Oregon Income Tax Increases – Sales Tax in Disguise?

Recent articles in The Oregonian laid accolades on the Oregon legislature for all they have done for us during this last session–really important things like banning puppy mills, making it illegal to “top off gas tanks when filling,” requiring calorie counts on chain restaurant menus, and raising the cost of higher education, which, by the way, has increased tenfold in the last 15 years.  Don’t get me wrong, I have always been against the way pet stores have bred the poor puppies in rotten conditions, but I take exception to giving accolades to our government officials during a time of economic stress for spending so much time on trivial pursuits and for not delving into the real reasons behind our budget problems.

I won’t elaborate on the fact that raising taxes historically has produced less income to the government than when tax rates were lowered.  The fact is when more income is generated, more tax is paid.  When the incentive and ability to make money are lowered by raising taxes, less revenue is generated.  Instead I will explain with an actual example how the changes this legislature made during this economy will, in fact, make many businesses think harder about closing their doors and relocating across the river. I will also point out that many businesses this year with between two and twenty  million dollars in sales will possibly have losses, not income.  I will of course acknowledge that my view is somewhat skewed to an observation of only the 120 corporate clients I have firsthand experience with, but this is most likely a reasonable sample of small business in Oregon.

Currently in Oregon, all business entities established as C-corporations filing federal Form 1120, or set up as pass-thru entities such as multi-member LLCs filing federal Form 1065, and S-Corporations filing federal Form 1120S pay a minimum tax of $10 per year.  If the entity was a C-corporation, it would pay tax on its net taxable income at 6.6% but not less than $10, whereas the pass-thru entities only pay the $10, as their net taxable income is “passed through to the individual owners,” and the owners ADD it to their personal income tax returns and pay personal taxes on the combined amount.

Effective for tax years beginning on or after January 1, 2009, the minimum tax on  pass-thru entities goes to $150; however, for taxable C-corporation entities, the minimum tax will be based on the gross Oregon sales, regardless if the corporation has a net taxable income or not. I have long felt the $10 minimum was way too low. It takes much more than $10 to administrate the filing of these returns. I even feel that $150 is low. California, which has one of the nation’s highest minimums, is $800. However, to base the minimum on gross sales for a taxable C-corporation entity is nothing more than a disguised attempt to charge the entities a sales tax.

What the legislature and our governor do not understand is that small businesses provide much more in terms of long-term revenue to our State, regardless of whether they end up with a net taxable income. Let me give you the following example from an actual business that has operated in this state since 1971, employing between 50 and 100 people per year.

This company has an average of $19 million in sales per year and averages 60 employees, so the payroll is an average of $3.2 million per year. The company is a wholesale operation and purchases $12 million worth of products per year. The company provides health insurance and retirement benefits to its employees. It also pays rent to another Oregonian for $350,000. Sometimes we believe that the owner is taking a majority of the $3.2 million in wages.  However, in this example, the owner averages $200,000 or less. Now here is the kicker:  Because this company is generous to its work force, hiring, paying health insurance, retirement, and other expenses, its average annual net income is less than $200,000. And due to economic conditions, last year and this coming year, it will actually have zero net income.

Here is the problem with the current change to the C-corporation minimum tax:  This corporation, and many others like it, will provide jobs to Oregonians, will provide health insurance to Oregonians, will provide revenue to other entities from purchasing products, both in Oregon and across the country, will provide revenue to another entity for rent, will provide retirement to people who might not otherwise save, and for its efforts will pay Oregon $7,500 in minimum tax. In addition, Oregon will pick up revenue from the $3.2 million in wages, both in employment-related taxes and income taxes from those individuals, and from the $350,000 in rent. If you do the math, here is how it looks:  When the corporation makes a net of $113,636, it would pay 6.6%, or $7,500. But if it has a loss of, say, $100,000 and makes nothing, it would still pay $7,500.

Now, let’s examine this same company if it were a pass-thru entity meaning, again, that the net income or loss would be added to the individual’s return and taxed with the personal income. Let us further assume the owner received a salary of $200,000, owned a home with a mortgage and property taxes and, being generous, gave to various charities so that the owner had itemized deductions of $35,000, including a state income tax of $10,000. His state tax under these conditions would be approximately $15,000. Now, if the company had a loss of $100,000, which will be likely during these economic times, his Oregon tax, which would include the company, would go down to $6,000, plus the company’s minimum Oregon tax on a pass-thru entity of $150.

