Business Record - Iowa Biz

Legislature allows new 2010 deductions

The Iowa legislature passed a big business tax break just before April 15, after many Iowa businesses had already filed their 2010 returns. Just before ending their session yesterday, the legislature passed a bill that allows taxpayers to take that late-passed break on 2011 returns, instead of filing amended 2010 returns. 

The "Section 179 deduction" allows taxpayers to deduct the cost of qualifying fixed assets in the year of purchase, rather than through depreciation deductions over a period of years.  Until the Governor signed off on SF 512 on April 11, the Iowa "Section 179 deduction" limit for 2010 was $134,000. SF 512 increased it to $500,000, the amount allowed on federal returns, for 2010. 

So what about an Iowa business that had already filed returns, taking a Section 179 deduction of, say, $150,000 on its federal return, but only the $134,000 maximum deduction for Iowa? The usual answer is to file an amended Iowa return. But what if the business is a partnership or S corporation with, say, 10 or 15 owners? That amended return would trigger 10 or 15 amended 1040s for the owners to use the deduction. That's a lot of work, and maybe a lot of tax prep expense.

SF 533, passed late Wednesday this week, allows taxpayers to choose to take any additional 2010 Iowa Section 179 deduction on 2011 returns -- avoiding the time and expense of filing amended returns. This is only an option; they may still file amended returns if they prefer.

SF 533 allows taxpayers to claim two other deductions passed in SF 512 on their 2011 returns, rather than amending 2010: The $250 maximum "Educator Expense" deduction and the above-the-line college tuition deduction.

The legislature dropped the ball by passing major 2010 tax legislation so late, but at least now they've cleaned up some of their mess.

It's your return, no matter how much you pay your preparer

Why you shouldn't leave $3.4 million of income off your 1040

It's easy to accidentally leave a bit of income off your 1040. It even happens to preparers, especially under deadline pressure. If you have a big pile of 1099s, it's frightening how easy it is to lose track of one. When the 1099 is for $3.4 million, it can be a problem.

For too many taxpayers, tax return preparation is a mystery box. The W-2s, 1099s and receipts go in to your preparer, a tax return comes out. Many people have no idea what the income should be; all that matters is the refund. That apparently even goes for fancy-pants fund managers like Stephen Woodsum. 

Unfortunately, the taxpayer still is responsible for the numbers on the return, preparer or no preparer, as Mr. Woodsum learned this week in Tax Court. His 2006 Form 1040 had some big numbers on it, and when he picked it up from his preparer on Oct. 15, 2007 -- the last day of his six-month filing extension -- it showed adjusted gross income of $29.2 million. That would seem to be enough, but the IRS computers caught the $3.4 million on the 1099 that the preparer had, but missed somehow. The IRS assessed about $500,000 in additional tax and a penalty of about $100,000.

Mr. Woodsum went to Tax Court to get out of the penalty, arguing that because he gave the preparer the 1099, he made a reasonable attempt to report the correct income. The Tax Court took a hard line:

...when his own receiving of income was in question, Mr. Woodsum was evidently alert and careful. But when he was signing his tax return and reporting his tax liability, his routine was so casual that a half million-dollar understatement of that liability could slip between the cracks. We cannot hold that this understatement was attributable to reasonable cause and good faith.

Mr. Woodsum's problems provide lessons for the rest of us:

• It's your return. When you sign it, you own it, even if you paid someone good money to prepare it.

• Try to understand what's on the return.  If you don't, ask the preparer what's going on. If you prepare your own return and don't understand it, that's a big red flag.

• Don't wait until the last second to pick up or review your return. If you don't have time to look things over before the April 15 deadline, get an extension. If you are up against the Oct. 15 extended deadline, look over the return carefully as soon as you can and amend right away if something is wrong.

Oh, and if you get a 1099 for $3.4 million, make sure it shows up on that return somewhere.

- Joe Kristan

Tax traumas of the traveling employee

Even little businesses send employees on the road to other states. They may be unwittingly causing those employees to be subject to income tax in the neighboring states.

States started to take more of an interest in taxing short-term visitors when athletic salaries got very high. As a result, many states say as little as one day of in-state work subjects you to income tax. These rules may be ignored by many businesses, but they pose increasing risk as states improve their data-mining techniques while they scrounge for scarce cash.

Congress is considering a bill to limit the ability of states to tax brief employee stays. Tax Analysts reports ($link):

H.R. 1864, the Mobile Workforce State Income Tax Simplification Act, would allow a state to impose income taxes on an out-of-state employee's wages only if the individual spends more than 30 days working in that state during a calendar year. The threshold would not apply to professional athletes, entertainers and other high-profile individuals.

The 30-day rule would be a big improvement over current law, but the exception for "professional athletes, entertainers and other high-profile individuals" is misplaced. They want to pick LeBron James' pockets every time he shows up to play the Knicks, but there are plenty of athletes and entertainers who aren't LeBron James. Every traveling musician or minor-league hockey player would have the same reporting liability as LeBron, without the zillion-dollar income to pay compliance costs. 

In the meantime, every road warrior in sales and internal audit has potentially the same tax return filing requirements as the big athletes. That also means the employers have potential withholding liability in those states. It's important for employers to talk these situations over with their tax advisors to avoid unpleasant out-of-state surprises.

Link: HR 1864

Flickr image courtesy eric__I_E under Creative Commons license

The tax law wants you to buy a behemoth

A tax provision designed to encourage businesses to buy new machinery to fight the recession spur the recovery has a peculiar, and perhaps unintended, side effect: it makes 2011 a great time to buy a new giant SUV for your business. The Wall Street Journal reports:

The bottom line: This year Congress is running a large "bonus depreciation" special on cars weighing more than 6,000 pounds, such as the Cadillac Escalade and Nissan Armada. Taxpayers may deduct 100% of the car's cost in the first year—subject to the personal use disallowance, of course.

The new "100% Bonus" depreciation allows taxpayers to deduct the full cost of qualifying new machinery and equipment in the year it is placed in service. These costs are normally capitalized and deducted over a period of several years, rather than all at once. The 100 percent bonus depreciation differs from the similar "Section 179" deduction in that it only applies to new equipment, but it can generate a loss carryback.

The Wall Street Journal reports that BMW, General Motors, Ford, Jeep, Mercedes Benz, Porsche, Honda, Nissan, Toyota and Volkswagen all produce the big vehicles qualifying for the break. A list of such vehicles is posted here.

If you want to take deductions for business use of a vehicle, there are some things to keep in mind:

- The tax law requires you to document your business use. You need to keep a log or calendar documenting your business mileage, including the business purpose and distance for your trips. Commuting doesn't count.

- You can only deduct your depreciation to the extent you use your vehicle for business purposes. If your business use declines below 50 percent any year, you may have to "recapture" prior depreciation as non-cash taxable income.

- Don't buy something just for the deduction. Even after the tax savings, you are still out of pocket for most of the cost of the vehicle.

The TaxProf has more. You can read more about vehicle bonus depreciation here.

Flickr image courtesy Highway Patrol Images under Creative Commons License

Is it time to amend?

