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Can Becoming an S Corporation Reduce Taxes? Yes, Here’s How…

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A Brief Background on Self-Employment Tax

Sole proprietorships (Schedule C filers) pay self-employment (SE) tax of 15.3% on their net earnings from self-employment.  Net earnings from self-employment is basically equal to your business profit for the year multiplied by 92.35% (this is done to effectively allow a deduction for the employer portion of self-employment tax).

Example:  You have $50,000 profit in your business for the year.  To determine net self-employment income, you multiply your $50,000 profit by 92.35% which equals $46,175.  This $46,175 is then multiplied by the 15.3% self-employment tax rate to calculate your SE tax for the year of $7,064.78. 

The reason you multiply your profit by 92.35% is to allow a deduction from your profit for the 7.65% (100% minus 92.35%) employer portion of self-employment tax.

How does an S Corp Reduce SE Tax?

S Corporation owners pay FICA taxes (i.e., self-employment taxes) on wages they draw from the corporation.  S corporation owners do not pay FICA taxes on profit or on distributions they take from the corporation, assuming the owners are drawing reasonable compensation from the S corporation. 

Example:  Joan owns 100% of S Corp, Inc.  S Corp, Inc. has $55,000 in profit (after paying owner wages of $45,000) for the year.  Assume Joan’s wages of $45,000 for the year are reasonable.  Joan pays FICA taxes (employer and employee portions) of $6,885 on her $45,000 wages ($45,000 * 15.3%).  She does not pay FICA taxes on the $55,000 of profit she had during the year. 

Had Joan operated her business as a proprietorship, her FICA tax liability is calculated as follows:

Business Profit:           $100,000

Times:                           92.35%

Net Earnings from SE:     92,350

Times: SE Tax Rate:         15.3%

SE Tax=                        $14,129

As you can see, Joan saves $7,244 ($14,129 minus $6,885) in FICA taxes by being an S corporation.

Note:  If the S corporation pays unreasonably low wages, the IRS can recharacterize any distributions as wages and subject the owner to additional FICA taxes, plus penalties and interest.

How to Establish Reasonable Wages

Determining reasonable wages is based on a variety of factors, so it is a subjective determination.  Factors that are relevant include:

  • Training and experience

  • Duties and responsibilities

  • Time and effort devoted to the business

  • Dividend history

  • Payments to non-shareholder employees

  • Timing and manner of paying bonuses to key people

  • What comparable businesses pay for similar services

  • Compensation agreements

  • The use of a formula to determine compensation

There is a limit on the amount of proprietorship profit/wages that are subject to SE tax.  Wages/proprietorship profit under $106,800 are subject to SE tax of 15.3% (including Social Security and Medicare portions).  Wages/proprietorship profit over $106,800 are subject to SE tax of 2.45% (Medicare portion only).

Starting in 2013, an additional 0.9% tax is imposed on wages/proprietorship profit in excess of $200,000 for single filers and $250,000 for joint filers.

What are the SE tax rules for LLCs?  That’s a whole different bowl of mostaccioli.  Stay tuned for the answer.

 

 

Buzzkill Disclaimer: 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.

New Tax Benefit for Hiring “Long Term Unemployed” Employees

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When you hire someone, you and the employee each pay 6.2% Social Security tax on that employee’s wages (up to wages of $106,800 for 2010).  Under the new tax law, wages paid to a qualified new employee for employment between March 19, 2010 and December 31, 2010 are exempt from the 6.2% employer portion of the Social Security tax. 

Qualified New Employees are full-time or part-time workers who start work between February 4, 2010 and December 31, 2010 and who were not employed more than 40 hours during the 60-day period ending on their start dates.  However, the new worker cannot replace another worker unless that person quits voluntarily or was discharged for cause (i.e., you can’t fire and then rehire all your employees to qualify for the exclusion).

If you have qualifying wages during March, you didn’t claim the exclusion on your 1st quarter Form 941s (because the law passed on March 18, and the tax forms weren’t revised to include the exclusion).  You can claim the exclusion for Social Security taxes on qualifying new employees on your 2nd quarter Form 941.

The employee certifies on Form W-11 that he/she was not employed more than 40 hours during the 60-day period ending on his/her start date. 

Example:  On March 30, 2010 ABC Corp hires Joe, who has been unemployed for 70 days.  ABC Corp pays Joe $15,000 wages between March 30, 2010 and December 31, 2010.  Joe pays $930 Social Security tax on his wages.  Normally, ABC Corp would match Joe’s Social Security tax, but under the new exclusion, ABC Corp does not have to match Joe’s $930 Social Security tax payment.

