Business Record - Iowa Biz

Capital losses: how to take your medicine

It's a very wise or very lucky investor with capital gains to worry about this year.  For the rest of us, its capital losses as far as the eye can see.  While never pleasant, capital losses can provide a tax-time silver lining to the dark cloud over our portfolios.

What are the limits on deducting capital losses?  Tax planning would be too easy if we could take any amount of investment losses against our salary or business income.  Individuals get to deduct capital losses against ordinary income only to the extent of their capital gains for the year, plus $3,000.  Individual capital losses over these limits carry forward until you die; the capital gains + $3,000 limit applies to each year.  That means if you have a net capital loss of $999,000, and you never have another capital gain, you will get to offset $3,000 of ordinary income each year for the next 333 years, unless you happen to die first.

Corporations have stricter limits.  C corporations can only deduct capital losses to the extent of their capital gains for the year; they get no $3,000 spiff. Corporations do get to carry back capital losses for three years; if the corporation had a capital gain in its three prior tax years, it can fully offset it.  Any losses not used in a carryback three years carry forward to offset capital gains in the next five years; they then disappear forever.

What you have to do before year end to get a deductible capital loss?

First, capital losses are only deductible if they occur in a taxable account.  You can't deduct the capital losses you incur in your Individual Retirement Account or your 401(k). 

To deduct your capital loss, you have to recognize it through a sale.  You can't deduct lost value in your portfolio unless you sell loser stock (unless you are a "trader" and make a special election).  You have until the last trading day of the year to take the loss; the tax law recognizes losses on the trade date, rather than the settlement date.  Unless, of course, you're a short seller, in which case the settlement date controls (but then you probably don't have losses this year). 

Beware the Wash Sale rules!

The tax law punishes Sellers Remorse on capital losses.  If you sell a stock at a loss, but you buy other shares of the same stock in the thirty preceding or subsequent days, the "wash sale" rules disallow the loss until you sell the newly-purchased shares.  Under a recent and controversial IRS ruling, the wash sale rules apply even if you purchase the new shares in an IRA or 401(k) -- where you will never be able to use the capital loss.

Might you qualify as a "trader"?

Have you quit your day job to trade full-time?  Special rules apply to those with enough trading activity to be considered "traders," rather than investors.  If you have been spending your afternoons with Maria Bartiromo, consult your tax advisor about a Sec. 475(f) election that could allow you to claim your losses as ordinary.  But remember - the threshold for treatment as a "trader" can be hard to reach, and if your losses are ordinary, your gains will be ordinary too.

New president... same old tax planning?

For the first time since 1989 we will see a new president not named Bush or Clinton.  Does this change things for your business tax planning?

If we are to go strictly by campaign promises, we would anticipate a rate increase in 2009 for higher bracket taxpayers, accompanied by an increase in the top capital gain tax rate from 15 to 20 percent.  We would also expect a new set of targeted tax breaks for certain businesses, especially "green" businesses and alternative energy producers.

There are some hints that the Obama administration will follow through with its tax promises:

President-elect Barack Obama plans to push ahead with a middle-class tax cut soon after taking office, his choice for White House chief of staff said yesterday.

Rahm Emanuel also hinted that Obama would not postpone a tax increase for families earning more than $250,000 a year despite the deepening economic gloom. He said Obama's proposals would reduce taxes for 95 percent of working Americans by an average of $1,000 each, resulting in "a net tax cut" for the overall economy.

If that's true, taxpayers who pay taxes on their business income on their 1040s would prefer to have their income taxed in 2008, rather than 2009.  These taxpayers would reverse the usual year-end tax planning tricks; they would try to accelerate taxable income into this year and hold off on incurring or paying expenses until January.

But it's a long way from the campaign promise to reality.  Even when politicians mean what they say, things happen.  Congress always has its own ideas, and the continuing economic slump may cause second thoughts on increasing taxes right away.  One well-connected commentator says:

Tax hikes on the wealthy: They are not going to happen as long as the economy is in a slump. Obama may try for these rate increases in 2010, but not in 2009.

