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Author Archive for Kim M. Larsen EA CTFS – Page 2

How to Shift Corporate Ownership and Save on Taxes

By Kim M. Larsen EA CTFS
Friday, February 27th, 2015

It pays to plan ahead in almost any situation in life, and the future of your corporation is no different. You have multiple options for what to do with your business when you’re ready to step aside, but we’re going to focus on one in particular that provides you with a nice tax-saving strategy. In a private letter ruling, one man who owned 100 percent of his company’s stock was able to gift some of his stock to his children and then sold the rest to his corporation.[1] The great news is you can use the strategy with anyone—not just your kids.

Here’s how it worked for him:

  • He had a third-party appraiser determine the per-share value of the corporation.
  • His two children wanted to own and run the company, so he gifted shares to each of them.
  • Right after that, the corporation redeemed the remaining stock, providing the man with cash and a promissory note. This last move is important because it means that the children then owned 100 percent of the corporation and the father had the promise of future payments, as well as immediate cash.

What It Means in Terms of Taxes

In a situation like the one above, the recipients are not subject to any taxes for the gifts. The previous owner may be subject to taxes, depending upon how much each of the shares was worth. You pay no gift taxes for amounts less than $14,000 in 2014.[2] Anything over that amount dips into your estate tax and lifetime gift tax exemptions.[3]

Now, another thing to consider is how you will be taxed. You want to be taxed at the tax-favored capital gains rate for selling the stock to your corporation. In order to make this happen, you’ll need to file the right IRS-required elections for complete termination, as well as those that will allow you to avoid stock attribution rules on the shares given to the gift recipient(s).[4]

Without the termination election, you will be subject to taxes at the dividend rate, and you would receive no offset for your basis. Capital gains, on the other hand, are offset by your basis so that you are only taxed on the net gain. In addition, the cash plus promissory note combination is an installment sale, meaning the taxes will be paid on the cash only in the first year, and then tax payments will be made each year after that on the gains and interest received. As for the corporation itself, it will be able to deduct the interest it pays on the promissory note.

Of course, you should check the applicable mid-term minimum federal interest rates for such situations.[5] These rates can be used for your calculations when planning your retirement strategy. Also, you’ll want to use appropriate rates when you establish the promissory note.

In summary, by using this particular strategy for shifting corporate ownership, you’ll get up-front cash, interest on the promissory note, and tax-favored capital gains treatment on taxes. The recipient or recipients of your business have no tax burden on the transaction, and the corporation gets to deduct the interest payments made to you on the promissory note. This strategy works well if, like the man in the private letter ruling, you plan to transfer your corporation to your children. But, it works just as well for transferring the company to an employee, colleague, or current shareholder. Exiting your business should be planned just as carefully as every other decision you have made along the way.

  1. Private Letter Ruling 201228012 ↑
  2. IRC Section 2503(b); Tax Foundation ↑
  3. IRC Section 2010(c)(3); Tax Foundation ↑
  4. IRC Section 302(c)(2)(A)(iii) as specified by Reg. Section 1.302-4(a) ↑
  5. http://apps.irs.gov/app/picklist/list/federalRates.html ↑
Categories : Capital Gains, Corporations, Retirement, Tax Planning

Own Two Cars? Claim Business Tax Deductions on Both!

By Kim M. Larsen EA CTFS
Sunday, February 22nd, 2015

If you use your car for business, you’re well aware by now that you can deduct your business mileage. If you have a tax-deductible home office, you can even deduct your commute to and from work each day. But, did you know that you might also be able to claim expenses for more than one vehicle? For business owners who fit the requirements, you can significantly increase your tax savings with deductions on both your vehicles.

Marriage Status Makes a Difference

It seems like married couples often get the most benefits when it comes to tax savings, but deducting business mileage for two vehicles is actually easier for the single folks. A single person who drives more than one car has a good chance of deducting expenses for both. The married person, on the other hand, will have a bit of a harder time justifying this deduction on their tax return. It can be done, though.

Here’s what you need to prove for the deduction if you’re married:

  1. You drive more miles than your spouse.
  2. Most of your miles are business miles.
  3. The two vehicles are of comparable value.

Figuring Out if You Qualify

So, either you’re a single person with two cars, or a married person who uses both vehicles for business miles. Either way, you’ll need to know four numbers regarding your vehicles and mileage. They are:

  1. How many business miles you drive,
  2. How many total miles you drive,
  3. The cost of each vehicle, and
  4. The estimated proceeds if you were to sell each of the vehicles.

These numbers should be pretty easy to produce. After all, you are keeping track of your business mileage already, right?

Get ready for some really easy math. It turns out the deductions work the same regardless of whether you’re married, single, a sole proprietor, or the owner of a corporation. No matter your circumstance, you can take those four numbers above and determine whether the two car deduction creates an advantage for you.

Tip: One thing that does make a difference is if you have the car on a lease. In the case of a lease, you must use IRS mileage rates and cannot use the formula below.

How to Do the Math

Let’s do an example. For this example, you own two cars: Yellow Car and Blue Car. Yellow Car cost you $23,000 and Blue Car cost you $21,000, so you know those numbers for the formula already.[1]

Say you used to drive only one of the cars for business purposes, and you drove a total of 28,000 miles. In this scenario, you drive Yellow Car 30,000 total miles and Blue Car 8,000 total miles, for a grand total of 38,000. That gives you 93.3 percent business use for Yellow Car and 0 percent business use for Blue Car.

Given this scenario, you are putting more miles on Yellow Car, so it will be worth less at the time of sale—$2,000. Blue Car could sell for $5,000. These numbers, of course, will be an educated guess. Now, you get your total tax deduction by calculating the net cost of your vehicle (purchase price minus sale price), and then multiplying by your business-use percentage. For the single-car scenario, your deduction equals $19,593.

Now, let’s see what happens if you start dividing your business mileage between two vehicles. Your 28,000 business miles are now divided between two cars—14,000 miles each. And, your total mileage is also divided between both vehicles—19,000 total miles each (the grand total remains the same, 38,000 miles). This means you are now driving both vehicles for business use 73.7 percent of the time.

Your estimated sales proceeds in this case are $3,500 for each vehicle, since they are being driven the same number of miles. Now what are the tax deductions for each car? Yellow Car: $19,500 (net cost, or basis minus proceeds) multiplied by 73.7 percent equals $14,372. Blue Car: $17,500 multiplied by 73.7 percent equals $12,898. This gives you a total tax deduction of $27,270.

You just added an extra $7,677 to your tax deduction! When you file your tax return, these deductions will be claimed (and adjusted) under depreciation, Section 179 expensing, and/or gain or loss on sales. These three elements equal the business percentage of the net cost of your vehicle. Before you decide to start using two cars for business, run the numbers through this easy formula, and see if it would save you money. Regardless of whether you claim these deductions using IRS mileage, actual expenses, or Section 179 expensing, the formula accurately determines whether claiming expenses for two vehicles is a better solution for you.

  1. If you traded in an older vehicle for one of these, you may want to use the adjusted basis rather than the original basis, or cost of the vehicle. ↑
Categories : Business Expenses, Cars, Trucks & SUVs, Receipts, Records, Section 179, Spouse, Tax Planning

Have you out grown your S Corporation?

By Kim M. Larsen EA CTFS
Sunday, February 22nd, 2015

Here’s a cold hard fact for you business owners: the US has the highest statutory corporate tax rate in the world.[1] Of course, this is a thorn in the side of many business owners, considering the competitive disadvantage it gives in the global economy. As you’re no doubt aware, however, tax laws can change quickly. Given the current climate, it’s possible that S corporation owners may soon be considering the switch to either a C corporation or sole proprietorship.

It turns out that even the president has called for a change in the tax laws governing corporations. He has suggested that the maximum federal tax rate be 28 percent, and even lower than that for manufacturers.[2] The current federal rate is maximum 35 percent, so this would be a significant change. However, at the same time that the reduction of corporate rates is being discussed, individual tax rates are rising. In fact, the highest individual tax rate (39.6 percent) is now higher than the maximum corporate tax rate![3]

But, what does all this mean for business owners? It means that if you currently own an S corporation, you may be better off converting your business to a C corporation if individual taxes continue to rise and corporate taxes fall. So, you’ll want to keep a close eye on the changes in tax law in the coming years. Please note: Every business is different, and this advice may not be applicable to you, depending upon the industry you’re in. Always run the numbers before making a change in entity structure.

