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Tax update

Say Goodbye to 100 Percent Bonus Depreciation

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All good things must come to an end. On December 31, 2022, one of the best tax deductions ever for businesses will end: 100 percent bonus depreciation. 

Since late 2017, businesses have used bonus depreciation to deduct 100 percent of the cost of most types of property other than real property. But starting in 2023, bonus depreciation is scheduled to decline 20 percent each year until it reaches zero in 2027. 

For example, if you purchase $100,000 in equipment for your business and place it in service in 2022, you can deduct $100,000 using 100 percent bonus depreciation. If you wait until 2023, you’ll be able to deduct only $80,000 (80 percent). 

Does this mean you should rush out and purchase business property before 2022 ends to take advantage of the 100 percent bonus depreciation? Not necessarily. For many businesses, an alternative is not going away: IRC Section 179 expensing.

Both IRC Section 179 expensing and bonus depreciation allow business owners to deduct in one year the cost of most types of tangible personal property, plus off-the-shelf computer software. Both can be used for new and used property acquired by purchase from an unrelated party. Both also can be used to deduct various non-structural improvements to non-residential buildings after they are placed in service.

Moreover, the two deductions aren’t mutually exclusive. You can apply Section 179 expensing to qualifying property up to the annual limit and then claim bonus depreciation for any remaining basis. Starting in 2023, when bonus depreciation will be less than 100 percent, any basis left after applying Section 179 and bonus depreciation will be deducted with regular depreciation over several years.

But there are some significant differences between the two deductions:

  • Section 179 expensing is subject to annual dollar limits that don’t apply to bonus depreciation. But the limits are so large that they don’t affect most smaller businesses.
  • Section 179 expensing requires more than 50 percent business use to qualify for and retain the Section 179 deduction. For bonus depreciation, you face the more than 50 percent business use requirement only for vehicles and other listed property.
  • Unlike bonus depreciation, Section 179 expensing is limited to your net taxable business income (not counting the Section 179 deduction) and cannot result in a loss for the year.
  • The 2022 Section 179 deduction is limited to $27,000 for SUVs. There is no such limit on bonus depreciation.
  • You can use bonus depreciation to deduct land improvements with a 15-year class life, such as sidewalks, fences, driveways, landscaping, and swimming pools.

Generally, there is no great need to purchase and place the property in service by the end of 2022 to take advantage of 100 percent bonus depreciation. But there can be exceptions. 

For example, if you own a rental property and want to make substantial landscaping or other land improvements, you’ll get a larger one-year depreciation deduction using 100 percent bonus depreciation in 2022 than if you wait until 2023, when the bonus will be only 80 percent.

Avoid These Mistakes When Converting to an S Corporation  

 

At first glance, the corporate tax rules for forming an S corporation appear simple. They are not.

Basic Requirements

Here is what your business must look like when it operates as an S corporation:

  1. The S corporation must be a domestic corporation. 
  2. The S corporation must have fewer than 100 shareholders.
  3. The S corporation shareholders can be only people, estates, and certain types of trusts. 
  4. All stockholders must be U.S. residents.
  5. The S corporation can have only one class of stock. 

Simple, right? But what often appears simple on the surface is not so simple at all.

Don’t Forget Your Spouse

If you live in a community property state, your spouse by reason of community property law may be an owner of your corporation. This can be true whether or not your spouse has stock in his or her own name. 

If your spouse is an owner, your spouse has to meet all the same qualification requirements you do. This can raise two issues:

  1. If your spouse does not consent to the S corporation election on Form 2553, your S corporation is not valid.
  2. If your spouse is a non-resident alien, your S corporation is not valid.

 

Converting an LLC to an S Corporation

 

Method 1. To convert your LLC to an S corporation for tax purposes, you can use a method we call “check and elect.” It’s easy—just two steps. First, you “check” the box to make your LLC a C corporation. Then, you “elect” for the IRS to tax your C corporation as an S corporation. Here’s how you take the two steps:

  1. File IRS Form 8832 to check the box that converts your LLC to a C corporation.
  2. Then file Form 2553 to convert your C corporation into an S corporation.

Method 2. Your LLC can skip the C corporation step and directly elect S corporation status by filing Form 2553.

Loans That Terminate S Corporation Status

Don’t make a bad loan to your S corporation. With the wrong type of loan, you enable the IRS to treat that loan as a second class of stock that disqualifies your S corporation.

Small loans are okay. If the loan is less than $10,000 and the corporation has promised to repay you in a reasonable amount of time, you escape the second-class-of-stock trap.

