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The Most Beautiful Summary of Trump’s Business Tax Cut. Period.

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Republican U.S. presidential candidate Donald Trump speaks during a campaign rally at the Treasure Island Hotel & Casino in Las Vegas, Nevada June 18, 2016. REUTERS/David Becker - RTX2GYKG

With some very broad brushstrokes, the Trump administration laid out its tax plan.  It is still very early in the process, and skepticism about how much of the plan will survive negotiations should be maintained.  This article will discuss a substantial reduction in taxes for business owners.

Very Major Overview

During the campaign, Donald Trump proposed cutting the maximum business tax rate to 15%.  There was uncertainty as to whether this 15% maximum tax rate would also apply to pass through entities such as LLCs and S corporations.  The uncertainty has been resolved as it is now clear that the 15% maximum tax rate applies to pass through entities and to sole proprietorships.

Tremendous and Beautiful Tax Cut

Example:  John owns an S corporation and it has profit of $200,000.  Assume John has other income and he is in the 35% tax bracket.  Under current law, his tax liability on the $200,000 S corporation profit would be $70,000 (35% times $200,000).  Under the Trump proposal, John’s maximum tax rate on the S corporation profit would be 15%, so his tax under the Trump plan would be $30,000. 

Example:  Same facts as above except John is a member of an LLC and his share of the LLC profit is $200,000.  Again, his maximum tax rate under the Trump plan is 15%, so his tax on the share of the LLC profit would be $30,000.

You May Even Get Tired of Paying Lower Taxes and You’ll Say “Please, Please, It’s Too Much.  We Can’t Take It Anymore.”   

There has been an incentive for S corporation owners to minimize officer compensation because S corporation owners only incur payroll taxes on their payroll, not on the remaining business profit.  The Trump plan would further encourage S corporation owners to minimize officer compensation because officer compensation would remain subject to higher income tax rates, while S corporation profit would be subject to the 15% maximum rate.

Example:  Jennifer has an S corporation with $100,000 profit before officer compensation.  Assume she has other income and is in the 35% tax bracket.  She has officer compensation of $60,000 and S corporation profit of $40,000 after officer compensation. 

Under current law, her tax would be:

Tax on Officer Compensation:       $21,000 (35% times $60,000)

Tax on S corporation profit:         $14,000 (35% times $40,000)

Total Tax                                             $35,000

Under the Trump plan, her tax would be:

Tax on Officer Compensation:    $21,000 (35% times $60,000)

Tax on S corporation profit:         $6,000 (15% times $40,000)

Total Tax                                             $27,000

 Joan prefers paying tax at the 15% tax rate so she reduces her payroll to $40,000 (leaving S corporation profit of $60,000). 

Under Trump plan with officer compensation reduction, her tax would be:

Tax on Officer Compensation      $14,000 (35% times $40,000)

Tax on S corporation profit:         $9,000 (15% times $60,000)

Total Tax                                             $23,000

Joan saves $4,000 by reducing her higher-taxed payroll and increasing her S corporation profit that is taxed at the 15% maximum rate.

There is already incentive for S corporation owners to minimize officer compensation because officer compensation is subject to payroll taxes (generally 15.3% FICA plus unemployment taxes) while S corporation profit is not subject to payroll taxes.  The Trump plan increases the incentive to minimize officer compensation.

If you need help with small business taxes,

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 Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Realistic Like-Kind Exchange Scenarios

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A like-kind exchange allows a property owner to exchange properties with another person and defer paying tax on the exchange.  A prior post explained the basic mechanics of like-kind exchanges.  This post will focus on a couple more complicated, but also more realistic, situations.  These situations occur:

  • when one of the parties wants to receive cash instead of replacement property.  This situation usually involves a third or fourth person to qualify the transaction as a like-kind exchange.
  • when the exchanges do not occur simultaneously

Three Party Exchanges

Marty owns Property M.  Doc owns Property D.  Marty wants to enter into a like-kind exchange with Doc to acquire Property D.  Doc wants to sell Property D for cash.  After some searching, Marty finds Biff who wants to buy Property M for cash.

The three parties enter into a three party exchange as follows:

  1. Biff buys Property D from Doc for cash
  2. Biff exchanges Property D for Marty’s Property M in a like-kind exchange.

Everyone is happy—Doc gets the cash he wants; Marty exchanged Property M for Property D in a like-kind exchange; Biff paid cash and ultimately ended up owning Property M.

