Last Minute Tax Planning for 2018

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The dust has mostly settled on the tax changes for 2018, and we can identify a number of things you can still do to reduce your tax bill for 2018. Although I make reference to many changes in tax law, this is meant to be a planning tool, and not an exhaustive list of the changes.

Itemized Deductions vs Standard Deduction

Most taxpayers are entitled to the Standard Deduction, so unless your deductible items add up to more than the Standard Deduction there is no need to keep track of them. This has always been the case, but the Standard Deduction has increased substantially in 2018, and fewer people will be itemizing their deductions.

Previously, a single person got an automatic deduction of $6,350, and a married couple filing jointly $12,700. In 2018, though, these amounts are be increased to $12,000 and $24,000 respectively. That’s the good news. The bad news is that your deductible expenses may not do you any good if they fall below the new levels. The other bad news is that many of the expenses that were deductible in the past may either be eliminated or severely limited in 2018.

What You Can Deduct:

Medical expenses – You can deduct medical expenses that exceed 7.5% of your income. These expenses are deducted when they are paid, so you can accelerate or delay payments to maximize your deduction in a given year when you might exceed your standard deduction.

State and local taxes (SALT) – State income taxes, real estate taxes and personal property taxes have always been deductible, but in 2018, they are limited to $10,000 whether you are single or married. This will make a big difference to taxpayers in states with high taxes, but the impact will be reduced for many taxpayers who have paid Alternative Minimum Tax in the past. The common practice of accelerating payment of property taxes is no longer beneficial to most taxpayers.

Mortgage interest – Interest on home mortgages has previously been deductible on loans up to $1 million, and home equity loans up to $100,000. Starting in 2018, for new mortgages, the limit is reduced to $750,000. You can continue to deduct interest on your existing $1 million loans, but the deduction for home equity loans is gone – unless it falls under the $750,000 overall limit, and was used to improve the property. If you refinance your existing mortgage, the old $1 million limit still applies.

Charitable donations – Charitable donations are deductible up to 60% of your income, up from 50% in the past. Any excess can be carried forward to future years. The limit is 30% for gifts of stock, which is discussed later in this article. If your itemized deductions are below the new Standard Deduction, making a larger donation every second year could put you over the threshold in those years.

Gambling expenses, up to the amount of winnings, and investment interest, up to the amount of investment income, are still deductible.

What You Can’t Deduct:

Casualty and theft losses – This deduction has gone away, except for losses in a federal disaster area. You can no longer deduct losses from theft or other casualty losses. The existing income limitations still apply.

Unreimbursed employment expenses – Business expenses for employees (NOT self-employed or 1099 workers) are no longer deductible. These include union and professional dues, education expenses, home office expense, mileage, travel and meals, and other usual and necessary expenses incurred for the convenience of your employer, but which the employer will not reimburse. As I suggested last year, if you have substantial expenses of this nature, you may benefit from a change of status from employee to independent contractor. Also, if your income is relatively high, you should consider forming an S Corporation, as discussed later in this article, and in a separate article on this website.

Investment expenses – Fees paid to investment advisors are no longer deductible. Speak to your advisors to see if they can replace advisory fees with transaction-based fees, which are still deductible.

Legal expenses – Most personal legal expenses previously deductible are gone. Business related legal expenses are still deductible, as are fees related to discrimination lawsuits. Legal fees for divorce or child support are no longer deductible.

Hobby and not-for-profit rental expenses – You still have to report income from hobbies and casual rentals, but you can no longer deduct the related expenses. If you can generate a profit from these activities in some years, though, they could be considered to be for-profit business activities, and you could deduct your expenses in that case.

Tax preparation fees – The personal deduction for tax preparation is also gone. Fees for preparation of business or rental returns are still deductible.

Defer Income / Accelerate Deductions

There are opportunities to defer income items that would be taxable this year, and move them into next year. You may also be able to pay certain deductible expenses this year that you might have waited to pay next year. This strategy only makes sense, of course, if you are not expecting to be in a higher tax bracket next year.

