Tax relief in Iowa -- what will that mean?

Joe Kristan is a founding member of Roth & Company P.C.
Big changes in Iowa tax are suddenly likely next year as a result of the election of a Republican Iowa Senate. Now that tax changes can pass without bipartisan agreement, the incoming Senate majority leader, Bill Dix of Shell Rock, promises "tax relief" legislation in the coming Iowa General Assembly session.

One approach to tax relief is a tax cut. While the new Legislature might like to cut taxes all around, they probably need to cut spending to do so. Under current revenue projections, the state isn't expected to be collecting much revenue that it won't be spending right away. Spending cuts are hard (though if I were king, I'm sure I'd find some), so straight-up tax cuts are hard.

Fortunately, reducing tax revenue isn't the only way to relieve burdens caused by the tax law. A simple tax system with low rates and a broad base is less burdensome than one with high rates and complex special breaks for the well-advised and well-lobbied. The Legislature could provide tax relief by improving the tax system itself.

Iowa taxes need fixing. Iowa's business tax system consistently rates poorly in the Tax Foundation's State Business Tax Climate Index. We have the highest corporation tax rate in the nation, and our individual income tax rate is no bargain, either. Meanwhile, the tax base is hollowed out by special-interest tax breaks and economic development incentives. That makes the system inefficient and costly to comply with. It also means similar taxpayers can end up with wildly different tax burdens.

The Legislature has a road map pointing the way to a better system. Earlier this year the Tax Foundation released "Iowa Tax Reform Options: Building a Tax System for the 21st Century." It is the result of extensive research into the Iowa tax system and dozens of interviews with Iowa taxpayers and tax policy figures. It provides a menu of tax policy options that would give Iowa a better tax system without reducing state revenues. 

My favorite set of proposals from the "Iowa Tax Reform Options" study is its "Option A":

· A 5.15 percent flat individual income tax made possible by the repeal of federal deductibility and business tax credits, which also has the effect of eliminating the marriage penalty. 

· The retention of the current standard deduction of $1,970 and the $40 personal exemption credit.

· The repeal of both individual and corporate alternative minimum taxes. These add much complexity to Iowa's tax law while collecting little revenue.

· A 6.5 percent flat corporate income tax with the repeal of federal deductibility and all business tax credits. 

· The restoration of a three-year net operating loss carryback.

· The exclusion of business inputs from the sales tax base.

· The repeal of the inheritance tax.

This would be a tremendous improvement over the current system. We now have an 8.98 percent federal top individual rate and a highest-in-the-nation 12 percent corporate tax rate. Option A would reduce rates, lower compliance costs and retain popular breaks such as the Section 179 deduction and the earned income credit. It would also raise as much revenue as the current system.

What about Kansas? Some commentators fear tax relief efforts because Kansas botched its tax reforms a few years ago. That state still is struggling to balance its budget because of an ill-considered tax cut package.

Fortunately, there are better examples. North Carolina recently enacted tax reforms largely informed by Tax Foundation analysis. The reforms improved the state's ranking in the Business Tax Climate Index by 28 places, to 16th place. The state's financial health has also improved, with cash reserves higher now than before the reforms were enacted.

Tax relief is hard when you can't get by with less revenue. Fortunately, the Legislature can reduce tax burdens and make Iowa a better place in which to do business while keeping the state financially sound.

What we can learn from a fallen Tax Court judge

Joe Kristan is a founding member of Roth & Company P.C.

Taxcourt-entrance-300x225You might think a Tax Court judge, of all people, would know not to commit tax crimes -- and would know how to get away with it if she did. That's why tax professionals are agog that former Tax Court Judge Diane Kroupa has pleaded guilty to tax evasion. 

It's almost disappointing how pedestrian her tax crimes are. No offshore cash stashes, no mysterious shell corporations. Along with her husband, with whom she filed joint returns, Judge Kroupa took personal expenses as business deductions.

You can't do that. There is a lot of magical thinking about the power of a business tax return to allow you to deduct personal expenses. You could argue that the multilevel marketing industry thrives on this thinking. But it only works if the IRS doesn't notice it. Judge Kroupa learned what happens when they do.

When you have an unincorporated, wholly owned business, you report the tax consequences on Schedule C, Profit or Loss From Business. Any resulting income -- or loss -- is reported on your Form 1040.

The temptation arises to call everything you spend a business expense. After all, any income you have on the Schedule C starts out with a 15.3 percent self-employment tax. If you have a six-figure joint income, the regular tax on top of that starts out at 25 percent -- and that doesn't even include state taxes, which hit 8.98 percent in Iowa and 7.85 percent in Judge Kroupa's Minnesota.

Deductions gone wild. It's good to take deductions, as long as you know where to stop. It's easy to identify real business expenses -- say, a law license, or office supplies. But then you get into gray areas -- and suddenly gray is the new orange.

Judge Kroupa's husband, Robert Fackler, had a political consulting business that he reported on Schedule C on the couple's joint returns. The couple had a rather expansive view of what constituted "business" expenses, as laid out in the plea agreement:

KROUPA and Fackler fraudulently claimed the following personal expenses as Schedule C business expenses associated with the operation of Grassroots Consulting:

a. Various personal expenses associated with the Easton Residence including rent, utilities, Internet/cable service, garbage removal, and household cleaning;

b. Various personal expenses associated with the Plymouth Residence including household cleaning, bathroom remodeling, new windows, interior design fees, home repair, decorating, house painting, landscaping, plumbing repairs, washer/dryer, dishwasher, garbage removal, and Internet/cable service;

c. Personal expenses incurred for use of furniture to “stage” the Plymouth Residence when the defendants attempted to sell the house;

d. Limousine and taxi fees for travel by KROUPA for Tax Court business; and

e. Other personal expenses ...

The "other personal expenses" included Pilates classes, spa fees, jewelry and clothes. Oh, and vacations to Hawaii, Greece, China, Mexico, and Thailand. And music lessons, family photos, groceries ...

Encouraging the others. The IRS likes to publicize cases like this as a form of instruction -- sort of like the horrible car wreck movies they used to show in drivers-ed classes. But what are we to learn from the wreckage of a once-distinguished career? I can suggest a few things:

  • Not everything is deductible. Sometimes a busy entrepreneur will say, "I'm always on duty, so all my expenses are business expenses." It doesn't really work that way, despite books that invite the gullible to "deduct everything." 
  • A vacation doesn't become a business expense just because you have a business. There are times you can mix business with pleasure. If you are traveling for a business conference to Hawaii, you can also turn the trip into a vacation. But that doesn't make business expenses of your family's airfare to Oahu, or of your hotel expenses after the conference ends. And don't even think of appointing everyone in your family to your "board of directors" and calling the whole family vacation a deductible "directors' meeting." As I said, the IRS wasn't born yesterday.
  • The IRS looks for this stuff. There's nothing in this case that the IRS hasn't seen hundreds of times. The income tax is over 100 years old, giving the IRS plenty of time to figure out how to look for this sort of cheating. IRS business return examination programs have standard procedures to look for personal expenses run through the business, and they are pretty good at finding them.

By all means, deduct all of your real business expenses. A few expenses might be close calls. But not the trips to the day spa. 

I drove all my business miles backward that year!

20160907-1- Joe Kristan is a founding member of Roth & Company P.C.

Remember how well those excuses we told our parents and teachers worked? They don't work any better when you use them for your taxes. 

The Tax Court judges have heard them all. Some of my favorites:

My wife kicked me out of the house, so I didn't report my S corporation income.

My house flooded. Three times.

My father-in-law made me do it.

All these excuses are fun to read, but a lot less fun to try to make to an IRS agent or a judge with a straight face. It's always better to not need an excuse. Keeping thorough records for your business is a great place to start, and keeping a secure backup copy somewhere is better. You need to keep those records long enough to get through all IRS exams. While the IRS usually can only go after you for three tax years, sometimes they get six, so keep your tax records for seven years.

Good recordkeeping is even more important if you have travel and entertainment expenses. While the tax law allows judges to estimate business expenses if they have some basis for doing so (don't count on this), this doesn't go for meals, entertainment and travel deductions. You have to maintain timely records that include the time, place, amount and business purpose of these expenses, and you have to keep your receipts. The records have to be "contemporaneous," meaning you have to keep them as you go. 

All right, fine. That's a hassle. If the IRS comes, I'll do my log then. That works, right? Well it didn't work for a Florida real estate agent, who said she kept track of her miles on a day planer. The Tax Court noted a discrepancy:

... the day planner included an order form which provided a convenient way for the owner to purchase a new day planner for the coming year. In this case, the order form was for the calendar year 2014, a fact that completely undermined [her] testimony that she recorded information in the day planner contemporaneously in 2008.

Maybe some people just like to order their day planners five years ahead.

Another taxpayer, a traveling salesman, showed up in Tax Court with mileage logs that showed some amazing driving habits:

The most serious problem came from discrepancies in his mileage logs. He operated four vehicles during the 2009 tax year: a truck, a 1999 Jeep, a 2002 Acura, and a 2007 Acura. Mr. G claimed at trial that he recorded his daily mileage by writing the starting and ending odometer readings for each trip on a Post-it note. After he recorded the number, he would stick the Post-it note in his Day-Timer. But the mileage log for the 1999 Jeep stated that its odometer read 118,905 miles on January 1, 2009, while a Carfax report on the same vehicle showed an odometer reading of 126,121 in November 2007. Mr. G said that after he had the Jeep’s dashboard replaced there was a “new starting mileage” on the Jeep. But we also spotted a similar problem in the logs for Mr. G’s 2002 Acura: In November 2008 the Acura had an odometer reading of 109,422, but by January 1, 2009, it had run backward to 103,723. This time, Mr. G admitted that he couldn’t account for the discrepancy.

There must have been a mechanical problem. The car was stuck in reverse, and he had to drive it that way until he got it fixed, maybe? Whatever happened, it didn't get the taxpayer out of extra tax and penalties.

If you are a road warrior, keep track of mileage as you go. Write down the miles, who you are visiting, and the reason for the visit in your day planner or a car log. If you want to keep it handy and backed up, use one of the many smartphone apps designed for tracking business mileage. And drive safely!

Airbnb might get you extra cash, but it won't help your income tax bill.

20150810-2Renting your home out when you're away isn't new. An uncle who was an out-of-state high school track coach for years made an annual pilgrimage to Des Moines for the Drake Relays. He always rented the same house South of Grand, and the owner conveniently went to Florida for Relays Week to spend that rent.

What is new are services like Airbnb and that match up travelers and folks willing to rent their home, or maybe a spare bedroom. They makes it easier to earn a little side money out of the most expensive asset most people have.

Such rentals also mean new tax issues for the hosts.

While the tax law may allow real estate operators to deduct losses attributable to their rental properties under the right circumstances, things are different for taxpayers leasing their homes.

A special code Section, Sec. 280A, strictly limits deductions from a "residence." If you rent out a “residence,” you can’t deduct rental losses beyond the amount of rent you receive.

Worse, you have to allocate the property taxes and mortgage interest that you can deduct anyway to the time the property is rented before you can deduct anything else — say, utilities or depreciation. If the amount of interest and taxes allocated to rental exceeds rental income, you’re done — your other expenses aren’t deductible.

What is a "residence," anyway? One California taxpayer logically noted in Tax Court that if he was renting out the whole house while he was away, he certainly was not "residing" there that particular moment, so he wasn't subject to the Sec. 280A limits on residential losses. Nice try, that.

Section 280A(d) has a specific definition of "residence":

(1) In general For purposes of this section, a taxpayer uses a dwelling unit during the taxable year as a residence if he uses such unit (or portion thereof) for personal purposes for a number of days which exceeds the greater of—

(A) 14 days, or

(B) 10 percent of the number of days during such year for which such unit is rented at a fair rental.

For purposes of subparagraph (B), a unit shall not be treated as rented at a fair rental for any day for which it is used for personal purposes. 

So the computation is based on the use for the whole year. If you live in the house at least 10 percent of the number of days you rent it out during the year, or for at least 14 days if that's more than 10 percent of the rental days, it’s your residence, as far as the tax law is concerned. That means it applies to a lot of taxpayers with vacation homes.

Section 280A isn’t all bad news for taxpayers. It also provides that if you rent out a house for less than 15 days during the year, you don’t get to deduct any rental expenses, but you don’t have to include any rent you receive in income either.

Of course, the tax law isn't the only complication for would-be Airbnb hosts. West Des Moines strictly limits the ability of its residents to have paid house guests, and Waukee is considering similarly restrictions. That's too bad, as such restrictions needlessly interfere with the ability of homeowners to defray their ownership costs with rent-paying housesitters.

Does Iowa's deduction for federal taxes prevent tax increases?

-Joe Kristan is a founding member of Roth & Company P.C.

Iowa could lower its high income tax rates significantly with no revenue loss if it traded lower rates for elimination of Iowa's unusual deduction for federal taxes paid. Such a trade-off plays a big part in the recently released Iowa Tax Reform Options prepared by the Tax Foundation for the Iowa Taxpayers Association.

While policy geeks generally favor this trade-off, many taxpayers have doubts. 
A common argument against the trade-off goes something like this: "If we give up the deduction in exchange for lower rates, they'll turn around and raise the rates on us." They see the deduction as a sort of brake against higher rates.

The history of Iowa's income tax tells a different story. In fact, the deduction for federal taxes has allowed Iowa to raise its real tax rates.

The deduction for federal taxes paid obscures the real top tax rate. The deduction for federal taxes lowers the effective Iowa rate, and vice versa. Tax practitioners call the resulting actual rates the "crossed" rates. The current effective crossed Iowa tax rate on each additional dollar earned by a top-bracket taxpayer is about 5.184 percent.

