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2022 Year-End Edition – Tax-Saving Tips

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2022 tax Year-End Edition

2022 Year-End Edition - Tax-Saving Tips 

Last-Minute Year-End General Business Income Tax Deductions

The purpose of this letter is to get the IRS to owe you money.

Of course, the IRS will not likely cut you a check for this money (although, in the right circumstances, that will happen), but you’ll realize the cash when you pay less in taxes.

Here are six powerful business tax deduction strategies you can easily understand and implement before the end of 2022. 

 

  1. Prepay Expenses Using the IRS Safe Harbor

 

You just have to thank the IRS for its tax-deduction safe harbors.

IRS regulations contain a safe-harbor rule that allows cash-basis taxpayers to prepay and deduct qualifying expenses up to 12 months in advance without challenge, adjustment, or change by the IRS.

Under this safe harbor, your 2022 prepayments cannot go into 2023. This makes sense because you can prepay only 12 months of qualifying expenses under the safe-harbor rule.

For a cash-basis taxpayer, qualifying expenses include lease payments on business vehicles, rent payments on offices and machinery, and business and malpractice insurance premiums.

Example. You pay $3,000 a month in rent and would like a $36,000 deduction this year. So on Friday, December 30, 2022, you mail a rent check for $36,000 to cover all of your 2023 rent. Your landlord does not receive the payment in the mail until Tuesday, January 3, 2023. Here are the results:

  • You deduct $36,000 in 2022 (the year you paid the money).
  • The landlord reports taxable income of $36,000 in 2023 (the year he received the money).

You get what you want—the deduction this year. 

The landlord gets what he wants—next year’s entire rent in advance, eliminating any collection problems while keeping the rent taxable in the year he expects it to be taxable. 

 

  1. Stop Billing Customers, Clients, and Patients

 

Here is one rock-solid, straightforward strategy to reduce your taxable income for this year: stop billing your customers, clients, and patients until after December 31, 2022. (We assume here that you or your corporation is on a cash basis and operates on the calendar year.)

Customers, clients, and insurance companies generally don’t pay until billed. Not billing customers and clients is a time-tested tax-planning strategy that business owners have used successfully for years.

Example. Jake, a dentist, usually bills his patients and the insurance companies at the end of each week. This year, however, he sends no bills in December. Instead, he gathers up those bills and mails them the first week of January. Presto! He postponed paying taxes on his December 2022 income by moving that income to 2023.

 

  1. Buy Office Equipment

 

With bonus depreciation now at 100 percent along with increased limits for Section 179 expensing, buy your equipment or machinery and place it in service before December 31 and get a deduction for 100 percent of the cost in 2022.

Qualifying bonus depreciation and Section 179 purchases include new and used personal property such as machinery, equipment, computers, desks, chairs, and other furniture (and certain qualifying vehicles).

 

  1. Use Your Credit Cards

 

If you are a single-member LLC or sole proprietor filing Schedule C for your business, the day you charge a purchase to your business or personal credit card is the day you deduct the expense. Therefore, as a Schedule C taxpayer, you should consider using your credit card for last-minute purchases of office supplies and other business necessities.

If you operate your business as a corporation, and if the corporation has a credit card in the corporate name, the same rule applies: the date of charge is the date of deduction for the corporation.

But suppose you operate your business as a corporation and are the personal owner of the credit card. In that case, the corporation must reimburse you if you want the corporation to realize the tax deduction, which happens on the reimbursement date. Thus, submit your expense report and have your corporation make its reimbursements to you before midnight on December 31.

 

  1. Don’t Assume You Are Taking Too Many Deductions

 

If your business deductions exceed your business income, you have a tax loss for the year. With a few modifications to the loss, tax law calls this a “net operating loss,” or NOL.

If you are starting your business, you could very possibly have an NOL. You could have a loss year even with an ongoing successful business.

You used to be able to carry back your NOL two years and get immediate tax refunds from prior years, but the Tax Cuts and Jobs Act (TCJA) eliminated this provision. Now you can only carry your NOL forward, and it can only offset up to 80 percent of your taxable income in any one future year.

What does this all mean? Never stop documenting your deductions, and always claim all your rightful deductions. We have spoken with far too many business owners, especially new owners, who don’t claim all their deductions when those deductions would produce a tax loss.

 

  1. Deal with Your Qualified Improvement Property (QIP)

 

In the CARES Act, Congress finally fixed the qualified improvement property (QIP) error that it made when enacting the TCJA.

QIP is any improvement made by you to the interior portion of a building you own that is non-residential real property (think office buildings, retail stores, and shopping centers)—if you place the improvement in service after the date you place the building in service.

The big deal: QIP is not real property that you depreciate over 39 years. QIP is 15-year property, eligible for immediate deduction using either 100 percent bonus depreciation or Section 179 expensing. To get the QIP deduction in 2022, you must place the QIP in service on or before December 31, 2022.

Planning note. If you have QIP property on an already filed 2019 return that you did not amend, it’s on that return as 39-year property. You need to fix that—and likely add some cash to your bank account by making the fix.

Last-Minute Year-End Tax Strategies for Your Stock Portfolio 

When you take advantage of the tax code’s offset game, your stock market portfolio can represent a little gold mine of opportunities to reduce your 2022 income taxes. 

The tax code contains the basic rules for this game, and once you know the rules, you can apply the correct strategies. 

Here’s the basic strategy:

  • Avoid the high taxes (up to 40.8 percent) on short-term capital gains and ordinary income.
  • Lower the taxes to zero—or if you can’t do that, lower them to 23.8 percent or less by making the profits subject to long-term capital gains.

Think of this: you are paying taxes at a 71.4 percent higher rate when you pay at 40.8 percent rather than the tax-favored 23.8 percent. 

To avoid higher rates, here are seven possible tax planning strategies.

 

Strategy 1

 

Examine your portfolio for stocks you want to unload, and make sales where you offset short-term gains subject to a high tax rate, such as 40.8 percent, with long-term losses (a rate of up to 23.8 percent). 

In other words, make the high taxes disappear by offsetting them with low-taxed losses, and pocket the difference.

 

Strategy 2

 

Use long-term losses to create the $3,000 deduction allowed against ordinary income. 

Again, you are trying to use the 23.8 percent loss to kill a 40.8 percent rate of tax (or a 0 percent loss to kill a 12 percent tax if you are in the 12 percent or lower tax bracket).

 

Strategy 3

 

As an individual investor, avoid the wash-sale loss rule. 

Under the wash-sale loss rule, if you sell a stock or other security and then purchase substantially identical stock or securities within 30 days before or after the date of sale, you don’t recognize your loss on that sale. Instead, the code makes you add the loss amount to the basis of your new stock.

If you want to use the loss in 2022, you’ll have to sell the stock and sit on your hands for more than 30 days before repurchasing that stock.

 

Strategy 4

 

If you have lots of capital losses or capital loss carryovers and the $3,000 allowance is looking extra tiny, sell additional stocks, rental properties, and other assets to create offsetting capital gains.

