Posts Tagged ‘S corporation’

Why You Should Rent to Your Business

One of the most powerful tax strategies a small business owner has is the S corporation. Under most circumstances when a small business has grown beyond $30,000 to $50,000 of annual profits it is time to consider organizing as an S corporation or LLC electing to be treated as an S corporation for tax purposes. 

The tax savings can be significant. A sole proprietorship is taxed at ordinary rates, plus self-employment tax. For 2019 the SE tax is 15.3% of the first $132,900 of partnership and/or sole proprietorship profits. (If you have wages from other sources this is included in the $132,900. Once you exceed that limit from all these sources combined the SE tax declines to 2.9%.) Partnerships pass profits to the owners where they pay the SE tax along with income tax. For partnerships, guaranteed payments to partners and profits are both subject to the SE tax. 

An S corporation does not pay income tax. Instead, all the profits are passed-through to the owners of the entity and taxed as ordinary income only; SE tax does not apply to profits passed to owners of an S corporation. Owners of an S corporation are required to be paid reasonable compensation. The remaining profits avoid payroll taxes (FICA and FUTA) and SE tax. 

Small business owners usually want some legal protections as well. The corporate or LLC structure is available to accomplish these goals. The LLC is more flexible with additional legal advantages than straight corporate entities.

Once organized, the LLC can then elect to take on the characteristics of other types of entities for tax purposes. The LLC does NOT have a tax form at the IRS. The LLC either defaults to a disregarded entity (sole proprietorship or partnership if more than one owner) or elects to be treated as a corporation. The LLC can elect S status if they inform the IRS they want to be treated as a corporation. These are two separate elections: electing to be treated as a corporation (Form 8832) and then electing to be treated as an S corporation (Form 2553).

I discussed these advantages in greater detail in the past.

 

Proper Allocation of Assets

If you had an attorney handle your LLC set-up and a qualified tax professional handle the structuring of assets inside and outside of the business you already know the S corporation rarely, if ever, has real estate inside it. 

The proper structure of a business where the owners also control the real estate is to organize the business LLC, treated as an S corporation, to hold the business only and a separate LLC, defaulting to a disregarded entity, for the real estate. The business LLC then pays rent to the LLC holding the real estate. 

Recently a reader on this blog asked why this is important:

Comment from Hobo Millionaire:

Keith, would you mind explaining the benefit of you renting to your business vs your business buying the building and paying a note over time. Is there a tax issue with the depreciation? You can depreciate/offset your taxes and the business can’t? A specific post on this setup, showing actual numbers, would be great.

We will discuss why you never want to own real estate inside an S corporation or an LLC treated as such. 

Most of the time it is a mild inconvenience only. Then there are instances where the legal and tax problems are significant and serious.

Every issue surrounding separating the business entity from the real estate holding entity are easily remedied. 

 

Legal Problems

There is no law requiring you to separate the business from the real estate. However, the LLC is a legal structure designed to protect the LLC owners. If the real estate and business are held within one LLC, the real estate is at risk if the business gets sued. Depending on the industry, this can be a serious issue or a low-risk probability.

Separating business from real estate also makes it easier to sell fractional ownership of each easier. If the real estate is held inside the business LLC it is impossible to sell the real estate (or business) without selling the same fraction of the other at the same time. 

Example: If you sell 10% of the business LLC and the real estate is held within that LLC, you have sold 10% of the business and real estate. 

Held separately you can sell all or a fraction of either the business or real estate in any fraction you want. You can also add another member (or have fewer members) to the real estate investment without also including the individual in the business side of the equation. 

Once real estate is inside an S corporation there is no easy solution to removing it. Tax issues of holding real estate with a business inside the same LLC can be significant. 

Removing real estate from an LLC is deemed a sale of the real estate for tax purposes. This means all the gains and recapture of depreciation are currently reported and taxed accordingly. Even if you are a 100% owner of the LLC and remove the real estate from the LLC to your name only (ownership really hasn’t changed, now has it?) you will be taxed on the gains! 

Therefore, if you have real estate inside an S corporation it might be better to keep it there even though it isn’t an ideal situation. You should consult a qualified attorney and/or tax professional with experience in this area of practice to avoid making a bad situation worse.

 

Serious Tax Issues

S corporations are not taxed except in a few situations. In each situation where an S corporation does pay tax the S corporation was a C corporation first for a period of time. (Electing S status at the time the corporation is organized means there was no time when the company functioned as a regular (C) corporation.) 

Holding real estate inside an S corporation with accumulated earning and profits (AE&P) from when it was a C corporation has tax consequences. 

S corporations are subject to tax on Excess Net Passive Income (ENPI) when :

  1. The S corporation’s passive investment income is more than 25% of gross receipts, and
  2. At the end of the year the S corporation has AE&P from when it was a regular corporation.

The ENPI tax rate is 35%! Lets look at an example of where an S corporation might pay the ENPI tax.

XYZ Corp elects to be an S corporation with AE&P. XYZ has $100,000 of gross receipts this year. Of the $100,000 of gross receipts, $40,000 is passive investment income (dividends, interest, rents, royalties and annuities). Directly connected expenses to the production of the passive investment income  is $10,000.

The net passive income is: $40,000 – $10,000 = $30,000

25% of gross receipts are: $100,000 x 25% = $25,000

The amount by which passive investment income exceeds 25% of gross receipts is $15,000 ($40,000 net passive income – $25,000 25% of gross receipts).

ENPI calculation: $15,000 / $40,000 x $30,000 = $11,250.

XYZ as an S corporation with AE&P pays a passive investment income tax of $3,938 ($11,250 x 35%)

 

Easy Tax Problems to Fix

The good news is that all deductions related to real estate ownership remain intact even when you separate the business entity from the real estate entity. You can still borrow against the building and deduct the interest on the real estate holding LLC tax return, as well as, depreciation and other expenses paid and related to the property. 

You can still have a triple-net lease between the real estate LLC and the business LLC. This means the business LLC can still pay and deduct insurance costs, repairs and maintenance, property taxes, utilities and so forth. Only the interest and depreciation goes with the real estate LLC. Rent is paid by the business LLC and deducted; the rent is claimed as income by the real estate LLC. 

There are times where the real estate LLC might show a large loss due to a cost segregation study or some other tax strategy. This means your business might be earning a large profit while the real estate LLC gets a special tax benefit that allows a massive deduction which causes that LLC to show a loss.

Passive activity rules tell us we are limited in some instances, especially when our income climbs above $100,000. This is easily solved with a simple election on the individual’s tax return. (The LLCs don’t make the election. It is taken on the personal tax return level.) Having a large loss on the real estate LLC if you are a high earner would be a problem if there were no outs. 

The good news, again, is you can group the activities. By grouping the real estate LLC and business LLC activities you are allowed all the deductions as if they were one entity on the personal tax return. This resolved the passive activity rule issues.

 

Final Notes

There are no drawbacks to separating the real estate and business into separate LLCs that I’m aware of. Every attorney I’ve ever spoken with agrees with me on this. Real estate should never be held inside an S corporation or LLC treated as such. Any tax negatives are easily resolved with elections.

The issues involved with combining real estate and a business under a single S corporation are many. Legally you limit your options and put assets unnecessarily at risk. The tax problems are hard or impossible to resolve without inflicting additional tax pain.

Structured properly your business and assets can enjoy legal protections while basking in the light of lower taxes.