So what to do? 

Stay flexible.  This isn't the time to do anything that would be hard to undo.  For example, it would be unwise to terminate an S corporation election based on an anticipated rise in tax rates.  While you can always terminate an S election, you normally have to wait five years to reinstate it.

Close on big capital gain sales this year.  If you are sure you are going to incur a capital gain in either 2008 or 2009, it may be wise to take it this year.  While the capital gain rates may go up next year, they sure won't go down.  If the sale will be an installment sale, you can close this year and decide whether to take the capital gain in 2008 when you file your tax return.  If you extend your return, you may be able to wait until October 2009 to choose the year the 2008 gain is taxable.

Consult your tax advisor. Only your own tax advisor knows all the pieces to your tax puzzle.  Don't do anything involving real money without getting your tax pro involved.

Link: Tax Policy Center Analysis of Candidates' Tax Plans

You may be more international than you think

If there ever were a time that Iowa businesses could ignore international issues, those days are long gone.   Iowa entrepreneurs are crossing borders as near as Canada and as far away as China and India.  And where Iowa business goes, so goes the IRS.

Fearing cross-border tax evasion, Congress has imposed a number of reporting requirements with frightful penalties for non-compliance. 

For example, U.S. Taxpayers that either own or have signing authority over a foreign bank account are required to file Form 90-22.1, "Report of Foreign Bank and Financial Accounts." This report is commonly, and colorfully, known as the "FBAR" form.  An accidental violation of this requirement can trigger a $10,000 fine.  Willful violations can earn fines of the greater of $100,000 or half the value of the account.  You can imagine how that can add up over a few years.  And remember, even if you don't own the account, the reporting requirements apply even if you are just authorized to sign checks, say, on the company's Canadian bank.

If you are an officer, director or significant shareholder of a foreign corporation, you may have to file Form 5471.  This form is meant to identify whether certain U.S. tax rules apply to the income of the foreign corporation, and to highlight certain cross-border transactions.  The penalty for accidental failure to file this form is $10,000, and the IRS says it will automatically assess this penalty for late filings starting next year.  This penalty applies even if no income tax was underpaid; the IRS doesn't believe in "no harm, no foul."

U.S. Corporations with foreign ownership and foreign companies doing business here may have to file Form 5472.  This form identifies cross-border transactions the IRS might want to know about, and it also carries a $10,000 penalty for late filing.

Partnerships are required to withhold up to 30 percent of U.S. income allocatable to offshore partners using forms 8804, 8805 and 8813.  The IRS can assess penalties of up to 25 percent for late filing, and they can also collect any withholdings that were missed.

This just scratches the surface of international reporting requirements.   Foreign gifts,  offshore trusts and ownership of non-corporate entities are just some of the situations that trigger reporting requirements.

The bottom line?  As the world gets smaller, international tax reporting requirements are only getting bigger.  Neglecting them can get expensive in a hurry.

I got away with it, right until they arrested me...

It can be so tempting. Your company has made some money this year, and you'll need to pay some extra taxes. You promised your spouse a new kitchen. Why not have the company pay the remodeling contractor and call it "repairs"? The bigmouth at the golf course says that's how he afforded his new house. You get a deduction, a shiny new kitchen, a happy home and the joy of less tax.

At least until the IRS stops by. 

One thing the IRS has learned over the years is that people like to run their personal expenses through the business.  Standard IRS procedures include reviewing company invoices for company-paid personal expenses.  If the IRS comes by -- and they do like to visit closely -- there's a real good chance that they'll find this sort of thing.

And what happens if they do?  The IRS may not just ask for back taxes and penalties.  Ask the Wisconsin scrap metal dealer who got 18 months in federal prison -- on top of having to pay $351,753 in federal taxes, $263,814 in civil fines, and $285,733 in interest. 

Or ask the Iowa injection molding company owner who will serve a year in federal prison after pleading guilty to diverting funds from his company for, among other things, home remodeling. 

