Category: Tax Services

Posted on Jul 28, 2017

There’s a fine line between businesses and hobbies under the federal tax code. If you engage in an unincorporated sideline — such as a marketing director by day and an artist on the nights and weekends — you may think of that side activity as a business and hope to deduct any losses on your personal tax return. But the IRS may disagree and reclassify the money-losing activity as a hobby.

Lights, Camera, Action: Film Festivals Classified as a Hobby

The U.S. Tax Court recently concluded that a taxpayer who organized and operated film festivals couldn’t deduct a loss from the activity because he lacked the requisite profit motive. (Eric Zudak v. Commissioner, T.C. Summary Opinion 2017-41.)

The taxpayer was employed as the director of business development for a multimedia company. In 2013, he was paid approximately $240,000, traveled extensively and worked long hours for his employer.

The taxpayer also had an interest in film festivals. He noticed that these events were poorly organized and thinly attended. He believed that college towns would be ideal locations for film festivals, because they could be successfully marketed to students and faculty.

In 2012, the taxpayer established U.S. College Film Festival (CFF). He was the sole owner of this unincorporated organization. In 2013, CFF put on two film festivals that generated a net loss of roughly $32,000 (about $700 of revenue minus  $32,700 in expenses). The IRS disallowed the 2013 loss on the grounds that the activity was a hobby rather than a for-profit business.

The taxpayer took his case to the U.S. Tax Court. He showed that CFF’s financial results were improving: In 2014, CFF had about $29,500 of revenue and $63,200 in expenses; in 2015, CFF had a net loss of only about $1,800. Despite these improvements, the court felt there was no profit motive for the activity.

Factors that worked against the taxpayer included the following:

  • While the taxpayer was able to gather records to support CFF’s claimed expenses, he didn’t maintain those records in a businesslike manner. There was no indication that he’d prepared formal budgets, profit projections or breakeven analyses.
  • Although the taxpayer had attended a number of film festivals, he had no experience in organizing or operating them. He also didn’t consult anyone with such experience.
  • The taxpayer had no prior experience managing any kind of small business, so he couldn’t point to previous successes in similar activities.
  • CFF had a significant loss in 2013 and didn’t make a profit in either of the following two years. While the taxpayer was optimistic that CFF would eventually generate profits, it had not yet done so.
  • The taxpayer was gainfully employed full-time in a high-paying job that was his primary source of income.
  • The taxpayer enjoyed organizing, conducting and attending film festivals. He’d also used CFF, at least in part, to showcase a personal film project.

Although the taxpayer devoted much of his free time to planning, coordinating and attending CFF’s events in 2013, the court found that the facts of the case justified the IRS position that the film festival activity didn’t have the requisite profit motive. Therefore, the Tax Court concluded that the IRS had properly classified the activity as a hobby and disallowed the loss for 2013.
In general, the hobby loss rules aren’t taxpayer friendly. But there’s a ray of hope: If you heed the rules, there’s a good chance you can win the argument and establish that you have a business rather than a hobby. Here’s some guidance, along with a recent example of a taxpayer who ran afoul of the rules.

Hobby Loss Rules

If you operate an unincorporated for-profit business activity that generates a net tax loss for the year (deductible expenses in excess of revenue), you can generally deduct the full amount of the loss on your federal income tax return. That means the loss can be used to offset income from other sources and reduce your federal income tax bill.

On the other hand, the tax results are less favorable if your money-losing side activity is classified as a hobby, which essentially means an activity that lacks a profit motive. In that case, you must report all the revenue on your tax return, but your allowable deductions from the activity are limited to that revenue. In other words, you can never have an overall tax loss from an activity that’s treated as a hobby, even if you lose tons of money.

Moreover, you must treat the total amount of allowable hobby expenses (limited to income) as a miscellaneous itemized deduction item. That means you get no write-off  unless you itemize. Even if you do itemize, the write-off for miscellaneous deduction items is limited to the excess of those items over 2% of your adjusted gross income (AGI). The higher your AGI is, the less you’ll be allowed to deduct. High-income taxpayers can find their allowable hobby activity deductions limited to little or nothing.

Finally, if you’re subject to the alternative minimum tax (AMT), your hobby expenses are completely disallowed when calculating your AMT liability.

Why is the hobby loss issue an IRS hot button? After applying all of the tax-law restrictions, your money-losing hobby can add to your taxable income. That’s because you must include all the income on your return while your allowable deductions may be close to zero.

A Silver Lining: IRS Safe Harbor Rules

Now that you understand why hobby status is unfavorable and for-profit business status is helpful, how can you determine whether your money-losing side activity is a hobby or a business?

There are two safe harbors that automatically qualify an activity as a for-profit business:

  1. The activity produces positive taxable income (revenues in excess of deductions) for at least three out of  every five years.
  2. You’re engaged in a horse racing, breeding, training or showing activity, and it produces positive taxable income in two out of every seven years.

Taxpayers who can plan ahead to qualify for these safe harbors earn the right to deduct their losses in unprofitable years.

Intent to Make Profit

If you can’t qualify for one of these safe harbors, you may still be able to treat the activity as a for-profit business and deduct the losses. How? Basically, you must demonstrate an honest intent to make a profit. Factors that can demonstrate such intent include the following:

  • You conduct the activity in a business-like manner by keeping good records and searching for profit-making strategies.
  • You have expertise in the activity or hire expert advisors.
  • You spend enough time to justify that the activity is a business, not just a hobby,
  • You’ve been successful in other similar ventures, suggesting that you have business acumen.
  • The assets used in the activity are expected to appreciate in value. (For example, the IRS will almost never claim that owning rental real estate is a hobby even when tax losses are incurred for many years).

The U.S. Tax Court will also consider the history and magnitude of income and losses from the activity. In general, occasional large profits hold more weight than more frequent small profits, and losses caused by unusual events or bad luck are more justifiable than ongoing losses that only a hobbyist would be willing to accept.

Another consideration is your financial status — if you earn a large income or most of your income from a full-time job or another business you own, an unprofitable side activity is more likely to be considered a hobby.

The degree of personal pleasure you derive from the activity is also a factor. For example, running film festivals in lively college towns is a lot more fun than, say, working as a finance executive — so the IRS is far more likely to claim the former is a hobby if you start claiming losses on your tax returns. (See “Lights, Camera, Action: Film Festivals Classified as a Hobby” at right.)

Toeing a Fine Line

Business losses are fully deductible; hobby losses aren’t. So, taxpayers will prefer to have their side activities classified as businesses. Over the years, the Tax Court has concluded that a number of pleasurable activities could be classified as for-profit businesses rather than hobbies, based on the facts and circumstances of each case. Your tax advisor can help you create documentation to prove that you’re on the right side of this issue.

