 percent rate of the “virtual corporation” for the GILTI calculations.

The Section 962 election also produces a second benefit for individuals. With a Section 962 election in place, the taxpayer gets deemed-paid foreign tax credits for the foreign taxes paid by the controlled foreign corporation. The credits reduce the virtual corporation’s GILTI tax.

Example: Before the Section 962 election, a high-income taxpayer with $100,000 of GILTI income might pay a 37 percent tax, or $37,000 in GILTI taxes. However, with the Section 962 election, the taxpayer would pay a 21 percent tax tentatively, or $21,000 in GILTI taxes. In addition, the taxpayer potentially would get a tax credit for 80 percent of the foreign taxes paid on the $100,000 of GILTI income. If the foreign corporation pays $25,000 in foreign taxes, the deemed-paid foreign tax credits might equal $20,000, thereby reducing the net taxes paid to just $1,000.

Tax practitioners and taxpayers late to planning for the Section 951A GILTI tax probably want to consider a Section 962 election for the 2018 year.

Keep in mind, however, a predictable downside to creating that “virtual” corporation: That corporation triggers the traditional double-taxation inherent in a regular corporation on any dividends from the foreign corporation. And here’s one subtle nuance of the Section 962 election that tripped up a taxpayer in the recent Smith v. Commissioner (151 T.C. 5) case: That dividend often isn’t eligible for qualified dividend treatment.

Trick #5: Hold GILTI Income Source in a Real Corporation

The Section 962 election just described provides two of the benefits of holding an interest in controlled foreign corporation through a real U.S. corporation. But looking forward to 2019 and beyond, some taxpayers may want to actually set up a corporation and then contribute their controlled foreign corporation interest to that corporation.

Why? Holding a controlled foreign corporation interest through a real domestic corporation gives the U.S. taxpayer two additional benefits compared to a Section 962 election.

The first benefit is that when the U.S. corporation pays a dividend to its owners, those dividends will be qualified dividends under U.S. tax law.

The second benefit is the Section 250 foreign-derived intangible income deduction. This deduction essentially halves GILTI tax for U.S. C corporation taxpayers.

Note: Holding interests in controlled foreign corporations through a real corporation, then, delivers four benefits: the 21 percent tax rate, the deemed-paid foreign tax credits, certainty of qualified dividend income treatment, and then the foreign-derived intangible income deduction.

Tax practitioners who make a Section 962 election for 2018 may want to move quickly to set up a real U.S. corporation for 2019 to take advantage of the Section 250 deduction starting in 2019.

Trick #6: Revoke Subchapter S Status

A related trick: If someone owns an S corporation which in turn owns a controlled foreign corporation interest, the S corporation’s shareholders may want to revoke the Subchapter S status.

That revocation, which can be made for 2019 anytime before March 15^th, 2019, means the controlled foreign corporation interest would held by a regular corporation starting in 2019.

That regular corporation, of course, means a 21 percent flat tax rate, deemed-paid foreign tax credits, certain qualified dividend income treatment, and foreign-derived intangible income deductions.

Trick #7: Reduce Controlled Foreign Corporation Income

A simple but powerful trick needs to mentioned somewhere in this discussion: Reducing the income of the controlled foreign corporation.

For example, adding legitimate deductions to the controlled foreign corporation’s tax return (such as expenses for growing the business) should reduce the controlled foreign corporation’s income and will therefore reduce any GILTI tax.

As another example, adjusting transfer pricing so the U.S. parent corporation makes more and the foreign corporation makes less may reduce the controlled foreign corporation’s income and the related GILTI tax.

The above techniques don’t work as long-term solutions. They may, however, work as stop-gap measures for 2018.

Trick #8: Reduce Taxpayer’s Taxable Income

Individual taxpayers should also look the possibility they can reduce GILTI taxes by reducing their U.S. tax return taxable income.

For an individual taxpayer, as noted earlier, the GILTI tax formula in effect uses a taxpayer’s marginal tax rate. A low marginal tax rate means a lower GILTI tax.

If someone does something to dramatically lower their U.S. tax return taxable income—use big bonus depreciation deductions in 2018, for example—that reduction minimizes the GILTI tax.

Trick #9: Exit the Controlled Foreign Corporation

Some individuals and at least a few businesses should probably consider a crude, if effective, tax planning gambit: Terminating their ownership interest in a controlled foreign corporation that triggers the GILTI tax.

Here’s why termination sometimes makes sense to consider: Unfortunately, a taxpayer with low GILTI income and a low GILTI tax still needs to prepare the time-consuming 5471 forms.