Credit for Retaining Qualified New Employees

Above and beyond the above credit, employers can also claim a temporary tax credit of up to $1,000 for wages paid to each qualified new employee (same definition as above).  The worker must be kept on payroll for at least 52 consecutive weeks, and wages during the second 26 weeks must equal at least 80% of wages paid during the first 26 weeks.  In other words, you can’t hire employees and then dramatically lower their hours/wages after a few months. 

The credit equals the lesser of $1,000 or 6.2% of wages during the 52 weeks.  The credit will be claimed on a business’ income tax return, and not its payroll tax return.  Since the credit is not available until the tax year that a qualified employee has been on payroll for 52 weeks, the earliest you can claim the credit is on your 2011 income tax return.

Example:  XYZ Corp hires Jane (a qualified new employee) on April 1, 2010 and Jane  works until April 1, 2011.  Jane has wages of $30,000 between April 1, 2010 and December 31, 2010.  Jane has additional wages of $10,000 between January 1, 2011 and April 1, 2011. 

XYZ Corp can claim a Social Security tax exemption on Jane’s $30,000 wages between April 1, 2010 and December 31, 2010.  The exclusion amount is $1,860 ($30,000 * 6.2%). 

Additionally, since Jane has been employed for more than 52 consecutive weeks, XYZ Corp is also entitled to a credit of $1,000 (equal to 6.2% of the wages during the 52 weeks ($30,000 plus $10,000, but limited to a maximum credit of $1,000 per qualified employee).  Jane’s 52 week employment period ends in 2011, and XYZ Corp will claim the $1,000 tax credit on its 2011 tax return filed in early 2012.

Fine Print: This posting 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.

Keep in Mind that Michigan’s Single Business Tax was a Value Added Tax

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A value added tax (VAT) is a consumption tax, meaning that the tax is levied on the purchase of goods AND services.  The difference between a VAT and a sales tax is that the sales tax is imposed on the final sale price to the consumer.  The VAT is imposed on businesses throughout the production process and is based on the value added during each step in the production process ending with the final sale to the consumer.

Sales Tax Example:  A farmer produces wheat and sells wheat to a baker for $10.  The baker uses the wheat to make bread and sells bread to a deli for $25.  The deli uses the bread to make sandwiches and sells sandwiches to the public for $50.  Under a sales tax, purchases for resale are exempt from sales tax.  Therefore, the sales from the farmer to the baker and from the baker to the deli are exempt from sales tax.  The sales tax is imposed on the final sales price ($50) from the deli to the consumer.

VAT Example:  Under a VAT, the farmer would pay VAT on the $10 of added value.  The baker would pay VAT on its value added of $15 ($25 sales price minus $10 value added by farmer).  The deli would pay VAT on its value added of $25 ($50 sales price minus value added by farmer and baker of $25). 

Farmer’s VAT base is $10

Baker’s VAT base is $15

Deli’s VAT base is $25

Total VAT base is $50 (which is equal to the sales tax base of $50 in the first example).

There are 3 ways to calculate the value added through each step in the production process:

  • Subtraction Method:  Value added equals the difference between the firm’s sales and the firm’s purchases from other businesses.  (This is the method used in the above example)
  • Addition Method:  Value added equals the sum of a firm’s payments to its owners, to its lenders, and to its employees (the Michigan SBT was an addition method VAT)
  • Credit Invoice Method:  Each firm is subject to the VAT based on its total gross receipts, but is allowed a VAT credit for the amount of VAT paid by firms it purchases from.

Credit Invoice Method Example:  The farmer in the above example would pay VAT on its $10 of gross receipts.  The farmer gets no VAT credit because it had no purchases from other firms.  The baker pays VAT on its $25 of gross receipts.  The baker gets a VAT credit for $10 of value added by the farmer.  The deli pays VAT on its $50 of gross receipts.  The deli gets a VAT credit for the $25 value added by the baker.

Firm Gross VAT Base VAT Base Credit Net VAT Base
Farmer

$10

$0

$10

Baker

$25

$10

$15

Deli

$50

$25

$25

Notice that the total net VAT base by the firms is, once again, $50.  The credit invoice VAT is the most popular VAT in Europe.  It is popular because it forces businesses to keep records documenting the taxes they have paid on their purchases—no VAT credit is allowed unless properly substantiated.  It also allows governments to cross-check records of sellers and purchases to verify the correct VAT amounts are paid.

