Posts tagged " Tax Planning "

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

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.

Paying for College

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

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

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

So what can you do to make college more affordable?

College Bound

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

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

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

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

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

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

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

      College Graduation

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

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

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

Selling Your Home?

June 1st, 2016 Posted by Tax No Comment yet

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

Home sale

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

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

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

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

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

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

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

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

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

Self-Directed IRAs

May 31st, 2016 Posted by Tax No Comment yet

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


Self-Directed IRAs

What is a Self-Directed IRA?

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

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

 What is a Prohibited Transaction?

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

Disqualified Persons

The Internal Revenue Code defines disqualified persons as:

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

Prohibited Transactions

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

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

What are the consequences if there is a prohibited transaction?

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

Let’s look at an example:

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

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

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

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

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.

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.

Green Vehicle Tax Credits

May 9th, 2016 Posted by Tax Planning 3 comments

Is “going green” important to you?  Do you not only want to make your home energy-efficient, but drive a green vehicle as well?

The federal government has made that desire more affordable by offering 2 different tax credits to you, depending upon the type of “green vehicle” you are purchasing.

Green Vehicle

  1. Alternative Motor Vehicle Tax Credit.  This tax credit is available to individuals who purchase a qualifying fuel cell motor vehicle.  These vehicles are propelled by the power derived from one or more cells that convert chemical energy directly into electricity.  Generally, you can rely on the manufacturer’s certification that a vehicle qualifies for this credit.

    In order to qualify for this tax credit, you must: 1) be the owner of the vehicle; place the vehicle into service during the tax year; 3) the vehicle must be new (its “original use” must begin with you), 4) you must purchase the vehicle to use or lease to others; and 5) you must use the vehicle primarily in the United States.

    This credit is currently scheduled to expire at the end of 2016.

  2. Plug-In Vehicle Tax Credit.  This tax credit is available to individuals who purchase or lease a qualifying, four-wheeled plug-in electric vehicle manufactured primarily for use on public streets.  The value of this credit ranges from $2,500 to $7,500.  The base credit is $2,500, and an additional $417 for each kilowatt hour of battery capacity starting at 5 kilowatt hours, up to a maximum of $7,500.

    This credit will begin to phase out for a manufacturer’s vehicles when at least 200,000 qualifying vehicles have been sold for use in the United States, determined on a cumulative basis.  However, at this time no manufacturer has come close to selling 200,000 qualifying vehicles.  Click here for the IRS’s list of cumulative sales by manufacturer.

    To qualify for this credit, the vehicle must: 1) be manufactured primarily for use on public roads; 2) weigh less than 14,000 pounds; and 3) be able to exceed a speed of 25 miles per hour.

Solar Energy Tax Credit

May 6th, 2016 Posted by Tax Planning 4 comments

Do you want to use solar energy or another renewable energy source to power your home?  There is a tax credit available to help make that transition affordable for you.

Solar Energy

The Residential Energy Efficient Property Tax Credit is available to taxpayers who install qualified equipment to their home.  It does not have to your main residence (it can be on a second/vacation home).  Qualified equipment includes:

  • Solar Electric Equipment (i.e., solar panels);
  • Wind Turbines; and
  • Solar Hot Water Heaters.

The tax credit is equal to 30 percent of the cost of the alternative energy equipment that you have installed at your principal residence.

Unlike most other tax credits, there is no limit on the amount of credit available for most types of property.  However, this tax credit is non-refundable.  That means if you are not able to use the entire tax credit, then the unused portion is carried forward to the next year.

The Residential Energy Efficient Property Tax Credit is available for any qualified equipment that is installed before December 31, 2023.


Gary and Karen had solar panels installed on their principal residence on June 1, 2016 for a total installation cost of $90,000.  They are entitled to a tax credit of $27,000 (30% of the $90,000 installation cost).

Every year, Gary and Karen have a total federal income tax due of $12,000.

For the 2016 tax year, their usual $12,000 federal income tax bill was reduced to $0.  Gary and Karen will be receiving a tax refund from the IRS for any income tax withholdings or estimated tax payments that they made during the year.  They also have an unused tax credit of $15,000 that will be carried forward to 2017.

For the 2017 tax year, again their usual $12,000 federal income tax bill was reduced to $0.  Again, instead of writing a check to the IRS they will be receiving a refund for any income tax withholdings or estimated tax payments they made during the year.  They have an unused tax credit of $3,000 that will be carried forward to 2018.

For the 2018 tax year, they will finally exhaust their remaining tax credit but only have to pay $9,000 of federal income tax.

What is an IRA?

May 4th, 2016 Posted by Tax Planning No Comment yet

Everyone keeps telling you that you need to save for your retirement, but your company does not have a 401(k).  What are you supposed to do?  You can contribute to an Individual Retirement Account (IRA)!


There are 2 basic types of IRAs:

1) Traditional IRA

Qualified contributions to a Traditional IRA help to reduce your taxes because they are tax-deductible.  Contributions to a Traditional IRA are one the few ways in which you can actually reduce your tax bill after the year ends.  The governments allows you to make a contribution up until April 15th of the following year, and to take the deduction in the preceding year.

The amount you are allowed to contribute to a Traditional IRA changes frequently as it is adjusted for inflation, but in 2016 you are allowed to make a contribution up to $5,500, or $6,500 if you are age 50 or over.

Once invested into a Traditional IRA, all of the funds grow without being taxed.  You will not be taxed until you withdraw the funds! 

There are a few basic requirements in order to make a contribution to a Traditional IRA:

  • The contributor must be an individual (not a trust, company, etc.)
  • You must be under the age of 70.5
  • You must have sufficient earned income or compensation (at least as much as you contribute to your IRA)

Be careful though.  The ability to make a tax-deductible contribution phases out based upon whether or not your employer provides a company retirement plan, your tax filing status, and your income level.

2) Roth IRA

The principal difference between Traditional IRAs and Roth IRAs are that with Traditional IRAs the contributions are tax-free while with Roth IRAs the distributions are tax-free.

In 2016, you are allowed to make a contribution up to $5,500 or $6,500 if you are age 50 or over.  However, the contribution limitation changes based upon your tax filing status and your income level.

Once invested into a Roth IRA, all the funds grow tax-free.  Furthermore, all of the distributions are tax-free provided that you are over the age of 59 1/2 and have had the Roth IRA account for at least 5 years.

Again, there are a few basic requirements in order to make a contribution to a Roth IRA:

  • The contributor must be an individual (not a trust, company, etc.)
  • You must have sufficient earned income or compensation (at least as much as you contribute to your IRA).

You will notice that unlike with Traditional IRAs, there is no age restriction on being able to contribute to a Roth IRA.

Of course these are only the 2 most basic types of IRAs.  You may want to discuss non-deductible IRAs, SEP IRAs, and SIMPLE IRAs with a financial adviser to determine what type of IRA makes the most sense for your situation.