Business Record - Iowa Biz

Will the IRS help pay for your vacation?

Image via Wikipedia

Even in tough times, everyone could use a vacation.  While Congress takes its sweet time in enacting a vacation subsidy, creative taxpayers boldly try to enlist the IRS to help pay for their summer fun.  The results have been, at best, mixed.

Sherman Miller, a teacher in Roseville, Minn., sold insurance on the side. When he bought a condo in the resort town of Hayward, Wisconsin, he claimed that his trips there were all business.  The Tax Court tells the story:

Petitioner's insurance-related activity in Hayward consisted primarily of “prospecting” in the years here in issue. Petitioner considers that when an insurance agent meets potential clients who are willing to speak about insurance, the agent is “prospecting”. Petitioner's “prospecting” activities in the Hayward area consisted of going to dinner, playing golf at the Tagalong Country Club and having drinks with persons he considered potential clients.

Nice work if you can get it.  The judge wasn't convinced that it was all about business:

Petitioner called his business activity in Hayward “prospecting.” He said that he used two primary methods of prospecting, which were direct mail and “sunshining," and that the method he used in Hayward was “sunshining”. “Sunshining”, according to petitioner, was meeting people who would be likely candidates for purchasing insurance. Petitioner stated that a potential client was “anyone that is living and breathing and of appropriate age." If petitioner asked a golfing partner whether he needed insurance, he considered the game to be a business meeting and the expenses connected with that meeting deductible.

Unfortunately for Mr. Miller, the IRS tracked down some of his golfing partners, none of whom remembered the "insurance" parts of their rounds with him.

If you want to deduct travel expenses, the tax law makes you jump through some hoops.

• You need to show the trip is "primarily" for business.  Unless the trip is primarily for business, you get no travel deduction.  While facts and circumstances control, the main factor is how you spend your time.
• Document your business activity on the trip.  Be ready to show who you met with, what business you discussed and why it affects your business.  Receipts are good; results are even better.
• Leave the family behind.  Mr. Miller brought his wife to Hayward, where she spent her time knitting in the condo.  The judge said this was evidence that it was a personal trip, not a business trip.  But when you tell your spouse that the IRS is making you take separate vacations, don't blame me for the consequences.

And I know what you're thinking: "you're blogging this on your vacation and writing it off."  I wish.  The Tax Court has held that writing on the road doesn't by itself make your vacation deductible.  I'm sure the same goes for blogging.

Related: IRS discussion of business travel.

Should your S corporations be in a holding company?

The way the economy is going, a lot of entrepreneurs are going to be looking at taxable losses for 2009.   Those who run multiple businesses in separate S corporations should ponder an S corporation holding company before year-end.

S corporations generally don't pay their own income taxes.  They report their income on a Schedule K-1 issued to their owners, and the owners pick up the K-1 income on their 1040s.  S corporations are popular because they can distribute their earnings without further income tax, in contrast with double taxed C corporations.  They also can enable their owners to reduce their income with K-1 losses.

Unfortunately, shareholders need to have basis in their S corporation stock, or in loans they have made to their S corporations, for their K-1 losses to be deductible.  Entrepreneurs with multiple S corporations might find themselves with plenty of basis in a profitable S corporation, but no basis at all in a money-losing corporation.  That means they might pay tax even though they didn't actually make any money:

Example: Todd owns 100 percent of S corporations Razor Corporation and Market Street Brewing Company.  Razor has $1 million taxable income, while Market Street has a $1 million taxable loss in 2009.  At the beginning of the year, Todd has no basis in either company.  He makes no distributions or cash contributions to either company in 2009.  At year end, he has $1 million in basis in Razor, because undistributed taxable income increases the basis of S corporation stock.  Unfortunately, he still has no basis in Market Street, so his losses only carry forward until he either contributes basis to Market Street or it generates its own taxable income.

 Even though between the two companies Todd has no taxable income, he has to report $1 million of income from Razor without deducting any loss from Market Street.

A far better solution would have been to have the S corporations all under a single roof in an S corporation holding company.  For example, Todd could set up a new S corporation -- we'll call it Todd Holdings -- and contribute his stock in both companies to it.  The old S corporations would elect to be "Qualified Sub-S Subsidiaries," or "Q-Subs," of Todd Holdings.  Todd could then count the basis of the corporations together, enabling him to use the $1 million of year-end basis in Razor to take his Market Street loss.

Setting up holding companies is normally uncomplicated, but it can cause huge tax problems if not done properly.  Don't mess with your corporate structure without consulting a competent tax advisor.  If you get it set up by year-end, a holding company should provide the same benefit as if it were in place the whole year.

April 15? Feh. Missing the June 30 foreign financial account deadline can be much worse.

