Business Record - Iowa Biz

Getting your car expenses past the IRS auditor

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Entrepreneurs get around a lot, often in their cars. It's only fair that they get to deduct their business car expenses. Inconveniently, the tax law makes it your responsibility to document how much your auto use is business-related. What do you have to do to get your car deductions past an auditor?

Actual expense or standard mileage rate?

Taxpayers generally can choose between deducting their actual documented business expenses or their expenses using the IRS standard mileage rate. If you deduct actual expenses, you have to depreciate your car and save receipts for your gas, repairs, tires and so on; if you use the car for business and personal purposes, you have to document how many of your miles are business miles.

If you use the standard mileage rate, you only have to document the mileage.

How to document the miles?

The only sure way to get through an IRS audit unscathed is to maintain a current daily record of your business use. While specialized mileage logs exist, it's also acceptable to track your miles in your ordinary business calendar. It's very important to not your car's odometer reading at the beginning and end of the year, and preferably each month. In a pinch, you can go back to your appointment calendar to reconstruct your mileage, but this is a hassle, and your IRS agent may not be fully appeased.

Learn more about auto deductions at the IRS web site.

Shareholders held hostage

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Limited liability companies and S corporations are popular ways to do business in Iowa. Income of both S corporations and LLCs is only tax once; C corporations, in contrast, can be taxed twice. 

Yet the single-tax format can cause problems.  The single tax is achieved by having the business income taxed on the returns of their owners, rather than to the business itself.  Business income taxed on the return can be distributed to owners without a second tax. Most LLCs and S corporations distribute some or all of their earnings - at least enough to let their owners pay the tax on the business income.  But what if they don't?

That problem came up in a case decided yesterday by the Iowa Court of Appeals. An S corporation was owned by a family. When the mother died in 2006, her son Joseph exercised an option to purchase her shares at a formula price. The mother's Estate and Joseph couldn't agree on how the formula should work (a good story in itself), and it's taken three years (so far) to sort that out. In the meantime, the Estate has still owned the shares, and the company has remained profitable. That means the Estate has had to pay tax on its share of corporate income. 

Joseph, however, had the S corporation stop making distributions. 

So - the Estate had to pay tax on the earnings, even though it wasn't receiving any distributions.  Meanwhile, the formula price was fixed at the date of death, so the Estate wasn't getting any benefit from the income that it was paying the tax on. Or at least that's the way Joseph wanted it to work. This had the perhaps intended effect of putting pressure on the estate to settle.

The Court of Appeals of Iowa didn't let that stand.  While it sided with Joseph on how the formula should work, it wouldn't let him hold the distributions hostage (my emphasis):

The Estate specifically alleged that Joseph's decision to have the corporation stop making distributions sufficient to cover the ongoing tax liabilities breached that duty. Joseph acknowledged in his testimony that he caused DLDC to cease paying distributions. We conclude that this conduct was in bad faith, since it had the purpose and effect of forcing the Estate to bear the tax liabilities while Joseph received the corresponding profits on the Estate's shares, with no apparent justification...

Joseph engaged in bad faith and oppressive conduct, and breached the covenant of good faith and fair dealing in the buy-sell agreement, by discontinuing the longstanding practice of paying dividends during the pendency of this dispute. We agree with the Estate that the federal and state income taxes it was forced to pay on post-July 2006 profits without any distributions to pay them should be added to the compensation it receives from Joseph for its shares.

Unless this result is reversed by the Iowa Supreme Court, this case gives hope to minority owners of profitable LLCs and S corporations.  If a majority owner withholds income tax payment distributions, perhaps to force a sale, Iowa courts could well step in on behalf of the minority owners to force a payout.

But it would have been best to avoid this problem by including in the buy-sell option agreement a clause requiring a business to make distributions to cover taxes until the sale closes.

Note: Hat-tip to IowaBiz.com contributor Christine Branstad for her Twitter link to the case.

Your retirement plan as your venture capitalist?

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Like many professionals, a Minnesota lawyer had a little business on the side; a 57 percent interest in a corporation that owned a bowling alley. He had a self-directed profit sharing plan at his law firm. He needed some financing in the bowling business, so he directed his plan to make a loan to the bowling alley.

That went badly. The IRS assessed "prohbited transaction" penalties on the plan for making the loans.  These penalties, which start at 5 percent and can go as high as 100 percent, apply when a plan "fiduciary" makes engages in a "prohibited transaction" with "disqualified person."

The IRS said that his ability to control plan investments made him a fiduciary, and that his 57 percent ownership made him a disqualified person. 

