Category: Tax Services

Posted on Apr 4, 2017

What’s better for employees than a fringe benefit? Try one that’s tax-free.

The IRS recently published the updated Publication 15-B (2017), Employer’s Tax Guide to Fringe Benefits. This guide provides valuable insights into the taxation of statutory benefits and offers some clarifications and additions, including:

  • New examples of benefits that can’t be excluded from taxable income as “de minimis” fringe benefits,
  • More details about the limits on employee discounts, and
  • A new elaboration on when product testing benefits can be excluded as a working condition fringe benefit.

De Minimis Fringe Benefits

Plain and simple, a de minimis fringe benefit is a benefit can be excluded from the employee’s taxable wages (W-2) because the value of the property or service received is so small that accounting for it is unreasonable or administratively impracticable. An essential element of de minimis benefits is that they are occasional or unusual in frequency. They also mustn’t be a form of disguised compensation.

The updated IRS Pub 15-B lists the following as examples of nontaxable de minimis benefits:

  • Personal use of an employer-provided cell phone intended primarily for noncompensatory business purposes,
  • Occasional cocktail parties, group meals or picnics for employees and their guests,
  • Holiday or birthday gifts, other than cash, with a low fair market value, and
  • Flowers, fruit or similar items provided to employees under special circumstances (for example, on account of illness, a family crisis or outstanding performance).

To clarify the tax treatment, the updated publication also adds examples of benefits that are not excluded from taxable income, including:

  • Season tickets to sporting or theatrical events,
  • The value of the use of an employer-provided car or other vehicle to commute for more than one day a month,
  • Membership dues at a private country club or athletic facility (regardless of how often the employee uses them), and
  • The value of the use for a weekend of an employer-owned or leased facility, such as an apartment, hunting lodge, boat, etc.

In other words, you can serve birthday cake to employees with no tax strings attached, but you can’t give them the keys to your seaside cottage for the Fourth of July holiday weekend without tax consequences.

Employee Discount Benefits

Employee discounts are excluded from an employee’s taxable income if they are for “qualified property or services” provided to an employee or the employee’s spouse or dependent children. Dependent children in this case refers to natural, step and foster children who are either dependents of the employee or whose parents have died and haven’t yet reached age 25. A child of divorced parents is treated as a dependent of both parents.

The discounts are the difference between prices offered to the public and those offered to employees for the same items. “Qualified” services or property are those that are sold to consumers during the ordinary course of business, such as retail merchandise or membership at a gym. Property in this context doesn’t include real estate or personal property held for investment.

There are limits to the tax generosity allowed under the law. Specifically, those limits are:

  • For a discount on services, 20% of the price you charge nonemployee customers for the service.
  • For a discount on merchandise or other property, your gross profit percentage times the price you charge nonemployee customers for the property.

Protect Testing Benefits

The value of consumer goods provided to employees for product testing outside the workplace is considered a tax-free working condition fringe benefit as long as the testing program meets certain requirements. For instance, if an automaker offers a new model to an employee for evaluation, use of the vehicle can be tax-free to the employee.

The fair market value qualifies as a working condition benefit if all of the following conditions are met — requirements weren’t included in the previous version of IRS Pub 15-B:

  • Consumer testing and evaluation of the product is an ordinary and necessary business expense for your business.
  • Business reasons necessitate that the testing and evaluation must be performed off your business premises.
  • You provide the product for purposes of testing and evaluation.
  • You provide the product to your employee for no longer than necessary to test and evaluate its performance.
  • The product is returned to you at completion of the testing and evaluation period.
  • You impose limitations on your employee’s use of the product that significantly reduce the value of any personal benefit (this includes limiting your employee’s ability to select among different models or varieties of the product and prohibiting its use by anyone other than the employee.)
  • The employee submits detailed reports on the testing and evaluation.
  • You use and examine the results within a reasonable time.

What Doesn’t Count

The updated publication also explains factors that tend to indicate that a testing program isn’t bona fide. For example:

  • It’s a leasing, not testing, program if an employee leases consumer goods for a fee.
  • The program can’t be limited to a certain class of employees unless there’s a business reason for doing so.
  • The testing exclusion isn’t available to independent contractors or company directors.

Simply put, as long as businesses adhere to the rules, fringe benefits remain tax-free to employees and deductible by employers.

And the Award Goes to . . .

Special rules apply to the tax exclusion for “achievement awards” given to employees for length of service or safety.

Under the IRS guidelines, these awards:

  • Can’t be disguised wages,
  • Must be awarded as part of a meaningful presentation, and
  • Can’t be cash, cash equivalent, vacation, meals, lodging, theater or sports tickets, or securities.

There are additional requirements and dollar limits for achievement award plans. The most recent details are available in IRS Publication 5137, Fringe Benefit Guide.

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Posted on Mar 30, 2017

The following financial planning tips could help you achieve a similar — if not better — level of success than your parents or grandparents. These tips may seem like common sense, but the odds of you actually doing them are low. It’s not because you’re lazy (I hope). It’s because the financial balance sheet of many Americans has been plummeting since the 1980s. Also, your perception of the financial industry may not be exactly positive. I guess the question you have to ask yourself is: What have I got to lose — and also gain — by making a financial plan for my future?

1. Reduce Debts.

Yes, I’m going there first. Whether you are employed or starting a business, keeping debt in check is the first step to improving your financial position. Reports have shown that debt increases from your 20s through your 30s due to unpaid student loans as well as credit card debt, life changes and investments like buying a home.

Some young people get assistance from family members to pay off debt and get down payments for businesses or home purchases. If you are not in that position, there are trusted programs for student loan repayment as well as debt consolidation options through not-for-profit groups and banks. These programs reduce your monthly payments to improve cash flow.

Which leads me to options for business financing. Building a relationship with a trusted banker or CPA can help you explore options for financing a small business with better terms and lower interest rates. The most common and worst option is to use a credit card. Instead, explore SBA loans, business incubator programs in your community and even micro-loans from entrepreneurial organizations like BCL of Texas.

If possible, another way to manage debt is to increase your income. Ask for a raise. You may not get it, but you definitely won’t get it if you don’t ask. During performance reviews, cite the ways you have added value to the company, brought in or kept customers or improved processes. Prove your value with real examples.

Tip: To pay off your debt in less time, take the portion you were paying on a paid-off credit card, for example, and apply it to your next largest bill such as a car payment or your small business loan. You were paying that amount before, so you won’t miss it. As you pay off more debt, your monthly payment toward debt will stay the same but you will be able to apply a larger amount to specific bills — paying them off faster. Reserve debt like your mortgage until last because you receive an interest deduction on your taxes.

