Author Archives: Bruce - Your Host at The Tax Nook

LLCs, S-CORPORATIONS, AND PARTNERSHIPS – THE BASICS: PART 2

Hello again everyone!

With tax season now in motion, I wanted to take a bit of a break to complete Part 2 of this  blog post giving an overview of entity classification considerations for starting a new business (or looking at your ‘up and running’ business).

I hope that you found Part 1 to be insightful.
If, by chance, you missed Part 1 or simply would just like a refresher you can read that post here.

The second part will definitely continue the journey. So have a cup of coffee (or your favorite beverage) and let’s delve into Part 2 of LLCs, S-Corporations, And Partnerships – The Basics.

S Corporation Rules and Requirements

S corporations are just corporations that have elected to be taxed under special rules where the income and losses are passed through to the shareholders. Most, but not all, states recognize S corporations the same way the IRS does. There are a number of rules associated with S corporations. Violating them could result in a loss of S status. Should that occur, losses will be disallowed to the shareholders and profits will be taxed at the corporate level.

Making the S election is usually pretty straightforward. All of the shareholders must agree to make the election. In many states no separate election is necessary, filing the federal form automatically qualifies the corporation for S status in the state; in others you must file a separate state form.

Generally, the form must be filed within 2-1/2 months the corporation first has shareholders. Existing corporations can elect S status for a year by March 15 of that year (calendar-year corporations). There are exceptions to the rules, but this is not the place to make a mistake. You don’t want to find out some years down the road that you’ve been denied S-Corporation status. While the election is relatively simple, I would strongly recommend that you seek the services of a qualified professional to guide you through this process (this is not the time to be ‘penny wise and dollar foolish’).

There are several requirements associated with the shares of an S corporation:

  • The maximum number of shareholders is 100;
  • Shareholders can only be individuals, estates or certain trusts;
  • Shareholders must be citizens or residents of the U.S.; and
  • There can only be one class of stock.

The first requirement is unlikely to cause a problem for most corporations. All members of a family and their spouses are considered as a single shareholder for determining the 100-shareholder limit.

The second and third requirements can present pitfalls. Partnerships, corporations, and nonresidents cannot be shareholders. If an existing shareholder sells his or her shares to one of these persons, the S election will be terminated. An IRA cannot be a shareholder. (An inadvertent termination can often be remedied, but not without effort.)

The last requirement sounds innocent, but can often be a problem. While you’re unlikely to inadvertently issue preferred shares, the IRS has held that unequal distributions to shareholders can result in a second class of stock. For example, John Smith and Susan Jones each own 50% of SoapNSuds Inc. John takes a $50,000 salary; Susan takes only $10,000 annually. Neither takes any cash distributions. But SoapNSuds Inc. pays all the expenses of a car for Susan which Susan uses only 10 percent for business. The 90 percent of personal use is a distribution to Susan. Since Susan has gotten a preferential distribution, SoapNSuds Inc. may now have two classes of stock. Debt other than straight debt can be considered a second class of stock (e.g., convertible debt). Differences in voting rights generally won’t constitute a second class. Health or accident insurance premiums paid on behalf of a 2-percent plus shareholder aren’t considered distributions for the second class of stock requirement.

As always, the rules are far more complicated than discussed above. There are other requirements as well as exceptions.

 

Fringe Benefits

This is one of the drawbacks of partnerships and S corporations. Certain fringe benefits paid to any partners or more than 2-percent shareholders of an S corporation are not deductible. The fringe benefits generally include:

  • health and accident insurance,
  • qualified transportation fringes,
  • group term life insurance premiums on the first $50,000, and
  • meals and lodging furnished for the convenience of the employer.

Health insurance premiums are deductible, but only if included on the employee/shareholder’s W-2. The employee can then deduct the amount toward his or her adjusted gross income on their personal tax return. Meals and lodging furnished for the convenience of the employer include meals provided on company premises when employees can’t leave because of work requirements.

Most other fringe benefits, such as employee discounts, working condition fringes, no-additional cost services, and de minimis fringes should be deductible by the partnership or S corporation.

 

Attribution Rules

This is a technical area that’s beyond the scope of this blog post. However, you should be aware that stock ownership or an interest in a partnership can be attributable to a related party. For example, you own 50 percent of the stock of TicTak Inc. You pay the health insurance for your son who is an employee of TicTac Inc. Your son is deemed to be a more than 2-percent shareholder. In order for his health insurance to be deductible, you would have to include his health insurance premiums on his W-2.

 

Excessive Salary

Excessive salary issues have generally involved C corporations. Because dividends from a C corporation are not deductible by the corporation but income to the shareholder, the best tax way to take money out of a C corporation is generally by salary. But excessive salaries can be challenged by the IRS and deemed to be, in part, dividends.

With an S corporation, partnership, or similar entity, the IRS may take issue with excessive salaries paid to relatives, claiming you’re trying to shift income to a lower bracket taxpayer. So as an example, let’s say that you are the sole shareholder of MedBuzz Inc. a highly profitable medical electronics manufacturer. You’re in the top tax bracket (i.e., 39.6%). Your son works for the business on a part-time basis. He has a college degree but no special skills, but you pay him $275,000 per year. The IRS may decide he’s only worth $35,000 and disallow a deduction for the remainder.

If there is any question as to the salary paid to a relative, you should document hours worked and be able to show the salary is not excessive.

 

State Taxation

Most states tax S corporations the same as the Federal government does. (There are certain exceptions.) Of more concern are S corporations, partnerships and LLCs doing business in more than one state or where you have a nonresident shareholder. The partnership, S corporation, etc. must file in each state in which it does business. (This would be a good time to  check with a tax professional on the definition of doing business.) The shareholders or partners must file a personal tax return in those states or file a composite return. So, let me give a couple of examples to help clarify the above.

Example 1–Lobster Inc. is a Massachusetts corporation owned by two Massachusetts residents, Bob and Carol. Lobster Inc. is also doing business in New Yawk New York. Lobster Inc. has to file a New York state S corporation return. Both Bob and Carol have to file New York nonresident individual income tax returns reporting Lobster Inc.’s share of New York income on their nonresident returns.

Example 2–Clams Inc. is a Massachusetts corporation owned by Ted and Alice. Clams Inc. does business only in Massachusetts. Ted is a Massachusetts resident; Alice is a New York resident. Alice has to file a Massachusetts nonresident return reporting her share of Clams Inc.’s income.

That’s the general approach. Some states allow the use of a composite return. If that’s the case the corporation can file a return for the nonresidents and pay the tax directly. While the approach is simpler, the total tax should be about the same. Some states require composite returns; in some it is optional (if available). Many states now require making installment payments for nonresident shareholders.

 

Converted C Corporations

Converting from a C (regular) corporation to an S corporation is generally easy and you can usually avoid any current tax consequences. But there are traps to watch out for.

The first is the built-in gains tax. It involves appreciated assets held by the corporation while it was a C corporation and sold by the S corporation. Because the sale of appreciated assets would be taxed twice to a C corporation, but not to an S corporation, were it not for the built-in gains tax, converting to an S corporation would provide a loophole.

Example–In 1996 Green Acres Inc., then a C corporation, purchased 100 acres of land for $100,000. In 2015 when the land is worth $400,000, Green Acres Inc. converts to S corporation status. Green Acres Inc. sells the land in 2017 for $650,000. Any appreciation in the land after Green Acres Inc. converted to S corporation isn’t subject to the built-in gains tax. But the $300,000 gain ($400,000 value at time of conversion less $100,000 purchase price) is subject to the special tax.

The tax rate is the highest tax rate applied to corporations. The tax does not apply to assets held by the S corporation longer than 5 years at the time of sale. Therefore, in the example above, if Green Acres Inc. had converted to S corporation status in 2010, the tax would not have applied.

As always, the rules are more complex and you may be able to avoid the tax by careful planning.

The second danger associated with a converted C corporation involves excess net passive investment income. The S corporation must first have accumulated earnings and profits as a C corporation (while the rules aren’t exactly the same, accumulated earnings and profits are similar to retained earnings). Then it must have more than 25 percent of its gross receipts from royalties, rents, dividends, interest, and annuities. An S corporation that meets these tests is subject to a separate tax at the highest corporate tax rate on the excess net passive income.

While the tax is unlikely to affect most operating corporations (an S corporation in the business of renting property enjoys a special exception to the rent rule), there is a real danger for corporations where operations have been terminated. For example, ABC Inc. has been in business for many years about half of them as a C corporation. It sells most of its operations for cash. Rather than distributing the cash, the corporation invests it and collects dividends and interest.

