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Author Archive for Kim M. Larsen EA CTFS – Page 3

Did You Know Your Car Can Accelerate Your Tax Savings?

By Kim M. Larsen EA CTFS
Sunday, February 8th, 2015

Would you like thousands, or even tens of thousands, more dollars in tax deductions every year? Of course you would! To boost your deductions, you can count on your vehicle to be a deduction generator if you use it to drive from one business location to another. The only thing you have to do is keep the right records in order to prove your business mileage. Your tax records, like your car, require regular maintenance in order to function properly.

The Documentation You Need

We can look at the court case of salesman, Marcus Crawford, for an example of what a difference minor deviances in documentation can make.[1] Crawford spent much of the work day driving to meet customers. He tried to defend is vehicle deductions in an amount greater than $20,000 by providing 1) destination notes on his daily calendar, and 2) saved gas receipts. Although this sounds like decent record keeping, the IRS rejected this documentation and Crawford got none of the deductions. Zero.

Unfortunately for Mr. Crawford, the IRS is pretty strict about documentation for vehicle deductions. Here’s what you actually need in order to qualify:[2]

  1. A mileage log
  2. Receipts that support your mileage log

Crawford’s proof didn’t work because it failed to document the true number of miles spent driving to each location and how the location was related to his business activities. A proper log divides mileage into the appropriate categories:

  • Personal mileage
  • Commuting mileage
  • Business mileage
  • Investment mileage
  • Rental property business mileage

Here’s a hypothetical example:

Note that rental property mileage should be calculated separately from other business mileage. This is so you can determine Section 179 expensing for your vehicle. Additionally, you see that the miles marked for the trip to the grocery store are zero. Why? It’s because the stop was located on the way between two other stops, so it does not generate any additional mileage.[3] Although the grocery trip is a personal stop, you would have had to drive the same distance from one office to the other whether you stopped for groceries or not.

In some cases, it may be more convenient to group the mileage together for multiple stops. This is perfectly fine as long as you document it that way. For example, a real estate professional may make a note indicating multiple stops to show the same client six different properties. These six stops can go together on one line of your mileage log.

Simplifying Your Record-Keeping by Sampling

Writing down every single stop you make every day for the entire year sounds fun, right? Not so much. If tracking your mileage is starting to sound like too much work to even be worth it, keep reading. Per the IRS, you are allowed to track your mileage for only part of the year, and then use that sample to calculate your total business mileage for the rest of the year. You have two options:[4]

  1. Keep a mileage log one week out of every month, or
  2. Keep a mileage log for three consecutive months.

By using the second option, you can log your mileage for one three-month period and then forget about it for the rest of the year. This is the better way to go because the one week a month method increases your risk of missing a month, and when that happens, the IRS no longer accepts your records. It does not accept “almost” with mileage logs.

There is one little catch. If you use the three consecutive months method, those months must be representative of your driving habits for the entire year. For those of you who work in a business with noticeable seasonal fluctuations in your business mileage, you’d better stick to the one week a month strategy.

Supporting Your Log

Okay, so you’ve logged your mileage and labeled its category for either three consecutive months, or one week out of each month for the year. You’re all set, right? Not so fast. The IRS isn’t so trusting that it will just accept the records you’ve individually recorded. So, you’ll have to back up your mileage sheets with evidence from other sources that match your records.

Some documents the IRS may request during an audit include:[5]

  • Inspection slips, repair receipts, and any other records that record your vehicle’s total mileage
  • A copy of your calendar or appointment book that indicates your business activities for the year
  • A copy of your mileage log

Each of these proofs will be cross-referenced with each other to ensure that everything matches up. That means if your gas receipt shows you were in Henderson, NV on a day your mileage log shows you staying in Riverside, CA, you’ve set off a red flag that may cancel your deductions.

What If You Don’t Keep Paper Records

Certainly many business people are switching over to digital record keeping. If you prefer to track mileage on an app, that’s no problem. However, it may be a good idea to keep paper print-outs as backup until you’re certain the app’s records meet the requirements of the IRS. Always keep some kind of backup of your digital records. You never know when a glitch, virus, or hacker may delete all your records, or render your app inactive.

Tracking your vehicle mileage isn’t too difficult once you set up a system for yourself. Remember, you only have to do it for part of the year. The IRS mileage rate for deductions is $0.56 per mile, so with the right documentation, you can claim thousands in deductions just by going about your normal work routine.

  1. Marcus O. Crawford, TC Memo 2014-156. ↑
  2. IRS Publication 463, Travel, Entertainment, Gift, and Car Expenses (2013), Dated Jan. 14, 2014, p. 25-27. ↑
  3. Reg. Section 1.274-5T(c)(6)(i)(C). ↑
  4. Reg. Section 1.274-5T(c)(3)(ii)(A). ↑
  5. Internal Revenue Manual Exhibit 4.13.7-20 — Examination Documentation Requirements Paragraphs – Cont. 6 [09-01-2006]. ↑
Categories : Business Expenses, Cars, Trucks & SUVs, Depreciation, Listed Property, Receipts, Records, Tax Planning

Increase Deductions on Your Vacation Home with a Hidden Tax Technique

By Kim M. Larsen EA CTFS
Sunday, February 8th, 2015

Usually, when you want to research which tax deductions are available to you, you go to the IRS’s publications and tax regulations documents. The IRS can even be pretty helpful at times by letting you know exactly what you need to do in order to get your deductions. However, the technique in this article won’t be found in any of the typical tax literature. In fact, you’d only find it if you’ve been reading up on old court cases or tax treatises.

The Precedent

So, how does this tax tactic help you if it’s not approved in IRS documents? Aside from the typical sources for supporting your deduction strategies, you can also use tax court precedents. In 1981, Dorance and Helen Bolton found their money trapped behind vacation home deduction limits, but they decided to get creative and find a way around those limits.

Because they set this precedent, you can legally use the same technique today, even though the IRS doesn’t publicize it for everyone’s use. In fact, the IRS’s calculation methods for vacation homes are much more stringent. Nevertheless, the IRS is required to allow the method used by the Boltons because the tax court has ruled it a legal tax strategy.

How this Money-Saving Strategy Works

Do you have a second home, a ski cabin or beach house for example, that you both rent out and use for your personal use? If so, you’ve probably found that the vacation home rules cap the deductions allowed for rental expenses.[1] Additionally, for properties that qualify as a “residence” those rules are at their most stringent. Your property is considered a residence for tax purposes if you take advantage of its personal use for the greater of the following two time periods:[2]

  • More than 14 days in a year, or
  • More than 10 percent of the days you rent it at fair rental price during the year.

You see, when your home qualifies as a residence, you have to split your deductions between residence and rental property, and that creates two primary disadvantages for you: 1) your rental expenses are limited to your rental income, and 2) part of your mortgage interest and property tax deductions are considered rental expenses, which—because of the limit in #1—reduces the amount of other rental expenses you are able to deduct.

Now, here’s what the Boltons did to mitigate these disadvantages. They were able to come up with a way to decrease the amount of mortgage interest and property taxes that counted as rental expenses. Let’s take a look at how their method differs from that of the IRS:

  • IRS Method—Count the property’s total use. That means of your tenants rent the property for 75 days and you personally use it for 25, you divide the rental use days by the total number of days, 100. The use percentages divide up as 75 percent rental and 25 percent personal. Assuming your mortgage interest and property taxes come to $10,000, you must count $7,500 (i.e. 75 percent of $10,000) towards the rental expense limit.
  • Bolton Method—Determine percentages for the entire year, not just for days of use. With this calculation, you take that same 75 days of rental use and divide it by 365 days, giving you only 21 percent rental use for the year. Again, given $10,000 in mortgage interest and property taxes, you now take 21 percent of that, getting a rental expense total of only $2,100. The Bolton method leaves you with an additional $5,400 of rental expenses that can be deducted.

