Considering Admitting a New Partner into Your Partnership?

Admitting a new partner may be a simple matter, but tax planning can help avoid various tax problems associated with admitting a new partner. If your partnership has any unrealized receivables or substantially appreciated inventory items, the change in ownership is treated as a sale of those items and the current partners will recognize a taxable gain. For this purpose, unrealized receivables include not only accounts receivable, but also depreciation recapture and certain other ordinary income items. To defer gain recognition on those items, it is necessary that they be allocated to the current partners even after the entry of the new partner.

Another potential trap is any "built-in gain or loss" on assets that were held by the partnership before the new partner was admitted be allocated to the current partners and not to the entering partner. Generally speaking, "built-in gain or loss" is the difference between the fair market value and basis of the partnership property at the time the new partner is admitted. For example, an apartment complex purchased for $500,000 ten years ago has appreciated and now has a fair market value of $800,000. This requires allocating depreciation to the new partner based on his share the depreciable property using current fair market value at the time of admission. This reduces the amount of depreciation allocated to the existing partners and will require a special allocation of the “built-in gain or loss” when partnership assets are sold.

These are complex rules that may require the partnership adopt special accounting procedures and tracking. Before admitting a new partner, review the proposed transaction with a qualified tax professional and take the appropriate measures to minimize the immediate tax consequences to existing partners.

Applying Research Tax Credits to Payroll Taxes

Recent changes in the federal tax law now allow companies to offset payroll taxes with federal research tax credits. This situation most likely applies to startup companies that are incurring payroll expenses, but not yet generating taxable income. This change is effective for tax years beginning in calendar year 2016.

The payroll tax election may influence some of you to undertake or increase your research activities. On the other hand, if you are engaged in or are planning to engage in research activities without regard to tax consequences, let the below discussion simply serve as notice that some tax relief could be in your future.

Why is the election important?

Many startup businesses may not pay income taxes for the first several years of operations, even if they have some cash flow, or even net positive cash flow and/or a book profit. Thus, general business tax credits, including the research credit, offer no immediate benefit for the startup company. On the other hand, many startup companies have large payrolls during the startup phase and incur payroll tax liabilities. The payroll tax election these startups to get immediate use out of the research tax credits. Because every dollar of credit-eligible expenditure can result in as much as a 10 cent tax credit, that's a big help in the start-up phase of a business-the time when help is most needed.

What businesses are eligible?

To qualify for the election the business (1) must have gross receipts for the election year of less than $5 million and (2) be no more than five years past the period for which it had no receipts (the start-up period). Also, the election cannot be made for more than six years in a row.

Limits on the election

Research tax credits can only be applied against the employer's "social security" portion of FICA taxes. So the election can't be used to lower (1) the employer's liability for the "Medicare" portion of FICA taxes or (2) any FICA taxes that the employer withholds and remits to the government on behalf of employees.

Companies can elect up to apply up to $250,000 of the research tax credits to payroll taxes annually. In the case of a Schedule C business or a C corporation the election can only be used for those research credits which, in the absence of an election, would have to be carried forward. Therefore, a C corporation can't make the election for research credits that the taxpayer can use to reduce current or past income tax liabilities.

This is a basic overview of how the research tax credit can be applied to offset payroll taxes. Identifying and substantiating expenses eligible for the research credit itself is a complex area. Please contact us, if you are interested in discussing the research tax credit and how it might benefit your company.

529 Education Savings Plans

Do you have a child or grandchild who is going to attend college or trade school in the future? Are you concerned with how to pay for their education? If so, you are like many of us that desire our children or grandchildren to continue their education and are concerned with how to pay for it.

You have may have heard about qualified tuition programs, also known as 529 plans (named for the Internal Revenue Code section that provides for them). 529 plans allow prepayment of higher education costs on a tax-favored basis, by deferring or even completely eliminating the taxes on any earnings of the account. You can think of it as a Roth IRA for education.


Types of 529 Plans

There are two types of programs:

Prepaid plans allow you to buy tuition credits or certificates at present tuition rates, even though the beneficiary may not be starting college for some time. Prepaid plans were popular when first introduced, but have declined in availability; and
Savings plans that allow the account owner to make contributions and earn a return until the funds are withdrawn at a later date.

How 529 Plans Work

Contributions are not deductible for federal income taxes however, many states offer credits and deductions for contributions to state sponsored plans. Using a state sponsored plan doesn’t limit the beneficiary to attending school in that state. Most state plans offer great investment choices with low investment costs. The website www.savingforcollege.com publishes information on states offering credits and deductions for 529 contributions. 