If you sell stocks to purge the capital losses, you can immediately repurchase the stock after you sell it—there’s no wash-sale “gain” rule.

 

Strategy 5

 

Do you give money to your parents to assist them with their retirement or living expenses? How about children (specifically, children not subject to the kiddie tax)?

If so, consider giving appreciated stock to your parents and your non-kiddie-tax children. Why? If the parents or children are in lower tax brackets than you are, you get a bigger bang for your buck by 

  • gifting them stock, 
  • having them sell the stock, and then
  • having them pay taxes on the stock sale at their lower tax rates.
 

Strategy 6

 

If you are going to donate to a charity, consider appreciated stock rather than cash because a donation of appreciated stock gives you more tax benefit.

It works like this: 

  • Benefit 1. You deduct the fair market value of the stock as a charitable donation.
  • Benefit 2. You don’t pay any of the taxes you would have had to pay if you sold the stock.

Example. You bought a publicly traded stock for $1,000, and it’s now worth $11,000. If you give it to a 501(c)(3) charity, the following happens:

  • You get a tax deduction for $11,000. 
  • You pay no taxes on the $10,000 profit.

Two rules to know:

  1. Your deductions for donating appreciated stocks to 501(c)(3) organizations may not exceed 30 percent of your adjusted gross income.
  2. If your publicly traded stock donation exceeds the 30 percent, no problem. Tax law allows you to carry forward the excess until used, for up to five years.

 

Strategy 7

 

If you could sell a publicly traded stock at a loss, do not give that loss-deduction stock to a 501(c)(3) charity. Why? If you sell the stock, you have a tax loss that you can deduct. If you give the stock to a charity, you get no deduction for the loss—in other words, you can just kiss that tax-reducing loss goodbye.

 

Last-Minute Year-End Medical Plan Strategies

 

All small-business owners with one to 49 employees should have a medical plan for their business.

Sure, it’s true that with 49 or fewer employees, the tax law does not require you to have a plan, but you should.

When you have 49 or fewer employees, most medical plan tax rules are straightforward.

Here are six opportunities for you to consider:

  1. Make sure to claim the federal tax credit equal to 100 percent of the required (2020) and the voluntary (2021) emergency sick leave and emergency family leave payments. You likely made payments that qualify for the credits.
  2. If you have a Section 105 plan in place and have not been reimbursing expenses monthly, do a reimbursement now to get your 2022 deductions, and then put yourself on a monthly reimbursement schedule in 2023.
  3. If you want to implement a Qualified Small Employer Health Reimbursement Arrangement (QSEHRA) but you have not yet done so, make sure to get that done correctly now. You are late, so you could suffer that $50-per-employee penalty should your lateness be found out. 
  4. But if you are thinking of the QSEHRA and want to help your employees with more money and flexibility, consider the Individual Coverage Health Reimbursement Arrangement (ICHRA). It’s got more advantages.
  5. If you operate your business as an S corporation and want an above-the-line tax deduction for the cost of your health insurance, you need the S corporation to (a) pay for or reimburse you for the health insurance and (b) put that insurance cost on your W-2. Make sure the reimbursement happens before December 31 and you have the reimbursement set up to show on the W-2.
  6. Claim the tax credit for the group health insurance you give your employees. If you provide your employees with group health insurance, see whether your pay structure and number of employees put you in a position to claim a 50 percent tax credit for some or all of the monies you paid for health insurance in 2022 and possibly in prior years.

 

Last-Minute Year-End Retirement Deductions 

The clock continues to tick. Your retirement is one year closer.

You have time before December 31 to take steps that will help you fund the retirement you desire. Here are four things to consider.

 
  1. Establish Your 2022 Retirement Plan
 

First, a question: do you have your (or your corporation’s) retirement plan in place? 

If not, and if you have some cash you can put into a retirement plan, get busy and put that retirement plan in place so you can obtain a tax deduction for 2022.

For most defined contribution plans, such as 401(k) plans, you (the owner-employee) are both an employee and the employer, whether you operate as a corporation or as a proprietorship. And that’s good because you can make both the employer and the employee contributions, allowing you to put a good chunk of money away.

 
  1. Claim the New, Improved Retirement Plan Start-Up Tax Credit of Up to $15,000
 

By establishing a new qualified retirement plan (such as a profit-sharing plan, 401(k) plan, or defined benefit pension plan), a SIMPLE IRA plan, or a SEP, you can qualify for a non-refundable tax credit that’s the greater of

  • $500 or
  • the lesser of (a) $250 multiplied by the number of your non-highly compensated employees who are eligible to participate in the plan, or (b) $5,000.

The law bases your credit on your “qualified start-up costs.” For the retirement start-up credit, your qualified start-up costs are the ordinary and necessary expenses you pay or incur in connection with

  • the establishment or administration of the plan, or
  • the retirement-related education of employees for such plan.
 
  1. Claim the New Automatic Enrollment $500 Tax Credit for Each of Three Years ($1,500 Total)
 

The SECURE Act added a non-refundable credit of $500 per year for up to three years, beginning with the first taxable year (2020 or later) in which you, as an eligible small employer, include an automatic contribution arrangement in a 401(k) or SIMPLE IRA plan.

The new $500 auto-contribution tax credit is in addition to the start-up credit and can apply to both newly created and existing retirement plans. Further, you don’t have to spend any money to trigger the credit. You just need to add the auto-enrollment feature (which does contain a provision that allows employees to opt out).

 
  1. Convert to a Roth IRA
 

Consider converting your 401(k) or traditional IRA to a Roth IRA.

You first need to answer this question: How much tax will you have to pay to convert your existing plan to a Roth IRA? With this answer, you now know how much cash you need on hand to pay the extra taxes caused by the conversion to a Roth IRA.

Here are four reasons you should consider converting your retirement plan to a Roth IRA:

 
  1. You can withdraw the monies you put into your Roth IRA (the contributions) at any time, both tax-free and penalty-free, because you invested previously taxed money into the Roth account.
  2. You can withdraw the money you converted from the traditional plan to the Roth IRA at any time, tax-free. (But if you make that conversion withdrawal within five years of the conversion, you pay a 10 percent penalty. Each conversion has its own five-year period.)
  3. When you have your money in a Roth IRA, you pay no tax on qualified withdrawals (earnings), which are distributions taken after age 59 1/2, provided you’ve had your Roth IRA open for at least five years.
  4. Unlike with the traditional IRA, you don’t have to receive required minimum distributions from a Roth IRA when you reach age 72—or to put this another way, you can keep your Roth IRA intact and earning money until you die. (After your death, the Roth IRA can continue to earn money, but someone else will be making the investment decisions and enjoying your cash.)
 

Last-Minute Section 199A Tax Reduction Strategies 

 

Remember to consider your Section 199A deduction in your year-end tax planning. If you don’t, you could end up with an undesirable $0 for your deduction amount.

