Posts under: Tax Planning

How the New GOP Tax Law Affects Owners and Investors of Real Estate

December 28, 2017 Business planning, Real Estate, Small Business, Tax Planning Comments Off on How the New GOP Tax Law Affects Owners and Investors of Real Estate

Real estate has always been a major step in achieving the American dream and so there was plenty of concern within the industry that major changes in the taxes affecting owners and investors of real estate would negatively impact the industry and the tax benefits of owning real estate.   While the final tax changes are expected to diminish the tax benefits for some owners such as:  homeowners who take out mortgages above $750K, homeowners using home equity lines of credit, or homeowners in certain markets with high state tax, the overall impact on real estate, in our opinion, is likely to be nominal.   Below is a summary of the current laws and changes to the tax laws affecting owners and investors in real estate.

State and Local Tax:

Prior Law:

Individuals who itemize their deductions can claim deductions for specific state and local taxes including real property taxes, state income taxes, and sales taxes.  Property taxes incurred in connection with a trade or business can be deducted from adjusted gross income without the need for itemizing.

New Law:

Individuals who itemize (which will likely decrease in light of the increase in standard deductions) are allowed to deduct up to $10,000 ($5,000 if married filing separately) for any combination of (1) state and local property taxes (real or personal), and (2) state and local income taxes.  Prepayments on state income taxes in 2017 for future tax years may not be deducted.

However, state, local and foreign property taxes or sales tax may be deducted when incurred in carrying on a trade or business or for the production of income (reported on Schedules C, E or F).

Conclusion:  Generally worse for Taxpayers who itemize and pay high state and local taxes.

Mortgage Interest:

Prior Law:

Individuals may deduct mortgage interest up to $1M ($500K if married filing separately) of home “acquisition indebtedness”  (secured debt to acquire, construct or improve) on their principal residence, and one other residence of the taxpayer which can include a house, condo, cooperative, mobile home, house trailer, or boat.

Individuals with Home Equity Lines of Credit (HELOCs) were allowed to deduct interest paid on up to $100K ($50K if married filing separately) of a Home Equity Line of Credit.

New Law:

For homes purchased after December 15, 2017, the deduction for 1st home mortgages would be limited to interest paid on mortgages up to $750K ($375K for married filing separate) and is not limited to only your principal residence.  For refinances, the refinanced loan will be treated the same as the original loan so long as the new refinanced loan does not exceed the amount of the refinanced indebtedness.

The deduction for interest on Home Equity Lines of Credit has been eliminated which applies retroactively.  However, the new tax law did not modify the definition of “acquisition indebtedness” and so interest on a Home Equity Line of Credit that was used to “construct or substantially improve” a qualified residence continues to be deductible.

Conclusion:  Worse for Taxpayers since the qualifying indebtedness was reduced from $1M to $750K for debts incurred after December 15, 2017, and indirectly due to the increase in standard deduction plus the elimination of deductions of home equity lines.

Depreciation of Real Estate:

Prior Law:

The cost of real estate “used in a trade or business” or “held for the production of income” must be capitalized and deductions made over time through annual depreciation deductions over 39 years (for non-residential) and 27.5 years (residential) using straight line depreciation.

Certain leasehold improvement property, qualified restaurant property and qualified retail  improvement property can be depreciated over 15 years.

New Law:

Same recovery period for residential rental real estate and non-residential.  However, the previous exceptions for qualified leasehold improvements, qualified restaurant property and qualified retail improvement have been modified and consolidated so that they each must meet the definition of a “qualified improvement property” which is then depreciated over 15 years.

Conclusion:  Nominal change

Capital Gains:

Current Law:   Capital Gains rates apply to any net gain from the sale of a Capital Asset or from Qualified Dividend Income.   Capital Gains and Qualified Dividend Income are subject to rates of 0%, 15% or 20%.  Any net adjusted capital gain that would otherwise be subject to the 10% or 15% income rate is not taxed.   Any net adjusted capital gain that would otherwise be subject to the rates between 15% to 39.6% income rate are taxed at 15%, and amounts taxed at 39.6% income tax rate are taxed at 20%.

New Law:  No change in structure, except that the income tax brackets are modified and the amounts subject to these rates will be indexed for inflation based on the Chained Consumer Price Index (C-CPI-U) beginning the end of 2017.  For 2018, the breakpoints would be as follows:

Under $77,200 (married filing jointly) or $38,600 (single) of income, no capital gains

15% Rate:            From $77,400 married filing jointly ($38,700 for single)

20% Rate:            From $479,000 married filing jointly ($425,800 for single)

Conclusion:   Generally better for investors due to the new tax brackets and indexing for inflation.

Exclusion on Gain on Sale of Personal Residence.

No change.  The rule allowing for an exclusion from capital gains in the amount of $500K married ($250K single) for sale of the personal residence used as such for two out of the last five previous years remains.

1031 Exchanges:

Current Law:  No gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged for like kind which is held for productive used in a trade or business or for investment.

New Law:  For transfers after 2017, gain deferral allowed for like kind exchanges of real property only, but real estate held primarily for sale (i.e. flips) would not be eligible.   This applies to exchanges completed after December 31, 2017.  However, so long as the relinquished property is disposed of prior to December 31, 2017, the non-recognition provisions of the prior law applies.

GOP Delivers Tax Reform for Christmas – Joy to the World for Individuals?

December 28, 2017 Tax Planning Comments Off on GOP Delivers Tax Reform for Christmas – Joy to the World for Individuals?

Well, folks – it’s finally here.  Congressional Republicans spent most of the fall crafting, arguing over, and adding and deleting provisions from a sweeping tax reform bill, and President Trump just signed it into law (and held up his huge signature to the cameras).  It’s the first significant legislative achievement of The Donald’s presidency and the first major overhaul of the tax code since 1986.  Also, just like Obamacare in 2010, the new tax law passed without a single vote from the minority party.  In contrast, the 1986 tax law passed with a simple “voice vote” in the House, and by a 97-3 majority in the Senate – results that can only be attributed to a long-forgotten and apparently outdated concept called “bipartisanship.”  I had to Google it – 21st Century lawmakers may want to think about doing the same.

Immediately after signing it, the President had the new law shipped to the North Pole to be loaded onto Santa’s sleigh and delivered to all Americans (both naughty and nice) just in time for Christmas.  He had to send it FedEx because the U.S. Postal Service couldn’t guarantee on-time delivery (#Sad).  Anyway, whether waking up to find the revised tax code in your stocking on Christmas morning made you feel like you got a brand new iPhone X or just a gigantic lump of government-issued coal will depend on several factors.  My job is to go through how those factors will affect individual taxpayers, so you can decide whether to drink a little more egg nog to celebrate your tax windfall, or to spend New Year’s Day plotting how to tell President Trump and Congressional Republicans: “You’re fired!!!” as soon as possible.

Tax Brackets

First, tax rates go down for all taxpayers.

Income Tax Rate Filing Type
2017 2018 Single Married-Joint
10% 10% $0-$9,525 $0-$19,050
15% 12% $9,525-$38,700 $19,050-$77,400
25% 22% $38,700-$82,500 $77,400-$165,000
28% 24% $82,500-$157,500 $165,000-$315,000
33% 32% $157,500-$200,000 $315,000-$400,000
33%-35% 35% $200,000-$500,000 $400,000-$600,000
39.6% 37% $500,000+ $600,000+

 

So, what are the big picture takeaways here?