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Iowa's legislature saw fit to change the rules of the 2010 tax game last month, after most Iowans had probably already tallied their scorecards.

So should we amend our Iowa 2010 returns right away?

Let's review what the legislature has done:

 - It has "coupled" with all federal tax legislation for 2010 except for "bonus" depreciation. That means, among other things:

- Taxpayers can take $500,000 of "Section 179" deduction on Iowa returns, just like on the federal returns. Until the change was made, the Iowa limit was $134,000.

- Iowa follows federal rules now for charitable contributions from IRAs in 2010. For 2009, IRA qualified distributions to charities for those more than 70 1/2 were excluded from federal income; they were included in Iowa income and a charitable deduction was taken on Iowa schedule A.

 - A bunch of smaller deduction that were not available on 2009 Iowa returns are now available on 2010 returns. These include the $250 educator expense deduction, the deduction for college tuition and fees, and the optional sales tax deduction for those not deducting income taxes. 

 - Taxpayers who took the new employee health care tax credit had to add the credit back to federal taxable income. That add-back now also is required for Iowa returns.

Go here for a complete list of changes.

No doubt many Iowa returns were filed before the legislature and the governor did that.  Should you amend your returns right away if you qualify for these benefits or have to pay more?

I understand that the Iowa Department of Revenue is working on a legislative proposal that would enable taxpayers to take some of the new deductions on 2011 returns, rather than amending their 2010 returns. The department isn't really staffed to handle a flood of amended returns and many taxpayers would rather not pay to have an amended 2010 return prepared if they can use their new 2010 deductions in 2011.

If you can take your Iowa 2010 $250 educator expense in 2011, it's hardly worth filing an amended return to claim a $17 refund. Even a big additional Section 179 deduction might be worth waiting for if it is coming out of an S corporation or partnership on a batch of K-1s, where each individual owner would also have to file an amended return.

Iowa may also come out with a streamlined amended return process for 2010 refunds. So it may well be worth waiting a few weeks to see what the legislature and the Department of Revenue come up with before filing your refund claims. But if you now have an additional $366,000 Section 179 deduction for 2010, you probably don't want to wait very long to claim it.

Sadly, if you owe, they will likely catch up to you eventually by electronically comparing your Iowa filings to your federal returns. In that case, you might as well amend and stop the interest. 

The tax deadline isn't the time to cheap out

Maybe you spent hundreds of dollars to have a preparer do your the 1040 that reports your business income. Or maybe you spent the 32 hours the 1040 instructions say is the average estimated time it takes to do a business 1040. Either way, you've made a substantial investment in time or money.

But you still have to get it to the IRS. The best way is to file electronically. You get an electronic receipt to prove you filed on time, and any refunds come back much more quickly.

If you aren't filing electronically, now isn't the time to cheap out. You ought to spring for the extra $5.10 to file your return "certified mail, return receipt requested." It's well worth the time and trouble of going to the post office to get that postmarked receipt. The tax law is full of sad stories of taxpayers who lost thousands of dollars because they didn't have a postmark to document that they filed on time. Don't let it happen to you!

If there's no post office open or handy -- or you don't finish your return until after the post office closes -- you can also use a mailing receipt from one of the designated private delivery services authorized by IRS for timely return shipment. As private delivery services don't deliver to post office boxes, you'll want to refer to this list of service center street addresses. But be sure the delivery service will get the date right, and that the shipment date on their records is the one you want.

Or you could just take your chances with a late-night post office.  Good luck with that.

And don't procrastinate, because Jiffy Express isn't a designated private delivery service.

Can I deduct my K-1 loss?

Losing money in your business is no fun, but that dark cloud can have a silver lining at tax time. Many small businesses are "pass-throughs" taxed as S corporations or partnerships (often in the form of "limited liability companies," or LLCs). As the income of these businesses is taxed on the owners' 1040s, the owners get to deduct the business losses reported on the business Schedule K-1 -- right?

It depends.  There are three hurdles that a K-1 recipient has to clear to deduct K-1 losses. 

The first hurdle is basis. Your basis starts with your investment in the K-1 business; it is increased by income and cash contributions and decreased by losses and distributions. In partnerships  -- but not S corporations -- an owner's basis may include a portion of the company's borrowings from third parties.

Unfortunately, the K-1s do a poor job of tracking owner basis.  You, or your tax preparer, may need to keep a separate schedule of your basis to determine whether you might deduct K-1 losses.

The next hurdle is whether your basis is "at-risk." The "at-risk" rules are an obscure leftover of tax shelter battles of the 1970s, but they still apply.They can be very complex, but their gist is that if your basis is attributable to borrowings that are "non-recourse" -- that you aren't personally liable for -- it is not "at risk," and losses attributable to that basis must be deferred. You may also not be considered "at risk" for related-party borrowing, especially if you borrow from your business or from a business associate to fund your ownership in the K-1 issuer.

Partnership K-1s provide some useful information in determining whether you have an "at-risk" issue. If you have losses in excess of your cash investment, and your share of debt on the K-1 part K is on the "nonrecourse" line, you are likely to have an at-risk problem. You will have to go to IRS Form 6198 to figure out whether you have to defer losses under the at-risk rules.

The "passive loss rules" are the final hurdle for deducting K-1 losses. These rules were enacted in 1986 to shut down that era's tax shelters. If you have "passive" losses in excess of "passive" income, you have to defer the losses until you have passive income in a future year, or until you dispose of the "passive activity" in a taxable transaction.

A loss is "passive" if you don't "materially participate" in the business. There are a number of tests that you can use to determine whether you materially participate, but the most common is working at least 500 hours in the business in a year. 

Real estate rental is passive by law, unless you are a "qualifying real property professional."  Special rules keep you from generating "passive" income to allow you to deduct passive losses. For example, land rent and most investment income is not considered "passive" under these rules. The passive loss limitation is computed on Form 8582.

These rules are complicated, even for tax pros. If you aren't sure where you stand, and the losses are significant to you, get in touch with a tax pro who works with small businesses.

Flickr image by naotakem under Creative Commons license.

Should you be sending some of your rent to the IRS?

The author of a best-selling book said "The World is Flat."  Though the world may never be as flat as that author's prose, Iowans find themselves dealing with foreign businesses more and more. Sadly, perfectly innocent transactions with foreigners can have tax land mines.

Pretend that a foreign company buys the Des Moines Building. Now pretend that you rent some prime space there for your business and pay $100,000 in lease payments this year to the landlord. The foreign company takes your money, but neglects to file a U.S. tax return. Would you be happy to then write a $30,000 check to the IRS? Happy or not, you might have to.

The tax law requires U.S. taxpayers to withhold 30 percent of rents paid to foreign taxpayers. If you didn't get the paperwork in order before taking that prime Des Moines Building space, the IRS could come after you for that 30 percent. So how do you protect yourself?

First, you get a Form W-9 from the landlord (you should be doing that anyway to find out whether you have to issue a Form 1099 for the rent). The W-9 includes a statement certifying that the signor is a U.S. person. As long as you don't know otherwise, the W-9 protects you. Even a foreign-owned corporation incorporated in the U.S. is a "U.S. person" -- but an LLC wholly-owned by a foreign person normally is not.

