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Self-Employment Tax Basics

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Self-Employment Tax Basics

If you own an unincorporated business, you likely pay at least three different federal taxes. In addition to federal income taxes, you must pay Social Security and Medicare taxes, also called the self-employment tax. 

Self-employment taxes are not insubstantial. Indeed, many business owners pay more in self-employment taxes than in income tax. The self-employment tax consists of 

  • a 12.4 percent Social Security tax up to an annual income ceiling ($147,000 for 2022) and 
  • a 2.9 percent Medicare tax on all self-employment income. 

These amount to a 15.3 percent tax, up to the $147,000 Social Security tax ceiling. If your self-employment income is more than $200,000 if you’re single or $250,000 if you’re married filing jointly, you must pay a 0.9 percent additional Medicare tax on self-employment income over the applicable threshold for a total 3.8 percent Medicare tax.

You pay the self-employment tax if you earn income from a business you own as a sole proprietor or single-member LLC, or co-own as a general partner in a partnership, an LLC member, or a partner in any other business entity taxed as a partnership. (There is an exemption for limited partners.)

You don’t pay self-employment tax on personal investment income or hobby income. For example, you don’t pay self-employment tax on profits you earn from selling stock, your home, or an occasional item on eBay.

The tax code bases your self-employment tax on 92.35 percent of your net business income.
That means your business deductions are doubly valuable since they reduce both income and self-employment taxes. In contrast, personal itemized deductions and “above-the-line” adjustments to income don’t decrease your self-employment tax. 

Some types of income are not subject to self-employment tax at all, including

  • most rental income,
  • most dividend and interest income,
  • gain or loss from sales and dispositions of business property, and 
  • S corporation distributions to shareholders.

You calculate your self-employment taxes on IRS Form SE and pay them with your income taxes, including your quarterly estimated taxes.

Self-Employment Taxes for Partners and LLC Members 

Here’s a question: Does a member of a limited liability company (LLC) or a partner in a partnership have to pay self-employment taxes on the member’s or partner’s share of the entity’s income? 

Incredibly, the answer is not always clear.

If you are a general partner in a general partnership, you must pay self-employment tax on your entire distributive share of the ordinary income earned from the partnership’s business. General partners also must pay self-employment tax on any guaranteed payments for services rendered to the partnership. 

Partnerships generally are not required to pay guaranteed payments to the partners. Guaranteed payments are like employee salaries; the partnership pays them without considering the partnership’s income. They are often incorrectly called “partner salaries.”

If you’re a limited partner in a limited partnership, you don’t pay self-employment tax on your share of the partnership’s profits. But you do pay self-employment tax on any guaranteed payments you receive.

That’s all well and good. But what about LLCs? They are the most popular business entity in the U.S. today, with an estimated count of 21 million. It is not always clear when LLC members (owners) pay self-employment tax.

LLCs are state law entities not recognized for federal tax purposes. In other words, they are always taxed as something else. The tax code taxes the single-member LLCs as a sole proprietorship unless the owner elects taxation as a corporation (which is rare). Thus, owners of single-member LLCs file Schedule C and pay self-employment tax on their net profit. It couldn’t be simpler.

LLCs with multiple members are treated as partnerships for tax purposes unless they elect taxation as a corporation. If a multi-member LLC is taxed as a partnership, should its members be treated as general or limited partners?

Under proposed IRS regulations:  

  • Members of member-managed LLCs cannot be treated as limited partners and must pay self-employment tax. 
  • Members of manager-managed LLCs can qualify as limited partners, provided they work no more than 500 hours per year in the LLC business.
  • Members of service LLCs engaged in health, law, engineering, architecture, accounting, actuarial science, or consulting must be classified as general partners.

Fortunately, you don’t have to follow the proposed regulations. The IRS has not finalized them and says it won’t enforce them.

You can look at U.S. Tax Court rulings instead. The leading case says an LLC owner may be treated as a limited partner only if he is a passive investor who does not actively participate in the LLC business.

New 62.5 Cents Mileage Rate

The IRS noticed that average gas prices across the United States exceeded $5.00 a gallon and took action.

Small businesses that qualify to use and do use the standard mileage rate can deduct 62.5 cents per business mile from July 1 through December 31, 2022. That’s up 4 cents a mile.

This brings up a practical question: what do you do if you track business mileage using the three-month sample method?

Three-Month Sample Basics

As a reminder, here are the basics of how the IRS describes the three-month test:

  • The taxpayer uses her vehicle for business use.
  • She and other members of her family use the vehicle for personal use.
  • The taxpayer keeps a mileage log for the first three months of the taxable year, showing that she uses the vehicle 75 percent of the time for business.
  • Invoices and paid bills show that her vehicle use is about the same throughout the year.

According to this IRS regulation, her three-month sample is adequate for this taxpayer to prove her 75 percent business use.

Sample-Method Solution to New July 1 Mileage Rate

To use the sample rate, you need to prove that your vehicle use is about the same throughout the year. Your invoices and paid bills prove the mileage part, and your appointment book can add creditability to consistent business and personal use. 

Keep in mind that the sample is just that—a sample—it’s pretty exact for the three months but not that exact for the year, although it must adequately reflect the business mileage for the year. 

If you have a good three-month sample, you take your business mileage for the year and apply the 58.5 cents to half the mileage and the 62.5 cents to the remaining half to find your deductions.

For example, say you drove 20,000 business miles for the year. Your deduction would be $12,100 (10,000 x 58.5 cents + 10,000 x 62.5 cents).

Mileage Record for the Full Year

If you have a mileage record for the entire year, no problem. Your record gives you the mileage for the first six months and the last six months. 

Paying Your Child: W-2 or 1099?

Here’s a question I received from one of my clients: “I will hire my 15-year-old daughter to work in my single-member LLC business, and I expect to pay her about $12,000 this year. Do I pay her through payroll checks and file a W-2?”

My Answer

Yes. And W-2 payment is essential. If you pay her on a 1099, she will pay self-employment taxes.

