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John Sanchez

Tax-Saving -Three Possible Ways to Deduct Your Dog or Cat

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Three Possible Ways to Deduct Your Dog or Cat

Dogs, cats, and other household pets are expensive. Owners spend an average of $1,270 to $2,800 a year to own a dog. Can you ever deduct these costs from your taxes?

The expenses for a family pet that provides you only with love and companionship are never deductible. They are purely personal expenses. 

But it is possible to deduct the expenses for a dog, a cat, or another animal if it qualifies as a

  • medical expense
  • business expense, or
  • charitable deduction.

The costs of buying, training, and maintaining a dog or another animal qualify as deductible medical expenses if you 

  • use the animal primarily for medical care, and
  • would not have paid the expenses but for the disease or illness involved. 

Medical deductions are allowed for service animals trained to aid their owners with a disability. Examples include guide dogs for people who are blind or have low vision, or dogs trained to carry items for people with physical disabilities.

You can also deduct as a medical expense emotional support animals, such as dogs, cats, or other animals that help people suffering from mental or emotional disabilities. Emotional support animals are more challenging to deduct than service animals because they can seem little different from regular pets. The animal should be prescribed (or at least recommended) by a licensed healthcare provider as part of a mental health treatment plan.

You can deduct dogs and other animals as a business expense if they serve a legitimate business purpose. For example, you can deduct a guard dog used for security at your business location. The guard dog should be trained and should be an appropriate breed for guarding purposes, such as a Rottweiler, German shepherd, or Doberman pinscher. Don’t try to deduct a small dog like a Chihuahua as a guard dog!

Cats have achieved business-deductible status when used for pest control at a business location.

If you foster dogs, cats, or other animals in your home, you may be able to take a charitable deduction for the reasonable expenses you pay out of your own pocket, such as pet food expenses and veterinary bills. You may not deduct the value of the time you spend fostering animals or the value of donating space in your home for this purpose.

To qualify for this charitable deduction, you cannot foster animals on your own. You must do so on behalf of a Section 501(c)(3) charitable organization. You must also obtain a written acknowledgment from the charity if your expenses exceed $250.

 

Got IRS Penalties? Know the Rules, Pay Nothing

If the IRS has recently claimed that you owe a penalty for late filing, late payment, or missed employment tax deposits, pause before making any payment. You may not have to pay that penalty at all.

The IRS often imposes steep penalties for filing tax returns late, failing to pay taxes on time, or not depositing employment taxes correctly. However, several strategies can help you get those penalties removed—and in some cases, even refunded if you have already paid them.

Common IRS Penalties and Their Impact

Some of the most common penalties include:

  • Late filing penalty. For individual or C corporation returns, this can be up to 5 percent of the unpaid tax for each month the return is late, maxing out at 25 percent. Partnerships and S corporations can incur penalties of $245 per partner or shareholder per month.
  • Late payment penalty. This penalty is generally 0.5 percent of the unpaid tax per month, maxing out at 25 percent.
  • Penalty for failure to deposit employment taxes. This penalty ranges from 2 percent to 10 percent, depending on how late the deposit was.

 

Strategies for Relief

Here are a few ways to potentially avoid or reduce these penalties:

First-time abate. If this is your first time receiving a penalty—or your first time in over three years—you may be eligible for a “first-time abate.” This is one of the easiest and most common ways to remove a penalty. It applies to failure-to-file, failure-to-pay, and failure-to-deposit penalties. As long as your tax compliance history is clean, you may qualify.

Partnership relief. If your business is a partnership with 10 or fewer partners, and if all partners filed their tax items on time, you may be eligible for relief under Revenue Procedure 84-35. This is a little-known but effective option.

Reasonable cause. If neither of the first two options applies, you can request penalty relief by showing that there was a reasonable cause for your late filing or payment. This could include illness, a natural disaster, or other significant life events that impacted your ability to meet IRS deadlines.

Next Steps

If you believe any of the penalties you’re facing may qualify for relief, you may be able to remove those penalties with a simple phone call. Using the right approach and trigger words when speaking to the IRS can make all the difference.

If you have already paid the penalties, you can use IRS Form 843 to file for a refund if you do so within three years of filing the return or within two years of paying the penalty.

 

Know the Three Ways the Tax Law Treats Personal Property Rentals

Here are some key points about renting personal property, which includes equipment, vehicles, and furniture. The tax treatment differs from real estate rentals, and how you classify the rental activity will affect how you report income, expenses, and potential self-employment tax.