If you find out the taxpayer isn't a U.S. person, you might still be able to avoid the withholding. If the foreign taxpayer treats the rent as "effectively connected" with a U.S. trade or business, they can give you a Form W-8 ECI -- letting you off the hook for withholding. Alternatively, they may provide a Form W-8 BEN, allowing you to withhold at a reduced rate under the provisions of the tax treaty with the landlord's home country.

If your foreign taxpayer can't give you a W-8 ECI, then you have to withhold. The withholding has to be deposited based on a schedule available on the IRS website; you have three days to deposit withholding of $2,000 or more. You have to report the withholdings on Form 1042, due on March 15 the following year.

The Moral?  Foreign landlords can lead to unhappy tax surprises.  Fortunately, you can protect yourself by getting a W-9, and by taking the proper precautions if it turns out you do have a foreign landlord.

In a hurry? Maybe you shouldn't be.

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No business owner enjoys doing taxes. Even at its best, it's a distraction from what you'd rather be doing. When the law changes every year and your preparer always seems to want the tax information sliced just a little differently, it can be a headache. So you want to just get the stupid thing filed and done with.

If you do business in Iowa, this probably isn't the year to hurry.

Congress enacted two big changes in how fixed assets were depreciated for 2010:

• It increased the maximum "Section 179 deduction" to $500,000. Section 179 allows taxpayers to take a current deduction for asset purchases that would otherwise have to be capitalized and written off over a period of years through depreciation. 

• It enacted "100 percent bonus depreciation" for most new assets placed in service after Sept. 8, 2010. That means qualifying assets -- most "new" assets (not used) with a life of up to 20 years -- can be written off in the year of purchase without regards to the limits that apply to Section 179 deductions.  For example, bonus depreciation can create an operating loss that can be carried back to get prior year taxes refunded; Section 179 does not. New assets placed in service before Sept. 9, 2010 qualify for "50 percent bonus depreciation," where half of the cost is immediately deductible and the rest of the asset cost is depreciated over a period of years.

Iowa has not "coupled" with increases in Section 179 limits or bonus depreciation in recent years. The current Iowa House of Representatives voted to adopt both the increased Section 179 deduction and the federal bonus depreciation rules effective for 2010. The Iowa Senate is considering similar legislation, but its future is uncertain.

As a result, your tax preparer doesn't know what Iowa's depreciation rules will be for 2010.  If the legislation fails to pass, no bonus depreciation will be available for 2010 Iowa tax returns, and the maximum Section 179 deduction on an Iowa return will be $134,000. 

That's why you might want to wait and see what the Iowa General Assembly ends up doing. If you file and guess wrong, you may have to amend your Iowa returns. If you have a pass-through entity - an S corporation or a partnership -- the wrong guess could require amending all of the owners' personal Iowa 1040s.

Amending returns costs money. So though you naturally want to be done with your taxes, this probably is the year to be patient on getting your Iowa business taxes done.  Meanwhile, follow the Business Record and taxupdateblog.com to see which way the Iowa General Assembly comes down on this.

Come out with your hands up

The IRS has just launched a new "amnesty" program for taxpayers with offshore bank accounts. The tax law has strict rules for reporting offshore financial accounts with balances rising over $10,000 and severe financial penalties for non-compliance. Of course, the penalties can be much worse than financial when tax fraud is involved. 

Unfortunately, many otherwise innocent taxpayers have offshore accounts that have not been reported on Form TD F 90-22.1, the "FBAR" form. A business may have an account overseas to make it easier to pay vendors or accept export payments, or an individual posted overseas may have inadvertently triggered an FBAR filing requirement just by having a personal bank account.  The IRS has been taking a "shoot the jaywalkers" approach to minor technical violations, making it an expensive nightmare for such taxpayers to come into compliance. This program offers such taxpayers an opportunity to get in compliance at a small cost, or in some cases, no cost.

Taxpayers who have been avoiding tax, whether inadvertently or purposefully, can also come in from the cold by paying their back taxes and a penalty of up to 25 percent of the highest offshore account balance. That might seem like a high price to pay, but it may be a good deal, as Janet Novack explains at Forbes.com:

Under the initiative, a taxpayer who put $1 million in a foreign account in 2003 and earned $50,000 of interest income on it each year, none of it reported to the IRS, would owe $518,000 in back taxes and penalties. If that taxpayer doesn’t participate and is found out, he could be assessed a stunning $4.5 million in back taxes and FBAR and tax fraud penalties. And, of course, he could be criminally prosecuted and go to jail.

Foreign bank account secrecy is rapidly becoming a memory. With the IRS securing thousands of names of Swiss account holders, and with other names becoming public via Wikileaks, there is no assurance that a secret offshore account can stay that way. If you have such an account, the time to contact your lawyer about the program is now.  The program requires filing amended returns to report all offshore income by its Aug. 31, 2011, deadline. Aug. 29 will be too late to start.

How to protect yourself from payroll tax disaster

A busy entrepreneur needs to know when to delegate.  As your business grows, you have to trust vendors and employees to do more.  But as a man once said, "trust, but verify."  The "verify" part is especially important in dealing with your payroll taxes.

A Des Moines businessman has learned this lesson the hard way.  Somehow -- perhaps as a result of an employee dropping the ball, but it's not certain -- his distribution company got behind on its payroll taxes.  The federal courts found that he paid other vendors before he got the payroll tax debt straightened out.  When a "responsible person" does so "willfully," he becomes personally liable for the payroll taxes, even if the business is incorporated.  The court ruled that the businessman was on the hook:

"The term willfully does not connote a bad or evil motive, but rather means a voluntary, conscious, and intentional act, such as the payment of other creditors in preference to the United States." Willfulness is generally a question of fact, but if a responsible person knew of payments to other creditors after he was aware of the failure to pay over withholding taxes to the government, his actions are willful as a matter of law."

So can you wash your hands of the problem by outsourcing the payroll function?  No.  If you provide cash to the payroll service and they fail to remit it -- maybe because they steal it -- the IRS will come looking for the money.  They don't count stolen tax deposits as payment of withheld payroll taxes. 

As we said, the entrepreneur can't do everything.  You have to trust, but you can verify your payroll taxes.  If your business is enrolled in the Electronic Federal Tax Payment System (EFTPS), you can go online to make sure your payroll taxes are being deposited.  Whether you outsource your payroll or do it in-house, it only takes a minute to check your payments. 

Getting behind on payroll taxes can be enough to sink a business.  That's why you entrepeneurs should bookmark the EFTPS website, know your password, learn how to access your account, and at least once in a while, verify.

You may have already messed up your payroll

Congress changed the payroll tax rules for 2011 less than two weeks before the start of the year, so it's hardly surprising that some of the millions of employers out there haven't got the message.  Are you one of them?

The new law reduced the employee share of the FICA tax from 6.2 percent to 4.2 percent, for 2011 only. The employer tax remains 6.2 percent, on wages up to the $106,800 FICA base. That means many employees who have already received 2011 paychecks have been overwithheld.

If you have overwithheld on your employees, what should you do?  The IRS says you should make it up by under withholding the same amount overwithheld sometime before March 31. 

