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Archive for Business Expenses – Page 4

Use Cost Segregation to Raise Your Net Worth

By Kim M. Larsen EA CTFS
Saturday, January 24th, 2015

Tax planning tips often have two priorities—defer your income and accelerate deductions. Would you like to know an easy way to do the second one? You can make a huge difference in depreciation deductions by using a strategy called cost segregation.

What Cost Segregation Means

Cost segregation allows you to separate a building you own into two components, land improvement and personal property. This lets you to realize deductions on the building more quickly. Cost segregation, essentially, speeds up the depreciation of your deductions. Faster depreciation means more money in your pocket now.

How does it work? Let’s assume you have several buildings depreciating on a 39-year plan. By segregating the costs, perhaps 30% of each of those properties could be depreciated in only 5 years, instead. You can implement a plan like this regardless of when you purchased the building. It could be a place you have already owned for years, a renovation you are undertaking, or even a new property you plan to purchase.

Here’s a break-down of how a property’s costs may be segregated:

  • 20% spent on equipment
  • 20% spent on land improvements
  • 60% spent on the building

You could just lump all the costs together and slowly watch 100% of your investment depreciate over a period of up to 39 years. Or, you could separate the costs out and see 20% depreciated in 5 years and another 20% in 15 years. By depreciating the components separately, you raise your net worth! Getting this time advantage makes a huge cash difference for you.

Why Timing is Important

What do all those numbers mean to you? If you have a property that cost you $1 million, tax law allows you to depreciate the equipment, land improvements, and building all the way to zero. So, your property has the potential to produce $1 million in depreciation. That means deductions for you on your tax return. By using cost segregation, you can use those deductions sooner, giving you an edge on tax benefits. Those tax benefits mean more cash available to you now for investing to your advantage.

You may be asking yourself if it can really make that much of a difference. Consider this example: you 1) earn 6% on your investments after taxes, 2) are in the 50% tax bracket, and 3) have $2 million to depreciate. You can use modified accelerated cost recovery system (MACRS) to depreciate it over 5 years, or you can depreciate it on a straight-line schedule of 39 years. Given those circumstances, in today’s dollars you would have:

  • $852,624 investment earnings from using MACRS depreciation
  • $382,427 investment earnings from using the straight-line depreciation

As you can see, that’s a huge difference!

How to Make Cost Segregation Work for You

The cost segregation strategy may not be right for every property owner every year. Here are a few tips for knowing when it will pay off:

  • When passive loss rules aren’t limiting your real-estate deductions, and you are able to benefit from the advantages of a quicker deduction (cost segregation generates a bigger loss on your tax return, which does you no good if your losses are limited);
  • When you are in a position to benefit from the value over time, that is, you intend to keep the building or continue renting it out for the long-term; and
  • When you will pay less for a cost segregation study than what the actual cash benefits will be.

Let’s put it into real numbers for you. You have, for example, a modified adjusted gross income of $200,000 and are subject to passive loss rules. If you have a $35,000 net loss on your rental properties but no passive income, then the $35,000 is a passive loss. It’s not deductible this year, and you will have to carry it forward to next year to see if you can offset it with passive income then.

Qualifying to deduct passive losses is the number one piece to the puzzle of cost segregation. No current deduction available for your losses means no time benefit to the value of your money. Additionally, the longer the amount of time you keep the building, the greater than financial benefit to you when using cost segregation. You may even be able to apply a 1031 exchange both to defer taxes and take your cost segregation benefits from one building to another, giving you some flexibility in the amount of time you hold onto a property. You’ve got plenty to gain, including:

  • Quicker depreciation
  • Section 179 expensing of personal assets that qualify
  • Reduced transfer taxes (because you separated the costs of personal property and real property)
  • Possible reduced property taxes
  • Asset replacement identification (to write off an undepreciated item)
  • A write-off for the cost segregation study fee[1]
  • Look-back depreciation if you use cost segregation on a building you already own and have not segregated before[2] (Make sure you time this right; the IRS allows one automatically approved accounting method change every 5 years, so you would benefit from completing all cost segregations at one time.[3])
  • Owe no user fee to the IRS[4] (most accounting method changes require payment of $2,700)
  • A one-time chance to make a large adjustment by claiming all of the previous years’ depreciation in a lump sum (IRS Form 3115)
  • The opportunity to increase your benefit from a property inheritance

Just be aware that every financial action carries risk. Personal property’s depreciation recapture tax can be higher than that of real property. You could be looking at up to 10 percent higher tax rates when you sell the property (depending upon your income level), so be sure to consider that when making your decision. Hint: As always, watch out for the alternative minimum tax (AMT). For personal property, you can use a 150 percent declining balance depreciation instead of the AMT’s preferred 200 percent declining balance.