Let's go back to 1975, when Gov. Robert Ray signed an increase in Iowa's top tax rate from 7 percent to 13 percent. At that time the top federal tax rate was 70 percent. When you make the circular crossing computation, taking deductions into account, the top Iowa rate for top federal bracket taxpayers before this increase was 2.208 percent. Afterward, the effective rate went up to 4.29 percent. That's a 94 percent increase in the top tax rate. If the deduction for federal taxes can't brake a near-doubling of the top effective tax rate, it's not a very good brake.


Crossed iowa rates 1971-2016

Chart by the author.

The first round of Reagan tax cuts took the top federal rate down to 50 percent. This made the Iowa deduction for federal taxes worth that much less, so the top effective Iowa rate soared to 6.952 percent. The state government cheerfully pocketed the windfall.

The 1986 federal tax reforms lowered the top federal rate to 28%. At that point, Iowa decided to give its taxpayers some of the windfall back, lowering the top stated rate to 9.98 percent. The real Iowa top marginal rate, though, actually went up to 7.39 percent when the 1986 federal tax reforms took full effect in 1988.

In 1990, the feds started backsliding on the Reagan tax reforms, and the subsequent federal rate increases, combined with the cut in the Iowa top rate to 8.98 percent, has brought the top crossed Iowa rate down to 5.184 percent. While better than its peak 7.39 percent rate, that's still a 284 percent increase over the 1974 effective rate, and a 20 percent increase over the 1975 top rate.

The deduction for federal taxes hasn't prevented increases in the top Iowa effective rate. It just has camouflaged them.

The possible dream of fixing Iowa's business taxes

-Joe Kristan is a founding member of Roth & Company P.C

There's a lot about Iowa for businesses to like. We have a highly-educated workforce, good schools, attractive employment laws, short commutes, good infrastructure, and reasonable housing prices.

Our business tax system, in contrast, is nothing to brag about. Iowa's business tax climate has been consistently ranked near the bottom in the Tax Foundation's Business Tax Climate Index. Iowa has the highest corporation tax rate in the country. Because the U.S. has the highest federal corporation tax rate in the Organization for Economic Cooperation and Development (OECD), that means the combined federal and state corporate tax rate is the highest in the developed world. 2016 corporate tax map

The high rates have motivated industries to carve out their own special breaks, meaning the tax falls on those unlucky businesses without pull or lobbyists -- that is, most of them. Those businesses grow more slowly because they have competitors with lower tax costs. They move to more tax-friendly states, or they never move to Iowa in the first place.

It doesn't have to be this way. The Tax Foundation recently released Iowa Tax Reform Options: Building a Tax System for the 21st Century. As the title implies, it offers a menu of tax reforms to make Iowa's tax system much more fair and business-friendly while still generating the same revenue as the current system.

The report offers ideas for sales tax, property tax, and inheritance taxes, but the income tax provisions are especially exciting. The most ambitious revenue-neutral plans would replace Iowa's current nine bracket individual income structure, with its top rate of 8.98 percent, with a flat 5.15 percent tax. It would replace Iowa's 12 percent corporation tax with a 6.5 percent top rate. It would do so by dumping Iowa's archaic deduction for federal taxes and by repealing the dozens of special interest business tax credits.

There will be opposition. For example, in 2015 just 8 businesses claimed 61.6% of the Research Activities Credit, the largest single business credit, to the tune of $35 million. They will be highly motivated to keep that money.

The report shows just how expensive these breaks are for the rest of us. It shows that if a repeal of special interest tax credits is combined with the end of the corporation 50 percent deduction for federal income taxes, the corporate tax can be a flat 6.5 percent. If the special interest credits are retained,  the revenue-neutral rate can only come down to 9 percent. That's a 38 percent rate increase on everyone to provide special favors for a few.

Iowa Tax Reform Options shows that we can reduce rates and greatly simplify Iowa's business taxes while retaining popular features of the current system. These include the full federal Section 179 deduction for asset purchases, single-factor apportionment of multistate income for C corporation, and Iowa's unique apportionment tax credit for S corporations.

Iowa's tax system can be much better while raising the same amount of revenue. They would improve Iowa's business tax climate from one of the worst to the 10th best. Iowa Tax Reform Options should be the basis for the tax debate in the next General Assembly.

Tax season impasse: why your 2015 Iowa tax return may be on hold

-Joe Kristan is a founding member of Roth & Company P.C

Taxpayers barely averted a national tax filing season disaster this season when Congress and the president agreed in December to permanently extend important tax provisions that had expired at the end of 2014. Now our governor and legislators are doing their best to subject Iowa to the filing season nightmare that the rest of the country dodged.

Coupling20160213Iowa's tax law doesn't automatically tie to federal changes.
The Legislature passes a "code conformity" bill, or "coupling" bill, every year to incorporate desired federal tax changes into Iowa's income tax. This has been important because Congress habitually enacts many important tax provisions for only one or two years at a time. Since 2010 the governor has proposed to adopt all of the federal "expiring provisions" retroactively every time they were renewed by Congress, with the exception of "Bonus Depreciation."

The biggest of these for most Iowa businesses is the "Section 179 deduction," which allows taxpayers to deduct the cost of up to $500,000 of fixed assets that would otherwise be depreciated over a period of years. A number of other business and personal tax provisions are affected, including research credits, the provision for IRA charitable contributions, and the above-the-line student loan interest deduction.  

The Section 179 deduction is popular with Main Street businesses. With the prices for much farm equipment running well into six figures, the deduction is a big deal for farmers, but it is also important to other businesses. Failing to couple with the federal deduction would leave Iowans with a maximum $25,000 Section 179 deduction on their Iowa returns -- a significant tax increase to businesses in every county. 

Most tax people assumed the pattern of conforming to everything but bonus depreciation would continue. The Governor surprised us last month by proposing (SSB 3107) to conform to only one 2015 tax change -- the research credit. He proposed to conform with none of the remaining changes for 2015. He then would conform with all the changes -- except for Section 179 and bonus depreciation -- for 2016 and beyond.

The Governor's position was unpopular in the General Assembly. The Iowa House swiftly voted 82-14 to couple with all federal 2015 changes except bonus depreciation (HF 2092). It apparently was so unpopular that the Governor this week changed his mind and came out in favor of the House bill.

Senate Majority Leader Gronstal now holds the cards, as he can keep the House-passed bill from ever coming up for a Senate vote. The Legislature is now at an impasse. Prior to the Governor's change of heart, it appeared that no Section 179 coupling would occur. Now we can expect Senator Gronstal to use coupling as a bargaining chip for his priorities.

It's unclear when we will know what Iowa's 2015 tax law is. Iowa returns aren't due until April 30, and it’s still possible that they won't pass a coupling bill by then. The default result if nothing happens is no coupling. While I expect coupling to occur, it may take some time for the poker game to play out.

This poses a dilemma for taxpayers. If they assume that that the expiring provisions won't be re-enacted for Iowa, they'll incur the expense of filing amended returns to claim refunds if the governor and the majority leader eventually go along with the legislature. If optimistic taxpayers assume the extenders are eventually adopted, they face penalties if they guess wrong.  Iowans wanting to file their taxes the right way, for sure, are just out of luck. 

Tax credits for a few vs. business deductions for everyone


-Joe Kristan is a founding member of Roth & Company P.C

Every targeted tax break is a choice to favor one business or economic activity over another. Most years, that choice is hidden in the budget process. Not this time.

This year the General Assembly can choose between two tax policy approaches. The choices:

  1. A provision to allow all profitable businesses in the state to deduct currently their costs of purchasing machinery and equipment, up to a generous limit -- one identical to a provision in the federal tax law. It is used widely by farmers and small businesses, benefiting thousands of filers.
  1. A series of provisions -- some new, but most at least a few years old -- that provide tax credits to selected businesses and industries who convince the General Assembly that they deserve special treatment - and regardless of whether they actually have taxes to pay.

As things stand now, the Iowa General Assembly seems likely to choose the second option. And that says a lot about how poorly the Iowa business income tax system treats smaller businesses.

Option 1 is the "Section 179 deduction." The federal tax bill, passed in December, makes permanent the $500,000 annual limit on the deduction, which allows taxpayers to take a current deduction in the year machinery and equipment is first used; otherwise, the deduction is spread over a period of years through depreciation deductions. This limit has been at $500,000 for several years on a temporary basis, and Iowa has allowed the same deduction since 2010.

The $500,000 limit has been popular. It is available regardless of whether your business is bio-chemical, renewable fuels, films, or another economic development flavor-of-the-month. It’s simple to administer – you just use the number you claim on your federal return.

Governor Branstad recently told Iowa business leaders that the state can't afford to renew the $500,000 amount. Instead, the deduction will be limited to $25,000 per year in 2015 and future years. This tax increase could net the state somewhere around $90 million in additional revenue in any given year. Because it is a matter of timing, it is close to revenue neutral over a five-year period.

Option 2 is to expend the millions of dollars of tax credits in the budget targeted to promote specific industries, lure businesses, or favor certain investments. For example, the budget includes a new credit for "Renewable Bio-Chemical production." While the number of taxpayers who would receive this credit is unknown, it's safe to say that it is a tiny fraction of those who benefit from the $500,000 Section 179 limit. It's possible that fewer than 100 Iowa businesses will qualify for the new credit.

The budget also continues to fund a refundable research credit, which operates as a $40 million cash grant program to some of Iowa's largest businesses. It funds another $37.4 million renewable fuel and bio-fuel credits, and $20.1 million in sales tax refunds to big businesses lured to Iowa by the economic development bureau. Altogether, the budget provides around $277 million in tax credits to lure new businesses or to subsidize business behavior the state has deemed worthy of special favors. These credits are permanent; they generate no offsetting revenue in future years.

Might these special favors be better for the economy than some farmer or small business who buys a new tractor or machine? You could make that case, but it would be plausible only if these favors were enacted by a process where the state looked at the vast menu of possible industries to support and carefully evaluated which ones were more persuasive. That never happens. Instead, the credits follow the path of the notorious Iowa film industry credits, where an industry gets some legislators and business boosters excited and builds support -- sometimes with "studies" funded by booster groups. There is no evaluation of the opportunity costs, of whether the funds would be better used elsewhere.

Boosters of these favors will remind us of what wonderful employers the recipients of these special favors are. While that may be true, the employers in every county who stand to lose their Section 179 deduction are wonderful too -- and in this budget, they (and their employees, suppliers and customers) pay for the special favors. They may not feel that they're less important than the industries favored with tax credits. There are a lot more of them. Whether their numbers will enable them to prevent having their taxes increased remains to be seen.

Joe Kristan wrote this piece. He speaks only for himself, not for his firm, colleagues or clients.

Forget April 15. Well, don't, actually, but Dec. 31 matters more.

Drinkbus-Joe Kristan is a founding member of Roth & Company P.C

A bibulous friend told me long ago that New Years Day is for amateurs. The real drinkers' holiday is St. Patrick's Day. In the same way (well, not really, but bear with me), tax dilettantes focus on April 15, when Dec. 31 is where the real action is. You can do big things up through year-end. After that, it's mostly scorekeeping.

Let's assume you have a pretty good handle on where you stand tax-wise with your business income. If you don't, figure it out and come right back, we'll still be here. OK, good. Here are some things that have to be done this year to make a difference on your 2015 calendar-year tax return.

Are your new fixed assets "placed in service?" Congress has finally enacted the $500,000 maximum "Section 179" allowance permanently, effective for 2015. Section 179 lets you deduct the cost of qualified assets right away, rather than depreciating them over a period of years. They also have renewed "bonus depreciation" for 2015 through 2019. But these tax breaks only work when an asset is "placed in service" during the year. That means the asset is on the premises and ready to use. "Bought and paid for" isn't enough.

Many vehicle dealers are touting the purchase of a new car as a tax saver. That's fine, but you have to take delivery, and remember that there are restrictions on Section 179 and bonus depreciation for business vehicles.

Full-featured qualified pension or profit sharing plans have to be in place by the end of 2015 to accept deductible 2015 contributions. Yet if the plan is in place, the funding can wait until the due date of your 2015 return, including any extensions.

Expenses to related parties have to be paid by Dec. 31 to generate a deduction. For example, a law firm that is trying to bonus out its taxable income to its sole owner by the end of 2015 has to have the cash in the owner's hands by Dec. 31. And don't do something cute like loaning the money back to the company before the check clears, or endorsing the year-end bonus check back to the company without cashing it. That will go badly.

Sales of stock have to be made by Dec. 31. With exceptions that probably don't apply to you, sales of publicly-traded stocks are counted on the trade date, even if they settle after year-end. If you have recognized capital gains in 2015, you can sell loss shares as late as Dec. 31 and offset the gains. Long-term losses can offset short-term gains, and vice-versa. Naturally there are some catches -- you can't buy back the loss shares within 30 days before or after the sale, and you have to use a taxable account (rather than, say, a retirement account). And this doesn't work for short sales; they have to be settled to count.

You have to have basis in your S corporation at year-end to deduct losses that the S corporation generates. And don't even think of funding your S corporation on Dec. 31 to take losses and then pulling the money out the next day.

Take a credit card mulligan. Payments by credit cards are the same as cash, even if you don't pay your credit card balance until next year. Same goes with other deductible expenses financed by third-party debt.

As always, consult your tax pro to see how these ideas apply to you before you pull the trigger. There are limits -- for example, you can't buy 10 years worth of office supplies and expect to deduct it all this year. If it seems too good to be true, it probably is.