If the time comes when you are, indeed, ready to change your entity structure to something other than an S corporation, here’s what you need to know.

Moving Away from the S Corporation

Regardless of the reason you are converting your S corporation to another entity structure, the ways to do so remain the same. You have two options:

  1. Liquidate your business and convert to a sole proprietorship or partnership. Liquidating an S corporation is fairly similar to liquidating a C corporation.[4] You’ll basically need to sell your assets and convert them to personal assets. Using this option allows you the flexibility to reincorporate your business in the future if you choose to do so.
  2. Terminate the S election on your tax documents and convert to a C corporation. You have two options for doing this. You can send the IRS a revocation of your S election with two simple steps: 1) prepare a form stating your revocation, and 2) acquire the written consent of more than half your shareholders.[5] Note that the IRS does not provide these forms. Alternately, you can change certain aspects of your business so that it no longer qualifies for S corporation status. If you choose either one of these termination methods rather than liquidating, you will not be able to elect S corporation status again for your business for five years (unless you request special consent from the IRS).[6]

When you decide to convert to a C corporation using the revocation method, you’ll want to make sure you follow all the correct procedures regarding the consents:

  • Community Property States—If you live in one of these states, your spouse is automatically a shareholder in your corporation unless you took specific steps to prevent this. That means your spouse will also have to provide consent if you are the sole shareholder.[7]
  • Nonvoting Stock—When determining whether you have majority shareholder consent, know that nonvoting stock counts equal to voting stock.[8]
  • Tenant Rules—You must have the other tenant’s consent for stock you own as a joint tenant, tenant by the entirety, or tenant in common.

We’ve laid out the details for two separate ways to convert your S corporation to a C corporation, but if at all possible, you should use the revocation method. Why? Because it gives you clear documentation showing that you have ceased your S corporation. Trying to disqualify your business for S corporation election does not provide you with a specific date that your business ceased to be an S corporation.

However, if it’s not possible to meet the revocation requirements on time, all you have to do is violate one of the requirements for S corporation status intentionally.[9] The date of the violation is the date your S corporation ceases to exist and becomes a C corporation.[10] A couple of easy ways to invoke a disqualifying event is to create a second class of stock or give stock to a shareholder who is ineligible for S corporation stock.

Timing It Right

If a change in tax law does make it advantageous for you to ditch the S-corporation entity structure, then you’ll want to make sure you complete the change on time in order to get the full benefits. Completing the revocation in the first two and a half months of the tax year means the IRS considers your business a C corporation for the whole year.[11]

If you miss this deadline, you can still get some of the benefits intended from the change. You’ll simply have an S short year and a C short year, dividing your tax year into two periods. Whatever day you finalize the termination of your S corporation is the date your C corporation tax period begins.[12]

Having a split tax year means you have to divide all your income, credits, losses, and deductions between the two periods. You have two options for doing this: 1) you can divide the amounts evenly over the course of the year, or 2) you can treat the two as entirely separate tax years, that is, you close the books.[13] The first option is the default method, so you’ll have to specifically elect the second option if you so choose.

To figure the amounts by dividing them evenly throughout the year, you simply determine how many days your company was an S and how many it was a C. For example, if you close the S corporation on April 1, your business spent 90 days as an S (January 1-March 31). The entire year’s income, credits, losses, and deductions would be multiplied by 90/365 to get the S year portion.

Alternately, if you close the books and treat the periods as two separate tax years, you may be able to plan your expenses in order to maximize the deductions under a specific entity structure. You could, for instance, incur larger expense under the S corporation and pass them through to your individual return.[14] In order close the books, you’ll need consent from all shareholders.[15]

The choice of entity structure for your business is an important one. However, it doesn’t have to be permanent. Occasionally, it is to your advantage to keep an eye on changes in tax laws that affect the entity structure of your company. As always, check your strategies with your tax advisor to make sure you follow all procedures and obtain the proper documentation.

  1. See this Tax Foundation article. ↑
  2. See the Washington Post article on this. ↑
  3. 2014 tax brackets ↑
  4. See IRC Section 1371(a) ↑
  5. IRC Section 1362(d)(1)(B). ↑
  6. IRC Section 1362(g). ↑
  7. Reg. Section 1.1362-6(b)(2)(i). ↑
  8. Reg. Section 1.1362-6(a)(3)(i). ↑
  9. T.J. Henry Assocs., Inc., 80 TC 886 (1983) ↑
  10. IRC Section 1362(d)(2)(B); Reg. Section 1.1362-2(b)(2). ↑
  11. IRC Section 1362(d)(1)(C)(i); Reg. Section 1.1362-2(a)(2). ↑
  12. IRC Section 1362(e)(1)(A); Reg. Section 1.1362-3(a). ↑
  13. IRC Section 1362(e)(3). ↑
  14. IRC Section 1366(a). ↑
  15. Reg. Section 1.1362-6(a)(5). ↑
Categories : Corporations, Tax Planning

Selling a Piece of Real Estate? You Don’t Have to Pay Taxes, Even if You Don’t Use Section 1031

By Kim M. Larsen EA CTFS
Friday, February 20th, 2015

Overpaying taxes puts a damper on anyone’s mood. You should be paying precisely what you owe—no less, and no more. When it comes to selling your real estate, you really don’t have to pay taxes on that sale right away. One way to avoid the taxes is by using a Section 1031 exchange, but you actually have other options. This article will show you how to take advantage of them.

Option 1

With this option, you combine the strategies of creating a charitable remainder and a wealth replacement trust rather than selling the property. Then, voila! You don’t have to pay any taxes. Here are the steps:

  1. Create a charitable remainder trust and donate the property to the trust. With the donation, include terms that grant income to your and your spouse for the remainder of your lives. This can be either a percentage of the trust income (charitable remainder unitrust) or a fixed income (charitable remainder annuity trust).[1] The former type can accept future property donations to the trust.
  2. In the trust, designate one or more charities to receive the remainder of the trust’s balance upon the death of the second spouse.
  3. Establish a wealth replacement trust. This is a term-life insurance trust. It should include a second-to-die policy so that both wife and husband are covered. The trust acts as the insurance policy applicant, owner, and payer of premiums.

How does this option save you money? First, you avoid paying taxes on the sale of the property, which would have reduced the amount available from the proceeds for future investments. Second, you’re able to deduct the charitable expenses right away. Of course, you will be subject to the limits on charitable donations. However, if you exceed that limit for the current tax year,[2] you can carry the remainder over for the next five years.[3] Additionally, you get a tax write-off on the remainder interest that you gave away to the charity. Tax law includes expectancy tables to calculate this value, which is the value of your charitable contribution.[4]

This strategy also has another benefit, which comes from establishing the wealth replacement trust. You see, this trust receives the insurance proceeds when the surviving spouse passes away. The trust then gives those proceeds to the heirs, so you increase what is left for your children.

To sum up the benefits of this combined strategy:

  • You don’t pay capital gains taxes for transferring the property to the charitable remainder trust.
  • You invest at the pre-tax value rather than only have the after-tax amount to invest.
  • You get a deduction for your charitable donation.
  • The trust provides income to pay the insurance premiums.
  • Your heirs receive a significant amount of money.
  • You benefit your favorite charity, your heirs, and yourself, and pay nothing (or close to nothing) in taxes.

What kind of numbers are we talking about? If your real estate is worth $1 million and you sold it, you would pay $300,000 in taxes. You could then invest the remaining $700,000 in CODs (at 2 percent interest) and make $14,000 annually, pre-tax. But, with the charitable remainder trust strategy, the trust sells the real estate for $1 million and sets up a 5 percent return for you in the charity’s investment portfolio. In this scenario, you get a $94,000 deduction for the donation, plus annual income of $50,000. You can then pay $15,000 per year from that $50,000 for a $1 million life insurance policy with your children as the beneficiaries. Which do you think is the better deal?