Here are three possible year-end moves that could, in the right circumstances, simultaneously (a) reduce your income taxes and (b) boost your Section 199A deduction.

 

First Things First

 

If your taxable income is above $170,050 (or $340,100 on a joint return), your type of business, wages paid, and property can increase, reduce, or eliminate your Section 199A tax deduction.

If your deduction amount is less than 20 percent of your qualified business income (QBI), then consider using one or more of the strategies described below to increase your Section 199A deduction.

 

Strategy 1: Harvest Capital Losses

 

Capital gains add to your taxable income, which is the income that 

  • determines your eligibility for the Section 199A tax deduction,
  • sets the upper limit (ceiling) on the amount of your Section 199A tax deduction, and
  • establishes when you need wages and/or property to obtain your maximum deductions.

If the capital gains are hurting your Section 199A deduction, you have time before the end of the year to harvest capital losses to offset those harmful gains.

 

Strategy 2: Make Charitable Contributions

 

Since the Section 199A deduction uses your Form 1040 taxable income for its thresholds, you can use itemized deductions to reduce and/or eliminate threshold problems and increase your Section 199A deduction.

Charitable contribution deductions are the easiest way to increase your itemized deductions before the end of the year (assuming you already itemize).

 

Strategy 3: Buy Business Assets

 

Thanks to 100 percent bonus depreciation and Section 179 expensing, you can write off the entire cost of most assets you buy and place in service before December 31, 2022.

Bonus depreciation can help your Section 199A deduction in two ways:

 
  1. The big asset purchase and write-off can reduce your taxable income and increase your Section 199A deduction when it gets your taxable income under the threshold.
  2. The big asset purchase and write-off can contribute to an increased Section 199A deduction if your Section 199A deduction currently uses the calculation that includes the 2.5 percent of unadjusted basis in your business’s qualified property. In this scenario, your asset purchases increase your qualified property, which in turn increases your Section 199A deduction.
 

Last-Minute Year-End Tax Strategies for Marriage, Kids, and Family 

Are you thinking of getting married or divorced? If yes, consider December 31, 2022, in your tax planning. 

Here’s another planning question: do you give money to family or friends (other than your children, who are subject to the kiddie tax)? If so, you need to consider the zero-taxes planning strategy. 

And now consider your children who are under the age of 18. Have you paid them for the work they’ve done for your business? Have you paid them the right way?

 

Here are five strategies to consider as we come to the end of 2022.

 
  1. Put Your Children on Your Payroll
 

If you have a child under the age of 18 and you operate your business as a Schedule C sole proprietor or as a spousal partnership, you need to consider having that child on your payroll. Why? 

  • First, neither you nor your child would pay payroll taxes on the child’s income. 
  • Second, with a traditional IRA for the child, the child can avoid all federal income taxes on up to $18,950 of earned income.

If you operate your business as a corporation, you can still benefit by employing the child even though both your corporation and your child suffer payroll taxes.

 
  1. Are you working through a Divorce situation?
 

The marriage rule works like this: you are considered married for the entire year if you are married on December 31.

Although lawmakers have made many changes to eliminate the differences between married and single taxpayers, the joint return will work to your advantage in most cases.

Warning on alimony! The Tax Cuts and Jobs Act (TCJA) changed the tax treatment of alimony payments under divorce and separate maintenance agreements executed after December 31, 2018:

 
  • Under the old law, the payor deducts alimony payments and the recipient includes the payments in income.
  • Under the new law, which applies to all agreements executed after December 31, 2018, the payor gets no tax deduction and the recipient does not recognize income.
 
  1. Stay Single to Increase Mortgage Deductions
 

Two single people can deduct more mortgage interest than a married couple can. 

If you own a home with someone other than a spouse, and if you bought it on or before December 15, 2017, you individually can deduct mortgage interest on up to $1 million of a qualifying mortgage. 

For example, if you and your unmarried partner live together and own the home together, the mortgage ceiling on deductions for the two of you is $2 million. If you get married, the ceiling drops to $1 million.

If you and your unmarried partner bought your house after December 15, 2017, the reduced $750,000 mortgage limit applies, and your ceiling is $1.5 million.

 
  1. Get Married on or before December 31
 

Remember, if you are married on December 31, you are married for the entire year.

If you are thinking of getting married in 2023, you might want to rethink that plan for the same reasons that apply to divorce (as described above). The IRS could make considerable savings available to you for the 2022 tax year if you get married on or before December 31, 2022.

To know your tax benefits and detriments, you both must run the numbers in your tax returns. If the numbers work out, you may want to take a quick trip to the courthouse.

 
  1. Make Use of the 0 Percent Tax Bracket
 

In the old days, you used this strategy with your college student. Today, this strategy does not work with that student because the kiddie tax now applies to students up to age 24. 

But this strategy is a good one, so ask yourself this question: do I give money to my parents or other loved ones to make their lives more comfortable?

If the answer is yes, is your loved one in the 0 percent capital gains tax bracket? The 0 percent capital gains tax bracket applies to a single person with less than $41,675 in taxable income and to a married couple with less than $83,350 in taxable income.

If the parent or other loved one is in the 0 percent capital gains tax bracket, you can add to your bank account by giving this person appreciated stock rather than cash.

Example. You give Aunt Millie shares of stock with a fair market value of $20,000, for which you paid $2,000. Aunt Millie sells the stock and pays zero capital gains taxes. She now has $20,000 in after-tax cash, which should take care of things for a while.

Had you sold the stock, you would have paid taxes of $4,284 in your tax bracket (23.8 percent x $18,000 gain).

Of course, $4,000 of the $20,000 you gifted goes against your $12.06 million estate tax exemption if you are single. But if you’re married and made the gift together, you each have a $16,000 gift-tax exclusion, for a total of $32,000, and you have no gift-tax concerns other than the requirement to file a gift-tax return that shows you split the gift.

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.

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.

Tax-Saving Tips (Deduction)

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Make Sure You Grab Your Home Internet Deduction

Tax saving tips internet deduction

If you do some work at home, you’re probably using your home internet connection. Are your monthly internet expenses deductible? Maybe.

The deduction rules depend on your choice of business entity (proprietorship, corporation, or partnership).

Deduction on Schedule C

If you operate your business as a sole proprietorship or as a single-member LLC, you file a Schedule C to report your business income and expenses. As a Schedule C taxpayer, you may deduct ordinary and necessary expenses, which include business-related internet subscription fees.

You can deduct your use of your home internet whether or not you claim the home-office deduction, as follows:

  • If you claim the home-office deduction on your Form 1040, the internet expense goes on line 21 (utilities) of IRS Form 8829 as either a direct or an indirect expense.
  • If you do not claim the home-office deduction, enter the business portion of your internet expenses as utilities expenses on line 25 of your Schedule C.