The earnings on the account aren't taxed while the funds are in the program. Beneficiaries can be changed on the account and account owners can roll over the funds in the program to another plan for the same or a different beneficiary without income tax consequences.

Distributions from the program are tax-free up to the amount of the student's qualified higher education expenses. These include tuition, fees, books, supplies, and required equipment. Reasonable room and board is also a qualified expense if the student is enrolled at least half-time.

Distributions in excess of qualified expenses are taxed to the beneficiary to the extent that they represent earnings on the account. A 10% penalty tax is also imposed.

Eligible schools include colleges, universities, vocational schools, or other postsecondary schools eligible to participate in a student aid program of the Department of Education. This includes nearly all accredited public, nonprofit, and proprietary (for-profit) postsecondary institutions. A school should be able to tell you whether it qualifies.

Contributions made to the qualified tuition program are treated as gifts to the student, but the contributions qualify for the annual gift tax exclusion, which is currently $14,000. If your contributions in a year exceed the exclusion amount, you can elect to take the contributions into account ratably over a five-year period starting with the year of the contributions. Distributions from a qualified tuition program are not subject to gift tax, but a change in beneficiary or rollover to the account of a new beneficiary may be.

Summary

529 Plans are a great way to save for a child or grandchild’s education. These plans can yield tax savings since earnings are not taxed if used for qualified education expenses. Many states offer credits or deductions, so it may be beneficial to start a plan to use for paying current post-secondary education expenses. If you are considering how to pay for college expenses of a child or grandchild, consult a qualified tax professional.

Using Stock Redemptions to Create Liquidity for C Corporation Owners

Shareholders of closely-held C Corporations often find themselves in a tax dilemma when it comes to creating liquidity from their investment. Generally, the shareholder is compensated for work performed (Ordinary income to the shareholder) or for risk taken and paid in the form of dividends. Compensating a shareholder has many tax considerations that are not covered in this post. For dividends, the issue is double taxation whereby the corporation is not allowed to deduct the dividend from taxable income and the shareholder is taxed on the dividend received. By limiting the deduction of the dividend at the corporate level and taxing the recipients of the dividend, any dividends paid are subject to taxation at the corporate and individual levels. This double taxation can push the combined effective federal tax rate to over 60%. Based on this, you can see why S Corporation status has become the standard for small to medium size businesses. However, there are many small to medium size C Corporations that continue to exist today.

Stock redemptions can be structured in a manner that lets shareholders take cash out of the corporation while minimizing the tax cost. While dividends are taxable to non-corporate taxpayers at capital gains rates, the advantage of property structuring a stock redemption is that shareholders are only taxed on the "gain," i.e., you are not taxed on the portion of the cash attributable to your basis in the redeemed stock. The safest two approaches to structure a redemption are Substantially Disproportionate Redemptions and Complete Termination of Interests, as described below. If the redemption cannot be structured as describe below, it may be taxable as a dividend, defeating the purpose of the stock redemption.

The substantially disproportionate redemption and the complete termination of interest tests are designed to provide safe-harbors for redemptions where the shareholder who receives cash from the corporation has a meaningful decrease in his or her stock ownership in the corporation.

Substantially Disproportionate Redemptions

To qualify as substantially disproportionate redemption,

The shareholder’s interest after the redemption (in both all voting stock and all common stock) must be less than 80% of their interest before the redemption, and
the shareholder must possess less than 50% of the voting power of all voting stock after the redemption. 

 

Thus, if a shareholder owned 50% of the only class of stock of the corporation before the redemption, the test is satisfied if their interest is less than 40% (80% times 50%) after the redemption,.

Keep in mind that when computing the ownership percentages, you must take into account the reduction in total share outstanding after the contemplated redemption.

Also, the attribution rules discussed below apply and should be evaluated before structuring a stock redemption.

Complete Termination of Interest

If the redemption completely terminates your interest in the corporation it treated as giving rise to a sale, rather than a dividend. The requirements for a complete termination can be satisfied by a waiver of family attribution, as described below, however, other attribution rules are not waived.

Attribution Rules

Attribution rules apply when determining how much stock is owned before and after a redemption. These attribution rules treat a shareholder as owning shares owned by certain family members as well as entities in which the shareholder has an interest. Thus, even when a shareholder’s actual ownership is sufficiently reduced by a redemption to qualify under one of the safe-harbor tests, the redemption may fail to qualify if shares owned by other persons or entities are attributed to the shareholder.