1)   Generally speaking, the rates themselves are lower pretty much across the board.  The progression is 10%-12%-22%-24%-32%-35%-37%, instead of 10%-15%-25%-28%-33%-35%-39.6%.

2)   The dollar amounts subject to lower rates are generally higher.  Let’s take taxpayers who are married filing jointly – they get an additional $400 of income taxed at the lowest 10% rate, then the next bracket up caps at $77,400 instead of $75,900, the next one up caps at $165,000 instead of $153,100, then at $315,000 instead of $233,350, and so forth.  At the top, only income above $600,000 is taxed at the highest rate, instead of everything above $470,700.  The results are similar for single taxpayers.

Deductions

While the tax brackets and rates are certainly important, anyone who’s done their own taxes knows that before those numbers apply, you have to determine how much of your income is actually subject to taxation.  This is where the ever-popular “tax deduction” comes in.  Tax deductions come in two primary flavors: 1) “Above the line” deductions; and 2) “Below the line” deductions.

Above the Line Deductions

Above the line deductions are those you enter on the first page of your tax return.  They are technically “adjustments to income” because they are subtracted from your gross income to determine your Adjusted Gross Income (“AGI”).  Generally speaking, above the line deductions are more valuable than their below the line brethren.  This is for two main reasons: 1) You can take above the line deductions even if you don’t itemize your below the line deductions – they are taken in addition to (not instead of) the standard deduction (if you go that route) below the line; and 2) As alluded to above, they reduce your AGI – and the lower your AGI, the more below the line deductions and tax credits you may qualify for.  Let’s go through some of the most common above the line deductions to see what, if anything, has changed under the new law

1)   Traditional IRA Contributions – No change.  Still an above the line deduction, and contribution limits remain $5,500 for people under 50, and $6,500 for folks 50 or older.

2)   Contributions to Other Qualified Retirement Plans – Here, we’re talking about 401(k)’s, 403(b)’s, and other types of retirement plans.  Contributions to these remain above the line deductions as well.  In fact, if your employer withholds your contributions from your paycheck, these contributions are already deducted for you and are not even reported as income on your W-2.  The new law doesn’t make any significant changes here.

3)   Health Savings Account Contributions – There had been talk that the GOP would “supercharge” this deduction by greatly increasing the annual HSA contribution limits.  No such luck.  HSA contributions for 2018 are capped at $3,450 for individuals and $6,900 for families (which represents a small inflation-related increase over 2017, which had already been announced).  These contributions remain an above the line deduction.

4)   Student Loan Interest Payments – This is a big one for those of us who went to graduate school and have what one of my former law school classmates likes to call a “soul-crushing” student loan debt burden.  The current law provides some minor relief from that soul-crushing burden by allowing an above the line deduction for up to $2,500 of student loan interest paid during the year, as long as your income doesn’t exceed certain AGI limits.  The House bill eliminated this deduction completely, and prompted thousands of sad-face emojis from grad school alumni across the country.  Luckily, the Senate swooped in, and in the final law, the student loan interest deduction survived without change.

Below the Line Deductions

When it comes to below the line deductions, we all have two choices, take the Standard Deduction offered by the government, or, if they add up to being more than the Standard Deduction, list and report the various types of expenses the government has decided that you may deduct from your taxable income (i.e. “itemize” your deductions).  Let’s see what happened to some of the most popular below the line deductions:

1)   The Standard Deduction – Before we get into the individual itemized deductions, we have to talk about the Standard Deduction because the changes here will likely lead to a lot less people itemizing.  The amount of the Standard Deduction has increased from $6,350 to $12,000 for individuals, and from $12,700 to $24,000 for folks who are married and filing jointly.  So, cue the confetti and champagne, right?  Not so fast.

While it expands the Standard Deduction, the new law also repeals the “Personal Exemption” which was $4,050 per family member in 2017, subject to being phased out at certain AGI levels.  So, in 2017, a married couple with three children under the age of 18 taking the Standard Deduction could deduct a total of $32,950 below the line: $20,250 ($4,050 x 5 family members) worth of Personal Exemptions, and an additional $12,700 for the Standard Deduction.  In 2018, by taking the Standard Deduction again, that same family of five will only be able to deduct $24,000 below the line because there are no Personal Exemptions available.

2)   Mortgage Interest Deduction – The current law allows you to deduct interest paid on up to $1 million of qualified home acquisition indebtedness with respect to your principal residence and one other residence, as well as interest paid on up to $100,000 of qualifying home equity indebtedness.

The new law does not change anything when it comes to deducting interest on loans used to purchase such residences prior to December 15, 2017.  However, it does place a new cap of $750,000 of acquisition indebtedness used to acquire, build, or substantially improve such residences after December 15, 2017.  It also eliminates any deduction for home equity indebtedness, effective January 1, 2018, without any grandfathering for existing home equity indebtedness. This means that once you kiss your significant other at midnight on New Year’s Eve, you can also kiss goodbye any deduction for home equity indebtedness.

3)   State and Local Tax (“SALT”) Deduction – Currently, you can take a deduction for the amount you pay in state and local property and real estate taxes, plus either the amount you pay in state and local income taxes or state and local sales taxes.  After nearly being eliminated completely, the final law preserves the SALT deduction, but caps it at $10,000 (in the aggregate between property taxes and either income or sales taxes) per year.  In addition, to prevent folks from attempting to maximize their state and local tax deductions in 2017 (before the cap takes effect in 2018), the new rules explicitly state that any 2018 state income taxes paid before the end of 2017 are not deductible in 2017 (and instead will be treated as having been paid at the end of 2018). However, this restriction applies only to the prepayment of income taxes (not property taxes), and applies only to actual 2018 tax liabilities.

4)   Charitable Deduction – No major changes here.  However, while the limit for this deduction is currently 50% of AGI, it will be increasing to 60% of AGI starting in 2018.

5)   Medical Expense Deduction – The current law permits a deduction for medical expenses in excess of 10% of AGI (7.5% of AGI for people 65 and older).  The House bill eliminated this deduction entirely.  However, the Senate stepped in again, and the new law not only retains the deduction, but allows the deduction to begin at 7.5% of AGI for all taxpayers in 2017 (yes, retroactively) and 2018.  After that, the deduction is only available to the extent that expenses exceed 10% of AGI for all taxpayers (so, there’s no 7.5% AGI carve out for those 65 and older).

Tax Credits

Tax credits are awesome because, unlike both above and below the line deductions, they are subtracted from your actual tax liability, instead of from your taxable income.  So, while a $100 tax deduction might save you as much as $37 in taxes in 2018 (if you are in the highest 37% tax bracket), a $100 tax credit will save you $100 in taxes.  Put another way, tax credits reduce the amount of tax you owe dollar for dollar.

There are tax credits out there that apply to premiums for health insurance purchased on the Health Insurance marketplace, certain education expenditures, folks living abroad, and other situations, but I am going to focus on two credits that apply to families and parents:

1)   The Child Tax Credit – Currently, parents get a $1,000 tax credit for each qualifying child under the age of 17, but that credit phases out starting at $75,000 of AGI for individuals, and $110,000 of AGI for those of us who are married filing jointly.  Under the new law, the credit is increased to $2,000 per qualifying child, and the phase out wouldn’t kick in until $200,000 of AGI for individuals and $400,000 of AGI for married couples filing jointly.  In many cases, this will help to offset the loss of the personal exemptions described above.  Of the $2,000 credit per child, $1,400 is “refundable.”  This means that if the application of the credit brings your total federal income tax liability below $0, up to $1,400 of the credit, per child, will still be added to the refund check the government will send you.