Four Party Exchanges

Assume the same facts as above, except that Biff does not want to acquire Property D because of environmental liability concerns.  A like-kind exchange can be accomplished through a four party exchange involving a qualified intermediary.

A qualified intermediary is a person who is not the taxpayer or a disqualified person and who expressly agrees under the terms of an exchange agreement to acquire the taxpayer’s relinquished property, transfer the relinquished property to another taxpayer, acquire the replacement property, and transfer the replacement property to the taxpayer.

A disqualified person is either related to the taxpayer or someone that has acted as the taxpayer’s agent, such as an attorney, accountant, real estate agent/broker,  at any time during the prior two years.  However, routine financial services provided to the taxpayer during this time by a financial institution (i.e., a bank), title insurance company, or escrow company are not taken into account—these institutions may serve as qualified intermediaries.

To see this in action, assume four parties enter into the following simultaneous exchanges:

  1. Marty engages Title Company as a qualified intermediary
  2. Title Company borrows money and buys Property D from Doc for cash (Doc receives the cash he wanted)
  3. Title Company exchanges Property D with Marty’s Property M (Marty exchanges Property M for Property D in a like-kind exchange)
  4. Title Company sells Property M to Biff for cash and pays off the loan (Biff pays cash to directly purchase Property M)

When Exchanges Do Not Occur Simultaneously

These exchanges are referred to as deferred exchanges.  These can occur when someone who wants to enter into a like-kind exchange finds a cash buyer for his property but needs additional time to find replacement property.  In these situations, the person will transfer property to the buyer, the buyer will transfer proceeds to an escrow agent, and the escrow agent will purchase replacement property to the seller once replacement property has been identified.  The seller cannot take possession of the cash, otherwise the transaction will fail as a like-kind exchange; that is why the escrow agent takes possession of the cash.

There are two primary requirements in deferred exchanges:

  • Identification Period:  Before this period expires, the taxpayer must identify replacement property to the other party who is obligated to transfer the replacement property to the taxpayer.  The identification period begins on the date the taxpayer transfers the relinquished property and ends 45 days after.  Up to three replacement properties can be identified without regard to the market value of the replacement property.  If more than three replacement properties are identified, the market value of all identified replacement properties cannot exceed 200% of the relinquished property.
  • Exchange Period:  Before this period expires, the taxpayer must receive the replacement property.  The exchange period also begins on the date the taxpayer transfers the relinquished property and ends on the earlier of (1) 180 days after OR (2) the due date (including extensions) of the tax return for the year in which the transfer of the relinquished property occurs.

Example:  Fred wants to exchange Property F in a like-kind exchange.  Barney wants to buy Property F for cash.  Fred enters into a deferred exchange where he transfers the property to Barney and Barney transfers cash to an escrow agent who will acquire the replacement property when it’s identified by Fred.  Fred has 45 days to identify replacement property to the escrow agent beginning the date he transfers the property to Barney.  Fred has 180 days to receive the replacement property beginning on the date he transfers the property to Barney. 

Assume Fred transfers the property to Barney in December.  Fred believes the exchange period will end in 180 days during June.  He files his tax return by April 15 and does not file an extension.  Fred closes on the replacement property in May, within the 180 days.  However, Fred failed the exchange period requirement because his return was not extended.  Remember—the exchange period ends on the earlier of (1) 180 days after the transfer or (2) the due date (including extensions) of the tax return.  Here, the April 15 unextended due date marked the end of the exchange period because it is earlier than 180 days after the transfer.  The exchange does not qualify as a like-kind exchange and Fred has a taxable gain based on the difference between the market value of the new property and his cost in the relinquished property. 

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 Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

 

Defer Tax with a Like-Kind Exchange (aka 1031 Exchange)

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1031People who sell real estate at a gain often want to use the proceeds to purchase additional real estate.  However, people have to pay tax on the gain before they can use the proceeds to buy more real estate.  Often, they are surprised that they have to pay tax on the gain when they’re rolling the proceeds into more real estate.