2. Increase Liquidity.

What is the result of paying off debt? Cash flow. Cash is king when trying to save money or run a business. There is often hidden cash in small businesses that don’t review accurate or timely financial statements. For example, we commonly discover invoices 60 days overdue or longer — money that should be in your account to support cash flow.

The leading cause of business failure — or a household for that matter — is insufficient cash flow. What often happens is that we spend what we earn. That is, any extra cash created from paid-off debt is spent on other needs and wants. It happens most often when we aren’t following a budget.

The ‘B’ word. When you don’t have a budget, you fall down through impulses and convenience. For example, eating out at bars, restaurants, expensive coffee shops and convenience stores is much more expensive than cooking food at home. You can still eat out, but a monthly budget for eating out will preserve your cash (and also give you an excuse with friends for staying in when you’re tired).

In the same way, a budget for your business will show you where expenses are increasing before they get out of control. Regular review of accounts receivables will support more timely customer payments. Accurate financial statements will keep your business in compliance for taxes and loan covenants as you grow.

Tip: If you haven’t already, invest in a program like QuickBooks® to easily and accurately record and monitor your financial position as well as pay bills, produce reports and support tax planning. Business owners, you can outsource bookkeeping to your CPA. You will benefit from well-organized financials and more time to attract new customers. Cornwell Jackson also offers outsourced payroll services.

3. Build Reserves and Investments.

A common rule of thumb for saving money has been to build an emergency fund that supports your household for six months. But let’s start small. A savings account that covers even one month of expenses is better than nothing.

Building reserves is easier without debt, but not impossible. By working from a budget for yourself and/or your business, you will naturally experience more cash flow. A portion of that cash can be set aside for emergencies and eventually for investments. Business owners, on average, should have cash reserves of 15 to 50 percent. Some financial planners suggest saving up to 40 percent of your personal income, living on 50 percent and giving 10 percent (more on giving in a moment).

If you don’t already participate in an employer-sponsored 401(k) plan, a simple IRA or a self-employment pension (SEP) for retirement, start saving now. Yes I know you may distrust Wall Street. Plus, a study by Harvard showed that most people aren’t wired to save for a rainy day. Who knows if saving will add up to anything or if you’ll even be around to enjoy it? I suggest having several different vehicles for saving to make it more fun. You can invest in bonds, land, a franchise, gold…the point is that savings allows you to have options to make investments when the timing and opportunities are right. Don’t you wish you had some shares of that latest app that just went public? Yeah, me too.

Tip: The key to savings? Don’t touch it. Some people transfer savings automatically from their paychecks to their savings and retirement accounts. Business owners can either build a percentage for savings into their customer agreements (i.e. raise prices) or allocate a portion of each invoice toward cash reserves. Out of sight is out of mind.

4. Pay it Forward.

When it comes to being generous, millennials are pretty great. We are more likely to share our assets out of generosity than from obligation. Sure, it’s partly for survival purposes and partly because we like doing stuff together.

When you have a stronger financial position, you can be even more generous. Your business may allow you to select a particular cause to support — donating a portion of your proceeds or doing team fund-raisers. You can also support the livelihoods of employees. It’s a commonly cited statistic from the Small Business Administration that small businesses create a larger percentage of new jobs in the U.S. (companies of 100 people or less) than larger companies.

Your business may even target a social cause. In Dallas, the United Way of Tarrant County actually held a pitch competition with the support of entrepreneurial groups to promote social change ideas.

You can also pay it forward personally. As I mentioned earlier, I support recruitment at my firm as well as new employee onboarding. My leadership position has not only improved my income, but also my ability to give back. And isn’t that higher sense of purpose what we crave most from our careers anyway?

Tip: Who has helped you along the way and which causes pull at your heart? Look in that direction to start giving back as you advance in your career or business aspirations. You need a bigger reason for working so hard or starting a business than making money. Previous generations have taught us that.

What’s Next?

This guide is really a wake-up call to prepare you for business ownership or new financial opportunities. You have the power and the intelligence to influence our economy. Get started now. For more tips:

  • The AICPA has a campaign called “Feed the Pig” that offers many resources
  • Your local bank or credit union likely has a resources section for increasing savings or exploring financing
  • You can join a local entrepreneurial or small-business mentoring group for ideas as well as accountability for your goals. Find your group in the Dallas/Fort Worth area using the Meetup app.
  • Read new articles on Cornwell Jackson’s blog and in our Knowledge Base section.

Download the Whitepaper: Financial Planning for Millennials Gaining Career Success   

 

Mike Rizkal, CPA is a partner in Cornwell Jackson’s Audit and Attest Service Group. In addition to providing advisory services to privately held, middle-market businesses, Mike oversees the firm’s ERISA practice, which includes annual audits of approximately 75 employee benefit plans. Did we mention that he’s a millennial and will take any opportunity to be outdoors, including outdoor grilling? Contact him at mike.rizkal@cornwelljackson.com.

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Posted on Mar 29, 2017

The Internal Revenue Code offers two federal income tax credits for post-secondary education expenses: the American Opportunity credit, and the Lifetime Learning credit.

The Basics of Higher Education Credits

The American Opportunity credit can be up to $2,500 per eligible student per year. More specifically, the credit equals:

  • 100% of the first $2,000 of an eligible student’s qualified expenses, plus
  • 25% of the next $2,000 of qualified expenses.

So, the maximum annual credit for an eligible student is $2,500. Families with several eligible students can claim multiple American Opportunity credits. However, the credit can be claimed only for the first four years of a student’s undergraduate education. Also, this credit is phased out at higher income levels. Finally, 40% of the allowable American Opportunity credit is generally refundable, which means that amount can be collected even if the taxpayer has no federal income tax liability.

The Lifetime Learning credit can be up to $2,000 per year. More specifically, the credit equals 20% of the first $10,000 of an eligible student’s qualified expenses. However, only one Lifetime Learning credit can be claimed on your return, regardless of how many students in your family may be eligible for the credit. The Lifetime Learning credit is also subject to a phase-out rule that takes effect at much lower income levels than the American Opportunity credit phase-out rule.
While these credits aren’t new, you should be aware of several recent developments that might affect your 2016 federal income tax return if you have students in your family who may be eligible for these credits. In light of these developments, here are four tips to help preserve and maximize your credits.