 

 

More Wealth Building Resources

Credit Cards can be a powerful money management tool when used correctly. Use this link to find a listing of the best credit card offers. You can expand your search to maximize cash and travel rewards.

Personal Capital is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Capital is free?

Side Hustle Selling tradelines yields a high return compared to time invested, as much as $1,000 per hour. The tradeline company I use is Tradeline Supply Company. Let Darren know you are from The Wealthy Accountant. Call 888-844-8910, email Darren@TradelineSupply.com or read my review.

Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to sky rocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.

QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. QuickBooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.

cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

Worthy Financial offers a flat 5% on their investment. You can read my review here. 

Should We Run Our Marriage Like a Business?

#marriage #shouldimarry #businessplanning #personalfinance #love #interpersonalrelationshipsTwo and a half years ago when I started this blog I had a vision for what it would become. The original primary goal was to encourage readers to slide a chair around behind my desk and view the world from my side of the desk. I’ve always found the world interesting from my perch. Things I would never know or experience were front and center due to my position in the world. It all fascinated me.

Before long I expanded my vision. I wanted this blog to be a sort of personal journal to my children. When I’m gone (and hopefully while I’m still here) my girls can reference the thoughts of their dad. Some things are modified to protect the guilty (as I like to say), but the flavor is all there. Who and what I am is on these pages. This is the most real me I’ve ever presented. It took decades of writing, learning and growing to reach the point where I was comfortable exposing myself to the world. (Please disregard the indecent exposure.)

Tax professionals don’t always see the world as I do. My practice is small so I serve a discreet clientele. I actually sit with my clients periodically when things get real. I know about marriages on the rocks before the world at large. I consult with clients with a medical death sentence before even their family knows. Sometimes I even know before their spouse does. While it is interesting, it is never easy advising in these situations. How do you tell a client their child needs to be institutionalized to protect parent and child? How do you tell a wife she should or shouldn’t divorce her husband? How do you explain to a client she must tell her husband about the massive gambling losses she suffered and that they are bankrupt?

If I refuse to help it only gets worse. The client came to me and closed the door before she sat down because it is serious. Problems raising the kids and marriage issues are common. Financial and tax issues are front and center because finances (and sometimes taxes) are affected by their situation and any response they consider. I’m always uncomfortable advising clients on how to deal with their children; I’m nervous when advising a woman she should divorce her husband and report the abuse to the police. It breaks my heart when the patrol car is out front of the office as I help a client deal with a criminal issue.

When my world was confined mostly to the local market is one thing. Now this blog has spread my reach to the entire world and certainly the entire U.S. One of these difficult questions has come as a call from the dark and I’m scared. I’m scared no matter what I do people will be hurt. Even ignoring the echo from the abyss has consequences.

Voice From Over the Transom

These types of questions cropped up in consulting sessions over the last few years. I’ve consulted (and/or prepared taxes for) people on every continent, except Antarctica. (Anyone at the Amundsen-Scott South Pole Station need to talk to a friendly accountant to break up the monotony of the endless night? I’ll donate a free hour just for the opportunity to say I served every continent on the planet.)  The level of personal questions generally is lower than from local clients because blog clients on the other side of the landmass are at a different place (metaphorically speaking). Until now.

About a dozen emails grace my inbox per day during the summer from readers (more around and during tax season). Some are congratulatory, showing appreciation and require little or no response. Some I can’t answer easily or right away so they linger in my inbox until I decide how to respond or it just gets too old and I let it pass. (I hate it when I do that and I do it too often.)

Then there are the emails I must answer and answer now. Sometimes readers contact me (clients, too) because it is a desperate situation. No response is a response and a bad one. The email I’m about to share approaches this level.

The email literally had a headline. I used it as the title of this post. I wanted to tweak it, but decided against it. Here is the email:

Dear Wealthy Accountant,
I found out about you listening to the ChooseFI series on YouTube. I had a question about my situation and was wondering if you had any advice. My partner and I are not married, but we live together, have a 5 year old and are expecting our second child. My SO (significant other) is self-employed as an artist and averages over 100k/annually and pays considerable taxes for it. My question is what is our best tactic for taxation, would we be better off getting married (even with me going back to school in the future) or should we keep our current situation and my SO “hire” me as an employee to help him with some administrative chores. I plan on staying home with our baby-on-the-way for 3-4 years. Thoughts?

At first I was going to send it to my assistant to recommend a consulting session where I get paid. The answers this woman was asking required more than a curt response and I felt there were serious personal risks to her if she got bad advice. Then I felt bad asking her for payment for such a personal issue.

I received her email in the early evening and decided to sleep on it before responding. The next morning I emailed back I wanted to write a blog post on her email, name excluded. She emailed agreement.

The reason for a full-blown post is because her question has similarities to many others I get. At first glance it seems she is asking tax questions. But the real question is revealed in her headline used as the title of this post. Her real question is: Should I marry the father of my children?

This is where I must weigh my words carefully. A living, breathing human being will listen to my words and take them seriously. This is the life of a man and woman. Two children are involved! No matter what I do will affect her decision.

I have no choice. The voice from the dark has become a plea. I cannot turn my back. I am honor and duty-bound to respond. There will be a price to an unnamed accountant as well.

The Easy Part

There is an easy and hard part to the request. I’ll do the easy part first because, well, it’s easier and this post is making me emotional. Besides, I tend to talk taxes when I’m avoiding the real issue.

The readers SO is an artist earning over $100,000 annually. I read that to mean somewhere between $100,000 and $150,000.

Our kind reader asks about taxes, but prefaces that with getting married. We’ll deal with marriage later.

According to the email, our reader’s SO is self-employed. YIKES! Of course he’s getting killed in taxes. As a sole proprietor, your SO is paying more tax than in any other part of the tax code. I can’t even cheat and trick my computer into getting his tax bill higher. Here is what I want you to do. (I’m talking to my email reader now. Please grab a chair, slide it behind my desk and observe.)

Without seeing the actual tax return, the probability is your SO should organize as an LLC and elect to be treated as an S corp. (Call my office if you want me to help you set this up.) This blog’s birth came about when I gave Mr. Money Mustache the same advice and I wrote about it here.

You never mentioned which state you come from. Each state has its own department handling LLCs and incorporations. There are fees involved. Some states (Texas, California, Delaware come to mind) have very high fees. Here is a little trick to save money. You don’t have to organize your LLC in your home state or where you live!

If the home state has reasonable fees you can have an attorney do the paperwork or set it up yourself. You act as your own registered agent. (LLCs and corporations need a registered agent to manage their filings. You must live in the state to manage the filings such as annual reports.)

If you reside in one of the high fee states, I have a solution. Wisconsin, where your favorite accountant resides, isn’t a high fee state! Since my practice is in Wisconsin I can act as your registered agent. After the initial organization setup costs, Wisconsin charges $25 annually, plus a $1 processing fee. If you use other online services to setup your LLC they automatically act as your registered agent. It’s where they make most of their money. They also charge $200 and up annually. Most are now over $300 per year, plus state fees. I’m such a nice man because my office charges $109 (at this time) and that includes the $26 Wisconsin wants.

