Business Record - Iowa Biz

Playing with fire: Using an IRA to finance your business

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?

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. 

Most 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

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 86-272. This 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.

Deductions 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?

When 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!

With 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

Congress 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

With 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

The 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:

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):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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?

The 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

Year-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.

The 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?

It 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.

• Any gift more than $5,000 -- except for cash or publicly-traded securities -- must also have a "qualified appraisal" or the deduction goes to zero. The tax casebooks are full of horrendous stories of taxpayers who have lost enormous deductions because no appraisal wasn't received, because the appraiser wasn't a "qualified appraiser," or because the appraisal itself didn't meet IRS requirements.

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.

• Special rules apply to donations of tangible personal property, like art. If the property is sold in the year of contribution, the deduction can't exceed your cost. If the property is sold within three years, you may have to recaputure part of your donation.

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 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.

What the tax changes in Obamacare mean for entrepreneurs in 2013

While 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

"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.

The 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

The 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!

The 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?

The 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...

Many 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?

Well, 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. 

At 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

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.

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.

When 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

Happy 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:

• The business mileage standard rate is 55.5 cents, unchanged from 2011.
• The maximum compensation or self-employment income subject to FICA tax is $110,100; the maximum eligible for the reduced rate through February is $18,350; amounts over that paid as compensation will be recovered through a special 2% income tax, unless the break is extended beyond February.
• The maximum 401(k) deferral for 2012 is $17,000 (up from $16,500), plus the $5,500 "catch up" for taxpayers 50 and older.

Have a great 2012!

- Joe Kristan

Flickr image courtesy prettyinprint under Creative Commons license.

 

It's time for joy, family... and to make deductible payments for related parties!

The holidays are a time for families to gather, eat, and share memories.  And, it seems, to scheme to reduce taxes.  At least that seems to be what the tax code assumes, with its rules restricting deductions for payments to relatives.

Yes, you can usually deduct payments to relatives...but only in the year the relatives include them in income. 

Accrual-method taxpayers can deduct payments owed to unrelated employees if they are made within 2 1/2 months of year-end.  Many non-wage payments to unrelated taxpayers accrued at year-end can be deducted if paid as long as 8 1/2 months after year end.

But Code Section 267 only allows a deduction to a related party "as of the day as of which such amount is includible in the gross income of the person to whom the payment is made." That's no problem if the "related party" is on the accrual method, because they will be accruing the income at the same time you accrue the expense. But if the related party is a cash-basis taxpayer, you have to pay up to get that deduction.

Who is "related?" It's a wide net. Most problems arise with closely-held accrual-method businesses and their cash basis owners. If you have a C corporation, only owners of more than 50% of the stock, and their families (siblings, spouses, ancestors and descendants) are related. For pass-through entities -- partnerships and S corporations -- any owner is a related party, along with members of owners families and anybody related to the family members.  Commonly-owned businesses are also considered related.

The broad definition of related parties for pass-throughs means that if a calendar year accrual-method S corporation accrues a bonus for a 2011 shareholder's nephew payable in January 2012, the deduction gets deferred until 2012. The same thing applies to interest expense, rental expense, or any other expense owed to a cash-basis related party.

So enjoy the holiday turkeys, roasts, hams and bowl games.  Just make sure you take the time to cut the checks to any relatives to whom you owe deductible expenses, if you want that deduction this year. Check with your tax pro to make sure you get it right.

- Joe Kristan

Flickr image courtesy snowpea&bokchoi under Creative Commons license.

Prison - the reason you shouldn't "borrow" your payroll taxes

Every entrepreneur struggling to stave off hungry creditors has probably taken a wistful look at that pot of cash set aside from employee paychecks to send to the IRS as withholdings and payroll taxes.  Some go so far as to "borrow" that money to pay other creditors, leaving the IRS hanging.

Don't do it.  It's very expensive money. 

• If you are one day late making a deposit, you have a 2% penalty; and the penalties go up as high as 15%.  You also have to pay interest on the late amount.