For those of you who miss the Michigan SBT…

The Michigan SBT was an addition method VAT.  Let’s work through an example between a subtraction method VAT and an addition method VAT (Michigan SBT).

Deli Corp Income Statement

Revenues:                                $250,000

Payments to other Businesses:   $190,000

Wages:                                     $  75,000

Interest to Lenders                     $ 15,000

Net Loss                                   ($30,000)

Under a subtraction method VAT, the VAT base is equal to:

Gross receipts                             $250,000

Less purchases from other firms ($190,000)

for a VAT base of $60,000.  If there is a 10% VAT tax, the business’ VAT tax liability is $6,000.

Under an addition method VAT, the VAT base equals the payments to owners, lenders, and employees. 

The VAT base is the sum of:

Payments to owners              ($30,000)

Interest to Lenders                 $15,000

Wages                                   $75,000

for a VAT base of $60,000 (same as under a subtraction method VAT).

For those of you who filed SBT returns, the addition method should look familiar—notice starting off with business income/loss and adding wages and interest.  Of course, there were several other additions and subtractions, which is why the complication of the SBT lead to its demise.  It was replace by the much simpler MBT [sarcasm]—composed of a modified gross receipts tax, a business income tax, a surcharge, a small business credit, and dozens of other targeted tax breaks. 

Fine Print: This posting 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.

 

Tax Changes in the New Health Care Act.

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A somewhat controversial bill passed the House this weekend that created a substantial number of changes in the tax laws.  This article will explain some of the new changes.  Keep in mind that this is a fluid situation, and things may change.  This article explains the tax provisions in the Patient Protection and Affordable Care Act, and does not cover the Reconciliation Act (which must now pass the Senate).  OK, let’s begin.

Credit for Individuals who Purchase Health Insurance through a State Benefit Exchange

To help people pay insurance premiums, the premium assistance credit is available for individuals with household incomes between 100% and 400% of the federal poverty level who do not receive health insurance through an employer or a spouse’s employer.  The premium assistance credit will be available after December 31, 2013.

An eligible individual will enroll in a plan offered through an exchange and report his income to the exchange.  Based on the information provided to the exchange, it will calculate the available credit.  Treasury will pay the credit directly to the exchange, and the individual is responsible for the balance of the premium.

If You Don’t Buy Health Insurance, You’ll Have to Pay an Excise Tax

The act requires individuals to maintain minimum amounts of health insurance coverage.  The penalty is $750 if the person does not have minimum coverage.  The fee for an uninsured person under age 18 will be half of the adult fee.  The total household penalty may not exceed 300% of the per-adult penalty.  The penalty will be phased in between 2014 and 2016.  The IRS cannot enforce payment of the penalty through liens and seizures or criminal penalties.

Small Business Credit

Small businesses (any business with 25 or fewer employees and average annual wages of less than $40,000) will be eligible for a credit of up to 50% of nonelective contributions made on behalf of employees for insurance premiums.  This credit is available for small businesses beginning January 1, 2010.

Reporting Requirement

The act requires insurers that provide minimum coverage to report information to both the covered individual and to the IRS.  This information is:

  • name, address, and SSNs of the primary insured, and others insured under the policy
  • the dates of coverage during the year
  • whether the coverage is a qualified health plan offered through an exchange
  • the amount of any premium tax credit
  • other information as the Secretary may require

Medical Care Itemized Deductions

Currently, medical expenses are deductible only to the extent that they exceed 7.5% of your adjusted gross income.  Under the new act, medical expenses must now exceed 10% of adjusted gross income to be deductible.

Increase to Medicare Tax

The Medicare portion of FICA is currently 1.45%.  The Medicare tax is increased by 0.9% for joint filers earning $250,000 and single filers earning $200,000 per year.  This provision takes effect January 1, 2013.

Employer Responsibility

A large employer (at least 50 full time employees during the preceding year) that does not

  • offer coverage for all its full time employees,
  • offer minimum essential coverage that is “unaffordable,” or
  • offer minimum essential coverage and the plan covers less than 60% of the cost of benefits,

is required to pay a penalty if the employee is certified as purchasing insurance through a state exchange AND the employee receives a premium assistance credit.

The penalty for any month is equal to the number of full time employees over a 30 employee base multiplied by one-twelfth of $2,000 (i.e., maximum $2,000 per employee per year).

Fees on Health Plans

This fee is equal to $2 multiplied by the average number of lives covered by the policy per year.

