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.

Why SUVs may be a better choice than an automobile used for business?

Other than being comfy and nice to drive, SUVs may be a better choice than a car when it comes to business vehicles.

Limitations Placed on Cars

Cars are subject to more restrictive rules than those that apply to other depreciable assets and are not eligible for bonus and addition write-offs that are afforded to SUVs. This is due to the so-called "luxury auto" rules which artificially cap depreciation and expensing deductions for cars. For example, for an automobile first placed in service in 2016, the maximum depreciation deduction for the first tax year in its recovery period (i.e., 2016) is limited to $3,160; $5,100 for the second tax year; $3,050 for the third tax year; and $1,875 for each succeeding tax year. The effect is generally to extend the number of years it takes to fully depreciate the vehicle.

SUVs

SUVs may come with additional gasoline costs, but they aren’t subject to the same tax rules as cars. The regular annual depreciation and expensing caps for passenger automobiles don't apply to trucks or vans (and that includes SUVs) that are rated at more than 6,000 pounds gross (loaded) vehicle weight. Also you may also be eligible to elect to expense up to $25,000 of the cost of the SUV in the first year and then depreciate the remainder of the cost. These tax benefits are subject to adjustment for non-business use.

Business Use

If business use of the vehicle doesn't exceed 50% of total use, the SUV isn't eligible for the first year expensing and has to be depreciated on a straight-line method over a six-tax-year period.

Summary

Before making the decision to purchase an SUV or car used for business, you should consult with a qualified tax professional.

Read This Before Leasing Property from a Related Party

 

It is very common for corporations to lease property from a shareholder or other related party. In fact, we advise clients to generally not hold real estate inside of corporations, but rather to hold real estate in an LLC with a lease arrangement with their corporations. Holding real estate inside of a corporation can create potential tax traps that are avoided by owning property individually or in an LLC. We’ll discuss this more in a future post.

Generally, transactions with related parties are subject to more scrutiny from tax authorities. This is particularly true in the case of lease agreements. If the IRS finds rent paid to a related party to be "unreasonable," the deduction will be reduced. “Excessive” rent can be recharacterized as a distribution of profits, or a gift, as the case may be. Taking specific steps at the inception of the rental arrangement to support the rental rate and terms will place the related parties in a better position to defend the lease if questioned by the tax authorities.

Establishing fair rental value.

Establish the rent in your transaction in line with rent paid by unrelated parties for property that is comparable to yours. You can contact independent realtors or brokers to get appraisals based on comparable properties. Retain documentation from multiple parties to support the rent rate.

In cases where the fair rental values obtained from independent parties are below the amount you seek to set for your transaction, carefully document why your particular property should be valued higher. Consider the improvements made to the property, special features or location, etc. Rent is often viewed as a combination of a property's value with a reasonable rate of return. You may be able to justify setting a higher rent by showing that rates of return for your particular industry or investments run higher than elsewhere.

Percentage rentals

In some cases rent is set as a percentage of profits. This acceptable technique and can be used to protect against inflation or other risk factors. However, percentage rental agreements can be subject to even higher scrutiny by tax authorities, particularly high income years. Protect yourself against a potential disallowance in such years by documentation to show that the percentage rental arrangement was reasonable when it was established. 

If it's a usual practice to use percentage rentals in your industry, keep your arrangement in line with industry standards. Document this through industry information, independent appraisals and analyses to support that the terms of your transaction are market-based when you initiate the arrangement. 

Formal lease. Be sure that your rental arrangement is set down in a formal written lease and is properly executed. Corporations should also take all appropriate formal action related to the transaction. 

Just because your transaction is with a related party, don’t change any of your standard business practices. From the tax standpoint it's even more important to undertake the proper formalities for these transactions. In several cases, rent paid to a related party has been disallowed because it wasn't required under a formal lease.

Summary

Before entering into a lease agreement with a related party, consult your tax professional and thoroughly document how the rate and terms of the lease were established.

