Category: Income Taxes

The Traveling Salesman

~ C.O.R.E. Beliefs ~ Leave a comment

I love telling stories about the good, and not-so-good, things clients have done over the years.  Actually, to be honest, I like the not-so-good stories as they are educational and hopefully stop others from going down a path they might regret.

Part of my role is technical compliance and final reviewer of tax work.  My responsibility is to make sure that any significant tax position taken was backed up by adequate documentation and research.  I couldn’t stop clients from taking risky positions, but I could stop the firm from agreeing to dumb things that we couldn’t defend.

One tax return comes to mind.  It was a new client and I was having trouble getting my head around his small business.  It was on Schedule C and reported a loss of about $100,000.  He had a W2 for about $150,000 so was getting about 30K back in refunds.

What stood out most were two items.  Negative gross profit of $60,000 and an RV on the books which generated about $25,000 of depreciation.

Negative gross profit, by the way, comes from when you sell your product for less than the total cost of those products.  In this case, he had revenues of $12,000 and Cost of Goods sold of $72,000.

I wouldn’t sign off and the partner wanted to know what my concerns were.  I asked him if he talked to the client about his “business” and the answer was, “Not really.”

So, I was indulged and the client came in for a meeting.  I asked him to explain how his business worked.  He bought product, he told us and traveled up and down I-5 stopping at county fairs to sell his product.

Interesting.  We didn’t notice any fees for space rental at any events, though.

That’s because he parked his RV in the lot and sold on the outside.  Ok.

How many customers did the $12,000 represent?  We inquired.

One, he replied.  One client.  So what was the $4,000 of meals and entertainment?

He took this client out to dinner and to various ball games and other events because of their loyalty.

Who is this client? we asked dreading the answer.

His wife.

Yeah.  He and his wife took the summer off to travel and he bought stuff and he “sold” it to her.  Because she was such a loyal customer, he gave her a substantial discount on buying the stuff she “wanted”.  And he rewarded her loyalty with dinners and events.

Now, I know you are thinking BS, I am making this up.  I swear I am not.  Public accountants get some of the most entertaining and too-good-to-be-true stories out there.

Our main problem was that his prior accountant let him get away with it.  We suggested that he face the fact that on audit, the IRS would probably say this was a hobby (we didn’t bother to let him know it was probably outright tax fraud) and to protect the prior losses, he should shut down his business and maybe consider starting it up in 2 or more years after a cooling-down period.

He said no thank you but appreciated our advice.  He paid us for the work we did, took his “records” and went to find another tax preparer who wouldn’t be so nosey.

The moral of the story?  You may have heard the old saying that “Pigs get fat and hogs get slaughtered”.  Sometimes, it doesn’t pay to push the boundaries of acceptability.  He may never have been audited – hell he might have even been turned down by the next dozen tax preparers and decided he wasn’t going to win and dropped it – but it was still an extremely risky position to take and there was no real defense.

There are ways to make a business work while you travel.  But the odds are, the bigger the loss, the greater the risk, so documentation is vital to winning.  So, as you prepare for the end of the year and are looking to work with someone who wants to help you be successful, consider an accountant with integrity and who is willing to help you get everything right to protect you from major risks.  If you need the name of one, feel free to write me and I will send back the contact information for one or two to help you.

Have a great Tuesday.

 

The tangled web of pass-throughs

~ C.O.R.E. Beliefs ~ Leave a comment

No doubt like many a tax-nerd, I spent part of the weekend trying to understand the senate and house tax bills and their impact on clients.  Obviously, it is a waste of time as there is no guarantee that either will become law as the tax acts are going to conference but, it is educational none-the-less.

I wrote the other day about how it works for individuals but now, what about someone who owns rental properties or other pass-through business?

Nothing I have read so far indicates that they are doing much in the way of changing the Passive Activity Loss (PAL) rules, so your investment in a rental property while probably still follow current law which means that you will likely not be able to take rental losses if you make more than $125K.  On the other hand, if your rental is a Passive Income Generator (PIG), you could see some tax savings… maybe.