As long as you meet these guidelines, cost segregation can be a terrific option for raising your net worth. You will need to hire professionals to perform the study (typically CPA’s and engineers), so check with your tax advisor about whether this option is a good fit before moving forward. If it looks like you will benefit, you can look for a team to perform the study at The American Society of Cost Segregation Professionals . The cost segregation professionals will take care of all the documentation you need for proving your segregation to the IRS.

  1. See “Cost Segregation Applied,” by Jay A Soled, JD, and Charles E. Falk, CPA, JD,Journal of Accountancy, August 2004. You can write off this cost as a 162 expense. ↑
  2. Reg. Section 1.446-1T(e)(5)(iii). ↑
  3. Revenue Procedure 2006-12 ↑
  4. Revenue Procedure 2012-39 ↑
Categories : Business Expenses, Cost Segregation, Depreciation, Rental Properties, Tax Planning

How Commissioned Employees Have Vanquished the AMT and You Can, Too

By Kim M. Larsen EA CTFS
Tuesday, January 20th, 2015

When it comes time to prepare your taxes, you may have an unpleasant surprise waiting in the alternative minimum tax (AMT). Despite its intention of ensuring that top earners pay their fair share of taxes, the AMT really can be a kick in the pants for employees, who cannot deduct their business expenses. Particularly in the case of commissioned employees, this creates a huge difference in the amount of taxes they pay.

What You Need to Know about the AMT

The AMT was created during the 1986 tax reform, and it basically taxes income that is deductible under the regular tax, such as employee business expenses. Here are just a few of the types of employees who pay their own work expenses:

  • Mortgage brokers and bankers,
  • Insurance sales professionals,
  • Traveling sales professionals,
  • Real estate sales professionals, and
  • Emergency room physicians.

Why are commissioned employees particularly burdened by this tax? It’s because they often have a slew of business-related expenses that they pay out of pocket. Then, here comes the AMT to tell them they are not allowed to deduct any of those expenses. However, independent contractors performing the exact same duties as those commissioned employees can deduct many of their expenses.

What Employees Can Do about It

If your income level boxes you into the AMT, you don’t have to give up and lose thousands of dollars to additional taxes. And yes, it is potentially thousands. Take, for instance, the case of Dan Butts, an Allstate insurance agent. In one year, he paid about $10,000 more in federal income taxes than agents at State Farm.

What did Butts do wrong? Nothing—the difference lay in how he was designated by his employer. Butts was considered a W-2 employee, but the State Farm agents were independent contractors with 1099’s. Look at that scenario again. Butts did the same job, at the same pay, and with the same deductions as the agents at another company, but because of his designation, he paid $10,000 more in taxes.

That is a ridiculous situation for an employee to be in simply because the AMT does not permit deductions for business expenses! Fortunately, if you’re in a commissioned position, like Butts, you can do something about this unfair situation. He simply amended his tax return to put his W-2 employee commission earnings on the Schedule C form that self-employed individuals (including contractors) use. He deducted his expenses and saved that $10,000.

Of course, the IRS noticed that he used the wrong form, and he ended up going to court over the issue. . . and winning! Of note in this case is that the court granted Butts independent contractor status even though he had been employed as an employee with Allstate for years and enjoyed employee benefits[1]. The ruling went his way because he carried a “risk of loss”, just like the agents who were independent contractors.

However, you should keep in mind that using the Schedule C to avoid the AMT may work differently in various fields. For instance, a mortgage loan officer named Dan Cibotti worked for Liberty Trust Mortgage, Inc. as a commission-only W-2 employee. More and more commissioned employees are filing on Schedule C, and Cibotti was one of them. In his case, the court ruled that he was considered an independent contractor, despite having a W-2 that reported his income as an employee, because[2]:

  • He set his own hours and chose his own work location and method of finding clients;
  • His employer did not provide him an office;
  • He claimed a home-office deduction;
  • He was paid 100% on commission;
  • He had the possibility of gain or loss on his business activities; and
  • He received no employee benefits, such as a retirement plan or health insurance.

As you can see, the two situations were quite different, but each involved a commissioned employee who fought for his right to file as an independent contractor and won.