Deducting Business Meals and Entertainment

Business Meals and Entertainment are part of every small business. If you incur business meals and entertainment keep in mind that you’ll need to follow these rules to support the deduction and even then the business meals and entertainment expenses will be limited:

Ordinary and necessary - All business expenses must meet the general deductibility requirement of being "ordinary and necessary" in carrying on the business. Another way to look at it is to ask if the expenses are customary or usual, and appropriate or helpful to the conduct of your business. Thus, if it is reasonable in your business to entertain clients or other business people you should be able to pass this general test.

 

"Directly related" or "associated with" – In addition to being ordinary and necessary, meals and entertainment expenses must be either "directly related to" or "associated with" the business. 

To be directly related, the expense needs to involve an active discussion aimed at getting immediate revenue. These expenses need to have an objective of getting additional business and not just general goodwill. It also requires that you discuss business actively during the event. If the expense takes place in a clear business setting, it is easy to meet the directly related test. But when the discussion takes place at a sporting event, night club or party, it doesn’t meet this test. However the expense may qualify as "associated with" the active conduct of business if the meal or entertainment event precedes or follows (i.e., takes place on the same day as) a substantial and bona fide business discussion. Under these circumstances, the event will be considered associated with the active conduct of the business if its purpose is to get new business or encourage the continuation of a business relationship. For meals, you (or an employee of yours) must be present for the expense to qualify.

Substantiation. There’s an old saying in the accounting field that “if it wasn’t documented, it didn’t happen.” Almost as important as qualifying for the deduction are the requirements for proving that it qualifies. Using a reasonable estimate isn't sufficient to stand up to the IRS. To substantiate the expenses, keep documentation that establishes the amount spent, the time and place, the business purpose, and the business relationship of the individuals involved. For expenses of $75 or more, you will also need a copy of the receipt to go along with the documentation. There are several apps that make it easy to meet these requirements from the convenience of your smart phone.

Deduction limitations. Now you have jumped through the first three hurdles just to learn that additional limitations may apply. First, expenses that are "lavish or extravagant" aren't deductible. There’s no hard and fast rule about what is lavish or extravagant, but most of us have enough common sense to understand what would raise additional scrutiny. More importantly, however, once the expenditure qualifies, it is only 50% deductible, reducing the tax benefit.

 

Summary

 

When it comes to business meals and entertainment here’s a quick list to keep in mind:

• Is it an ordinary and necessary part of our business?
• Is it directly related or associate with the prospect of obtaining immediate new business?
• Did I document amount spent, the time and place, the business purpose, and the business relationship of the individuals involved?
• If the expense was over $75, did I keep the receipt?
• Could the expenditure be considered as lavish or extravagant?

Answer these questions and document your business meals and entertainment to support the deductions. As always, consult a qualified tax professional with any questions you have regarding your business.

Your Business May Benefit from the Research Tax Credit

Legislation in late 2015, made the Research Tax Credit permanent and not part of the federal tax provisions that were commonly referred to the “extender provisions”.

Basics of the Credit

We are not going to get into many of the specifics of the Research Tax Credit here, but rather just provide you with a quick overview.

Sometimes referred to the Research and Experimentation Tax Credit, this credit can apply to many businesses and industries. It doesn’t require that you have lab and conduct scientific experiments. Many businesses have processes whereby they are modifying and improving existing products and processes and assuming the risk of failure if the improvement is not achieved. While not all businesses are eligible for the credit, it is worth a quick analysis to determine if it does apply and is cost effective to calculate and take the credit. Also, many states have research credits that can be sold to other taxpayers thus, providing the business with a source of capital if the tax credit is not of value to the business. Along these lines, the federal research tax credit may be used in certain situations to offset payroll tax liabilities. This is a big change that can benefit companies, especially those in the startup phase.

The statutory rules for the research tax credit essentially provided for a credit equal to the sum of (1) 20% of the excess of the "qualified research expenses" (QREs) over the greater of (a) 50% of the QREs or (b) an amount based on a formula that takes account of the QREs and gross receipts in certain earlier tax years, (2) 20% of the excess of research payments paid to certain outside organizations over an amount calculated under a complex formula, and (3) 20% of amounts paid or incurred to an energy research consortium for energy research.