Deduction When You Operate as a Corporation

When you operate your business as a corporation, you are an employee of that corporation. Because of the Tax Cuts and Jobs Act (TCJA), the only way for you to reap the benefits of the home internet deduction (or a home office) is to have your corporation reimburse you for the deduction. In the case of a reimbursed employee expense,

  • the corporation deducts the expense as a utility expense, and
  • you receive the reimbursement as a tax-free reimbursed employee business expense.

Why is the reimbursement method the only way for the corporate owner to get the deduction? The TCJA eliminated the 2018-2025 deduction for miscellaneous itemized expenses. These include unreimbursed employee expenses, such as internet connection fees.

Deduction When You Operate as a Partnership

If you have deductible home internet expenses and/or a home office and operate as a partner in a partnership, you have two ways to get a tax benefit:

  1. Deduct the costs as unreimbursed partner expenses (UPE) on your personal return.
  2. Or get reimbursed tax-free from your partnership via an accountable plan (think “expense report”).

Substantiating Your Home Internet Expense Deduction

Where business owners can run into trouble with the IRS is in substantiating their internet expense deduction. 

You should have no problem showing the total cost for your home internet connection—just total your monthly bills. The problem is in establishing what percentage of the total cost was for business, because only that percentage is deductible. 

Ideally, you should keep track of how much time you use your home internet connection for business and how much time for personal use. A simple log or notation on your business calendar or appointment book—indicating approximately how many hours you were online for business each day while working at home—should be sufficient. 

Google it and you can find software and apps that will track your internet use.

Instead of tracking your home internet use every day throughout the year, you could use a sampling method such as that permitted for tracking business use of vehicles and other listed property. There is no logical reason the IRS shouldn’t accept such a sampling for internet use.

Selling Your Home to Your S Corporation

The strategy behind creating an S corporation and then selling your home to that S corporation comes into play when

  • you want to convert your home to a rental property and take advantage of the exclusions, or
  • you need more time to sell the home to realize the benefits of the $250,000 exclusion ($500,000 if filing a joint return).

With this strategy, one question often comes up: If a married couple sells their home to their S corporation to be a rental property, can the owners be the renters?

Answer: No. In this situation, the tax code treats your S corporation as you, the individual taxpayer, and thus you would be renting from yourself, and that would produce no tax benefits.

In effect, the S corporation renting the residence to the owner of the S corporation is the same as homeowners renting their residence to themselves. It produces no tax benefits.

On the other hand, your S corporation could rent the home for use as a principal residence to your son or daughter or other related party, and the tax code would treat that rental the same as any rental to a third party.

Reverse Mortgage as a Tax Planning Tool

When you think of the reverse mortgage, you may not think of using it as a tax planning tool. 

If you are house rich but cash poor, the reverse mortgage can 

  • give you the cash you desire,
  • save you a boatload of both income and estate taxes, when used in the right circumstances.

With a reverse mortgage, you as the borrower don’t make payments to the lender to pay down the mortgage principal over time. Instead, the reverse happens: the lender makes payments to you, and the mortgage principal gets bigger over time. 

You can receive reverse mortgage proceeds as a lump sum, in installments over a period of months or years, or as line-of-credit withdrawals. After you pass away or permanently move out, you or your heirs sell the property and use the net proceeds to pay off the reverse mortgage balance, including accrued interest. 

So, with a reverse mortgage, you can keep control of your home while converting some of the equity into much-needed cash.

In contrast, if you sell your residence to raise cash, it could involve an unwanted relocation to a new house and trigger a taxable gain way in excess of the federal home sale gain exclusion break—up to $500,000 for joint-filing couples and up to $250,000 for unmarried individuals. 

The combined federal and state income tax hit from selling could easily reach into the hundreds of thousands of dollars. 

For instance, the current maximum federal income tax rate on the taxable portion of a big home sale gain is 23.8 percent—20 percent for the “regular” maximum federal capital gains rate plus another 3.8 percent for the net investment income tax. And that’s just what you have to pay the feds.

With the reverse mortgage, you can avoid paying income taxes on the sale. And perhaps even better yet, you can avoid estate taxes. 

The federal income tax basis of an appreciated capital gain asset owned by a deceased individual, including a personal residence, is stepped up to fair market value as of the date of the owner’s death or (if the estate executor chooses) the alternate valuation date six months later. 

When the value of an asset eligible for this favorable treatment stays about the same between the date of death and the date of sale by your heirs, there will be little or no taxable gain to report to the IRS—because the sale proceeds are fully offset (or nearly so) by the stepped-up basis. Good!

Big Tax Break: Qualified Improvement Property

Do you own or lease non-residential (think “commercial”) real property for your business, or rent non-residential real property to others? 

If so, interior improvements you make to the property may be fully deductible in a single year instead of over multiple years. 

But to be deducted instantly, the improvements must fit into the category that the tax code calls “qualified improvement property” (QIP).

What Is QIP?

Ordinarily, non-residential real property is depreciated over 39 years. And so are improvements to such real property after it is placed in service.

But Congress wants to encourage business owners to improve their properties. So, starting in 2018, the TCJA established a new category of depreciable real property: QIP, which has a much shorter recovery period than regular commercial property—15 years. But even better, for tax years 2021 and 2022, QIP can qualify for that immediate 100 percent bonus depreciation deduction. 

QIP consists of improvements, other than personal property, made by the taxpayer to the interior of non-residential real property after the date the building was first placed in service. For example, QIP includes interior improvements or renovations to any of the following:

  • Office building (or single offices)
  • Restaurant or bar
  • Store
  • Strip mall
  • Motel or hotel
  • Warehouse
  • Factory

Since QIP applies only to non-residential property, improvements to residential rental property such as an apartment building are not QIP. 

Transient Property

Airbnb and similar short-term residential rentals also qualify as non-residential property if they are rented on a transient basis—that is, over half of the rental use is by a series of tenants who occupy the unit for less than 30 days per rental. 

QIP Examples

Examples of interior improvements that can receive QIP treatment include the following:

  • Drywall
  • Ceilings
  • Interior doors
  • Modifications to tenant spaces (if the interior walls are not load-bearing)
  • Fire protection
  • Mechanical
  • Electrical
  • Plumbing
  • Heating and air interior equipment and ductwork
  • Security equipment

QIP does not include improvements related to the enlargement of a building, an elevator or escalator, or the internal structural framework of a building. Structural framework includes “all load-bearing internal walls and any other internal structural supports.”

Placed in Service

QIP consists only of improvements made after the building was placed in service. But for these purposes, “placed in service” means the first time the building is placed in service by any person. By reason of this rule, you can purchase an existing property that was placed in service by an owner anytime in the past, renovate it before you place it in service, and still get QIP treatment.

But you have to make the improvements. You can’t acquire a building and treat improvements made by a previous owner as QIP.

How to Deduct Qualified Improvement Property

You may deduct the cost of QIP in one of three ways:

  • use first-year bonus depreciation,
  • use IRC Section 179 expensing, or
  • depreciate the cost over 15 years using straight-line depreciation.