Cadillac Tax

The tax is equal to 40% of the cost of an insurance policy over a threshold amount.  For 2018, the threshold amount is $10,000 for individual coverage and $27,500 for family coverage, multiplied by the health cost adjustment percentage (defined in the act) and increased by the age and gender adjusted excess premium amount (as defined in the act).   Got that?

Miscellaneous Taxes

10% tax on indoor tanning.

Currently, HSA distributions that are not used to pay medical expenses are subject to a 10% penalty.  The act increases the penalty amount to 20%.

The adoption credit has been increased to $13,170 per eligible child, and is now a refundable credit.

I don’t know about you, but I have a headache.  Before I lie down for a nap I want to mention again that this is a fluid situation, and the Reconciliation Act has not yet passed the Senate.  My intention here is to give you a glimpse of the upcoming tax law changes.

Fine Print: This posting 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.

New Law Allows Life Insurance to be Exchanged for Long Term Care Insurance

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If you’ve ever exchanged one life insurance policy for another, you know that you are not usually taxed on the transfer.  This is because of a special provision in the tax code (Section 1035) that prevents gains from being recognized on such an exchange. 

If this provision did not exist, you would be taxed on the excess of

  • the cash value of your policy over
  • the accumulated premiums you’ve paid in (minus tax-free distributions)

Starting January 1, 2010 no gain or loss will be recognized on the exchange of:

  • a life insurance contract for a qualified long term care insurance contract
  • an endowment insurance contract for for a qualified long term care insurance contract
  • an annuity contract for a qualified long term care insurance contract
  • a qualified long term care insurance contract for another qualified long term care insurance contract

This provision was added by the Pension Protection act of 2006 (and it only took four years to take effect!).

Long term care insurance cannot be exchanged (tax-free) for any of the above insurances (an exchange will tax be free only into long term care insurance, not from long term care insurance).

This new law presents a great opportunity to fund a long term care insurance contract. 

Care must be exercised to execute an effective tax-free exchange. Normally, the transfer must occur directly between the two insurance companies. If the taxpayer receives a check for the replaced policy, a surrender may be deemed to have occurred, even if the check is immediately endorsed over to the new insurance company. Insurance companies typically help taxpayers execute tax-free exchanges. The insurance company whose policy is exchanged must issue the taxpayer a Form 1099-R showing the transaction to be a Section 1035 tax-free exchange.

So, what is qualified long term care insurance.  Well, the long term care policy must provide coverage only for long-term care services, be guaranteed renewable, have no cash value, and use refunds or dividends only to reduce future benefits. A qualifying policy does not cover expenses eligible for Medicare reimbursement unless Medicare is a secondary payer or the policy pays a per diem benefit without regard to actual expenses. In addition, certain consumer protection standards must be met.  Glad you asked?

Fine Print: This posting 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.

New Michigan Tax Credit to Reimburse You for Additional FUTA Taxes

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The FUTA tax rate is normally 6.2%.  If you pay state unemployment taxes, you get a 5.4% FUTA rate reduction credit.  Subtracting the 5.4% credit from the 6.2% FUTA base is the 0.8% FUTA tax rate we know and love.  When a state has a negative balance in its unemployment tax reserves, it borrows from the federal government.  When a loan is outstanding for 2 or more years, the FUTA rate reduction credit is reduced by 0.3% for the first year, and an additional 0.3% for the second year. 

Michigan’s rate reduction credit in 2009 was reduced by 0.3% to 5.1%.  Thus, our FUTA rate for 2009 is 1.1%.  However, an employer that has paid Michigan unemployment taxes for five or more years, and has a positive balance in its unemployment experience account will receive a credit of up to 50% of the extra FUTA paid in 2009. The credit is nonrefundable and can only be used to offset future Michigan unemployment taxes.
 

The credit is claimed by filing form UIA 1110.

The credit is the LESSER of:

  1. 50% of the additional FUTA tax paid in 2009
  2. the employer’s taxable wages for 2009 multiplied by the Nonchargeable Benefits Component (NBC) of the employer’s unemployment tax rate for 2009.  The NBC is shown on the Unemployment Tax Rate Determination letter you receive each year (usually in December).

The employer must meet the following criteria:

  • has applied for the Michigan tax credit
  • has paid Michigan unemployment taxes for five years or more
  • has a positive reserve ending balance in its unemployment experience account as of June 30 of the previous calendar year
  • has filed all quarterly tax reports for the year prior to the credit claim (i.e., 2009 reports must have been filed)
  • has paid the additional FUTA taxes for 2009 (the taxes have to be paid by the end of 2010)
  • has paid its FUTA taxes prior to applying for the Michigan credit
  • has certified the amount of additional 2009 FUTA taxes when it applies for the credit.

