Accounting/Finance

Year-end business deductions: the two-minute drill.

Joe Kristan is a CPA at Roth & Company P.C.

While April 15 gets all the glamor, tax-savvy folks know that December 31 is where the real action is. While you add up the score in April, December is when you run the two-minute drill.

You can't run a good two-minute offense if you don't know the rules of the game (to continue the sports theme at least one paragraph too far). It doesn't help that with last-minute legislative tax law changes, year-end planning this year is like running a two-minute drill in a game of Calvinball. Yet we have to plan with the tax law we have, not the one we would prefer, so here are some notes you can write on your wrist as you call your year-end tax plays.

100_0438Figure out where you are on the field. The quarterback running a two-minute drill will call different plays on one ten-yard line than he will on the other. You need to pencil out your taxable income to-date for any year-end planning moves to succeed other than by accident. When you run the numbers, you may find that your deductions will end up being more valuable next year.

If you are planning for your business, figure out whether you are a cash-basis or an accrual-basis taxpayer. The rules to get a deduction are different.

Cash-basis businesses record their income when they receive the check. The tax law says you can't defer income by letting uncashed checks accumulate; if you can deposit a check, you've earned it, as far as the IRS is concerned.

Cash basis taxpayers generally deduct an expense when it is "paid." When does that happen?

- If the item is paid for with a credit card, it is "paid" when it is charged to the card, even if the card balance isn't paid until a later year.

- If the item is paid with a check, it is "paid" when the check is mailed (postmarked), even if the check isn't cashed until a later year.

There are limits on cash-basis deductions. For example, you can't prepay items for more than a year at a time, and there are other rules that can apply to deal with taxpayers that try to do too much of a good thing.

Accrual basis taxpayers pick up income when they have earned the income, even if they haven't been paid yet. For example, a wholesaler will normally record income when it ships the goods, even on credit. Accrual taxpayers generally get their deductions when they meet the "all events" test: all events have occurred to fix the liability, and it can be determined with reasonable accuracy. 

The tax law applies some special limits to expense accruals. For example, the tax law has an "economic performance" requirement that limits accruals until "economic performance" of the activity giving rise to the deduction take place.

You can't just accrue an expense and never pay it if you want to deduct it. Accrued compansation has to be paid within 2 1/2 months of year-end to be deductible. Most other expenses need to be paid no later than 8 1/2 months after year-end.

The related party rules are the biggest practical limit on accrual-method deductions. An accrual basis taxpayer can't deduct an amount accrued to a cash-basis "related party" -- such as a bonus accrued to an owner -- until the related party has to include the payment in income. Whether you are "related" depends a lot on what entity you use to run your business. For example, a person owning 10 percent of a corporation would not be related to a corporation taxed as a C corporation, but would be related if the same corporation were an S corporation. You might even be related to an entity that you don't own at all if a relative is an owner.

Of course, being cash-basis or accrual-basis does nothing to help you deduct an expense that isn't deductible in the first place. Not everything your business can write a check for gets you an immediate deduction, or a deduction at all. Payments for salary have to be "reasonable," so writing a "salary" check to Grandma in Florida whose service to the business consists of monitoring her bingo card isn't going to work. If you buy a car for the business, you face annual deduction limits for vehicles. Owner life insurance premiums are rarely deductible. You get the idea.

With the likely re-enactment of the $500,000 Section 179 expense and 50 percent bonus depreciation for 2014, many owners are tempted to buy a new depreciable asset by year-end to get a big deduction. Be careful. It's not enough to pay for a fixed asset by year end; it has to be "placed in service" by then to be deductible this year. That means the asset has to be on-site and set up and ready to operate. A new machine in a crate on the loading dock at year-end isn't "in service" and won't give you a deduction.

And be sure to consult your tax professional. Even the best quarterback needs a good coach. Every taxpayer is different, and a move that might score for Jill might be a distance and loss-of-down penalty for Jane.

 

The C corporation dilemma and how not to solve it.

Joe Kristan is a CPA at Roth & Company P.C.

One big reason the business world has moved away from using "regular" corporations is because they pay two taxes on their income. These "C corporations," as tax geeks call them, pay taxes on their income as it is earned. If they distribute the after-tax earnings to their shareholders as dividends, the owners pay tax on their 1040s. If the owners sell their shares, they pay capital gain tax on the undistributed earnings embedded in the stock price.

100_0263When it comes time to sell, C corporation owners face this issue in a big way. Buyers usually want to buy assets. That way they get to amortize or depreciate the purchased assets at their fair value, rather than their historical cost. They also don't have to buy any hidden sins that would come with corporate stock.

The sellers are less excited about an asset sale. It means they have to pay tax on all of the gains at the corporate level, and another capital gain tax when they liquidate the corporation. A prompt liquidation is usually done to avoid "personal holding company tax" problems.

It would sure be nice if you could find an accommodator to buy your stock,  who could then sell the assets to the real buyer -- an accommodator who has a bunch of tax losses they could use to make the gain go away. That was the thinking of a Texan who ended up in Tax Court recently.

The Texan got in touch with a company that promised just such benefits. They worked out a deal. A recent Tax Court decision describes how such deals are set up:

"Midco transactions" or "intermediary transactions" are structured to allow the parties to have it both ways: letting the seller engage in a stock sale and the buyer engage in an asset purchase. In such a transaction, the selling shareholders sell their C Corp stock to an intermediary entity (or "Midco") at a purchase price that does not discount for the built-in gain tax liability, as a stock sale to the ultimate purchaser would. The Midco then sells the assets of the C Corp to the buyer, who gets a purchase price basis in the assets. The Midco keeps the difference between the asset sale price and the stock purchase price as its fee. The Midco's willingness to allow both buyer and seller to avoid the tax consequences inherent in holding appreciated assets in a C Corp is based on a claimed tax-exempt status or supposed tax attributes, such as losses, that allow it to absorb the built-in gain tax liability.

The IRS has never liked this, and back in 2001 (Notice 2001-16) they warned taxpayers off of these "Midco" deals. The courts have sided with the IRS.

But what if you liquidate and there is no corporation to collect from? You're not out of the woods. The Tax Court found that the Texan had "transferee liability" for the corporation's tax on its sale because he ended up with the cash out of the company.

The moral? The potential for C corporation double tax is most easily dealt with by not being a C corporation in the first place. That's why so many businesses are set up as LLCs or S corporations, where the income is taxed only once -- on the owner's returns.

Many C corporations set up in the past few years may end up qualifying for a special tax exemption for sales of their stock. If held for more than five years, "Section 1202 stock" is 50 percent to 100 percent tax free on sale; it can apply to stock purchased from February 18, 2009 through December 31, 2013. Congress is likely (but not certain) to further extend this break with legislation later this year. This doesn't solve all C corporation problems -- benefits are usually limited to the original owners of the stock, for example -- but it sure is handy when it does apply.

If you are stuck with the double-tax problem, planning might make it hurt less, but as the Texan learned, there are no easy off-the-shelf solutions.

Cite: Cullifer, T.C. Memo 2014-208.

 

Obamacare mandates: What's a taxpayer to do?

Joe Kristan is a CPA at Roth & Company P.C.

Last year's Supreme Court decision upholding the Affordable Care Act as a constitutional tax provision means that the court battles were over, right? 

Hardly. And the continuing controversy will likely leave many taxpayers in suspense over their 2014 federal tax bills well into next year.

While the ACA has been ruled constitutional, the operation of the complex law remains at issue. Last month two important federal appeals courts reached opposite conclusions on whether policies purchased through federally-established exchanges are eligible for tax credit subsidies. The D.C. Court of Appeals ruled in Halbig that only policies purchased through state-established exchanges qualify for the tax credits. The Fourth Circuit, which covers Maryland, North Carolina, and Virginia, ruled that policies purchased on federal exchanges could earn tax credits. 

20121120-2As only 14 states have enacted exchanges, this is a big deal -- without subsidies, the effective cost of health insurance would drastically increase for many taxpayers.

The controversy is likely headed to the U.S. Supreme Court, but no ruling is likely until next year. That poses a problem for taxpayers, as the ultimate decision determines whether two key Obamacare taxes apply in 2014.

The ACA relies on tax penalties to encourage certain behavior by taxpayers. The "employer mandate" applies in 2014 to businesses employing over 100 "full-time equivalent" employees. Employers subject to the mandate face a penalty that is triggered when an employee qualifies for tax credits on the purchase of a policy on the exchange. No tax credits, no penalty.

The individual mandate applies when a qualifying individual fails to purchase an "affordable" policy -- taking the tax credits into account. If the courts hold that the tax credits don't apply to policies purchased on federal exchanges, then the individual mandate -- at the greater of $95 or 1% of your income -- will no longer apply to people in those states because the available policies would no longer be "affordable." More on how mandates may be affected here.

So what's a taxpayer to do? Of course, you should start by consulting your own tax adviser. While you can make a good argument that the D.C. Circuit decision for now gives you a defensible return position to not pay the tax, my inclination is to play it safe. While I think the D.C. Circuit's decision limiting tax credits to state-established exchanges is the correct reading of the tax law, the Supreme Court won't be asking my opinion. The Administration has asked the full D.C. Circuit to review the decision, which was made by a three-judge panel, so it could be reversed sooner. And if they disagree with me, the IRS won't let you use my opinion as an excuse.

That's why I consider it prudent to assume, in planning for the individual mandate and employer mandate, that the courts will uphold the credits.  If you plan as if the mandate will apply, you will be managing your employee base, your insurance purchases, and your employee time policies, in ways to keep your costs down. You will also be setting aside funds to pay any mandate tax penalties that apply. And if the courts do the unthinkable and agree with me, you will find yourself with a windfall -- always a better result than a sudden unplanned tax liability.

The April 15 day-trader deadline

20130409-1Joe Kristan is a CPA at Roth & Company P.C.

We usually think of April 15 as the deadline for settling up with the IRS for last year.  But for the nation’s doughty day traders — especially the unlucky ones — it’s an important deadline for this year. 

The tax law normally limits capital losses to capital gains, plus $3,000. That means many busy traders will have to hope for great advances in life extension technology to ever fully deduct their capital loss carryforwards.

There is an escape from the $3,000 treadmill for taxpayers who qualify as “traders.” The IRS explains what it means to be a “trader”:

 To be engaged in business as a trader in securities, you must meet all of the following conditions:

  • You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation.    
  • Your activity must be substantial, and    
  • You must carry on the activity with continuity and regularity.

The following facts and circumstances should be considered in determining if your activity is a securities trading business:

  • Typical holding periods for securities bought and sold.    
  • The frequency and dollar amount of your trades during the year.    
  • The extent to which you pursue the activity to produce income for a livelihood, and
  • The amount of time you devote to the activity.

If the nature of your trading activities does not qualify as a business, you are considered an investor, and not a trader.

These are pretty steep tests. You pretty much need to be trying to do it for a living; another day job is a bad fact, as in this case.  But if you pass these tests, you can make a “mark-to-market election” under Section 475(f) of the Internal Revenue Code to deduct trading losses as ordinary. If you make this election on time, it applies to 2014 taxes. It’s too late to make the election for 2013.