Things went to court, and both the Tax Court and the 8th Circuit Court of Appeals sided with the IRS.  

This doesn't mean that one can never use qualified plan investments to finance a closely held business.  It does mean that if you want to do so, you need to be extremely cautious. Such investments can have baleful results; everything from punitive prohibited transaction taxes to income taxes within an otherwise tax-exempt retirement plan to plan disqualification and severe income taxes on the plan balance. 

The qualified plan rules are very tricky, which is why the tax court didn't hit the bowling, er, kingpin with additional penalties.  The court noted that the lawyer/bowler hired another

...lawyer with extensive experience in the area of retirement plans. He was fully aware of all of the relevant facts. He researched the issue and advised petitioner that he believed the loans would not violate any of the provisions of ERISA or cause any tax liability under section 4975. The ERISA provisions involved are highly complex, and the fact that his conclusion was erroneous does not mean that petitioner's reliance was not reasonable.

If an experienced ERISA lawyer can make a mistake, you can too.  

Worse, the IRS is very skeptical of taxpayers who use retirement plan funds in their businesses.  "Abusive" retirement plan arrangements are among the IRS's "dirty dozen" tax abuse schemes.

Even if you negotiate the retirement plan rules and safely tap plan funds for your business, you still should ask yourself whether it's really a good idea. Usually you are only tempted to tap these funds because there aren't other savings to tap.

It's not always a great idea to put the last of your savings into the always-risky world of small business. 

Pork-barrel tax bill takes aim at professional S corporations

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NASCAR is more important to Congress than your small professional practice. 

That's the inescapable conclusion arising from the "extenders" bill (HR 4213) that passed the House of Representatives last week.  The bill will subject K-1 earnings of professional S corporations to self-employment tax for the first time.  Worse, it will do so in a way that will be a compliance and planning nightmare.

The self-employment tax -- the self-employed taxpayer's version of the Social Security and Medicare tax -- starts at 15.3 percent on earnings up to the FICA base (currently $106,800, less any W-2 earnings subject to FICA tax).  Any amounts over the FICA base are still subject to the 2.9 percent. Medicare portion of the tax.  While salaries paid out of an S corporation are subject to FICA taxation, S corporation earnings passing through on a K-1 have always been exempt from FICA and self-employment tax.

Here's where the underprivileged folks at NASCAR come in.  A special tax break for race car tracks is set to expire, along with dozens of other so-called "temporary" tax breaks that Congress routinely passes for only a year at a time to conceal their real multi-year cost.  To pay to extend these porky provisions (for example, the biodiesel subsidy) for one more year, the bill would permanently subject some - but not all - professional S corporations to self-employment tax on their K-1 earnings. 

It would apparently be too simple to just subject all professional S corporations to self-employment tax.  It would instead apply to two sets of S corporations:

• Those who are partners in professional partnerships, and
• Those professional S corporations where "the principal asset of such business is the reputation and skill of 3 or fewer employees."

This obviously discriminates against smaller professional shops in favor of their larger multi-owner competitors.  It also creates obvious compliance nightmares.  How is a multi-owner professional corporation supposed to determine whether it's "principal" asset is the "reputation and skill" of three or fewer people?  Can it buy its office building to make that the "principal asset?"  What factors are used in valuing "reputation and skill?"  The bill provides no answers, creating a compliance nightmare for taxpayers and an enforcement nightmare for the IRS.

H.R. 4213 isn't final yet, but the Senate may take it up as early as today.  Call Senator Grassley, Senator Harkin, and anybody else you know in Washington and let them know how you feel about this wretched provision.  Unless, of course, NASCAR really is more important than your professional practice. 

Iowa's 10-year business sale tax break

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What do you need to hold for ten years?

If you run a business in Iowa and it goes well, you might be able to hang in there and stay in business for 10 years or more. If it goes really well, you might be able to sell out for a nice profit. If all that happens, you might get to cash out without paying Iowa tax on your capital gains.

Iowa has a special tax break for for capital gains of businesses when you meet two conditions:

- A 10-year holding period, and
- Ten years of material participation at the time of sale

You can qualify if you sell substantially all of the assets of the business in a single sale, or on any sale of business real estate, such as farmland.

But if you have owned the business for 10 years and you sell, do only the assets that you've held for 10 years qualify for the break? If you bought a new location seven years before the sale, will that qualify?  A newly-released letter from the Iowa Department of Revenue says it does:

The rule does not require each individual asset be held more than ten years. Since the asset was held more than one year, the deduction should have been allowed.