The FICA change isn't the only one that applies for 2011 payrolls. The income tax withholding tables have been adjusted to reflect the end of the "Making Work Pay" tax credit. You can find IRS guidance on all of these 2011 changes in their Notice 1036.

Flickr image courtesy Marcin Wichary under Creative Commons license.

Too late for year-end tax planning? Not for 2011!

Yes, 2010 is in the books, at least as far as year-end tax planning is concerned.  There are still some things you might be able to do to affect your 2010 taxes - perhaps an IRA contribution.

But the big 2010 issues are settled and now it's all about adding up the score.

You may have spent yesterday frantically making last-minute tax moves, but for the most alert taxpayers, year-end planning starts today -- for 2011. For tax planning tools that allow you to earn money tax-free or tax-deferred, today is the best day of the year to make your payments.  Think about it: the whole point of something like an IRA is to earn income that's not subject to current tax.  The sooner you move money from a taxable account to a tax-deferred account, the longer you get the tax advantage.

So let's do some year-end planning right now and start funding our tax-deferred savings vehicles.  Here are the most important 2011 limits:

IRA contributions: lesser of earned income or $5,000; for married couples, spouses can use spouse income to qualify.  For taxpayers who turn 50 by year-end, the limit is $6,000.  Whether you qualify for a deductible or "Roth" contribution will depend on your 2011 income.

401(k) deferral:  $16,500 annual limit, plus $5,500 for those who turn 50 this year, or have already done so.

Health Savings Account contributions: $3,050 for single plans and $6,150 for family plans.  These contributions require you to have a qualifying high-deductible health plan.

College Savings Iowa contributions: The 2011 limit for CSI contribution deductions on Iowa returns hasn't been announced, as far as I can tell, but the 2010 limit is $2,811 per donor, per donee.   The 2011 amount won't be any less than that, so you can put it the $2,811 now and top it off later.

So get busy! If you get your contributions in now, you can spend Dec. 31 making your hangover plans.

 Flickr Image courtesy Pinti 1 under Creative Commons license.

2010 year-end tax planning: shooting at a moving target

Year-end tax planning usually follows a standard pattern:

 - Estimate your income and deductions for this year and next year

 - Decide whether you want to move income or deductions into this year

 - Assuming you want to defer income and accelerate deductions (the usual answer), identify ways to do so that won't make you worse off after tax.

 - Consider whether you should make any year-end gifts to family as part of your estate planning.

It's more complicated this year.

As of the morning of Dec. 16, we aren't even sure what the income tax rates will be. We don't know what the rules are for gifts made today. We aren't even certain what rules will apply for deducting the cost of business assets purchased today.

Entrepreneurs are used to acting on imperfect information and we can give you just that.  We think that by the end of the day today Congress will have passed the big "framework" tax bill that extends the Bush-era tax rates through 2012. If that happens, here are some keys to your 2010 year-end planning.

 - 100 percent bonus depreciation. The "Framework" will let businesses deduct 100 percent of the cost of most new machinery and equipment bought after Sept. 8, 2010 that is placed in service before year-end. Current law also allows you take a "Section 179" deduction up to $500,000 for new or used business equipment placed in service this year.  Bonus depreciation is usually better when available because there are fewer limits on the deduction. Also, bonus depreciation can create a "net operating loss" that you can carry back to get refunds of prior year taxes. 

 - Beware related parties. The tax law disallows or delays many deductions if they involve related parties, such as controlled businesses or family members.

 - Watch out for alternative minimum tax. Some deductions, like the deductions for state and local taxes, aren't counted for AMT; prepaying such expenses can be a waste of money.

 -Don't overdo it. While cash-basis taxpayers can usually deduct expenses paid, the tax law disallows most deductions if they are prepaid for more than one year in advance. Though I would be thrilled if my clients paid five years of accounting fees in advance, they would have to spread their deduction over the five years.

 - Talk to your tax advisor. That's always a good idea when you are doing tax planning, but with huge tax law changes happening, it's more important than ever.

Flickr image courtesy Erik Charlton under Creative Commons license

Sometimes it's better to give right now

It's looking more and more possible that the federal estate tax, which went away for 2010, will return with a vengeance in 2011. If Congress fails to act -- and they have failed to solve this problem since 2001 -- the estate tax will return for deaths after Dec. 31 with a 55 percent top rate and a $1 million per decedent lifetime exclusion. That makes December a crucial month for estate planning for entrepreneurs who might otherwise face this tax.

And no, not by dying this month.

The federal estate and gift tax has always had a too-little-understood bias towards lifetime gifts. 

It comes from three sources:

• There is an annual gift-tax exclusion, currently $13,000 per donor, per-donee. That means a married couple with four children can over a 10-year period move $1,040,000 out of their taxable estates without touching their lifetime $1 million exemption.

• Inflation shrinks the $1 million lifetime gift exemption each year. The sooner you use it, the more it's worth. An appreciating asset gifted now is an asset that will grow outside of your taxable estate.

• If you go beyond the lifetime exemtion and incur gift tax, you pay the gift tax only on the amount that goes to your gift recipients.  The estate tax, in contrast, applies to everything in the estate -- including the amount used to pay the gift tax.  For example, at a 50 percent rate, somebody wanting to get $1 million to the next generation needs $1.5 million -- $1 million to give away and $500,000 to send to IRS.  If you wait until death, you need to have $2 million in the estate to get $1 million to the next generation at a 50 percent rate. The $2 million owned at death would be subject to a $1 million estate tax at 50 percent.  Another way to put it is that if you measure the estate tax the same way as the gift tax -- based on what goes to the next generation -- a 50 percent Estate Tax is equivalent to a 100 percent gift tax. 

Next year the estate tax and gift tax rates will both be 55 percent. Gifts completed in 2010, in contrast, will face only a 35 percent gift tax rate. If the Estate tax returns to 55 percent as scheduled, a 35 percent gift tax rate is a tremendous bargain, relatively speaking.

Of course you shouldn't be throwing this kind of cash around without professional advice. Estate planning has to take many things into account besides taxes, and you need to consider possible future estate and gift tax changes. Still, if you think your taxable estate, or that of your spouse after you die, will significantly exceed $1 million, now is the time to visit your estate planning professional to possibly take advantage of the "sale" on gift tax rates that ends Dec. 31.

Flickr image courtesy Howard Dickins under Creative Commons license.

How much can I prepay and deduct this year?

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Taxes make people do strange things. People beg their vendors and professionals to send them a bill, so that they can pay it and deduct it this year, lowering this year's taxes. Does that work, and does it makes sense if it does?

Taxpayers often may deduct prepaid expenses. "Cash basis" taxpayers can usually deduct business expenses in the year for which they are paid. Most Schedule C, Schedule E and Schedule F tax returns are cash basis. Likewise, such taxpayers normally only pay taxes in income for the year in which it is paid.

Accrual taxpayers, in contrast, normally deduct expenses in the year the expense relates to. For example, an accrual basis taxpayer who prepays January rent in December would normally deduct the payment in January, as that is the month the payment relates to.  Even so, they often can adopt an accounting method that enables them to deduct a limited amount of prepaid expenses.