Family Attribution

A shareholder is treated as owning shares held by his spouse, parents, children, and grandchildren, but not those held by siblings nor grandparents.

However, in applying the complete termination of interest test, family attribution do not apply if immediately after the redemption the shareholder does not have any interest in the corporation as a shareholder, officer, director or employee. The redeeming shareholder can retain an interest solely as a creditor. The redeeming shareholder must also not acquire such an interest within ten years of the redemption (other than by bequest or inheritance).

Keep in mind that if redeeming shareholders must notify the IRS if they acquire shares within the ten year window by bequest or inheritance. Also, if the redeeming shareholder transferred shares to family members within ten years of redemption, the IRS may challenge the validity of the redemption on the basis of tax avoidance. In these situations, make sure that you document and support the business reason for the transfers such as retirement or overall plan to transfer the business to family members.

Entity attribution

Shareholders are treated as owning shares owned by a partnership, S corporation, trust, or estate, in proportion to his or her interest in the entity. Stock is also attributed through a regular ("C") corporation if 50% or more of its stock is owned directly or indirectly by (or for) the shareholder.

Options

A person who owns an option to acquire stock (or a series of options) is treated as owning the stock.

Other rules

Stock owned by reason of applying one attribution rule may, under certain circumstances, be treated as actually owned for purposes of applying another attribution rule.

Non-deductibility of Expenses

Corporations cannot deduct any amount paid or incurred in connection with the reacquisition of its stock or the stock of any related person. This includes transactions treated as redemptions. However, interest and other fees on debt incurred to finance the redemption are deductible.

Summary

Stock redemptions can be a tax effective way for shareholders to liquidate a portion or complete interests in a C Corporation.

Partial redemptions must take attribution rules into account and be structured to satisfy the Substantially Disproportionate Redemptions rules.

Complete Terminations of Interests are in effect a sale of the shareholder’s stock and also must consider the attribution rules as well as other restrictions that may be reviewed by the IRS. 

Before executing a stock redemption, consult with a qualified tax professional to structure the transaction properly and avoid issues. 

When a taxpayer can't pay the balance due

It happens – You’ve had a good year and get surprised by your tax liability when your return is ready to file. The growth in your business has tied up funds that you need to pay taxes. Or maybe you took a retirement plan distribution to pay outstanding medical bills and didn’t withhold for the related tax liability.

First and most importantly, taxpayers should not let the inability to pay their tax liability in full prevent them from filing tax returns properly and on time. When you find yourself in this situation, pay as much as you can, and consider borrowing the funds for payment. In most cases, it is advisable to pay state liabilities first so that you are only dealing with one taxing agency on past due balances. Filing without full payment can save you substantial amounts in filing penalties, as discussed below. Following procedures for payment extension and installment payment arrangements can keep the IRS from instituting its collection process (liens, property seizures, etc.).

Common Tax Penalties

Federal “Failure to File” penalties accrue at the rate of 5% per month or part of a month (to a maximum of 25%) on the amount of tax your return should show you owe. The Federal “Failure to Pay” penalty is gentler, accruing at the rate of only ½% per month or part of a month (to a maximum of 25%) on the amount actually shown as due on the return. In cases where both apply, the failure to file penalty drops to 4.5% per month so the total combined penalty remains at 5%.

The maximum combined penalty for the first five months is 25%. Thereafter the failure to pay penalty can continue at 1/2% per month for 45 more months (an additional 22.5%). Thus, the combined penalties can reach a total of 47.5% over time. Both of these penalties are in addition to interest you will be charged for late payment.

Missed estimated tax payments result in an additional penalty for the period running from each payment's due date until the tax return due date, normally April 15th. This penalty is computed at 3% above the fluctuating federal short term interest rate for the period.

Undue Hardship Extensions

Keep in mind that an extension of time to file your return does not mean you have an extension of time to pay your tax bill. An extension of time for payment may be available, however, if you can show payment would cause "undue hardship”. If granted, you will avoid the failure to pay penalty, but you will still be charged interest. The undue hardship extension will give you an extra six months to pay the tax shown as due on your tax return.

If the IRS determines a "deficiency," i.e., that you owe taxes in excess of the amount shown on your return, the undue hardship extension can be as long as 18 months and in exceptional cases another 12 months can be tacked on. However, no extension will be granted if the deficiency was the result of negligence, intentional disregard of the tax rules, or fraud.