Option 2

Another option for business-savvy individuals is to use Section 721, which involves transferring the property to a partnership. Section 721 negates any gain or loss (to you, the partnership, or its partners) when you contribute property and get partnership interest in return.[5] One way to do this is transfer your real estate to an operating partnership (OP) of a real estate investment trust (REIT). The REIT then acts like a real estate mutual fund with diversified holdings. Since you receive OP units as part of the exchange, you are then entitled to periodic distributions of the REIT. Additionally, these units can be converted into shares of the REIT. The primary benefit of this method is that you both avoid taxes and the transfer and increase the liquidity of your investment.

Normally, when you transfer property that has a mortgage liability that exceeds the property’s basis, you trigger taxes. That’s because the excess mortgage is considered a gain. How do you avoid the taxes? You simply need to know about a special REIT called a UPREIT.[6] The UPREIT guarantees an equivalent liability portions to the REIT, making excess mortgage cease to be an issue. Therefore, you pay no taxes.

Option 3

Another way to reduce your tax burden is to use a regular installment sale to dispose of your real estate.[7] This method is also called “holding paper”, and your primary benefit is an increase in net worth by holding a secured note at a higher interest rate than you would get at a financial institution. It works like this: you pay taxes as you get paid. That means you can earn interest on the gross amount since you don’t have to pay the taxes right away.

But, you may encounter situations where you do have to pay those taxes up front:[8]

  1. If you have to recapture depreciation that exceeds straight-line depreciation, or
  2. If you have to recapture low-income or rehab property investment tax credits.

The IRS considers your disposition an installment sale if you sell the property and then receive at least one payment after the close of the taxable year in which the sale occurs.[9] The payments are comprised of three parts: 1) a taxable portion of the principal payment, 2) a nontaxable portion of the principal payment, and 3) interest.

So, how much does this help your bottom line? Let’s say you sell a piece of investment property for $250,000 after selling expenses. The property’s tax basis is $125,000, so your profit would be the remaining $1250,000. With an installment sale, you divide that profit number by the $250,000 net proceeds, giving you a gross profit percentage of 50 percent (i.e. every receipt of principal is a 50 percent taxable gain). Upon closing the sale, you receive a down payment of $30,000, which is 50 percent return of capital (from your basis) and 50 percent taxable gain.

Afterwards, you receive a payment of which $700 is principal (the rest is interest). For tax purposes, you again divide the principal into 50 percent taxable and 50 percent nontaxable. As far as that interest is concerned, you are required by tax law to charge interest at a minimum rate for installment contracts—the lower of the Applicable Federal Rate (AFR) or 9 percent. The AFR is published monthly by the IRS.[10] To get the most from your installment sale, keep an eye on the interest rates and wait until you can get a higher rate. Then, add points to the interest rate if you can.

When selling your real estate, it’s usually best to avoid paying up-front taxes. The 1031 exchange is an efficient way to do this, but it only works if you plan to replace the property in order to continue building your real estate portfolio. In contrast, each of these options is a strategy to reduce or completely get rid of the taxes you would pay upon sale. This leaves you with more money to invest and grow in other opportunities. When it comes to real estate, you always have choices about when to pay taxes or even whether to pay them at all.

  1. IRC Sections 664(d)(1-2) and 453(b) ↑
  2. IRC Section 170(b)(1)(A). ↑
  3. IRC Section 170(d)(1)(A). ↑
  4. Regs. 20.2031-7A(f); 1.664-4. ↑
  5. IRC Section 721. ↑
  6. IRC Section 357. ↑
  7. IRC Section 453. ↑
  8. IRC Section 453(i). ↑
  9. IRC Section 453(b)(1). ↑
  10. IRC Sections 483 and 1274; IRS Publication 537 on Installment Sales (2008), page 10 ↑
Categories : Capital Gains, Real Estate, Retirement, Tax Planning

Thinking about Buying a Business? Your Opportunities for Tax Deductions Have Already Begun!

By Kim M. Larsen EA CTFS
Friday, February 20th, 2015

Are you aware of business start-up deductions? If you’re not, you should find out right away! You don’t want to miss out on these tax-deductible activities that are only valid when you’re starting a new business. In fact, you don’t have to start your own business; you can get these tax benefits from simply buying a business. Fortunately, this article deals you in on the details.

It Pays to Plan

Before you even purchase your new business, you can start keeping track of your deductible expenses. That’s right, you are eligible for deductions related to merely thinking about your soon-to-be business. Here’s an example. Let’s say you invite a friend to dinner because she purchased her business only a few years ago, and you’d like to find out more about what goes into starting a newly purchased company. That dinner is deductible because you have a business purpose for the expense—you are seeking necessary information for your venture. These expenses are called “start-up expenses”.

Whether you create or buy a business, you will by necessity go through an investigatory phase. If you don’t do this, you may want to reconsider going into business for yourself! However, the rules about how deductions work are a little different in each situation, so we’ll stay focused on the process for purchasing an existing company.

Basically, you are going to incur expenses while you analyze your options and make a decision about what kind of (and then which) business to buy. That is the extent of the investigatory phase. After that, start-up expenses stop, and you begin tracking business expenses.

Here’s a breakdown of the steps and what expenses you may be looking at:

  • Investigating Possible Businesses—First of all, let’s make clear that when we say “buy a business”, we are talking about actually purchasing an active business, not buying corporate stock. If during this period, you spend $41,000 to analyze and review your options, you can begin writing off those expenses the day the escrow closes on your purchase. You get a $5,000 write-off on the first day, and $200 each month after for the 180 months.[1]
  • Identifying Your Prospective Business—In order to take advantage of the expenses for your investigatory phase, you must identify the business you plan to purchase. If after investigating the possibilities, you do not identify a target business, you will not be eligible for any deductions. At the point when you identify your target business, your investigative expenses stop. In the event that you identify a target business but do not end up buying it, you are still eligible for acquisition and facilitative costs, but not the investigative costs.
  • Buying the Business—Once you have identified the business and move forward with purchase, any additional expenses are considered capitalization rather than start-up costs. These are costs that you cannot benefit from until you later sell or leave your business. The IRS has what is called a “bright-line rule” regarding the date your research of possible businesses ends and acquisition activities begin.[2] It is either 1) the date of your letter of intent (or similar documentation), or 2) the date that a binding written contract is executed between you and the target business (unless board approval is required, in which case it’s the date terms are approved by the board or its authorized committee). The IRS will go with whichever of these two dates is earlier.[3]

Take a look at that last bit about the bright-line rule. That means that if you hire an accounting firm, for instance, to investigate your target company, the firm may continue to provide services to you after you submit a letter of intent. The accounting firm will make a financial analysis in the investigatory phase, but it also could review the target company’s books and records after that point. Only the services provided before submission of your letter of intent count as start-up costs.[4] The additional services are capital costs.

Of course, the IRS never makes things easy, so there is an exception to the above bright-line rule. It wouldn’t be tax law if there weren’t, right? You see, some expenses are inherently facilitative, meaning they cannot be counted as investigatory expenses. What about the bright-line date, you may say. It doesn’t matter. Facilitative expenses are capital costs regardless of the date you incurred them. Here are some examples that are inherently facilitative to a purchase:[5]

  • Appraisal costs
  • The cost of a formal written evaluation of the transaction
  • The cost to have a purchase agreement prepared
  • Any costs necessary to obtain shareholder approval
  • Costs for negotiating the transaction
  • Costs for structuring the transaction
  • Any costs for conveying property, such as title registration or transfer taxes

When Corporations Are Involved

Things are always a little trickier when corporations are the entities making the transaction. You may find yourself in one or both of the following situations: you could be purchasing a corporation, and/or your corporation may be the buyer. Let’s look at a few scenarios.