Taxpayers in this situation can avoid paying tax immediately on the sale by entering into a like-kind exchange.  In a like-kind exchange, taxpayers exchange their property with another taxpayer’s property without cash exchanging hands.  If taxpayers can’t find another party to exchange properties with, multi-party exchanges (described in my next blog) can be structured.

Like-kind exchanges can include business for business, business for investment, investment for business, or investment for investment property.  Inventory, partnership interests, and stocks and bonds do not qualify for like-kind exchange treatment.  The term like-kind refers to the nature and character of the property and not to its grade or quality.  Real estate can be exchanged only for other real estate, and personal property can only be exchanged for other personal property.

A major benefit of like-kind exchanges is that the taxpayer can acquire new property on a pre-tax basis.

Example:  Suzy has property with a $100,000 cost and a $250,000 market value.  If she sells the property she will pay tax of 15% on her $150,000 gain, which amounts to $22,500.  After paying tax, Suzy only has $227,500 of the proceeds left to purchase new property.  If Suzy can enter into a like-kind exchange, she can defer paying tax and will be able to acquire new property worth the $250,000 value of her old property.

With a like-kind exchange, tax is deferred rather than avoided.  When a taxpayer exchanges a property, the original cost of the old property is applied to the new property.

Example:  Barney owns Parcel 1 which he bought for $100,000 but is now worth $250,000..  Andy owns Parcel 2, which he bought for $120,000 but is now worth $250,000.  They exchange properties.  Barney now owns Parcel 2, with a cost of $100,000 and a market value of $250,000.  Andy now owns Parcel 1 with a cost of $120,000 and a market value of $250,000.  Neither pays tax at the time of the exchange.  However, tax is not permanently avoided because Barney will have a taxable gain of $150,000 when he later sells Parcel 2 and Andy will have a taxable gain of $130,000 when he later sells Parcel 1.

To fully defer tax, no cash or assets other than the exchanged properties can change hands.  If cash (including relief from debt) changes hands, taxable gain may be recognized to the extent of cash and other assets received.  Cash and other assets received in a like-kind exchange are referred to as “boot”.

Example:   Barney owns Parcel 1 which he bought for $100,000 but is now worth $250,000.  Andy owns Parcel 2, which he bought for $120,000 but is now worth $230,000.  They exchange properties and Andy pays Barney $20,000 because his property is worthless than Barney’s.  Barney’s economic gain is $150,000, but his taxable gain is limited to the $20,000 cash he received.  Andy’s exchange is still completely tax deferred because he received no boot.

Example 2:  Barney owns Parcel 1 which he bought for $100,000 but is worth $250,000. Assume Barney has a $20,000 mortgage on Parcel 1.  Andy owns Parcel 2, which he bought for $120,000 but is worth $230,000.  They exchange properties and Andy assumes Barney’s $20,000 mortgage.  Since Barney was relieved of the $20,000 mortgage, he has received boot.   Barney’s economic gain is $150,000, but his taxable gain is limited to the $20,000 mortgage relief he received.  Andy’s exchange is still completely tax deferred because he received no boot.

The basis of the new property is equal to the basis of the old property:

  • Plus boot paid
  • Less boot received
  • Plus gain recognized

For both of the above 2 examples, Barney’s basis in Parcel 2 is:

Basis of Parcel 1:              $100,000

Plus boot paid:                  $0

Less boot received:          ($20,000)

Plus gain recognized:          $20,000

Basis of Parcel 2:               $100,000

If Barney immediately sells Parcel 2 for $230,000, he will recognize a gain of $130,000 ($230,000 sales price less basis of $100,000).  When you add this $130,000 gain on sale to the $20,000 gain Barney recognized when he received the $20,000 boot, you have $150,000 which is the economic gain Barney had in Parcel 1.  Notice how the economic gain of $150,000 is taxed as Barney received cash of $20,000 during the like-kind exchange, and $130,000 when he sells Parcel 2 for cash.

For both of the above 2 examples, Andy’s basis in Parcel 1 is:

Basis of Parcel 2:               $120,000

Plus boot paid:                  $20,000

Less boot received:                   $0

Plus gain recognized:                 $0

Basis of Parcel 1:               $140,000

If Andy immediately sells Parcel 1 for $250,000, he will recognize a gain of $110,000 ($250,000 sales price less basis of $140,000).  This is the economic gain he had in Parcel 2.

