Individuals whose businesses are incorporated typically do not have to worry about self-employment tax if they are paying themselves a reasonable salary. Any salary taken by owner-employees is subject to FICA taxes (Social Security and Medicare). FICA taxes are deducted from the shareholder’s paycheck and are remitted regularly through payroll tax payments to the IRS. Owners of sole proprietorships, partnerships, and limited liability companies (LLCs)—are not considered “employees” but “self-employed individuals”. Instead of paying FICA tax through wages, self-employed people pay self-employment tax. Partners, sole proprietors and LLC members do not take a regular salary through payroll, so there is no tax withheld from the payments they take which are called “draws”.
Self-employed individuals pay self-employment tax equal to the employer and employee share of FICA tax. In other words, they pay 15.3% (comprised of 12.5% for Social Security tax and 2.9% for Medicare tax) on the net earnings of their business. In basic terms, net earnings from self-employment is calculated by subtracting total expenses from total income. Oftentimes, self-employed clients get confused because they think they only pay tax on the draws they pay themselves from the business. This is not the case, however, because if the business is profitable and no draws are taken, the owner will still pay 15.3% self-employment tax on those profits. The draws that the owner takes do not decrease the net profits of the business and generally have no effect on self-employment tax. There are some “draws” called ‘guaranteed payments” taken by some partners in a partnership that do decrease the profits of the other partners, but those guaranteed payments are still subject to the 15.3% self-employment tax for the partner who has received such payments. An LLC can elect to be taxed as a corporation thereby allowing the owners to take a regular salary and have some control over the self-employment tax that they pay. This is a good option for LLCs that are profitable.
Extender from PATH Act means you can take bonus depreciation on your 2015 returns – but should you?
Once again, bonus depreciation has been extended allowing taxpayers to recover the costs of depreciable property more quickly by claiming additional first-year depreciation for qualified assets. The Protecting Americans from Tax Hikes Act of 2015 (the PATH Act) extended 50% bonus depreciation through 2017. Many taxpayers may benefit from claiming this break on their 2015 returns however some might save more tax in the long run if they elect out of bonus depreciation.
What type of assets qualify for bonus depreciation?
For 2015, new tangible property with an IRS stipulated depreciable life of 20 years or less (such as computers, office furniture or equipment) qualifies for bonus depreciation. Off-the-shelf computer software, water utility property and qualified leasehold-improvement property also qualifies. The new assets must also have been put in to use in 2015 in order to qualify for any depreciation deduction.
To bonus or not to bonus, that is the question…
Typically, taxpayers always want to maximize their tax deductions in the current year. But wise tax planning calls for considering the effects of this year’s choices on future year’s tax burdens. If a taxpayer has assets that are eligible for bonus depreciation and they expect to be in the same or a lower tax bracket in future years, taking Section 179 deduction first, then bonus depreciation is most likely a good tax strategy. Doing so will defer tax, which generally is beneficial and usually the goal of tax planning.
However, if a business is growing and expects to be in a higher tax bracket in the near future, it may be better off forgoing bonus depreciation altogether. Why? Because it makes sense to decrease deductions in years when a taxpayer is in a lower tax bracket, when they expect to have a higher taxable income in future years. They will need the depreciation deductions more in the years they have higher taxable income, so electing out of bonus depreciation and not taking Section 179 deductions can be a smart tax move. Deductions are worth more when your tax bracket is higher.
Have questions about depreciation? We can help
If you’re unsure whether you should take bonus depreciation on your 2015 return — or you have questions about other depreciation-related breaks, such as Sec. 179 expensing — contact us – we can help.
Are You Eligible to Deduct Home Office Expenses?
Just because you have a home office space doesn’t mean you can deduct expenses associated with it.
Home Office Requirements
The eligibility requirements for deducting home office expenses differ depending upon if you are an employee or if you are self-employed. For example, as an employee, having a home office must be for your employer’s convenience and not just your own. The IRS even has a “Convenience of Employer Test” in which an employee’s home office is deemed to be for an employer’s convenience only if it is:
- a condition of employment
- necessary for the employer’s business to properly function, or
- needed to allow the employee to properly perform his or her duties.