While the April 15 deadline for 1040s is ugly enough, there are a lot of ways to deal with it.  There are extensions, and even installment agreements.  If you miss the deadline, the late filing penalty tops out at 25 percent of the underpayment -- not fun, exactly, but often manageable. 

Now imagine that the penalty for filing a late 1040 were half the balance in your bank accounts, but no less than $10,000.  But that's outrageous - they'd never be that nasty, would they?

Yes they would.  And they are.  Just not for your 1040.

Foreign Bank Account Reports due June 30

The horrific penalty of 50 percent of the highest balance in a bank account for the year, but no less than $10,000, applies for late filers of Form 90-22.1, the Report of Foreign Bank and Financial Accounts. It is due June 30, and no extension is available.   What's worse, you might need to file the form -- sometimes called the "FBAR" form -- even if you don't own a foreign bank account.

You are required to file the FBAR if you are a "United States person" and you have either

- A financial interest, or
- signature authority

over foreign financial accounts exceeding $10,000 in aggregate. 

If your business keeps a bank account in Canada or China because you buy things there, the business needs to file -- as does everybody in your company with signature authority on such an account, down to the payables clerk who signs checks attached to your approved Chinese purchase orders.  An exception may apply to employees of some larger companies.

Of course you don't have to have a business to have a foreign bank account.  The FBAR requirements apply, for example, to personal bank accounts you might have opened while on a temporary overseas assignment.  They also apply to accounts with offshore gambling Web sites.

Be sure to document your filing!  FBAR filings must be postmarked no later than June 30.  While it is always a good idea to send tax filings Certified Mail, Return Receipt Requested, it's especially important with FBAR reports.  Practitioners report that the Detroit Service Center, where the reports are filed, throws away the postmarked envelopes the forms come in.  Then the IRS (outrageously) asserts penalties for forms that come in as early as July 2.  When that happens, a postmarked certified mail receipt, which costs $4.90, can save you $10,000 or more.

If you have missed prior FBAR deadlines, consider taking advantage of the current IRS semi-amnesty that runs into September.

Is it time to own up to offshore bank accounts?

The penalties for failing to tell the Treasury about offshore bank accounts are ugly: the greater of $10,000 or 50 percent of the account balance for each year the account goes unreported.  The penalties can wipe out your accounts in a hurry.  They can also assert criminal penalties if they are in a bad mood.

The IRS has scored some well-publicized victories in its battle against offshore tax evasion.  Offshore banking secrecy seems to be crumbling.  It might just be a matter of time before the IRS catches up with those Cayman Island bank accounts.

Now the IRS is offering a deal.  It's not exactly "get out of jail free" -- it's more like "get out of jail at a tremendous discount."  The deal: if you self-report under the IRS program, they will not prosecute you, and they will assert a maximum total penalty of 20 percent.  They will also require you to pay tax, with interest and penalties, on any unreported income.  For a hypothetical $1 million account, the taxes and penalties under the amnesty would be $386,000; if they catch you, they would exceed $2.3 million, not counting the legal fees you'll have if they try to send you to prison.

Florida tax attorney Peter Pappas says the IRS offer is a good deal:

If you have owned a foreign bank account in the past five years and have not disclosed it to the IRS, we urge you to take advantage of the IRS’s voluntary disclosure program. If you do not do so and the U.S. discovers your non-compliance on its own, you can expect it to assess the full amount of penalties and seriously consider criminal prosecution.

The Treasury considers accounts on offshore internet gambling sites to be offshore bank accounts; if you are going to gamble, don't gamble that the IRS will miss your account.  Folks wanting to bring their offshore accounts in from the cold should contact a good tax lawyer to get the process started.

Link: IRS offshore amnesty FAQ.

Legislature stimulates C corporations with a kick in the teeth

As Iowa businesses struggle with one of the worst years in decades, the Iowa legislature decided they need to suffer a bit more.  They have reached into the pockets of both profitable and money-losing C corporations.

Loss carrybacks yanked.  With SF 483, the legislature took away the ability of C corporations to carry back Net Operating Losses to get refunds of Iowa taxes paid in profitable years. An example:

Bob Corporation makes $200,000 in Iowa-source taxable income in 2008, its first tax year. It pays Iowa tax of $17,500. Like with so many businesses, things go bad in 2009 and Bob loses $200,000. Between the two years, Bob has no income. Bob Corporation throws in the towel and closes the business after 2009.

Until SF 483, Bob Corp. could carry the 2009 loss back to 2008 and recover the taxes paid. It's a fair result - no income for two years, and no tax. Under the proposed change, Bob Corp. would never recover the 2008 tax. The 2009 loss could only be carried forward - a useless privilege when the business closes.

