Categories
Federal Income Tax

Keep Real Estate Out of Your Corporation

Including the wrong kinds of assets in a corporation can be an expensive mistake. Things that are worth more over time, like investments, collectibles, and especially real estate, should be kept out of a closely-held corporation.  This mistake costs more for C-corporations than for S-corporations, but even  S-corps should be cautious about what assets they hold.  Business real estate is generally best owned personally, in a single-member LLC, or in an LLC taxed as a partnership.

Real Estate in C-corporations

A family’s biggest asset is usually its home, and a business’s biggest asset is usually its real estate.  This might be the corporate offices, a workshop, a garage, or retail space.  It may seem normal that a business would own its own building, but that’s often a bad idea.  Closely held corporations usually shouldn’t own any kind of real estate.  If a small business needs real estate, the shareholder should buy it, not the corporation.  Here’s why:

Photo of 384 Court Street Auburn, ME 04210

If the corporation is organized as a C-corporation, the profits get taxed twice.  Any business profits are taxed at the corporate level, and then taxed again when they’re paid out to the shareholder as a dividend.  If a company owns its real estate, it probably bought it because owning was be cheaper than renting.  That means that owning the property drives up the amount of income that gets taxed twice.

The opposite happens when the shareholders own the real estate.  When the shareholder owns the real estate, the rent expense is a deduction for the corporation and the shareholder’s rental profits are only taxed once.  The business can’t pay more than market rent for the space, but paying rent near the high end of the market is a great way to get money out of a c-corp.

Owning land or buildings inside the corporation might be a minor mistake while the business is operating, but it can be a disaster when the owner retires.   With a little bit of luck, retirement means usually means selling the business for lots of money.  If a buyer can’t afford the property or wants to move the business, the shareholder can be stuck owning an empty building in the corporation or renting it out.  This creates an ongoing tax and paperwork burden that would be much easier if the real estate was held personally.

The real pain comes when the shareholder sells the property.  C-corps don’t get capital gains rates, so selling the corporate real estate can quickly drive the corporation’s income into the higher tax brackets.  How big a of a a problem is that?

It’s a big one.  With a top marginal rate of 39% kicking in for corporate incomes between $100,000 and $335,000, and a top Maine corporate tax rate of 8.93%, a C-corp shareholder who sells property inside of the corporations might lose 40% of their gains to taxes before they even get the money out of the company.

 

Withdrawing the after-tax profit from the corporation will trigger a federal tax on dividends as high as 20%.  For Maine residents, the state taxes top out at 7.15%.  For a high-income shareholder, the dividends could also be subject to new federal Net Investment Income Tax of 3.8%.  Altogether, this means that a corporate shareholder might be left with as little as 42% of his or her gains.  This is all just because the shareholder made the wrong decision about how to buy the property corporation decades earlier.  These estimates simplify a few things, but are ballpark accurate.

If that same shareholder had held the building in his or her own name and leased it to the corporation, the profits from selling the building would only be subject to capital gains tax, ordinary income tax on depreciation recaptured, and state income tax.  2013 regulations clarify that gains from selling real estate that is rented to a shareholder’s active trade or business will not be subject to the net investment income tax.  Therefore, the same shareholder who would lose 58% of his or her real estate gains to taxes if the building were held by the corporation might pay less than half of that in taxes if the building were held personally.

Real Estate in S-Corporations

S-corporations don’t pay tax at the shareholder level.  Owning property in an S-corp isn’t as bad, but even S-corporations should still keep real estate in the shareholder’s name.

 

Holding real estate inside of an S-corporation can create problems when a shareholder joins or leaves the business.  Imagine that one shareholder is running a business and someone else wants to buy-in and run it with them.  If the business owns the real estate, the new shareholder needs to come up with enough money to by their share of the business and their share of the property at the same time.  If the shareholder owned the land or buildings, the new shareholder could buy stock in the business now, and wait years before buying the property it occupies.    This makes it easier for new owners to buy-in to the operating business because they don’t have to come up with payment for their share of the real estate value at the same time as their share of the business value.

Even sole-shareholder can run into problem with real estate in his or her S-corporation when they go to sell their business or when it makes sens for the business to move on to a new location.  The shareholder can’t re-purpose the real estate for personal use without triggering a taxable event, and if he or she sells the business, the new owner may not want the real estate to go with it.

Conclusion

Avoid tax headaches by keeping real estate out of your closely-held corporation.  Any corporation thinking of buying real estate in its own name should talk to its tax professional, and any tax pro worth his or her salt will probably have one piece of advice.  “Don’t do it”.