What you should realize is that the very generous immediate write-off for business purchases does not include buildings.  You will still need to capitalize the purchase of rental property.  And it appears that the tax life will likely remain as it is today – 27.5 for residential and 39 for commercial.

If your rental is a PIG and throws off $10,000 of income, your tax liability would be no more $2,500 under the House’s version as this one taxes pass-through income at 25% maximum.  Obviously, if your total income puts you in a lower tax bracket, you would be taxed at that rate.  The senate version, on the other hand, provides a deduction of 23% of taxable income.  But as will all things tax-related, it isn’t quite that simple.  It limits the deduction to 50% of wages paid.

Since this is a rental property, you will likely not have employees.  Therefore 50% of zero is, of course, zero.  Since this is zero, you would pay tax at your regular tax rate.  Again, if you are in a lower tax bracket, it doesn’t really matter but, if you make more than $200,000, then you are in the 32% bracket and there really isn’t any savings.

The senate version is aimed at S Corporations and attempts to exert pressure on shareholder/employees to take “reasonable compensation”.  But take the following fact patterns.  Z Company has $1.0 Million of profits before taking into consideration officer wages.  Z Company employs 50 employees and has $2.0 Million in payroll.

50% of $2.0Million is $1.0 Million.  23% of $1.0 Million is $230,000.  Without the owner/officer taking payroll, they will get the full 23% deduction.  It doesn’t matter that the owner did not take wages.  For what it is worth, W2 wages could be as low as $560,000 in this example, with or without officer compensation, before the shareholder starts to lose the deduction.

Another problem is that both versions limit the types of businesses that can qualify.  Professional services businesses will not get to take advantage of the lower rates since it is assumed that professionals do not employ others.  So, take a doctors office: the doctor has a front desk person, an office manager, four nurses and the doctor.  Six employees.  Compared to a small contractor with a bookkeeper, a foreman and 4 laborers.  Also six employees.  If they both make the $1.0Million of profit and pay $600,000 in wages, the contractor gets the deduction of $230,000 and the doctor doesn’t.  This is true even if the contractor works more hours than the doctor.

It will be interesting to see how the pass-through entity issue plays out in conference.

Have a great day.

 

First run at the new tax law

~ C.O.R.E. Beliefs ~ Leave a comment

Just for fun, I created a quick spreadsheet to calculate individual taxes based on the new tax law – at least the parts that make sense this morning.  I will be adding to it as I go along.  The calculations are based upon the Senate version.

It is simpler, I will give congress that.  I put the spreadsheet together in about 30 minutes from scratch.  Here is something to think about though, $12,000 is a lot of property tax and mortgage interest.  And $24,000 is a heck of a hurdle for a married couple.

If your current mortgage value is under $200,000 and your property tax is less than $3,500 you will probably not get above $12,000 for the standard deduction if you are single.  If you are married you will need a mortgage above $450,000 to get close to the $24,000 limit.

A single person making $50,000 will have a 2018 tax liability of $4,370 under the Senate plan.  A single person making this amount will likely not have a mortgage above $200,000, and will therefore take the standard deduction of $12,000.

A married couple making $72,000 combined and with one child under 16 will owe taxes of $5,379, before the child tax credit.  If the tax credit is $2,000, their net tax is $3,379.

Since it is unlikely that this couple would have a mortgage above $450,000, they would also take the standard deduction.

A married couple with no children who makes $150,000 with a $450,000 mortgage will likely itemize as their property tax and interest will be above $24,000.  Their tax would be $17,430.  If they didn’t have a mortgage, their tax would be about $17,700.