We won’t get into specifics of what the IRS considers an undue hardship here, but merely being inconvenienced by the tax liability is not enough for the IRS to grant the extension. You’ll have to document and support the undue hardship.

Also, as a condition to the granting of an extension of time for payment of any tax or deficiency, the IRS may require a bond not exceeding twice the tax.

To apply for an undue hardship extension, you’ll file form 1127 with the IRS. The process requires a statement of assets and liabilities as well as an itemized list of receipts and disbursements for the 3 months preceding the tax due date.

Borrowing Money to Pay Taxes

Consider borrowing money, if you don't think you can get an extension of time to pay your taxes. Loans from relatives or friends are often the simplest method to pay the bill. One advantage of such loans is that the interest rate will probably be low. Obtaining a loan from a bank or other commercial source is another alternative, but such loans are not likely to be made on favorable terms to a hard pressed taxpayer. Moreover, interest on a loan to pay taxes is nondeductible personal interest. In contrast, taking out a home equity loan and using the proceeds to pay off your tax debts, will probably be at a lower rate than other types of loans, and the interest payments may be deductible even if the loan proceeds aren't used in connection with the house.

You can also use credit cards or debit cards to pay the income tax bill whether you file your income tax return by mailing a paper copy or by computer. Several companies are authorized service providers for purposes of accepting credit card or debit card payments. Only those cards approved by IRS may be used. However, as with other loans from businesses, credit card loans are likely to be at relatively high interest rates and the interest is not deductible. Moreover, the service providers also charge a fee based on the amount you are paying.

Installment Agreement Request

Requesting the IRS to enter into an installment payment agreement is another way to defer your tax payments. This request is made on Form 9465 or by applying for a payment agreement online. The IRS charges a fee for installment agreements, which will be deducted from your first payment after your request is approved.

Form 9465 requires less information than the hardship extension application. For liabilities under $50,000, you will not be required to submit financial statements. Even if your request to pay in installments is granted, you will be charged interest on any tax not paid by its due date. But the late payment penalty will be half the usual rate (1/4% instead of 1/2%), if you file your return by the due date (including extensions).

The fee for entering into an installment agreement is $120, except that the fee is $52 when the taxpayer pays by way of a direct debit from the taxpayer's bank account, and, notwithstanding the method of payment, the fee is $43 if the taxpayer is a low-income taxpayer.

Note that an installment agreement request can be made after your hardship extension period expires. Additionally, IRS has the authority to enter into an installment agreement calling for less than full payment of the tax liability over the term of the agreement. It may do so if it determines such an agreement will facilitate partial collection of the liability.

The IRS may terminate an installment agreement if the information you provided to IRS in applying for the agreement proves inaccurate or incomplete or IRS believes collection of the tax involved is in jeopardy.

The IRS may modify or terminate an installment agreement if the taxpayer misses a payment, fails to pay other tax liabilities or to provide the IRS with requested financial information, or the taxpayer’s financial condition changes significantly.

The IRS must give you a 30 day notice before altering, modifying or terminating the installment agreement and it must explain its reasons for the action. This notice requirement does not apply when collection of the tax is in jeopardy.

A $5,000 penalty applies to any person who submits an application for an installment agreement if any portion of the submission is either based on a position which the IRS has identified as frivolous, or reflects a desire to delay or impede the administration of federal tax laws. The IRS may also treat that portion of the submission as if it had never been submitted. However, the penalty is clearly aimed at those who abuse the process and should not deter taxpayers with legitimate applications from using the installment agreement process.

Avoiding More Serious Consequences

Don’t hide your head in the sand if you run into financial difficulties. Failing to file their tax returns only complicates the situation. It is very important to file a properly prepared return even if full payment cannot be made. Include as large a partial payment as you can with the return and start working with the IRS for a hardship extension or installment agreement as soon as possible. The alternative will include escalating penalties, plus the risk of having liens assessed against your assets and income. Down the road, the collection process will also include seizure and sale of your property. In many cases, these tax nightmares can be avoided by taking advantage of arrangements offered by the IRS.
Summary

Don’t let financial circumstances prevent filing timely and accurate returns. Address the issue directly and pay as much as you can afford to pay. Installment agreements and hardship extensions are tools that can help in dealing with the balance due. Loans or credit card payments can be another solution for paying the tax debt.

If you find yourself in a position where you cannot pay your current liability, consult a qualified tax professional to walk you through the options and represent you when dealing with the IRS or state tax authorities.

Meals and lodging provided by an employer may be excludable from the employee's income.