The legislation that made the research tax credit permanent also added two features that are especially favorable to small business. First, it provides that beginning in 2016 eligible small businesses ($50 million or less in gross receipts) may claim the credit against alternative minimum tax (AMT) liability. Also, beginning in 2016, the new law provides that the credit can be used by certain even smaller businesses against the employer's portion of the Social Security portion of the employer's payroll tax (i.e., FICA) liability.

Summary

The federal research tax credit is now permanent.
Many businesses may not realize that the research credit can be applicable to their business.
Recent legislation allows the credit to be used to offset payroll taxes in certain situations.
Many states offer a research tax credit, some of which can be sold to other taxpayers.
Utilize tax professionals specializing in the research tax credit to determine if your business qualifies and if the process will be cost effective.
Businesses subject to AMT are no longer limited in their utilization of the tax credit.

As we always advise, seek a qualified tax professional to explain and determine if the research tax credit applies to your business.

Paying Taxes By Credit or Debit Card

Cash or check may be soon replaced with Plastic or App in today’s economy. Even the IRS and several states give you the option to pay your tax bill online via credit or debit card today.

Authorized Service Providers

You will find a list of authorized service providers that accept online payments on behalf of the IRS at https://www.irs.gov/uac/pay-taxes-by-credit-or-debit-card. The companies have their own fee schedules which are listed on link above. They accept American Express, Discover Card, MasterCard, and VISA credit and debit cards. If you file early, you can still wait until April to make the online payment.

Paying With Your Return

Taxpayers may have the option of making credit card payments for the balance due on Form 1040, 1040A, or 1040EZ through tax software or through professional preparers using certain types of tax software. Some tax preparation software provides combined electronic filing and electronic payment for those who want to pay taxes with a credit card. But some tax preparation software may not allow taxpayers to make partial payments. At this time, our software does not offer the option to pay by card.

Various Tax Payments Available

In addition to balances due on individual returns, taxpayers can pay individual estimated taxes; installment payments; payments with extension of time to file (Form 4868); trust fund recovery penalty; and Form 5329 (IRA taxes) through this service. For forms in the 1040 series, credit card payment options begin in January. However, if you don't pay your full tax liability by the due date in April (see below), you probably will be liable for interest and penalties. Certain business and fiduciary tax payments can also be made using the above methods.

Advantages and Disadvantages

One advantage of using the credit card method, aside from the obvious one of being able to delay paying your tax liability, is that if you participate in any credit card incentive program, such as airline mileage or certain reward programs, you will earn points by charging your taxes. A disadvantage is the convenience fee charged by service providers (both for credit and debit card transactions). This fee, may be deductible on next year’s return as a miscellaneous itemized deduction.

Summary

Like most businesses today, the federal government and some states accept credit and debit card payments. You will have to determine if the convenience and possible card incentives outweigh the fees associated with paying by credit or debit card.

Employer Reporting of Health Coverage

With the change in administration and current initiative to either abolish, replace or possibly rewrite the Affordable Care Act commonly known as Obamacare, there is much uncertainty regarding the healthcare mandate and how employers are affected by the Act.

Basic Reporting Requirements

Currently, certain employers are required to report information related to their employee's health coverage.

Employers with 50 or more full-time employees also referred to as applicable large employers (ALEs) must use Forms 1094-C and 1095-C to report the information about offers of health coverage and enrollment in health coverage for their employees. Form 1094-C reports summary information for each employee and Form 1095-C is filed with the IRS. Forms 1094-C and 1095-C are also used in determining whether an employer owes payments under the employer shared responsibility provisions, also known as the "employer mandate". Under the employer mandate, an employer can be subject to a penalty if it does not offer affordable minimum essential coverage that provides minimum value to substantially all full-time employees and dependents. Form 1095-C is also used in determining eligibility of employees for premium tax credits.