Don’t Claim Computer Costs Unless Required by School

The U.S. Tax Court recently decided that the cost of a computer isn’t eligible for the American Opportunity credit unless the school specifically requires the student to have one. In this case, the taxpayer bought a computer for his college English class, because he needed the computer to prepare a paper while he was traveling. According to the Tax Court, the cost of the computer wasn’t a qualifying expenditure for the American Opportunity credit, because having a computer wasn’t a condition of the student’s enrollment. (Djamal Mameri v. Commissioner, T.C. Summary Opinion 2016-47)

Claim Credits When Tuition Is Paid (Not When It’s Billed or Due)

In another recent Tax Court decision, the taxpayer was a student at Arizona State University. In December 2011, the taxpayer prepaid his tuition for the spring semester of 2012. The tuition bill wasn’t actually due until January 2012. The taxpayer then claimed a $2,500 American Opportunity credit on his 2012 federal income tax return, based on the tuition for the 2012 spring semester. (Lucas McCarville v. Commissioner, T.C. Summary Opinion 2016-14)

The IRS disallowed the taxpayer’s credit for 2012, citing tax code provisions that stipulate that tuition payments made in the current year (2011 in this case) for educational sessions that begin in the first three months of the following year (2012 in this case) are eligible for the American Opportunity credit only in the current year (the year of payment, which was 2011 in this case).

The taxpayer had already claimed the maximum $2,500 American Opportunity credit on his 2011 return. So he was attempting to include the payment for the spring 2012 semester tuition (paid in 2011) on his 2012 return in order to claim a $2,500 American Opportunity credit for that year. The Tax Court agreed with the IRS, requiring credits to be claimed in the year in which a bill is paid, regardless of when it’s due.

Ask a Tax Pro to Help Reconcile Credits with Tuition Statements

Tax law requires post-secondary educational institutions to supply annual Form 1098-T, Tuition Statement, to taxpayers and the IRS. Taxpayers are supposed to use the amount of qualified tuition and related fees reported on these forms to calculate their allowable education credits. In turn, the IRS can use the same information to see if taxpayers got it right. But this common-sense provision won’t work the way it is supposed to anytime soon. As a result, there will be ongoing confusion about tuition and fee information reported on Form 1098-T.

For pre-2016 years, Form 1098-T issued by educational institutions could report either:

  • Payments received by the institution during the year for qualified tuition and related fees, or
  • Amounts billed by the institution during the year for qualified tuition and related fees.

Many institutions chose to report amounts billed, because that information was more easily retrieved from their accounting systems. However, the amount billed during the year isn’t what a taxpayer needs to know to calculate the allowable credit for that year. Instead, taxpayers need to know the amount paid during the year. Therefore, the information reported on Form 1098-T can be misleading to both taxpayers who claim education credits and to the IRS when reviewing the credits.

Congress attempted to correct this situation by requiring educational institutions to report qualified tuition and related fees paid during the year, starting with Form 1098-T issued for 2016. However, many institutions complained that they didn’t have time to reprogram their accounting systems to provide that information. The IRS caved by giving institutions the option to continue reporting amounts billed during the year on Form 1098-T issued for both 2016 and 2017.

Therefore, Form 1098-T issued for both 2016 and 2017 can report either:

  • The total amount billed by the institution during the year for qualified tuition and related fees, or
  • The total amount paid to the institution during the year.

Taxpayers must base their education credit calculations on amounts paid during the year, but Form 1098-T for 2016 and 2017 may not supply that information. As a result, reconciling credit amounts claimed on tax returns with tuition and fee amounts reported on Form 1098-T will continue to be problematic for many taxpayers.

Beware of Fraud Prevention Measures

Fraudulent claims for higher education tax credits have become common. So, Congress enacted two anti-fraud controls that apply to 2016 returns:

First, you can’t claim the American Opportunity credit for a student who doesn’t have a federal tax identity number (TIN) issued on or before the due date of the return for that year. For a U.S. citizen, the TIN is his or her Social Security number (SSN). Noncitizens can obtain TINs that aren’t SSNs.

Second, when you file your tax return, you must include the educational institution’s employer identification number (EIN) on Form 8863, Education Credits, for each student for whom you claim the American Opportunity or Lifetime Learning credit.

Need Help?

College is expensive. So, why not let Uncle Sam help make it more affordable via higher education tax credits? Contact us about navigating the rules to ensure you maximize the credits that are currently available under the tax law.

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Posted on Mar 27, 2017

If you own a profitable, unincorporated business with your spouse, you’re probably fed up with high self-employment (SE) tax bills.

Self-Employment Tax Basics

For 2016, the maximum 15.3% self-employment (SE) tax rate hits the first $118,500 of net SE income. For 2017, the 15.3% rate hits the first $127,200 of net SE income. It includes 12.4% for the Social Security tax component and 2.9% for the Medicare tax component.

Above the Social Security tax ceiling, the Social Security tax component goes away, but the Medicare tax component continues at a 2.9% rate before rising to 3.8% at higher income levels.

If you have an unincorporated small business in which both you and your spouse participate, you may have been treating it as a 50/50 spouse-owned partnership or as a spouse-owned LLC that’s treated as a 50/50 partnership for tax purposes. The more profitable your business is, the more you’re paying in SE tax bills. That’s because you and your spouse must separately calculate your respective SE tax bills. For 2017, that means you will each pay the maximum 15.3% SE tax rate on the first $127,200 of your respective shares of net SE income from the business.

An unincorporated business in which both spouses are active is typically treated as a partnership that’s owned 50/50 by the spouses — or a limited liability company (LLC) that’s treated as a partnership for tax purposes and owned 50/50 by the spouses. In either case, you and your spouse must separately calculate your respective SE tax bills.

For 2017, that means you’ll each pay the maximum 15.3% SE tax rate on the first $127,200 of your respective shares of net SE income from the business. (See “Self-Employment Tax Basics” at right.) Those bills can mount up if your business is profitable. Here are three ways spouse-owned businesses can lower their combined SE tax hit.

1. Establish that You Don’t Have a Spouse-Owned Partnership (or LLC)

To illustrate the adverse tax consequences of operating a spouse-owned partnership, suppose you expect your business to generate $250,000 of net SE income in 2017. You and your spouse must separately calculate SE tax. So each of you will owe $19,125 ($125,000 x 15.3%), for a combined total of $38,250. To make matters worse, your SE tax bill is likely to increase every year due to inflation adjustments to the Social Security tax ceiling and the growth of your business.

These adverse effects apply only if you have a business that is properly treated as a 50/50 spouse-owned partnership or a spouse-owned LLC that’s properly treated as a 50/50 partnership for federal tax purposes.

Several IRS publications attempt to create the impression that involvement by both spouses in an unincorporated business automatically creates a partnership for federal tax purposes. For example, the Tax Guide for Small Business says, “If you and your spouse jointly own and operate an unincorporated business and share in the profits and losses, you are partners in a partnership, whether or not you have a formal partnership agreement.”