 

 

Categories
Federal Income Tax

Small Landlords Not Required To File Form 1099

Photo of 384 Court Street Auburn, ME 04210There is significant confusion surrounding whether or not landlords need to file form 1099s for the amounts that they pay for services.  Owning a rental property is an activity carried on regularly and continuously for profit, and many landlords consider themselves to be in business.  However, the IRS considers most rental activities to be passive activities, rather than active businesses.  If that is the case, are landlords exempt from filing form 1099?

Congress sought to clear up the confusion in 2010 when they passed a law that explicitly defined receiving rental income as conducting the trade or business of renting out property, subject to 1099 reporting requirements.  Congress later repealed that part of the law before it took effect (Hill).  Repeal aside, the IRS continued to include questions about 1099s on page 1 of Schedule E, the form individuals use to report rental income.   One question asks if the taxpayer is required to file form 1099, and the other asks if they have done so.  The has caused many small landlords to wonder if they needed to file 1099s for any service providers that they’ve paid more than $600 during the year.  These questions on schedule E have even confused a number of CPAs and other tax professionals on the issue.

The AICPA tried to clear up the confusion among its members  with an article about 1099 requirements for rental properties and also wrote a open letter to the IRS in 2013 to express its position and request further guidance.  It is the position of the AICPA that landlords only need to file form 1099 when their rental activities rise to the level of a trade or business (Porter).  This means that most owners of rental properties who are not engaged in other real estate businesses do not need to file 1099 forms.  In the letter, the AICPA proposes changes to the language of the form and instructions that would clarify this point.

The specific criteria used to determine if a landlord is running a business or merely investing are discussed here, but it is the position of the AICPA and this author that most small landlords remain exempt from the requirement to file 1099 forms for their service providers, despite the recently-added questions on Schedule E.

 

Resources

American Institute of Certified Public Accountants. (17, January, 2013).  Letter to the IRS.  http://www.aicpa.org/interestareas/tax/resources/individual/toolsandaids/pages/rentalproperties1099-miscrequirements.aspx.  Retreived 6, January, 2013.

Hill, Claudia.  (2013, March 6). Should Landlords be Filing 1099s for Service Providers. Forbes.com.  Retrieved 6, January, 2014 from http://www.forbes.com/sites/irswatch/2013/03/06/should-landlords-be-filing-1099s-for-service-providers/

Internal Revenue Service.  (2013).  Schedule E (Form 1040) Supplemental Income and Loss – Draft.  Retrieved from http://www.irs.gov/pub/irs-dft/f1040se–dft.pdf

Categories
Federal Income Tax

Tax-Advantaged Plans for Doctors

Tax-Advantaged Savings for Doctors

Doctors and other high-earning professionals can be some of the most challenging clients to find tax savings for.  Their incomes are too high for them to claim a lot of common deductions and credits, but because that income comes in the form of wages, they don’t have access to all of the the tax planning opportunities that are available to business clients.   Retirement plans offer some of the easiest opportunities for tax savings, and doctors do have many of the same options as other taxpayers.

Despite what some would consider to be a very good income, doctors often don’t have the cash flow, especially early in their careers, to maximize all of their available savings options. Because some plans offer more tax savings than others, the best tax savings can often be had for the fewest dollars by maximizing contributions in the following order:

  1. 401(k) to the company match
  2. HSA if enrolled in a compatible health plan
  3. IRA or Spousal IRA
  4. 401(k) with no match
  5. Non-deductible IRA with Roth rollover
  6. Other Options

401(k) with Company Match
Contributing enough to a 401(k) ( or similar plan) to get the company match will almost always get the best possible tax savings for a doctor’s retirement dollars. Employers will often match 50% to 100% of the first 3% an eligible employee saves in an employer-sponsored plan. The employee contribution comes out after payroll taxes but before income tax. The employer contribution goes in with no tax at all.  With the new top Federal tax rate of 39.6% and the top Maine state income tax rate of 7.95%, the very highest earners could find themselves saving about 44 cents on every dollar that they contribute to the plan.  Once you factor in the tax that they save on the employer contribution, high-earning doctors stand to save about 92 cents in tax for every dollar they contribute, up to the company match.  The income tax piece of this savings is a deferral, but most doctors can expect to be in a lower tax bracket during retirement, making some of the savings permanent.

