This past weekend, as part of passing New Jersey’s 2019 budget, Governor Murphy signed into law a series of changes to the state tax laws. These changes have will have a disproportionate effect on the state’s highest earners and corporations. These affected taxpayers will undoubtedly look for alternative structures to mitigate the impact of the new laws.

This relatively small group of high earners pegged to contribute to this spending plan is still reeling from the stunning blow delivered to New Jersey residents by Congress through the virtual elimination of the SALT deduction. The only question that remains is how many members of that group will seek refuge to states that do not levy a personal income tax and have much lower property and franchise taxes.

How these aggressive tax policies will attract new corporations and high net worth persons to New Jersey is also of significant concern for the state’s long-term fiscal growth and prosperity.

Below is a list of changes to the Gross Income Tax, Sales Tax, Corporate Business Tax and a new Tax Amnesty Program that are intended to increase revenue to pay for the state’s new spending plan.

Gross Income Tax

  • Top income tax bracket of 10.75 percent for income exceeding $5 million.
  • Employers that are subject to the state’s income tax withholding requirements to withhold 15.6 percent on salaries and wages in excess of $5 million for tax year 2018.
  • Eliminates an exclusion from New Jersey source income (for nonresidents) for carried interest/income from providing investment management services and imposes a 17 percent surtax on such management income for Gross Income Tax and Corporation Business Tax purposes.
  • Eliminates tax exemption provided to pass-through entities receiving and selling Grow New Jersey credits.

Sales Tax

  • Sales tax nexus of: $100,000 in taxable sales or 200 or more separate transactions.
  • Sales tax collection and reporting requirements on a “marketplace facilitator,” which is defined to mean any person or business that provides a forum to a retailer to advertise, promote and list the retailer’s products and that also collects receipts from the customer and remits payment to the retailer.

Corporation Business Tax (CBT)

  • For corporations with allocated net income of more than $1 million annually other than public utilities, the new law imposes a surtax of 2.5% for tax years beginning on or after January 1, 2018 through December 31, 2019 and 1.5% for tax years beginning on or after January 1, 2020 through December 31, 2021.
  • For tax years beginning after December 31, 2016, the 100% dividends-received-deduction (“DRD”) for dividends paid to the taxpayer by one or more subsidiaries owned by the taxpayer (if more than 80% ownership defined by voting power) is reduced to 95 percent for 80 percent-owned subsidiaries.
  • The law also only allows a deduction for interest paid to a foreign related member if the related member is in a foreign country with a comprehensive US tax treaty in place and is subject to tax in the foreign country at an effective rate within three percentage points of the New Jersey rate.
  • The law changes the sourcing rules for certain service providers that operate in and out of New Jersey. Under the new law, the service is sourced to the location where the benefit is received and not where the service is performed. If the benefit is received in more than one state, reasonable approximation may be used. For individuals, the default sourcing rule is the customer’s billing address; for others it could be the location from where the services are ordered in the customer’s regular course of operations or the billing address if the location from where the order was made is unavailable.
  • No deduction is allowed for the deduction under IRC Section 965. This section requires a taxpayer to be taxed on a deemed dividend for deferred foreign income and provides for a deduction to achieve the lower repatriation tax rate. This deduction will not be relevant to the calculation of CBT. Likewise, the deduction provided in new IRC Section 199A, which acts to minimize income from flow-through entities, will have no effect on the CBT. Aside from clarifying the states’ position on these Federal changes, these will ensure that there is no reduction in revenue because of the new Federal tax laws.

Tax Amnesty

  • A 90-day tax amnesty period to run through no later than January 15, 2019.
  • Under the new amnesty program, any taxpayer with liabilities for returns due on or after February 1, 2009, can pay the tax, plus half the interest due as of November 1, 2018 and avoid any penalties with the exception of criminal and civil fraud penalties.

Many of our clients are evaluating the impact of the latest tax changes by asking their accountants to run individual and corporate projections to assess the impact for 2018, 2019 and beyond. Many are also contemplating taking up residence in lower tax jurisdictions such as Florida.

Our next blog post will detail the feasibility of achieving non-resident status (only paying tax on New Jersey source income) while maintaining a residence in New Jersey, but avoiding New Jersey tax on your worldwide income by becoming a permanent resident of Florida.

 

With the continued proliferation of online sales projected to reach $414 billion by the end of 2018, the states, eager to capture their share of this online revenue, have reached for businesses that have no physical contact with the state.