Larger loans are more closely scrutinized. If you have a larger loan, your loan escapes the second-class-of-stock trap if it meets the following requirements:

  1. The loan is in writing.
  2. There is a firm deadline for repayment of the loan.
  3. You cannot convert the loan into stock.
  4. The repayment instrument fixes the interest rate so that the rate is outside your control.

 

Buying an Electric Vehicle? Know These Tax Law Changes

 

There’s good and bad news if you’re in the market for an electric or plug-in hybrid electric vehicle. 

The good news is that the newly enacted Inflation Reduction Act includes a wholly revamped tax credit for electric vehicles that starts in 2023 and continues through 2032. 

The bad news is that the credit, now called the “clean vehicle credit,” comes with many new restrictions.

The clean vehicle credit remains at a maximum of $7,500. But beginning in 2023, to qualify for the credit, 

  • you will need an adjusted gross income of $300,000 or less for marrieds filing jointly or $150,000 or less for singles; and
  • you will need to buy an electric vehicle with a manufacturer’s suggested retail price below $80,000 for vans, SUVs, and pickup trucks, or $55,000 for other vehicles.

But that’s not all. The 2023-and-later credit includes new domestic assembly and battery sourcing requirements.

The new law reduces or eliminates the credit when the vehicle fails the battery sourcing requirements. Currently, no electric vehicle will qualify for the full $7,500 credit. Manufacturers are working feverishly to change this, but it could take a few years.

The new credit is not all bad—it eliminates the cap of 200,000 electric vehicles per manufacturer. Thus, popular electric vehicles manufactured by GM, Toyota, and Tesla can qualify for the new credit if they meet the price cap and other requirements. 

And then, starting in 2024, you can qualify for a credit of up to $4,000 when purchasing a used electric vehicle from a dealer (not an individual). But income caps also will apply to this credit.

Also, starting in 2024, you’ll be able to transfer your credit to the dealer in return for a cash rebate or price reduction. This way, you can benefit from the credit immediately rather than waiting until you file your tax return.

If you are locked out of the new credit because your income is too high or you wish to purchase a too-expensive electric vehicle, consider buying a qualifying electric vehicle (assembled in North America) on or before December 31, 2022.

If you buy an electric vehicle for business use in 2023, you have a second option: the commercial clean vehicle credit.

Claim Your Employee Retention Credit   

If you had W-2 employees in 2020 and/or 2021, you need to look at the Employee Retention Credit (ERC).

As you likely know, it’s not too late to file for the ERC. And now is a good time to get this done.

You can qualify for 2020 credits of up to $5,000 per employee and 2021 credits of up to $7,000 per employee for each of the first three quarters. That’s a possibility of $26,000 per employee. 

One of our clients—let’s call him John–had 10 employees during 2020 and 2021. He qualified for $260,000 of tax credits (think cash). You could be like John.

You claim and adjust the ERC using IRS Form 941-X, which you can file anytime on or before March 15, 2024, if you file your taxes as a partnership or an S corporation, or April 15, 2024, if you file on Schedule C of your Form 1040 or as a C corporation.

You have three ways to qualify for the ERC:

  1. Significant decline in gross receipts. Here, you compare the gross receipts quarter by quarter to those in 2019. To trigger any ERC under this test, you need a drop of more than 50 percent in 2020 and a drop of more than 20 percent in 2021.
  2. Government order that causes more than a nominal effect. Here, your best bet is to use the safe harbor for nominal effect. This requires looking at either your 2019 quarterly receipts or your 2019 quarterly hours worked by employees, and seeing that the 2020 or 2021 shutdown order would have affected the 2019 figures by more than 10 percent.
  3. Government order causes a modification to your business. Here, you also have a safe harbor. The IRS deems that the federal, state, or local COVID-19 government order had a more-than-nominal effect on your business if it reduced your ability to provide goods or services in the normal course of your business by not less than 10 percent. 

The ERC can help all businesses that qualify, even those businesses that did not suffer during the COVID-19 pandemic.

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

 

Earn 9.62 Percent Tax-Deferred Interest with Series I Bonds

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Inflation is seldom a good thing. 

But when it comes to investing, the U.S. Treasury Department has an inflation opportunity that’s downright amazing. You can buy bonds that pay 9.62 percent interest—tax-deferred—with no downside risk, and with no state or local income taxes when you cash them in.