However, in many cases, the IRS will have a tough time making the argument that a business is a 50/50 spouse-owned partnership (or LLC). Consider the following quote from an IRS private letter ruling: “Whether parties have formed a joint venture is a question of fact to be determined by reference to the same principles that govern the question of whether persons have formed a partnership which is to be accorded recognition for tax purposes. Therefore, while all circumstances are to be considered, the essential question is whether the parties intended to, and did, in fact, join together for the present conduct of an undertaking or enterprise.”

The IRS private letter ruling identifies these factors, none of which is conclusive, as evidence of this intent:

  • The agreement of the parties and their conduct in executing its terms,
  • The contributions, if any, that each party makes to the venture,
  • Control over the income and capital of the venture and the right to make withdrawals,
  • Whether the parties are co-proprietors who share in net profits and who have an obligation to share losses, and
  • Whether the business was conducted in the joint names of the parties and was represented to be a partnership.

In many situations where both spouses have some involvement in an activity that has been treated as a sole proprietorship or in an activity that has been operated as a single-member LLC (SMLLC) that has been treated as a sole proprietorship for tax purposes, only some of the factors listed in the private letter ruling are present. Therefore, the IRS may not necessarily succeed in arguing that the business is a spouse-owned partnership (or LLC).

That argument may be especially weak when:

    • The spouses have no discernible partnership agreement, and
    • The business hasn’t been represented as a partnership to third parties, such as banks and customers.

If your business can more properly be characterized as a sole proprietorship or as an SMLLC that is treated as a sole proprietorship for tax purposes, only the spouse who is considered the proprietor owes SE tax.

Let’s assume the same facts as in the previous example, except that you take a supportable position that your business is a sole proprietorship operated by one spouse. Now you have to calculate SE tax for only that spouse. For 2017, the SE tax bill would be $23,023 [($127,200 x 15.3%) + ($122,800 x 2.9%)]. That’s much less than the combined SE tax bill from the first example ($38,250).

2. Establish That You Don’t Have a 50/50 Spouse-Owned Partnership (or LLC)

Not all businesses are owned 50/50 by their owners. Say your business can more properly be characterized as a partnership (or LLC) that’s owned 80% by one spouse and 20% by the other spouse, because one spouse does much more work than the other.

This time, let’s assume the same facts as in the previous example, except that you take a supportable position that your business is an 80/20 spouse-owned partnership (or LLC). In this scenario, the 80% spouse has net SE income of $200,000, and the 20% spouse has net SE income of $50,000.

For 2017, the SE tax bill for the 80% spouse would be $21,573 [($127,200 x 15.3%) + ($72,800 x 2.9%)], and the SE tax bill for the 20% spouse would be $7,650 ($50,000 x 15.3%). The combined total SE tax bill is $29,223 ($21,573 + $7,650), which is significantly lower than the total from the first example ($38,250).

3. Liquidate Spouse-Owned Partnership and Hire One Spouse as an Employee

This strategy is a little more complicated than the previous strategies. First, you’ll need to dissolve your existing spouse-owned partnership or spouse-owned LLC that’s treated as a partnership for federal tax purposes, and start running the operation as a sole proprietorship or SMLLC treated as a sole proprietorship for federal tax purposes. Even if the partnership (or LLC) owns assets and has liabilities, this step is generally a tax-free liquidation under the partnership tax rules.

The second step is to hire one spouse as an employee of the new proprietorship (SMLLC). Pay that spouse a modest cash salary, and withhold 7.65% from the salary checks to cover the employee-spouse’s share of Social Security and Medicare taxes. As the employer, the proprietorship must pay another 7.65% directly to the government to cover the employer’s half of Social Security and Medicare taxes. However, since the employee-spouse’s salary is modest, the Social Security and Medicare tax hits will also be modest.

The third step is to consider setting up a Section 105 medical expense reimbursement plan for the employee-spouse. Use the plan to cover your family’s out-of-pocket medical expenses, including health insurance premiums, by making reimbursement payments to the employee-spouse out of the proprietorship’s business checking account. Deduct the plan reimbursements as a business expense of the proprietorship. On the employee-spouse’s side of the deal, the plan reimbursements are free of federal income, Social Security and Medicare taxes because the plan is considered a tax-free fringe benefit.

The fourth step is to deduct, on the sole proprietorship’s (SMLLC’s) tax schedule, the medical expense plan reimbursements, the employee-spouse’s cash salary, and the employer’s share of Social Security and Medicare taxes. These deductions also reduce the proprietor’s net SE income and the SE tax bill for the business.

Finally, you’ll need to calculate the SE tax bill for the spouse who is treated as the proprietor. This minimizes the SE tax hit, because the maximum 15.3% SE tax rate applies to no more than $127,200 of SE income (for 2017), vs. up to $254,400 if you continue to treat your business as a 50/50 spouse-owned partnership (or LLC).

Important note: If you have employees other than the spouse, your business may have to cover them under a Section 105 medical expense reimbursement plan.

Consult a Tax Pro

SE taxes can quickly add up, but there are several strategies that spouse-owned businesses can use to reduce their combined total bill. Consult your tax advisor before using any of these strategies to avoid any potential pitfalls and make the optimal choice for your business.

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Posted on Mar 17, 2017

We know it’s a tough transition to stare at your 30s and say good-bye to youth. Seriously, though, millennials have great opportunities to transform how people live, work and do business in the next three decades. With that power comes great responsibility to manage your finances wisely. This article will stare into the abyss of mortality with you and help you recognize the possibilities to soar rather than settle.

We’ve paid so much attention to millennials in the past decade because frankly, there are a lot of us. Current estimates put our generation at 86 million in the U.S.; that’s 7 percent larger than the Baby Boom generation according to Barron’s. By 2020, millennials are expected to be 50 percent of the US workforce and 40 percent of all voters. Our generation will have significant influence over working conditions (already happening) and over the role of government (with unified efforts).

There may be several minor issues holding millennials back from success:

  • Debt
  • Older retirement ages
  • Fewer available jobs
  • Time
  • Distrust of institutions

Did I say minor issues? Yes, you can either accept your fate as doomed or do what many millennials are doing: build a career from scratch. Some call it a portfolio career, in which an individual has several jobs or enterprises happening at the same time. Others just call that being entrepreneurial.

Entrepreneurial Potential

Reports in Entrepreneur and Forbes call millennials the “most entrepreneurial generation.” I’m not sure that’s true given that the “greatest generation” built a new economy after World War II with a lot of closely held and family-owned businesses that later became household names. They, like us, had little choice but to pick up their feet and make something out of a changing society. Their kids, the Boomers, eventually cut their long hippie hair and followed suit (see what I did there?) and either went into mom and dad’s business or took the college route to a white-collar profession. Today, Boomers are working longer or starting new businesses with the idea that retirement is not about lounging by a pool (because boring). It’s about the ability to choose how you work.