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Posted on Jul 26, 2017

Many business entities are set up as partnerships. Although there are legitimate reasons for some businesses to choose this structure, partnership status may be undesirable for certain activities involving more than one co-owner.

Determining if a Partnership Exists for Tax Purposes

Unsure whether your activity should be classified as a partnership? In 2012, the U.S. Court of Appeals for the Ninth Circuit upheld a 2010 U.S. Tax Court decision that provides guidance on this issue. (William F. Holdner v. Commissioner, 9th Cir., No. 11-71593, October 12, 2012)

In this case, the Tax Court concluded that a profitable farming, ranching and timberland business conducted by a father and son was a 50/50 partnership for tax purposes. In doing so, the court considered the following eight factors:

1. Written or oral agreement of the parties and their conduct in executing its terms.

2. Contributions of money or services by the parties.

3. Control over income and capital and right to take withdrawals.

4. Whether the parties were co-proprietors with mutual obligations to share losses.

5. Whether the venture was conducted in joint names of parties.

6. Whether the parties filed partnership returns or otherwise represented to the IRS or others that they were engaged in a joint venture.

7. Whether separate books were maintained for the venture.

8. Whether the parties exercised mutual control over and assumed mutual responsibilities for the venture.

Keep in mind that this case doesn’t set precedent beyond the 9th Circuit. But other circuits deciding similar cases might look to the 9th Circuit’s reasoning.

Tax-related reasons to avoid partnership status include:

Tax reporting requirements. Partnerships are required to file annual partnership returns on Form 1065 and issue K-1s to the co-owners. If you can avoid partnership status, each co-owner simply reports the tax results from that person’s ownership interest directly on the appropriate form or schedule.

Tax elections. If a partnership exists, certain tax elections must be made at the partnership level (such as the Section 179 election for first-year depreciation). If you can avoid partnership status, co-owners can make tax elections independently at the co-owner level.

Like-kind exchanges. A partnership interest, by definition, is ineligible for tax-deferred like-kind exchange treatment even if the partnership’s only asset is real estate. But, if you can avoid partnership status, co-owners can trade fractional real estate ownership interests in like-kind exchanges.

The Basics

What qualifies as a partnership? For federal income tax purposes, any unincorporated joint venture or other contractual or co-ownership arrangement, in which two or more participants 1) jointly conduct a business or investment activity, and 2) split the income and expenses, will generally be treated as a partnership.

This general rule holds true even when the joint venture or arrangement isn’t recognized as a separate entity under applicable state law. Put another way, a partnership can be deemed to exist for federal income tax purposes even when there’s no partnership under state law.

There are three arrangements that avoid partnership status for federal income tax purposes:

1. Mere co-ownership, rental and maintenance of real property.

2. A mere agreement to share expenses.

3. When, under certain conditions, the IRS allows taxpayers to “elect out” of partnership status that would otherwise be deemed to exist.

Electing out of partnership tax status is available in the following circumstances:

Jointly owned investment property. Here, the parties must 1) own the investment property in question as co-owners, 2) be able to dispose of their shares independently, and 3) not actively conduct a business. In addition, the co-owners must be able to independently calculate their taxable income from the activity without the necessity of calculating partnership taxable income. This provision is often used to elect out of partnership status for real estate co-ownership arrangements.

Real estate co-ownerships under tenancy-in-common and joint tenancy arrangements often involve “mere co-ownership, rental, and maintenance of real property.” This is the first item in the list of arrangements that avoid partnership status (above). Even so, making an affirmative election out of partnership status will remove any doubt about these types of arrangements.

Joint operating agreements. Here, the parties must engage in the joint production, extraction or use of property (such as oil, natural gas, or other minerals). The parties must own the property as co-owners or hold a lease granting exclusive operating rights as co-owners (such as an oil and gas lease).

In addition, the parties must retain the right to separately take in kind their shares of the property produced, extracted or used. They can’t jointly sell the property that is produced or extracted except under an arrangement that doesn’t extend beyond one year. Finally, each party must be able to independently calculate taxable income from the activity without the necessity of calculating partnership taxable income.

Securities dealers. Dealers in securities can also qualify to elect out of partnership status for short periods in conjunction with joint efforts to underwrite, sell or distribute securities offerings.

Limited liability companies (LLCs) generally can’t elect out of partnership status for federal tax purposes. Why? In most states, state law provides that an LLC, not its individual members, owns the LLC’s property. Additionally, most state LLC statutes provide that an LLC member can’t demand a distribution of property.

The Election Process

There are two ways to elect out of partnership status. The first way is for co-owners to make an affirmative election by the due date, including any extension, of the partnership return that would otherwise be required. This generally means the first year of any activities that create tax consequences for the co-owners. The affirmative election is made by filing a blank partnership tax return form that includes only the name or other identification of the organization, its address and a statement containing certain information required by IRS regulations.

The second way to elect out of partnership status is to show that, based on facts and circumstances, the co-owners always intended to be excluded from Subchapter K of the Internal Revenue Code starting with the arrangement’s first tax year.

Important note: The facts-and-circumstances method is not the preferred way to elect out of partnership tax status. That method is a relief provision intended for co-owners that fail to affirmatively elect out using the blank Form 1065 method. The IRS may be reluctant to accept elections made under the facts-and-circumstances method.

Failure-to-File Penalties

If you fail to file a partnership return when it’s required, steep penalties may apply. For tax years beginning in 2017, the monthly penalty for failing to file a partnership return or failing to provide required information is $200 per partner. The penalty can be assessed for a maximum of 12 months.

For example, the maximum penalty for failing to file a calendar-year 2017 Form 1065 for an unincorporated two-person business that must be treated as a partnership would be $4,800 (2 x $200 x 12 = $4,800).

The IRS provides a limited exemption from the failure-to-file penalty, however. This exemption is available to domestic partnerships with 10 or fewer partners — but only when all the partners have reported their proportionate shares of income and deductions on timely filed tax returns.

Need Help?

Deciding when a partnership exists for federal income tax purposes can be tricky. Your tax advisor can help you determine whether you have a partnership and can handle any extra tax filings that may be necessary.

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Posted on Jul 17, 2017

The IRS recently issued a reminder about claiming the home office deduction. In particular, it explained a simplified method that offers a time-saving option. But many taxpayers who maintain a home office fare better tax-wise by deducting expenses under the regular method. Others may not be eligible to deduct any home office expenses. Here’s why.

Tax Wisdom of Soliman

Historically, self-employed taxpayers have fought the IRS over the determination of a principal place of business when their work was conducted at multiple job locations. The matter was finally resolved by the U.S. Supreme Court in a landmark, taxpayer-friendly ruling. (Commissioner v. Soliman, 506 U.S. 168, January 12, 1993.)

