Step Carefully with Loans Between a Business and its Owner

It’s common for owners of closely held businesses to transfer money into and out of the company. But it’s critical to make such transfers properly. If you don’t, you might hear from the IRS.


Why Loans are Better

When an owner withdraws funds from the company, the transfer can be characterized as compensation, a distribution or a loan. Loans aren’t taxable, but compensation is and distributions may be taxable.

If the company is a C corporation, distributions can trigger double taxation — in other words, corporate earnings are taxed once at the corporate level and then again when they’re distributed to shareholders (as dividends). Compensation is deductible by the corporation, so it doesn’t result in double taxation. (But it will be subject to payroll taxes.)

If the business is an S corporation or other pass-through entity, there’s no entity-level tax, so double taxation won’t be an issue. Still, loans are advantageous because compensation would be taxable to the owner (and incurs payroll taxes), and distributions, even though maybe not taxable themselves, would reduce an owner’s tax basis, which makes it much harder to deduct business losses.

There are also some advantages to treating advances from owners as loans. If they’re treated as contributions to equity, for example, any reimbursements by the company may be treated as distributions and possibly be taxable in a C corporation situation.

Loan payments, on the other hand, aren’t taxable, apart from the interest, which is deductible by the company. A loan may also give the owner an advantage in the event of the company’s bankruptcy, because debt obligations are paid before equity is returned.

How to Define It

Establishing that an advance or a withdrawal is truly a loan is important. If you don’t make that distinction, and the IRS determines that a payment from the business is really a distribution or compensation, you (and, possibly, the company) could end up owing back taxes, penalties and interest.

Whether a transaction is a loan is a matter of intent. It’s a loan if the borrower has an unconditional intent to repay the amount received and the lender has an unconditional intent to obtain repayment.

Unfortunately, even if you intend for a transaction to be a loan, the IRS and the courts aren’t mind readers. So, it’s critical that you document any loans and treat them like other arm’s-length transactions. Among other things, you should execute a promissory note and charge a commercially reasonable rate of interest — generally, no less than the applicable federal rate.

Set and follow a fixed repayment schedule and secure the loan using appropriate collateral. (This will also give the lender bankruptcy priority over unsecured creditors.) And you must treat the transaction as a loan in the company’s books. Last, you must ensure that the lender makes reasonable efforts to collect in case of default. Also, for borrowers who are owner-employees, you need to ensure that they receive reasonable salaries, to avoid a claim by the IRS that loans are disguised compensation.

Looking Good

The IRS keeps a wary eye on business owners who borrow from themselves. We can help you through the process to withstand the scrutiny of the agency’s gaze.

Four Types of Information You Need to Prepare For Disaster

When you read the phrase “disaster prep,” you may envision bottled water and boarded-up windows. But information is also a critical asset to have following a natural or manmade catastrophe. Here are four specific types of information you need:
  1. Personal identification records. These documents will enable you to prove the identity of your family members, maintain contact with relatives and employers, and apply for disaster assistance from the Federal Emergency Management Agency (if necessary) after a disaster. These records include driver’s licenses, birth certificates, marriage and divorce licenses, passports, and Social Security cards.
  2. Financial and legal documentation. This category includes documents related to financial accounts, insurance policies, your estate (for example, your last will and testament), and your tax and ongoing financial obligations, such as your mortgage, car payments and credit cards. You will still be responsible for these obligations after a disaster, so make sure you can access these documents easily.
  3. Medical information. This includes the names and contact information for your doctors, copies of health insurance policies and identification cards, immunization records, a list of medications you take, and copies of current prescriptions. Such information could be crucial in the immediate aftermath of a disaster.
  4. Important financial contacts. There may be several different professional advisors you’ll want to contact as soon as possible quickly following a catastrophe. They likely include your insurance agent, attorney, CPA, bank representative and investment advisor. Store their contact information in your mobile phone or, better yet, in a cloud data storage server so you can access it from anywhere.

How Businesses Can Assess Risk of Worker Misclassification

Classifying a worker as an independent contractor frees a business from its portion of payroll tax liability and allows it to forgo providing overtime pay, unemployment compensation and other employee benefits. It also frees the business from responsibility for withholding income taxes and the worker’s share of payroll taxes.