There are two benefits if this appeals to you. First, you do NOT have to file a Wisconsin tax return; you’re not doing business here (unless you are from Wisconsin and I don’t know it). Second, a registered agent is where legal documents get delivered. If your SO gets sued, process service takes place at my office if the attorney follows the rules. This is important. If you are not available and the process server can’t deliver paperwork it is sent to the state. You could have a court date and miss it because you were unaware. You would lose by default and could be liable for the damages awarded in the suit. As registered agent, my office is open all normal business hours. My heart doesn’t flutter when the sheriff delivers paperwork, either. I only ask, “Who’s this one for?” Then I get my team on the horn and speed-dial you until we make contact. We also email and use other means to reach you. There are procedures to make sure the court is aware if you haven’t been made alerted to the suit.

You Are an Entity

Either my office or a local accountant can help you elect to treat your LLC as an S corp. This is important. As an S corp your SO gets a reasonable wage and the rest flows to his personal return without FICA/self-employment tax. This is a meaningful tax savings.

If he is not already doing so (and qualifies), an office in the home deduction is possible. Under new tax rules this can be more valuable than ever before with the standard deduction higher now. Your facts and circumstances will dictate.

Most important of all, he can super charge his retirement savings. The options are endless. This blog (and others) discuss a variety of retirement plan choices. If you tell me what your goals are and more details on your situation, I’ll tell you what you want. Once again, facts and circumstances prevail. And don’t believe what most blogs publish. You can pack away over $300,000 per year in a deductible retirement account in certain cases (it depends on your age (the older you are the more you can deduct) and profit level). You tell me how much you want socked away in a tax sheltered retirement plan and I’ll share the vehicle you’ll drive to the Vanguard index fund. Okay?

The New Employee

You can be an employee of your SO or the LLC he sets up. He can provide you health care benefits (usually) and deduct the premiums. However, if he is a sole proprietor, his premiums are deductible (usually) as an adjustment to income on his personal return. This means he still pays SE tax on the premiums. We used to use Section 105 to work around this issue for married people. I don’t see 105s much anymore as there are so many easier alternative options.

An LLC electing as an S corp avoids this issue, as the entity claims the deduction. (Tax professionals reading this: I’m keeping this simple for my kind reader’s sake. My statement is 98.27845363% accurate. We don’t have time in this post to discuss why my statement isn’t 100% true.)  If handled correctly, the health insurance premiums are reflected on the W-2. Technically there is a FICA tax issue, but mitigated by adjusting payroll to reflect a lower reasonable wage based on a lower level of profits due to the premium deduction by the entity.

This gets complicated; I understand. I’m glossing this over and tax pros are rolling their eyes because I’m telling a half truth. But from your viewpoint, it will look pretty much like I outline it. And my goal is to give non-tax professionals a reasonable way to view the options they can understand without years of tax experience.

In short, you can (and if you provide services for your SO’s business) and should be a W-2 employee. Even a token wage of say $15,000 allows you health benefits paid for and deductible by the business, plus the opportunity to start building your retirement account. Whether he remains a sole prop or decides to go the LLC route, there is a benefit to you and your SO (most likely) for doing so. Marriage also plays a role so we will address that next.

So, Should We Run Our Marriage Like a Business?

In short: NO!!!

What you and your SO have is not a business; you have an interpersonal relationship! You have a business relationship with a prostitute, not a loving SO. Can I be more blunt?

Mrs. Accountant and I have a nurturing 30+ year marriage. Mrs. A works part-time for my business. She is an employee of the entity! Yes. But my relationship with Mrs. A is not a business relationship!

Maybe I’m reading your email wrong. Tax issues do play a part in the decision-making process of living together, marriage and having children. Reading between the lines, I think your income is really low. As a result, there is probably a tax advantage to getting married.

But you don’t get married to save on taxes!

Even going back to school will probably be a better tax deal if you are married, not that that should be the reason to marry.

Please, come with me. (I’m putting my arm around your shoulder and guiding you to a chair where we can talk face-to-face without a desk between us. I lean in close and talk in a low, calm voice as a father does.) I have two young adult daughters. As their dad I tell them to think clearly when planning a life with someone. Living together is as serious a matter as marriage.

You have a child together and another on the way. (Congratulations!) You have a beautiful and awesome responsibility. If you are in love and have talked adequately about a life together as husband and wife, and worked out any issues and still find you want a life together, then have that life. It ends soon enough. Jordan Peterson says the meaning of life is to end needless suffering. Loneliness is a form of suffering. You have it in your grasp to end that. Your ships met in the night and both of you decided to sail together. With two children you already know the right thing to do.

Marriage has massive risks, especially for the male. But you already have children! And there are incredible benefits for both parties, as well. If you are ready, do what your heart tells you. Your mind should have ironed out all the issues by talking honestly together. If you are happy as you are, then don’t change anything. If marriage is both your callings, then do that.

Please, for the love of God, don’t get married (or refrain from getting married) due to taxes.

If you need anything else, you have my email. My door is always open to discuss this with all the personal details.

 

 

More Wealth Building Resources

Personal Capital is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Capital is free?

Side Hustle Selling tradelines yields a high return compared to time invested, as much as $1,000 per hour. The tradeline company I use is Tradeline Supply Company. Let Darren know you are from The Wealthy Accountant. Call 888-844-8910, email Darren@TradelineSupply.com or read my review.

Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to sky rocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.

QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. QuickBooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.

A cost segregation study can save $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

Worthy Financial offers a flat 5% on their investment. You can read my review here. 

 

How and When to File a Superseding Tax Return

There is no question the tax code is massive. No matter how knowledgeable or experienced you are, mistakes will happen. The consequences of such mistakes can be minor or they can cost serious amounts of additional tax, interest and penalties.

Filing an amended return is your only option after the due date, including extensions. An amended return solves most problems. Interest and penalties may apply. In some cases even an amended return can’t fix an error; you could lose entire deductions forever.

The number of elections available is large. Some are irrevocable. Making, or failing to make, an election is set in stone in some cases with the original return. Failure to check one little box can cost you a large deduction permanently.

A superseding return may be the only option if you file it on time.

Amended or Superseding Return

A superseding tax return incorporates the new information into the original tax return if filed by the due date, including extensions. 

A superseding return is filed after a subsequent return and before the due date, plus extensions. (That was worth repeating.) The second return is a superseding return. A superseding return it generally treated as the original return, incorporating the new information and modifying (superseding) the earlier return.

Here is a small example where a superseding return is valuable tool.

A common error involves the Section 1.263(a)-1(f) de minimis safe harbor election. Most tax professionals (and readers of this blog) know they can deduct assets up to $2,500 rather than depreciate these expenses over a number of years if they make the appropriate election. The election is required every year. (The IRS says the election must be made “timely”. I take this to mean the election must be made on an original return filed by the due date, plus extensions. A late filed return may not allow the election.) The election is irrevocable.

In my office we automatically make this election for all returns with rental properties or a small business. (All corporate and partnerships returns also automatically get the election.)

Making the safe harbor election covers items a client may have neglected to inform the tax preparer of. If the election is made and not necessary, no harm done. If the election is necessary and forgotten, serious potential harm exists.

 

The IRS is less than clear when it comes to superseding returns. Corporations (S-corps, too) have a nifty box to check when e-filing a superseding return. Only corporations can electronically file a superseding return. Be sure to check the appropriate box or the IRS will probably reject the return as duplicate.

There are IRS instructions on when a superseding return must be filed on an individual income tax return. Unfortunately there are no instructions how to do it!