It's asking a lot of the last few days of the tax year to solve all of your tax problems, but there's a lot more you can do now than you will be able to do in April.


Estimated tax payments: who needs to file quarterly.


-Joe Kristan is a founding member of Roth & Company P.C

When you leave the nest to start your own business, you leave behind the safe world of payroll withholding. No longer will your taxes magically disappear from your paycheck, only to show up when you file your tax return to get back some of that money the IRS has been sitting on for you (with no interest, thank you very much). Whether you are making your way in the sharing economy or starting a business where some or all of your income is reported on a Schedule C or a K-1, you have to satisfy the tax man without it all coming out of your paycheck.

But how? And what happens to me if I don’t pay estimated taxes?

Let’s start with the penalties. The tax law imposes a penalty for each quarter in which your taxes paid in -- taking into account both wage withholding and estimated tax payments -- fall short. The penalty is best understood at a non-deductible interest charge on the underpayment (no, they don’t pay interest if you pay in too much). The interest rate used is currently 3 percent, but it changes quarterly based on prevailing interest rates. So a taxpayer who is short $10,000 for a quarter, but makes it up in the next quarter, will pay $10,000 x 3 percent / 4, or $75, as a non-deductible penalty.

The penalty is assessed when you file your 1040 for the year in which the payments were due.

How do I pay? Most taxpayers use the old-fashioned paper quarterly vouchers, Form 1040-ES, but more taxpayers are using electronic means. Individuals can sign up for EFTPS, the Electronic Federal Tax Payment System, or through IRS Direct Pay.. Iowa offers similar options. And, of course, payroll withholding also counts.

How much is enough? The easiest way to avoid an underpayment penalty is to base it on your prior year tax. If your four equal quarterly payments this year add up to at least as much as your computed tax from last year, your have no penalty. If you had adjusted gross income of at least $150,000 last year, the safe harbor is 110 percent of last year’s tax, instead of 100 percent.

Paying in based on last year sometimes isn’t a great idea. If you had a great year last year, but this year isn’t so hot, paying quarterly tax estimates based on last year's income might hurt. So if equal quarterly tax payments this year, plus withholding, equal at least 90 percent of the taxes computed when you file your tax return next April, you are OK, and you pay any shortfall on April 15 without penalty.

Business income can be volatile. If you keep good books, you can go quarter-by-quarter on your income. The formula can be a bit complicated, but the idea is simple enough: if you have a poor first quarter but a good second quarter, you pay the first quarter tax based on the poor first quarter and catch up without penalty in the second quarter.

When are quarterly payments due? The first quarter payment is due at the same time as your prior-year 1040, on April 15. Remaining installments are due June 15, Sept. 1, with the final payment due Jan. 15 of the next year. Iowa due dates are in the same months, but at month-end. Taxpayers often prepay the fourth installment in December to move up deductions for the payments to the prior tax year, but that’s something to discuss with your tax pro; if you are subject to alternative minimum tax, prepaying state taxes may do no good.

One weird trick! for taxpayers who realize they are behind on their estimates. Withholding taxes are considered to be paid pro-rata throughout the year. Taxpayers can boost their withholding for the last few paychecks of the year by giving their employers a new W-4. It also works with year-end bonus payments made during the year. It can work well for S corporation owners who draw a paycheck in addition to their K-1, and for married couples with one entrepreneur and one person earning a traditional paycheck. But don’t overdo it; if you try to pay in all of your taxes with one year-end withholding payment, you might get unwanted attention from the tax man. Hogs get slaughtered.

Remember states. Every state with an income tax has rules that are similar, but not always identical, to the IRS rules.

Corporations that pay their own taxes follow a different set of rules, and the rules for payment of payroll taxes are entirely different.

Work with your tax pro. Computing taxable income can be difficult, especially if your tax life is complicated. That’s why tax pros exist in the first place. Good records and a good tax professional can help you avoid underpayment penalties without letting the tax man use more of your hard-earned money than you have to.

How your calendar might help you beat the IRS.

Ulmclock-Joe Kristan is a founding member of Roth & Company P.C.


Professionals who charge by the hour are used to keeping track of how they spend their workdays. The tax law is making time-trackers of the rest of us. And tracking time made a five-figure difference in the tax life of a Brooklyn apartment owner who recently beat the IRS in Tax Court.


The “passive activity” rules (IRS offers free oxymorons, no extra charge) have made it worthwhile for taxpayers to keep track of hours worked since they were enacted in 1986. If your business income and loss is reported on your 1040, these rules apply to you. It matters for sole proprietorships reported on schedule C, partnerships and S corporation income reported on schedule E, and farm income reported on schedule F.


The rules keep you from deducting a loss when you are a “passive” investor in the “activity.” If your “passive losses” exceed your “passive income” for a year, you can’t deduct the net loss;  the disallowed loss carries forward until you either generate passive income, or until you sell the activity in a taxable sale.


For the most part, whether you are “passive” depends on how much time you spend on an activity. You have to meet one of these tests:


  • 500 hours worked in the activity in a tax year.

  • 100-500 hours worked in the activity in a tax year, and when combined with other 100-500 hour activities, you get over 500 hours. This is for people running multiple businesses.

  • Over 100 hours, and more than anyone else.

  • Substantially all of the activity in the business.

  • You have met one of the hours tests in five of the prior 10 years.


If you rent real estate, you also must prove that you are a “real estate professional" before you can deduct rental losses. It’s a test that’s hard to meet for taxpayers who aren’t involved in the real estate industry.


If you have a business loss in a year, these tests become a big deal. They might eliminate your taxes on your other income, or even give you a tax loss that you can carry back to prior years for a refund.


The IRS can be distrustful of taxpayers claiming losses, and they may ask you to prove your time spent. You aren’t required to keep a time sheet, but then you have to prove your involvement by other means. That may be easy if you have a full-time business you show up at and run, but it is harder for part-time side businesses. The best way is to keep a calendar of your time.


A Brooklyn, New York man with a full-time real estate job (a real estate professional) had to prove the IRS that he wasn’t passive in managing the two apartments above his home. Fortunately, he did keep a calendar of his time, and the Tax Court ruled that he showed that he spent over 500 hours managing his business. the record keeping saved the taxpayer $25,174.60 in taxes and penalties that the Tax Court overturned.


Many other taxpayers who weren’t so careful have lost their deductions, sometimes into six figures. And don’t count on preparing a time log retroactively if the IRS ever comes calling. The results can be embarassing.


So when it comes to your business losses, time really is money. Keep track of it. And get your tax professional involved to make sure your recordkeeping and reporting will get you through an IRS exam.

Chasing the Tax Fairy

-Joe Kristan is a founding member of Roth & Company P.C.

There is no Tax Fairy, but there are many believers. 

Tax-fairyTaxes hurt. It's human nature to want to believe in something that stops the pain. That's why clients regularly ask their tax pros why they haven't recommended some foolproof plan discovered at the gym, or on the golf course, or on Reddit. They really want their tax pros to introduce them to the Tax Fairy.

Belief in the Tax Fairy takes many forms. Let's cover some commonly-told Tax Fairy tales.

The ESOP Tax Fairy. Employee Stock Ownership Plans, done properly, can be a useful tax tool, though one with compliance risks and costs. But it isn't a Tax Fairy. You can't use an ESOP to hide all of the income of a profitable family-owned business and still keep the business all in the family. You certainly can't use an ESOP if for a business that isn't a corporation. You can't keep your personal investments in an ESOP. Nor can you keep your house, your cars, your snowmobiles, or your vacation cottage in an ESOP. If you are doing any of these things, you're looking for the Tax Fairy in the wrong place, and you need to talk to a specialist practitioner right away.

The Home-based Business Tax Fairy. We've all seen versions of this. My favorite was one from the 1990s based on selling golf equipment. It was touted as making all of one's golf costs -- tee times, new clubs, trips to nice courses in warm places -- tax deductible. Because you were in the golf business! It didn't much matter whether you made a profit from selling golf things, because the tax savings from your golf deductions made it pay.

In real life the tax authorities don't look at it that way. The tax law requires you to have an objective of making money before taxes. Deductions that look too much like fun come in for special scrutiny. If the tax man determines you aren't really in it for a pre-tax profit, there go your deductions, and here come penalties and interest. Whether it's golf gear, vitamins, or household cleaners, Uncle Sam doesn't want your tax refund to be your business plan. 

The Pennies-on-the-Dollar Tax Fairy. This particular Tax Fairy cult singlehandedly supported dozens of talk-radio shows and late-night TV reruns in the past decade. Celebrity tax practitioners promised to reduce your IRS debt to "pennies on the dollar." But despite the ads' promises and the up-front payments made by desperate or deluded tax debtors, the Tax Fairy never showed up. Big settlement firms like TaxMasters, Roni Deutch, and J.K. Harris collapsed in bankruptcy, and the only "pennies-on-the-dollar" settlements many customers received were their bankruptcy recoveries on fees paid to the settlement outfits. In real life, "pennies-on-the-dollar" settlements happen, but only when you convince the IRS that you really are too broke to pay what you owe. Whatever it accomplishes in reducing your tax debt, poverty has compelling non-tax drawbacks.

The "Classic 105" Tax Fairy. This apparition of the fairy emerges from the mists of fringe benefit law. Hank Stern of Insureblog saw it described this way:

My employer claims that signing up for this "105 Classic Plan" will allow me to make 30%+ of my income tax free. The jist [sic] of it is that they will take $560 per (bi-weekly) pay period out of my check, somehow "make it tax free" and refund most of it back through some vague "loan" that I apparently don't have to pay back.

This will reduce my income taxes pretty massively... but not only that, the company making my money untaxable claims it will pay 75% of all my out of pocket medical expenses up to $12,000

So: some employer really believes you can call part of what you pay to your employees a "loan," with no requirement to repay it, and therefore make it tax-free to the employee, while still getting a deduction? Rather than getting into the (many) technical reasons this doesn't work, let's just use common sense. The income tax has been around since 1913, and it funds the majority of a trillion-dollar federal budget. Do you think it would still work after over 100 years if it were this easy to avoid? Do you think they would wait 102 years to fix a loophole this big?

The Tax Fairy appears in multitudes of ways. We won't even talk about the VEBA Tax Fairy, The offshore employee leasing Tax Fairy, or the great Turn-of-the-century Tax Fairy Mania. But most versions of the Tax Fairy myth contain a few common elements. They promise an easy way to make your taxes go away. They tell you that your regular tax pro is a milquetoast or a charlatan for not embracing their wonderful tax-saving qualities. And if they ever get looked at by the IRS, they all fail.

If someone tells you that they have found the Tax Fairy, check with your tax pro. In the long run, it's a better bet than the Tax Fairy.

Who should own the bricks?

IMG_1218-Joe Kristan is a founding member of Roth & Company P.C.

So the business is up and running, and you've decided you want to move into permanent space. After careful thought (considering the points discussed here), you've decided to buy the building that houses your business.

Who should own it?

The right answer needs to consider your tax structure and your estate and family planning.

Many older businesses are set up with the business owner having personal title to the real estate and renting it to the business. This remains a useful tactic:

- It gives C corporation owners a way to get cash out of their businesses without incurring taxable dividends. C corporation earnings are normally taxed twice - once on the corporate tax return as it is earned, and again as dividends when distributed.

- A variation of this can help with estate planning. The building is purchased by the next generation on a mortgage and leased to the business. The lease funds the debt service, and the equity buildup goes to the next generation. This can be an efficient estate planning tool.

- It can make it easier to sell your business. A buyer may not want the real estate, for any number of reasons. Getting appreciated real estate out of a business can be a tax nightmare. Closing a business sale is hard enough without complicating it with unwanted assets.

- Iowa's tax rules enable a tax-free sale of business real estate if it has been used in a business in which the taxpayer has "materially participated" for ten years -- if the land has also been held for ten years. A similar exclusion is also available if all of the assets of a business are sold, but that break doesn't apply to sales of part of a business, or to sales of corporate stock or partnership interests. Where the business sale has to be a stock deal, owning the real estate separately can allow at least part of the deal to avoid Iowa tax.

Reading between the lines, you may have deduced that owning real estate in a corporation can be awkward. If you already own real estate inside a corporation, it is probably best to leave it there. If you are acquiring new real estate, though, it is usually best to own it individually or in a partnership (including LLCs).

If your business itself is in a partnership format, including an LLC, it matters less who owns the real estate. It is much easier to shuffle assets into and out of a partnership without incurring tax than it is with a corporation (but not so easy that you should try it without tax advice).

Of course every situation is different. If you have co-owners of your business, ownership of real estate can become a sore point. You have to set a fair rent to keep co-owners and the IRS happy. Your lenders may have something to say about your decision. And you can't let the tax tail wag the business dog. Be sure to work closely with your tax and legal advisers before you commit to anything.

How states try to tax the visiting employee

When you get a good order from an out-of-state customer, you do what you need to do to make that customer happy. If that means you send employees to the customer location to make sure the customer is happy, off they go.

And that state wants your employees to pay taxes there.

IMG_1390It may seem ridiculous, but states can tax visiting employees who spend as little as a day there. Not all states do, but some states are very aggressive about taxing their business visitors. They don't vote, after all. And the states can also collect penalties from employers who fail to file payroll tax returns.

Many large employers are on top of this, issuing W-2s in the states their employees visit.

Smaller employers, lacking large HR departments, are sometimes less careful, taking their chances that their cross-border employee visits will go unnoticed.

This is becoming a riskier bet. As they get better at data-mining, states are getting better at identifying visitors.