Long-lived assets are different.  Neither cash or accrual method taxpayers can deduct expenses that provide a benefit that lasts more than 12 months. Such expenses are deductible over the life of the asset. For example, if your tax preparer pre-bills you the next five years worth of tax prep fees, your deduction will not exceed the amount for the first 12 months after this tax year -- and it may be less. If you buy machinery and equipment, you can only start to recover the property in the year in which you place the asset in service -- not the year you buy it. That's true whether you plan to depreciate the asset or use the "Section 179" deduction.

Related parties are also troublesome. You normally can't deduct a payment to a related party - a family member or a family-held corporation for example - prior to the year that the related party pays tax on the income.

Finally, ask yourself: do I really want to give up cash now to save some portion of it on this year's return? Even a top-bracket Iowan is looking at a combined federal and state rate of 42 percent or so for 2010. If you prepay $1 in December instead of January to save 42 cents in taxes in April, that might make sense. If you prepay $1 this December instead of next December to move up a 42 cent benefit by one year, it's hard to make that math work.

Needless to say, this stuff is complicated.  You should work with your own tax advisor to make sure you get your year-end planning right.

Don't pay the seller's income tax

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Remember when the Japanese were taking over the country? Back in the late 1970s and early 1980s, everyone thought that Nagasaki was being avenged by a Japanese takeover of strategic U.S real estate, like Pebble Beach golf course.

The Japanese takeover never quite worked out, but that didn't stop Congress from making sure that foreigners at least paid income tax when they sold their real estate.  The Foreign Investment in Real Property Tax Act of 1980 requires buyers to withhold 10 percent federal income tax when buying real estate from those diabolical foriegn sellers. The IRS can force a buyer who fails to withhold the 10 percent from the purchase payment to come up with the 10 percent withholding out of his own assets.

This rule makes it important for you to know who you are buying real estate from. The withholding rules apply if you are buying from a "foreign person." A U.S. corporation is not a "foreign person," even if it is owned by overseas interests. A U.S. partnership is not a foreign person even if there is a foreign partner. But a U.S. disregarded entity -- like a single-owner limited liability company -- can be trouble. "Disregarded entities" are, well, disregarded for purposes of FIRPTA withholding. If a single-owner LLC is owned by a foreign person, FIRPTA withholding could be required.

So how do you protect yourself from having to pay an extra 10 percent of the purchase price to the IRS on behalf of a foreign owner? By getting a Certificate of Nonforeign Status from the seller, signed under penalties of perjury. The certificate should (Treasury Reg. 1.1442-2(b)(2)):

State that the transferor is not a foreign person.

Sets forth the transferor's name, identifying number and home address (in the case of an individual) or office address (in the case of an entity), and

In the case of anyone other than an individual, it should state that the seller is not a disregarded entity.

It should be signed under penalties of perjury.

If your seller is a foreign person, there are a few exceptions to FIRPTA withholding. The most widely used is for non-citizens who sell a residence for under $300,000. If no exception applies, you remit the withholding to the IRS with Form 8288, and you tell the seller the amount withheld on Form 8288-A. The Form 8288 is due with payment 20 days after the property is transferred. It's always wise to get your tax professional involved to make sure you have the bases covered.

Even though nobody worries about the Japanese real estate anymore, FIRPTA withholding seems here to stay. Don't get caught up paying tax for some crafty Canadian just because you didn't withhold 10 percent when you bought his building.

When buying real estate, make sure you don't end up paying the seller's income tax.

Tax moves when times are bad

As "recovery summer" slips into "full-employment fall," not everybody is feeling it. Two years of tough times has brought many businesses to grief. If the wolf is at your office door, here are a few things to keep in mind:

- Pay your payroll and withholding taxes above all else.  If you withhold taxes from employee paychecks and fail to pay it to IRS or the state, they can collect personally from "responsible persons." Responsible people can be owners, but they can also be financial personnel who choose to pay vendors instead of the government. Failure to pay withholding can even result in criminal charges.

- Don't "borrow" employee 401(k) deferrals. The feds can get very, very angry with you for that.

- If things look dire, be honest with your bankers. They are more likely to work with you if they trust you.

- Talk to your tax advisors before you restructure your debt. Debt workouts can have strange consequences. They can generate taxable income at a time when your cash is very tight. 

- Talk to your attorney about bankruptcy options. Sometimes you can keep the business open to fight another day through a bankruptcy reorganization. It's more likely to work the sooner you get started. If you wait until you can't make payroll, it may be too late. If done right, keeping the business going can be the best deal for creditors while giving the old owners a chance to recover some of their losses.

Flickr image courtesy TheTruthAbout under Creative Commons license  .

New tax breaks for the 2010 tax planning home stretch

The 2010 tax year is three-fourths over for most of us. By now, we should have a decent idea of what sort of year we're having, so it's time to get serious about our year-end tax planning.

The president this week signed a new law that could make a big difference in your 2010 tax planning. Some key provisions:

$500,000 Section 179 deduction limit.  The tax law normally requires taxpayers to capitalize equipment costs and recover them only over time through depreciation. Section 179 allows taxpayers to elect to deduct the entire cost of most assets in the year they are placed in service. The tax law prior to now limited the deduction in a year to $250,000 worth of qualifying assets. For 2010 and 2011, that limit is raised to $500,000, if no more than $2 million of assets are placed in service during the year. Section 179 is available for most assets other than real property, though it is temporarily available for certain leasehold improvements and restaurant buildings.

50 percent Bonus Depreciation. This has been extended through the end of 2010. This rule, which enables taxpayers to deduct half the cost of new equipment in the year it is placed in service, had been set to expire at the end of 2009. It now applies retroactively for all of 2010.

Planning for the use of these new breaks won't be easy. Normally it's a good idea to accelerate deductions, but that's not a sure thing this year. With the top rates scheduled to increase from 35 percent to 39.6 percent next year, and as high as 43.4 percent by 2014, top-bracket businesses may find that the deductions will be worth more to them after 2010.

Another complication: Iowa may not recognize these deductions. Iowa has ignored bonus depreciation in recent years and it failed to go along with the increased Section 179 deduction of $250,000 last year. 

With 2011 tax rates up in the air, this is the toughest tax planning environment in many years. Stay flexible, and talk to your tax pro before you do anything big in your 2010 planning. 

Further reading:

500K Section 179, extended bonus depreciation enacted

Tax breaks in the new small business bill

 Image credit: Flickr image courtesy thekirbster under Creative Commons license.

Why cheating on taxes can be expensive even if you are never caught.

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Everybody has heard the old lawyer joke (though it works for accountants too): A recently-departed lawyer checks in at the pearly gates for his interview with St. Peter. The attorney asks "why did you take me so soon? I'm only 45?" St. Peter says "You must be mistaken. From the amount of time you billed, you have to be at least 70."

Old paperwork can catch you at the door of paradise when you run a business, too. Some businesses go for years and years reporting all of their income to the IRS, except for the big chunks they leave off the tax returns. It seems like a sweet deal until it's time to sell the business. 