Superseding personal returns MUST be paper filed. Some tax professionals prefer filing a superseding personal return in the format of an original return and writing “SUPERSEDING RETURN” across the top of the first page. Because this will probably be flagged as a duplicate return another method is advised.

A superseding personal return should be prepared as an amended return on Form 1040X. (There is no superseding box to check.) All amended personal returns filed before the due date, including extensions, are automatically treated as superseding, incorporating the new data and modifying the original return. This means a forgotten irrevocable election CAN be made and is treated as if made on the originally filed return.

If a superseding return is filed before the due date (without consideration for extensions) interest and penalties are also avoided.

Amended returns filed after the due date, including extensions, are not incorporated into the original return. A required “timely” election is not allowed at this point.

In English, What Does This Mean?

The concept is short and simple, but often forgotten. A business owner may discover forgotten deductions for her business return when filing her personal return. The superseding return is a simple and fast solution for a previously filed corporate return. Add the new data, check the box marking the return as superseding and electronically file.

Individuals file an amended return for the same result, which must be mailed.

It sounds like a minor issue. When I review returns from outside my firm I need a powerful tool to make changes, especially when elections are involved. The tax code doesn’t automatically grant you preferred treatment. Special treatment must be requested in writing. Many elections are irrevocable. Many elections are required on an originally return filed by the due date, including extensions.

In English, filing an amended return before the due date (including extensions) on a personal return supersedes the originally filed return and solves most election issues. You can add a forgotten election if you catch it in time. Waiting for the IRS letter is too late. Consider the superseding return an amended return with a really tight due date, allowing you full sway in how the original return looks. It also eliminates or reduces interest and penalties.

Preliminary Report on Estimated Tax Savings with the New Tax Law

Tax season is still early in the tooth but patterns are starting to emerge.

My software allows me to use current year data to estimate results based on the Tax Cuts and Jobs Act changes. With a couple hundred returns under the belt already the impact of the changes are mostly expected with a few surprises thrown in.

Since planning will be so important this year I wanted to share my findings. Please understand these are estimated results. Several factors are hard to nail down in these estimates as the accounting industry is still deciding how to handle certain issues and the IRS still has to write regulations interpreting the changes.

One of the biggest issues not accounted for is the business income deduction as it is adjusted for guaranteed payments to partners and reasonable compensation to S corporation owners. If you aren’t familiar with these terms you can still benefit from my early findings.

Expected Results

Some results were expected. High income taxpayers are doing rather well with the new rules. My original thought was the biggest benefits would go to those well up the tax bracket ladder.

That has been the case, but significant tax reductions are being felt by those down to $100,000 of income and even lower!

My reading of the tax bill led me to believe lower income taxpayers wouldn’t benefit much. Eliminating personal exemptions while increasing the standard deduction was mostly a wash on the surface as the amounts generally offset.

The child tax credit enhancements are helping families with children. In the end, families in the upper middle class are doing well based on estimates.

Unexpected Results

The reason for this post is the unexpected results. Common knowledge on how the tax changes will affect taxpayers has been written about ad nauseam. There are plenty of surprises I do want to share.

As the first tax returns came in it started to look like the majority of clients would see nickels and dimes to their tax savings or additional tax next year. These early clients also tend to have very simple returns with lower income (at least for my client list).

My team and I review the expected changes with every client. We quickly discovered the tax savings frequently crawled lower down the income ladder. I personally find this a pleasant surprise. If a tax cut is going to work you need to give the break to those who will spend it. People like me only add it to the investment heap without helping the nation’s economy much.

Eliminating personal exemptions and replacing it with a higher standard deduction didn’t hurt as much as feared, especially if children are involved. Households without children are seeing minor changes unless their income is higher where they benefit from the lower tax brackets and longer time spent in lower brackets.

Retired clients were expected to see modest adjustments. However, because many retired persons can control their income stream somewhat due to timing of withdrawals from retirement accounts, they can react to the changes and plan for an overall lower tax liability.

The most unexpected result was the percentage of clients who will see a tax reduction. My client base is not a typical cross-section of the country. Low income taxpayers generally seek a different type of tax professional.

Of those facing a higher tax liability the numbers can be large. Most tax increases are nominal, but a few are significant. The worst part is I can’t tell you what to look out for. It always involves something unusual that affects the return negatively. All I can do is encourage a consultation with a tax professional after tax season. My guess is most taxpayers will find more value in a consulting session than they have for many years.

Two expected changes that turned unexpected are having a serious effect. Miscellaneous deductions on Schedule A, subject to 2% no longer apply in 2018 and after. These deductions had no affect for most taxpayers since the deductions in this category had to exceed 2% of adjusted gross income before it counted.

As a good accountant I studiously entered the information from clients even if I knew it wouldn’t count so they could see I didn’t miss it.

The things in the “subject to 2%” area of Schedule A include tax preparation fees, safe deposit box, union dues and specialty work clothes (uniform, safety glasses, steel tipped boots, et cetera). Most of these items are small enough not to change the amount itemized.

Certain education expenses fall into this category, too, along with certain legal fees from protecting or increasing taxable income.

But the biggest losers involve unreimbursed employee business expenses. Sales people top the list. I also have a rock band where equipment and travel not reimbursed by the band are no longer deductible.

Miles add up fast for traveling sales people. When I say traveling it usually involves local clients. Distant travel is more likely to be reimbursed by an employer.

There are a few planning tips. First, it’s best if the employer reimburses expenses. They’re not reported by the taxpayer receiving the reimbursement and deductible by the employer.

For the rock band and a few other clients I might recommend changing from an S corporation to a partnership. Before making this change it is vital to have your tax situation reviewed by a competent tax professional.

The reason for my recommendation to change to a partnership is that unreimbursed partnership expenses are fully deductible on page two of Schedule E and listed as UPE. The downside is the possibility of higher self-employment taxes.

The final Schedule A issue relates to the limitation on the so-called SALT (state and local taxes) deduction. In 2018 and after the SALT deductions are limited to $10,000. Most people assumed this only affected high income taxpayers from high tax states. Think again.

I have several clients from low tax states facing the cap. One Texas client saw a reduced estimated deduction because real estate and sales taxes pushed him above $10,000. And Texas doesn’t have an income tax!

Cautions

The more returns my office prepares the more I’m convinced clients will need to sit with me this summer and plan. You, kind readers, need to do the same.

I’m setting some appointments already. Due to the demands tax professionals will face this summer I recommend setting an appointment early. My office will accept consulting sessions from the beginning of May until the end of December. (The two weeks after the due date are for “me” time.)

One more thing before you prepare for the weekend.

There is a lot of confusion about the ACA (Obamacare) penalty for not having health insurance. The penalty applies for the current 2017 tax return being filed AND the 2018 return. The healthcare coverage penalty disappears in 2019!

My advice is plan. Of all years, this will be the one that gives you more bang for the buck than you’ve enjoyed for a long time.

Now go and have some fun. See y’all tomorrow for Stalking the Accountant.

Blogging and Taxes with the New Tax Bill

Bloggers often miss many opportunities when organizing their taxes. Writing on a regular schedule occupies a large part of the creative artist’s time. Taxes frequently become an afterthought.

Over the last two year several bloggers have approached me to review their tax situation. Some ended up as clients; other I only consulted.

A pattern has emerged. There are certain elements bloggers tend to forget. Non-cash deductions are almost always missed. Bloggers also frequently use the wrong entity structure to maximize benefits.

