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).

How Often Should Business Income Be Taxed?

A recent post (August 26, 2016) on the Tax Justice website was titled:  Why We Must Close the Pass-Through Loophole? Well that ‘kinda’ caught my attention as I was trying to think what the “loophole” might be?  A loophole is a provision that can be used beyond its intended purpose because the rule is not written specifically enough. When a rule is being used as intended, it is not a loophole. So, for example, sometimes the mortgage interest deduction is called a loophole, but it is not. People deducting interest on the mortgages on their primary and vacation homes are using the rule as intended.

A figurine struggling to hoist a barbell with the word tax written on each end of the barbell.
Double Taxation! Is It Necessary?

The “loophole” that was the subject of that blog post is large businesses operating as partnerships rather than as corporations. Partnerships, S-Corporations and Sole Proprietors do not pay corporate income tax. Instead, the income is taxed directly to the owners and only one level of income tax is paid at the federal level (and state level). In contrast, C corporations pay the corporate income tax AND when they distribute earnings (dividends) to shareholders, the shareholders pay income tax. Therefore, C corporation income is taxed twice.

That just happens to be the way it works in our (i.e., the United States for readers abroad) tax system. It doesn’t have to work that way and not all countries double tax corporate income. In the U.S., there is some relief in that ‘qualified dividends’ received by individuals are subject to the lower capital gains tax rate.

Over the years, there have been numerous studies by the government and various organizations on how to ‘integrate’ the corporate tax. In other words to have corporate income taxed only once.  There are numerous ways this can be done.  Two easy ones would be to not have a corporate tax (only tax dividends) or not tax dividends (only tax corporate income at that level when earned).  Neither is ideal because not all corporations pay dividends and not all corporate shareholders are taxable (a lot of corporate stock is owned by tax-exempt organizations).

The Tax Reform Act of 1986 called for the United States Treasury to study corporate taxation. This resulted in two reports issued in 1992 on corporate integration (January 1992 and December 1992).  Most recently, Senator Orrin Hatch, chair of the Senate Finance Committee (SFC) reported that he is working on a plan for corporate ‘integration’ and the SFC held two hearings on an approach called the ‘Dividends Paid Deduction’ model (May 17, 2016 and May 24, 2016. You can also see the Joint Committee on Taxation report prepared for the hearings right here.

Some of the advantages of corporate ‘integration’ include:

  • Treats all business entities similarly (although this also depends on the corporate versus individual tax rates applicable to business income).
  • Removes or lessens a corporation’s tax preference for debt over equity.

So, I will ask the question a bit differently from the The Tax Nook blog post: why not eliminate double taxation of corporate income and find a way to tax all business entities similarly?

So, what do you think?

_________________________________________________________________________________________________

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).

Categories: Business, Income Tax

Are You Making Money With Pokémon Go? The IRS Is Watching!

Pokémon GO has been downloaded an estimated 30 million times since its release on July 5 with more daily active users than the mobile versions of Pandora, Twitter, and Netflix . Millions of users every day log in and attempt to catch different types of Pokémon, ranging from Pidgey to Charmander to Squirtle and, of course, the most recognizable Pokémon, Pikachu.

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Last month, I touched on the Pokémon GO phenomenon. You can read that article here.

The amount of money being spent is mind-blowing with millions of dollars being generated every day. Nintendo, which controls one third of Pokemon, has seen its stock value double and because of the way iPhone charges users, Apple is said to be in a position to make billions. Not surprisingly, entrepreneurs are looking for ways to crack the Pokémon GO market, too. Here are a few ideas generating interest:

  • Drive: One cab driver in Mexico came up with the idea of driving customers around to help them “hunt” for Pokémon. Emilio Cacho, a 29-year-old cab driver, started calling his cab “Poketaxi” after offering his services to players. Mr. Cacho, who charges by the hour as a “Pokémon hunter”, has received more than 20 calls since he got started. BUT WAIT! Do you want to hear the irony? Cacho doesn’t even play the game, saying, “I don’t even know how to play, but I downloaded the app to help my clients.” And Cacho isn’t alone – there’s also a Pokémon bus.
  • Walk: You don’t even have to be a cab driver to earn extra cash You can just use your feet. You can take a user’s Pokémon GO account for a walk. Those users that are too busy to catch creatures on their own or maybe don’t want to deal with the heat are willing to pay. Ads are showing up online like this one on Craigslist in Houston (will walk for $15/hour).
  • Write: If you’ve figured out all of the best spots and strategies for catching Pokémon, why not share your expertise? You can write your own “how to” guide to help new users figure out the game. You can post your tips online via the web, newsletter, or eBook to sell or monetize.
  • Make a Video: If writing isn’t your strong suit, why not share your expertise? “How to” videos are popping up online every day telling users how to find the best creatures, what to spend money on (and what to avoid), and master tips. Monetizing those videos with ads can bring in extra revenue.
  • Promote: Small businesses have figured out that advertising Pokéstop locations can be a great advertising tool: attaching specials to Pokéstop locations can bring in new customers. Some businesses are even using lures (you have to buy these) to attract Pokémon to woo customers. New ideas for promotion are constantly bouncing around the internet. The possibilities are practically endless.

