ESOPs Offer Businesses Tax and Other Benefits

Wouldn’t it be great if your employees worked as if they owned the company? An employee stock ownership plan (ESOP) could make that a reality. Under an ESOP, employee participants take part ownership of the business through a retirement savings arrangement. Meanwhile, the business and its existing owner(s) can benefit from some tax breaks, an extra-motivated workforce and potentially a smoother path for succession planning.

How ESOPs Work

To implement an ESOP, you establish a trust fund and either:

  • Contribute shares of stock or money to buy the stock (an “unleveraged” ESOP), or
  • Borrow funds to initially buy the stock, and then contribute cash to the plan to enable it to repay the loan (a “leveraged” ESOP).

The shares in the trust are allocated to individual employees’ accounts, often using a formula based on their respective compensation. The business must formally adopt the plan and submit plan documents to the IRS, along with certain forms.

Tax Impact

Among the biggest benefits of an ESOP is that contributions to qualified retirement plans such as ESOPs typically are tax-deductible for employers. However, employer contributions to all defined contribution plans, including ESOPs, are generally limited to 25% of covered payroll. But C corporations with leveraged ESOPs can deduct contributions used to pay interest on the loans. That is, the interest isn’t counted toward the 25% limit.

Dividends paid on ESOP stock passed through to employees or used to repay an ESOP loan may be tax-deductible for C corporations, so long as they’re reasonable. Dividends voluntarily reinvested by employees in company stock in the ESOP also are usually deductible by the business. (Employees, however, should review the tax implications of dividends.)

In another potential benefit, shareholders in some closely held C corporations can sell stock to the ESOP and defer federal income taxes on any gains from the sale, with several stipulations. One is that the ESOP must own at least 30% of the company’s stock immediately after the sale. In addition, the sellers must reinvest the proceeds (or an equivalent amount) in qualified replacement property securities of domestic operation corporations within a set period.

Finally, when a business owner is ready to retire or otherwise depart the company, the business can make tax-deductible contributions to the ESOP to buy out the departing owner’s shares or have the ESOP borrow money to buy the shares.

Risks to Consider

An ESOP’s tax impact for entity types other than C corporations varies somewhat from what we’ve discussed here. And while an ESOP offers many potential benefits, it also presents risks such as complexity of setup and administration and a strain on cash flow in some situations. For help determining whether one may make sense for your business, contact us.

Four Questions to Ask Before Hiring Household Help

When you hire someone to work in your home, you may become an employer. Thus, you may have specific tax obligations, such as withholding and paying Social Security and Medicare (FICA) taxes and possibly federal and state unemployment insurance. Here are four questions to ask before you say, “You’re hired.”

 

1. Who’s considered a household employee?

A household worker is someone you hire to care for your children or other live-in family members, clean your house, cook meals, do yard work or provide similar domestic services. But not everyone who works in your home is an employee.

For example, some workers are classified as independent contractors. These self-employed individuals typically provide their own tools, set their own hours, offer their services to other customers and are responsible for their own taxes. To avoid the risk of misclassifying employees, however, you may want to assume that a worker is an employee unless your tax advisor tells you otherwise.

2. When do I pay employment taxes?

You’re required to fulfill certain state and federal tax obligations for any person you pay $2,100 or more annually (in 2018) to do work in or around your house. (The threshold is adjusted annually for inflation.)

In addition, you’re required to pay the employer’s half of FICA (Social Security and Medicare) taxes (7.65% of cash wages) and to withhold the employee’s half. For employees who earn $1,000 or more in a calendar quarter, you must also pay federal unemployment taxes (FUTA) equal to 6% of the first $7,000 in cash wages. And, depending on your resident state, you may be required to make state unemployment contributions, but you’ll receive a FUTA credit for those contributions, up to 5.4% of wages.

You don’t have to withhold federal (and, in most cases, state) income taxes, unless you and your employees agree to a withholding arrangement. But regardless of whether you withhold income taxes, you’re required to report employees’ wages on Form W-2.

3. Are there exceptions?

Yes. You aren’t required to pay employment taxes on wages you pay to your spouse, your child under age 21, your parent (unless an exception is met) or an employee who is under age 18 at any time during the year, providing that performing household work isn’t the employee’s principal occupation. If the employee is a student, providing household work isn’t considered his or her principal occupation.