The Tax Cut and Jobs Act signed into law late last year has added numerous new elements to consider when planning your taxes. Bloggers need to consider these additional options or risk overpaying their taxes.

This is a good time as we head into tax season to review the tax rules affecting bloggers. We will cover the more common issues and expand into finding the best vehicle (entity) to use for your blog with a discussion on how the new tax rules affect your decision-making process as you operate your blog.

Income

Taxable income comes from several directions when running a blog. Google and similar advertising platforms provide a steady stream of income.

Amazon is a nice side niche getting worse every day as they reduce the fees paid on virtually every category.

Some bloggers have a specific advertiser lock in a location on their blog. All this income is reportable and subject to tax.

Serious money is earned from books and programs. Most bloggers understand these need to be reported on their return.

Other affiliate programs can turn a nice blog side gig into serious money. Good recordkeeping should assure you don’t miss any reportable income saving you angst should an audit letter arrive.

Before we leave income I want to point out one income source I bet everyone in the blogosphere is missing: awards swag. As a recent winner of the Plutus Awards for Best New Personal Finance Blog of 2017, I received some swag. There was some pretty cool stuff in there. The IRS also makes it very clear this is reportable income. It’s not my job to police you. My job is to inform. (Yeah, I know. Party pooper!)

Deductions

Bloggers have more business expenses than they realize. Even blogger clients think they have virtually no expenses! I have my hands full educating them. I also stalk my blogger clients as they tend to write what they are doing in their blogging business which gives me a good idea of what expenses will show up in their financials. When the financials lack the expected deductions I inform my client of my stalking tendencies and chisel the deductions out of them. Sometimes their blog post IS the deduction substantiation!

Bloggers who have a designated area in the home used on a regular and exclusive basis for their blog have several deductions coming their way. A proration of all home expenses are allowed as a deduction, plus all expenses directly related to the work space (repairs and maintenance, for example). Depreciation is also allowed.

If recordkeeping for a small office in the home is too much work you can always use the safe harbor of $5 per square foot of office space. The maximum home office deduction allowed with the safe harbor is $1,500 per year. Property taxes and mortgage interest are then fully reportable on Schedule A should you itemize.

There is a small issue between actual expense and the safe harbor of the home office. Sometimes the blog might not be profitable or only has a small profit. The home office deduction cannot cause a loss on Schedule C (for sole proprietors). Unused home office deductions are carried to the next year when actual expenses are used whereas the safe harbor deductions are permanently lost if you are unable to use them currently.

Office supplies, promotional expenses, postage and blog maintenance fees are all deductible. Most out-of-pocket blog related expenses are written off in the year paid (assuming most bloggers are cash basis taxpayers).

Travel is common in the industry. I find most bloggers are unsure of what travel they can deduct so they don’t take any deductions at all except for conferences they attend. More is deductible than you might expect.

If you always wanted to see Australia or retired and travel the world while writing a blog to fill time the expense is NOT deductible! A pure pleasure trip down under is not business related. But there might be several opportunities to deduct some expenses.

A blogger in this genre wanted to know if he could deduct some travel expenses where personal was intermixed. He was in the Philippines and was invited by another blogger to visit him is Taiwan (I think). He made the trip so he could discuss some business plans for his blog. I argue the air flight and all related expenses to travel from the Philippines to Taiwan are deductible, including, hotel and the meals and incidentals per diem (more on the per diem later). If he flew back to the Philippines or home I would argue this is deductible. If he flew on to a personal destination the last leg of travel might not be allowed. However, as long as the business portion of the travel is still in effect it should be an allowed deduction.

There are several non-cash deductions related to travel. Business miles are deductible. You can also deduct a per diem for meals and incidentals (M&IE) for each day on the road (technically, every overnight outside the metropolitan area of your residence). Lodging expenses also have a per diem for employees, but not owners or employee-owners; owners must use actual lodging expenses.

There are two ways to calculate your M&IE deduction: the high-low method or based on the rate for each city you conducted business in (involving overnight travel) and actual expense. The high-low method is easier. You get a flat M&IE rate of $57 for most areas within the continental U.S. (CONUS) and $68 for a few high cost areas.

DOT workers have a special rate of $63 within CONUS and $68 outside CONUS (OCONUS).

There are rates for OCUNUS as well for non-DOT workers.

You are allowed to switch methods during the year, BUT you must use the same method within a single business trip.

Meals and incidental expenses are 50% deductible for businesses; 80% for DOT workers (ie. truckers).

There is a modest amount of recordkeeping involved, but worth the effort. The per diems add up fast.

If your spouse travels with you and performs business related activities they may also qualify for a deduction of their travel expenses, including the M&IE per diem.

Business or Hobby

This question has taken on more meaning in 2018. For 2017 hobby expenses are still reported on Schedule A, subject to 2% (the first 2% of AGI of deductions in this category (safe deposit box, tax preparations fees, hobby expenses et cetera) reduce the actual deduction). In 2018 the “subject to 2%” part of Schedule A disappears. This means hobby expenses are never deductible in 2018 and after until they either change the Tax Code or the current provisions expire at the end of 2025.

I think most bloggers are a business even if they think they aren’t. Not making a profit doesn’t mean you are a hobby! If you have a profit motive and conduct your affairs in such a manner you are almost certainly a business.

If you make a profit more than 2 out of a five year period the IRS automatically assumes you are a business and not a hobby.

Business Structure and Entities

When you hang a shingle saying you are in business you are in business. You default to a sole proprietorship or partnership if there are two or more owners.

It’s a good idea to get some legal liability protection with an entity. Organizing as an LLC is the most common way to conduct business. You can also organize as a corporation and elect to be treated as an S corporation.

To kill the pain of tax planning.

LLCs have a huge advantage; they can take on the flavor of any tax treatment available. An LLC can be a disregarded entity and reports their taxes as a sole proprietor (Schedule A of the individual tax return) or a partnership if there are two or more owners.

Organizing your business as an LLC means you can elect to be treated as a corporation and therefore, can elect to be treated as an S corporation (a pass-through entity).

The biggest advantage an LLC has is the ability to change flavors (how they are taxed) without reorganizing the entity. You can start as a disregard entity taxed as a sole proprietor and later elect to be treated as an S corporation. The first election can be made at any time without question by the IRS. Any subsequent change must be after five or more years since the last election changing how the entity is taxed. Example: An LLC is treated as a disregarded entity starting in 2015. The business grew so the owner elected to be treated as an S corporation in 2017. Since the first election is automatic at any time the election is allowed. The LLC cannot again change how it is taxed until tax year 2023, the five-year required waiting period.

Which Entity is Best

The sole proprietorship (or disregarded entity) is the easiest to account for. The business income and expenses all are reported on the personal tax return on Schedule C. The one drawback of the sole proprietorship is the self-employment tax.

Most clients don’t make a lot of noise when I show them their income tax, but they squeal like a stuck pig when I show them the SE tax added on top. The SE tax is 15.3% on top of income taxes. There are some limits to the SE tax we will not cover here.

Once you have any significant blog income you will want to be an S corporation or LLC treated as such. As your income rises the taxes assessed a sole proprietor become increasingly painful.

S corporations (we will discuss regular corporations (C corps) in the next section on recent tax changes) are pass-through entities. Profits flow to the personal tax return. These profits are assessed income tax only, no SE tax.