As mentioned earlier, QIP placed in service in 2021 and 2022 is eligible for 100 percent bonus depreciation. That is, you can deduct the entire cost in one year, without limit. 

Starting in 2023, the tax code reduces bonus depreciation by 20 percent per year until it is completely phased out for property placed in service in 2027.

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

 

Tax Credits for Schedule C Businesses without Employees

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Tax Credits

Obtaining a tax credit is the next best thing to paying no taxes at all. 

The tax code contains over 30 non-refundable tax credits for businesses. These are part of the general business tax credit and are claimed on IRS Form 3800, General Business Tax Credit, and on Schedule 3 of Form 1040. The general business credit is not itself a tax credit, but rather an overall limitation on the total credits that a business can claim each year.

What if you’re a Schedule C business owner who doesn’t have employees and isn’t involved in one of the niche businesses that come with a credit? You’re not necessarily left out of the tax credit bonanza. Here are six tax credits that many Schedule C businesses with no employees can claim (and of course, you can qualify for these credits with employees, too).

  • Credit for Increasing Research Activities

The credit for increasing research activities is intended to encourage businesses to invest in scientific research and experimental activities. 

Any technological research qualifies, so long as it relates to a product’s new or improved function, performance, reliability, or quality. The research must involve the physical or biological sciences, engineering, or computer science. 

You don’t have to have employees to get this credit, because you can claim the credit for 65 percent of the cost of hiring third parties to perform research activities on your behalf, such as outside contractors, engineering firms, or research institutes. 

If you qualify, calculating the credit is worthwhile.

  1. Qualified Plug-In Electric Drive Motor Vehicle Credit

If you purchase a new electric vehicle, you may be able to claim a credit. These include fully electric vehicles (EVs) and plug-in hybrid EVs (PHEVs).

The maximum credit is $7,500, and the minimum is $2,500. But the actual amount depends on the size of the vehicle’s battery. EVs generally get the maximum $7,500, while PHEVs often qualify for less. For example, a Ford Mustang Mach-E qualifies for a $7,500 credit, while a Subaru Crosstrek Hybrid gets only $4,502. 

Unfortunately, the credit phases out the year after a manufacturer reaches 200,000 total EV car sales in the U.S. 

Tesla and General Motors are the only two manufacturers so far to reach the limit, and the credits for their EVs are now completely phased out. So you won’t get a federal credit if you purchase a Tesla or a Chevy Volt. Toyota and Ford will probably be next to cross the 200,000-EV threshold.

When you claim the credit for a business vehicle, you reduce the vehicle’s depreciable basis by the credit amount. You then depreciate the remaining adjusted basis as you would for any other business vehicle.

  1. Disabled Access Tax Credit

The Americans with Disabilities Act (ADA) prohibits private employers with 15 or more employees from discriminating against people with disabilities in the full and equal enjoyment of goods, services, and facilities offered by any “place of public accommodation”—this includes businesses open to the public.

The disabled access tax credit is designed to help small businesses defray the costs of complying with the ADA. But you don’t have to have employees to claim the credit. The credit may be claimed by any business with either

  • $1 million or less in gross receipts for the preceding tax year, or
  • 30 or fewer full-time employees during the preceding tax year.

The amount of the tax credit is equal to 50 percent of your disabled access expenses that exceed $250 in a year but are not more than $10,250. Thus, the maximum credit is $5,000.

  1. Business Energy Tax Credit

There is a business energy credit based on the cost of qualified energy property used in a trade or business or for the production of income, such as a residential rental building. The credit ranges from 10 percent to 30 percent of the cost of such property. 

The credit can be claimed for various types of renewable energy installations, including thermal and geothermal energy, wind turbines, and fuel cells. 

But small businesses most often claim the credit for the cost of installing solar panels and related equipment to generate electricity to provide illumination, heating, or cooling (or hot water) in a business structure, or to provide solar process heat. 

Unlike the solar credit for homeowners, there is no dollar limit on this business credit. The credit is 26 percent of the cost of solar property whose construction begins in 2020, 2021, or 2022. 

The tax code reduces the credit percentage to 22 percent if construction begins during 2023. 

  1. Rehabilitation Tax Credit

The rehabilitation tax credit helps defray part of the cost of rehabilitating historic old buildings. The credit is available only if you rehab a certified historic building or a building located in a registered historic district. The credit can be claimed for commercial, industrial, agricultural, and residential rental historic buildings.

The secretary of the interior must certify to the secretary of the treasury that the project meets their standards and is a “Certified Rehabilitation.” If your building is not already registered as historic but you think it should be, you can nominate it for historic status by contacting your state historic preservation office. 

  1. New Energy-Efficient Home Credit

If you’re a building contractor who builds homes, there is a tax credit just for you. You can get a credit of up to $2,000 for building an energy-efficient home. 

The credit is available for all new homes, including manufactured homes, built between January 1, 2018, and December 31, 2021. To meet the energy savings requirements, a home must be certified to provide heating and cooling energy savings of 30 percent to 50 percent compared with a federal standard. 

A reduced credit of $1,000 is available for manufactured homes with a heating or cooling consumption at least 30 percent less than a comparable house and with the Energy Star label.

Are More Credits on the Way?

In the news, you have been reading and hearing about the Build Back Better bill that passed the House and is being considered by the Senate. There are lots of tax credits in the bill. But there are three things to know as of December 1, 2021.

  1. The Senate will likely create and try to pass its own version of this bill.
  2. If the Senate passes the bill in a different form, the bill will go to a conference with both House and Senate members, who will make more changes.
  3. Regardless of what happens, we don’t see any changes in the current bill or expect any changes that will affect the information in this newsletter. The changes, if any do become law, will apply to 2022 and later.

Tax Credits for Schedule C Business Owners with Employees

If you hire an employee for your Schedule C business, you can qualify for several valuable tax credits. 

Each credit is different, and certain limitations apply to all or most employer tax credits.

Remember, like we said above, tax credits are the best. They beat deductions. Note the difference below (using the 32 percent bracket): 

  • A $1,000 deduction for wages reduces your income taxes by $320. 
  • A $1,000 credit reduces your taxes by $680 ($1,000 - $320).

Many tax credits are not available if you hire a person related to you, including children, stepchildren, a spouse, parents, siblings, step-siblings, nephews, nieces, uncles, aunts, cousins, or in-laws.

Eight Valuable Tax Credits for Business Owners

Below are listed the eight non-refundable tax credits that Schedule C business owners can claim when they hire employees. 

  1. Work Opportunity Tax Credit (WOTC)

The WOTC rewards employers for hiring employees from groups the IRS has identified as having “consistently faced significant barriers to employment.” 

  1. Family and Medical Leave Credit

Federal law doesn’t require that you give paid leave to your employees who need to take time off for family reasons (such as the birth of a child) or due to their illness or that of a family member. (A few states require some paid leave that’s funded through payroll deductions.) 