4. How do I make tax payments?

You pay any federal employment and withholding taxes by attaching Schedule H to your Form 1040. You may have to pay state taxes separately and more frequently (usually quarterly). Keep in mind that this may increase your own tax liability at filing, though the Schedule H tax isn’t subject to estimated tax penalties.

If you owe FICA or FUTA taxes or if you withhold income tax from your employee’s wages, you need an employer identification number (EIN).

There’s no statute of limitations on the failure to report and remit federal payroll taxes. You can be audited by the IRS at any time and be required to pay back taxes, penalties and interest charges. We can help ensure you comply with all the requirements.

Don’t Let the Kiddie Tax Play Costly Games With You

It’s not uncommon for parents, grandparents and others to make financial gifts to minors and young adults. Perhaps you want to transfer some appreciated stock to a child or grandchild to start them on their journey toward successful wealth management. Or maybe you simply want to remove some assets from your taxable estate or shift income into a lower tax bracket. Whatever the reason, beware of the “kiddie tax.” It can play costly games with the unwary.

 

An Evolving Concept

Years ago, the kiddie tax applied only to those under age 14. But, more recently, the age limits were revised to children under age 19 and to full-time students under age 24 (unless the students’ earned income is more than half of their own support).

Another important, and even more recent, change to the kiddie tax occurred under the Tax Cuts and Jobs Act (TCJA). Before passage of this law, the net unearned income of a child was taxed at the parents’ tax rates if the parents’ tax rates were higher than the tax rates of the child. The remainder of a child’s taxable income — in other words, earned income from a child’s job, plus unearned income up to $2,100 (for 2018), less the child’s standard deduction — was taxed at the child’s rates. The kiddie tax applied to a child if the child:

  • Hadn’t reached the age of 19 by the close of the tax year, or the child was a full-time student under the age of 24 whose earned income was less than half of their own support, and either of the child’s parents was alive at such time,
  • Had unearned income exceeding $2,100 (for 2018), and
  • Didn’t file a joint return.

Now, under the TCJA, for tax years beginning after December 31, 2017, the taxable income of a child attributable to earned income is taxed under the rates for single individuals, and taxable income of a child attributable to net unearned income is taxed according to the brackets applicable to trusts and estates. This rule applies to the child’s ordinary income and his or her income taxed at preferential rates. As under previous law, the kiddie tax can potentially apply until the year a child turns 24.

The Tax in Action

Let’s say you transferred to your 16-year-old some stock you’d held for several years that had appreciated $10,000. You were thinking she’d be eligible for the 0% long-term gains rate and so could sell the stock with no tax liability for your family. But you’d be in for an unhappy surprise: Assuming your daughter had no other unearned income, in 2018 $7,900 of the gain would be taxed at the estate and trust capital gains rates, equal to a tax of $795.

Or let’s say you transferred the appreciated stock to your 18-year-old grandson with the plan that he could sell the stock tax-free to pay for his college tuition. He won’t end up with the entire $10,000 gain available for tuition because of the kiddie tax liability.

Fortunately, there may be ways to achieve your goals without triggering the kiddie tax. For example, if you’d like to shift income and you have adult children (older than 24) who’re no longer subject to the kiddie tax but in a lower tax bracket, consider transferring income-producing or highly appreciated assets to them.

A Risky Time

Many families wait until the end of the year to make substantial, meaningful gifts. But, given what’s at stake, now is a good time to start a methodical process to determine the best possible way to pass along your wealth. After all, with the many changes made under the TCJA, the kiddie tax might affect you in ways you weren’t expecting. The best advice is to simply run the numbers with an expert’s help. Please contact us for more information and some suggestions on how to achieve your financial goals.

Beware of Tax Traps When Making an Employee a Partner

In today’s competitive employment market, offering an employee an equity interest in your business can be a powerful tool for attracting and retaining top talent. If your company is organized as a partnership, however, beware of the tax traps of doing so.

Employees pay half of the Social Security and Medicare taxes on their wages, through withholdings from their paychecks. The employer pays the other half. Partners, on the other hand, are treated as being self-employed — they pay the full amount of “self-employment” taxes through quarterly estimates.