When you pay her on a W-2, neither you nor your daughter pays any Social Security or Medicare taxes, and in most states, you also don’t pay any unemployment taxes.

Key point 1. Your single-member LLC is a “disregarded entity” for federal tax purposes. It’s taxed as a sole proprietorship (unless you elect corporate treatment). In this instance, you are the child’s parent, enabling “no Social Security or Medicare taxes” for both your child and your proprietorship.

Key point 2. Your daughter has a $12,950 standard deduction. This means she also pays zero tax on earned income up to that amount.

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

Alert: A Massive New FinCEN Filing Requirement Is Coming

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Massive New FinCEN Filing Requirement Is Coming

Do you own a corporation, limited liability company (LLC), limited partnership, limited liability partnership, limited liability limited partnership, or business trust? 

Or are you planning to form one of these entities? 

If so, be alert. There’s a new federal filing requirement coming.

Back in 2021, Congress passed a new law called the Corporate Transparency Act (CTA) that requires corporations, LLCs, and other business entities to provide information about their owners to the Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN), which is a unit separate from the IRS. 

The CTA is part of a government crackdown on corruption, money laundering, terrorist financing, tax fraud, and other illicit activity. It targets the use of anonymous shell companies that facilitate the flow and sheltering of illicit money in the United States. 

Businesses subject to the law will have to file a “beneficial owner report” with FinCEN, including each beneficial owner’s full legal name, date of birth, and residential street address, as well as an identifying number from a legal document such as a driver’s license or passport. FinCEN will include the information in a database for use by law enforcement, national security and intelligence agencies, and federal regulators that enforce anti-money-laundering laws. The database will not be publicly accessible. 

Violations of the CTA can result in a $500-a-day penalty (up to $10,000) and up to two years’ imprisonment.

The CTA did not take effect immediately. Rather, Congress gave the FinCEN time to write regulations governing how the CTA should be applied and to give businesses a heads-up about the new law. FinCEN has now issued its proposed regulations, and they take a fairly hard line on how the law will be applied.

Here are four things the new regulations make clear.

  1. The filing requirement may begin soon. The CTA goes into effect when the proposed regulations become final, which is expected to occur sometime in mid-to-late 2022. As soon as it goes into effect, 
  • new corporations, LLCs, and other entities will have to comply with the filing requirement within 14 days of being formed, and
  • existing entities will have one year to comply. 
  1. Millions of small businesses are affected. The reporting requirements will apply to almost every small business that is not a sole proprietorship or general partnership, including corporations, LLCs, limited liability partnerships, limited liability limited partnerships, business trusts, and most limited partnerships—over 30 million in all. 

Larger companies with more than 20 full-time employees and $5 million in gross receipts are exempt. 

  1. There will be many beneficial owners. The proposed regulations make it clear that a company can have multiple beneficial owners, and it may not always be easy to identify them all. There are two broad categories of beneficial owners:
  • any individual who owns 25 percent or more of the company, and
  • any individual who, directly or indirectly, exercises substantial control over the company.
  1. Law and accounting firms are not exempt. Neither the CTA nor the proposed regulations contain any exemption for legal or accounting firms, except for the relatively few public accounting firms registered under Section 102 of the Sarbanes-Oxley Act of 2002. Thus, any law or accounting firm that is a professional corporation or an LLC will have to file a beneficial owner report unless it has more than 20 employees and $5 million in annual income. 

Deduct a Cruise to Mexico

You may not have thought of this, but taking a cruise ship to Mexico for a business meeting is acceptable as a deductible form of transportation.

Because Mexico is in the tax law–defined North American area, the law says that you need no stronger business reason to deduct your trip to Mexico than you need to deduct a trip to Chicago, Illinois, or Scottsdale, Arizona.

Less-than-one-week rule. If your trip is outside the 50 states but inside the North American area and if the trip is for seven or fewer days (excluding the day of departure), then the law allows you to deduct the entire cost of travel to and from this business destination. Mexico fits this location rule.

Cruise ship transportation. The law authorizes any type of transportation to and from your travel destination, so long as it is not lavish or extravagant. The cruise ship cost is not a lavish or extravagant expense, as the law precludes this possibility by placing luxury water limits on this type of travel. 

The daily luxury water limit is twice the highest federal per diem rate allowable at the time of your travel.

Example. Say you are going to travel by cruise ship during September 2022. The $433 maximum federal per diem rate for September 2022 comes from Nantucket, Massachusetts. Your daily luxury water limit is $866 (2 x $433). 

Thus, for you and your spouse, two business travelers, the daily limit is $1,732. On a six-night cruise, that’s a cruise-ship cost ceiling of $10,392. If you spend $12,000, your deduction is limited to $10,392. If you spend $8,000, you deduct $8,000. 

Are Self-Directed IRAs for Real Estate a Good Idea?

The stock market is tanking while real estate continues to skyrocket. 

If your retirement savings have taken a hit, you may be wondering if this is the time to invest in real estate through your IRA, Roth IRA, or SEP-IRA.

You can’t invest in real estate with a traditional IRA or Roth IRA (or SEP-IRA) you establish with a bank, brokerage, or trust company. These types of IRA custodians typically limit you to a narrow range of investments, such as publicly traded stocks, bonds, mutual funds, ETFs, and CDs. 

But you can invest in real estate if you establish a self-directed IRA with a custodian that allows self-directed investments. There are dozens of such IRA custodians.

Real estate is the single most popular investment in self-directed IRAs. The self-directed IRA can be used for all types of real estate investments: multi-family rental properties, single-family homes, commercial rentals, raw land, farmland, international real estate, tax lien certificates, trust deeds and mortgage notes, and private placements.

Investing in real estate through a self-directed IRA is one way to diversify your retirement holdings. There are also some tax advantages. 

And there are several disadvantages and complications you should carefully consider.

First, you need to understand that owning real estate in a self-directed IRA is not like owning it any other way, because you and your self-directed IRA must be totally separate—self-dealing is not allowed. 