If you buy now, you earn that 9.62 percent for six months, guaranteed. At the end of six months, the Treasury Department

  • adds the interest you earned to your principal, and
  • pays interest on your new principal balance at the new rate it will determine this year, on November 1.

Example. You buy $10,000 of Series I bonds on September 24. You earn 9.62 percent for six months for a total of $481 ($10,000 x 9.62 percent ÷ 2). On March 24, your principal balance is $10,481 ($10,000 + 481). 

Let’s say Treasury sets the November 1 interest rate at 9 percent. During the six months from March 24 to September 24, 2023, you earn interest at 9 percent on $10,481. Now, at the end of a full year, you have $10,953 in your TreasuryDirect I bond account.

The big deal with an I bond is fourfold:

  • You can’t lose your principal (e.g., your $10,953 in the example above can’t go down).
  • Interest rates on I bonds track with the consumer price index inflation rate, which has been high.
  • You earn tax-deferred compound interest until you cash in.
  • The interest is exempt from state and local income taxes.

You have much to like with the Series I bond. And there’s little to dislike. Perhaps the biggest dislike is the $10,000 limit on I bond purchases, but you can use your business entities, trusts, gifts, and even your living trust to make purchases of I bonds and create a much higher limit than $10,000.

With the gifting strategy, you can have more than one gift box per donee, so you have opportunity there too.

The biggest deal with the I bond is that it carries no downside risk. It can’t go below its latest redemption value, and the interest rate can’t go below zero.

The one thing you need to pay attention to is the interest rate. It changes with inflation. The Fed wants to lower inflation to its target 2 percent. For most people, this means that the I bond could be a short-term investment—say, one to five years. 

But think in the short term now. Where else can you earn 9.62 percent tax-deferred interest, risk-free?

New and Improved Energy Tax Credits for Homeowners   

The president signed the Inflation Reduction Act into law on August 16, 2022. It contains some valuable tax credits for homeowners. 

When it comes to taxes, nothing is better than a tax credit since it is a dollar-for-dollar reduction in the taxes you must pay (unlike a tax deduction that only reduces your taxable income). In other words, a $1,000 credit saves you $1,000 in taxes.

The new law extends and expands three tax credits intended to encourage homeowners to make their homes more energy efficient and to facilitate the use of electric vehicles. 

Energy Efficient Home Improvement Credit

The new law creates the 2023 Energy Efficient Home Improvement Credit that helps homeowners pay for various types of energy efficiency improvements, including

  • exterior windows, skylights, and doors;
  • home insulation;
  • heat pumps, water heaters, central air conditioners, furnaces, and hot water boilers;
  • biomass stoves and boilers; and
  • electric panel upgrades.

The old credit contained a tiny $500 lifetime cap. Lifetime caps are gone beginning in 2023. 

Instead, the new law gives you a $1,200 annual cap along with specific caps on some improvements. But overall, you can perform many energy efficiency projects over several years and collect a credit each year. 

Residential Clean Energy Credit

Most taxpayers earn the Residential Clean Energy Credit by installing solar. Two good things here. First, the new law extends the credit through 2034. Second, the new law increases the credit from 26 percent to 30 percent for eligible property placed in service in 2022 through 2032. 

There is no annual or lifetime cap on this credit. The average solar project cost on a home is over $20,000, so this credit can save you more than $6,000. 

You can also apply this credit to the cost of storage batteries, solar water heaters, geothermal heat pumps, small residential wind turbines, and residential fuel cells.

Home Electric Vehicle Charger Credit 

The new law extends through 2032 the tax credit for installing a home electric charger. The amount of credit remains the same: a non-refundable credit equal to 30 percent of the cost of a home charger, capped at $1,000. But starting in 2023, the credit will be available only for homeowners who live in low-income or rural areas.

Claiming the ERC When You Own Multiple Entities

Do you qualify for the employee retention credit (ERC)? Did you claim it? 

It’s not too late. You can still amend your 2020 and 2021 payroll tax returns. 

Remember, this can be worth up to $5,000 per employee in 2020 and up to $7,000 per employee per quarter for the first three quarters of 2021, for a 2021 total of $21,000 ($26,000 per qualifying employee for 2020 and 2021 combined). 

Example. Let’s say you have 10 employees who fully qualify for the credit. That’s a $260,000 tax credit (think cash): ($5,000 + $7,000 + $7,000 + $7,000) x 10 = $260,000.

Who Must Aggregate Businesses?

When you own more than one entity, you face special rules when it comes to the ERC. And you don’t have to own the other entity entirely to face the special rules.