Often, when employees receive partnership interests, the partnership incorrectly continues to treat them as employees for tax purposes, withholding employment taxes from their wages and paying the employer’s share. The problem with this practice is that, because a partner is responsible for the full amount of employment taxes, the partnership’s payment of a portion of those taxes could be treated as a guaranteed payment to the partner.

That payment would then be included in income and trigger additional employment taxes. Any employment taxes not paid by the partnership on a partner’s behalf are the partner’s responsibility.

Treating a partner as an employee can also result in overpayment of employment taxes. Suppose your partnership pays half of a partner’s employment taxes and the partner also has other self-employment activities — for example, interests in other partnerships or sole proprietorships. If those activities generate losses, the losses will offset the partner’s earnings from your partnership, reducing or even eliminating self-employment taxes.

As you can see, there’s much to consider. Please contact us before making this move.

Three Common Types of IRS Tax Penalties

Around this time of year, many people have filed and forgotten about their 2017 tax returns. But you could get an abrupt reminder in the form of an IRS penalty. Here are three common types and how you might seek relief:

1.     Failure-to-file and failure-to-pay. The IRS will consider any reason that establishes that you were unable to meet your federal tax obligations despite using “all ordinary business care and prudence” to do so. Frequently cited reasons include fire, casualty, natural disaster or other disturbances. The agency may also accept death, serious illness, incapacitation or unavoidable absence of the taxpayer or an immediate family member.

If you don’t have a good reason for filing or paying late, you may be able to apply for a first-time penalty abatement (FTA) waiver. To qualify for relief, you must have: 1) received no penalties (other than estimated tax penalties) for the three tax years preceding the tax year in which you received a penalty, 2) filed all required returns or filed a valid extension of time to file, and 3) paid, or arranged to pay, any tax due. Despite the expression “first-time,” you can receive FTA relief more than once, so long as at least three years have elapsed.

2.     Estimated tax miscalculation. It’s possible, but unlikely, to obtain relief from estimated tax penalties on grounds of casualty, disaster or other unusual circumstances. You’re more likely to get these penalties abated if you can prove that the IRS made an error, such as crediting a payment to the wrong tax period, or that calculating the penalty using a different method (such as the annualized income installment method) would reduce or eliminate the penalty.

3.     Tax-filing inaccuracy. These penalties may be imposed, for example, if the IRS finds that your return was prepared negligently or that there’s a substantial understatement of tax. You can obtain relief from these penalties if you can demonstrate that you properly disclosed your tax position in your return and that you had a reasonable basis for taking that position.

Generally, you have a reasonable basis if your chances of withstanding an IRS challenge are greater than 50%. Reliance on a competent tax advisor greatly improves your odds of obtaining penalty relief. Other possible grounds for relief include computational errors and reliance on an inaccurate W-2, 1099 or other information statement.

Deducting Home Equity Interest Under the Tax Cuts and Jobs Act

Passage of the Tax Cuts and Jobs Act (TCJA) in December 2017 has led to confusion over some longstanding deductions. In response, the IRS recently issued a statement clarifying that the interest on home equity loans, home equity lines of credit and second mortgages will, in many cases, remain deductible.

 

How it used to be

Under prior tax law, a taxpayer could deduct “qualified residence interest” on a loan of up to $1 million secured by a qualified residence, plus interest on a home equity loan (other than debt used to acquire a home) up to $100,000. The home equity debt couldn’t exceed the fair market value of the home reduced by the debt used to acquire the home.

For tax purposes, a qualified residence is the taxpayer’s principal residence and a second residence, which can be a house, condominium, cooperative, mobile home, house trailer or boat. The principal residence is where the taxpayer resides most of the time; the second residence is any other residence the taxpayer owns and treats as a second home. Taxpayers aren’t required to use the second home during the year to claim the deduction. If the second home is rented to others, though, the taxpayer also must use it as a home during the year for the greater of 14 days or 10% of the number of days it’s rented.

In the past, interest on qualifying home equity debt was deductible regardless of how the loan proceeds were used. A taxpayer could, for example, use the proceeds to pay for medical bills, tuition, vacations, vehicles and other personal expenses and still claim the itemized interest deduction.