A few other things to keep in mind:

- Holding period rules follow federal holding period rules -- so holding periods of gifted assets, inherited assets and like-kind exchanges go back to the original purchase date.

- "Material participation" is determined under the federal "passive loss" rules.  That means for most businesses, you have to sell within five years after retirement to qualify.  A special rule allows retired farmers who have 10 years in the business to sell anytime.

- The exclusion is not available for a sale of stock or of a partnership interest, except for gains on liquidation for a corporation that has made a qualifying sale of substantially all of its assets.  

- It only applies to capital gains.  If part of your gain is from the sale of ordinary income items, like inventory, that will still be taxed by Iowa. This is another reason to pay careful attention to how you allocate your sales price.

Will your exempt organization turn into a pumpkin May 15?

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Most people think of April 15 as the big tax day. However, May 15 may be much worse if you are on the board of a little tax-exempt organization.  On May 15 hundreds of thousands of small tax-exempt organizations will suddenly become taxable corporations, required to file Form 1120 and pay taxes every March.  And it's board members of booster clubs, garden clubs, little leagues and so on that will be held responsible.

Why? Because of a largely-unnoticed provision in a 2006 tax bill. The rule requires all nonprofits to file tax forms. Organizations with incomes under $25,000 had been exempt from filing requirements until their 2007 filings were due.  If an exempt organization fails to file for three straight years, you you are no longer a tax-exempt organization.

So if you are on a board of a luncheon club, civic organization or other local do-good outfit, it's time to make sure that filing has been done. Fortunately it's very easy for little outfits. For small charities -- those with income under $25,000 -- the necessary compliance requires only eight pieces of information, with no detailed financial information, to be entered on online Form 990-N. For larger exempt organizations, the IRS will require a Form 990, 990-EZ, or 990-PF. For calendar year returns, these are due May 15. If you need more time for your 2009 filing, you can get a three-month extension on Form 8868. Special exemptions apply to some religious organizations.

Extend or Amend?

You've done your part.  You've gotten all of your tax information to your preparer in order and on time.  But you still are waiting on a K-1 from a partnership or S corporation.  It probably won't be big -- why not just file now and be done with it?

It can be tempting, especially if you think you have a big refund coming, to just go ahead and file anyway.  Even so, it's usually a bad idea.

Most businesses are set up nowadays as S corporations or partnerships (limited liability companies with multiple owners are usually taxed as partnerships).  Their income is taxed on the owner's returns directly. They can distribute their income without incurring an additional tax; any funds not distributed increase the owners' basis in their investment, reducing future capital gains.

The K-1 is the way S corporations and partnerships break out their income so the owners can report it properly on their own returns.  Unfortunately for owners, these can take a long time to prepare for a complex business, or one without great bookkeeping.  They don't have to be distributed at the same time as 1099 forms (normally January 31); in fact, they can be issued as late as September 15 on extended returns.

If you are up against the April 15 deadline and still waiting for your K-1, it's usually much better to extend your return.  If you file an extension, you only have to prepare the actual return once -- saving you time and preparer costs.  If you amend, you give the IRS two returns to look at instead of only one.  And if you file without the K-1 and don't correct the return when you finally get the K-1, chances are good that the IRS will notice. 

There are times taxpayers will want to file without a K-1.  If you have a huge refund coming, maybe it's worth the hassle of amending a return later to get the refund now.  Sometimes a failing or failed business just doesn't get a K-1 out in time even for extended returns; then you have to file as best you can.  But normally, extend, don't amend.  You can e-file an extension or file Federal Form 4868.  Remember, extending the return deadline doesn't extend your deadline for paying taxes.  Iowa doesn't require a separate extension form if you are 90% paid in; if you need to pay some cash, send Iowa a payment with Form IA 1040-V by the April 30 Iowa deadline.

Expense reimbursements or income?

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An old joke, sometimes attributed to Lincoln:

'"Father," said one of the rising generation to his paternal progenitor, "if I should call this cow's tail a leg, how many legs would she have?" "Why five, to be sure." "Why, no, father; would calling it a leg make it one?"

The tax law works that way, too.  Just as calling a tail a leg doesn't make it a leg, calling a payment of taxable wages a non-taxable expense reimbursement doesn't make it one.  Some members of Congress might be about to learn this the hard way.  The Wall Street Journal reports:

When lawmakers travel overseas on official business they are given up to $250 a day in taxpayer funds to cover meals and expenses. Congressional rules say they must return any leftover cash to the government.

They usually don't.