2)   The Child and Dependent Care Credit – This provision allows you to claim a tax credit equal to somewhere between 20% and 35% (depending on your AGI) of actual child and dependent care expenses up to $3,000 for one person, and up to $6,000 for two or more people.  This credit was not changed (or seriously threatened to be changed) during the tax overhaul process.

One more thing, Republicans also used the opportunity of crafting a new tax law to strike a serious blow to the crowning legislative achievement of President Trump’s predecessor – namely, Obamacare.  Starting in 2019, the penalty for failing to purchase qualifying healthcare will be reduced to $0.  This is what they mean when they say the new tax law repeals the ‘individual mandate.”

At the end of the day, at least in the short term (the law expires in 2025, unless it is subsequently renewed), most Americans will see at least a small increase in their paychecks because of the new law.  So, who are some of the biggest winners and losers under the new system?

Winners: People with Multiple Children under Age 17.  Most Americans will qualify for the full $2,000 credit, per child.  So, if you’ve got five kids under 17, that’s a $10,000 tax credit and $7,000 of it is refundable.

Losers: High Income Taxpayers in High Tax States.  For some people in places like New York, New Jersey and California, the $10,000 limitation on the SALT deduction will increase their taxable income by $50,000 or more.  Yikes – I guess Republicans figure they weren’t winning these states anyway!

Winners: People with High Medical Expenses.  The Medical Expense Deduction survived and was even expanded for 2017 and 2018.

Losers: Empty Nesters and People without Children.  The Child Tax Credit serves to at least partially offset the loss of the Personal Exemption (and in some cases the math even comes out better for parents).  No such luck if you don’t have any kids under 17.

Winners: Charitable Donors.  Republicans retained this deduction, and increased the percentage of donations that can be deducted.

Five Benefits of the Solo 401K

November 6, 2017 Retirement Planning, Tax Planning Comments Off on Five Benefits of the Solo 401K

For many Americans, saving for retirement is like exercising or eating healthy, we know we should do it but most of us don’t.   In fact, a survey published by the Washington Post reported that over 70% of Americans are not saving enough for retirement and a study by the US Government Accountability Office reported that as many as half of American households 55 or older have NO retirement savings at all!   A recent Merrill Lynch report estimates the average cost of retirement to be nearly $750,000 but this obviously depends on your standard of living and life expectancy.   With advances in technology increasing our lifespans, we need to plan accordingly in order to have what we need in retirement.

The Solo 401K is the ideal vehicle for small business owners with no full time employees to save for retirement through its generous contributions limits which can offset your taxable income.  If your small business generated a profit this year and you are looking for a nice year-end tax deduction, the Solo 401K may be the perfect solution for you.  We have compared the other available retirement options for small businesses and the Solo 401K consistently wins hands down.  Some of the benefits include:

1. Tax Savings: In 2017, the employee contribution limit is $18,000, or $24,000 if you are 50 or over.  Compare this with the contribution limit of $5,500 for IRAs.   In addition, the business itself can do an employer match up to 25% of the employee’s W-2 compensation.  For an example, let’s assume you have a net income of $100,000 in your s-corp business and you took $35,000 as your salary.  Your contributions (traditional) and tax savings are as follows.

Employee traditional 401K Contribution                                 <$18,000>

Employer Match at 25% of $35K                                                <$8,750>

Total Solo K Contributions                                                            $26,750

 

Tax Savings (approx. 25% federal):                                           $6,700 (approx.)

Plus State Income Tax Savings Depending on State

For a calculator that allows you to determine your contribution levels based on your income, refer to this website, check your business entity type (sole prop LLC, partnership, s-corp) and it will calculate the solo K contribution amounts.

2. The Ability to Self Direct: The solo 401Ks established by KKOS  allows you to self-direct your retirement account which means, with very few exceptions, you can invest in virtually any type of investment you want.  Rather than be stuck with the investment options that Merrill Lynch or Charles Schwab offers, with a self directed 401K, you can invest in “what you know.”    Do you want to be a lender and get a fixed rate of interest through your 401K?  Or perhaps purchase a rental property if your interest is real estate?  Maybe a startup company in an industry you have an interest.  All of these options are possible with a self directed 401K.

3. No Third Party Custodian: By contrast to an IRA which requires a third party custodian, the 401K owner in a solo 401K can acts as his/her own trustee.  The other options to self-direct is through a self-directed IRA, however, in a self-directed IRA (without an IRA/LLC) all of your transactions needs to be processed through the third party IRA custodian.  Some clients have reported that they were unable to secure a deal due to the delays of having to go through the third party custodian.  On the other hand, with a solo 401K, you, as the trustee of the 401K, have the freedom enter into transactions or make investments on behalf of the 401K thereby eliminating the expense and delay of involving a third party custodian.  You’ll also have a checking account and “checkbook control” such that you can sign checks or send wires to make investments or to pay expenses. With freedom, of course, comes responsibility and so you must be intimately familiar with the rules and restrictions for self directing your 401K to avoid penalties and taxes with the IRS.

4. You can take a Personal Loan from your 401K: With an IRA, there are  very limited circumstances where you can use money from the retirement account for personal reasons and because of these restrictions, using IRA money for personal purposes is not a viable option.  With a 401K, you can take a loan of up to $50,000 or 50% of the value of the 401K, whichever is less, and use those funds for any purpose.   401K loans must be in writing using a compliant 401(k) participant loan note and, must provide for, at a minimum, quarterly repayments within five (5) years.  However, for individuals who need quick access to cash, the 401K loan is usually a much better options compared with those available for IRAs.

5. No UDFI Tax:   When you leverage your investment in an IRA with borrowed funds, any income that is received that is attributable to those leveraged funds is subject to Unrelated Debt Financed Income Tax (UDFI).   For example, if you buy a $100,000 rental property through your IRA, but 50% of the purchase price was from a non-recourse loan, 50% of any income from that investment will be subject to this UDFI tax.    By contrast, there is no UDFI tax for 401K investments arising from debt on real estate.   So any income you generate from that $100,000 property in your 401K would grow tax deferred even though you only really used $50,000 of retirement funds to generate the income.   That’s having your cake and eating it too!

In order to qualify for a solo 401K, you must have a small business that generates business income (sorry, rental properties alone generally do not qualify as a small business).   The 401K must be established before the end of this year in order to obtain the tax benefits for this year.   For those business owners who are looking for year-end tax strategies to lower your taxes, the solo 401K may be the perfect fit.

For more information on how the Solo 401K works, take a look at our 1 hour solo 401K webinar available here.

The New “Centralized Partnership Audit Regime” – A Seismic Shift or Much Ado about Nothing?

October 31, 2017 Business planning, IRS, Tax Planning Comments Off on The New “Centralized Partnership Audit Regime” – A Seismic Shift or Much Ado about Nothing?

An article on IRS audits…just what you needed to read before going to bed tonight, and I’m not kidding. Now, don’t be embarrassed if you haven’t heard of the Centralized Partnership Audit Regime (“CPAR”). If you think it sounds like something out of a George Orwell novel that only CPA’s and Tax Attorneys care about – well then, you’re half right. It’s not from Nineteen Eighty-Four. It is a real thing; the sort of thing people in my profession like to bring up when they’re trying to sound smart at cocktail parties – the most boring cocktail parties EVER.