If you have business income – self-employed, partnership, etc. – you can delay billing your customers or clients, so you don’t receive payment until after December 31. Similarly, you can speed up payment of some of your expenses to get a deduction this year. A very important change in 2018 is the Qualified Business Income deduction. It is discussed later in this article, and should be considered when you are looking at deferring or accelerating income.

If you have a rental property, and your income is under $100,000, you may be eligible to deduct up to $25,000 of rental losses against your regular income. The deduction phases out completely when your income goes over $150,000. It is a good incentive to defer income or accelerate expenses if you are in this range.

Talk to your employer about receiving any year-end bonus after December 31, so you don’t pay tax on it until next year.

Alimony will no longer a deductible expense for divorces finalized after 2018, and will no longer be income to the recipient, so try to speed the process or slow it down, depending on your objective.

Alternative Minimum Tax (AMT)

Alternative Minimum Tax has not gone away, but there have been substantial changes, which will result in fewer people paying AMT. The thresholds have been increased, and two of the main causes of AMT, state and local taxes and unreimbursed employment expenses, have been eliminated or severely limited. Incentive Stock Options are still an AMT item, so speak to your tax advisor well in advance of exercising any ISOs, as careful planning could reduce the tax impact.

Take Investment Losses Before Year-End

If you have losses on taxable investments, think about selling them this year. They will offset any capital gains you may have, but even if your losses are more than your gains, you can use up to $3,000 to reduce other income, and you can carry any excess losses forward to future years.

Retirement Plans

Make the maximum contributions to your retirement plans.

You can deduct contributions of $18,000 (more if you’re over 50) to your 401(k) plan – but at least make sure you contribute enough to get the full amount of your employer’s matching program. Your employer can contribute up to $18,000 as well.

You may be able to deduct up to $5,500 (more if you’re over 50) to a traditional IRA. If you don’t make a contribution before the end of the year, you have until April 15th. Contributions to a ROTH IRA are not deductible, but penalties are much less severe if you have to withdraw funds early.

If you are in an income category where you are not eligible to deduct contributions to a traditional IRA or contribute to a ROTH IRA, consider a “back door ROTH.” You can make a non-deductible contribution to a traditional IRA, then convert it to a ROTH. It sounds a bit tricky, but it is still allowed.

If you’re self-employed or have an S Corporation, you can contribute to a SEP IRA or a similar plan. You can deduct approximately 20% of your self-employment income, up to $55,000. The good news is that you can make your contribution all the way up to the filing deadline, including extensions, which gives you plenty of time to calculate your income. If you have an S Corp, you can also take advantage of a SEP IRA, but it must be paid by the corporation, and the amount depends on the W-2 salary you receive from the corporation.

If you have a corporation or partnership, you should also look into a Defined Benefit retirement plan. There are important cost and other business issues involved in the decision, but you could potentially take a deduction of up to $250,000 – substantially more than a SEP IRA.

Don’t take money out of your traditional IRA or 401(k) plan if you are under 59 ½ years old. There is a 10% penalty on top of the regular tax, and some states have an additional penalty. Before you take an early withdrawal, though, remember that you may be able to borrow from your 401(k), but not from your IRA. There are also penalties for early withdrawal from a ROTH, but your original contributions are not taxed a second time.

You can take a distribution from your IRA without a penalty if you are a first-time home buyer, if you make qualified tuition payments, and several other special situations. Remember that if you have a 401(k), and plan to make tuition payments, roll the 401(k) over into a traditional IRA first.

Consider rolling over your traditional IRA into a ROTH IRA. You will pay tax on the full amount when you roll it over, but if you expect to be in a low tax bracket this year, for any reason, this might be a good time to do it. Also, there is no required minimum distribution from a ROTH IRA after age 70 ½.

Start taking minimum required distributions from your traditional IRA if you turn 70 ½. There is a 50% tax if you don’t.