Furthermore, these forms are not just expensive, they are risky to prepare. (The penalty for failing to file a 5471 form, or for filing a 5471 that isn’t substantially complete, starts at $10,000. And word on the street is, the IRS more regularly assesses this penalty these days than it has in the past.)

Someone with a very small, strategically insignificant foreign business interest, therefore, may want to look at just dumping that investment and removing that complexity from their return.

Trick #10: Ignore the Section 951A GILTI Tax

One final “response” to the burden of the Section 951A tax accounting bears mentioning.

Taxpayers in a few small business and investment situations may simply want to ignore the tax and its complexity.

No, no, don’t misunderstand us. These taxpayer’s accountants will still need to deal with the Section 951A calculations, the 5471 forms and then any resulting income taxes.

But high-income taxpayers with small controlled foreign corporation investments may want to focus their tax planning on other more significant opportunities.

Example: A taxpayer with $5 million of taxable income and $100,000 of GILTI income may just want to accept paying the 37 percent GILTI tax on the $100,000.

Final Comments

Four closing comments: First, tax practitioners and taxpayers who don’t work regularly on international tax planning issues need to be careful using any of the tricks discussed above. Review the relevant regulations carefully before you pull the trigger on some tactic. (People probably also want to wait for final regulations whenever possible.)

Second, if you’re a tax practitioner with clients impacted by Section 951A, you possibly should have been filing 5471 forms in past. You will, accordingly, want to check out whether you need to go back and file these late returns. (By the way, filing late 5471s counts as another activity you need to be really careful about.)

Third, if you need to deal with the Section 951A GILTI tax for some client, you probably want to make sure the Section 965 transition tax was correctly handled on the 2017 tax return and 5471. The Section 965 transition tax probably should have been paid by any taxpayers who need to deal with the Section 951A GILTI tax. We think a number of taxpayers and tax practitioners missed this requirement due largely to the crazy timing the transition tax required.

And fourth, note that when Congress passed the new GILTI rules, it included a provision authorizing the Treasury to create regulations to prevent avoidance of the GILTI tax, as the Treasury determines appropriate [Section 951A(d)(4)]. The Treasury has released proposed regulations that include anti-abuse rules, but no regulations have been finalized on this topic yet. Accordingly, as you plan around GILTI you’ll want to stay on top of this evolving area of tax law.

Interested in More Small Business Tax Insights?

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The post Section 951A GILTI Tax Avoidance: Ten Tricks appeared first on Evergreen Small Business.

The Section 951A GILTI tax hits imputed income from controlled foreign corporations. And at a high level, GILTI works simply.

How the Section 951A GILTI Tax Works

Say you own 10% of a controlled foreign corporation (“CFC”) with no fixed assets that makes $1,000,000 a year before foreign income taxes. In this case, you may owe U.S. income taxes on 10% of the CFC’s profit, or $100,000.

Let’s say this CFC’s foreign corporate income tax rate is 25%. Since the CFC has no fixed assets, all of its income ($1,000,000 – $250,000 of tax = $750,000) is GILTI income. If your marginal tax rate before GILTI equals 37%, the GILTI rules make you pay 37% of regular tax on your $75,000 share of the profit, or $27,250. In many cases, this GILTI income is also subject to net investment income tax, in which case you would pay an additional 3.8% tax on top of the first 37%, or $75,000 × 40.8% = $30,600.

As an individual taxpayer, you can’t claim a foreign tax credit against this tax (only C corporations can do that), so the total tax burden you’ll end up paying on this $100,000 of pre-tax income is $25,000 of foreign taxes + $30,600 of U.S. income taxes = $55,600 of total income taxes.

And this important clarification: You owe the GILTI taxes even though you haven’t actually received any of the $100,000.

Note: If you don’t know yet whether you or your business owes GILTI or want more information, we’ve got a longer discussion here: Will Your Small Business Owe GILTI Tax?

This imputed income and the resulting taxes have some investors and entrepreneurs tax scrambling. People want—and need—ways to dial down this new surprise tax.

We continue to think that for many small businesses, the cleanest and simplest way to avoid GILTI is to elect to have their foreign subsidiaries treated as disregarded entities or partnerships (as discussed in the above-linked article). However, the Section 962 election deserves consideration.

How the Section 962 Election Works

When a taxpayer makes a Section 962 election, the tax accounting changes for an individual or pass-through entity.

That change? Well, think of the 962 election as basically inserting a “pretend” domestic C corporation between the foreign corporation and the individual owner.

In other words, if Steve owns a controlled foreign corporation but makes a Section 962 election, Steve calculates the tax he owes on Subpart F and GILTI income of the CFC using C corporation tax rates. For 2018 the corporate tax rate is only 21% (and no NIIT or AMT to worry about), compared to a top marginal rate of 37% for individuals (plus NIIT and AMT to potentially worry about).