  • You Only Buy Common Stock—If you take over a corporation through common stock, any investigatory expenses are not deductible. This is because you have gained an investment rather than an actual business or trade interest.[6]
  • You Buy Stock Plus Assets—If stock purchase is included in the process to fully take over a corporation, that is a different matter. When you acquire a business’s assets, even when stock is also exchanged, you are eligible for start-up deductions and amortization.
  • Your Corporation Is the Acquirer—Unlike the sole proprietor, who claims start-up expenses on the Schedule C, an S or C corporation will claim these expenses on the corporate tax return. Always keep in mind that your corporation is a separate entity from you. Do not pay any of the costs incurred by your corporation. If you do, make sure the corporation reimburses you. Doing otherwise will cause headaches with your taxes.
  • You Form the New Business as Corporation—When you do this, you incur organization expenses for setting up your company’s entity structure. This can include fees paid to incorporate, legal services required to set up the corporation, accounting services, and expenses related to organizational meetings for directors or stockholders. These costs are separate from investigatory costs and capitalization costs.[7] The good news is that they can be amortized just like start-up expenses. You claim up to $5,000 in the first year and amortize the remainder over 180 months.[8]

Now you know what to do as far as acquiring your business, but what if the business fails or is sold before you finish seeing the full benefits of amortization? No worries. For sole proprietors, you deduct the remaining (unamortized) costs as a business loss.[9] For corporations, both the unamortized start-up and organization costs are deducted on the corporation’s final tax return.[10]

Tax law is not written to slow down businesses, despite the fact that it can get complicated. On the contrary, legislators know that the opening of new businesses benefits the whole economy. That’s why your able to write-off expenses like the ones discussed here. Take advantage of it! The benefits are available so that you and your business can succeed.

  1. IRC Section 195(b). ↑
  2. TD 9107. ↑
  3. Reg. Section 1.263(a)-5(e). ↑
  4. Reg. Section 1.263(a)-5(e) ↑
  5. Reg. Section 1.263(a)-4(e)(2). ↑
  6. H. R. Rep. No. 1278, 96th Cong., 2d Sess. 3, 9-13 (1980). ↑
  7. Reg. Section 1.248-1(b)(2). ↑
  8. Reg. Section 1.248-1T(a). ↑
  9. IRC Section 195(b)(2). ↑
  10. Liquidating Co., 33 BTA 1173. ↑
Categories : Business Expenses, Entertainment, Receipts, Records, Start Up, Tax Planning, Travel

Deducting Business Education? Here’s What You Need to Know

By Kim M. Larsen EA CTFS
Wednesday, February 18th, 2015

Depending upon the field you’re in, business education can be a significant expense. Do you have to keep up with certain certifications? Do you need to learn a particular skill? Are you seeking more knowledge about running a business in general and gaining customers?

Lori Singleton-Clark attained an online MBA in order to increase her business knowledge. In one year of the program, she spent $14,787 on her business education, and that is the deduction she claimed on her tax return. Guess what? Ms. Singleton-Clark fought the IRS and won her deduction in court.[1] Even more encouraging is the fact that she did not hire an attorney and was able to represent herself sufficiently by having the right documentation.[2]

Why We Have Business Education Deductions

The government wants to help out people who are in business. It’s beneficial to the economy for the government to help businesses succeed. Because the government acknowledges the vast amount of information necessary to run a company, they give you tax breaks in order to get that knowledge and use it for the advantage of your business. Depending upon your industry, this knowledge could come in any number of forms, such as:

  • Learning to play golf
  • Learning to fly a plane
  • Learning about software
  • Finding out more about marketing
  • Obtaining writing skills
  • Obtaining negotiating skills
  • Obtaining selling skills

Education does not just mean taking classes. You may obtain your education at seminars or conventions.[3] Or, you may even hire a private coach.[4] As long as this education meets the requisites for deductible business education, you can save money on this necessity. So, how do you qualify?

Qualifying for the Deduction

The basic rule for qualifying for the deduction is pretty simple. In order to deduct the expense, the education obtained must either improve the skills you need in your business or maintain your current business skills, and it cannot train you for a new business.[5] Let’s break that rule down into some more specific guidelines:

  1. You must already be in the business the education pertains to.[6]
  2. In the business does not mean simply working in the field. To qualify, you must already have the basic, entry-level education required for the business—you cannot deduct minimum-requirement training.[7] However, if regulations change after you’ve entered the business, your expenses qualify if you need to get up-to-date with new requirements.
  3. The determination that you need the education can come either from yourself, from an employer, or from a change in legislation regarding your industry.[8]

Here are some examples of education costs that do not qualify:

  • Courses taken in the pursuit of a bachelor’s degree
  • A nurse taking courses to become a medical doctor
  • A legal assistant obtaining a law degree

But, these do qualify:

  • A dentist taking additional coursework to become an orthodontist[9]
  • A teacher seeking a Master’s or Ph.D. in their field[10]
  • A psychiatrist obtaining psychoanalyst training[11]

These latter three situations qualify for the deduction because each person is maintaining their current job (they are still a dentist, teacher, and psychiatrist) but increasing their skills.

Case Examples

Patrick O’Donnell did not get his deduction for the cost of attending law school. O’Donnell was a CPA who worked with lawyers regarding taxes. Although he already worked with lawyers and continued in the same position after receiving his law degree, he was not eligible for the deduction because it qualified him to eventually switch careers and become a lawyer if he chose. That is, a law degree is the bare minimum requirement for being a lawyer; thus, it is entry-level education for a particular field.[12] Bachelor’s degrees and medical degrees work the same way.[13] You will not be able to deduct any of these degrees.

An MBA degree, on the other hand, often is deductible. That’s because the majority of people who pursue the degree are already in business. Therefore, the degree contributes to knowledge in an area they are already involved in. Robert Beatty, for example, earned an MBA in order to improve his administrative, management, and interpersonal skills. He worked in management as an engineer, and the skills he obtained directly improved his business.[14] Beatty did get his deduction.

However, you may want to know a few tips about proving you are in the business for which you are receiving and deducting an MBA:

  • It’s best if you’ve been in the business for a few years before beginning the MBA. Trying to get one after only a few months in a new business could be harder to justify to the IRS.
  • If it’s possible, pursue your degree part time rather than full time. This allows you to continue working in your business while you obtain the degree.
  • If you decide to go the full-time route, you’d better plan your time efficiently. Quitting your business and doing nothing for a year before beginning the degree program may mean no deduction.

Daniel Allemeier, Jr. is another example of someone who pursued the MBA and won his deduction.[15] He was a well-respected salesperson and trainer for a dental products company, and after being with the organization for three years, he chose to get an MBA. Shortly after enrolling in the degree program, Mr. Allemeier’s employer promoted him to marketing manager. The employer’s policy stated that it would not reimburse employees for education, so Allemeier chose to pay for his MBA himself while continuing to work full time. Although his employer did not require this education, the CEO of the company did encourage it in Allemeier’s case.

Do you see why Mr. Allemeier was able to defend his deduction?

  • He had been in the same business for several years;
  • His degree did not qualify him specifically for any other profession;
  • The MBA coursework improved the skills he currently used in his position; and
  • The MBA was not a requirement for his promotion, even if it may have helped in that regard.

In another court case, Deputy District Attorney Edward Kosmal defended his deduction for Spanish lessons. He won because he worked in a community with many Spanish speakers, and this education helped him to better perform his job.[16]

Kenneth Knudtson was even able to deduct the cost of flying lessons.[17] He successfully proved an ordinary and necessary business expense for both the cost of his plane and the lessons because he used this transportation method to visit customers and suppliers for his automobile windshield wiper motor rebuilding company. The companies he visited were spread over a wide area, and this made flying himself a reasonable choice for his business practice, considering how important it was for him to maintain close working contact with his suppliers.

What’s important to note is that it’s the circumstances that determine whether you get your deduction, not the particular courses you take. Ronald Beckley was an FBI special agent who had a pilot’s license before joining the FBI. He was sent on multiple missions as a pilot, but he was unable to take some missions because he lacked an instrument rating. Beckley took the courses he needed to perform his job better, but he also took several other courses that certified him as a commercial pilot and flight instructor. When his case went to court, Beckley was able to deduct the expense for the instrument rating, but not the expense for the other courses.[18] Those courses did not contribute to skills for his current position, and they qualified him to work in another field—as a commercial pilot.

Here’s a funny example. David Kohen failed a different part of the requirements. He had obtained his law degree, and rather than entering the profession, he chose to wait and pursue postgraduate courses in tax law. Unfortunately for Mr. Kohen, both the IRS and the court denied his deduction because he had never actually practiced law, and therefore was not in the business and did not have skills to “improve” or “maintain”.[19] That’s right—the postgrad in tax law could not justify and defend his tax deductions!