The third trap uses the same tests as in the second (excess net passive income and accumulated earnings and profits) but adds a third test–three years of excess passive income. Here the penalty is termination of S corporation status. Clearly something you want to avoid.

The fourth trap involves distributions. Generally, distributions of income from S corporations are nontaxable. The shareholders pay tax on all the income when earned, so they avoid a second tax on distributions. For converted C corporations with accumulated earnings and profits distributions out of the earnings while the entity was an S corporation are nontaxable. But once those earnings have been distributed, additional earnings will be from accumulated earnings and profits of the former C corporation and are taxed just like ordinary dividends.

There are several options to avoiding these problems, but they may depend on your specific situation.

 

Basis

I’ve discussed basis in other places, but a review is worthwhile. Generally, your basis in an S corporation, partnership or LLC is equal to:

Your original and any subsequent capital contributions, + your share of the income of the entity, + your share of the separately stated income (e.g., dividends, interest, etc.), – your share of the losses, – your share of the separately stated deductions (e.g., a Section 179 expense option), – your share of the distributions.

There are a number of items that can enter into the calculation (such as when property rather than cash is contributed to the entity), but the basic approach remains the same. In addition to your basis in equity capital, S corporation shareholders and partners have a basis in any money loaned to the entity. Partners can increase their basis in the partnership by partnership debts for which they are liable. Once your equity basis has been exhausted by losses, additional losses will reduce your loan basis.

Your basis is important for determining your amount at-risk, the amount up to which you’re allowed to deduct the losses of the entity. It also determines your gain or loss on the sale of the business.

Just because you can’t take the losses doesn’t mean they don’t reduce your basis. The Section 179 expense option can create a particular trap. Because of a limitation, you may not be able to use the deduction elected by the S corporation or partnership, but your share of the amount elected will reduce your basis.

Another trap arises from nondeductible expenses. Even though they don’t decrease your profit or increase your loss, they do reduce your basis. The most commonly encountered one is the 50 percent of meal and entertainment expenses that aren’t deductible.

 

Loss Limitations

I’ve said that income and losses of S corporations, partnerships, LLCs, etc. are passed through to the partners, shareholders, etc. That’s generally true, but in order to take the losses you have to pass some tests. The first I discussed in Part 1, material participation. (Actually the material participation test is applied first.) But you also have to have sufficient amount at-risk. That is, your economic investment in the entity must be at least as much as the losses.

What’s your amount at-risk in the entity? A complete discussion would be involved, but most taxpayers won’t get into the nuances. In most cases, your amount at-risk is very similar to your basis. And, in many cases, a shareholder or partner needs to go no further. But there can be substantial differences, particularly in the case of partnerships. Here are some points:

  • You are not at risk with respect to amounts protected by nonrecourse loans, guarantees or stop-loss agreements.
  • You are not at risk with respect to amounts borrowed from a person who has an interest (or than as a creditor) in the entity or a person related to a person with such an interest.
  • In some cases the at-risk rules can be applied separately to separate activities.

Two examples based on simple situations should help clarify.

Example 1–Vince invests $5,000 in XYZ Inc. to start the business (he’s the only shareholder). During year 1 XYZ Inc. has income of $30,000 and Vince takes a distribution of $9,000. Vince’s basis in XYZ Inc. at the end of year 1 is $26,000 ($5,000 + $30,000 – $9,000). In year 2 XYZ Inc. has a loss of $15,000 and Vince takes a distribution of $2,000. Vince’s basis at the end of the year is $9,000. In year 3 XYZ Inc. has a loss of $16,000; Vince takes no distribution. Vince can only deduct $9,000 of the $16,000 loss. The remaining $7,000 loss can be carried forward and used in a year when he has sufficient basis.

Example 2–The facts are the same as in example 1, but in year 3 Vince loans XYZ Inc. $10,000. The loan increases his total basis in XYZ Inc. to $19,000 (the $9,000 equity basis at the end of year 2 plus the $10,000 loan basis). Viince can take the full $16,000 loss, leaving him with no equity basis (you use equity first) and only $3,000 in loan basis ($10,000 original loan basis less $7,000 loss applied to loan basis).

Here comes a trap. Assume XYZ Inc. ceases operations (just to simplify the example) when XYZ Inc. starts repaying the loan to Vince, a portion of each principal payment will be income because Vince’s basis in the loan is only $3,000.

A second trap involves loans from a party who has an interest in the entity other than as a creditor. For example, Vince and Kathy are 40-60 shareholders in XYZ Inc. Vince wants to increase his interest to 50 percent and borrows $30,000 from Kathy to make an equity investment. Vince is not at risk for the $30,000 additional investment.

It sounds like I have spent a considerable amount of time explaining what may sound like a fine point. However, many small businesses are financed with only a minimal amount of equity and a large amount of debt.

Partnerships, LLCs and sole proprietorships can get more complicated. The basic rules are the same. But your amount at-risk in a partnership or sole proprietorship is increased by any loans for which you are personally liable and decreased by the relief of any debt for which you are liable. For example, Bonnie and Clyde are 50-percent partners in Green2Go Co., a general partnership. Each contributed $5,000 to start the business. Green2Go Co. borrows $20,000 from Ketchum Bank to purchase inventory. Bonnie and Clyde are considered to have increased their amount at risk by their share of the loan, $10,000 each.

But that increase is elusive. Assume Green2Go Co. has losses of $30,000 ($15,000 for each) in the first year. Bonnie and Clyde can deduct all the losses because their amount at risk is $15,000 each. That decreases the at risk amount to zero. Assume in year two Green2Go Co. has cash flow but no profit for the partners. Green2Go Co. uses $10,000 of the cash generated to pay off the bank loan. Bonnie and Clyde will have $5,000 of taxable gain because of the reduction in the bank loan. A similar situation could occur if the partner is no longer at-risk with respect to the loan or investment.

 

Sale of Interest

Selling your interest in an S corporation can be as simple as signing over the shares of stock. More than likely you’ll draft a purchase and sale agreement providing for a noncompete clause, payment terms, etc. Some of the proceeds will be outside the gain or loss on the business. For example, the noncompete agreement is usually between the owner of the business and the buyer. The corporation isn’t involved. It’s more complicated in the case of a partnership, since there are a number of special issues to be dealt with and that’s beyond the scope of this blog post. However, the starting point for computing gain or loss is similar.

Whether you have a gain or loss on the sale of an asset is determined by your selling price and the basis. That can be good news or bad news, depending on your basis. Keep in mind that your basis in an S corporation or partnership depends on your equity investment plus any income less losses and distributions. For example, Vince started XYZ Inc. with $5,000. Over the years XYZ Inc. has had income of $85,000; Vince takes no distributions. He sells his stock for $160,000; he has a $70,000 gain (selling price of $160,000 less $90,000 basis). Katlin started World Inc. with a $100,000 investment. World Inc. has losses of $90,000; her basis is $10,000 ($100,000 investment less $90,000 in losses). Katlin sells her stock for $160,000. She has a gain of $150,000 ($160,000 selling price less $10,000 basis).

As always, things can be more complicated. The point to remember here is that your gain or loss is based on more than just your original investment.

 

Distributions

In our Part 1 of this article I said it really doesn’t matter if you take a distribution or not, the income from an S corporation, partnership, etc. is taxable to you. But what about the distribution? Is that taxable? This is another time when the answer depends on your basis.

Generally, distributions up to your basis are nontaxable. Distributions in excess of your basis are taxed as a capital gain.

Example–Chris invested $5,000 to start LMN Inc. LMN Inc. has had earnings of $23,000. Chris takes a distribution from the company of $35,000. At the time of the distribution, Chris’ basis in LMN Inc. was $28,000. Of the $35,000 distribution, $28,000 is nontaxable, the remaining $7,000 is treated as a capital gain and, assuming the required holding period is met, taxed at long-term capital gain rates.

The rules for partnerships are similar. How can you distribute more money than you put in? Simple. If you financed the business with debt or even have accounts payable, you could have cash available for distribution.

In the discussion above I assumed that only cash is distributed. Distributing property (e.g., a truck used in the business given to your son) will complicate the issue. A distribution of appreciated property by an S corporation could result in a taxable gain. And the amount of the distribution will be the fair market value of the property. A distribution of property by a partnership won’t result in gain until it’s sold by the partner. But a distribution of property encumbered by a liability (a truck with a loan outstanding on it) can trigger an overall decrease in partnership liabilities. The reduction in the partners’ liability will result in a deemed distribution to the partners.