A taxpayer who tallies $100,000 of GILTI income (after grossing up for the deemed-paid FTC), therefore, would potentially pay $21,000 of income taxes.

A second wrinkle appears in the Section 962 election too. The taxpayer’s virtual corporation can use deemed-paid foreign tax credits paid by the controlled foreign corporation to reduce the GILTI tax.

Deemed-paid foreign tax credits get a little complicated. But suppose for sake of illustration that the controlled foreign corporation pays a 25% local income tax. In this case, the foreign tax credit might equal 80% of that 25%, or 20% (in effect).

That 20% credit would then cut the 21% GILTI tax rate to effectively 1%: The 21% GILTI tax – the 20% deemed foreign tax credit equals 1%.

In the final accounting, therefore, a Section 962 election means some investor or entrepreneur might pay a very low tax rate on the imputed GILTI income.

But this election doesn’t work as cleanly as one might hope or expect.

The Section 962 Election GILTI Gotcha

The Section 962 election comes with a downside. That downside?

When you make this election you don’t just get the benefit of the 21% corporate tax rate and the deemed paid foreign tax credit; you also get the double-taxation that comes with C corporations if the taxpayer ever gets a dividend from the controlled foreign corporation.

For example, suppose that the next year, the controlled foreign corporation pays the taxpayer a $75,000 dividend from the money already recognized as GILTI income and on which she or he has already paid U.S. income tax.

Note: I calculate the $75,000 by subtracting the $25,000 of local or “foreign” income taxes from the $100,000 of controlled foreign corporation profits.

On that $75,000 dividend, the taxpayer again pays income taxes—though only to the extent the dividend exceeds the “corporate income tax” you already paid on the money once before, or $74,000.

If the local country and the U.S. have a comprehensive tax treaty in place, the taxpayer probably treats the $74,000 payment as a qualified dividend. But that may still mean a 20% qualified dividend rate plus 3.8% net investment income tax, or $17,612 in total. And many countries don’t have such treaties in place, so dividends paid out of many CFCs are actually ordinary dividends, not qualified dividends.

Note: You don’t treat this dividend paid by the foreign corporation as paid by a faux domestic C corporation, but as paid directly out of the foreign corporation. So, this is where that analogy starts to fall apart a bit.

In the end, then, the taxpayer may net $56,388 of after-tax cash flow. Out of a $100,000 of controlled foreign corporation profits, the U.S. taxpayer pays $25,000 in foreign taxes, $1,000 of GILTI tax, and $17,612 in individual income taxes for a total of $43,612.

On $100,000 of income, that $43,612 of income taxes equates to a 43.612% tax rate. $43,612 is better than $55,600. But not by as much as some taxpayers may have hoped.

Note, too, what happens if the dividends aren’t qualified: the taxpayer instead likely pays $74,000 × 40.8% = $30,192 on the dividend, for a total of $25,000 + $1,000 + $30,192 = $56,192. So in that situation, the election actually costs tax.

One Other Wrinkle Worth Mentioning: An Actual C Corporation

One other note: If a taxpayer holds a controlled foreign corporation through an actual U.S. C corporation, as compared to just making a 962 election (which creates a sort of temporary “virtual” corporation, and only for some parts of the tax code), the taxpayer enjoys an additional benefit: the foreign-derived intangible income deduction.

The foreign-derived intangible income deduction counts as a big benefit. It essentially halves GILTI for U.S. C corporation taxpayers.

The 962 election doesn’t get you the foreign-derived intangible income deduction, though. And note, too, as we mentioned above, that a 962 election doesn’t guarantee qualified dividend treatment for the dividends paid out of the “pretend domestic C corporation.” So in effect, the Section 962 election compares unfavorably to the option of actually, truly holding controlled foreign corporation interests through a U.S. C corporation.

A Final Comment about Section 962 Election GILTI Tactic

The upshot of all this? Don’t rush too quickly to make choose a Section 962 election as the way you avoid GILTI.

You may need to use the Section 962 election as a temporary “patch.”

But in the long run, probably options like treating the foreign controlled corporation as a pass-through or disregarded entity or owning a controlled foreign corporation through a real U.S. C corporation make more sense.

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The post Section 962 Election: An Answer to GILTI? appeared first on Evergreen Small Business.

In addition, certain aspects of the tax don’t quite line up with Congress’ stated intention for enacting the new rules. So, it would be understandable for practitioners to not realize, in the chaos of tax season, that § 965 tax applied to their clients—particularly their non-C-corporation clients.