The Section 475(f) election comes at a price. If you make this election, gains are ordinary, too, and you have to mark your gains and losses on open positions to market at year-end — paying tax as if you had sold the positions on December 31. Yet if you are exclusively trading short-term, where you pay taxes on gains at ordinary rates anyway and have few open positions at any time, this may not be a great sacrifice.

This election cannot be extended, so traders need to make the election by next Monday.  You make the election for 2014 by attaching a statement to your 1040 or extension for 2013 with the following information:

1. That you are making an election under section 475(f) of the Internal Revenue Code;

2. The first tax year for which the election is effective; and

3. The trade or business for which you are making the election.

Happy trading!

Fear the Family (and other related parties)

Joe Kristan is a CPA at Roth & Company P.C.

Iabiz 20140129Judging by income tax law alone, Congress seems to think that "The Sopranos" provides the standard business model for family financial transactions. The tax code is full of special rules that punish transactions between family members, on the assumption that they can't do business without trying to pull a fast one on their tax filings. You can't accrue a deduction to a cash-basis relative, for example, and you can't deduct a loss on a sale to family

A Kansas City entrepreneur recently learned about another related party rule, good and hard.  

Gary Fish started a successful tech company, FishNet Security, described on its website as "the No. 1 provider of information security solutions that combine technology, services, support and training." From 1998 the company was operated as an S corporation, a common tax structure under which the earnings of the corporation are taxed directly on the owner's 1040.

In 2004, he got an opportunity to get some cash out of his investment.  While the technical details were a bit convoluted, for tax purposes it came down to having his S corporation contribute the operating business to a new corporation; a private equity group contributed cash.  Mr. Fish received some stock in the new corporation, along with $9,698,699 of the private equity cash. 

The formation of a new corporation is normally tax-free.  Internal Revenue Code Section 351 allows taxpayers to exchange appreciated assets for stock without recognizing gain, as long as the contributing parties own 80% or more of the company after the transaction. But the tax law triggers taxable gain to the extent a taxpayer receiving stock also receives "boot" -- cash or other non-stock property -- in the deal.  

As with many tech companies, the value of the business was mostly in its intangible assets -- its "goodwill." The new corporation was treated as buying goodwill. The tax law says purchased goodwill can be amortized for tax purposes over 15 years. And here is where things went bad for Mr. Fish.

When "goodwill" is sold, the tax law normally treats it as a capital gain. An obscure part of the Code, Section 1239, can change that result. If you sell anything that can be depreciated or amortized to a related party -- things like machinery, buildings, and, yes, goodwill -- Section 1239 makes the gain ordinary. The idea is to prevent a taxpayer from selling something to a relative at reduced capital gain rates and then getting depreciation deductions against ordinary income, which is taxed at higher rates. This would not be very a attractive trick for goodwill, where the capital gain tax is paid right away while the deductions are spread over 15 years, but nobody ever said the tax law has to make sense.

Among the related parties affected by Section 1239 are corporations where a taxpayer owns over 50% of the stock value. While the capital structure of the new corporation was complex, the Tax Court judge determined that Mr. Fish owned more than 50% of the value of its stock. As a result, the $9,698,699 of "boot" gain recognized on the goodwill transferred to the new corporation was ordinary income, not capital gain.

In 2005, capital gain was taxed at 15%, while the top ordinary income rate was 35% (current rates are 20% and 39.6%; if the Obamacare surtax applies, both rates are increased by another 3.8%). Using those rates, Section 1239 increases Mr. Fish's federal tax bill on the gain from $1,454,805 to $3,394,545 -- $1,939,740 of unhappiness, if it isn't overturned by a higher court.  

Does this mean you can never do business with relatives without, er, sleeping with the fishes, tax-wise? No. But, like Tony Soprano, you need to be very careful doing so. You should work very closely with your tax advisor when engaging in finance with friends and family, including friendly family-owned businesses. Mr. Fish could give you about $1,939,740 reasons why.  

Cite: Fish, T.C. Memo. 2013-270

What's new in year-end tax planning

Joe Kristan is a CPA at Roth & Company P.C.

There are a few new twists to year-end planning this year. Some important tax breaks are scheduled to expire at the end of the year, and some new provisions affect how old tax planning tools can be used.  

Two key tax breaks for buying equipment are slated for big changes at year-end: "Section 179" and "50% bonus depreciation." Section 179 allows many taxpayers to fully deduct the cost of assets that would otherwise only be recovered over a period of years. The maximumm Section 179 deduction is scheduled to decline from $500,000 for tax years beginning in 2013 to $25,000 for years beginning in 2014. 

Bonus depreciation allows a 50% writeoff of otherwise depreciable property in many cases where Section 179 is unavailable. With few exceptions, it is scheduled to go away for assets placed in service after 2013. 

While there is a chance these breaks will be extended retroactively, how many of us want to place money on Congress doing something? To get either deduction, the property has to be "placed in service" by year-end. "Placed in service" means "in a condition or state of readiness and availablilty for a specifically assigned function." That means in the posession of the taxpayer on the premises where it will be used, and ready to go. It does not mean on-order, paid for, in a crate on the loading dock, or on a Fed-Ex truck somewhere.

Two old tax planning tools are affected by the 3.8% "Net Investment Income Tax" under Obamacare. This tax applies to individuals with incomes over $200,000 (single filers) or $250,000 (joint filers). It also applies to many taxable trusts. The two tools are prepaying income taxes and harvesting capital losses.  

Personal state income taxes are deductible in the year paid. (Iowa allows a deduction for federal income taxes). Estimating the tax due in April has long been in the tax planning toolkit. It has been less useful in recent years because it doesn't help taxpayers owing alternative minimum tax. But even if you have alternative minimum tax, prepaying state income taxes can reduce the net investment income tax.

Capital losses. Individuals are allowed to deduct capital losses to the extent of capital gains, plus $3,000 ($1,500 for married filing separate returns). If you have capital gains, and you have some losers in your portfolio, now is the time to sell them off. Just make sure you avoid the "wash sale" rules by not replacing the loss shares in the 30 days preceding or selling the loss sale. Also be sure to not sell to a related party, as those losses won't be deductible. Newly-issued regulations make these losses available to offset net investment income, to the extent they are otherwise deductible.

Year-end tax planning is very taxpayer-specific. You can't look at an article or post and know how to proceed. Without a projection of your taxable income for this year, you can hardly even start year-end tax planning. Once you have an idea where you stand, you can take a shot at your year-end planning. 

In any case, get together with your tax advisor before you make any year-end moves. There are other tools that might fit your needs, and there's enough at stake to make sure you do it right.

IRA is to startup funding as dynamite is to kindling

Joe Kristan is a CPA at Roth & Company P.C.

Equity is to startups like kindling is to a good campfire.  You might not get anything started without it. 

For many would-be entrepreneurs, retirement savings in an individual retirement account are the biggest potential source of startup funds. Yet getting money out of a traditional IRA triggers tax, and unless you are age 59 1/2 or older, a 10% early withdrawal penalty.

Some folks try to get around this problem by having the IRA itself be the equity investor. That can be a little like kindling a campfire with dynamite, as a Missouri man recently learned in Tax Court. 

The taxpayer, a Mr. Ellis, took about $320,000 from his 401(k) plan and rolled it into a self-directed IRA. He then had the IRA invest almost all of the funds in a new corporation (technically, an LLC that elected to be taxed as a corporation) in exchange for 98% ownership interest of the corporation. The corporation then went into business as a used car dealership, with the IRA owner as the general manager of the dealership.

The IRS said the result was a "prohibited transaction" that terminated the IRA, making the entire $320,000 of IRA assets immediately taxable. The Tax Court agreed:

In essence, Mr. Ellis formulated a plan in which he would use his retirement savings as startup capital for a used car business. Mr. Ellis would operate this business and use it as his primary source of income by paying himself compensation for his role in its day-to-day operation. Mr. Ellis effected this plan by establishing the used car business as an investment of his IRA, attempting to preserve the integrity of the IRA as a qualified retirement plan. However, this is precisely the kind of self-dealing that [the prohibited transaction rule] was enacted to prevent.

The results are hugely unpleasant: $163,123 in taxes and penalties.

The tax law is not generally friendly to retirement plans investing in active businesses.  There are cases where it can be done -- ESOPs, for example -- but it requires careful and well-advised planning, as the consequences of doing it wrong can be catastrophic. 

The tax laws are this way for a good reason: that money is supposed to be a nest egg, your cushion to land on when you stop working. Startups aren't exactly a widows-and-orphans kind of investment. If your retirement-funded start up goes bad, so do your retirement plans. They are at best a startup funding source of last-resort -- and if your business plan requires them, you might want to reconsider your business plan.

-Joe Kristan

 

Dress for success, but don't look to the IRS for any fashion help.

Joe Kristan is a CPA at Roth & Company P.C.

It's standard career advice to dress for the job you want, not the one you have. But they never tell you how you pay for boss clothes on an underling budget. It's only natural to try to get some wardrobe help on your tax return. 

Sadly, it's easy to make a fashion mistake on your 1040.

20110225-1If anybody needs to look sharp, it's TV anchors and actresses. The camera is unforgiving in a Hi-Def world, so thrifty wardrobe choices can stand out like a cheap suit. But the IRS has no fashion sense.

Anietra Hamper was a personality on a Columbus, Ohio TV station. She had to buy her own work clothes, and she took a common-sense approach to her deductions, according to the Tax Court:

She would ask herself "would I be buying this if I didn't have to wear this" to work, "and if the answer is no, then I know that I am buying it specifically" for work, and therefore, it is a deductible business expense.

An actress who was a stand-in for the "Penelope Garcia" character on the show "Criminal Minds" took a similar approach, according to the Tax Court:


Petitioner also claimed as business expenses items including makeup and beauty expenses, wardrobe expenses, and laundry and cleaning expenses. She claims that these expenses were necessary because of the unique dress and makeup of the character Garcia.


Unfortunately, the tax law takes a different approach. IRS Publication 529 explains:

You can deduct the cost and upkeep of work clothes if the following two requirements are met.

  • You must wear them as a condition of your employment.

  • The clothes are not suitable for everyday wear.

It is not enough that you wear distinctive clothing. The clothing must be specifically required by your employer. Nor is it enough that you do not, in fact, wear your work clothes away from work. The clothing must not be suitable for taking the place of your regular clothing.

Examples of workers who may be able to deduct the cost and upkeep of work clothes are: delivery workers, firefighters, health care workers, law enforcement officers, letter carriers, professional athletes, and transportation workers (air, rail, bus, etc.).

Musicians and entertainers can deduct the cost of theatrical clothing and accessories that are not suitable for everyday wear.

In the case of our TV anchor, the court said that that studio wear didn't make the cut, even though she wouldn't have purchased the items if she were, say, a welder:

Although she is required to purchase conservative business attire, it is not of a fashion that is outrageous or otherwise unsuitable for everyday personal wear. Given the nature of her expenditures, it is evident that petitioner's clothing is in fact suitable for everyday wear, even if it is not so worn. Consequently, the Court upholds respondent's determination that petitioner is not entitled to deduct expenses related to clothing, shoes, and accessory costs, as these are inherently personal expenses. Additionally, because the costs associated with the purchase of clothing are a nondeductible personal expense, costs for the maintenance of the clothing such as dry cleaning costs are also nondeductible personal expenses.