It's not just temporary visits that can cause state tax hassles. Telecommuting brings its own set of complications for employers. Cara Griffith of Tax Analysts explains:

Employers may also forget that telecommuting can present significant issues for withholding. That is because the default is for employers to withhold income tax for the state in which an employee performs services. However, an employee may telecommute from State A but report to State B. In most instances, the employer will have to withhold from State A because that is where the services are performed. Various state rules, such as those in New York, have complicated the issues surrounding telecommuting.

If an employer fails to withhold and remit state payroll taxes, the penalties can add up. The "Mobile Workforce State Income Tax Fairness and Simplification Act" (S.386) would only allow states to tax traveling employees who spend more than 30 days in-state. It has been blocked by some states -- New York in particular -- that love to pick visitors' pockets.

Until something like this passes, employers need to monitor their employee travels and their telecommuters. They just may need to file state payroll returns in other states.

Contact your tax professional to learn more.

An obscure tax deadline that could cost you big

Joe Kristan is a founding member of Roth & Company P.C.

You're finished with your returns and extensions. No more deadlines until next year…


If you or your business has anything going on across the border, a big deadline looms.

Taxpayers with "foreign financial accounts” have a June 30 deadline to report the accounts on a so-called “FBAR” filing, on pain of severe fines.

And it’s not just owners – you have this filing requirement even if you only have signing authority – for example, on a business account where you work. 

This requirement applies both to U.S. residents and U.S. citizens and legal residents abroad. For example, an Iowan who opens a local bank account while on a posting overseas for paycheck direct deposit may find themselves with a filing requirement.

FBAR filings are required when a taxpayer has an interest in a foreign financial account with a value of $10,000 US or more at any time during the year. Financial accounts include bank accounts and brokerage accounts. They also include some things you might not expect – for example, retirement accounts in foreign countries and accounts at gaming web sites located offshore.

Not everything foreign is a foreign financial account requiring FBAR filing.

A U.S. brokerage account that owns foreign stocks doesn’t trigger the FBAR requirement. Nor does ownership of a U.S. mutual fund that invests in foreign stocks or bonds. And direct ownership of a foreign corporation, partnership or loan is not a financial account -- though such assets could trigger other IRS reporting requirements.

The FBAR report is filed on Form 114; this form can only be filed electronically.

The FBAR requirement has surprised many taxpayers over the years, and the IRS can assess penalties of up to 50% of the account balance for each year of willful failure to file. The severity of the penalties and the obscurity of these rules has led the Treasury to implement programs to allow non-filers to come in from the cold.

The success of these has been mixed, as the IRS agents sometimes fail to distinguish between an honest ignorance of the rules and tax evasion.

Still, for most taxpayers who have relatively small account balances and who have no tax liabilities, the process of catching up on filing has become relatively painless.

To learn more about the FBAR requirements, visit this IRS foreign asset disclosure page.  To learn more about the IRS relief programs, the “FAQ” on the Offshore Voluntary Disclosure Initiative is a good place to start.

If you think you may have back filings that need to be caught up, or if you have more questions, consult your tax advisor.

What an Iowa income tax might look like with a fresh start.

We've talked about why Iowa's tax law is bad for business, and about some easy fixes to make it a little better. But let's dream bigger. What would Iowa's tax law look like if you could start over from scratch?

If Iowa's income tax were a car, it would look like this.

I would start with the Tax Foundation's Principles of Sound Tax Policy, including

Simplicity: Administrative costs are a loss to society, and complicated taxation undermines voluntary compliance by creating incentives to shelter and disguise income.
Neutrality: Taxes should not encourage or discourage certain economic decisions. The purpose of taxes is to raise needed revenue, not to favor or punish specific industries, activities, and products.
Broad Bases and Low Rates: As a corollary to the principle of neutrality, lawmakers should avoid enacting targeted deductions, credits, and exclusions. If tax preferences are kept to a minimum, substantial revenue can be raised with low tax rates. Broad-based taxes also produce relatively stable tax revenues from year to year.
I would add:
Business income should be taxed only once, unless avoiding double taxation does violence to simplicity, neutrality, and broad bases with low rates. 
A system designed from scratch would apply the ultimate simplification to Iowa's corporation income tax: it wouldn't have one. Iowa's corporation income tax is rated the very worst, with extreme complexity and the highest rate of any state. 
Eliminating the corporation income tax would eliminate the justification for almost all of the various state incentive tax credits, all of which violate the principles of neutrality and simplicity in the first place. For its astronomical rates and complexity, it generates a paltry portion of the state's revenue, typically 4-7 percent of state receipts.
For S corporations, a from-the-ground-up tax reform might tax Iowa resident shareholders only on the greater of distributions of S corporation income, or interest, dividends, and other investment income earned by the S corporations. The investment income provision would prevent the use of an S corporation as a tax-deferred investment. The effect would be to put S corporations on about the same footing as C corporations.
The Individual Income Tax couldn't be eliminated without radically restructuring both state spending and other state taxes, but it can be made much better.
I would start by basing the individual tax base on adjusted gross income -- taxable income before personal exemptions and itemized deductions. That would put non-itemizers on the same footing as itemizers.  I would allow only deductions for gambling losses, non-employee business expenses deductible on federal returns, and investment interest expense, to prevent grossly unfair anomalies that would otherwise result. That's it.
It would eliminate all other deductions and credits and put the savings into lowering rates. The Iowa 1040 would then just take federal adjusted gross income, with a few lines for deducting Treasury interest and the some other minor adjustments.
There would be no alternative minimum tax. There would be a generous exemption for low-income earners. If the new system keeps an earned income tax credit, the exemption would be high enough to keep taxpayers in the "phase out range" of the credit from paying income tax on top of their credit loss. If there were an earned-income credit, there would be no other credits except for taxes paid in other states and countries.
There would be no deduction for federal taxes. This deduction would be built into lower rates. Iowa is almost unique in allowing a deduction for federal taxes, and it makes Iowa's income tax look worse to outsiders than it really is. It is the opposite of simplification.
Put all of these things together, and you should be able to get Iowa's individual rate under 5% -- perhaps close to 4% -- without reducing individual tax collections.
0% corporate rate, sub-5% individual rate -- now that's a lot easier sell to a business pondering an Iowa location than a 12% corporation rate, 8.98% individual rate, and the occasional tax credit to ease the pain.
Of course, we aren't starting with a clean slate.  We have a tax system now that is encrusted with decades of breaks that seemed like a good idea at the time. People who have good deals now will fight to keep them, even if they mean other people have to pay more. But even if we can't reach the promised land of a completely clean, simple and neutral income tax, we can get to a better place if we try heading that way. And a good start is to not head in the wrong direction, by at least not enacting any more special breaks and tax credits.

Baby steps towards fixing Iowa's business tax climate

Everyone talks about Iowa's bad business tax climate, but nobody ever does anything about it. What should a would-be climate-changer do?

Iabiz20140225As we discussed here last month, Iowa consistently has a poor rating for its business tax climate because of its tax complexity and high rates. High rates and complexity are twins. When rates get high, the well-connected lobby for tax breaks, each of which make things more complicated. When there are lots of tax breaks, the rates have to go higher to raise more revenue. The standard approach to tax reform is to do the opposite --  lower the rates, and pay for it by eliminating tax breaks.

Tax reform is hard, but you don't have to do it all at once. A few baby steps, and the grown-up steps can come later.

Some first steps that would make life easier for Iowans without affecting tax policy or state revenues:

Eliminate the alternative minimum tax for individuals and corporations. One of the reasons reason the Tax Foundation's annual Business Tax Climate Index gives Iowa low marks is because every taxpayer is required to compute both a "regular" tax and the AMT, paying the one that produces the higher tax. But Iowa's AMT applies to very few taxpayers. It is rare to see it in tax practice unless you have clients who are public-company executives with incentive stock options. The Iowa Department of Revenue doesn't even track AMT receipts -- which fuels my suspicion that AMT revenues in Iowa amount to a rounding error in the state budget. Eliminating the AMT would simplify a lot while costing the state little.

Make Iowa's tax system automatically adopt federal changes, unless the legislature votes a specific exception. Iowa every year passes a "code conformity" law to mirror federal changes in the computation of taxable income. Because large parts of the federal tax law are enacted only a year at a time, often in December, tax season is well under way before Iowans have an official tax law. It would be much easier if federal changes were automatically adopted. If Iowa wanted to exclude an area of the law from automatic changes -- like it does with depreciation -- that would be easy enough to do as part of a "floating conformity" approach. Much simplification, little or no revenue loss.

Tie all return due dates to federal due dates. While Iowa returns are generally due at the end of the month federal returns are due, there are exceptions. For example, non-resident alien individual federal returns are due on June 15, but Iowa wants them on April 30, and imposes penalties if they are filed on the federal deadline. That's unfair and un-neighborly.

Then there are reforms that would be harder to enact, but that have policy arguments that are so strong, they might win out. These would include:

Encourage or require "composite" returns or withholding for pass-through non-resident taxpayers. Almost all other states do a version of this. This would make it much easier for Iowa to collect taxes on Iowa-source income from non-resident owners partnerships and S corporations, and would almost surely generate revenue that could be used to lower rates.

Repeal the deductibility of federal taxes in exchange for lower rates. Just incorporating the tax benefit of the federal deductibilty into Iowa's rate structure would bring the top rate down from 8.98% to somewhere between 5.5% and 6.9%.

Repeal "refundable" or "transferable" incentive tax credits and roll the savings into lower rates. When "refundable" credits exceed your Iowa tax, the state mails you a check for the difference. "Transferable" credits can be sold -- in effect, allowing third parties to buy Iowa tax reduction at a discount. These amount to unappropriated subsidies; if the legislature wouldn't vote a corporate subsidy as an appropriation, it shouldn't be paid  through a tax return. 

Iowa's research activities credit alone gave checks to corporations of $37 million in 2014 -- $11.7 million to a single corporation. Just ending the refundability of this credit would save the state enough revenue to shave a full percentage point off of Iowa's highest-in-the-nation 12% corporation tax rate.

That's the easy stuff. Enacting just these ideas would improve Iowa's tax system, but that would leave much undone. What would an Iowa income tax look like if we wanted to start it over and make it as friendly as possible for taxpayers and growing Iowa businesses? We'll talk about that next time.


Is Iowa’s business tax climate really that bad?

IMG_0605Joe Kristan is a CPA at Roth & Company



The Tax Foundation says Iowa has the 10th-worst business tax climate among the states. Their detailed overview of Iowa’s tax system explains:


States that score well on the Index have broad bases and low rates, but Iowa has narrow bases and high rates on many taxes…


Competing states like South Dakota and Indiana offer more competitive corporate tax climates while Iowa can leave prospective businesses with sticker shock because of its 12 percent corporate income tax rate.


Further, many Iowa businesses file income taxes through the individual tax code, which has a high top rate of 8.98 percent. Even Illinois is more competitive in this regard; it files individual income at a single rate of 5 percent.


All true. Of course, defenders of Iowa’s tax system can make some worthwhile points:


  • Most states don’t allow deductions for federal taxes. Iowa does, making the effective top rate lower than the rates quoted by the Tax Foundation.

  • Iowa corporations can use “single-factor” apportionment. This allows Iowa corporations to pay taxes based only on Iowa sales, so Iowa-based corporations with a national market pay a lower effective rate than corporations based in states that use a traditional tax system that takes into account property and payroll in-state, as well as sales.

  • Iowa allows a “refundable” research credit that can result in startups, especially software companies, receiving cash subsidies even in loss years.

  • Iowa has dozens of other special tax credits that can eliminate taxes; some can even result in a negative income tax, with the state writing checks for qualifying taxpayers.


And what Iowa's defenders say is true. Big Iowa companies can find themselves paying surprisingly little tax here.


Unfortunately, by the time Iowa advocates get to the tax credit part of the story, the audience has already tuned out. It’s easier to tell South Dakota’s story: “We don’t have any income taxes!”


Even after all of the explaining, the Tax Foundation’s main points remain true. Iowa’s corporation tax rate is the highest in the U.S. (even taking the deduction for federal income taxes into account). In fact, it is the highest in the developed world. Our individual tax rate is high, even considering the federal tax deduction. All of the special breaks make Iowa's income tax very complex. And while Iowa has many tax credits, they are often narrowly tailored and require consulting and string-pulling to obtain. Many small businesses don’t qualify for the wonderful tax breaks, but they still have to pay their accountants to comply with the resulting complex and confusing tax system.


While there is recognition at the Statehouse that Iowa’s tax system is a problem, there’s a long way to go to overcome forces that like the current system. Every special tax credit and tax break benefits somebody who’d hate to see it go. Politicians like “targeted” tax breaks, as they can attend ribbon cuttings for companies that get the special deals.


Meanwhile, nobody cuts a ribbon for the businesses that don’t get the special breaks. There is no press release to tell the story of the Iowa business that has to pay taxes at the top Iowa rate, while competing with South Dakota competitors. There is no press conference when an business leaves Iowa to take its state tax rate from 12 percent to zero. There’s no ribbon cutting for a business that loses business to competitors with lower tax burdens.


I believe Iowa is a great place to do business. That’s in spite of its tax system, not because of it. Iowa could collect the same amount of tax with a much better tax system. We’ll talk about how it could be made better next time.

Year-end business deductions: the two-minute drill.

Joe Kristan is a CPA at Roth & Company P.C.

While April 15 gets all the glamor, tax-savvy folks know that December 31 is where the real action is. While you add up the score in April, December is when you run the two-minute drill.