Millennials do seem to have entrepreneurial characteristics, probably by necessity because it’s been so difficult to find employment that fits their degrees. They have:

  • Optimism
  • Digital skills
  • Networks
  • Practicality

Most people our age were taught that everybody gets a fair shot and that it’s fun to work in groups. Our networks have expanded from local to global and we would rather shop online than bother with a store — unless it’s to try something on and then buy it online.

We are open to new technologies and we catch on to them pretty quickly to make life easier. Plus, we prefer to find people with skills we don’t possess and then collaborate to achieve a goal. These four characteristics move us toward leadership in a company or entrepreneurship, both of which can improve our financial position for the future.

I was fortunate. I started at Cornwell Jackson as a first-year auditor in 2004 right out of college from Texas Tech. I was doubly fortunate to have a lot of mentorship and professional development through my family and the firm, which helped me move into leadership positions to support the audit team as well as recruiting. I became a partner in 2015. A great part of my job is helping young leaders and entrepreneurs create financial stability through strong accounting processes and skills.

The good news is that you have time. On average, an entrepreneur doesn’t take the leap into business ownership until his or her late 30s or early 40s. You can still get your financial house in order to plan for small business ownership — or even a side venture from your “day job.”

Continue Reading: Financial Planning Tips to Help You Gain Success

 

Mike Rizkal, CPA is a partner in Cornwell Jackson’s Audit and Attest Service Group. In addition to providing advisory services to privately held, middle-market businesses, Mike oversees the firm’s ERISA practice, which includes annual audits of approximately 75 employee benefit plans. Did we mention that he’s a millennial and will take any opportunity to be outdoors, including outdoor grilling? Contact him at mike.rizkal@cornwelljackson.com.

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Posted on Mar 13, 2017

In a significant case, homebuilders that want to realize income under the completed contract accounting method based on an entire development won a victory.

The United States Court of Appeals for the Ninth Circuit upheld a lower court ruling affirming that a homebuilding group could defer tax under the completed contract method rather than use the percentage-of-completion accounting method.

Background

A long-term contract covers the manufacture, building, installation, or construction of property, if not completed in the tax year in which the contract is signed. Although there are certain exceptions, contractors with these contracts generally must use the percentage-of-completion method, realizing income over time.

Under the regulations for long-term contracts, a job is complete on the earlier of:

1. When the subject matter of the contract is used by the customer for its intended purpose and at least 95% of the total allocable contract costs have been incurred by the taxpayer (the 95% test), or

2. When there is final completion and acceptance.
With the completed contract method, however, contractors don’t report any income until a contract is complete, although payments are received before completion. The completion date is determined without regard to whether secondary items in the contract have been used or finally completed and accepted.

The completed contract method may be engaged instead of the percentage-of-completion method in home construction and other real property construction contracts if the contractor:

Estimates that the contracts will be completed within two years of the start date, and

Meets a $10 million gross receipts test.
A home construction contract is one where 80% or more of the estimated total contract costs is reasonably expected to be attributable to the building, construction, reconstruction, or rehabilitation of dwelling units contained in buildings containing four or fewer dwelling units, and to improvements to real property directly.

Facts of the Case

Shea Homes Inc. and several subsidiaries formed an affiliated group of corporations. The group built and sold homes in master planned community developments in Arizona, California and Colorado. The communities ranged in size from 100 homes to more than 1,000. The group’s business model emphasized the special features and amenities of master planned communities, which can include parks, golf courses, lakes, bike paths, and jogging trails.

The purchase price of each home included the building, lot, improvements to the lot, infrastructure and common area improvements, financing, fees, property taxes, labor and supervision, architectural and environmental design, bonding and other costs. Income from the sale of homes was based on completion of the entire development, rather than on the sale of each individual home. The IRS disagreed with the group’s use of that accounting method and assessed deficiencies. Eventually, the case went to court.

Round 1. The Tax Court looked at eight representative developments out of 114 that the group built during the tax years in question.

The group contended that completion and acceptance didn’t happen until the last road was paved and the final performance bond required by state and municipal law was released.

The IRS argued that the subject matter of the taxpayers’ contracts consisted only of the houses and the lots upon which the houses were built. Under the tax agency’s interpretation, the contract for each home met the completion and acceptance test when escrow was closed for the sale of each home. It also said that these contracts, which were entered into and closed within the same tax year, weren’t long-term contracts.

But the U.S. Tax Court upheld the group’s interpretation of the completed contract method. It also held that the subject matter of the contracts consisted of the home and the larger development, including amenities and other common improvements.

The court rejected the IRS argument that the subject of the contract was just the lot and the house, and that the common improvements in the development were only secondary items that didn’t affect completion of the contract.

Court’s Interpretation of the Primary Subject

The primary subject matter of the contracts included the house, lot, improvements to the lot, and common improvements to the development, the court ruled. The amenities were crucial to the sales effort and buyers’ purchase decisions as well as to obtaining government approval for the development. Accordingly, the amenities were an essential element of the home sales contracts.

Round 2: On appeal, the IRS tried a different argument. It conceded that the group’s home construction contracts encompassed more than just individual homes and lots and included common improvements of each planned community that the group was contractually obligated to build.

But it asserted that the group had applied the 95% test incorrectly.

The IRS argued that each contract pertained to the particular home and lot plus the common areas, but not the other homes in the community. By taking this approach, the IRS reasoned that the 95% test would be met only when the group incurred 95% of the budgeted costs of the home, lot and common amenities, but not the costs of the other homes.

The Ninth Circuit Court didn’t buy that argument. It said that the group’s application of the 95% test clearly reflected income because the purchasers of the homes were contracting to buy more than the homes’ mere “bricks and sticks.” . They were paying a premium because they expected to enjoy benefits and a certain lifestyle from the community’s amenities.

The Ninth Circuit affirmed the Tax Court’s decision.

A Victory for Deferring Taxes

This case clearly signals a victory for homebuilders that want to realize income under the completed contract method based on an entire development, not the separate sales of individual homes. However, other considerations may come into play. Consult with your tax advisor about the facts of your specific situation. (Shea Homes, Inc., No. 14-72161, CA-9, 8/24/16).

Another Circuit Court Sides with the IRS

The IRS prevailed in a similar case, but with a couple of important differences.

The Fifth Circuit Court of Appeals upheld a U.S. Tax Court decision that a residential land developer’s sale and custom lot contracts constituted long-term construction contracts, but weren’t home construction contracts as defined by tax law. Thus, the developer couldn’t use the completed contract method.

There are two critical distinctions in this case from the Shea Homes case before the Ninth Circuit Court of Appeals:

1. The taxpayer in this case wasn’t a homebuilder, but rather a land developer that sold finished lots to builders that sold the homes to consumers.

