How Spouse-Owned Businesses Can Reduce Self-Employment Taxes

If you own a profitable, unincorporated business with your spouse, you probably find the high self-employment (SE) tax bills burdensome. An unincorporated business in which both spouses are active is typically treated by the IRS as a partnership owned 50/50 by the spouses. (For simplicity, when we refer to “partnerships,” we’ll include in our definition limited liability companies that are treated as partnerships for federal tax purposes.)

For 2018, that means you’ll each pay the maximum 15.3% SE tax rate on the first $128,400 of your respective shares of net SE income from the business. Those bills can mount up if your business is profitable. To illustrate: Suppose your business generates $250,000 of net SE income in 2018. Each of you will owe $19,125 ($125,000 × 15.3%), for a combined total of $38,250. Fortunately, there may be ways your spouse-owned business can lower your combined SE tax hit.

Divorce Yourself From the Concept

While the IRS creates the impression that involvement by both spouses in an unincorporated business automatically creates a partnership for federal tax purposes, in many cases it will have a tough time making the argument — especially when the spouses have no discernible partnership agreement and the business hasn’t been represented as a partnership to third parties (such as banks and customers).

If you can establish that your business is a sole proprietorship (or a single-member LLC treated as a sole proprietorship for tax purposes), only the spouse who is considered the proprietor owes SE tax. So, let’s assume the same facts as in the previous example, except that your business is a sole proprietorship operated by one spouse. Now you have to calculate SE tax for only that spouse. For 2018, the SE tax bill is $23,172 [($128,400 × 15.3%) + ($121,600 × 2.9% Medicare tax)]. That’s much less than the combined SE tax bill from the first example ($38,250).

Show a Lopsided Ownership Percentage

Even if you do have a spouse-owned partnership, it’s not a given that it’s a 50/50 one. Your business might more properly be characterized as owned, say, 80% by one spouse and 20% by the other spouse, because one spouse does much more work than the other.

Let’s assume the same facts as in the first example, except that your business is an 80/20 spouse-owned partnership. In this scenario, the 80% spouse has net SE income of $200,000, and the 20% spouse has net SE income of $50,000. For 2018, the SE tax bill for the 80% spouse is $21,722 [($128,400 × 15.3%) + ($71,600 × 2.9%)], and the SE tax bill for the 20% spouse is $7,650 ($50,000 × 15.3%). The combined total SE tax bill is only $29,372 ($21,722 + $7,650).

Explore All Strategies

More-complicated strategies are also available. Contact us to learn more about how you can reduce your spouse-owned business’s SE taxes.

Study Up On the Tax Advantages of a 529 Savings Plan

With kids back in school, it’s a good time for parents (and grandparents) to think about college funding. One option, which can be especially beneficial if the children in question still have many years until heading off to college, is a Section 529 plan.


Tax-Deferred Compounding

529 plans are generally state-sponsored, and the savings-plan option offers the opportunity to potentially build up a significant college nest egg because of tax-deferred compounding. So, these plans can be particularly powerful if contributions begin when the child is young. Although contributions aren’t deductible for federal purposes, plan assets can grow tax-deferred. In addition, some states offer applicable state tax incentives.

Distributions used to pay qualified expenses (such as tuition, mandatory fees, books, supplies, computer-related items and, generally, room and board) are income-tax-free for federal purposes and, in many cases, for state purposes as well. (The Tax Cuts and Jobs Act changes the definition of “qualifying expenses” to include not just postsecondary school costs, but also primary and secondary school expenses.)

Additional Benefits

529 plans offer other benefits, too. They usually have high contribution limits and no income-based phaseouts to limit contributions. There’s generally no beneficiary age limit for contributions or distributions. And the owner can control the account — even after the child is a legal adult — as well as make tax-free rollovers to another qualifying family member.

Finally, 529 plans provide estate planning benefits: A special break for 529 plans allows you to front-load five years’ worth of annual gift tax exclusions, which means you can make up to a $75,000 contribution (or $150,000 if you split the gift with your spouse) in 2018. In the case of grandparents, this also can avoid generation-skipping transfer taxes.

Minimal Minuses

One negative of a 529 plan is that your investment options are limited. Another is that you can make changes to your options only twice a year or if you change the beneficiary.

But whenever you make a new contribution, you can choose a different option for that contribution, no matter how many times you contribute during the year. Also, you can make a tax-free rollover to another 529 plan for the same child every 12 months.

More to Learn

We’ve focused on 529 savings plans here; a prepaid tuition version of 529 plans is also available. If you’d like to learn more about either type of 529 plan, please contact us.

TCJA Draws a Silver Lining Around the Individual AMT

The Tax Cuts and Jobs Act (TCJA) didn’t eliminate the individual alternative minimum tax (AMT). But the law did draw a silver lining around it. Revised rules now lessen the likelihood that many taxpayers will owe substantial taxes under the AMT for 2018 through 2025.