Classification of Personal Property Rentals

The tax code treats personal property rentals in three ways:

  1. Business. If your primary purpose is to earn income and the activity is continuous, it is considered a business. You must report the income on Schedule C, subject to self-employment tax.
  2. For-profit activity. If the rental is profit-motivated but sporadic, it’s a for-profit activity. You report the income on Schedule 1. There’s no self-employment tax.
  3. Not-for-profit activity. If the rental activity is primarily for personal reasons (e.g., for recreation), it is considered not-for-profit. You report the income on Schedule 1, but cannot deduct expenses related to the activity.

 

Renting to Your Own Business

If you rent personal property to your own business, the tax implications depend on the business structure.

Sole proprietorship or single-member LLC. Rentals between you and your business are not taxable events.

Corporation, partnership, or multi-member LLC. Renting to your business is a taxable event. The business can deduct rental payments, and you report the income on your tax return.

For C corporations, this can help avoid double taxation, as rent payments are taxed only once as income to you.

Self-Rental Rule

The “self-rental” rule applies to renting personal property to a business in which you materially participate. The rule works like this:

  • If the rental activity produces net income, it is characterized as non-passive income, meaning you can’t deduct passive losses against this income. 
  • If the rental activity creates a loss, the loss continues as a passive loss, which you can offset only with passive income.

 

Key point. Self-rental gives you the worst of both worlds—passive classifications.

Grouping

You can avoid the self-rental rules with the grouping election. You may group your property rental with your business when the group forms an appropriate economic unit and

  • the rental activity is insubstantial relative to the business activity, or vice versa, or
  • each owner of the business activity has the same proportionate ownership interest in the rental activity.

Caution 1. The tax code prohibits grouping real and personal property rentals.

Exception. If you rent the business building or office unit to your business and such rental includes furnished offices, the prohibition on combining activities does not apply. You can group with the business activity under the grouping rules above.

Caution 2. The self-rental grouping election does not work with a C corporation.

If you have questions, don’t hesitate to contact me.

Tax Guide to Deducting Long-Term Care Insurance Premiums

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Tax Guide to Deducting Long-Term Care Insurance Premiums

Tax Guide to Deducting Long-Term Care Insurance Premiums

Long-term care costs can be substantial, and neither Medicare nor Medicaid provide comprehensive coverage for most people. Long-term care insurance can help protect your finances, and there may be ways to deduct the premiums, depending on your business structure.

Here are four key points to consider:

  1. C corporations can provide long-term care insurance as a fully deductible, tax-free benefit to owners.
  2. Sole proprietors or single-member LLCs with a spouse as the only employee may be able to deduct 100 percent of the premiums through a Section 105-HRA plan.
  3. S corporation owners, partners, and other sole proprietors may be able to deduct premiums subject to age-based limits.
  4. If you don’t qualify for business-related deductions, you might deduct premiums as itemized deductions subject to age-based limits and the 7.5 percent floor.

Smart Solutions That Decrease Social Security and Medicare Taxes

Here are some important updates and strategies regarding Social Security and Medicare taxes that may significantly impact your business.

For 2024, the Social Security tax ceiling increased to $168,600, resulting in a maximum Social Security tax of $20,906 for high-earners. The Social Security Administration projects this ceiling to rise annually, reaching $242,700 or more by 2033. Additionally, the government adds a 2.9 percent Medicare tax to all wages and self-employment income, with an extra 0.9% for high-income earners.

If you’re self-employed, these taxes can be particularly burdensome. Here are three strategies that can potentially reduce your tax liability:

  1. Operate as an S corporation. This structure allows the corporation to pay you a reasonable salary and distribute the remaining profits to you, exempt from self-employment taxes.
  2. Leverage community property rules. Married filers living in community property states can use IRS rules to eliminate or create a spouse partnership in order to reduce self-employment taxes.
  3. Avoid the husband-wife partnership classification. With close attention to partnership attributes, you can avoid the husband-wife partnership classification and reduce overall self-employment taxes.

Each of these strategies has specific requirements and potential trade-offs.

What Happens When You Die and Your S Corporation Owns the Rental?

You may own an S corporation with a rental property as its sole asset.

A common concern with this approach is what happens when the owner passes away, specifically regarding the step-up in basis.

Here’s good news. While technically the rental property itself doesn’t receive a step-up in basis upon your death, your heirs will achieve the same outcome. It works like this:

  • Your heirs inherit the S corporation stock at its stepped-up fair market value.
  • When the S corporation sells the rental property, it recognizes a gain.
  • The gain on the rental property increases your heirs’ basis in the S corporation stock.
  • Upon liquidation of the S corporation, your heirs recognize a capital loss that offsets the earlier gain.

The result is that your heirs can potentially sell the property without incurring any federal income tax liability, effectively achieving the same outcome as they would with a traditional rental property basis step-up.