Here are just a few examples of who has to aggregate businesses for purposes of the ERC:

  • Howard operates his dental practice as an S corporation, and he also owns three rental properties that he deems businesses.
  • Carla Corporation operates 11 subsidiary corporations located in seven states.
  • Jack, Jake, and Jim own one-third of four corporations.

Okay, So What?

When you aggregate the business entities into one for the ERC, you have to consider the following questions:

  • Are you now (because of the aggregation) a small or a large employer under the 100 (2020) or 500 (2021) large-employer test?
  • What does the aggregation of the businesses mean for your qualifying under the decline-in-gross-receipts test?
  • What is the effect of a government COVID-19 shutdown or modification order on one of the entities, and how does it affect the aggregated group?
  • How do you treat employees who work for more than one of the entities?

A Little More

In most cases, identifying the group to aggregate is going to be straightforward, but it can get pretty complicated with some entities. The bottom line is that it’s likely worthwhile to aggregate and see what’s possible for the ERC.

When you aggregate, you look at gross receipts compared with 2019, and you also look to government shutdown orders. Obviously, you use the best results you find with either (a) the gross receipts drop or (b) the shutdown orders.

There’s a pleasant surprise with the government shutdown order, because if that order affects one entity in the group, the IRS says it affects the entire group. For example, Sam owns five retail corporations. One was shut down by governmental order. That shutdown applies to all five corporations and can create tax credits with each of the five.

New Business Tax Credits for Your Electric Vehicle Purchases   

You may have heard that the newly enacted Inflation Reduction Act includes an expanded tax credit for electric vehicles. 

Although this personal credit has gotten most of the publicity, the new law launched a new commercial clean vehicle credit—specifically for business-use electric vehicles. And it’s much better than the credit for personal-use electric vehicles.

The new law’s personal-use electric vehicle credit is now called the clean vehicle credit. It comes with many new restrictions: 

  • It is available only if your adjusted gross income is no more than $300,000 (married, filing jointly) or $150,000 (single). 
  • It applies only to electric vehicles with a manufacturer’s suggested retail price below $80,000 for vans, SUVs, and pickup trucks, or $55,000 for other vehicles.
  • It must pass complex tax-law-defined North American assembly and sourcing requirements that prevent many electric vehicles from qualifying.

Luckily, if you purchase or lease an electric vehicle for business use in 2023 or later, none of the clean vehicle credit restrictions apply. Instead, you can qualify for the business-use electric vehicle credit. The credit is available for fully electric cars, plug-in hybrid electric vehicles, and fuel cell vehicles. 

The maximum credit is $7,500 for electric vehicles with a gross vehicle weight rating (GVWR) of less than 14,000 pounds and a whopping $40,000 for electric vehicles with a GVWR of 14,000 pounds or more.

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

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.

Donor-Advised Funds: A Tax Planning Tool for Church and Charity Donations

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Donor-Advised Funds

Do you give money to 501(c)(3) charities?

Do you get a tax benefit from those donations?

Recent changes in the tax code have done much to destroy your benefits from church and other tax-deductible 501(c)(3) donations. But there’s a way to donate the way you want, get revenge on the tax code, and realize the tax benefits you deserve.

This get-even tool is the donor-advised fund, an increasingly popular way to donate to your church and other 501(c)(3) organizations. Indeed, donor-advised funds have exploded over the past few years, with over one million donor-advised fund accounts in existence as of 2020. 

Example. You donate $100,000 to the fund today. You get the $100,000 deduction now. From the fund, you donate $10,000 a year to a charitable organization (probably more as your money in the fund grows tax-free).

National investment firms such as Fidelity, Schwab, and Vanguard have all created donor-advised funds. These “commercial” donor-advised funds hire an affiliated for-profit investment firm to manage the assets in the accounts for a fee that varies based on the account balance.

You can also establish a donor-advised fund account with a community foundation that has a local orientation; a single-issue non-profit, such as a university or an environmental charity like the Sierra Club; or an independent, non-commercial organization such as the American Endowment Foundation, National Philanthropic Trust, or United Charitable.

You can always donate cash, including money in IRAs and 401(k)s, to your donor-advised fund account. But many donor-advised funds also accept non-cash donations, including

  • stocks, bonds, and mutual fund shares,
  • real estate,
  • privately owned company stock,
  • LLC and limited partnership interests,
  • Bitcoin and other cryptocurrency, and
  • life insurance.