Anyway, despite the sleep-inducing name, the CPAR is something many of our clients need to be aware of – namely clients who file (or should be filing) an annual Form 1065 Partnership Tax Return. So, if you are involved in a partnership, try to stay awake – this is for you.

A little background: The CPAR was enacted into law by the Bipartisan Budget Act of 2015 (“BBA”). As with most federal laws, the statute itself is nice and all, but the real meat comes in the form of the administrative rules implementing the law. The Proposed Rules for the BBA were introduced earlier this year, and barring something really crazy (which can’t be ruled out in the Washington D.C. of 2017) they will go into effect for all tax years beginning on or after January 1, 2018.

In a nutshell, the CPAR will replace the rules that currently govern partnership audits (which come from the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”). The intent of the CPAR is to make it simpler and easier for the examine partnerships, particularly large partnerships with multiple tiers or levels of ownership.

So, What’s New in the CPAR?

1) “Partnership Representative” Replaces “Tax Matters Partner”: Currently, a partnership is required to designate a “Tax Matters Partner.” This is typically done in an Operating or Limited Partnership Agreement. While the Tax Matters Partner can bind the partnership in connection with an audit, it cannot bind the individual partners. In addition, a partner who is not the Tax Matters Partner has certain rights during an audit, including notification rights and the right to participate in the proceedings.

Under the CPAR, the Tax Matters Partner is replaced by the concept of a “Partnership Representative” who is the sole point of contact between the partnership and the IRS. Unlike with the Tax Matters Partner, all partners and the partnership itself are bound by the actions of the Partnership Representative and no one other than the Partnership Representative is vested with a statutory right to participate in a partnership-level audit proceeding. Neither state law nor the partnership agreement itself may limit the authority of the Partnership Representative when it comes to an audit.

Under the CPAR, a partnership must designate its Partnership Representative in the partnership’s annual tax return. Unlike with the Tax Matters Partner, the Partnership Representative may or may not be a partner. The only hard and fast requirement is that the Partnership Representative have a “substantial presence” in the United States. The Partnership Representative designation must be made separately for each tax year and is effective only for that year. One Orwellian tidbit here is that if you fail to designate a Partnership Representative, the IRS is allowed to pick one for you!!! This is a little scary. Again, the Partnership Representative does not have to be a partner in the partnership – so it is at least conceivable that the IRS could appoint as Partnership Representative a non-partner third-party who then becomes the sole point of contact for the IRS regarding the audit and is vested with full authority to bind the partnership in an audit.

Given the above, under the CPAR it becomes more important than ever that you don’t blow off your annual 1065 Partnership Return. File the return on time and name a Partnership Representative! A pretty simply recipe to avoid IRS trouble. I have seen some chatter online about amending operating or partnership agreements to make this designation. However, while this is certainly a good place for the partners agree in writing as to who will be designated the Partnership Representative (or how the Partnership will choose the Partnership Representative), the actual designation must be made on the filed partnership return.

2) “Imputed Underpayment” and the “Push Out Election”: These will become important if you are ever in an audit, but we will not be going into detail here. They are technical changes regarding how the IRS notifies the partnership of an amount owed after audit, and how and when a partnership can decides to pay what is owed at the partnership level, or “push out” that liability to the individual partners.

Am I Stuck with the CPAR?

The short answer is “not necessarily.” Partnerships with 100 or fewer partners – all of whom are considered “Eligible Partners” by the IRS can opt out of the CPAR. Eligible Partners are defined as:

  1. Individuals
  2. C-Corporations
  3. S-Corporations
  4. The Estates of Deceased Partners

So, if any partner is a trust, a disregarded entity (such as a single-member LLC), or another partnership, opting out is simply not an option. Just like naming a Partnership Representative, opting out of CPAR is done annually, when you file your 1065 partnership return. In order to successfully opt out, you will need to provide the IRS with the name, tax ID number, and federal tax classifications of all partners. Also, the election to opt out only applies to the year to which your tax return applies, so it will need to be done each year going forward.

If you opt out, the IRS will be required to initiate deficiency proceedings at the partner level (instead of the partnership level) to adjust items associated with the partnership and thereby assess and collect any tax that may result from those adjustments. This makes life harder for the IRS, and for this reason, it will likely make sense for eligible partnerships to opt out of CPAR – if they can. The decision to opt out can be made in an operating or partnership agreement, but will need to be submitted to the IRS each year as part of filing the 1065 partnership return.

Because opting out makes a partnership audit more difficult for them, the IRS has stated its intention to closely scutinize any partnership’s decision to opt out. This will include analyzing whether the partnership correctly identified all of its partners. For example, the IRS could conduct a review of a partnership’s partners to confirm that none are acting as nominees or as agents for a beneficial owner.

At the end of the day, for most of our clients, the shift to CPAR will not be noticed. Most partnerships don’t get audited, and if they do, the partners work together to get through it. However, by taking the steps to opt out of CPAR (if eligible), or to make sure a Partnership Representative is named (if opting out isn’t a possibility), you can avoid running into a CPAR problem that could have otherwise been avoided.

8 Core Tax Concepts Every Entrepreneur Needs to Know

October 24, 2017 Business planning, Corporations, Small Business, Tax Planning Comments Off on 8 Core Tax Concepts Every Entrepreneur Needs to Know

Of the many virtues that entrepreneurs have, one such virtue is the desire and ability to get as much information and knowledge as they can by reading books, attending speaking events, researching on the internet, etc. However, ‘taxes’ aren’t one of the topics entrepreneurs seek out, and it’s for a justifiable reason.

Many believe the topic of taxes to be either too boring or overly complicated, and it typically is when presented improperly.  Yet, so many business owners are starving and anxious to learn tax and legal principles. Inspired by those teachers of tax and legal topics that make it truly interesting, I have tried to summarize in this article the top 8 Core Tax Concepts that every entrepreneur needs to know:

