Trump Tax Plan

November 9th, 2016 Posted by Tax No Comment yet

By now, you have hTrumpeard the news that Donald J. Trump is the President-Elect of the United States.  As such, he will have a tremendous amount of input on federal tax law.  So, what has he proposed?

Individual Income Taxes

Currently, there are 7 ordinary income tax brackets ranging from a 10% tax rate to 39.6% tax rate.  Donald Trump has proposed reducing this to only 3 ordinary income tax brackets ranging from a 12% tax rate to a top rate of 33%.

Donald Trump has proposed keeping the capital gains rates the same.  Under his proposal, individuals in the 12% ordinary income tax bracket would pay 0% on their capital gains.  Individuals in the 25% ordinary income tax bracket would pay 15% on their capital gains.  Individuals in the 33% ordinary income tax bracket would pay 20% on their capital gains.

In addition, high-income Americans are currently subject to a 3.8% Net Investment Income Tax.  Donald Trump has proposed eliminating this surtax along with the rest of the Affordable Care Act.

In terms of deductions, the Trump plan increases the standard deduction.  For married joint filers, the standard deduction would increase from $12,600 to $30,000.  However, this comes at the cost of the personal and dependency exemptions which would be eliminated.

Finally, Donald Trump’s proposal puts a cap on the amount of itemized deductions that can be claimed.  This cap is $100,000 for single individuals, and $200,000 for married couples filing jointly.

Business Income Taxes

The Trump tax plan calls for massive changes for businesses.

Currently, the only type of business entity that pays “business taxes” are c-corporations.  All other business entities (S-corporations, partnership, and Limited Liability Companies (LLCs)) are “pass through” entities.  That means that income from those entities pass through to the individual owners, and taxes on that income are paid by the individual owners at their ordinary income rates.

The Trump proposal instead reduces the business tax rate from a maximum of 35% to 15%, and creates a unified business rate.  Instead of pass through entities paying ordinary income tax rates, they would instead pay the same 15% rate that c-corporations would pay.

Another significant change would be the treatment of capitalized assets.  Currently, certain assets such as machinery and equipment must be capitalized and the acquisition cost is depreciated (expensed) over a number of years.  Donald Trump’s proposal would allow the full cost of these assets to be expensed in the year of acquisition.

Finally, businesses would no longer be able to take a deduction for many expenditures under this proposal.

Estate Taxes

Under current law, estates with more than $5.45 million of assets ($10.9 million if married and electing to utilize the portability election), adjusted annually for inflation, are subject to a 40% estate tax.  The beneficiaries of the estate then receive a “step-up” in value for the assets they inherit.

The Trump tax proposal eliminates the estate tax, and along with the the “step-up” in value beneficiaries would receive, but only for beneficiaries of an estate worth more than $10 million.

 

Is Your Business a Hobby?

November 9th, 2016 Posted by Tax No Comment yet

Are you living your dream?  Are you passionate about your business?  Can you not wait to get back to your business everyday?

The IRS might think that you love your business so much that it is really a hobby.

What is the difference between a business and a hobby?

With a business, you are entitled to deduct all ordinary and necessary expenses.  With a hobby, however, you can only deduct the expenses to the extent you have income.

The IRS uses 9 factors to determine whether a taxpayer is engaged in a business or a hobby.

hobby

  1. Was the activity conducted in a business-like manner?
    The rationale behind this factor is that you will act differently if you are conducting a business rather than simply engaging in a hobby.  For example, someone in the business of being in a band might schedule a number of performances, and have a plan on how to increase attendance.  Someone in the hobby of being in a band might have performances on an ad hoc basis.  Some elements that may be considered are: whether there is a business plan; if you maintain financial records; if there is a separate bank account; and whether you acted as a prudent business person.
  2. The taxpayer’s expertise or that of his/her advisers.
    Whether you have sufficient expertise to demonstrate that you know how to make the activity profitable is another important factor.
  3. The time and effort expended in the activity.
    The more time you dedicate to the activity, the more likely it is that the activity will be consider a business.
  4. Do you expect the activity’s assets to increase in value?
    If the activity involves accumulating assets, such as coins, you must show that you expected the value of the assets to increase.  That would indicate that you had the intention to sell them for a profit, which is an important factor to be considered a business.
  5. The taxpayer’s success in similar activities.
    If you have been successful with related activities, it is more likely to be considered a business.  On the other hand, if all of your similar activities have lost money then it is more likely to be considered a hobby.
  6. The taxpayer’s history of income or loss.
    This is similar to the prior factor, except that it looks only at this one activity.  If this activity consistently makes money, then it is likely to be considered a business.  If it consistently loses money or only occasionally makes a profit, it is likely a hobby.
  7. The amount of occasional profits.
    If you make a lot of money, then it is more likely to be considered a business.  If the activity only makes a minimal amount of money, it is more likely to be considered a hobby.
  8. The taxpayer’s financial status.
    If most of your income is derived from other sources, then this activity will look like a hobby.  On the other hand, if most of your income comes from this activity it looks like a business.
  9. The personal pleasure the taxpayer derives from the activity.
    This is a subjective factor.  You can love what you do, but if it looks like that is a greater motivation for you than money it will likely be deemed a hobby.