Donating stock or mutual fund shares that have appreciated is a great tax strategy. Here’s why:

  • If you owned the stock for more than one year, you get a deduction equal to its fair market value at the time of the donation. 
  • And you don’t pay any capital gains tax on the appreciated value of the stock. 

Example. Dennis owns 1,000 shares of Evergreen stock that’s publicly traded on NASDAQ. He paid $10,000 for the stock back in 2010, and the shares are worth $100,000 today. 

He establishes a donor-advised fund in 2022 and donates the stock. 

  • He gets a $100,000 charitable deduction for 2022. 
  • He pays no federal tax on his $90,000 gain. 

As you can see, there are many benefits to donor-advised funds for the charitably inclined, and few drawbacks. 

Transferring Your Home to Your Adult Child

With today’s home prices and the crazy real estate market, it’s likely difficult for your children to buy a home. And it’s conceivable that you are ready to move on from your existing home. 

If this is true, consider the three options below.

Option 1: Make an Outright Gift

Say you’re feeling so generous that you might just simply give your home to your adult child. What a deal for the kid! 

Tax-wise, if you make the gift this year, it will reduce your $12.06 million unified federal gift and estate tax exemption. To calculate the impact, reduce the fair market value of the home you would be giving away by the annual federal gift tax exclusion, which is $16,000 for 2022. The remainder is the amount that would reduce your unified federal exemption. 

If you’re married, your spouse has a separate $12.06 million unified federal exemption. If you and your spouse make a joint gift of the home, each of your unified federal exemptions will be reduced. To calculate the impact, take half of the fair market value of the home minus the $16,000 annual exclusion. The remainder is the amount by which you would reduce your unified federal exemption. Ditto for your spouse’s separate exemption. 

If your child is married and you give the home to your child and his or her spouse, you can claim a separate $16,000 annual exclusion for your child’s spouse. 

If you expect the home to continue to appreciate (seemingly a pretty good bet), getting it out of your estate by giving it away is a good estate-tax-avoidance strategy. 

Option 2: Arrange a Bargain Sale

Say you’re feeling generous, but not so generous that you want to simply give away your home. Fair enough. 

Consider selling the home to your child for less than fair market value. For federal gift tax purposes, this is treated as a gift of the difference between the home’s fair market value and the bargain sale price. Tax-wise, this can work out okay.

Warning. Do not make a bargain sale or an outright gift of the home if you intend to continue living there until you die. In these scenarios, expect the IRS to argue that the home’s full date-of-death fair market value must be included in your estate for federal estate tax purposes, even if you were paying fair market rent to your child.

Option 3: Arrange Full-Price Sale with Seller Financing from You

The idea of giving your child a free house might be unappealing to you. Very well.

Consider selling the home to your child for its current fair market value with you taking back a note for a big part of the purchase price. 

Assume you’re feeling charitable. If so, you can charge the lowest interest rate the IRS allows without any weird tax consequences. That’s called the “applicable federal rate” (AFR). 

AFRs change monthly in response to bond market conditions and are generally well below commercial rates. In May 2022, the long-term AFR, for loans of more than nine years, is only 2.66 percent (assuming annual compounding). The mid-term AFR, for loans of more than three years but not more than nine years, is only 2.51 percent (assuming annual compounding). 

As this was written, the going rate nationally for a 30-year fixed-rate commercial mortgage was around 6.1 percent, while the rate for a 15-year loan was around 5.1 percent. 

So, for a loan made in May 2022, you could take back a 30-year note that charges the long-term AFR of only 2.66 percent. Alternatively, you could take back a nine-year note that charges the mid-term AFR of only 2.51 percent. Either arrangement would be a money-saving deal for your child. 

Selling Your Appreciated Vacation Home? Consider the Taxes

The tax-code-defined vacation home rules come into play when you have both rental and personal use of a home. Thus, you can have tax-code-defined vacation homes in the city, in the suburbs, and in recreation areas.

If you have no combined rental and personal use of the home, the rules are easy. The property is one of the following:

  • Principal residence
  • Second home
  • Rental property

But when you have both rental and personal use of the home, your tax life gets more complicated because you have entered the tax code’s vacation home section. In this situation, the property in a more complicated way is one of the following:

  • Principal residence
  • Second home
  • Rental property

If it’s a principal residence, then the $250,000/$500,000 home sale exclusion is available when you sell. 

If it’s simply a second home, you can’t use the exclusion and you pay taxes at capital gains rates—and you may suffer the net investment income tax (NIIT) as well.

