InvestmentNews has asked readers to submit their tax questions. Here are the first three of them. If you would like your tax questions answered, please write to assistant managing editor Chris Latham at firstname.lastname@example.org.
QUESTION: I want to know two things. First: Exactly how does the deduction work for pass-through entities? Is it an off-the-top deduction of income on the taxpayer's personal income tax form? Second: I am a financial adviser, self-employed, structured as a sole proprietorship, married filing jointly. Do I now qualify for the pass-through deduction subject to phase-out limits? — Matthew Sherman
ANSWER: First, the pass-through is a deduction to taxable income and not adjusted gross income. We can't tell yet where that deduction will be specifically located on the physical 2018 tax return, but the new law is clear that it's a deduction to taxable income, like an itemized deduction.
Second, Section 199A of the new tax law describes how pass-through entities may claim the 20% deduction. From our reading of 199A, the deduction applies to all small businesses, including financial advisers, if their taxable income is below a certain threshold ($157,500 for singles, or $315,000 if filing jointly). The deduction phases out, so advisers with income over $207,500 (singles) and $415,000 (couples) cannot claim the deduction.
(More: Trump signs $1.5 trillion tax cut)
Q: I have read varying opinions. Will financial advisers and other service providers be able to become LLCs in order to take advantage of pass-through tax rates? — Richard Cass, Senior Vice President, Ameriprise Financial Services, in Tarrytown, N.Y.
A: Advisers could establish a pass-through entity in the form of an LLC (including a single-member LLC), a Sub S corporation, or a sole proprietorship. There are some legal and other tax ramifications to the form of entity, so those should be included in the decision.
Q: Not so much related to the new tax bill, but could have been impacted by a new FIFO rule: Can ETF redemption in kind be used to avoid capital gains taxes?
Suppose I buy $1 million of an ETF. It rises in value to $2 million. I now have $1 million in unrealized gains. I redeem my ETF shares for the underlying securities. Do the shares in the underlying securities maintain the tax basis of whatever lots the Authorized Participant gives me? If so, can the Authorized Participant selectively give low-basis lots to nontaxable investors and high-basis lots to taxable investors? If the Authorized Participant gives me lots with no unrealized gains, and I then sell these shares, have I realized any capital gains? Or did I just make my $1 million in unrealized gains disappear? — David Neiterman, Business Development Manager, Smartleaf, in Cambridge, Mass.
A: Tax basis represents an investor's original cost. A low-basis security is one that has experienced a large appreciation, and vice versa for a high-basis security — for example, if you bought XYZ stock at $10 per share and it is now $100 per share, it has low basis. If you bought ABC stock for $100 a share and it is now worth $100, that is high basis.
In a redemption, the ETF issuer can select which shares to distribute to the authorized participant. Thus, an ETF could distribute low-tax-basis stocks in kind. The basis carries over, and the capital gain is realized when the stock is sold.