  1. The IRS treats different types income VERY differently. This principle is at the CORE of so much of our advising. For example, income you make in your operational business is NOT taxed the same as income you make in your rental real estate “business”. So as you read books, attend speaking events, etc., keep in mind that the principles taught (and the advice if you’re talking to your tax professional) are going to depend in large part on the TYPE of income.
  2. Corporate Income Tax versus Pass-through Entities i.e. LLC’s, S-corps, Sole Props, Partnerships. A pass-through entity is a business entity that does NOT pay income tax at the “entity” level but rather, the income tax liability is passed-through to the owner(s) of the business (hence avoiding the double taxation that is often associated with c-corporations). In other words, the manner in which income generated by an LLC taxed as a sole proprietorship or partnership is very different than a c-corporation. There are a lot of false assumptions that entrepreneurs have about their tax situation and a lot of that comes from internet research – not because the article was bad, but because they simply misapplied it to their situation. For example, if an entrepreneur whose business is taxed as a partnership comes across an article about business taxes is going to become very confused if the articles is referring to corporate income taxation, unless they REALIZE the article is not referring to “pass-through entities” such as theirs. The result would be that if that entrepreneur tried to apply the principles in that article to their business, it would be confusing and likely not helpful.
  3. There are all sorts of taxes – It’s important to keep them straight. If you regularly read books, attend speaking events, listen to podcasts, etc., and you hear taxes, don’t assume it’s ALWAYS about income taxes. For example, technically, self-employment taxes, which is discussed frequently, is different than income tax. And when you’re in the world of small business, real estate, estate planning, etc., trying to get as much “self-learning” as you can, there’s even more types of tax out there which may or may not apply to you. For example, there’s income tax, self-employment tax, estate tax, property tax, gift tax, payroll tax, sales tax, and many more. So always make sure you’re aware of which type of tax that author, or speaker, etc., is referring to.
  4. Generally, a tax-write off is whatever costs and expenses are customary and appropriate in your industry and helpful to your business. Actually, the verbiage in the tax code is “ordinary” and “necessary”, but thanks to the courts, those words have been defined to mean “customary” and “appropriate”. So if you’re a house flipper out genuinely trying to make money in your business and you have costs and expenses along the way, you’ll typically be able to write off any and all expenses that are customary and appropriate for someone in the house flipping business.
  5. Some business “write-off’s” must be amortized over time. With some exception, when you/your business buys equipment or assets, generally that cost IS deductible BUT will have to be spread out or amortized over multiple tax years based on the IRS schedule for that particular asset/equipment.
  6. Basis. One of the core principles of taxation is that your cost to acquire an asset is called your basis, and that’s important because when you decide to sell that asset, the tax consequences of that transaction will be determined “based” (bad pun) on the selling price of the asset/equipment over and above the basis (note: by the time you sell that asset, the basis will have adjusted and so it’s referred to as your “adjusted basis”). That excess amount, if any, is a capital gain and is typically taxed differently than your “ordinary” business income. Selling an asset in your business (or the business itself) can become quite complicated, but so long as you remember this core tax concept, it will help you when discussing transactions with your tax professional(s).
  7. Most tax deductions are “entity-agnostic”. Most of the tax write-off’s that a typical entrepreneur are going to have will be available to them regardless of whether they operate as a sole proprietorship, LLC, or corporation. For example, if you’re trying to claim expenses associated with your business that you incur in the course of traveling, meeting with clients, etc., those costs will generally be deductible regardless of whether you operate your business as a sole proprietor, partnership, s-corporation, or c-corporation.
  8. Don’t let the “tax tail wag the dog”. I’m not suggesting your business is a “dog”, but if your business doesn’t need a certain expense or you wouldn’t buy a certain expense otherwise, it usually doesn’t make sense to incur such an expense simply to claim another tax write-off. For example, it’s exciting when you read a book or attend a speaking event that mentions a certain tax write-off, but if you don’t need that expensive new piece of equipment, particularly if you’re just starting out in your business, that huge expense, notwithstanding the fact that it is deductible, could run your business into the ground.

In sum, keep reading, attending speaking events, listening to podcasts, but if you will keep these core principles in mind you’ll have much better success in implementing some of the strategies you read/learn about. This article is not intended as legal or tax advice. If you’re an entrepreneur or potential entrepreneur and have tax and legal questions, please contact our office.

Simple is Sexy: Maximize Retirement Contributions for Tax, Asset Protection, and Estate Planning Benefits

September 25, 2017 Asset Protection, Retirement Planning, Tax Planning Comments Off on Simple is Sexy: Maximize Retirement Contributions for Tax, Asset Protection, and Estate Planning Benefits

Many clients appreciate our ability to see the big picture.  For example, when it comes to asset protection, estate planning, and tax planning, none of these practice areas happen in a vacuum, meaning the methods and tools used for asset protection will almost always affect and impact your estate plan and/or tax plan, for good and for bad, and vice versa.  These areas should be coordinated together.  While a lot of clients appreciate that, they often times overlook or fail to maximize the full benefits that come with funding and investing with a retirement account because it just doesn’t seem, well, sexy.  Keep reading.

  • Asset Protection. Effective asset protection rarely involves a transfer of all of your assets into some foreign off-shore jurisdiction.  For many people, there are much less expensive and effective ways to protect your assets and one of those ways is to put your money into retirement accounts.  So before you take other, more expensive, efforts to protect your assets, make sure you’re fully contributing to your retirement accounts because the funds inside your retirement accounts are generally protected from your creditors, though it varies from state to state in terms of the extent of the protection and the type of retirement account(s) e.g. ERISA v. Non-ERISA, etc..  Our office can help you determine the extent of the creditor protection based on your state and the type of retirement account but generally speaking all retirement accounts are protected from creditors at least up to $1M.
  • Estate Planning. One of the primary purposes of setting up an estate plan is the ability to transfer assets upon your death without having to go through the probate court.  One of the features of a retirement account is that upon your death it will directly transfer to whomever you listed on the account’s beneficiary designation form without having to go through the probate court!  So at a minimum, make sure to keep your retirement account beneficiary forms updated.  I am not suggesting you don’t need an estate plan at all, but if you fail to set one up, at least your retirement account would transfer upon your death without going through probate court.
  • Tax Planning. It typically makes sense to sell an asset or receive income when you’re in a lower income tax bracket.  There are all sorts of financial vehicles and instruments to accomplish these objectives, but once again, the “low hanging fruit” is to acquire assets and receive income into a retirement account.  Presumably during your peak income earning years i.e., 30’s, 40’s, and 50’s, rather than paying tax on your income and then contributing in a taxable account where the income is taxable, you defer the income tax liability until your later years once you’ve retired, under the presumption that when you’re retired, you are in a lower income tax bracket, AND the contributions you made into the retirement account are tax deductible!!  Plus, the money you would have paid in taxes stays in your account fully invested allowing the account to grow more quickly. Further, the REAL power of using a retirement account for tax planning is to utilize a Roth account because even though the contributions are not deductible, any qualified distributions are tax-free, even after your death!  In other words, when that Roth account is inherited, no tax is paid on distributions to heirs, unlike with a traditional retirement account where in the hands of the heirs, distributions are taxed.

Here’s a fictional story to illustrate my point.  Mart Kohlersen is 57 years old.  He’s worked for 35 years and done very well for himself.  He has an investment account portfolio worth $1.8M and owns a lot of toys (boat, ATV’s, RV’s, etc.).  He owns his home outright which is worth $950,000 and has $10,000 in a retirement account because he figures he’ll live off his investment account and downsize his house when he retires if needed so he never bothered to put much funding into his retirement account.  One day, while driving his ATV, he seriously injures somebody.  His insurance is insufficient and he loses in the lawsuit.  The plaintiff obtains a $1.5M judgment against Mart.  His accounts are garnished and assets are sold, leaving him with a much smaller investment account and a much smaller house.  And no more toys.  To make matters worse, Mart died later that year without an estate plan, and for the next five years, his siblings and kids fought in probate court significantly and further depleting what assets were left/available.  It’s a sad story, and he definitely would have benefited from some much better asset protection, tax planning, and estate planning, BUT, EVEN if he did nothing else different except fully contribute to his retirement accounts, here’s a much happier ending:  If he would have fully contributed to a retirement account throughout his lifetime, a large portion of his net worth would be inside  retirement accounts and thus protected from the aforementioned creditor, and thus remain intact to receive the tax benefits discussed above, AND said account(s) would have directly passed to whomever he named as the beneficiary(ies) without having to go through probate court!

In sum, I’m not suggesting that the ONLY investment vehicle should be your retirement account.  There are annual contribution limits which make it impossible to put all of your funds in a retirement account.  However, I am suggesting that if you will take advantage of fully contributing to your retirement account as much as possible, the RESULT is you will have a large account that has built-in, automatic features that provide creditor protection, estate planning, and tax planning.  Our office is available to discuss your situation and make sure your estate plan, asset protection plan, and tax plan is well coordinated and includes taking advantage of this “low hanging fruit”.