Many prospective buyers to want to see the tax returns when they are looking to purchase a business. Sometimes tax returns are the only financial statements a small business has. If the tax returns make it look like the business is barely scraping by, the buyer cuts his offer. It's at least awkward to explain why the business is so much more profitable than the IRS ever knew.

Awkward? It can be downright dangerous. The owner of AJ's Green Dry Cleaners and Laundromat in Palo Alto, Calif., showed his prospective buyer the "real" books, which had $194,000 or so more sales than the tax returns showed. That didn't score many points with the prospective buyer, who turned out to be an undercover IRS agent. The dry cleaner will have to spend 10 months cleaning up in a federal prison. 

Federal and state governments continue to get better at tracking down tax evasion, and prospective buyers can be forgiven for wondering why they should trust somebody willing to lie to the IRS.  Paying taxes is painful, sure, but it's the best way to go in the long run.

Your tax refund may vanish in two weeks

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Thousands of small businesses will lose a big refund in the next few weeks without even knowing it.  Don't let your business be one of them.

One of the recent "stimulus" bills allows taxpayers to carry back their 2008 or 2009 tax losses five years, instead of the normal two years.  Such taxpayers have to elect to do so no later than six months after the original due date for their returns.  That's Oct. 15 for individuals, who might have losses from their Schedule C business, or for a partnership or S corproation.  The deadline is Sept. 15 -- two weeks from today -- for calendar year C corporations.

Even these deadlines are extensions.  The election was originally to be made on the original tax returns for the years, but the IRS has allowed a six-month grace period.  You can find the details here.

Many taxpayers will get a bigger refund by carrying their loss back for more than two years.  An obvious example would be somebody who had a lot of income in 2004, 2005, and 2006, broke even in 2007 and 2008, and had a terrible 2009. 

So if you had a losing 2008 or 2009, see your tax advisor about whether you made the five-year carryback election, and if not, whether you should.  In this economy, you need all the "stimulus" you can find.

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.

Taxes: one step over the (state) lines

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It is an Amazon world.  Buying cheaply from distant vendors and selling to customers far away is important even to the smallest businesses.  Unfortunately, tapping markets in other states can easily ensnare you in other state tax systems.

States can impose income taxes on out-of-state businesses with activities that go beyond sales activities to generate orders to be approved out-of-state.  That can be an easy bar to clear.  A Council Bluffs contractor who crosses the river to do a project in Nebraska not only crosses the state line, but also the line that subjects him to the Nebraska income tax.  A salesman who also maintains an inventory in a state to fill orders there brings his employer into that state's income tax.

For sales tax, the bar is even lower.  Having a non-employee salesman in a state can subject all of your sales in that state to sales tax there, even if the activity does not meet the level that triggers income taxes there.

Being subject to income taxes isn't the end of the world.  If an individual pays taxes in another state, it may reduce home state taxes dollar for dollar; all states imposing an individual income tax provide a credit for taxes paid in other states.  Corporate taxpayers subject to taxes in other states may be able to take advantage of favorable tax rules in the home state, like Iowa's "single-factor" apportionment rules. 

Still, taxes in another state are a hassle.  The states all have their own rules for computing taxes, their own deadlines, and, often, their own unhelpful tax bureaucracy.  It's much less of a hassle, though, when you plan for it than when some state assesses you for five years of back taxes.

If you are doing a project across state lines, let your tax pro know.  When you put together your information for your 2009 business tax returns, be sure to put list out your sales, property and payroll by state.  Let your preparer know if you are renting business property out of state.  If you aren't sure whether you've done enough in another state to trigger tax there, go over things with your tax advisor.

It's not too soon to start your year-end 2010 tax planning!

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Though you can't do your December tax planning in January, what you do in January can make December a lot easier.  Big changes loom in the federal income tax in 2011, so this is a big tax planning year for many entrepreneurs.

Thrifty taxpayers like to make maximum contributions to tax-deferred savings vehicles like 401(k) plans and individual retirement accounts.  If you really want to do it right, you fund these on the earliest possible date, rather than waiting until the final contribution deadline; that gives you an extra year of tax-deferred earnings.  Here are some maximums for 2010:

• Individual Retirement Accounts: $5,000 ($6,000 for taxpayers who turn 50 during 2010).  
• 401(k) elective deferrals: $16,500 ($22,000 for 50-year-olds)
• Health Savings Accounts: $3,050 for single plans and $6,150 for family plans.
• Deductible Colleges Savings Iowa Section 529 plan Contributions: $2,811 per donor, per donee.

One of the biggest, and scariest, tax planning tools available this year is the ability of all taxpayers to convert a traditional IRA to a Roth IRA.  Taxpayers would have to pay tax on their deferred IRA income to do so, but earnings on Roth IRAs, handled properly, are tax-free forever.  The ability to obtain permanent tax exemption on IRA assets is big, but paying a bunch of tax right now is scary -- even though you can pay the tax over two years. 

With tax rates almost certainly rising at higher income levels in 2011 (the only question is how much), a lot of tax-planning will be turned on its head this year.  Traditional planning involves accelerating deductions and deferring income.  With higher rates in store, deferring income to 2011 could be costly. 

It's not too early to start talking to your tax pro about these issues.  It's a lot easier to do your year-end planning when you spread it out over 12 months.

It doesn't have to be this way

Iowa has the 46th-best best state tax environment for business in the country.  That's a nice way of saying it has one of the worst.  High rates leavened with complex loopholes for the well-lobbied make our tax environment  poisonous for entrepreneurs.

It's easy to imagine a better tax world: the world of the Quick and Dirty Iowa Tax Reform.  It looks like this:

1. Eliminate the Corporation income tax. The Iowa corporation income tax has the highest stated rate in the country, and one of the highest effective rates. The only reason it doesn't destroy Iowa's economy altogether is that it is so riddled with loopholes that collections are very low - well below 5 percent of the state budget. Yet it is a very expensive tax to administer and to comply with. Eliminating the tax would send a powerful message to companies looking for a place to invest for the long term.

2. Reduce the Iowa individual income tax to 4 percent or less. 3.99 percent would be much more attractive to entrepreneurs and executives considering Iowa locations. It would bring our rate decisively below all of the border states except for Illinois and South Dakota. Only a low rate will enable Iowans to give up the large number of special breaks that make compliance and tax administration expensive.

3. Strip down the Iowa tax law. To get the rate down to this level, Iowa will need to strip its tax law of a host of politically-motivated tax breaks. These include, among others:

- All economic development tax credits - ethanol, films, research and development, "targeted" jobs and the like, they all should go. Low rates are more important than any of these, all of which serve primarily to fund the well-connected.

- The deduction for Federal income taxes. If the rates are low enough, the deduction doesn't matter nearly as much. If its built into the rates, you protect poorly advised taxpayers who have a big once-in-a-lifetime income item - say, from selling a business - and losing the value of the deduction by paying the tax when it is due, rather than prepaying in the year of sale.

- The exclusion for ten-year capital gains.

- The credits for tuition funds, community foundations, and the like.

- The special pension and tuition breaks for old folks. Any breaks for poor folks should be in the form of a generous low-income exemption. Old folks with low income aren't necessarily more worthy than younger folks. In fact they often are much more wealthy than their younger counterparts.

