Senate Proposal: Deductions

November 16th, 2017 Posted by Tax Planning No Comment yet

When the Senate Finance Committee released its tax reform proposal, it included a new business deduction, changes to the standard deduction, and changes to itemized deductions.  For a discussion of how the tax proposal would affect tax rates, please read our last post.

Business “Pass-through Income” Deduction

The Senate’s proposal included a brand new tax deduction for pass-through income.  If you operate your business as a partnership (including LLCs opting to be taxed as a partnership), S-corporation, or sole proprietorship, you may be eligible for this deduction.  This deduction is equal to 17.4% of your “domestic qualified business income”.

There are two significant limitations placed upon this deduction.  First, the deduction cannot be more than 50% of the taxpayer’s allocable share of the business’ W-2 wages.  However, this limitation does not apply if the taxpayer has taxable income under $250,000 ($500,000 if married and filing a joint tax return).

The second limitation is based upon the type of business the taxpayer operates.  If the business is a specified service business (e.g., lawyer, doctor, accountant, consultant, financial advisor, etc.), it would not be eligible for the deduction.  However, again this limitation does not apply if the taxpayer has taxable income under $250,000 ($500,000 if married and filing a joint tax return).

Standard Deduction

This tax reform proposal would nearly double the current standard deduction.  For 2017, the standard deduction is $6,350 for single individuals, $9,350 for heads of households, and $12,700 for married couples choosing to file a joint tax return.

Under the Senate’s proposal, the standard deduction would be $12,000 for single individuals, $18,000 for heads of households, and $24,000 for married couples choosing to file a joint tax return.

Taxpayers typically elect to take the standard deduction unless their total itemized deductions are greater.

Itemized Deductions

Itemized deductions are currently made up of 5 categorizes of deductions.  Those are: qualified medical expenses, taxes, interest, charitable contributions, and miscellaneous itemized deductions.

Medical Deductions

Image from irs.com

Medical

Unlike the House proposal, the Senate would not make any changes to medical deductions.

Taxes

The Senate’s proposal calls for the complete elimination of the deduction for state and local taxes.  This means that state income taxes would no longer be deductible.  It also means that property taxes would no longer be deductible.

However, when the taxes are being paid in connection with a trade or business (i.e., when the deduction would be reported on Schedule C or E), it is still deductible.

Interest

Under current law, an individual is allowed to deduct interest on home acquisition indebtedness of up to $1,000,000 (i.e. a $1 million dollar mortgage), and home equity indebtedness of up to $100,000 (i.e. a $100,000 home equity line of credit).

The Senate proposal would not make any changes to the mortgage interest deduction for home acquisitions.  It would, however, repeal the deduction for home equity interest.

Charitable Contributions

An individual is currently allowed to to deduction the value of their charitable contributions.  However, the amount deducted may not be greater than 50% of their adjusted gross income.  Any excess amount is carried forward to future years for up to 5 years until they are used.

This proposal would increase this amount to 60% of the taxpayer’s adjusted gross income.

Miscellaneous

The Senate’s tax proposal would eliminate most miscellaneous itemized deduction such as: tax preparation fees, professional dues, union dues, hobby expenses, tools and supplies used for work, etc.

The Senate’s proposal would also remove the overall limitation currently imposed upon the total amount of itemized deductions a taxpayer may claim.

Personal Exemptions

In addition to the changes listed above, the proposal would eliminate personal exemptions.

AMT

Finally, like the House of Representatives the Senate would repeal the Alternative Minimum Tax.

Click here to compare this proposal to the House of Representative’s proposal.

Senate Proposal: Tax Rates

November 13th, 2017 Posted by Tax Planning No Comment yet

On November 9, 2017, the Senate Finance Committee released its proposal for tax reform.  It varies from the House of Representatives proposal in a number of ways.  We will be discussing those differences over the next several posts, but will be starting with the tax rates.

Ordinary Income

Current Tax Rates

There are currently 7 ordinary income tax brackets.

For single individuals in 2018, your first $9,525 of income is taxed at a 10% rate.  A 15% rate applies to your income over $9,525 to $38,700.  The 25% tax bracket applies to your income over $38,700 to $93,700.  Your income over $93,700 to $195,450 is taxed at a 28% rate.  A 33% rate applies to your income over $195,450 to $424,950.  Your income over $424,950 to $426,700 is taxed at a 35% rate.  All of your income over $426,700 is taxed at a 39.6% rate.