Essential Tax & Legal Tips for the NEW Business Owner

August 28, 2017 Business planning, Law, Tax Planning Comments Off on Essential Tax & Legal Tips for the NEW Business Owner

Starting a business is a process.  It is MUCH more than filing the one or two page articles/certificate of formation with the state.  At the same time, it doesn’t have to be so complicated and overwhelming that you never start.   Further, not only is starting a business a process, it’s a process that is unique to YOU.  It is not a cookie-cutter one size fits all proposition.  What your business and YOUR situation require may be completely different than anyone else you might know who is self-employed.  Having said that, here are 8 tips that apply to all businesses, but how to USE these tips will be different for each business owner:

  1. Operate out of and properly maintain the appropriate entity formation for YOUR situation. While it is true you can operate your business as a sole proprietorship, I think it’s generally better to operate your business out of an entity such as an LLC or corporation.  First, I think it has a positive impact on your mindset as a business owner in that it makes you feel more “legit”and others will see you the same. More importantly, it is always better to operate your business out of an entity such as an LLC or corporation as those companies prevent liability of the business from extending to the owners.  Lastly, operating out of an entity can in certain situations produce tax savings such as when operating out of an S-corporation to save self-employment taxes. This is generally recommended for operating businesses who have $30-$40k net annual income.
  2. Make sure you have a partnership/ownership agreement if there are other owners. If you have somebody that you trust to own and run your business WITH YOU, that’s a great thing, and hopefully you continue to have a great business relationship with that person(s).  But don’t let that be a reason to NOT get your relationship in writing through a written agreement that you both/all would sign to memorialize the rights and obligations of each other.  If the business fails or one of the owners wants out or isn’t “pulling their weight” and you didn’t address this in writing BEFORE the crisis/event has occurred, that friendly business partner could wind up AGAINST YOU.
  3. Embrace bookkeeping. Embrace the fact that bookkeeping is one of the keys to maximizing tax write-offs and commit to either obtain the right training to do it yourself OR see the value in outsourcing it to someone who knows what they’re doing.  Maybe your strength as an entrepreneur is the marketing/sales side of business, or you have the relationships to be successful, but when it comes to taxes, you must keep good records, and for all your strengths, if you’re not organized, you’re going to get killed in an IRS audit.  So either learn to be organized with your records in terms of tracking expenses and use a good bookkeeping software (Mark Kohler offers a great set of videos that train on how to use Quickbooks), or outsource it to someone else who is good at it so you can focus on what you do best. The clients who embrace bookkeeping usually have more write-offs and deductions come tax-time as they rarely miss an opportunity to expense something.
  4. Have periodic tax and legal consults with your attorney and CPA. Unfortunately, many small business owners don’t use a business attorney ever, and maybe only meet with their CPA once a year, assuming they even use a CPA.  I think the cost of meeting with a good business attorney and CPA at least twice a year is worth the cost.  Prevention is much less expensive than the cost of getting “sick”, whether “sick” is an unnecessary amount or risk exposure that leads to a lawsuit, or whether “sick” is failure to maximize tax write-offs and you’re paying more than necessary to Uncle Sam, OR, maybe without a good CPA you’re TOO aggressive on your taxes or even worse, you don’t file a return at all and the IRS comes knocking.  Not to mention meeting with your attorney and/or CPA is a tax write-off!  On the legal side, it is good to get periodic “checkups” on how your business is structured, what has changed, what’s coming up that is new in your business, etc., so that your business attorney can guide you on mitigating your risks and protecting against liabilities.  On the tax side, it’s good to also get periodic “checkups” to talk about tax strategies and which ones you aren’t maximizing or implementing, or which ones you’re doing wrong that is going to be a problem in an audit, i.e. health care, paying kids, auto, home office, dining, entertainment, travel, tax deductible contributions to retirement plans, owning real estate, etc.
  5. Be sure to have adequate insurance for your business. This legal tip is not new or cutting edge by any means, but the failure to follow it could be catastrophic to your business.  A good insurance broker can help a great deal to match up the appropriate amount of insurance (in terms of amount and policy types) for YOUR business.   You don’t want to spend TOO much of your business income on insurance premiums but if you don’t have any insurance, if/when a liability comes up in your business, and you don’t have an appropriate insurance policy to divert that financial responsibility for that claim/liability to an insurance company, it puts the full force of that claim or liability on potentially ALL of the assets and income of your business.
  6. Make sure to use contracts in your business and don’t rely on verbal conversations or handshake deals. You may have heard that under the law in most situations verbal contracts are enforceable.  That doesn’t mean you should RELY on them, especially with the core aspects of your business i.e. your clients, your vendors, your business partners, etc., you want to properly memorialize the agreement IN WRITING.  This will make it SO much easier to prove your case in court if the other party violates/breaches the written contract versus trying to prove they breached/violated a contract that is not in writing and signed by all parties.  You should have a good service contract or something applicable that is provided to your customers.  This not only helps with enforcing any liabilities or claims you have against them (non-payment for example), but it also is REALLY helpful to clarify the SCOPE of what your business WILL do for them and what your business will NOT do for them.  If you don’t clarify that in writing, you have no idea what your customer assumes or expects, so even it doesn’t result in a lawsuit, it can create a rift between your business and that client and result in bad press about your business on social media, etc.
  7. Make sure you are properly characterizing your workers (independent contractor v. employee). There is a temptation for the small business owner to view/consider ALL of their workers as independent contractors.  The small business owner loves to do that because there’s no payroll tax, no added costs for worker’s compensation, unemployment, employee benefits, etc.  Unfortunately, the federal and state taxing authorities do not take YOUR word alone that your workers are actually independent contractors.  IF you improperly classify workers as independent contractors and the government (state or federal) determines they are employees, you will have fines and penalties.  Don’t misunderstand, you can have workers that ARE independent contractors, so long as they are TREATED as independent contractors, and the key word there is “independent”.  If you’re going to micro-manage what they wear, when they work, how they work, where they work, etc., that doesn’t sound very “independent” and it sounds at lot like an employee, which it is sometimes necessary to have that much control of your workers, but you can’t have it both ways, if you treat them like employees, you have to accept that it comes with things like payroll taxes, unemployment, worker’s comp, etc.
  8. Have an exit strategy (including an estate plan). Understandably your primary concern is getting the business STARTED, so you might think it would be unproductive to think about an exit strategy so early in the “game”, but it is so important to have that in your mind.  Do you want to grow the business and sell it soon as possible or hold onto it and pass it loved ones, or maybe you want to buy out your partner’s ownership (or vice versa).  There are many unknowns that make it difficult to have any certainty about what WILL happen, but it’s very productive to consider the ways in which it COULD happen and form an opinion on what seems most appealing to you.  But REGARDLESS of what your exit strategy is, you should make sure your business ownership and estate plan is coordinated.  Even if you plan to sell the business as soon as possible, and you have no plans of owning the business for the long-term, the spontaneity of death requires that even in that situation, your business ownership be coordinated with your estate plan.  Don’t forget about incapacity either.  This could mean you have power of attorney documents in your estate plan that contemplates ownership/operation of your business if you become incapacitated.

