Posts tagged " Business "

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.

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.

Child Care Tax Credit

May 11th, 2016 Posted by Tax Planning No Comment yet

If you own a business, you know how important it is to retain your top talent.  You can offer great pay, benefits, and interesting work, but your employees may decide that it is cheaper to stay home than to pay for child care.  How can you compete with that?

One option may be to provide child care for your employees, and the federal government will help pay for it through the Employer-Provided Child Care Tax Credit.  This tax credit is equal to 25% of qualified child care expenditures and 10% of qualified child care resource and referral expenditures, up to a maximum tax credit of $150,000.

Child Care

Qualifying expenditures include:

  • Costs to acquire, construct, rehabilitate, or expand the property that is being used as a qualified child care facility, as long as it is not part of the principal residence of the employer or any of the employer’s employees;
  • The operating costs of the qualified child care facility; and
  • Contracts with a qualified child care facility to provide services to employees.

The operating costs of the facility includes, in addition to all normal expenditures for this type of facility, the cost to train employees and to offer scholarship programs.

To get a better understanding of how this tax credit operates, lets look at an example:

XYZ Corporation has been experiencing a high turnover rate because of the number of young parents that it employs.  In an effort to retain a greater number of its most valued employees, it decided to convert some unused office space into a daycare facility at a cost of $300,000.  XYZ Corporation hired several individuals with extensive training in the field to operate the facility at a cost of $200,000 per year.

XYZ Corporation can claim a federal income tax credit of $125,000 (25% of the qualified expenses) in the first year, and a $50,000 tax credit (25% of the operational costs) in the following years.

Why Have a 401(k)?

May 2nd, 2016 Posted by Tax Planning 2 comments

Most financial experts will give you 2 main pieces of financial advice: 1) start saving for your retirement early, and 2) contribute enough to a 401(k) plan to maximize the employer match.

Every 401(k) plan is different as businesses set them up in order to best meet their needs and the needs of their employees.  However, a typical arrangement is for employers to match their employees contributions to their 401(k) plans $0.50 on the dollar, up to 3% of the employees gross salary.

If that is how your 401(k) plan works, you should contribute at least 6% of your gross salary to your 401(k) plan.  That effectively increases your salary by 3%! Why would you want to leave money on the table?

You should consider contributing even more than that to your 401(k) plan, as long as you can afford to do so.  As we discussed previously, due to compounding interest your retirement account can grow significantly.  The more you are able to contribute while young, the more growth you are likely to see.

401(k)

But why should an employer set up a 401(k) plan for the employees?  You may like the idea of helping your employees save for retirement, but do you want to deal with the cost and extra administrative burden?  That is up to you, but there are a few tax and non-tax benefits to setting up a plan:

$1,500 Tax Credit. Employers are entitled to claim a tax credit equal to 50% of the cost to set up and administer the plan, and to educate employees about the plan.  The credit is worth a maximum of $500 per year for each of the first 3 years of the plan.  If you are unable to use this credit in any given year, the unused portion can be carried back or forward to other tax years.  There are a few basic requirements that you should discuss with a CPA.

  • Tax Deduction.  Every penny that an employer contributes to a 401(k) plan, including to his or her own, is a tax deduction.  As an employer, you are also able to deduct the cost of administering the plan and educating your employees about the plan.  This is because the IRS considers the operation of a 401(k) plan to be an ordinary and necessary business expense.
  • Better Employee Recruitment and Retention.  For any business, having great employees is essential.  They represent you, so it is important that you are able to recruit the best possible employees and retain them once you have them.  All else being equal, I would choose to work for a company that has a 401(k) plan over one that doesn’t.  It shows employees that you care about them and their retirement.  It helps to build loyalty to your company.

Small Taxpayer Safe Harbor

April 1st, 2016 Posted by Tax No Comment yet

Under the IRS’s repair regulations, most of the costs associated with repairing/improving your rental property would have to be capitalized (expensed over a number of years).  However, the regulations provide the Small Taxpayer safe harbor which may allow you to deduct all the repairs, maintenance, improvements, and similar activities in the year in which the expense is incurred.

Small Taxpayer Safe Harbor

Who counts as a “small taxpayer”?

To be considered a small taxpayer, in this context, you must have annual gross receipts for the 3 preceding years of less than $10 million per year.

However, if you have been in business for less than 3 years, then you will determine your average annual gross receipts for the number of years, including any short taxable years, that you have been in the business.  For short taxable years, you must annualize the gross receipts.

What buildings are eligible?

In order for a building to qualify under this safe harbor, the original unadjusted basis (i.e., the purchase price of the building) basis must be $1 million or less.  In addition to commercial buildings, single family residences, and multi-family residences, the definition of building includes, condominiums, cooperatives, or leased buildings or leased portions of a building.

What other conditions have to be met?

The aggregate cost of all the repairs, maintenance, improvements, and similar activities cannot exceed the lesser of $10,000 or 2 percent (%) of the unadjusted basis of the building.