If you’re hoping to pick up some extra cash in the Pokemon GO craze, here’s what you need to keep in mind from a tax perspective (Oh, you didn’t think it would be that easy…….did you?):

  1. Income is Income. It doesn’t matter if your extra income is from walking Pokémon accounts or investing in the stock market, income is reportable unless it’s otherwise excluded.
  2. Understand What’s Business and What’s Just for Fun. Income may be income but how it’s reported can vary depending on whether you’re engaged in a business or a hobby. Hobbies and businesses are reported on differently on your Federal Income Tax return and they are treated differently for purposes of self-employment tax (business income is subject to self-employment tax while hobby income is not). When it comes to deductions, if you earn income in the pursuit of a hobby, you can offset the income with deductions but you cannot claim deductions that exceed your income – there’s no loss for a hobby. So if you spend more than you make, you’re out of luck. If, however, you earn income in the pursuit of a business, you can not only offset the income with deductions, you can carry any losses forward or backward. These rules are sometimes referred to as the “hobby loss rules” and they are important. To distinguish a bonafide business from a hobby, the Internal Revenue Service (IRS) looks at a bunch of different factors including whether you expect to make money (if so, you’re typically a business) as well as whether you are actually making money (again, typically a business). So how seriously you treat your new pursuit will matter. For more on distinctions between a hobby and a business, click here.
  3. Keep Good Records. It may seem like all good fun when you’re chasing a Pikachu, but you want to be able to verify your income and your expenses. The best way to do this is contemporaneously. If you’re working by the hour, keep a log of your time. Save your invoices and document income. When it comes to expenses, keep receipts and describe the nature of the expense (you can write this right on the receipt, or use a scanner and upload the image with an explanation). But, don’t get rid of those receipts immediately after Tax Day. You can read an article from our blog describing how long to keep your tax records by clicking here.
  4. You May Need to Prorate Some Expenses. Typically, you can only deduct expenses that are primarily for business use. Sometimes, you may have items like your cell phone or your car that are used for business and personal reasons. When it comes to those expenses, all is not lost. You can typically deduct the business portion of the expense. To figure that out, you’ll want to document your use and note when it’s for business. The easiest way to do this is to keep a log of your time and mileage. If, at the end of the year, you find, for example, that 30% of the use was for business, then you can typically deduct 30% of the expense. Some exceptions apply (for example, the IRS always considers a primary home landline personal, even if you jump up and down all the while swearing that it’s used solely for business). And, be careful, cars can be tricky.
  5. You May Need to Make Estimated Payments. The extra few hundred dollars you earn from walking or ad revenue might not drastically affect your tax bill, but if you’re making a significant amount of money, you’ll want to plan ahead. If you expect to owe more than $1,000 at tax time from your extra efforts, you’ll want to make estimated payments. Estimated taxes must be paid quarterly: if you skip a payment or pay late, you may be subject to a penalty.
  6. Consider Hiring a Tax Professional. Don’t assume that hiring a good tax professional will be complicated or expensive. If your tax situation becomes more complicated from your side business, especially since all of your income will no longer be reported by your employer on a form W-2, you may need help. Don’t hire just on cost.

Sometimes, a side business is just that. But if it turns out to be something more, don’t ignore the business side of things.

__________________________________________________________________________________________________

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).

 

Categories: Business, Income Tax

YOUR BUSINESS MAY BE OPERATING IN MORE THAN ONE STATE….AND THAT MIGHT BE A BIG AND COSTLY SURPRISE TO YOU!!

      Why you might ask?

Well let me tell you….since you asked.

