Monday, January 23, 2017

Avoid an Inadvertent S Corporation Termination

Once a corporation is granted Subchapter S corporation status, shareholders and managers should take precaution to avoid and inadvertent termination in the election.

 
Transfers to Ineligible Shareholders
 
S corporations tend to be held by a small number of shareholders and generally it is not common to have transfers or issuance of additional shares of stock. Transfers to an ineligible shareholder will terminate the corporation’s Subchapter S election.
 
In general, only individual U.S. citizens or residents, decedent estates, certain types of trusts, and certain exempt organizations may be S corporation shareholders. In the case of a stock issuance or transfer, it is important to confirm that all the shareholders are eligible shareholders including:
 
    1.   That no shareholder is a nonresident alien, a partnership, or a corporation;
    2.   That all trusts are properly structured to be eligible shareholders, and
    3.   That any election required for a trust shareholder are made.
 
In order to prevent a shareholder from terminating an S corporation's status by transferring his shares to an ineligible shareholder, a shareholders' agreement should prohibit transfers of any shares to any person other than a permitted S corporation shareholder and require a similar undertaking on the part of any transferee as a condition to any transfer. In addition, if permitted by local law, a restriction should be imposed in the corporation's charter or by-laws that would void a purported transfer to an ineligible shareholder.
 
Avoid violating the shareholder limitation
 

S corporations are limited to having 100 shareholders at any time. The S status will terminate if the limit is exceeded at any time in the future, whether as a result of new issuances or transfers of shares. New issuances of stock require corporate action. If permitted by law, governing documents should restrict the issuance and transfer of stock to avoid exceeding the 100 shareholder limit.
 
Transfers by shareholders can be somewhat more problematic, since they can occur without any action on the part of the corporation. Shareholders' agreements should prohibit transfers:
 
  • To a person who is not already a shareholder, or
  • That cause the 100 shareholder limit to be exceeded.
 
In addition, shareholders’ agreements should require that any transfers be conditioned on the transferee being subject to the same restrictions as the transferor. 
 
One Class of Stock
 
An S corporation is limited to one class of stock. Precaution should be taken to ensure that distributions are equal amongst shareholders. Any future changes to the capital structure of the corporation, including purported debt owed by the corporation that may be re-characterized as equity should be reviewed to ensure that the one class of stock is not violated.
 
However, S corporations are allowed to use various equity incentive compensation arrangements without violating the one class of stock restriction. If you are considering an equity incentive compensation plan, consult with a qualified tax professional to avoid an inadvertent termination.
 
Excess Passive Investment Income
 
C corporations that convert to an S corporation often have accumulated earnings and profits. An S election will terminate if, for a period of three consecutive tax years, its "passive investment income" exceeds 25% of its gross receipts.
 
This is a complex area to manage however, corporations can manage this requirement. After the S election, keep track of the corporation's passive investment income to monitor if the 25% limitation may be exceeded. Excess passive income is subject to a special tax and the S corporation status terminates only if the 25% limit is exceeded for three consecutive years. 
 
S corporations in danger of exceeding the 25% passive income limitation for three consecutive years have two basic approaches to avoid termination of S corporation status. First, a termination can be avoided by stripping out those earnings and profits by way of a dividend. The corporation must elect to treat distributions as coming from pre-S corporation earnings and profits first. In cases where the corporation needs to maintain cash, but needs to strip out earnings and profits, a "deemed" dividend election can be made. Keep in mind that an actual distribution out of pre-S corporation earnings and profits or under the deemed dividend election, is generally taxable to shareholders as a dividend. This varies from distributions of S corporation earnings which are generally treated as a return of capital.
 
Another approach to avoiding termination under the passive income rules requires managing the corporation's operations so that the 25% passive income limit is not exceeded. Since termination only occurs after the limit is exceeded for three consecutive years, S corporations willing to incur the tax on excess passive income have sufficient time to take action to avoid a termination.
 
This is managed by reducing the amount of passive investment income, and/or by increasing the amount of other income. One possible solution is the acquisition of a business that produces gross receipts which are not passive investment income, even if the acquisition does not produce much in the way of net income, since this test is based on gross receipts. Another possible solution is to restructure certain operations so that passive income (e.g., certain rental income) becomes active income.
 