As mentioned, it’s best to be established in your business for several years before pursuing additional formal education. If you take the leap to leave your job while obtaining this education, you only have a chance at winning your deduction if you can prove that your absence was temporary. Unfortunately, the IRS and the courts disagree on the definition of “temporary absence”.

Robert Picknally benefited from this difference when he won his business education expense deduction.[20] After working for 10 years, he left for 3 in order to get a PhD. However, he was not able to get a job afterwards. In this situation, the IRS states the leave was not temporary because it lasted longer than one year (the IRS safe harbor limit). The courts, on the other hand, allow longer than a year if you can prove that you intend to stay in the same business after your temporary absence. Whether Picknally was actually able to find work in the same field did not matter, and the IRS even filed an acquiescence stating that the one-year-safe-harbor rule could be overridden when certain facts and circumstances make it appropriate.

Filing the Return

When you file your tax return, how you claim the deduction depends upon what kind of entity structure your business runs under. Here are a few possible scenarios:

  • Independent Contractor or Sole Proprietor—If you’re an individual business owner or freelancer, you use Schedule C of Form 1040 in order to claim your expenses. You’ll just put the business education deduction on this form with your other business expenses, and it will reduce your state income taxes, federal income taxes, and self-employment taxes.
  • S or C Corporation—When you operate as a corporation, things get a little trickier because you are considered an employee of your corporation. Because of this, you actually have two options for making the deduction. Either you can make the deduction as an individual, unreimbursed by your company for the business expense, or the corporation can make the deduction after reimbursing you for your employee business expense.

You do not want to take this first option, and here’s why: employees get the shaft when it comes to deducting business expenses. First, this option relegates your education costs to the miscellaneous itemized deductions category, meaning they are reduced by 2 percent of adjusted gross income.[21] Second, if you do not itemize deductions, you lose any benefit. And third, employee business expenses could trigger the alternative minimum tax (AMT), where they are disallowed.

The best choice for the owner of a corporation is to have the corporation take the deduction, after reimbursing you in a timely and appropriate manner. Your corporation gets a deduction, you get the cash (from your company), and you have no taxable income on this.[22] Perfect!

Now, here’s how you protect this perfect situation from the IRS. When your corporation deducts employee business expenses, it has the burden of proof on your behalf. So, your company should set up an accountable plan for providing reimbursements on these expenses. The accountable plan requires the employee to prove they complied with the rules of the plan before receiving reimbursement. It’s easy to do and could be something as simple as filling out and signing an expense report that states the employee met the qualification requirements for deductible education. You’ll also need the receipts. Providing this proof to your corporation builds protection both for you and your business entity.

Armed with this information, you’ll be able to choose educational options that benefit your business and are tax-deductible. But, you don’t really need to put up a fight—the government wants you to gain education. Typically, more educated individuals earn more money, and the government knows it shares in your financial growth. Education really is a smart investment, both for tax-savings and future success.

  1. Lori A. Singleton-Clarke v Commr., TC Summary Opinion 2009-182. ↑
  2. “Nurse Outduels IRS over M.B.A. Tuition,” by Laura Saunders, The Wall Street Journal, January 9, 2010 ↑
  3. Coughlin v Commr., 203 F.2d 307 (2d Cir. 1953); 260 F.2d 80 (9th Cir. 1958). ↑
  4. Walter G. Lage v Commr., 52 TC. 130 (1969). ↑
  5. Reg. Section 1.162-5. ↑
  6. Reisinger v Commr., 71 TC. 568 (1979). ↑
  7. Reg. Section 1.162-5(a)(2). ↑
  8. IRC Section 67(b). ↑
  9. Rev. Ruling 74-78. ↑
  10. Rev. Ruling 68-580. ↑
  11. Reg. Section 1.162-5(b)(3)(ii). ↑
  12. Patrick L. O’Donnell v Commr., 62 TC. 781 (1994), affirmed 519 F.2d 1406 (7th Cir., 1975). ↑
  13. Thomas J. Cangelosi v Commr, TC Memo 1977-264. ↑
  14. Robert C. Beatty v Commr., TC Memo 1980-196. ↑
  15. Daniel R. Allemeier, Jr. v. Commissioner, TC Memo 2005-207 ↑
  16. Edward J. Kosmal v Commr., TC Memo 1979-490, affirmed per curiam, 82-1 USTC ¶9255 (9th Cir., 1982). ↑
  17. Kenneth L. Knudtson v Commr., TC Memo 1980-455. ↑
  18. Ronald J. Beckley v United States, 490 F.Supp. 123 (S.D. Ga. 1980). ↑
  19. David M. Kohen v Commr., TC Memo 1982-625 ↑
  20. Robert Picknally v Commr., TC Memo 1977-321, Acq. AOD 1978-60. ↑
  21. IRC Section 67(b). ↑
  22. Rev. Ruling 76-71. ↑
Categories : Business Expenses, College, Education, Tax Planning

How You Can Deduct Your S Corporation Board Meeting with Your Spouse

By Kim M. Larsen EA CTFS
Wednesday, February 18th, 2015

When it comes time to deduct business expenses on a tax return, most corporation include expenses for board meetings. After all, that’s undeniably a business expense, right? Well, sometimes it’s not so clear, like when the only two board members are a wife and husband. If you and your spouse jointly hold stock in your S corporation, how do you prove your right to a deduction? Can you go to a restaurant or take a business trip and still deduct the meeting?

Proving Your Business Purpose

When your board meeting consists of just your spouse and yourself, you have to be careful that the IRS has sufficient evidence documenting the business activities of the meeting. How do they know the event was a board meeting, and not just a pleasant lunch date? Husbands and wives have been conducting business together since before the birth of US tax law. You can study precedent cases to find out how the IRS is likely to view your situation.

Unfortunately, not many cases exist regarding this particular scenario, so you have to look at similar situations regarding deductible business expenses. In the case of Ben Heineman, the IRS questioned him for building an office at his vacation property, costing $1.4 million in today’s dollars (the office was built in 1969). Heineman stated that he could perform certain work (such as making business plans) better with his family and away from the distractions of the Chicago offices. Not exactly the same situation as a board meeting, but the same requirements for determining whether an expense is business or personal.

Heineman was the president and CEO of Northwest Industries, Inc., which had its principal offices in Chicago, IL. Not wanting to spend his summers in Chicago, he built the office at his vacation home in a resort area, Sister Bay, Wisconsin. During the period of the year when Mr. Heineman used this office (from about August until Labor Day), he worked at least 5 hours per day, six to seven days per week. He used this time to perform duties essential to the Chicago offices, including long-term business planning.

In the end, the courts ruled in favor of Mr. Heineman, stating it didn’t matter if it would have been less expensive for him to get a second office in Chicago. He had a necessary and ordinary business reason for the trip—he could concentrate better on his work at that location. Therefore, he was entitled to his deduction.

What the Heineman Case Means for You

Why is this case important for your board meeting scenario? The only deductions that Mr. Heineman claimed were depreciation on his office building and maintenance expenses for it. He did not claim traveling expenses for the trip between Chicago and Wisconsin. However, he did travel—to his vacation property. According to tax law travel regulations, you are able to deduct business expenses incurred on a trip that is otherwise personal, and that is why Mr. Heineman was able to deduct his second office expenses.

The same travel regulations would apply to you if you take your spouses-only board meeting to an out-of-town location. So, what you need to show the IRS (with accepted documentation) is:

  1. Business was the primary purpose of the trip, and
  2. Business actually took place during the trip.

All you have to do to establish business as the trip’s primary purpose is to ensure that you conduct business on more days than you partake in personal activities. Fulfilling the requirement that the trip was necessary for business is tougher. How do you show that it was necessary to go out of town? Again, look at Heineman. You could have some very good reasons for going out of town to conduct business: get away from ringing phones, find peace and quiet to concentrate, or not to be distracted by email or employees.

As for proving that you conducted business, you simply keep records of evidence that you did work. These could include:

  • Documents generated on this trip (such as a business plan)
  • A recording of business conversations that took place
  • Evidence that you were in a business setting
  • A print log showing you physically printed business documents to be discussed and reviewed

The out-of-town board meeting can be a bit of hassle to document, so if you’re banking on the deductions making the cost of the trip worthwhile, you’d better make sure you plan efficiently and can back up your claim to the business purpose of the trip. The funny thing, however, is that an in-town board of directors meeting for a wife and husband is even more difficult to prove.

