There have been sweeping changes to both the federal and New Jersey tax laws for the first half of 2018.  At the federal level, the elimination of the state and local tax (SALT) deduction, which for decades allowed people to itemize and deduct state and local income and property taxes from their federal bill is now being capped at $10,000.

It has been widely publicized that residents of states with high SALT such as New York and New Jersey will pay much more in overall taxes than those residents of states with no income and/or low property taxes. Northeast states attempting to counteract the impact of recent federal tax laws by forming associations to sue Washington or disguising property taxes as charitable contributions are seemingly ineffective solutions.  To compound the impact of the SALT limitation, New Jersey has recently increased its highest marginal rate to 10.75% for those families with income in excess of $5 million, enacted laws to impose a surtax on carried interests and increased corporate business tax rates.  For more details concerning New Jersey recent tax law changes, see our previous blog post here.

As the 2019 tax season gets underway, high net worth residents of New Jersey and New York will find significant increases in their annual state tax bills. Accountants should be the first to anticipate client questions as to whether a change in residency to states such as Florida could alleviate this increased state tax burden and to what extent state tax savings can be achieved while continuing to own a residence in New Jersey or New York.

The short answer is yes. A well counseled client who becomes a permanent resident of Florida can spend significant time in New Jersey and/or New York and maintain a residence here, but successfully avoid state taxes on non-New Jersey and New York source income. On the other hand, snowbirds, spending three to five months in Florida and the balance of their time in New Jersey / New York face serious exposure, including an audit resulting in an additional assessment of tax, interest and penalties by filing a non-resident return or no state tax return without meeting the statutory requirements for non-residency status.

There are many considerations in changing permanent residence from New York or New Jersey to a tax friendly state such as Florida in an effort to escape the harsh effects of these new tax laws. Aside from feasibility issues — such as whether telecommuting is a viable option and whether children and spouses are amenable to relocating — there needs to be a thorough tax analysis before making that decision to relocate as to whether: (i) changing residence will necessarily reduce state income tax (i.e., is the income sourced in New Jersey or New York); and (ii) if so, to maximize the level of preparedness in anticipation for what will likely be a residency audit from the New York and/or New Jersey tax authorities.

New York has one of the most sophisticated residency audit programs in the country.  New Jersey is also expected to ramp up its program in light of the most recent changes to its tax laws.  The purpose of a residency audit is to determine whether you correctly filed your non-resident or part-year resident income tax return or if no return is filed in the years immediately following a move outside of the state.  The likelihood of a residency audit is particularly high during the first year in which an individual files a non-resident tax return or no return at all.

Once audited, in making the determination of whether an individual is resident of New York or New Jersey, the auditor will first determine whether an individual is domiciled in New York or New Jersey.

If the auditor is persuaded a taxpayer has successfully changed his or her domicile from New York or New Jersey to a different state, that person can still be taxed as a “statutory resident” if he or she maintains living quarters in New York or New Jersey for substantially all of the year and spends more than 183 days in that state.

In a residency audit, the auditor will request EZ-Pass records, cell phone records, calendars, credit card and bank account statements along with travel records.

In addition, the auditor may also request utility bills, vehicle registration and voting registration in an effort to determine how strong your ties are to a specific location and whether you sufficiently abandoned your former domicile.

More intrusive steps may be taken when the auditor is not satisfied with the information that he or she has received and can even subpoena your records from third parties or depose you and/or your family members. If it is determined that you are a resident of a New York or New Jersey and you did not properly file a resident return, in addition to an assessment of unpaid tax, there can be substantial penalties and interest.  For example, in New York, the penalty for late filing is 5% of the tax due for each month (or part of a month) that the return is late, up to a maximum of 25%.  And the penalty for late payment is 0.5% of the unpaid amount for each month (or part of a month) it is not paid, up to a maximum of 25%.  New Jersey also imposes similar penalties for failure to file and failure to pay tax along with interest charges.

If you are a resident of New York or New Jersey and you are considering changing your residency (whether tax motivated or otherwise), it is important that you seek the advice of an experienced SALT counsel to fully understand the potential benefits, feasibility and most importantly, how to effectively prepare for what will likely be a residency audit twelve to eighteen months after you file a New York or New Jersey non-resident return or no state tax return.

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.

 

On March 13, 2018, the IRS announced that the Offshore Voluntary Disclosure Program (OVDP) will be closing on September 28, 2018. This program has been in place since 2009.

In general, US persons, that is, citizens and residents of the US, must report their worldwide income on their US income tax returns. They also must report their financial accounts held outside the US on an annual FBAR (FinCEN Form 114) if the aggregate balance of their accounts exceeds $10,000.

The OVDP offers a structured program for taxpayers to amend income tax returns to report any unreported foreign income, submit any unfiled international tax filings, and disclose the existence of financial accounts outside the United States.

To participate in the OVDP, taxpayers have had to pay a substantial civil penalty based on the value of the unreported accounts, in addition to paying back taxes with a 20% penalty and interest.

The incentive to participating in the OVDP is that the IRS will not criminally prosecute the taxpayer for the failure to report his or her accounts and that all other potential civil penalties will not be assessed in lieu of the one OVDP penalty.

The OVDP is intended for those taxpayers who knew that the law required reporting of their foreign accounts but who decided to not report such accounts on an FBAR or on other international tax filings. These taxpayers have the most to gain from participating in the OVDP and remain exposed if they choose to not come into compliance.

The OVDP requires eight years of amended return filings, six years of FBAR filings, as well as several other items to be submitted to the IRS. The IRS requires a complete OVDP submission by the September 28 deadline. These submissions require time to compile the necessary documentation and to prepare amended returns. It is important for those not in compliance to decide on participating now – well before the September deadline – or you will not be able to complete the OVDP.

What options do taxpayers have if they didn’t file FBAR’s or report their foreign income but their mistakes were inadvertent? This is referred to as a “non-willful” case and is common for many taxpayers who have accounts from their home country that were opened before moving to the US or for those whose tax return preparer did not advise them as to what the tax law requires. The IRS is continuing a program known as “Streamlined Filing Compliance Procedures,” for non-willful violations. These procedures, which may also require a penalty, will continue past September. There are also other ways to return to compliance.

What will IRS enforcement in this area look like once the OVDP is ended? We believe that examinations in this area will only increase. The IRS has gathered a decade’s worth of material on foreign institutions and bankers through the OVDP. This data, along with the information that the IRS now receives from many foreign countries pursuant to a law known as FATCA, allows the IRS to identify non-compliant taxpayers much more easily today than in the past. These international audits are quite intrusive and can expose taxpayers to substantial penalty. We expect the number of these audits to increase.

Once the OVDP option has ended, taxpayers will still be able to voluntarily come forward to disclose past misdeeds. (The IRS has stated that the precise details how to do so will be forthcoming.) It is clear, though, that as onerous as the OVDP penalty is now, the toll to come into compliance in the future will only be greater.

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.