 

In Conclusion:

As I wrap up this two-part post I will say that I know that this post was a long read (in addition to Part 1) but the length just reflects how intricate choosing an entity classification can be for your business. The decision is not to be taken lightly.

But, keep in mind, what I covered in these two posts only scratched the surface. So, if you are starting a business or even if you are already ‘in business’, give Solid Tax Solutions
(SolidTaxSolutions.com) a call so that we can help you make informed and smart decisions for your business.

We can be reached at (845) 344-1040 year round.

__________________________________________________________________________________________________

Bruce – Your Host at The Tax Nook

Our Firm’s Website: SolidTaxSolutions.com (or just click on the icon on right sidebar of this page).

Other Social Media Outlets: Facebook.com/SolidTaxSolutions (or just click on the icon on right sidebar of this page).

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LLCs, S-CORPORATIONS, AND PARTNERSHIPS – THE BASICS: PART 1

Hello All!

Over the past year a number of people who have started a business or contemplated starting a business, have asked me various questions about LLCs, S-Corporations, and Partnerships and which of these forms of ownership is best.

These questions have come to me by way of visits to our office, through this blog, facebook (facebook.com/solidtaxsolutions), or even through twitter (twitter.com/@SolidTax1040). But there was a common denominator among these questions. A lack of understanding of what these entities represent and the responsibilities required by each.

So, I’ve decided to put pen to paper (so to speak) to give a foundation on which business formation and operation decisions can be made.

I’ve decided to break this up into two parts so as not to overwhelm. But keep in mind that the two parts do not represent all that needs to be considered when forming a business or contemplating changing the ‘entity type’ for the business.

So, here we go…………

 

CAUTION

While it’s too early to predict what effect any tax legislation in 2017 will have on S corporations and partnerships, you should be aware that significant changes are possible.

An Introduction

LLCs, S corporations, and partnerships, have been around for some time and are very popular with small businesses. But despite their extensive use, there are still a number of misconceptions among business owners and the entities have their own particular traps. This blog post is not a detailed treatise, and certainly won’t make you an expert. That would take way to many pages. Rather, I’ve tried to assemble a list of misconceptions and traps that I’ve encountered over the years. Many of the basic rules are the same for LLCs, S corporations, partnerships . I’ll point out important differences as I discuss the topic.

Notes:

  • The Middletown company used in the examples below is always assumed to be an S corporation or a partnership or LLC.
  • References to owners can mean either shareholders or partners.
  • LLCs are generally treated as partnerships (Note: An LLC can also have only one member in which there would be a different tax treatment. But for now I will talk about the LLC as if there is more that one ‘owner’, hence partnership treatment).

 

Basic Operation of a Pass-Through Entity

S corporations, LLCs and partnerships are known as pass-through entities. The idea behind a pass-through entity is that the entity doesn’t pay any taxes. Instead, the income and losses and certain separately stated items are passed through to the shareholders or partners and reported on their personal tax returns. That’s the big advantage of a pass-through. If a business operates as a C (regular) corporation, it pays a corporate level tax. Any payments made to the shareholders are taxed again on the shareholder’s personal tax return (therefore a double tax for C corporation shareholders. But I digress). Avoiding the corporate tax can produce substantial savings, depending on the tax level of the corporation. An additional advantage is that accidental constructive dividends (e.g., when the corporation pays for a shareholder’s personal expenses) avoid the double tax. Instead, in the case of a pass-through entity, the deduction is simply disallowed and considered a distribution.

In the simplest situation, the income or losses are passed through to the shareholders/partners. For example, Middletown, LLC has two equal partners, Darren and Fred. For the year it (the partnership) has gross receipts of $250,000 and expenses of $140,000. Of the total net income of $110,000, $55,000 is reported on Darren’s K-1 and the same amount reported on Fred’s K-1. Darren and Fred report the income on their respective Form 1040s.

 

Separately Stated Items

But, it’s often more complicated. Some items are considered to be “separately stated”. Instead of affecting the income or expense of the entity, they’re passed through to the owners separately. For example, Middletown, LLC makes a charitable contribution of $200. Instead of deducting that amount from Middletown, LLC’s income, it’s reported separately on the K-1 to the owners. The owners can take their share of the contribution on Schedule A of their 1040, but only if they itemize. Similarly, interest and dividend income isn’t included in the entity’s gross income, but passed through to the owners and reported on their Form 1040.

Unfortunately, a number of items that you might consider to be business income and expenses are also passed through to the shareholder/partners separately. They include the -Section 179- expense option (writing off equipment purchases), capital gains and losses, gains and losses on the sale of equipment, all credits including the work opportunity, disabled access, energy, foreign taxes, certain special expenses such reforestation expense deduction. Investment expenses, such as portfolio management fees, must also be separately stated.

Rental activities must also be passed through separately. For example, Middletown, LLC’s business is providing advice to manufacturers. Because the partners saw an opportunity to buy a building containing five small offices at an attractive price, they did so. The income and expenses of the rental property are reported on a specific tax form and the net income (or loss) is not reported on Middletown LLC’s return but passed through to the owners.

Tax Tip 1–Problems can arise if the entity has more than one owner and the owners have different tax situations. For example, Middletown, LLC bought raw land as an investment three years ago. Sue and Fred each own 50% of Middletown, LLC. Fred has a large capital gain this year; Sue rarely has investment activity. The land has declined significantly in value and Fred wants to sell it. His share of the loss could be used to offset his gain. Sue can only take $3,000 of the loss this year and carry the remainder forward indefinitely. Passive losses resulting from rentals might be limited by the phase-out of the $25,000 exception for one or more owners, but not for other owners, depending on their individual tax situation. There are other examples.

Tax Tip 2–Using the S corporation or partnership to hold investments, make contributions, etc. can increase the complexity of a return. That will add to preparation cost and make tracking certain items more difficult. While often a minor concern, before complicating your business, make sure there’s a valid reason for doing so. That may be particularly true with respect to rental properties in the business. It is often smarter to hold them in your own name or a separate LLC for both tax and non-tax reasons.

 

Salaries, Distributions, and Business Income

This, unfortunately, could be one of the most misunderstood areas of pass-through entities. More than once I’ve heard a taxpayer say “How could I owe so much money? I didn’t take a salary last year.” Or “I won’t take a salary so I’ll save on taxes”. Here’s were the rules on S corporations and partnerships and LLCs separate.

Basically, whether or not you take anything out of your pass-through entity, the owners will be taxed on all the income. In the case of a partnership or LLC, all the income is taxable as self-employment income. That means you’ll owe the self-employment tax on your share of the income.

An S corporation is just a ‘wee bit’ more complicated. Let us first assume that you take no salary from the corporation. In that case, like a partnership or LLC, all the income of the corporation is still taxable to the owners, but is not subject to the self-employment tax. Before you think you’ve spotted a loophole, you should be aware that the IRS requires corporate officers/employee/shareholders to take a salary. The salary you take will be subject to the usual FICA and Medicare taxes (as well as state and federal unemployment). Your share of the FICA/Medicare is withheld from your salary; the business pays the other half, just as if you were an employee at an unrelated employer.

A couple of examples should make it clearer.

Example 1–Fred is the sole shareholder of Middletown, Inc., an S corporation. Middletown, Inc. needs the cash, so Fred decides not to take a salary during 2016. He takes no distributions from the corporation of any kind. At the end of the year, Middletown, Inc. has a profit of $250,000. On his Form 1040, Fred reports the entire $250,000 of corporate profit as income. Fred has no other items of income, so his adjusted gross income is $250,000. (I assumed no other income to make the examples easier.) Example 2–Sue is the sole shareholder of Chester Inc., an S corporation. Chester, Inc. has excess cash. Sue takes her regular salary $100,000 and a distribution of $60,000. At the end of the year, Chester, Inc. has a profit of $150,000 (after accounting for Sue’s salary). On her Form 1040, Sue reports the corporation’s profit of $150,000 as income and the $100,000 salary as income. The distribution of $60,000 doesn’t enter into the computation. She has no other items of income, so her adjusted gross income is $250,000 ($100,000 in salary plus the $150,000 of Chatham’s profit).

Clearly, either way, the total income from the entities reported by the shareholders are the same. It doesn’t matter how you take the money out, or even if you take it out. The only difference will show up in FICA and Medicare taxes. By taking less of a salary, you can avoid some of these taxes. The flip side is that you’ll have less earned income for funding a pension plan or for other purposes.