You see, tax law specifies that you cannot deduct personal, family, or living expenses. That means deducting a meal at a restaurant as a business expense is going to be awfully difficult to justify to the IRS, particularly when no one else is participating other than you and your spouse. You’ll see why with an example of a couple who was not allowed to deduct their board meeting expenses.

Mr. and Mrs. Duquette were the sole board members of Norman E. Duquette, Inc. and attempted to deduct expensive meals at two separate restaurants on January 1 and February 1. At the meals, they discussed items such as approval of payment for trips and determining whether to move the business to Naples, Florida. Unfortunately for the Duquettes, the court decided that the couple had no evidence that the issues required significant discussion.

The Duquettes had no employees, and the couple both lived and worked together. The court found no proof that could justify a husband and wife having an expensive dinner in this situation, when they could have just as easily had the discussions elsewhere without the expense. Here is the IRS’s standard stance on the matter (from the Internal Revenue Manual): “Board meetings between husband and wife are not ordinary and necessary business expenses, but personal entertainment expenses, and are therefore not deductible” (Treas. Reg. Section 1.162).[1]

The takeaway from this is that fine dining expenses are not deductible as a wife-and-husband board meeting under official IRS policy. That does not necessarily mean you cannot deduct such expenses, but you’d better be prepared to have a rock-solid justification for it (i.e. a well-documented business reason). Unlike the Heineman case, the Duquette case does not set a precedent (and neither does the IRS audit manual).

Applying the Cases to Your Situation

If your spouse-only board meeting needs to be away from home, either in-town or out, you need to be able to answer the question “Why?” Heineman had something concrete to show the IRS and the court—a business plan that he developed because he was able to concentrate and focus better at the second office. The Duquettes, in contrast, failed to produce any evidence of work effort during the meetings.

To take advantage of deductions for a spouses-only board meeting for your S corporation, you should be confident that you have at least a 50-50 shot at your reasons being accepted, and whoever prepares your taxes has to back up that assertion. Your tax preparer is at risk of severe penalties for filing a return that doesn’t have a justifiable 50-50 chance. When using this strategy, show the Heineman case to whoever prepares your taxes. But, remember that you are highly unlikely to be able to deduct the in-town, husband-and-wife meeting at a restaurant.

Still want to conduct a meeting during a meal? If it’s an issue that requires a third party, such as your attorney, then go ahead! It’s only when spouses dine together exclusively that the deduction becomes difficult. But, when the two of you are meeting to discuss business matters with someone else who is necessary to the discussion, it makes sense that you must find a location to meet (just be sure to document the business purpose!).

  1. Internal Revenue Manual 4.10.10, Paragraph 9707. ↑
Categories : Business Expenses, Corporations, Entertainment, Tax Planning, Travel

Want to Convert to an S Corporation? Watch Out for These Common Mistakes

By Kim M. Larsen EA CTFS
Tuesday, February 17th, 2015

At some point, many proprietors weigh the benefits of switching to an S corporation. In truth, an S corporation entity structure does offer a variety of tax advantages. The basic process of converting to an S corporation is fairly simple.[1] However, tax law always has its hidden caveats.

When dealing with the IRS, they always know their rules. Unfortunately, taxpayers are not always so fortunate. That’s why you need to make sure you understand the tax ramifications before you start paperwork and other steps to switch your company over to an S corporation. For one thing, you want to make sure that the IRS views your S corporation as exactly that, and not a C corporation, which works completely differently when it comes to taxes. Also, you’ll want to understand all those tax advantages available to you. If you’re not aware of them, you can’t use them.

Functioning as an S Corporation

So, just because you have an S corporation on paper doesn’t necessarily mean that’s what you’re operating as. In order to be work under this entity structure, you have to meet these basic requirements:[2]

  • The company must be a domestic corporation;
  • It must have fewer than 100 shareholders;
  • Only people, estates, and certain kinds of trusts can be shareholders;
  • Only US residents can be shareholders; and
  • The corporation can have stock only in one class.

These rules should be fairly easy for the typical business owner to meet. However, the rules have a few hidden elements, and if you miss one of them, the S corporation will revert to a C corporation, possibly with disastrous results to your business. In fact, the IRS can revert your entity to a C corporation for up to three years back.[3]

Tricky Rules

Here’s one of the implied rules that don’t get listed about S corporation—community property laws. If you live in a state with community property laws, your spouse may be an owner in your corporation, even if he or she doesn’t actually have in stock by name.[4] This means your spouse also has to meet all of the requirements. In community property situations:

  • Your S corporation is invalid if your spouse is a nonresident alien.[5]
  • Your S corporation is invalid if your spouse fails to consent to the S corporation election on IRS Form 2553.[6][7]

In fact, entity structures are a lot more fluid than you may think. LLCs can easily become an S corporation for tax purposes by taking only two steps. It’s called “Check and Elect”[8].

  1. File Form 8832 and check the box to convert your LLC to a C corporation.[9]
  2. Then, file Form 2553, which allows the IRS to tax your C corporation as an S corporation.[10]

Here’s another tip about implied rules that sneak into those requirements. Certain types of loans paid by you to your company can be treated by the IRS as a second class of stock for your corporation. Look at the rules above—more than one class of stock and your company is disqualified from filing taxes as an S corporation.

Usually, loans under $10,000 are okay, as long as your corporation has a plan in place to pay back the loan relatively quickly.[11] Larger loans, however, are a bit of a stickier situation. You can still avoid them being classified as a second class of stock if:

  1. You have the loan in writing;
  2. Your corporation has a firm deadline for repaying the loan;
  3. The loan cannot be converted into stock; and
  4. The instrument for repayment uses a fixed interest rate, keeping the rate out of your control.[12]

So, loans may be viewed as stock and cancel out your S corporation benefits. But, it turns out you actually can safely have two different classes of stock, as long as the two kinds of stock have no differences except voting rights (a hidden benefit!).[13] This means you could create a class of voting stock and a class of nonvoting stock. You just have to keep all other aspects of the stock the same. Nonvoting stock can be a big advantage when you want to allow certain people to have distributions but no ability to make business decisions.

What Else You Need to Know

As with any tax requirement, filing to create an S corporation must be completed at the right time. Your business typically has to meet all S corporation requirements on the day you file the election.[14] Here’s an example of how the deadlines work. If you file in 2014 to be an S corporation with an effective date of January 1, 2015, then you must meet the requirements on the day you filed—in 2014.[15]

What this means is you should not file unless and until your business meets the requirements. Luckily, if you forget to file before the end of the previous year, you’re able to file up to two months and 15 days after the first of the year (March 15 for a business that uses the calendar year as the taxable year), and your S corporation will still be effective as of the first of the year. Keep in mind, however, that this only works if your business met all the S corporation requirements from the beginning of the year and you had the consent of all shareholders for that year.[16]

Remember the community property state laws? They could come into play here. If you live in a community property state and get divorced on in February, you would need your ex-spouse’s consent for the S corporation election because they were a shareholder during January, while you were still married.

Additionally, C corporations wanting to convert to an S corporation may face their own unique challenges. Here’s a quick overview of concerns that may cost you extra in taxes:

  • Built-in Gains Tax—To convert, you’ll sell your C corporations assets upon conversion. This means you could be subject to the built-in gains tax if the assets are now worth more than their basis.[17]
  • Passive Investment Income—Higher taxes are an issue when more than 25 percent of your S corporation’s income is passive investment income, such as rents, interest, dividends, royalties, or annuities, and the previous C corporation had accumulated profits and earnings.[18]
  • LIFO Recapture—This is a recapture tax that you may owe if the LIFO (Last-In First-Out) accounting method was used for your C corporation’s inventories.[19]
  • Loss of Tax Attributes—Generally you lose out on the ability to claim C corporation losses or take minimum tax credits when you switch over to an S corporation.[20]

As you can see, it’s easy to think you followed all the rules and still get caught in a tax trap. Fortunately, now that you’re aware of the additional hidden rules, you’ll see them coming and be able to plan ahead so that you don’t find yourself in a tax disaster. S corporations can generate significant tax benefits, but make sure the change is worth it and you follow the rules.