Paying taxes is bad, but paying taxes, interest and penalties is worse. And doing all this and going away to federal prison is a grand slam of misfortune.  It's wise to keep your personal spending out of your business and stick with above-the-table plans for reducing your tax bill. 

The perks of running for high office, and your own business

There are plenty of drawbacks to running for president, but there is at least one perk, of sorts: free tax advice. Candidates have taken to releasing there tax returns in recent elections. This gives them access to the collective wisdom of an Internet full of armchair tax advisers.

When Barack Obama released his 2000-2006 tax returns, the blog world noticed that Mr. and Mrs. Obama had not opened a Simplified Employee Pension (SEP) plan. The SEP, a glorified IRA, enables self-employed taxpayers to deduct up to 25% of their self-employment income when they contribute it to a SEP-IRA account. Sen. Obama's income came from his writing; his wife had consulting income.

You can set up and fund a SEP as late as the due date of your return. The only documentation required is a Form 5305-SEP for your records and a deposit to your SEP account with your friendly banker or broker by April 15 - or October 15 - if you extend your 1040. You may be able to contribute as much as $46,000 to a SEP for 2008.

SEPs aren't just for politicians. They are available to any business. Because they generally require proportionate contributions for all employees, they are most popular with self-employed taxpayers. While they aren't as flexible as other qualified plans, they are the easiest to run, and they are the only kind that can be set up after year-end.

Senator Obama's free advice didn't go unheeded. The Obamas' 2007 return featured $45,000 in SEP contributions -- saving $15,000 for taking money from one pocket and putting it in another.

Home is where the job is

It has become the custom of candidates in the presidential elections to release their income tax returns.  Occasionally, the candidate suffers the annoyance of having to promptly amend returns because of an obvious error, but mostly this is just a chance to see how much more our would-be leaders make than we do, and how selective they are about charitable donations.

Sometimes, though, we can learn from the candidates' tax issues. This past week it came out that Vice-Presidential Candidate Sarah Palin received "per diem" meal allowances when she stayed at her Wasilla, Alaska residence. The IRS explains "per diem" expenses:

Generally, amounts employers pay employees to reimburse them for substantiated business expenses are not subject to income tax or employment tax. For reimbursements for expenses for meals and other incidentals associated with business travel, employees get this exclusion for reimbursements for each day of travel up to the federal per diem rates without having to actually substantiate the amounts of the expenses.

The tax law normally applies strict documentation requirements for business meals. But if you reimburse employees for business travel away from home at the IRS per-diem rates, you don't have to collect receipts from the employees for their meals. If you don't follow the IRS rules, the employer has to put the reimbursements on the employee W-2 as income. If reimbursements exceed the per-diem amount, the excess is W-2 income.

We'll assume that an Alaska governor has plenty of business travel from the isolated capital of Juneau to Anchorage, Alaska's largest city; in Alaska terms, Wasilla is near Anchorage, so it's reasonable to stay there on Anchorage business.  But how can staying in your own house be travel "away from home?"

Under the tax law, your "tax home" is the focal point of your business activities. If an Iowa executive only keeps an apartment in Des Moines, where his job is, but jets to Scottsdale for weekends with his family at the mansion, his "tax home" is in Des Moines.  That means his expenses of traveling to and from Scottsdale are non-deductible "commuting," and if the business pays his Des Moines meal and apartment costs, they have to go on his W-2.

Likewise, we can expect the tax home of the Governor of Alaska to be Juneau, the state capital. If the trip to Wasilla is a business trip, it is "away from home" as far as the tax law is concerned, and the state can pay the governor per-diems up to the IRS limits without having to put them on her W-2. Any per-diems in excess of IRS amounts, or for amounts on non-business trips, would be taxable compensation.

In the interest of non-partisanship, our next installment will use the Obama family returns to illustrate a tax-saving opportunity for the self-employed.

S corporation salaries: how much is enough?

The idea of keeping your salary low seems counterintuitive to an entrepreneur.  The whole point of the game is to make money, right?  Well, yes, but sometimes there are better ways to make it than through salary, tax-wise. 