Accordingly, this post exists to warn practitioners about the nature of the § 965 tax and provide some actionable insight on what to do about it.

Who Owed Section 965 Transition Tax

The 965 tax hit U.S. shareholders owning a “deferred foreign income corporation.” The new statute defines a “deferred foreign income corporation” as any “specified foreign corporation” with post-1986 E&P which the U.S. hasn’t yet taxed.

Probably most specified foreign corporations are “controlled foreign corporations” (“CFCs”). As a refresher for those who don’t work with foreign investment reporting all that much, a CFC is a foreign corporation where U.S. shareholders owning individually at least 10 percent of the foreign corporation stock collectively own more than 50% of the foreign corporation’s stock. These are the foreign corporations we’ve been reporting on 5471s for years.

However, one important thing to realize about the new § 965 is that the definition of “specified foreign corporation” is broader than that of a CFC. A specified foreign corporation (often abbreviated “SFC”) can be a controlled foreign corporation. But it can also be any foreign corporation with at least one U.S. corporation as a shareholder. So, some clients of yours who own foreign corporations may have needed to file a 5471 for the first time last year because their foreign corporation counted as an SFC.

In addition, it would be understandable if a taxpayer assumed that § 965 transition tax only applied to C corporations. The idea behind the transition tax, after all, was to tax pre-2018 earnings held inside foreign subsidiaries before C corporation parent companies transitioned to a new territorial tax system. However, § 965 applies to all U.S. shareholders, not just U.S. C corporations. And there’s no special “small taxpayer” exception to help the little businesses get around the complexity.

Examples of Foreign Corporations Triggering a Section 965 Transition Tax

Two examples show how easily U.S. taxpayers with small corporations overseas fall into the Section 965 tax trap.

Example 1: Your small business wholly owns a foreign subsidiary. Maybe a small Irish brewery operating (predictably) as an Irish corporation. Your small business formed the subsidiary ten years ago and most years the brewery makes a small profit. In this case, that Irish corporation counts as a deferred foreign income corporation (because the Irish corporation is a CFC.) Your 2017 tax return should have reported the earnings accumulated over the last ten years as taxable income.

Example 2: For three decades, you and five college friends have individually owned 10.2% shares of a foreign corporation that operates a small hotel for surfers in Costa Rica. (Local, foreign investors hold the remaining shares and manage the property.) The Costa Rican corporation counts as a deferred foreign income corporation (because the Costa Rican corporation is a CFC.) The 2017 tax returns of each of the individual U.S. taxpayers owning shares should have reported the earnings accumulated over the last ten years as taxable income.

Calculating the Section 965 Transition Tax

The one bit of good news in all of this? The Section 965 transition tax isn’t terribly expensive if you know how to calculate it correctly.

The tax is approximately either 15.5% or 8% of any foreign income previously untaxed by the US. (Compare that to 2017 top marginal tax rates of 35% or 39.6%). And taxpayers can often claim a foreign tax credit for foreign income taxes paid in prior years—if the tax preparer is careful and knows what they’re doing.

Note: For taxpayers who owe the tax in 2017, to calculate the actual Section 965 income amounts and then the deductions the law allows, you need to read IRS Publication 5292 and use its worksheets. For taxpayers who owe the tax in 2018, you’ll use future Form 965 and its supporting schedules (currently still in draft).

Section 965 Transition Tax Elections

Furthermore, the Section 965 statute provides some special elections that taxpayers can make to delay paying the tax.

A Section 965(h) election, for example, lets a taxpayer pay the tax in eight payments over the next eight years.

Another election, the 965(i) election, lets an S corporation delay paying the transition tax until a triggering event. “Triggering events” include stuff like the S corporation revoking its election or liquidating.

Alternative Minimum Tax and Net Investment Income Tax

One bad surprise about the Section 965 tax? The income the Section 965 tax “taxes” seems to be subject to both AMT and net investment income tax. The law is a little murky about this. (Probably the statute was poorly written.)

What If You Flubbed This?

If your 2017 tax return should have included the Section 965 transition tax, you’re going to need to amend the tax return, calculate the tax, and then pay what you owe.

Omitting this tax from your tax return is a big deal. It’s like “omitting” the AMT tax, the self-employment tax, or the net investment income tax from a return.

But you have another serious issue if you bungled the Section 965 transition tax.

If you owed a Section 965 transition tax for 2017, you also owed the IRS a Form 5471 for either 2017 or 2018—even if the foreign corporation triggering the tax wasn’t a CFC.

A caution: The penalties for filing late 5471 forms can be severe. You probably want an experienced tax accountant to help with this.

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