Until the U.S. Supreme Court’s ruling last week in South Dakota v. Wayfair, 2018 WL 3058015 (Sup. Ct. June 21, 2018), physical contact was the traditional hallmark for establishing “nexus.”  Nexus is the link between an out-of-state business and a given state that provides that state with the jurisdiction under the U.S. Constitution to impose sales tax on businesses participating in inter-state commerce.

The Supreme Court finally caught up to the changing market place last week overturning in Wayfair the “physical presence” test established in Quill Corp. v. North Dakota, 504 U.S. 298 (1992).  The Court ruled that the physical presence test is “unfair and unjust” to the brick and mortar businesses competing against virtual competitors.  To level the playing field, South Dakota passed an “economic nexus” law requiring out-of-state sellers to collect sales tax if they derive more than $100,000 of gross revenue from the state or conduct more than 200 transactions in the state.  South Dakota prevailed on the constitutional challenge brought by the e-commerce company Wayfair even though the law imposed sales tax without requiring a business to have physical presence in the state.

The Court in Wayfair expressed that the states should be allowed to “seek long-term prosperity” through economic nexus legislation (estimates indicate the physical presence test has cost states billions of dollars in uncollected sales tax).  In fact, many states’ laws had already blurred the once bright-line Quill physical presence rule.  For example, New York passed click-through nexus legislation in 2008, creating a presumption of physical presence for online retailers that had referral agreements with residents of the state as a result forcing online retailers to collect sales tax on New York shipments.  The online retailers Overstock and Amazon challenged this law but it was upheld by New York’s highest court.  In the aftermath of this decision, New Jersey passed its own similar law and also entered into a tax collection and job creation agreement with Amazon.  The online giant conceded having nexus with the state and then, as an apparent concession, built fulfillment distribution centers in New Jersey in conjunction with collecting sales tax on its online sales.

Under this new Supreme Court precedent, New York, New Jersey and other states do not need to prove physical presence by indirect means, but can move forward with implementing legislation to directly impose sales tax on online businesses on receipts generated from the state.

In light of the Supreme Court decision and the liberation of the states from the yoke of the physical presence test, online and other hybrid businesses should not delay conducting “nexus studies” of their business practices, which we regularly conduct for our clients.  This helps companies determine and plan for potential exposure in an audit, including the personal liability exposure for owners and officers for uncollected sales tax that is not dischargeable in bankruptcy.

 

The recently enacted 2017 tax act (originally called the Tax Cuts and Jobs Act – “Tax Reform Act”) contains sweeping changes to US international tax rules that will affect international  businesses and cross border investments.   A review of how to take advantage of these new rules can reap significant benefits or avoid tax pitfalls, as discussed below.

New Territorial Tax System

The Tax Reform Act adopts a new territorial system of taxation (also known as a participation exemption system), which may eliminate or reduce US income taxes on income earned outside the US by US C corporations (“C corps”).  If a C corp owns 10% or more of a foreign corporation that pays a dividend, then the C corp receives a 100% dividends received deduction (“DRD”) for the foreign source portion of the dividend, which will eliminate or reduce the US tax imposed on the dividend.  This DRD is only available for C corps and not for S corporations or individuals.

A DRD will not apply if the foreign corporation is a passive foreign investment company (“PFIC”) unless the foreign corporation is also a controlled foreign corporation (“CFC”) as discussed below.  A PFIC is a foreign company whose income predominantly comes from passive investments (such as marketable securities).

The new territorial system does not apply to income earned by a C corp from a foreign branch.  Income from a foreign branch is subject to US tax, although if foreign tax is imposed on that income, then a foreign tax credit may reduce or eliminate US tax.  As a result, businesses that operate as C corps may want to incorporate their foreign branches to eliminate US tax on branch income.

This system also can reduce the taxable gain realized when a C corp (but not an S corporation or an individual) sells the stock of a foreign corporation.  If the C corp owns the stock of a foreign corporation for one year or more, pre-2017 law recharacterizes any amount realized by the C corp on the sale as a deemed dividend to the extent of the accumulated earnings and profits of the foreign corporation.  The Tax Reform Act provides that such deemed dividend is eligible for the participation exemption system and thus, is not subject to tax.  As a result, a US C corp can eliminate part or all of the taxable gain on the sale of stock of a foreign subsidiary.

New Global Intangible Low-Taxed Income (“GILTI”) Tax

While labeled a tax on intangible income, the GILTI tax is actually a current tax imposed on US shareholders of CFCs on their share of any income earned by the CFC that exceeds a 10% return on investment.  A CFC is any foreign corporation if US shareholders own more than 50% of its stock; for this purpose, a US shareholder is any US person who owns 10% or more of the voting stock or value of the stock of the foreign corporation.  If a CFC has certain types of passive income known as Subpart F income, then US shareholders must include in their income their share of the Subpart F income even though no dividend is paid to them.