If you need help with small business taxes,

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 Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

 

 

You May Not Get Any Amended Form 1099s for Investment Income This Tax Season

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smart-investmentsOne of the more annoying aspects of tax filing has been the amended Form 1099s that people receive from investment brokers late in the filing season that require amended returns. Well, the number of these amended Form 1099s may decline substantially this filing season.

For investment income Form 1099s filed after December 31, 2016 (i.e., for tax years 2016 and later) there is a new safe harbor for de minimis errors on informational returns. If the broker makes an error that differs from the correct amount by no more than $100 or tax withheld differs by no more than $25, the broker is not required to issue a revised Form 1099 unless the payee elects that the safe harbor not apply.

Most of the corrected Form 1099s issued late in the filing season tend to report changes that are fairly small amounts, and they are generally under $100. So this safe harbor should substantially reduce the number of amended tax returns that are required because of corrected investment income Form 1099s.

If you have any questions on how this applies to you, please feel free to give us a call at 248-538-5331.

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Is This the End of the Individual Mandate?

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crazy-sign1The IRS recently announced that it will not reject 2016 tax returns that are silent on whether the taxpayer has complied with the individual mandate of the Affordable Care Act.  These provisions require taxpayers to have qualifying health care coverage, qualify for an exemption, or pay a penalty.  The IRS previously stated that such “silent” returns would be rejected; however, the IRS has shifted its policy to comply with a recent Presidential executive order.  While the individual mandate is still law, it is possible that the IRS may not enforce the penalty.  Caution is advisable.  It is still very early in this process and guidance is still vague.

Background on the Individual Mandate

On their tax returns, taxpayers who had qualifying health coverage for every month of 2016 for themselves, their spouses, and dependents had to check the box on line 61 (Health Care: Individual Responsibility).  A taxpayer that couldn’t check the box because there were coverage lapses must generally either claim a coverage exemption or pay the penalty for the lapse months.

The Executive Order

President Trump’s first executive order stated his intent to seek prompt repeal of the ACA.  The executive orders stated:

To the extent permitted by law, the Secretary of Health and Human Services and the heads of all other executive departments and agencies with authorities and responsibilities under the Act shall exercise all authority and discretion available to them to waive, defer, grant exemptions from, or delay the implementation of any provision or requirement of the Act that would impose a fiscal burden on any State or a cost, fee, tax, penalty, or regulatory burden on individuals, families, healthcare providers, health insurers, patients, recipients of healthcare services, purchasers of health insurance, or makers of medical devices, products, or medications.

While the Trump Administration cannot simply repeal the individual mandate, which is part of a law passed by Congress, they could make the regulatory exemptions from it so broad that the exemptions swallow the rule and the individual mandate is essentially unenforced.  Possibly…

One cause for concern is that even though the IRS will now process returns that are silent on compliance with the individual mandate, the IRS says that if it has questions about a tax return, taxpayers may receive follow up questions and correspondence at a future date.

Based on existing law prior to the executive order, the IRS will not issue liens or levies to collect the penalty and they will not initiate audits based on nonpayment of the penalties.  The IRS’ only recourse for nonpayment of the penalty is to reduce refunds owed to taxpayers.

If you have any questions on how this applies to you, please feel free to give us a call at 248-538-5331.

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Home Office Deductions

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When you qualify to take a home office deduction, the business
portion  of the following expenses (which are usually not deductible) become deductible:

  • utility costs
  • home insurance premiums
  • repairs
  • the lower of the cost of your home or its fair market value (this is done through depreciation deductions)

A couple of caveats:

  • the home office deduction is limited to the income from the business (or job) for which you are using the home office
  • home office deductions for employees are only allowed if the employee’s home office is used for the convenience of the employer
    • So if your employer provides you with an office at work, but you choose to work at home, you can’t take a home office deduction because you are working at home for your own convenience.
    • If your employer does not provide you with an office at work (or the availability of the employer’s office is too restrictive), your home office is more likely to be for the convenience of your employer and be deductible.