2. The tax deferral resulting from the use of the completed contract method by the Shea group was, on average, less than five years. In contrast, the deferral period in the Fifth Circuit case was much longer in a number of instances. (Howard Hughes Company, LLC, 805 F.3d 175, CA-5, 10/27/15)

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Posted on Mar 10, 2017

The first part of the new OSHA “illness and injury” reporting regulations is straightforward enough. It states that those who are already required to file these reports must now submit the forms electronically, via a secure OSHA website. Companies not currently required to file injury and illness reports aren’t affected by the new rules.

Electronic reporting, says OSHA, will allow the agency to “use its enforcement and compliance assistance resources more efficiently.”

Electronic Filing Timetable

The requirement to report electronically varies by the size of the company, which is calculated according to its peak employment during the prior calendar year. Be aware that a single employer can have more than one establishment, defined by OSHA as “a single physical location where business is conducted or where services or industrial operations are performed.”

Companies with at least 250 employees must electronically submit injury and illness information from OSHA forms 300, 300A and 301. These companies must begin submitting information from form 300A electronically as of July 1, and information from all forms by July 2018.

Smaller companies (those with at least 20 employees) are also subject to the same timetable if they operate in one of 66 industries deemed by OSHA to be “high risk.” These industries range from agriculture to waste treatment, from psychiatric and substance abuse hospitals to museums. Even if you don’t think of your industry as “high risk,” it would be prudent to reference OSHA’s classification system.

Companies with fewer than 20 employees that are already subject to OSHA reporting in non-high-risk industries can continue reporting on paper forms.

Combating Retaliation

The thornier provision of the new OSHA regulations is intended to improve on certain existing rules which were put in place to prevent employer retaliation after an employee reports a work-related illness or injury. Before the new regulations took effect, OSHA was limited in its ability to punish an employer that it believed had discharged or discriminated against an employee based on a complaint. First, the employee needed to file a complaint with OSHA within a month of the alleged retaliation.

Under the new rule, OSHA will be able to go after employers it believes has retaliated, even without an employee complaint, and even if the employer “has a program that deters or discourages reporting through the threat of retaliation.” This change, OSHA believes, gives the agency “an important new tool in encouraging employers to maintain accurate and complete injury records.”

What Will OSHA Look for?

A key area that OSHA will review in looking for retaliation is whether a company has a post-accident drug testing policy. The mere existence of a policy isn’t problematic but might be if an employer uses it to threaten employees who file work-related accident or injury reports. Here’s OSHA’s statement: “Drug testing policies should limit post-incident testing to situations in which employee drug use is likely to have contributed to the incident, and for which the drug test can accurately identify impairment caused by drug use.”

OSHA also states that “drug testing that is designed in a way that may be perceived as punitive or embarrassing to the employee is likely to deter injury reporting.”

Before OSHA can claim that an employer’s post-accident drug testing policy is evidence of the intent to discourage accident reporting, the agency has to make a reasonable case. How? An example would be when an accident involves more than one employee, but only the employee who reported the accident was subjected to a drug test.

Root Causes

Suppose, on the other hand, OSHA concludes that the employer’s drug-testing policy serves “as a tool to evaluate the root causes of workplace injuries and illness in appropriate circumstances,” as stated in agency guidelines. In that case, it would likely not be troubled by such a policy.

Employers may also protect themselves by establishing formal and logical criteria that may trigger drug testing. For example, when an accident results in a minimum level of property damage or severity of injury, a drug test will be the norm.

In addition, for employers that have a mandatory post-accident drug testing requirement, periodic checking to see if the policy has positively resulted in curbing future accidents may be helpful. In cases where no positive impact is discernible, employers might consider eliminating the policy.

Finally, be sure you’ve complied with the longstanding OSHA requirement that you post OSHA’s Job Safety and Health “It’s the Law” poster at your worksite. This is a list of worker rights that includes employees’ ability to “raise a safety or health concern with your employer or OSHA, or report a work-related injury or illness, without being retaliated against.”

Beat OSHA to the Punch

With OSHA heating up its efforts to find and eliminate retaliation, employers would be wise to proactively review their policies when an injury or illness report is filed. Even where there’s no intent to retaliate, if the appearance of “payback” is there, you could be in hot water. Remember, OSHA no longer requires an employee complaint if it wants to raise the hood on your processes and take a look. Beat them to the punch by ensuring your company gets and stays in compliance.

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Posted on Mar 8, 2017

Are any of your workers subject to wage garnishments?

The Department of Labor’s Wage and Hour Division (WHD) has revised and clarified its guidance on the meaning of earnings under the Consumer Credit Protection Act (CCPA). The expanded list includes:

  • Lump sum payments: Previously, the department said payments must be periodic to be covered earnings.
  • Cash wages paid directly to employees and the amount of the tip credit claimed by the employer (previously, the division said that tips are gratuities, not compensation).

The revisions are contained in Fact Sheet #30: The Federal Wage Garnishment Law, Consumer Credit Protection Act’s Title III (CCPA).

Other forms of compensation defined as earnings under the law include:

  • Wages,
  • Salaries,
  • Commissions,
  • Bonuses, and
  • Other compensation, such as periodic payments from a pension or retirement program or payments from an employment-based disability payment program.

Crucial Definition

The federal definition of earnings is critical because if the funds aren’t CCPA-protected earnings, states can decide whether to garnish those funds and how much, if any, of those funds to protect from garnishment.

A wage garnishment is any legal or equitable procedure through which a portion of a person’s earnings must be withheld for the payment of a debt. Most garnishments are made by court order.

Other types of legal or equitable procedures for garnishment include IRS or state tax collection agency levies for unpaid taxes and federal agency administrative garnishments for nontax debts owed the federal government.

Title III of the CCPA prevents employers from firing workers because their wages have been garnished for any one debt and limits the amount of an employee’s earnings that may be garnished in a week. The protection doesn’t apply if the earnings are being garnished for a second or subsequent debt.

Garnishment Limit

In addition, Title III limits the amount of earnings that may be garnished in any workweek or pay period to the lesser of:

  • 25% of disposable earnings, or
  • The amount by which disposable earnings are greater than 30 times the federal minimum hourly wage, which currently is $7.25 under the Fair Labor Standards Act.

In no event can the amount of an individual’s disposable earnings that may be garnished exceed the percentages specified in the CCPA. Garnishment limits don’t apply to certain bankruptcy court orders or to voluntary wage assignments where workers voluntarily agree that their employers may turn over a specified amount of their earnings to creditors.

States have their own garnishment laws (see box below). When state and federal garnishment regulations differ, employers must observe the law that calls for the smaller garnishment or prohibits the discharge of an employee when earnings have been subject to garnishment for more than one debt.