This test is applied on a building by building basis.

How are qualifying expenditures treated?

If a taxpayer meets all of the above-listed qualifications, then the amount he/she spends on repairs, maintenance, improvements and other similar activities are able to be deducted that year.

What happens when the expenditures are greater than the safe harbor amount?

Like I mentioned before, the aggregate cost of all the repairs, maintenance, improvements, and similar activities cannot exceed the lesser of $10,000 or 2% of the unadjusted basis of the building. If it does, even by $1, then this safe harbor cannot apply to any of the expenditures related to that building.

How does a taxpayer claim the protection of the Small Taxpayer safe harbor?

If a taxpayer wishes to take advantage of the de minimis safe harbor, they must file an election with the IRS by attaching a statement to their timely filed original federal tax return, including extensions, for the taxable year the safe harbor is being claimed.  The statement must include:

  • The title “Sec. 1.263(a)-3(h) Safe Harbor Election for Small Taxpayers”;
  • The taxpayer’s name;
  • The taxpayer’s address;
  • The taxpayers identification number; and
  • A description of each eligible building property to which the taxpayer is applying the election.

If the taxpayer is a partnership or an S corporation, then the election must be made at the entity level.

Examples of the Small Taxpayer Safe Harbor

Example 1

Adam, a qualifying small taxpayer, owns an office building.  Adam has an unadjusted basis of $850,000 in the building and during 2014 incurs $9,000 of repair, maintenance, improvements, and related expenses.

The building has an unadjusted basis of less than $1 million, so it is a qualifying building.  Similarly, the aggregate expenses of $9,000 is less than $10,000 or 2% of the unadjusted basis of the property ($17,000).  Therefore, if Adam elects to make the safe harbor election for small taxpayers”, he may deduct the entire $9,000.

Example 2

Barry, a qualifying small taxpayer, is a real estate investor.  He owns 2 rental properties, House A and House B.  House A has an unadjusted basis of $350,000, and House B has an unadjusted basis of $400,000.  In one year, Barry spends $8,000 in repair, maintenance, improvement, and related expenses on House A.  Similarly, he spends $7,000 in repair, maintenance, improvement, and related expenses on House B.

Both buildings have an unadjusted basis of less than $1 million, so they are both qualifying properties.

While Barry spend less than $10,000 on House A, the $8,000 he did spend is greater than 2% of the unadjusted basis of the property ($7,000) so he is not eligible to make the safe harbor election for small taxpayers for his House A expenditures.

However, Barry is able to make the safe harbor election for small taxpayers for House B.  Barry only spent $7,000 on House B, which is less than $10,000 and 2% of the unadjusted basis in the property ($8,000).

De Minimis Safe Harbor

March 30th, 2016 Posted by Tax No Comment yet

Anyone who owns a building or business equipment knows that occasionally it is necessary to have some work done to keep it in good condition.  In the last post, we discussed how under the IRS’s repair regulations most of these costs would have to be capitalized (expensed over a number of years) unless one of 3 safe harbors applies.  The first safe harbor is the De Minimis Safe Harbor.

Taxpayers that have a procedure in place to claim property as an expense on its books and records may be entitled to expense either $2,500 or $5,000 per item depending on whether the company has an applicable financial statement.

What is an “applicable financial statement”?

According to the Internal Revenue Code’s Regulation, an applicable financial statement is:

  • A financial statement required to be filed with the Securities and Exchange Commission;
  • A certified audited financial statement that is accompanied by the report of an independent certified public accountant; or
  • A financial statement required to be provided to the federal or a state government or any federal or state agency.

What does the Internal Revenue Code mean by a procedure in place to claim property as an expense on its books or records?

At the beginning of the taxable year, a taxpayer must have a written accounting procedure in place specifying how certain expenditures will be treated.  Essentially, the procedure must specify that expenditures for less than a specified amount or that have an economic useful life of less than 12 months will be treated as an expense on the taxpayer’s books.  However, the decision to implement this procedure must be made for non-tax reasons.  In other words, there has to be a rationale for this procedure other than classifying the expenditure as a repair for taxes.

When can taxpayers expense $5,000 per item as a repair?

A taxpayer may expense up to $5,000 per item if:

  1. The taxpayer has an applicable financial statement;
  2. The taxpayer has at the beginning of the taxable year a written accounting procedure treating as an expense for non-tax purposes amounts paid for property costing less than a specified dollar amount or with an economic useful life of 12 months or less;
  3. The taxpayer treats the amount paid for the property as an expense on its applicable financial statement in accordance with its written accounting procedures; and
  4. The amount paid for the property does not exceed $5,000 per item.

When can taxpayers expense $500 per items as a repair?