S corporations are required to pay owners reasonable compensation. This is a wide road to travel and offers plenty of opportunities with serious pitfalls for the overaggressive. The owner’s wages are subject to FICA taxes (the twin sister of SE taxes). The remaining profits are taxed for income only.

Decision Tree Using Recent Tax Law Changes

For decades the entity decision was fairly straight forward. Once profits hit $30,000 – $50,000 it was time to think about an S corporation. Some businesses require higher profits before considering an S corporation, but anything under $30,000 is hard to justify considering the additional payroll accounting costs for owners and additional tax return preparation fees for the S corporation tax return.

The Tax Cut and Jobs Act changed all that. Regular corporations are now a consideration. Tax rates have dropped significantly for C corporations, except for those with profits less than $50,000.

C corporations always had one serious flaw small businesses couldn’t overlook: the double taxation of dividends. Now that the corporate tax rate is a flat 21% and all other business owners face a tax rate as high as 29.6% after considering the new 20% business income deduction, regular corporations are back in play.

For the first time in my career I have to seriously consider the regular corporation as an option. The choices are no longer so simple.

Also, reasonable compensation has more than one purpose. Most business owners want to keep their wage as low as possible to minimize FICA taxes. Now, S corporation owners may need to reconsider a HIGHER wage and FICA taxes to meet the cap on the business income deduction ($315,000 for joint returns and $157,500 for all others). An S corporation with one owner filing jointly on her personal return and $450,000 in profits will not qualify for the business income deduction. If the owner takes reasonable compensation of say $150,000, the S corporation will only have a $300,000 profit and the owner WILL qualify for the deduction if she files a joint return.

(Note: Don’t be confused about the reasonable compensation and guaranteed payments to partners issues. Wages can bring down the income and qualify the owner for the deduction for the cap. Reasonable compensation and guaranteed payments to partners do NOT count when using the formula for business owners above the cap. The formula above the cap is 50% of wages excluding those we mentioned OR 25% of wages excluding those we mentioned, plus 2.5% of the value of qualified property at purchase, generally unadjusted. (Think real estate.))

Time is on Your Side

Sweat is running down your forehead by now, I’m sure. Not to worry.

Review your books and make sure you didn’t miss any deductions for 2017. Things haven’t changed much this year. However, bonus depreciation on assets with a class life of 20 years or less is 100% if placed is service on or after September 27, 2017. For most businesses opting out of bonus depreciation this year is a bad idea. A bigger deduction this year coupled with a bigger profit next year when 20% of profits are a deduction is a powerful planning point.

We have plenty of time to review your situation before deciding which entity structure is right for you. Your favorite accountant will be busy this summer.

My office will review all business clients after tax season to determine if changes are appropriate.

For you, kind bloggers and readers, you are welcome to contact my office to review your situation. Most reviews will be after tax season. We will have time to facilitate any recommended changes to take full advantage of the new tax law. Don’t be surprised if you missed several deductions. Bloggers do that a lot.

I may ask one favor if you do contact my office. I might ask you to give me a plug on your blog because I’m a bit of a traffic whore. All you’ll be asked to say in an Irish accent is:

“Oh, that Wealthy Accountant fella is one swell guy.”

Now that wouldn’t hurt too much, would it?

2017 Tax Bill: Small Business is Punished for Raising Wages

Normally I don’t like to comment on a tax bill before it becomes law, hence the reason I’ve only commented once on the current bill as it wound its way through the halls and committees of Congress. Now that the bill is sitting on the President’s desk awaiting his signature I’m comfortable opening a dialog on some of the issues I see the regular press has missed.

Since the beginning I’ve called this a Swiss cheese tax bill because it has so many holes in it I can drive a truck through with my eyes closed without a worry I’ll hit a wall. I suspect many of these holes will be closed in time. Until then, fuel up the truck fellas. We’re going for a ride.

The Missing Link

Pass-through entities don’t pay taxes at the corporate rate, instead, passing certain items, including profits, to the owners to be reported on their personal tax return. Income is generally taxed at ordinary rates.

The current bill reduces the tax rate for regular corporations (C corps) to 21% while individual tax rates top out at 37% for individuals. To level the playing field between regular corporations and pass-through entities (S corps) the bill included a 20% deduction on pass-through business income.

The deduction is limited to $315,000 of eligible income for married couples and $157,500 for single filers. However, a last minute change greatly enhanced the advantage!

A formula was inserted which will allow the 20% deduction of income on amounts greater than the income limits. The formula for the deduction is the greater of: 1.) 50% of wages, or 2.) 25% of wages, plus 2.5% of the value of qualified property at purchase.

Real estate is the target of this formula. It will allow for massive deductions for certain real estate investors at rates tremendously higher than many other small business owners will get.

But that isn’t what I want to talk about today.

A Load of Swiss Cheese

Traditional news outlets will give you the basics of the tax bill. I’ll touch on the same issues in the near future. For now there is a pressing issue we need to discuss instead.

The above business deduction for pass-through entities makes current year (2017) business deductions more valuable than if taken next year if you are under the income limit! This includes real estate investors where the deduction can be much higher.

As I read the bill, my interpretation is the deduction extends to sole proprietors and small landlords. When the IRS provides regulations on how the new deduction is handled I may have to give updated advice later. It’s unclear if small landlords and sole proprietors get the deduction without creating a pass-through entity. As I read the bill it is allowed without the extra paperwork. But the IRS may disagree and it might be necessary to hold real estate in a partnership, or if there is only one owner, an S corp. (Gulp! Did I say that?) I’ll keep you up to date. As soon as I have more clarity I’ll pass it along. Either way, there should be a way for owners of income property and sole proprietors to take advantage of the new deduction.

There are two reasons for business owners/landlords to accelerate expenses before year-end: 1.) Tax rates are declining slightly for many individual taxpayers, and 2.) A deduction is worth less next year.

This might seem counter-intuitive, but Congress may have passed a tax bill that discourages pay increases and capital expenditures by small businesses and investors of investment property.

Deducting as much as possible this year makes sense with rates going down in 2018. Buying an asset and expensing it, if possible, is worth more now than it will be in a  week and a half after publication of this post due to the lower rates AND the business income deduction!

An example illustrates the disincentive to invest in more capital expenditures and payroll next year. Suppose we have a small business with $200,000 of profits. If the business is planning an investment in a new piece of equipment costing $50,000, the owner’s tax benefit is reduced by 20% in 2018 and after! It looks like this under the new tax bill:

Without equipment purchase:

Income: $200,000

20% business deduction: $40,000

Income reported on personal tax return by owner: $160,000

With equipment purchase:

Income: $200,000

Deduction for expensed equipment purchase: $50,000

Income after equipment deduction: $150,000

20% business deduction: $30,000

Income reported on personal return by owner: $120,000

The equipment cost $50,000, but the reduction in income is only $40,000! The business owner saw a reduction in tax benefits from the increased expense by 20%.

We can debate the method used to deduct the property (expense versus depreciate), but the premise is the same: every business expense is worth 20% less starting January 1, 2018!

Look at it this way. If a small business owner increases wages, as Congress says they are incentivized to do, they will suffer the cost of the higher wages AND a reduction in the new business credit! The business owner will cough up the added payroll expense, plus payroll taxes, and face a decline in the business credit.

If the small business owner REDUCES wages, they are rewarded under the new tax bill! If a business owner cuts payroll by $100,000, she will save payroll taxes AND have a higher income of which 20% is deducted. The $100,000 increase in business income will only have $80,000 subjected to tax.