Each state has its own regime for corporate income tax, sales tax, use tax, and other revenue raisers. Typically, you are subject to a state’s taxes if you have a nexus to the state.  Nexus means having a substantial physical presence within a state, such as maintaining offices, warehouses, or a sales force. The presence may be permanent or temporary.

However, as states look to expand their ability to tax, the concept of nexus is growing as well, and may cause you to become subject to a state’s taxes without any conscious decision on your part to transact business there. so, for example, merely traveling on business by airplane creates nexus in a number of states. And with the advent of online sales, a number of states have created “click-through nexus“, where online (remote) sellers with a certain level of sales are deemed to have sufficient nexus to collect sales tax in the state where the sales occur (the location of the buyer even though the seller is in another state).

The 2016 Bloomberg BNA survey of State Tax Departments found some startling information that you should know about when it comes to nexus. (Note: You can download a complimentary copy of the survey, but you have to provide your email, name, company, and zip code).

Key Findings From the Survey:

      • Using FedEx or UPS to deliver goods in another state can create sales tax nexus for remote sellers (this is so in 1 out of 4 states).
      • Because of the complicated tax rules, some businesses may be subject to double taxation (i.e., tax on the same income, sales, etc. in more than one state). While there may be some deductions or credits for taxes paid in one location against taxes in other, the write-offs may not fully account for the taxes.
      • Guidance on how pass-through entities (S Corporations, Partnerships) should apportion income to the states in which there is nexus is largely unclear; only 6 states have clear guidance rules.

Bottom line

Talk with your tax advisor to determine your business’s exposure to taxes in states that you may not think have a physical presence in. If you learn you will be treated as having a nexus elsewhere, then discuss ways to minimize your tax bill in any of these other states.

___________________________________________________________________________________________________

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).

Categories: Business, Income Tax, Sales Tax

Are You Planning to Buy High End Residential Real Estate?

Even though this post is not directly about taxes I wanted to timely share information that could, under certain circumstances, affect a segment of the population as a result of a recent action by a bureau of the U.S. Treasury. Don’t worry, I’ll keep this article short.

The Financial Crimes Enforcement Network (FinCEN) has announced Geographic Targeting Orders (GTO) that will temporarily require U.S. title insurance companies to identify the natural persons behind shell companies used to pay “all cash” for high-end residential real estate in six major metropolitan areas. FinCEN remains concerned that all-cash purchases (i.e., those without any bank financing) may be conducted by individuals attempting to hide their assets and identity by purchasing residential properties through limited liability companies or other opaque structures. So to better understand this vulnerability, FinCEN issued similar GTOs earlier this year covering transactions in Manhattan and Miami-Dade County, Florida. The GTOs announced yesterday will expand upon the valuable information received from the initial GTOs. You can see the complete release here——> https://www.fincen.gov/news_room/nr/pdf/20160727.pd f.

So, I promised that I would keep this post short. But, I hope that this information is helpful to those potentially affected.

Stay tuned!

___________________________________________________________________________________________________

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).

Categories: Business, Uncategorized

Will Government Regulating Compensation for Big Business Affect Your Small Business?

A proposed rule under the Dodd-Frank Act would require Wall Street firms with $250 billion or more in assets to defer bonuses to top executives for four years (instead of the current three years). The rule is meant to curb risk-taking. Political rhetoric by some presidential candidates has also taken aim at Wall Street compensation. Why should small business owners on Main Street care what happens to executive compensation for those on Wall Street?

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Does Small Business Need More Government Regulations?

Here’s the Reason I Care: It comes down to government regulation. If the government can tell certain companies how much they can pay, and when, the government can also tell small business owners what they can reap from their companies. There are already various rules impacting what businesses can pay, and most of these rules already impact small businesses.

Here’s a summary:

Tax limits on compensation. Only reasonable compensation is tax deductible. The issue only comes up for owners and other top management, primarily in connection with C corporations. There’s no dollar amount for it; it depends on facts and circumstances (what would a hypothetical independent investor in the business pay for compensation to owners and top management?). Compensation to S corporation owner-employees must also be reasonable so that it’s not low-balled to avoid employment taxes.

No tax deduction can be claimed by a firm that pays reasonable compensation if it exceeds a set amount in certain situations: up to $1 million ($500,000 for the top 5 executives in medical insurance companies and companies directly assisted by the government under the Emergency Stabilization Act) and up to $500,000 for compensation to service providers covered by a Covered Health Insurance Provider (CHIP).