Parallel Universe

Think of the AMT as a parallel universe to the regular federal income tax system. The difference: The AMT system taxes certain types of income that are tax-free under the regular tax system and disallows some regular tax deductions and credits.

The maximum AMT rate is 28%. By comparison, the maximum regular tax rate for individuals has been reduced to 37% for 2018 through 2025 thanks to the TCJA. For 2018, that 28% AMT rate starts when AMT income exceeds $191,100 for married joint-filing couples and $95,550 for others (as adjusted by Revenue Procedure 2018-18).

Exemption Available

Under the AMT rules, you’re allowed a relatively large inflation-adjusted AMT exemption. This amount is deducted when calculating your AMT income. The TCJA significantly increases the exemption for 2018 through 2025. The exemption is phased out when your AMT income surpasses the applicable threshold, but the TCJA greatly increases those thresholds for 2018 through 2025.

If your AMT bill for the year exceeds your regular tax bill, you must pay the higher AMT amount. Originally, the AMT was enacted to ensure that very wealthy people didn’t avoid paying tax by taking advantage of “too many” tax breaks. Unfortunately, the AMT also hit some unintended targets. The new AMT rules are better aligned with Congress’s original intent.

Under both old and new law, the exemption is reduced by 25% of the excess of AMT income over the applicable exemption amount. But under the TCJA, only those with high incomes will see their exemptions phased out, while others — particularly middle-income taxpayers — will benefit from full exemptions.

Need to Plan

For many taxpayers, the AMT rules are less worrisome than they used to be. Let us help you assess your liability and help you plan accordingly.

 

Sidebar: High-income earners back in the AMT spotlight

Before the Tax Cuts and Jobs Act (TCJA), many high-income taxpayers weren’t affected by the alternative minimum tax (AMT). That’s because, after multiple legislative changes, many of their tax breaks were already cut back or eliminated under the regular income tax rules. So, there was no need to address the AMT.

If one’s income exceeds certain levels, phaseout rules chip away or eliminate other tax breaks. As a result, higher-income taxpayers had little or nothing left to lose by the time they got to the AMT calculation, while many upper-middle-income folks still had plenty left to lose. Also, the highest earners were in the 39.6% regular federal income tax bracket under prior law, which made it less likely that the AMT — with its maximum 28% rate — would hit them.

In addition, the AMT exemption is phased out as income goes up. This amount is deducted in calculating AMT income. Under previous law, this exemption had little or no impact on individuals in the top bracket, because the exemption was completely phased out. But the exemption phaseout rule made upper-middle-income taxpayers more likely to owe AMT under previous law. Suffice it to say that, under the TCJA, high-income earners are back in the AMT spotlight. So, proper planning is essential.

People on the Move!

We are excited to announce our promotions for 2018. We look forward to what the future holds for you all. Thank you for all you do for our clients and our firm!

Semi-Senior Accountant

Nick Hoff, Alton

Emily Keeven, Highland

Kayla Ervin, Edwardsville

Katelin Feldmann, Alton

Michael Kanallakan, Jerseyville

Maggie Stock, Belleville

Travis Wellen, Belleville

Noah Feldmeier, Belleville

Senior Accountant

Josh Goodnick, Belleville

Justin Goode, Jerseyville

Tyler Jackson, Alton

Jay Gensert, Alton

Kelly Kellerman, Belleville

Garrett Hay, Belleville

Accounting Supervisor

Jenni Flowers, Carrollton

Manager

Carrie Evans, Highland

Andrea Suhre, Belleville

 

Is Your Company Overpaying on Sales and Use Taxes?

It’s a safe bet that state tax authorities will let you know if your business hasn’t paid enough sales and use taxes. But the lines of communication may not be so open if you’re overpaying. For this reason, many businesses use reverse audits to find overpayments so they can seek reimbursements.

In most states, businesses are exempt from sales tax on equipment used in manufacturing or recycling, and many states don’t require them to pay taxes on the utilities and chemicals used in these processes, either. In some states, custom software and other computer equipment are exempt if used for research and development projects. These are just a few examples of potentially available exemptions.

Many companies have sales and use tax compliance systems to guard against overpaying, but if you haven’t reviewed yours recently, check to make sure it’s functioning properly. Employee turnover, business expansion or downsizing, and simple mistakes all can take their toll.

A formal reverse audit can extend across your business, going back as far as the statute of limitations on state tax reviews. If your state auditors can review all records for the four years preceding the audit, for example, the audit could encompass the same timeframe.

To be clear, reverse audits are often time consuming and complex. But a well-executed one can not only reap tax refund rewards now, but also help update your compliance systems going forward. Let us help you target the exemptions available to your business and ensure refund claims are properly prepared before submittal.