The Tax Reform Act provides that a US shareholder of any CFC must include in gross income, for a taxable year, its GILTI in a manner generally similar to the inclusion of Subpart F income.  GILTI means the excess of the shareholder’s net CFC tested income over the shareholder’s net deemed tangible income return in that CFC.  The shareholder’s net deemed tangible income return is an amount equal to the excess of 10% of the aggregate of the shareholder’s pro rata share of the qualified business asset investment (“QBAI”) in that CFC over certain interest expense of each CFC with respect to which it is a US shareholder.  The QBAI is essentially a book value concept since it is based on the tax basis of the CFC’s assets and not their fair market value.  As a result, the 10% threshold can easily be exceeded.

US shareholders who are C corps are given special tax benefits that can eliminate the GILTI tax.  First, under the new law, a C corp can deduct 50% of the GILTI inclusion amount, which reduces the potential corporate tax from 21% to 10.5%.  Second, for any amount of GILTI included in the gross income of a C corp, the C corp would be deemed to have paid foreign income taxes equal to 80% of the foreign taxes paid by the CFC with respect to such income.  If the CFC pays foreign taxes of 13.125% or more, then this special foreign tax credit will eliminate any GILTI tax.  Individuals and S corporations get no similar treatment and pay full US tax on any GILTI inclusion amount.

Conclusion

US taxpayers should carefully review the structure of their foreign entities with their advisors to determine if the new territorial tax system may apply to them, and whether any foreign corporations may qualify as CFCs, which will subject their US shareholders to the new GILTI tax as well as numerous other rules affecting CFC shareholders.  Since the Tax Reform Act limits the benefits of the new territorial tax system to C corps and also only allows C corps benefits to eliminate the GILTI tax, US taxpayers should consider owning foreign stock in a C corp.  Individuals who own foreign corporate stock may want to transfer such stock to C corps; S corporations owning foreign corporate stock also may want to restructure to take advantage of these new rules.  While this task may not be simple, the tax benefits may significant.

The recently enacted 2017 Tax Act (originally called the Tax Cuts and Jobs Act – “Tax Reform”) made major changes to the US tax system.  Because C corporations (“C corps”) are now taxed at a flat 21% federal income tax rate, many business owners are asking whether they should structure their businesses as C corps.  The answer, unfortunately, is not simple.  Business owners should discuss the various considerations of this decision with their tax advisors.  Here are some of the pros and cons of using a C corp after Tax Reform:

1. Benefits.  C corp income is taxed at a flat 21% rate whereas partnership income flowing through to an individual partner is subject to tax at a maximum 37% rate.  In addition, C corps can fully deduct state and local taxes whereas an individual’s deduction is limited to a maximum of $10,000.

2. Pass-through income (eg, S corporation or partnership) may be eligible for a 20% deduction for qualified business income (QBI), but that still leaves the effective tax rate at 29.6% (ie, higher than the C corp 21% tax rate).  Furthermore, the 20% QBI deduction is not allowed for most service businesses (except for partners or S corp shareholders whose taxable income is less than $315,000 ($157,500 if not married filing jointly), with the benefit phased out over that amount so it is totally lost once the partner’s taxable income equals $415,000 ($207,500 if not married filing jointly).  There are also other limitations that only generally allow the QBI deduction to be claimed if the business employs many people or owns depreciable tangible property (such as real estate).  Bottom line – you have to run the numbers.

3. The drawback to C corps, of course, is that they are subject to two levels of taxation, one at the corporate level on earnings and one at the shareholder level, for example, on dividends.  Dividends usually are taxed at the qualified dividend rate of 20%, though there is usually no preferential tax rate at the state and local level.  Dividends also may be subject to the 3.8% net investment income tax.  If only federal taxes are considered, the effective federal double tax rate is 39.8%.

This may be the deciding factor for many businesses.  If a business does not make distributions to its owners (for example, the owners generally take only salary and perks and profits are reinvested), then a C corp structure may result in income tax savings.  On the other hand, if the business distributes all of its profit out to its owners annually, then the double tax resulting from a C corp structure will be disadvantageous.

4. If the C corp accumulates cash, it can be subject to one of two penalty tax regimes – accumulated earnings tax and personal holding company tax.