Part II of Form 1095-C reports the following information for each employee who was an ALE's full-time employee for any month of the calendar year:

Employee's name, social security number (SSN), and address,
Employer contact and Employer Identification Number (EIN), including the contact person's name and phone number,
Description of the offer of coverage (using one of the codes provided in the instructions) and the months of coverage,
Each full-time employee's share of the cost for coverage under the lowest-cost, minimum-value plan offered by the employer, by calendar month, and
Applicable safe harbor (using one of the codes provided in the instructions) under the employer shared responsibility or employer mandate penalty.

Employer-Sponsored Self-Insurance Plans

When an ALE offers health coverage through an employer-sponsored self-insured plan, the ALE is required complete Part III of Form 1095-C. Keep in mind that a self-insured plan also includes a plan that offers some enrollment options as insured arrangements and other options are under self-insured options. Part III reporting includes the name, SSN, and coverage information about each individual employee and dependents covered under the employer's health plan. ALEs also indicate the months for which these individuals were covered in Part III.

Group and Multiemployer Health Plans

When coverage is offered through an insured health plan or a multi-employer health plan, the issuer of the insurance or the sponsor of the plan providing the coverage provides the information about the health coverage to any enrolled employees, and the employer should not complete Form 1095-C, Part III, for those employees.

Employers Not Subject to the Employer Mandate

Employers providing employer-sponsored self-insured health coverage that are not subject to the employer mandate, are not required to file Forms 1094-C and 1095-C and reports instead on Forms 1094-B and 1095-B for employees who enrolled in the employer-sponsored self-insured health coverage. On Form 1094-C, an employer can also indicate whether any certifications of eligibility for relief from the employer mandate apply.

Summary

Employers should be aware of the reporting requirements under ACA and monitor any legislative changes that may change or eliminate current requirements. ALEs have been through two complete reporting cycles at the time of this writing and should understand how ACA affects their business. This is a fairly complex area for even large employers. It is advisable for employers to obtain specific training on the topic and engage a qualified consultant to assist them in the reporting process when necessary. Since this area is a rather complicated and stretches outside of the normal area of taxation, consultation may come from specialists including tax professionals.

Does Your Employer Offer Financial and Retirement Counseling?

Some employers may offer financial counseling services as a benefit to their employees. It is a nice benefit, but keep in mind that the employee receiving the benefit must report value of this benefit as income on their tax return. However, the employee may be entitled to an offsetting deduction that would allowing them avoid tax on some of the benefit.

Benefit is Treated as Income

These employer provided services can often quite extensive, including consideration of your savings and investments, life insurance coverage, real estate, retirement benefits and personal tax and estate planning advice. These services are typically provided by a professional consulting firm that is paid by the employer as a fringe benefit. The value of these services will be reported by your employer as wages on your W-2. The employer is also required to withhold income tax and FICA from the amount it reports as wages. Keep in mind that if your employer provides only minor and infrequent financial services, such as information about your employee benefits and how they affect your tax situation, you wouldn't be taxed on their value.

Taxation of the Benefit

Reporting the benefit as income doesn't necessarily mean that you will be fully taxed on it. You may be entitled to some deductions that can reduce the amount subject to tax.

Individual taxpayers are permitted to deduct investment expenses, such as expenses related to the collection or production of income. They also may deduct expenses related to the determination, collection, or refund of tax. Financial counseling fees included in your income are also deductible as if you had paid them yourself.

These expenses are claimed as miscellaneous itemized deductions, which are allowed only to the extent they exceed 2% of your adjusted gross income. You would add the deductible counseling expenses together with your other deductible investment and employment related expenses and any other miscellaneous deductions you might have, and subtract out 2% of your adjusted gross income. Only the balance, if any, would reduce your income subject to tax.

Retirement Planning Services

Under a special rule, employer provided retirement planning services aren't taxable if the employer maintains a retirement plan. The advice that can be provided tax-free isn't limited to information about the plan, but includes information about your income needs in retirement and how those income goals can be achieved.