You can't run a good two-minute offense if you don't know the rules of the game (to continue the sports theme at least one paragraph too far). It doesn't help that with last-minute legislative tax law changes, year-end planning this year is like running a two-minute drill in a game of Calvinball. Yet we have to plan with the tax law we have, not the one we would prefer, so here are some notes you can write on your wrist as you call your year-end tax plays.

100_0438Figure out where you are on the field. The quarterback running a two-minute drill will call different plays on one ten-yard line than he will on the other. You need to pencil out your taxable income to-date for any year-end planning moves to succeed other than by accident. When you run the numbers, you may find that your deductions will end up being more valuable next year.

If you are planning for your business, figure out whether you are a cash-basis or an accrual-basis taxpayer. The rules to get a deduction are different.

Cash-basis businesses record their income when they receive the check. The tax law says you can't defer income by letting uncashed checks accumulate; if you can deposit a check, you've earned it, as far as the IRS is concerned.

Cash basis taxpayers generally deduct an expense when it is "paid." When does that happen?

- If the item is paid for with a credit card, it is "paid" when it is charged to the card, even if the card balance isn't paid until a later year.

- If the item is paid with a check, it is "paid" when the check is mailed (postmarked), even if the check isn't cashed until a later year.

There are limits on cash-basis deductions. For example, you can't prepay items for more than a year at a time, and there are other rules that can apply to deal with taxpayers that try to do too much of a good thing.

Accrual basis taxpayers pick up income when they have earned the income, even if they haven't been paid yet. For example, a wholesaler will normally record income when it ships the goods, even on credit. Accrual taxpayers generally get their deductions when they meet the "all events" test: all events have occurred to fix the liability, and it can be determined with reasonable accuracy. 

The tax law applies some special limits to expense accruals. For example, the tax law has an "economic performance" requirement that limits accruals until "economic performance" of the activity giving rise to the deduction take place.

You can't just accrue an expense and never pay it if you want to deduct it. Accrued compansation has to be paid within 2 1/2 months of year-end to be deductible. Most other expenses need to be paid no later than 8 1/2 months after year-end.

The related party rules are the biggest practical limit on accrual-method deductions. An accrual basis taxpayer can't deduct an amount accrued to a cash-basis "related party" -- such as a bonus accrued to an owner -- until the related party has to include the payment in income. Whether you are "related" depends a lot on what entity you use to run your business. For example, a person owning 10 percent of a corporation would not be related to a corporation taxed as a C corporation, but would be related if the same corporation were an S corporation. You might even be related to an entity that you don't own at all if a relative is an owner.

Of course, being cash-basis or accrual-basis does nothing to help you deduct an expense that isn't deductible in the first place. Not everything your business can write a check for gets you an immediate deduction, or a deduction at all. Payments for salary have to be "reasonable," so writing a "salary" check to Grandma in Florida whose service to the business consists of monitoring her bingo card isn't going to work. If you buy a car for the business, you face annual deduction limits for vehicles. Owner life insurance premiums are rarely deductible. You get the idea.

With the likely re-enactment of the $500,000 Section 179 expense and 50 percent bonus depreciation for 2014, many owners are tempted to buy a new depreciable asset by year-end to get a big deduction. Be careful. It's not enough to pay for a fixed asset by year end; it has to be "placed in service" by then to be deductible this year. That means the asset has to be on-site and set up and ready to operate. A new machine in a crate on the loading dock at year-end isn't "in service" and won't give you a deduction.

And be sure to consult your tax professional. Even the best quarterback needs a good coach. Every taxpayer is different, and a move that might score for Jill might be a distance and loss-of-down penalty for Jane.


The C corporation dilemma and how not to solve it.

Joe Kristan is a CPA at Roth & Company P.C.

One big reason the business world has moved away from using "regular" corporations is because they pay two taxes on their income. These "C corporations," as tax geeks call them, pay taxes on their income as it is earned. If they distribute the after-tax earnings to their shareholders as dividends, the owners pay tax on their 1040s. If the owners sell their shares, they pay capital gain tax on the undistributed earnings embedded in the stock price.

100_0263When it comes time to sell, C corporation owners face this issue in a big way. Buyers usually want to buy assets. That way they get to amortize or depreciate the purchased assets at their fair value, rather than their historical cost. They also don't have to buy any hidden sins that would come with corporate stock.

The sellers are less excited about an asset sale. It means they have to pay tax on all of the gains at the corporate level, and another capital gain tax when they liquidate the corporation. A prompt liquidation is usually done to avoid "personal holding company tax" problems.

It would sure be nice if you could find an accommodator to buy your stock,  who could then sell the assets to the real buyer -- an accommodator who has a bunch of tax losses they could use to make the gain go away. That was the thinking of a Texan who ended up in Tax Court recently.

The Texan got in touch with a company that promised just such benefits. They worked out a deal. A recent Tax Court decision describes how such deals are set up:

"Midco transactions" or "intermediary transactions" are structured to allow the parties to have it both ways: letting the seller engage in a stock sale and the buyer engage in an asset purchase. In such a transaction, the selling shareholders sell their C Corp stock to an intermediary entity (or "Midco") at a purchase price that does not discount for the built-in gain tax liability, as a stock sale to the ultimate purchaser would. The Midco then sells the assets of the C Corp to the buyer, who gets a purchase price basis in the assets. The Midco keeps the difference between the asset sale price and the stock purchase price as its fee. The Midco's willingness to allow both buyer and seller to avoid the tax consequences inherent in holding appreciated assets in a C Corp is based on a claimed tax-exempt status or supposed tax attributes, such as losses, that allow it to absorb the built-in gain tax liability.

The IRS has never liked this, and back in 2001 (Notice 2001-16) they warned taxpayers off of these "Midco" deals. The courts have sided with the IRS.

But what if you liquidate and there is no corporation to collect from? You're not out of the woods. The Tax Court found that the Texan had "transferee liability" for the corporation's tax on its sale because he ended up with the cash out of the company.

The moral? The potential for C corporation double tax is most easily dealt with by not being a C corporation in the first place. That's why so many businesses are set up as LLCs or S corporations, where the income is taxed only once -- on the owner's returns.

Many C corporations set up in the past few years may end up qualifying for a special tax exemption for sales of their stock. If held for more than five years, "Section 1202 stock" is 50 percent to 100 percent tax free on sale; it can apply to stock purchased from February 18, 2009 through December 31, 2013. Congress is likely (but not certain) to further extend this break with legislation later this year. This doesn't solve all C corporation problems -- benefits are usually limited to the original owners of the stock, for example -- but it sure is handy when it does apply.

If you are stuck with the double-tax problem, planning might make it hurt less, but as the Texan learned, there are no easy off-the-shelf solutions.

Cite: Cullifer, T.C. Memo 2014-208.


Obamacare mandates: What's a taxpayer to do?

Joe Kristan is a CPA at Roth & Company P.C.

Last year's Supreme Court decision upholding the Affordable Care Act as a constitutional tax provision means that the court battles were over, right? 

Hardly. And the continuing controversy will likely leave many taxpayers in suspense over their 2014 federal tax bills well into next year.

While the ACA has been ruled constitutional, the operation of the complex law remains at issue. Last month two important federal appeals courts reached opposite conclusions on whether policies purchased through federally-established exchanges are eligible for tax credit subsidies. The D.C. Court of Appeals ruled in Halbig that only policies purchased through state-established exchanges qualify for the tax credits. The Fourth Circuit, which covers Maryland, North Carolina, and Virginia, ruled that policies purchased on federal exchanges could earn tax credits. 

20121120-2As only 14 states have enacted exchanges, this is a big deal -- without subsidies, the effective cost of health insurance would drastically increase for many taxpayers.

The controversy is likely headed to the U.S. Supreme Court, but no ruling is likely until next year. That poses a problem for taxpayers, as the ultimate decision determines whether two key Obamacare taxes apply in 2014.

The ACA relies on tax penalties to encourage certain behavior by taxpayers. The "employer mandate" applies in 2014 to businesses employing over 100 "full-time equivalent" employees. Employers subject to the mandate face a penalty that is triggered when an employee qualifies for tax credits on the purchase of a policy on the exchange. No tax credits, no penalty.

The individual mandate applies when a qualifying individual fails to purchase an "affordable" policy -- taking the tax credits into account. If the courts hold that the tax credits don't apply to policies purchased on federal exchanges, then the individual mandate -- at the greater of $95 or 1% of your income -- will no longer apply to people in those states because the available policies would no longer be "affordable." More on how mandates may be affected here.

So what's a taxpayer to do? Of course, you should start by consulting your own tax adviser. While you can make a good argument that the D.C. Circuit decision for now gives you a defensible return position to not pay the tax, my inclination is to play it safe. While I think the D.C. Circuit's decision limiting tax credits to state-established exchanges is the correct reading of the tax law, the Supreme Court won't be asking my opinion. The Administration has asked the full D.C. Circuit to review the decision, which was made by a three-judge panel, so it could be reversed sooner. And if they disagree with me, the IRS won't let you use my opinion as an excuse.

That's why I consider it prudent to assume, in planning for the individual mandate and employer mandate, that the courts will uphold the credits.  If you plan as if the mandate will apply, you will be managing your employee base, your insurance purchases, and your employee time policies, in ways to keep your costs down. You will also be setting aside funds to pay any mandate tax penalties that apply. And if the courts do the unthinkable and agree with me, you will find yourself with a windfall -- always a better result than a sudden unplanned tax liability.

The April 15 day-trader deadline

20130409-1Joe Kristan is a CPA at Roth & Company P.C.

We usually think of April 15 as the deadline for settling up with the IRS for last year.  But for the nation’s doughty day traders — especially the unlucky ones — it’s an important deadline for this year. 

The tax law normally limits capital losses to capital gains, plus $3,000. That means many busy traders will have to hope for great advances in life extension technology to ever fully deduct their capital loss carryforwards.

There is an escape from the $3,000 treadmill for taxpayers who qualify as “traders.” The IRS explains what it means to be a “trader”:

 To be engaged in business as a trader in securities, you must meet all of the following conditions:

  • You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation.    
  • Your activity must be substantial, and    
  • You must carry on the activity with continuity and regularity.

The following facts and circumstances should be considered in determining if your activity is a securities trading business:

  • Typical holding periods for securities bought and sold.    
  • The frequency and dollar amount of your trades during the year.    
  • The extent to which you pursue the activity to produce income for a livelihood, and
  • The amount of time you devote to the activity.

If the nature of your trading activities does not qualify as a business, you are considered an investor, and not a trader.

These are pretty steep tests. You pretty much need to be trying to do it for a living; another day job is a bad fact, as in this case.  But if you pass these tests, you can make a “mark-to-market election” under Section 475(f) of the Internal Revenue Code to deduct trading losses as ordinary. If you make this election on time, it applies to 2014 taxes. It’s too late to make the election for 2013.

The Section 475(f) election comes at a price. If you make this election, gains are ordinary, too, and you have to mark your gains and losses on open positions to market at year-end — paying tax as if you had sold the positions on December 31. Yet if you are exclusively trading short-term, where you pay taxes on gains at ordinary rates anyway and have few open positions at any time, this may not be a great sacrifice.

This election cannot be extended, so traders need to make the election by next Monday.  You make the election for 2014 by attaching a statement to your 1040 or extension for 2013 with the following information:

1. That you are making an election under section 475(f) of the Internal Revenue Code;

2. The first tax year for which the election is effective; and

3. The trade or business for which you are making the election.

Happy trading!

Fear the Family (and other related parties)

Joe Kristan is a CPA at Roth & Company P.C.

Iabiz 20140129Judging by income tax law alone, Congress seems to think that "The Sopranos" provides the standard business model for family financial transactions. The tax code is full of special rules that punish transactions between family members, on the assumption that they can't do business without trying to pull a fast one on their tax filings. You can't accrue a deduction to a cash-basis relative, for example, and you can't deduct a loss on a sale to family

A Kansas City entrepreneur recently learned about another related party rule, good and hard.  

Gary Fish started a successful tech company, FishNet Security, described on its website as "the No. 1 provider of information security solutions that combine technology, services, support and training." From 1998 the company was operated as an S corporation, a common tax structure under which the earnings of the corporation are taxed directly on the owner's 1040.

In 2004, he got an opportunity to get some cash out of his investment.  While the technical details were a bit convoluted, for tax purposes it came down to having his S corporation contribute the operating business to a new corporation; a private equity group contributed cash.  Mr. Fish received some stock in the new corporation, along with $9,698,699 of the private equity cash. 

The formation of a new corporation is normally tax-free.  Internal Revenue Code Section 351 allows taxpayers to exchange appreciated assets for stock without recognizing gain, as long as the contributing parties own 80% or more of the company after the transaction. But the tax law triggers taxable gain to the extent a taxpayer receiving stock also receives "boot" -- cash or other non-stock property -- in the deal.  

As with many tech companies, the value of the business was mostly in its intangible assets -- its "goodwill." The new corporation was treated as buying goodwill. The tax law says purchased goodwill can be amortized for tax purposes over 15 years. And here is where things went bad for Mr. Fish.

When "goodwill" is sold, the tax law normally treats it as a capital gain. An obscure part of the Code, Section 1239, can change that result. If you sell anything that can be depreciated or amortized to a related party -- things like machinery, buildings, and, yes, goodwill -- Section 1239 makes the gain ordinary. The idea is to prevent a taxpayer from selling something to a relative at reduced capital gain rates and then getting depreciation deductions against ordinary income, which is taxed at higher rates. This would not be very a attractive trick for goodwill, where the capital gain tax is paid right away while the deductions are spread over 15 years, but nobody ever said the tax law has to make sense.