For these reasons, the federal government looks unfavorably on misclassifying a bona fide employee as an independent contractor. If the IRS reclassifies a worker as an employee, your business could be hit with back taxes, interest and penalties.

Key Factors

When assessing worker classification, the IRS typically looks at the:

Level of behavioral control. The more control the company exercises, the more likely the worker is an employee. So, the IRS looks at the extent to which the company instructs a worker on when, where and how to work; what tools or equipment to use; where to purchase supplies and so on.

Level of financial control. Independent contractors are more likely to invest in their own equipment or facilities, incur unreimbursed business expenses, and market their services to other customers. Employees are more likely to be paid hourly, weekly or bimonthly; independent contractors are more likely to receive a flat fee.

Relationship of the parties. Independent contractors are often engaged for a specific project, while employees are typically hired permanently (or at least for an indefinite period). Also, workers who serve a key business function are more likely to be classified as employees.

The IRS examines a variety of factors within each category, as well as the totality of facts and circumstances.

Protective Measures

When in doubt, reclassify questionable independent contractors as employees. This may increase your tax and benefits costs, but it will eliminate reclassification risk.

From there, modify your relationships with independent contractors to better ensure compliance. For example, you might exercise less behavioral control by reducing your level of supervision or allowing workers to set their own hours or work from home.

Also, consider using an employee-leasing company. Workers leased from these firms are employees of the leasing company, which is responsible for taxes, benefits and other employer obligations.

Handle With Care

Taxes, interest and penalties aren’t the only possible negative consequences of a worker being reclassified as an employee. Your business also could be liable for employee benefits that should have been provided but weren’t. Contact us if you have questions about worker classification.

Double Up On Tax Benefits by Donating Appreciated Artwork

From a tax perspective, appreciated artwork can make one of the best charitable gifts. Generally, donating appreciated property is doubly beneficial because you can both enjoy a valuable tax deduction and avoid the capital gains taxes you’d owe if you sold the property.

The extra benefit from donating artwork comes from the fact that the top long-term capital gains rate for art and other “collectibles” is 28%, as opposed to 20% for most other appreciated property.

Requirements

The first thing to keep in mind if you’re considering a donation of artwork is that you must itemize deductions to deduct charitable contributions. Now that the Tax Cuts and Jobs Act has nearly doubled the standard deduction and put tighter limits on many itemized deductions (but not the charitable deduction), many taxpayers who have itemized in the past will no longer benefit from itemizing.

For 2019, the standard deduction is $12,200 for singles, $18,350 for heads of households and $24,400 for married couples filing jointly. Your total itemized deductions must exceed the applicable standard deduction for you to enjoy a tax benefit from donating artwork.

Something else to be aware of is that most artwork donations require a “qualified appraisal” by a “qualified appraiser.” IRS rules contain detailed requirements about the qualifications an appraiser must possess and the contents of an appraisal.

IRS auditors are required to refer all gifts of art valued at $50,000 or more to the IRS Art Advisory Panel. The panel’s findings are the IRS’s official position on the art’s value, so it’s critical to provide a solid appraisal to support your valuation.

Finally, note that, if you own both the work of art and the copyright to the work, you must assign the copyright to the charity to qualify for a charitable deduction.

Deduction Tips

The charity you choose and how the charity will use the artwork can have a significant impact on your tax deduction. Donations of artwork to a public charity, such as a museum or university with public charity status, can entitle you to deduct the artwork’s full fair market value. If you donate art to a private foundation, however, your deduction will be limited to your cost.

For your donation to a public charity to qualify for a full fair-market-value deduction, the charity’s use of the donated artwork must be related to its tax-exempt purpose. If, for example, you donate a painting to a museum for display or to a university’s art history department for use in its research, you’ll satisfy the related-use rule. But if you donate it to, say, a children’s hospital to auction off at its annual fundraising gala, you won’t satisfy the rule.

Careful Planning

To reap the maximum tax benefit of donating appreciated artwork, you must plan your gift carefully and follow all applicable rules. Contact us for help.

The Tax Cost of Divorce Has Risen for Many

Are you divorced or in the process of divorcing? If so, it’s critical to understand how the Tax Cuts and Jobs Act (TCJA) has changed the tax treatment of alimony. Unfortunately, for many couples, the news isn’t good — the tax cost of divorce has risen.

What’s Changed?