You, the self-directed IRA owner, should not benefit from your self-directed IRA other than through distributions from the self-directed IRA. And your self-directed IRA itself should not benefit from you other than through contributions you make to the account.

In practical terms, this means you, your relatives, and certain other “disqualified persons” cannot do business with your self-directed IRA. For example, you can’t

  • sell property you personally own to your self-directed IRA,
  • purchase or lease property from your self-directed IRA,
  • personally guarantee loans taken out by your self-directed IRA to purchase property,
  • receive rental income from a rental property held in a self-directed IRA, or
  • repair or improve any self-directed IRA property.

If you do any of these things, your self-directed IRA could lose its tax-deferred status. If that happens, you then pay taxes on the value of all the property the IRA owns.

When your self-directed IRA owns real estate, you also don’t benefit from real estate tax deductions such as depreciation and the 20 percent qualified business income (QBI) deduction.

It may not be pleasant to think about, but upon your death, there is no step-up in basis for real estate held in the self-directed IRA. Instead, your beneficiaries pay tax at ordinary rates on any money or property distributed from a traditional self-directed IRA. This eliminates one of the most valuable tax benefits for real estate owners.

Don’t get the idea that self-directed IRAs are all bad. None of the income from property held in a self-directed IRA is taxable to you personally. Likewise, if you sell property in a self-directed IRA, you need pay no personal tax on any profit. You pay tax only when you withdraw money from a traditional IRA. 

With a self-directed Roth IRA, you pay no tax at all on withdrawals after age 59 1/2, provided your IRA held the property for at least five years.

But you need to balance these benefits with all the potential drawbacks.

The IRS Wants to Know about Your Crypto

Cryptocurrency such as bitcoin is all the rage these days. Crypto is not legal money. It is property, similar to gold. Like gold, its use can result in taxable income.

The IRS is concerned that you and millions of Americans are using crypto without paying tax on the earnings. To clarify that it expects you and other taxpayers to report crypto earnings, the IRS added the following question about cryptocurrency to the top of Form 1040:

At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?

You must answer this question under penalty of perjury, even if you have never heard of bitcoin and don’t know what cryptocurrency is. You can’t leave the field blank.

Unfortunately, this is something of a trick question. It is so broadly worded; you’d think any transaction involving digital currency requires a “yes” answer. But that is not the case. 

IRS guidance makes clear that it is interested only in virtual currency transactions that result in taxable income (or loss) that must be reported on a taxpayer’s return.

Thus, for example, if you simply purchased bitcoin during the year and held on to it, you should answer “no” to the crypto question. The same goes if you received crypto as a gift, or transferred crypto from one wallet to another. 

You should answer “yes” to the crypto question if you purchased or sold goods or services with crypto, received new crypto through mining or staking activities, exchanged crypto for dollars or other crypto, or got new crypto from a hard fork. All these activities result in taxable income (or loss).

What should you do if you answered the crypto question wrong? 

If you answered the crypto question “yes” when you should have answered “no,” you don’t have to do anything. There is no need to amend your tax return. 

On the other hand, if you answered “no” when it should have been “yes” and you did not report your taxable virtual currency transactions, you need to file an amended or superseding return. If you fail to do so, you may get a letter from the IRS advising you to file an amended return and pay any taxes due. The IRS began sending out such letters in 2019.

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

 

Benefits of the ERTC

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In response to the COVID-19 pandemic, congress passed several broad-sweeping legislative initiatives. Starting in March of 2020, the CARES Act was passed providing small businesses economic relief nationwide. Among the initiatives included in the legislation was the Paycheck Protection Program (PPP) and the Employee Retention Tax Credit (ERTC). Both initiatives were intended to encourage business owners to keep employment rolls active to avoid the likely tsunami of unemployment claims, further impacting the overall economy.

Benefits of the ERTC

Many business owners were uninformed on the benefits of the ERTC primarily due to Congress’ initial ban on availing of both programs. Initially, Congress denied business owners who took a PPP loan to also avail themselves of the ERTC. After all, faced with the option of practically ‘Free’ money (PPP), why consider the lesser appealing ERTC.

Until 9 months later. On December 27th, Congress passed the Consolidated Appropriations Act (CAA) which made some retroactive changes to the Cares Act ERTC provisions. Among those being allowing business owners who took a PPP loan to also avail themselves of the ERTC. However, with one caveat. Wages used to claim PPP forgiveness could not also be used to claim ERTC.

So how can you determine if you qualify? Well, depends on which year your referring to. Read on..

Different rules for Different Years

For 2020, the eligibility rules are as follows:

  • Eligibility qualifications:
    • Business had a >50% reduction in Gross Receipts compared to same quarter in 2019, or
    • Business operations were fully or partially suspended due to a government mandated order  (More on this later.)
  • Credit is 50% of up to $10,000 of qualified wages per employee for the entire year ($5k max per employee for 2020)

For 2021, the eligibility rules get better:

  • Eligibility qualification:
    • Business had a >20% reduction in Gross Receipts (Big Difference from 2020 rules) compared to same quarter in 2019. This assessment could alternatively use the immediately preceding quarter compared to same quarter in 2019.
    • Business operations were fully or partially suspended due to a government mandated order 
  • Credit is 70% of up to $10,000 of qualified wages per employee PER QUARTER (Big difference from 2020 rules). 

Is the calculation that simple?

While the ERTC calculation for eligible wages is simple, determining eligible ERTC wages can be complex. Due to the inability to claim same wages for PPP loan forgiveness, the ERTC wage eligibility must be determined at the employee level individually. Also keeping in mind that the ERTC eligibility is determined by QUARTER. While PPP forgiveness wages, paid during the PPP Covered Period, can span more than 1 quarter. One can easily see how complex the exercise to determine eligible wages can be. In addition, keeping audit ready records of how eligible wages were determined is critical as these amended payroll tax form filings are auditable for up to 6 years.

What is considered partial suspension of operations?