Just because a break isn't mentioned here doesn't mean I want to keep it.

4. Make federal taxable income the starting point for Iowa taxable income. If you use federal AGI as the starting point, you can achieve even greater simplification and lower the rates further. Unmodified AGI as a tax base can create grossly unfair results, but it if you allow a deduction for gambling losses and Schedule A investment interest, you get a decent base. Federal changes in income computation would automatically be incorporated in Iowa's tax code, absent a vote of the legislature otherwise. It also makes Iowa's tax forms potentially postcard-sized.

5. Make Iowa's tax forms into a reconciliation format, starting with Federal taxable income. Have lines to back out federal Treasury income, which the state can’t tax. If Iowa chooses to tax muni bond income, have a line for that. Have one last line for all (any) other addbacks and subtractions, which would feed from separate detail schedules.

6. The most difficult issue is taxation of S corporations. I would allow S corporations to elect to be Iowa C corporations and make Iowans taxable on distributions from the corporation as if they were C corporations. Electing corporations would have to report distributions to Iowa shareholders to the state, and the shareholders would be taxed as if the distributions were taxable dividends; otherwise electing corporations would pay no tax on Iowa-source income. Iowans owning Non-electing S corporations would be taxed in Iowa on all their S corporation income. This would achieve near-parity between Iowa C and S corporations.

For every business that loses a chance to shake down the state for new credits, a hundred will be better off for not having to deal with high rates and complexity. When the legislature sits down this month to tweak the tax system to pay for their spending, ask them for a tax system that benefits you instead of the out-of-staters with the expensive lobbyists.

Make sure you can take that year-end deduction

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When you're spending money to get a tax deduction for your business by the end of the year, you might as well make sure the deduction will hold up when your friendly neighborhood IRS agent comes calling. 

If you're a cash-basis taxpayer - if you aren't sure, check your business tax return or your 1040 schedule C or schedule F - you will need to show that you spent the money to claim the expense this year.  Some things to remember:

• A credit card is as good as cash.  Better, even, because if you incur a business expense before the end of the year, you have your credit card statement to prove it.
• If you mail a check for a business expense, the check needs to be in the mail and postmarked in 2009 to be a deductible 2009 expense.  If it's a big check, maybe you should spend a few bucks extra to send it Certified Mail so you can document the postmark.
•  If you receive a check in the mail, it's taxable the day you receive it, even if you don't deposit it.
• There is no "close is good enough" rule for cash basis taxpayers.  Just because you could have paid a bill doesn't get you a deduction if you didn't pay it before year-end.
• Don't overdo it.  If you prepay expenses more than a year out, you don't get the deduction until the year to which the payment applies.

If you are an accrual-basis taxpayer, your big year-end issues come from related-party payments.   For example, a C corporation can only deduct payments to an over-50 percent owner if the payment is made before year-end.  If you and a family member both own stock, you combine your ownership to see if you own over 50 percent. For C corporation personal service corporations -- doctors, lawyers, consultants, and accountants -- that pay all of their earnings out as salary, this is a critical issue; any earnings left at year-end get taxed at a flat 35 percent federal rate.  S corporations and partnerships are related to all of their owners for purposes of taking deductions.  They are also related to anybody in the owner's family up to kissing cousins, more or less, including ancestors, lineal descendants, spouse and siblings.

If you are looking for a deduction from buying equipment or fixed assets -- say, a Section 179 deduction or a bonus depreciation deduction -- make sure that your asset isn't just purchased, but placed in service too, before year-end.  It doesn't count if it's sitting on the dock in the packing cases. 

For more year-end planning information, check out the Tax Update Blog's year-end planning series of posts.  Be sure to involve your tax pro in your year-end planning -- when it's time to do the return, it's too late.

Got losses? Turn them into cash.

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Back in September, we were jumping up and down warning taxpayers with 2008 Net Operating Losses about the looming September and October deadlines to carry them back five years.

Never mind.

Congress has just changed the rules again, giving a mulligan to taxpayers who missed their chance to carry back 2008 losses five years. Normally taxpayers can only take federal losses back to recover taxes paid in the prior two years. Congress has also extended the five-year loss carryback to 2009 and has applied it to more taxpayers. The rules are a bit complex (okay, screwy) so follow along closely:

Smaller businesses: Taxpayers who elected to carry back losses from businesses with average gross receipts for the preceding three years of less than $15 million, three, four or five years for both 2008 and 2009. 

A taxpayer who qualified to elect the extended carryback for 2008, but failed to do so, has to choose between the 2008 or 2009 losses for the extended carryback.

Larger businesses: Taxpayers can elect to carry back losses from businesses with average gross receipts over $15 million, three, four or five years for either 2008 or 2009, but not both. These taxpayers had been excluded from the old five-year carry back.

But not really all of five years: Losses carried back to the fifth (2003 for 2008 losses) can only offset 50 percent of the taxable income for the fifth year. If you elect to carry back losses back only four years, you can offset 100 percent of the fourth prior year's income.

What if I have already carried back my 2008 losses? If you carried your losses back five years, you may still have to amend your carry back returns if alternative minimum tax limited your carry back refund.  A rule that limits the benefit of losses for AMT purposes has now been suspended. If you are a larger business and have carried back losses already for the two years formerly allowed, you will be able to re-file and go back five years. The IRS is expected to issue guidance soon on how to do this (UPDATE, 11/23 - see below).

How does the $15 million limit work?  If your business losses come from a partnership or S corporation, the $15 million test is applied at the entity level. If an S corporation has sales of $16 million, it's a larger business, even to a shareholder whose share of the sales is less than $16 million.

When do I have to claim the carryback?  By the due date of your 2009 returns, including extensions, by filing Form 1139 (corporations) or 1045 (individuals).

How does this affect my year-end planning?  If your losses come from one of the smaller businesses who already has used the extra carryback for 2008 losses, the new provisions don't affect your planning that much because you can carry back losses from both 2008 and 2009. Other taxpayers, who have to choose between 2008 and 2009 losses for the five-year carry back, should wait to carry back the 2008 losses until they make sure that gets you a better result than carrying back the 2009 losses.

Consult your tax pro.  There's a lot to think about when you carry back your NOLs and your tax pro can help make sure you make the most of your losses.

UPDATE, 11/23/2009: The IRS has issued guidance on claiming the extended NOL carryback period.

Information returns for fun and vengeance

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Information returns, like 1099 forms, are meant to help the tax system work by enabling the IRS to make sure that income gets properly reported.  The IRS matches the information returns against 1040s and sends friendly "Dear Taxpayer" letters if they don't match up.

Creative taxpayers have found information returns useful for other things. Like vengeance.

After the breakup of his marriage, an ex-son-in-law still owed money to his ex-wife's mother.  Ex-Mom and Ex-Son never could work out a settlement, so Ex-Mom gave up on the debt -- and reported it to the son as "cancellation of indebtedness income" on a Form 1099-C filed with the IRS.

Ex-Son was unhappy with this - so unhappy that he sued Ex-Mom, claiming the 1099-C was fraudulent because the tax law didn't require her to send him one.  The court sided with Ex-Mom, saying the tax law doesn't mind too much information reporting.