Among the related parties affected by Section 1239 are corporations where a taxpayer owns over 50% of the stock value. While the capital structure of the new corporation was complex, the Tax Court judge determined that Mr. Fish owned more than 50% of the value of its stock. As a result, the $9,698,699 of "boot" gain recognized on the goodwill transferred to the new corporation was ordinary income, not capital gain.

In 2005, capital gain was taxed at 15%, while the top ordinary income rate was 35% (current rates are 20% and 39.6%; if the Obamacare surtax applies, both rates are increased by another 3.8%). Using those rates, Section 1239 increases Mr. Fish's federal tax bill on the gain from $1,454,805 to $3,394,545 -- $1,939,740 of unhappiness, if it isn't overturned by a higher court.  

Does this mean you can never do business with relatives without, er, sleeping with the fishes, tax-wise? No. But, like Tony Soprano, you need to be very careful doing so. You should work very closely with your tax advisor when engaging in finance with friends and family, including friendly family-owned businesses. Mr. Fish could give you about $1,939,740 reasons why.  

Cite: Fish, T.C. Memo. 2013-270

What's new in year-end tax planning

Joe Kristan is a CPA at Roth & Company P.C.

There are a few new twists to year-end planning this year. Some important tax breaks are scheduled to expire at the end of the year, and some new provisions affect how old tax planning tools can be used.  

Two key tax breaks for buying equipment are slated for big changes at year-end: "Section 179" and "50% bonus depreciation." Section 179 allows many taxpayers to fully deduct the cost of assets that would otherwise only be recovered over a period of years. The maximumm Section 179 deduction is scheduled to decline from $500,000 for tax years beginning in 2013 to $25,000 for years beginning in 2014. 

Bonus depreciation allows a 50% writeoff of otherwise depreciable property in many cases where Section 179 is unavailable. With few exceptions, it is scheduled to go away for assets placed in service after 2013. 

While there is a chance these breaks will be extended retroactively, how many of us want to place money on Congress doing something? To get either deduction, the property has to be "placed in service" by year-end. "Placed in service" means "in a condition or state of readiness and availablilty for a specifically assigned function." That means in the posession of the taxpayer on the premises where it will be used, and ready to go. It does not mean on-order, paid for, in a crate on the loading dock, or on a Fed-Ex truck somewhere.

Two old tax planning tools are affected by the 3.8% "Net Investment Income Tax" under Obamacare. This tax applies to individuals with incomes over $200,000 (single filers) or $250,000 (joint filers). It also applies to many taxable trusts. The two tools are prepaying income taxes and harvesting capital losses.  

Personal state income taxes are deductible in the year paid. (Iowa allows a deduction for federal income taxes). Estimating the tax due in April has long been in the tax planning toolkit. It has been less useful in recent years because it doesn't help taxpayers owing alternative minimum tax. But even if you have alternative minimum tax, prepaying state income taxes can reduce the net investment income tax.

Capital losses. Individuals are allowed to deduct capital losses to the extent of capital gains, plus $3,000 ($1,500 for married filing separate returns). If you have capital gains, and you have some losers in your portfolio, now is the time to sell them off. Just make sure you avoid the "wash sale" rules by not replacing the loss shares in the 30 days preceding or selling the loss sale. Also be sure to not sell to a related party, as those losses won't be deductible. Newly-issued regulations make these losses available to offset net investment income, to the extent they are otherwise deductible.

Year-end tax planning is very taxpayer-specific. You can't look at an article or post and know how to proceed. Without a projection of your taxable income for this year, you can hardly even start year-end tax planning. Once you have an idea where you stand, you can take a shot at your year-end planning. 

In any case, get together with your tax advisor before you make any year-end moves. There are other tools that might fit your needs, and there's enough at stake to make sure you do it right.

IRA is to startup funding as dynamite is to kindling

Joe Kristan is a CPA at Roth & Company P.C.

Equity is to startups like kindling is to a good campfire.  You might not get anything started without it. 

For many would-be entrepreneurs, retirement savings in an individual retirement account are the biggest potential source of startup funds. Yet getting money out of a traditional IRA triggers tax, and unless you are age 59 1/2 or older, a 10% early withdrawal penalty.

Some folks try to get around this problem by having the IRA itself be the equity investor. That can be a little like kindling a campfire with dynamite, as a Missouri man recently learned in Tax Court. 

The taxpayer, a Mr. Ellis, took about $320,000 from his 401(k) plan and rolled it into a self-directed IRA. He then had the IRA invest almost all of the funds in a new corporation (technically, an LLC that elected to be taxed as a corporation) in exchange for 98% ownership interest of the corporation. The corporation then went into business as a used car dealership, with the IRA owner as the general manager of the dealership.

The IRS said the result was a "prohibited transaction" that terminated the IRA, making the entire $320,000 of IRA assets immediately taxable. The Tax Court agreed:

In essence, Mr. Ellis formulated a plan in which he would use his retirement savings as startup capital for a used car business. Mr. Ellis would operate this business and use it as his primary source of income by paying himself compensation for his role in its day-to-day operation. Mr. Ellis effected this plan by establishing the used car business as an investment of his IRA, attempting to preserve the integrity of the IRA as a qualified retirement plan. However, this is precisely the kind of self-dealing that [the prohibited transaction rule] was enacted to prevent.

The results are hugely unpleasant: $163,123 in taxes and penalties.

The tax law is not generally friendly to retirement plans investing in active businesses.  There are cases where it can be done -- ESOPs, for example -- but it requires careful and well-advised planning, as the consequences of doing it wrong can be catastrophic. 

The tax laws are this way for a good reason: that money is supposed to be a nest egg, your cushion to land on when you stop working. Startups aren't exactly a widows-and-orphans kind of investment. If your retirement-funded start up goes bad, so do your retirement plans. They are at best a startup funding source of last-resort -- and if your business plan requires them, you might want to reconsider your business plan.

-Joe Kristan


Dress for success, but don't look to the IRS for any fashion help.

Joe Kristan is a CPA at Roth & Company P.C.

It's standard career advice to dress for the job you want, not the one you have. But they never tell you how you pay for boss clothes on an underling budget. It's only natural to try to get some wardrobe help on your tax return. 

Sadly, it's easy to make a fashion mistake on your 1040.

20110225-1If anybody needs to look sharp, it's TV anchors and actresses. The camera is unforgiving in a Hi-Def world, so thrifty wardrobe choices can stand out like a cheap suit. But the IRS has no fashion sense.

Anietra Hamper was a personality on a Columbus, Ohio TV station. She had to buy her own work clothes, and she took a common-sense approach to her deductions, according to the Tax Court:

She would ask herself "would I be buying this if I didn't have to wear this" to work, "and if the answer is no, then I know that I am buying it specifically" for work, and therefore, it is a deductible business expense.

An actress who was a stand-in for the "Penelope Garcia" character on the show "Criminal Minds" took a similar approach, according to the Tax Court:

Petitioner also claimed as business expenses items including makeup and beauty expenses, wardrobe expenses, and laundry and cleaning expenses. She claims that these expenses were necessary because of the unique dress and makeup of the character Garcia.

Unfortunately, the tax law takes a different approach. IRS Publication 529 explains:

You can deduct the cost and upkeep of work clothes if the following two requirements are met.

  • You must wear them as a condition of your employment.

  • The clothes are not suitable for everyday wear.

It is not enough that you wear distinctive clothing. The clothing must be specifically required by your employer. Nor is it enough that you do not, in fact, wear your work clothes away from work. The clothing must not be suitable for taking the place of your regular clothing.

Examples of workers who may be able to deduct the cost and upkeep of work clothes are: delivery workers, firefighters, health care workers, law enforcement officers, letter carriers, professional athletes, and transportation workers (air, rail, bus, etc.).

Musicians and entertainers can deduct the cost of theatrical clothing and accessories that are not suitable for everyday wear.

In the case of our TV anchor, the court said that that studio wear didn't make the cut, even though she wouldn't have purchased the items if she were, say, a welder:

Although she is required to purchase conservative business attire, it is not of a fashion that is outrageous or otherwise unsuitable for everyday personal wear. Given the nature of her expenditures, it is evident that petitioner's clothing is in fact suitable for everyday wear, even if it is not so worn. Consequently, the Court upholds respondent's determination that petitioner is not entitled to deduct expenses related to clothing, shoes, and accessory costs, as these are inherently personal expenses. Additionally, because the costs associated with the purchase of clothing are a nondeductible personal expense, costs for the maintenance of the clothing such as dry cleaning costs are also nondeductible personal expenses.

20130920-1It might have been a closer call for our actress, but the Tax Court reviewer went thumbs-down:

Neither petitioner’s records nor her testimony tied specific items of expense to the type of clothing and related items that would not be suitable for everyday wear. To the extent that items cannot be tied to petitioner’s job with “Criminal Minds”, her arguments about the uniqueness of Garcia are not persuasive.

Not being much of a TV viewer, I can't say whether a normal person would go out in public dressed like Penelope Garcia, though at least one commentator suggests one would not. Our actress needed to convince the judge that her purchases met the standard for "theatrical clothing and accessories that are not suitable for everyday wear." Her performance in Tax Court failed to convince the relevant critic (my emphasis):

Neither petitioner’s records nor her testimony tied specific items of expense to the type of clothing and related items that would not be suitable for everyday wear. To the extent that items cannot be tied to petitioner’s job with “Criminal Minds”, her arguments about the uniqueness of Garcia are not persuasive.

So what does the tax law tell the fashion-conscious aspiring boss? First, that it's difficult to deduct work clothes, and probably impossible for us cubicle monkeys. Even for actors and others, you need to be able to show the connection between your clothing purchases and your roles, and you need to have receipts to prove what your expenses are.  Otherwise, your deductions might close early to a bad IRS review.

-Joe Kristan

When you buy business assets, no do-overs.


Joe Kristan is a CPA at Roth & Company P.C.

When a business goes up for sale, the buyer often prefers to buy the business assets, rather than corporate shares or LLC interests. Buying only the assets minimizes the baggage you might assume if you buy the corporation stock. 

Tax planning often favors an asset purchase. If you buy assets, you normally get to re-start the depreciation of the business, and you can deduct purchased "goodwill" of the business over 15 years. Purchasers of stock normally get no "step-up" of the business assets for depreciation. 

The tax law wants business buyers and sellers to agree on the purchase price allocation. That is to keep the buyers and sellers from "whipsawing" the tax man. Sellers typically want to allocate sale price to non-depreciable land, to long-lived buildings, and to goodwill, because those gains are taxed at favorable capital gain rates. In contrast, buyers want to allocate purchase price to inventory and equipment - which they can deduct sooner, but which generate high-rate ordinary income to the seller. 

The buyer and seller have to report the allocation on Form 8594 with their tax returns so the IRS can make sure the buyer and seller aren't taking differing positions. If they do take differing positions, the IRS can assess each taxpayer based on the other taxpayer's allocation, they just step aside and let them fight it out.

A company named Peco Foodsbought two poultry processing plants in Mississippi. They went ahead and filed their Form 8594, as they were supposed to. Then they had second thoughts. 

They hired an appraisal company to do a “cost segregation study.” Engineers looked over the purchased buildings and identified components they considered to really be part of the manufacturing machinery, and therefore eligible to be written off over a shorter life. They filed tax returns using the results of the study, taking larger depreciation deductions.

The IRS didn't like that, as this led to a "whipsaw." They disallowed the additional deductions, saying the buyer was stuck with the original allocation. The Tax Court agreed, and now the Eleventh Circuit Court of Appeals has upheld the Tax Court:

In binding Peco to both agreements, the Commissioner can be assured that both the buyer, (Peco) and the respective sellers, (Green Acre and MD), treat the assets consistently for federal tax purposes... As the Danielson court observed, “where parties enter into an agreement with a clear understanding of its substance and content, they cannot be heard to say later that they overlooked possible tax consequences.”

The Moral?  No do-overs. You only get one shot at the purchase price allocation when you buy a business. The purchase price allocation needs to be addressed early in your negotiations. If you want to have experts come in for a cost segregation study, you should do it as part of your due diligence before the deal closes, or under agreement afte the close with the seller. You can't unilaterally change the allocation. 

Be sure to consult with your own tax advisor at all stages of any business purchase or sale.

-Joe Kristan

Health care taxes: what's delayed, what isn't

Joe Kristan is a CPA at Roth & Company P.C.

Last week, an obscure Treasury official released a surprise announcement via blog post that President Barack Obama's Administration won't enforce the penalties on "large" employers who fail to provide "essential" health coverage until 2015. The penalties were slated to take effect in 2014.

The announcement was greeted with relief by many employers trying to figure out how to deal with the penalties; 2013 employment levels would have determined which employers were "large" (50 "full-time equivalent" employees). It probably also was a relief to many folks at 50-employee companies who were on the bubble. But it also caused confusion about whether other Obamacare rules would be delayed. Sadly, no (for the most part).

The only other major component of the Affordable Care Act that will be delayed are some verification requirements for individuals applying for health insurance subsidies

Some things that are not delayed, at least as of now:

In other words, most of Obamacare is still in effect, for now.  Plan accordingly.

-Joe Kristan

Playing with fire: Using an IRA to finance your business


Joe Kristan is a CPA at Roth & Company P.C. 

When that great opportunity to start or buy a new business comes along, you probably need some cash to jump on it.  For many of us, our IRAs are the biggest financial asset. Yet unless it's a Roth IRA, you generally have to pay tax to get at the money, and if you are under 59, you also owe a 10% penalty. You may be able to get most or all of the cash in your Roth IRA tax-free, but then future earnings on those funds are taxable.