• If the business goes under before you pay the IRS, the liability doesn't go away.  "Responsible persons" who fail to remit withheld taxes for their business can be held personally liable for the unpaid amount, even if the business is run in an LLC or corporation that otherwise shields the owner from liability.  

• You can go to jail.  Consider this case from South Dakota last year:

The former owner and president of two businesses in Brookings, South Dakota, who collected taxes from his employees and then failed to account for and pay those federal income and FICA taxes, was sentenced November 15, 2010, to 21 months in federal prison.

Michael D. Hoppe, age 60, from Watertown, South Dakota, received the prison term after a May 27, 2010, guilty plea in federal court in Sioux Falls. Hoppe was convicted of one count of failing to account for and pay taxes.

While paying payroll taxes may make it hard to run your business, prison walls make it much harder. 

- Joe Kristan

Flickr image courtesy Dan4th under Creative Commons license.

IRS offers $10,000 prize for filing new form!

Well, that's one way of putting it.  More accurately, the IRS will take $10,000 hard-earned dollars out of your pocket if you are don't file some forms related to international taxes.

You say "I'm in Des Moines, I don't have to worry about international tax forms!" Don't be so sure.  It's surprisingly easy to find yourself needing to file a form out of the IRS international tax series. Some common situations:

- You have a foreign financial account, or you have signature authority over one you don't own.

- You have loaned money to an offshore borrower.

- You have invested in an offshore venture. Many Iowans, for example, have been investing in Brazilian farm ventures.

The standard IRS fine for failing to file these forms is $10,000, and they assert the $10,000 penalty automatically.  The most common forms Iowans have encountered up to now include:

• Form 5471, reporting investments in non-US corporations;
• Form 8865, reporting investments in non-US partnerships;
• Form 3520, reporting interests in non-US trusts or cross-border gifts, and
• Form TD F 90.22-1, reporting interests in offshore financial accounts.

Now there is a new Form reporting broader classes of offshore financial instruments.  New Form 8938 requires you to report many offshore financial assets missed by other forms.  Unless the interest is held in a securities account, interests in partnerships, closely-held corporations and even public companies will have to be reported on 1040s filed for 2011.

Even if the interest is already reported on one of the old forms, the IRS is requiring a Form 8938 filing, if only to refer to the other form.  Examples we've seen of assets that would need to be reported are the Brazilian farm partnerships and shares of Canadian insurer Sun Life received as demutualization proceeds.  Single taxpayers will need to file if their holdings of foreign financial assets are $50,000 at the end of 2011 or $100,000 during the year; the thresholds are $100,000 and $200,000 for joint filers.

Except for Form TD F 90.22-1, these forms are all filed with your tax return.  Be sure you let your tax professional know about any Non-United States investments you have.  Unless you are happy to spare the $10,000, of course.

- Joe Kristan

Two months left to control your 2011 tax destiny

By now most of us have a pretty good idea how 2011 is going to come out for our businesses. That means now is the time to get serious about our tax planning. By the time you are gathering your information for your tax returns next year, most of the best tax-planning opportunities are behind us.  Now is the time to take charge of your 2011 year-end planning.

First, make sure you have a good idea of how your income is shaping up. Wrap up your October financials and make an estimate of how the last two months will go. Then get out a crystal ball and take a shot at estimating your 2012 income.

Then get together with your tax advisor to see how that translates to taxable income.  Many items have different tax treatment than financial statement treatment.  Once you have a good idea of where your taxable income is headed, ponder your options.