Waiver of Inadvertent Termination
 
Maybe you are reading this and you have just determined that your S corporation has inadvertently terminated its subchapter S election. If that is the case, all is not lost. It is possible to apply to IRS for a "waiver" of an inadvertent termination of S status.
 
Summary
 
In summary, 
  • Avoid transfers of stock to ineligible shareholders. 
  • Take precautions to ensure the S corporation stock is limited to 100 or fewer shareholders.
  • Treat all shareholders equally and take measures to ensure that neither explicit nor implicit actions do not create additional classes of stock.
  • In the case of a C corporation that later elects S corporation status, avoid excess passive activity income.
  • If an inadvertent termination has occurred consider requesting a waiver from the IRS.
 
Consult a qualified tax professional if you believe your S corporation may have inadvertently terminated its subchapter S election.
 

Monday, January 16, 2017

Deferred Like Kind Exchanges

Deferred Like-Kind Exchanges also known as Starker Exchanges are a great way for property owners to defer gains on appreciated property. Like-kind exchanges don’t apply to personal residences and before entering into a deferred exchange, you should consult a tax professional to ensure that the properties involved in the exchange qualify a like-kind property.

Like-kind exchanges come in many variations. The most basic form of a like-kind exchange is where two property owners exchange properties in a trade. In this form, the exchange of property happens simultaneously.

In a "deferred" like-kind exchange there is a delay in the receipt of the like-kind property. By carefully timing the exchange transactions to meet the like-kind exchange requirements, you should be able to defer the tax on all or part of your gain on the exchanged property. In certain cases, you can even accomplish a "reverse" deferred exchange, where you acquire a “replacement” property before identifying the “relinquished” property that you will be exchanging.

Deferred exchanges can be used when you have a buyer for your appreciated property, but have not identified a property that you want to purchase. Similarly, you may identify a property that you want to acquire before closing on the sale of an appreciated property that you own.

Under the like-kind exchange rules, you can transfer your property to the buyer in a deferred (non-simultaneous) exchange as long as you follow these rules for identifying and purchasing a replacement property.

The property you are to receive must be "identified" no later than the day that is 45 days after your property is transferred. Identification must be made in writing and clearly describe in appropriate detail the property to be transferred.
The actual transfer must occur no later than the earlier of:
the day 180 days after your property is transferred, or
the due date (including extensions) of your tax return for the year in which you gave up your property in the exchange.

Taxpayers should pay particularly careful with this second requirement. Transfer of the relinquished property in the exchange late in the year, does not automatically allow the taxpayer 180 days to receive the replacement property. For example: the transfer of the relinquished property on December 10th will require the taxpayer to obtain an extension for filing their tax return, if the replacement property will not be acquired by April 15th of the following year (April 15th is earlier than the day which is 180 days after December 10th). Note, however, that no extensions can be obtained on the 45-or 180-day periods themselves.

Alternative arrangements

If the time limits outlined above are too restrictive in your case, we may be able to work out alternative arrangements which effectively give the exchanging party more time to come up with the replacement property. These arrangements can involve:

leasing your property to the other party for a period of time, rather than transferring it outright, granting an option to buy your property to the other party which could be exercised when the replacement property becomes available, or transferring your property to an independent trust or escrow arrangement to be held until the exchange can be made.

Reverse Exchanges

Another possibility, is a reverse exchange called a qualified exchange accommodation arrangement. Following the rules set out by the IRS, you can arrange to have the property you want to acquire transferred to an accommodation party until the property you will relinquish has been identified. The transaction turns the timing rule mentioned above on its head by requiring sellers to identify the relinquished property you intend to exchange within 45 days of the date that the replacement property is transferred to the accommodation party.

Qualified Intermediaries

Before initiating a sales contract on a property that you want to utilize a deferred exchange on, you need to engage a qualified intermediary to facilitate the deferred exchange. Most title companies can give you a list reputable qualified intermediaries. The qualified intermediary cannot be your tax advisor.

Qualified intermediaries, basically step into the exchanger’s shoes in holding proceeds from the sale of the relinquished property until the closing on the replacement property. Similarly, in the case of a reverse exchange, they qualified intermediary will purchase the replacement property on your behalf and hold it until the sale of the relinquished property. You’ll pay the qualified intermediary a fee for their role in the deferred exchange.