But if you choose to provide such paid leave, the federal tax code may reward you with a family and medical leave tax credit. 

  1. Credit for Small Employer Health Insurance Premiums

If you have fewer than 50 full-time-equivalent employees, you are not required to provide your employees with health insurance. But if you elect to do so, you may qualify for the small business health care tax credit. This tax credit is available to eligible employers for two consecutive tax years.

  1. Credit for Small Employer Pension Plan Start-Up Costs

This credit is for the cost of setting up an employee pension plan, including a new 401(k) plan, 403(b) plan, defined benefit plan (a traditional employee pension plan), profit-sharing plan, SIMPLE IRA or SIMPLE 401(k), or SEP-IRA. 

The costs covered by the credit include the expenses to establish and administer the plan and to educate employees about retirement planning.

  1. Credit for Employer-Provided Childcare Facilities and Services

This little-used credit is intended to encourage employers to provide childcare to their employees. There are two ways to get the credit:

  1. Build, acquire, rehabilitate, or expand an on-site childcare facility for your employees’ children, and help pay to operate it.
  2. Contract with a licensed childcare program, including a home-based provider, to provide childcare for your employees.

The second option is more realistic for smaller businesses. Businesses often partner with childcare companies such as the Learning Care Group, Bright Horizons, and KinderCare to offer this benefit.

  1. Empowerment Zone Employment Credit

Is your business located in one of the designated empowerment zones? 

These are areas of high poverty and unemployment identified by the U.S. Department of Housing and Urban Development or the secretary of agriculture. 

You might be surprised about which places the government designates as having high poverty and unemployment. It’s worth checking out.

You can claim a credit equal to 20 percent of the first $15,000 in wages you pay to full- or part-time employees who both live and work in an empowerment zone. Thus, the maximum credit is $3,000 per employee (20 percent x $15,000). The employees must work for you for at least 90 days.

  1. Credit for Employer Differential Wage Payments to Military Personnel

This credit is available if you have an employee in the military reserves who is called to active duty for more than 30 days. If you continue to pay the employee all or part of that employee’s wages while he or she is on active duty, you can claim a credit equal to 20 percent of the payments, up to $20,000.

  1. Indian Employment Credit

This credit is available only if you hire an enrolled member of an American Indian tribe who both lives and works on an Indian reservation. If this is the case, you may claim a tax credit equal to 20 percent of the wages and health insurance benefits you provide the employee. The Indian employment credit ends December 31, 2021.

When Is a Partner in a Partnership a 1099 Worker?

When the individual production activity of a partner is outside his or her capacity as a member of the partnership, the partnership has two choices:

  1. Allocate the production income to the partner, and have the partner treat the expenses as unreimbursed partner expenses (UPE).
  2. Treat the partner as a 1099 independent contractor for the individual production.

Unreimbursed Partner Expenses

As a partner in a partnership, you generally can’t deduct any of the partnership expenses on your individual tax return—the partnership should pay for and deduct its own business expenses.

But if your partnership agreement or business policy forces you as an individual partner to pay for expenses out of pocket, with no reimbursement available, then you can deduct the business expenses in full on your individual tax return as UPE.

Because the UPE is a trade or business expense, it also reduces your self-employment tax. 

Treatment as a 1099 Independent Contractor

The tax code is clear on how this works. IRC Section 707(a)(1) states:

If a partner engages in a transaction with a partnership other than in his capacity as a member of such partnership, the transaction shall, except as otherwise provided in this section, be considered as occurring between the partnership and one who is not a partner.

Thus, under this treatment, you would treat that activity as independent contractor activity and report the income to the partner on IRS Form 1099-NEC, Nonemployee Compensation.

The partnership agreement should clearly define how it will treat a partner’s individual production.

Make Extra “Catch-Up” Contributions to Retirement Accounts

After reaching age 50, you can make additional “catch-up” contributions to certain types of tax-advantaged retirement accounts. For the 2021 tax year, this opportunity is available if you’ll be age 50 or older on Friday, December 31, 2021.

Specifically, with an employer-sponsored 401(k), 403(b), 457, or SIMPLE plan, you can make extra salary-reduction catch-up contributions to your account—assuming the plan allows catch-up contributions. 

If you are self-employed and have set up a 401(k) plan or SIMPLE IRA for yourself, you can also make extra catch-up contributions to your account.  

Finally, you can make extra catch-up contributions to a traditional or Roth IRA. 

These catch-up contributions can carry a hefty punch because they are above and beyond the “regular” annual contribution limits that otherwise apply. 

The following table shows maximum allowable catch-up contributions for the 2021 tax year:

Tax Credits table

If you’re married and both you and your spouse are age 50 or older, the amounts shown above can potentially be doubled, assuming both spouses have accounts set up in their respective names. 

But with an employer-sponsored plan, maximum salary-reduction catch-up contributions to your account might be less than the indicated amounts—depending on employee participation levels and the terms of the plan. 

The Question: How Much Are Catch-Up Contributions Worth?

This is where it gets interesting. While some folks eagerly embrace any chance to contribute more money to tax-advantaged retirement accounts, others might need some encouragement. Those in the latter category may dismiss catch-up contributions as inconsequential unless proven otherwise. Fair enough. So let’s prove otherwise.

Proof: Make 401(k), 403(b), or 457 Plan Catch-Up Contributions 

Assume you turn 50 during 2021 and contribute an extra $6,500 to your account for this year, and then you do the same for the subsequent 15 years (for a total of 16 years), up to age 65. Here’s how much extra you could accumulate by that age in your 401(k), 403(b), or 457 account (rounded to the nearest $1,000), assuming the annual rates of return indicated below:

Tax Credits table

These are substantial amounts. Of course, we are talking before-tax numbers here.  

Proof: Make SIMPLE Plan Catch-Up Contributions 

Say you turn 50 during 2021 and contribute an extra $3,000 for this year, and then you do the same for the subsequent 15 years (for a total of 16 years), up to age 65. Here’s how much extra you could accumulate by that age in your SIMPLE plan account (rounded to the nearest $1,000), assuming the annual rates of return indicated below:

table

Not bad! Once again, remember that these are before-tax numbers.  

Proof: Make IRA Catch-Up Contributions 

Say you turn 50 during 2021 and contribute an extra $1,000 for this year, and then you do the same for the subsequent 15 years (for a total of 16 years), up to age 65. Here’s how much extra you could accumulate by that age in your IRA (rounded off to the nearest $1,000), assuming the annual rates of return indicated below:

table

These are before-tax numbers for traditional IRAs but after-tax numbers for Roth IRAs.

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

 

529 withdrawals and more tax-saving tips

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Taxation of 529 College Savings Account Withdrawals

529 withdrawals

The big advantage of 529 plans is that qualified withdrawals are always federal-income-tax-free—and usually state-income-tax-free too.

What you may not know is that not all 529 withdrawals are tax-free qualified withdrawals, even in years when you have heavy college costs.