Here is the comparison:  Nothing else in the company is different other than whether it is a pass-thru entity or a C-corp. The owner’s salary is the same, the company expenses and operations are the same. But in one case, the loss saves the taxpayer $9,000 in Oregon taxes, and in the other case, because it is a C-Corporation, not only does the individual still pay $15,000 but the corporation is out another $7,350, for a total difference of $16,350. Even if there isn’t a loss and the company just breaks even, the difference is the minimum tax of $7,350. All this is only because of the type of entity the business chose years ago.

I do not believe the Oregon legislature understands the tax system, or they are more concerned with just showing they did something rather than developing a well thought out change that does not penalize the only source of revenue that they need to correct their budget problems. That source is the working America.

Single Member LLC Owner Liable for Unpaid Employer Payroll Tax

Single member limited liability companies seem to be the popular choice these days for small business owners that want limited liability protection without the extra cost  and hassle of an S-Corporation or a two-member LLC.  However, SMLLC owners need to be aware of the court case listed below regarding payroll tax liability as they are personally liable not only for trust fund withholdings taken from employee checks (Code Sec 6672), but also the employer share of payroll taxes.

Medical Practice Solutions, LLC, Carolyn Britton, Sole Member, Petitioner v. Commissioner, Docket No. 14668-07L, 132TC, No. 7 (3/31/09)

Medical Practice Solutions follows several similar rulings in the last few years regarding disregarded entities (SMLLCs) and payroll tax liability, and given the current recession it is very important the single member LLC owners understand that their limited liability protection does not extend to unpaid employer payroll tax liabilities.  In plain terms, employer payroll tax consists of the taxes not deducted from the employees check, which would be taxes like employer Social Security and Medicare tax, federal unemployment tax, and state unemployment tax.  The trust fund withholdings are the amount deducted from the employee’s gross pay that need to be paid to the respective agencies, which business owners have always been personally liable for.

On average, most employers stay current with their payroll tax liability, and most underpayments are the result of calculation errors.  However, over the years I have witnessed several employers get behind on their payroll tax liabilities due to large drops in income, embezzlement and theft, and business owners over-extending themselves in too many business ventures.  In addition, I have seen many businesses close their doors that had to deal with significant amounts of debt and/or were facing a lawsuit.  If you have a SMLLC or are thinking of starting one, you should definitely talk to your attorney about this.  If it is of significant concern, you may consider adding a spouse or friend to the LLC to take advantage of the credit ordering rules available to a two-member LLC.

I would also recommend using a payroll service provider or a CPA that will get you in the discipline of depositing your payroll tax timely.  Whether you have a SMLLC or not, the IRS is not a creditor you want to put off as the penalties involved with payroll tax payments are very substantial.

Oregon 2009 Individual Income Tax Increases

In our previous post, we discussed the Oregon business tax increases resulting from House Bill 3405, which passed the Oregon Senate last Thursday.  Coupled with HB3405 is the sister bill regarding individual tax increases – House Bill 2649.  This bill is also headed for Governor Kulongoski, who has already made a statement of support for the bill, so now is the time to start looking at the details and adjusting your estimated tax payments if needed.

Individual Tax Rate Increases

For tax years beginning on or after January 1, 2009, the Oregon income tax rate increases for individuals with taxable income of more than $125k is as follows (previous tax rate was a flat 9% at these income levels):

• 10.8% on excess taxable income over $125k but under $250k
• 11% on excess taxable income over $250k

For tax years beginning on or after January 1, 2012, the 10.8% rate is reduced to 9.9% for excess taxable income over $125k but under $250k; however, the 11% rate for excess taxable income over $250k remains the same.

The tax rate on taxable income under $125k remains unchanged at 9%, so we are just talking about the income above $125k here.  For a more detailed breakdown of the rates at different income levels, see page 2 of HB2649.

Phase-Out of Federal Income Tax Subtraction

HB2649 also creates a new phase-out of the Federal income tax subtraction that starts at $125k for single taxpayers and $250k for married filing joint.  Under current law, there is no phase-out of the subtraction and as of 2008, the maximum deduction was $5,600 MFJ or $2,800 single/MFS.  Below are the phase-out windows for the subtraction under HB2649 beginning January 1, 2009:

• Single/MFS – phase-out starts at $125k with complete phase-0ut at $145k.
• MFJ -  phase-out starts at $250k with complete phase-0ut at $290k.