Requirements of the Home Office Deduction

A home office must be used REGULARLY and ***EXCLUSIVELY***as:

  • your principal place of business
  • a place where you meet with customers or clients
  • connected with your business if your home office is in a separate structure

If there is any personal use of your home office, it is not being used exclusively for business and the home office deduction is not allowed.  There are only two exceptions to the exclusivity rule:

  • you are running a daycare out of your home
  • the home office is being used to store inventory

If you are running a daycare or using your home office to store inventory, you can take a home office deduction even if the home office is not being used exclusively for business (but the home office deduction is reduced by the percentage that it is being used for personal reasons).

Principal Place of Business Requirement

There are two ways to meet the principal place of business requirement:

  • You meet the facts and circumstances test
    • the nature of the work performed at each location
    • the amount of time you spend at each location is considered.
  • You perform managerial or administrative work out of your home office, and you do not perform substantial administrative or managerial work at another fixed location.

Example:  Doc is a cardiologist who has a home office where he:

  • does billing work
  • reads medical journals
  • schedules appointments
  • does some bookkeeping work for his business

Under the facts and circumstances test, the IRS looks to Doc’s business and the nature of the work he performs at each location.  Doc is a cardiologist and performs surgery and consults at hospitals.  Since the work of a cardiologist is primarily surgical and consultative, Doc cannot take a home office deduction because his primary work is done at hospitals.

However, Doc can take a home office deduction because he performs managerial and administrative work out of his home office (and doesn’t do such work at other locations). 

This fact scenario is based on the Solimon v. Commissioner case.  In this case, the Supreme Court agreed with the IRS and disallowed a home office deduction under the facts and circumstances test.  Congress responded by changing the law to allow home office deductions for administrative and managerial work done in a home office.

A very important advantage of having your home as your principal place of business is that commuting expenses become deductible.  Normally, your commute to your first business stop (and from your last business stop to your home) are nondeductible.  When your home is your principal place of business, commuting expenses from your home office to your first business stop (and from your last business stop to your home office) become deductible.

A Place where You Meet with Customers/Clients

You must actually meet with customers/clients at your home (i.e., teleconferencing or videoconferencing does not count).  Not much more to say here.

Connected with Your Business if the Home Office is in a Separate Structure

The “connected with” requirement is a much less stringent requirement to meet than the principal place of business requirement.  A separate structure can include a detached garage or barn.  The reasoning for the less stringent standard is because a separate structure is less likely to be used for personal reasons (e.g., you are more likely to watch TV or have company in your den than you are to watch TV or invite company to your detached garage).

Simplified Home Office Deduction

There is a simplified method of computing the home office deduction.  The home office deduction can be calculated by multiplying $5 by the square footage of the home office.  The maximum square footage of the home office under this method is 300 square feet, and the maximum home office deduction will therefore be $1,500.  Of course, taxpayers still have the option of calculating the home office deduction under the actual expenses method if it results in a larger deduction.

Taxpayers who use the simplified method may still fully deduct mortgage interest, real estate taxes, and casualty losses as itemized deductions.  Additionally, businesses expenses such as advertising, wages, and supplies are still deductible.   Depreciation may not be claimed.

Use the Power of Positive Mental Attitude to Lower Your Taxes (2017 Top Tax Scams)

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scamThe IRS is in the process of releasing its 2017 Dirty Dozen list of tax scams. It updates this list each tax season to alert taxpayers of tax scams they may encounter during the filing season. Tax scams making the list this year include:

Falsely Padding Deductions

The majority of taxpayers file honest and accurate tax returns each year. However, each year some taxpayers “fudge” their information. This is why falsely claiming deductions, expenses or credits on tax returns remains on the “Dirty Dozen” list of tax scams.

Significant penalties may apply for taxpayers who file incorrect returns including:

  • 20 percent of the disallowed amount for filing an erroneous claim for a refund or credit.
  • $5,000 if the IRS determines a taxpayer has filed a “frivolous tax return.” A frivolous tax return is one that does not include enough information to figure the correct tax or that contains information clearly showing that the tax reported is substantially incorrect.
  • In addition to the full amount of tax owed, a taxpayer could be assessed a penalty of 75 percent of the amount owed if the underpayment on the return resulted from tax fraud.

Taxpayers may be subject to criminal prosecution and be brought to trial for actions such as:

  • Tax evasion
  • Willful failure to file a return, supply information, or pay any tax due
  • Fraud and false statements
  • Preparing and filing a fraudulent return, or
  • Identity theft.