That's a lesson entrepreneurs can take to heart.  The penalties for failing to issue information returns can get expensive in a hurry, starting at $50 for each failure to file them on time.

The tax law requires businesses to issue many information returns. Common ones include:

• W-2s to employees
• 1099-MISC to non-employees who receive $600 or more in payments from the the business during the year.
• 1099-INT to recipients of $10 or more in interest from the business during the year.

There are broad exceptions to the requirement; the biggest one is that most payments to corporations are exempt from the reporting requirements.

The 1099-C issued to report debt forgiveness by the Ex-Mom is required only of a "...governmental agency, a financial institution, or other organization in the business of lending money." But there's no penalty, other than preparation costs, of issuing an extra 1099.  Missing just a handful of those you do need to issue, however, can cost thousands.  The IRS requires many of these to be filed electronically; the penalties for failing to file the right way can be as high as for not filing at all (to be sure, there are serious penalties for maliciously filing false 1099s).

Check with your tax pro to learn more about information return requirements, and visit "A Guide to Information Returns" on the IRS website.

Oh, and think twice before borrowing from your mother-in-law.

Passive activity: Is that the opposite of vigorous rest?

Some entrepreneurs spend all of their time on one thing.  Others like to have a lot of things going on. If you multitask, you may have run into the "passive loss" rules at tax time.  If your passion is real estate rental, you almost certainly have.

The passive loss rules were designed to thwart mass-market tax shelters popular in the early 1980s. They only allow losses from "passive activities" to the extent of income from other "passive activities." Disallowed losses carry forward indefinitely to offset future "passive" income, or until they are allowed when the activity is sold.  Except for real estate, a business activity is "passive" depending on how much time you spend on it.  While there are a number of tests, the two most important ones are:

- You are not "passive" if you spend 500 hours or more on a business activity in a year, and

- You are not "passive" if you spend at least 100 hours on an activity, and you spend more than 500 hours on multiple 100-500 hour activities in a year.

Real estate rental losses are normally passive in any case, but a special rule applies to "materially-participating real estate professionals."  These are folks who spend at least 750 hours each year in a real estate trade or business, and who don't spend more time on other things.  The tax law defines "real estate trade or business" for this rule as:

any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

These taxpayers don't automatically avoid the passive loss rules for rental real estate; they just get to apply the regular 100-500 hour rules. 

If you think you might be on the edge for how much time you spend on an activity, start keeping track of it on your appointment calendar.  It's up to you to prove your hours to the IRS. 

For more on the passive activity rules, go here.  These rules are complicated -- there's a lot more to them than what's in this post -- so get your tax pro involved.

Who can own an S corporation? Who should?

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S corporations are popular with entrepreneurs.  Unlike C corporations, they make it easy for owners to be taxed only once on their business income, while avoiding some of the complications of partnership (LLC) taxation. S corporation income is taxed directly to the corporate shareholders, rather than to the corporation itself. Iowa S corporation owners get a special break for out-of-Iowa sales that is unavailable to Iowa LLC owners.

Still, S corporations aren't for everyone. Just this week the Tax Court ruled that Individual Retirement Accounts can't own S corporations (there is a narrow exception for bank S corporations). An ineligible shareholder can be very expensive; if an ineligible shareholder owns a corporation, it is taxed as a C corporation, with a second layer tax applied on any withdrawn dividends. 

So who can own an S corporation? 

• Individuals.
• Grantor Trusts.
• "Qualified Sub-Chapter S trusts" (QSSTs) - trusts owned by individuals that distribute all of their income annually and which file an election with the IRS.
• "Electing Small Business Trusts" -- trusts that don't qualify as QSUBs but which elect to pay a tax at the trust level, at the top individual tax rate, on their S corporation earnings.
• Certain tax-exempt organizations, including charities and ESOPs -- but not IRAs.
• Certain voting trusts and trusts of decedents.
• Descendent estates.

Who can't?

• Corporations (except for wholly-owned S corporation subsidiaries).
• Partnerships.
• Insurance companies.
• Certain "split-interest" trusts, like charitable remainder trusts.
• IRAs (with a limited exception for banks).

Who shouldn't?

• If a non-ESOP retirement plan or a charity owns S corporation stock, they are subject to "unrelated business income tax" -- a version of the corporate income tax - on their share of S corporation earnings.  This can add much complexity and unhappiness to a charity's tax life.  
• If you aren't willing to deal with unpredictable income and estimated tax payments each quarter, you probably won't like owning an S corporation.

The decision on what entity you will use for your business is one you should make in consultation with your tax pro.

Offshore Account Update.  The IRS has extended its amnesty for unreported offshore accounts until Oct. 15.  If you have an offshore account and you haven't filed the TD 90-22.1 form with the U.S. Treasury, the amnesty could be a pretty good deal.  Don't wait until Oct. 14 to see your tax pro if are interested.

Like-kind exchanges: stay inside the lines

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People who make a bundle selling a piece of real estate tend to feel good about real estate investments.  They want to put that money right back into real estate.  The tax law goes pretty far to accommodate such folks.  Section 1031, the "like-kind exchange" section of the tax code, allows taxpayers who follow its rules to roll the proceeds of an investment real estate sale into a new property.  Done right, the gain is deferred until the replacement property is sold.  But one little foot-fault in doing the deal can make the whole thing taxable.

The Basics.  Section 1031 allows you to exchange one property directly for another property of "like-kind" without current tax.  It also allows you to sell a property through an intermediary and roll the proceeds into a replacement property bought from a third party if you carefully follow IRS procedures.  You have 45 days from the time you sell the property to identify replacement properties and 180 days to close.

There are a lot of ways for a swap to go wrong.  Things to be careful about:

Be careful about the 45 and 180 day deadlines.  You have to identify candidate properties in writing in 45 days with your intermediary.  If you wait until day 46, you lose.  If you close on day 181, you might as well never close.

Be careful about your intermediary. One major east-coast intermediary recently went bankrupt because of poor investments of escrowed proceeds.  A Florida man recently received a 100-year prison sentence after looting the escrowed funds of intermediary companies he owned.  Make sure the intermediary is sound, and be careful that the intermediary can only hold your proceeds in the safest investments.  If the intermediary fails, you stand to lose your entire sales proceeds.

Watch out for related parties.  A Hawaii developer had the intermediary buy replacement real estate from another company controlled by the same owners.  This blew up the exchange, making a $12 million gain taxable.

Be sure your property qualifies.  Section 1031 only works when the property is both "like-kind" and "held for investment or for use in a trade or business.  While real estate is generally like kind to other real estate, partnership interests and corporate stock never qualify.  The "held" rule can trip up flippers who try to cash out of property held only briefly.  Personal-use property doesn't qualify; this rule can trip up folks who try to use Section 1031 to sell their vacation homes.  The IRS provides a handy safe harbor for folks looking to swap vacation property.

Get professional help.  Section 1031 is normally taxpayer friendly, but only if you observe the formalities.  Once careless foot-fault can wreck the whole deal.  Use an attorney who understands these things, and get your tax professional involved.

Further reading: IRS.gov, Like-Kind Exchanges Under IRC Code Section 1031