To see how the numbers work out after deductions, here’s the Boltons’ case:[3]

  • 91 days of rental use
  • 30 days of personal use
  • 244 unoccupied days
  • $2,700 in gross rental income
  • $3,475 in expenses for mortgage interest and property taxes
  • $2,693 in expenses for rental property maintenance

The Boltons were able to claim an additional $1,738 in deductions. Adjusting for today’s dollars, you can save substantially more than that. This case has been on the books for more than 30 years and remains seldom-used, but the IRS is required by precedent tax law to allow it.[4] Now you know the secret, so start claiming your full rental deductions on your vacation home this year.

  1. IRC Section 280A(e). ↑
  2. IRC Section 280A(c)(5) and (d)(1). ↑
  3. Bolton v Commr., 77 TC 104, aff’d 694 F.2d 556 (9th Cir.). ↑
  4. McKinney v Commr., 732 F.2d 414. ↑
Categories : Investments, Leases, Passive Income & Losses, Real Estate, Rental Properties, Tax Planning, Vacation Homes

Getting the Most from Your Real Estate Options

By Kim M. Larsen EA CTFS
Sunday, February 8th, 2015

Plenty of people will tell you that real estate options are a great way to make money. And, that can be true . . . if you have the right knowledge. By learning how to get the most from options on your real estate investments and rentals, you can increase your profits.

Stand-Alone Purchase Option

One category that can generate profit is the stand-alone purchase option. If you own a property, and someone would like the right to buy that property at a specific price and over a specific time period, this option allows you to receive cash from someone the day you authorize the option. Two things then may happen: 1) the buyer lets the option lapse, and you keep the cash and the property, or 2) the option is exercised, which means you sold your property (and often receive a selling-price bonus).

Here are some of the primary financial reasons people have for leasing their property with the option to buy:

  • Increase profits by fixing a higher rent price (typically applying some of this to the option amount).
  • Increase profits by requiring up-front cash for the option.
  • Protect your real estate by having a tenant who takes better care of the property (because it may eventually be theirs if they use the option).
  • Reduce costs by requiring the tenant to maintain the property and take responsibility for repair work.

Of course, if you are on the other side of the transaction and are buying the option, then you’ll want to arrange some kind of reward for yourself should you use the option. Often, people like to structure these options so that they get a better price on the property because they exercised the option (this is the most desirable outcome for the buyer).

Whether you’re buying or selling, options look pretty straightforward, but circumstances can complicate matters. Some options are structured to require that they be exercised. However, if you enter into such an option, it is viewed as a sales contract under tax law. If, for example, the rent for an option is so high that it forces a tenant to buy, tax law ignores the option, and your contract ends up as a sales contract as far as tax purposes are concerned. It turns out options are not as simple as they appear; varying scenarios can butt up against tax and legal obstacles.

In fact, even a lease without the option to buy can end up being viewed as a sale under tax law. How does this happen? If the tenant takes on the majority of rights, responsibilities, and enjoyment to the extent that they act as the owner of the property, the IRS ignores the lease.

Needless to say, it can come as quite a surprise when the IRS decides your lease is to be considered a sale. So, this article aims to provide some practical advice for securing your after-tax profits and navigating the additional rules associated with leases.

Keeping Control of Your Finances

Your after-tax financial results will depend upon how well you understand the rules regarding when a lease with an option to buy turns into a sale. The rules fall into three categories: 1) commercial real property, 2) personal property, and 3) a house or apartment used as the primary residence by the tenant.

By structuring your rent-to-own agreements so that they comply with tax law, you can avoid unpleasant legalities. These legal situations can result in additional consequences, such as negative articles on the front page of national newspapers, an attorney general investigation if you’re under Florida jurisdiction, or corrective legislation in a Texas jurisdiction.

Now that you have an idea of why you need to handle your options correctly, let’s look at a hypothetical scenario. You have a tenant who buys an option from you for $10,000 that allows her to buy your rental property for $300,000 at any point within the next 15 months. The tenant can do one of two things. She could exercise her option, in which case you treat the $10,000 as sales proceeds on the day the purchase option is used.[1] Or, she could choose not to use the purchase option, and you receive normal income from the $10,000 on the day the option lapses.[2]

Regardless of what your tenant decides, you get a good deal for several reasons:

  • You receive up-front payment for the option.
  • You can use the cash from purchase of the option on the day you receive it because it’s yours no matter which decision the tenant eventually makes.
  • You have no income taxes to pay for this money until the option lapses or is used.

As for your tenant, if she decides to exercise the option, the $10,000 acts as additional basis in the property for her. The lapse of the option depends on the nature of the property. If she intends to use it as a rental unit, the same rules apply that would apply to a loss on the sale of rental property.[3]

Given our hypothetical 15-month holding period, your tenant’s loss would be under Section 1231 (which applies only to long-term gains and losses). This is great for her because Section 1231 allows for:

  • Net section 1231 gains are tax-favored long-term capital gains, and
  • Net Section 1231 losses to be deducted as tax-favored ordinary losses.

However, if the tenant wanted to purchase the rental unit as a personal residence, she would not get the deduction for the option’s lapsing. That’s because a lapsed option for personal property generates a personal loss, which is not deductible.[4] So, options aren’t too difficult to figure out, but they can produce vastly different results under different circumstances.

Options that are Actually Conditional Sales

An option gives the purchaser the right to exercise a property purchase at terms and price that are determined at the start.[5] Some options, however, are actually masked sales. Obviously, any option that is exercised becomes a sale. But, if the option turns into a sale before it is exercised, then it is a sales contract rather than an option.

Here are a few examples that are not options:

  • Nonrefundable deposits—these do not specify terms for a continuing offer for a particular time period
  • High option prices that force the use of the option—the force makes it a sale from its beginning
  • Incidents of ownership and actions that convey possession imply a sale

You may have noticed that some of these are judged by the particular circumstances. For instance, what is considered a price that’s high enough to force a sale is somewhat subjective and depends upon the property and the parties involved. Because of this, issues of what is a sale or what is an option can be complicated. To add to the matter, an option that includes a lease gets even trickier.

In fact, sometimes the lease itself is considered a sale rather than a lease. That means you can really end up with results far different from what you intended when you combine a lease with an option, and either or both of them could end up actually being sales.

When it comes to taxes, a whole system of rules is in place to determine whether a lease is a lease or a sale. Here’s an example. Some public companies will use synthetic leases in order to make their profits look better to investors. These synthetic leases are reported as leases in their financial statements, but reported as purchases in their tax return. Because this strategy makes their profits look better, it increases the performance of the company’s stock. Because the tax return shows a purchase, the company can also depreciate the deductions.

Another example of a lease that’s considered a sale on taxes is a dealer’s rent-to-own program. One such contract’s status as a sale was determined in IRS private letter ruling 9338002. The IRS’s reasoning is that the lease-with-option-to-buy compels customers to make each of the monthly payments so they can own the item. Additionally, payments in such cases are usually high enough that customers pay market value for the item early on, at which point it makes no sense for them not to continue paying until they own the item. In fact, the IRS ruling states that such contracts produce substantially more revenue than if customers bought the item outright.

According to the IRS, the dealer does not have a true lease for tax purposes because:

  • The customer is effectively required to make a purchase by agreeing to the contract,
  • The rental payments end up far exceeding the amount necessary to transfer the title, and
  • The option price is zero, which contributes nothing towards the item’s fair value when the option is exercised (completion of payments).