Criminal prosecution could lead to additional penalties and even prison time.

Excessive Claims for Business Credits

Avoid improperly claiming the fuel tax credit, a tax benefit generally not available to most taxpayers. The credit is generally limited to off-highway business use, including use in farming. Taxpayers should also avoid misuse of the research credit. Improper claims generally involve failures to participate in or substantiate qualified research activities and/or satisfy the requirements related to qualified research expenses.

Inflated Refunds

“Exercise caution when a return preparer promises an extremely large refund or one based on credits or benefits you’ve never been able to claim before,” said IRS Commissioner John Koskinen. “If it sounds too good to be true, it probably is.”

Watch Out for Fake Charities

Be on guard against groups masquerading as charitable organizations to attract donations from unsuspecting contributors. Be wary of charities with names similar to familiar or nationally-known organizations. Contributors should take a few extra minutes to ensure their hard-earned money goes to legitimate and currently eligible charities. IRS.gov has the tools taxpayers need to check out the status of charitable organizations.

Watch Out for Crooked Tax Preparers

Be on the lookout for unscrupulous return preparers. The vast majority of tax professionals provide honest high-quality service. But there are some dishonest preparers who set up shop each filing season to perpetrate refund fraud, identity theft and other scams that hurt taxpayers. Legitimate tax professionals are a vital part of the U.S. tax system.

Be Vigilant Against Criminals

Tax-related Identity theft – with its related scams to steal personal and financial data from taxpayers or data held by tax professionals – remains a top item on the Dirty Dozen list because it remains an ongoing concern even though progress is being made.

The IRS and its partners remind taxpayers they can do their part to help in this effort. Taxpayers and tax professionals should:

  • Always use security software with firewall and anti-virus protections.
  • Make sure the security software is always turned on and can automatically update.
  • Encrypt sensitive files such as tax records stored on the computer.
  • Use strong passwords.
  • Learn to recognize and avoid phishing emails, threatening phone calls and texts from thieves posing as legitimate organizations such as a bank, credit card company and government organizations, including the IRS. Do not click on links or download attachments from unknown or suspicious emails.
  • Protect personal data. Don’t routinely carry a Social Security card, and make sure tax records are secure. Treat personal information like cash; don’t leave it lying around.

Phone Scams

Phone calls from criminals impersonating IRS agents remain an ongoing threat to taxpayers. The IRS has seen a surge of these phone scams in recent years as scam artists threaten taxpayers with police arrest, deportation and license revocation, among other things.

Phishing

Taxpayers need to be on guard against fake emails or websites looking to steal personal information. The IRS will never send taxpayers an email about a bill or refund out of the blue. Don’t click on one claiming to be from the IRS. Be wary of strange emails and websites that may be nothing more than scams to steal personal information.

If you have any questions on how this applies to you, please feel free to give us a call at 248-538-5331.

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Before You Start Development on that Land Investment…

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sale to s corporationLand prices have been recovering since the Great Recession. People who hold land for investment may be interested in developing then selling the land. If held for more than 12 months, gains from sales of investment real estate are subject to favorable capital gain rates (generally 15%, but up to 23.8% for high income individuals). However, people who do any development of the land generally will not qualify for capital gain treatment; they will be subject to ordinary income rates (up to 43.4%) on their entire gain from the sale of developed land.

Example: Jane owns a parcel of land she bought as an investment 20 years ago. She originally paid $200,000 for the parcel and it is now worth $300,000. Jane has not performed any development activity on the land. If she sells the land, her gain of $100,000 will be subject to the favorable capital gain tax rate of 15%. Her tax on the sale will be $15,000.

Example 2: Same as above, except that Jane spent $20,000 improving and developing the lane. She sells the parcel for $350,000. Her cost basis in the land is the $200,000 purchase price plus the $20,000 she spent on improvements–$220,000. If she sells the land for $350,000 her gain will be $130,000. Since she began developing the land, the gain of $130,000 no longer qualifies for capital gain treatment. The gain will be taxed at ordinary income rates. If Jane is in the 28% tax bracket, the tax on her gain will be $36,400.

Tax Strategy: Sell the Undeveloped Land to Your S Corporation

Through a tax-saving strategy, it is possible to have pre-development gains subject to the capital gain tax rate, and only gains from development will be subject to ordinary income rates. This is done by selling the investment land to an S corporation that the real estate investor owns before performing any development activity.

