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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Year-End Planning for 2008

With a little over a month remaining in 2008, it is important to start year-end planning for tax year 2008 as there are still a number of things you can do to save on taxes and avoid costly mistakes.  

If your income has increased from 2007 or you have some big, one-time gains, it is crucial that you pay 100% of your estimated state tax in the form of a estimates by 12/31/08.  If you have been paying state estimates all year, you will still want to have your CPA estimate your taxable income to see if the 4th quarter estimate needs to be adjusted as estimates are always based on the prior year.  If you are lucky enough to live in Washington or another state without state income tax, you still should watch out-of-state income and keep documentation on sales tax paid on big ticket items.

Why is it so important to pay your 4th quarter state tax estimate by 12/31/08 rather than the 1/15/09 deadline listed on the coupon?

Well, the reason is twofold:

  1. By paying the state tax within the taxable year, you increase your itemized deductions as state income tax is one of the vital itemized deductions if you live in a state with income tax.
     
  2. You also avoid possible alternative minimum tax (AMT) tax consequences in future years by paying your state tax in the taxable year.  If you have significant income in one year and lower income the next year but you fail to make the 4th quarter state estimate until January (or worse – you pay in April or after with your return), then you could end up with AMT tax in that subsequent year with the lower income as state income tax is a preference item for AMT.

 

There is a lot to think about for 2008 tax planning, and I hope to cover many of the different opportunities and tax traps in the next few weeks in upcoming posts.  However, talk to your CPA sooner than later – it will could end up saving you a considerable amount tax and a lot of regret.

Housing Assistance Tax Act of 2008 – Part 2

Well, here is the bad news I promised on the Housing Assistance Tax Act of 2008 and that is the closing of a “loophole” that was a great piece of tax planning for clients with rental properties.  I fail to see the “assistance” in this tax act…

Under current law, you can take a property that was rental property or vacation home, make it your primary residence for 2 out of 5 years, and then use the home sale exclusion to exclude taxable gain of up to $250k for single and $500k married-filing joint.  You would have to recapture any post May 6, 1997 depreciation you took on the rental property, and there are many other complexities you would need to go over with your CPA, but that should give you the general idea of what a great deal this is since normally the sale of a rental property would trigger capital gains tax – plus County and City tax if you are so unlucky to have rental properties with Portland or Multnomah County.

Well, unfortunately all sweet deals come to an end, and on 1/1/09 everything changes with regard to the home sale exclusion and properties that have had business use, or “non-qualifying use”.  For sales after 12/31/08, any business use of a property you later claim as a primary residence for purposes of the home sale exclusion is going to cost you.  Rather than deal with valuations on 1/1/09, the new law figures the portion of taxable appreciation on a pro-rata basis.  The total gain on the sale of the property will be multiplied times a fraction – (periods of non-qualified use after 1/1/09 / period the taxpayer owned the property).

For example, lets assume you bought a rental property in 2007 that you rented through the end of 2009 that then became your primary residence for 2010 and 2011.  You then sold the house conveniently on 12/31/2011 for a gain of $100k.  Also, while you rented the house lets assume you took $20k in depreciation.  How much of the gain is taxable under the new law?  Well, the house was rented for three years; however, the non-qualifying use is only for periods after 1/1/09, so we only calculate one year of non-qualifying use out of the five that you owned the property.  The taxable gain would 20% of $100k plus recapture of the $20k you took in depreciation, which is required under current law.  That last year of rental activity ended up costing you a taxable gain of $20k!

Of course I am simplifying the new law and there are likely to be some forthcoming guidance from the IRS on how this will all work and be reported, but it is definitely not good news.  My advice is that if you are looking to sell a rental property in the near future and don’t mind living in it for two years, I would suggest moving in before 1/1/09 to avoid the effects of this law.  As long as your exclusion covers the gain, then all you would have to worry about is the depreciation recapture, and hopefully in two years the housing market will have recovered so you could sell at a good price.  🙂

Well, hopefully that wasn’t too painful.  It is only money…

Office in Home Depreciation

When meeting with new clients that have sole proprietorships or single-member LLCs,  I often find that their prior accountant or CPA had them take depreciation on the portion of their home used for an office in home.  I am not necessarily against taking the deduction, but I do think it is not right for everyone and often business owners do not realize the ramifications if they sell their home.

Depreciation claimed on a qualified office in home (See IRS Pub 535) can come back and haunt you years later when you sell your home.  Under current tax law, you can you sell your primary residence that you have lived in and owned for two out of the last five years and exclude up to $250k of gain ($500k if married filing joint).  Of course I am simplifying IRC Sec 121 here – there are many other rules and exceptions (see IRS Pub 523) – but that is the basic idea and it is a great exlusion for most people as long as they have not lived in their homes for too long.  However, if you took any post May 6, 1997 depreciation on an office in home that was within the main dwelling unit or structure, then you are looking at some Section 1250 depreciation recapture upon sale – which is ordinary income.  In other words, all that depreciation you took over the years now has to be claimed as income, which is a very unwelcome surprise for most taxpayers to say the least…especially if they have the full 10 years of depreciation.  However, It is only money…right?

Now there are many exceptions and other rules involved with this issue.  First, any depreciation that was limited or not allowed does not have to be recaptured.  Also, there are a whole set of rules for office structures that are separate from the main dwelling unit, so if you have a greenhouse or separate office building on your property – be prepared for a lot of questions from your CPA.  Other than that, talk to your CPA or accountant in advance about this and do not wait until you are already in the process of selling your home as there is some planning that can be done to minimize the tax consequences.

For those of you just starting a business – you might want to consider not taking the depreciation component of the office in home deduction – especially if you are planning on moving in the next few years.  If you are in a home that you plan on staying in for the next 10+ years, then it might not be a bad idea, but regardless of you situation – hopefully you are now more aware of a potential problem and can start planning more effectively.