The single person making $50,000 has an effective tax rate of 11.5%

The married couple making $150,000 with a mortgage has an effective tax rate of 14%

The married couple making $150,000 without a mortgage has an effective tax rate of 14.4%

A married couple making $150,000 with a mortgage and 2 children has an effective tax rate of 10.8%

Obviously, it is what is missing that matters.  Many of our clients have employment related expenses that will no longer be allowed as a miscellaneous itemized deduction.  And, from what I have read, medical expenses will no longer be taken into consideration.  We have several families with an aged parent in a care facility because they cannot be left alone.  This is $80,000 that is no longer a deduction and those gains, interest and dividends, pensions and social security will end up with a tax hit of about $10,000 or an effective tax rate of 14.6%.

I will spend some time looking at the corporate side the rest of the day and tomorrow and have some thoughts on that by the end of the weekend.

Enjoy your Saturday.

 

 

 

 

Living Trusts and QSSTs

~ C.O.R.E. Beliefs ~ Leave a comment

One of the tax projects that we are working on involves a couple where the husband passed away in 2012 who owned a successful small business.  As we go through the process of trying to make sure all the appropriate steps were taken, my research leads me to potential issues related to S Corporations, Living Trusts and QSST elections.  This is a simple thought experiment but the overall issue is likely to be a potential problem as baby boomer’s age and we find their estates have ownership of S Corporation stock.

Husband (H) was the owner of all the shares and owned the shares prior to his marriage to wife (W).  The S Corporations shares were titled to the living trust of Husband.  The shares, per the will, specified that half of the shares were to go to a marital trust and the other half directly to W.  The marital trust stated that W could not sell the shares and they would all go directly to their 4 children at the time of her death.

Husband passed away in 2012.  The problem beings when the 2012 return reports the S Corporation shares on the joint return which reported H as deceased and W as surviving spouse.  The Company’s tax preparer changes the name and tax id number to W’s on the 1120-s K-1 in accordance to W’s statements and their understanding of the living trust document.  All shares are now in W’s name and reported on her 1040 return as the preparer knew about the living trust arrangement.

This creates lots of problems.  The will stated how the assets were to be divided and from the look of it, it wasn’t handled correctly.  Possibly, the shares transferred directly to W through the living trust would be valid, but what about the shares that were supposed to be transferred to the marital trust?  If the shares are owned by the marital trust, was a Qualified Subchapter S Trust (QSST) election filed with the IRS?  Can the marital trust even qualify as a QSST because of the successor beneficiaries listed in the will?

If the QSST is considered invalid or isn’t made, then the S election is terminated.  Without a valid S election, the income is no longer passed to the shareholders.  Income is first taxed at the corporate level and then the dividends – the S Corporation distributions – are taxed to the shareholder at time of receipt.

The tax consequences can be significant.  Let’s say that the Company made $1.0 Million in taxable income as an S Corporation.  It distributes all $1.0 Million to the shareholders.  The shareholders, W in this case, would pay about $390,000 in tax.  Without a valid S election, the Corporation ends up being taxed on that $1.0 Million, which costs about $350,000 and then W is taxed on the $1.0 Million in dividends, which costs her personally about $200,000.

$550,000 in taxes compared to $390,000.  And worse, the Company owed the tax but it may have distributed all its available cash, leaving W to wonder how she is going to pay the tax bill.  And if she used the remaining $610,000 to pay her living expenses, she can’t even loan the money back to the Company to pay its tax bill.

And remember, this is for the last 5 years, so almost $800,000 in additional taxes could be owed.

If you own S Corporation stock and have it titled to your living trust, you may want to talk with your estate planning attorney or CPA to make sure instructions are available to make sure something like this doesn’t happen.  Make sure your will aligns with your living trust and takes into consideration the fact that some assets have special rules about transfers to trusts.  And if you need the name of a practicing attorney or accountant who specializes in trusts and estates in Oregon or Washington, let me know and I will send you a few contacts you can discuss your concerns with.  Proper planning will make sure your wishes are carried out well and your beneficiaries receive what you planned for them.

Have a great weekend.