Example: Carrying on with the same fact scenario as above. Instead of developing the land herself, Jane first sells her investment property that she purchased for $200,000 to her 100% owned S corporation. The purchase price is the $300,000 market value of the land. She recognizes a $100,000 gain that is taxed at the 15% capital gain tax rate. Her tax on the pre-development gain is $15,000.

Her S corporation will now develop the land. The S corporation spends $20,000 to develop the land and the land is now worth $350,000. The S corporation’s cost basis in the land is the $300,000 purchase price plus $20,000 development costs–$320,000. When the S corporation sells the developed land for $350,000, it recognizes a $30,000 gain that is taxed at Joan’s ordinary tax rate of 28%. The tax on the $30,000 gain is $8,400. Her and her S corporation’s total tax is $23,400.

The Tax Savings

If she developed the land herself, her total tax would be $36,400 on $130,000 of total gain. By first selling the land to her S corporation, she is able to preserve capital gain treatment on the pre-development gain ($100,000) and only pays ordinary income tax rates on the gain allocable to development ($30,000). Her total tax with the S corporation strategy is $23,400. She saved $13,000.

Strategy Does NOT Work with an LLC

This strategy will generally only work with an S corporation. It will not work with LLCs because there is a rule denying capital gain treatment when an LLC owner sells property to his LLC and the property is ordinary income property of the LLC. Since the property held by the LLC will be sold at ordinary income rates, the LLC owner’s gain on the sale to the LLC will also be ordinary income.

Make Sure It’s a Bona Fide Sale for Fair Market Value

For this strategy to work, the sale to the S corporation must be a bona fide sale for fair market value. There should be a sales agreement, and if the sale is on an installment agreement, regular payments should be made and interest to the S corporation should be charged.

If you have any questions on how this applies to you, please feel free to give us a call at 248-538-5331.

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

IRS Taxes Sweat Equity

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sweat equityWhen a taxpayer forms an LLC and contributes appreciated property to the LLC, the taxpayer generally does not recognize gain on the transfer.   The IRS does not force taxpayers to recognize gain on property contributions to LLCs because taxpayers didn’t sell or exchange the property; they continue to own an interest in the contributed property, albeit through a business entity.  Naturally, there are exceptions to this rule where gain can be recognized such as where debt encumbered property is transferred to the LLC or investments are transferred to an investment LLC.

On the other hand, when a taxpayer performs services (i.e., sweat equity) in exchange for an interest in an LLC, the taxpayer will usually recognize compensation income equal to the fair market value of the LLC interest received.  The IRS treats the transaction as if the taxpayer received cash compensation (which is taxable), and then used the cash to purchase the LLC interest at fair market value.

There are two forms of ownership interests in an LLC—a capital interest and a profits interest.  A capital interest gives the owner a claim to assets when the LLC is dissolved.  A profits interest is defined as an interest other than a capital interest.  Helpful.  Basically, a profits interest does not entitle the owner to assets upon the LLC’s liquidation, but instead entitles the owner to a share of the LLC’s profits (if any).

A taxpayer who performs services in exchange for a capital interest recognizes income in the amount of the fair market value of the capital interest.  However, a taxpayer who performs services in exchange for a profits interest will not recognize income on receipt of the profits interest.  This is because the profits interest holder is not entitled to liquidation proceeds of the LLC, but is instead entitled solely to LLC profits (if any).  Profits interests holders therefore have an speculative value in their interests and will not recognize income upon receipt of the interest, but will instead pay tax on any profits that are allocated to them.

Example 1:  Thelma and Louise form an LLC.  Thelma contributes land that is currently worth $50,000 and was originally purchased for $20,000 for a 50% capital interest.  Louise will perform real estate advisory services for a 50% capital interest.  Since both parties own a 50% capital interest, each would be entitled to 50% of the assets upon liquidation—Thelma and Louise would each own 50% of the land upon liquidation.  Thelma does not recognize income upon her contribution because it is a contribution of property.  Louise will recognize income of $25,000 because she contributed services in exchange for a capital interest.