LLC and LLP Owners Should Befriend the PAL Rules

The limited liability company (LLC) and limited liability partnership (LLP) business structures have their advantages. But, in years past, the IRS treated LLC and LLP owners as limited partners for purposes of the passive activity loss (PAL) rules. This could be a tax negative. Fortunately, LLC and LLP owners can now be treated as general partners, which means they can meet any one of seven “material participation” tests to avoid passive treatment.


Rules to Own By

The PAL rules prohibit taxpayers from offsetting losses from passive business activities (such as limited partnerships or rental properties) against nonpassive income (such as wages, interest, dividends and capital gains). Disallowed (that is, suspended) losses may be carried forward to future years and deducted from passive income or claimed when the passive business interest is disposed in a taxable transaction.

There are two types of passive activities: 1) trade or business activities in which you don’t materially participate during the year, and 2) rental activities, even if you do materially participate (unless you qualify as a “real estate professional”).

The 7 Tests

Material participation in this context means participation on a “regular, continuous and substantial” basis. Unless you’re a limited partner, you’re deemed to materially participate in a business activity if you meet just one of seven tests:

  1. You participate in the activity more than 500 hours during the year.
  2. Your participation constitutes substantially all participation for the year by anyone, including nonowners.
  3. You participate more than 100 hours and as much or more than any other person.
  4. The activity is a “significant participation activity” — that is, you participate more than 100 hours but less than one or more other people, yet your participation in all significant participation activities for the year totals more than 500 hours.
  5. You materially participated in the activity for any five of the preceding 10 tax years.
  6. The activity is a personal service activity in which you materially participated in any three previous tax years.
  7. Regardless of the number of hours, based on all the facts and circumstances, you participate in the activity on a regular, continuous and substantial basis.

The rules are more restrictive for limited partners, who can establish material participation only by satisfying tests 1, 5 or 6. If you have questions about meeting the material participation tests, please contact us.

Proudly Introducing our New Principals

We are very excited to officially announce the two newest members of our Principal group, Danny Phipps, CPA and Cory Gallivan, CPA. Danny has been working in our Carrollton and Jerseyville offices since 1994, and Cory has been with our Alton office since 2000. They are both dynamic, passionate leaders in our firm and we look forward to all they bring to our leadership team.

Congratulations, Danny and Cory!

Assessing Your Exposure to the Estate Tax and Gift Tax

When Congress was debating tax law reform last year, there was talk of repealing the federal estate and gift taxes. As it turned out, rumors of their demise were highly exaggerated. Both still exist and every taxpayer with a high degree of wealth shouldn’t let either take their heirs by surprise.


Exclusions and Exemptions

For 2018, the lifetime gift and estate tax exemption is $11.18 million per taxpayer. (The exemption is annually indexed for inflation.) If your estate doesn’t exceed your available exemption at your death, no federal estate tax will be due.

Any gift tax exemption you use during life does reduce the amount of estate tax exemption available at your death. But not every gift you make will use up part of your lifetime exemption. For example:

  • Gifts to your U.S. citizen spouse are tax-free under the marital deduction, as are transfers at death (bequests).
  • Gifts and bequests to qualified charities aren’t subject to gift and estate taxes.
  • Payments of another person’s health care or tuition expenses aren’t subject to gift tax if paid directly to the provider.
  • Each year you can make gifts up to the annual exclusion amount ($15,000 per recipient for 2018) tax-free without using up any of your lifetime exemption.

It’s important to be aware of these exceptions as you pass along wealth to your loved ones.

A Simple Projection

Here’s a simplified way to help project your estate tax exposure. Take the value of your estate, net of any debts. Also subtract any assets that will pass to charity on your death.

Then, if you’re married and your spouse is a U.S. citizen, subtract any assets you’ll pass to him or her. (But keep in mind that there could be estate tax exposure on your surviving spouse’s death, depending on the size of his or her estate.) The net number represents your taxable estate.

You can then apply the exemption amount you expect to have available at death. Remember, any gift tax exemption amount you use during your life must be subtracted. But if your spouse predeceases you, then his or her unused estate tax exemption, if any, may be added to yours (provided the applicable requirements are met).

If your taxable estate is equal to or less than your available estate tax exemption, no federal estate tax will be due at your death. But if your taxable estate exceeds this amount, the excess will be subject to federal estate tax.

Be aware that many states impose estate tax at a lower threshold than the federal government does. So, you could have state estate tax exposure even if you don’t need to worry about federal estate tax.

Strategies to Consider

If you’re not sure whether you’re at risk for the estate tax, or if you’d like to learn about gift and estate planning strategies to reduce your potential liability, please contact us.