Summary

Financial and retirement counselling are great benefits employers may offer to employees. It shows that the employer is concerned for the financial well-being of their employees. From the employee perspective, these are services that they may not otherwise choose to obtain. While the benefits are taxable, the employee should consider as if they are obtaining a valuable benefit for a fraction of the cost they would pay themselves. For example, if the employee has an effective tax rate of 20%, services priced at $2,000 will cost the employee only $400 (in the form of taxes on the benefit). In most cases we’d all like to buy something for an 80% discount. If your employer offers financial and retirement planning as a benefit, you should consider taking advantage of it. The relatively low cost to you in the form of taxes could yield you big benefits in the long run.

Notifying the IRS of an Address Change

Almost all of us will make a move during our lifetime. Whether you are making a move across town or across the country, you need to add the IRS to the list of organizations to notify of an address change.

Notifying the IRS of your address change is important because you’ll want to deposit any refunds the IRS may send you as soon as possible and secondly, failing to respond to a tax notice can be costly.

The IRS doesn't have to prove delivery to meet its responsibilities in many cases. The IRS is only required to send correspondence to your "last known address." The "I never got it" defense is lost if IRS properly sent the notice to your old address.

The IRS won't owe you any interest for the delay, if a refund is delayed due to a change in your address not reported to the IRS.

Similarly, notices of tax deficiency require a 90 day response otherwise you will lose the right to contest the matter in the Tax Court. While you can still wage the battle in federal district court, you will have to pay the tax first, and there may be other tactical disadvantages of doing so. You will also be assessed penalties and interest costs even though you didn't know you had an outstanding tax liability.

There are other notices IRS must send to you before taking certain actions affecting you so it’s in your best interest to keep IRS informed about your current address.

How to Notify the IRS of your Address Change

Filing a tax return showing your new address will make the change of address, but only after the return is processed. This could take many weeks after you file. The U.S. Postal Service will also notify the IRS of any permanent forwarding address, but this also takes time to process. To be safe, you should notify IRS of the change directly.

For your convenience, click on this link for Form 8822 which you can use to notify IRS of the change. Be sure to sign the form, make a copy for your records, and send the original to the IRS at the address listed in the instructions. If your children file income tax returns, you must file a separate Form 8822 for each.
Also, don’t overlook changing your address with any states that you file income taxes with.

Gain or loss on sale of property received as a gift

Everyone likes to receive gifts, especially if its cash. But if you happen to be considering gifting property or stock or are the lucky recipient of such a gift, there are a few things you’ll need to know. There are tax consequences to the recipient if the property is sold at a later date. And just to clarify, inherited property is not the same a gifted property.

When gifted property is sold, recipient or donee will determine the gain or loss using the “basis” transferred from the donor. For most property you buy yourself, the basis is simply your cost. For property received as a gift, however, special basis rules apply.

General rule-carryover basis

Generally, you receive the same basis in the property that the donor had in it. This is referred to as the "carryover" basis, because the donor's basis carries over to you as donee along with the gift. Taxpayers are often unaware of this rule and mistakenly believe the basis to be the value of the gift when they receive it. Along with the carryover basis, the donor’s holding period also carries over to the done. Thus, gifts of property held for over one year by the donor carry a long-term holding period. If the gifted property was held for less than one year, it carries a short-term holding period unless the donee continues to hold it for over one year from the date it was acquired by the donor.

For Example: Kyle bought shares of stock for $1,000 and gave it to his nephew Allen when the stock was worth $9,000. Allen later sold the stock for $11,000. Allen's basis in the stock is only $1,000-the same basis Kyle had in the stock. Thus, Allen must report a $10,000 of gain on the sale.

If Allen sells the stock for $6,000, he will report a gain of $5,000, even though the stock declined in value in his hands. Allen is only be able to report a loss if he sells the stock for less than $1,000.

