Family Employee Payroll Tax Exemption Clarified

The IRS recently issued temporary and proposed regulations that extend tax savings to family-owned businesses that employ their minor children and are organized as single-member limited liability companies.  Essentially, it is nothing more than a clarification on a position that many taxpayers were already taking, but it is worth mentioning, as it is an important tax planning strategy that can produce huge tax savings with the right circumstances.

If you have a business structured as a sole proprietorship or partnership, and you have children that could work in your business, you could be eligible for some big tax savings.  For example, if you paid them up to $5,800 each (the amount of the 2011 standard deduction), they would not be subject to:

  • Federal income taxes on the income,
  • Employee social security tax (4.2% in 2011), or
  • Any Medicare tax (1.45%).

In addition, your business would not have to pay the following taxes:

  • Employer social security tax (6.2%),
  • Employer Medicare tax (1.45%),
  • Federal unemployment tax (.008% on first $7,000 of wages), and
  • Possibly state unemployment tax and other state payroll taxes.

Not only is the payment exempt from almost all employee and employer payroll taxes, it also moves income that would have been taxed at your high marginal tax rate to your children’s rate, which in this case would be zero on the federal side.  Depending on the state, there may be a small amount of state income tax involved, but overall it is going to be very minimal in comparison to the tax that you would have paid at your marginal tax rate.

Better yet, the wages can be used to fund a Roth IRA, a college savings account, or school expenses that would have been paid with or without the payment for wages, so really it is a great benefit that doesn’t necessarily affect cash flow if you plan it out ahead of time.  Lastly, don’t forget the benefit of teaching your children work ethic and getting them involved in your business at a young age.  We work with many fourth-generation family-owned businesses, so this is an important benefit even without the tax exemption.

The Fine Print

What’s the catch?  Well, to make sure the payroll paid to your children will pass IRS scrutiny, the following steps need to be taken:

  • Your child actually has to perform the work,
  • The pay rate needs to be reasonable,
  • Actual paychecks have to be given to your child from the company, and
  • You need to document the work just like you would with any other hourly employee.

As to the type of work, it just needs to be ordinary and necessary for your business and reasonable considering the age of the child.  Have them clean your office or warehouse, file paperwork, or fill in on big projects that you would normally have to hire temporary workers for.  With today’s tech savvy teenagers, you can even have them help out with IT tasks or set up computers and devices.  Whatever you have them do, make sure you treat them just like an unrelated employee if you want to avoid problems with the IRS.

To qualify for exemption from employee and employer social security and Medicare taxes, your child has to be under the age of 18.  The exemption from federal unemployment tax lasts until they reach 21.  There are also many exceptions and details that apply depending on the type of business, and payroll tax reports and W-2s will have to be filed, so it is definitely something that you will need to discuss with your tax professional before starting.

The Recent Clarification by the IRS

Single-member limited liability companies (SMLLCs) are considered disregarded entities for tax purposes and are required to be reported on the member’s 1040 tax return using Schedule C, and up until this point the rules on this payroll tax exemption explicitly included sole proprietorships and partnerships.  The new proposed regulations now specifically include SMLLCs in the list of entities that can take the family employee tax exemption.  This is good news if you have a SMLLC and have been claiming the exemption, and for those that were hesitating because of the wording of the rule.

If you have a corporation, you are not eligible for the exemption; however, in most cases there would still be a tax benefit to paying wages to your children.

If you have a family-owned business in the Portland area and would like to find out more about this tax strategy and others like it, feel free to email or call me at 503.244.8844 to set up an appointment.

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Accounting for Health Insurance Premiums

At this point in the year, many of you are now familiar with the Small Business Health Care Tax Credit.  If you qualified for the credit for 2010, you likely witnessed first hand all the extra information that is required for the credit calculation.  Below is an except from our recent newsletter on the tax credit.

Health Insurance Premium Bookkeeping
Much of the tax credit calculation revolves around eligible employee hours and wages; however, once an employer is determined to be eligible for the credit, much more information is needed with regards to the employer’s health insurance premiums.  Fortunately, a few simple procedural bookkeeping changes can greatly simplify this portion of the calculation:

  • Classification of owner and family member insurance – when posting health and dental insurance premium payments, make sure premiums for owners and their family members are posted to a separate sub-account of employee benefits.  These premiums are not included in the calculation, so it is important that they be separated.
  • Premiums for seasonal workers – even though it is important to classify seasonal worker wages and hours separately from eligible employees, their premiums are actually included in the calculation, so make sure their premiums are included with those for eligible employees.
  • Record coverage information in books – in order to finish the calculation, you have to report the type of coverage (single or family) and the number of employees with each coverage type.  To simplify this final step, be sure to note this information in the “memo” field in your books when recording the premium payment.  Typically, this information is provided on the bill from the insurance company, and it is much easier to record this each month than pull all the bills at year end.