Estimated tax requirements increased.  Before this year, Iowa corporations could avoid penalties for estimated tax underpayments by paying in 90 percent of their tax liability through quarterly payments, with the rest due with their tax return.  SF 478 raises the 90 percent requirement to 100 percent, starting with yesterday's first quarter estimated tax payment for 2009. 

So whether your C corporation makes or loses money in 2009, the legislature has found a way into your pockets.  

Not all of the news is bad, but the good news comes from the IRS, not Iowa.  The IRS has made it easier for taxpayers with 2008 net operating losses to qualify for a five-year carryback period by removing a requirement to elect the carryback with the original 2008 return. 

So the IRS is more compassionate to money-losing corporations than the Iowa General Assembly.  Way to go, legislators.

April 16 resolutions

The 2008 tax year is water under the bridge.  It's time to turn your attention to 2009.  Here are nine ways to make 2009 less taxing.
 
1. Start funding your IRA or SEP now, a little at a time.  Many taxpayers can save money with an IRA or Simplified Employer Plan, but they just don't have the cash when the April 15 funding deadline comes around.  Don't wait.

2. Start keeping that mileage log.  Whether they do it with a PDA, an appointment calendar, or a specialized log book, folks who deduct business mileage are much better off at tax time - and especially audit time - when they have support for their mileage expense.

3. Save those business meal and entertainment receipts, and write down what they were for.  The tax law requires you to be able to document the time, place, parties involved and business purpose of all meal expenses.  If you don't do it right away, you'll never remember it.

4. Act like a real business.  Many entrepreneurs keep seat-of-the-pants records.  While understandable, it makes it hard to tell if you are really making money, and how much.  It also is very costly at tax time when your tax pro has to charge you for sifting through the debris of your business records.  Buy Quickbooks or a similar program and learn how to use it. It will save you enough time and effort to pay for itself. 

5. Use your 401(k).  Salary deferral through a 401(k) is the easiest way to shelter income from taxes.  Most employers match some or all of the amount employees defer; you're crazy if you turn down the bosses money by not at least maximizing the employer match.

6. If you qualify, start a health savings account and use it.  Health Savings Accounts are like IRAs, except withdrawals for health care are never taxed.  If you have a qualifying high-deductible health plan, this is an easy tax shelter.

7. If your income isn't subject to withholding, watch your estimated tax payments.  If you're making money, be sure you keep up with your payments.  If you're losing money, don't send the IRS money if you don't need to.  See your tax pro.

8. Don't mix up personal and business expenses.  If you are running personal expenses through your business, it can make for an awkward discussion when somebody is interested in buying you out.  It's even more awkward when the IRS comes calling.

9. Focus on what ends up in in the cigar box.  Some folks are so obsessed with lowering taxes that they lose sight of the real game - making money.  If you have to pay a little tax to make some money, take the money.

Think twice before you put an LLC in your IRA

A reader asks:

I just received a k-1 1065 from a new LLC which is included in my IRA  this year.

Because my investment is included in my IRA portfolio do i have to report the income shown on the k-1?

That's a great question. It would be an even better question to ask before buying an LLC in your IRA. That's because LLCs often generate income that is - surprise! - taxable to the IRA.

The tax law frowns on tax-exempt entities like IRAs holding business assets. While it's OK to hold investments that generate interest and dividends in an IRA, Congress thought it would be unfair for taxable businesses to have to compete against tax-exempts. That's why the tax law imposes the Unrelated Business Income Tax, or UBIT, on business income earned by tax exempt entities. The UBIT is, in general, the corporation tax system applied to business income earned by exempt entities.

When UBIT applies to an IRA, the IRA has to pay income tax itself on Form 990-T at rates up to 35 percent. State income taxes can also apply. Of course, the after-tax income of a traditional IRA may be taxed again when it is distributed to the IRA owner.

If you have income taxable to an IRA coming from an LLC taxed as a partnership, it should be on line 20 of the LLC's Form 1065 K-1, listed with code "V". In this case, "V" doesn't stand for "Victory."

The Moral: LLCs and IRAs are a poor mix unless the LLC only holds investments that generate interest and dividend income. If you own an LLC that generates business income in your IRA, you may need to file Form 990-T by April 15.

Welcome to our state, stranger!

Al Franken has been waiting out the last remaining 2008 U.S. Senate vote count for four months now.  If he hadn't run into multi-state income tax troubles, he might be comfortably settled into Walter Mondale's old seat.  Mr. Franken's tax troubles show how tricky state taxes can be for a small business.

His problems arose as he traveled around the country for appearances and speeches.  All it took was a single money-earning visit to, say, Boise to drag him into the Idaho income tax system.  A comedy club here, a college there and soon you have to file in a bunch of states.  When it came up during his campaign, Mr. Franken had to pay $70,000 in back taxes in 17 states.

