Monday, May 22, 2017

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Savings plans that allow the account owner to make contributions and earn a return until the funds are withdrawn at a later date.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 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.


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.

Monday, May 8, 2017

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.


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.


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. 

Tuesday, May 2, 2017

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.


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.