Reduce Taxes by Using the Best Cryptocurrency Accounting Method

Consider this happy scenario: You purchased one Bitcoin for $15,000 14 months ago and another six months later for $40,000. Today, you sell one Bitcoin for $60,000. You’re a genius! But is your taxable gain $45,000 or $20,000? 

It all depends on your crypto accounting method.

Many crypto owners are enjoying substantial gains at a time of surging cryptocurrency prices. When you sell multiple crypto units in the same year, you reduce your taxable gains using a crypto accounting method that provides the highest possible tax basis for each unit sold, resulting in the lowest taxable profit.

As you might expect, the default method approved by the IRS doesn’t always provide the highest basis, resulting in higher taxes. The IRS made FIFO (first in, first out) the default method. It requires you to calculate your basis in chronological order for each crypto unit sold. With FIFO, your basis in the above example is $15,000, and your taxable profit is $45,000.

You can use a method other than FIFO. The other methods are called “specific identification methods” and include HIFO (highest in, first out) and LIFO (last in, first out). With HIFO, you are deemed to sell the crypto units with the highest cost basis first; your basis in the above example would be $40,000, and your taxable profit only $20,000.

Because HIFO sells your crypto with the highest cost basis first, it ordinarily results in the lowest capital gains and the largest capital losses. But using HIFO can cause loss of long-term capital gains treatment if you have not held the crypto for more than one year.

Using HIFO or LIFO is more complicated than using FIFO. You must keep records showing

  • the date and time you acquired each crypto unit,
  • your basis and the fair market value of each unit at the time it was acquired,
  • the date and time each unit was sold or disposed of, and
  • the fair market value of each unit when sold or disposed of.

If you lack adequate records, the IRS will default to the FIFO method during an audit, which could result in more taxable profit.

It’s next to impossible to manually create the needed crypto records, particularly if you have many trades. Most crypto owners use specialized crypto tax software that automates the basis and gain/loss calculations and can even fill out the required tax forms.

You can change your crypto accounting method from year to year without obtaining IRS permission—for example, you can change from FIFO to a specific identification method such as HIFO. You don’t have to disclose which method you use on your tax return.

Avoid the Hidden Dangers of the Accumulated Earnings Penalty Tax

If you run your business as a regular C corporation, beware of the accumulated earnings tax (AET). 

The IRS can use the AET to penalize C corporations that retain earnings in the business rather than pay them to shareholders as taxable dividends. When retaining earnings, the C corporation first pays the corporate tax of 21 percent on those earnings.

When the corporation distributes those already taxed earnings to shareholders, the shareholders include those distributed earnings as dividends in their taxable income, where they are taxed again at the shareholders’ capital gains rate.

The AET is a flat 20 percent tax. It is a penalty tax imposed after an audit in which the IRS concludes that the corporation paid out insufficient dividends when compared with the amount of income accumulated by the corporation. 

You have AET exposure when your C corporation has large balances in retained earnings, cash, marketable securities, or loans to shareholders reported on its balance sheet on IRS Form 1120, Schedule L.

The IRS can impose the AET on any C corporation, including public corporations. However, closely held C corporations are the most likely targets because their shareholders have more influence over dividend policy than do public corporations’ shareholders.

Historically, IRS auditors have not prioritized the AET, but anecdotal evidence suggests this may change.

Fortunately, there are many ways to avoid problems with the AET—for example:

  • Elect S corporation status.
  • Retain no more than $250,000 in earnings ($150,000 for corporations engaged in many types of personal services)—all C corporations are allowed to retain this much without incurring the AET.
  • Establish that the corporation needs to retain earnings above $250,000/$150,000 for its reasonable business needs—for example, to provide necessary working capital, fund expansion needs, pay debts, or redeem stock. 

The key to avoiding the AET is to document the reasons for accumulating earnings beyond $250,000/$150,00 in corporate minutes, board resolutions, business plans, budget documents, or other contemporaneous documentation.

If you have questions, don’t hesitate to contact me.

Claim Up to $32,220 Today

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Claim Up to $32,220 in Missed 2021 Self-Employed COVID-19 Sick and Family Leave Credits Today

Claim Up to $32,220 in Missed 2021 Self-Employed COVID-19 Sick and Family Leave Credits Today

Were you self-employed during 2021? If so, there is a good chance that you could have qualified for COVID-19 sick and family leave credits worth as much as $32,220.

If you’re like many self-employed individuals or partners, you probably never heard about these tax credits. Unlike employee retention credit for employers, the special temporary credits for the self-employed received relatively little publicity. Many tax professionals were unaware of them. As a result, many self-employed individuals and partners never applied for them.

You qualified for the credits if you could not work or telework for various COVID-related reasons—for example, if you suffered from COVID-19; were under quarantine; underwent COVID testing; or looked after a friend, roommate, or family member impacted by the virus.