The same set of criteria are used when judging real property leases.[6] First of all, the IRS defines three parties in a leveraged lease—the lessor, the lessee, and the lender to the lessor. The IRS will look at the following criteria to determine whether a lease is really a lease:[7]

  • The landlord (lessor) is at least 20 percent invested in the property;
  • The renter (lessee) cannot purchase the property for less than fair market value when the option is used; and
  • The lessee cannot have paid for property modifications, improvements, or additions.

Sometimes these criteria are out of your control. For example, it’s possible that after agreeing to an option, your property dramatically increases in value. That means that when the option is exercised, it will no longer reflect the fair market value, and does not meet the second criterion above. You should also watch out for vacation home tax rules, which you can run into when renting out a property, and are quite different from the tax laws for options.[8]

The purpose of setting up a lease with the option to buy is for you, as the current property owner, to make more money and ensure that your real estate is well care for by the tenant. In order to gain the financial benefits, you’ll need to understand the tax laws surrounding options. So, for your convenience, here’s a bit of advice for meeting the six standards in Revenue Ruling 55-540 and those in Revenue Procedure 2001-28:

  • Don’t apply the tenant’s rent to lessee equity.
  • Don’t give the property title to the lessee in exchange for a certain amount of rents or payments made.
  • If the option is relatively short, don’t make the payments a large portion of the total price to be paid.
  • Don’t allow rent prices to exceed fair market value substantially.
  • Don’t put add an interest equivalent to the rent due.
  • Have at least 20 percent invested in the property.
  • Require the option exercise price to be at least fair market value.
  • Don’t allow the lessee to make property modifications, improvements, or additions.

Take the right precautions, and you’re more likely for an IRS judgment to go the way you planned.

  1. IRC Section 1234(a)(1). ↑
  2. Reg. Section 1.1234-1(b). ↑
  3. Reg. Section 1.1234-1(a)(1). ↑
  4. Reg. Sections 1.1234-1(f); 1.1234-1(g) Example (2). ↑
  5. Black’s Law Dictionary, sixth edition, p. 1094. ↑
  6. Revenue Ruling 55-540 ↑
  7. Revenue procedure 2001-28 ↑
  8. IRC Section 280A(d)(2). ↑
Categories : Investments, Land, Leases, Real Estate, Tax Planning

Is a Home Office Worth Having? It is If You Want to Save on Taxes for Your S Corporation!

By Kim M. Larsen EA CTFS
Sunday, February 8th, 2015

Operating your single-owner business as an S corporation has a variety of tax advantages. One way to ensure your tax advantages is to have your company reimburse you for the costs of keeping a home office. This tax savings strategy enables you to:

  • Convert the mileage from your commute into business mileage, thus increasing your vehicle deductions;
  • Consider a portion of your home expenses to be business expenses; and
  • Avoid home office audit risks on your tax return.

And, here’s even more good news when you employ this strategy—you never pay back those tax savings, even when you sell your house. Of course, in order to reap these benefits, you will have to make sure you follow the proper procedures (including documentation) regarding the office in your home. Many of these apply even if you operate your business under an entity structure other than S corporation.

Getting Reimbursed for Your Office

By tax law, S corporation owners are able to make deductions on home office expenses, and there’s more than one way you can go about doing so. However, the best way is to have your corporation reimburse you for the employee-business expenses you incur from having an office at your home.[1]

Let’s just look at the basics for a moment. When you create an office in your home, you have switched a portion of your house to business use from personal use. So, on your taxes, part of your home is considered a business asset. If, as an example, you used 1/3 of your house for office space, then 1/3 would be a business asset and 2/3 would be a personal asset.

Office Location Makes a Difference

Did you know that where you locate the office in your home can make a big difference on your tax savings? In fact, in the right location, your office is eligible for a $250,000/$500,000 home profit exclusion from taxes. This exclusion applies when you eventually sell your home. That’s right—how you locate your office now can affect tax savings at the time of sale. Specifically, you get a break on taxes for up to $250,000 (filing singly) or $500,000 (filing jointly) of profits on the sale of your personal residence.[2]

What does the business portion of your home have to do with this? Well, you generally have two possible scenarios:[3]

  1. The office is inside the walls of your home. If this is the case, you’re in a good position because the home sale profit exclusion applies to both the business and personal portions of your residence. The only exception to this is depreciation recapture (which will be further explained).
  2. The office is outside the walls of your home. An example of this would be an office located in a detached garage, guest house, or some other separate structure. In this situation, you’ll need to do a little more planning in order to get the best possible result. The tax exclusion will only apply to the residential part of your property. The sale of the business part will generate taxable business gains, as well as recapture on depreciation. However, as you’ll see discussed below, you can use a Section 1031 exchange to get out of those taxes.

Anytime you sell a house, you have a recapture tax for the depreciation you claimed. Regardless of the location of your home office, the home sale profit exclusion does not get rid of the recapture.[4] Before you start to feel gloomy about this, know that depreciation still gives you an advantage, even with the recapture tax, and here’s why:

  • You defer this payment until the year of sale, and
  • It’s possible for your depreciation deduction to be greater than (up to 36.9 percent rates) your recapture tax rate (up to 25 percent).[5]

Of course, it would be even better to just get rid of that recapture tax all together, wouldn’t it? Well, you can.

Making a 1031 Exchange

For any business gain you have left that is not covered by the profit exclusion you can make a like-kind, Section 1031 exchange. In fact, the IRS has provided guidance specifically on how to combine the home sale profit exclusion with the 1031 exchange for selling a house with an office.[6] Section 1031 will not dispose of your tax. What it does instead is defers it. But, here’s the really nifty bit, you can keep on making 1031 exchanges with every home sale and deferring that payment for the rest of your life. Then, the home goes up to fair market value and your taxable gains disappear.

The most important thing you need to know about making the 1031 exchange is that you must hire a professional intermediary to handle the monetary exchange. Don’t worry—you’ll spend less on an intermediary than what you would have paid in taxes, and a professional will ensure that you go through the process correctly.

Here’s how Section 1031 works when your office is inside your home (this example comes from the IRS):[7]

  1. You bought your home for $210,000 and split it into 1/3 business use and 2/3 personal use.
  2. Because you split the basis between business and personal, you have a business use basis of $70,000 and a personal use basis of $140,000.
  3. With a $30,000 depreciation for your office, that leaves a business use basis of $40,000 (reduced from $70,000).
  4. When you sell your home, it will split into a business portion and a personal portion. So, if you sell the house for $360,000, then you have sale prices of $120,000 for the business part and $240,000 for the personal part.
  5. You qualify for the full $250,000 Section 121 exclusion (single filing).
  6. Determine the gain on both parts of the home. In this example it’s $80,000 for business ($120,000 – $40,000) and $100,000 for personal ($240,000 – $140,000).
  7. Apply the profit exclusion to both parts (personal first). Don’t include recapture. Applying the $250,000 exclusion to your $100,000 personal gain gives you zero taxable gains, and you are left with $150,000 of profit exclusion. This remainder is applied to the business portion, except for your $30,000 of depreciation recapture.
  8. Finally, you defer the $30,000 using a Section 1031 exchange to acquire a new house with a new home office and watch the taxes disappear!

And, what about when your office is in a structure outside of the main residence? The example above changes a little bit. Here’s how it all works out:

  1. Determine the gain on both parts of the home. This is done in exactly the same way as it’s calculated in steps 1-6 above.
  2. Apply the profit exclusion to both parts of your residence. This step, however, is different from above. In this case, the exclusion does not apply to the business portion, which is located outside the walls of your home. You still get $0 in personal gain, but business gains will come to $50,000 capital gains and $30,000 depreciation recapture (determined by the $80,000 in business gains calculated above).
  3. Here’s the good news. You can still use a 1031 exchange to defer both the $50,000 in capital gains and the $30,000 in depreciation recapture.