Outside of these factors, there is a safe harbor available to taxpayers.  If the activity has been profitable for 3 out of the last 5 tax years, including the current year, then the IRS will presume that the activity is carried on for profit (i.e., that it is a business).  If you breed, show, train, or race horses, you only have to be profitable for 2 out of the past 7 years in order to qualify for this safe harbor.

Shareholder Compensation

August 1st, 2016 Posted by Tax No Comment yet

As a small business owner, you spend countless hours working on your business.  Now that  the business is finally generating a profit, the last thing you want to is pay more in taxes than you need to.

If your business is set up as a partnership or an LLC, your income is subject to self employment taxes.  However, if your business is established as an S-corporation, you are not subject to self-employment taxes.  This is because you are treated as an employee of the S-corporation.  As an employee, your wages are subject to the same payroll taxes that any employee’s wages are subject to.

CompensationSelf-employment taxes are designed to achieve a similar result as payroll taxes.  Therefore, theoretically there should not be any significant difference in taxes paid between an LLC and an S-corporation. However, many S-corporation shareholder-employees discovered a loophole.  If an S-corporation shareholder-employee takes very little to no compensation and primarily takes shareholder distributions from the business, less taxes would be paid.

Be warned though that S-corporation shareholder-employees are required to take a reasonable salary.  There are a number of factors that are used to determine what is a reasonable salary:

  • Timing and experience;
  • Duties and responsibilities;
  • Time and effort devoted to the business;
  • Dividend history;
  • Payments to non-shareholder employees;
  • Timing and manner of paying bonuses to key people;
  • What comparable businesses pay for similar services;
  • Compensation agreements; and
  • The use of a formula to determine compensation.

If the IRS determines that your compensation is inadequate or unreasonable, it has the authority to reclassify amounts you received as a distribution as compensation.

There have been a number of tax court cases in recent years in which the IRS has successfully reclassified distributions as compensation.  In one case, the shareholder was the only employee of the business and he did not take any salary.  Instead, all the money he withdrew from the business was classified as distributions.  Because all of the income was derived from his own efforts and the distributions paid to him would be a reasonable amount for a full-time worker in his position, the courts upheld the IRS’ reclassification of the distributions as compensation.

In another case, a business owner with over 20 years of experience within his field paid himself a salary of $24,000 and took more than $200,000 in distributions.  It was eventually determined that others in a similar position within his industry were paid a salary of $67,000, so a portion of his distributions were reclassified.

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

Image from www.moneyobserver.com

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).

 

Adoption Tax Credit

June 6th, 2016 Posted by Tax No Comment yet

Are you considering adoption?

Adopting a child can be truly rewarding, but the process can be expensive.  However, the cost can be partially offset through the Adoption Tax Credit.

Adoption

For 2016, families can claim a tax credit worth up to $13,460.  You may qualify if you adopted a child and paid qualified expenses relating to adoption.  While this tax credit is non-refundable, any unused portion may be carried forward for up to 5 years.

Qualifying expenses are all reasonable and necessary fees, including:

  • Court costs;
  • Attorney fees;
  • Travel expenses; and
  • Other expenses directly related to the legal adoption of an eligible child.

An eligible child is a child under the age of 18 (who is not the child of your spouse or from a surrogate parenting arrangement), or an individual of any age who is physically or mentally incapable of caring for him or herself.

If you are adopting a U.S. child with special needs, you may qualify for the full $13,460 regardless of your actual qualified expenses once the adoption becomes final.