There is a situation where you can end up disadvantaged from a tax standpoint.

Example 3–Middletown, Inc. has net income of $20,000 through late December. Fred, a 100% shareholder takes a $50,000 salary that creates a net loss of $30,000 for Middletown, Inc. Fred’s basis (I’ll discuss that later; for now assume it’s his investment in the corporation) is $5,000. Fred can only deduct losses up to his basis. On his personal return he’ll report $50,000 of salary, but can only deduct $5,000 of his loss.

With a partnership or LLC, the results are similar. Leave the money in or take it all out. You’re still taxed on the full amount earned. In addition, you’ll pay the self-employment tax on the full amount either way.

There may be reasons for not taking the money out, such as loan covenants, avoiding contributing funds back to the business for cash flow purposes, etc., but there are no real tax advantages or disadvantages.

 

Hobby Loss Rules

Just because you incorporated or set up an LLC or partnership doesn’t mean you’re immune from the hobby loss rules. The rules prevent taxpayers from deducting losses from activities that are not real businesses. This is rarely an issue if you’ve got an operating business with employees, a storefront, you have one or more years of income despite losses, etc. But if you run the business as a sideline, there are significant recreational elements (e.g., horse boarding, dog breeding), you have consistent losses that are unlikely to be reversed and you don’t carry on the activity in a business like manner (e.g., don’t keep good records, don’t attempt to reverse losses, don’t have professional advisers) you could be in trouble.

If you fall into the latter category (e.g., it’s a sideline) there are a number of steps you can take to insure you won’t have a problem with the IRS.

 

Separate Activities

Tax law requires S corporations, partnerships and LLCs (and sole proprietorships) to break down their businesses into separate activities for purposes of the passive activity rules. (See next.) This could mean that if your S corporation, etc. has more than one activity, you may not be able to use losses from one to offset profits from another. For example, Middletown, Inc. has two businesses. Fred manages and operates a machine shop that rebuilds aircraft engines in Albany, NY. Sue runs Middletown Inc.’s two stores selling kayaks on Cape Cod. Neither Fred nor Sue interfere in the operation of each other’s respective activities. They get together a few hours monthly to review the combined financial statements and provide each other with business advice. Middletown Inc. must account for the businesses separately and losses from the kayak sales can’t be used to offset profits from engine rebuilding.

While this may be an extreme example, the message here is that you should not assume that you can put two completely diverse businesses together so that the losses may be utilized. When do you have to split the business into separate activities? That’s a difficult question that depends on the facts. The IRS will look at five factors–similarities or differences in the types of businesses; extent of common control; extent of common ownership; geographical location; and interdependence between the activities. There’s a good chance you won’t run into the situation. And, fortunately, even if you do, the answer is often obvious. In the example above, there’s no chance this is a single activity. But the operation of a chain of auto repair shops would be a single activity, as would rebuilding aircraft engines and operating an airport.

 

Passive Activities and Material Participation

One of the reasons for the complexity of the rules surrounding S corporations and partnerships stems from the ability to pass through losses to the owners. The uncontrolled use of partnerships (and S corporations to a lesser extent) in the early 1980’s led to restrictions on the use of the losses. Congress wanted to deny losses to passive investors while allowing them to owners who were active in the business. They arrived at the concept of “material participation”. If the owner materially participated in the business (as most small business owners do), the losses could be used to offset other income such as dividends, interest, salaries, etc. On the other hand, owners who did not materially participate (passive investors) could not use these losses to offset other income. They could be used to offset other passive income or used to offset other income when the investment was completed disposed of.

What’s material participation? There are seven tests. Pass any one and you’re in. Most business owners will pass one of these three tests:

  1. You participate in the activity for more than 500 hours during the tax year.
  2. Your participation constitutes substantially all of the participation in the activity of all individuals (including non owners) for the tax year.
  3. You significantly participate in the activity and your total participation in all significant participation activities during the year exceeds 500 hours. The threshold for significant participation is 100 hours.

Most small business owners will pass the first test. But participation counts only if it’s actually managing or working in the business. The second test is available for sidelines or very small businesses. So for example, let’s say that you’re a flight instructor and on trips to various airports you try and sell a line of aviation electronics. You’re the only employee and spend about 300 hours a year at the business. Test 3 is for owners who own a number of businesses and significantly participate in each of them for more than 100 hours a year, but don’t make the 500 hour test for any one business.

Keep in mind that there are four other tests. I’ve found that most small business owners qualify under the three listed above.

If you don’t materially participate in the activity, you can’t currently deduct the losses. The losses are passive and can only be used to offset current or future passive income or on the disposition of the activity. And that’s the reason for the definition of activity. In our example above, Sue can deduct her losses in the kayak activity. Fred can’t. He can only deduct losses incurred in his aircraft engine operation.

What does it all mean? Before you agree to part with a bunch of cash and join your buddies in a new venture, you should thoroughly understand the rules. While it still may be a good deal even if you can’t take any losses currently, you may want to reconsider.

Don’t get hung out to dry with your business, contact Solid Tax Solutions
(SolidTaxSolutions.com)
. It will be worth it.

We can be reached at: (845) 344-1040.

Are you ready for Part 2? Well you can read it right here.

__________________________________________________________________________________________________

Bruce – Your Host at The Tax Nook

Our Firm’s Website: SolidTaxSolutions.com (or just click on the icon on right sidebar of this page).

Other Social Media Outlets: Facebook.com/SolidTaxSolutions (or just click on the icon on right sidebar of this page).

Twitter: Twitter.com/@SolidTax1040 (BTW, We Follow-Back).

The Self-Employment Tax. What is It and How Does it Effect You?

If you’re just beginning business (or even if you have an existing business) as a sole proprietor, a partner in a partnership or a member of an LLC (limited liability company), it’s very important you understand the self-employment tax. Failure to take the tax into account when making your estimated tax payments could result in a substantial penalty. At the very least, you’ll have a big surprise when you file your 1040 in April. If you’re familiar with this tax, you should still read this article. There are plenty of pointers that many taxpayers overlook.

So let’s start off with: What the heck is the Self-Employment Tax? If you’re a sole proprietor or a partner or an LLC member, you are not considered to be an employee. You will receive no W-2 and nothing is withheld from your pay for FICA (Federal Insurance Contributions Act) or medicare taxes. (If you’re an employee, 7.65% is withheld from your pay and your employer matches that amount, paying a total of 15.3% to the government). In order to collect a similar amount for social security and medicare, a sole proprietor has to pay 15.3% of his self-employment income. The tax is sometimes called SECA (Self-Employment Contributions Act). It’s actually more complicated than that; I’ll get into the details shortly.

Employers will make regular deposits of FICA and other withheld taxes to the IRS. Individual taxpayers who owe the self-employment tax are responsible for paying the FICA and medicare taxes directly to the IRS. That’s done through quarterly estimated tax payments. For most taxpayers that’s April 15, June 15, September 15, and January 15. There’s no separate tax return. Instead, when you file your individual income tax return you must complete Schedule SE (Self-Employment Tax) to compute the tax and report the liability on the back of Form 1040. The self-employment tax is reported separately and added to your individual income tax on Form 1040. Estimated tax payments and withholdings are credited against your total tax liability.

Example: Sue Smith has self-employment income during 2016. The associated self-employment tax is $4,500. Her regular income tax liability for the year will be $3,250. In addition, she withdrew money from an IRA and owes a penalty of $500. She worked a regular job for part of the year and had $1,500 in income tax withholdings. She made estimated tax payments of $3,000. Here’s a computation to show what she owes with the tax return.

	Income tax liability                         $3,250
	Self-employment tax                           4,500
	Early withdrawal excise tax			500
	 Total liability                              8,250
	Less: Withholdings                           (1,500)
	Estimated tax payments                       (3,000)
         Net tax due with return                      3,750

Sue owes $3,750 with her tax return. Even though it’s paid to the IRS, the self-employment tax portion will end up with the Social Security Administration. However, when it comes time to compute the penalty due for tax underpayments during the year, no distinction is made. If you’re in the 15% bracket or the lower portion of the 25% bracket, the self-employment tax can easily be more than your income tax. For example,  lets say that you’re married, no children, take the standard deduction, have $40,000 of net income on your Schedule C and have $3,000 of other income. For 2016 your income tax liability would be about $1,990 (after accounting for a deduction for one-half of the self-employment tax on your income taxes); your self-employment tax would be $5,652.