Loss property

When the value of property to be gifted decreases while owned by the donee, special rules apply. In this case, the donor's basis is higher than the value of the property and the donee must keep track of two figures for basis purposes. To measure gain on a later sale, the general carryover basis rule applies and the donee’s basis is the same that the donor had. But to measure loss on a later sale, the donee’s basis is limited to the value of the property at the time of the gift.

For example: Lauren bought stock for $12,000 and gave it to her nephew Ted when it was worth $8,000. Ted sold the stock for $6,000 and reports a $2,000 loss ($6,000 less the basis of $8,000).

Assuming the same facts as above, except that Ted sells the stock for $15,000. Ted's basis is $12,000, the same basis Lauren had and Ted’s gain is $3,000.

Under these rules, if a donee sells the gifted property for an amount in between donor’s original cost and the property's date of gift basis and basis, there will be no gain or loss on the sale.

Using the same information as above, except that Ted sells the stock for $10,000. Here, to measure Ted's loss, his basis would be $8,000, so there's no loss on the sale for $10,000. Similarly, to measure Ted's gain, his basis would be $12,000, so there's no gain on a sale for $10,000. Thus, Ted reports no gain or loss on the sale.

Did the donor pay gift tax?

If the value of the gifted property exceeds the annual gift tax exclusion (currently $14,000), the donor may have paid federal gift taxes on it. If so, the donee is able to increase the basis by any federal gift taxes attributable to appreciation in the gifted property. Donee’s will want to ask if the donor paid any gift tax and provide this information to their tax professional to ensure the correct basis is used.

Getting basis information

It's important to get the basis information you need from the donor. Many donors include this in the cover letter that accompanies the gift. If your donor didn't, you may find it awkward to say, "Thanks for the generous gift-what did you pay for it?" In this case, donees may ask their tax professional to contact the donor to explain the need for this information.

Don’t delay in getting the basis information when you receive a gift. It can be difficult to go back and establish basis at a later date and if you can't establish basis, IRS can impose a zero-basis treating the entire sale price as gain. Don't put yourself at risk in this fashion.

If you are considering making a gift of property or are the recipient of a gift, discuss the gift with your tax professional and obtain the documentation that you will need to support your basis in the property when it is eventually sold.

Deducting Local Transportation Costs

If you are in business, you’ll undoubtedly incur local transportation costs and you will want to make sure you can deduct these costs. If you are not deducting the actual costs incurred for a business vehicle, you’ll want to deduct local travel based on mileage.

Local transportation refers to travel in which you aren't away from your tax home (the city or general area in which your main place of business is located) long enough to require sleep or rest. Different rules apply if you are away from your tax home for significantly more than an ordinary work day and need sleep or rest in order to do your work.

 

Commuting Costs

When it comes to local transportation rules, your commuting costs are not deductible. So any fares or transportation costs between your home and business are nondeductible. But maybe you work during your commute, e.g., via a cell phone, or by performing business-related tasks while on the train or bus. Unfortunately for you, this does not change the deductibility of the commuting costs.

However, there is an exception for commuting to a temporary work location that is outside of the metropolitan area in which you live and normally work. A temporary work location is one where your work is realistically expected to last (and does in fact last) for no more than a year.

Local Travel

Now that you have endured the commuting costs and arrived at work, the cost of any local trips you take for business purposes is a deductible business expense. This includes the cost of travel from your office to visit a client, pick up supplies, etc. Also, if you have two business locations, the costs of travel between them is deductible.

Recordkeeping

Save the receipts for taxi or public transportation and make a notation of the expense in a logbook, and record the date, amount spent, destination, and business purpose. If you use your car, note miles driven instead of amount spent along with any tolls paid or parking fees. There are many apps that can be used to track your business mileage. We use and recommend MileIQ which is available for Apple or Android. MileIQ makes it easy to track mileage for business as well as personal medical and charitable mileage that may be deductible on your individual tax returns. It’s not free, but as the old saying goes – You get what you pay for! Contact us and we’ll refer you to MileIQ for a 20% discount on an annual subscription.
The IRS changes the mileage deduction rate each year, so another advantage to MileIQ is that the app takes care of the change in rates for you.

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.

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.