There are four separate credits:

  1. Credit for Sick Leave—January 1, 2021, through March 31, 2021
  2. Credit for Family Leave—January 1, 2021, through March 31, 2021
  3. Credit for Sick Leave—April 1, 2021, through September 30, 2021
  4. Credit for Family Leave—April 1, 2021, through September 30, 2021

The COVID-related sick leave credit was for up to 10 days from January 1, 2021, through March 31, 2021, plus an additional 10 days from April 1, 2021, through September 30, 2021. The maximum credit was $511 per day ($200 per day if you cared for others).

The COVID-related family leave credit was capped at $200 per day. Up to 50 days of credits were available from January 1, 2021, through March 31, 2021, plus an additional 60 days from April 1, 2021, through September 30, 2021. From January 1, 2021, through March 31, 2021, the credit was available only if you needed to care for a child whose school was closed or whose caregiver was unavailable because of COVID. From April 1, 2021, through September 30, 2021, lawmakers greatly expanded eligibility to include caring for yourself, roommates, friends, and relatives.

You were supposed to claim the credits on your 2021 tax return. But if you overlooked the credits, don’t worry. You can still claim them by amending your 2021 tax return. You need to file a completed 2021 IRS Form 7202, Credits for Sick Leave and Family Leave for Certain Self-Employed Individuals, along with Form 1040-X.

To determine your eligible sick and family leave days, you’ll likely have to consult your calendar for 2021, emails, vaccination or other medical records, school records, or other records showing the days you could not work for COVID-related reasons. 

You don’t need to file any documentation with your amended return. Just keep it with your tax records. 

You must file your amended return within three years (including extensions). The deadline is April 18, 2025, or if you filed for an extension, up to October 15, 2025. But why wait? Amend your 2021 tax return today, and you’ll get your money as soon as possible.

Shutting Down Your S Corporation

As you consider the process of shutting down your S corporation, it is crucial to understand the federal income tax implications that come with it. Here, I outline the tax basics for the corporation and its shareholders under two common scenarios: stock sale and asset sale with liquidation.

Scenario 1: Stock Sale

One way to shut down an S corporation is to sell all your company stock. The gain from selling S corporation stock generates a capital gain. Long-term capital gain tax rates apply if you held the shares for more than a year. The maximum federal rate for long-term capital gains is 20 percent, but this rate affects only high-income individuals.

If you are a passive investor, you may also owe the 3.8 percent Net Investment Income Tax (NIIT) on the gain. But if you actively participate in the business, you are exempt from the NIIT. Additionally, state income tax may apply to the gain from selling your shares.

Scenario 2: Asset Sale and Liquidation

A more common way to shut down an S corporation involves selling all its assets, paying off liabilities, and distributing the remaining cash to shareholders. Here’s how the tax implications unfold.

Taxable gains and losses. The S corporation recognizes taxable gains and losses from selling its assets. These gains and losses are passed to shareholders and reported on their personal tax returns. You will receive a Schedule K-1 showing your share of the gains and losses to report on your Form 1040.

Long-term gains and ordinary income. Gains from assets held for more than a year are typically taxed as Section 1231 gains at long-term capital gains rates. But gains attributable to certain depreciation deductions are taxed at higher ordinary income rates, up to 37 percent. Real estate depreciation gains attributable to straight-line depreciation can be taxed up to 25 percent.

NIIT considerations. Passive investors may owe the 3.8 percent NIIT on passed-through gains, while active participants are exempt.

Liquidating distributions. The cash distributed in liquidation that exceeds the tax basis of your shares results in a capital gain, taxed as a long-term capital gain if held for more than a year. If the cash is less than the basis, it results in a capital loss.

Tax-Saving Strategy for Asset Sales

Your number one strategy for tax savings is to allocate more of the sale price to assets generating lower-taxed gains (e.g., land, buildings) and less to those generating higher-taxed ordinary income (e.g., receivables, heavily depreciated assets).

Compliance and Reporting

Report asset sales and allocations on IRS Form 8594 (Asset Acquisition Statement Under Section 1060).

File the final federal income tax return using Form 1120-S, including final shareholder Schedule K-1s.

Know the Exceptions to the 10 Percent Penalty on Early IRA Withdrawals

Early withdrawals from a traditional IRA before age 59 1/2 generally incur a 10 percent penalty tax on the taxable portion of the withdrawal. There are several exceptions to this rule that can help you avoid the penalty under specific circumstances. Below, we have outlined the key exceptions that may apply to your situation.

Substantially equal periodic payments. You can arrange for a series of substantially equal periodic payments. This method requires careful calculation and adherence to strict rules but allows penalty-free withdrawals.

Medical expenses. Withdrawals for medical expenses exceeding 7.5 percent of your adjusted gross income, or AGI, are exempt from the penalty.