For adopting children without special needs, when you are eligible to claim the tax credit depends both upon whether the child is a U.S. citizen or resident and when the qualified expense is paid:

  1. If you are adopting a child who is a U.S. citizen or resident:
    • Any qualifying expenses paid before the year the adoption becomes final can be claimed the year after the year of the payment;
    • Any qualifying expenses the year the adoption becomes final can be claimed that year; and
    • Any qualifying expenses paid after the year the adoption becomes final can be claimed in the year of payment.
  2.  If you are adoption a foreign child:
    • Any qualifying expenses paid before the year the adoption becomes final cannot be claimed until the year the adoption becomes final;
    • Any qualifying expenses paid the year the adoption becomes final can be claimed that year; and
    • Any qualifying expenses paid after the year the adoption becomes final can be claimed in the year of payment.

Basically, if you are adopting a child who is a U.S. citizen or resident you can use the qualifying expenses to claim the tax credit even if the adoption does not become final, but if you are adopting a foreign child it must become final.

Additionally, if your employer has a qualified adoption assistance program, any amounts paid to you or on your behalf for the purposes of adopting a child may be excluded from your income.

This tax credit does phase out based upon income.  In 2016, if your modified adjusted gross income is greater than $201,920 it begins to phase out and will be completely phased out when your modified adjusted gross income reaches $241,920.

Paying for College

June 3rd, 2016 Posted by Tax Planning No Comment yet

College is expensive.  There is no getting around that one simple fact.  In one survey, it was determined that for the 2012-2013 school year, the average cost for an in-state public college was $22,261, and the average cost for a private college was $43,289.  Keep in mind that is a per-year cost, and included is the cost of tuition, fees, book, and housing.

The cost hasn’t gone down since then, and it isn’t likely to any time soon.

So what can you do to make college more affordable?

College Bound

Of course there are academic and athletic scholarships.  If you can get any type of scholarship that is of course the ideal situation.  Not only is it “free” money, but it is non-taxable to the extent that it is used to pay for your tuition, fees, books, and other course-related supplies.

It is also very common to take out student loans.  There are a variety of types of student loans, but a common feature for tax purposes is that the interest paid on student loans is deductible.  This deduction phases out for single individuals with income over $75,000 and married couples with income over $155,000.

Already paying for college?  There are several federal tax credits that you can take advantage of:

    • The American Opportunity Credit. This credit is worth up to $2,500 per year per eligible student.  This credit is available for the first 4 years of higher education at an eligible school.  You are able to claim the credit to cover the costs of tuition and required fees, books, and other course-related materials.   An added bonus with this tax credit is that it is partially refundable.  This means that you can get a tax refund of up to $1,000 even if you do not owe taxes.

    • The Lifetime Learning Credit.  This credit is worth up to $2,000 per year per tax return.  The credit is available even after the first 4 years of higher education.

There are also several ways to help to save for college that have tax advantages.

    • Savings Bond Interest Exclusion.  All of the interest income from Series I and Series EE bonds issued after 1989 are tax-free.  To qualify, the bond owner must have been at least 24 years old when the bond was issued, and the money must be used to pay qualified education expenses for yourself, your spouse, or a dependent.  This tax benefit phases out based upon your income level.

      College Graduation

    • 529 Savings Plans.  Your investment into a 529 Savings Plan grows tax-deferred, and the distributions from the plan that are used to pay for the beneficiary’s college costs are tax-free.  With a 529 Savings Plan, the full value of your account can be used at any accredited college or university in the country.  Any non-qualified distributions are subject to a 10% penalty on the earnings and will be taxed.

    • 529 Prepaid Plans.  Prepaid tuition plans are guaranteed to increase in value at the same rate as college tuition.  This means that tuition rates are locked in, offering peace of mind if you expect college tuition to rise. If the student attends an in-state public college, the plan pays the tuition and the required fees.  If the student decides to attend a private or out-of-state college, the plans typically pay the average of in-state public college tuition.  If a student decides not to attend college, the plan can be transferred to another member of the family.  529 Prepaid Plans are exempt from federal income taxation.  If no member of your family attends college, any non-qualified distributions are subject to a 10% penalty on the earnings and will be taxed.