Summary

Deferred exchanges can be an effective way to defer tax on the exchange of an appreciated property.

Variations of the deferred exchange give buyers and sellers flexibility in structuring like-kind exchanges.

The current low capital gains rates may negate the benefit of deferring gains, especially when exchange fees are factored in.


Strict rules apples to the timing of deferred like-kind exchanges.

If you are contemplating a like-kind exchange of any sort, you should consult a qualified tax professional. This article is intended only as an overview of deferred like-kind exchanges. Your individual tax circumstances affect the ability to complete a deferred like-kind exchange as well as the overall tax effectiveness of a like-kind exchange.

Monday, January 9, 2017

Taking a Depreciation Deduction for Automobiles

One of the first questions we usually get when someone starts a business is “Can I write-off my car?” First, it depends on the level of business usage of the vehicle. When a vehicle is only used partially for business, the “write-offs” are limited and if business use is below 50%, depreciation is limited to the straight-line method.
 
Secondly, all business owners should understand that special limitations apply for vehicles which may result in it taking longer for you to depreciate a car than it would other business property.
Separate depreciation allowances for a car only comes into play if you choose to determine the cost of its business use by the "actual expense" method. If, instead, you use the standard mileage rate, a depreciation allowance is built in as part of the rate.
 
Depreciation Periods
 
When using the actual expense method in calculating the depreciation allowance, the car is treated as an asset with a 5-year recovery period. Under regular depreciation tables, the cost of a car is actually depreciated over a 6-year span according to the following percentages:
 
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
20%
32%
19.2%
11.52%
11.52%
5.76%
Depreciation takes place over six years because depreciation is deemed to start in the middle of the first year and ends in the middle of the sixth year. But wait – It gets worse!
 
Additional “Luxury Auto” Limitations
 
Under the “luxury automobile” rules there are depreciation ceilings for passenger vehicles with an unloaded gross vehicle weight of 6,000 pounds or less. These ceilings, are indexed for inflation, extend depreciation beyond the sixth year for cars costing more than what the total depreciation allowance would be over the six years.
At the time of this writing, the 2017 ceilings have not been announced by the IRS however, it is most likely that the ceilings will not change from the 2016 levels. For most cars first put in service in 2016 and 2017, the ceilings are:
 
Initial Year
Year 2
Year 3
All Subsequent Years
$3,160
$5,100
$3,050
$1,875
Slightly higher ceiling amounts apply for certain light trucks and vans (passenger autos built on a truck chassis, including minivans and light SUVs). Business owners cannot avoid these limitations via an election to "expense" the car (a Code Sec. 179 election).
 
With the limitations applying, it takes significantly longer than the regular six years to depreciate the entire cost of the car, if it is not disposed of sooner. Say that you buy a passenger vehicle with a GVW less than 6000 pounds for $35,000 and no additional bonus depreciation is available. The depreciation is limited as follows, extending the write-off of the vehicle to 16 years:
 
Year
Annual Depreciation Allowed
Undepreciated Cost

1
$3,160
$31,840
2
$5,100
$26,740
3
$3,050
$23,690
4
$1,875
$,19,940
5 to 16
$1,875
$19,940 less $1,875 per year until fully depreciated in year 16.
Partial Business Use
 
When the car is used partly for business purposes and partly for personal purposes, the limits are reduced to the business percentage. For example, the initial year maximum depreciation deduction for a qualified automobile used 75% for business is $2,370 (75% of $3,160). The "personal" 25% portion ($790) is disallowed.
 
Leased Vehicles
 
The depreciation limitations on “luxury” vehicles cannot be avoided by leasing a car instead of buying it. The mechanics of the tax rules are different with leases however, essentially lease payments in excess of the depreciation ceilings are added back to taxable income.
 
Practical Application
 
What is the impact of these limitations from the standpoint of the business decisions you must make?
Passenger vehicles under GVW of 6000 pounds are significantly limited for depreciation.
These limitations raise the "after-tax" cost of automobiles used for business.