Under previous rules, a taxpayer who paid alimony was entitled to a deduction for payments made during the year. The deduction was “above-the-line,” which was a big advantage, because there was no need to itemize. The payments were included in the recipient spouse’s gross income.

The TCJA essentially reverses the tax treatment of alimony, effective for divorce or separation instruments executed after 2018. In other words, alimony payments are no longer deductible by the payer and are excluded from the recipient’s gross income.

What’s the Impact?

The TCJA will likely cause alimony awards to decrease for post-2018 divorces or separations. Paying spouses will argue that, without the benefit of the alimony deduction, they can’t afford to pay as much as under previous rules. The ability of recipients to exclude alimony from income will at least partially offset the decrease, but many recipients will be worse off under the new rules.

For example, let’s say John and Lori divorced in 2018. John is in the 35% federal income tax bracket and Lori is a stay-at-home mom with no income who cares for John and Lori’s two children. The court ordered John to pay Lori $100,000 per year in alimony. He’s entitled to deduct the payments, so the after-tax cost to him is $65,000. Presuming Lori qualifies to file as head of household, and the children qualify for the full child credit, Lori’s net federal tax on the alimony payments (after the child credit) is approximately $8,600, leaving her with $91,400 in after-tax income.

Suppose, under the same circumstances, that John and Lori divorce in 2019. John argues that, without the alimony deduction, he can afford to pay only $65,000, and the court agrees. The payments are tax-free to Lori, but she’s still left with $26,400 less than she would have received under pre-TCJA rules.

The pre-2019 rules can create a tax benefit by reducing the divorced couple’s overall tax liability (assuming the recipient is in a lower tax bracket). The new rules eliminate this tax advantage. Of course, if the recipient is in a higher tax bracket than the payer, a couple is better off under the new rules.

What To Do?

If you’re contemplating a divorce or separation, be sure to familiarize yourself with the post-TCJA divorce-related tax rules. Or, if you’re already divorced or separated, determine whether you would benefit by applying the new rules to your alimony payments through a modification of your divorce or separation instrument. (See “What if you’re already divorced?”) We can help you sort out the details.

 

Sidebar: What if you’re already divorced?

Existing divorce or separation instruments, including those executed during 2018, aren’t affected by the TCJA changes. The previous rules still apply unless a modification expressly provides that the TCJA rules must be followed. However, spouses who would benefit from the TCJA rules — for example, because their relative income levels have changed — may voluntarily apply them if the modification expressly provides for such treatment.

Planning for the Net Investment Income Tax

Despite its name, the Tax Cuts and Jobs Act (TCJA) didn’t cut all types of taxes. It left several taxes unchanged, including the 3.8% tax on net investment income (NII) of high-income taxpayers.

You’re potentially liable for the NII tax if your modified adjusted gross income (MAGI) exceeds $200,000 ($250,000 for joint filers and qualifying widows or widowers; $125,000 for married taxpayers filing separately). Generally, MAGI is the same as adjusted gross income. However, it may be higher if you have foreign earned income and certain foreign investments.

To calculate the tax, multiply 3.8% by the lesser of 1) your NII, or 2) the amount by which your MAGI exceeds the threshold. For example, if you’re single with $250,000 in MAGI and $75,000 in NII, your tax would be 3.8% × $50,000 ($250,000 – $200,000), or $1,900.

NII generally includes net income from, among others, taxable interest, dividends, capital gains, rents, royalties and passive business activities. Several types of income are excluded from NII, such as wages, most nonpassive business income, retirement plan distributions and Social Security benefits. Also excluded is the nontaxable gain on the sale of a personal residence.

Given the way the NII tax is calculated, you can reduce the tax either by reducing your MAGI or reducing your NII. To accomplish the former, you could maximize contributions to IRAs and qualified retirement plans. To do the latter, you might invest in tax-exempt municipal bonds or in growth stocks that pay little or no dividends.

There are many strategies for reducing the NII tax. Consult with one of our professionals before implementing any of them. And remember that, while tax reduction is important, it’s not the only factor in prudent investment decision-making.

What Every Teacher Should Know About Their Usual Tax Break

When teachers are setting up their classrooms for the new school year, it’s common for them to pay for a portion of their classroom supplies out of pocket. A special tax break allows these educators to deduct some of their expenses. This educator expense deduction is especially important now due to some changes under the Tax Cuts and Jobs Act (TCJA).