DOL minimum compensation rules. The Department of Labor, states, and some municipalities have minimum wage rules that require employers to pay workers at least a minimum hourly rate. By executive order, there’s a special federal minimum wage rule that applies to federal contractors, including small businesses that do work for the government. What’s more, a pending rule that is expected to take effect shortly would hike the compensation limit for employees subject to overtime pay rules.

Bottom Line

Small businesses are hypersensitive to the marketplace. If competitors raise their compensation, most others try to follow suit in order to attract and retain good employees. In other words, the marketplace sets the level of compensation.

Does this mean I oppose minimum wage rates? Not necessarily; they’ve been in place since 1938 (the hourly rate was fixed at that time at 25¢ per hour, which if adjusted for inflation would be $4.22 in 2016). I’m just a little leery of the government setting a rate that will work for all. If the rate is too high, small businesses will be forced to cut the number of workers, reduce hours, or find non-labor solutions (e.g., robotics).

So, let’s all be cautious of government action regarding compensation.

What do you think?

___________________________________________________________________________________________________

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).

Categories: Business

Do You Have A Business or Do You Have A Hobby? Does It Make a Difference?

Millions of Americans have hobbies such as sewing, woodworking, fishing, gardening, stamp and coin collecting, but when that hobby starts to turn a profit, it might just be considered a business by the IRS.

Business or a Hobby and Taxes!
I Don’t Know if I Have a Business or a Hobby. How Will Each Affect my Taxes?

Definition of a Hobby vs. a Business

The IRS defines a hobby as an activity that is not pursued for profit. A business, on the other hand, is an activity that is carried out with the reasonable expectation of earning a profit.

The tax considerations are different for each activity so it’s important for taxpayers to determine whether an activity is engaged in for profit as a business or is just a hobby for personal enjoyment.

Of course, you must report and pay tax on income from almost all sources, including hobbies. But when it comes to deductions such as expenses and losses, the two activities differ in their tax implications.

Is Your Hobby Actually a Business?

If you’re not sure whether you’re running a business or simply enjoying a hobby, here are nine factors you should consider:

  1. Whether you carry on the activity in a businesslike manner.
  2. Whether the time and effort you put into the activity indicate you intend to make it profitable.
  3. Whether you depend on income from the activity for your livelihood.
  4. Whether your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business).
  5. Whether you change your methods of operation in an attempt to improve profitability.
  6. Whether you, or your advisers, have the knowledge needed to carry on the activity as a successful business.
  7. Whether you were successful in making a profit in similar activities in the past.
  8. Whether the activity makes a profit in some years, and how much profit it makes.
  9. Whether you can expect to make a future profit from the appreciation of the assets used in the activity.

An activity is presumed to be for profit if it makes a profit in at least three of the last five tax years, including the current year (or at least two of the last seven years for activities that consist primarily of breeding, showing, training, or racing horses).

The IRS says that it looks at all facts when determining whether a hobby is for pleasure or business, but the profit test is the primary one. If the activity earned income in three out of the last five years, it is for profit. If the activity does not meet the profit test, the IRS will take an individualized look at the facts of your activity using the list of questions above to determine whether it’s a business or a hobby. (It should be noted that this list is not all-inclusive.)

Business Activity: If the activity is determined to be a business, you can deduct ordinary and necessary expenses for the operation of the business on a Schedule C on your Form 1040 without considerations for percentage limitations. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is appropriate for your business.

Hobby: If an activity is a hobby, not for profit, losses from that activity may not be used to offset other income. You can only deduct expenses up to the amount of income earned from the hobby. These expenses, with other miscellaneous expenses, are itemized on Schedule A and must also meet the 2 percent limitation of your adjusted gross income in order to be deducted.

What Are Allowable Hobby Deductions?

If your activity is not carried on for profit, allowable deductions cannot exceed the gross receipts for the activity.

Note: The Internal Revenue Code limits deductions that can be claimed when an activity is not engaged in for profit.

Deductions for hobby activities are claimed as itemized deductions on Schedule A, Form 1040. These deductions must be taken in the following order and only
to the extent stated in each of three categories:

  • Deductions that a taxpayer may claim for certain personal expenses, such as home mortgage interest and taxes, may be taken in full.
  • Deductions that don’t result in an adjustment to the basis of property, such as advertising, insurance premiums, and wages, may be taken next, to the extent gross income for the activity is more than the deductions from the first category.
  • Deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent gross income for the activity is more than the deductions taken in the first two categories.

