Accounting/Finance

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

20111201iabizEvery entrepreneur struggling to stave off hungry creditors has probably taken a wistful look at that pot of cash set aside from employee paychecks to send to the IRS as withholdings and payroll taxes.  Some go so far as to "borrow" that money to pay other creditors, leaving the IRS hanging.

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

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

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

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

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

- Joe Kristan

Flickr image courtesy Dan4th under Creative Commons license.

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

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

Iabiz20111116You say "I'm in Des Moines, I don't have to worry about international tax forms!" Don't be so sure.  It's surprisingly easy to find yourself needing to file a form out of the IRS international tax series. Some common situations:

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

- You have loaned money to an offshore borrower.

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

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

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

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

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

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

- Joe Kristan

Two months left to control your 2011 tax destiny

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

20111101iabizFirst, make sure you have a good idea of how your income is shaping up. Wrap up your October financials and make an estimate of how the last two months will go. Then get out a crystal ball and take a shot at estimating your 2012 income.

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

Your options might include:

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

Last but not least,

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

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

- Joe Kristan

Flickr image by Baaker2009 under Creative Commons license.

To C or not to C

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

20111001iabiz Graduated corporate rates, the low rate on corporate dividends, and an exemption from payroll taxes combine to make subchapter C the most advantageous choice for a lot of small business profits. If a business owner can afford to leave profits inside the corporation, the resulting deferral of individual tax only makes subchapter C more attractive.

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

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

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

  • The 15% bracket can only be used in one corporation with the same owners.
  • "Personal service corporations," including law, medical, accounting and consulting practices, don't get the lower brackets.
  • Appreciated assets inside a C corporation can be trapped there because a distribution is taxed to the corporation as a sale and to the recipient as a dividend at fair-market value.  This can get very expensive when it comes time to sell.

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

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

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

- Joe Kristan

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

 


When two S corporations are one too many

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

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

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

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

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

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

- Joe Kristan

Don't flush that home office deduction

20110901iabiz With the rise of the Internet and the wonderful business computer tools now available, more entrepreneurs make do without fancy rental office than ever before. But not everyone who works at home qualifies for a home office deduction. A Florida accountant learned that the hard way in Tax Court recently.

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

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

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

  • The space you deduct must be used (1) regularly AND (2) exclusively for business. A bedroom or part of bedroom that you don't use for anything else might be deductible, but not a bathroom that's also used for personal reasons. (I'm still trying to figure out how a home bathroom could have a business purpose.)
  • You can deduct the percentage of the space compared to your home's total living space.
  • You can deduct direct expenses related to the home office, like a separate phone line.
  • You can also deduct indirect expenses, like roof repairs, using the percentage.

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

- Joe Kristan

Flickr image by dfwcre8tive2009 under Creative Commons license.

What should I do about my capital losses?

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

20110816iabiz The tax law is not very friendly to stock market losses.  Most of us can only deduct our capital losses to the extent of our capital gains, plus $3,000.  Capital losses carry forward as long as you live, usable to the extent of future capital gains; if you have none, you at least get the $3,000. Long-term gains can offset short-term losses, and vice-versa.

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

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

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

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

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

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

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

- Joe Kristan

Flickr image courtesy donjd2 under Creative Commons license.

 

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

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

20110731iabiz It's not so easy. 

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

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

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

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

IRS Publication 463 explains what the rules really are:

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

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

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

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

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

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

20110716iabiz Be careful. A depression-era relic in the tax law could bite you.

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

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

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

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

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

Flickr image courtesy SheriW under Creative Commons license.

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. 

20110701biz 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.

20110616iabiz 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.

20110601iabiz 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.

20110516-1IABIZThe 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?

Iowa State Capitol in Des Moines, Iowa, after ...Image via Wikipedia

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.

20110416iabiz 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?

20110401iabiz

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.

IABIZ 20110316 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.

Iowa State Capitol in Des Moines, Iowa, after ...Image via Wikipedia

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.

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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 Treas_logo 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.

EFTPS 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

20110116-1bizCongress 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.

20110101ibizYou 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

20101216-1 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. 20101201iabiz

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?

Deep down inside we all love math T-shirtImage by Network Osaka via Flickr

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

The famous Witch Tree at Pescadero Point, Pebb...Image via Wikipedia

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

20101016IBAs "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

20101001BIZ 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.

Seal of the United States Internal Revenue Ser...Image via Wikipedia

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.

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Your tax refund may vanish in two weeks

Twas the night before...(Explored)Image by Insight Imaging: John A Ryan Photography (Having a via Flickr

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.

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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.

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Shareholders held hostage

US Supreme Court building, front elevation, st...Image via Wikipedia

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.

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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. 

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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. 

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Iowa's 10-year business sale tax break

Typical Iowa Farm, Muscatine County, Iowa.Image via Wikipedia

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.

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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.

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Extend or Amend?

96227200 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.

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Expense reimbursements or income?

Young Abraham LincolnImage via Wikipedia

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.

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Income taxes matter even when you lose money

Income taxImage by alancleaver_2000 via Flickr

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.


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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.

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