Many small businesses are conducted through S corporations.  These corporations - sometimes called "Subchapter S" or "Sub S" corporations after their home in the tax code - don't pay tax on their earnings.  Instead the earnings are taxed on the personal returns of the owners.   The S corporation reports its taxable income to the owners on Schedule K-1. 

Now these K-1 earnings are not subject to Social Security or Medicare tax.  That's why you might want to keep your salary down and your K-1 earnings up: the salary, reported to you on form W-2, is subject to a combined 15.3% Social Security ("FICA") and Medicare tax, up to the amount of the "FICA Base" ($102,000 for 2008).  The 2.9% Medicare tax applies to all salary, regardless of the FICA Base.  So if a business makes $100,000 and the owner takes zero salary but $100,000 on the K-1, he avoids $15,300 in employment taxes.  At least that's the idea.

The IRS doesn't care for this.  All new S corporations get a warning from the IRS that they have to pay "reasonable" salaries to working owners so they don't unfairly avoid employment taxes.  And there's the rub: they never really tell you what that means, and nobody really knows.

We can address the extremes easily enough.  If you have a profitable law or medical S corporation and you take no salary, the IRS will come after you.  And if you take all of your earnings as salary and none on the K-1, the IRS has to leave you alone. 

But what of the many situations in between?  If your corporation is losing money, does an owner-employee have to take a salary?  In IRS exams I've seen, no, but past performance is no guarantee of future results.  And what of a highly-profitable S corporation whose aging founder is stepping away from the business - does he still have to take a "reasonable" salary? 

One example that gained some notoriety involved former presidential candidate John Edwards.  His S corporation law firm made over $20 million one year, and he took "only" $360,000 or so in salary.  Can a $60,000 IRS agent assert that a $360,000 salary is unreasonably low?  At least without giggling?

There are no hard and fast rules in this area.  A good rule of thumb is the old tax maxim "pigs get fat, but hogs get slaughtered."  If you own a profitable business and work full-time there, and you take zero salary, you are asking for trouble.  But if you take a salary that reflects your role in the business, you should be fine, even if it's skinny.  After all, Warren Buffet only pays himself $100,000.  And remember, if you pay yourself too little, you may be cutting yourself out of tax savings in your company retirement plan.  In any case, business owners should run their compensation arrangements by their own tax advisors.

Iowa to hedge fund industry: go away.

When most people think "Iowa," they think "corn and beans."  They don't think "financial services."  That's a mistake.  Our financial services economy dwarfs our ag economy:

Source: Federal Reserve Bank of Chicago.  Full chart here.

Sadly, the Iowa Department of Revenue hasn't gotten the memo.  An obscure tax policy decision at the Department guarantees that a big part of the financial services industry will stay away from Iowa.

In the last 20 years the financial service industry has embraced investment partnerships (often in the form of Limited Liability Companies) for private equity investments and for private investment pools.  A hedge fund is one brand of investment partnership.  The fund doesn't pay its own taxes; the income passes through to the tax returns of its owners.  Hedge fund income is typically interest, dividends and capital gain.  Very few states try to tax non-resident partners on investment income - so-called "non-business income" -- from partnerships with in-state headquarters.  Unfortunately, Iowa is one of them.

The Iowa Department of Revenue takes the position that investment income of non-resident partners of Iowa investment partnerships is fully taxable in Iowa as "business" income. That means a Florida investor in an Iowa investment partnership is expected to pay Iowa tax of up to 8.98 percent on dividends, interest and capital gains earned through an Iowa partnership - income that would be free of state income taxes if he earned the money directly.

There is nothing in Iowa's tax law that requires the department to take this view.  Iowa's statute that distinguishes "business" and "non-business" income is virtually identical to the New York statute, and New York doesn't try to tax non-resident partners on income earned from New York partnerships.  Not coincidentally, New York has a dynamic financial services industry that includes world-class private equity and hedge funds.  Until the Department of Revenue or the legislature make some changes, Iowa never will.