Higher education expenses. You can use penalty-free withdrawals for qualified higher education expenses for you, your spouse, and your children.

First-time home purchase. You can withdraw up to $10,000 (lifetime limit) for qualified home acquisition costs without penalty.

Birth or adoption. You can withdraw up to $5,000 for expenses related to the birth or adoption of a child.

Emergency expenses. Starting January 1, 2024, you can withdraw up to $1,000 annually for emergency personal expenses without penalty.

Disaster recovery. Withdrawals for qualified disaster recovery expenses are exempt from the penalty, up to an aggregate limit of $22,000.

Disability. If you are disabled and cannot engage in substantial gainful activity, you can withdraw funds without penalty.

Long-term care. Beginning December 29, 2025, you can take penalty-free withdrawals for qualified long-term care expenses.

Terminal illness. Withdrawals due to terminal illness are exempt from the penalty.

Post-death withdrawals. Amounts withdrawn after the IRA owner’s death are not subject to the penalty.

Military reservists. Active-duty military reservists called to duty for at least 180 days can withdraw funds without penalty.

Health insurance premiums during unemployment. If you receive unemployment compensation for 12 consecutive weeks, you can withdraw funds to pay for health insurance premiums without penalty.

Domestic abuse victims. Starting January 1, 2024, you can take penalty-free withdrawals of up to $10,000 if you are a victim of domestic abuse.

IRS levies. Withdrawals to pay IRS levies on the IRA account are not subject to the penalty.

It’s important to note that SIMPLE IRAs incur a 25 percent penalty for early withdrawals within the first two years of participation. Additionally, Roth IRAs have different rules, allowing penalty-free access to contributions but potentially taxing and penalizing withdrawals of earnings.  If you have questions, don’t hesitate to contact me.

Cost Segregation: Is This Strategy for You?

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Cost Segregation

One significant tax benefit of owning residential rental property or non-residential commercial or investment property is depreciation—a deduction you get without spending any additional money.

But regular depreciation for real property is slow. Residential rental property is depreciated over 27.5 years and non-residential property over 39 years, providing a relatively small deduction each year.

Fortunately, there is a way you can speed up your depreciation deductions—especially during the first year or years you own the property: cost segregation.

“Cost segregation” is the technical term for separately depreciating the elements of property that are not real property. These are elements other than land, buildings, and building components. They include

  • improvements made to the land, such as landscaping, swimming pools, paved parking areas, and fences; and
  • personal property items inside a building that are not building components—for example, refrigerators, stoves, dishwashers, and carpeting in residential rentals.

Using cost segregation does not increase a property owner’s total depreciation deductions, but it does accelerate them over the first few years because personal property has a five- or seven-year depreciation period and land improvements a 15-year period. 

In addition, by using bonus depreciation and/or Section 179 expensing, owners can deduct all or most of the cost of personal property and land improvements the first year they own the property—providing a potentially enormous first-year deduction.

A cost segregation study must be conducted to identify which building elements are personal property and land improvements and then to determine their depreciable basis. Studies can be conducted by engineers or done more cheaply with other methods that the IRS views as less reliable.

Cost segregation may not be advisable for every property owner—for example, where it results in a loss that can’t be deducted due to the passive loss rules, or where the owner intends to sell the property within a few years and has to recapture as ordinary income the cost-segregated depreciation deductions.

The best time to perform a cost segregation study is the same year you buy, build, or remodel your real property. But you can wait until a future year—perhaps when you have enough rental or other passive income to use the speeded-up depreciation deductions.

 

Tax Implications of Shutting Down a Sole Proprietorship

As you consider shutting down your sole proprietorship or your single-member LLC treated as a sole proprietorship for tax purposes, it’s crucial to understand the tax implications of this decision. Here’s an overview of key points you need to consider.

  1. Asset Sale Tax Implications

When you sell a sole proprietorship, you sell its assets, not the company. Federal tax rules tell you how to allocate the total sale price to specific business assets. This allocation is critical as it impacts the calculation of taxable gain and loss.

  1. Taxable Gain and Loss
  • Gain. You have a taxable gain if the allocated sale price exceeds the asset’s tax basis (original cost plus improvements minus depreciation/amortization).
  • Loss. You incur a deductible loss if the tax basis exceeds the sale price.
  1. Special Rules for Depreciable Real Estate

For depreciable real estate, specific federal income tax rules apply:

  • Section 1250 ordinary income recapture. The portion of the gain on sale attributable to tax-code-defined “additional depreciation.” It’s taxed at ordinary income rates. 
  • Section 1231 gains. Gains from the sale or exchange of real estate used in a trade or business, which the tax code treats as long-term capital gains if the gains exceed any non-recaptured Section 1231 losses from the previous five years.
  • Unrecaptured Section 1250 gain. The portion of gain from the sale of real estate attributable to depreciation deductions previously taken on the property that were not recaptured as ordinary income under Section 1250. The unrecaptured 1250 gain is taxed at a maximum rate of 25 percent.
  1. Other Depreciable or Amortizable Assets

Gains attributable to depreciation or amortization deductions are recaptured and taxed at higher ordinary income rates. Remaining gains on assets held for more than one year are taxed at lower long-term capital gains rates.