Not All About Tax Increases

There are some small “benefits” they threw into HB2649:

• Oregon will exempt the first $2,400 of unemployment income received.
• They will not charge penalty and interest to taxpayers that underpay as a result of the tax increases (how gracious of them).

I am sure they will be releasing more detailed information after the Governor signs this into law, but hopefully this helps give you an basic understanding of the new changes.  To get an idea of the impact of the tax increase, review these 2006 Oregon tax statistics.

If you will be affected by these tax increases, be sure to call your CPA or tax professional as you may want to revise your remaining Oregon estimated tax payments for 2009 – or at least get an estimate of the additional tax that will be due.

Oregon Business Tax Increase Update

As many of you may already know, there was a bit of drama last Wednesday in the Oregon Senate when House Bill 3405, which increases taxes on corporations and businesses in Oregon, was derailed by just one vote.  However, Thursday the vote changed and bill passed the Senate,  and now it is on its way to Governor Kulongoski, who has already made a statement about it leaving no doubt that we need to start preparing the changes.

All businesses in Oregon or doing business in Oregon are affected by this change – whether you have a C-Corporation, S-Corporation, LLC, LLP, or partnership, you will be paying more for Oregon excise tax, filing fees, and annual registration fees.  Here is what you will need to know:

Increased Minimum Excise Tax

The low $10 minimum tax for filing business entities (not including disregarded entities) has been increased to $150 for tax years beginning on or after January 1, 2009.  For C-Corporations, the minimum tax of $150 only applies to corporations with Oregon sales less than $500k.  C-Corporation with Oregon sales over $500k will now pay a minimum tax based on a multi-tiered calculation based on the level of sales.

C-Corporation Minimum Excise Tax Increase

Oregon minimum excise tax for C-Corporations can now range from $150 all the way up to $100k depending on the level of Oregon sales.  For a complete breakdown of the tax based on Oregon sales tiers, see page 2 of HB3405.  Here is a quick summary of the minimum tax amounts for smaller businesses:

• Oregon sales over $500k but under $1 million = $500 tax
• From $1 million to 2 million = $1,000 tax
• From $2 million to 3 million = $1,500 tax
• From $3 million to 5 million = $2,000 tax

In addition, the tax rate for C-Corporations increases from 6.6% (current rate) to 7.9% for taxable income in excess of $250k.

Filing Fee Increases

In addition to tax increases, HB3405 will double most business registration filing fees with the Oregon Secretary of State from $50 to $100.  Some filing fees, like those for authority to transact business in the state,  will increase to $275.

Increased Document Fees

Most copy and certificate fees will also increase at the Secretary of State’s office.  In addition, the notary public fees will increase from $20 to $40.

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All in all, the increases are not a surprise for most of us.  The Oregon excise tax has been much lower than similar taxes in most states, and there was talk before the recession about increasing the tax to $50.  However, for the small business owner in Portland, this is not the best news – especially after the Multnomah County minimum tax increase for 2008.

For those of you with C-Corporations, you may want to talk with your CPA regarding the cost to convert to an S-Corporation.  For many, the large amount of built-in gains tax would not make the conversion worthwhile, but with this tax increase and the likely upcoming expiration of qualified dividends and low capital gains rates, it is definitely worth looking into as some could see long-term tax savings.

Loans from S-Corporation Shareholders

If you were to loan me $20k today, would you insist on loan documents, regular payments, and interest?  Of course you would!  Such requirements and documentation would seem to be common sense, so why do many shareholders fail treat the loans to their S-Corporations the same way?

An S-Corporation is a separate legal entity, and any transactions between shareholder and the corporation have to be treated as such.  Any funds contributed by the shareholder are either capital contributions or loans from the shareholder.  If the corporation pays personal expenses for the convenience of the shareholder, the payment has to be reclassified as a loan from shareholder repayment or a distribution.  There needs to be a very clear distinction between shareholder and corporation with these transactions and the documentation should be the same as if the transactions were with an unrelated third-party.