Quite a bit of work for a credit which may be in the ballpark of a few hundred dollars. 


Fine Print: This posting 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.

A Walkthrough of Itemized Deductions

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Medical Expenses

You can take a deduction for medical expenses for you, your spouse, and your dependents.  Medical expenses include amounts paid for the diagnosis, cure, mitigation, treatment, or prevention of disease.  Examples include expenses for: regular checkups, dental expenses (including braces), health insurance paid with after tax dollars, prescription medication, cosmetic surgery (but only if it is done to correct a congenital defect or correct a deforming disease).  If you spend money on property improvements to help a disabled or sick household member, the deductible amount is the cost of the improvement over the increase in market value of the house.  For example, if you spend $20K to install an elevator, but it only adds $8K to the market of the home, the $12K excess is the deduction.  Some improvements are fully deductible such as railways and ramps, modifying doorways, etc.

Now, deducting medical expenses can be difficult because you can only deduct the medical expenses in excess of 7.5% of your adjusted gross income (that’s the bottom line on the first page of your tax return).  So, to use easy numbers, if you make $100K, only expenses in excess of $7.5K are deductible.  Basically, medical expenses are a hardship deduction because they have to be very high compared to your income.

Taxes 

You can deduct either state income taxes (that’s the MI withholding you see on your check stubs) or state sales tax.  The sales tax deduction is for states that have no income tax.  The sales tax deduction can be based on the actual sales tax you paid during the year, or based on a percentage of your income.  Even if you use the percentage of income method to deduct sales taxes, sales taxes for large purchases (such as cars) can be added on top of the estimate.
You can deduct real estate taxes in the year you pay them.  So if you pay your winter real estate taxes by December 31, you can take a current deduction for the taxes.  One note here.  If there is a special assessment on your property tax bill, that cannot be deducted.  It is added to the cost of your home, and will reduce your gain (if any) when you sell the home.  This isn’t very helpful because you can exclude up to $500K of gain when you sell your home as long as you’ve lived in and owned the home for more than 2 years.
There is a new deduction for sales taxes paid on vehicles with a cost up to $49,500.  In the past few years, you could always take a sales tax deduction for vehicle purchases, but now you can claim state income taxes as a deduction, and take an additional deduction for sales taxes on new vehicles.  This only applies to NEW vehicles.  If you don’t itemize, the sales tax deduction is added to your standard deduction.

Other taxes include personal property taxes.  These are the property taxes you pay on your cars, boats, motor cycles, and any other personal property.  Other taxes also include any foreign tax you pay (for example if you worked in another country, or you have foreign investments).

Interest

There are two types of deductible mortgage interest.  Acquisition mortgage interest, which is interest used to purchase or substantially improve a home.  An example of a substantial improvements is adding an extension.  You can deduct acquisition interest on a mortgage of up to $1M.  The second type of mortgage interest is home equity interest.  Home equity interest is for mortgages that are secured by your home, but the interest is still deductible regardless of how the money is spent.  You can deduct home equity interest on mortgages up to $100K; however, if the sum of home acquisition debt and home equity debt exceed the market value of your home, a portion of the home equity interest will not be deductible.


Example:  Jimmy buys a $200,000 home with a $200,000 home acquisition mortgage (with interest only payments).  Five years later when Jimmy’s home is worth $220,000, Jimmy takes out a home equity loan of $30,000.  Since the sum of the acquisition debt and home equity debt exceed the market value of the home by $10,000, interest on the $10,000 excess is not deductible (i.e., only 2/3 of the interest on the home equity loan is deductible).
Points are basically prepaid interest.  If you pay points on the purchase of a new home, they are fully deductible in the year of purchase.  If you pay points on a refinance or home equity loan, the points are deducted over the term of the new loan.   

Charity

I want to focus on recordkeeping—there have been some changes in the past few years.  If you make a cash donation under $250, you need either a bank acknowledgement or a receipt from the charity.  So if you make weekly donations at church, you can no longer take a deduction unless you get a receipt from the church or you write a check each week.  For cash contributions over $250, you MUST have a receipt from the charity before you file your return (or when it is due whichever is earlier).  There was a court case where a couple actually donated several thousands of dollars to a church but did not get a receipt.  Their deduction was challenged.  They later got a church receipt and presented it to the tax court, but it was ignored because they did not have the receipt at the time they filed their return.  So it is very important to have a receipt for cash donations over $250. 

Fine Print: This posting 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.