It’s pretty clear that converting part of your home into an office for your S corporation makes good financial sense. If you don’t have an appropriate space inside your home, you can make an office in a detached structure. The math works out a bit differently, but you can still save big on taxes when you plan correctly.

  1. Reg. Section 1.62-2(d)(1). ↑
  2. IRC Section 121. ↑
  3. Reg. Sections 1.121-1(e)(1) and 1.121-1(e)(4) example 5. ↑
  4. IRC Section 121(d)(6). ↑
  5. IRC Section 1(h)(1)(E). ↑
  6. Rev. Proc. 2005-14. ↑
  7. Example 3 from Rev. Proc. 2005-14. ↑
Categories : Business Expenses, Home Office, Tax Planning

Qualifying for Your Home Office Deduction—Simplified

By Kim M. Larsen EA CTFS
Sunday, February 8th, 2015

You may know which expenses qualify for home office deductions, but are you savvy about the requirements for your office qualifying to take these deductions in the first place? In order to make home office deductions, your office must pass the “regular use” test. It’s just what it sounds like—a determination of whether you regularly do business from the office in your home.

What the IRS Says

The IRS states in its audit manual, “Regular use means that you use the exclusive business area on a continuing basis. The occasional or incidental business use of an area in your home does not meet the regular use test even if that part of your home is used for no other purpose.”[1] Obviously, setting up an area exclusive to your business, filling it with files, and never going in there will not cut it, but this definition does little to pinpoint exactly what does count.

According to the IRS, they consider your individual facts and circumstances when determining regular use.[2] Great, but that leaves things pretty vague when you’re trying to plan for your tax return. So, instead, we’ll take a look at court precedents to get a better idea of what exactly you need to do to get your deduction.

  • The Frankel Case—Max Frankel was the editor of The New York Times. In his case, he claimed that he used his home office to communicate by phone with prominent politicians at all levels of government, as well as community leaders and labor leaders. Records indicated that Frankel averaged a call per night, and Frankel stated that it may have taken several calls to complete a single discussion. The U.S. Tax Court decided in his favor, stating that the frequency was enough to qualify Frankel’s home office for regular use.[3]
  • The Green Case—Because of the circumstances of his work, and because many of his clients were unable to make calls during daytime hours, John Green took a large number of client phone calls at home after his regular work hours. This was a required condition of his employment. The calls averaged 2 ¼ hours per night, five nights per week. Again, the Tax Court decided the frequency met regular use requirements for a home office.[4]

Like any tax strategy, passing the regular use test requires one important item—sufficient evidence. Another court case, involving Anthony Cristo, illustrates this need. The court stated:[5]

“We do not suggest that the frequency or regularity of meetings or dealings must match the level we faced in Green in order to meet the requirements for regular use. However, in this case we have so little information that we cannot tell whether the facts, if we knew them, would satisfy any reasonable interpretation of regular use.”

What does this mean for you? It means that no matter how good a claim you have to regular use of the office in your home, you will lose out on those deductions if you can’t prove it with substantial evidence. The truth is you only need two pieces of evidence in order to prove regular use:

  1. A log recording how you spent your time, and
  2. Documents that support your log of time spent.

Your log can be as simple as keeping an appointment notebook or printed sheets from a calendar application. Note your schedule, including phone calls, meetings, opening mail/responding to business email, and any other business activities you complete at your home office. Next, you need something to corroborate with the log.

  • You say you responded to emails on this day at a certain time? Keep your sent emails. They’re time and date-stamped and prove that you were indeed responding to email.
  • You claim to have met a client at your home? You could keep a guest log and have the client sign in. Or, you could provide email correspondence of your client’s agreement to meet at that time.
  • You devoted 2 hours each evening to making and taking phone calls? This one is easy to prove. You simply need to provide your phone bill as documentation. Make sure you get a detailed copy.

Sure, keeping records is a pain in the butt. Just set up a routine now and stick with it. You can make it even easier by creating a checklist for yourself. Every day, go through the checklist and make sure you took care of logging and documenting your hours, that way you won’t forget anything. Once it becomes part of your routine, you’ll see that keeping emails or having people sign a guest log really isn’t all that hard—and your deductions may hinge upon it.

A Checklist to Get You Started

What do you need to do to comply with the IRS regular use rules?

  1. Use your home office more than 10 hours per week on average (this is a subjective number because the IRS has never given a specific amount of time required, but 10 hours seems to be a safe bet based on past cases).
  2. Build proof indicating that you actually did work for those 10 hours or more.

That’s it. It shouldn’t be too hard to find business activities you can do from your home office for just a couple of hours per day/night. This article already gives you a few easy ideas, as well as simple ways to document them. Start keeping good records now, and taking care of any tax issues that arise will be no problem.

  1. Internal Revenue Manual Exhibit 4.10.10-3 — Standard Explanation Paragraph 4814 Test for Home Office (Last Revised: 01-11-2011). ↑
  2. Prop. Reg. Section 1.280A-2(h). ↑
  3. Max Frankel v Commr., 82 TC 318. ↑
  4. John W. Green v Commr., 78 TC 428; Rev on another issue, 52 AFTR 2d 83-5130, 707 F2d 404 (CA9, 5/31/1983). ↑
  5. Anthony B. Cristo v Commr., TC Memo 1982-514. ↑
Categories : Business Expenses, Home Office, Receipts, Records, Tax Planning

Considering a Historic Building for Your Business? These Tax Credits are Good News

By Kim M. Larsen EA CTFS
Sunday, February 8th, 2015

Historic buildings make a beautiful location for doing business. Unfortunately, many of them may seem out of the price range of small business owners. But, that’s not necessarily the case. The state and federal governments have an interest in preserving these properties, and they are willing to give you tax credits for buying and restoring a historic building. The credits reimburse a large proportion of your restoration costs.

This really is a great incentive to go for a building that will give your company a unique and professional feel. You see, unlike deductions, tax credits reduce your taxes dollar-for-dollar. For example, when you spend $20,000 and get a 50 percent tax credit, you save $10,000 on your tax bill. It’s that simple. It depends which state you live in, but tax credits could save you up to 70 percent on the restoration costs, making a historic building a much more reasonable option.

Federal and State Credits

You have two separate tax credit options available to you from the federal government.[1] The first is a 20 percent credit for rehabilitating an income-producing building that has been deemed a certified historic structure by the Secretary of Interior, through the National Park Service. The other is for rehabilitating non-historic buildings that were put into service prior to 1936, and the credit is for 10 percent of the rehab cost.

You can also get an additional credit from most states, and it’s perfectly legal to take advantage of both the state and federal credits. Tax credits at the state level can be anywhere from 0 to 50 percent. You can check the laws for your state at the National Trust for Historic Preservation . If you’re fortunate enough to live in a state that provides a 50 percent credit, you’ll get up to 70 percent off the rehab costs when combined with the federal credit.

Other Credits

A few other credits also exist that may help you with the purchase of a building. Here a few you might consider:

  • If you’re buying in a low-income area, you could qualify for the new markets tax credit for loans and investments in such locales.[2]
  • The low-income housing tax credit is available for real estate investments in affordable housing.[3]
  • Another option is available that is not a credit but is still a good option to keep in mind regarding your business property. You can donate your historic building to a qualified 501(c)(3) organization.