The recovery period on a car used for business is most likely well beyond it’s useful life unless bonus depreciation in the first year can be applied (bonus depreciation other than the section 179 expensing election which is not available for passenger vehicles under GVW of 6000 pounds)

Business owners may want to consider:
 
Upgrading to a vehicle that qualifies for the section 179 expensing election in order to accelerate the write off of a business vehicle, or purchasing a used vehicle at a lower cost to reduce the depreciation recovery period.
 
Before making a decision to purchase a new vehicle for your business, consult with a qualified tax professional.

Monday, December 26, 2016

Qualified dividends taxed at favorable capital gain rates

Ever look at your year-end investment tax forms and wonder what “Qualified Dividend” means? In a nutshell, it means you are taxed at the favorable capital gains rates. 

Capital Gains Rates - Qualified dividends are taxed at the same favorable 0%, 15%, or 20% rates that apply to long-term capital gains. Dividends that aren't qualified are taxed as ordinary income, at rates as high as 39.6%. 

Additional Net Investment Income Tax - If you are a “high earning” taxpayer(1), the qualified dividends are subject to a 3.8% tax on net investment income tax. After the 3.8% tax is factored in, the top rate on capital gains and qualified dividends is 23.8%. 

What are Qualified Dividends? - Qualified dividends are received from domestic corporations or from qualified foreign corporations, which include U.S. possessions corporations, foreign corporations whose stock is traded on established U.S. securities markets, and foreign corporations eligible for income tax treaty benefits. 

Holding Periods – Be aware that there are 61 day and 91 day holding period rules for common and preferred stocks, respectively. We won’t discuss the details here. 

Dividends That Are Not Treated as Qualified - Qualified dividend income does not include the following:
 
 (1) dividends on any share of stock to the extent the taxpayer is under an obligation to make related payments with respect to positions in substantially similar or related property, for example, in connection with a short sale;

(2) any payment in lieu of dividends, for example, payments received by a person who lends stock in connection with a short sale;

(3) dividends that you elect to treat as investment income for purposes of the rules governing the deduction of investment interest;

(4) dividends from a tax-exempt charitable, religious, scientific, etc., organization, religious or apostolic organization, qualified employee trust, or farmers' cooperative;

(5) deductible dividends paid by mutual savings banks, etc.;

(6) deductible "applicable dividends" paid on "applicable employer securities" held by an employee stock ownership plan (ESOP);

(7) dividends received as a nominee.
 
Mutual Fund Dividends - If you own shares of a mutual fund that holds dividend-paying stock then, to the extent that the dividends received by the mutual fund are qualified dividend income the dividends are taxable at the 0%, 15%, or 20% maximum rates. The mutual fund reports your dividend income on Form 1099-DIV including the qualified dividend income.

Other Pass Through Entities - Dividends received partnerships, S corporations, estates, trusts, and real estate investment trusts (REITs) you own are tracked and reported to you by that entity. By and large, the qualified dividend income of these entities is taxed as qualified dividend income by the partner, shareholder or beneficiary.
 
Effect of capital losses on dividends - While qualified dividend income is taxed at the same rates as long-term capital gain, it isn't actually long-term capital gain. Therefore, you can't use capital losses that otherwise enter into the computation of your taxable "net capital gain" (the excess of net long-term capital gain over net short-term capital loss) to offset your qualified dividend income. As a result, generally, your qualified dividend income will be taxed in full at the 0%, 15%, or 20% rates.
 
However, if your capital losses exceed your capital gains for the tax year, the excess, up to $3,000, can be used to offset other income. This offset can be used against qualified dividend income, but only after it's been used against taxable income other than qualified dividend income. However, this "ordering" rule is actually a benefit, because offsetting taxable income other than qualified dividend income, which is taxable at rates up to 39.6%, saves more tax than offsetting qualified dividend income, which is taxed at no more than 20%.
 
Planning - The taxation of dividends at the favorable 0%, 15%, and 20% rates may make investments in dividend-paying stock significantly more advantageous than investments that produce income taxed at rates as high as 39.6% (for example, rental real estate, or any type of investment that produces taxable interest).
 
Please consult a qualified tax advisor if you have any questions on whether any of your dividend income is qualified dividend income.

(1) Taxpayers with modified adjusted gross income (MAGI) that exceeds $250,000 for joint returns and surviving spouses or $200,000 for single taxpayers and heads of household.

