Monthly Archives: September 2010

President Obama Signs a New Tax Law…New Blog Post

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On September 27 (yesterday) the President signed into law the Small Business Jobs Act of 2010.  There is some good news in this latest tax law change.  This post will provide a brief overview of the new law, and future blog posts will elaborate on each of the topics in this post.

Section 179 Deduction Increased for 2010 and 2011

The Section 179 deduction is a first-year deduction allowed for purchases of most tangible personal property.  The amount of the annual deduction for 2010 and 2011 is increased to $500,000 from $250,000.  There is a phaseout based on the amount of property you buy in a year.  The Section 179 deduction is phased out by one dollar for each dollar of tangible property purchases over $2 million ($800,000 under prior law). 

Up to $250,000 of Qualified Real Property is Eligible for Section 179 in 2010 and 2011

Under prior law, Section 179 was allowed only for tangible personal property.  For any tax year beginning in 2010 or 2011, a taxpayer can treat up to $250,000 of qualified real property as Section 179 property.

What is qualified real property?  It is:

  • qualified leasehold improvement property
  • qualified restaurant property
  • qualified retail improvement property

Clear?  Don’t worry-I’ll have a post on this topic in the very near future.

50% Bonus Depreciation is Back-But Just for 2010

50% bonus depreciation expired in 2009, but has been extended to 2010 under the new law.  Under bonus depreciation, you can immediately deduct 50% of the purchase price of qualifying property in the year of purchase.  Qualifying property includes most machinery, equipment or other tangible personal property, most computer software, and certain leasehold improvements.

Deduction for Start Up Expenses is Increased to $10,000

When taxpayers incur otherwise deductible expenses (such as payroll for training, advertising, or supplies) before a business opens, such expenses are usually deducted over 15 years.  Under prior law, up to $5,000 of such “start up” expenses could be deducted in the first year of business and the remainder deducted over the normal 15 years.  Under the new law, up to $10,000 of start up expenses can be deducted in the first year of business, and the remainder is deducted over 15 years. 

Health Insurance Costs for Self and Family are Deductible for Self Employment Tax for 2010

A self employed person can deduct the amount paid during the year for health insurance for herself, her spouse, her dependents, and effective March 30, 2010 for any child under age 27 as of the end of the year.  Under old law, the health insurance expense was not deductible against self employment income (which is taxed at a 15.3% FICA rate). 

For 2010 only, the health insurance expenses are also deductible against self employment income. 

Tax Treatment of Cell Phones is Simplified

Under old law, cell phones were considered listed property which required substantial recordkeeping that no one complied with.  There were some news stories earlier in the year that reported that the IRS would require 25% of the cost of employer-paid cell phones to be treated as compensation to employees to estimate their personal use of cell phones.  This never took effect.

Beginning in 2010, cell phones are no longer considered listed property.  To support a deduction for cell phones, the employer need only substantiate their cost, in much the same way as the employer supports the deduction for other types of business equipment.

Retirement Plan Distributions May Be Rolled Over to a Roth 401k

Under old law, rollovers to a designated Roth account (such as a Roth 401k) could only have been made from another designated Roth account.  Under new law, a distribution from an applicable retirement plan (401k, 403b, 475) that maintains a qualified Roth contribution program, a distribution from the portion of the plan that is not a designated Roth account may be rolled over to the designated Roth account portion of the plan. 

The rollover is not tax free.  The taxpayer must pay tax based on the market value of the distributed assets.  A 10% penalty will apply if any of the roll over funds are withdrawn within five years of the rollover. 

If there is a rollover in 2010, the income can be recognized over 2011 and 2012.  However, if there is a distribution of the rollover funds in 2010 or 2011, some of the income deferred to 2011 or 2012 will be recognized earlier.

So, that’s an overview of the brand new tax law.  I’ll be posting more often in the next couple weeks to expand on the above topics. 

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.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230.

Disallowed Losses: Pain in the S Corporation

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There are certain rules that may prevent you from deducting losses from your business.  The concern of the IRS is that business owners are taking loss deductions when they are not suffering an actual economic loss.  One way to limit taxpayers’ losses to the amount of economic loss they actually incur is through basis limitations.  This post will focus on the basis rules applicable to S corporations.

What is Basis?