20130920-1It might have been a closer call for our actress, but the Tax Court reviewer went thumbs-down:

Neither petitioner’s records nor her testimony tied specific items of expense to the type of clothing and related items that would not be suitable for everyday wear. To the extent that items cannot be tied to petitioner’s job with “Criminal Minds”, her arguments about the uniqueness of Garcia are not persuasive.

Not being much of a TV viewer, I can't say whether a normal person would go out in public dressed like Penelope Garcia, though at least one commentator suggests one would not. Our actress needed to convince the judge that her purchases met the standard for "theatrical clothing and accessories that are not suitable for everyday wear." Her performance in Tax Court failed to convince the relevant critic (my emphasis):

Neither petitioner’s records nor her testimony tied specific items of expense to the type of clothing and related items that would not be suitable for everyday wear. To the extent that items cannot be tied to petitioner’s job with “Criminal Minds”, her arguments about the uniqueness of Garcia are not persuasive.

So what does the tax law tell the fashion-conscious aspiring boss? First, that it's difficult to deduct work clothes, and probably impossible for us cubicle monkeys. Even for actors and others, you need to be able to show the connection between your clothing purchases and your roles, and you need to have receipts to prove what your expenses are.  Otherwise, your deductions might close early to a bad IRS review.

-Joe Kristan

When you buy business assets, no do-overs.

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Joe Kristan is a CPA at Roth & Company P.C.

When a business goes up for sale, the buyer often prefers to buy the business assets, rather than corporate shares or LLC interests. Buying only the assets minimizes the baggage you might assume if you buy the corporation stock. 

Tax planning often favors an asset purchase. If you buy assets, you normally get to re-start the depreciation of the business, and you can deduct purchased "goodwill" of the business over 15 years. Purchasers of stock normally get no "step-up" of the business assets for depreciation. 

The tax law wants business buyers and sellers to agree on the purchase price allocation. That is to keep the buyers and sellers from "whipsawing" the tax man. Sellers typically want to allocate sale price to non-depreciable land, to long-lived buildings, and to goodwill, because those gains are taxed at favorable capital gain rates. In contrast, buyers want to allocate purchase price to inventory and equipment - which they can deduct sooner, but which generate high-rate ordinary income to the seller. 

The buyer and seller have to report the allocation on Form 8594 with their tax returns so the IRS can make sure the buyer and seller aren't taking differing positions. If they do take differing positions, the IRS can assess each taxpayer based on the other taxpayer's allocation, they just step aside and let them fight it out.

A company named Peco Foodsbought two poultry processing plants in Mississippi. They went ahead and filed their Form 8594, as they were supposed to. Then they had second thoughts. 

They hired an appraisal company to do a “cost segregation study.” Engineers looked over the purchased buildings and identified components they considered to really be part of the manufacturing machinery, and therefore eligible to be written off over a shorter life. They filed tax returns using the results of the study, taking larger depreciation deductions.

The IRS didn't like that, as this led to a "whipsaw." They disallowed the additional deductions, saying the buyer was stuck with the original allocation. The Tax Court agreed, and now the Eleventh Circuit Court of Appeals has upheld the Tax Court:

In binding Peco to both agreements, the Commissioner can be assured that both the buyer, (Peco) and the respective sellers, (Green Acre and MD), treat the assets consistently for federal tax purposes... As the Danielson court observed, “where parties enter into an agreement with a clear understanding of its substance and content, they cannot be heard to say later that they overlooked possible tax consequences.”

The Moral?  No do-overs. You only get one shot at the purchase price allocation when you buy a business. The purchase price allocation needs to be addressed early in your negotiations. If you want to have experts come in for a cost segregation study, you should do it as part of your due diligence before the deal closes, or under agreement afte the close with the seller. You can't unilaterally change the allocation. 

Be sure to consult with your own tax advisor at all stages of any business purchase or sale.

-Joe Kristan

Health care taxes: what's delayed, what isn't

Joe Kristan is a CPA at Roth & Company P.C.

Last week, an obscure Treasury official released a surprise announcement via blog post that President Barack Obama's Administration won't enforce the penalties on "large" employers who fail to provide "essential" health coverage until 2015. The penalties were slated to take effect in 2014.

The announcement was greeted with relief by many employers trying to figure out how to deal with the penalties; 2013 employment levels would have determined which employers were "large" (50 "full-time equivalent" employees). It probably also was a relief to many folks at 50-employee companies who were on the bubble. But it also caused confusion about whether other Obamacare rules would be delayed. Sadly, no (for the most part).

The only other major component of the Affordable Care Act that will be delayed are some verification requirements for individuals applying for health insurance subsidies

Some things that are not delayed, at least as of now:

In other words, most of Obamacare is still in effect, for now.  Plan accordingly.

-Joe Kristan

Playing with fire: Using an IRA to finance your business

IAbiz20130522

Joe Kristan is a CPA at Roth & Company P.C. 

When that great opportunity to start or buy a new business comes along, you probably need some cash to jump on it.  For many of us, our IRAs are the biggest financial asset. Yet unless it's a Roth IRA, you generally have to pay tax to get at the money, and if you are under 59, you also owe a 10% penalty. You may be able to get most or all of the cash in your Roth IRA tax-free, but then future earnings on those funds are taxable.

That's why it's tempting to try to have the IRA itself own a business. A recent Tax Court case shows that IRA ownership of a small business is playing with fire.

The biggest danger of owning your business in an IRA has been the risk of having a “prohibited transaction.” The tax law has hair-trigger rules for pension funds and other exempt organizations to prevent abuse of the funds by related parties or trustees. If you have one, you have a penalty tax of at least 15%, and maybe 100%. Worse, you terminate your IRA.

The Tax Court case involved a C corporation owned by IRAs. As is typical in a closely-held business, the lenders wanted a loan guarantee from the entreprenuers. Disaster ensued:

The Tax Court said this constituted an “indirect extension of credit” to the IRA (my emphasis):

 As the Commissioner points out, if the statute prohibited only a loan or  loan guaranty between a disqualified person and the IRA itself, then the prohibition could be easily and abusively avoided simply by having the IRA create a shell subsidiary to whom the disqualified person could then make a loan. That, however, is an obvious evasion that Congress intended to prevent by using the word “indirect”. The language of section 4975(c)(1)(B), when given its obvious and intended meaning, prohibited Mr. Fleck and Mr. Peek from making loans or loan guaranties either directly to their IRAs or indirectly to their IRAs by way of the entity owned by the IRAs.

This was a prohibited transaction, blowing the IRA. That meant when the corporation was sold in 2006, instead of a tax-free sale inside an IRA, it was a taxable sale by the owners. The result was over $400,000 in additional taxes, plus another $90,000 in penalties.

I suspect there are a lot of similar taxpayers out there.  They will be following this case if it is appealed with intense interest. If this ruling holds, this will be a catastrophe to such folks, in the same league as the ruin caused by Incentive Stock Options (ISOs) exercised just prior to the dot-com collapse. The ISO disaster was bad enough to get Congress to enact legislative relief. 

-Joe Kristan

The REIT way to reduce taxes?

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Some entreprenuer friends got excited when The New York Times ran Restyled as Real Estate Trusts, Varied Businesses Avoid Taxes.  A sample:

A small but growing number of American corporations, operating in businesses as diverse as private prisons, billboards and casinos, are making an aggressive move to reduce — or even eliminate — their federal tax bills. They are declaring that they are not ordinary corporations at all. Instead, they say, they are something else: special trusts that are typically exempt from paying federal taxes.

The trust structure has been around for years but, until recently, it was generally used only by funds holding real estate. Now, the likes of the Corrections Corporation of America, which owns and operates 44 prisons and detention centers across the nation, have quietly received permission from the IRS to put on new corporate clothes and, as a result, save many millions on taxes.

Changing from a standard corporation to a real estate investment trust, or REIT — a designation signed into law by President Dwight D. Eisenhower — has suddenly become a hot corporate trend.

So is your tax advisor failing to tell you about a great new way for your business to avoid taxes? Probably not.

Real Estate Investment Trusts are nice for those who can use them. They get to deduct earnings they pay out to their owners as dividends, avoiding the double-tax that applies to most "C" corporations. The distributions qualify for the lower 23.8% top rate on dividends for the recipients, instead of the top 43.4% rate on individual rental income. 

Sadly, they probably aren't for you. First, they only work if you have the right kind of income. This limits mostly passive real estate or real estate mortgages; other assets have to be in a taxable non-REIT entity. Some entities can make this work by dividing up their assets between the REIT and the taxable entity, but it doesn't fit everybody.

A bigger obstacle may be the ownership restrictions. A corporation requires at least 100 shareholders to elect REIT status. So you can get around that if you have 99 close friends who are willing to own token shares, right?  

Wrong. You don't qualify as a REIT if five or fewer shareholders own more than 50% of the REIT. What's more, attribution rules add the shares of related owners together, so you can't get around that by giving ownership to, say, your kids.

Who can use a REIT? A corporation with a wide ownership base and a lot of real-estate related assets. REITS with Des Moines connections include General Growth Properties and Macerich, led by Des Moines native Arthur Coppola. Owners of smaller real estate businesses can sometimes get REIT benefits through an "UPREIT" partnership with an existing REIT. But for most entrepreneurs, REIT status is unavailable. That's a shame; if I had my way, all corporations would be taxed like REITs.

-Joe Kristan

So you owe the IRS on your 2012 return and cash is tight. What now?

With the increase in tax rates from 2012 to 2013, many entrepreneurs accelerated income into 2012 to beat the higher rates. Now the bills are coming due. 

Iabiz20130331Most entrepreneurs operate as "pass-throughs" like S corporations or LLCs taxable as partnerships, so their business income hits their personal returns. Those are due April 15. A lot can happen between year-end and April 15, so cash will be tight for some folks. What options do you have when you owe the IRS on April 15?

First, don't blow it off. At the very least you want to extend the return, even if you can't pay all you owe.

- If you owe money and you don't bother to extend the return, the IRS will charge you 5% of the unpaid balance, plus another 5% for each month the balance goes unpaid. They also charge interest.

- If your 2012 tax liability is at least 90% paid in by April 15, you can extend your return and pay the rest by the extended due date of October 15 without penalty. The IRS will charge interest on the unpaid balance. The rate changes quarterly and is currently 3%.

- Normally if you are less than 90% paid in by April 15 and you extend, the IRS charges interest plus a 1/2% penalty, plus 1/2% for each additional month the tax remains unpaid. That 1/2% is a much better deal than the 5% penalty that applies when you don't bother to extend your return.

This year the penalty-free deal for those 90% paid-in is extended to many additional taxpayers. Congress didn't get around to finalizing 2012 tax law until January 2013, so the issuance of many tax forms was delayed. The IRS has waived the 1/2% late-payment penalty for tax returns that include one of the delayed forms (Notice 2013-24). That means that if you extend a return that will be filed with one of the delayed forms, you may only owe interest on any unpaid amount if you pay the balance by the October 15 extended due date. There is a catch: the IRS requires a "good faith" computation of the tax due and payment of the amount shown on the extension.  That may limit the usefulness of the deal.