Lower Your Taxes by Going Back to 2004 (DeLorean Not Required)

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When you have a business loss for any year, you can either carry the loss back to prior years or forward to future years.  When you carry a loss back to prior years, you can get refunds of taxes you paid in prior years (usually within 90 days of filing the refund claim).  If you carry losses forward, you have to wait for future years to get a tax benefit.

Prior to the 2009 American Recovery Act, you could only carry a loss back two years.  The 2009 Act allowed you to carry losses back up to five years.  This allowed you to carry losses back to 2003 and get refunds of taxes you paid during the boom years.  Under the Recovery Act, the five year carryback was ONLY available for the 2008 tax year. 
Congress just extended this tax break to 2009.  On November 6, Congress passed the Worker, Homeownership, and Business Assistance Act of 2009.  This allows business owners to carry back losses suffered in 2009 for up to 5 years prior.  So you can carry back losses to 2004.  However, the loss that you can carry back to 2004 is limited to 50% of your taxable income for 2004.  This 50% limit does not apply to years 2005 to 2008.  If the losses exceed 50% of your taxable income for 2004, the excess loss is carried forward to future years. 


Example:  Joan had a successful business earlier in the decade, but she’s had a tough past few years.  Her taxable income over the past few years is:

Year    Taxable Income      Tax Rate
2004        $150,000               28%
2005        $100,000               28%
2006        $  50,000               25%
2007        $  15,000               15%
2008        $        50                 0%

In 2009, she loses $100,000 in her business.  Under the new law, she can carry the $100,000 back up to five years to 2004.  However, the loss is limited to 50% of her taxable income in 2004 ($75,000).  The remaining $25,000 loss can be carried forward into 2005. 


Under old law, taxpayers could carry losses back only 2 years and forward 20 years.  Under old law, Joan could carry her loss back to 2007 (offsetting $15,000 of income) and 2008 (offsetting $50 of income).  The remaining $84,950 loss would have to be carried forward.

Notice that by carrying the loss back 5 years, her loss offsets income that was in a higher tax bracket.  The purpose of the 5 year carryback is to put money in taxpayers pockets sooner than if they could only carry losses back two years and forward twenty years.  By allowing taxpayers to carry back losses to the boom years, their losses will offset income that was taxed at a higher tax rate rather than if they had to carry losses into the future when their tax rates may not be as high (as they are rebuilding their businesses). 

My theory for the 50% loss limitation in 2004 is that 2004 was a boom year in tax revenues and the government wants to limit how much of that tax revenue they have to refund to taxpayers. 

A few remaining notes:

  • If you received any TARP funds, you are not eligible for the increased carryback period
  • the claim for extended carryback has to be filed by the extended due date of your tax return by filing
    • Form 1045 or 1040X if you are an individual
    • Form 1139 or 1120X if you are a C corporation
  • the carryback period is 3, 4, or 5 years.  You should experiment with the carryback period that yields the highest refund.

Fine Print: This posting 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.

If You Eat or Sell Food and Hate Sales Tax, This Post is for You.

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Background

Michigan has a 6% sales tax (if you weren’t aware of this, stop reading this post and pick up a newspaper).  Sales taxes, when compared to taxpayers’ incomes, are regressive.  This is because people with low incomes spend a higher portion of their incomes than do high income people.  Therefore, lower income people pay a higher percentage of their incomes in sales tax.

Quick Example:  Joan makes $100,000 per year and spends $80,000 annually.  She pays sales tax of $4,800 (6% * $80,000).  Her sales tax as a percent of her income is 4.8% ($4,800 / $100,000).  Jim makes $30,000 and spends $28,000 per year.  He pays sales tax of $1,680.  His sales tax as a percent of his income is 5.6%  Notice how Jim (who has a lower income) pays a higher percentage of his income in sales taxes—this is regressivity. 

One way that the state tries to ameliorate the regressivity problem is by exempting food from sales tax since food is a larger budget item in lower income people’s budgets.  The problem is that EVERYONE’s food purchases (rich or poor) becomes exempt from sales tax.  Hey, government is doing the best it can.

The Meat & Potatoes of the Post

Food and food ingredients are exempt from sales tax; however, prepared food is still subject to sales tax.  The Michigan Department of Treasury just issued a bulletin explaining how to distinguish prepared food from food exempt from sales tax.  (PAY ATTENTION THOSE OF YOU WHO BELIEVE A FEDERAL SALES TAX WILL SIMPLIFY THE TAX SYSTEM).