For married couples choosing to file a joint tax return, your first $19,050 is taxed at a 10% rate.  A 15% rate applies to your income over $19,050 to $77,400.  The 25% tax bracket applies to your income over $77,400 to $156,150 is taxed at a 25% rate.  Your income over $156,150 to $237,950 is taxed at a 28% rate.  A 33% rate applies to your income over $237,950 to $424,950 .  Your income over $424,950 to $480,050 is taxed at a 35% rate.  All of your income over $480,050 is taxed at a 39.6% rate.

You may expect that the married filing jointly tax brackets would be exactly double the single tax bracket.  However, once you get to the 28% tax bracket you will notice that is not true.  This is what is known as the marriage penalty.

Senate Tax Rates

There would be 7 ordinary income tax brackets under the Senate proposal.

Tax Rates

Image from www.calnonprofit.com

For single individuals, your first $9,525 of income is taxed at a 10% rate.  A 12% rate applies to your income over $9,525 to $38,700.  From over $38,700 to $60,000 your income is taxed at a 22.5% rate.  The 25% tax bracket applies to your income over $60,000 to $170,000.  A 32.5% rate applies to your income over $170,000 to $200,000.  Your income over $200,000 to $500,000 is taxed at a 35% rate.  At $500,000 and above your income is taxed at a 38.5% rate.

For married couples choosing to file a joint tax return, your first $19,050 of income is taxed at a 10% rate.  A 12% rate applies to your income over $19,050 to $77,400.  From over 77,400 to $120,000 your income is taxed at a 22.5% rate.  The 25% tax bracket applies to your income over $120,000 to $290,000.  A 32.5% rate applies to your income over $290,000 to $390,000.  Your income over $390,000 to $1 million is taxed at a 35% rate.  At $1 million and above your income is taxed at a 38.5% rate.

As you may have noticed, the Senate proposal preserves the marriage penalty, but only for the 32.5% and 35% tax brackets.

House Tax Rates

There would be 4 ordinary income tax brackets under the House of Representatives proposal.

For single individuals, your first $44,999 of income is taxed at a 12% rate.  Your income from $45,000 to $199,999 is taxed at a 25% rate.  A 35% rate applies to your income from $200,000 to $499,999.  At $500,000 and above your income is taxed at 39.6% rate.

For married couples choosing to file a joint tax return, your first $89,999 of income is taxed at a 12% rate.  Your income from $90,000 to $259,999 is taxed at a 25% rate.  A 35% rate applies toy our income from $260,000 to $999,999.  At $1 million and above your income is taxed at a 39.6% rate.

The House of Representatives also maintain the marriage penalty for the 35% tax bracket.

Capital Gains

Current Tax Rates

Currently, there are 3 tax rates that apply to capital gains (0%, 15%, and 20%).

In 2018, the 0% tax rate applies if your taxable income is $38,700 if you are single and $77,400 if you are married filing a joint tax return.

The 15% tax rate applies if your taxable income is between $38,701 and $426,700 if you are single and $77,401 and $480,050 if you are married filing a joint tax return.

The 20% tax rate applies if your taxable income is above those thresholds.

House and Senate Tax Rates

The House and Senate proposals would maintain the same three capital gains rate (0%, 15%, and 20%).  They would also have the rates apply to the same income limits even though they are changing the underlying tax brackets.

In our next post, we will discuss the Senate’s new deduction for business income, as well as their proposed changes to the standard deduction, itemized deductions, and AMT.

 

Tax Proposal: Selling Your House

November 10th, 2017 Posted by Tax Planning No Comment yet

The ability to exclude up to $500,000 of gain on the sale of a principal residence is one of the most popular aspects of the current income tax code.  The House of Representatives’ tax reform bill may modify that benefit.  Click here for an explanation of how the exclusion currently operates.

Tax Benefit at Issue

If you are a home owner, you are entitled to exclude up to $250,000 of gain on the sale of your principal residence ($500,000 if you are married and filing a joint tax return) as long as you meet certain eligibility requirements.  The exclusion itself is not changing, but the eligibility requirements might.

House SoldHolding Period

The current law requires that you must own the house for 2 out of the 5 years prior to the date of sale.  You are also required to use the house as your principal residence for 2 out of the 5 years prior to the sale.

The House of Representatives’ proposal changes this time period.  Under their proposal, you must own and use the house as your principal residence for 5 out of the 8 years prior to the sale.

Income Test

The proposal also imposes a new income test.  In order to claim the exclusion, your modified gross income in the year of sale and the 2 preceding years must average less than $250,000 ($500,000 if you are married filing jointly).  If your income exceeds this threshold, the exclusion phases out.  The phase out is one dollar for every dollar your average modified gross income exceeds the limit.