Don't be on the hook for unpaid payroll taxes

Times are getting tough for many businesses.  When you need to pay for some crucial inventory, it's very tempting to "borrow" from the IRS by not remitting withholding and payroll taxes. 

Don't.

As a Louisville optometrist discovered last month, the IRS has a long memory for unpaid payroll taxes and powerful tools to collect them.  If your business fails to remit its payroll taxes, the IRS can collect them from any "responsible person."  Having the business in a corporation or LLC doesn't help.   Even if you aren't the owner, the IRS will go after you if they decide you stiffed the IRS to pay other creditors.

The Louisville optometrist, Larry Joel, had invested in a chain of optometry stores.  They began to struggle and they stopped remitting their payroll taxes in 1994.  By the time the bank took the store away, they were behind over $1 million on payroll taxes. 

The IRS targeted Mr. Joel as a "responsible person" for the payroll tax based on his majority ownership, his signing of payroll tax returns, and his authority to sign checks.  He claimed that he wasn't involved in the day-to-day operations, and that he wasn't an officer, so he wasn't responsible.  Unfortunately for Mr. Joel, the judge sided with the IRS, saying "the government cannot be made an unwilling partner in a floundering business."

The bottom line?  Mr. Joel is personally liable for unpaid taxes of $1,275,140.57.  Or so.

Keep in mind that there can be more than one responsible person.  For example, in a case involving the old Access Air the IRS tried to tag three people as "responsible persons" for unpaid taxes, including a controller. 

The Moral?  If you are thinking about stiffing the IRS to pay somebody else, think again, or you might still be trying to clean up the mess long after your business is forgotten.  If you have a financial function for a company and you are told to stop remitting payroll taxes by your boss, it's time to polish up the resume before you end up on the hook yourself.

Floods and Taxes

Since we last visited IowaBiz, Iowa has had some interesting weather.  From the Birdland Neighborhood to the Mississippi, Iowa businesses were pounded by floods and storms.  Now the insurance adjusters are starting to write checks.  What does it mean to your taxes?

Let's say the building housing your business was wiped out. You paid $200,000 for the building long ago. After depreciation, the building basis was only $50,000. The building had gone up in value and was insured for $1,000,000, and the insurance company is writing you a check for the whole amount.

The tax law typically treats a business casualty loss as an "involuntary conversion." The tax law defaults to treating insurance proceeds as taxable, but you may avoid current tax if you invest the insurance proceeds in replacement property by the end of the second year following the year the recovery is paid. This works only if you reinvest the insurance proceeds in property "similar or related in service or use," and only if you file an election under Sec. 1033. 

What does "similar or related in service or use" mean? Unfortunately, the tax law is fuzzy on this. If you invest the proceeds in continuing the same business that you were in before, that should be fine. If you decide to invest in a different line of business, that can be trouble.

Fortunately, the requirements for tax deferral are easier for businesses in a presidentially-declared disaster area.  Most of Iowa is covered by such a declaration for the recent floods and storms.  Disaster-area taxpayers only need to re-invest insurance proceeds in tangible property to be used in any trade or business, under a special rule (Sec. 1033(h)(2)). 

The catch? To the extent you avoid recognizing gain under the Sec. 1033 involuntary conversion rules, you don't get basis for the property purchased with the insurance proceeds. The taxpayer who used $1,000,000 in proceeds to buy a building and equipment, and who elected not to pay tax on the proceeds, would only get to depreciate the $50,000 basis that was in the old building.

If you are affected by a disaster, there are other important tax steps you can take, including deducting disaster losses on an amended 2007 return - allowing you to get a tax refund that can help you rebuild.  Be sure to get in touch with your tax advisor.

Links:

IRS Publication 547, Casualties, Disasters and Thefts

IRS 2007 Disaster Losses Kit for Businesses.

List of Iowa's Presidentially-declared disaster areas.

Order a flood relief T-shirt.

Thanks to the Des Moines Business Record for picking up the sponsorship of IowaBiz!