In certain circumstances, an employer may provide employees with meals and lodging as part of their employment package.
 

Generally, the value of meals and lodging provided to employees is taxable like many other benefits. However, the Internal Revenue Code provides an exclusion for meals and lodging that are provided "for the convenience of the employer" on the "business premises." For lodging, an additional requirement is that the employee must be required to accept it as a condition of employment.
 

Convenience of the Employer
 

Under the "convenience of the employer" test, the primary reason for providing the meals or lodging must be to benefit the employer, i.e., to enable the employee to do his job. In a special circumstance, meals provided to all employees may be excludable where more than half of the employees fall under the convenience of the employer test. For example, if more than half of a hospital’s employees must be on call at all times, all employees can be furnished a meal in the hospital because keeping them on the premises allows them to satisfy work-related obligations. Similarly, a hotel manager who must be on the premises at all times can be furnished lodging at the location to enable him to perform his duties. However, for the lodging to qualify for the exclusion, the employee's acceptance of the lodging must be a "condition of employment," i.e., the lodging must be necessary for the employee to perform his duties. It is also important to note that the exclusion only applies for meals and lodging which is provided in kind: not for cash allowances for such items.
 

The "convenience of the employer" test and the business premises requirement may be difficult to apply to particular circumstances. With the ever evolving business environment that we work in today, employers will want to review and document all the facts involved in providing meals or lodging to employees.
 

Employer’s Benefit
 

If excludable benefits can be provided to your employees, you should be able to structure an employee benefit package at a reduced cost to take advantage of the employee's tax savings. For example, if an employee spends $1,000 on meals at work he would need to be paid roughly $1,334 in taxable salary to cover this cost (assuming a 25% income tax bracket). But if the $1,000 in meals qualify as excludable under the rules discussed above, the employer can provide the meals directly and offer $1,334 less in salary while maintaining the employee's economic position.
 

From the employee's perspective, the excludable meals should be viewed as a benefit worth more in equivalent salary than their actual value.
 

Summary
 

Employers that can structure employee benefit packages to include excludable meals or lodging, should provide the employees with information on the effective value of the benefit. Keep in mind that these benefits must be for the convenience of the employer and in the case of lodging, included as a condition of employment. Before structuring a compensation package the includes meals and lodging, consult with a qualified tax professional.

Manage Your Own Investments? Here’s How to Deduct Your Investment-Related Expenses.

Many clients, especially retired clients, take an active role in managing their own investments. If you fall in this category, you may be able to deduct the cost of subscriptions to financial periodicals, clerical expenses, etc.

Most taxpayers will deduct such expenses as production-of-income expenses which are deductible only as itemized deductions and thus are subject to the 2% floor on miscellaneous itemized deductions. However if you meet certain criteria, you may be able to these expenses as business expenses in arriving at adjusted gross income.

Deducting Investment Expenses as Businesses Expenses

To deduct investment-related expenses as business expenses, you must be engaged in a trade or business. The Supreme Court held many years ago that an individual investor isn't engaged in a trade or business merely because he or she manages their own securities investments, regardless of the amount of the investments or the extent of the work required.

However, taxpayers that are considered to be traders are able to deduct their investment-related expenses as business expenses. A trader is also entitled to deduct home-office expenses if the home office is used exclusively on a regular basis as his or her principal place of business. 

Since the Supreme Court's decision, there has been extensive litigation on the issue of whether a taxpayer is a trader or investor. The Tax Court has developed a two-part test that must be satisfied in order for a taxpayer to be a trader. Under this two-part test, a taxpayer's investment activities are considered a trade or business only where both of the following are true:

the taxpayer's trading is substantial (i.e., sporadic trading won't be a trade or business), and
the taxpayer seeks to profit from short-term market swings, rather than from long-term holding of investments. 

So, the fact that a taxpayer's investment activities are regular, extensive, and continuous isn't in itself sufficient for determining that a taxpayer is a trader. In order to be considered a trader, a taxpayer must show that he or she buys and sell securities with reasonable frequency in an effort to profit on a short-term basis. Even a taxpayer who made over 1,000 trades a year with trading activities averaging about $16 million annually was held to be an investor because the holding periods for stocks sold averaged about one year.

Summary

For most investors, investment-related expenses are treated as a miscellaneous itemized deduction subject to 2% of AGI. If the investor meets the two-part criteria noted above, the investment-related expenses are treated as a business deduction from AGI.

If you have questions regarding your investment-related expenses, consult a qualified tax professional.