Background

Dr. Soliman, an anesthesiologist, performed services in three hospitals for about 30 to 35 hours a week. He didn’t have an office in any of the hospitals. His only office was a room in his condominium where he worked two to three hours a day. During that time period, he would work on administrative matters, such as:

  • Contacting patients, surgeons and hospitals by telephone,
  • Maintaining billing records and patient logs, and
  • Preparing treatments and presentations.

However, Dr. Soliman never saw any patients at his home office.

Under the view of the Supreme Court in this case, later codified by a 1997 tax law, home office deductions should be allowed where:

  1. The individual taxpayer uses a home office to conduct administrative or management activities of his or her business, and
  2. The business has no other fixed location where the individual conducts substantial administrative or management activities.

Thus, Dr. Solimon was allowed to deduct his home office expenses. This ruling opened the door to home office deductions for taxpayers in other walks of life — such as landscapers and plumbers — who do administrative work at home and perform actual services at multiple locations.
Regular and Exclusive Use

Most home-related expenses, such as utilities, insurance and repairs, aren’t deductible. But if you use part of your home for business purposes, you may be entitled to deduct a portion of these everyday expenses, within certain limits.

In general, you’ll qualify for a home office deduction if part of your home is used “regularly and exclusively” as your principal place of business. Here’s an overview of these two tests:

1. Regular use. You must use a specific area of your home for business on a regular basis. Incidental or occasional business use is not regular use. The IRS considers all the facts and circumstances for this determination.

2. Exclusive use. You must use a specific area of your home only for business. This area can be a room or other separately identifiable space. It’s not necessary for the space to be physically partitioned off from the rest of the room. However, you don’t meet the requirements for the exclusive use test if the area is used both for business and personal purposes.

Rules for Employees

If you’re an employee, the home office must be used for the employer’s convenience. In essence, this requirement should be spelled out in an employment contract with the company. For this reason, home office deductions are more likely to be claimed by self-employed taxpayers than employees who work for an unrelated business.

Typically, you won’t qualify for deductions if you bring work home at night from your daytime office, either. Consider the relative importance of the activities performed at each place where you conduct business and the amount of time spent at each business location.

Principal Place of Business Tests

Your home office will qualify as your principal place of business if you 1) use the  space exclusively and regularly for administrative or management activities of your business, and 2) don’t have another fixed location where you conduct substantial administrative or management activities. (See “Tax Wisdom of Soliman” at right.)

Examples of activities that are administrative or managerial in nature include:

  • Billing customers, clients or patients,
  • Keeping books and records,
  • Ordering supplies,
  • Setting up appointments, and
  • Forwarding orders or writing reports.

Other Ways to Qualify

If your home isn’t your principal place of business, you may deduct home office expenses if you physically meet with patients, clients or customers on your premises. To qualify, the use of your home must be substantial and integral to the business conducted.

Alternatively, you can claim the home office deduction if you use a storage area in your home — or if you have a separate free-standing structure (such as a studio, workshop, garage or barn) that’s used exclusively and regularly for your business. The structure doesn’t have to be your principal place of business or a place where you meet patients, clients or customers.

Two Methods: Actual Expenses vs. Simplified

Traditionally, taxpayers deduct actual expenses when they claim a home office deduction. Deductible home office expenses may include:

  • Direct expenses, such as the cost of painting and carpeting a room used exclusively for business,
  • A proportionate share of indirect expenses, such as mortgage interest, property taxes, utilities, repairs and insurance, and
  • A depreciation allowance.

Keeping track of actual expenses can be time consuming. Fortunately, there’s a streamlined method that’s allowed under a tax law change that went into effect in 2013: You can simply deduct $5 for each square foot of home office space, up to a maximum total of $1,500.

For example, if you’ve converted a 300-square-foot bedroom to an office you use exclusively and regularly for business, you can write off $1,500 under the simplified method (300 square feet x $5). However, if your business is located in a 600-square-foot finished basement, the deduction under the simplified method will still be only $1,500 because of the cap on the deduction under this method.

As you can see, the cap can make the simplified method less beneficial for larger home office spaces. But even for spaces of 300 square feet or less, taxpayers often qualify for a bigger deduction using the actual expense method. So, it can be worth the extra hassle.

Hypothetical Example

To illustrate how this might work, let’s assume that your 3,000-square-foot home is your principal place of business. You use a 300-square-foot bedroom as your home office. For 2017, you expect to have $1,500 of direct expenses for your home office plus $10,000 of indirect expenses for the entire home, including utilities, insurance and repairs. (For simplicity, we’ll disregard mortgage interest and property taxes that would be deductible on Schedule A, “Itemized Deductions.”) Based on IRS tables, you’re also entitled to a $500 depreciation allowance.

Using the simplified method, you’re eligible to deduct $1,500, as described above. But, if you keep the required records to deduct your actual expenses, you could deduct $3,000 for your home office — $1,500 in direct expenses, $1,000 in indirect expenses (10% of $10,000) and $500 in depreciation. That’s double the maximum amount you could deduct with the simplified method. The deduction would be even greater if the home office space were larger.

Flexibility in Filing

When claiming the home office deduction, you’re not locked into a particular method. For instance, you might choose the actual expense method in 2017, use the simplified method in 2018 and then switch back to the actual expense method thereafter. The choice is yours.

This is a valuable tax-saving opportunity for many taxpayers, especially those who are self-employed and work from home. Consult with your professional tax advisor regarding what’s right for your personal situation.

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Posted on Jul 13, 2017

What should you do if you discover an error on a previously filed individual tax return? For example, you might have missed some tax-saving deductions and credits on your 2016 personal federal income tax return that you filed in February. Or you might have recently discovered that you failed to claim some legitimate tax breaks on your 2015 return that you filed last year. Here are the rules for filing an amended return.

The Basics

The first thing to know is that you should not attempt to correct the situation by filing another original return using Form 1040. That will just create confusion at the IRS and cause headaches for you. Instead, file Form 1040X, “Amended U.S. Individual Income Tax Return.”

How long do you have to file an amended return? The answer depends on whether you’re asking for a refund or you owe additional taxes.

When claiming a refund. The sooner you file an amended return, the sooner you’ll receive any refunds due. So it doesn’t pay to wait. If amending your return will produce a tax refund, the deadline for filing Form 1040X is generally the later of:

  1. Three years after the original return for the year in question was filed, or
  2. Two years after the tax for that year was paid.

Most taxpayers focus on the three-year rule. If you filed your original Form 1040 before the April 15 due date — adjusted for weekends and holidays — you’re considered to have filed the return on April 15 for purposes of the three-year rule. However, if you extended the return to October 15 — adjusted for weekends — you’re considered to have filed on the earlier of the actual due date or the October 15 extended deadline.