Here are six important points to know about 529 withdrawals.

Point No. 1: You Usually Have Several Payment Options

Say you are the 529 account owner or plan participant. Plans commonly use both terms to describe the person who established and controls the account. This letter will use account owner.

As the account owner, you can generally have a withdrawal check cut in your own name or have an electronic deposit made into your own account.

Alternatively, you can have a withdrawal issued in the name of the account beneficiary (the college student for whom you set up the 529 account, usually a child or grandchild) or issued directly to the educational institution for the benefit of the account beneficiary.

You choose your payment option by submitting a withdrawal request to the 529 plan.

Point No. 2: Watch Out for Withdrawals from 529 Accounts Funded with Custodial Account Money

Say you funded the 529 account with money that came from a custodial account that was set up for the account beneficiary—your child or grandchild—under your state’s Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA).

In this situation, you must use any money taken from the custodial account for the benefit of the child or grandchild.

You can’t take a 529 account withdrawal for yourself if the 529 account was funded with money from a child’s or grandchild’s custodial account. Because the money in the 529 account came from the custodial account, the 529 account money legally belongs to your child or grandchild, not you.

On the other hand, if you funded the 529 account with your own money, the money in the account is fair game. You can take withdrawals and do whatever you want with them—subject to the potential federal income tax implications explained later.

Point No. 3: The IRS Knows about Withdrawals

For any year that a 529 withdrawal is taken, the plan must issue a Form 1099-Q, Payments From Qualified Education Programs (Under Sections 529 and 530), by February 1 of the following year.

If the withdrawal goes to the 529 account beneficiary (your child or grandchild), the 1099-Q goes to him or her. If the withdrawal goes to you as the account owner, the 1099-Q goes to you.

Either way, the IRS gets a copy, so the IRS knows what happened.

Point No. 4: Withdrawals May Be Taxable Even in Years When Substantial College Costs Are Incurred

When the Form 1099-Q shows withdrawn earnings, the IRS becomes interested in the 1099-Q recipient’s Form 1040 because some or all of the earnings might be taxable. Here’s the deal on that.

Withdrawn earnings are always federal-income-tax-free and penalty-free when total withdrawals for the year do not exceed what the IRS calls the account beneficiary’s adjusted qualified education expenses, or AQEE, for the year.

AQEE equals the sum of the 529 account beneficiary’s

  • college tuition and related fees;
  • room and board (but only if the beneficiary carries at least half of a full-time course load);
  • required books, supplies, and equipment;
  • computer hardware and peripherals, software, and internet access costs; and
  • expenses for special needs services.

Next, you must subtract any federal-income-tax-free educational assistance to calculate the account beneficiary’s AQEE.

According to the IRS, tax-free educational assistance includes costs covered by

  • tax-free Pell grants;
  • tax-free scholarships, fellowships, and tuition discounts;
  • tax-free veterans’ educational assistance;
  • an employer’s tax-free educational assistance program under Internal Revenue Code Section 127; and
  • any other tax-free educational assistance (other than assistance received in the form of a gift or an inheritance).

In addition, tax-free educational assistance includes any costs used to claim the American Opportunity tax credit or the Lifetime Learning tax credit.

Key point. You can also include in AQEE

  • up to $10,000 annually for the account beneficiary’s K-12 tuition costs;
  • the account beneficiary’s fees, books, supplies, and equipment required to participate in a registered apprenticeship program; and
  • interest and principal payments on qualified student loan debt owed by the account beneficiary or a sibling of the account beneficiary—subject to a $10,000 lifetime limit.

Bottom line. When withdrawals during the year exceed AQEE for the year, all or part of the withdrawn earnings will be taxable. When withdrawals don’t exceed AQEE, all the withdrawn earnings are federal-income-tax-free.

Point No. 5: When You Keep a Withdrawal, There Are Tax Consequences

Assuming the 529 account was funded with your own money (as opposed to money from a custodial account), you are free to change the 529 account beneficiary to yourself and then take federal-income-tax-free withdrawals to cover your own AQEE if you decide to go back to school.

But if you take a withdrawal that you use for purposes other than education, report the taxable portion of any related account earnings as miscellaneous income on your Form 1040. Taxable amounts may also get hit with a 10 percent penalty tax to boot (see below).

Finally, if you liquidate a loser 529 account (worth less than the total amount of contributions), there are no federal income tax consequences. (The government stopped participating in your losses for tax years 2018-2025.)

Point No. 6: Withdrawals Not Used for Education Can Also Be Hit with a 10 Percent Penalty Tax

As explained earlier, some or all of the earnings included in a 529 withdrawal taken during the year must be included in gross income when the withdrawn earnings exceed the account beneficiary’s AQEE for the year. But there’s more.

According to the general rule, the taxable amount of earnings is also hit with a 10 percent penalty tax.

But the 10 percent penalty tax doesn’t apply to earnings that are taxable only because the account beneficiary’s AQEE was reduced by

  • tax-free Pell grants;
  • tax-free scholarships, fellowships, and tuition discounts;
  • tax-free veterans’ educational assistance;
  • tax-free employer-provided educational assistance;
  • any other tax-free educational assistance; or
  • costs used to claim the American Opportunity or Lifetime Learning tax credit.

In addition, the 10 percent penalty tax doesn’t apply to earnings withdrawn when the account beneficiary attends one of the U.S. military academies (such as West Point, Annapolis, or the Air Force Academy).

Finally, the 10 percent penalty tax doesn’t apply to earnings withdrawn after the account beneficiary dies or becomes disabled.

Tax-Home Rules You Should Know

When you travel out of town overnight, you need to know the tax-home rule. The IRS defines your tax home, and it’s not necessarily in the same town where you have your personal residence.

If you have more than one business location, one of the locations will be your tax home. It’s generally your main place of business.

In determining your main place of business, the IRS takes into account three factors:

  1. the length of time you spend at each location for business purposes;
  2. the degree of business activity in each area; and
  3. the relative financial return from each area.

Here’s a recent court case that illustrates this rule.

Akeem Soboyede, an immigration attorney, was licensed to practice law in both Minnesota and Washington, D.C., and he maintained solo law practices in both Minneapolis and Washington, D.C.

Although Mr. Soboyede’s primary personal residence was in Minneapolis, he divided his time between his office in Minneapolis and his office in Washington, D.C.

Get ready for a chuckle: in court, Mr. Soboyede admitted in his testimony that he did not keep the necessary documentation because he “did not know . . . [he] was going to get audited.”

Due to the lack of records, the IRS disallowed most of the deductions. The remaining issue for the court was the travel expenses for lodging, for which Mr. Soboyede had the records.

The court noted that Mr. Soboyede’s lodging expenses were only deductible if he was “away from home” as required by Section 162(a)(2).

In deciding whether Mr. Soboyede’s tax home was in Minneapolis or Washington, D.C., the court used the following two factors:

  • Where did he spend more of his time?
  • Where did he derive a greater proportion of his income?