Making Sure You Qualify

In order to get the tax credits for your historic building, you must use it for the purpose of producing income. Some qualifying examples include:

  • Apartments
  • Single-family rentals
  • Industrial buildings
  • Commercial buildings
  • Agricultural buildings

Although some forms of residential real estate are included in the list, you may not claim the historic tax credit for your personal home. However, if you own a property that you use for both your home and an office space or rental unit, it’s possible for you to qualify on just the part of the building you don’t use for your residence.

Important tip: If you don’t plan on keeping the property for more than five years, you will have to repay some of the federal tax credit at the time of sale. This is because the federal government has a five year recapture period for this purpose. On the other hand, if you do keep the property for more than five years, you don’t pay any recapture and benefit from 100 percent of the building’s increased value.[4]

You’ll also need to check the recapture rules for your state, which are separate from the federal recapture period.

Additional Guidance

Now know just how substantial the available historic tax credits are, but you’ll also need some advice on how to get the whole process started:

  1. Use the National Park Service website to search for historic places.
  2. Find contact information for the historic preservation office in your state. They’ll be able to help you with state-specific information throughout the process.
  3. Look for an architect with experience in historic preservation. This is not only important to maintaining your building, but also to your taxes. That’s because the Secretary of Interior has to certify your historic restoration as authentic.[5] Here are some of the regulations:[6]
  • Justification for window removal
  • Justification for alterations to the storefront
  • Ensuring that replacement sash matches with the original size, color, trim details, pane configuration, and reflective qualities (you can see that the requirements are pretty specific)
  1. Make sure you know the specifics for the tax credits available to you in your area. Before you make a purchase, you should consult your tax advisor and the state preservation office.
  2. This should go without saying, but just so we’re clear, be certain that you will make a profit. Calculate the numbers with the after-tax adjusted rate-of-return formula. This is also called the managed internal rate of return (MIRR).

What Do the Credits Cover?

Basically, any costs that are part of renovation, restoration, rehab, or reconstruction of a historic building qualify for tax credits, and a variety of business structures are eligible, including S corporations, partnerships, personal service corporations, closely held corporations, and individuals. The lessee of a historic building also qualifies for credits on the expenses for renovating or rehabilitating a qualifying building. Expenses that do not qualify include:

  • Costs for acquiring the building[7]
  • The price of the land or other features like sidewalks, landscaping, or parking lots[8]
  • New construction[9]
  • Personal property[10]
  • Expanding the volume of the building[11]

There is a caveat that could prevent you from gaining the full benefit of these tax credits if you’re a high income earner—the AMT (alternative minimum tax). The AMT is calculated separately from your regular taxes and works to eliminate some of the deductions you would normally be entitled to. At tax return time, you’ll pay either the AMT or regular taxes, whichever is higher.

Because the highest earners often have the most deductions, the AMT was created as a way to cap that lost tax revenue. You can’t use the historic renovation credit if you’re paying the AMT in a particular year, but you may carry the denied credits back one year and forward 20 years.[12] Just keep track of your credits and rehab expenses, and don’t forget to claim the benefit in a year when you don’t pay the AMT.

It’s important to make sure you check all the details with your tax advisor and document your strategy. If you’re going to go to the work and expense of renovating a historic building for your business, you want to make sure you get the tax advantage you’re expecting. Otherwise, you can find your business with a heavy and unexpected financial burden. With the right plan in place, a renovated building can establish your business as being committed to the local community, its culture, and its history.

  1. IRC Section 47. ↑
  2. IRC Section 45B. ↑
  3. IRC Section 42. ↑
  4. IRC Section 50(a). ↑
  5. IRC Section 47(c)(2)(C). ↑
  6. Federal Taxes Affecting Real Estate (6th Edition), Thom V. Glynn, Esq., Release No. 33, May 2005, Section 5.03[4][b]. ↑
  7. Reg. Section 1.48-12(c)(9). ↑
  8. Reg. Section 1.48-12(c)(5). ↑
  9. Reg. Section 1.48-12(b)(2)(iv). ↑
  10. IRC Section 47(c)(2). ↑
  11. Reg. Section 1.48-12(c)(10). ↑
  12. Tax Aspects of Historic Preservation, Mark Primoli, IRS, October 2000, p. 11. ↑
Categories : Business Expenses, Investments, Tax Planning

Make Your Records Rock Solid to Avoid Audit

By Kim M. Larsen EA CTFS
Sunday, February 8th, 2015

This article isn’t about any particular way to save money on your taxes. However, it will make a huge difference in your taxes no matter what strategy you use for your tax return. Even the absolute best tax methods can leave you at the mercy of an auditor when you don’t properly document and keep records. Sure, you may think it’s a hassle, but is putting in a few hours up-front on an organized record-keeping system worth thousands, even tens of thousands, of dollars in tax savings? You bet!

The Rules of Record Keeping

Here’s the fact—the IRS is never just going to take your word for it that you spent X number of dollars on justifiable and legal business expenses that are now tax-deductible on your return. Sorry, no documentation, no deduction.

So, with that in mind, here’s the first rule you need to know.

Rule #1 Always keep your accounts separate. In fact, you should have separate checking accounts for:

  • Each spouse,
  • Each corporation,
  • Each Schedule C business you report, and
  • Your rental properties (you may even want a few separate accounts for these if they are very different kinds of rentals).

How about an example of why this is so important. Let’s say you own a sole proprietorship, and you cover your spouse under a Section 105 medical reimbursement plan. If you’re using one checking account jointly for your household and your business, you would have to write the reimbursement check to yourself—and that negates your Section 105 plan.

That’s exactly how Darwin Albers lost out on deductions for his 105 plan.[1] Keep your business and personal accounts separate—just do it.

Rule #2 Earnings go to the account belonging to the business that earns the money. Do not take payments in your personal name. If you do, they cannot be assigned to your corporation. The person or entity that earns any given income is taxed for said income.[2] If you follow the rule above, then it’s easy not to mix personal receipts into your business account and vice versa. Although it’s possible to argue with the IRS that some receipts in a given account are not taxable, it’s not worth the frustration and wasted time.

Rule #3 Keep track of your deductible expenses each day. Don’t wait until two weeks from the purchase to write down your expenses (or save them in your file). For one thing, it increases the chance that you may miss something. For another, the IRS requires that deductible expenses are recorded within one week. The idea of doing daily record keeping may make you want to just toss your files over your shoulder (don’t—you’ll hate reorganizing them up later), but it really is good practice. After all, how hard is it to save a receipt and make a note about why you spent the amount?

Rule #4 Keep a log for each set of expenses. For most deductions, you need evidence that proves your business use or business purpose for the expense. Want to deduct vehicle expenses? Keep a log to track daily mileage. Want to deductions on your rental properties? You’d better keep track of how you materially participate in your real estate or how you qualify for status as a real estate professional. Planning to make deductions for your home office? Again, you need a log, this time to keep track of how many hours you spend working in that office. You’ll have to consistently spend more than 10 hours per week working from your home office in order to claim it on your tax return.[3] By keeping track on a daily basis, you can take advantage of the sampling method of calculating your deductions in some cases (such as vehicle mileage); this method allows you to take a sample from a three month period rather than calculating the exact sums.[4]

Rule #5 Keep track of travel and entertainment costs. For travel expenses, you have to prove (with documentation) where you were each day and why. Your business entertainment costs also need proper documentation, including what you spent money on, how much, when, and where the expense occurred. Your receipt will cover all of those, but you’ll additionally need to note who you entertained and why (i.e. the benefit to your business).

In the case that you operate your business as a corporation, you’ll have to turn the expenses in to your company. You can do this by paying with a corporate credit card, or you can have the corporation reimburse you for the expenses. Making sure the company pays is important; otherwise you’ll only get employee-business deductions for those expenses.