If it’s a rental, you face the capital gains rules, NIIT, unrecaptured Section 1250 gain taxes, and release of some (if grouped) or all (if not grouped) passive activity suspended losses.

When you have rental use after 2008 and then convert the rental to your principal residence, you must use a rental/residence fraction to determine how you will be taxed.

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

 

Health Savings Accounts and more tax-saving tips

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Health Savings Accounts: The Ultimate Retirement Account

Health Savings Accounts

It isn’t easy to make predictions, especially about the future. But there is one prediction we’re confident in making: you will have substantial out-of-pocket expenses for health care after you retire. Personal finance experts estimate that an average retired couple age 65 will need at least $300,000 to cover health care expenses in retirement.

You may need more.

The time to save for these expenses is before you reach age 65. And the best way to do it may be a Health Savings Account (HSA). After several years, you could have a fat HSA balance that will help pave your way to a comfortable retirement.

Not everyone can have an HSA. But you can if you’re self-employed or your employer doesn’t provide health benefits. Some employers offer, as an employee fringe benefit, either HSAs alone or HSAs combined with high-deductible health plans.

An HSA is much like an IRA for health care. It must be paired with a high-deductible health plan with a minimum annual deductible of $1,400 for self-only coverage ($2,800 for family coverage). The maximum annual deductible must be no more than $7,050 for self-only coverage ($14,100 for family coverage).

An HSA can provide you with three tax benefits:

  1. You or your employer can deduct the contributions, up to the annual limits.
  2. The money in the account grows tax-free (and you can invest it in many ways). 
  3. Distributions are tax-free if used for medical expenses. 

No other tax-advantaged account gives you all three of these benefits. 

You also have complete flexibility in how to use the account. You may take distributions from your HSA at any time. But unlike with a traditional IRA or 401(k), you do not have to take annual required minimum distributions from the account after you turn age 72. 

Indeed, you need never take any distributions at all from your HSA. If you name your spouse the designated beneficiary of your HSA, the tax code treats it as your spouse’s HSA when you die (no taxes are due). 

If you maximize your contributions and take few distributions over many years, the HSA will grow to a tidy sum. 

 

Partnership with Multiple Partners: The Good and the Bad

 

The generally favorable federal income tax rules for partnerships are a common reason for choosing to operate as a partnership with multiple partners instead of as a corporation with multiple shareholders. The most important partnership tax benefit rules can be summarized as follows: 

  • You get pass-through taxation. 
  • You can deduct partnership losses (within limits).
  • You may be eligible for the Section 199A tax deduction. 
  • You get basis from partnership debts. 
  • You get basis step-up for purchased interests. 
  • You can make tax-free asset transfers with the partnership.
  • You can make special tax allocations. 

Partnership taxation is not all good stuff. There are a few important disadvantages and complications to consider:

  • Exposure to self-employment tax
  • Complicated Section 704(c) tax allocation rules
  • Tricky disguised sale rules
  • Unfavorable fringe benefit tax rules

Limited partnerships are obviously treated as partnerships for federal income tax purposes, with the generally favorable partnership taxation rules mentioned above.

Limited partners generally are not exposed to liabilities related to the partnership or its operations. So, you generally cannot lose more than what you’ve invested in a limited partnership—unless you guarantee partnership debt. 

So far, so good. But you must also consider the following disadvantages for limited partners:

  • Limited partners usually get no basis from partnership liabilities. 
  • Limited partners can lose their liability protection. 
  • You need a general partner. 

On the plus side, limited partners have a self-employment tax advantage.

Since your partnership will have multiple partners, multiple issues can come into play. You’ll need a carefully drafted partnership agreement to handle potential issues even if you don’t expect them to arise. For instance, you may want to include

  • a partnership interest buy-sell agreement to cover partner exits;
  • a non-compete agreement (for obvious reasons);
  • an explanation of how tax allocations will be calculated in compliance with IRS regulations;
  • an explanation of how distributions will be calculated and when they will be paid (for instance, you may want to call for cash distributions to be made annually in early April to cover partners’ tax liabilities from their shares of partnership income for the previous year);
  • guidelines for how the divorce, bankruptcy, or death of a partner will be handled;
  • and so on. 

Key point. No type of entity (including a limited partnership in which you are a limited partner) will protect your personal assets from exposure to liabilities related to your own professional malpractice or your own tortious acts. 