The list of qualifying forms is here. The most common ones on entrepreneur returns are likely to be Form 4562, the depreciation form, and Form 8582, the "passive activity" form.  Some of the other forms qualifying for the penalty relief are Form 8903 for the "Domestic Production Activities Deduction" and Form 8863, for education tax credits.

Remember, you still need to pay the taxes eventually; if you do have the cash, you are likely to want to pay up, as it's hard nowadays to earn 3% after-tax on six-month money (the IRS interest is non-deductible). In any case, you should work with your tax own advisor in making any decision on how and when to pay your taxes.

The Colonel knows why your business might have to file returns in other states

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Tax returns for other states are an expensive annoyance. It can be even more expensive and annoying if you don't file them.

State governments love to tax out-of-state businesses. It's very tempting for politicians to pick the pockets of taxpayers who don't vote in their elections. Aggressive taxing agencies with improved abilities to spot potential pockets to pick are making it harder for out-of-state businesses to ignore state filing requirements.

There are two sets of restrictions on states that want to tax your business. The first is the Constitution, which requires there to be some connection to a state before a business can be taxed. The Supreme Court's Quill decision of 1992 imposed a "physical presence" test. This limit has been eroded over the years by aggressive states that have asserted an "economic presence" limit. States using the "economic presence" test consider the presence of "intangible" assets in a state, like trademarks, to be enough to subject a business to tax. Iowa successfully taxed KFC Corporation under this argument even though KFC had no presence in Iowa other than franchisees using KFC trademarks for their chicken outlets in Iowa.

The second limit on states trying to impose income taxes is PL 86-272This law, enacted in 1959, prevents states from taxing income of some out-of-state companies even if they otherwise could tax them under the constitution. This law protects corporations whose only activity in a state is solicitation of orders that have to be approved and shipped from out-of-state. This protection only applies to income tax. That means businesses may be required to collect sales tax and pay "doing business" taxes in a state without being required to pay income tax. It provides no protection to businesses that do more than "solicit." Providing warranty or other services in a state is all it takes to put you over the line.

The inevitable question: Should I just ignore other states and wait for them to catch me?  That has always been hazardous, and it becomes a worse bet every year. If you don't file a return in a state where you are taxable, the statute of limitations never expires, and your potential tax liability never stops growing

States have more tools than ever to spot non-filers. "Data-mining" is the best gift to state revenue departments since the invention of the auditor. If you have an employee in a state, it's only a matter of time before they notice if you don't file business returns there. If you own property, they can match up property tax records with income tax filings. They can use building permits or other local licenses to identify people who should be filing. They can walk back customer Use Tax reports to you if you are a vendor.

The Moral: As your business grows, be sure to discuss with your tax pro your activities in other states. Otherwise state revenue departments may have expensive and unpleasant surprises for you down the road.

-Joe Kristan

If a fire is worth fighting, it's worth fighting in style. But the firefighter still can't deduct the Benz.

Iabiz20130218Deductions for personally-owned vehicles are hard to get. A San Francisco firefighter learned that the hard way in Tax Court this month.

Mr. & Mrs. McCormack had a Schedule C home renovation business. They decided it needed a vehicle. So naturally they deducted it. From the Tax Court opinion:

The business was named Northside Construction and was identified as such on Schedule C. During 2009 Northside Construction had two jobs that generated $5,360 of gross receipts. The $41,818 loss deducted for the business was based primarily on $33,600 of depreciation and section 179 expense taken for the purchase of a 2007 MB 450 GL automobile that was acquired on October 5, 2009.

"MB" stands for "Mercedes Benz."

The IRS poked around, and found the car wasn't just used in the Schedule C business. The taxpayers then stumbled over the obstacle that disallows so many auto deductions: poor recordkeeping.

Petitioners claim that the car was used 100% of the time for business use in Northside Construction and for transportation by Mrs. McCormack for her San Francisco Fire Department responsibilities. Mr. McCormack kept a log for his business use of a Silverado truck on behalf of Ranger Pipelines, Inc., but did not keep the log in the automobile. Mrs. McCormack did not keep a log

If you don't keep an automobile log, you have at least two strikes on you if you try to deduct auto costs. The IRS had no trouble getting strike three across. Mrs. McCormack was an employee of the San Francisco Fire Department. Sec. 179 allows taxpayers to elect to deduct costs of assets that would otherwise be capitalized and recovered through depreciation. You can't take Sec. 179 for use of a car as an employee "unless such use is for the convenience of the employer and required as a condition of employment."

On top of that, you have to use a vehicle more than 50% in a qualifying business to take a Sec. 179 deduction. So things went badly:

There is no evidence in the record that the city of San Francisco required its fire department personnel to use their own automobiles while employed for the city, nor is there any evidence to suggest that the city failed to supply vehicles to its employees to provide fire department services for its citizens. On the contrary, Mrs. McCormack testified that during 2009 she used fire engines and ambulances provided by the city and did not otherwise keep a record of mileage for the automobile use as an employee. Consequently, Mrs. McCormack's use of the automobile as an employee of the city of San Francisco is not treated as business use for purposes of the Internal Revenue Code. When Mrs. McCormick's use of the automobile as an employee is coupled with the admitted personal use of the automobile for family and household purposes and the limited business use by Mr. McCormack, the Court holds that the business use of the automobile was less than 50%...

Petitioners may not deduct section 179 expenses for the MB 450 GL automobile purchased October 5, 2009. Furthermore, because of the failure to substantiate business use by means of a log or otherwise, no depreciation on the automobile, a listed property, may be claimed.

What can we learn from this tax conflagration?  Several things:

  • If you want to deduct business use of a car, you need to keep a log as you go.  Telling your tax preparer "Oh, 30,000 miles, 100% business" doesn't work well if you are audited.
  • If you do use your car as an employee, it's much better to turn in your mileage and get reimbursed than to try to get it as a tax return deduction. Employee business expenses are only deductible when they exceed 2% of your adjusted gross income -- and not deductible at all for alternative minimum tax.
  • If you deduct a car on your Schedule C, you can count on the IRS taking a close look at it on examination. If it's a luxury car, more so.

Cite: McCormack, T.C. Summ. Op. 2013-9.

Follow-up on January 4 post. Governor Branstad has signed into law a bill adopting most of the January "Fiscal Cliff" legislation for 2012 Iowa tax returns. As expected, the bill conforms most of the retroactive provisions of the Fiscal Cliff tax bill, including expanded Section 179 deductions, but not the expansion of "Bonus Depreciation."  More here.

Image Credit: Wikimedia Commons.

-Joe Kristan

Tough tax return choice for 2012: Pay more now to save later?

20130104-1When taxpayers have an option to deduct an expense sooner than later, it's usually an easy choice -- sooner! Why give the government money now instead of later? A no-brainer.

It's a brainer this year. The steep increase in tax rates for 2013 might make you less eager to take all the deductions you can in 2012. There are two important increases in tax rates this year. The "Fiscal Cliff" legislation increases the top effective "regular" income tax rate for individuals to 40.78%. Many business owners will also have to pay an additional 3.8% "Net Investment Income" tax in addition under Obamacare. That combined rate of more than 44% compares to a 35% top individual rate for 2012. That means deductions will be worth a lot more in 2013.

That leaves businesses with some perplexing choices on their 2012 tax returns. For example, the Fiscal Cliff bill increased the "Section 179" deduction maximium to $500,000 in 2012 and 2013. That means taxpayers can deduct up to $500,000 in expenditures that would otherwise have to be capitalized and depreciated over a period of years. The natural reaction is to deduct as much as you can as fast as you can. The new higher rates could make that costly.

For example, assume a taxpayer places a $500,000 computer system into service into 2012. If a top-braket taxpayer takes a Section 179 deduction in 2012, the tax benefit of the deduction is about $175,000, ignoring state taxes. If the taxpayer instead depreciates the system over its usual five year life, it will get a $100,000 deduction in 2012 and the remaining $400,000 over 2013-17, for a total tax benefit of about $211,000.

That means the taxpyer can reduce taxes from 2013-17 about $31,000 by not taking the biggest possible deduction this year. Is it worth paying less now to pay more later? That depends. If you are short of cash now, you might take the big deduction anyway -- you don't care about future taxes if you can't stay in business until then, and that big deduction might be the difference between staying alive and not. 

But the implied cost of funds for getting smaller tax benefit now for a bigger one later works out to over 11%. That's pretty expensive money.

Bottom line? Every taxpayer is different. You should discuss with your tax advisor whether it's worth paying extra 2012 taxes to save taxes in future years. The Section 179 deduction is just one instance where you might have to make that choice.

-Joe Kristan

January: the month to start your 2013 year-end tax planning!

20130116iabizWith tax rates going up this year, the tax planning stakes for 2013 have increased. Many taxpayers wait until December to get serious about their tax planning. They ask too much of one month.

If you really want to get a handle on your 2013 tax bill, the time to get serious is now. What to do? For starters: 

Maximize your 401(k) contribution.  This is the easiest way to save money -- by taking it out of one pocket and putting it away in another.  If your employer matches, so much the better. Remember, though, that if you are the employer, your contribution may be limited by employee participation. The maximum 401(k) contribution for 2013 is $17,500 ($23,000 for taxpayers who will be 50 by year-end).

Reconsider your withholding. Taxes have gone up, folks, and not just for "millionaires and billionaires." While the new highest rates kick in at $400,000 for single filers and $450,000 for joint taxpayers, other tax increases apply at much lower levels, including the hidden tax from the phase-out of itemized deductions and the new 3.8% "Net investment income" tax enacted with Obamacare.

Make your other tax-advantaged savings contributions now. Many of us wait until the last minute to fund Individual Retirement Accounts, Health Savings Accounts, and Section 529 plans. That's disorganized thinking. The sooner you fund these tax-deferral vehicles, the sooner the earnings escape the grasp of the tax man. The 2013 limits for these plans:

  • IRA: $5,500 ($6,500 for taxpayers age 50 or older during 2013).
  • HSA: $3,250 for single coverage, $6,450 for family coverage.
  • College Savings Iowa: $3,045 per donor, per donee.

Finally, if you use your car for business, start keeping a mileage log. The IRS is examining more small businesses every year, and car expenses are one of their favorite targets. Keeping track of your business mileage can make the difference between a "no change" and an ugly audit.

None of this will make your tax problems go away, but they are a good start. Consult your tax advisor to make sure you are doing it right.

-Joe Kristan

The 'fiscal cliff' bill and Iowa entrepreneurs

20121116-1iabizCongress changed the rules of the tax game for 2012 after time expired. About two hours into 2013 they passed HR 8, the "Fiscal Cliff" legislation, finally settling the tax law for 2012 and 2013. The bill raises the top federal tax rate on profitable S corporations to more than 40% starting in 2013, as expected, but it could have been much worse. It fixes two huge flaws in the tax law, and it provides some unexpected benefits to buyers of fixed assets in 2012 and 2013. 

