Monthly Archives: July, 2016

Avoiding Phantom Income

July 25th, 2016 Posted by Tax Planning No Comment yet

I am going to go off on a limb and guess that you do not want to pay any more tax than you are required to.  You don’t enjoy paying taxes on the income you earn, so you certainly do not want to pay taxes on “phantom income”.  Phantom income is income that is reported to the IRS for tax purposes but that you did not actually receive.

Phantom income

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One of the most common instances of phantom income that occurs is when an individual purchases an ownership interest in a partnership (or an LLC that is taxed as a partnership) that owns appreciated assets.  Lets look at an example to understand what I mean:

Years ago, Tom and Ed formed an LLC.  They each contributed $75,000 to the business, and used those funds as a down payment to purchase a rental property for $600,000.  They borrowed the remaining $450,000.  Over the years, the property appreciated in value and is now worth $750,000.  Sam is interested in joining the LLC and agrees to purchase a one-third ownership interest for $250,000.  As part of that purchase, he acquired one-third of the “original basis” in the rental property ($200,000).

If the LLC sold the property the next day, it would recognize a gain of $150,000.  Each owner’s K-1 would show capital gains of $50,000 which they would be required to report on their individual tax return.  However, this is not fair to Sam.  He already paid for the appreciation on the property when he purchased his ownership interest, so he should not be taxed on it now.  This is phantom income.

To avoid this issue, partnerships  and LLCs can make an election under Internal Revenue Code Section 754.  If this election is made, for tax purposes the business would step up the basis of the rental property to reflect the additional contribution made by Sam.  Therefore, after this election is made the business would show a basis in the rental property of $650,000.

Upon the sale of the rental property, this basis would be specially allocated among the owners.  Tom and Ed would each still have a basis of $200,000, and Sam would have a basis of $250,000.  Therefore, if the rental property was sold for $750,000, Tom and Ed would show capital gains of $50,000 each and Sam would not show any capital gains.

Another element of this election is that if the Section 754 basis is allocated to depreciable property, the Section 754 basis can be depreciated.  In Sam’s case, residential rental property can be depreciated over 27.5 years so Sam is able to depreciate his $50,000 over 27.5 years for an annual tax deduction of $1,818.

College Access Tax Credit

July 20th, 2016 Posted by Tax Planning No Comment yet

Most likely if you are donating your money to a charitable cause, you are doing so for reasons other than the tax benefits (although the tax benefits are likely a welcome bonus).  However, California is offering tax savings through the College Access Tax Credit that may be reason enough to contribute.

California’s goal in offering this tax credit is to bolster the Cal Grants program, which benefits to low-income college students.

Tax CreditThis tax credit is available to individuals and business entities that file tax returns in California.  To qualify, a taxpayer must apply for a credit allocation reservation. This is a fairly simply process of providing identifying information and the amount that you wish to contribute.  California will then send the taxpayer approval along with instructions on how to send the contribution.  The taxpayer must be prepared to make the contribution within 20 days of the date of the Notice of Allocation Reservation (the approval form).

This tax credit is worth 50% of the contributed amount for tax years 2016 and 2017 (the year in which this credit is due to expire).  However, if you make the contribution through an S-corporation (which I strongly recommend), the S-corporation is also entitled to a tax credit equal to 16.67 percent of your contribution.

In addition to the California tax savings, the contribution is deductible on your federal income tax return as a charitable contribution.  This means that, if you take itemized deductions, you will have federal tax savings as well.  However, the amount of your federal benefits depends upon your marginal tax rate.

Lets look at an example:

Richard, a California taxpayer, is the 100% shareholder of an S-corporation.  The S-corporation makes a $10,000 contribution to the College Access Tax Credit Fund.  As a result, the S-corporation is entitled to a tax credit of $1,667.  The corporation’s shareholder (Richard) is entitled to California tax credit of $5,000 and a $10,000 federal charitable contribution deduction. If Richard is in the top federal tax bracket (39.6%), his charitable deduction would be worth $3,960 to him.  All together, Richard and his S-corporation saved $10,627 by making a $10,000 contribution (a net gain of $627).