Answer: Washington, D.C. Think about this: He had his home in Minneapolis, but the court ruled that his “tax home” was in Washington, D.C. As a result, he lost his travel deductions.

Principal Residence Gain Exclusion Break

Here’s a look at how to apply the $250,000 ($500,000, if married) principal residence tax break when getting married or divorced, or when converting another property into your home.

In both marriage and divorce situations, a home sale often occurs. Of course, the principal residence gain exclusion break can come in very handy when an appreciated home is put on the block.

Sale during Marriage

Say a couple gets married. They each own separate residences from their single days. After the marriage, the pair files jointly. In this scenario, it is possible for each spouse to individually pass the ownership and use tests for their respective residences. Each spouse can then take advantage of a separate $250,000 exclusion.

Sale before Divorce

Say a soon-to-be-divorced couple sells their principal residence. Assume they still are legally married as of the end of the year of sale because their divorce is not yet final. In this scenario, the divorcing couple can shelter up to $500,000 of home sale profit in two different ways:

  1. Joint return. The couple could file a joint Form 1040 for the year of sale. Assuming they meet the timing requirements, they can claim the $500,000 joint-filer exclusion.
  2. Separate returns. Alternatively, the couple could file separate returns for the year of sale, using married-filing-separately status. Assuming the home is owned jointly or as community property, each spouse can then exclude up to $250,000 of his or her share of the gain.

To qualify for two separate $250,000 exclusions, each spouse must have

  • owned his or her part of the property for at least two years during the five-year period ending on the sale date, and
  • used the home as his or her principal residence for at least two years during that five-year period.

Sale in Year of Divorce or Later

When a couple is divorced as of the end of the year in which their principal residence is sold, they are considered divorced for that entire year. Therefore, they will be unable to file jointly for the year of sale. The same is true, of course, when the sale occurs after the year of divorce.

Key point. Under the preceding rules, both ex-spouses will typically qualify for separate $250,000 gain exclusions when the home is sold soon after the divorce. But when the property remains unsold for some time, the ex-spouse who no longer resides there will eventually fail the two-out-of-five-years use test and become ineligible for the gain exclusion privilege.

Let’s see how we can avoid that unpleasant outcome.

When the Non-Resident Ex Continues to Own the Home for Years after Divorce

Sometimes ex-spouses will continue to co-own the former marital abode for a lengthy period after the divorce. Of course, only one ex-spouse will continue to live in the home. After three years of being out of the house, the non-resident ex will fail the two-out-of-five-years use test. That means when the home is finally sold, the non-resident ex’s share of the gain will be fully taxable.

But with some advance planning, you can prevent this undesirable outcome.

If you will be the non-resident ex, your divorce papers should stipulate that as a condition of the divorce agreement,

  • your ex-spouse is allowed to continue to occupy the home for as long as he or she wants, or
  • until the kids reach a certain age, or
  • for a specified number of years, or
  • for whatever time period you and your soon-to-be ex can agree on.

At that point, either the home can be put up for sale, with the proceeds split per the divorce agreement, or one ex can buy out the other’s share for current fair market value.

This arrangement allows you, as the non-resident ex, to receive “credit” for your ex’s continued use of the property as a principal residence. So, when the home is finally sold, you should pass the two-out-of-five-years use test and thereby qualify for the $250,000 gain exclusion privilege.

The same strategy works when you wind up with complete ownership of the home after the divorce, but your ex continues to live there. Stipulating as a condition of the divorce that your ex is allowed to continue to live in the home ensures that you, as the non-resident ex, will qualify for the $250,000 gain exclusion when the home is eventually sold.

Little-Known Non-Excludable Gain Rule Can Mean Unexpectedly Higher Taxes on a Property Converted into Your Principal Residence

Once upon a time, you could convert a rental property or vacation home into your principal residence, occupy it for at least two years, sell it, and take full advantage of the home sale gain exclusion privilege of $250,000 for unmarried individuals or $500,000 for married, joint-filing couples. Those were the good old days!

Unfortunately, legislation enacted back in 2008 included an unfavorable provision for personal residence sales that occur after that year. The provision can make a portion of your gain from selling an affected residence ineligible for the gain exclusion privilege.

Let’s call the amount of gain that is made ineligible the non-excludable gain. The non-excludable gain amount is calculated as follows.

Step 1. Take the total gain, and subtract any gain from depreciation deductions claimed against the property for periods after May 6, 1997. Include the gain from depreciation (so-called unrecaptured Section 1250 gain) in your taxable income. Carry the remaining gain to Step 3.

Step 2. Calculate the non-excludable gain fraction.

The numerator of the fraction is the amount of time after 2008 during which the property is not used as your principal residence. These times are called periods of non-qualified use.

But periods of non-qualified use don’t include temporary absences that aggregate two years or less due to changes of employment, health conditions, or other circumstances specified in IRS guidance.

Periods of non-qualified use also don’t include times when the property is not used as your principal residence, if those times are

  • after the last day of use as your principal residence, and
  • within the five-year period ending on the sale date.

The denominator of the fraction is your total ownership period for the property.

Step 3. Calculate the non-excludable gain by multiplying the gain from Step 1 by the non-excludable gain fraction from Step 2.

Step 4. Report on Schedule D of Form 1040 the non-excludable gain calculated in Step 3. Also report any Step 1 unrecaptured Section 1250 gain from depreciation for periods after May 6, 1997. The remaining gain is eligible for the gain exclusion privilege, assuming you meet the timing requirements.

The Basics of Depreciation

Are you thinking about buying personal property (such as a car, a computer, or other equipment) or real property (such as a building)? If you use the property for personal purposes, it’s not deductible.

But if you use it in a business, you can deduct the full cost using regular depreciation, bonus depreciation, or IRC Section 179 expensing.

Regular depreciation takes three to 39 years depending on the property involved, while bonus depreciation allows you to deduct 100 percent of the cost of personal property in one year through 2022. Up to $1,050,000 of personal property may also be deducted in one year under IRC Section 179.

But depreciation won’t begin if you purchase property with the intent of beginning a new business. You must actually be in business to claim depreciation. This doesn’t require that you make sales or earn profits—only that your business is a going concern.

Also, depreciation doesn’t begin the moment you purchase property for your business. It begins only when you place property in service in your business. You don’t have to use the property to place it in service, but the property must be available for use in your active business. This could occur after you purchase the property.

Finally, if you use regular depreciation, you must apply rules called conventions to determine the month in which your depreciation deduction begins. The earlier in the year, the larger your deduction for the first year.

The default rule is that regular depreciation for personal property begins July 1 the first year (mid-year convention). But if you purchase 40 percent or more of your total personal property for the year during the fourth quarter, your depreciation begins at the midpoint of the quarter in which it is placed in service (mid-quarter convention).

First-year depreciation for real property begins at the middle of the month during which the property is placed in service (mid-month convention).

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