That's why it's tempting to try to have the IRA itself own a business. A recent Tax Court case shows that IRA ownership of a small business is playing with fire.

The biggest danger of owning your business in an IRA has been the risk of having a “prohibited transaction.” The tax law has hair-trigger rules for pension funds and other exempt organizations to prevent abuse of the funds by related parties or trustees. If you have one, you have a penalty tax of at least 15%, and maybe 100%. Worse, you terminate your IRA.

The Tax Court case involved a C corporation owned by IRAs. As is typical in a closely-held business, the lenders wanted a loan guarantee from the entreprenuers. Disaster ensued:

The Tax Court said this constituted an “indirect extension of credit” to the IRA (my emphasis):

 As the Commissioner points out, if the statute prohibited only a loan or  loan guaranty between a disqualified person and the IRA itself, then the prohibition could be easily and abusively avoided simply by having the IRA create a shell subsidiary to whom the disqualified person could then make a loan. That, however, is an obvious evasion that Congress intended to prevent by using the word “indirect”. The language of section 4975(c)(1)(B), when given its obvious and intended meaning, prohibited Mr. Fleck and Mr. Peek from making loans or loan guaranties either directly to their IRAs or indirectly to their IRAs by way of the entity owned by the IRAs.

This was a prohibited transaction, blowing the IRA. That meant when the corporation was sold in 2006, instead of a tax-free sale inside an IRA, it was a taxable sale by the owners. The result was over $400,000 in additional taxes, plus another $90,000 in penalties.

I suspect there are a lot of similar taxpayers out there.  They will be following this case if it is appealed with intense interest. If this ruling holds, this will be a catastrophe to such folks, in the same league as the ruin caused by Incentive Stock Options (ISOs) exercised just prior to the dot-com collapse. The ISO disaster was bad enough to get Congress to enact legislative relief. 

-Joe Kristan

The REIT way to reduce taxes?


Some entreprenuer friends got excited when The New York Times ran Restyled as Real Estate Trusts, Varied Businesses Avoid Taxes.  A sample:

A small but growing number of American corporations, operating in businesses as diverse as private prisons, billboards and casinos, are making an aggressive move to reduce — or even eliminate — their federal tax bills. They are declaring that they are not ordinary corporations at all. Instead, they say, they are something else: special trusts that are typically exempt from paying federal taxes.

The trust structure has been around for years but, until recently, it was generally used only by funds holding real estate. Now, the likes of the Corrections Corporation of America, which owns and operates 44 prisons and detention centers across the nation, have quietly received permission from the IRS to put on new corporate clothes and, as a result, save many millions on taxes.

Changing from a standard corporation to a real estate investment trust, or REIT — a designation signed into law by President Dwight D. Eisenhower — has suddenly become a hot corporate trend.

So is your tax advisor failing to tell you about a great new way for your business to avoid taxes? Probably not.

Real Estate Investment Trusts are nice for those who can use them. They get to deduct earnings they pay out to their owners as dividends, avoiding the double-tax that applies to most "C" corporations. The distributions qualify for the lower 23.8% top rate on dividends for the recipients, instead of the top 43.4% rate on individual rental income. 

Sadly, they probably aren't for you. First, they only work if you have the right kind of income. This limits mostly passive real estate or real estate mortgages; other assets have to be in a taxable non-REIT entity. Some entities can make this work by dividing up their assets between the REIT and the taxable entity, but it doesn't fit everybody.

A bigger obstacle may be the ownership restrictions. A corporation requires at least 100 shareholders to elect REIT status. So you can get around that if you have 99 close friends who are willing to own token shares, right?  

Wrong. You don't qualify as a REIT if five or fewer shareholders own more than 50% of the REIT. What's more, attribution rules add the shares of related owners together, so you can't get around that by giving ownership to, say, your kids.

Who can use a REIT? A corporation with a wide ownership base and a lot of real-estate related assets. REITS with Des Moines connections include General Growth Properties and Macerich, led by Des Moines native Arthur Coppola. Owners of smaller real estate businesses can sometimes get REIT benefits through an "UPREIT" partnership with an existing REIT. But for most entrepreneurs, REIT status is unavailable. That's a shame; if I had my way, all corporations would be taxed like REITs.

-Joe Kristan

So you owe the IRS on your 2012 return and cash is tight. What now?

With the increase in tax rates from 2012 to 2013, many entrepreneurs accelerated income into 2012 to beat the higher rates. Now the bills are coming due. 

Iabiz20130331Most entrepreneurs operate as "pass-throughs" like S corporations or LLCs taxable as partnerships, so their business income hits their personal returns. Those are due April 15. A lot can happen between year-end and April 15, so cash will be tight for some folks. What options do you have when you owe the IRS on April 15?

First, don't blow it off. At the very least you want to extend the return, even if you can't pay all you owe.

- If you owe money and you don't bother to extend the return, the IRS will charge you 5% of the unpaid balance, plus another 5% for each month the balance goes unpaid. They also charge interest.

- If your 2012 tax liability is at least 90% paid in by April 15, you can extend your return and pay the rest by the extended due date of October 15 without penalty. The IRS will charge interest on the unpaid balance. The rate changes quarterly and is currently 3%.

- Normally if you are less than 90% paid in by April 15 and you extend, the IRS charges interest plus a 1/2% penalty, plus 1/2% for each additional month the tax remains unpaid. That 1/2% is a much better deal than the 5% penalty that applies when you don't bother to extend your return.

This year the penalty-free deal for those 90% paid-in is extended to many additional taxpayers. Congress didn't get around to finalizing 2012 tax law until January 2013, so the issuance of many tax forms was delayed. The IRS has waived the 1/2% late-payment penalty for tax returns that include one of the delayed forms (Notice 2013-24). That means that if you extend a return that will be filed with one of the delayed forms, you may only owe interest on any unpaid amount if you pay the balance by the October 15 extended due date. There is a catch: the IRS requires a "good faith" computation of the tax due and payment of the amount shown on the extension.  That may limit the usefulness of the deal.

The list of qualifying forms is here. The most common ones on entrepreneur returns are likely to be Form 4562, the depreciation form, and Form 8582, the "passive activity" form.  Some of the other forms qualifying for the penalty relief are Form 8903 for the "Domestic Production Activities Deduction" and Form 8863, for education tax credits.

Remember, you still need to pay the taxes eventually; if you do have the cash, you are likely to want to pay up, as it's hard nowadays to earn 3% after-tax on six-month money (the IRS interest is non-deductible). In any case, you should work with your tax own advisor in making any decision on how and when to pay your taxes.

The Colonel knows why your business might have to file returns in other states


Tax returns for other states are an expensive annoyance. It can be even more expensive and annoying if you don't file them.

State governments love to tax out-of-state businesses. It's very tempting for politicians to pick the pockets of taxpayers who don't vote in their elections. Aggressive taxing agencies with improved abilities to spot potential pockets to pick are making it harder for out-of-state businesses to ignore state filing requirements.

There are two sets of restrictions on states that want to tax your business. The first is the Constitution, which requires there to be some connection to a state before a business can be taxed. The Supreme Court's Quill decision of 1992 imposed a "physical presence" test. This limit has been eroded over the years by aggressive states that have asserted an "economic presence" limit. States using the "economic presence" test consider the presence of "intangible" assets in a state, like trademarks, to be enough to subject a business to tax. Iowa successfully taxed KFC Corporation under this argument even though KFC had no presence in Iowa other than franchisees using KFC trademarks for their chicken outlets in Iowa.

The second limit on states trying to impose income taxes is PL 86-272This law, enacted in 1959, prevents states from taxing income of some out-of-state companies even if they otherwise could tax them under the constitution. This law protects corporations whose only activity in a state is solicitation of orders that have to be approved and shipped from out-of-state. This protection only applies to income tax. That means businesses may be required to collect sales tax and pay "doing business" taxes in a state without being required to pay income tax. It provides no protection to businesses that do more than "solicit." Providing warranty or other services in a state is all it takes to put you over the line.

The inevitable question: Should I just ignore other states and wait for them to catch me?  That has always been hazardous, and it becomes a worse bet every year. If you don't file a return in a state where you are taxable, the statute of limitations never expires, and your potential tax liability never stops growing

States have more tools than ever to spot non-filers. "Data-mining" is the best gift to state revenue departments since the invention of the auditor. If you have an employee in a state, it's only a matter of time before they notice if you don't file business returns there. If you own property, they can match up property tax records with income tax filings. They can use building permits or other local licenses to identify people who should be filing. They can walk back customer Use Tax reports to you if you are a vendor.

The Moral: As your business grows, be sure to discuss with your tax pro your activities in other states. Otherwise state revenue departments may have expensive and unpleasant surprises for you down the road.

-Joe Kristan

If a fire is worth fighting, it's worth fighting in style. But the firefighter still can't deduct the Benz.

Iabiz20130218Deductions for personally-owned vehicles are hard to get. A San Francisco firefighter learned that the hard way in Tax Court this month.

Mr. & Mrs. McCormack had a Schedule C home renovation business. They decided it needed a vehicle. So naturally they deducted it. From the Tax Court opinion:

The business was named Northside Construction and was identified as such on Schedule C. During 2009 Northside Construction had two jobs that generated $5,360 of gross receipts. The $41,818 loss deducted for the business was based primarily on $33,600 of depreciation and section 179 expense taken for the purchase of a 2007 MB 450 GL automobile that was acquired on October 5, 2009.

"MB" stands for "Mercedes Benz."

The IRS poked around, and found the car wasn't just used in the Schedule C business. The taxpayers then stumbled over the obstacle that disallows so many auto deductions: poor recordkeeping.

Petitioners claim that the car was used 100% of the time for business use in Northside Construction and for transportation by Mrs. McCormack for her San Francisco Fire Department responsibilities. Mr. McCormack kept a log for his business use of a Silverado truck on behalf of Ranger Pipelines, Inc., but did not keep the log in the automobile. Mrs. McCormack did not keep a log

If you don't keep an automobile log, you have at least two strikes on you if you try to deduct auto costs. The IRS had no trouble getting strike three across. Mrs. McCormack was an employee of the San Francisco Fire Department. Sec. 179 allows taxpayers to elect to deduct costs of assets that would otherwise be capitalized and recovered through depreciation. You can't take Sec. 179 for use of a car as an employee "unless such use is for the convenience of the employer and required as a condition of employment."

On top of that, you have to use a vehicle more than 50% in a qualifying business to take a Sec. 179 deduction. So things went badly:

There is no evidence in the record that the city of San Francisco required its fire department personnel to use their own automobiles while employed for the city, nor is there any evidence to suggest that the city failed to supply vehicles to its employees to provide fire department services for its citizens. On the contrary, Mrs. McCormack testified that during 2009 she used fire engines and ambulances provided by the city and did not otherwise keep a record of mileage for the automobile use as an employee. Consequently, Mrs. McCormack's use of the automobile as an employee of the city of San Francisco is not treated as business use for purposes of the Internal Revenue Code. When Mrs. McCormick's use of the automobile as an employee is coupled with the admitted personal use of the automobile for family and household purposes and the limited business use by Mr. McCormack, the Court holds that the business use of the automobile was less than 50%...

Petitioners may not deduct section 179 expenses for the MB 450 GL automobile purchased October 5, 2009. Furthermore, because of the failure to substantiate business use by means of a log or otherwise, no depreciation on the automobile, a listed property, may be claimed.

What can we learn from this tax conflagration?  Several things:

  • If you want to deduct business use of a car, you need to keep a log as you go.  Telling your tax preparer "Oh, 30,000 miles, 100% business" doesn't work well if you are audited.
  • If you do use your car as an employee, it's much better to turn in your mileage and get reimbursed than to try to get it as a tax return deduction. Employee business expenses are only deductible when they exceed 2% of your adjusted gross income -- and not deductible at all for alternative minimum tax.
  • If you deduct a car on your Schedule C, you can count on the IRS taking a close look at it on examination. If it's a luxury car, more so.

Cite: McCormack, T.C. Summ. Op. 2013-9.

Follow-up on January 4 post. Governor Branstad has signed into law a bill adopting most of the January "Fiscal Cliff" legislation for 2012 Iowa tax returns. As expected, the bill conforms most of the retroactive provisions of the Fiscal Cliff tax bill, including expanded Section 179 deductions, but not the expansion of "Bonus Depreciation."  More here.

Image Credit: Wikimedia Commons.

-Joe Kristan

Tough tax return choice for 2012: Pay more now to save later?

20130104-1When taxpayers have an option to deduct an expense sooner than later, it's usually an easy choice -- sooner! Why give the government money now instead of later? A no-brainer.

It's a brainer this year. The steep increase in tax rates for 2013 might make you less eager to take all the deductions you can in 2012. There are two important increases in tax rates this year. The "Fiscal Cliff" legislation increases the top effective "regular" income tax rate for individuals to 40.78%. Many business owners will also have to pay an additional 3.8% "Net Investment Income" tax in addition under Obamacare. That combined rate of more than 44% compares to a 35% top individual rate for 2012. That means deductions will be worth a lot more in 2013.

That leaves businesses with some perplexing choices on their 2012 tax returns. For example, the Fiscal Cliff bill increased the "Section 179" deduction maximium to $500,000 in 2012 and 2013. That means taxpayers can deduct up to $500,000 in expenditures that would otherwise have to be capitalized and depreciated over a period of years. The natural reaction is to deduct as much as you can as fast as you can. The new higher rates could make that costly.