To illustrate, suppose you filed your 2016 tax return on March 1, 2017, and paid the tax due on that date. You now realize you should have itemized deductions instead of taking the standard deduction. Based on the three-year rule, you have until April 15, 2020, to file an amended 2016 return and claim your refund. On the other hand, if you extended your 2016 return to October 16, 2017, and then file before the extended deadline on September 1, 2017, the three-year period for filing an amended 2016 return starts running on September 1, 2017.

When additional taxes are due. This is a trickier scenario. If you discover that you understated your tax liability on the original tax return, you’re expected to file an amended return and pay the additional tax. If you don’t and the IRS discovers the error, the government will bill you for:

  1. The unpaid tax amount plus interest, which is currently at a 4% annual rate, compounded daily, and
  2. The additional failure-to-pay interest charge penalty at a 6% annual rate.

The sooner you file an amended return and pay the tax due, the sooner you’ll stop racking up interest and the failure-to-pay penalty.

You may also be assessed other penalties, depending on the nature of your underpayment — but the IRS can waive all penalties if you show you had a reasonable cause for the underpayment. For example, you might have reasonable cause if you received incorrect information from a third party, such as an inaccurate Schedule K-1 from a partnership or S corporation investment.

Although IRS audits are relatively rare these days, there is a strong chance of getting caught for omitting income that’s automatically reported to the IRS on an information return, such as Form W-2 or Form 1099.

Also, beware of the three-year statute of limitations rule: The IRS generally has three years after the date the original return was filed to discover errors and omissions and assess additional tax, interest and penalties. But a longer six-year statute of limitations rule applies if the original return understated gross income by over 25%. In addition, there’s no statute of limitations on a fraudulent return.

Bottom Line

Filing an amended return is relatively straightforward if you expect a refund — as long as you’re within the requisite two- or three-year window of opportunity. But when you’ve underpaid your taxes, filing an amended return can be a dicey situation. Always consult a tax professional first to discuss the full consequences of amending your return.

Generally, if the original return understated your tax bill by only a small amount, your tax advisor will recommend that you amend your return and pay the additional taxes, interest and penalties as soon as possible.

For larger understatements, let your tax advisor take the reins. He or she has experience in dealing with past-due taxes and may be able to get you off the hook with minimal or no penalties. But be prepared to pay at least the past-due tax plus interest. He or she can also help you file amended business returns, if needed.

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Posted on Jul 12, 2017

Organizations that advocate for paid parental leave recognize that for most employers, the decision of whether to offer that benefit will be rooted in economics. In a competitive environment, it’s a rare employer that can afford to add to personnel costs without a bottom line-based rationale.

The motivation of employers in California, New Jersey, Rhode Island, New York and the District of Colombia, includes obeying state law. However, in some of those states, the compensation employees receive while on leave may be less than the full amount of their earnings, and is funded by a state-run insurance system that employees fund via mandatory payroll-deducted premiums.

What’s the outlook for paid parental leave? Based on a recent survey by the Society for Human Resource Management (SHRM), dealing with employer-paid family leave practices, growth appears to be on the horizon. SHRM’s analysis includes this prediction: “A competitive labor market may prompt more organizations to adopt robust, paid parental-leave policies in order to attract needed workers.”

Industry Variation

SHRM’s research shows that 18% of U.S. employers offer paid maternity leave, and 12% also offer paid paternity leave. Paid parental leave is most common in the technology sector, where competition for talent is intense. 

Research by WorldatWork, another professional membership group, delved into the same topic in 2016. Assessing the prevalence of paid parental leave policies is tricky because companies often don’t distinguish between paid family leave benefits, and paid leave earmarked specifically for new parents. Below are some of the findings.

Among companies that do offer paid leave to new parents as a separate benefit from their overall paid family leave policy:

  • More than half limit the time period to six weeks or less,
  • More than one-third make employees eligible to receive it immediately upon being hired,
  • Less than half have a one-year waiting period, and
  • The largest segment, about one half, requires new parents to use the benefit within the first year of parenthood, while just over one-third have a six-month deadline.

Potential Benefits

According to a report compiled by the National Partnership for Women and Families, employers that offer paid leave plans may enjoy many benefits as a result, some of which are listed below.

Paid leave:

  • Improves worker retention, reducing turnover costs. First-time mothers who take paid leave are more likely to return to the same employer than to an employer who doesn’t offer paid leave,
  •  Increases worker productivity, according to survey data from California employers, where paid family leave is mandatory,
  •  Boosts employee loyalty and morale,
  •  Helps put smaller employers in a position to compete with larger employers, and
  •  Heightens competitiveness in the global economy for American businesses. (Most industrialized countries mandate paid family leave.)

These claims are general, so assessing the potential benefits of having a paid leave plan in your workplace will require some analysis on your own part. Here are some questions suggested by SHRM to help with such an evaluation.

1. Which job categories or demographic segments of your workforce are most vital to your success? For example, you may find that the group you most rely on is composed of younger employees who are more likely to need paid parental leave.

2. What motivates the workers who are most vital to your success? It’s possible that the employees who are most likely to take advantage of paid parental leave would place a higher value on some other form of compensation, such as more generous paid vacations.

3. What’s the competitive landscape in your labor market? If you’re not having a turnover problem or if your competitors aren’t offering paid family leave, you may not feel compelled to consider it.

4. What’s your overall employment strategy and workplace culture? If your primary employment value proposition is, for example, schedule and career flexibility and a “family friendly” culture, paid family leave would be a natural fit.

5. Crunch the numbers. While it’s impossible to project with precision the cost in “extra” wages and financial payoff that’s involved in reduced employee turnover and higher productivity levels, you’ll need to give it a shot. If you move forward with a paid family leave policy, after you have accumulated some history, you will be able to verify or correct the preliminary conclusions you have drawn.

Going Forward

Will paid maternity and related family leave benefits become more commonplace, as often predicted? The answer will depend on the conclusions employers draw as they consider these and other questions and factors beyond their control, including the future strength of the economy and birth rate trends.

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Posted on Jul 11, 2017

Sometimes it’s clear when an employee is entitled to overtime pay, and how much, and other times it isn’t.The issue can become especially tricky when employees are paid at least partially in commissions. In a recent case, a federal appellate court remanded back to a lower district court its ruling on the allocation of commissions in determining overtime pay. The appeals court said the lower court didn’t properly interpret federal overtime law. (Freixa v. Prestige Cruise Services, LLC, CA-11, No. 16-13745, 4/14/17).

Key Facts of the Case

The District Court for the Southern District of Florida had ruled that a cruise ship employee who received commissions was ineligible for overtime pay. As a sales representative, the employee sold cruise trips to customers. He received a fixed salary of $500 a week plus commissions. During the one year he was with the company, he earned over $70,000 in compensation. Of this amount, 63% was paid in commissions.