First, the bad news. The bill raises the stated top individual income tax rate to 39.6%. This rate will apply to taxable income more than $400,000 for single filers and $450,000 for joint filers. The top rate had been 35%.The bill also raises the top dividend and capital gain rate from 15% to 20%, for taxpayers in the new 39.6% top bracket. 

The new tax law also re-enacts the "phase-out" of itemized deductions and personal exemptions for higher-income earners. This has the effect of increasing the top rate an additional 1.188%, to 40.788%.

It's even worse than that, though, with the 3.8% new "net investment income" tax enacted separately with Obamacare also taking effect for 2013. This tax applies to interest, dividends, most capital gains, rental income and "passive" K-1 income. Considering all of these taxes, and taking deductions for taxes paid into account, an Iowa taxpayer could face a marginal rate -- the rate on each additional dollar earned -- as high as 47.6%.

There is good news. The bill permanently "patches" the alternative minimum tax, retroactive to 2012. Without the patch, some taxpayers could have had additional 2012 taxes of more than $9,000. 

The bill also permanently sets the estate tax lifetime exemption at $5 million, though it raises the rate on taxable estates to 40%. The rate in 2012 was 35%.

The bill also omits some terrible ideas that had been thrown out, including a hard dollar cap of $25,000 or $50,000 for itemized deductions. This limit would have hit Iowa pass-through owners hard, as it would have restricted their deductions for state taxes paid on business income.

Bonus good news. The bill retroactively increases the "Section 179 deduction" maximum for 2012 to $500,000. That will also be the maximum deduction for 2013. This deduction, which lets taxpayers deduct all of the cost of equipment that would otherwise have to be capitalized and deducted over several years, had been set at $139,000 for 2012 and $25,000 in 2013. 

The bill also extends 50% "bonus depreciation" on new fixed assets through 2013. It had been set to expire in 2012.

These silver linings come with their own Iowa cloud. The Section 179 changes and bonus depreciation won't apply in computing Iowa income tax unless the legislature enacts conforming legislation. The legislature has not conformed with bonus depreciation. It has conformed with the federal Section 179 limits in recent years, but Iowa won't accept returns with the new limits until the legislature acts. Depending on how fast the legislature acts, it could delay filings of Iowa returns where Section 179 is an issue.

The bill also extends a raft of "expiring provisions" for another year, including the research credit and the wind energy production credit. It doesn't extend the 2% reduction in employee Social Security tax and self-employment tax.

Be sure to visit with your tax professonal to see how these provisions will affect you and your business.

Additional coverage:

Tax Update Blog, Senate passes fiscal cliff bill in wee hours; House acts today.

Taxgirl,  House Passes Senate Budget Bill Convincingly: We Have A Tax Deal!

Year-end techniques from the edge of the Fiscal Cliff.

With less than two weeks left in the tax year, the politicians haven't reached a "fiscal cliff" deal. The latest rumors combine some version of a tax increase for higher incomes with a cap on the value of itemized deductions.  For example, a dollar of income might face a 39.8% tax rate, while a dollar of charitable contributions might save you only 28 cents.  Other proposals would simply cap the amount of itemized deductions allowed, perhaps at $50,000.


While you should consult your tax advisor about your year end planning moves, some thoughts to keep in mind:
  • If you want your itemized deduction to count this year, to be sure you get a full benefit, you should have it mailed and postmarked this year if you pay it by check.  Timely mailed, timely paid is the rule here.

 

  • A charitable contribution or tax payment made with a credit card counts this year, even if you don't pay your credit card bill until next year.

 

  • Additional itemized deductions for state and local taxes won't reduce your 2012 federal tax bill if you are subject to alternative minimum tax this year.

 

  • If you choose to recognize a capital gain this year to avoid the pending tax increases, the trade date is considered the date the gain is taxed, even if the settlement date is later.

 

  • If you aren't planning to sell an asset in the next two or three years anyway, it might not make sense to pay tax on the gain now to avoid a future tax increase.

The politicians may not settle on the tax law until the last minute, so stay in touch with your tax advisor and stay flexible.

-Joe Kristan

'Fiscal Cliff' follies: Why it may pay to take deductions early

20121202iabizWith the potential "fiscal cliff" tax rate hikes looming, the math tells us that deductions will be more valuable to top-bracket taxpayers next year. The top federal individual tax rate is scheduled to rise to 39.6% next year, from the current 35%.  A $100 deduction is worth $39.60 next year, vs. $35 this year.

Yet the math may be deceiving. The politicians may end up with a fiscal cliff compromise that can make many deductions worthless after this year.  Republican negotiators, including Iowa's Senator Grassley, have floated a $50,000 cap on allowable itemized deductions.  

Such a cap would pose a huge problem for entrepreneurs whose income is taxed on their 1040s via S corporations or partnerships. State income taxes on their business income are itemized deductions on the owner 1040s. When combined with home mortgage interest and charitable contributions, many reasonably successful entrepreneurs would shoot past a $50,000 cap.

Nothing has been enacted yet, and such a cap may never happen. But it may happen effective for 2013, and prudent taxpayers should keep this in mind. Possible self-defense steps include making sure state income tax liabilities are paid in 2012, rather than waiting until 2013. Taxpayers with big charitable pledges may want to be ready to make them this year, possibly via a donor-advised fund; the Des Moines Community Foundation sponsors one. 

Whatever you do, make any moves only in consultation with your tax advisor. Each tax situation is different. Taxpayers who owe alternative minimum tax this year will get no benefit from prepaying state income taxes, for example. Be ready and stay flexible. 

More reading on this issue here.

Related: What the fiscal cliff looks like from the back side of the election.

What the fiscal cliff looks like from the back side of the election

20121116-1iabizThe election results have cleared away some of the fog from the tax planning scene for year end, but visibility is still poor. 

What we know  

There will be a tax increase on "investment income" and wage and self-employment income starting next year. Investment income for taxpayers with adjusted gross income over $200,000 (single filers) or $250,000 (joint filers) face a new 3.8% Obamacare surcharge on their investment income. "Investment income" is broadly defined and includes taxable interest, dividends, capital gains, rental and royalty income, and "passive" income from K-1s. 

Taxpayers with wage and self-employment income face a new .9% Medicare surtax for wages or self-employment income exceeding $200,000 (single filers) or $250,000 (joint filers). This is the first time a Medicare tax rate has depended on joint income. Because employers can't know what a spouse makes, this will require many taxpayers to pay additional Medicare tax when they file their 2013 returns. Employers will withhold the .9% tax on wages over $200,000.

What we don't know

We don't know what the tax rates will be for 2013. If Congress and the President fail to agree on a plan for next year, the tax rates effective in 2000 will return, with a 39.6% top rate for ordinary income. The top rate on capital gains would rise from 15% to 20%, and the top rate on dividends would rise from 15% to 39.6%. Of course the 3.8% tax on investment income would also apply. You can see a state-by-state map of the effects of going off this "fiscal cliff" here.

We don't even know what the Alternative Minimum Tax rules are for this year 

Congress has not yet "patched" the AMT by increasing the annual exemption amount. If they fail to do so, some taxpayers may be surprised by an additional tax bill of more than $8,000 this coming April.

What to do? 

You should consult your tax advisor before you do anything. Some steps advisors will be discussing in the coming weeks with their clients include:

  • Reversing the usual tax planning by accelerating income and deferring deductions. If rates are going up, deductions will be worth more next year, while income taxed this year will be treated more kindly.
  • Examine the timing of capital gain income. For taxpayers who are going to be selling a stock or other capital asset anyway, this year may well be the time to do so. While that's true for taxpayers in top brackets for obvious reasons, it's also possibly true for taxpayers in lower brackets; the zero rate for capital gains for lower bracket taxpayers will expire this year.
  • Consider electing out of installment sales. The tax law lets taxpayers choose to be taxed on 2012 installment sales in 2012, even if the payments on the sales will be made in later years.
  • Dividend distributions. C coporations and S corporations with old C corporation earnings will contemplate whether to distribute earnings to be taxed without the 3.8% Obamacare surtax. If cash is tight, they will consider making distributions in the form of notes to get the income out this year.
  • Fixed asset elections. Taxpayers usually choose to write off fixed assets as fast as possible through "bonus depreciation" and "Section 179" expensing. If rates go up, that may be counterproductive.
  • Family gifting. The current $5 million lifetime gifting and estate tax exclusion will decline, perhaps all the way to $1 million. Advisors will be looking at ways to move wealth to the next generation before year-end.

Above all, stay flexible, be ready to act fast, and stay in touch with your tax advisor. The politicians may or may not change the tax picture in the coming weeks, so flexibiltiy is important.

-Joe Kristan

Tax stakes for entrepreneurs next Tuesday

When entrepreneurs cast their votes next Tuesday, they will be choosing between presidential candidates with very different approaches to tax policy. 

President Obama has made increasing taxes on incomes over $200,000 the centerpiece of his tax policy. He would allow the Bush-era tax cuts, which he has extended though his first term, to finally expire. This would raise the top rate of income tax to 39.6%. The 3.8% "Obamacare" tax on investment income and other provisions he supports would increase the top marginal tax rate to more than 44%. The 3.8% tax, scheduled to take effect for 2013, would also apply to interest, dividends, and many capital gains. It would not apply to business income when the taxpayer "materially participates" in the business.

Mitt Romney's tax plan is built around a 20% across-the-board individual tax rate cut, to be paid for by a eliminated deductions and tax breaks. He would also repeal the 3.8% investment income tax. 

These individual rates are important to entrepreneurs because most business are now organized as "pass-throughs" -- typically as S corporations or LLCs taxed as partnerships. Income of pass-through businesses is taxed on their owners' 1040s, so the top individual rate is also the top rate on business income. The Romney approach, with its 28% top rate, takes the tax law in a very different direction than the Obama 44%+ top rate.

How much does the top rate matter?  Quite a bit. A lot of business income is taxed on 1040s showing over $200,000 in business income, as this chart from the Tax Foundation shows:

20121019-1

The two candidates are closer in their approach to corporate income taxes. Both support a reduction in the top corporation rate -- Romney to 25% and Obama to 28%. 

The Tax Policy Center has posted excellent summaries of the two candidates tax plans:

What is Mitt Romney’s Tax Plan?

What Is Barack Obama’s Tax Plan?

Happy voting!

-Joe Kristan

Payroll taxes: Once is enough

The recent news about a local payroll tax provider falling behind on remitting client payroll taxes should be a wake-up call to businesses that outsource their payrolls. The good news is that the payroll service's attorney says that all taxes entrusted by the clients for transmission to the government will get to the government, eventually. 

Cases in other states have not had such a happy ending. In 2006, for example, clients of a New York payroll service learned that $3 million of payroll taxes sent to the service had not been remitted, and the money was gone. The firm's clients had to pay their payroll taxes a second time -- first to a thief, and then again to the government. That can be a ruinous expense.

Outsourcing payroll administration is common for good reasons, but most taxpayers don't realize how much risk they are taking when they make that decision. That's why even when you outsource your payroll taxes, you should still monitor the provider. 