If your hobby is regularly generating income, it could make tax sense for you to consider it a business because you might be able to lower your taxes and take certain deductions.

Still wondering whether your hobby is actually a business? Give us a call and we’ll help you figure it out.

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

Or, visit our web site 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).

Categories: Business

How Long Should I Keep My Tax Records?

Was that a question that you’ve ever asked?

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I know that I get that question asked of me quite frequently. Whether from a new client, or attending a social gathering, or even at a baseball game (I was actually asked this at a Mets baseball game at Citifield by a fellow fan during casual conversation).

Now that we are in full swing of this year’s tax season, you are probably wondering what old records can be discarded. If you are like most taxpayers, you have records from years ago that you are afraid to throw away. It would be helpful to understand why the records must be kept in the first place.

Generally, we keep tax records for two basic reasons: (1) in case the IRS or a state agency decides to question the information reported on our tax returns, and (2) to keep track of the tax basis of our capital assets so that the tax liability can be minimized when we dispose of them.

With certain exceptions, the statute for assessing additional taxes is three years from the return due date or the date the return was filed, whichever is later (IRC section 6501(a) in case you feel ‘geeky’). However, the statute of limitations for many states is one year longer than the federal law (Note: in NYS the rule is: Three years after the date the tax return was filed). In addition to lengthened state statutes clouding the recordkeeping issue, the federal three-year assessment period is extended to six years if a taxpayer omits from gross income an amount that is more than 25 percent of the income reported on a tax return (NYS is six years after the tax return was filed). And, of course, the statutes don’t begin running until a return has been filed. There is no limit where a taxpayer files a false or fraudulent return to evade taxes (same for NYS).

If an exception does not apply to you, for federal purposes, most of your tax records that are more than three years old can probably be discarded; add a year or so to that if you live in a state with a longer statute.

Examples – Susan filed her 2013 tax return before the due date of April 15, 2014. She will be able to dispose of most of the 2013 records safely after April 17, 2017 (April 15, 2017 falls on a Saturday). On the other hand, Bob files his 2013 tax return on June 2, 2014. He needs to keep his records at least until June 2, 2017. In both cases, the taxpayers may opt to keep their records a year or two longer if their states have a statute of limitations longer than three years. Note: If a due date falls on a Saturday, Sunday or holiday, the due date becomes the next business day.

The Big Problem!

The problem with the carte blanche discarding of records for a particular year because the statute of limitations has expired is that many taxpayers combine their normal tax records and the records needed to substantiate the basis of capital assets. These need to be separated and the basis records should not be discarded before the statute expires for the year in which the asset is disposed. Thus, it makes more sense to keep those records separated by asset. The following are examples of records that fall into that category:

Stock Acquisition Data – If you own stock in a corporation, keep the purchase records for at least four years after the year the stock is sold. This data will be needed to prove the amount of profit (or loss) you had on the sale.

Stock and Mutual Fund Statements (If you reinvest dividends) – Many taxpayers use the dividends they receive from stocks or mutual funds to buy more shares of the same stock or fund. The reinvested amounts add to the basis in the property and reduce gain when it is finally sold. Keep statements at least four years after the final sale.

Tangible Property Purchase and Improvement Records – Keep records of home, investment, rental property, or business property acquisitions AND related capital improvements for at least four years after the underlying property is sold.

For example, when the large $250,000 and $500,000 home exclusion was passed into law several years back, homeowners became lax in maintaining home improvement records, thinking the large exclusions would cover any potential appreciation in the home’s value. Now that exclusion may not always be enough to cover sale gains, particularly in markets where property values have steadily risen, so records of home improvements are vital. Records can be important, so please use caution when discarding them.

What About The Tax Returns Themselves?

While disposing of the back-up documents used to prepare the returns can usually be done after the statutory period has expired, you may want to consider keeping a copy of your tax returns (the 1040 and attached schedules/statements plus your state return) indefinitely. If you just don’t have room to keep a copy of the paper returns, digitizing them is an option.

If you have questions about whether or not to retain certain records,
contact Solid Tax Solutions first. We are available year-round. Our phone number is: (845) 344-1040.

It’s better to make sure, before discarding something that might be needed down the road.

__________________________________________________________________________________________________

<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).

Categories: Business, Income Tax