The commissions were calculated monthly and paid the following month. Both parties agreed in court that the sales rep worked an average of 60 hours a week during his employment, but they disagreed about the number of hours he worked in any individual week.

Subsequently, the employee sued the cruise ship line for overtime pay. He argued that the compensation he received in certain weeks fell below the required threshold for the exemption from overtime that applies to retail workers who are paid commissions.

Lower Court’s Rationale

The district court acknowledged that the law generally requires a calculation of the regular rate of pay on a week-to-week basis. But the court found it difficult to determine the exact weeks during which the sales representative earned commissions.

As a result, it decided to divide his entire remuneration for the year across every hour in every week he worked — assuming 60 hours of work a week — to arrive at an average hourly rate of $23.45. Because that rate exceeded the exemption threshold of $10.88 per hour, the district court awarded summary judgment in favor of the cruise ship company.

In reaching this decision, the district court said it believed its calculation conformed with federal regulations that allow for a different “reasonable and equitable method” to calculate the regular rate of pay “if it is not possible or practicable to allocate the commission among the workweeks of the period in proportion to the amount of commission actually earned or reasonably presumed to be earned each week” (29 CFR 778.120).

Appeals Court’s Rationale

But that wasn’t the end of the story. After the sales representative appealed, the Eleventh Circuit Court overturned the lower court’s ruling, saying that the district court had misinterpreted the federal regulations.

The appeals court ruled that when commissions are computed monthly, those earned in one month might not be allocated across weeks worked in other months. Instead, federal regulations limit the district court to allocating commissions across weeks within the time period in which they were earned. The appeals court cited a related regulation that required as a general rule, “that the commission be apportioned back over the workweeks of the period during which it was earned” (29 CFR 778.119).

Based on the context of this and other regulations, the appeals court said it’s clear that the term “period” means “computation period.” For the sales representative in this case, it refers to each month of his employment, not the entire year that he worked. For example, the court said it believed that the district court could allocate commissions earned in January across weeks worked in January, but not across weeks worked from February through December.

We haven’t heard the last word on this matter. The case was remanded back to the district court for further proceedings.

What the Upper Court Cited

The regulation cited by the appeals court says that if calculation and payment can’t be completed until after the regular pay day, the employer may disregard the commission in computing the regular hourly rate until the amount of commission can be determined. Until then, the employer may pay overtime at a rate not less than one and one-half times the hourly rate paid the employee, excluding the commission.

Then, when the commission can be determined, the employer must pay any additional overtime compensation due once the commission is included. To compute the additional overtime, “it is necessary, as a general rule, that the commission be apportioned back over the workweeks of the period during which it was earned.”

The additional compensation must be not less than one-half of the increase in the hourly rate of pay attributable to the commission for that week in question multiplied by the number of overtime hours worked.

Key point: In accordance with the the Fair Labor Standards Act of 1938, an exemption to the usual overtime pay requirements exists for employees who work for a retail or service establishment if two requirements are met:

  1. The regular rate of pay exceeds one and one-half times the minimum hourly rate (that is, $10.88 an hour), and
  2. More than half of the compensation for a reasonable period (but not less than one month) represents commissions paid on goods and services.
    This calculation of overtime pay under this exemption was at the core of the above case.

Avoid Rapid Decisions

The rules in this area are complex and may be open to interpretation. Don’t make any quick assumptions about your company’s responsibilities without consulting with your professional payroll advisors.

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Posted on Jul 10, 2017

Have you ever thought about becoming a landlord? This option may be tempting if your local real estate market is surging and rental rates are strong, especially if you’re already planning to relocate or downsize to a smaller home.

Ideally, you’ll be able to shelter most or all of the rental income with tax deductions and eventually sell the property for a higher price than you originally paid. In the meantime, however, it’s important to understand the confusing tax rules that apply when a personal residence is converted into a rental.

Special Basis Rule

Once you become a landlord, you can depreciate the tax basis of the building part of a residential rental property (not the basis of the land) over 27.5 years. In plain English, this means you can deduct from your taxable income a portion of the building’s value every year for the next 27.5 years. However, a special basis rule applies to a rental property that was formerly a personal residence.

Under the special rule, the initial tax basis of the building portion of the property for purposes of calculating your postconversion depreciation write-offs equals the lower of:

  • The building’s fair market value (FMV) on the conversion date, or
  • The building’s regular basis on the conversion date.

Regular basis usually equals original cost plus the cost of any improvements (excluding any normal repairs and maintenance).

When You Sell

The rules become really confusing when you sell the property. To determine if you have a deductible loss, a similar special basis rule applies. That is, you must use the lower of:

  • The property’s FMV on the conversion date, or
  • The property’s regular basis on the conversion date.

Additionally, you must reduce the initial basis by depreciation deductions taken during the rental period. The special basis rule and the depreciation deductions greatly reduce the odds of having a deductible loss on a sale, especially when property values are below historical levels. With property values recovering in many areas, however, the chances of reporting a taxable gain have increased.

Your tax basis for purposes of calculating whether you have a taxable gain on a sale is simply the property’s regular basis on the sale date. Regular basis generally equals the original cost of the land and building, plus the cost of any improvements minus depreciation deductions claimed during the rental period.

Sellers in Limbo

When a converted property is sold, you must use the special basis rule to determine if you have a deductible loss on the sale, but you must use the regular basis rule to determine if you have a taxable gain. Following two different basis rules can sometimes cause sellers to have neither a taxable gain nor a deductible loss. This happens whenever the sale price falls between the two basis numbers.

Confused? Here are some examples of how to calculate gains and loss to help clarify.

Example 1: No tax gain or loss on sale

To illustrate how this works, suppose you convert your home to a rental while the market is recovering — but it hasn’t returned to its previous peak by the time you sell. Here’s how the numbers might shake out:

Regular basis on conversion date $300,000
Postconversion depreciation deductions ($13,000)
Regular basis for tax gain $287,000
FMV on conversion date $235,000
Postconversion depreciation deductions ($13,000)
Special basis for tax loss $222,000

If the net sale price is between $222,000 and $287,000, you have no tax gain or loss, because the sale price falls between the two basis numbers.

Example 2: Modest gain on sale

Alternatively, suppose you convert a property in a market that’s still in the early stages of recovery, and you intend to hang onto it for a while before selling.

Regular basis on conversion date $300,000
Postconversion depreciation deductions ($32,000)
Regular basis for tax gain $268,000
FMV on conversion date $285,000
Postconversion depreciation deductions ($32,000)
Special basis for tax loss $253,000

If the net sales price is above $268,000, you have a taxable gain. For example, with a net sale price of $345,000, you must report a taxable gain of $77,000 ($345,000 – $268,000). That is because, in this example, the postconversion depreciation deductions reduced the regular basis and the value of the property jumped. As a result, the sale price exceeds the regular basis, which produces a modest taxable gain on the sale.