Old School

Before 2018, employee business expenses were potentially deductible if they were unreimbursed by the employer and ordinary and necessary to the “business” of being an employee. A teacher’s out-of-pocket classroom expenses could qualify.

But these expenses had to be claimed as a miscellaneous itemized deduction and were subject to a 2% of adjusted gross income (AGI) floor. This meant employees, including teachers, could enjoy a tax benefit only if they itemized deductions (rather than taking the standard deduction) and only to the extent that all their deductions subject to the floor, combined, exceeded 2% of their AGI.

Now, for 2018 through 2025, the TCJA has suspended miscellaneous itemized deductions subject to the 2% of AGI floor. Fortunately, qualifying educators can still deduct some of their unreimbursed out-of-pocket classroom costs under the educator expense deduction.

New School

Back in 2002, Congress created the above-the-line educator expense deduction because, for many teachers, the 2% of AGI threshold for the miscellaneous itemized deduction was difficult to meet. An above-the-line deduction is one that’s subtracted from your gross income to determine your AGI.

You don’t have to itemize to claim an above-the-line deduction. This is especially significant with the TCJA’s near doubling of the standard deduction, which means fewer taxpayers will benefit from itemizing.

Qualifying elementary and secondary school teachers and other eligible educators (such as counselors and principals) can deduct above the line up to $250 of qualified expenses. If you’re married filing jointly and both you and your spouse are educators, you can deduct up to $500 of unreimbursed expenses — but not more than $250 each.

Qualified expenses include amounts paid or incurred during the tax year for books, supplies, computer equipment (including related software and services), other equipment and supplementary materials that you use in the classroom. For courses in health and physical education, the costs of supplies are qualified expenses only if related to athletics.

More Details

Some additional rules apply to the educator expense deduction. If you’re an educator or know one who might be interested in this tax break, please contact us for more details.

Tax Document Retention Guidelines for Small Businesses

You may have breathed a sigh of relief after filing your 2018 income tax return (or requesting an extension). But is your office strewn with reams of paper consisting of years’ worth of tax returns, receipts, canceled checks and other financial records? Or perhaps your computer desktop is filled with a multitude of digital tax-related files? You’ll find it easier to file next year if you cut down on the clutter. To perform a summer cleanup, follow these retention guidelines.


General Rules

Retain records that support items shown on your tax return at least until the statute of limitations runs out — generally three years from the due date of the return or the date you filed, whichever is later. That means you can now potentially throw out records for the 2015 tax year if you filed the return for that year by the regular filing deadline. But some records should be kept longer.

For example, there’s no statute of limitations if you fail to file a tax return or file a fraudulent one. So, you’ll generally want to keep copies of your returns themselves permanently, so you can show that you did file a legitimate return.

Also bear in mind that, if you understate your adjusted gross income by more than 25%, the statute of limitations period is six years.

Some Business Specifics

Records substantiating costs and deductions associated with business property are necessary to determine the basis and any gain or loss when the property is sold. According to IRS guidelines, you should keep these for as long as you own the property, plus seven years.

The IRS recommends keeping employee records for three years after an employee has been terminated. In addition, you should maintain records that support employee earnings for at least four years. (This timeframe generally will cover varying state and federal requirements.) Also keep employment tax records for four years from the date the tax was due or the date it was paid, whichever is longer.

For travel and transportation expenses supported by mileage logs and other receipts, keep supporting documents for the three-year statute of limitations period. Regulations for sales tax returns vary by state. Check the rules for the states where you file sales tax returns. Retention periods typically range from three to six years.

When in Doubt, Don’t Throw it Out

If you’re unsure whether you should retain a document, a good rule of thumb is to hold on to it for at least six years or, for property-related records, at least seven years after you dispose of the property. But, again, you should keep tax returns themselves permanently, and other rules or guidelines might apply in certain situations. We can answer any questions you might have.

Consider the Flexibility of a Self-Directed IRA

Traditional and Roth IRAs can be relatively “safe” retirement-savings vehicles, depending on what they’re invested in. But a drawback is that they limit your investment choices. A self-directed IRA gives you more flexibility in your investment choices but comes with greater risk as well.