Fortunately, you can do so. Taxpayers enrolled in the Electronic Federal Tax Payment System (EFTPS) can go online and check that their payroll taxes are being remitted by the third-party payroll service. It looks like this (details obscured for obvious reasons):

Iabiz20121024-1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Is it a hassle? A little, but not compared to paying payroll taxes a second time. And if your payroll service provider says the way they do business doesn't let you check your deposits on EFTPS, you need to ask whether you are taking a risk that you can't afford.

-Joe Kristan

 

What is this "Fiscal Cliff," and why are we in this handbasket?

20121001iabizThe financial press says we are heading to the edge of a fiscal cliff at year-end. Is there any way to keep from going over it, and if not, is there any way to soften the landing?

The "Fiscal Cliff" is the potential expiration of a series of federal tax breaks that will occur absent new legislation on January 1, 2013, combined with the Obamacare tax increases that take effect then. There are dozens of tax rules affected; the biggest include:

- An increase in the top rate on ordinary income -- the rate on most income passing through on shareholder and partner K-1s -- from 35% to 39.6%.  For "passive" investors, the top rate will be 43.4%.

- An increase in the top rate on most capital gains from 15% to 23.8%. 

- An increase in the top rate on dividends from 15% to 43.4% -- nearly tripling the second tax on C corporation earnings.

- A reduction in the lifetime estate and gift tax exemption from $5 million to $1 million, combined with an increase in the top estate tax rate from 35% to 55%. 

There will also be a new .9% tax on single W-2 income over $200,000 or joint W-2 income over $250,000, as well as a 3.8% tax on "passive" or "investment" income (this tax is included in the top rates listed above). 

What to do?  Everybody's situation is different. It's unwise to take action ahead of the fiscal cliff without talking to your tax advisor. Here are some of the ideas that advisors will be discussing with their clients in the coming months:

  • Pre-emptive dividends. Some taxpayers may consider paying dividends out of their corporations by December 31 to take advantage of the current 15% federal rate. Some of these taxpayers will be S corporations purging old C corporation earnings.
  • Close out some capital gains. If you are going to be selling an asset soon anyway, selling this year may save some some money.
  • Make large family gifts.  For taxpayers with enough assets to make where the diffence between a $5 million, this is an obvious thing to look at. Not everybody can or should make gifts that big, but if you are ever going to do so, this is a good time to do it.
  • Accelerate income and defer expenses. This reverses the usual strategy of deferring income and accelerating expenses, but if rates go up, it makes sense. It's silly to defer income just to see it taxed at a higher rate, and deductible expenses are worth more as deductions when rates are higher.

Of course, all of this is contingent on politics. In general terms, an Obama victory makes a trip over the fiscal falls much more likely, while a Romney victory increases the chances of an extension of the current tax rates. Of course, the composition of Congress also matters. The politicians may extend some provisions while letting others expire.  Whatever happens, it makes sense to stay flexible pending the election outcome, but to start to prepare for a big tax increase. 

-Joe Kristan

Related:

A step away from the fiscal cliff?

Journal of Accountacy Tax and fiscal cliff resources

Timing is everything: capital investments for the last quarter of 2012

20120916iabizYear-end capital investment could make more of a difference than usual this year.  Two important tax provisions favorable to capital investments expire at the end of 2012.  That means it can make a big difference in your tax bill whether you get those assets in place by the end of this year.

Bonus depreciation is scheduled to go away after this year.  The tax law normally requires businesses to deduct the cost of capital expenditures -- equipment, software, etc. -- over a period of years.  "Bonus" depreciation allows taxpayers to deduct some or all of those costs in the year the capital asset is placed in service.  For 2012 taxpayers can deduct 50% of the cost of "new" assets (though not most buildings) in the first year; the remaining 50% of the cost is recovered over the asset's normal tax life. 

Secition 179 is even more important to most entrepreneurs than bonus depreciation.  Qualifying investments can be fully deducted under Section 179 in the year they are placed in service.  Section 179 has two important advantages to Iowa taxpayers.  First, it can be used on purchases of used equipment, unlike bonus depreciation.  Second, Iowa recognizes Section 179, but not bonus depreciation, so it provides a state tax break that bonus depreciation doesn't. 

Taxpayers can deduct the cost of assets under up to $125,000 for tax years beginning in 2012.  That number is scheduled to decline to $25,000 in 2013. 

Section 179 is subject to some important limits.  The abiity to take the Section 179 deduction phases out dollar for dollar in 2012 as fixed asset purchases for the year exceed $500,000.  Also, unlike with bonus depreciation, you cannot create a loss with a Section 179 deduction, so you can't use it to generate a loss carryback to recover prior-year taxes.

To claim either a Section 179 deduction or bonus depreciation for an asset, a calendar-year taxpayer has to have the asset "placed in service" by December 31.  That doesn't mean ordered by year end, or sitting in a box on the loading dock when you close for New Years.  It means hooked up and ready to run.

Year-end planning this year is even more fraught with uncertainty than usual.  Top federal tax rates are scheduled to increase from 35% to 39.6% after this year -- and to 43.4% for "passive" investors in business.  Depending on the outcome of the elections, that increase may or may not happen.  If the tax increase happens, many taxpayers will be better off not taking bonus depreciation or 179; they may even want to delay placing assets in service. 

It's unwise to buy an asset you don't really need just for the tax break.  For assets you will need for your business anyway, it's best to have the flexibility to place the asset in service this year.  Depending on politics and your business needs, you can decide whether you want to plug in that new asset, and qualify for bonus depreciation and Section 179, closer to year end.  You can also wait until you file you return to decide whether to opt out of bonus depreciation and Section 179, in case you want to use the deductions in years with higher tax rates.

With so much uncertainty, it's more important than ever to consult your tax advisor on these decisions.  So do that.

Wisconsin trucker skids into "self-rental" rule

It’s common for taxpayers to rent things to their businesses. Owners of C corporations often find rentals a tax-efficient way to pull cash out of a business and get a rent deduction, instead of paying non-deductible dividends. Sometimes an owner of a multi-owner business will also provide the real estate via rental. It usually works fine, but a Wisconsin trucking operator last week learned in Tax Court of a tax trap that sometimes lurks in self-rental.

Iabiz20120816The taxpayer ran his Wisconsin trucking business as a C corporation -- a corporation that pays its own taxes. If a C corporation pays dividends, they are taxable to the owner and non-deductible to the corporation -- so corporate income is taxed both when it is earned and when it is distributed.

The trucking company owned no trucks. Instead it leased them from an S corporation owned by the taxpayer, and also from the taxpayer personally. An S corporation pays no taxes; its income is instead taxed directly on the shareholder’s returns, and distributions of taxable income are not taxed again. In short, the rental income showed up on the owner's 1040, and the C corporation took a deduction while getting cash to its owner.

So far, so good. Unfortunately the "passive loss" rules add another wrinkle. The passive loss rules were enacted largely to shut down the leasing tax shelters of the 1980s. They say that rental losses are normally "passive," deductible only to the extent of "passive" income. The taxwriters of the day feared that business owners would get around these rules by renting items to their own business to artificially create passive income that would allow them to continue to deduct passive losses. Their response was the "self-leasing" rule.

The self-leasing rule says that if you have income from leasing an "item" to a non-passive business that you own, that income is non-passive -- but self-rental losses are still passive. That means self-leasing income doesn't help you deduct passive losses.

The Wisconsin taxpayer had taxable income on the trucks he leased through his S corporation, but losses on the trucks leased personally. The IRS examined his return and told him he couldn't deduct the self-rental loss against the self-rental income. The Tax Court last week upheld the IRS. They also told the taxpayer that he was lucky the IRS didn't make things even worse:

we conclude that each individual tractor and each trailer was a separate “item of property” within the meaning of section 1.469-2(f)(6), Income Tax Regs. However, because respondent has not contested petitioners’ netting of gains and losses within TRI [the S corporation], only TRI’s net income is recharacterized as nonpassive income.

In other words, the court said the IRS could require the taxpayer to break out the income tractor-by-tractor and disallow the losses on each lease generating a tax loss.

The case gives us two important lessons:

1. Rental income from items rented to your non-passive business doesn't help you deduct other "passive" losses.

2. If you rent multiple items to your business, you should make sure each item generates taxable income.  This could affect how you structure your leases and what depreciation decisions -- like bonus depreciation -- you take.

These rules are complex, so be sure to get your tax advisor involved early.

-Joe Kristan

Big charitable contribution, no deduction?

20120701iabizIt may be better to give than to receive, but it's sure easier to give when it cuts your tax bill. That's why gifts of appreciated long-term capital gain property are in every tax planner's toolkit. You can get a deduction for the full value of the property without ever paying tax on the property's appreciation. Even cash contributions can fail as tax deductions without the right paperwork. 

Any good tax tool can be abused, so Congress has enacted a long list of formal requirements that property contributions have to meet. If you fail to get the paperwork right, your deduction goes to zero, no matter how valuable your contribution is. While the rules can be complex, here are some that come up often:

  • Any gift more than $250 -- cash or property -- requires a written receipt from the charity stating the amount, if any, of value received by the donor (other than intangible or religious value). That means if you get 50-yard line seats for your donation to good-old Alma Mater U., they have to tell you how much of your donation was for the seats; you can't deduct that part. No receipt, no deduction -- even if you have a cancelled check.
  • Any gift of property more than $500 must be reported on IRS Form 8283 with your tax return. This can subject your return to greater scrutiny. If you aren't sure your dropoff at Salvation Army was really worth more than $500, that's something to think about.

This rule can wreck your dedection even in instances where you have strong evidence of the value without an appraisal. For example, if you donate a parcel of land to charity and the charity sells it right away, you still need an appraisal. You can't just rely on the actual sales price, as reasonable as it may seem. No appraisal, no deduction. You even need an appraisal for a deduction of more than $5,000 even if you paid more for the donated property than the deduction you are taking.

While these are some of the commonly-encountered rules, there are some more obscure ones. For example, there are special rules limiting the deduction for "qualified taxidermy property," because hunters were "paying" for their safaris by donating their stuffed trophies to museums. 

The bottom line? If you want to deduct a property donation, get your tax advisor involved early. The money you save on professional fees can turn out to be a bad bargain indeed.

-Joe Kristan

Will your 1040 help pay for your vacation home?

English: Sunburst Lake with Sunburst Ranger Ca...English: Sunburst Lake with Sunburst Ranger Cabin in Mount Assiniboine Provincial Park, British Columbia, Canada (Photo credit: Wikipedia)

People who buy a vacation home often need an excuse to help overcome their better judgment. Sometimes the idea that they will get some deductions out of that lake cabin is enough to push them over the edge. But is it so?

Yes, there are tax breaks for second homes. The biggest one is the home mortgage interest deduction, available for up to two homes, to a maximum of $1.1 million in debt. You can also deduct property taxes, at least if you aren't subject to alternative minimum taxes. But what about the home itself, and your out-of-pocket costs? Can you claim the cabin as a rental property, deduct depreciation, insurance, and maintenance, and move your property taxes to an "above-the-line" schedule E deduction? Probably not.

To get beyond home-mortgage and property-tax deductions, you need to claim rental losses. Under the "passive loss" rules, rental real-estate deductions are normally "passive." Short-term rentals can avoid this rule, but then you have to show "material participation" in the short-term rental activity. Unless you are on-site, that's hard to do, and probably impossible if you have an agent helping you with the rentals.