In my experience, I have seen this issue come up in IRS audits and with bank loan renewals and applications – especially with S-Corporations owned by a single shareholder.  Without other shareholders to help keep things formal and a clear separation between business expenses and shareholder personal expenses, the single shareholder can get lazy and end up using their S-Corporation like a personal checking account.  If matched with very poor documentation, this can lead to big problems with the IRS – even loss of the S-election status in serious cases.

How can you avoid these problems and make sure you are properly documenting your shareholder loans?  Here are my suggestions based on my experiences with small S-Corporations:

• Keep your personal expenditures and transactions out of the S-Corporation.  It is a separate legal entity and there is no reason for co-mingling personal and business transactions except for the occasional payment for the convenience of the shareholder.
• Reimburse any expenses paid personally on a regular basis via an signed expense report.  Attach receipts and document the who, where, what, and why for meals and entertainment, travel, and other expenses that need explanation as to the business purpose.
• Avoid using personal credit cards for the business; however, if you must resort to this, try to use the card(s) exclusively for business and then use other personal credit cards for personal transactions.
• If you loan funds to the S-Corporation, keep a record of the loan and try to have the corporation make regularly scheduled repayments.  If the loan exceeds $10k, the corporation needs to start tracking and paying interest on the loan principal.
• Talk with your CPA and make sure you understand any reclassification entries made to loans from shareholder accounts.
• Use a lawyer that specializes in small business that will prepare demand notes and documentation for the loan from shareholder on a regular basis.  Many small S-Corporations try to cut corners in this area and it can really hurt them down the line.
• Document, document, document!  I know life is busy and small businesses require more time than you have, but do not get behind on this or create excuses for yourself.  If you cannot meet documentation requirements, then you should not be incorporated.

LLC vs. S-Corporation, Round 1

When setting up a business and deciding on entity type, most people are looking for 1) liability protection and 2) tax savings – specifically lowering self-employment tax liability.  For small businesses, the two best options are the LLC or the S-Corporation, and many tax or legal professionals seem to advocate for one team or the other so it is hard to know what entity is truly best for your business.  Well, I am not your advisor and I have been on both teams, so hopefully I can provide you with some balanced information and after a couple rounds, hopefully we will have a winner for your business…

Will the business own appreciating property like real estate?

If your business has anything to do with real estate rentals or owning and managing commercial or residential property, then LLC is the early winner.  This is vitally important – you should never put real estate into a corporation.  If a CPA or tax practitioner recommends this for a new small business, I would consider it malpractice.

Basically, if you put real property into an S-Corporation, then you are going to have a taxable event if you transfer it out of the corporation in the future and you will pay tax based on the fair market value of the property at that time.  I could tell you some horror stories on this issue, but trust me – if you have a residential or commercial property, put it in an LLC.
LLCs are perfect for real estate as you can move the property in and out of the entity without any taxable events.  Plus, they are much easier to setup, administer, and report for tax purposes.  Even better, if you have one owner, you can use the single-member LLC for your real estate and then the tax reporting is simplified so that you only have to complete a Schedule E as part of your personal return.

How many owners will the business have?

This is another important question to look at upfront, as it can result in a knock out in round one.  If you will be the sole owner of the business, then your options are limited to the following:

Single-member LLC (SMLLC)

The only LLC offering for the single-owner business is a great option for easy setup, administration, and tax reporting; however, it is going to cost you in the form of self-employment tax.  To the IRS, The SMLLC is no different than a sole proprietorship – in fact, the SMLLC is reported on Schedule C just like a sole proprietorship.  Unfortunately, this means that you will pay self-employment tax (15.4%) on the entire amount of your net taxable earnings.  This can really add up – especially if you are a consultant with few expenses and/or minimal capital asset needs.  After a few years of paying a hefty tax bill, most business owners are willing to put up with some extra administration and tax prep costs in exchange for a much lower tax bill via use of the S-Corporation while paying themselves a reasonable wage.

S-Corporation

The big winner for single-owner businesses is clearly the S-Corporation as most business owners can end up saving thousands.  With an S-Corporation, you do not pay self-employment tax on the earnings, BUT the owner must pay himself a “reasonable” salary, which means you are paying payroll taxes on the Federal and state level.  Usually, if you sit down with a CPA and lay this all out, they should be able to give you a ballpark of your tax savings each year; however, there are costs related with this:

• Legal costs – it is not cheap to setup, but I would never suggest a D.I.Y for an S-Corporation.  Get it setup right and avoid legal problems later.