  1. Non-Compete Agreement Payments

Payments received under a non-compete agreement are treated as ordinary income but are not subject to self-employment tax.

  1. Tax-Saving Strategies

To minimize tax liability, strategically allocate more of the sale price to assets generating lower-taxed long-term capital gains and less to those generating higher-taxed ordinary income.

  1. Tax Return Reporting

Report gains and losses on IRS Form 4797 and Schedule D for capital gains and losses. Use IRS Form 8594 to allocate the sale price and IRS Form 8960 to calculate the net investment income tax, if applicable (not likely).

  1. State Income Tax

You may also owe state income tax on gains from the sale of your business.

Takeaways

Properly managing the shutdown of your sole proprietorship or single-member LLC involves careful planning and accurate reporting to optimize tax outcomes.

 

Limited Partners and Self-Employment Taxes

Self-employment taxes are substantial, and most people want to minimize them. Self-employed taxpayers often avoid self-employment taxes by operating as an S corporation.

The distributions from the S corporation are not subject to self-employment tax. But Social Security and Medicare tax must be paid on the shareholders’ employee compensation (which must be reasonable based on the services they provide). S corporations are also subject to various legal restrictions that can be inconvenient. 

How about using the partnership form to avoid self-employment tax? This doesn’t work for general partnerships because general partners always have to pay self-employment taxes on their distributive share of the ordinary income earned from the partnership’s business.

But what about limited partnerships? These are partnerships that contain two classes of partners:

  1. General partners who are personally liable for partnership debts and manage the business 
  2. Limited partners whose personal liability for partnership debts is limited to the amount of money or other property they contribute

The tax law provides that limited partners “as such” don’t have to pay self-employment tax on their distributive share of partnership income. 

Moreover, in about half the states, limited partnership laws have been revised to permit limited partners to work for the partnership without losing their limited liability.

Does this mean limited partners in many states can work for the partnership and avoid paying self-employment tax on their share of the partnership income? High-earning limited partners—hedge fund managers, for example—could save substantial tax if this were the case.

Unfortunately, in Soroban, a recent precedential decision involving a highly successful hedge fund and well-paid limited partners, the U.S. Tax Court held that the answer to this question is “no.”

The court held that the limited partner exception to self-employment taxes applies only to limited partners who are passive investors, not to those actively involved in the partnership business.

Soroban is the latest in a series of cases involving self-employment taxes for partnership-like entities that the IRS has won. The other cases involved active participants in a state limited liability partnership, a limited liability company taxed as a partnership, and a professional limited liability company. Only passive investors in these entities can avoid self-employment tax.

Encouraged by these victories, the IRS is writing regulations requiring a functional analysis to determine whether a person is a limited partner. The IRS is also likely to conduct more self-employment audits of limited partnerships.

Understanding these scenarios and planning accordingly can help mitigate tax burdens and streamline the dissolution process. If you have questions, don’t hesitate to contact me.

Protect Yourself from Payroll Fraud

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Protect Yourself from Payroll Fraud

Owning and running a business means wearing many hats, including keeping a close eye on your payroll taxes. Here’s a real-life story that underscores the importance of vigilance.

Rodney Taylor trusted his corporation’s accounting to Robert Gard, CPA. Over several years, Gard embezzled between $1 million and $2 million, including funds meant for payroll taxes.

Despite Gard’s actions, Taylor was held responsible for settling the unpaid payroll taxes with the IRS as the business owner and “a responsible party” under tax law.

This case teaches a vital lesson: delegation is necessary in business, but you cannot delegate your legal responsibilities. Here are two proactive measures to help safeguard your business:

  1. Direct oversight: Ensure you personally receive payroll reports for initial review.
  2. Regular verification: Periodically confirm that payroll tax payments have been made via the IRS Electronic Federal Tax Payment System (EFTPS).

By incorporating these practices, you can significantly reduce the risk of embezzlement and ensure compliance with tax regulations, protecting your business’s financial health.

 

Selling Your Home to Your S Corporation

If you’re considering turning your home into a rental property, selling it to your S corporation can offer significant tax advantages.

 

Advantages of Selling to Your S Corporation

– Tax-free profit on the home sale: By selling your home to your S corporation, you can take advantage of the home-sale profit exclusion—up to $500,000 for married couples—assuming you meet the eligibility requirements.