HSA (Health Savings Account) Contributions

HSAs are one of this author’s favorite forms of retirement savings because they can be kept for retirement or used to pay current medical expenses.  An HSA is an account, similar to an IRA, that taxpayers can contribute to if they have certain high- deductible health insurance plans.  Unlike an IRA, there are no income limites on HSA eligibility, making HSAs a great way for doctors to defer tax on additional income.   Contributions made to an HSA go in before income tax and payroll taxes, but they come out tax free if used to pay for medical expenses.  If there’s money in an HSA when the taxpayer reaches retirement age, it can be withdrawn.  Money taken from an HSA in retirement is subject to income tax, but not to early withdrawal penalties.    A word of caution, however – HSA funds withdrawn early for non-medical expenses are subject to a 20% penalty, in addition to being fully taxable.

IRAs and Spousal IRAs

IRAs and Spousal IRAs are only occasionally an option for doctors because most doctors have an employer-sponsored retirement plan available.  A taxpayer who is not eligible to participate in an employer-sponsored can conttibute to an IRA and claim a tax deduction no matter how high their income, but when an employer plan is available, the deduction passes out at certain income levels.  Single taxpayers earning more than $59,000 and married taxpayers who earn more than $95,000 begin to lose their IRA deductions if they are able to participate in an employer plan

The idea behind a spousal IRA is that a homemaker married to a higher earning tax payer ought to be able to save for retirement based on his or her spouse’s earned income, even if they have no earned income of their own. Married couples with only one wage earner have a higher income cap on IRA deductions than couples where both workwork and are eligible.  The spousal IRA is available to married couples with adjusted gross incomes under $188,000 in 2013 and $191,000 in 2014 if the working spouse is covered by another retirement plan.  There is no income limit on the IRA deduction if neither spouse is covered by a company plan.

The reason why a deductible IRA can be better than an unmatched 401(k) contribution is that the fees in an IRA trend to be lower than on a 401(k), and with a wider range of investments available, there are more low cost investment options. Asset allocation and cost control are among the most important factors in building wealth over time.

Unmatched 401(k) Contributions

Additional retirement savings after the spousal IRA has been funded (or is not available) should go into a 401(k) or similar plan, even if no match is available. The primary advantage to continuing to fund the 401(k) comes from being in a different tax bracket in retirement – it allows money to be put aside now with a net tax rate around 44% and later withdrawn with a marginal rate that’s likely to be below 30%.

Nondeductible IRA with Roth rollover

Roth IRAs were created as a vehicle to help people who expected to be in a higher tax bracket during retirement.  Money goes into a Roth IRA after taxes, and comes out tax-free during retirement.  The principal of a Roth can also be withdrawn tax and penalty free at any time.  This makes it an ideal investment vehicle for a lower wage-earner who may need some of the money before retirement.  Its main advantage to a doctor or other high-earning professional is the growth each year is not taxed.  This means that its still usually a better option than a taxable account.

Technically, high-income taxpayers are not allowed to contribute to a Roth IRA.  The income limit to contribute prohibits Roth contributions for taxpayer with an AGI at or above $188,000 in 2013 for a married couple, but there’s a catch.  Taxpayers can contribute to a traditional IRA at any income level, they just lose the deduction if their incomes are too high.

There has been a substantial loophole surrounding Roth IRA conversions since 2010.  Previously, higher-earners were barred from contributing to a Roth or converting a traditional IRA to a Roth.  This means that a doctor or other high-earner who doesn’t have other balances in a traditional IRA can fund one with a non-deductible contribution, and immediately convert it to a Roth IRA, tax-free. 

Other Tax Advantaged Savings Options

Once contributions to retirement  accounts have been maximized, there are many other options that provide some tax advantages, each with their own rules and benefits.  Some options include:

  • College savings plans for children and other relatives
  • Municipal bonds or municipal bond funds
  • Annuities and similar products

Conclusion

Investors should not let tax consideration rule their investment decisions, but when the amount of money as available to invest is less than the available limits on tax advantaged around, choosing the right account types to invest in can yield significant savings.

 

Categories
Federal Income Tax

Credentials

When it comes to selecting a tax return preparer, it is important to understand his or her credentials.  Albert Bergen is a Certified Public Accountant licensed as both an individual and an accounting firm to practice in the state of Maine.

Maine CPAs need to complete 150 or more college credit hours, including at least 15 credit hours of accounting, have at least two years of supervised accounting experience, and pass a series of rigorous tests which cover a variety of finance, accounting, audit, and business subjects as well as income tax regulations.   Certified Public Accountants must adhere to a strict code of professional conduct in addition to the tax preparer regulations published in the Treasury Department’s Circular 230,  and must complete 40 hours of continuing professional education (CPE) annually.  This means that CPAs who chose to focus their practices on income taxes are the ideal professionals for small businesses and a solid choice for individuals.