Most likely, you won’t pass the employer convenience test if you have another office provided by your employer but like to take work home with you. However, you would pass the test if your employer doesn’t provide you with an office, or if there is some valid business reason why you must work at home.
If you’re self-employed, generally your home office must be your principal place of business, but there are a few exceptions.
Whether you’re an employee or self-employed, the space must be used regularly (not just occasionally) and exclusively for business purposes. If, for example, your home office is also a family room, guest room or where your kids do their homework, the space is NOT a home office in the eyes of the IRS.
How Does the Home Office Deduction Affect Taxes?
The home office deduction can be a nice tax break – especially for self-employed people because you save not only on regular income tax but that pesky 15.3% self-employment tax as well! How the deduction works – the first step is figuring out the square footage of your home office, then you divide that number by the total square footage of your home. The result is a percentage. You may be able to deduct that percentage of your mortgage interest, property taxes, home owner’s insurance, utilities and certain other expenses, as well as the depreciation allocable to the office space.
In the last couple of years, the IRS has created a simpler “safe harbor” deduction in lieu of calculating, allocating and substantiating actual expenses. The safe harbor deduction is capped at $1,500 per year, based on $5 per square foot up to a maximum of 300 square feet.
For employees and S-corporation shareholders, home office expenses are a less beneficial miscellaneous 2% itemized deduction. This means you’ll get a tax break only if these expenses plus your other miscellaneous itemized expenses exceed 2% of your adjusted gross income (AGI).
Finally, be aware that we’ve covered only a few of the rules and limits here. If you think you may be eligible for the home office deduction, contact us for more information.
Need Help Navigating the Complexities of Staffing Across State Lines?
Businesses of all sizes that operate interstate are subject to a significant regulatory burden with regard to compliance with non-resident state income tax withholding laws, which can take operating resources away from these businesses. Forty-one states impose a personal income tax on wages and partnership income, and there are many differing tax requirements regarding withholding income tax of nonresidents among those 41 states. The amount of research that goes into determining what each state law requires is expensive and time-consuming. The recordkeeping can be burdensome, particularly since a state’s withholding threshold can be as low as one day’s work in another state. Is your business operating between states or planning to in the future? Todd & Co. CPA Group, Ltd. is a member of the American Institute of CPAs, the professional organization supporting CPAs, which advocates on behalf of CPAs and their small business clients. Our membership helps us keep our clients current on new developments, so we can help you navigate through state laws and determine withholding requirements for mobile staff. Contact us today (757) 926-4109 if you need help determining payroll and income tax withholding rules for your out-of-state operations.
Out of State Operations Require Special Reporting
The decision of whether to trade in an old business car or try to sell it for cash generally should be based on factors such as the amount you can get on a sale versus a trade-in, and the time and bother a sale will entail. However, important tax factors also may affect your decision-making process. Here’s an overview of the complex rules that apply to what appears to be a simple transaction, and some pointers on how to achieve the best tax results.
In general, the sale of a business auto yields a gain or loss depending on the net amount you receive from the sale and your basis for it. Your “basis” is your cost for tax purposes and, if you bought the asset, usually equals your cost minus the depreciation deductions you claimed for the auto over the years. Under the tax-free swap rules, trading in an old business auto for a new one doesn’t result in a current gain or loss, and the new car’s basis will equal the old car’s remaining basis plus any cash you paid to trade up. As a general rule, you should trade in your old business car if you used it exclusively for business driving, and its basis has been depreciated down to zero, or is very low. The trade-in often avoids a current tax. For example, if you sell your business car for $9,000, and your basis in it is only $7,000, you will have a $2,000 taxable gain, but if you trade it in, a current tax is avoided because any gain is deferred. Your basis in the new car will be lower than it would be if you bought it without a trade-in, but that doesn’t necessarily mean lower depreciation deductions on the new car. Because of the so-called “luxury auto” annual depreciation dollar caps, your annual depreciation deductions on a new car may be the same whether you sold the old car or traded it in.