Going Forward

Now that other cases have set the precedent, it is becoming easier for insurance agents and other commissioned employees to avoid the AMT. In fact, the IRS, in chief counsel notice N(35)000-141(a), ordered its lawyers not to challenge individuals who claimed independent contractor status under the Butts precedent, but the IRS can be a stubborn entity. The notice that allowed independent contractor status also instructed the lawyers to:

  • Calculate self-employment tax on the agent’s net income and allow a credit just for the employee share of FICA and Medicare (i.e., employer payments are not included);
  • Calculate taxes on employee benefits, like employer-paid medical insurance and Section 125 contributions;
  • Calculate taxes on 401(k) contributions and make the taxpayer aware that they may not fall back on the Lozon decision, which concluded that such contributions were not taxable until withdrawn[3].

This notice has since expired, but if you plan to pursue independent contractor status, it would be wise to compare AMT savings with the potential tax disbursement outlined in the above IRS strategy.

Other Cases

Several other cases for independent contractor status have gone to court with varying results. Wesley Wickum, a district manager for Combined Insurance Co. of America, amended three years of tax returns and reclaimed $27,000. His salary included commission from his sales, bonuses, and override commissions based on the salespeople he recruited and supervised. In a funny twist, his company had previously considered the salespeople and managers to be independent contractors, but had changed the status out of fear of IRS penalties for wrongly classifying employees as contractors!

You can see the repercussions on business. The AMT hurts a company’s best salespeople—those who make the most commissions. When such a worker is classified as employee instead of contractor, the AMT comes into play, and may cause the best salespeople to leave the company.

A sales agent named Paul Hathaway also amended three years of tax returns after learning of the Butts case[4]. He was a commissioned employee, and although his company provided a W-2 each year and gave him benefits, he paid his own expenses for food, samples, travel, telephone, stationary, and business cards.

William Johnson and Barbara Lewis, on the other hand, lost each of their cases for independent contractor status. Johnson was a full-time hospital equipment salesperson who worked on commission, but the court ruled that he was an employee because his employer 1) restricted him from hiring employees and 2) required that he file daily call reports[5]. Lewis sold hair care products to salons and also made commissions. The court ruled her an employee by status because 1) her employer required her to file daily sales activity reports, 2) her employer supplied her with leads, which she was expected to follow up on, and 3) she had a negligible “risk of loss”[6].

AMT Tax Savings

If you’re going to claim independent contractor status for your commissioned income, take these cases as examples what kind of evidence you need. Remember, your savings could be thousands of dollars. Need an example? Let’s say you’re a mortgage loan officer, like Wickum in the case above. If you made $200,000 and spent $125,000 in business expenses, you have a net income of $75,000.

With regular taxes, those business expenses are reduced by 2 percent, leaving a regular taxable income of $79,000 (.02 x $200,000 = $4,000; $125,000 – $4,000 = $121,000; $200,000 – $121,000 = $79,000). But, for AMT purposes, this employee gets no deductions on those expenses. That means the taxable income is the full $200,000. That’s a huge difference!

So, if the employee files taxes on Schedule A, the amount owed is $45,000. On Schedule C (as an independent contractor), it would only be $15,000. You can see why commissioned employees argue for their contractor status.

If your work situation involves unreimbursed business expenses and a status as employee, you have options to establish your status as an independent contractor for tax purposes. Since the IRS has established a position on this issue, you can start by discussing your status with the local IRS district director. If necessary, you can escalate the situation by requesting a private letter ruling from the IRS. This route does cost money, but it will likely be less costly than going to court. Litigation like the Butts case has not happened in years, so you have a good chance of a ruling in your favor if your circumstances and evidence are sufficient. The AMT seems to be here to stay for the present, so don’t let thousands of dollars slip away from you every year.

  1. Butts v. Commissioner, TC Memo 1993 478, affd. per curiam 49 F.3d 713 (11th Cir. 1995). ↑
  2. Dean Cibotti v Commr., TC Summary Opinion 2012-21. ↑
  3. Lozon v. Commr., TC Memo 1997-250. ↑
  4. Paul E. Hathaway v. Commr., TC Memo 1996-389. ↑
  5. William O. Johnson v. Commr., TC Memo 1993-530. ↑
  6. Donald J. Lewis, Jr., v. Commr., TC Memo 1993-635. ↑
Categories : AMT, Business Expenses, Cars, Trucks & SUVs, Depreciation, Employees, Entertainment, Home Office, Receipts, Records, Self-employment Tax, Tax Planning, Travel
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