What to Remember

No matter what kind of business costs you incur, you need to remember these two primary pieces of information: 1) prove what you bought and 2) prove that you, in fact, paid for it. As mentioned above, a receipt or paid invoice covers the first part of this. In order to prove payment, you can use a credit card receipt or statement, canceled check, or bank statement (for electronic transfers). Note: An item is considered paid for when you charge it to your credit card, regardless of when you pay the amount to your card.[5]

Don’t pay with cash. It makes things more difficult for you. If you pay with cash, an auditor will want to know where the cash came from, how you can show cash trail and tie it to the payment, whether you can prove an ATM withdrawal, and most importantly, did you really pay for something in cash or are you just making up a deduction? Paying with pretty much any other method is much less of a hassle.

A Note on Petty Cash

Petty cash works for some small businesses. If it’s what you’re accustomed to and you haven’t had any problems, then by all means continue using the system. However, many small business owners end up kicking themselves in the pants with a petty cash system. You’ll likely find it easier to use a reimbursement system.

With the reimbursement system, your company simply writes you a check for the expense when you provide documentation for it (a receipt or expense report, for instance). Because you have to present documentation for reimbursement, you’re less likely to get caught without evidence for your spending, as you could with petty cash.

Statutes of Limitations and How Long to Keep Records

The IRS has statutes of limitations on when either you or it can make changes to a tax return (this is not just the period during which they can audit you). Here are the time frames given in IRS publications:[6]

  • No limit if you did not file a return
  • No limit if you filed a fraudulent return
  • Three years after filing if you filed on time (or with extensions), you did not understate your income by 25 percent or greater, and you did not file fraudulently
  • Six years after filing if you filed on time (or with extensions) but you understated your income by greater than 25 percent
  • If you filed an amended return or already made changes to the original return (like a quick refund claim), either three years after filing or two years after paying the tax
  • Seven years from filing for a claim filed for a bad-debt deduction or loss from worthless securities

If you have employees, you need to save your employment tax records for four years after whichever date comes later, the date payroll taxes were paid or the date they were due.

Because these statutes of limitations also indicate how long the IRS can audit your return, you need to ensure that you hang on to all of your records until the risk of audit has passed. This could mean keeping records for a period of multiple years. In the case of assets, like office equipment and office buildings, the records are relevant throughout the asset’s entire depreciable class life. As long as you are still depreciating an asset, it will be in that year’s tax return. When using Section 179 to expense an asset, you also have a potential recapture throughout the depreciable class life.

Here’s an example. You buy a desk for $1,500 and depreciate it over the MACRS life of seven years. This depreciation actually takes eight years, so you need the original purchase receipt in year eight in order to prove your deduction. Additionally, you will need to retain that purchase record for three years after that when the statute of limitations expires (for a total of eleven years). It works the same with Section 179, except that you also have recapture exposure during those eight years of depreciation.

Would you like an easy way to keep track of this? Just make a permanent file for any assets with a life greater than one year. This way, you don’t need to keep track of class lives or time frames on the statutes of limitations.

And, here’s another quick tip for keeping those records organized:

Simplify your file system by devoting separate drawers for each tax year. In those drawers, you’ll put any information on assets, income, and other information applicable to your return. This method is for assets other than those you keep in your permanent file. The first drawer will be where you put all documents as you acquire them throughout the year. The next drawer is last year’s tax documents. The drawer after that contains documents from three years ago, and so on until you reach the year at which your statute of limitations expires. Each year, you move the drawers down one level and dump the one at the bottom of the line. You can also use this method for any employee tax files.

You see? It really isn’t all that difficult to keep your records straight. You’ll be thankful you did when it comes time to prepare your return.

  1. Darwin J. Albers v Commr., TC Memo 2007-144. ↑
  2. United States v Basye, 410 U.S. 441, 449, 451 (1973); Lucas v Earl, 281 U.S. 111 (1930). ↑
  3. John W. and Regina R. Z. Green v Commr., 78 TC 428 (1982), reversed on other grounds, 707 F2d 404 (CA9, 1983). ↑
  4. IRS Reg. Section 1.274-5T(c)(3)(ii)(C), Example 1. ↑
  5. E.g., Rev. Rul. 78-38; Rev. Rul. 78-39. ↑
  6. IRS Pub., 583, Starting a Business and Keeping Records (Rev. January 2007), Record Keeping. ↑
Categories : Audits, Business Expenses, Cars, Trucks & SUVs, Depreciation, Entertainment, Receipts, Records, Tax Planning, Travel

How to Reduce Your Taxes with a Win-Win IRA Strategy

By Kim M. Larsen EA CTFS
Tuesday, February 3rd, 2015

You know the deal with a traditional IRA. You put your tax-deferred money in and breathe a sigh that you didn’t pay taxes on that income. However, looming over your shoulder is the knowledge that eventually, you will pay big for the withdrawal of those funds. Is there anything you can do to minimize the impact?

Yes. The best thing to do is not to put off planning your IRA tax strategy and do something now to reduce your future tax burden. Instead, start paying something now. Why? You should do this because certain years are better than others for paying extra tax. You see, certain circumstances allow you to have additional taxable income but not actually pay any more in taxes. Here are some scenarios:

  • You can offset your income with losses;
  • You fall into a lower tax bracket than usual this year because of less income from other sources;
  • The current year’s tax rates are lower overall; or
  • Some of your investments lose value, such as in a downturn in the stock market.

You may think it would be hard to know when these scenarios will pop up. Fortunately, tax law itself gives you some assistance in making the most of these opportunities.

Switching between Traditional and Roth IRAs

As mentioned above, both your contributions and earnings are taxed when you withdraw cash from your IRA. Make those withdrawals when you’re in a high tax bracket, and you could be eating up your retirement savings pretty quickly. This is especially applicable if you choose to continue working after you reach retirement age. Your work income makes it more likely that you’ll be in a higher bracket. Additionally, once you reach 70 ½ you’re required to take mandatory distributions from your traditional IRA.

Unlike a traditional IRA, you pay taxes up-front with a Roth IRA. Because of this, you can convert from traditional to Roth in order to pay taxes at the most opportune time for you. Here’s the basic information you need:

  • When you convert to the Roth IRA, you will pay taxes, so make the conversion in a year when you plan to have a lower tax bill.
  • After converting, your earnings will continue to accrue and compound tax-free within the Roth IRA.
  • You can undo the conversion (or just a part of the conversion) up until October 15 of the next year, allowing you to make a strategy for how much tax to pay in that year.
  • Since you’ve already paid taxes upon conversion to the Roth IRA, you can withdraw money from it without paying any taxes again, as long as you’re at least 59 ½. This includes on the earnings you make. You will have to wait five years from your first Roth IRA contribution (for any Roth IRA in your name) to take advantage of this.[1]

So, let’s say you expect to claim a $20,000 loss on your federal income tax return this year. From your traditional IRA, you transfer $20,000 to a Roth IRA. What happens next? First, you get a tax deduction for the amount you put into the traditional IRA. Then, you pay no taxes on the transfer to a Roth IRA. Finally, once you’re 59 ½ you pay no taxes when you withdraw the money from the Roth account (again, as long as it’s been at least five years since your first ever Roth contribution).

Now, here’s the part that really reduces your risk from this strategy. You are allowed to undo the Roth conversion![2] For instance, you may have transferred funds from a traditional IRA to a Roth account because your business had been slow and you expected a low tax year (the perfect time to pay IRA taxes). However, after the conversion, it’s possible that your business takes off and your income increases.

In this case, the increased income could put you in a higher tax bracket and make it less beneficial to pay those taxes now. No problem. The IRS will allow you to undo the conversion. They also call this “recharacterizing” the conversion. Simply put, it’s like you never transferred funds to a Roth IRA in the first place. If you find yourself in this situation, just make sure you keep an eye on deadlines—you have until your next tax return is due to undo the change.