Gaining More Control

A self-directed IRA is simply an IRA that gives you greater control over investment decisions. Traditional IRAs typically offer a selection of stocks, bonds and mutual funds. Self-directed IRAs (available at certain financial institutions) offer greater diversification and potentially higher returns by permitting you to select virtually any type of investment, including real estate, closely held stock, limited liability company and partnership interests, loans, precious metals, and commodities (such as lumber and oil and gas).

A self-directed IRA can be a traditional or Roth IRA, a Simplified Employee Pension (SEP) plan, or a Savings Incentive Match Plan for Employees (SIMPLE). It’s also possible to have a self-directed individual 401(k) plan, Health Savings Account or Coverdell Education Savings Account.

Self-directed Roth IRAs are particularly powerful estate planning tools, because they offer tax-free investment growth. (See “IRAs and your estate plan.”)

Navigating the Tax Traps

To avoid pitfalls that can lead to unwanted tax consequences, caution is required when using self-directed IRAs. The most dangerous traps are the prohibited transaction rules.

These rules are designed to limit dealings between an IRA and “disqualified persons,” including account holders, certain members of account holders’ families, businesses controlled by account holders or their families, and certain IRA advisors or service providers. Among other things, disqualified persons may not sell property or lend money to the IRA, buy property from the IRA, provide goods or services to the IRA, guarantee a loan to the IRA, pledge IRA assets as security for a loan, receive compensation from the IRA or personally use IRA assets.

The penalty for engaging in a prohibited transaction is severe: The IRA is disqualified and all its assets are deemed to have been distributed on the first day of the year in which the transaction took place, subject to income taxes and, potentially, penalties. This makes it very difficult to manage a business, real estate or other investments held in a self-directed IRA. So, unless you’re prepared to accept a purely passive role with respect to the IRA’s assets, this strategy isn’t for you.

Considering the Option

If you have assets such as precious metals, energy or other alternative investments, a self-directed IRA may be worth your while to consider. Contact us to discuss further.

 

Sidebar: IRAs and Your Estate Plan

IRAs are designed primarily as retirement-saving tools, but if you don’t need the funds for retirement, they can provide a tax-advantaged source of wealth for your family. For example, if you name your spouse as beneficiary, your spouse can roll the funds over into his or her own IRA after you die, enabling the funds to continue growing on a tax-deferred basis (tax-free in the case of a Roth IRA).

If you name a child (or someone other than your spouse) as beneficiary, that person will have to begin taking distributions immediately. But if the funds are held in an “inherited IRA,” your beneficiary can stretch the distributions over his or her own life expectancy, maximizing the IRA’s tax benefits.

No Surprises: Why You Should Check Your Tax Bracket

Many taxpayers learned some tough lessons upon completing their 2018 tax returns regarding the changes brought forth by the Tax Cuts and Jobs Act (TCJA). If you were one of them, or even if you weren’t, now’s a good time to check your bracket to avoid any unpleasant surprises next April.

Under the TCJA, the top income tax rate is now 37% (down from 39.6%) for taxpayers with taxable income over $500,000 for 2018 (single and head-of-household filers) or $600,000 for 2018 (married couples filing jointly). These thresholds are higher than they were for the top rate in 2017 ($418,400, $444,550 and $470,700, respectively), so the top rate probably wasn’t too much of a concern for many upper-income filers.

But some singles and heads of households in the middle and upper brackets were likely pushed into a higher tax bracket much more quickly for the 2018 tax year. For example, for 2017 the threshold for the 33% tax bracket was $191,650 for singles and $212,500 for heads of households. For 2018, the rate for this bracket was reduced slightly to 32% — but the threshold for the bracket is now only $157,500 for both singles and heads of households.

So, a lot more of these filers found themselves in this bracket and many more could so again in 2019. Fortunately for joint filers, their threshold for this bracket has increased from $233,350 for 2017 to $315,000 for 2018. The thresholds for these brackets have increased slightly for 2019, due to inflation adjustments. If you expect this year’s income to be near the threshold for a higher bracket, consider strategies for reducing your taxable income and staying out of the next bracket. For example, you could take steps to accelerate deductible expenses.

But carefully consider the changes the TCJA has made to deductions. For example, you might no longer benefit from itemizing because of the nearly doubled standard deduction and the reduction or elimination of certain itemized deductions. For 2019, the standard deduction is $12,200 for singles and married individuals filing separately, $18,350 for heads of households and $24,400 for joint filers.