Many states and local government units have issued full or partial closures of certain non-essential businesses. For many business owners, state mandated closure or suspension of non-essential procedures. Since instances like these could fall under the ‘Partial suspension of operations’, many business owners may qualify for ERTC if they fail to meet the reduction in gross receipts test.

Does the ERTC need to be repaid?

Unlike the PPP loan, the ERTC is a payroll tax credit which is claimed by filing an amended 941-X for the appropriate quarter. The IRS will issue a refund check for the amount of the ERTC claimed. At the time of this article, ERTC refunds have been taking anywhere from 6-9 months.

Since most many businesses, in the authors experience, are most likely to be eligible for the ERTC for the 2nd or 3rd quarter of 2020 time is of the essence to claim the credit as the window is closing to amend these 941 filing in mid to late 2023.

Is the ERTC Taxable income?

Well, no. but kind of.

For those quarters which an ERTC is claimed, business owners will need to reduce wage expenses by the ERTC. In short, if you are filing for ERTC claim for 2Q 2020 you will most likely need to amend your business tax return to REDUCE wage expense. The reduction will consequently increase your taxable net income thus creating a taxable event. Despite the tax consequences of claiming the ERTC, most situations prove the cash flow positive benefits outweigh the cost.

The Employee Retention Credit cannot be overlooked as another potential opportunity to improve the working capital for your business, enabling further growth and financial strength to move ahead into 2022.

The ERTC-Experts team at John A Sanchez & Company have been helping dozens of business owners claim the Employee Retention Credit. To date, we’ve helped business owners claim over $1 million in ERTC funds helping to strengthen their working capital and enabling their businesses to thrive.

To explore how our ERTC-Experts team can help your business, find us at www.ERTC-Experts.com for more information and resources on the ERTC. While you’re there, apply for a no cost evaluation to determine if you qualify.

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

Tax-saving tips September Update

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Tax-saving

Save Your Employee Retention Credit

In what clearly must have been a mistake, the IRS issued Notice 2021-49 to deny the employee retention credit (ERC) on the wages paid to most C and S corporation owners.

According to the IRS:

  • Your corporation can qualify for the ERC on the wages paid to a more than 50 percent owner of an S or C corporation if that owner does not have any living brothers and sisters (whether whole- or half-blood), spouse, ancestors, or lineal descendants.
  • Your corporation cannot qualify for the ERC on the more than 50 percent owner’s wages if one of those relatives (other than the spouse) is alive.

Example 1. Tom owns 100 percent of his S corporation, and he has no living relatives. Under this new IRS notice, Tom’s corporation can qualify for up to $33,000 in ERC on Tom’s wages.

Example 2. John owns 100 percent of his S corporation, but he has one living relative, a two-year-old daughter. John’s corporation does not qualify for the ERC. Under the new IRS notice, the two-year-old daughter owns by attribution 100 percent of the S corporation, and the IRS says that John, now a tainted relative, works for her and does not qualify for the ERC.

Whoa, that’s not logical!

Also, it may be technically incorrect.

And it’s possible that lawmakers will kill this IRS rule.

To Amend or Not to Amend

Let’s start with this premise. You are a more than 50 percent owner of a corporation. You thought that your corporation qualified for the ERC. At various times before August 4, 2021, the day when the IRS issued Notice 2021-49, you filed your claim to the ERC for 2020 and the first two quarters of 2021.

As we mentioned, when you filed, you believed (as a more than 50 percent owner of a C or S corporation) that wages paid to you by the corporation qualified for the ERC. We did too.

But then, on August 4, 2021, the IRS issued Notice 2021-49 and said no—you don’t qualify. What now? Here’s what we think you should do:

  1. Do nothing now. There’s no hurry. You have until April 15, 2024, before you have to do anything about your 2020 ERC.
  2. Don’t claim the ERC for the more than 50 percent corporate owner for calendar year 2021 quarters 3 and 4 until you have clarification that you qualify. Again, there’s no hurry. You can file a Form 941-X anytime within the three-year statute of limitations.

If you are upset by this IRS notice, it’s a good idea to communicate that dissatisfaction to your U.S. senators and congressional representatives. For some ideas on what message to convey, here’s a sample letter for your use.

Vaccinated? Claim Tax Credits for Your Employees and Yourself

Vaccinated - Tax-saving

As the nation suffers from the ravages of the super-contagious COVID-19 Delta variant, the federal government desperately wants all American workers and their families to get vaccinated.

If you have employees, you probably feel the same way. Indeed, more and more employers are implementing vaccine mandates—a trend that will likely grow after the FDA gives final approval to the COVID-19 vaccines.

COVID-19 vaccine mandates are highly controversial.

One thing that’s not controversial is giving your employees paid time off to get vaccinated and to deal with the possible side effects of vaccination (usually, short-lived flu-like symptoms). The federal government does not require that employers provide such paid time off, but it strongly encourages them to do so. And it’s putting its money where its mouth is, by providing fairly generous tax credits to repay employers for the lost employee work time.

You can also collect these credits if your employees take time off to help family and household members get the vaccination and/or recover from its side effects. There’s only one thing better than having an employee vaccinated: having an employee’s entire family vaccinated.

How big are the credits?

  • Employers who give employees paid time off to get vaccinated against COVID-19 and/or recover from the vaccination can collect a sick leave credit of up to $511 per day for 10 days, plus a family leave credit of up to $200 per day for 60 additional days.
  • Employers who give employees paid time off to help household members get vaccinated and/or recover from the vaccination can get a sick leave credit for 10 days and family leave credit for 60 days, both capped at $200 per day.

What if you are self-employed and have no employees? You haven’t been left out. Similar tax credits are available to self-employed individuals who take time off from work to get vaccinated or who help family or household members do so.

But you must act soon. These sick leave and family leave credits are available only through September 30, 2021.

One more thing: these are refundable tax credits. This means you collect the full amount even if it exceeds your tax liability. Employers can reduce their third-quarter 2021 payroll tax deposits in the amount of their credits. If the credit exceeds these deposits, employers can get paid the difference in advance by filing IRS Form 7200, Advance Payment of Employer Credits Due to COVID-19.