Hint: You can give yourself some time to decide whether you need to recharacterize the conversion by applying for a filing extension on your tax return. You’ll then have until October 15. Just as you can undo a conversion, you can also redo it when the time is right, but you’ll have to wait until the later of 1) 30 days after the initial recharacterization or 2) the start of the next year after conversion.[3]

Other Factors to Consider

There is another reason, aside from increased income, why you may want to undo an IRA conversion. You could experience a decline in value for your investments after you make the transfer. If you convert $50,000 from your traditional IRA to a Roth IRA, and the investments drop in value to $30,000, you’ll end up paying higher taxes than if you’d converted after the drop in value. You pay $16,500 for the larger transfer, whereas you would have only paid $9,900 for transferring the smaller amount.[4]

If your investment value drops, why would you want to be stuck with thousands of dollars more in taxes? Instead, you just recharacterize the conversion and save that extra $6,600, waiting to convert the $30,000 back to a Roth IRA once the wait period is up.

As if this strategy isn’t advantageous enough, there’s actually something else you can do to maximize your tax benefit. Do you have multiple investments in your traditional IRA? If so, it would be a smart move to convert those investments separately into their own Roth IRA.

Keeping in mind the example above about declining investments, consider the following scenario. You have a Roth IRA in which you converted two different investments. The value of one increases at the same time that the other’s value decreases. Now, you have to decide whether to undo the conversion, but both investments are tied together (i.e. you cannot undo only one). Don’t get yourself into that frustrating situation!

Instead, transfer each investment into its own separate Roth IRA. Now, when the investments perform differently, you can choose which conversion to recharacterize, giving you more control over your tax strategy.[5] Once the conversions are complete and taxes are paid, you can later consolidate the two accounts, making them easier to maintain.

Although it takes a little more careful observation on your part, you can really maximize your retirement savings by planning the best years to pay taxes on your IRA. Many people debate whether the traditional or Roth account is better (although if you only stick with one, the results are a gamble). The truth is you don’t have to gamble with how much you pay in taxes. You can, and should, decide when you are ready to pay the taxes on your retirement account.

  1. IRC 408A(d)(2). ↑
  2. IRC Section 408A(d)(6) and (7); Reg. Section 1.408A-5(Q&A-1). ↑
  3. IRS FAQ Regarding IRA Recharacterizations. ↑
  4. Given a 33 percent tax rate. ↑
  5. Reg. Section 1.408A-5(Q&A-2). ↑
Categories : Investments, Retirement, Tax Planning

The Relationship between Your Salary and Your Taxes

By Kim M. Larsen EA CTFS
Tuesday, February 3rd, 2015

It’s no secret that the more money you earn from your S corporation, the higher your tax bracket. But, have you actually run the numbers to see what damage—if any—your current salary is actually doing? If not, it’s time you did. As a business owner, you can’t leave financial matters to chance.

A big, fat salary may look nice, but it could actually be losing you money. By capping your own income at the proper amount, you can save yourself thousands of dollars in taxes. The old adage, “A penny saved, a penny earned” certainly applies when it comes to dealing with tax brackets.

Calculating the Right Number

Some may think the solution is to dramatically reduce your salary, but watch out for that tactic! If you set your salary too low, this can also arouse the suspicion of the IRS and elicit an audit. Did you know that if you set your salary unusually low, you could end up paying not only back taxes, but also penalties and interest? Luckily, this article is your guide to getting the amount right—for the most advantage and least audit risk.

The IRS actually has guidelines to setting reasonable salaries for S corporation owners. Keep in mind these are just guidelines created by the IRS—not tax law—but playing by IRS rules goes a long way towards reducing your chances of audit. The good news for you is that a few recent court cases help taxpayers like you to understand how these guidelines are held up (and how you can justify your salary).

Salary Case Examples

First, let’s look at how reducing your salary lowers your payroll taxes. For a sole proprietor earning $100,000 in business income for the year, $14,130 will be paid in self-employment taxes.[1] However, if you form an S corporation and give yourself a salary of $50,000, you pay only $7,650 of payroll taxes between yourself and your corporation combined.[2] That’s nearly $6,500 in tax savings! The remaining $50,000 can be considered a distribution, and those are not subject to payroll taxes.[3]

To see how all this is viewed by the IRS, let’s examine the results of precedent cases:

  • The S Corporation Accountant—David Watson operated his accounting business as an S corporation.[4] His corporation also happened to be a 25 percent partner in an accounting firm. For several years, the firm paid Watson’s corporation more than $200,000. Watson’s self-appointed salary, however, was only $24,000. As you can guess, this is far below the average salary for an accountant.

In fact, the IRS determined that for the area of the country where Watson did business, a reasonable salary was more like $91,044. They came to this conclusion using the Management of Accounting Practice survey conducted by the American Institute of Certified Public Accountants, which listed compensation. For an accountant with no investment interest, average salary was $70,000.

However, Watson did have investment interest. Considering that owners billed at rates 33% higher than directors, the IRS’s valuation expert then increased the reasonable amount by 33% and decreased that amount to reflect fringe benefits that were not taxed—coming up with the $91,044.

In the end, the court sided with the IRS expert and Watson’s salary was adjusted to the more reasonable number. He still took the majority of his income payroll tax-free as distributions (giving him bigger savings than he would have as a sole proprietor), but he got hit with $23,431.23 in payroll taxes owed, penalties, and interest.

  • The Real Estate Professional—Sean McAlary entered the real estate business before the housing crash.[5] His success allowed him $240,000 in distributions from his S corporation in 2006. The mistake he made was taking absolutely no salary—$0—despite being entitled to $24,000, according to corporate minutes.

Using methods similar to those above, the IRS valuation expert determined a reasonable salary of $100,755. Using the California Occupational Employment Statistics Survey, the expert found real estate brokers’ median wage to be $48.44 per hour. That wage was then multiplied by a 40-hour work week and again by 52 weeks. This was despite evidence that McAlary actually worked longer hours and rarely took days off. The court adjusted this finding slightly, and McAlary’s salary for tax purposes was considered to be $83,200, still making distributions a majority of his income.

  • The Glass Blocks Manufacturer—Frederick Blodgett produced glass blocks to be used in homes and other real estate. Unfortunately, the construction industry in his area had a bad year in 2006, and his company felt the fall.[6] So, in the following two years, he ended up loaning his S corporation $55,000. The corporation’s net income for each of the two years was $877 and $8,950.

For 2007 and 2008, Blodgett drew no salary from his corporation. Instead, he took what he described as a mix of distributions and loan repayment, in a total of $30,000 per year. His plan was not viewed his way by the court. The “loans” were deemed capital contributions, making 100 percent of his corporation’s payments to him distributions.

It was decided by the IRS, and held up by the court, that the $30,000 per year distributions would be assigned as Blodgett’s salary. Rather than doing calculations like those in the above cases, the IRS simply stated that someone in Blodgett’s field would make at least that much. The decision gave Blodgett’s business a net loss for the year.

Applying the Lessons

You can see a few tips from these examples. First of all, when setting your salary, consider what other professionals in your field make in your area. Being self-employed, you may not always be able to match yourself to a single profession with compensation statistics. In that case, choose a best match that you can reasonably back up.

Of course, you are also a business owner, so after comparing wages, you’ll need to adjust for several factors. Decrease your wage to account for:

  • Your business’s profit relative to similar businesses in your area (if your profits are smaller);
  • The number of hours you work (if you work less than full-time); and
  • Factors that contribute to your corporation’s success outside of your own personal efforts (for instance, unusually good market conditions for a particular year).