If you are married and for whatever reason did not file a joint tax return in a preceding year, that year will not be included in determining your average modified gross income.

Frequency

You will only be able to claim this exclusion once every 5 years.  The rule currently is that it can only be used once every 2 years.

Tax Reform Proposal: Examples

November 9th, 2017 Posted by Tax Planning No Comment yet

In the past 3 posts in our series, we discussed how the House of Representative’s tax reform bill would change individuals’ tax rates, amount of taxable income, and their tax credits.  Now, we are going to illustrate how all those changes come together and could affect you.

Example 1

Justin is single and works as a teacher in San Diego earning a $50,000 salary.  Every year, he spends at least $250 on supplies for his classroom.  Justin is renting an apartment with friends.

Under the current tax system (with 2016 tax rates), Justin would owe $5,628 in federal taxes.  This is because he had $50,000 in adjusted gross income and is able to deduct up to $250 as educator expenses.  His standard deduction of $6,300 is greater than his almost non-existent itemized deductions, and his personal exemption is $4,050.  That means his taxable income is $39,400, and he is in the 25% marginal tax bracket.

Under the tax reform proposal, Justin would owe $4,536 in federal taxes.  He still has $50,000 of income, but he is no longer entitled to the educator expense deduction.  His standard deduction is now $12,200 but he does not have a personal exemption.  His taxable income is $37,800, and he is in the 12% marginal tax bracket.

Example 2

Ryan and Amy are married and both work for the City of San Diego earning a salary of $60,000.  Amy also invested into a friend’s business years ago as a passive investor, and has $20,000 of ordinary income per year from that investment.  Ryan and Amy own a house, and owe $400,000 on it.  They will have to pay mortgage interest of $14,000 and property taxes of $7,000.  They made charitable contributions of $2,000.  They paid $5,500 of California income taxes during the year.

Under the current tax system (with 2016 tax rates), they would owe $17,393 in federal taxes.  This is because they have $140,000 in adjusted gross income.  They itemized their deductions and are able to deduct a total of $28,500, and have personal exemptions worth $8,100.  That means that their taxable income is $103,400, and they are in the 25% marginal tax bracket.

Under the tax reform proposal, they would owe $17,200 in federal taxes.  They still have $140,000 of adjusted gross income, but now instead of itemizing their deductions they are taking a standard deduction of $24,400 and do not have a personal exemption.  Their taxable income is $115,600, and they are in the 25% marginal tax bracket.

Example 3

Tom and Carolyn are married and live in California.  Tom is an engineer with an annual salary of $70,000.  Carolyn is a doctor who owns her own practice (as a sole proprietorship), and this year she has $300,000 of business income.  They own a house and owe $1.2 million on it.  They will have to pay mortgage interest of $44,000 and property taxes of $12,000.  They made charitable contributions of $10,000.  They paid $24,000 of California income taxes during the year.

Under the current tax system (with 2016 tax rates), they would owe $85,972 in federal taxes.  This is because they would have $362,976 of adjusted gross income ($370,000 of income less a deduction of $7,024 for self-employment taxes).  They itemize their deduction and are able to deduct a total of $84,587.  That is because their mortgage interest deduction is limited slightly due to the size of the loan, and there is an overall limitation on the amount of itemized deductions they are allowed to take due to their income.  They are only entitled to personal exemptions of $4,698 due to income limitations.

Their taxable income is $273,480, and would have federal taxes of $68,209, but they are in AMT and therefore owe an additional $5,390 in federal taxes.  In addition, due to the amount and nature of their income they would owe $14,048 in self-employment taxes and $873 as a Medicare surtax.  They are in the 33% marginal tax bracket.

Under the tax reform proposal, they would owe $83,882 in federal taxes.  They still have $362,976 of adjusted gross income, and would still be allowed to itemize their deductions.  However, because they cannot deduct state taxes or as much mortgage interest, their itemized deduction is only $40,333.  They do not have any personal exemptions.  Their taxable income is $322,643, and there is no AMT under the tax reform proposal.  They would owe $68,981 in federal income taxes, and the same $14,048 in self-employment taxes and $873 as a Medicare surtax.  Although their total taxable income would have otherwise pushed them into the 35% tax bracket, because 30% of the business income is taxed at a 25% rate they never left that tax bracket.

Example 4

Frank and Mary are married and live in California.  They own a very successful real estate development company together (which is organized as an S-corporation), and will make $800,000 of net profit.  They own a house and owe $1 million on it.  They will have to pay mortgage interest of $38,000 and property taxes of $15,000.  They made charitable contributions of $30,000.  They paid $67,000 of California income taxes during the year.