One last example: Prior to January 1, 2018 it is illegal to deduct 20% of a business’s profits for fake business miles or other non-cash deduction. Starting January 1, 2018 you don’t have to cheat to get the benefit; it’s codified!

Final Thoughts

Congress has sold this massive tax bill as a job creator. Instead of taking time to get a solid piece of legislation written, they rushed it and it shows.

The incentive to small businesses is clear: CUT PAYROLL! This will have the opposite effect of what was intended.

Sure, businesses will need to spend on updating equipment eventually. But the longer they can hold off the better they will fare; they get a 20% deduction off the top before they spend a penny. A smart small business owner will have more incentive than ever to CUT wages and capital expenditures. And for the altruistic business owner, a tax penalty applies in the form of a reduction in the new business deduction if they do increase wages.

Real estate investors tend to hire fewer people so the effect is less. Even still, spending on improvements entail up to a 20% penalty for each outlay as the business deduction is reduced.

My favorite deductions have always been of the non-cash nature; I get a deduction and keep the money, too.

I hope y’all love Swiss cheese because there will be plenty to go around until they change the tax law.

 

Note: This is self-serving as all get-out, but this is one simple example of how this tax bill will harm the economy and the workforce, the backbone, of America. If you can see past my self-promotion, spread this post everywhere: social media, email and links. Don’t forget your elected officials in Washington. Don’t be afraid to expand on the consequences of this tax bill. There is plenty to spur the economy. But there is also plenty to slow the economy as well. With small business employing so many people in this country it is imperative to get the word out so the people who can facilitate appropriate change can take action with this new knowledge.

Applying Cost Segregation on a Tax Return

A few weeks ago I wrote about the massive tax benefits to investment property owners and business owners who also own commercial real estate using a cost segregation study. Some of you took me up on the offer and now are up for a significant tax reduction. Then the problems started. I didn’t anticipate the large number of tax professionals who didn’t know how to handle cost segregation studies on a tax return.

Before you call your tax preparer bad names, know most tax professionals rarely, if ever, see a cost segregation study in their office. When the rules changed a few years back I doubt 1 in 100 accountants handled their client tax returns correctly as it pertained to the repair regs and tangible property rules. The good news is the changes only required certain actions in the first year of accounting method changes. The bad news is that most tax professionals don’t know how to handle a cost segregation study on the actual tax return when a client comes in with one. Not to worry. Your favorite accountant will spill the beans on how to get it done right.  No picking on your accountant either. This is advanced tax planning and tax law can be miles from tax application at times.

Tax professionals will find this helpful; taxpayers should find value, too. Knowing of a tax advantage is only worth something if you can apply it. There are two major issues surrounding cost segregation studies: tracking the components/elements listed by the study and taking full advantage of the additional depreciation allowed.

Reading the Cost Segregation Report

When you get your report it will list the building components by item and class. In most cases you will see components listed under 5-year, 15-year, and either 27.5- or 39-year property, depending if it is residential or commercial real estate. Sometimes a component will also fall under 7-year property.

It is important to add each item separately to the depreciation schedule, even the 27.5- or 39-year property. The 5- and 15-year property accelerates the current depreciation deduction. But even the long end of the depreciation schedule has value. The roof, doors, electrical, plumbing and painting eventually need upgrading. When you upgrade any component you deduct the remaining undepreciated basis left in the replaced component.

The same applies to short end of the depreciation schedule. The parking lot, sidewalk and landscaping are 15-year properties. A replacement of any of these will trigger the remaining basis for deduction of said component.

The original estimate of tax savings from a cost segregation study underestimates the benefits as it assumes only the increased depreciation expense related to the 5- and 15-year property. There are only a few components that are not replaced prior to the component being depreciated. The foundation is one such item. But even things like plumbing and electrical are likely to need an upgrade before 39 years!

The advantage of the cost segregation study is the separate listing of components. The additional deduction from the old component (when replaced) helps offset the cost of the upgrade. Coupled with the repair regs, investment property owners and businesses with commercial real estate are better able to match deductions with the outlay of capital. A difficult issue in business and with landlords is the outlay of cash to improve a property only to wait up to 39 to get a tax benefit. Without a cost segregation study the cash is spent on the improvement and also taxed currently, increasing the cash needs to undertake a project. Cost segregation and the repair regs help eliminate some of the problem, allowing more projects to move forward.

Preparing the Tax Return

The concept of the cost segregation study is easy to understand. Then you run into the issue of application. Accelerated depreciation causes problems unless you make certain elections on your tax return.

Investment property owners need to consider passive activity rules. Once income reaches six figures, passive activity rules suspend some or all losses until the passive activity has a gain or is disposed of.

The normal structure of many small businesses makes passive activity rules an acute problem. It is common for small businesses to conduct business as an S corporation or an LLC treated as an S corporation. Real estate should never be held inside an S corp. Therefore, real estate is usually held in a second LLC treated as a disregarded entity by the same owners. In many instances this real estate does not generate enough rental income to handle all the additional depreciation from the cost segregation study. Passive activity rules kick in and undo all the cost segregation advantages.

This is where grouping comes in. The IRS says you can group activities using any “reasonable method”. This is a wide road to travel. It isn’t a free-for-all, but as long as the group of activities constitutes an appropriate economic unit the grouping should be allowed. The implications to passive activity rules are significant.

There are five factors in determining if a group constitutes an economic unit: 1.) similarities and differences in the activities; 2.) extent of common control; 3.) extent of common ownership; 4.) geographical location; and 5.) interdependencies between the activities. Once a grouping is made it cannot be changed unless the original grouping was inappropriate, the facts and circumstances change, or the IRS disallowed the original grouping.

Because of the interrelated nature of the real estate used by an entity to conduct business, grouping of the two activities is a reasonable step to take. Landlords can also group activities in a similar fashion.

Grouping allows the business and the real estate profits to be combined. The real estate fair rental value paid by the business may not be enough to generate a gain and passive activity rules then limit the loss. By grouping the business with the real estate used by the business, the accelerated depreciation resulting from a cost segregation study is now possible to currently deduct.

One final note: A disclosure is required when grouping activities. The structure of your business determines the type of disclosure required. Partnerships and S corporations already have rules in place requiring a disclosure attachment to Schedules K-1.

Form 3115

There is one more monster in the room: Form 3115, Change in Accounting Method. Form 3115 has been revamped over the last few years and is now down to 8 pages. Not to be afraid. You only fill out the portions of the form applicable to your situation. If time permits, I will write a post this summer with a filled-in Form 3115 as it applies to cost segregation studies. The best news of all is that if you do the cost segregation study the first year the property is owned there is no need to file Form 3115. You only need to file Form 3115 to catch up on depreciation you should have used all the prior years.

This is a complex area of tax code. I recommend hiring a tax professional to handle grouping issues. Your accountant may not work with grouping often, but she has all the books and resources available to prepare the tax return properly with all regulations considered. And they will are more likely to make the required elections and disclosures, protecting you in an audit.

If I Were an IRS Auditor

17142377126_48d2650b0cThe IRS has a complex formula in determining who to audit so secret even the government doesn’t know what it is. This secret is the subject of much debate and some even claim to know the formula. (They also have the secret formula to Coca Cola.)