In sum, your business needs you as the business owner to make sure your business is healthy from both a tax and legal perspective.  These tips are a great starting point to make sure that happens.  Our office is available to assist and would love to help you and your business with implementing these and other tips specifically to you and your business.

Bitcoin Basics: What is Cryptocurrency?

July 3, 2017 Business planning, Law, Tax Planning Comments Off on Bitcoin Basics: What is Cryptocurrency?


Questions about Bitcoin have increased dramatically as investors have seen the price of Bitcoin rise from 30 cents per Bitcoin in 2011 to $2,550 per Bitcoin in July 2017. This article answers basic questions about Bitcoin and we’ll have two follow-up articles addressing IRA ownership of Bitcoin and about accepting Bitcoin in your business. Needless to say, there’s a “bit” of uncertainty when it comes to whether or not one should invest in Bitcoin (sorry –bad pun) but here’s a breakdown of the basics.

What Is Bitcoin And How Does it Work?

Bitcoin is one type of digital currency also known as crypto currency. Users of Bitcoin pay each other directly without traditional intermediaries such as banks or even governments using what is known as blockchain technology to effectuate transactions. First, you would install a Bitcoin wallet on your device and it will generate a Bitcoin address. When you provide your Bitcoin address, the person paying you can transfer funds to your address and into your Bitcoin wallet. This transaction and all transactions on the Bitcoin network are done using this blockchain technology, which is a ledger that tracks balances. Cryptography i.e. mathematical proofs that provide high levels of security are used to strengthen the security of the Bitcoin network. By the way, cryptography is not some untested technology – it is through cryptography that online banking is currently done. As a Bitcoin user, you would authorize a transaction using a secret piece of data called a private key. A transaction isn’t finalized until it has been mined, which is a confirmation process to ensure the integrity of the transaction. You can learn more at www.bitcoin.org. I will write another article regarding whether a small business owner should consider accepting Bitcoin as a form of payment.

Where Did It Come From And Is It Risky?

Bitcoin was created in 2008 by an anonymous creator. Many executives in the financial sector are cautious or even skeptical, but others are optimistic and confident that it is not going anywhere. Fidelity CEO Abigail Johnson believes in the future of digital currency and has been a proponent of Bitcoin.. One of the biggest complaints against digital currency is the lack of security/protection from hackers. JP Morgan Chase CEO Jamie Dimon has been a notable critic citing its use by criminals looking to transact outside of the traditional financial system. In 2015, a notorious online drug sales scheme was orchestrated using Bitcoin. There was an incident in Japan in 2013 in which digital hackers stole about $450M worth of Bitcoin. A similar incident happened in Slovenia in 2013. Other controversies surrounding Bitcoin include the disappearance of notable Bitcoin start-up companies Neo and Bee in 2014. In 2015 there were arrests when it was learned that Bitcoin company MyCoin was running a Ponzi scheme in Hong Kong. There have been quite a few money laundering cases here in the U.S. involving Bitcoin.

Should I Invest In It And How Do I Invest In It?

Most people investing in Bitcoin are using a relatively small portion of their investment portfolio i.e. I don’t know anyone who is investing most or all their “eggs” in the digital currency. A lot of people are excited about it, but like any investment, if you don’t time it right and/or you don’t know what you’re doing you can and probably will lose money. The concept, however, in simplistic terms is that you buy the digital currency at a certain price and sell it for more than you paid for it. There is the famous story of Kristoffer Koch who paid $27 in 2009 for 5,000 Bitcoins which has now been valued at almost $1M. Currently, 1 Bitcoin equals approx. $2,550 U.S. Dollars, so it would cost you over $10,000 to buy 4 Bitcoins right now. Over the last three or four years, the value of Bitcoin has continued to increase and it is the dramatic increase in value that has caused the recent stir and attention around digital currency investing. Others are attracted to Bitcoin as a protection against government currency. These investors fear a failure in the financial markets, which will dilute and may cause value declines in the dollar or other government currencies. These investors prefer to hold their Bitcoin directly, rather than through a fund.

Assuming you’ve done your research and are comfortable with the process, in terms of actually investing, one option is to invest in the Bitcoin Investment Trust (GBTC). GBTC is a publicly traded security that solely invests in Bitcoin. This allows an investor to use a traditional investment vehicle to realize gains (or losses) as the price of Bitcoin fluctuates without actually possessing and storing bitcoins. However, investing in bitcoin through the GBTC provides only a fractional value of the actual price of bitcoin and so in terms of ease and convenience, the GBTC is a good option, but at least for now, it’s not the best option to capitalize on the full value of Bitcoin. Coinbase, Inc. is another option – it is essentially a digital exchange where you can invest in Bitcoin as well as other cryptocurrencies (see below). Another option is to invest in actual Bitcoin through a self-directed IRA, which I will write about in another article.

What Are Other Types of CryptoCurrency?

Bitcoin is not the only form of digital currency – others include Litecoin, Peercoin, Primecoin, Namecoin, Ripple, Quark, Mastercoin, and Ether(Ethereum).

In sum, like any investment, it requires due diligence and a correct timing of the market(s). As you can tell, there have been some crazy tales of Ponzi schemes and fraud but also stories of incredible returns. In any case, I don’t think digital currency is going away anytime soon – I guess you could say that the stories in this article have been “tales from the crypt”-o currency (it was a stretch but I decided to go for it).

How to Donate to Charity and Beat the Tax Man

June 20, 2017 Estate Planning, Real Estate, Tax Planning Comments Off on How to Donate to Charity and Beat the Tax Man

I have a close relative who works in fund-raising for a fairly large university.  While he loves receiving large charitable donations in the form of immediately available cash or other marketable assets (such as real estate and publicly-traded stock), he knows that such donations are often simply not possible or practical for the average person.  This is why a huge buzzword in the world of fund-raising for non-profits is “Planned Giving.”

What Is “Planned Giving”?

Planned Giving is the present day legal commitment by a donor to give some assets or property to a charitable organization or institution at a future date. The future date is usually the death of the donor.

There are several types of planned gifts. Some people make outright gifts of assets such as appreciated securities or real estate.  Some planned gifts are payable upon the donor’s death such as a life insurance policy where the beneficiary is a charitable organization.  Still other planned gifts provide a financial benefit, as well as a tax deduction, for the donor.  Examples of this are: 1) Charitable Remainder Trusts, which provide an income stream for the donor, and at the death of the donor, the charity receives what is left in the trust; and 2) Charitable Lead Trusts, which essentially do the opposite and produce a stream of income for a charity, and the donor’s heirs receive what remains in the trust when the donor passes away.

What Is a Charitable Remainder Trust (“CRT”)?

A CRT is a tax-exempt irrevocable trust designed to reduce the taxable income of individuals by first dispersing income to the beneficiaries of the trust for a specified period of time and then donating the remainder of the trust to a designated charity. If you have a highly appreciated asset (e.g. real estate), the CRT will avoid capital gains taxes that would otherwise be due if you or your company sold the asset.

Who Should Be Thinking About a CRT?

People who:

  • Have a highly appreciated marketable asset (usually real estate or stock);
  • Want to save on taxes (i.e. they don’t want to take the capital gains tax hit);
  • Want an income stream over the rest of their life or over a certain number of years;
  • Want to make a donation to charity; and
  • Want to totally or partially disinherit their children. This isn’t the case if you structure it correctly!

How Does a CRT Work?

The diagram below goes through the steps involved in a CRT.  However, in a nutshell:

1)   A tax-exempt trust is created with the help of a professional.