 

Send Tax Documents Correctly to Avoid IRS Trouble

 

You have heard the horror stories about mail sent to the IRS that remains unanswered for months. Reportedly, the IRS has mountains of unanswered mail pieces in storage trailers, waiting for IRS employees to process them.

Because the understaffed IRS is having so much trouble processing all the documents it receives, you need to protect yourself when you send an important tax filing due by a specific deadline.

If you can file a document electronically, do so. The IRS deems such filings as filed on the date of the electronic postmark.

If you must file a physical document with the IRS, don’t use regular U.S. mail, Priority Mail, or Express Mail.

Why not?

When you mail a document with these methods, the IRS considers it filed on the postmark date, but only if the IRS receives it. What if the U.S. Postal Service doesn’t deliver it or the IRS loses it? You’ll have no way to prove the IRS got it—and the IRS and most courts won’t accept your testimony that it was timely mailed.

Don’t take this chance. Instead, file physical documents by certified or registered U.S. mail, or use an IRS-approved private delivery service (generally, two-day or better service from FedEx, UPS, or DHL Express). When you do this, the IRS considers the document filed on the postmark date whether or not the IRS receives it. 

Make sure to keep your receipt.

 

Tax Implications When Your Vacation Home Is a Rental Property

Health Savings Accounts and more saving tips, home for rental

If you have a home that you both rent out and use personally, you have a tax code-defined vacation home.

Under the tax code rules, that vacation home is either

  • a personal residence or
  • a rental property.

The tax code classifies your vacation home as a rental property if

  • you rent it out for more than 14 days during the year, and
  • your personal use during the year does not exceed the greater of (a) 14 days or (b) 10 percent of the days you rent the home out at fair market rates.

Count actual days of rental and personal use. Disregard days of vacancy, and disregard days that you spend mainly on repair and maintenance activities.

For vacation homes that are classified as rental properties, you must allocate mortgage interest, property taxes, and other expenses between rental and personal use, based on actual days of rental and personal occupancy. 

 

Mortgage Interest Deductions 

 

Mortgage interest allocable to personal use of a rental property does not meet the definition of qualified residence interest for itemized deduction purposes. The qualified residence interest deduction is allowed only for mortgages on properties that are classified as personal residences. 

 

Schedule E Losses and the PAL Rules

 

When allocable rental expenses exceed rental income, a vacation home classified as a rental property can potentially generate a deductible tax loss that you can claim on Schedule E of your Form 1040. Great!

Unfortunately, your vacation home rental loss may be wholly or partially deferred under the dreaded passive activity loss (PAL) rules. Here’s why. 

You can generally deduct passive losses only to the extent that you have passive income from other sources (such as rental properties that produce positive taxable income). 

Disallowed passive losses from a property are carried forward to future tax years and can be deducted when you have sufficient passive income or when you sell the loss-producing property. 

 

“Small Landlord” Exception to PAL Rules

 

A favorable exception to the PAL rules currently allows you to deduct up to $25,000 of annual passive rental real estate losses if you “actively participate” and have adjusted gross income (AGI) under $100,000. The $25,000 exception is phased out between AGI of $100,000 and $150,000.

 

The Seven-Days-or-Less and Less-Than-30-Days Rules 

 

The IRS says the $25,000 small landlord exception is not allowed

  • when the average rental period for your property is seven days or less, or
  • when the average period of customer use for such property is 30 days or less, and significant personal services are provided by or on behalf of the owner of the property in connection with making the property available for use by customers. 

“Real Estate Professional” Exception to PAL Rules 

 

Another exception to the PAL rules currently allows qualifying individuals to deduct rental real estate losses even though they have little or no passive income. To be eligible for this exception, 

  1. you must spend more than 750 hours during the year delivering personal services in real estate activities in which you materially participate, and 
  2. those hours must be more than half the time you spend delivering personal services (in other words, working) during the year. If you can clear those hurdles, you qualify as a real estate professional. 

The second step is determining whether you have one or more rental real estate properties in which you materially participate. If you do, those properties are treated as non-passive and are therefore exempt from the PAL rules. That means you can generally deduct losses from those properties in the current year.

 

Meeting the Material Participation Standard 

 

The three most likely ways to meet the material participation standard for a vacation home rental activity are when the following occur:

  • You do substantially all the work related to the property.
  • You spend more than 100 hours dealing with the property, and no other person spends more time on this property than you do.
  • You spend more than 500 hours dealing with the property.

In attempting to clear one of these hurdles, you can combine your time with your spouse’s time. But if you use a management company to handle your vacation home rental activity, you’re unlikely to pass any of the material participation tests.