What’s deductible now

The TCJA limits the amount of the mortgage interest deduction for taxpayers who itemize through 2025. Beginning in 2018, for new home purchases, a taxpayer can deduct interest only on acquisition mortgage debt of $750,000.

On February 21, the IRS issued a release (IR 2018-32) explaining that the law suspends the deduction only for interest on home equity loans and lines of credit that aren’t used to buy, build or substantially improve the taxpayer’s home that secures the loan. In other words, the interest isn’t deductible if the loan proceeds are used for certain personal expenses, but it is deductible if the proceeds go toward, for example, a new roof on the home that secures the loan. The IRS further stated that the deduction limits apply to the combined amount of mortgage and home equity acquisition loans — home equity debt is no longer capped at $100,000 for purposes of the deduction.

Further clarifications

As a relatively comprehensive new tax law, the TCJA will likely be subject to a variety of clarifications before it settles in. Please contact us for help better understanding this provision or any other.

How to be Tax-Smart When it Comes to Mutual Funds

Mutual funds are so common these days that many people overlook the tax considerations involved. Here are some tips on how to be tax-smart with these investment vehicles.

 

Avoid year-end investments

Typically, mutual funds distribute accumulated dividends and capital gains toward the end of the year. It’s generally wise to avoid investing in a fund shortly before such a distribution. Why? Because you’ll end up paying taxes on gains you didn’t share in.

Don’t fall for the common misconception that investing in a fund just before a distribution date is like getting “free money.” True, you’ll receive a year’s worth of income right after you invest, but the value of your shares will immediately drop by the same amount, so you won’t be any better off. Plus, you’ll be liable for taxes on the distribution as if you had owned your shares all year.

You can get a general idea of when a fund anticipates making a distribution by checking its website periodically. It’s also important to make a note of the “record date” — because investors who own shares of the fund on that date participate in the distribution.

Invest in tax-efficient funds

When it comes to tax efficiency, not all funds are created equal. Actively managed funds tend to be less tax efficient — that is, they buy and sell securities more frequently, generating a greater amount of capital gains, much of it short-term gains taxable at ordinary-income rates. To reduce your tax liability, consider investing in tax-efficient funds, such as index funds, which generally have lower turnover rates, and “passively managed” funds (sometimes described as “tax managed” funds), which are designed to minimize taxable distributions.

Another option is exchange-traded funds (ETFs). Unlike mutual funds, which generally redeem shares by selling securities, ETFs are often able to redeem securities “in kind” — that is, to swap them for other securities. This limits an ETF’s recognition of capital gains, making it more tax efficient.

But don’t ignore tax-inefficient funds

Tax-inefficient funds may have a place in your portfolio. In some cases, actively managed funds may offer benefits, such as above-market returns, that outweigh their tax costs.

If you invest in actively managed or other tax-inefficient funds, ideally you should hold them in nontaxable accounts, such as traditional IRAs or 401(k) plan accounts. Because earnings in these accounts are tax-deferred, distributions from funds they hold won’t have any tax consequences until you withdraw them. And if the funds are held in a Roth account, qualifying distributions will escape taxation altogether.

Make no assumptions

It’s important to do your due diligence on mutual funds. Don’t assume that a fund that historically has been tax efficient will stay that way in the future. Feel free to contact us for help.

 

Sidebar: Reinvested distributions can lead to double taxation

Many investors elect to have their distributions automatically reinvested in their mutual funds. But it’s important to remember that those distributions are taxable regardless of whether they’re reinvested or paid out in cash.

Reinvested distributions increase your cost basis in a fund, so it’s critical to track your basis carefully to avoid double taxation. If you fail to account for these distributions, you could end up paying tax on them twice — once when they’re paid and again when you sell your shares in the fund.

Elderly Couple

When an Elderly Parent Might Qualify as Your Dependent

It’s not uncommon for adult children to help support their aging parents. If you’re in this position, you might qualify for an adult-dependent exemption to deduct up to $4,050 for each person claimed on your 2017 return.

Basic Qualifications

For you to qualify for the adult-dependent exemption, in most cases your parent must have less gross income for the tax year than the exemption amount. (Exceptions may apply if your parent is permanently and totally disabled.) Social Security is generally excluded, but payments from dividends, interest and retirement plans are included.