Prepared food is:

  • food sold in a heated state or that is heated by the seller
  • two or more ingredients mixed by the seller for sale as a single item
  • food sold with eating utensils provided by the seller (knives, spoons, forks, napkins) (presumably sporks are also included).

Prepared food does not include:

  • food that is only cut, repackaged, or pasteurized by the seller
  • raw eggs, fish, meat, poultry, and foods containing those raw items requiring cooking by the consumer
  • food sold in an unheated state by weight or volume as a single item, without eating utensils
  • bakery items (cakes, rolls, muffins, etc.) sold without eating utensils.

Example:  John has a bakery.  The bakery has a small eating area.  A woman comes in and buys a pie.  The pie is put into a box and taken home by the woman without eating utensils.  The pie is not prepared food and is exempt from sales tax.  A couple then walks into the bakery and orders the same type of pie.  They are going to eat the pie in the eating area and receive forks and napkins with the pie.  The pie is now prepared food and is subject to sales tax.

Example 2:  Jody has a small grocery store that sells some cooked food.  She sells fried chicken to customers.  Since the chicken is sold in a heated state, it is prepared food subject to sales tax.  Now let’s say she freezes the chicken after cooking it, and sells frozen chicken by the pound to customers without eating utensils.  The chicken is now sold in an unheated state and is no longer prepared food—it is now exempt from sales tax.  If she hands them a fork by accident it’s subject to sales tax 🙁

Other Items of Note in the State’s Bulletin

Bottled water is exempt from sales tax.

Ice for human consumption is exempt.  Bagged (crushed or cubed) is presumed for human consumption.  Ice sold in block form is presumed not for human consumption.

Bakery items are not subject to tax if sold without eating utensils.  If the baker sells a donut with a napkin, it becomes subject to sales tax (the napkin is an eating utensil).

Delicatessens.  Food sold in an unheated state by weight or volume as a single item, without eating utensils, is not prepared food and is exempt from sales tax.  Therefore, deli trays of cheese & crackers, lunch meats, or vegetables & dip, sold in an unheated state without eating utensils are exempt. 

Alcoholic beverages are subject to sales tax.

Sealed Non-Alcoholic Beverages.  Not prepared food so long as they are not sold in a heated state or with an eating utensil (cup) provided by the seller. 

Food purchased under the federal food stamp program is not subject to sales tax.

Vending Machines.  Food or drink which is heated or cooled mechanically, electrically, or by other artificial means to an average temperature above 75 degrees Fahrenheit or below 65 degrees Fahrenheit before sale are subject to sales tax (unless they are exempt as non-prepared food).  Vending machine sales of prepackaged gum, cookies, crackers and chips are exempt from sales tax if sold at room temperature.

Example:  You buy a cooled can of soda from a vending machine.  It is cooled below 65 degrees, but sealed non-alcoholic beverages are not prepared food so it is still exempt.  You buy a cup of coffee from a vending machine?  It is taxable because it is heated above 75 degrees and it is not in a SEALED container.

Conclusion and Call to Action

There you have it.  A brief overview of one of the exemptions from sales tax (there are many others).  The complexity of the sales tax tends to surprise some people, but it can give the complexity of the income tax a run for its money.  My call to action is for you to panic and write insulting letters to your representatives.

 

Fine Print: This posting 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.

A Few Things You Need to Know about Debt Discharge Income…And A Few Things You Don’t Want to Know

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Generally speaking, the tax code taxes all income.  If you find a $20 bill on the street, it is taxable (seriously).  When you borrow money, you may have better cashflow, but you do not have taxable income because you are legally obligated to pay the money back. 

Example:  Joe borrows $100,000.  Joe has no taxable income because he is obligated to pay the money back.  Joe has no increase in income.

When a lender discharges (forgives) a borrower’s debt, the borrower has taxable income because the borrower received money but did not pay it back.

Example:  Joe borrows $100,000 and is unable to pay it back.  The lender discharges the debt.  Joe has debt discharge income because Joe is made better off by the $100,000 loan that he does not have to pay back.

Of course in tax law there are always exceptions.  I want to discuss three important exceptions that allow taxpayers to defer (notice I didn’t say exclude) debt discharge income.

Debt Discharge When Taxpayer is Insolvent

Insolvency occurs when the market value of your assets is worth less than your debts.  To the extent that you are insolvent, any debt discharge income is not currently taxable.

Example:  Joe borrows $100,000.  A year later, all of Joe’s assets are worth $150,000 and his debts are $210,000.  Joe still owes $100,000 on the debt, he defaults on the loan, and the lender discharges the debt.  Joe is insolvent to the tune of $60,000 ($210,000 debt less $150,000 assets).  Thus, he can defer $60,000 of the debt discharge income.  He is currently taxed on the remaining $40,000 debt discharge income.