Questions over issues other than the amount being garnished or termination must be referred to the court or agency initiating the action. For example, the CCPA contains no provisions controlling the priorities of garnishments, which are determined by state or other federal laws.

Child Support and Alimony

Under court orders for child support or alimony, the garnishment law allows up to 50% of an employee’s disposable earnings, and sometimes up to 60% depending on the situation. An extra 5% may be garnished for support payments that are more than 12 weeks in arrears.

Violations of Title III may result in:

  • The reinstatement of a discharged employee,
  • Payment of back wages,
  • Restoration of improperly garnished amounts, and
  • Criminal prosecution, fines and prison terms if the violations are willful.

The fact sheet provides several detailed examples on computing the amount subject to garnishment. Among them:

  1. An employee receives a bonus one week of $402. After deductions required by law, the disposable earnings are $368. In this week, 25% of the disposable earnings may be garnished. ($368 times 25% = $92).
  2. An employee paid every other week has disposable earnings of $500 for the first week and $80 for the second week, for a total of $580. In a biweekly pay period, when disposable earnings are at or above $580 for the period, 25% may be garnished. In this example, $145 can be taken (25% times $580). It doesn’t matter that the disposable earnings in the second week are less than $217.50.
  3. Under a garnishment order (with priority) for child support, an employer withholds $90 a week from the wages of an employee who has disposable earnings of $295 a week. A garnishment order for the collection of a defaulted student loan is also served on the employer.

If there was no garnishment order (with priority) for child support, Title III’s general limitations would apply to the garnishment for the defaulted student loan, and a maximum of $73.75 (25% times $295) would be garnished each week. However, the existing garnishment for child support means in this example that no additional garnishment for the defaulted student loan may be made. That’s because the amount already garnished is more than the 25% that may be generally garnished. Additional amounts could be garnished to collect child support, delinquent federal or state taxes, or certain bankruptcy court ordered payments.

States Weigh In On Law to Promote Uniformity

The Uniform Law Commission last year wrapped up three years of work by finalizing the Uniform Wage Garnishment Act (UWGA). The UWGA is aimed at helping put employers one step closer to having a standardized approach for processing wage garnishments across states.

The UWGA streamlines the garnishment process and ensures nationwide consistency. It’s also intended to cut costs for employers.

The law must still be adopted by state legislatures before becoming effective. So far Nebraska has introduced legislation to adopt the measure and others are expected to follow.

The commission is a 125-year-old organization that drafts legislation to improve commerce between the states. The panel is comprised of commissioners of the 50 states, Puerto Rico and the Virgin Islands.

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Posted on Mar 6, 2017

Did you know that, once you turn age 70½, you must start taking mandatory annual withdrawals from your traditional IRAs, including any simplified employee pension (SEP) accounts and SIMPLE IRAs that you set up as a small business owner?

Beyond Your IRAs

Different rules and conditions may apply to RMDs from inherited accounts and your qualified employer-sponsored retirement plans, including:

  • 401(k) plans,
  • 403(b) plans,
  • 457(b) plans,
  • Profit sharing plans, and
  • Other defined contribution plans.

If the retirement plan account is an IRA or the account owner is a 5% owner of the business sponsoring the retirement plan, the RMDs must begin once the account holder is age 70 ½.

The rules regarding RMDs can be complex, so be sure to contact your tax advisor to ensure you’re in compliance.
These mandatory IRA payouts are called required minimum distributions (RMDs). And there’s a stiff penalty if you fail to take timely distributions.

Unfortunately, taking RMDs also will cause you to report additional taxable income on your federal income tax return. This will increase your federal income tax liability and possibly your state income tax liability, if applicable. Here are the rules regarding RMDs and a tax-smart strategy for meeting your RMD obligations.

If You Hit the “Magic Age” in 2016

Your first RMD must be taken by no later than April 1 of the year after the year you turn 70½. So, if you hit the “magic age” last year, the April 1 deadline for you to take your initial RMD is almost here. Remember, however, that this initial RMD is for the 2016 tax year, even though you still don’t have to withdraw it until April 1, 2017.

If you fail to withdraw the full RMD amount by April 1, 2017, the IRS will charge you a penalty equal to 50% of the shortfall (the difference between the RMD amount you should have taken for the 2016 tax year and the amount you withdrew through April 1, 2017).

If you already took one or more traditional IRA withdrawals last year that equaled or exceeded the amount of your RMD for the 2016 tax year, you can ignore the April 1 RMD deadline. Just remember to take your second RMD, for the 2017 tax year, by December 31, 2017. The calendar year-end deadline applies for all future years too.

Calculating RMDs

For the 2016 calendar year, the RMD amount that you must withdraw by April 1, 2017, if you turned 70½ in 2016 — or were required to withdraw by December 31, 2016, if you previously turned 70½ — equals the combined balance of all your traditional IRAs (including any SEP accounts and SIMPLE IRAs) as of December 31, 2015, divided by a life-expectancy factor based on your age as of December 31, 2016.

You can choose to withdraw that amount from any one of your traditional IRAs or from several IRAs. If your spouse also has one or more traditional IRAs set up in his or her own name, the RMD rules apply separately to those accounts. So, if your spouse turned 70½ last year, he or she may need to heed the April 1 deadline, too.

Important note: Roth IRAs established in your name are exempt from the RMD rules for as long as you live. So, you can continue to invest the full amount of your Roth IRA balances and continue to produce tax-free income throughout your lifetime.

Consider a Tax-Free Alternative

Instead of taking taxable RMDs, individuals who have reached age 70½ can make annual cash donations to IRS-approved charities directly from their IRAs. These so-called qualified charitable distributions (QCDs) come out of your traditional IRA free from federal income tax. (Other IRA distributions, including RMDs, are generally at least partially taxable.)

Unlike cash donations to charities, you can’t claim itemized deductions for QCDs. However, the tax-free treatment of QCDs equates to a 100% deduction, because you’ll never be taxed on those amounts.

As an added bonus, a QCD coming from a traditional IRA counts as a distribution for purposes of complying with the RMD rules. Therefore, if you turned 70½ last year and haven’t yet taken your RMD for last year, you can arrange for one or more QCDs between now and April 1, 2017, to meet all or part of your RMD obligation for the 2016 tax year. In other words, you can substitute one or more tax-free QCDs for the RMD that you would otherwise have to take by April 1, 2017, and pay taxes on.

Following QCD Guidelines

A QCD must meet the following requirements:

  • It can’t occur before the IRA owner turns 70½.
  • It must meet the requirements for a 100% deductible donation under the itemized charitable deduction rules. If you receive any benefits that would be subtracted from a donation under the normal charitable deduction rules — such as tickets to a sporting or social event — the IRA distribution isn’t considered a QCD, and you’ll owe taxes on it.