Closely held C corps are subject to the personal holding company tax if 60% or more of their income is passive income, which they retain in the C Corp and do not distribute to their shareholders, though the personal holding company tax often can be avoided.  In addition, a C corp is subject to the accumulated earnings tax if it accumulates earnings beyond the reasonable needs of the business.

5. Sale of company.  If a company is sold, it is most often structured as an asset sale, which results in two levels of tax for a C corp – one tax to the corporation when it sells its assets in exchange for cash (or a note, etc.) and a second tax if the corporation is liquidated and the stockholders exchange their (low basis) shares for the sale proceeds.  For a company that may be sold in the near future, C corp status would be disadvantageous.  On the other hand, if there are no plans to sell the company (eg, children in the business), this may not be a concern.

The owner may consider whether he or she can own goodwill, client lists or other intangible assets in his or her own name rather than in the corporation to avoid double tax.  See Martins Ice Cream, Norwalk, and related tax cases on “personal goodwill.”

6. Step-up at death.  If an owner dies owning C corp stock, the stock will receive a step-up in basis to its fair market value.  This will avoid a shareholder level tax if the C corp liquidates.  However, it does not avoid a tax to the corporation on any appreciated assets that are distributed in liquidation or later sold by the C corp.

7. Losses.  If a partnership has losses that flow through to its partners, those losses would not flow through if the entity becomes a C corp, so C corp status would be disadvantageous.

8. Timing and related issues.  A company that is an LLC can elect to be treated as a corporation for tax purposes.  If a decision is made to terminate S corp or partnership status, then termination would have to be completed by March 15 to be effective this year.  Also, an S corporation that terminates its S status has a five year waiting period to convert back to S status.  If the C corp converts to S corp status in the future, then it may be subject to a built-in gain tax and other concerns if it later converts to an S corp and has accumulated earnings and profits.

If an S corp converts to a C corp, there is a two-year post termination period to take out AAA.  The Tax Reform bill provides that distiributions within this period will be partly treated as AAA (tax-free) and partly treated as previous C corp E&P (taxable 23.8 dividend).

Also, given the uncertainty surrounding the Tax Reform bill and the possibility that the rules could be changed again, some business owners may be reluctant to convert to C corp status and then get “stuck” if the rates or rules change.

9. Outbound foreign.  Under the new international tax rules, ownership of foreign corporations by a C corp rather than an individual has several advantages.  Dividends paid by a foreign corporation to a C corp can escape any tax while dividends paid to an individual are fully taxable.  If a foreign corporation has income that exceeds a base threshold amount (generally, 10% of the book value of its assets) and the foreign corporation does not distribute those excess earnings to its US shareholder, then the new “GILTI” tax applies to treat the US shareholder as receiving a deemed taxable dividend of that excess amount.  But C corps pay a lower tax rate on this income or may not pay any tax at all.

If you, as a business owner, are asking yourself, “Should I be a C corp?” note that there is not a “one size fits all” answer.  Have your CPA run the numbers using the new tax rules and rates.  Speak to your tax attorney to review the specifics of your situation.  Revisit this decision periodically.

The new tax bill passed by Congress is expected to be signed into law by President Trump in the next few days.  Based on the changes that will take place as of January 1, 2018, there are several items that taxpayers should consider implementing prior to December 31, 2017.

Please note that each taxpayer’s situation is different and each suggestion below should be discussed with the taxpayer’s tax and financial advisors to determine what steps, if any, should be implemented now or deferred until next year or whether it should be implemented at all depending on the taxpayer’s business and tax attributes.

Items to consider:

  • Prepay real estate property taxes if you have amounts due for 2018 (cannot prepay NJ or NY state income taxes)
  • Prepay home equity interest (no deduction after this year)
  • Make charitable contributions this year, especially if not itemizing deductions in 2018
  • Accelerate business deductions
  • Medical expense deduction floor reduction to 7.5% only lasts through 12/31/18, so incur medical expenses if possible before then
  • Delay or accelerate Roth conversion
  • Defer or accelerate income*
  • If you are a US person with foreign businesses, potentially converting to an S corporation before year end could be beneficial due to a “deemed repatriation” of profits in the new bill
  • If you have children in private elementary, junior high or high schools and have not already been funding 529 plans, consider use of 2017 annual exclusions not otherwise exhausted to fund 529 plans

 

*Deferral of income until 2018 could save taxes for some taxpayers because of the lower marginal rates, while acceleration of income could save taxes for others due to the limitation on deductions of state and local taxes.  Whether or not a taxpayer is subject to AMT also plays a role.  Again, each taxpayer should consult his or her own tax and financial advisors for specific advice.