In addition, you must have contributed more than 50% of your parent’s financial support. If you shared caregiving duties with one or more siblings and your combined support exceeded 50%, the exemption can be claimed even though no one individually provided more than 50%. However, only one of you can claim the exemption in this situation.

Important Factors

Although Social Security payments can usually be excluded from the adult dependent’s income, they can still affect your ability to qualify. Why? If your parent is using Social Security money to pay for medicine or other expenses, you may find that you aren’t meeting the 50% test.

Also, if your parent lives with you, the amount of support you claim under the 50% test can include the fair market rental value of part of your residence. If the parent lives elsewhere — in his or her own residence or in an assisted-living facility or nursing home — any amount of financial support you contribute to that housing expense counts toward the 50% test.

Easing the Burden

An adult-dependent exemption is just one tax break that you may be able to employ on your 2017 tax return to ease the burden of caring for an elderly parent. Contact us for more information on qualifying for this break or others.

Foreign Accounts Call for Specific Reporting Requirements

In an increasingly globalized society, many people choose to open offshore accounts to deposit a portion of their wealth. When doing so, it’s important to follow the IRS’s strict foreign accounts reporting requirements. In a nutshell, if you have a financial interest in or signature authority over any foreign accounts, including bank accounts, brokerage accounts, mutual funds or trusts, you must disclose those accounts to the IRS and you may have additional reporting requirements.

To do so, your tax preparer will check the box on line 7a of Schedule B (“Interest and Ordinary Dividends”) of Form 1040 — regardless of the account value. If the total value of your foreign financial assets exceeds $50,000 ($100,000 for joint filers) at the end of the tax year or exceeds $75,000 ($150,000 for joint filers) at any time during the tax year, you must provide account details on Form 8938 (“Statement of Specified Foreign Financial Assets”) and attach it to your tax return.

Finally, if the aggregate value of your foreign accounts is $10,000 or more during the calendar year, file FinCEN (Financial Crimes Enforcement Network) Form 114 — “Report of Foreign Bank and Financial Accounts (FBAR).” The current deadline for filing the form electronically with FinCEN is April 15, 2018, with an automatic extension to October 15.

Failure to disclose an offshore account could result in substantial IRS penalties, including collecting three to six years’ worth of back taxes, interest, a 20% to 40% accuracy-related penalty and, in some cases, a 75% fraud penalty. For further information, contact us.

Get an Early Tax “Refund” by Adjusting Your Withholding

Each year, millions of taxpayers claim an income tax refund. To be sure, receiving a payment from the IRS for a few thousand dollars can be a pleasant influx of cash. But it means you were essentially giving the government an interest-free loan for close to a year, which isn’t the best use of your money.

Fortunately, there’s a way to begin collecting your 2018 refund now: You can review the amounts you’re having withheld and/or what estimated tax payments you’re making, and adjust them to keep more money in your pocket during the year.

Choosing to adjust

It’s particularly important to check your withholding and/or estimated tax payments if:

·      You received an especially large 2017 refund,

·      You’ve gotten married or divorced or added a dependent,

·      You’ve bought a home,

·      You’ve started or lost a job, or

·      Your investment income has changed significantly.

Even if you haven’t encountered any major life changes during the past year, changes in the tax law may affect withholding levels, making it worthwhile to double-check your withholding or estimated tax payments.

Making a change

You can modify your withholding at any time during the year, or even more than once within a year. To do so, you simply submit a new Form W-4 to your employer. Changes typically will go into effect several weeks after the new Form W-4 is submitted. For estimated tax payments, you can make adjustments each time quarterly payments are due.

While reducing withholdings or estimated tax payments will, indeed, put more money in your pocket now, you also need to be careful that you don’t reduce them too much. If you don’t pay enough tax throughout the year on a timely basis, you could end up owing interest and penalties when you file your return, even if you pay your outstanding tax liability by the April 2019 deadline.

Getting help

One timely reason to consider adjusting your withholding is the passage of the Tax Cuts and Jobs Act late last year. In fact, the IRS had to revise its withholding tables to account for the increase to the standard deduction, suspension of personal exemptions, and changes in tax rates and brackets. If you’d like help determining what your withholding or estimated tax payments should be for the rest of the year, please contact us.