Example 3: Big gain on sale

Now, let’s suppose you convert a property in a strong market. You’ve owned it for years and its FMV never fell below what you paid for it. In this case, the special basis rule for determining if you have a tax loss does not apply.

Regular basis on conversion date $235,000
Postconversion depreciation deductions ($26,000)
Regular basis for tax gain $209,000
FMV on conversion date $285,000

Assuming the property is sold for $360,000, your taxable gain would be a whopping $151,000 ($360,000 – $209,000). In this example, the postconversion depreciation deductions reduced the property’s basis and the value jumped after the conversion. So the sales price substantially exceeds the basis, generating a significant taxable gain on the sale.

Principal Residence Gain Exclusion

Fortunately, some landlords may be able to shelter their gain on the sale of a recently converted property with the principal residence gain exclusion. When allowed, the gain exclusion really helps: Unmarried property owners can potentially exclude gains of up to $250,000, and married joint-filing couples can potentially exclude up to $500,000.

Important note: If you qualify for the gain exclusion, you can’t use it to shelter the part of a gain that’s attributable to depreciation deductions. In the previous example, if the gain exclusion applied, the taxpayer must still report a taxable gain of $26,000, which equals the amount of the postconversion depreciation deductions. But that’s much less than the total gain of $151,000.

To qualify for this exclusion, the tax rules require that you use the property as your principal residence for at least two years during the five-year period ending on the sale date. So, it’s impossible to meet the two-year usage requirement once you’ve rented the property for more than three years during that five-year period.

So, this tax break is allowed only if you’ve rented the property for no more than three years after the conversion date at the time you sell.

Ready to Convert?

Home-to-rental conversions can be a lucrative financial proposition for some property owners. But the tax rules can be confusing. To help understand the rules and evaluate whether you should become a landlord, contact your tax advisor. He or she can help decide what’s best for your situation. Beyond taxes, your tax pro will help you factor other considerations into your decision.

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Posted on Jul 8, 2017

Do you provide car rides through a mobile app, rent out your spare room using an online platform or repair computers for local businesses on demand? If so, you may be considered part of the “sharing economy” (also known as the Gig or on-demand economy).

Participation in this emerging method of distributing services can be a good way to earn money in your down time, pursue a more flexible lifestyle and provide cash to offset the expenses associated with owning a vehicle or a home. The IRS recently offered some guidance for this rising trend. Here’s a summary of the key points.

Employee vs. Independent Contractor

First and foremost, there’s no free tax ride. Uncle Sam wants his cut of your earnings from any sharing economy activity — and your state tax agency may be eyeing it, too. The good news is that some of your tax liability could be offset by deductible business expenses.

When providing on-demand services, you’ll generally be classified as an independent contractor, rather than an employee. Certain exceptions apply — for example, if you’re a corporate officer of the firm providing the service.

Employees receive W-2 forms from their employers. But contractors will usually receive 1099 forms for participating in the sharing economy jobs, which must be reported on Schedule C on the individual’s federal tax return. The type of 1099 form depends on the volume of your activities. The company will issue:

  • Form 1099-MISC if you only occasionally provide services, or
  • Form 1099-K if you had more than 200 transactions and received at least $20,000 in payments for the year.

Instead of having taxes regularly withheld from their paychecks, self-employed contractors must make quarterly estimated tax payments to the IRS. Otherwise, they could be assessed tax penalties and interest on the amounts that weren’t paid, as well as any regular tax that’s owed. These adverse consequences could happen even if a contractor is ultimately entitled to a tax refund at the end of the year.

Taxes are a “pay-as-you-go” proposition. Self-employed taxpayers often rely on estimated tax payments to pay both their income tax liability and self-employment tax (the equivalent of FICA tax for employees). Payments must be made quarterly according to the IRS schedule:

  • First estimated payment is due on April 15,
  • Second estimated payment is due on June 15,
  • Third estimated payment is due on September 15, and
  • Fourth estimated payment is due on January 15 of the following tax year.

These deadlines move to the next business day if the due date falls on a weekend or a holiday. For example, the estimated payment for the fourth quarter of 2017 is due on Tuesday, January 16, 2018, because Monday, January 15, 2018, is Martin Luther King Day.

Some taxpayers participating in the sharing economy may have another option: The requisite amount of tax can be paid through any combination of estimated tax payments and regular income tax withholding. Therefore, if you’re employed at another job, you could increase your withholding to compensate for the extra tax you’ll owe from your sharing economy job. Simply fill out a revised Form W-4 and submit it to your employer. Your tax advisor can help you figure out the right amount of incremental withholdings.

Deductible Expenses

Depending on your circumstances, you may be able to claim deductions for expenses incurred to provide on-demand services. What costs qualify? In general, a business expense must be “ordinary and necessary” or the IRS won’t allow you to deduct it. Consider the following examples.

Drivers. Typically, the biggest expense for drivers on Uber, Lyft and other ride-sharing apps is vehicle depreciation. Subject to the annual limits for luxury cars, you may be able to write off at least some of the vehicle’s cost over time, based on the percentage of business use. In addition, you may deduct other operating expenses, such as gas, oil, insurance, car washes and repairs.

There’s a simplified alternative to keeping detailed records that are required for deducting actual expenses (including depreciation): You may use the IRS flat rate of 53.5 cents per business mile in 2017. Under this alternative, you can also deduct related tolls and parking fees.

Landlords. If you will take an extended vacation this year, have an unused spare room or own a second home, you might rent the unoccupied property to a tenant through an online platform, such as Airbnb, HomeAway or VRBO.

Deductions for rentals are limited to the amount of rental income if your personal use of the residence exceeds the greater of 14 days or 10% of the time the place is rented out. But, if you rent out a place for 14 days or less, there are no tax consequences: You don’t have to report the income, but you can’t claim deductions either.

When renting out property, beware of the rules for hotels and bed-and-breakfast properties. If you provide substantial services primarily for the guest’s convenience, such as regular cleaning, changing linen or maid service, you may be classified as running a hotel business. This classification could increase your tax liability, but your tax pro may have suggestions to avoid that pitfall. For example, you might consider charging a separate cleaning fee at the end of the rental, rather than providing complementary daily maid service.

Office space. To save overhead expenses, some small business owners opt to share office space, especially in high-priced business districts, through sharing platforms like WeWork. Essentially, the company rents out space in an office building and finds tenants to sublet smaller units. Each tenant maintains a desk, a computer and other essentials. But tenants collectively share common amenities, including a kitchen, lobby and general receptionist. As an added benefit, professionals who share office space can network with other like-minded professionals, which may lead to joint ventures and other forms of collaboration and revenue-sharing.

