New Deduction of up to 20% of Qualified Business Income for Small Businesses
One of the most significant incentives to small business owners offered by the 2017 Tax Act is the new deduction of up to 20% of the Qualified Business Income (“QBI”) earned by certain small businesses. This deduction reduces taxable income without having to make an expenditure. For business owners who are eligible for this new deduction, careful planning and structuring is normally necessary in order to maximize the financial benefit of these new provisions.
These new rules can be complicated and a knowledgeable advisor is crucial. There will be many small business owners who lose out on the benefits of this new deduction (or only benefit at a fraction of what they could have) because of not adequately planning for how to structure certain aspects of their business to maximize the deduction. It is important to start planning for this new deduction as early in the year as possible. Call us today to discuss how your business may maximize the benefit of this new deduction.
Note that taxpayers operating a so-called “specified service trade or business” might be limited in their ability to take this new deduction. For a white paper further discussing these new provisions which provide for a deduction of up to 20% of QBI, click here.
Capital Gains Invested in Opportunity Zones
Included in the Tax Cuts and Jobs Act of 2017 is a provision which offers a tremendous strategy for deferring the recognition of capital gains which are reinvested in what is referred to as a “Qualified Opportunity Fund” (or “QOF”).
In very general terms, under new Section 1400Z, the tax recognition of capital gains from the sale to, or exchange with, an unrelated person of any property held by the taxpayer, may, at the election of the taxpayer, be deferred if the taxpayer invests such capital gains in a QOF during the 180-day period beginning on the date of such sale or exchange.
In general, a QOF is an investment vehicle that meets certain requirements that holds at least 90 percent of its assets in qualified opportunity zone property. Central to this definition is the requirement that the property be used in a qualified opportunity zone. The Treasury has identified qualified opportunity zones in numerous locations throughout the country including throughout Florida and within the Tampa Bay area.
While intuitively, one might be inclined to believe that these opportunity zones are in extremely economically blighted areas. This is sometimes the case, however, there are many areas which may surprise taxpayers. For example, in the Tampa Bay area, substantially all of downtown Tampa (west of what is commonly referred to as the Channelside area that is east of Meridian Avenue) is in an opportunity zone. In addition, the International Mall located adjacent to Tampa International Airport is in an opportunity zone.
There are three potential benefits for taxpayers who take advantage of the new Section 1400Z provisions.
First, the portion of the capital gain which is properly invested in a QOF is not recognized in taxable income until the earlier of (1) the date on which such investment is sold or exchanged, or (2) December 31, 2026.
Second, for investments in a QOF which are held by the taxpayer for at least 5 years, the tax basis of the investment is increased by an amount equal to 10 percent of the amount of gain deferred as a result of the initial deferral described above. If the investment in the QOF is held by the taxpayer at least 7 years, the tax basis of the investment is increased by an additional 5 percent of the amount of the gain deferred above.
Third, for investments held for at least 10 years, the taxpayer may elect to have the tax basis of the investment be equal to the fair market value of such investment on the date the investment is sold or exchanged.
The above provisions may be illustrated by the following example. Assume that on January 1, 2019, an individual sells common stock to an unrelated individual which is a capital asset for $1 million in which the individual has a tax basis of $400,000, thereby recognizing a capital gain of $600,000. Further assume that on May 1, 2019 this individual invests the $600,000 gain in a QOF and elects to defer the gain under new Section 1400Z. Assume further that this individual ultimately sells this interest in the QOF on June 30, 2030 for $3 million and elects to step up their tax basis to fair market value.
Under the above facts, the individual’s income tax consequences are as follows:
In 2019, the individual recognizes no capital gain on the sale of the stock. The individual does need to properly disclose the sale and deferral on their timely filed individual income tax return. The individual’s income tax basis in their investment in the QOF is zero.
As of January 1, 2024, the individual’s investment in the QOF increases by 10 percent of the gain, or $60,000 ($600,000 capital gain x 10%).
As of January 1, 2026, the individual’s investment in the QOF increases by an additional 5 percent of the gain, or $30,000 ($600,000 capital gain x 5%).
On December 31, 2026, the individual recognizes the tax gain that was deferred, which is equal to $510,000 ($600,000 original gain less $60,000 basis increase less $30,000 basis increase). This capital gain is reported on their 2026 tax return and tax under the rates in effect at that time.
On June 30, 2030, absent Section 1400Z, the individual has a tax gain of $2,400,000 calculated by taking the $3 million sales price and subtracting $600,000 of tax basis. Since the individual held the investment for at least 10 years, the taxpayer may elect to increase the tax basis in their investment to the fair market value of the investment on the date that the investment is sold or exchanged. As a result of this election, the individual’s taxable gain is zero.
Section 1400Z is a radically new provision. Despite the first set of proposed regulations being issued in October 2018, there remain many unanswered questions. It is hoped that additional regulations will provide guidance with respect to many of these questions.
The rules for new Section 1400Z are extremely complicated. The discussion above is merely intended as a very general overview and should not be relied upon in lieu of consulting with a knowledgeable tax advisor. If you have an interest in exploring these incentives further, please call us to arrange a meeting. In the meantime, click here for a free white paper discussing this opportunity for substantially reducing the financial impact of taxes on capital gains reinvested in a Qualified Opportunity Fund.
Contact us today at (813) 760-0722 or email us at firstname.lastname@example.org to set up an appointment where we can explore how you may be to take advantage of these new tax incentives in your unique situation.