How this happens

State tax compliance is a bane of small business life. It can take surprisingly little activity in a state to trigger "nexus," making you subject to that state's income taxes.

Mr. Franken's problem is common. Undoubtedly, many little businesses hop in and out of states without bothering to file.  That can be a dangerous habit. If you never file in a state, the statute of limitations never stops running, and you can theoretically be assessed taxes there forever.

States can tax the income of visiting businesses if they do anything more in the state then promote sales to be filled from out of state.  Maintaining inventory, doing consulting or construction projects, or almost anything else can subject you to income taxes in a state, even if you only do it for a day or two. 

Some states, like Texas, Michigan and Ohio, have enacted "gross receipts" or "franchise" taxes that have even a lower "nexus" threshold.  If you even sneeze in the general direction of Texas, you probably have to file there.

States are getting more sophisticated at identifying taxpayers who do business in a state, and this is becoming an issue to more taxpayers as interstate business becomes more common even for small businesses in the information age. Of course, states love to tax out-of-state taxpayers because they can't vote. Perhaps personal experience will make Mr. Franken sympathetic to legislation that would prevent states from taxing businesses that only are in a state a few days in a tax year.

If you have customers in multiple states, it might be time to sit down with your tax adviser. If you have potential problems for old years, your tax adviser might contact the state and work out a deal to limit exposure to, say, three years back taxes without penalties to encourage you to come forward voluntarily. But, as the mutual funds say, your results may differ

Do you really have 180 days to close on that Section 1031 swap?

One of the nastier land mines in the tax law is the deadline for closing on a purchase in a deferred "like-kind exchange." When you have a deferred exchange, Section 1031 gives you 45 days to identify the property you want to receive in the swap. The deadline for actually closing on the replacement property is the sooner of:

- 180 days after giving up the property, or
- The due date of the tax return for the year in which the exchange was entered into.

This means if you entered into an exchange after Oct. 18, 2008, you need to either close on your replacement property by April 15 (or March 15, if your corporation did the exchange).

Fortunately, the tax law gives you a simple way to get your full 180 days to close your exchange,  extending your return.  If your return is due before the 180 days runs out, an extension gives you the full 180 days.

But be careful. If you file your 1040 before April 15 an extension doesn't count. Don't be in such a hurry for your refund that you make your like-kind exchange taxable.

You can learn more about exchanges at this IRS site.

Related: No do-overs when the swap takes too long.

Stimulus tax breaks: what's in it for your business

The "stimulus" bill passed by Congress last Friday has some tax breaks that will generate cash for those businesses fortunate (or unfortunate) enough to qualify. 

Estimated tax breaks.  If more than half of your income comes from a small business, your "protective" estimated tax payments might go from 100 percent or 110 percent of your 2008 tax to 90 percent, if you qualify.

Bonus depreciation and asset expensing.   The "Section 179 deduction" allows businesses to currently deduct the cost of some assets that would otherwise be capitalized and expensed over several years through depreciation deductions.  The bill extends the 2008 cap on the deduction, $250,000, through 2009.  It would otherwise have been limited to purchases of $113,000. 

The bill also extends the 200 percent "bonus depreciation" rules through 2009.  You may deduct half the cost of assets qualifying for bonus depreciation in the year of purchase; you depreciate the rest of the cost under the usual rules. Qualifying property is generally new depreciable business property other than real estate.

Five year Net Operating Loss Carryback.  If you are unfortunate enough to have had a really bad 2008 - bad enough that you end up with a net operating loss on your 2008 tax return - the new law may allow you to carry it back five years, rather than the normal two years, to get refunds of prior year taxes.  This will benefit those who either had a loss that exceeded combined 2006 and 2007 taxable income.  It will also help some taxpayers who also expect a 2009 NOL; they will be able to offset 2008 losses against 2003 - 2006 income that would otherwise have offset 2007 income; that will leave some 2007 income available for offset.

Unfortunately and stupidly, the five-year carryback only applies to 2008 losses; it looks like 2009 will be the big loss year for many more taxpayers.  The five-year carryback is limited to taxpayers whose gross receipts averaged $15 million or less during 2005-2007.  Congress decided not to let larger businesses get refunds of their taxes from the good years to keep their doors open and their people employed, in favor of taking that money to "create jobs."

The stimulus bill has some more narrowly-focused business provisions, including some "built-in gains tax" relief for some S corporations and some relief for those who have debts forgiven.  It also has the 2009 version of the "AMT patch," keeping many businesses out of alternative minimum tax for another year.  It also has a bunch of tax provisions that aren't strictly business-related, which you can read more about here, here and here.

None of this stuff is simple, unfortunately, so consult your own tax advisor before you do anything to secure one of these tax breaks.