Detailed computation. While all you need do is complete Schedule SE to figure your tax liability, you should know that the computations aren’t as simple as portrayed above. Keep in mind that the total FICA tax is really made up of two pieces. The first portion is the 12.4% OASDI (Old Age, Survivors, and Disability Insurance). The tax only applies to earnings of $127,200 or less (2017 amount; it’s indexed for inflation). The second portion is for medicare. That’s 2.9% of all your self-employment income or wages. There’s no upper limit on that portion. Beginning in 2013 an additional 0.9% medicare tax is assessed on self-employment income in excess of $200,000 (single) or $250,000 (married filing joint). In an effort to equalize the tax burden of individuals and corporations (who get to deduct their half of the FICA taxes), the calculations involve several steps. Assume in the steps below your net self-employment income is $140,000.

Step 1. The tax isn’t on all of your net earnings. The base is only 92.35% of net earnings. Thus, the base using our $140,000 of self-employment income is $129,290.

Step 2. Only the first $127,200 (2017 amount) is subject to the full 15.3% tax. Thus, multiply $127,200 by 15.3%; the result is $19,461.60. The difference between $129,290 and $127,200 is $2,090. That amount is taxed at only 2.9%, so the tax is $60.61. The total tax is $19,522.21 ($19,461.60 + $60.61).

If your self-employment income was only, say $60,000, you would only have to first multiply by 92.35%, then by the full tax rate, 15.3%.

Step 3. If, during the year, you also received wages or a salary as an employee and your employer withheld FICA, the computations are more complex. Those wages will count toward meeting the wage base. Use the ‘long-form’ on Schedule SE to compute the tax. Thus, if you’ve already had a salary of $127.200 or more, the earnings from your sole proprietorship (or partnership, etc.) would only be subject to the 2.9% medicare tax and the 0.9% additional Medicare tax (when applicable).

Step 4. You can deduct one-half of the self-employment tax on the front page of Form 1040. Using the numbers from our example, that would be $9,761.11. Since this amount reduces your adjusted gross income (AGI), the deduction is worth more than if it were simply an itemized deduction.

When computing your earnings subject to the tax, you’ve got to net your profits and losses from all your business activities that would be subject to the tax. For example, you have $60,000 of self-employment income as a partner and a $35,000 loss from your auto repair shop you run as a sole proprietorship. Your net earnings subject to the tax are $25,000. If you have a net loss, you’re not liable for the tax.

Beginning in 2013 there’s an Additional Medicare Tax of 0.9% on self-employment income (as well as regular wages) on income over $200,000 ($250,000 for a married couple filing jointly; $125,000 married filing separate). For a single individual, computation is easy since there’s only one income. For a married couple the threshold applies to the couple. For example, Wilma has a job in Manhattan and makes $175,000 a year. Fred works in Middletown and makes $50,000. Fred has a side business and made $45,000 in 2014. The couple has a total of $270,000 in earned income and pays tax an additional tax of 0.9% on the $20,000 ($270,000 less the threshold amount of $250,000).

Persons Subject to the Self-Employment Tax. You’re subject to the tax if you were self-employed and your net earnings from that source were $400 or more. (You’re considered self-employed if you carry on a trade or business either as a sole proprietor or partner in a partnership). You don’t have to be in business on a full-time basis. Part-time work also qualifies.

A trade or business is generally an activity carried on for a livelihood or in a good faith attempt to make a profit. While this depends heavily on the facts and circumstances, the IRS wins most of the cases on this issue. There have been a few situations where a taxpayer was able to show he wasn’t in a trade or business, but don’t count on being able to do so. You might be able to show that, for example, you grow fruit for your own consumption. You’ve done so for a number of years and never sold any. Because of crop losses by others in your area, you can sell enough one year to show a small profit. In subsequent years you don’t sell any of your crop. You might be exempt. Get good advice if you’re going to make such a claim.

Special Situations:

  • Inactive partners are subject to the self-employment tax.
  • Limited partners are only subject to the tax on guaranteed payments such as salary and professional fees received for services performed.
  • Retired partners are not subject to the tax on retirement income. However, the amounts received must be under a written plan that meets certain requirements.
  • The income from a single member LLC (treated as a sole proprietorship for federal tax purposes) is self-employment income.
  • The law is not entirely clear on LLC members where the LLC is treated as a partnership. However, guaranteed payments to a member should be considered self-employment income. An LLC member who is active in the LLC should also be considered liable for the self-employment tax on his or her distributive share.
  • Resident aliens are generally subject to the same rules as U.S. citizens. Nonresident aliens generally do not pay the self-employment tax.
  • Executors and administrators of estates may or may not be liable for the tax. You are liable if you’re a professional fiduciary, an attorney, or a nonprofessional fiduciary and your duties require extensive managerial activities on your part for an extended period of time or your fees are related to the operation of the business and you actively participate in the business. If your duties are limited to handling an ordinary estate where any business management is small or nonexistent, then the income is not subject to the self-employment tax.
  • Fishing crew members come under some special rules. Generally, they’re considered self employed if they take a share in the catch.
  • Newspaper carriers and distributors are generally considered independent contractors and subject to the tax. Carriers or distributors and vendors under the age of 18 are not subject to the self-employment tax.
  • Notary public fees are not subject to the tax.
  • Trailer park owners may or may be liable for the tax. The outcome here depends on the amount of services provided to the tenants. Minimal services such as sewerage, water, electrical connections, etc. won’t result in the income being subject to the tax. Substantial services beyond those required for occupancy (such as maintaining a recreational hall, operating a laundry facility, etc.) will make the earnings self-employment income.
  • Director’s fees received in performing services as a director of a corporation are self-employment income.
  • S corporation income distributed to you is not subject to the self-employment tax. However, you can’t avoid the FICA taxes by not taking a salary. If you take no, or too low a salary, the IRS can recharacterize some of the earnings as salary that’s subject to FICA taxes.
  • Your spouse is subject to the self-employment tax if he or she is a partner in your business. You may want to put him or her on the payroll as an employee. That way you withhold FICA taxes and your business pays its portion, just as you would for a regular employee. Talk to your tax advisor about this approach. You may be able to make higher contributions to your pension plan and deduct health insurance premiums.
  • Income subject to the tax. Finding your self-employment income is generally straight forward. It’s the bottom line on your Schedule C. If you’re a partner, you should be able to get the info from your K-1.

Even though associated with the business, some income is not considered self-employment income. For example, gains and losses on the following types of property are not included:

        1. Investment property.
        2. Depreciable property or other fixed assets used in the business.
        3. Livestock held for draft, diary, breeding, or sporting purposes and not held primarily for sale, regardless of how long the livestock were held or whether they were raised or purchased.
        4. Standing crops sold with land held more than one year.
        5. Timber, coal, or iron ore held for more than one year, if an economic interest was retained.

 

      • Income from the sale of property that is stock in trade or held primarily for sale to customers is subject to the self-employment tax.

Example: Middletown Lawns, a sole proprietorship, sells small tractors, lawn mowers, etc. At the end of 2017 it sells some old inventory at a substantial loss. The loss reduces the owner’s self-employment income (the loss is taken on Schedule C).

Example: The facts are the same as in the example above, but Middletown Lawns also owns some equipment that is used only for rentals. Middletown Lawns sells this equipment at a loss. The loss doesn’t reduce the owner’s self-employment income. Similarly, if the equipment were sold for a gain, it wouldn’t increase the owner’s self-employment income.

  • Dividends and interest received on securities are generally not self-employment income. However, interest you receive in your business (e.g., interest on overdue accounts receivable) is part of your self-employment income and subject to the tax. Payments for lost income, such as insurance payments after a casualty to your business, are subject to the tax.
  • Real estate rental income and personal property leased with the real estate is generally not self-employment income. However, if you receive rent as a real estate dealer, the income is included in your self-employment income.
  • Renting personal property (e.g., equipment) generates self-employment income.
  • Hotel or motel income is generally subject to the tax. Whether or not income from a real estate rental or hotel is subject to the tax depends on the facts and circumstances. If you provide substantial services for the convenience of the occupants, not normally provided with the rental of rooms for occupancy only, the income is subject to the self-employment tax. For example, providing maid service for individual rooms would make the income subject to the tax. On the other hand, the cleaning of stairways and lobbies would not.