Charitable Donations

Charitable donations are a nice deduction, assuming your total deductions exceed the Standard Deduction. If you have shares of stock that have appreciated in value, consider donating the stock to charity. If you have owned the stock for more than one year, you can deduct the entire appreciated value of the stock, and avoid capital gains tax or Net Investment Income Tax (NIIT). The limit is 30% of your income, but any excess can be carried forward to future years.

Gifts

You can make tax-free gifts of up to $15,000 ($30,000 for a married couple) per recipient. (Remember that gifts are not taxed to the recipient, but to the giver). Gifts in excess of this amount require filing a gift tax return, but you won’t actually pay tax until you go over your lifetime limit of $11,180,000.

Qualified payments for tuition or medical expenses are not considered a gift, as long as they are paid directly to the educational institution or the medical provider.

Some people, in anticipation of their death, make gifts of real estate or other valuable property to family members. Be sure to speak with a tax advisor before you do this, as an inheritance could have a much more favorable tax benefit to your family member than a gift.

Avoid the “Kiddie Tax”

If your dependent children (under 19, or under 24 if they are full time students) have investment income over $2,100, it will be included in your income, and taxed at your full rate, including NIIT. So think carefully before you give them stocks to sell to pay for college.

Depreciation Opportunities

You can deduct 100% of qualifying asset purchases up to $1,000,000 (with phase-outs if your total purchases exceed $2.5 million) under Section 179. This is a tremendous incentive to buy capital assets which you would otherwise have to expense over several years. There are exclusions, but many of the excluded items are eligible for a 100% special depreciation allowance in the year of purchase. These are terrific deductions. If you are planning to buy assets, buy them before year-end, and reduce your taxes for 2018.

Filing Deadlines

Individual tax returns for 2018 are due on April 15, 2019, or may be extended to October 15. Remember that it is an extension to file only, but taxes are still due on April 15. Form 1065 Partnership (including LLC) Returns are due on March 15 (September 16 with an extension), as are Form 1120S subchapter S corporation returns. Single member LLCs do not file Form 1065, so they are due with individual returns on April 15.

There are severe penalties for late filing of partnership, LLC and S Corp returns. For personal returns, there is only a penalty if you owe money.

Form 1099-Misc and Form W-2 must be issued to employees and contractors, as well as to the IRS or Social Security Administration, by January 31. It’s a good idea to confirm all employee information and W-9 information before the end of the year. Remember that Form 1099-MISC must be issued to all individuals and partnerships to whom you paid over $600 during the year. There are penalties for not filing these forms.

Estimated Payments

The theory is that we are supposed to pay our taxes as we earn the money. This is easy when your employer withholds tax from every pay check, but not so easy for people with self-employment, partnership, S Corp, rental or investment income. That’s where estimated payments come in.

Generally speaking, in order to avoid a penalty, you are required to pay either 90% of this year’s tax by January 15, or 100% of last year’s tax (or 110% if your income is high). There is a quarterly schedule of payment dates, but it would be a good idea to make a payment before the end of the year if you expect to have a high tax bill. The penalty is not huge, but why pay a penalty when you can avoid it?

States have estimated payment requirements, too.

Business Issues – Sole Proprietors, Corporations and Partnerships

There have been substantial changes to the taxation of business income, starting with a reduction of the tax rate on C Corporations to a flat 21%. Corresponding changes were made to income from sole proprietorships and pass-through business entities.

Deduction of Expenses:

Something to consider is that unreimbursed expenses which are no longer deductible for an employee can still be deducted if you change your status to independent contractor, partnership or S Corporation. This change is having a big impact on the entertainment industry, among others.

By the way, entertainment expenses are no longer deductible. This includes such things as tickets to sporting events.

QBI Deduction – This is Important:

There is a potential deduction on your personal tax return of up to 20% of your Qualified Business Income, or income from a trade or business. This applies to income from a sole proprietor as well as a partner with pass-through income from a partnership or a shareholder with pass-through income from an S Corporation.