  1. The “S” in S corporation refers to its location in the tax code: Subchapter S of Chapter 1. ↑
  2. IRC Section 1361; you can find a thorough checklist of how to qualify in the Instructions for Form 2553. ↑
  3. The statute of limitations typically prevents assessments for periods more than three years in the past. See Barnes Motor & Parts Co. v U.S., 309 F. Supp. 298 (EDNC 1970) ↑
  4. Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin are community property states. Also, Alaska allows married couples to opt-in to community property. ↑
  5. IRC Section 1361(b)(1)(C). ↑
  6. IRS Form 2553, Election by a Small Business Corporation ↑
  7. Reg. Section 1.1362-6(b)(2)(i). ↑
  8. The choice to be a C corporation is called “checking the box.” The choice to be an S corporation is called an election. ↑
  9. See Rev. Rul. 2009-15 and IRS Form 8832, Entity Classification Election (Rev. January 2012). ↑
  10. IRS Form 2553, Election by a Small Business Corporation ↑
  11. Reg. Section 1.1361-1(l)(4)(ii)(B)(1). ↑
  12. IRC Section 1361(c)(5)(B). ↑
  13. IRC Section 1361(c)(4). ↑
  14. See Rev. Rul. 86-141 and IRS Form 2553, Election by a Small Business Corporation. ↑
  15. Assuming your taxable year matches up with the calendar year. ↑
  16. IRC Section 1362(b). ↑
  17. IRC Section 1374. ↑
  18. IRC Section 1375; see definition of “passive investment income” in IRC Section 1362(d)(3)(C). ↑
  19. IRC Section 1363(d). ↑
  20. IRC Section 1371(b). ↑
Categories : Corporations, Tax Planning

Hire Your Kid and Get a Tax Break

By Kim M. Larsen EA CTFS
Tuesday, February 17th, 2015

Do you want to find out a better way to teach your child about money than just giving an allowance? If you own your own business, you can pay your kid in a way that benefits both you and the child when it comes time for taxes. You see, it’s possible to get a deduction by hiring your child to work in your company, and your kid could get the money without paying any taxes! Compare that to paying taxes first (without the deduction) and then paying an allowance out of after-tax dollars.

A Precedent Case

Sally Wilson hired her 13-year-old to work in her proprietorship, and she paid the child $5,700. For doing so, she got back $2,600 from state and federal governments. If Wilson’s business functioned as a corporation, she still could have gotten back $644. This extra money comes from hiring-your-child tax breaks.

Additionally, Ms. Wilson’s child paid zero taxes. That’s because the child can take the standard deduction (instead of itemizing property taxes, mortgage interest, charitable donations, etc.). In 2009, the standard deduction was $5,700 (the total amount of the child’s income). The standard deduction is $6,200 for 2014 and $6,300 for 2015.

Why You Should Hire Your Child

Hiring your child is a great way to teach them about finances, as well as what it takes to work and earn money. Aside from that, your own child can make a terrific employee because you already know and trust them.

There’s an added benefit to this tactic if you plan to help your child pay for college. Legally, your child can put money into an IRA (traditional or Roth) to grow tax-free, and because your child is employed by a parent, they can take out that money penalty free to use for college. This is a big advantage for you and your child.

Considering the $6,200 standard deduction for 2014, let’s look at what would happen if your kid earned $11,200. Zero taxes are paid for the $6,200, and if your child puts the additional $5,000 in a traditional IRA, then zero tax dollars are paid for the entire earnings! That’s right—your kid could nearly double their income and still not pay a single penny in taxes.

The benefits are still impressive even when you pay your child even more throughout the course of the year. Let’s use Ms. Wilson’s example again. If she had paid her child $19,050, she would have received total benefits from state and federal deductions equaling $8,763 (saving 7 percent in state income tax, 14 percent in self-employment tax, and 25 percent in federal income tax). She would keep that money. The child has taxable income only on what’s left after the standard and IRA deductions. The tax would have equaled $1,035, and the child would have kept $18,015 (including what is in the IRA).

You may be wondering, “What about the payroll taxes?” Well, if your business is a sole proprietorship (or partnership owned only by the parents of a child), then payments to a child under 18 are not subject to Social Security or Medicare taxes.[1] Additionally, no unemployment taxes have to be paid by such an entity while the employed child is under 21.[2]

Other Considerations

Perhaps you’ve heard of the kiddie tax, which puts a limit on how much income an underage child can bring home without paying taxes. Don’t worry—it doesn’t apply to this situation. The kiddie tax applies only to net unearned income.[3]

As for age restrictions regarding hiring your child, tax law has none. In fact, in one case that the IRS acquiesced to, a couple hired all three of their children to work at their mobile home park operation.[4] The youngest was 7. What the IRS does care about is that you are paying the children fair wages for services rendered. In this case, it noted that compensation paid to children is only deductible if the amount is reasonable and paid for actual services rendered, and parents may deduct amounts paid to their minor children.[5] That means you’ll have to have documentation proving the wages were fair.

Of course, the IRS will be keeping a closer eye on you to make sure that the child actually is an employee and performing services for the business.[6][7] One way to provide documentation of this is to keep a timesheet for your child’s earned wages. And, here’s an extra tip: don’t try to deduct food and lodging expenses for your child employee. Parents are legally liable for the support and maintenance of their minor children.[8]

Maybe the IRS doesn’t mind, but what about child labor laws? For the most part, parents employing their own children are exempt from child labor laws. According to the Fair Labor Standard Act, parents can have their children under age 16 work for any number hours at any time of day in a business owned solely by the parents.[9] The Department of Labor, however, does have prohibitions about employing children in hazardous jobs.[10] Check their website for a list .

What About Corporations?

The rules for corporations differ, of course. As you saw in the numbers above, if Ms. Wilson had been the owner of a corporation, she would have gotten significantly less in tax benefits. That’s because a corporation is not the mother or father of a child. As a corporation, your business will have to pay unemployment taxes, and the corporation and your child will be responsible for Social Security and Medicare taxes.

If you’re going into business and already have children, you may want to consider the different outcomes of hiring your child when choosing an entity structure. When choosing, keep in mind that hiring your under-18 child for a proprietorship or partnership definitely pays off. But, hiring your under-18 child for an S corporation or C corporation may or may not. It’s important that you run the numbers in those situations.

Ensuring Against Audit

As with any tax strategy, the key to winning your child employee deductions with the IRS is to provide adequate documentation. Here are some tips for providing enough proof:

  • Have an Employer ID—Even if your child is your only employee, you need to get an employer ID number in order to make the employer-employee relationship legitimate. You can do this online or call the IRS at 1-800-826-4933.
  • Track Work with a Time Sheet—Having your child fill out a time sheet is a great way to keep proof of the time they worked and the wages they earned. In one case, Vernon E. Martens hired his four children, but failed to require time sheets and lost out on 80 percent of his deductions.[11]
  • Have Support for Your Pay Scale—If you want to pay your child more than minimum wage, you’ll need documentation supporting the wage. One way to do this is to determine how much it would cost if you hired someone outside the family, and adjust for variables such as skill level and whether it takes your child longer to complete the task than it might take someone else. However, if you’re just paying minimum wage, there’s no need to document your reasoning.
  • Always Use Payroll Checks—Checks maintain a clear trail from your business account to your kid’s checking or savings account. There’s no question left about the amount paid or whether it was paid by the business. When you hire your child, the money you pay is theirs, and you must be able to show that the pay went to a separate account, not one of your own. Also, be sure to check the payment if you use a payroll service; they may mistakenly take out Medicare and FICA, which is unnecessary for a minor.
  • Fill Out Payroll Forms (Both State and Federal)—These are the documents you have to fill out to set up your child as an official employee of your business and properly prove the child’s earnings and any taxes due. The federal forms include IRS Form W-4, IRS Form W-2, IRS Form 941, and IRS Form 940. Even though your minor is exempt from withholding for FICA, Medicare, and unemployment taxes, you’ll still need to turn in those forms. You can find all the forms at the IRS Forms and Instructions page.