– Higher depreciation deductions: The sale increases the depreciable basis of your property, leading to higher annual depreciation deductions.

 

Addressing Potential Concerns

– Property tax increase: The sale may lead to higher property taxes due to reassessment at current market value, but the overall tax savings and increased depreciation typically outweigh these costs.

– Homestead exemption loss: Converting your home to a rental property means losing any homestead exemption benefits, whether or not you sell to your S corporation. Therefore, this is not a disadvantage unique to the sale.

– Legitimacy of the transaction: Selling to your S corporation is a related-party transaction, but it is legitimate under tax law. The profit is treated as ordinary income, but if you can apply the home-sale exclusion, you avoid federal taxes on that income.

 

Steps to Implement

– Form an S corporation: Establish a separate S corporation to hold your former home as rental property.

– Get an appraisal: Obtain an independent appraisal to determine the fair market value of your home.

– Follow formal procedures: Use professional services to handle the title transfer and legal documentation, ensuring the sale reflects an arm’s-length transaction.

– Keep thorough records: Maintain detailed records to support the transaction’s legitimacy if the IRS investigates.

 

Conclusion

Selling your home to your S corporation before converting it to a rental property can offer substantial financial benefits. Despite the potential for increased property taxes, the tax savings and enhanced cash flow can result in a net positive financial outcome.

 

Home-Office Deduction Without Business Income?

You might have heard that you can’t claim a home-office deduction without business income. That’s a misconception. Here’s why:

 

Key Points

– Claim business deductions regardless of income: Even if your business didn’t generate income this year, you should still claim all business deductions. This might create a net operating loss, which can be carried forward to offset future taxable income.

– Claim home-office deduction without income: Home-office expenses that aren’t deductible this year can be carried forward to future years. This is particularly important for deducting business miles.

– Impact on business miles: If you don’t claim your home office as your principal place of business, trips to many business locations are considered personal miles. Claiming the home office simplifies this.

– File a tax return: Even without business income, file a tax return to claim these deductions and losses.

 

Action Steps

– Document your home office: Keep records proving your home office is your principal place of business.

– Claim all deductions: Even in loss years, ensure you claim all possible deductions.

 

Conclusion

A home office can provide substantial tax advantages, even when your business income is minimal or nonexistent. Position yourself to fully utilize these benefits now and in the future.

 

Tax Implications of Dissolving a Partnership

Considering winding down your partnership? Here’s what to expect in three common scenarios of dissolution.

 

Scenario 1: One Partner Buys Out the Others

When one partner buys out the others, the departing partners will likely recognize a capital gain or loss on their sale. The remaining partner’s new basis in the acquired assets becomes their foundation for a new business structure, whether as a sole proprietorship or another entity.

 

Scenario 2: Liquidation with Asset Sale

If the partnership liquidates by selling all assets and distributing cash, each partner must report their share of gains or losses on Schedule K-1. These gains could be taxed as long-term capital gains or ordinary income, depending on the asset type and depreciation recapture rules.

 

Scenario 3: Distributing Assets Directly to Partners

The most complex scenario involves directly distributing all assets to the partners. This can lead to varied tax outcomes based on asset type and each partner’s basis in the partnership. Gains may arise if “hot assets” like appreciated inventory or receivables are included.

 

General Considerations

– Tax forms: Regardless of the scenario, file a final partnership tax return (IRS Form 1065) and issue a final Schedule K-1 to each partner.

– State taxes: Be aware of potential state tax obligations.

– Passive losses: Liquidating the partnership may make suspended passive losses deductible.

Understanding these scenarios and planning accordingly can help mitigate tax burdens and streamline the dissolution process. If you have questions, don’t hesitate to contact me.

Turn Your Vacation—Even a Luxurious One—into Tax-Deductible Business Travel

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Turn Your Vacation—Even a Luxurious One—into Tax-Deductible Business Travel

Here’s an idea: how about transforming your next vacation into business travel?

With careful planning, your transportation to any destination could be fully deductible. This includes airfare—even first-class—luxury hotel stays, and cruise expenses. If you can tie your travel to business purposes, you can enjoy substantial tax savings, depending on your tax bracket.

 

Two Main Types of Deductible Expenses

Transportation. If your trip within the U.S. primarily serves business purposes, you can deduct 100 percent of your transportation costs. But if the trip is mainly personal, you cannot deduct transportation.

Living expenses. While on a business trip, you can deduct lodging and meal costs on your business days but not on personal days.