If your income (excluding capital gains and losses) is under $157,500 ($315,000 if you are married) you will be eligible for the full 20% deduction. The benefit phases out, however, so that there is no deduction when your income reaches $207,500 (or $415,000 if you are married). There are exceptions, though, and this is where planning can make a big difference.

If you are in a Specified Service business, you can’t get any benefit from the QBI deduction after you pass the phase out income range. Specified Service businesses include those related to health, law, accounting, consulting, performing arts and others. Engineering and architecture are specifically excluded from this group, and are eligible for further deductions, as discussed below.

If your business pays W-2 wages, and you are not a Specified Service business, then you can take a QBI deduction of up to 50% of wages paid, up to the 20% maximum. Alternatively, you can use 25% of wages and 2.5% of the undepreciated cost of property used in your business. This also applies to your share of pass-through income, wages and qualified property from a partnership or S Corporation.

Important planning point – As a shareholder of an S Corporation, you are required to pay yourself a reasonable W-2 salary, and this counts toward the QBI deduction. So, if your income exceeds the threshold, and you don’t have any employees, you should consider forming an S Corporation. See a more thorough discussion in another article on this website.

Net Operating Losses:

NOLs can no longer be carried back 2 years, as they have in the past. They must be carried forward, but now only 80% can be carried forward. You may want to look at opportunities to defer some expenses, as discussed earlier, so the full amount can be deducted next year.

Rules for S Corps and Partnerships:

There are very specific rules related to S Corps and Partnerships, and now is a perfect time to be sure you in compliance before year-end. It would be a shame to lose out on the tax benefits of these business entities.

S Corp Salary – If you have a Subchapter S Corporation, don’t forget that you are required to pay yourself a reasonable salary. A benefit of having an S Corp is that not all of your profits need to be subject to employment taxes, but you do need to pay yourself a salary, and issue yourself a W-2 as an employee. Issuing yourself a 1099 is not a substitute. Speak to your tax advisor about what is considered a reasonable salary.

Retirement plans – As discussed above, there are opportunities for S Corp shareholders and partners in partnerships and LLCs to make very substantial tax-deferred contributions to SEP and other retirement plans. The contributions are a percentage of your partnership income or your S Corp salary. It is important to remember that the retirement plans MUST be in the name of the S Corp or the partnership. Individual shareholders and partners cannot have their own individual SEP plans.

Health Insurance – Your health insurance payments may be deductible on your personal return if you are a shareholder in an S Corp or a partner in a partnership or LLC, and you meet certain requirements. Remember, though, that the payments must be made by the corporation or LLC – or reimbursed if you make the payments yourself. Payments for your health insurance made by your S Corp must be included as compensation on your W-2, but are not subject to payroll taxes. Make this clear to your payroll processing company. Payments by your partnership or LLC are treated as distributions. If you have a single member LLC, you can make payments from your business or personal account.

Do you need your LLC or S Corp? – Are you getting any real benefit from it? If you are in a state that has a minimum LLC or S Corp tax, you may be paying for something you don’t really need. California’s minimum tax is $800, and you’re also paying for a relatively expensive tax return. If limited liability is a big concern, consider buying insurance that offers appropriate protection. Closing the LLC or S Corp before year-end won’t reduce your 2018 tax bill, but it will cut future costs… See the article I wrote earlier on this website.

I would be pleased to discuss your tax planning issues.

Maybe You Should Have an S Corporation – A Tax Planning Discussion

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Who May Benefit

This article may benefit you if:

  1. Your income is over $157,500 ($315,000 if married filing jointly),and
  2. You are:
  • Self-employed, or
  • A partner in a partnership or a member of an LLC that is taxed as a partnership

Suggestion: You may spare yourself some reading by jumping to the two examples I provided below.

Overview

The tax changes in 2018 include some provisions that are very favorable to businesses. One important change was to drop the tax rate for C corporations to a flat 21%. This is a significant reduction, but doesn’t apply to businesses that operate as partnerships, LLCs, S corporations or sole proprietorships.