For general information on the Small Business Health Care Tax Credit, refer to our post from last year.

Self-Employed Health Insurance Deduction Enhanced

When the Small Business Jobs Act (SBJA) came out in late September, I posted about this deduction on Twitter; however, I never had time to post a full summary because of the tax deadline.  Well, the tax deadline is history and it is time to start looking at some of the new tax changes passed this year and get ready to year-end tax planning.

This was my favorite tax change so far this year – especially since I recently joined the ranks of the self-employed – and it basically allows a self-employed individual to get the same type of pre-tax treatment for health insurance that is available to employees under 125 plans.  Under the SBJA, the self-employed health insurance deduction now reduces self-employment tax in addition to ordinary tax.  This is a great extra tax reduction for sole proprietors and active partnership and LLC/LLP owners.

What would this look like?  Let’s take an active member in a profitable LLC that pays family health insurance premiums of $1,200/month.  Under old rules, the total health insurance premiums for the year of $14,400 would be a deduction on the front of the 1040 on line 29; however, this would only be a deduction against ordinary tax.  Under the new rule, the LLC member would save approximately $2,000 in self-employment tax.  This is a great benefit as long as there is net income and some self-employment tax to offset, and it is definitely needed as small business owners usually pay fairly large monthly premiums for health insurance.

Even better – the new tax rule applies to the self-employed taxpayer’s first tax year beginning after December 31, 2009.  This means that when you are doing your year-end tax planning for 2010, you may find that you have an extra tax deduction this time around.

Read more about this deduction and the SBJA

Small Business Health Care Tax Credit

With all the new incentives out there for employers and recent tax law changes, most small business owners are likely feeling a little overwhelmed.  Between the COBRA subsidy, the HIRE act, and the new incentives & changes from the Health Care Reform Act – being an employer has become much more complicated.  In fact, if you are not keeping up on the changes and planning ahead – you could be missing out some credits and incentives that are available to your business.

One of the specific credits from the Health Care Reform Act that requires some current planning in 2010 is the Small Business Health Care Tax Credit, which is a 35% tax credit based on premiums paid to cover employees.  As the name suggests, you have to be a small business – one with fewer than 25 full-time employee equivalents (FTEs).  In addition, you have to pay average annual wages below $50,000 per FTE.  Lastly, as the employer, you have to pay health insurance premiums under a “qualifying arrangement”, which in simple terms means you pay a uniform percentage of not less than 50% of the premium cost of coverage for each enrolled employee.

I probably lost many business owners right there; however, after reading the fine print in the law you may find that you qualify after all.  The most important fine print: wages paid to business owners or their family members are not included in calculating the average wages or the number of employees.  This is very good news for corporations as the shareholder wages would have likely made most ineligible for the credit right off the bat.  This could work out well for small, family-owned businesses that provides health insurance and employs a number of non-family employees.

Then we hit the final hurdle – as an employer, do you pay at least 50% of the premium cost of coverage for all your employees?  Even if you do not pay a full 50% or even provide this employee benefit at all, you should at least run the calculation to see what your potential benefit would be.  It may be worth looking into.  Not only do you get a tax credit, but in this economy, such an employee benefit could be given in lieu of pay increases.

To calculate you potential tax credit, check out the calculator at smallbusinessmajority.org.

More detailed information on the tax credit:
IRS Q&A Page on the Small Business Health Care Tax Credit
White House Summary & Fact Sheet

2009 Year-End Tax Planning – Part 2

Year-End Tax Planning for Small Business Owners

For 2009, there are plenty of year-end tax planning opportunities available to the small business owner.  Some new provisions help businesses that have been dramatically affected by the recession while others help businesses that have had very a profitable year.  Below is a general overview of several of the more important planning opportunities.

Bonus Depreciation:

Many companies used the bonus depreciation provision in 2008; however, due to the current economic conditions, business owners are much more restrained with regard to capital expenditures than in prior years.  Nick Parsons, one of the partners at our firm, recommends concentrating on capital purchases that are needed and will help generate more profit for the business rather than just purchasing for the sake of tax savings.  He also recommends looking at purchases that will need to be made in the next five to six months and accelerating those purchases if possible before year-end.  Even if the business had a poor year, bonus depreciation could produce a tax loss and actual tax refunds with the new net operating loss carryback rules (see below).

Bonus Depreciation details:

  • Only available for NEW property, 20 year class life or less
  • Provision is scheduled to expire after 2009
  • Must be placed in service before year-end

Code Section 179 Depreciation:

Businesses with net taxable income are taking advantage of the new limits on 179 depreciation ($250k), which allow you to write-off the entire cost of the fixed asset within the year of purchase.  However, many businesses are looking at losses this year, so the bonus depreciation can be a better option.  Regardless, using the right mix of bonus and 179 depreciation can create a net operating loss that can be carried back five years under the new rules (see below).