Monday, December 19, 2016

Deducting Foreign Business Travel



In today’s business environment, even small businesses may have the opportunity to conduct business with customers outside of the United States. Along with this opportunity comes the question can such costs be deducted for tax purposes? Depending on the facts and circumstances, foreign business travel can be deducted.

 
 
Business versus Personal Travel

For a trip entirely for business purposes, you can deduct all the travel costs, plus meals (at 50%), lodging, and some incidental costs such as for laundry and dry cleaning.

If the trip is primarily personal, none of the costs of travel to and from the destination are deductible, even if some time is spent on business. However, lodging, meals, etc. would be deductible for the business days.

Mixed Purpose Travel

When a primarily business trip incorporates personal travel, the rules are more complex. In this case, the costs allocable to the personal (vacation) part of the trip generally cannot be deducted. For example, a trip covering ten days includes four personal and six business days. Meals, lodging, etc. are only deductible for the business days and only 60% of the travel costs (airfare, etc.) are deductible, reflecting the fact that only 60% of the days of the trip were business days.

One Week Test

If the primary purpose of the trip is business and the trip does not last for more than a week, the allocation of part of the travel costs to the nondeductible portion is not required. A week is defined as seven consecutive days, not counting the day of departure, but counting the day of return.

25% Test

For trips lasting more than a week, no allocation is required if the personal days are less than 25% of the total days spent on the trip. In this test, the total days of the trip include the day of departure and the day of return. As long as business is conducted during a day, it's counted as a business day. Business days also include days spent traveling to or from a business destination and weekend days or holidays falling between two business days.

Deducting Trips that Fail the One Week and 25% Tests

If your trip does not pass the one week or 25% tests, you may still be able to deduct all of the travel costs if you can show that the chance to take a vacation was not a major consideration for the trip. The larger the vacation portion, the more difficult it will be to make your case.

As you can tell from the above discussion, the tax implications of foreign travel can get quite complex, depending on the nature of trip. Before planning a foreign trip and taking the deduction, consult a qualified tax professional.

Monday, December 12, 2016

Taking Advantage of the Self-Employed Health Insurance Deduction

Taking Advantage of the Self-Employed Health Insurance Deduction

Many of us small business owners are faced with the rising costs of company provided health insurance. If you are a sole proprietorship, partner or more than 2% shareholder in an S Corporation (referred to as “self-employed”), proper treatment of health insurance costs allows you a 100%, helping to offset the rising cost of health insurance.

Normal Limitations on Health Insurance Deductions

For taxpayers that are not self-employed, the ability to deduct health insurance costs is limited. Health insurance premiums included with other medical expenses are deductible as an itemized deduction, only to the extent that total medical costs exceed 10% of the taxpayer’s adjusted gross income (7.5% if over age 65). For most taxpayers, the deduction does not exceed the threshold and thus there is no tax benefit for the medical expenses they have paid.

Different Rules for Self-Employed Health Insurance

Self-employed taxpayers have a tax advantage when it comes to health insurance. Their health insurance deduction is an "above the line" deduction, reducing adjusted gross income (AGI)-100% of the health insurance costs for the self-employed owner, spouse, dependents, and for any child of the self-employed who is under age 27 as of the end of the tax year.

Example. Mark is self-employed and pays $6,000 in health insurance premiums and has no other medical expenses. His AGI is $100,000. Since 10% of $100,000 equals $10,000, Mark cannot claim an itemized medical expense deduction for the health insurance premiums. However, since Mark is self-employed, he can deduct the entire $6,000 above the line.

Partners in partnerships that provide health insurance can also benefit from this treatment. The cost of the health insurance is reported on the partner’s K-1 and treated similarly as described above. Keep in mind that the partner must be subject to self-employment income from the partnership to qualify for the deduction.

If you own 2% or more of an S Corporation that provides you with health insurance, the deduction works slightly different. In this case, the health insurance is included in the shareholder’s taxable earnings on their W-2. Wait, that sounds like it created taxable income for the shareholder. Yes it did, but the increase in taxable earnings for the shareholder also decreased earnings from the S Corporation that are reported from the shareholder’s K-1. So the net effect is no increase in taxable earnings. The shareholder is then able to deduct cost of the health insurance above the line and realize a 100% deduction.