Debt Discharge in Bankruptcy

When debt is discharged under Title 11 (bankruptcy), all of the debt discharge income is deferred, even if the taxpayer is not insolvent.  This is a much more favorable rule than the insolvency rule because the deferred debt discharge income is not dependent on the taxpayer being insolvent.

Example:  Same as above except that Joe declares bankruptcy and the $100,000 debt is discharged.  Here, the entire $100,000 is deferred from tax.

Foreclosure & Discharge of Mortgage Debt

There is a special rule for acquisition debt on a principal residence.  Acquisition debt is borrowed to finance the acquisition, construction, or substantial improvement of a home—it may include refinance loans, but only to the extent that it refinances acquisition debt.  Under this rule, up to $2 million of debt forgiveness can be deferred even if the borrower is not insolvent and not in bankruptcy.  Forgiveness can include restructuring the debt or losing the principal residence in foreclosure. 

Example:  Joe takes out a $100,000 mortgage and buys a $150,000 house.  The entire $100,000 mortgage is acquisition debt because it is used to acquire a principal residence.  If Joe takes out a home equity loan for $20,000 to fund a vacation and pay off credit cards, the $20,000 home equity loan is not acquisition debt because it is not used to acquire a principal residence. 

Say, What’s All This Talk About Deferral?

The policy reason behind the tax relief for debt discharge is that if the taxpayer is insolvent, bankrupt, or has lost his principal residence, the taxpayer is suffering financially and it would be unjust to hit him with taxes on the discharged debt. Especially since he probably doesn’t have the cashflow to pay it.

The tax law defers debt discharge income until the taxpayer is better off financially.  This occurs through attribute reduction.  This means you have to take the amount of deferred debt discharge income and reduce certain items such as:

  • Net Operating Losses (NOLs)
    • When your business losses exceed your business income for a year, you have an NOL that can be carried back or forward to offset income in other years
    • Your NOLs are reduced by deferred debt discharge income so more of your income will eventually be taxed.
    • Thus, you pay the tax when you receive income (and have better cashflow) rather than when your debt was discharged.
  • Basis of property
    • “Basis” basically means the cost of an asset.  If you buy a $10,000 piece of equipment, its basis is $10,000.  Basis can be adjusted for items such as depreciation.  If you deduct $1,000 of depreciation on the piece of equipment, its basis is now $9,000.
    • The higher the basis of an asset, the lower the gain when you sell it.  The higher the basis of an asset, the more depreciation you can deduct against it.
    • The basis of assets is reduced by deferred debt discharge income so that more of the gain is taxed when you sell the asset, and less depreciation can be claimed against the asset when its basis is reduced.
    • Thus, the debt discharge income is eventually recognized when you sell the asset, or through lower depreciation deductions

There are other tax attributes, but I just mentioned the two fun ones.  A special note—when you have debt discharge income on your principal residence under the new rule, ONLY the basis of your principal residence is reduced by the deferred discharge income—no other attribute reductions are required.  This will be relevant when home acquisition debt is restructured. 

One Final Complication

Most mortgage debt is recourse debt, meaning that the lender can come after you for any deficiency after a foreclosure sale.  When a foreclosure or short sale occur, there is a debt discharge component and a gain or loss component.

DEBT DISCHARGE = AMOUNT OF DEBT LESS MARKET VALUE OF PROPERTY

GAIN/LOSS = MARKET VALUE OF PROPERTY LESS BASIS

Only the debt discharge component can be deferred under one of the above exceptions.  Gain/loss is not affected by the debt discharge rules.  On a personal residence, the gain may be excluded under the special $500,000 principal residence gain exclusion, and loss is disallowed as a personal loss.

Example:  Jane buys a home for $200,000 with a $150,000 mortgage.  Jane loses the home when its market value is $120,000 (and the mortgage is still $150,000).

Debt discharge = amount of debt ($150,000) less market value of property ($120,000) = $30,000.  This may be deferred under the special rule for debt discharge on a principal residence.

Gain/loss = market value of property ($120,000) less basis ($200,000).  Here, Jane has a loss of $80,000 but it is not deductible because it is a personal loss.  If Jane had a gain, it could be excluded under the special $500,000 principal residence gain exclusion (assuming she meets the requirements).

If the foreclosed asset was a business asset, the loss component would be deductible and could offset the debt discharge income.

Fine Print: This posting 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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