Example 2:  Same as above except that Louise received a profits interest instead of a capital interest.  If the LLC liquidates, Louise will not share in the liquidation assets.  Instead, Thelma will receive 100% of the land.  Louise will not be taxed on her contribution of services because she received only a profits interest.  However, Louise will recognize income for any profits that are allocated to her in the future.

While a profits interest is generally not subject to tax because of their unascertainable value, there are circumstances where their value is ascertainable.  In these circumstances, the profits interests will be taxable upon receipt.  These circumstances include:

  • the profits interest relates to a substantially certain and predictable stream of income from the partnership assets (such as a net lease);
  • the partner disposes of the profits interest within two years of receipt; or
  • the profits interest is a limited partner interest in a publicly traded partnership.

While a capital interest received in exchange for services usually is taxable, it is not immediately taxable if the capital interest is subject to a substantial risk of forfeiture.  Property is subject to a substantial risk of forfeiture if the rights to its full enjoyment are conditioned (directly or indirectly) upon either of the following:

  • Future Performance of Substantial Services. A requirement of future performance (or refraining from performance) of substantial services by the recipient is a substantial risk of forfeiture. The regularity of the performance of services and the time spent in performing them tend to indicate whether the required services are substantial.
  • Occurrence of a Condition Related to a Purpose of the Transfer. For example, a requirement that the recipient complete an advanced educational degree, obtain a professional designation, or attain a certain job position within the company to receive unrestricted access to the property would likely be a substantial risk of forfeiture, which would exist until that condition was met.

When the capital interest is subject to a substantial risk of forfeiture, the service provider will not recognize gain until the substantial risk of forfeiture is eliminated.

Example:  Same as Example 1 above except that Louise’s capital interest will be forfeited if Louise does not provide 5 years of services to the LLC.  Since Louise’s capital interest is subject to a substantial risk of forfeiture, it is not taxable in the year of receipt.  Instead, it will be taxable after Louise completes 5 years of service and her capital interest is fully vested.

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 Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

 

IRS Issues Reminder of What Is Needed to Prove Charitable Deductions

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charitable donationsAs people are getting their last minute tax deductions in before the end of the year, the IRS published reminders to taxpayers of what documentation is needed to claim charitable donations.

The documentation requirements are strict and if there is any deficiency in proof, the IRS can disallow the deduction even if you can prove payment with a canceled check or receipt.

So, here are the requirements:

Rules for Clothing & Household Items

To be deductible, clothing and household items must be in good condition or better. A clothing or household item (e.g., furniture, furnishings, electronics, etc.) for which a taxpayer claims a deduction of over $500 does not have to be in good condition if the taxpayer includes a qualified appraisal of the item with the return.

Donors must get a written acknowledgment from the charity for all gifts worth $250 or more.

Rules for Donating Money

To deduct donations of money, regardless of amount, the taxpayer must have a bank record or a written statement from the charity showing the name of the charity and the date and amount of the contribution.

Bank records include: canceled checks, bank or credit union statements, and credit card statements. The bank record should show the name of the charity, the date of the donation, and the amount paid.

For payroll deductions, the taxpayer should retain a pay stub, a Form W-2 showing donations, or other document furnished by the employer showing the total amount withheld for charity, along with the pledge card showing the name of the charity.

For money donations $250 or more, the taxpayer MUST receive an acknowledgment from the charity BEFORE filing the tax return in order to claim the deduction. If an acknowledgment is not received, the taxpayer cannot claim the deduction even if proof of donation is established by bank record.

Other Reminders

Only donations to qualified organizations are deductible. Donations directly to needy individuals are not deductible. The IRS maintains a database of qualifying organizations at https://apps.irs.gov/app/eos/mainSearch.do;jsessionid=mg3hp1dT8jJZjNPqoF3SdA__?mainSearchChoice=pub78&dispatchMethod=selectSearch

Contributions are deductible in the year made. Thus, donations charged to a credit card before the end of the year count for 2015 even if the credit card bill isn’t paid until the following year. Donations by check are deductible in 2015 if they are mailed out before the end of the year.

For individuals, only taxpayers who itemize their deductions can claim deductions for charitable contributions.

For donations of all property, including clothing and household items, the taxpayer should get from the charity a receipt that includes the name of the charity, the date of the contribution, and a reasonably detailed description of the donated property.

To see how this applies to you, give us a call at 248-538-5331.

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

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