Your options might include:

• Planning your cash-basis deductions:  If you are a cash-basis taxpayer, you can move many deductions between years just by choosing which year you write the check.
• Take a close look at related party expenses:  When you are an accrual-basis taxpayer, you still are on a cash basis with expenses paid to cash-basis related parties.
• Ponder fixed asset purchases:  If you are going to be purchasing fixed assets anyway, 2011 may be the year to buy them.  New business property is eligible for "100% bonus" depreciation in 2011, allowing you to deduct the entire cost in the year of purchase.  Usually fixed asset costs are capitalized and deducted as depreciation over a period of years.  Even if you are buying used equipment, you may be eligible to take a Section 179 deduction for up to $500,000 of business asset purchases.
• Consider retirement plans:   If you have been looking to add a profit/sharing or 401(k) plan to your employee compensation package, you need it in place by year-end if you want to deduct contributions for 2011.

Last but not least,

• Consider your tax payments:  It often is good to make your tax payments for the tax year during the tax year.  This helps you match your deductions for taxes paid to your income, and it may help you avoid Alternative Minimum Tax.  This is especially helpful when your income fluctuates from year to year.

The tax planning game is pretty much over at year-end.  After that, it's mostly just adding up the score.

- Joe Kristan

Flickr image by Baaker2009 under Creative Commons license.

To C or not to C

While most entrepreneurs set up their businesses as "pass-through entities" taxable on their personal returns, the traditional corporation retains fans.  "C" corporations pay their own tax, unlike "S corporations," which "pass through" their income to their owners returns.   Economist Martin Sullivan ponders why this old format still hangs on: 

Graduated corporate rates, the low rate on corporate dividends, and an exemption from payroll taxes combine to make subchapter C the most advantageous choice for a lot of small business profits. If a business owner can afford to leave profits inside the corporation, the resulting deferral of individual tax only makes subchapter C more attractive.

While the top tax rate for individuals and corporations is 35%, C corporation rates are as low as 15% for the first $50,000 of taxable income.  This can be attractive to a top bracket individual. Some tax-free fringe benefits are also available to owners only in C corporations.

In venture capital deals, sometimes C corporations are required because they are funded by tax-exempt entities.  If business income passes through to tax-exempts, they may have to pay "Unrelated Business Income Tax."  They prefer dividends and capital gains from C corporations, which they can receive tax-free.

Still, there are good reasons for the popularity of pass-throughs. 

• The 15% bracket can only be used in one corporation with the same owners.

• "Personal service corporations," including law, medical, accounting and consulting practices, don't get the lower brackets.

• Appreciated assets inside a C corporation can be trapped there because a distribution is taxed to the corporation as a sale and to the recipient as a dividend at fair-market value.  This can get very expensive when it comes time to sell.

You should consult with your tax professional when it's time to choose a tax structure for your business.  You might also want to ponder these words from the standard treatise on corporation taxes:

Decisions to embrace the corporate form of organization should be carefully considered, since a corporation is like a lobster pot: easy to enter, difficult to live in, and painful to get out of.

Though, a C corporation is still likely to have a better ending than the lobster.

- Joe Kristan

Image by Hartmut Inerle via Wikipedia under Creative Commons Attribution-Share Alike 3.0 Unported license.

 

When two S corporations are one too many

Entrepreneurs often set up a new corporation for each new business. It makes sense; if one has a catstrophe, the others are shielded from the damage. But if you aren't careful, multiple corporations can cause a tax catastrophe. It caused a $16 million problem in Tax Court this month for a Michigan couple.

Owners of "S corporations" may be eligible to deduct the corporations business losses against other income on their personal tax returns. There are a number of limits on such losses, starting with the owners' "basis" in their S corporation stock.  Basis starts with their investment in the company; it is increased for earnings of the business and additional investments, and reduced for losses and distributions from the business.  Owners may also get basis for losses from personal loans to the S corporation.

If you have two corporations, one might be profitable, but the other might be losing money -- and short on basis.  Owners may be caught with non-deductible losses at year-end if they can't figure out how to get the basis where it needs to be.  That's what happened to the Michigan couple.

The easiest way to deal with this problem might be an "S corporation holding company."  If you have two S corporations with identical ownership, you can contribute all of their stock to a new corporation (it has to be all of the stock).  The new corporation makes a timely S corporation election on Form 2553, and the now-subsidiary corporations file timely "Q-Sub" elections. 