 

Five Essential Rules for Deductibility

To ensure your travel expenses qualify as business deductions, consider these guidelines:

  • Profit motive. You should expect the trip to contribute to your business’s profitability.
  • Overnight stay. Only trips that require you to stay overnight qualify.
  • “For only” test. Ask yourself if a rational businessperson would undertake the trip solely for business reasons.
  • Primary purpose test. The primary reason for your travel must be business-related, with the majority of your days spent on business activities.
  • Record-keeping. Documenting your trip’s business purpose, expenses, and activities is crucial.

 

Real-Life Success Stories

Numerous taxpayers have successfully deducted their travel expenses by adhering to these principles. For instance, corporate meetings held in attractive locations with substantial business discussions and activities have been fully deductible. Similarly, traveling to expand business operations or attending conventions relevant to your business qualifies.

 

Avoid Common Pitfalls

However, trips primarily for entertainment or lacking a clear business purpose have led to denied deductions. Establishing and documenting a legitimate business rationale for your travel is essential.

 

Take Action

Before planning your next trip, consider how you might integrate business purposes. Whether you are attending a seminar relevant to your industry or meeting with potential clients, these activities could significantly reduce travel costs through tax deductions.

 

BOI Reporting Deemed Unconstitutional for Some

On January 1, 2024, the Corporate Transparency Act (CTA) went into effect. The CTA requires most smaller corporations, most limited liability companies, and some other business entities to file a beneficial ownership information (BOI) report with the U.S. Department of the Treasury Financial Crimes Enforcement Network (FinCEN). 

The BOI report identifies and provides contact information for the human beings who own or control the entity. FinCEN will share this information with law enforcement to combat money laundering and other illegal activities.

About 32 million existing and most new businesses are subject to this filing requirement. Since the first of the year, about 500,000 BOI reports have been filed online at the FinCEN website. 

But on March 1, 2024, a federal district court (federal trial court) in Alabama ruled that the Corporate Transparency Act was unconstitutional. In National Small Business United v. Yellen, No. 5:22-cv-01448 (N.D. Ala. 2024), the court issued an injunction staying enforcement of the CTA against the two plaintiffs in the case: a single individual business owner and the National Small Business Association—a 65,000-member nonprofit organization of small business owners.

The district court ruling created some uncertainty among businesses subject to the CTA (termed “reporting companies”). Here’s what you need to know:

  • If you were not a member of the National Small Business Association as of March 1, 2024, this decision has no immediate impact on you. FinCEN still expects all reporting companies to comply.
  • As expected, the Justice Department, on behalf of the Department of the Treasury, filed a notice of appeal on March 11, 2024. In other words, this trial court decision is far from the final word on the CTA’s constitutionality.
  • No one can predict how the courts will ultimately rule, but many legal experts believe there are strong legal grounds to reverse the trial court’s decision.
  • If your reporting company existed before 2024, you have until January 1, 2025, to comply with your BOI filing requirement. So you can wait until late 2024 to see what happens with the pending litigation.
  • If your reporting company was formed during 2024, you have only 90 days after your articles of incorporation, articles of organization, or similar documents were filed with the secretary of state to file your BOI report. You can’t afford to wait.

Meanwhile, New York adopted its own BOI reporting law that applies only to limited liability companies formed in New York or formed out of state that register to do business in New York. Existing LLCs must file their reports with the New York Department of State by January 1, 2025. Newly formed LLCs will file their reports when they file their articles or registrations. Other states, such as California, are considering enacting similar laws.

 

Tax Reform Doubles Down on S Corporation Reasonable Compensation

From 2018 to 2025, the Tax Cuts and Jobs Act is offering a 20 percent deduction on pass-through business income, with specific eligibility criteria. This deduction impacts the choice of entity. For instance, should you operate as a sole proprietorship or an S corporation?

 

The Importance of Reasonable Compensation

When operating your business as an S corporation, you must pay yourself “reasonable compensation.” Failing to do so can result in penalties, increased taxes, and missed deductions.

 

Balancing Act for S Corporation Owners

Lowering salary. While reducing your salary might seem attractive to increase pass-through income and the Section 199A deduction, it risks IRS penalties and reduced benefits.

Increasing salary. Conversely, a higher salary increases payroll taxes and potentially reduces your Section 199A deduction.

 

Unique Situation: Zero Salary

In rare cases, you might not need the S corporation to pay you a salary (e.g., you do not actively provide services to your S corporation). This setup can maximize your pass-through income and Section 199A deduction, but it requires careful planning to ensure legality.

 

S Corporation versus Sole Proprietorship

Choosing between an S corporation and a sole proprietorship is a nuanced decision, impacted by the Section 199A deduction, payroll taxes, and reasonable compensation requirements. While S corporations can offer Social Security and Medicare tax savings, sole proprietorships benefit from a more straightforward tax structure and potentially higher Section 199A deductions under certain conditions.

If you have questions, don’t hesitate to contact me.