2)   The donor places the asset in the CRT.  Are taxes due here?  No – and the donor gets a charitable deduction for making the donation that he/she can carry forward for up to five years!

3)   The property is sold to a third party and the proceeds are deposited into a CRT-owned account.  Are taxes due here?  Not if the property is owned free and clear!  These proceeds are then invested, and no taxes are owned when those investments appreciate in value!

4)   Payments in a set amount or set percentage are made from the CRT account to the donor on a regular basis (quarterly, annually, etc.).  Payments are either made for the life of the grantor or for a term of years.  Are taxes due on this income?  Yes, but the charitable deduction gained when the donation is made can be used to offset at least some of this income!

5)   The donor can use some of the income from the trust to buy a life insurance policy in order to make sure their heirs aren’t left out in the cold.  Do beneficiaries owe tax when they receive life insurance proceeds?  No!

6)   In some cases, the life insurance proceeds may be in the multiple millions of dollars, and could cause an estate tax problem for the heirs.  This issue can be taken care of by the proper use of an Irrevocable Life Insurance Trust (“ILIT”) – which is another subject for another day.

7)   At the death of the donor, or at the end of the term of years, whatever remains in the CRT is donated to the charity.  Does anyone owe taxes here?  No!

 

 

Who Are the Winners and Losers in a Properly-Structured CRT?

1)   The Donor – Winner!  Because he or she gets to avoid the capital gains hit on selling a highly appreciated asset, gets a tax advantaged stream of income, and gets to make a charitable donation that gives them warm fuzzies – and may end up helping to get their name on a building at their favorite university!

2)   The Charity – Winner!  The charity gets an irrevocable promise from the donor to donate assets at some point in the future.  With good investment of the funds in the CRT, the final donation to the CRT can end up being significant.

3)   The Donor’s Heirs – Winners!  Instead of inheriting a piece of appreciated real estate that they need to market and sell, they get tax-free life insurance proceeds, and will avoid possible estate tax issues if an ILIT is used.

4)   The IRS – Loser (for once)!  When properly structured, the only taxes paid in all of these transactions are those owed by the donor when they receive payments from the trust.  However, the charitable deduction will offset at least some of this income.

Now, there are plenty of details to sort through, but please give me a call if you’d like to discuss the CRT further and find out if it is something that might make sense for you.

Just “Having” an S-Corp May Not be Enough

February 21, 2017 Business planning, Law, Real Estate, Tax Planning Comments Off on Just “Having” an S-Corp May Not be Enough

Just “having” an S-Corporation may not be enough. It’s important you make sure to reap the tax and legal benefits of your S-Corp if you’re going to set one up.

If you routinely read articles in this space or have heard any of our attorneys speak around the country, you are probably aware that we are big fans of the S-Corporation structure as a way for folks who own and operate small operational businesses (i.e. ones where they are selling goods or services and are not someone else’s W-2 employee) to get some limited liability protection and (probably more importantly) to save on self-employment taxes.

When self-employed folks don’t incorporate and instead operate as a sole proprietorship, their entire net profit from the business is subject to self-employment taxes. If you don’t do anything about them, self-employment taxes will eat up about 15.3% of your income – before we even talk about income taxes. So, on a net profit of $100,000, a self-employed person will pay about $15,300 in self-employment taxes

If instead, a self-employed person operates as an S-Corporation, they can do a “salary/dividend split” on the net income from the business. In a salary/dividend split, the business owner will pay himself a “reasonable” salary from the S-Corporation’s profits. A general rule of thumb is that roughly 1/3 of the company’s net profit is considered a reasonable salary. Self-employment taxes are paid on the amount of the salary, and the rest of the income flows through to the business owner as a type of “dividend” from the S-Corporation. That dividend is not subject to self-employment taxes.

So, if a small business owner has the same $100,000 of net profit and operates as an S-Corporation, he will pay himself a “reasonable” salary of about $33,000 and pay self-employment taxes of about $5,000 (instead of $15,300). The remaining $67,000 flows through to the owner free of self-employment taxes. We love the S-Corporation structure for self-employed doctors, dentists, engineers, realtors, commissioned salespeople, certain types of real estate investors, and others whose income would otherwise be subject to the 15.3% tax.

Right now, you’re probably either thinking: “Yep, Jarom, you’re preaching to the choir. I already have my s-corp and I’m saving a bunch on my self-employment taxes!” OR “Man, I need to look into an s-corp right away!” Either way, please keep reading because establishing an s-corp and doing the correct tax filings is only part of the equation.

The recent U.S. Tax Court Case of Fleischer v. Commissioner (2016 T.C. Memo. 238, filed 12/29/16) demonstrates that just having an S-Corporation may not be enough to save on self-employment taxes. Mr. Fleischer is a financial consultant who signed on as an independent contractor representative for a couple different brokerage houses. He also established an S-Corporation, and funneled his income through that entity to save on self-employment taxes in roughly the same way I described above.

So, why was Mr. Fleischer in Tax Court? Well, the IRS sent him something called a Notice of Deficiency. The Notice basically said that his use of the S-Corporation to save on self-employment taxes was invalid, and that he owed roughly $42,000 in back taxes, plus penalties and interest. Mr. Fleischer disputed the Notice, and the case went before a Tax Court judge.

The IRS argued that the Notice they sent was proper because the income at issue belonged to Mr. Fleischer, personally, and not to his S-Corporation. In support of this argument, the IRS presented evidence (which was unrefuted by Mr. Fleischer) showing: 1) Mr. Fleischer signed both independent contractor representative agreements in his personal capacity, not on behalf of his S-Corporation; and 2) Payment for Mr. Fleischer’s work went to Mr. Fleischer personally, not to his S-Corporation’s bank account.

Mr. Fleischer’s primary argument in response was that he had to sign the agreements and receive payment in his own name because he, not his S-Corporation, is licensed and registered as a financial advisor, and it would cost him millions of dollars to get the same required licenses for his company.

The Tax Court wasn’t impressed with Mr. Fleischer’s arguments, and ruled that he was indeed on the hook for all the taxes, penalties and interest the IRS asked for in the Notice. While the Tax Court’s decision in Fleischer isn’t necessarily binding on other cases, it is instructive for those hoping to use the S-Corporation to save on self-employment taxes – and have that use stand up under IRS scrutiny. Namely, it drives home two important points:

1)   To the extent possible, all of your S-Corporation’s contracts – especially those where it will be receiving income – should be in the name of your S-Corporation. This is crucial. One of the huge factors the IRS looks at when determining whether income belongs to a corporation is the existence “between the corporation and the person or entity using the services [of] a contract or other similar indicium recognizing the corporation’s controlling position.” A contract between your S-Corporation and the person or entity paying it will satisfy this factor. Besides, entering into contracts in the name of the S-Corporation also helps from a limited liability standpoint if the other party wants to sue for breach of that contract.

2)   Again, to the extent possible, all payments for goods or services provided should be made to the S-Corporation directly. Such direct payments may serve as “other similar indicium recognizing the corporation’s controlling position.” At the very least, these direct payments will save you from being in a position where you have to explain to the IRS why income being reported through you S-Corporation went first to you personally.

The S-Corporation is a wonderful and legitimate tool to save on taxes. Please just take the time to make sure you are using and operating it correctly. Doing so will save you time, money and headaches if you are ever audited by the IRS (or sued in your business).