If the health insurance plan is a High Deductible High Premium plan, the self-employed taxpayer can contribute to a health savings plan that if also deductible above the line, further increasing tax savings for the self-employed taxpayer.

A Few Rules to Consider

These rules only apply for any calendar month in which you aren't otherwise eligible to participate in any subsidized health plan maintained by any employer of yours or of your spouse, or any plan maintained by any employer of your dependent or your under-age-27 child.

Also, the deduction can't exceed your earned income from the trade or business for which the health insurance plan was established.

For partners and S Corporation owners, proper treatment of the health insurance and any HSA contributions on the K-1 or W-2 is critical for the deduction. Make sure to review the presentation and reporting of this information with your tax professional before the end of the tax year.

Summary

The tax benefits of a self-employed individual's health insurance costs effectively reduces your cost of health insurance. You may wish to consider changing your coverage in light of these savings. Proper reporting of these costs are critical to taking the 100% deduction, otherwise you may limited or prevented from deducting the health insurance costs.

Please consult a qualified tax professional to discuss how best to structure your compensation and health insurance before taking the self-employed health insurance deduction.

Monday, December 5, 2016

Hardship Withdrawals and Loans from 401(k) Plans

Hardship Withdrawals and Loans from 401(k) Plans

Life doesn’t always go as smoothly as we have planned. Sometimes we are faced with an immediate financial need that has us eyeing our 401(k) retirement plan as a solution to that need. If you find yourself in this situation, you should be aware of the possible ways you may access this source of funds before you reach retirement.
Generally, distributions from a 401(k) plan while you're still employed and before you reach age 59½ are not permitted. However, an unusual financial obligation and an immediate need for cash, may permit you to take a distribution for financial hardship. IRS rules spell out what is an immediate and heavy financial need, which include funeral expenses for a family member. On the other hand, distributions to purchase a boat or a television do not qualify as an immediate and heavy financial need.

Limits on Hardship Withdrawals

Hardship withdrawals are limited to amounts attributable to elective contributions to the plan. Elective contributions are the amounts you have contributed to the 401(k) plan, not including employer matching or profit sharing contributions. This also includes the earnings attributable to your contributions. Hardship withdrawals are taxable distributions (except to the extent of Roth 401(k) contributions) and if you're under age 59½, you may be subject to a 10% addition to tax on premature distributions.

Consider the possible 10% early withdrawal penalty as well as ordinary income taxes when establishing the amount of tax to be withheld from the hardship withdrawal. Many times clients withhold for the 10% penalty thinking they have covered the taxes only to be surprised that they also owe income tax on the withdrawal.

Also, special rules apply to the withdrawal of any "after-tax" or voluntary contributions, other than Roth 401(k) contributions, that you may have made to your plan.

A Loan from the 401(k) Plan May Be a Better Alternative

Another way to get cash from your 401(k) plan is through a plan loan. If your plan provides for loans and certain conditions are met, you can borrow the funds tax-free. Loans must be repaid along with interest within a five-year term. The amount of any plan loan is generally limited to 50% of the value of your vested balance with a limit of $50,000. The five-year repayment requirement doesn't apply if the loan is for the purchase of a residence.

Unlike a taxable hardship distribution, a plan loan doesn't require that you establish an immediate and heavy financial need. Your ability to borrow from your 401(k) plan depends on requirements under the terms of the plan.

Another point to keep in mind is that a plan loan-unlike a hardship distribution-doesn't reduce the value of your 401(k) assets. Your account remains fully vested, subject, of course, to your obligation to repay the loan, with interest. If you are unable to repay the loan or leave employment before the loan is fully repaid, the unpaid balance will be considered as a withdrawal, subject to early withdrawal penalties (if under age 59½) and ordinary income taxes.

Summary

If you participate in your company's 401(k) plan, the value of your account balance may well be your most significant financial asset. While contributions to your 401(k) plan are intended for retirement savings, if you happen to be facing, or anticipate facing, major financial obligations, you should be aware of the possible ways you may access this source of funds while you're still working.

Before making a 401(k) hardship withdrawal or loan, consult a qualified tax advisor.