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

IRAs for Kids, and more tax saving tips

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Child saves money, IRAs for Kids

IRAs for Kids

Working at a tender age is an American tradition. What isn’t so traditional is the notion of kids contributing to their own IRA, especially a Roth IRA. But it should be a tradition, because it’s a really good idea. 

Here’s what you need to know about IRAs for kids. Let’s start with the Roth IRA option. 

Roth IRA Contribution Basics 

The only federal-income-tax-law requirement for a child to make an annual Roth IRA contribution is to have enough earned income during the year to cover the contribution. Age is completely irrelevant. 

So if a child earns some cash from a summer job or part-time work after school, he or she is entitled to make a Roth contribution for that year. 

For both the 2021 and 2022 tax years, your working child can contribute the lesser of

  • his or her earned income for the year, or 
  • $6,000. 

While the same $6,000 contribution limit applies equally to Roth IRAs and traditional IRAs, the Roth option is usually better for kids.

Key point. A contribution for your child’s 2021 tax year can be made as late as April 15, 2022. So, there’s still time for that.

Modest Contributions to Child’s Roth IRA Can Amount to Big Bucks by Retirement Age

By making Roth contributions for a few years during the teenage years, your kid can potentially accumulate quite a bit of money by retirement age. 

But realistically, most kids won’t be willing to contribute the $6,000 annual maximum even when they have enough earnings to do so. 

Say the child contributes $2,500 at the end of each year for four years. Assuming a 5 percent annual rate of return, the Roth account would be worth about $82,000 in 45 years. Assuming a more optimistic 8 percent return, the account value jumps to a whopping $259,000. Wow! 

You get the idea. With relatively modest annual contributions for just a few years, Roth IRAs can be worth eye-popping amounts by the time your “kid” approaches retirement age.

Vacation Home Rental—What’s Best for You: Schedule C or E?

Vacation Home Rental

Do you have a beach or mountain home that you rent out?

If the average period of rental is less than 30 days, you likely have a choice—either

  • claim the income and expenses on Schedule C, or
  • claim the income and expenses on Schedule E.

When Is Schedule C a Good Choice?

If you show a tax loss on your rental property, Schedule C is a great choice because it allows you to deduct your rental losses against all other income (assuming you materially participate in the rental property).

If you show taxable income on the rental property, Schedule C is not good because it causes you to pay self-employment taxes.

When Is Schedule E a Good Choice?

If you show taxable income on the transient rental, Schedule E is best because you don’t pay any self-employment taxes on Schedule E income.

If you show a loss on your transient rental and you materially participate, you can deduct your losses against all other income, but those Schedule E losses do not reduce self-employment income.

Okay, now you know how to play the game.

IRS in Summary Mode

In recent advice, the IRS stated that rentals of living quarters are not subject to self-employment tax when no services are rendered for the occupants.

But if services are rendered for the occupants, and the services rendered

  1. are not clearly required to maintain the space in a condition for occupancy, and 
  2. are of such a substantial nature that the compensation for these services can be said to constitute a material portion of the rent, 

then the net rental income received is subject to the self-employment tax.

Entertainment Facility: Perk for You, Your Net Worth, and Your Employees

Imagine this: your Schedule C business buys a home at the beach, uses it solely as an entertainment facility for business, pays off the mortgage, and deducts all the expenses. 

Now say, 10 years later, without any tax consequence to you, you start using the beach home as your own.

Is this possible? Yes. Are there some rules on this? Yes. Are the rules difficult? No.

Okay, so could you achieve the same result if you operate your business as a corporation? Yes, but the corporation needs to rent the property from you or reimburse you for the facility costs, including mortgage interest and depreciation—because you want the title to always be in your name, not the corporation’s name.

The beach home, ski cabin, or other entertainment facility must be primarily for the benefit of employees other than those who are officers, shareholders, or other owners of a 10 percent or greater interest in the business, or other highly compensated employees. In this situation, you create

  • 100 percent entertainment facility tax deductions for the employer (you or, if incorporated, your corporation), and 
  • tax-free use by the employees. 

The employee facility deduction is straightforward. It has three splendid benefits for the small-business owner:

  1. You deduct the facility as a business asset.
  2. Your employees get to use the facility tax-free.
  3. You own the property and can use it personally without tax consequences once you no longer need it for business use. (Note that when you sell, you will have a gain or loss on the sale and some possible recapture of depreciation.)

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