While basis is a critical concept in tax law, it is not defined in the Internal Revenue Code or in Treasury regulations.  Basis is basically your investment in a business (i.e., the amount you “put into” the business).  To generate basis, you have to incur some type of actual economic outlay.  You cannot deduct losses in excess of your basis in the business.  Any distributions that exceed your basis in the S corporation are taxed as capital gains.  Basis is therefore advantageous and should generally be maximized.

Determining the Initial Basis in an S Corporation.

A shareholder’s initial basis in an S corporation depends on how the shares are acquired.

If Shares are Acquired by: Then Basis is:
outright purchase from an existing shareholder the initial cost of those shares
forming and capitalizing the S corporation equal to cash plus the original cost (not current market value) of assets contributed plus gain recognized on the transfer (if any)
gift equal to the basis in the hands of the donor (generally)
inheritance equal to the fair market value of the shares on the date of death (if the estate tax is in effect)
holding stock on the date the corporation makes an S corporation election the shareholder’s original basis in the stock
providing services to the corporation equal to the fair market value of the stock (the shareholder has compensation income for the services provided in exchange for the stock)

Shareholders generate basis in an S corporation by loans they make DIRECTLY to the S corporation.  It is VERY important to note that only direct loans to the business create basis—bank loans and other third party loans to the business do NOT generate basis.

Example:  Joan invests $5,000 from her savings accounts in her newly formed S corporation.  The S corporation borrows $20,000 from a bank to pay business expenses.  Joan has a basis in her S corporation of $5,000 for her cash contribution.  She can deduct losses up to her $5,000 basis.  The $20,000 bank loan to the S corporation does not increase Joan’s basis. 

Example 2:  Same facts as in the above example.  The S corporation has lost all of the $25,000 invested in it.  How much can Joan deduct as a loss on her tax return?  Only $5,000—her basis in the S corporation.  The $20,000 bank loan does not create basis.

Even if the shareholders personally guarantee bank loans and other third party loans to S corporations, they still do not receive basis for such loans.

A solution is to have the bank make the loan directly to the shareholder and then the shareholder will make a loan to the S corporation.

Example:  Now assume that Joan personally borrows $20,000 from a bank then loans it to the S corporation.  Joan now has a basis of $25,000 in the S corporation ($5,000 cash contributed plus $20,000 in direct shareholder loans).  Now that Joan’s basis is $25,000, she can deduct the full loss of $25,000.

If a business is going to have significant bank or third party debt, the business may be better off being organized as an LLC.  LLC members can receive basis for their shares of the LLC’s third party debt.

Any losses disallowed under the basis limitation are carried forward into future years and can be deducted if the shareholder’s basis in the S corporation increases.

How Shareholder Basis is Increased and Decreased

In addition to increasing basis by contributing cash, property, and making direct loans to the S corporation; each shareholder’s basis is adjusted each year by pass-through items of income, loss, and deduction, and by distributions to the shareholder.  Adjustments are generally made to stock basis in the following order.

  • increased by pass-through income and gain items;
  • decreased by distributions; and
  • decreased for pass-through items of loss or deduction.

Example:  Tina has a $5,000 basis in her S corp stock.  The S corp has current year revenues of $100,000, deductions of $50,000, and Tina received distributions during the year of $60,000.

Her basis and allowed losses are:

Initial Basis                   $5,000

Income Items             $100,000 (revenues)

Basis                         $105,000

Distributions              ($70,000)

Remaining Basis         $35,000

Allowed Losses          ($35,000) (limited to remaining basis)

Disallowed Losses      $ 15,000 (which are carried forward)

Example 2:  Same as above except that S corp only has $50,000 of revenues for the year:

Initial Basis                  $5,000

Income Items              $50,000 (revenues)

Basis                          $55,000

Distributions              ($70,000)

Excess Distributions    $15,000 (since distribution exceed basis,

                                              the shareholder has a capital

                                              gain in the amount of the excess

                                              distribution – $15,000)

Basis                            $0 (reduced to $0 by distributions)

Disallowed Losses         $50,000 (which are carried forward)

Wasn’t this fun.  The basis rules tend to trip up taxpayers when there’s a significant amount of third party debt for which the taxpayer does not receive basis.

If you have any questions on how these rules apply to you, please feel free to contact me with questions.

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.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230.

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