The documentation requirements for these credits are modest, and you’ll have to file a couple of new forms with your 2021 tax return.

IRS Private Letter Rulings: Are They Worth It?

Do you have a question about how to apply the tax law to a potential transaction? Wouldn’t it be great if you could get the IRS to give you an answer in advance of filing your tax return?

You may be able to do so by obtaining a private letter ruling (PLR) from the IRS.

You get a PLR by filing a request with the IRS National Office. The IRS is ordinarily bound by the answer it gives a taxpayer in a PLR. But PLRs may not be relied on by other taxpayers.

This sounds great in theory—but in practice, seeking a PLR is usually not a good idea.

There are many reasons why:

  • PLRs are expensive. The filing fee is $3,000 for the smallest businesses. Larger businesses must pay as much as $38,000. You’ll also need professional help to prepare a detailed PLR request.
  • A PLR may not be necessary. The IRS has automatic or simplified methods for obtaining its consent without a PLR for many common situations, including late S corporation elections, late IRA rollovers, and various changes in accounting method.
  • PLRs are unavailable for many types of tax questions, including those that (a) are under IRS examination, (b) were clearly answered in the past, or (c) are too fact intensive.
  • PLRs can take a long time to obtain—six months or more for complex questions.
  • PLRs can backfire. Even if the IRS issues a favorable PLR, you now will be on the agency’s radar, which may increase your chances of an audit.

Given all these drawbacks, you should seek a PLR only when a cheaper alternative is unavailable—for example, when you need to do a late IRA rollover and don’t qualify for the streamlined IRS procedure.

In some instances, it’s wise to seek advance IRS approval of complex transactions involving substantial money. Obtaining a favorable PLR in such a case would assure you the transaction passes IRS muster. But these instances are rare.

Prorated Principal Residence Gain Exclusion Break

Here’s good news. IRS regulations allow you to claim a prorated (reduced) gain exclusion—a percentage of the $250,000 or $500,000 exclusion in select circumstances.

The prorated gain exclusion equals the full $250,000 or $500,000 figure (whichever would otherwise apply) multiplied by a fraction.

The numerator of this fraction is the shorter of

  • the aggregate period of time you owned and used the property as your principal residence during the five-year period ending on the sale date, or
  • the period between the last sale for which you claimed an exclusion and the sale date for the home currently being sold.

The denominator for this fraction is two years, or the equivalent in months or days.

When you qualify for the prorated exclusion, it might be big enough to shelter the entire gain from the premature sale. But the prorated exclusion loophole is available only when your premature sale is due primarily to

  • a change in place of employment,
  • health reasons, or
  • specified unforeseen circumstances.

Example. You’re a married joint-filer. You’ve owned and used a home as your principal residence for 11 months. Assuming you qualify under one of the conditions listed above, your prorated joint gain exclusion is $229,167 ($500,000 × 11/24). Hopefully that will be enough to avoid any federal income tax hit from the sale.

Premature Sale Due to Employment Change

Per IRS regulations, you’re eligible for the prorated gain exclusion privilege whenever a premature home sale is primarily due to a change in place of employment for any qualified individual.

“Qualified individual” means

  1. the taxpayer (that would be you),
  2. the taxpayer’s spouse,
  3. any co-owner of the home, or
  4. any person whose principal residence is within the taxpayer’s household.

In addition, almost any close relative of a person listed above also counts as a qualified individual. And any descendent of the taxpayer’s grandparent (such as a first cousin) also counts as a qualified individual.

A premature sale is automatically considered to be primarily due to a change in place of employment if any qualified individual passes the following distance test: the distance between the new place of employment/self-employment and the former residence (the property that is being sold) is at least 50 miles more than the distance between the former place of employment/self-employment and the former residence.

Premature Sale Due to Health Reasons

Per IRS regulations, you are also eligible for the prorated gain exclusion privilege whenever a premature sale is primarily due to health reasons. You pass this test if your move is to

  • obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of disease, illness, or injury of a qualified individual, or
  • obtain or provide medical or personal care for a qualified individual who suffers from a disease, an illness, or an injury.

A premature sale is automatically considered to be primarily for health reasons whenever a doctor recommends a change of residence for reasons of a qualified individual’s health (meaning to obtain, provide, or facilitate care, as explained above). If you fail the automatic qualification, your facts and circumstances must indicate that the premature sale was primarily for reasons of a qualified individual’s health.

You cannot claim a prorated gain exclusion for a premature sale that is merely beneficial to the general health or well-being of a qualified individual.

Premature Sale Due to Other Unforeseen Circumstances

Per IRS regulations, a premature sale is generally considered to be due to unforeseen circumstances if the primary reason for the sale is the occurrence of an event that you could not have reasonably anticipated before purchasing and occupying the residence.

But a premature sale that is primarily due to a preference for a different residence or an improvement in financial circumstances will not be considered due to unforeseen circumstances, unless the safe-harbor rule applies.

Under the safe-harbor rule, a premature sale is deemed to be due to unforeseen circumstances if any of the following events occur during your ownership and use of the property as your principal residence:

  • Involuntary conversion of the residence
  • A natural or man-made disaster or acts of war or terrorism resulting in a casualty to the residence
  • Death of a qualified individual
  • A qualified individual’s cessation of employment, making him or her eligible for unemployment compensation
  • A qualified individual’s change in employment or self-employment status that results in the taxpayer’s inability to pay housing costs and reasonable basic living expenses for the taxpayer’s household
  • A qualified individual’s divorce or legal separation under a decree of divorce or separate maintenance
  • Multiple births resulting from a single pregnancy of a qualified individual

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

Tax-Saving Tips

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Don’t Miss Out on the Employee Retention Credit

Tax-Saving Tips

It’s hard to imagine that a small business does not qualify for some or all of the employee retention credit (ERC).