Optional methods. If your gross income is $2,400 or less you may be able to use an optional method of computing the self-employment tax. You’ve got to meet a number of tests. I won’t go into the details here, because so few people normally qualify. However, you should be aware the method exists. It allows you to pay the self-employment tax if your profit for the year is small or if you have a loss. Why pay more taxes than you have to? Using the method allows you to qualify for social security coverage when you normally wouldn’t. That increases your quarters of coverage. It may also allow you to claim a larger credit for dependent care expenses and the earned income credit.

Estimated tax payments. As discussed, you pay the self-employment tax along with your estimated individual income taxes during the year. The law doesn’t make a distinction. That is, your income tax and self-employment tax are added together and treated as one. The same rules apply. That is, you can usually avoid a penalty if you pay in at least as much as your prior years’ liability. You may be able to reduce your estimated payments by annualizing your income and making payments based on your actual income during the year.

 

So, in closing this particular blog post, let me say that this presentation was an overview of (and primer about) the Self-Employment Tax.

Keep in mind that each business (and the form of ownership that each business takes) is different and has its own Self-Employment Tax ‘details‘.

Solid Tax Solutions (SolidTaxSolutions.com) can help you with ‘Self-Employment Tax’ issues or any other issues concerning your existing business, new business, or business that you are considering.

You can reach us (year-round) at: (845) 344-1040.

__________________________________________________________________________________________________

Bruce – Your Host at The Tax Nook

Our Firm’s Website: SolidTaxSolutions.com (or just click on the icon on right sidebar of this page).

Other Social Media Outlets: Facebook.com/SolidTaxSolutions (or just click on the icon on right sidebar of this page).

Twitter: Twitter.com/@SolidTax1040 (BTW, We Follow-Back).

A New Presidential Administration Will Soon Be Upon Us. What Tax Changes Can We Expect???

Effects on Businesses

What do the election results mean to your business? Your taxes? There’s no one answer to that. As far as the effect on your business, with small exceptions, it should be positive. Most experts believe they’ll be a move away from regulations that have negatively impacted many businesses. But the actual impact will vary widely. The plumber working on his own faces regulation on the local, county, and town level. Federal rules probably have little, if any, effect. Some health care businesses will do much better, as evidenced by the surge in prices for drug companies. Some will do worse as many hospitals believe the demise of Obamacare will hurt their business.

Donald J. Trump

Donald J. Trump

It can get far more complicated. Will home prices rise? It depends. If immigration (legal and illegal) is severely restricted, new home prices will rise because smaller contractors often use immigrant labor. Higher interest rates, which some professionals predict, would also have an effect on home prices. On the other hand, reduced regulation of banks could ease lending rules which could offset higher interest rates. And a lower tax rate would increase available income.

From a business standpoint, the best advice is to analyze the situation, listen to any trade organizations, and don’t overreact in either direction. While it seems fairly certain Obamacare will be attacked rather quickly, many other changes could take much more time.

Effect on Taxes

What will happen to taxes? Some changes are fairly predictable, some aren’t. Here’s my brief rundown of the most predictable ones. These are based on President-Elect Trump’s proposals.

Individual Tax Rates: They’re heading lower, at least the top rates. The proposed rates are 12 percent, 25% and 33%. The lowest rate would apply to the first $75,300 for those married folks filing jointly ($37,650 for single); 25% on taxable income up to $231,450 ($190,150 single). Everything above those levels would be taxed at 33%. The 3.8% tax on net investment income would be eliminated. The head-of-household filing status would be eliminated.

NoteThe income breakpoints indicated are based on a House of Representatives proposal.

Capital Gains: The capital gain rates might be unchanged, with the exception of eliminating the 3.8% tax on investment income. The same rates would apply to qualified dividends.

Deductions: The standard deduction would increase to $30,000 for married filing jointly ($15,000 for single). There would be a $200,000/$100,000 cap on itemized deductions. No personal exemptions.

Childcare: An above the line deduction for child and elder care expenses limited by a taxpayer’s income.

Alternative Minimum Tax: Trump’s proposal would be to eliminate the tax.

Corporate Tax Rates: The corporate rate would drop to 15% under Trump’s proposal. That may be unrealistically low. Passthrough entities would be taxed at 15%, but taxed again on distributions. Good news for businesses that retain a substantial share of their income.

Section 179 Expensing: The limitation would increase from $500,000 to $1 million per year.

Estate Taxes: The estate tax would be eliminated. But so could the stepped up basis on assets at death, at least on assets above the current estate tax threshold.

Those are the highlights, the ones that affect the most taxpayers, and the ones that have the best prospect of passing.

But the devil is in the details. Here are some points to consider.

Congress: The Republicans do have a majority in both houses, but the Senate for one, is thin and not all members vote the party line. That means some compromise might be necessary. In addition, the Trump plan isn’t the only one. The House has its own plan. And many individual members have their own thoughts.

Paying for the Cuts: The cuts have to be paid for in some way. Some estimates put the 10-year deficit increase at $9 trillion. There is some sleight-of-hand that can be used to ignore at least part of the problem currently, but it’ll show up quickly. That’s happened in the past. The economy will have to grow faster than it has in some time to solve the problem. If not, tax rates could creep higher after the initial cuts. That’s happened in the past. It might be avoided with significant spending cuts, but that approach has proved elusive in the past. And at some point spending cuts will be felt at the voting booth.

Fewer People will Itemize: That’s definitely true. And for a number of taxpayers, taxes will be simpler. But having three tax rates rather than seven won’t help much. Most tax returns are prepared by professionals on computer. Few people actually use the tax tables to compute their tax liability. And for many taxpayers, itemizing isn’t the problem. It’s dealing with capital gains, education expenses, rental properties, a sole proprietorship, etc. and that will continue to cause headaches.

State Taxes: Most states use federal taxable income as a starting basis for their tax. Many states use the same itemized deductions, some with modifications. Unless they change their approach, you still could be itemizing.

Retirement Plans: Look for additional benefits for contributions to retirement plans.

Other Changes: It’s more than likely that Trump’s proposals will be incorporated into a host of other changes. Where this will end up is hard to predict. Overall tax liabilities are almost sure to be lower, but deductions for individuals reduced. There could be cutbacks in certain credits and other deductions for particular industries or taxpayer benefits. Thus, some taxpayers may benefit less than others. Once more information is available, you should discuss your situation with your tax advisor.

Timing of Changes: Clearly nothing will happen in 2016 to affect 2016 returns. Any changes will be in 2017 although the actual timing is difficult to predict. At this point many experts predict early attention to taxes, but it may be far enough along in the year that some of the changes will not be retroactive to the beginning of 2017.

Tax Planning: The safe bet now is to defer income into 2017 and take deductions this year. For a more detailed discussion of tax planning and to see how any upcoming tax changes will affect you, contact Solid Tax Solutions (SolidTaxSolutions.com). We can be reached, all year-long, at (845) 344-1040.

___________________________________________________________________________________________________

Bruce – Your Host at The Tax Nook

Our Firm’s Website: SolidTaxSolutions.com (or just click on the icon on right sidebar of this page).

Other Social Media Outlets: Facebook.com/SolidTaxSolutions (or just click on the icon on right sidebar of this page).

Twitter: Twitter.com/@SolidTax1040 (BTW, We Follow-Back).

You and Your Spouse Own a Business Together. What are the Tax Issues?

Ahhhhh……….The Husband and Wife owned business.

Love, love, love……….

A man and a women holding hands.

No one knows for sure how many businesses in the U.S. are co-owned by spouses.

A professor from Oklahoma State University estimated in 2000 that there were 3 million such businesses, so the number today likely is much higher.

Some giant corporations — Fiji Water, Forever 21, Panda Express, and Houzz — were founded by husband-wife teams.

There are many personal issues that couples face when co-owning a business.

Here are some of the tax issues that spouses co-owning a business should think about.

Tax Filing for Spousalpreneurs

A couple who co-owns and operates a business that is unincorporated and shares in the profits and losses are in a partnership, whether or not they have a formal partnership agreement. Usually they must file a partnership tax return, Form 1065, as well as report the income, losses, etc. on their personal return. However, they can elect to file Schedule Cs along with their Form 1040 instead of Form 1065, saving them from the complexities of the partnership return. To make this election:

  • Both spouses must materially participate in the business, which essentially means working on a day-to-day basis. (Material participation tests can be found at the IRS.) Neither spouse can be merely an investor.
  • Each spouse must file a Schedule C to report his or her share of income, gain, loss, deduction, and credit attributive to the respective interests in the business. If they split things equally, then both Schedule Cs will look the same.
  • Each spouse must file a Schedule SE to pay self-employment tax on his/her share of the net income from the business. This is the same action that would occur if the couple had filed a partnership return.