In my neighborhood if you have an S corporation and get audited, I apologize. The lady who handles S corporation audits at the IRS around here was once an employee of mine. I take full responsibility for my limited role in training her. I am ashamed of my behavior.

But an IRS audit is not really an issue for most people. IRS audits are at all-time lows and do not look to be expanded much in the future. Most audits are not the dreaded visit to the IRS office or the auditor showing up at your place. Most audits are of the correspondence type, where they send you a letter. Correspondence audits are generally narrow in focus and are the result of a misplaced number or a mismatch on the tax return with information the IRS has.

Since so few people get audited nowadays, there should be no worry among taxpayers of a visit from your friendly government revenue agent. Still, I audit proof every tax return I prepare and train my employees to do the same. This isn’t cheating either. I am talking about preparing a tax return in a manner that doesn’t encourage scrutiny.

Who I Would Audit

The IRS seems to take an erratic course when choosing who to audit. Areas I would consider fertile ground for audit are ignored and areas where the ground has more stones is gleaned for any additional revenue.  It seems counterproductive to take such an approach.

Since so much income is now reported to the IRS, most returns are easy to eliminate from audit consideration, or so you would think. Business owners and landlords are prime audit candidates since they receive income not always reported to the IRS. But there are millions of small businesses and landlords. You can’t audit them all.

The IRS selects tax returns for audit using their DIF System (Discriminant  Inventory Function System). Other methods are used to uncover unreported income (UI DIF: Unreported Income Discriminant Index Formula). Only a government could come up with such names and acronyms.

The higher your DIF score the greater the chance of audit. The system works pretty well and is constantly tweaked and updated to improve efficiency. It also misses by a mile more often than not.

When you have 30 plus years in the tax industry you start to get a feel for who is pulling a fast one on their tax return. I am wrong periodically, but usually I can sniff out malfeasance.

There are two types of tax returns I would focus on auditing if I were an IRS auditor. The first is S corporations showing a loss and the other is people deep in debt and still spending.

The S corporation seems a strange choice. It isn’t. Since debt by an S corporation does not increase basis unless the debt is from the shareholder, all kinds of nasty surprises show up if the corporation shows a loss above basis. This is a complex area of tax law we will not delve into today. All I will say is please, if you have an S corporation, never have the company borrow from anyone but you, the owner. Guaranteeing a loan doesn’t help. Talk to a tax professional if you have this issue.

What I do want to focus on today is the type of person incentivized to cheat on their taxes: those deep in debt and spenders. A better way to look at who I would audit is to look at who I would not audit.

Who I Would Not Audit

If I worked for the IRS there is a group of people I would avoid auditing except for the most extreme cases. People reading this blog are awful candidates for audit! Why? Because savers don’t have a reason to cheat on their taxes. The people reading this blog are more interested in investing every penny they can. Instead of cheating on their taxes so they can spend more or to fund a heavy burden of debt, they cut spending on stupid stuff to free capital for investments in index funds and real estate.

People with a lot of toys are perfect candidates for audit. Decades in the business has proven my theory correct. When I see a client with a lot of big-boy toys they always perform poorly in audit. It is so bad I am nervous just preparing their returns. You know they have some serious preparer penalties out there. Never paid one; don’t want to start now.

A couple of things always concern me. When a client drives up in Hummer I am certain they don’t want to pay my fee (or they can’t). In the interview process I may learn of a lifestyle filled with lots of stuff coupled with debt. The risks these clients present my firm and me is higher. If I know of income and/or expenses, they must go on the return. It’s the stuff I don’t know about that keeps me thinking. The IRS may not believe I didn’t know. And then those preparer penalties show up again.

Avoiding Audit and Winning if You Are Audited

There is no fool-proof, 100% guaranteed way to prevent an audit. There are things you can do to significantly reduce your chances of getting that letter from your uncle in Washington.

  • Report all income as it appears on tax documents.
  • Make adjustments on the tax return for incorrect tax documents.
  • Disclose positions you are taking on the tax return if you are adjusting for a tax document and for issues that make the return look like it has an issue (large charitable contributions, large business expenses, et cetera).

Where tax documents do not report the transaction to the IRS you need to consider how the return looks. Cost of goods sold higher than normal or other business or rental expenses should be covered in a disclosure included with the return. Better yet, change the mechanics of the tax return without changing the final result.

usa_-_irs_cidTo prevent the IRS computer from throwing a fit, I will change how I handle certain numbers. This usually applies to small business owners, side gigs, hobbies, and landlords. For example, let’s say you have a really large advertising expense for a program in your business that failed to generate expected revenue. First, I would add a disclosure to the return. I would also break it up if possible. I might list the Yellow Pages ad separately to bring down the out of place advertising number.

Before you ever file your tax return you should review the return with the eyes of an auditor. What would you question if you worked for the IRS? Be brutally honest. Many returns selected for audit never get called because the auditor reviews the return and knows there is not much to gain if they open the file. As long as her supervisor doesn’t demand the audit take place, the thing will eventually run out of stat. The best audit is the one you never have to fight. Even if you win on all counts in an audit you still have time and money invested defending yourself.

When you review your tax return for things that look off, consider changing how you report the item. Again, I am not talking cheating. What I suggest is breaking big number up so they don’t look so out of place. When in doubt, disclose. Too many tax professionals are afraid to disclose a position they are taking with the IRS. They think it alerts the IRS to something they should audit. I disagree.

When the IRS sees a disclosure attached to a tax return it means you took the time to research the issue. You already self-audited. The IRS might disagree, but collecting more tax revenue is more difficult when the taxpayer already went out of her way to prepare an accurate return. My experience shows the same. I have never had a client audited when there was a disclosure attached to the return. Ever! That doesn’t mean I will not have one waiting for me when I get to the office. Even if there is one waiting for me, the number of audits of returns with a disclosure is very small.

The IRS is Reading this Blog

IRS auditors probably read this blog. It doesn’t bother me. They want to know how I conduct business, fine. One of the local auditors worked for me for a short time and knows how I conduct business. Like any tax professional, I sometimes get things wrong. Shit happens. What I don’t allow is willful errors. Judgment calls are part of the trade. Some returns we are happier with than others.

Since this is a public blog written by the owner of an accounting firm and we can assume the IRS is watching, let me share a few additional tips. I cannot remember the last time I saw a tax return audited from someone who maxes out their retirement account. I can’t remember ever seeing one. I think the IRS knows what I know; savers rarely cheat on their taxes. What would their incentive be? These people think along the lines of spending less. Their attitude is: my taxes are what they are. I’ve done everything I can to reduce them.

And reduce them they have. How much cheating do you have to do to get the same benefit as filling every retirement account you can? If you sock away $20,000 into your 401(k) and IRAs, the IRS can easily see what you did. Drop an extra 20k into the contributions to charity line on Schedule A and the revenuers might just want to verify that.

So how do you reduce your risk of audit to near zero? Simple! Spend less, pay off debt and save/invest more. The IRS is defenseless against such intelligent financial planning. It’s all legal. Pay off a credit card and you now have tax-free income! All that interest was not deductible and is now free for you to use elsewhere. In effect, tax-free income.

You can double down on the benefits by pushing the interest saved on consumer debt into a retirement account to get additional tax advantages. And the IRS has nothing to talk to you about. Your life is simpler. The government has less interest in your money. And you can finally start living the life you dreamed.

That is something everyone should be happy doing. Even an IRS auditor.