And remember, this is a tax credit—one of the very best things that tax law has to offer. True, it’s not as valuable as some other tax credits, because you have to reduce your payroll income tax deductions for the credits, but the ERC certainly puts you ahead.

And you can be looking at big bucks. The possible ERC is $5,000 per employee for 2020 and $28,000 per employee for 2021. That’s $33,000 per employee.

For 2020, you have two ways to qualify:

  1. You had a gross receipts drop during a 2020 calendar quarter of more than 50 percent when compared to the same calendar quarter of 2019. The more than 50 percent test is the trigger for the ERC, and you automatically qualify for that quarter and the following 2020 quarter.
  2. You suffered from a federal, state, or local government order that fully or partially suspended your operations (under this rule, you qualify for the ERC on the days you suffered the full or partial suspension, even if you did not lose any money).

For 2021, you have three ways to qualify:

  1. You suffered a federal, state, or local government order that fully or partially suspended your operations (under this rule, you qualify for the ERC on the days you suffered the full or partial suspension, even if you did not lose any money).
  2. Your gross receipts for a 2021 calendar quarter are less than 80 percent of gross receipts from the same quarter in calendar year 2019.
  3. As an alternative to number 2 above, using the preceding quarter to your 2021 calendar quarter, your gross receipts are less than the comparable quarter in 2019.

You can see by the rules that the government wants to help your small business. Take advantage.

One final note. You may not double-dip. Wages you use for the ERC may not be used for the Paycheck Protection Program (PPP), family leave credit, or similar COVID-19 programs.

Loophole: Harvest Tax Losses on Bitcoin and Other Cryptocurrency

Here’s something to know about cryptocurrencies.

Because cryptocurrencies are classified as “property” rather than as securities, the wash-sale rule does not apply if you sell a cryptocurrency holding for a loss and acquire the same cryptocurrency before or after the loss sale.

You just have a garden-variety short-term or long-term capital loss, depending on your holding period. No wash-sale rule worries. This favorable federal income tax treatment is consistent with the long-standing treatment of foreign currency losses.

That’s a good thing, because folks who actively trade cryptocurrencies know that prices are volatile. And this volatility gives you two opportunities:

  1. profits on the upswings
  2. loss harvesting on the downswings

Let’s take a look at the harvesting of losses:

  • On day 1, Lucky pays $50,000 for a cryptocurrency.
  • On day 50, Lucky sells the cryptocurrency for $35,000. He captures and deducts the $15,000 loss ($50,000 - $35,000) on his tax return.
  • On day 52, Lucky buys the same cryptocurrency for $35,000. His tax basis is $35,000.
  • On day 100, Lucky sells the cryptocurrency for $15,000. He captures and deducts the $20,000 loss ($35,000 - $15,000) on his tax return.
  • On day 103, Lucky buys the same cryptocurrency for $15,000.
  • On day 365, the cryptocurrency is trading at $55,000. Lucky is happy.

Observations:

  • Assuming Lucky had $35,000 in capital gains, Lucky deducted his $35,000 in cryptocurrency capital losses. If he had no capital gains, he had a $3,000 deductible loss and carried the other $32,000 forward to next year.
  • On day 365, Lucky has his cryptocurrency, which was his plan on day 1. He thought it would go up in value. It did, from its original $50,000 to $55,000.
  • Lucky’s tax basis in the cryptocurrency on day 365 is $15,000.

Here’s what Lucky did:

  1. He kept his cryptocurrency.
  2. He banked $35,000 in losses.

Be alert. Losses from crypto-related securities, such as Coinbase, can fall under the wash-sale rule because the rule applies to losses from assets classified as securities for federal income tax purposes. For now, cryptocurrencies themselves are not classified as securities.

Planning point. If you want to harvest losses, make sure you hold a cryptocurrency and not a security.

Don’t Make a Big Mistake by Filing Your Tax Return Late

Tax-Saving Tips

Three bad things happen when you file your tax return late.

What’s Late?

You can extend your tax return and file during the period of extension; that’s not a late-filed return.

The late-filed return is filed after the last extension expired. That’s what causes the three bad things to happen.

Bad Thing 1

The IRS notices that you filed late or not at all.

Of course, the “I didn’t file at all” people receive the IRS’s “come on down and bring your tax records” letter. In general, the meeting with the IRS about non-filed tax returns does not go well.

For the late filers, the big problem is exposure to an IRS audit. Say you’re in the group that the IRS audits about 3 percent of the time, but you file your tax return late. Your chances of an IRS audit increase significantly, perhaps to 50 percent or higher.

Simply stated, bad thing 1 is this: file late and increase your odds of saying “Hello, IRS examiner.”

Bad Thing 2

When you file late, you trigger the big 5 percent a month, not to exceed 25 percent of the tax-due penalty.

Here, the bad news is 5 percent a month. The good news (if you want to call it that) is this penalty maxes out at 25 percent.

Bad Thing 3

Of course, if you owe the “failure to file” penalty, you likely also owe the penalty for “failure to pay.” The failure-to-pay penalty equals 0.5 percent a month, not to exceed 25 percent of the tax due.

The penalty for failure to pay offsets the penalty for failure to file such that the 5 percent is the maximum penalty during the first five months when both penalties apply.

But once those five months are over, the penalty for failure to pay continues to apply. Thus, you can owe 47.5 percent of the tax due by not filing and not paying (25 percent plus 0.5 percent for the additional 45 months it takes to get to the maximum failure-to-pay penalty of 25 percent).

The Principal Residence Gain Exclusion Break

The $250,000 ($500,000, if married) home sale gain exclusion break is one of the great tax-saving opportunities.

Unmarried homeowners can potentially exclude gains up to $250,000, and married homeowners can potentially exclude up to $500,000. You as the seller need not complete any special tax form to take advantage.

To take full advantage of the principal residence gain exclusion break, you must pass two tests: the ownership test and the use test.