For tax purposes, you can deduct 100% of your shared office expenses. This option may be easier and subject to fewer limitations than home office deductions.

Professionals. The sharing economy isn’t just for people who own hard assets, such as vehicles or real estate, or who perform manual labor, such as the services of a housekeeper or handyman. Increasingly, professionals — including attorneys, physicians and computer programmers — are participating in the Gig.

A major expense for these professionals is the vehicle used to travel to and from freelance assignments. Additionally, they may be able to deduct at least some of the costs of electronic devices — such as tablets and smartphones — based on the percentage of business use.

Bottom Line

The tax rules that govern sharing economy activities are still evolving. Contact your tax pro for additional guidance. Although the standard principles for self-employed individuals generally apply to people with sharing economy jobs, there are some exceptions and subtle nuances. Your advisor can help ensure that you’re in compliance with the latest rules.

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Posted on May 22, 2017

Summer — the traditional wedding season — is just around the corner. Marriage changes life in many ways. Here’s how it may affect your tax situation.

Marital Status

Your marital status at year end determines your tax filing options for the entire year. If you’re married on December 31, you’ll have two federal income tax filing choices for 2017:

  • File jointly with your spouse, or
  • Opt for “married filing separate” status and then file separate returns based on your income and your deductions and credits.

Here are two reasons most married couples file jointly:

1. It’s simpler. You only have to file one Form 1040, and you don’t have to worry about figuring out which income, deduction and tax credit items belong to each spouse.

2. It’s often cheaper. The married filing separate status makes you ineligible for some potentially valuable federal income tax breaks, such as the child care credit and certain higher education credits. Therefore, filing two separate returns may result in a bigger combined tax bill than filing one joint return.

Risks of Filing Jointly

Filing jointly isn’t a sure-win for one big reason: For years that you file joint federal income tax returns, you’re generally “jointly and severally liable” for any underpayments, interest and penalties caused by your spouse’s deliberate misdeeds or unintentional errors and omissions.

Joint-and-several liability means the IRS can come after you for the entire bill if collecting from your spouse proves to be difficult or impossible. They can even come after you after you’ve divorced.

However, you can try to claim an exemption from the joint-and-several-liability rule under the so-called “innocent spouse” provisions. To successfully qualify as an innocent spouse, you must prove that you:

  • Didn’t know about your spouse’s tax failings,
  • Had no reason to know, and
  • Didn’t personally benefit.

If you file separately, you’re certain to have no liability for your spouse’s tax misdeeds or errors. So, if you have doubts about a new spouse’s financial ethics, the best policy may be to file separately.

Penalty vs. Bonus

You’ve probably heard about the federal income tax “penalty” that happens when a married joint-filing couple owes more federal income tax than if they had remained single. The reason? At higher income levels, the tax rate brackets for joint filers aren’t twice as wide as the rate brackets for singles.

For example, the 28% rate bracket for singles starts at $91,901 of taxable income for 2017. For married joint-filing couples, the 28% bracket starts at $153,101. If you and your spouse each have $90,000 of taxable income in 2017, for a total of $180,000, you’ll pay a marriage penalty of $807. That’s because $26,900 of your combined taxable income will fall into the 28% rate bracket ($180,000 – $153,100). If you stay single, none of your income will be taxed at more than 25%. The marriage penalty is usually a relatively modest amount; so, it’s probably not a deal-breaker.

On the other hand, many married couples collect a federal income tax “bonus” from being married. If one spouse earns all or most of the income, it’s likely that filing jointly will reduce your combined tax bill. For a high-income couple, the marriage bonus can amount to several thousand dollars a year.

Important note: The preceding explanation of the marriage penalty and bonus assumes that the current federal income tax rates will remain in place for 2017. However, rates and rate brackets could change depending on tax reforms that may be proposed and enacted before year end. Ask your tax advisor for the latest details on federal tax reform efforts.

Home Sales

When people get married, they often need to combine two separate households before or after the big day. If you and your fiancé both own homes that have appreciated substantially in value, you may owe capital gains tax.

However, there’s a $250,000 gain exclusion for single taxpayers who sell real property that was their principle residence for at least two years during the five-year period ending on the sale date. The gain exclusion increases to $500,000 for married taxpayers who file jointly.

Suppose you and your fiancé both own homes. You could both sell your respective homes before or after you get married. Assuming you’ve both lived in your respective homes for two of the last five years, then you could both potentially claim the $250,000 gain exclusion. That’s a combined federal-income-tax-free profit of up to $500,000.

Conversely, let’s say you sell your home and move into your spouse’s home. After you’ve both used that home as your principal residence for at least two years, you could sell it and claim the larger $500,000 joint-filer gain exclusion.

In other words, you could potentially exclude up to $250,000 of gain on the sale of your home. Then you could later claim a gain exclusion of up to $500,000 on the sale of the house that your spouse originally owned. With a little patience and some smart tax planning, you could potentially exclude a combined total gain of $750,000 on your home sales.

Got Questions?

Getting hitched may open up new tax risks — and some new tax planning opportunities. It pays to be well-informed. Contact your Cornwell Jackson tax advisor for guidance on how getting married could change your tax situation in 2017.

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Posted on May 18, 2017

This is not a political article. It is more about pondering the possibilities for manufacturers who are waiting to see how a new federal tax plan may change how they structure their businesses. With tax reform on the legislative horizon, we looked at a handful of potential changes under discussion to provide some context for tax planning later this year.

Seven Considerations as You Plan for the Plan

You have your Trump tax plan and you have your Republican “A Better Way” blueprint for America plan. I’m not stepping into the role of telling you which plan is better. That’s why we elect political representatives and choose which media to follow. I’m going to attempt, given the current legislative updates, to highlight the areas of most importance to manufacturers and distributors. We expect that some version of tax reform will occur in 2017. In the meantime, use this as a guide to anticipate a change in business structure or other tax planning decisions.

We will address the following areas:

  • Capital expenditures
  • Interest expense deduction
  • Tax rates by business structure
  • Cross-border provisions
  • Employer mandates for health care coverage
  • Export income exclusion
  • Carried interest

100% First-Year, Write-offs of Capital Expenditures

The Republican tax plan aligns with the Trump plan on allowing companies to write off all spending on new capital investments, from equipment to computers. The idea is to boost spending on productivity-enhancing outlays, according to an article in Bloomberg. In theory, it sounds better to write off all your capital expenses in one year rather than over time, as the current tax code allows.That being said, it may be a non-event for many mature companies with minimal annual capital expenditures, as we currently enjoy a potential $500,000 annual full expensing election under Section 179 and there is also additional bonus depreciation available under the current law.

So this proposed change will particularly benefit companies with significant capital spending plans or the expansion into a new production line or lines that may have been postponed.

