Monday, January 30, 2017

Miscellaneous Itemized Deductions

Everyone wants more deductions when it comes to taxes, right? If you own a home, make charitable contributions, pay state income taxes or have medical expenses, then chances are you already itemize rather than take the “standard deduction”. The “standard deduction” is an amount taxpayers are allowed to deduct based on their filing status. If your potential itemized deductions exceed the “standard deduction”, then you can deduct more than the allowed standard deduction.
As we mentioned, the largest potential itemized deductions include, medical expenses, home mortgage interest, state and local taxes and charitable contributions. But there are other potential miscellaneous itemized deductions.
First, you should understand that when it comes to deductions, often there are thresholds to meet before the allowable items become deductible. In the case of most miscellaneous deductions, that threshold is 2% of your adjusted gross income or AGI. You are able to deduct these miscellaneous itemized deductions to the extent they exceed 2% of your AGI. Note that since it is an itemized deduction, it can only be claimed if you itemize your deductions and don't claim the standard deduction.
For example, a taxpayer with AGI of $75,000 has miscellaneous itemized deductions total $2,000. If he itemizes deductions, he can claim a $500 deduction for his miscellaneous items: $2,000 − $1,500 (2% of $75,000).
What are miscellaneous itemized deductions?
The following are itemized deductions subject, in total, to the 2% rule described above:
1. Tax return preparation costs including the fees to have your tax return prepared as well as other costs related to determining your taxes, such as appraisal costs or legal fees.
2. Employment-related expenses of an employee other than those reimbursed under an arrangement that meets special requirements. If you incur deductible expenses in connection with your employment, they are miscellaneous deduction items. These include out-of-pocket expenses for which you aren't reimbursed by your employer.
Expenses for which you are reimbursed or are paid an expense allowance but not under an arrangement that meets specific requirements requires that you include the reimbursements or allowances in income and then separately deduct the expense as a miscellaneous itemized deduction.
If your employer’s arrangement meets the requirements, the reimbursement or allowance isn't included in income and the expense isn't deducted. To meet the requirements the arrangement must require you to give a detailed account of your expenses to your employer and to return any excess allowance amounts you received over the expenses incurred.
3. Investment expenses, and expenses of producing or collecting taxable income. This category includes investment advisor's fees, investment publications, and the cost of a safe deposit box.
4. Hobby expenses. Expenses related to an activity that is a mere "hobby" (not a trade or business) are only deductible up to the extent of your income from the activity. You are taxed on the income and then only separately deduct the related expenses as miscellaneous itemized deductions.
Taxpayers with a relatively high AGI are often limited when it comes to miscellaneous itemized deductions and if you are subject to alternative minimum tax (AMT), the miscellaneous itemized deductions are not allowed for the AMT calculation.
When it comes to itemized deductions, many taxpayers take extra effort to track and report expenses when preparing information to provide to their tax profession. In some cases, taxpayers cannot itemize on their federal return, but benefit from itemized deductions on their state returns. You should discuss the need to track these potential deductions with your tax professional before taking the time and effort. If you clearly cannot itemize, save yourself the trouble.

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.