To provide a similar benefit to these businesses, the IRS introduced Section 199A Qualified Business Income deduction. This allows individuals with income from businesses that operate as partnerships, LLCs, S corporations or sole proprietorships to take a tax deduction of 20% of their share of Qualified Business Income (QBI)… But there are rules, definitions and restrictions:

The rules and restrictions include a phase-out of the deduction, when your income exceeds certain thresholds. BUT these restrictions are reduced or eliminated if your business has W-2 payroll expenses or substantial investment in qualified assets.

S Corps are required to pay a reasonable W-2 salary to their owners, but partnerships, LLCs and sole proprietors cannot. That’s why you may want to form an S Corp.

Why is the QBI Deduction Important?

You can take a tax deduction of up to 20% of the net income generated by your business. It can be a very big deal.

What is QBI?

Qualified Business Income is the income from your trade or business.

There are no restrictions on the types of businesses income that qualify for the QBI deduction, as long as the idividual claiming the deduction has taxable income under $157,500 (or $314,000 if married filing jointly). For those with higher taxable income, you will not be able to claim the deduction if you are in a Specified Service Business, as described below.

QBI is not intended to include income from personal services, so it specifically excludes employment income, as well as income from Specified Services Businesses – in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletic, financial and brokerage services. Engineers and architects, however, are eligible for the QBI deduction. Speak to your tax professional for a more thorough and complete discussion of your eligibility.

Owners of rental properties may also qualify for the QBI deduction, but the value of the properties will help you qualify if your income is above the phase-out thresholds, so the benefit of an S Corp would probably be irrelevant. And would also bring up other complex issues.

Payroll Expenses Can Save the Day

The QBI deduction phases out to nothing if your income exceeds $207,500 (or $415,000 if married filing jointly)… UNLESS your business had W-2 payroll expenses or substantial qualified assets. Let’s focus on the payroll:

If you are above the taxable income threshold, and if your income is not from a Specified Services Business, you can still claim the QBI deduction in an amount up to 50% of the W-2 payroll of the business.

Partnerships and other businesses may have employees, and their wages would count in this calculation, but many businesses don’t pay any W-2 wages at all, so they would lose the QBI deduction. Certainly, sole proprietors and partners in partnerships can’t pay themselves salaries… BUT S Corps can.

Example 1 – Sole Proprietor

A real estate broker operating as a sole proprietor earns $275,000 from his business activities, and reports his income on Schedule C of his tax return. He is not married, so he will pay tax on the entire $275,000. His income is over the threshold, so there is no QBI deduction.

If the same real estate broker operated his business as an S Corp, he would be required to pay himself a reasonable salary – say $125,000. Ignoring a few other details, his Qualified Business Income would be $150,000 ($275,000 income, less $125,000 W-2 salary paid to him by the company). His QBI deduction would be the lesser of (a) 20% of his QBI – $30,000, and (b) 50% of the W-2 wages – $62,500.

In this case, the real estate broker gets a tax deduction of $30,000 by forming an S Corp.

Example 2 – Partnership (or LLC taxed as a partnership)

The partnership earned $400,000. Partner A owns 50%, and received guaranteed payments for his services of $125,000. His income of $325,000 ($125,000 guaranteed payment, plus $200,000 share of partnership income) is fully taxed at ordinary tax rates. He is single, so his income is too high to qualify for the QBI deduction.

If the partnership filed an election to be treated as an S Corp, his guaranteed payment of $125,000 would be paid as W-2 wages, and his QBI would be $200,000. Assuming his business partner also received the same salary, and again ignoring a few details, his QBI deduction would be the lesser of (a) 20% of his QBI – $40,000, and (b) 50% of his share of W-2 wages – $67,500.

In this case, the partner gets a tax deduction of $40,000 by electing to have the partnership taxed as an S Corp.

NOTE: Even though the deadline for S Corp election has passed, the partnership can apply for late filing relief, and there is a good possibility that the S Corp election can be made effective for 2018.