However, you should consider selling your old business car for cash rather than trading it in if you used it exclusively for business driving and depreciation on the old car was limited by the annual depreciation dollar caps. In this situation, your basis in the old car may exceed its value. If you sell the old car, you will recognize a loss for tax purposes. However, if you trade it in, you will not recognize the loss.
For example, let’s you bought a $30,000 car several years back and used it 100% for business driving. Because of the annual depreciation dollar caps, you still have a $16,000 basis in the car, which has a current value of $14,500. Now, you want to buy another $30,000 car. If the old car is sold, a $1,500 loss will be recognized ($16,000 basis less $14,500 sale price). If the old car is traded in for a new one, there will be no current loss. Of course, if the old car’s value exceeds its basis, the tax-smart move is to trade it in and thereby avoid the gain.
You also may be better off selling your old business car for cash rather than trading it in, if you used the standard mileage allowance to deduct car-related expenses. For 2016, the allowance is 54¢ per business mile driven. The standard mileage allowance has a built-in allowance for depreciation, which must be reflected in the basis of the car. When it’s time to dispose of a car, the depreciation allowance may leave you with a higher remaining basis than the car’s value. Under these circumstances, the car should be sold in order to recognize the loss. All of this sounds very complicated, and it is. Before you sell or trade in your business car or lease a new one, please give us a call and we’ll set up a meeting to discuss your options.
We often get asked about the requirements for deducting business meals and entertainment expenses. This type of expense requires you to jump through several extra hoops to qualify as deductible and is subject to limitations. Nevertheless, if you pay careful attention to the rules outlined below, the expenses should qualify as deductible.
- Ordinary and necessary business expenses. All business expenses must meet the general deductibility requirement of being “ordinary and necessary” in carrying on the business. These terms have been fairly broadly defined to mean customary or usual, and appropriate or helpful. Thus, if it is reasonable in your business to entertain clients or other business people you should be able to pass this general test.
- “Directly related” or “associated with.” A second level of tests especially applicable to meals and entertainment expenses must also be satisfied. Under them, the business meal or entertainment must be either “directly related to” or “associated with” the business. “Directly related” means involving an “active” discussion aimed at getting “immediate” revenue. Thus, a specific, concrete business benefit is expected to be derived, not just general goodwill from making a client or associate view you favorably. And the principal purpose for the event must be business. Also, you must have engaged actively during the event, via a meeting, discussion, etc. The directly related test can also be met if the meal or entertainment takes place in a clear business setting directly furthering your business, i.e., where there is no meaningful personal or social relationship between you and the others involved. Meetings or discussions that take place at sporting events, night clubs, or cocktail parties—essentially social events—would not meet this test. If the “directly related” test cannot be met, the expense may qualify as “associated with” the active conduct of business if the meal or entertainment event precedes or follows (i.e., takes place on the same day as) a substantial and bona fide business discussion. This test is easier to satisfy. “Goodwill” type of entertainment at shows, sporting events, night clubs, etc. can qualify. The event will be considered associated with the active conduct of the business if its purpose is to get new business or encourage the continuation of a business relationship. For meals, you (or an employee of yours) must be present. That is, for example, if you simply cover the cost of a client’s meal after a business meeting but don’t join him at it, the expense does not qualify.
- Substantiation. Almost as important as qualifying for the deduction are the requirements for proving that it qualifies. The use of reasonable estimates is not sufficient to stand up to IRS challenge. You must be able to establish the amount spent, the time and place, the business purpose, and the business relationship of the individuals involved. Obviously, you must set up careful and detailed record-keeping procedures to keep track of each business meal and entertainment event and to justify its business connection. For expenses of $75 or more, documentary proof (receipt, etc.) is required.