A taxpayer may expense up to $2,500 per item if:

  1. The taxpayer does not have an applicable financial statement;
  2. The taxpayer has at the beginning of the taxable year a written accounting procedure treating as an expense for non-tax purposes amounts paid for property costing less than a specified dollar amount or with an economic useful life of 12 months or less;
  3. The taxpayer treats the amount paid for the property as an expense on its books and records in accordance with these accounting procedures; and
  4. The amount paid for the property does not exceed $500 per item.

What counts as part of the cost of each item?

Taxpayers electing to apply the de minimis safe harbor must include as part of the cost per item all the additional costs (delivery fees, installation fees, etc.) if these additional costs are included on the same invoice as the tangible property.  However, if they are not included on the same invoice as the tangible property they are not required to be included as part of the cost of the item.

How does a taxpayer claim the protection of the de minimis safe harbor?

If a taxpayer wishes to take advantage of the de minimis safe harbor, they must be aware that it is not selectively applied but instead applies to all amounts paid during the taxable year for applicable property.

Taxpayers must file an election with the IRS by attaching a statement to their timely filed original federal tax return, including extensions, for the taxable year the safe harbor is being claimed.  The statement must include:

  • The title “Sec. 1.263(a)-1(f) de minimis safe harbor election”;
  • The taxpayer’s name;
  • The taxpayer’s address;
  • The taxpayer’s ID number;
  • A statement that the taxpayer is making the de minimis safe harbor election under Section 1.263(a)-1(f).

Repairs: Expense or Capitalize?

March 28th, 2016 Posted by Tax No Comment yet

Anyone who owns a house knows that it will periodically require work to keep it in good condition.  This work can often end up being very expensive.

The IRS allows business owners and investors to deduct as a business/investment expense the full cost of these repairs if it determines that it is an ordinary repair.  However, if the IRS determines that the work amounts to an improvement or that it extends the useful life of the property, it will not allow an immediate deduction and instead requires the work to be capitalized.

This has caused a lot of controversy between the IRS and taxpayers trying to determine what qualifies as ordinary repairs and maintenance and what is an improvement that must be capitalized.

The IRS has issued regulations that took effect on January 1, 2014 in an attempt to clarify the issue.

Repairs

As a general rule, you are required to capitalize:

  • The cost of purchasing new property (e.g. buildings or equipment);
  • The cost of making permanent improvements to buildings; or
  • The cost of restoring property that has already been fully or partially depreciated to its original condition (essentially extending the useful life of the property).

What do you mean by capitalizing the cost?

As I mentioned before, if an expenditure is deemed to be an ordinary repair then the full cost of the repair may be expensed in the year that the cost is incurred.  However, if it is not deemed to be a repair it has to be capitalized.

If a cost is capitalized, it is transformed from being an expense into being a depreciable asset.  This asset is then depreciated (expensed) over the useful life of the asset.  The useful life of the asset is determined based upon what the asset is.  For example, a residential building is depreciated over 27.5 years while an “improvement” is depreciated over 15 years and office furniture is depreciated over 7 years.

Most people would prefer to deduct the entire cost of the work required to keep their property in good condition right away instead of over a number of years, so most taxpayers would prefer to have the work classified as a repair.

There are 3 safe harbors with the Internal Revenue Code Regulations that, if met, allow a taxpayer to treat their expenditures as repairs.  These safe harbors are:

  1. The de minimis safe harbor;
  2. The small taxpayer safe harbor; and
  3. The routine maintenance safe harbor.

These safe harbors will be the subject of the next several blog posts.

S-corp vs. LLC: Unequal Allocations

March 11th, 2016 Posted by Tax Planning No Comment yet

As we have discussed, there are a number of important differences between S-corporations and LLCs.

S-corporations have to follow the traditional corporate formalities, while the formalities that LLCs have to comply with are far more relaxed.

California S-corporations pay the state a tax equal to the greater of 1.5% of their net income or $800.  California LLCs, on the other hand, pay the state $800 in taxes and then may have to pay an additional LLC fee based upon their revenue.

The shareholders (owners) of an S-corporation can choose to take their compensation from the business as salary or as distributions.  The members (owners) of an S-corporation, however, can only take their compensation from the business as a distribution.

An additional difference between the two is the amount of flexibility the owners have in allocating income, losses, and distributions between the owners.

The shareholders (owners) of an S-corporation must divide all income, gains, losses, and deductions in proportion to their ownership percentage. Therefore, if you own 30% of an S-corporation then you will pick up 30% of the corporation’s taxable net income on your tax return, and you are entitled to 30% of all the distributions made.

The members (owners) of an LLC, on the other hand, are allowed to have unequal allocation of income, gains, losses, and deductions as long as certain criteria are met. For example, you and your co-owner each own 50% of the LLC. You may have decided among yourselves that all of the depreciation deductions will be allocated to you, while all of the other items of income, gain, losses, and deductions will be split 50:50. You are allowed to do that as long as several requirements are met.  Those requirements are too complex to discuss in this blog, so I strongly recommend talking to a CPA if you are considering establishing an LLC whose operating agreement authorizes non-proportional allocation of income, gains, losses, and deductions.