• Accounting Fees – keeping your accounting data on a spreadsheet may not cut it anymore – especially if you use a lot of credit cards and loans.  Be prepared to pay a bookkeeper or an accountant to get your books setup right so that the tax preparation goes smoothly.

• Tax Prep fees – S-Corporation returns require much more work and typically range from $750 – $2000 or higher depending on complication.  Plus, you now have to file quarterly payroll tax returns and payroll to process, which can run you about $95/quarter even with one employee using ADP, Paychex, of your CPA.

If your savings are still substantial after factoring in these costs, then you should definitely go with the S-Corporation, but make sure you have a good lawyer and a good CPA that you like as you will be talking to them frequently for the first few years.

Well, round 1 is in the bag and we are tied at 1 a piece.  In round 2 we will deal with issues for businesses with more than owner.

Just remember – never choose an entity for your business without consulting a CPA and lawyer as every situation and business is unique.  Give me a call at 503.224.8844 if you need a CPA or a lawyer to help you with your new business.

Tax Return Adjusting Entries

When you get your corporate, LLC, partnership, or other business tax return from your CPA or tax preparer, do they give you adjusting entries to import or manually input into your accounting system?  Do they review your QuickBooks file and advise you on how to record the transactions in a more effective manner?

Adjusting journal entries are so crucial to the success of your accounting system, and often many CPAs and tax preparers get so busy that they never get around to this important aspect of their preparation services.  If you do not receive adjusting journal entries, make sure you ask your tax preparer for them today.  These entries will correct any errors, make important reclassifications of transactions, record depreciation, and match your books to the tax return.

In some cases, if your QuickBooks file and/or accounting records are really poor, your accountant may suggest starting a new file rather than providing journal entries, but most of the time your tax preparer should be able to provide this service without much additional work.  In addition, you should ask for depreciation entries for the current year, and amortization schedules for any loans.

Make sure you are getting more than just a tax return from your CPA or tax preparer as any tax preparer can give you that.  You should expect your preparer to come alongside you aside you and advise and equip you so that you can be more successful, maximize your tax savings, and make solid financial decisions for your business.

If you are looking for or considering a new CPA, give me a call at 503.244.8844 or email at brian@PandGCPA.com as I would love to hear from you.

City of Portland Tax Extension Reminder

We are at the 11th hour for filing tax returns today – hopefully you have filed already or have sent in an extension.

Just a quick, last-minute reminder for those of you who have not yet filed the 2008 return for your corporation, LLC, partnership, or sole proprietorship business and do business in the City of Portland and/or Multnomah County – remember to extend your City of Portland return.

Unfortunately, many forget this return and end up with some sizable penalties when they finally file.  However, the City has made the process much easier than prior years as payment is no longer required, so you have no excuse this year.

File Online – quick and painless, credit card payment option

Download the Fillable Pdf – for those of you who want to wait at the post office.

Happy Tax Day!

Tax Season Update

Just a quick update…

I am surviving tax season this year, but as always it really takes a lot out of me.  I have been working solid 60 hour weeks while also researching tax law at night to tackle issues that have come up this season.  It has been one the best tax seasons yet, but I am exhausted at this point and looking forward to 15th.

Thank you for all your questions over the last weeks or so – I will try my best to catch up on them and start putting together some new material for the blog.  I really appreciate the questions as they have actually inspired new posts.

Making Work Pay Credit & New Withholding Tables

If you are a small employer that calculates your payroll manually – please be advised that new withholding tables have been released and any payroll on or after today, April 1st, 2009, have to be calculated using the new tables.

Withholding Tables

IRS IR-2009-13 – Information on the change

For those of you who use QuickBooks, be sure you download the latest update and that your subscription is current.  You will not really notice much a change in preparing the payroll, but you can be sure your employees will start asking questions as it is all of the news today.

For those of you that are married with a double income and adjusted gross income of more than $150k – this could actually reduce your withholding in certain circumstances.  More to come on this as it develops.  The timing of this is horrible for CPAs!  We are in the final leg of long hours changes to payroll preparation is the last thing we want to deal with.

By the way, this is not an April Fools joke.  I only wish this whole “stimulus” bill was only a joke.