The tax law treats the new corporate group as a single corporation for basis purposes, eliminating the need to try to shuffle basis between them at year end.  The lawyers are happy because the liabilities of the businesses are still in separate corporations under state law.

Of course, don't try this at home.  Check with your tax and legal advisors before messing with your corporate equity structure.

- Joe Kristan

Don't flush that home office deduction

With the rise of the Internet and the wonderful business computer tools now available, more entrepreneurs make do without fancy rental office than ever before. But not everyone who works at home qualifies for a home office deduction. A Florida accountant learned that the hard way in Tax Court recently.

The accountant worked out of a home office. When you take a home office deduction, you get to deduct some otherwise non-deductible home expenses attributable to your business space.  The catch: the space has to be used "exclusively" for your business. And they mean it.  From the Tax Court:

Petitioner argued that he also used the hallway and the bathroom adjacent to this bedroom exclusively for his accounting business. Petitioner testified, however, that his children and other personal guests occasionally used the bathroom. Accordingly, the hallway and the bathroom were not used exclusively for business purposes.

Jean Murray explains what you need to know about your home office deduction:

• The space you deduct must be used (1) regularly AND (2) exclusively for business. A bedroom or part of bedroom that you don't use for anything else might be deductible, but not a bathroom that's also used for personal reasons. (I'm still trying to figure out how a home bathroom could have a business purpose.)

• You can deduct the percentage of the space compared to your home's total living space.

• You can deduct direct expenses related to the home office, like a separate phone line.

• You can also deduct indirect expenses, like roof repairs, using the percentage.

If you are a Schedule C entrepreneur, you compute the deduction on Form 8829.  If you are an employee, it gets more complicated, so check with your tax advisor or IRS Publication 587.

- Joe Kristan

Flickr image by dfwcre8tive2009 under Creative Commons license.

What should I do about my capital losses?

Maria Bartiromo has been the bearer of grim tidings for many of us in recent days. If your net worth has taken a hit, can you get some of it back from the IRS at tax time?

The tax law is not very friendly to stock market losses.  Most of us can only deduct our capital losses to the extent of our capital gains, plus $3,000.  Capital losses carry forward as long as you live, usable to the extent of future capital gains; if you have none, you at least get the $3,000. Long-term gains can offset short-term losses, and vice-versa.

The $3,000 allowance can be cold comfort. At $3,000 per year, some of us will have to outlive Methuselah to use up our carryfowards.  Still, there may be some tax moves available to ease your pain.

If you already have capital gains that you have cashed out for the year, sell enough losers to generate capital losses to offset them.  Remember, this only works in taxable accounts.  Selling a stock for a loss in an IRA or 401(k) does nothing for you, and losses in taxable accounts of course do not offset income from IRAs or retirement plans.

If you already have loss carryforwards, you can rearrange your portfolio without paying taxes.  If you have some gain stocks that it's time to unload, you can do so.

Be sure you know what your loss really is.  If you inherited a stock, your "basis" -- the amount you compare to your sale price to determine gain or loss -- is normally the date-of-death value.  If you were gifted shares, you step into the basis of the giver.  And if the stock has split or came from a merger of another company, you may have to pick your way through old transactions to learn your basis.

Beware the "Wash Sale" rules.  If you sell shares at a loss, purchasing the same shares in the 30 days before or after the loss sale will disqualify the loss on your tax return.

If you are a very active trader, there is an election to have all of your capital gains and losses treated as ordinary income -- not so great when you're making money, but a blessing when you've lost a bundle.  Unfortunately, it's too late to make that election for this year, as the deadline for the election is April 15 of the year you want the election to be effective.  It might be useful for 2012, though. 

If you need more information, Kelly Phillips Erb has a great general discussion of capital losses at her Forbes blog.

- Joe Kristan

Flickr image courtesy donjd2 under Creative Commons license.