Under the current tax system (with 2016 tax rates), they would owe $229,772 in federal taxes.  This is because they have $800,000 of adjusted gross income.  They itemized their deductions and are able to deduct $135,339 due to a reduction of $14,661 as a result of an overall limitation on the amount of itemized deductions.  Due to income limitations, they are not entitled to a personal exemption.

Their taxable income is $664,661, and they owe income taxes of $208,872 on that amount.  They owe an additional $20,900 as a Medicare surtax.  They are in the 39.6% tax bracket.

Under the tax reform proposal, they would owe $216,800 in federal taxes.  They still have $800,000 of adjusted gross income, and would still be allowed to itemize their deductions.  However, because they cannot deduct state taxes or as much mortgage interest, their itemized deduction is only $64,000.  There are no personal exemptions.  Their taxable income is $736,000.  They would owe $190,900 in federal income taxes and the same $20,900 as a Medicare surtax.  Although they are in the 35% tax bracket, $240,000 of their business income was still taxed in the 25% tax bracket.

Tax Reform Proposal: Credits and Adjustments

November 8th, 2017 Posted by Tax Planning No Comment yet

There are a number of changes that will occur if Congress passes the tax reform bill that the Republican leadership in the House of Representatives proposed on November 2, 2017. Among these are changes to the deductibility to certain adjustments to income as well as changes to a number of tax credits.

Loss of Certain Deductions

Here are some items that will no longer be deducted as an adjustment to income:

  • Alimony (but only for divorce and separation agreements entered into after December 31, 2017);
  • Educator expenses (currently only $250 is allowed);
  • Interest on student loans;
  • Moving expenses; and
  • Tuition expenses.

Tax Credits

There are a number of tax credits that will be affected (positively or negatively) by the proposed changes to our tax system:

  • Adoption Tax Credit
    • This tax credit that partially offsets the cost of adopting a child will no longer be available.
  • Child Tax Credit
    • Currently, taxpayers under certain income thresholds are entitled to a $1,000 non-refundable tax credit per qualifying child.  The value of this tax credit will go up to $1,600.  Up to $1,000 of the credit will be refundable.
    • Under the tax reform bill, there will be an additional non-refundable tax credit for claiming other family members as dependents.
  • Credit for the Elderly and Permanently and Totally Disabled
    • This tax credit, which because of its restrictions, is not believed by the author to be widely used, will no longer be available.
  • Education Tax Credits
    • The three current education credits (i.e. American Opportunity, Hope, and Lifetime Learning) are combined into one tax credit that is worth up to $2,500.
  • Plug-in Electric Vehicle Tax Credit
    • This popular tax credit, which is worth up to $7,500 for purchasing a qualifying plug-in electric vehicle, will no longer be available.Tax Credits

The value of these deductions and credits greatly depends upon your personal situation. In our next post, we will provide examples of how how the changes in tax rates, deductions, exemptions, and credits comes together.

Tax Reform Proposal: Changing Taxable Income

November 7th, 2017 Posted by Tax Planning No Comment yet

If enacted, the tax reform bill proposed on November 2, 2017 will be the most sweeping change to our tax law since 1986.  In our last post, we discussed what the tax rates would be under this proposal.  Now, we are going to discuss how the proposal will change your taxable income.

To calculate your taxable income, you start with your adjusted gross income (essentially your income plus or minus certain adjustments.  Next, you subtract from that the greater of your standard deduction or your itemized deductions.  Finally, you subtract from that amount your personal exemptions.

Under this proposal, the same basic mechanism is in place but the components were modified.

Standard Deduction

First, the standard deduction has been nearly doubled.  For married couples choosing to file a joint tax return, the standard deduction will increase from $12,700 to $24,400.  For single individuals, the standard deduction is half that amount.

Itemized Deductions

Next, what qualifies as an itemized deduction has changed.  Under the current system there are 5 main categories of itemized deductions: medical expenses, taxes, interest, charitable contributions, and miscellaneous.  This proposal will change each category in the following ways:

  • Medical
    • Currently, medical expenses are only deductible if they exceed a certain threshold.  Instead, medical expenses will no longer be deductible.
  • Property Taxes
  •  Taxes
    • Taxpayer can currently deduct the greater of their sales tax or state income taxes.  Under this proposal, sales and state income taxes are no longer deductible.
    • Property taxes will still be deductible, but only up to $10,000.
  • Interest
    • Taxpayers can deduction their mortgage interest on loans up to $1.1 million.  Mortgage interest will continue to be deductible, but only on loans up to $500,000.
  • Charitable Contributions
    • Currently, qualifying charitable contributions are entirely deductible, up to 50% of your adjusted gross income.  This will increase up to 60% of your adjusted gross income.
  • Miscellaneous
    • There are a number of “miscellaneous” itemized deductions that will no longer be deductible.  These include: personal casualty losses, tax return preparation fees, and unreimbursed employee expenses.
    • The current overall limitation on the amount of itemized deductions allowed will be removed.