In addition, there’s a $100,000 limit on total QCDs for the year. But if you and your spouse both own IRAs, you’re each entitled to a separate $100,000 annual QCD limit.

Need Help?

Individuals who are 70½ or older should be aware of the RMD rules and the deadlines that apply in the year they turn 70½ and beyond. If you have questions or want more information about RMDs, or you’re interested in taking advantage of the QCD option, contact your tax advisor.

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Posted on Feb 24, 2017

If you own an unincorporated small business, you may be getting fed up with high self-employment (SE) tax bills. One way to lower your SE tax liability is to convert your business to an S corporation.

SE Tax Basics

Sole proprietorship income as well as partnership income that flows through to partners (except certain limited partners) is subject to SE tax. These rules also apply to single-member limited liability companies (LLCs) that are treated as sole proprietorships for federal tax purposes and multimember LLCs that are treated as partnerships for federal tax purposes.

For 2017, the maximum federal SE tax rate of 15.3% hits the first $127,200 of net SE income. That rate includes 12.4% for the Social Security tax and 2.9% for the Medicare tax.

The rate drops after SE income hits $127,200 because the Social Security tax component goes away above the Social Security tax ceiling of $127,200 for 2017 (up from $118,500 for 2016). But the Medicare tax continues to accrue at a 2.9% rate, and then it increases to 3.8% at higher income levels because of the 0.9% additional Medicare tax. (This 0.9% tax applies to the extent that wages and SE income exceed $200,000 for singles and heads of households, $250,000 for married couples filing jointly, and $125,000 for married couples filing separately. The tax is part of the Affordable Care Act, so it likely will disappear if the ACA is repealed or replaced.)

We’ll refer to the Social Security and Medicare taxes collectively as federal employment taxes.

Example 1

Suppose your sole proprietorship is expected to generate net SE income of $200,000 in 2017. Your SE tax bill will be $21,573 [($127,200 x 15.3%) + ($72,800 x 2.9%)]. That’s a sizable amount — and it’s likely to get bigger every year due to inflation adjustments to the Social Security tax ceiling and the growth of your business.

SE Tax Reduction Strategy

To lower your SE tax bill in 2017 and beyond, consider converting your unincorporated small business into an S corporation and then paying yourself (and any other shareholder-employees) a modest salary. Distribute most (or all) of the remaining corporate cash flow to the shareholder-employee(s) as federal-employment-tax-free distributions. Here’s why this SE tax-saving strategy works.

For compensation paid to an S corporation employee in 2017, including an employee who also is a shareholder, the FICA tax rate is 7.65% on the first $127,200. This includes 6.2% for the Social Security tax and 1.45% for the Medicare tax. Above $127,200, the rate drops to 1.45% because the Social Security tax component goes away. But the 1.45% Medicare tax component continues indefinitely. At higher wage levels, S corporation employees must also pay the additional 0.9% Medicare tax. FICA tax is paid by the employee through withholding from employee paychecks.

The employer then pays in matching amounts of Social Security tax and Medicare tax (other than the additional 0.9% tax) directly to the U.S. Treasury. So the combined FICA and employer rate for the Social Security tax is 12.4%, and the combined rate for the Medicare tax is 2.9%, rising to 3.8% at higher income levels. These are the same as the SE tax rates. That’s the bad news.

The good news is that S corporation taxable income passed through to a shareholder-employee and S corporation cash distributions paid to a shareholder-employee aren’t subject to federal employment taxes. Only wages paid to shareholder-employees are subject to federal employment taxes.

This favorable federal employment tax treatment places S corporations in a potentially more favorable position than businesses that are conducted as sole proprietorships, partnerships or LLCs (if treated as sole proprietorships or partnerships for federal tax purposes).

Example 2

Assume the same facts as the previous example, except this time you operate your business as an S corporation that generates net income of $200,000 before paying your salary of $60,000. (Assume you could find somebody to do the same work for about that amount.) Only the $60,000 salary amount is subject to federal employment taxes, which amount to $9,180 ($60,000 x 15.3%). That’s significantly lower than you’d pay as a sole proprietor ($21,573).

The Caveats

This tax-saving strategy isn’t right for every business. Here’s some food for thought as you consider changing your business structure:

1. Operating as an S corporation and paying yourself a modest salary will save SE tax as long as your salary can be proven to be reasonable, albeit on the low side of reasonable. Otherwise you run the risk of the IRS auditing your business and imposing back employment taxes, interest and penalties.

However, you can help minimize the risk that the IRS will successfully challenge your stated salary amounts if you gather objective market evidence to demonstrate that outsiders could be hired to perform the same work for salaries equal to what you’re paying shareholder-employee(s).

2. A potentially unfavorable side effect of paying modest salaries to S corporation shareholder-employee(s) is that it can reduce your ability to make deductible contributions to tax-favored retirement accounts. If the S corporation maintains a Simplified Employee Pension (SEP) or traditional profit-sharing plan, the maximum annual deductible contribution for each shareholder-employee is limited to 25% of his or her salary.

So, the lower the salary, the lower the maximum contribution. However, if the S corporation sets up a 401(k) plan, paying modest salaries won’t preclude generous contributions.

3. Operating as an S corporation will require some extra administrative hassle. For example, you must file a separate federal return (and possibly a state return, too).

In addition, transactions between S corporations and shareholders must be scrutinized for potential tax consequences, including any transfers of assets from an existing sole proprietorship or partnership to the new S corporation. State-law corporation requirements, such as conducting board of directors meetings and keeping minutes, must be respected.

In most cases, these drawbacks are far less burdensome than the potential SE tax savings. Your tax advisor can help you minimize the downsides and work through the details.

Weighing the Upsides and Downsides

Converting an existing unincorporated business into an S corporation to reduce federal employment taxes can be a smart tax move under the right circumstances. That said, consult your tax advisors to ensure that all the other tax and legal implications are considered before making the switch.

Mechanics of Converting to S Corporation Status

To convert an existing sole proprietorship or partnership to an S corporation, a corporation must be formed under applicable state law and business assets must be contributed to the new corporation. Then an S election must be made for the new corporation by a separate form with the IRS by no later than March 15, 2017, if you want the business to be treated as an S corporation for calendar year 2017.

If you currently operate your business as a domestic limited liability company (LLC), it generally isn’t necessary to go through the legal step of incorporation in order to convert the LLC into an entity that will be treated as an S corporation for federal tax purposes. That’s because the IRS allows a single-member LLC or multimember LLC that otherwise meets the S corporation qualification rules to simply elect S corporation status by filing a form with the IRS. However, if you want your LLC to be treated as an S corporation for calendar year 2017, you also must complete this paperwork by no later than March 15, 2017.

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