To 179 or Not to 179

International CXT

For most business owners faced with questions on how to depreciate their fixed assets, usually the most common response is to expense as much as possible using Section 179 and then depreciate the remaining portion using MACRS.  This makes sense and usually saves considerable tax in the current year; however, you might want to put some more thought into that question the next time your CPA calls when working on your tax return as there are some additional considerations that you should be aware of:

1) Recapture

Like a ghost, recapture can come back and haunt you and the great deduction you took a few years may end up costing in the end with a higher tax rate on the gain from sale of the asset.  Capital gains rates are great right now (although that may be changing after the elections), but if you sell personal property that you took 179 depreciation on, you will end up with ordinary income rather than the capital gain you were hoping for.  The formulas are complex and it is something you would have to sit down with a CPA or accountant to discuss fully and apply it to your specific circumstances, but the bottom line is that you need to consider how long you will be holding a fixed asset when you are deciding on depreciation.  If you are planning on selling the asset after a few years, MACRS depreciation could be a better route to go in the long run.

2) The “Next Year”

Life is great in a tax year when you have a big 179 depreciation deduction, but what about the “next year”?  Lets say you had a good year and made a healthy net income, so in December you bought a ton of new equipment, or maybe a new commercial van that still qualifies for Sec 179 (maybe the above pictured truck over 14,000 GVW).  April comes and you get a big refund and your safe harbor estimated tax payments are nice and low – life is good.

You have another good year and get to December, but the problem is that you do not need much new equipment because of all you purchased last December and trading for a new vehicle using a 1031 exchange will have minimal impact.  Luckily, you realized the problem from reading my blog and called your CPA before year-end to get your 4th quarter estimated tax payments adjusted; however, this is not often the case.  For most, the “next year” can be painful – especially for those who file closer to October 15th.  Estimated tax payments are always based on 100% of the prior year tax liability less withholdings (110% if AGI is over $150k), and so if Sec 179 depreciation lowers you taxable income by $50k, you will be paying estimates based on that reduced amount.  Then the next year if business net income was the same but you only have $10k in Sec 179 deductions, your taxable income is going to be $40k higher – which can result in large amounts due with the return since your estimates were based on the reduced income from the prior year.   The next thing you know you are learning about installment agreements.  😦

3) Shareholder Basis Issues

If you are an S-Corp and you max out your 179 depreciation deduction ($125k for 2007, $250k for 2008 due to the Economic Stimulus Act), you could end up with a large loan to shareholder balance on your tax return.  This results mainly because most smaller S-Corporation owners take distributions based on cash flows and book net income; however, deductions like Sec 179 cause a distortion of net income on the tax return and a timing difference (as an asset that would have been depreciated over 5 years is now expensed completed in the current year).  If taxable net income is much lower than the book income that the distributions were based on, then you can end up with distributions in excess of your debt basis to the point where you have reduced retained earnings to zero and the excess distributions become a loan to shareholder account that technically you should be charging regular interest on (unless you want to take the excess distributions as capital gain).  The banker will then look at your return and see that you owe the company a large sum, and even though they understand Sec 179 and timing differences, they still do not like seeing this account when renewing a loan.  It is definitely something to consider if you have similar circumstances and you have to face renewal every year.

Bottom line – think before you 179 and always look to the “next year” and beyond.

Possible AMT Patch Battle Complicates Year-End Planning

It is that time of year again…and I am not talking about Christmas shopping or the recent snow showers. No, it is actually time once again for last minute tax planning for 2007 and calculating your 4th quarter estimated tax payments. Well, this year Congress is adding some complication to your planning and calculation…as well as frustrating the IRS and tax software programmers.

If you haven’t been following the latest developments, then you will definitely want to tune in this week as the Senate returns to take up the House Bill H.R. 3996 that would once again “patch” the AMT (alternative minimum tax) problem by raising the AMT exemption for a year so that millions of households are not affected. An AMT patch is usually not a problem for Congress to pass – in fact, that has been the solution for the past couple years. However, this time we have a Democratic lead Congress that reestablished the pay-as-you-go system (PAYGO), and basically the hold up on the patch is a fight over a matter of principle that could end costing many of us some big tax dollars. I don’t really want to get into the politics of this, but basically the Democrats want to have tax offsets to pay for the $50 billion in lost revenue and the Republicans argue that no tax offset is needed because AMT was never intended to tax to the extent it currently is and therefore it really isn’t “lost” revenue. Regardless of where you stand on this, time is running out and the big problem is how it affects your year-end tax planning.

For those of that are required to pay estimated tax payments, this could really affect you. If your income is fairly consistent and you are paying in 100% of the prior year tax liability (110% if your AGI was over $150k), then you don’t have as much to worry about in your year-end planning – although you should still pay attention to the AMT patch developments as it could mean more tax liability due on April 15th, 2008. However, those of you that are not paying in 100% of the prior year liability to safe harbor yourself against penalties will want to be very careful in your year-end tax planning. If a deadlock on the AMT issue prevents passage of a patch bill, then your tax liability for 2007 could higher than you had projected.

I don’t want to make too much out of this as it may become a moot point by the end of the week, but just make sure you keep informed on the issue and be cautious with your 4th quarter estimated tax payment if you are not paying safe harbor amounts. Also, if you have a CPA prepare estimated tax calculations in the next month, please make sure you understand what the numbers are based on. Most CPAs will probably base estimates on the AMT patch being passed, but you might have them calculate the effect on tax without the patch just to make sure you safe for 2007.

To read more about the AMT, please check out the following links:
New York Sun Article
Investors.com Article