Now that you’ve learned all the advantages of hiring your child as an employee for your proprietorship or partnership, it’s time to teach your child the value of money. You’re giving your kid a wonderful opportunity to begin investing early. As mentioned above, your kid can even save up for college with an IRA, which stretches the tax savings even further.

  1. IRC Section 3121(b)(3)(A); Reg. Section 31.3121(b)(3)-1. ↑
  2. IRC Section 3306(c)(5). ↑
  3. IRC Section 1(g). ↑
  4. Eller v Commr., 77 TC 934; Acq. 1984-2 CB 1. ↑
  5. AOD 1985-004. ↑
  6. Gerald W. Jordan v Commr., T.C. Memo. 1991-50. ↑
  7. Denman v Commr., 48 T.C. 439, 450 (196). ↑
  8. Rev. Rul. 73-393. ↑
  9. http://www.dol.gov/elaws/esa/flsa/cl/exemptions.asp ↑
  10. http://www.dol.gov/elaws/esa/flsa/docs/haznonag.asp ↑
  11. Vernon E. Martens v Commr., No. 90-3104, May 91 (4th Cir.). ↑
Categories : Business Expenses, Employ Your Kids, Employees, Payroll, Tax Planning

Why You May Want to Consider Antiques as Business Assets

By Kim M. Larsen EA CTFS
Tuesday, February 17th, 2015

It’s already well-known that antiques can make a wonderful personal asset for collectors. If you know how to choose the right pieces, you can see a nice return on investment from quality antiques. But, have you ever thought of doing the same with your business? Let’s put it this way, if you could choose between two desks for your office, both for the same price, do you go with the regular desk or the antique?

In many cases, the antique could be a better choice. Thanks to newer tax laws, antiques are now assets under Section 179, just like any other standard business equipment. That means you’ll get the same business tax deductions regardless of which desk you choose. So, why opt for the antique? For the same reason you might buy an antique for a personal collection. A regular desk will likely depreciate over the years, but the antique is a money-maker, likely to increase in value. The final difference could be thousands of extra dollars for your business.

Antiques as Smart Choices

Let’s put together an example so you can see just how the numbers work. Both desks cost $5,000 to purchase. In 10 years, the antique desk would be worth $15,000 and the regular desk would be worth $500. For the sake of this example, we’ll say you’re in the 35% income tax bracket and 15% capital gain bracket when you sell the piece of furniture. Here’s what your federal taxes would be on the antique:

  • 15% of the $10,000 in capital gain equals $1,500
  • 35% of the $5,000 in depreciation recapture equals $1,750

That means you’ll keep $11,750 after taxes from the sale of your antique desk. Compare that to only $325 from the sale of the regular desk ($500 from the sale minus 35% in recapture taxes). You can see how choosing antiques for multiple items in your office can quickly increase your business’s gains!

What kind of items could be purchased as antiques?

  • Conference tables
  • Desks
  • Rugs
  • Business car
  • Cabinets
  • Clocks
  • Paperweights
  • Bookcases
  • Coatracks
  • Umbrella stands
  • Chairs

Think of the possibilities! Any antique that functions just as well as a new purchase is a great investment. It could increase in value, and thus increase your net worth. Just don’t try to buy an antique computer!

Many business owners don’t even consider antiques when purchasing equipment. But, why not? When you choose antiques, you usually get a quality piece of furniture that looks beautiful in your office. They still count as depreciable Section 179 assets. And, they could increase in value. Even if a particular antique choice doesn’t increase its value significantly, you’ve lost nothing (as long as you pay reasonable prices).

Cases Regarding Antiques as Business Assets

Several previous court cases have held up the ability to count antiques as business assets. In particular, Liddle[1] and Simon[2] allowed these two professional musicians to depreciate antique and collector violins as business assets. These musicians used the violins in their role with the Philadelphia Orchestra.

The instruments involved in the case were already 300 years old when purchased. They were bought for $30,000 and had increased in value to $60,000 in less than 10 years when the musicians had depreciated them to zero. Regarding this case, the court noted that the Economic Recovery Tax Act of 1981 (ERTA) had changed the rules for depreciation. Prior to ERTA, antiques could not be depreciated in a business, no matter how often they were used for business purposes.

The cases went through the Tax Court, the Second Circuit Court of Appeals, and the Third Circuit Court of Appeals. Thanks to the decisions made in these courts, the musicians (and you) may now depreciate antiques and count them as a Section 179 expense. ERTA set the path for this by changing the useful-life rules to statutory depreciation periods. So, what does all this mean for you? It means you qualify for tax-favored expensing and depreciation when:

  • During the normal course of business, you actually use the antiques (they are not decorative).
  • The antiques are subject to the same wear and tear that any other business asset would be.

Interestingly, the IRS did not agree with the decisions of the courts in the cases of Liddle and Simon. In 1996, they formally issued a non-acquiescence and stated that in the seven other circuits they would go after taxpayers who tried to depreciated antiques.[3] However, to date they have never done this.

The circuit for the above cases covers the areas of Vermont, Connecticut, New York, New Jersey, Pennsylvania, Delaware, and the Virgin Islands. This means that if you work in one of those areas, the IRS cannot attack your antique depreciation because the courts have already made their decisions regarding that circuit.

Further, it is unlikely that the IRS will actually go after you for business antique depreciation no matter where you live. That’s because courts can order the IRS to pay attorney’s fees for bringing a case that is “not substantially justified.” Per IRS Publication 556, that means:[4]

  • The IRS didn’t follow its own published guidance, such as announcements, private letter rulings, revenue rulings, and regulations.
  • The IRS has taken on substantially similar cases in another circuit’s courts of appeal and lost.

Therefore, even if you live outside the Second and Third Circuits, you are unlikely to be hassled by the IRS about depreciation of antiques. Bringing a similar case in other circuits could obligate the IRS to pay attorney fees, and the IRS has not tried since the time of these cases.

When Preparing Your Taxes

Just remember to follow certain rules established during Liddle and Simon. Artwork does not count as a depreciable business asset, as found in the Noyce case.[5] Any antique furniture or equipment you plan to depreciate on your taxes must be physically used as a part of your business and subjected to the wear and tear of ordinary office equipment.

It turns out you actually get a better deal on taxes than the antique dealer who sells you the piece. A dealer gets to deduct the antique’s cost as a cost of sale, but he pays both self-employment taxes and regular income taxes on the profit. A business owner, on the other hand, deducts the cost at the time of purchase with Section 179 expensing rather than having to wait for the sale. Also, because the item is counted as a business asset, when you do sell it the amount of profit that exceeds the purchase price is a Section 1231 gain, which is a tax-favored capital gain as long as you used the antique in your business for more than one year (assuming you have no offset from Section 1231 losses).

All of this sounds pretty good so far, right? Well, here’s some even better news. If you’re kicking yourself for having antiques that you have not deducted in your business because you weren’t aware of the rules, you can claim those benefits on this year’s tax return. You just claim the depreciation retroactively with a Form 3115.

For business antiques you buy this year, you can expense up to $125,000 of qualifying purchases. You get immediate deductions for this. Down the road, when you sell the items, you’ll get tax-favored capital gains benefits on the amount of appreciation. All in all, you come out way ahead, even with the price of recapture taxes on the depreciation. After all, a regular piece of office equipment is worth much less when you’re ready to sell it. It’s clear that antiques are a good financial choice when you need to select furniture or equipment for practical use in your business.

  1. Brian P. Liddle v Commr., No. 94 7733, 76 AFTR2d &95 5327, 3d Cir, September 8, 1995, aff’g 103 T.C. 285, 94 TNT 165 8 (1994). ↑
  2. Richard L. Simon v Commr., No. 94 4237; 76 AFTR2d &95 5496; 95 2, 2nd Cir., October 13, 1995, aff’g 103 T.C. 247, 94 TNT 165 7(1994). ↑
  3. AOD 1996 009, July 15, 1996. ↑
  4. IRS Pub. 556, Examination of Returns, Appeal Rights, and Claims for Refund (Rev. August 2005), p. 10. ↑
  5. Noyce v Commr, 97 T.C. 689. ↑
Categories : Antiques, Business Expenses, Depreciation, Investments, Section 179, Tax Planning
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