Divorce

It’s not uncommon for spouses who co-own a business to get divorced. What happens in the property settlement? Some spouses continue to co-own the business after divorce. Others may transfer interests to the other so that only one spouse owns and runs the business after the couple splits up.  How the business interests are addressed all depends on the couples involved.

From a tax perspective, the transfer of property incident to divorce is tax free. This means the transferring spouse does not recognize any gain or loss on the transfer to the other spouse. The spouse who now owns the business steps into the shoes of the other spouse when it comes to tax basis, so that if the business is later sold, the recipient-spouse recognizes the gain on any appreciation the transferor-spouse had but did not recognize at the time of the property settlement.

If spouses try to co-own and run a business after the divorce but it doesn’t work out, they can still part ways tax free. That’s what happened recently to one couple who had co-owned three dance-related businesses. After 17 months following the divorce, one party bought out the other for $1.6 million, and the Tax Court said this wasn’t a sale but rather part of the property settlement.

Innocent Spouse Relief

Spouses who co-own businesses typically file joint tax returns. These tax returns include the couple’s business income. By filing jointly, each spouse is jointly and severally liable for the tax due on the return, plus any interest and penalties. Can an owner obtain innocent spouse relief for the actions of the other spouse? Seems so.

In another recent case, one spouse was the sole owner of the business; the other handled the books and all other back-office operations. This spouse routinely had the tax return prepared and, after obtaining the other’s signature, filed it. The problem: She didn’t file it one year and he was assessed interest and penalties (she had died by this time). While he owed the tax, the Tax Court gave him innocent spouse relief for the interest and penalties.

Bottom Line

Spouses who co-own businesses should have very good lawyers and tax professionals so that each spouse’s interests are protected.

Solid Tax Solutions (SolidTaxSolutions.com) is skilled in such matters and can be reached year-round at: (845) 344-1040.

__________________________________________________________________________________________________

Bruce – Your Host at The Tax Nook

Our Firm’s Website: SolidTaxSolutions.com (or just click on the icon on right sidebar of this page).

Other Social Media Outlets: Facebook.com/SolidTaxSolutions (or just click on the icon on right sidebar of this page).

Twitter: Twitter.com/@SolidTax1040 (BTW, We Follow-Back).

Considerations for Small Business Owners in Voting for a New U.S. President.

After a long, contentious, and heavily covered race to the U.S. presidency, the 2016 campaign cycle is coming to end in only a few weeks. Chances are you’ve been overloaded with news and commentary and—whichever candidate you support—you’ll be somewhat relieved after the results are announced on November 8th.

A side-by-side picture of Hillary Clinton and Donald Trump

But that doesn’t mean you should tune out until then. Between the candidates’ platforms, tax plans, and stances on topics such as healthcare, immigration, and consumer protection, there are important issues at stake that may directly affect your business and industry.

Which Election Issues Matter Most to Entrepreneurs?

As a business owner, you have several political agenda items to consider before you vote on Election Day:

What Will the Proposed Healthcare Reform Mean for Your Small Business?

The Affordable Care Act, signed into law in 2010 and commonly referred to as “Obamacare,” made healthcare a focal point of political discourse—in large part because of its effects on America’s businesses. Some business owners support the Affordable Care Act for providing employees with mandatory insurance coverage, while others complain that the law places an excessive financial burden on employers.

Have You Analyzed Each Candidate’s Tax Plan?

Although virtually every presidential candidate in recent history has pledged to make taxes more advantageous to small businesses, tax plans vary wildly by administration when it comes down to the details. A business owner would be wise to scrutinize each candidate’s proposals to determine:

  • The tax breaks and incentives for business owners
  • Which types of taxes will be increased
  • Whether income brackets and business categories are changing, and if so, to what extent

How Will Federal Regulations Impact Your Industry?

From safeguarding consumer privacy to providing accommodations for disabled employees, companies are subject to all kinds of federal regulations, though some industries are more regulated than others. The two major parties fundamentally disagree about the scope and authority of these regulations and the agencies in charge.

The Consumer Financial Protection Bureau (CFPB), which lawmakers established in 2010 as part of the Dodd–Frank Wall Street Reform and Consumer Protection Act. Republicans believe the CFPB has too much unchecked power over financial institutions, while Democrats argue for the agency’s necessity and seek to sustain it—if not expand its influence.

Where Do You Stand With Minimum Wage?

Several states have recently passed legislation increasing state minimum wage, and the subject is a hotly debated one in Washington as well. A federal minimum wage hike is not simply an issue of cost versus savings, but large-scale economics and government intervention.

Some business owners advocate for raising the minimum wage, citing that better pay increases productivity and reduces turnover. Others contend that a $12–15 minimum wage would put their organizations out of business or cause them to lose their competitive edge domestically and globally.

What About Federal Loan Availability for Rising Entrepreneurs?

Do you believe it should be easier for business owners to borrow credit? A “yes” or “no” answer places you firmly on one side or the other of the political spectrum. The parties’ stances on banking regulations and Wall Street reform tell you a lot about what the availability of loans under their administrations would look like, but there’s more to the story than that.

Aside from the candidates’ promises to promote small business growth, the various outcomes of the election could have significant repercussions on the economy, as consumer attitudes shift and lenders become more or less confident as a result.

Does Your Small Business Depend on International Trade?

Speaking of broad economic impact, each candidate’s attitudes on international trade could weaken or strengthen U.S. businesses, depending on your perspective. It may be easier or more difficult during the next few years to establish overseas corporate partnerships, reach consumers in different countries, and sell products and services all over the world.

What’s Your Take on Immigration & the Startup Visa Proposal?

According to the Partnership for a New American Economy, over 40% of Fortune 500 companies were founded by immigrants or children of immigrants. America’s policies on immigration fuel innovation and competition, which aren’t necessarily net-positive or net-negative effects for each and every company.

So, while border control is a deeply personal issue for many on all sides of the debate, there’s a business case to be made either way—so long as you can differentiate the facts from the rhetoric.

Where Can You Go for Detailed Information About Each Candidate?

In the next few weeks, take the time to educate yourself on each candidate’s positions. Here are a few resources that will help you start researching before you cast your vote:

If at any point during your research you wonder how certain regulations and tax codes will affect your specific business don’t hesitate to contact us.

So, what other small business issues would you like the candidates to talk about?

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Bruce – Your Host at The Tax Nook

Our Firm’s Website: SolidTaxSolutions.com (or just click on the icon on right sidebar of this page).

Other Social Media Outlets: Facebook.com/SolidTaxSolutions (or just click on the icon on right sidebar of this page).

Twitter: Twitter.com/@SolidTax1040 (BTW, We Follow-Back).

Hurricane Preparations

This post, due to the nature of the topic, will be short.

In light of Hurricane Matthew’s impending arrival I want to say, first of all, that my heart goes out to those who have dealt with or are about to deal with Matthew.

A street with a 'Hurricane Evacuation Route' sign.

Here are a couple of tips that may be of help to you.

For individuals and businesses in Florida and South Carolina, there’s not much time left for preparations. There are two things you can do–or have your kids do:

  1. Take pictures of the interior of the house and important or valuable items, then take pictures of the exterior.
  2. Either take your computer with you or download your most important files onto a flash drive. Accounting records, business data, etc. as well as any personal information such as bank and brokerage account numbers, etc. In the future you should consider backing up the computer to the cloud or to an outboard hard drive (if you don’t already). Make sure you put the flash or hard drive in a waterproof container before leaving the house.

Again, my heartfelt best wishes to those who have been affected by Matthew or who will be dealing with this hurricane very soon.

Bruce

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Bruce – Your Host at The Tax Nook

Our Firm’s Website: SolidTaxSolutions.com (or just click on the icon on right sidebar of this page).

Other Social Media Outlets: Facebook.com/SolidTaxSolutions (or just click on the icon on right sidebar of this page).

Twitter: Twitter.com/@SolidTax1040 (BTW, We Follow-Back).

A Sole Proprietorship May Be The Easiest Route to Travel for SOME Businesses!

A lot of people think that the first step to starting a business is incorporating or organizing a Limited Liability Company (LLC). While both types of entities can provide your business with additional protection, they’re not the answer for everyone. And that protection comes at a cost. I’ve created a list of some factors that should be reviewed before deciding on an LLC, a corporation, or a sole proprietorship. For the sake of this post, I will assume that your business, at least in the beginning is a one-person show with no partners and no employees. While that leaves out many startups, it encompasses many more.