Enrolled agents can become licensed by applying to become an enrolled agent and either passing a rigorous exam covering income tax topics and the regulation of income tax preparers or having a certain amount of experience working for the IRS.   Enrolled agents must complete 72 hours of continuing professional education every three years and must comply with the tax preparer regulations published in the Department of the Treasury’s Circular 230.  This means that enrolled agents are a solid choice of tax professional for individuals, but may not necessarily have the accounting or finance background to advise small business clients effectively, unless they have sought that knowledge out independently of their professional licensing.

Registered Tax Return Preparer is a new designation that was intended to ensure a basic minimum standard of competency among individuals who prepare a tax return for compensation.  Those regulations were struck down by the US Supreme Court as an over-reach of the IRS’s authority.  Accordingly, there are currently (October, 2013) no testing or professional education requirements for RTRPs.

There are a few other groups authorized to prepare tax returns for the public, but they are less common and can explain their qualifications themselves.  Individuals who prepare tax returns for compensation without signing them, or by entering “Self Prepared” on the preparer’s signature line are operating outside of the regulations governing income tax preparers and should not be used.

Categories
Income Tax Maine

Pine Tree Development Zone Income Tax Credit

Businesses that have been approved for Pine Tree Development Zone (PTDZ) status by the Maine Department of Economic and Community Development are eligible for an income tax credit designed to eliminate their Maine income tax on the additional activity that results from expanding their operations in qualifying industries in Maine.  This can be an extremely generous tax credit, but it requires more forethought than most other income tax benefits because the business must go through the application process before it hires the additional people or adds assets.

Calculating the Pine Tree Development Zone Tax Credit – Corporations

The basic calculation of the credit for C-corporations is fairly simple compared to the calculation for individuals and pass-through businesses.

  1. Calculate Maine income tax without regard for the PTDZ credit or any other Maine tax credits.
  2. Add up all of the additional Maine payroll and the value of all of the Maine property in the qualifying business activity since the company received its PTDZ certification.
  3. Add up all of the Maine property and payroll.
  4. Divide the amount from #2 by the amount from #3.  This is called the apportionment factor.
  5. Multiply the company’s income tax from step 1 the apportionment factor calculated in step 4.

Keep in mind that property the company owns is valued at cost, but property that the company leases is included in the calculation at a rate of 8-times its annual lease payment.  Note that real estate, personal property, leased property, and payroll all factor into this formula.  That means that a company which is adding a small number of qualifying jobs but making significant capital investments in the targeted industries can receive a credit against a substantial portion of its Maine income taxes.

Calculating the Pine Tree Development Zone Tax Credit – Pass-throughs

S-Corporations, partnerships, and LLCs with Pine Tree Development Zone businesses have no corporate-level income tax to take a credit against.  These businesses report their total income and their PTDZ income out to their owners.  The PTDZ income divided by the total income is called the apportionment factor, and is used at the individual level for calculating the income tax credit.

Calculating the Pine Tree Development Zone Tax Credit – Individuals

In addition to the regular PTDZ tax credit worksheet, individuals must include worksheet PTE and a copy of their Pine Tree Development Zone certificate with their  Maine income tax returns.  Worksheet PTE performs a two-step calculation.  First, it figures out what percentage of the taxpayer’s income comes from the PTDZ business and then multiplies that apportionment factor to determine the PTDZ tax credit from the business. The PTDZ credit cannot reduce Maine tax below zero and it cannot be carried forward to later years, but it is applied before all other tax credits.  This means that the PTDZ credit can cause other credits which are refundable or eligible to be carried forward to drive income tax below zero or provide a benefit in future years.

Tax Tip: Owners of PTDZ businesses who add funds to a tax deferred account such as an IRA, 401(k), SEP, Simple, or HSA can increase their PTDZ credit percentage for the year, which may make those accounts more attractive than they usually are because those contributions will reduce federal and Maine income tax without reducing the PTDZ tax credit.

The Pine Tree Development Zone Tax Credit – Multiple Businesses

The Maine income tax forms and guidance documents are silent about how an individual who owns interests in multiple PTDZ businesses should calculate the tax credit.  Each of the worksheets refers only to Pine Tree Development Zone Business in a singular sense.  This author believes that taxpayers who own interests in multiple PTDZ businesses should file separate worksheets to determine the credit separately for each business.  They should then include a statement totaling the credits attributable to each PTDZ business and report the total credit on schedule A of their Maine income tax returns.

Resources

Maine Revenue Service – Pine Tree Development Zone Tax Credit

Maine Revenue Service – Worksheet for claiming the income tax credit

Maine Revenue Service – Worksheet PTE

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