Personal Exemptions

In addition to the changes to the standard deduction and itemized deductions, this proposal eliminates personal and dependency exemptions.

AMT

Finally, it is worth noting that this proposal repeals the Alternative Minimum Tax (AMT).  Basically, AMT is a calculation of how much tax the government believes you should be paying based upon your income.  Its application results in certain itemized deductions becoming worthless.  If this tax reform proposal passes, if a person qualifies to take itemized deductions they would simply get their itemized deductions without worrying about whether AMT makes the deductions worthless.

As a result of all of these changes, your taxable income will likely be different than it would be under the current system.  Whether it will be higher or lower depends upon your particular circumstances.  Even if your taxable income is higher you may end up paying less taxes due to the change in the tax rates and the other changes we will be discussing in the next post.

Tax Reform Proposal: New Tax Rates

November 6th, 2017 Posted by Tax Planning No Comment yet

On November 2, 2017, the Republican leadership in the House of Representatives unveiled their tax reform proposal. This tax reform proposal, if enacted, would be the most sweeping piece of tax legislation since 1986. Because the actual bill is over 400 pages long, we will be covering several major aspects of it over several blog posts rather than all at once.

If you heard nothing else about the proposed tax reform, you heard that the tax rates that apply to individuals would be decreasing. That is true, although not as straight-forward as it sounds as we will be discussing here and in future posts.

Tax Reform

Ordinary Income

Under the proposal, there would be 4 ordinary income tax rates: 12%, 25%, 35%, and 39.6%.

For single individuals, the 12% rate applies to your first $44,999 of income.  The 25% rate applies when your income is between $45,000 and $199,999.  The 35% rate applies when your income is between $200,000 and $499,999.  All income above $500,000 is taxed at a 39.6% rate.

For married couples filing jointly, the 12% rate applies to your first $89,999 of income.  The 25% rate applies when your income is between $90,000 and $259,999.  The 35% rate applies when your income is between $260,000 and $999,999.  All income above $1 million is taxed at a 39.6% rate.  For married couples choosing to file separately, the tax brackets are one-half of the filing jointly tax brackets.

Capital Gains

While this proposal does not change the current capital gains tax rates (i.e. 0%, 15%, and 20%), it does change the income thresholds at which the various rates apply.

For single individuals, the 0% capital gains tax rate applies if your income is less than $38,600.  The 15% capital gains rate applies if your income is between $38,600 and 425,799.  The 20% capital gains rate applies if your income is $425,800 or above.

For married couples filing jointly, the 0% capital gains tax rate applies if your income is less than $77,200.  The 15% capital gains rate applies if your income is between $77,200 and $478,999.  The 20% capital gains rate applies if your income is $479,000 or above.

For married couples filing separately, the 0% capital gains tax rate applies if your income is less than $38,600.  The 15% capital gains rate applies if your income is between $38,600 and $239,499.  The 20% capital gains rate applies if your income is $239,500 or above.

Business Rate

Under the House Republicans proposal, business owners may also benefit from a lower tax rate. Businesses that are operated as a sole proprietorship, partnership, limited liability company (LLC), or an S-corporation currently do not pay federal income taxes themselves, but instead “pass thru” the income and losses to the owners. The owners then pay taxes on that business income at their individual tax rates. Under this proposal, owners of these “pass thru” entities would still report the business income on their individual tax returns, but now may pay a maximum tax rate of 25% on a portion of their business income, if they qualify.

All income from passive activities (e.g. a business that you invest in but have no active role in operating) would be taxed at the 25% rate. However, if you are actively operating a business, the government does not want you to disguise your compensation (which may be taxed at a higher rate depending upon what your taxable income is for the year) as business income. Therefore, they apply a formula to determine what percentage of your business income should qualify for the 25% business tax rate. They do allow a safe harbor percentage of 30%, and also allow taxpayers to make a “facts and circumstances” determination rather than using the prescribed formula.

However, certain types of businesses do not qualify for the 25% business tax rate. These businesses are those in the fields of: health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any business where the principal asset is the reputation or skill of one or more of its employees. These businesses are typically thought of as “personal services” businesses.

In the next post, we will be discussing changes to the standard deduction, itemized deductions, and personal exemptions and how those changes will affect your taxable income.

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.