Posts in Tax

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.

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.

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.

Rental Real Estate

May 16th, 2016 Posted by Tax No Comment yet

There are a number of different ways that financially successful people obtain their wealth, but once they have it most will tend to diversify their investments among stocks, bonds, and rental real estate.  They diversify their assets in order to reduce the risk that any particular type of financial calamity will have too large of an impact on them.

So what makes rental real estate an attractive investment vehicle?

It could be the simple business model.  Person A needs a place to live.  Person B owns an extra house.  Person A pays Person B to live there.

It could be that it is a tangible investment.  An investment simply feels more real if you can see it before your eyes.

Or it could be that the investor expects the property value to rise and wants to finance the property through others paying rent.

In addition to all those reason, I think the tax incentives that the government gives rental property owners is a big factor.

Rental Real Estate

There are a number of tax advantages to owning rental real estate.

  • Depreciation.  When you are renting out real estate, you are entitled to depreciate the full value of the building over a number of years (how many depends on whether it is a residential or non-residential property).  This means that you can depreciate both the amount of cash you paid plus the amount that you borrowed on the property.  Note: Only the building is depreciable, not the value of the land.
  • Expenses are deductible.  All the expenses you incur in renting the property are deductible.  This includes mortgage interest, property taxes, a property manager, HOA fees, utilities, etc.  Of particular value is the mortgage interest deduction.  As I mentioned above, you are already allowed to depreciate the mortgage, but this deduction allows you to deduct the interest paid as well.
  • Capital Gains.  When you eventually sell the property, assuming that you purchased as a rental and operated it in that manner, any gain will be taxed at capital gains rates which are significantly lower than ordinary income tax rates.

Taking advantage of these incentives means that in some years investors may have a positive cash flow but little to no taxable income.

There are some limitations on these benefits.  Because of tax games that were played in the 1980s, Congress has categorized all rental income as “passive income” and only allows passive losses to offset passive income.  There are two exceptions.

The first is for real estate professionals, which we will not discuss here.  The second exception allows individuals to deduct up to $25,000 of rental losses if they actively participated in the real estate activity.  This exception phases out for individuals with modified adjusted gross incomes of greater than $100,000.

Disability Insurance

April 6th, 2016 Posted by Tax 1 comment

Do you know what will happen to you if you ever are seriously injured and become disabled?  If you do not, you are among a majority of working age American citizens who have not planned for this eventuality.

According to a July 2013 article, the Council for Disability Awareness published a statistic stating that over 1 in 4 people currently in their 20s will become disabled before they retire, and that 6% of working-age Americans are currently disabled.

According to the Insurance Journal’s June 2011 article, only 49% of US workers have short-term disability insurance and only 44% have long-term disability insurance.

Disability Insurance

But lets focus on those who do have disability insurance.  Are there any tax consequences for those who are disabled and receive disability insurance proceeds?

Frankly, the answer to that depends upon how you obtained your disability insurance.

There are four instances in which the they will not be taxable:

  1. You paid the premiums on the disability policy yourself;
  2. The insurance is provided through your employer, but the premiums are paid with after-tax dollars.  Effectively, this means that you paid the premiums yourself through your paycheck;
  3. The insurance is provided through your employer’s cafeteria plan; or
  4. The disability proceeds are reimbursements for actual medical expenses, permanent loss or loss of use of a part of the body, or permanent disfigurement.

On the other hand, if your employer pays the disability insurance premiums and those premiums are not taxable to you, then the proceeds are taxable.

 

Personal Injury Settlements

April 4th, 2016 Posted by Tax No Comment yet

Have you been injured in a car accident?

Many people who are injured in car accidents, or through other types of accidents, may end up being financially compensated through a legal settlement.  The last thing you will want to do is to have that money, which is supposed to go towards paying your medical bills, be taxed.

Fortunately, depending upon how the personal injury settlement is structured, it may not be.

Personal Injury

Personal Injury

If you receive a settlement for personal physical injuries, and did not take an itemized deduction for medical expenses related to the injury in prior years, the full amount is non-taxable.  However, if you claimed medical expenses related to the injury in a prior year, you must include that portion of the settlement as income.

Emotional Distress or Mental Anguish

If a portion of your settlement is for emotional distress or mental anguished originating from a personal physical injury, then it too is non-taxable.  However, the emotional distress or mental anguish must originate from a personal physical injury.

Lost Wages

If a portion of your settlement is for lost wages, that portion is fully taxable.

Property’s Loss-in-Value

The taxable portion of a settlement relating to your property’s decrease in value depends upon your basis in the property (original purchase price less any allowable deprecation).  If the decrease in value is less than the adjusted basis of your property, that portion of the settlement is not taxable.  However, if the property settlement exceeds your basis in the property, the excess is taxable income.

Punitive Damages

Punitive damages are fully taxable, even in personal injury cases.

It is very important when your attorney is negotiating a settlement that he/she classifies the settlement in a way that minimizes your tax burden.  The IRS will generally respect the classification of the settlement as long as it is consistent with the type of injury suffered.