    • Education Savings Account.  Up to $2,000 can be contributed to a Coverdell Education Savings Account in any year.  The amounts deposited into the account grow tax-free until distributed, and the distributions are tax-free as long as they are used for qualified education expenses.  If a distribution exceeds qualified education expenses, the portion attributable to earnings will be subject to a 10% penalty and will be taxed.

Selling Your Home?

June 1st, 2016 Posted by Tax No Comment yet

Are you looking to sell your home?  Then you may be able to take advantage of a major tax benefit!

Home sale

You may be entitled to exclude $250,000 of gain from the sale of your personal residence.  If you are married, you may be entitled to exclude $500,000 of gain!

In order to exclude this gain, you must meet 3 tests.

  1. Ownership Test.   You must have owned the home as a principal residence for at least 2 of the 5 years prior to the sale.  If married, either or both spouses can meet this test.
  2. Use Test.  You must have used the home as a principal residence for at least 2 of the 5 years prior to the sale.  If married, both spouses must meet this test.
  3. Frequency Test.  The exclusion applies to only one sale every 2 years.  If married, this test is not met if either spouse has claimed this exclusion within the past 2 years.

If both spouses do not meet the use and frequency test, then a portion of the exclusion may still be claimed.  In this case, instead of being able to claim the full $500,000 exclusion, the couple would only be able to claim the $250,000 if one spouse meets all 3 tests.

Even if you do not meet these tests, you may be able to claim a reduced exclusion!  A reduced exclusion is available if you sold your principal residence because of:

  • A change in your place of employment;
  • Health reasons; or
  • Unforeseen circumstances.

There is a safe harbor rule defining what qualifies under each of these three exceptions.

Lets look at an example.  In April 2014, John and Jane Smith purchased a small, 2 bedroom house for $500,000.  In September 2015, Jane gave birth to twins and they decided that they needed a larger home to accommodate their larger family.  In October 2015, with the help of a great realtor, the Smiths sold the same house for $800,000.

The Smiths have $300,000 of gain on the sale of their home.  They are afraid they will have to pay taxes on the full $300,000, but they talk to a CPA and learn that they do not have to.  Although they did not meet the 2 year ownership and use tests, they qualified for a reduced exclusion because the birth of multiple children from the same pregnancy is considered an “unforeseen circumstance.”  Because they owned and lived in the house for 18 months, they are able to take a reduced exclusion of $375,000 which is enough to eliminate their entire taxable gain.  They do not have to pay any tax on the sale and can use the extra $300,000 to buy a bigger house!

Self-Directed IRAs

May 31st, 2016 Posted by Tax No Comment yet

Traditionally IRAs invest in stocks and bonds.  However, through the use of self-directed IRAs, it is possible to have your IRA invest in real estate and businesses.

 

Self-Directed IRAs

What is a Self-Directed IRA?

Self-directed IRAs are simply IRAs whose custodian permits a wide array of investments beyond bonds and securities and provides for maximum control by the account holder.  Self-directed IRAs can include any investment, other than life insurance and collectibles, that are not specifically prohibited by federal law.

As with all other IRAs, self-directed IRAs must comply with various rules and regulations, including a rule against “prohibited transactions”.

 What is a Prohibited Transaction?

There are several types of transactions that the federal government have determined to be improper if conducted with the IRA account holder, his or her beneficiaries, or any disqualified person.

Disqualified Persons

The Internal Revenue Code defines disqualified persons as:

  1. A fiduciary of the plan (an IRA owner who exercises discretionary control over an IRA’s investments is a fiduciary);
  2. A person providing services to the plan;
  3. An employer whose employees are covered by the plan;
  4. An employee organization whose members are covered by the plan;
  5. A direct or indirect owner of 50% or more of any entity that is described in numbers 3 or 4 above.
  6. A family member of any of the above;
  7. A corporation, partnership, trust, or estate that is more than 50% owned directed or indirectly by any person described in numbers 1 through 5 above;
  8. An officer, director, 10% or more shareholder, or highly compensated employee (earning 10% or more of the employer’s yearly wages) of a person described in numbers 3, 4, 5, or 7 above;
  9. A 10% or more partner or joint venture of a person described in numbers 3,4, 5, or 7 above; or
  10. Any disqualified person who is a disqualified person with respect to any plan to which a multiemployer plan trust is permitted to make payments under Section 4223 of ERISA.