 

If it's really a vacation, the IRS doesn't want to pay for it

It's high vacation season in Iowa.  As your inbox fills with "Out of Office" auto-replies, you might be wondering whether there's a spot on your return to deduct a nice trip to somewhere cool.  Didn't you overhear somebody's doctor bragging about how his tax preparer let him write off his vacation to California because there might be sick people there?

It's not so easy. 

Yes, there are preparers who will let you deduct a vacation for even the most strained connection to your business.  The tax law itself, however, has a stricter standard, as the clients of an Iowa preparer have been learning. 

According to a U.S. District Court opinion, the preparer encouraged clients to employ relatives as distributors, or to sell to them, to make family vacations deductible:

You want to go visit your mother for Thanksgiving . . . . If you’re self-employed and you  sponsor your mom into your business, now you’re going to meet with your distributor. All of a sudden, that trip for Thanksgiving is a deductible business trip.

Sorry, Mom.  The tax law has a much stricter standard for these things.  Your trip has to be "primarily" for business reasons.  Good luck convincing an IRS agent that you really visited Mom for four days on Thanksgiving weekend to sell her vitamins. 

IRS Publication 463 explains what the rules really are:

If your trip was primarily for personal reasons, such as a vacation, the entire cost of the trip is a nondeductible personal expense. However, you can deduct any expenses you have while at your destination that are directly related to your business.

A trip to a resort or on a cruise ship may be a vacation even if the promoter advertises that it is primarily for business. The scheduling of incidental business activities during a trip, such as viewing videotapes or attending lectures dealing with general subjects, will not change what is really a vacation into a business trip.

The IRS isn't required to take your explanation of your travel costs on your word.  In fact, it's up to the taxpayer to document the amount, dates and times and business purpose of any travel expenses.  If you are in the real estate business and you happen to go to Arizona during Bowl Season, you have to do more than just say you are going to check out the great values in Tempe real estate.  Unless you can show you went there primarily to check out real estate, with dates, names, documentation and proof you are serious about it, don't even try to write off the trip. They aren't going to buy it.

And the preparers that say you can write off your vacations?  There is one less now.  Last month a federal judge permanently barred that preparer from the tax prep business.  That preparer's clients have been getting special attention from the IRS.

If your corporation has sold out, the IRS may be after your "incorporated pocketbook"

Every entrepreneur daydreams of cashing out someday. Sure, there will be taxes on the sale, but then we can just invest in safe stocks and bonds and pay tax on the interest at the nice low 15 percent corporation tax rate, right?

Be careful. A depression-era relic in the tax law could bite you.

The Personal Holding Company Tax arose during the Depression to get corporations to disgorge their accumulated cash to goose a staggering economy (sound familiar?). Over time, the justification shifted from stimulating the economy to preventing the shifting of income to an "incorporated pocketbook." The PHC tax hits "personal holding company taxable income" with a 15 percent tax, on top of the regular corporate tax.

The corporation sitting on cash after a successful asset sale is the classic candidate for a personal holding company tax. It can apply if "bad" income -- primarily investment income -- is at least 60 percent of business income, and more than half of the corporation's stock is held by five or fewer shareholders. Related shareholders count as one shareholder. Special rules allow banks and some other financial businesses to avoid the tax.

The PHC tax can crop up in more-surprising ways. For example, a subsidiary that is sitting on investment assets can end up paying PHC tax, even if the rest of the companies in the consolidated tax return have plenty of "good" active business income. A cash-rich corporation might run into this tax. So may a C corporation that loans money to related businesses.

S corporations don't pay Personal Holding Company tax, but those that are former C corporations face a similar tax. The S corporation version, the "Section 1375 tax," can result in the loss of S corporation status after three years. 

The surest way to avoid the PHC tax is to liquidate the personal holding company.  That can be painful, triggering both corporation and personal tax, but with capital gain rates at a historically low 15 percent rate, it may be time to bite that bullet.  If you think that PHC tax might apply to you, it's certainly time to talk to your tax advisor.

Flickr image courtesy SheriW under Creative Commons license.