  • To pass the ownership test, you must have owned the home for at least two years out of the five-year period ending on the sale date.
  • To pass the use test, you must have used the home as your principal residence for at least two years out of the five-year period ending on the sale date.

Key point. These two tests are completely independent. In other words, periods of ownership and use need not overlap.

If you’re married and you and your spouse file your tax returns separately, you can potentially qualify for two separate $250,000 exclusions.

If you’re married and file jointly, you qualify for the $500,000 joint-filer exclusion if

  • either you pass or your spouse passes the ownership test for the property and
  • both you and your spouse pass the use test.

When you file jointly, it’s also possible for both you and your spouse to individually pass the ownership and use tests for two separate residences. In that case, you and your spouse would qualify for two separate $250,000 exclusions.

Each spouse’s eligibility for the $250,000 exclusion is determined separately, as if you were unmarried. For this purpose, a spouse is considered to individually own a property for any period the property is actually owned by either spouse.

The other big qualification rule for the home sale gain exclusion privilege goes like this: the exclusion is generally available only when you have not excluded an earlier gain within the two-year period ending on the date of the later sale. In other words, you generally cannot recycle the gain exclusion privilege until two years have passed since you last used it.

You can claim the larger $500,000 joint-filer exclusion only if neither you nor your spouse took advantage of it for an earlier sale within the two-year period. If one spouse claimed the exclusion within the two-year window but the other spouse did not, the exclusion is limited to $250,000.

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

Tax-Saving Tips

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December 2020

Husband and wife working together with laptop, tax savings

Good News If Your PPP Loan Is for $50,000 or Less

As you likely know by now, the Paycheck Protection Program (PPP) loan and its forgiveness process have been an ever-changing (and often confusing) ride so far.

With the new rules for PPP loans of $50,000 or less, you escape the most difficult part of the loan forgiveness if you had to consider employees. And you may even obtain more loan forgiveness than you would have otherwise.

Before

Before the $50,000-or-less rule, you had to either suffer a reduction in loan forgiveness or meet one of the many exceptions that allowed you to

  • cut annual salaries or hourly wages by more than 25 percent, and/or
  • reduce the average number of employees or average hours paid.

After

Now, with a PPP loan of $50,000 or less, you don’t have to consider the myriad rules about employees. Regardless of what you did with your employees, you qualify for full forgiveness if

  • your PPP loan is for $50,000 or less,
  • you spent the PPP money on costs that are eligible for forgiveness, and
  • at least 60 percent of the forgiveness is for qualified payroll costs (including defined payroll for owners).

Example. You obtain a PPP loan of $34,000 based on your 2019 Schedule C income and pay to your part-time employee. When COVID-19 hit, you laid off your part-time worker and have not rehired him. Using SBA Form 3508S and the 24-week covered period, you qualify for 100 percent forgiveness of your $34,000 loan because you spent $20,833 (61 percent) on the deemed payroll to yourself and the remainder on five months’ rent and utilities.

Planning note. You are not an employee of your Schedule C business. You receive no W-2 income. But the PPP rules deem your 2019 Schedule C profits as your payroll for PPP loan purposes. The rules cap the Schedule C taxpayer’s loan amount and forgiveness at a maximum of $20,833 when Schedule C income is $100,000 or more.

Four Things to Know When Hiring Your Spouse

Husband and wife working together with laptop, tax savingsIf you own your own business and operate as a proprietorship or partnership (wherein your spouse is not a partner), one of the smartest tax moves you can make is hiring your spouse to work as your employee.

But the tax savings may be a mirage if you don’t pay your spouse the right way. And the arrangement is subject to attack by the IRS if your spouse is not a bona fide employee.

Here are four things you should know before you hire your spouse that will maximize your savings and minimize the audit risk.

  1. Pay benefits, not wages. The way to save on taxes is to pay your spouse with tax-free employee benefits, not taxable wages. Benefits such as health insurance are fully deductible by you as a business expense, but not taxable income for your spouse.

Also, if you pay a spouse only with tax-free fringe benefits, you need not pay payroll taxes, file employment tax returns, or file a W-2 for your spouse.

  1. Establish a medical reimbursement arrangement. The most valuable fringe benefit you can provide your spouse-employee is reimbursement for health insurance and uninsured medical expenses. You can accomplish this through a 105-HRA plan if your spouse is your sole employee, or an Individual Coverage Health Reimbursement Account (ICHRA) if you have multiple employees.
  2. Provide benefits in addition to health coverage. There are many other tax-free fringe benefits you can provide your spouse in addition to health insurance, including education related to your business, up to $50,000 of life insurance, and de minimis fringes such as gifts.
  1. Treat your spouse as a bona fide employee. For your arrangement to withstand IRS scrutiny, you must be able to prove that your spouse is your bona fide employee. You’ll have no problem if:
  • you are the sole owner of your business,
  • your spouse does real work under your direction and control and keeps a timesheet,
  • you regularly pay your spouse’s medical and other reimbursable expenses from your separate business checking account, and
  • your spouse’s compensation is reasonable for the work performed.

New IRS Efforts to Destroy Tax Deductions for PPP Paid Expenses

From what we know, when lawmakers originally passed the PPP they thought that under its provisions,

  • you did not pay taxes on the forgiveness amount, and
  • you also could deduct the expenses that you paid with the PPP money.

Obstacle

In late April, the IRS issued Notice 2020-32, which asserts that PPP loan recipients may not deduct business expenses paid using the PPP monies that gave rise to forgiveness (defined payroll, rent, utilities, and interest).

Lawmakers’ Take

In a letter to Secretary of the Treasury Steven Mnuchin on May 5, 2020, Senator Chuck Grassley (chairman of the Committee on Finance), Senator Ron Wyden (ranking member on the Committee on Finance), and Congressman Richard E. Neal (chairman of the Committee on Ways and Means) jointly stated that the IRS got this wrong and that the intent of the CARES Act was for the PPP to be a tax-free grant.