Take Note of the Distinctive Features of Roth IRAs

For some people, Roth IRAs can offer income and estate tax benefits that are preferable to those offered by traditional IRAs. However, it’s important to take note of just what the distinctive features of a Roth IRA are before making the choice.


Traditional vs. Roth

The biggest difference between traditional and Roth IRAs is how taxes affect contributions and distributions. Contributions to traditional IRAs generally are made with pretax dollars, reducing your current taxable income and lowering your current tax bill. You pay taxes on the funds when you make withdrawals. As a result, if your current tax bracket is higher than what you expect it will be after you retire, a traditional IRA can be advantageous.

In contrast, contributions to Roth IRAs are made with after-tax funds. You pay taxes on the funds now, and your withdrawals won’t be taxed (provided you meet certain requirements). This can be advantageous if you expect to be in a higher tax bracket in retirement or if tax rates increase.

Roth distributions differ from traditional IRA distributions in yet another way. Withdrawals aren’t counted when calculating the taxable portion of your Social Security benefits.

Additional Advantages

A Roth IRA may offer a greater opportunity to build up tax-advantaged funds. Your contributions can continue after you reach age 70½ as long as you’re earning income, and the entire balance can remain in the account until your death. In contrast, beginning with the year you reach age 70½, you can’t contribute to a traditional IRA — even if you do have earned income. Further, you must start taking required minimum distributions (RMDs) from a traditional IRA no later than April 1 of the year following the year you reach age 70½.

Avoiding RMDs can be a valuable benefit if you don’t need your IRA funds to live on during retirement. Your Roth IRA can continue to grow tax-free over your lifetime. When your heirs inherit the account, they’ll be required to take distributions — but spread out over their own lifetimes, allowing a continued opportunity for tax-free growth on assets remaining in the account. Further, the distributions they receive from the Roth IRA won’t be subject to income tax.

Many Vehicles

As you begin planning for retirement (or reviewing your current plans), it’s important to consider all retirement planning vehicles. A Roth IRA may or may not be one of them. Please contact us for individualized help in determining whether it’s a beneficial choice.

 

Sidebar: TCJA Eliminated Option to Recharacterize Roths

The passage of the Tax Cuts and Jobs Act late last year had a marked impact on Roth IRAs: to wit, taxpayers who wish to convert a pretax traditional IRA into a posttax Roth IRA can no longer “recharacterize” (that is, reverse) the conversion for 2018 and later years.

The IRS recently clarified in FAQs on its website that, if you converted a traditional IRA into a Roth account in 2017, you can still reverse the conversion as long as it’s done by October 15, 2018. (This deadline applies regardless of whether you extend the deadline for filing your 2017 federal income tax return to October 15.)

Also, recharacterization is still an option for other types of contributions. For example, you can still make a contribution to a Roth IRA and subsequently recharacterize it as a contribution to a traditional IRA (before the applicable deadline).

Charitable Contributions After the Tax Cuts and Jobs Act

Donating to charity is usually a selfless act, but that good deed in many cases also translated to a tax deduction for those that itemized on their annual filings. However, since the TCJA nearly doubled the standard deduction, this may result in less taxpayers itemizing. If you are one of these people, there may still be a way to benefit from charitable contributions without itemizing.

The TCJA almost doubled the standard deduction for most taxpayers. As a result, fewer individuals will itemize their deductions. The cap on taxes that may be claimed as an itemized deduction has also been limited to $10,000 for joint filers. These factors will also result in fewer individuals receiving any tax benefit from their charitable contributions.

There is still a way for certain individuals who don’t itemize to benefit from their charitable contributions. Taxpayers who are at least 70.5 years old and receiving required minimum distributions from their IRA (but not SIMPLE IRAs or SEP-IRAs) may have up to $100,000 transferred directly from their IRA to a qualified charity. The amount transferred to the charity reduces the otherwise taxable IRA distribution. These transfers are referred to as Qualified Charitable Distributions (QCDs). QCDs effectively allow the taxpayer to deduct the charitable contribution since these amounts reduce the taxable IRA distribution.


Let’s look at an example.

This taxpayer is 72 years old and has a required minimum distribution of $12,000. He does not have enough to itemize deductions and has traditionally given $5,000 to his church. Also, assume he has a combined federal and state tax rate of 30%. If he directs $5,000 of his required $12,000 distribution to be paid directly to his church, he is only taxed on $7,000 of the IRA distribution. If the amount is not directly transferred, he has $12,000 of taxable IRA distributions with no offsetting charitable deduction. By taking advantage of a QCD, he has saved $1,500 ($5,000 x 30%).

All taxpayers at least 70.5 years old and taking required distributions from their IRA should consider using the QCD to make their charitable contributions. Please contact us if you would like to discuss the QCD and whether this method would benefit you.