Taxpayers can't help employees avoid taxes just by calling compensation something else.  If you give each employee $200 per day to cover "expenses," but you never make the employees turn in receipts to document what those "expenses" might be, the IRS will make you put it on the employees' W-2s while making you, the employer, pay some employment taxes.

If you want to reimburse expenses of an employee without putting it in the employee's taxable income, the IRS says you need an "accountable plan" that passes three tests:

1. There must be a business connection and the expense must be reasonable.
2. There must be reasonable accounting for the expenses.
3. All excess reimbursements must be repaid in a reasonable time.

There are special rules where travel expenses are "deemed" substantiated without detailed accounting, but even those rules require certain conditions to be met -- they have to be incurred on a business trip, and the reimbursements have to be within federal "per-diem" guidelines.

What happens if you have a fixed employee reimbursement plan that's not "accountable"?  The amount has to be included in employee W-2 income, and the employee can only deduct it as a "miscellaneous itemized deduction" -- often a bad result. 

The Moral?  If you are reimbursing expenses, make sure that you require proper documentation.  If you have a per-diem travel expense reimbursement plan, make sure to follow IRS guidelines.  Otherwise you and your employees could both come out at the wrong end of a fight with the IRS.  That means you, too, Congressman.

Income taxes matter even when you lose money

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They call it an "income" tax.  If you are losing money, you can ignore it, right?

Well, no.  In fact, ignoring income taxes in a loss year can be very expensive, as a Georgia entrepreneur just learned in tax court.  He waited until 2007 to file his returns for 2001 and 2002, years when he lost money.  He then tried to use the "net operating losses" from those years against his 2003 income.  It was too late.

The tax law normally requires you to carry back business losses to the two years preceding the loss year; only losses left after applying them against the earlier years' income carry forward. Taxpayers can waive the carryback and elect to carry it all forward, but you have to do this on a timely return for the loss year. You have three years after the due date of a loss year return to carry back its NOLs.

By not filing timely 2001 and 2002 returns, our Georgian lost his opportunity elect to carry his losses forward.  By waiting more than three years after his loss year 1040s were due to carry back his losses, he lost his chance to get refunds from 1999 and 2000. 

There's an extra reason for businesses with tax losses to be on top if their 2009 taxes.  A temporary provision allows taxpayers with 2008 or 2009 net operating losses to carry them back up to five years, instead of the normal two.  But there's a catch - you must elect the five-year carryback by the due date of your 2009 tax return, including any extensions you obtain.  That means corporations have until March 15 to make this election (Sept. 15 if they extend the return), and individuals have until April 15 (Oct. 15 with an extension). Taxpayers who don't elect the five-year carryback in time get the usual two-year carryback.

The five-year carryback can be very valuable, especially if you are coming off more than one bad year. Many taxpayers have to go back that far to have enough income to absorb 2008 or 2009 losses.  By filing a timely return a money-losing business can get back some badly-needed cash from Uncle Sam.  If you are under the gun for getting the return done on time, get an extension.

Sadly, Iowa only allows a two-year carryback for individuals and no carryback at all for corporations.

Update, 5/6/2010: IRS allows automatic relief for late NOL elections.

Can you afford to pay your payroll taxes twice?

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It's hard enough to run a business without becoming a payroll tax expert, too.  That's why many people farm out their payroll function to a payroll service.  They almost all do a good job, but woe unto a business when a payroll service goes bad.

Customers of New York payroll service Paybooks Inc. lived the nightmare.  The owner of the payroll service allegedly spent $2 million of funds provided by his customers to pay their payroll taxes.  The IRS and state taxing authorities didn't have much sympathy.

Carpet store owner William Calder is typical of the Paybooks, Inc clients:

...he contacted taxing authorities on his own. Also like the others, he is upset about having to pay the full amount his business owes despite Paybooks having taken $66,000 from the store's account. After some negotiation, the IRS agreed to waive penalties but still charge interest for late payment of his federal taxes, Calder said.

After some negotiation, the IRS agreed to waive penalties but still charge interest for late payment of his federal taxes, Calder said. He rattled off a list of eight other small-business owners being similarly squeezed, including his personal attorney, who Calder said owes $18,000.

Fortunately, you can check up on your payroll service.  Businesses that enroll in EFTPS, the federal Electronic Payroll Tax Filing System, can go online to make sure their payroll taxes are being credited to their accounts. 

Whether you outsource your payroll or take care of it in-house, it never hurts to make sure your payroll accounts are in order.  Nobody wants to pay their payroll taxes to a thief and to the IRS.  It's enough fun to pay them once.