More problems arise if you actually use your vacation home. The tax law has a rule that limits "business" deductions from a rental property when you use the house personally for the greater of 14 days or 10% of the days the property is used or rented.  

There is one break that can be easily available. If you rent the vacation unit for less than 15 days, you get to exclude the rent from taxable income. But two weeks rent won't do much to make the monthly payments on the cabin.

The Moral? If you buy that north-country cabin, don't look for a lot of help from the IRS to help pay for it. If you really need the deduction to make it work, talk to your tax advisor before you commit.

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What the tax changes in Obamacare mean for entrepreneurs in 2013

20120629-1While the political future of the Affordable Care Act is unknowable, it has survived its courtroom challenge. That means many entrepreneurs will need to deal with important new tax provisions starting next year.

There are two important new ACA taxes taking effect in 2013:

  • A new .9% payroll tax on single taxpayers with salaries exceeding $200,000, or joint filers with combined salaries exceeding $250,000.
  • A new 3.8% tax on "unearned" income (a despicable description, by the way). It applies to income earned as interest, dividends, rents and capital gains. It also applies to income that is "passive" under the "passive loss" rules received on K-1s from S corproations, partnerships and trusts.

These taxes apply without regards to the insurance plans or coverage of either the employer or the employee; they are just taxes.

The payroll tax will require additional withholding on income that exceeds these numbers, but because the employer won't know an employee's spouse's salary, it will also require a new schedule on Form 1040. 

These taxes will motivate more taxpayers to operate as S corporations with salaries below the thresholds covered by this tax. They will take more of their income as distributions of K-1 income rather than salary, because S corporation K-1 income isn't subject to this tax.

The .9% surtax will make some taxpayers operating in LLCs taxable as partnerships consider the S corporation format. Generally entrepreneurs who are active in an LLC pay self-employment tax on all of their earnings from their LLC K-1s.  This will include the .9% surtax if their income is high enough, as well as the current 2.9% Medicare tax. By switching to the S corporation format and taking out a salary under the $200,000/$250,000 limits, they could save both the Medicare tax and the surtax.

The IRS may not take this sort of thing lying down. They recently forced an Iowa accountant to increase his reported wage income from $24,000 to over $90,000 annually to make him pay more medicare tax on his S corporation earnings. Still, there is a wide range of salaries that can be considered "reasonable" for this purpose, and the IRS has yet to show that they can force taxpayers to the $200,000 salary level.

The tax on "passive" income also makes it important for taxpayers, especially part-timers, to document how much time they spend working in the business in 2013.  The most common test for whether a taxpayer is "passive" is whether they spend 500 hours working in the business. Taxpayers may want to get in the habid of keeping a time diary if their participation might be otherwise hard to document.

It's time for entrepreneurs to start pondering these issues for next year. Involvement of a qualified tax professional is important.

-Joe Kristan

To deduct business expenses, start with a business

20120601iabiz"I don't use that corporation, but I keep it around so I can use more deductions."

"Everybody should have a schedule C to deduct more things."

These statements illustrate one of the most persistent 19th hole tax folk myths. People actually think that simply filing a corporation return, or having a purported business on a 1040 Schedule C, transforms the tax lead of nondeductible personal expenses to the gold of business deductions. This myth may be one of the pillars of the multi-level marketing industry. It really is a myth, as one tax practitioner learned in Tax Court last month.

The practitioner sold his tax businesses, but kept around a C corporation "management company." That corporation paid and deducted expenses for an airplane, for "rental" of an office in the practitioners home, and for other travel and meal expenses. Unfortunately, it didn't appear that the corporation "managed" anything but his tax liability. That meant there was no "trade or business," which the tax law for some reason says you need to have to deduct "trade or business expenses." 

Unfortunately for the taxpayer, using a C corporation caused him another problem: The funds spent on personal items were treated as "constructive dividends" to the taxpayer, taxable on his personal return. That meant he lost twice -- no corporate deduction, but taxable income on his 1040.

The Moral: Filing a business tax return doesn't turn a personal expense into a deduction.

-Joe Kristan

You negotiated a debt workout? The IRS may be glad to hear that.

The best-laid business plans can go awry. When that happens, everyone may be better off renegotiating the debt. If you do that, remember that the tax man has a seat at the table.

20120516iabizThe default rule under the tax law is that debt forgiveness generates taxable income. Fortunately for distressed debtors, there are some important exceptions. The most important:

-A reduction in purchase-money debt for an asset can be treated as a reduction in your purchase price, rather than debt forgiveness income.

-Debts forgiven under the terms of a bankruptcy decree are tax-exempt.

- Debt forgiveness income is taxable to the extent a taxpayer is insolvent.

A taxpayer is "insolvent" to the extent the value of assets are less than the taxpayer's liabilities. If a taxpayer has a negative net worth of $100,000 and has debt of $110,000 forgiven, the $10,000 difference is taxable income.

There are also debt forgiveness exclusions when home mortgage debt is forgiven, for business real property acquisition debt forgiveness, and for farm indebtedness.

If a taxpayer has debt forgiven that is tax-exempt,, it's not usually a free lunch. If the taxpayer has unused loss carryforwards or tax credits, they may be reduced or eliminated by the debt cancellation income. Alternatively, you may find yourself with a lower basis in some of your property, increasing your gain or reducing your loss on an eventual sale.

Sometimes what seems like debt forgiveness isn't taxed that way. For example, if your debt is settled by foreclosure, you have a taxable sale of the secured property to the extent of its value. Only the debt forgiven in excess of the value of the surrendered collateral is debt forgiveness income that may eligible for an exclusion.  

If property is foreclosed in settlement of non-recourse debt -- debt for which the creditor has no right to pursue the debtor beyond what is recovered in foreclosure -- the entire amount of the debt is considered to be the sale price of the property sold. This can be an expensive problem if the taxpayer has depreciated the property and has a low basis, triggering a big taxable gain on the foreclosure.

Taxation of debt forgiveness can be fiendishly complex. If you are negotiating a workoout, keep your tax advisor involved; after all, the IRS already is.

Image via Wikipedia

-Joe Kristan

Death and income taxes

IMG_1675The untimely death of Business Record managing editor Jim Pollock is a sad reminder of how little control we have of our destiny, no matter how carefully we plan. He struck me as a wise and kind man. I'll miss him and his Business Record work.

Unfortunately, the tax law doesn't think death is much of an excuse for not filing tax returns for the departed.  Here are some tax basics for survivors:

  • Death ends the tax year.  A surviving spouse can include the portion of the year up to the spouse's date of death on a joint return. 
  • Single or separate filers file a final 1040 for the tax year ending on the date of death.  The decedent's final return is due on the normal April 15 due date.
  • Normally the decedant's estate will report after-death income on a Form 1041.  An estate can choose to end its taxable year at any month end up to a year following the death.  If the estate makes distributions, the income is also distributed to the beneficiaries.  Income retained in the estate is taxed there under the trust rate schedules.
  • The way assets are held determines how after-death income is reported.  Jointly-held assets automatically are the property of the surviving spouse after death.  Assets held directly by the decedent go into the estate. If the dededent owned assets in a living trust, the assets and their income are disbursed under the terms of the trust.
  • Large estates may need to file Form 706, the federal estate tax return.  If the decedent was married, even smaller estates may want to file Form 706 to preserve for the surviving spouse whatever portion of the decedent's $5 million lifetime exclusion was left unused. Form 706 is due nine months after the date of death.  If it is not filed, any unused exemption is lost. The executor of a tiny estate would sure feel silly if the widow won the Powerball and suddenly had enough assets to use that extra $5 million exemption.

IRS Publication 559 is an excellent guide for helping executors and family members deal with the tax requirements of decedent returns.

- Joe Kristan

 

Get over your 1040 already!

20111040logoThe deadline for filing your 2011 1040 is Tuesday. Unless you are extending, of course. For the most part, the game is over for 2011, and there's little to do but add up the score.

Any more, 2011 is dwelling on the past. It's time to move on. What lessons can we draw from this filing season while the pain is still vivid?

DON'T FALL BEHIND.

The hardest tax problems are those when people don't keep up on their taxes. It can happen when you reduce your withholding too much. It can also happen when you don't keep up with your estimated tax payment obligations. If you own an interest in a partnership or an S corporation, it can become a problem in a hurry, especially if you spend the nice distributions they give you without putting them away for your taxes.

The first quarter federal estimated tax payment is due tomorrow. If your tax preparer gave you a voucher, file it with your check as instructed. It won't get any easier next April if you don't.

DO THE EASY STUFF NOW

Most people who come to their tax preparares in April looking for a miracle have already squandered most of their tax-saving opportunities. These are likely to be found at work. Take advantage of the easy stuff:

- Maximize your 401(k) contribution. If you aren't at least putting in enough to get the entire employer match, you are making an unforgivable financial blunder. More is better.

- Review your health plan opportunities. If your employer offers a Health Savings Account option, think not twice, but several times before rejecting it. Many employers offer generous breaks to switch to high deductible health insurance, and most of the time you'll be financially better off with an HSA. If there is no HSA at your job, make sure you take full advantage of the cafeteria plan.

- Start funding your 2012 IRA. The main benefit of these is tax-free buildup of earnings; if you fund it now instead of next April, your money is tax-sheltered an extra year.

- If you are saving for college, put a little money away in a Section 529 plan like College Savings Iowa every month.

EXPECT THE UNEXPECTED

One of the perplexing things about being a tax preparer is seeing somebody with a $500,000 W-2 unable to raise $30,000 to pay taxes in April. You should always have some amount of cash easily available. Some people advocate enough to pay six months of living expenses, but I think you can do with less - especially if you have some other investments, or if you have a house. If you are a homeowner, open a home-equity line of credit, and then don't use it except for emergencies - like a $30,000 tax bill.

AND DON'T FORGET TO FILE!

The SEP plan: The last way to cut your 2011 tax bill?

20120401iabizThe 1040 is due April 17.  You can get an extension until October 15, but you should be pretty much paid in by then.  With Iowa's economy improving, that means many entrepreneurs will be writing a check to the government.  Many of them are wondering whether there is anything they still can do to lower the 2011 tax bill.

Most of the good tax planning opportunities for 2011 ended when the year did.  If you are a solo operator -- if you don't have employees -- a Simplified Employee Pension still might be a big moneysaver for you.  These plans allow solo owners to put up to 20% of their business income away for retirement and deduct the contribution.  It's a deduction for taking money out of one pocket and putting it in another -- though to be sure, it has to stay in the other pocket until retirement on pain of early withdrawal penalties.

SEPs are the easiest form of qualified plan to set up.  All you have to do is set up an IRA with your friendly community banker and sign (but not file) Form 5305-SEP by the tax deadline.  If you don't extend your return, you have to fund your contribution by the deadline, but if you extend, you can wait until October 17.