If you’re able to reduce your salary by a reasonable amount because of one of these circumstances, be sure to document your reasoning in the corporate minutes. The lower salary will give you big savings on payroll taxes, as long as it remains reasonable.

As a final note, you do not have to take a salary if your S corporation is not making a profit.[7] Just be prepared by understanding that taking distributions in a year you don’t take a salary is a major red flag to the IRS. If you don’t take a salary in a particular year, try to eliminate or at least minimize the distributions you take.

Reducing your salary is a legal tax strategy for S corporation owners. As long as you don’t take it to the extreme, the technique is an easy way to keep more of your cash. So, research comparable salaries in your area, adjust it downward if you can do so justifiably, and always document your strategy.

  1. Assuming a 15.3 percent self-employment tax rate is applied to 92.35 percent of the income. See Schedule SE for rate details. ↑
  2. $50,000 x 15.3 percent. ↑
  3. Rev. Rul. 59-221. ↑
  4. Watson v US, 668 F.3d 1008 (8th Cir.). ↑
  5. Sean McAlary Ltd, Inc., TC Summary Opinion 2013-62. ↑
  6. Glass Blocks Unlimited, TC Memo 2013-180. ↑
  7. See Davis, d/b/a Mile High Calcium, Inc. v US, 74 AFTR 2d 94-5618. ↑
Categories : Audits, Corporations, Payroll, Tax Planning

Are You Liquidating Your S Corporation? Keep Track of Your Losses

By Kim M. Larsen EA CTFS
Tuesday, February 3rd, 2015

Change is a constant part of life, and perhaps you’re at the point where you’re moving on from your S corporation. It’s a big change, but just because you’re ending your ties with that particular business doesn’t mean it has disappeared entirely from your finances yet. You want to make sure that you get the most from your tax deductions when you disband your corporation.

Liquidation

That’s where liquidation can come into play. If the building and some of the assets owned by your corporation have decreased in value, liquidation (selling the assets at fair market value) allows you to:

  • Keep the building and some of the assets personally, and
  • Use losses from the drop in value on those assets to claim tax deductions on your personal tax return.

Of course, turning a business loss into a personal benefit is like a soufflé; if you don’t follow the instructions exactly, it could fall flat. So, here’s a little guidance:

  • Protect Your Assets—When your assets belonged to the corporation, you probably planned ahead and included some kind of liability protection for them. Well, they don’t stop being worth protecting after liquidation, so you can choose from a couple of options to keep them safe. Once choice is purchasing liability insurance. Another option is to transfer the personal assets to a limited liability company (LLC) or other limited-liability entity structure.
  • No New Corporations—Don’t create a new corporation, at least not as far as your now-personal assets are concerned. Tax law disallows the reincorporation of liquidations.[1] In some cases, if you wait long enough, you may be able to re-use the assets for another corporation you create. However, tax law doesn’t specify a specific amount of time that makes this action allowable. The longer you wait, the safer your liquidation will be. You also decrease the chance of the IRS denying your liquidation if your new business is distinct from the previous one.

Considering Losses

Although the particulars are different, S corporation liquidation is subject to the same rules as C corporation liquidation.[2] Since you are the shareholder of your S corporation, any gains or losses realized through the sale of assets pass through you. You see, when you receive the assets from your corporation, it’s as if they were sold at fair market value.[3]

Example: Your S corporation owns a piece of land. The basis is $1 million, but the fair market value is only $600,000. At the time of liquidation, you get the land in trade for your stock. The corporation then has a loss of $400,000 ($1 million minus $600,000). Now, if you can overcome the IRS loss barriers, then that loss passes to you for tax-deduction purposes.

Here are the loss barriers that may prevent you from realizing a deduction:

  • Inadequate Basis in Stock for Your S Corporation—This one is simple to calculate. Basically, you cannot reduce your stock basis lower than zero.[4] If you’re stock basis at time of liquidation is $150,000 and your losses are $400,000, you can only realize $150,000 of losses because any more would take your basis below $0. So, if you don’t have enough basis in stock, you could lose a whopping $250,000 in deductions.[5]
  • Tax-Free Property Contributions Made Recently—Was your corporation’s land previously your personal land? If so, and you gave it to the corporation within the most recent five years as a tax-free contribution, then the corporation cannot claim a loss on the land during liquidation[6] because the land was distributed to a majority shareholder (you, as the sole owner of an S corporation).[7] Put simply, you don’t get to deduct any losses. This does not apply, however, if the corporation bought the land, even from you.[8]
  • Disproportionate Asset Transfers—The majority of this information applies to sole owners of an S corporation, but as you may know, you can split income with S corporation stock. When you do that, you no longer own 100 percent of the company. In that case, the assets from liquidation must be transferred proportionately among all shareholders. Using the land scenario above, let’s say you own 99 percent of the stock, and your friend owns 1 percent. For the land, you should get a 99 percent interest from the corporation, with the other 1 percent going to your friend. Such would be the distribution for each asset. However, if you do not follow this rule, and you distribute assets disproportionately, the corporation cannot recognize loss on any property allocated to a majority shareholder (one who owns more than 50 percent of the stock).[9] As an example, if your corporation ignores the minor ownership of your friend and gives you all the land, no one will get to deduct the $400,000 loss. You do not want that to happen.

If these barriers create a problem for your ability to realize full loss deductions, liquidation may not be your best option.

What about Stock Losses?

Up until now we’ve talked about pass-through losses (the losses that passed from the corporation to you in liquidation). But, you’ll be happy to know that you also get a special tax break on stock losses.[10] This benefit allows you to consider some of your capital loss to be ordinary, tax-favored loss in amounts up to $50,000 if you file an individual return or $100,000 if you file a joint return.[11]

Of course, there is a stipulation. To qualify for this tax break, you must not have invested $1 million or more into the original capital contribution to your S corporation. Here’s a practical application using the land example above, and considering you meet the contribution qualification. After calculating your pass-through income and loss from the liquidation, you have an $800,000 basis. You then receive the land, valued at $600,000. You have a $200,000 capital loss on the stock ($800,000 minus $600,000. If you’re married and filing jointly, you can consider up to half of that $200,000 an ordinary loss (tax-favored).

The Deal Breaker

In the event that property passed from your S corporation to you is depreciable property (such as a building), any gain recognized on that property must be treated as ordinary income, not capital gain. This pretty much destroys your tax benefits from liquidation.[12] Why is the IRS oh-so-cruel? Actually, their reasoning makes sense. Upon receiving the building in liquidation, you will get ordinary deductions by depreciating the asset yourself. Getting the additional long-term capital gain benefits would be like double-dipping.

An additional warning: For those who operated a company as a C corporation, and then converted to an S corporation, you may be subject to the built-in gains tax when you liquidate.

It may seem like a lot to think about, but be sure to go over these guidelines when you’re ready to liquidate your S corporation. You could be looking at big money in liquidation assets. So, make sure you get the deductions you’re entitled to.

  1. Reg. Section 1.331-1(c). ↑
  2. See IRC Section 1371(a). ↑
  3. IRC Section 336(a). ↑
  4. IRC Section 1367(a)(2). ↑
  5. CCA 201237017, p. 4. ↑
  6. IRC Section 336(d)(1). ↑
  7. IRC Section 336(d)(1)(A). ↑
  8. See Genl. Expl. of Tax Reform Act of ’86 (PL 99-514), p. 341-344. ↑
  9. IRC Section 336(d)(1)(A)(i). ↑
  10. IRC Section 267(a)(1), second sentence. ↑
  11. IRC Section 1244. ↑
  12. IRC Section 1239. ↑
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