- Deduction limitations. Several additional limitations apply. First expenses that are “lavish or extravagant” are not deductible. This is generally a “reasonableness” test and does not impose any fixed limits on the cost of meals or entertainment events. Expenses incurred at first class restaurants or clubs can qualify as deductible. More importantly, however, once the expenditure qualifies, it is only 50% deductible. Obviously, this rule severely reduces the tax benefit of business meals and entertainment. If you spend about $50 a week on qualifying business meals, or $2,500 for the year, your deduction will only be $1,250, for tax savings of around $300 to $400.
Please call if you have any questions or would like my help in setting up record-keeping procedures.
A significant change in tax law became effective on January 1, 2013 – the implementation of the 3.8% Medicare surtax on net investment income of individuals, estates and trusts. This new tax came about as part of the funding provisions of the new healthcare legislation being phased in over the next few years. The tax affects all estates and trusts with a low taxable income as well as individuals with incomes starting as low as $125,000 (married filing separately), $200,000 (single) and $250,000 (joint/surviving spouse). With the imposition of this new tax, maximum federal tax rates for higher income individuals sky-rocket to as much as 43.4%!
For individuals, the tax applies to “net investment income” also called “unearned income” which is derived from deducting qualified investment expenses from gross investment income. Taxpayers that meet the income thresholds and also have income from interest, dividends, annuities, royalties, rents, or capital gains will be subject to the tax. Interesting planning opportunities are available for investors in pass-through entities, such as S-corporations, who might become subject to the tax due to the different types of income that generate from these entities and wind up on the shareholder’s individual income tax returns.
Since the current provisions seem to exempt trade or business income from non-passive pass-through entities for exclusion from the tax, S-corporation shareholders in particular who are currently treated as “passive” will want to consider the possibility of changing the nature of their investment from passive to non-passive by increasing their material or “active” participation in the activity. Taxpayers with more than one passive activity may be able to group similar passive activities, for which there is also common ownership and control or an inter-dependence between the activities, to meet the “active participation” requirements. This grouping is done on the individual’s tax return itself and not at the entity level. Investors who desire to take this route will want to ensure that they understand the time and managerial participation requirements put forth by the regulations. Although the rules allow for a taxpayer to switch between passive and non-passive treatment from year to year, depending upon the individual circumstances applying to each tax year, careful structuring of the shareholder’s role in the pass-through entity is necessary to ensure that the taxpayer can defend the change in case of subsequent tax authority examination or audit of the taxpayer’s tax returns. Taxpayers will want to discuss the passive activity and material participation rules with their CPA every year to ensure that the activities are treated correctly each year on the tax return.
Regardless of whether a shareholder is considered passive or non-passive, if they have outstanding loans to the corporation that are subject to either imputed or stated interest (typically a loan principal amount of $10,000 or more), the interest charged to the corporation and picked up by the shareholder will be considered subject to the new tax. With this in mind, the corporation can review and revise the interest rate to current market rates, which are still at considerable record lows. If possible, the company may want to refinance the shareholder’s loans through an unrelated funding source such as a bank, or possibly by factoring their receivables. Otherwise, the shareholder can choose to convert all or a portion of the loan to additional paid in capital. Many times capital contributions can be paid back as a tax-free return on investment once the company is in a position to do so. As long as the principal loan amount is below $10,000, it typically is not subject to deemed interest. Be warned however, that sometimes it is inadvisable to pay back shareholder loans, especially if the company has experienced net losses in prior years, as this may trigger other taxable income to the shareholder in turn negating the original purpose behind the effort of minimizing the 3.8% Medicare surtax in the first place.
Again, as with any tax planning strategy, these approaches should be carried out with care, in line with the bylaws of the corporation and properly documented. Shareholders should not wait until year-end to discuss these issues with both their CPA and attorney to ensure that transactions are correctly structured as early as possible in the year. Why not discuss these items with your tax preparer when you make your annual appointment this year? You’ll be glad you did.