For example, assume a taxpayer places a $500,000 computer system into service into 2012. If a top-braket taxpayer takes a Section 179 deduction in 2012, the tax benefit of the deduction is about $175,000, ignoring state taxes. If the taxpayer instead depreciates the system over its usual five year life, it will get a $100,000 deduction in 2012 and the remaining $400,000 over 2013-17, for a total tax benefit of about $211,000.

That means the taxpyer can reduce taxes from 2013-17 about $31,000 by not taking the biggest possible deduction this year. Is it worth paying less now to pay more later? That depends. If you are short of cash now, you might take the big deduction anyway -- you don't care about future taxes if you can't stay in business until then, and that big deduction might be the difference between staying alive and not. 

But the implied cost of funds for getting smaller tax benefit now for a bigger one later works out to over 11%. That's pretty expensive money.

Bottom line? Every taxpayer is different. You should discuss with your tax advisor whether it's worth paying extra 2012 taxes to save taxes in future years. The Section 179 deduction is just one instance where you might have to make that choice.

-Joe Kristan

January: the month to start your 2013 year-end tax planning!

20130116iabizWith tax rates going up this year, the tax planning stakes for 2013 have increased. Many taxpayers wait until December to get serious about their tax planning. They ask too much of one month.

If you really want to get a handle on your 2013 tax bill, the time to get serious is now. What to do? For starters: 

Maximize your 401(k) contribution.  This is the easiest way to save money -- by taking it out of one pocket and putting it away in another.  If your employer matches, so much the better. Remember, though, that if you are the employer, your contribution may be limited by employee participation. The maximum 401(k) contribution for 2013 is $17,500 ($23,000 for taxpayers who will be 50 by year-end).

Reconsider your withholding. Taxes have gone up, folks, and not just for "millionaires and billionaires." While the new highest rates kick in at $400,000 for single filers and $450,000 for joint taxpayers, other tax increases apply at much lower levels, including the hidden tax from the phase-out of itemized deductions and the new 3.8% "Net investment income" tax enacted with Obamacare.

Make your other tax-advantaged savings contributions now. Many of us wait until the last minute to fund Individual Retirement Accounts, Health Savings Accounts, and Section 529 plans. That's disorganized thinking. The sooner you fund these tax-deferral vehicles, the sooner the earnings escape the grasp of the tax man. The 2013 limits for these plans:

  • IRA: $5,500 ($6,500 for taxpayers age 50 or older during 2013).
  • HSA: $3,250 for single coverage, $6,450 for family coverage.
  • College Savings Iowa: $3,045 per donor, per donee.

Finally, if you use your car for business, start keeping a mileage log. The IRS is examining more small businesses every year, and car expenses are one of their favorite targets. Keeping track of your business mileage can make the difference between a "no change" and an ugly audit.

None of this will make your tax problems go away, but they are a good start. Consult your tax advisor to make sure you are doing it right.

-Joe Kristan

The 'fiscal cliff' bill and Iowa entrepreneurs

20121116-1iabizCongress changed the rules of the tax game for 2012 after time expired. About two hours into 2013 they passed HR 8, the "Fiscal Cliff" legislation, finally settling the tax law for 2012 and 2013. The bill raises the top federal tax rate on profitable S corporations to more than 40% starting in 2013, as expected, but it could have been much worse. It fixes two huge flaws in the tax law, and it provides some unexpected benefits to buyers of fixed assets in 2012 and 2013. 

First, the bad news. The bill raises the stated top individual income tax rate to 39.6%. This rate will apply to taxable income more than $400,000 for single filers and $450,000 for joint filers. The top rate had been 35%.The bill also raises the top dividend and capital gain rate from 15% to 20%, for taxpayers in the new 39.6% top bracket. 

The new tax law also re-enacts the "phase-out" of itemized deductions and personal exemptions for higher-income earners. This has the effect of increasing the top rate an additional 1.188%, to 40.788%.

It's even worse than that, though, with the 3.8% new "net investment income" tax enacted separately with Obamacare also taking effect for 2013. This tax applies to interest, dividends, most capital gains, rental income and "passive" K-1 income. Considering all of these taxes, and taking deductions for taxes paid into account, an Iowa taxpayer could face a marginal rate -- the rate on each additional dollar earned -- as high as 47.6%.

There is good news. The bill permanently "patches" the alternative minimum tax, retroactive to 2012. Without the patch, some taxpayers could have had additional 2012 taxes of more than $9,000. 

The bill also permanently sets the estate tax lifetime exemption at $5 million, though it raises the rate on taxable estates to 40%. The rate in 2012 was 35%.

The bill also omits some terrible ideas that had been thrown out, including a hard dollar cap of $25,000 or $50,000 for itemized deductions. This limit would have hit Iowa pass-through owners hard, as it would have restricted their deductions for state taxes paid on business income.

Bonus good news. The bill retroactively increases the "Section 179 deduction" maximum for 2012 to $500,000. That will also be the maximum deduction for 2013. This deduction, which lets taxpayers deduct all of the cost of equipment that would otherwise have to be capitalized and deducted over several years, had been set at $139,000 for 2012 and $25,000 in 2013. 

The bill also extends 50% "bonus depreciation" on new fixed assets through 2013. It had been set to expire in 2012.

These silver linings come with their own Iowa cloud. The Section 179 changes and bonus depreciation won't apply in computing Iowa income tax unless the legislature enacts conforming legislation. The legislature has not conformed with bonus depreciation. It has conformed with the federal Section 179 limits in recent years, but Iowa won't accept returns with the new limits until the legislature acts. Depending on how fast the legislature acts, it could delay filings of Iowa returns where Section 179 is an issue.

The bill also extends a raft of "expiring provisions" for another year, including the research credit and the wind energy production credit. It doesn't extend the 2% reduction in employee Social Security tax and self-employment tax.

Be sure to visit with your tax professonal to see how these provisions will affect you and your business.

Additional coverage:

Tax Update Blog, Senate passes fiscal cliff bill in wee hours; House acts today.

Taxgirl,  House Passes Senate Budget Bill Convincingly: We Have A Tax Deal!

Year-end techniques from the edge of the Fiscal Cliff.

With less than two weeks left in the tax year, the politicians haven't reached a "fiscal cliff" deal. The latest rumors combine some version of a tax increase for higher incomes with a cap on the value of itemized deductions.  For example, a dollar of income might face a 39.8% tax rate, while a dollar of charitable contributions might save you only 28 cents.  Other proposals would simply cap the amount of itemized deductions allowed, perhaps at $50,000.

While you should consult your tax advisor about your year end planning moves, some thoughts to keep in mind:
  • If you want your itemized deduction to count this year, to be sure you get a full benefit, you should have it mailed and postmarked this year if you pay it by check.  Timely mailed, timely paid is the rule here.


  • A charitable contribution or tax payment made with a credit card counts this year, even if you don't pay your credit card bill until next year.


  • Additional itemized deductions for state and local taxes won't reduce your 2012 federal tax bill if you are subject to alternative minimum tax this year.


  • If you choose to recognize a capital gain this year to avoid the pending tax increases, the trade date is considered the date the gain is taxed, even if the settlement date is later.


  • If you aren't planning to sell an asset in the next two or three years anyway, it might not make sense to pay tax on the gain now to avoid a future tax increase.

The politicians may not settle on the tax law until the last minute, so stay in touch with your tax advisor and stay flexible.

-Joe Kristan

'Fiscal Cliff' follies: Why it may pay to take deductions early

20121202iabizWith the potential "fiscal cliff" tax rate hikes looming, the math tells us that deductions will be more valuable to top-bracket taxpayers next year. The top federal individual tax rate is scheduled to rise to 39.6% next year, from the current 35%.  A $100 deduction is worth $39.60 next year, vs. $35 this year.

Yet the math may be deceiving. The politicians may end up with a fiscal cliff compromise that can make many deductions worthless after this year.  Republican negotiators, including Iowa's Senator Grassley, have floated a $50,000 cap on allowable itemized deductions.  

Such a cap would pose a huge problem for entrepreneurs whose income is taxed on their 1040s via S corporations or partnerships. State income taxes on their business income are itemized deductions on the owner 1040s. When combined with home mortgage interest and charitable contributions, many reasonably successful entrepreneurs would shoot past a $50,000 cap.

Nothing has been enacted yet, and such a cap may never happen. But it may happen effective for 2013, and prudent taxpayers should keep this in mind. Possible self-defense steps include making sure state income tax liabilities are paid in 2012, rather than waiting until 2013. Taxpayers with big charitable pledges may want to be ready to make them this year, possibly via a donor-advised fund; the Des Moines Community Foundation sponsors one. 

Whatever you do, make any moves only in consultation with your tax advisor. Each tax situation is different. Taxpayers who owe alternative minimum tax this year will get no benefit from prepaying state income taxes, for example. Be ready and stay flexible. 

More reading on this issue here.

Related: What the fiscal cliff looks like from the back side of the election.

What the fiscal cliff looks like from the back side of the election

20121116-1iabizThe election results have cleared away some of the fog from the tax planning scene for year end, but visibility is still poor. 

What we know  

There will be a tax increase on "investment income" and wage and self-employment income starting next year. Investment income for taxpayers with adjusted gross income over $200,000 (single filers) or $250,000 (joint filers) face a new 3.8% Obamacare surcharge on their investment income. "Investment income" is broadly defined and includes taxable interest, dividends, capital gains, rental and royalty income, and "passive" income from K-1s. 

Taxpayers with wage and self-employment income face a new .9% Medicare surtax for wages or self-employment income exceeding $200,000 (single filers) or $250,000 (joint filers). This is the first time a Medicare tax rate has depended on joint income. Because employers can't know what a spouse makes, this will require many taxpayers to pay additional Medicare tax when they file their 2013 returns. Employers will withhold the .9% tax on wages over $200,000.

What we don't know

We don't know what the tax rates will be for 2013. If Congress and the President fail to agree on a plan for next year, the tax rates effective in 2000 will return, with a 39.6% top rate for ordinary income. The top rate on capital gains would rise from 15% to 20%, and the top rate on dividends would rise from 15% to 39.6%. Of course the 3.8% tax on investment income would also apply. You can see a state-by-state map of the effects of going off this "fiscal cliff" here.

We don't even know what the Alternative Minimum Tax rules are for this year 

Congress has not yet "patched" the AMT by increasing the annual exemption amount. If they fail to do so, some taxpayers may be surprised by an additional tax bill of more than $8,000 this coming April.

What to do? 

You should consult your tax advisor before you do anything. Some steps advisors will be discussing in the coming weeks with their clients include:

  • Reversing the usual tax planning by accelerating income and deferring deductions. If rates are going up, deductions will be worth more next year, while income taxed this year will be treated more kindly.
  • Examine the timing of capital gain income. For taxpayers who are going to be selling a stock or other capital asset anyway, this year may well be the time to do so. While that's true for taxpayers in top brackets for obvious reasons, it's also possibly true for taxpayers in lower brackets; the zero rate for capital gains for lower bracket taxpayers will expire this year.
  • Consider electing out of installment sales. The tax law lets taxpayers choose to be taxed on 2012 installment sales in 2012, even if the payments on the sales will be made in later years.
  • Dividend distributions. C coporations and S corporations with old C corporation earnings will contemplate whether to distribute earnings to be taxed without the 3.8% Obamacare surtax. If cash is tight, they will consider making distributions in the form of notes to get the income out this year.
  • Fixed asset elections. Taxpayers usually choose to write off fixed assets as fast as possible through "bonus depreciation" and "Section 179" expensing. If rates go up, that may be counterproductive.
  • Family gifting. The current $5 million lifetime gifting and estate tax exclusion will decline, perhaps all the way to $1 million. Advisors will be looking at ways to move wealth to the next generation before year-end.

Above all, stay flexible, be ready to act fast, and stay in touch with your tax advisor. The politicians may or may not change the tax picture in the coming weeks, so flexibiltiy is important.

-Joe Kristan

Tax stakes for entrepreneurs next Tuesday

When entrepreneurs cast their votes next Tuesday, they will be choosing between presidential candidates with very different approaches to tax policy. 

President Obama has made increasing taxes on incomes over $200,000 the centerpiece of his tax policy. He would allow the Bush-era tax cuts, which he has extended though his first term, to finally expire. This would raise the top rate of income tax to 39.6%. The 3.8% "Obamacare" tax on investment income and other provisions he supports would increase the top marginal tax rate to more than 44%. The 3.8% tax, scheduled to take effect for 2013, would also apply to interest, dividends, and many capital gains. It would not apply to business income when the taxpayer "materially participates" in the business.

Mitt Romney's tax plan is built around a 20% across-the-board individual tax rate cut, to be paid for by a eliminated deductions and tax breaks. He would also repeal the 3.8% investment income tax. 

These individual rates are important to entrepreneurs because most business are now organized as "pass-throughs" -- typically as S corporations or LLCs taxed as partnerships. Income of pass-through businesses is taxed on their owners' 1040s, so the top individual rate is also the top rate on business income. The Romney approach, with its 28% top rate, takes the tax law in a very different direction than the Obama 44%+ top rate.

How much does the top rate matter?  Quite a bit. A lot of business income is taxed on 1040s showing over $200,000 in business income, as this chart from the Tax Foundation shows:


The two candidates are closer in their approach to corporate income taxes. Both support a reduction in the top corporation rate -- Romney to 25% and Obama to 28%. 

The Tax Policy Center has posted excellent summaries of the two candidates tax plans:

What is Mitt Romney’s Tax Plan?

What Is Barack Obama’s Tax Plan?

Happy voting!

-Joe Kristan

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