Prohibited Transactions

There are several types of transactions that are prohibited if done between the self-directed IRA and a disqualified person.  Here are a few examples (this is by no means a comprehensive list):

  • Selling property to or from the IRA;
  • Lending money to or borrowing money from the IRA;
  • Receiving unreasonable compensation for managing the IRA;
  • Using the IRA as security for a loan; or
  • Buying property for personal use with IRA funds.

What are the consequences if there is a prohibited transaction?

The penalties for engaging in a prohibited transaction are severe!  The Internal Revenue provides that if any prohibited transaction occurs, the account is no longer an IRA and it will be treated as if the assets within the account were distributed on the first day of the taxable year in which the prohibited transaction occurs.  This will trigger a 10% early withdrawal penalty, tax on the constructive distribution, and often an accuracy-related penalty for each of the tax years affected.

Let’s look at an example:

In 2010, Mark decided to roll over all $2,000,000 from his 401(k) plan to a self-directed IRA.  On July 1, 2011, the IRA purchased a rental property for $400,000 and left the remaining assets invested in securities. The IRA then hired Mark to manage the property and agreed to pay him 10% of the total rents received. Mark managed the property until late 2013 when the IRA sold it for $450,000.  For the years 2011 through 2013, Mark reported his “management fee” as income, but did not report any of the rental income or the gain on the sale of the property because he knew that income earned by an IRA is tax-deferred.

In 2014, Mark received a notice from the IRS informing him that he was being audited for the tax years 2011, 2012, and 2013.  After its audit, the IRS concluded that the IRA’s hiring of Mark and providing him compensation were prohibited transactions.  As a result, there was a deemed distribution of all of the IRA’s assets on January 1, 2011 (not only the $400,000 used to purchase the rental property).  Mark was assessed the following penalties:

  • Tax on $2,000,000+ deemed distributed to him on January 1, 2011 (plus penalties and interest);
  • 10% early withdrawal penalty on the $2,000,000+ deemed distributed;
  • 20% accuracy related penalty in 2011;
  • Tax on the 2011, 2012, and 2013 rental income (plus penalties and interest)
  • Tax on any interest, dividends, and capital gains from securities in 2011, 2012, and 2013 (plus penalties and interest);
  • Tax on the capital gains from the sale of the rental property in 2013 (plus penalties and interest); and
  • 20% accuracy related penalty in 2013.

It is not my intent to discourage anyone from using self-directed IRAs as investment vehicles.  However, it is very important to understand that it can be very easy for someone to engage in a prohibited transaction and incur very severe penalties as a result.  Therefore, if you are thinking about utilizing a self-directed IRA, talk to a tax professional to ensure that everything is done properly.

Home Office

May 23rd, 2016 Posted by Tax No Comment yet

Because of advances in technology, it is increasingly easy for people to work from home and save money doing so.

Having a home office means that you do not have to spend hours every month sitting in traffic trying to get to work, and you do not have to spend as much on fuel for your car.  It also means, if you own your own business, that you can save thousands of dollars in rent.  But it also is a tax deduction.  By claiming the home office deduction, you are allowed to deduct a portion of your living expenses such as utilities, that would otherwise be non-deductible.

This deduction is available to you whether you own your own business or work for someone else.  But if you are an employee, you must be working from home for your employer’s convenience and not your own.  If your employer requires that you work from home, then that test is met.

Home Office

Unfortunately, this deduction has been greatly abused by taxpayers and now the IRS is very strict in ensuring that your home office meets all of the requirements for the tax deduction.

The home office deduction is only permitted if the home office is used exclusively on a regular basis either: 1) as the principal place of business for any trade or business of the taxpayer; 2) as a place of business that is used by patients, clients, or customers in meeting or dealing with the taxpayer in the normal course of his or her trade or business; or 3) in the case of a separate structure that is not attached to the dwelling unit, in connection with the taxpayer’s trade or business.

To qualify under the “regular use” test, the home office must be used on a regular basis.  Working from home once a month does not count.

To qualify under the “exclusive use” test, you must use a specific area of your home exclusively for your business.  Even after “business hours,” you cannot use the space for non-business purposes.  Something as simple as your children “hanging out” in that room when you are not conducting business disqualifies the whole deduction.

However, if your home office meets these tests, the deduction can be substantial.  Under a new safe-harbor, the deduction is $5 for every allowable square foot, up to 300 square feet.  The deduction can be even greater if you keep track of all of your actual expenses, such as your mortgage, property taxes, and utilities.