It was interesting to note in the Bloomberg article that companies with large capital outlays may be viewed as more progressive or “newer,” and therefore more attractive to future investors. Regardless, companies so far don’t seem to be rushing out to buy new equipment in anticipation of 100 percent, first-year write-offs.

Conclusion: Stick to your budgets and plan your capital expenditures as if it’s still 2016. Don’t place reliance on this additional tax benefit if you exceed these limits, but consider it a potential  “bonus” if the law falls in your favor.

Loss of Interest Expense Deduction

In addition to potentially boosting the cost of PE deals and making asset deals more attractive, the loss of the interest expense deduction is designed to make debt financing less attractive for businesses and individuals.

Under the current tax code, interest expense on debt financing — from home mortgages, business loans, stock purchases — is deductible. It’s deductible for private equity firms that use investor cash and third-party leverage to finance the purchase of stock. With the exception of the mortgage interest deduction on your primary home, the Trump and Republican tax plans both propose to eliminate the interest expense deduction to offset the loss of tax revenue from the proposed 100 percent capital expense depreciation.

Companies that purchase physical assets will be better off expensing capital purchases than relying on interest expense deductions. However, companies that are heavily leveraged and PE firms potentially end up paying more tax.

Conclusion: Make a plan to pay off or refinance any high interest debt in 2017 and actively try to lock in any low interest debt for long term installment loans.

Change Business Structure or Not?

Both the Trump and Republican tax plans propose a large federal corporate/business tax rate reduction, putting the new rate at 15 or 20 percent. It was a key campaign promise, and comments made by President Trump in March regarding a tax reform package emphasized that he wants to lower the overall tax burden on businesses. Followers expect that release of details is still months away.

It’s unclear so far whether manufacturers should consider a business structure change. One proposal  talks about a lower tax rate for all businesses, while another noted that only C Corps would get the tax rate reduction to bring them in line with the tax structure of S Corps.

Conclusion: Watch for more details on the proposed tax rate reductions this summer. If your business is structured as an S Corp, there may (or may not) be a reason to discuss a structure change.

Zero Deduction for Cost of Imported Materials

One area that hasn’t been talked about much in the media, but will need more attention, is the cross-border provision for imported materials. Currently, manufacturers that use imported materials in their products can deduct the cost of those materials. A new proposal would eliminate the deduction on imported materials and only allow a deduction on U.S. sourced materials.

With a dramatic increase in the cost of materials to produce products, any lowering of the corporate tax rate will offer far less benefit for these manufacturers. It will also hit distributors of imported foreign materials hard.

With this proposal, I anticipate reporting complexity for manufacturers that have some products with imported materials and others with no imported materials.    Also, if a product is partially assembled in a foreign country, is the cost of labor still deductible while the materials cost is excluded? Enterprise systems would have to be reconfigured to account for proper tracking.

If passed, this increased cost will likely be passed on to retailers and consumers — adding to inflationary concerns.

Conclusion: Consider to what extent — if any — your company currently imports materials or partially assembled products. The jury is out on what form cross-border protections will take and may include a phased-in approach to offset huge tax burdens on U.S. importers.

Elimination of the Employer Mandate

Although not completely related to tax reform, something that President Trump and Republicans both agree on is elimination of the employer mandate to provide health care benefits. Because a healthcare reform plan is still a work in progress , we still have the employer mandate.

Conclusion: Although we will all be pleased with the reduction in the exhaustive paperwork and reporting requirements of Obamacare,  provide health care benefits anyway. It’s a baseline competitive feature for recruitment and retention of your most talented.

Planned Income Exclusion for domestically produced exported goods may eliminate need for IC-DISC structure

One of the cross-border tax proposals is that U.S. manufacturers that are exporting goods will get a 100 percent exclusion of these export revenues from U.S. tax. There are significant practical issues and questions surrounding this broad brush proposal, not limited to what is defined as U.S. manufacturing. Does use of  domestic distribution that does both export and domestic distribution qualify for this exclusion, will certain countries be excluded, will certain maquiladora arrangements be grandfathered or phased in over time?

Export tax minimization has been historically achieved through the IC-DISC (Interest Charge-Domestic International Sales Corporation). This helpful and sometimes misunderstood tax break for manufacturers and some professionals will be mostly obsolete if a tax reform bill excludes tax 100 percent on U.S.-based exports.

Set up as a separate entity, the IC-DISC is available to small and mid-sized manufacturers that export goods, but it may also apply to professionals like engineering or architectural firms that work on a project that will be built overseas. Manufacturers of parts of products that are exported may also be eligible. IC-DISC allows a reduction on 50 percent of export income by more than 50 percent. Profits are taxed at the lower dividend rate (15%) as opposed to ordinary income tax rates (34%+).

The elimination of taxes on exports may provide a boon to U.S. manufacturers, but it is widely anticipated that other countries may combat the U.S. shift in tax law with additional tariffs or import fees – that may eliminate or at least dampen the ability of manufacturers to use this tax advantage to help compete in overseas markets.

Conclusion: Investigate the IC-DISC if you think your company’s  export activities are sufficient to set up this structure, and use this as a back-up position in the event the “as defined” export exclusion becomes a more narrowly defined opportunity for utilizing this tax advantage. That being said, do the up front due diligence and cost benefit modeling – but delay any structure set-up action until later this summer.      

Eliminating the Carried Interest in Private Equity Structures

I don’t know how many times President Trump talked about eliminating “the carried interest loop-hole” during his campaign, but I’m sure someone tracked it in a video montage. Carried interest is defined by IRS regulation rather than statute, so the President could move forward without the assistance of Congress. The Republican tax proposal doesn’t mention this tax break.

Elimination of carried interest would result in equity investors paying more for distributions coming out of portfolio companies, which doesn’t impact owner-operator companies insofar as their tax rates, but it could add to concerns over inflation as investors seek to make up the losses through improved corporate performance.

Conclusion: If you have private equity investors as shareholders or they are a significant part of your overall exit plan, make sure you have a clear understanding of the changing tax metrics to this investor class, as there may be a required change(increase) to tax distributions from the Operating Company to address these metrics. Overall, it could cause some revision or amendment to various waterfall calculations and preferred return calculations to address the economic impact to this shareholder group.

While we’re waiting to see which elements of which tax reform proposal come out on top, consider the results of your previous tax year. If there are areas that didn’t pan out as you hoped, the Tax Group at Cornwell Jackson is available to review your returns and identify any opportunities that make sense — for 2017 at least.

 

Gary Jackson, CPA, is the lead tax partner at Cornwell Jackson. Gary has built businesses, managed them, developed leadership teams and sold divisions of his business, and he utilizes this real world practical experience in both managing Cornwell Jackson and in providing tax planning to individuals and business leaders across North Texas. Contact him at gary.jackson@cornwelljackson.com.

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