One minor detail to keep in mind – unlike bonus depreciation, the property does not have to be new to qualify for 179 depreciation.

Vehicle Depreciation:

If a business is looking to buy a new vehicle in the next six months, accelerating the purchase before year-end could be very beneficial.  The luxury auto depreciation limits have been increased from $2,960 to $10,960 through 2009 thanks to bonus depreciation rules.  There are different rules for trucks, vans, and SUVs, but for a typical passenger car used more than 50% in business – this provides great tax savings.

Five Year Carryback of Net Operating Losses:

Many businesses affected by the recession have been able to make use of the expanded net operating loss carryback rules for the 2008 tax year, and many received substantial cash refunds that helped them with current cash flow problems.  Now the carryback rules have been extended for 2009 tax losses, which should bring some more immediate help.  However, the rules are a little more complicated this time around:

  • For 2008, the expanded carryback was only applicable to businesses with gross receipts under $15 million.  The net operating loss could be carried back up to five years and there were no further complications.
  • For 2009, the rule is expanded for all businesses, however, there are complications:
    • For businesses under the $15 million gross receipts limit, the 2009 NOL can be carried back up to 5 years even if the 2008 NOL was carried back under the prior rule.  The only difference is that for 2009, you can only use ½ of the taxable income in the fifth year.
    • For businesses over $15 million in gross receipts, they can use the extended NOL carryback for 2008 OR 2009, but not both years.  Also, like with small businesses, they can only use ½ of the taxable income in the fifth year.

Solo 401k Contributions / Profit – Sharing:

For small business owners that had a good year and are looking for tax deductions while putting away for retirement, the solo 401k is an excellent vehicle that many ignore because of the extra reporting requirements.  Small, family-owned businesses often use the SIMPLE IRA plan to put away up to $11,500 ($14,000 age 50 & older) under the 2009 limits.  However, given sufficient self-employment income, the same small business owner can put away up to $49,000 ($54,500 age 50 & older) using a solo 401k plan and also make the same contribution for the business owner’s spouse if they are involved in the business.  The are special requirements for the solo 401k, so it is definitely something you need to speak with a professional about before opening an account.  However, even if the solo 401k is not an option for you, there are other 401k plans that would still save you much more than with a SIMPLE IRA plan.

Office In Home and Mileage Deductions

There is often a lot of confusion surrounding an office in home and the mileage deduction and the difference between commuting and business miles.  I have heard many accountants over the years selling the deductions like in an infomercial, claiming that by simply setting up an office in the home used exclusively for the business that it will amazingly increase their auto deduction by 60%.  Plus, if you act now, they will throw in an exclusive tax table mouse pad and two free months of the tax savings newsletter…

Seriously though, while an office in home can increase your auto deduction in many cases, it is unfortunately not that simple – as is the case with the majority of IRS rules.  It is very important you understand all the requirements so that you can maximize your deduction without exposing yourself to audit risk.

I am not going to get into the details of business vehicle expenses in this post, but in general terms, business use of a vehicle does not includes personal or commuting miles.  Whether you use the standard mileage rate or the actual expense method, your deduction is limited to actual business use – which will be calculated based on your mileage log or reports from your mileage calculator app (for you iPhone enthusiasts).  For your standard business owner with rented office space outside the home who does not perform substantial administrative and management activity from a home office, the miles to and from the office each day are not deductible.  Depending on the business owner’s commute, this can be a significant portion of overall vehicle use, so you can see why this is a crucial issue.

How can these commuting miles be turned into business miles?

Well, it can be a bit complex when reading IRS Pub 587 as there are many requirements and exceptions, so I set up this office in home deduction mind map using FreeMind software, which walks through the first few pages of IRS Pub 587 and lays everything out visually.  If you look at the first three requirements, you’ll notice that you have probably heard about them before if you have a general understanding of the office in home.  Exclusive, regular, and business use are usually what most people focus on because the classic example you think of with office in home is the sole proprietor who uses their home as the sole business location.  However, most small or micro-businesses have office space at a location outside the home, so the fourth requirement that the home office be the principle place of business is the most crucial issue.  If this requirement can be met either through an exception or by re-arranging your business operations, then you have a qualifying office in home and mileage from that office to other business locations would qualify as business mileage.

How can you satisfy the principle place of business requirement?

In order for your home office to be considered the principle place of business, it must be used exclusively and regularly for administrative and management activities including:

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

This means that it must be the only location that these administrative and management activities are conducted.  However, there are some exceptions to this rule and situations where it is permissible for these activities to be performed outside of the office in home :

  • service providers can conduct administrative activities at other locations (payroll service, etc);
  • management and administrative work done in a non-fixed location like a car or hotel room is permissible;
  • administrative activities can be conducted at a fixed location outside the home office if occasional and minimal;
  • substantial non-administrative, non-management activities can be performed outside the home;
  • and even if suitable space is available outside the home for administrative and management activities, you can still choose the home office as the primary location for these activities.

