Archive for Depreciation – Page 2

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

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.

Passive-Loss Rules Got You Trapped? You can Release Rental Property Tax Losses

If you’re feeling the pain from calculating your rental property loss deductions and finding that you can’t get some of that money back, you can thank lawmakers from 1986. That’s when the passive-loss rules came into being. These laws really complicated matters for taxpayers, but this article can help you to understand the ins and outs.

How Passive-Loss Rules Work

Basically, lawmakers have given you three possible tax buckets for any given taxable activity:

  1. Portfolio of stocks and bonds
  2. Active business activities involving material participation
  3. Passive-losses for rentals and other activities you don’t materially participate in

We’ll primarily look at the last one with this article. You’ll be happy to know that you do have some options for getting around the passive-loss problem. With the right knowledge, you can see tax benefits from your rental losses.

Before we delve into the solutions, let’s get an understanding of why you may have issues deducting your rental property losses. In order to get the tax benefit from your rental property loss, you (or you and your spouse) have to meet one of two requirements. To meet the first requirement, you must have passive income, such as from other properties or another source. Otherwise, you have to qualify as a real estate professional and actively participate in your rental property business.

Given those requirements, here’s an example of how your rental property losses can end up trapped and unable to be deducted. For the example, you have only one rental property (i.e. you have no other passive income), and you do not qualify as a real estate professional for tax purposes. If your property has produced a tax loss of $10,000 each year for the past six years, and your taxable income is $180,000, you can’t deduct any of those $60,000 in losses because you don’t meet either of the above requirements, and they can’t be deducted from either of the other income buckets.

Your Options

Let’s take a look at the three options you have for navigating these passive-loss rules. It turns out that even if you don’t meet the above requirements, you may have an opportunity to deduct your losses in certain scenarios.

  • Get Full Loss BenefitsTaxpayers who have a modified adjusted gross income of up to $100,000 can deduct all of their rental losses up to $25,000.[1] As your income rises above $100,000, your deduction is reduced by 50 cents per dollar, and once you reach a modified adjusted gross income level of $150,000, you lose this ability to claim losses easily.[2] For a practical example of how this works, let’s say your modified adjusted gross income from your business was $85,000, and you had rental losses of $21,000. In this case, you would be able to deduct the full $21,000.
  • Waiting for the BenefitRemember the $60,000 that were trapped in the example above? It turns out that you don’t just lose all chance of benefiting from those accumulated losses. They are still tax-deductible, but you have to find a way to release their ability to be deducted. In fact, here are four possible ways to get that money out of waiting:
  1. Change the rental property from passive to non-passive. If you’re the sole owner of your business, and you also own 100 percent of the rental property, you can simply convert half the rental property for business use (such as office space). Now 50 percent of you trapped losses can be released ($30,000) for use against the business income bucket[3]. If you operate as an S corporation, you’ll have to make a self-rental election.
  2. Produce additional passive income. If you produce, for example, $6,000 in passive income, you can release $6,000 of the trapped $60,000. Now, you just have to wait to release the other $54,000.
  3. Qualify as a real estate professional and prove your material participation in your real estate business. This option cannot release funds that have been waiting to be released because your qualification as a real estate professional is evaluated on a yearly basis. However, by qualifying, you are able to release your losses for the current tax year. So, the $10,000 for the year you qualify as a real estate professional will be offset against your business and portfolio income buckets. Other losses will have to be released using one of the other solutions.
  4. Sell your property. This option is further explained below.
  • Releasing the Full AmountIf you don’t meet the modified adjusted gross income threshold to take full advantage of loss deductions, there’s actually a very easy way to release the full $60,000 of our example losses. All you have to do is sell 100 percent of the property. When you sell to a third party, you can deduct the entire $60,000 at once. Here’s how you might handle this on your tax return:[4]
  1. You list your capital gain or loss on IRS Form 4797. It will be listed with your other Section 1231 gains and losses. A net gain will be taxed at the tax-favored rates of up to 15 percent, and a net loss will be limited to $3,000. But, don’t worry—anything over that amount can be carried forward.
  2. You also list any gain that is attributable to real-property depreciation (Form 4797). This will be taxed at the real-property depreciation recapture rate on Schedule D (up to 25 percent).
  3. You put the $10,000 loss for the current tax year on Schedule E.
  4. And, here’s the best part. You put the prior $60,000 of tax loss (in addition to the current year’s $10,000) on Schedule E, which finally ends up on your Form 1040 and the entire $70,000 offsets all your income.

To break it down for you, when you sell your property, you get to snub the passive-loss rules and pretend like they don’t even exist!

Passive-loss rules are frustrating, but know that you can eventually deduct your losses. You can even elect to group together multiple properties and use these exact same solutions. Getting the most benefit from your tax return is all about planning ahead. Now that you know how to get around the passive-loss restrictions, you can start planning for the techniques that work right for you and your properties.

  1. IRC Section 469(i).
  2. IRC Section 469(i)(3)(A).
  3. Reg. Sections 1.469-9(e)(4), Example (ii); 1.469-1(f)(4)(iii), Example 4.
  4. Instructions for Form 8582 (2011), revised Jun. 8, 2012, ps. 7-8.