The Words 'Sole Proprietorship'.

Here Are Some Points to Consider:

Potential Liability. If you’re designing and importing a children’s toys, you will need all the protection you can get. On the other hand, if you’re a carpenter your insurance should be able to handle most liability issues. Many professionals are likely to be sued personally even if the business is incorporated. Things quickly change if you have employees. If that’s the case a corporation or LLC can protect you personally.

Business Debts. In earlier times the corporate form was used mostly to protect owners from being personally liable for corporate debts. Today, it’s used for personal protection from a range of lawsuits. But for most small businesses, owners will be required to personally guarantee any bank, etc. loans. The only advantage to a corporation or LLC may be avoiding accounts payable on a default. And even a corporation or LLC won’t protect you if don’t respect the formalities of the entity.

Cost. If you do it yourself, the cost of setting up (and dissolving if it doesn’t work out) a corporation or LLC may be relatively small (generally between $125 and $800). Using an attorney will add to the cost. There may be annual fees such as filing fees and franchise taxes. These vary widely. Not much of an issue if the business is nicely profitable, but a burden if you’re suffering losses. If you do business as a corporation (S or C) you’ll have a separate return to file. That is a consideration if you have a professional prepare it.

LLC vs. S Corporation. While you could do business as a regular C corporation, you could find yourself subject to double taxes. Most small businesses elect S corporation status where profits and losses are passed through to the shareholders. An LLC with only one member is a separate entity for legal purposes, but is disregarded for federal tax purposes. That is, instead of filing a partnership return (the normal return for an LLC with more than one member (owner)), a single-member LLC reports its income and expenses on the owner’s Schedule C. That, plus the fact no balance sheet is required, can save some preparation costs at tax time.

DBA. If you’re doing business as a corporation or LLC you will decide on a name when filing with the state. While you could use your own name (e.g., Ralph Kramden, Inc.) that’s usually not the case. As a sole proprietorship, the default is to use your own name. That’s fine if you’re Ralph Kramden, Attorney-at-Law, but not so attractive if you want to brand the business. The solution is filing with your state for a Doing Business As (DBA) to do business under an assumed name (e.g., Ralph Kramden doing business as Brooklyn Auto Body). You have to decide if you want the extra work of a DBA.

Transactions Between You and Entity. If you’re doing business as a separate entity, you’ve got to respect the formalities. Business assets are purchased and titled in the name of the entity. Assets transferred to shareholders or LLC members should be accounted for on the books and for tax purposes. Loans are taken out in the name of the entity. Not in your name personally. Paying a corporate loan (or other expense) with a personal check won’t get you a deduction. The proper approach is either to make a loan or equity contribution to the business so the business can pay the expense and get the deduction. Alternatively you can submit an expense report and have the business reimburse you. Paying personal expenses with a business check as well as not respecting other formalities such as making customers, creditors, etc. aware that you’re doing business as an LLC or corporation can allow outsiders to challenge the existence of the corporation or LLC. It sounds simple enough, but most small business owners don’t follow through. A sole proprietorship doesn’t have these problems.

Switching Entities. If you start a business as a sole proprietorship and later decide to incorporate or change to an LLC, doing so is relatively straightforward and there are generally no tax consequences. Going in the other direction can be more complicated, particularly if you have fixed assets. In some cases there may be tax consequences.

The Best Approach? If you have or will have shortly, owners in addition to yourself, you might as well use a corporation or LLC from the businesses inception. If additional owners are unlikely (at least for some time) a sole proprietorship should be considered if the liability protection of an LLC or corporation isn’t needed. You should discuss the issue with your attorney and with your tax advisor.

Keep in mind that this discussion is in no way inclusive of all factors to be considered in starting a business.

So, if you are considering starting a business (or already have a business) give us a call for a consultation. Your business will thank you.

We can be reached at: (845) 344-1040. You can also learn more about us at our website:
SolidTaxSolutions.com.

__________________________________________________________________________________________________

Bruce – Your Host at The Tax Nook

Our Firm’s Website: SolidTaxSolutions.com (or just click on the icon on right sidebar of this page).

Other Social Media Outlets: Facebook.com/SolidTaxSolutions (or just click on the icon on right sidebar of this page).

Twitter: Twitter.com/@SolidTax1040 (BTW, We Follow-Back).

Uh-Oh! The IRS is Riding the Debt Collector Train. Again!

Sooooooo, the IRS has recently announced (on September 26) that it plans to begin a private collection program (authorized by the Fixing America’s Surface Transportation Act) for certain overdue federal tax debts next spring and has selected four contractors to implement the new program.

A 1040 tax return with the word 'Overdue' stamped on it.

The IRS Has Hired Private Debt Collectors to Collect Back Tax Debt.

The IRS has attempted to use private contractors twice in the past, both times finding it not cost effective. Now, under the law, the IRS is required to use qualified contractors to collect inactive receivables. An inactive receivable is one that meets one of the following requirements:

  1. At any time after assessment, the Internal Revenue Service removes such receivable from the active inventory for lack of resources or inability to locate the taxpayer,
  2. More than 1/3 of the period of the applicable statute of limitation has lapsed and such receivable has not been assigned for collection to any employee of the Internal Revenue Service, or
  3. In the case of a receivable which has been assigned for collection, more than 365 days have passed without interaction with the taxpayer or a third party for purposes of furthering the collection of such receivable.

Certain receivables are not eligible for collection using private collectors. They include:

  • Those subject to a pending or active offer-in-compromise or installment agreement,
  • Those classified as an innocent spouse case,
  • Those involving a taxpayer identified by the IRS as being:
    1. Deceased,
    2. Under the age of 18,
    3. In a designated combat zone,
    4. A victim of tax-related identity theft,
    5. Currently under examination, litigation, criminal investigation, or levy,
    6. Subject to pending or active offers in compromise,
    7. Subject to a right of appeal, or
    8. In a presidentially declared disaster areas and requesting relief from collection,
  • those currently under examination, litigation, criminal investigation, or levy, or
  • those currently subject to a proper exercise of a right of appeal under this title.

The new program, authorized under a federal law enacted by Congress last December, enables these designated contractors to collect, on the government’s behalf, outstanding inactive tax receivables. As a condition of receiving a contract, these agencies must respect taxpayer rights including, among other things, abiding by the consumer protection provisions of the Fair Debt Collection Practices Act. The IRS has selected the following contractors to carry out this program:

    • CBE Group 1309 Technology Pkwy Cedar Falls, IA 50613
    • Conserve 200 CrossKeys Office park Fairport, NY 14450
    • Performant 333 N Canyons Pkwy Livermore, CA 94551
    • Pioneer 325 Daniel Zenker Dr Horseheads, NY 14845

These private collection agencies will work on accounts where taxpayers owe money, but the IRS is no longer actively working their accounts. Several factors contribute to the IRS assigning these accounts to private collection agencies, including older, overdue tax accounts or lack of resources preventing the IRS from working the cases.

The IRS will give each taxpayer and their representative written notice that their account is being transferred to a private collection agency. The agency will then send a second, separate letter to the taxpayer and their representative confirming this transfer. Private collection agencies will be able to identify themselves as contractors of the IRS collecting taxes. Employees of these collection agencies must follow the provisions of the Fair Debt Collection Practices Act and must be courteous and respect taxpayer rights.

The IRS will do everything it can to help taxpayers avoid confusion and understand their rights and tax responsibilities, particularly in light of continual phone scams where callers impersonate IRS agents and request immediate payment.

Private collection agencies will not ask for payment on a prepaid debit card. Taxpayers will be informed about electronic payment options for taxpayers on IRS.gov/Pay Your Tax Bill. Payment by check should be payable to the U.S. Treasury and sent directly to IRS, not the private collection agency.

If you owe back taxes to the IRS, give Solid Tax Solutions a call (we are open year-round) at: (845) 344-1040.

We are also on the web at: SolidTaxSolutions.com.

__________________________________________________________________________________________________

Bruce – Your Host at The Tax Nook

Our Firm’s Website: SolidTaxSolutions.com (or just click on the icon on right sidebar of this page).

Other Social Media Outlets: Facebook.com/SolidTaxSolutions (or just click on the icon on right sidebar of this page).

Twitter: Twitter.com/@SolidTax1040 (BTW, We Follow-Back).