If your home office does not qualify for any of these exceptions and is not the principle place of business, there are still two more exceptions that could help you:

  • If you physically meet with clients, patients, or customer in you home office – and it is substantial and integral to your business;
  • or your home office is a separate structure from the dwelling unit.

Meeting either of these exceptions will qualify your office in home even though it is not the principle place of business.  Again, this would make your mileage from the home office to the other business office deductible as business miles.  This can create significant tax savings, but you have to make sure you have a solid position as this issue does often come up in IRS audits.

Let’s look at an example…

Dr. Bob is a dentist who has two dental offices in the metro area and his commute is significant since he lives far outside the city.  Without a qualifying office in home, the commute to the an office and the commute home are personal and are non-deductible commuting miles.  Any trips made between the offices or for other business purposes during the day are deductible, but that long commute that is a majority of the miles driven is personal.

Now let’s assume that Dr. Bob has a large bonus room that he converts into a home office.  The office is not separate from his house, and he does not meet with patients at his home (for a number of reasons), so he must make the home office be the only place for administrative and management activities or meet one of the exceptions.  If Dr. Bob uses a third party service provider for billing and factoring, he and his wife complete the bookkeeping in QuickBooks at the home office, and his wife sets up appointments from the home office – then I think he would have a very solid position for a qualifying office in home and the mileage from the home office would be deductible.  However, if all the billing is done internally at one or both of the dental offices, or if an internal bookkeeper does a majority of bookkeeping at one of the dental offices, or the office managers at the two offices setup up all the appointments – then I think Dr. Bob is going to have a very weak case for arguing that his home office is the principle place of business.

Every case is going to be different and most business owners are not going to have clear-cut circumstances like our Dr. Bob; however, it is very important you go over this in detail with your CPA or accoutant to make sure you have a solid position for the auto expenses you are claiming.  With the technology available today, many business owners should be able to arrange their business so that the requirements are met.

If you like to discuss this with me or need help in laying out a strategy to maximize your tax deductions, feel free to email or call me at 503.244.8844 to find out more about our consulting services.

Travel Expenses and Business Planning Trips

It is the that time of year again, when most people are on vacation – or at least they wish they were.  With the current heat wave in Portland, many would probably go for an Alaskan cruise right about now.  Whether it is colder weather you are looking for or a tropical paradise, if you are business owner, you should talk to your CPA or accountant about business planning trips and travel expense rules to make sure you are maximizing your deductions without getting too aggressive or raising your audit risk.

Whether you have an LLC, S-Corporation, Corporation, or a Single-Member LLC – you should consider an annual business planning meeting where you can get away from the everyday distractions that steal your focus and layout out your short and long term goals and strategies, look into new products or technologies, and brainstorm solutions for overcoming obstacles and bottlenecks in your business.  Without even getting into taxes, this makes sense from a marketing standpoint and would seem vital for a business to continue to thrive and grow.  Unfortunately, IRS agents are anything but marketers, so you have to make sure your deduction is well supported.

How do you maximize travel deductions that are also well supported before the IRS?  Here are my recommendations:

  • To write off the actual travel expenses to and from the destination, the trip must be related primarily to the taxpayers business.  If the trip is primarily personal in nature, then these costs are not deductible and only the expenses incurred while at the destination allocable to the business are deductible.
  • Document in detail all the business planning you completed on the trip, write-out the goals you came up with, and take care of any annual minutes and formal documents that should be completed for your entity.  Scribbling on a bar napkin will not cut it; in fact, the more documentation the better in this case as you need to prove substantial business reasons for the trip.
  • If your spouse joins you on the trip, his or her expenses are generally only deductible if they are an officer, shareholder, member, director, or employee of the business – or if there is a bona fide business purpose for them to be on the trip.
  • If it is a foreign trip, more detailed rules apply.  If the trip is seven days or less in length and primarily for business, then the travel is fully deductible.  However, if the trip is over seven days, the travel expense deduction is restricted if 25% or more of the days are not business days.  It becomes complicated as you can take advantage of “intervening days”, so you should definitely talk to your CPA or accountant first.

There are other considerations and the facts and circumstances of each trip need to be considered.  There is no clear rule on the number of personal days allowable before it becomes primarily a personal trip.  Also, bringing children on the trip can further complicate the issue as it can make it look much more like a personal vacation.  If anything – just make sure you document, document, and document some more, and again – I strongly suggest talking to your CPA or accountant before setting up a business planning trip that you intend to claim a business travel expense.

There is only a little over a month left of summer – get out there and do some business planning! 🙂