The Do-Nothings

The IRS was unmoved by the lawmakers’ letter. The IRS position was clear: no deduction for the expenses paid with the PPP money. The IRS understood that perhaps lawmakers didn’t mean that to happen, but in the eyes of the IRS, the way that the lawmakers enacted the law created the problem. To fix it, lawmakers simply need to pass a new law.

Frankly, we thought that lawmakers would pass a new law and take care of this problem. But no, that has not happened.

New Nails in the Coffin

On November 18, 2020, the IRS drove two new nails into the coffin regarding deductions for PPP monies that were forgiven and spent on payroll, rent, interest, or utilities.

  • Nail 1. In Revenue Ruling 2020-27, the IRS ruled that you may not deduct expenses paid with the PPP loan monies if you have received or expect to receive forgiveness of those loan monies.
  • Nail 2. In Revenue Procedure 2020-51, the IRS set forth safe-harbor procedures to follow if your PPP forgiveness is subsequently denied or if you decide not to apply for forgiveness.

With the rulings described above, the IRS has clarified its position to lawmakers: if you don’t like the non-deductibility of expenses paid with PPP monies, change the law.

What to Do Now

Join with hundreds of thousands of business taxpayers and tax professionals who are urging lawmakers to fix the non-deductibility issue.

To help encourage the action you desire (whether you’re for or against deductibility), get in touch with the lawmakers.

  • 3612 is the Senate bill to make the PPP forgiveness money used to pay business expenses tax-deductible. To express your yea or nay on S. 3612, contact your senators. You can find them at this link: https://www.senate.gov/senators/contact.
  • R. 6821 is the House bill to make the PPP forgiveness money used to pay business expenses tax-deductible. To express your yea or nay on H.R. 6821, contact your representative. You can find him or her at this link: https://www.house.gov/representatives.

Your yea or nay doesn’t need to be long or formal. You can fax, email, or phone and simply say you support or oppose the bill. It’s that easy—and it’s effective. Do it.

The IRS Goes Easy on Taxpayers Who Owe Back Taxes

Are you one of the over 11 million Americans who owe the IRS back taxes? The IRS temporarily suspended most collection efforts during the first wave of the coronavirus pandemic through its “People First Initiative.” This initiative expired July 15, 2020.

The IRS is now ready to go after delinquent accounts again. However, the agency recognizes that substantial numbers of taxpayers cannot pay what they owe right now. To help them, it has promulgated a new Taxpayer Relief Initiative.

The new Taxpayer Relief Initiative is relatively modest in scope, but it can be a big help if you owe the IRS.

Among other things, the new initiative gives you an extra 60 days to pay off a tax bill. You now have 180 days instead of 120 days to make a lump sum payment of all you owe.

The initiative also makes it easier to obtain, keep, and modify installment agreements with the IRS. These allow you to make monthly payments over several years.

If you owe $50,000 to $250,000, you may even be able to obtain an installment agreement without the IRS filing a tax lien on your property—something that has never been possible before.

The IRS is also stressing that it will help taxpayers who have already entered into installment agreements or offers in compromise with the agency and who are now having trouble making their payments.

You may also be able to get IRS penalties reduced or eliminated.

Whatever you do, don’t ignore a tax bill from the IRS. And never feel you’re helpless when confronted by the IRS collection juggernaut. You always have options, no matter how much you owe.

Tax-Smart College Savings Strategies for Parents

Parents Tax savingsCollege is expensive. Data for the 2019–2020 academic year indicates that the average cost of tuition, fees, room, and board was $30,500. The tax law has provisions to help you cover the costs, including Coverdell accounts, Section 529 savings plans, and Section 529 tuition plans.

Contribute to a Coverdell Education Savings Account

You can contribute up to $2,000 per year to the child’s Coverdell Education Savings Account (CESA). If you have several children, you can set up a CESA for each of them.

Contributions are non-deductible, but earnings are allowed to accumulate free of any federal income tax. You can then take tax-free withdrawals to pay for the account beneficiary’s post-secondary tuition, fees, books, supplies, and room and board.

Maybe not for you. Your right to contribute is phased out between modified adjusted gross income (MAGI) of $95,000 and $110,000 if you are unmarried, or between $190,000 and $220,000 if you are a married joint filer.

Contribute to a Section 529 College Savings Plan

Section 529 college savings plans are state-sponsored arrangements named after the section of our beloved Internal Revenue Code that authorizes very favorable treatment under the federal income and gift tax rules.

You as the parent of a college-bound child begin by making contributions into a trust fund set up by the state plan that you choose. The money goes into an account designated for the beneficiary whom you specify (your college-bound child).

You can then make contributions via a lump-sum pay-in or via installment pay-ins stretching over several years. The plan then invests the money using the investment direction option that you select.

When your child reaches college age, you can take federal-income-tax-free withdrawals to pay eligible college expenses, including room and board under most plans. Plans will generally cover expenses at any accredited college or university in the country (not just schools within the state sponsoring the plan). Community colleges qualify as well.

In essence, a Section 529 college savings plan account is a tax-advantaged way to build up a college fund for your child.

Don’t Confuse Savings Plans with Prepaid Plans

Don’t mix up Section 529 college savings plans with Section 529 prepaid college tuition plans—which we will give only a brief mention here. Both types of plans are properly called “Section 529 plans” because both are authorized by that section of the Internal Revenue Code. Both receive the same favorable federal tax treatment. But that’s where the resemblance ends.

The big distinction is that prepaid tuition plans lock in the cost to attend certain colleges. In other words, the rate of return on a prepaid tuition plan account is promised to match the inflation rate for costs to attend the designated school or schools—nothing more, nothing less. That’s okay if that’s what you really want.

No Kiddie Tax on Section 529 Plan

You don’t have to worry about the kiddie tax if you set up a custodial 529 plan in the child’s name. The 529 plan is an investment plan where the monies remain in the plan. You make contributions with after-tax dollars.

When the child takes the money out of the plan for college, he or she does so tax-free when the funds are used to pay for qualified higher education expenses.

If you have more questions, feel free to contact us.