The drawback of a SEP is that all employees have to have the same percentage of income contributed.  As you add employees, that can be an expensive way to reduce your taxes.  That's why bigger businesses usually switch to traditional profit-sharing plans, which have more flexible vesting and more ability to discriminate among classes of employees.  But in this age of independents, the SEP can be a great mulligan for your 2011 tax planning.  Heck, if it's good enough for the President, maybe it's good enough for you!  Of course, consult your tax advisor first.

Day trading? Heads you lose, tails IRS wins, unless...

20120316iabizMany strong men have thrown away day jobs to spend their afternoons with Maria Bartiromo -- and with their computers and Ameritrade accounts.

They have become day traders.

While it looks easy on television, it isn't, and big capital losses often ensue. That's a bad thing when you do your tax returns, because you can only deduct capital losses to the extent of capital gains, plus $3,000.  There are day traders out there with loss carry-forwards that they will be still using at that rate when their grandchildren move into assisted living.

There is another way, if you are a truly serious trader: the "Section 475(f) election."  If you make this election, you can deduct unlimited capital losses, at least until you run out of money.  But it's not for sissies, and it's easy to miss.

If you make the Section 475(f) election:

- You have to mark all of your positions to market - gains and losses - at year end.  That means you have to compute your taxes on any open positions at year end as if you had sold them at the year-en closing price. 

- Your gains don't qualify for the reduced rate on capital gains.

- You have to be able to demonstrate to the IRS that your trading activity rises to the level of a "trade or business."  Unless you have trading on a daily or almost daily basis and look to it for your livelihood, you probably don't make the cut.

Most importantly, you have to make a Section 475(f) election by April 15 of the year for which you want it to be effective. That means if you have big 2011 daytrading losses, it's too late.

To make the election for 2012, you need to follow the steps set out in Revenue Procedure 99-17.  That procedure requires you to attach a statement making the election either to a timely-filed 2011 tax return by April 17, 2012 or to a timely-filed extension. 

The Section 475(f) election is a serious step, which you should only take in consultation with your tax adviser.  But if you a very serious trader, it might pay off big at tax time.

- Joe Kristan

Where is that blasted 1099?

I want my tax return done!  I need that 1099!  I need that K-1!  I'm supposed to have that all in January! Right?

20120301iabizWell, no.

This can be a frustrating time for taxpayers expecting tax refunds.  It's worse than usual this year, as many of the information returns -- W-2s, K-1s, 1099s -- are coming in later than usual.  What's the hangup, and when am I supposed to have them?

W-2s should be issued by the end of January. 
If you don't have them yet, it's time to be concerned. 

Most 1099 forms should be issued by the end of January. 
If you worked in 2011 as an independent contractor, you should have your 1099-MISC by now.  You should probably have 1099-INTs for interest from your bank in hand.  Less happily, if you settled a debt for less than face, you should have a 1099-C. 

This year it's different for 1099s from stockbrokers. 
A tax law change requires them to report cost information on stock sales starting this year.  That has required massive upgrades to the information systems at the brokerage houses, so their deadline was moved back to February 17.  Many brokers have received permission to issue 1099 forms as late as March 15

The delay for stockbrokers also delays returns that need 1099-Bs from the brokers.  Many trusts can't issue their K-1s until they have the 1099 information, for example.  Investment partnerships also need their 1099s before they can issue K-1s to their owners.  Even many S corporations with investment accounts are on hold until they get the 1099s.

K-1s -- information returns from partnerships, S corporations and trusts -- don't have a January 31 deadline.
These forms only are due when the underlying returns that generate them are due.  S corporation returns are due March 15, and trust and partnership returns are generally due April 17 -- and they all can be extended automatically to September 15. 

If your business has to issue K-1s, don't take the March and April deadlines lightly.
Even though they can be extended.  Irate owners and beneficiaries want their forms, of course.  And if you do have to extend, make sure you really extend.  You need to file Form 7004 to get the automatic extension.  If you don't extend and you file late, the IRS assesses a penalty of $195 per month or part-month for each K-1.  That means missing the March 15 extension deadline by one day for a 10-shareholder S corporation means a $1,950 penalty. 

Extensions can be filed electronically.  If you must file them on paper, be sure to use certified mail, return receipt requested, or an authorized private delivery service that delivers to the IRS service center street addresses.

- Joe Kristan

Nope, still no tax fairy

Taxes are hard. Even if you farm them out to your friendly neighborhood tax preparer, you still have to put together your W-2s and 1099s and comb through your checkbooks and credit cards for deductions. When you run a business, you face the everyday drudgery of depositing payroll taxes, sending in your quarterly payments, and dealing with notices that seem to come out of nowhere from states you've never seen. 

IAbiz20120216At the end of a day full of this stuff, you flip on the television and you see somebody telling you that you can settle your tax debts with the IRS for pennies on the dollar. When you see this, for one shining moment you feel like a chump for spending time and money getting your taxes right and paying them on time. Why bother when you can just do a pennies-on-the-dollar deal anyway?

Because there is STILL no Tax Fairy.

Two of the biggest players in the pennies-on-the-dollar tax settlement industry recently closed their doors. The first was Roni Deutch, the self-styled "Tax Lady." In the face of allegations that she took up-front payments from desparate taxpayers and failed to follow through, she surrendered her law license on her way to bankruptcy and contempt of court charges.

Now JK Harris has joined Roni Deutch in federal bankruptcy court. Like Ms. Deutch, JK Harris ended up in bankruptcy after battling state attorneys general over its business practices.  The ability to make tax debts go away would be an extremely valuable attribute. The bankruptcy of these outfits is strong evidence that such ability is a myth. As Nevada tax practitioner Russ Fox explains:

  • Only about 15% of Offers in Compromise successfully make it through the IRS;
  • It typically takes over one year for an OIC to make it through the IRS;
  • Most individuals will not qualify for an OIC; and
  • If you look at the fine print of the commercials, you will see, “Case not typical. Your results may vary.”

When the IRS does accept an offer-in-compromise, they usually do so because you are truly broke. That's not really a taxpayer victory.

As unpleasant as dealing with your taxes might be, the alternatives are much worse. If you get into tax trouble, there's no Tax Fairy -- or Tax Lady -- to make it all better.

There is no tax fairy

NEW YORK - OCTOBER 25:  Tinker Bell and United...Image by Getty Images via @daylife

It's okay to dislike taxes.  In fact, it's normal and healthy. But that doesn't make them go away. It would sure be nice if a Tax Fairy could wave her wand and make them disappear. 

It's not going to happen.

People will have been seeking the Tax Fairy as long as there has been an income tax.  That's fine, until you think you have found her. 

- The founder of Buy.com sought the Tax Fairy in "OPIS," a tax shelter marketed by a national accounting firm designed to generate artificial losses.  The Tax Court ruled that there was no Tax Fairy, imposing $25.7 million in taxes and $10.7 million in penalties. 

- A defense industry consultant looked for the Tax Fairy in the "Millennium Plan," attempting to deduct contributions to a Section 419A(f)(6) welfare-benefit plan while earning tax-sheltered income and retaining access to the funds contributed.  The Tax Fairy never showed, and the Tax Court upheld $5.7 million in additional taxes and $870,000 in penalties.

- A group of medical professionals in North Platte, Nebraska, sought the Tax Fairy through a CPA from Bakersfield, California.  They attempted to hide their income and deduct personal expenses in "loan-out" corporations.  They were sentenced last week on federal tax charges, and the Tax Fairy never showed.

Tax professionals can do a lot.  They can make sure you pay no more than you need to; with the right facts they can delay your tax and sometimes get you nice refunds. They can guide you safely through the dangerous and byzantine byways of the tax law. 

But if you make a lot of money and you want to continue to control and use it, you will eventually have to pay taxes.  There is no special "de-tax" plan or double-secret pay-no-taxes-ever trust scheme that your preparer is just too lazy or ignorant to tell you about.

There is no Tax Fairy. 

- Joe Kristan

Image courtesy Wikipedia Commons.

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I want my tax forms right now!

Impatience can be a virtue for the entrepreneur.  You succeed because you move faster than the competition, because you don't wait for somebody else to take care of your customers.  That's one reason tax time can drive you crazy.

20120116iabiz-1When you were just starting out, you got your W-2, you filled out your forms, and you were done with your taxes in January, except maybe for waiting for your refund check.  Now, you almost certainly have to wait until well into February to have all of the information you need to file your returns.  For many entrepreneurs, the wait extends past the usual April 15 deadline.  What are the deadlines for issuing the forms needed to preparer 1040s?

W-2s are supposed to be issued by the end of January.  Wait for yours.  No reputable preparer will e-file your return in January off of your pay stub.  If it becomes clear that your employer won't be issuing one -- and that usually means waiting until February, at least -- you can file your return by attaching Form 4852 in place of your W-2.

1099 forms, reporting interest, dividends, independent contractor proceeds, among other things, normally are supposed to be sent to recipients by January 31.  Many financial institutions have received extensions as the information for these forms has gotten more complicated -- "qualified" dividends and basis of stock sold out of brokerage accounts, for example.  You might not have all of these until nearly March.

K-1 forms from partnerships and S corporations are not subject to a January 31 deadline.  The K-1s, which tell owners what items of their partnerships and corporations to report on their 1040s, can legally be issued as late as September 15 for calendar-year businesses.  These entities can be very complicated, and it can take a lot of time to prepare their returns.  Many of them have to wait on their own K-1s from other partnerships before they can issue yours. So there is no good alternative to patience.

But I'm in a hurry for my refund!  Shouldn't I just file anyway with what I have? 

Probably not. Unless you are waiting on an enormous refund, one that can save your business, it pays to stifle your impatience and delay filing until you have all of your tax information.  It's better to extend than amend:

  • Extended returns are not an audit flag.  Incorrect returns are.  The goverrnment continues to get better at matching K-1s and 1099s with returns, and chances are they'll come asking if they are different.
  • If you have to amend your return later because you didn't wait on a K-1, you get to pay the preparer twice. 
  • Every amended return or IRS matching notice is one more chance for the tax authorities to botch your account.

Patience is hard.  But sometimes, when it comes to filing your taxes, it's smart.

Related: Reading your K-1: partnership debt basis

Taxes: What's new for 2012

20120101iabizHappy New Year! So what does the tax law have in store for you in 2012? 

For entrepreneurs, the biggest change in the tax law might be the new rules for fixed assets.  Congress has not re-enacted the rules allowing "100% bonus depreciation" for new fixed assets. Instead, "50% bonus depreciation" applies.  For qualifying property, taxpayers will be allowed to deduct half of the cost of fixed assets placed in service in 2012; the remaining half of the cost will be depreciated over a period of years under the "MACRS" rules.  For example, a taxpayer buying a $10,000 computer system would get to deduct $6,000 this year: $5,000 "bonus" depreciation and 20% of the remaining $5,000 cost ($1,000) under the usual rules for five-year property.

The "Section 179" deduction limitation for fixed assets has also changed this year.  Section 179 allows businesses to deduct the cost of fixed assets -- new or used -- that would otherwise have to be capitalized and depreciated over a period of years.  For 2011, up to $500,000 in assets qualified for Section 179 treatment.  That goes down to $139,000 in 2012.

A few other tax numbers for 2012:

Have a great 2012!

- Joe Kristan

Flickr image courtesy prettyinprint under Creative Commons license.

 

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