Conclusion

This is not intended to be a thorough analysis of Section 199A of the tax code. Nor is it a full discussion of the pros and cons of an S Corp. Rather, it is an attempt to find good tax planning solutions. There are a lot of variables in the choosing the most appropriate business entity, and every situation is different. I would be happy to discuss your situation, and help you arrive at the most advantageous result.

Last Minute Tax Planning for 2017

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Year-end tax planning is going to be more difficult this year, in view of the uncertainty surrounding the tax reform currently proposed in the House and the Senate. Nevertheless, there are still a number of things you can do to reduce your tax bill for 2017.

There are major changes in the proposed tax legislation for 2018, so we need to think about both 2017 and 2018.

Itemized Deductions vs Standard Deduction

Most taxpayers are entitled to the Standard Deduction, so unless your deductible items add up to more than the Standard Deduction there is no need to keep track of them. A single person, for example, gets an automatic deduction of $6,350, and a married couple filing jointly gets $12,700. Under the proposed tax legislation, these amounts will be increased to $12,200 and $24,400 respectively. That’s the good news. The bad news is that expenses that were previously deductible may not do you any good if they fall below the new levels. The other bad news is that even if your itemized expenses are greater than these new amounts, many of the expenses that are currently deductible may either be eliminated or severely limited in the future. These include:

Medical expenses – You can currently deduct medical expenses that exceed 10% of your income (7.5% if you are 65 or older). This deduction is scheduled to be eliminated, so it would be wise to take care of any medical issues before the end of the year, and be sure to pay for them before December 31.

State and local income taxes – Your state tax is currently deductible, but the deduction will be eliminated under the current plans. If it looks as if you will owe state tax for 2017, it would be wise to make an estimated payment before December 31.

Property taxes – This deduction would be limited to $10,000 in 2018. Property taxes are typically paid in two installments – in Los Angeles, they are due on November 1 and February 1 – so why not pay both installments before year-end.

Mortgage interest – Deductibility of new mortgages will be limited, but existing loans will be unchanged. If you make your January payment in December, you could get a deduction this year that may not help you if you wait until next year.

Charitable donations – If you can deduct itemized expenses in 2017, but not in 2018, it would be advisable to make next year’s donations in 2017.

Unreimbursed employment expenses – Business expenses for employees (NOT self-employed or 1099 workers) will not be allowed under the proposed rules. These include union and professional dues, education expenses, home office expense, mileage, travel and meals, and other usual and necessary expenses incurred for the convenience of your employer, but which the employer will not reimburse.
You may find it appropriate to change your status from employee to independent contractor, if you meet the criteria, as many of these expenses will still be deductible from self-employment income. This can be a complex decision, so consult a tax specialist before making the change.

Be sure to pay for any such expenses before December 31, while they are still deductible. You could also purchase required equipment and supplies that you expect to need next year.

Defer Income / Accelerate Deductions

There are opportunities to defer income items that would be taxable this year, and move them into next year. You may also be able to pay certain deductible expenses this year that you might have waited to pay next year. This strategy only makes sense, of course, if you are not expecting to be in a higher tax bracket next year.

If you have business income – self-employed, partnership, etc. – you can delay billing your customers or clients, so you don’t receive payment until after December 31. Similarly, you can speed up payment of some of your expenses to get a deduction this year. Pass through income, such as partnership and S Corp income, may be taxed at lower rates under the new legislation, depending on your situation. If this is the case, then it would be wise to defer as much income as possible to next year. Speak with a tax specialist about this.

If you have a rental property, and your income is under $100,000, you may be eligible to deduct up to $25,000 of rental losses against your regular income. The deduction phases out completely when your income goes over $150,000. It is a good incentive to defer income or accelerate expenses if you are in this range.

Talk to your employer about receiving any year-end bonus after December 31, so you don’t pay tax on it until next year.

Alimony under current divorce agreements may continue to be deductible, but will be eliminated for future separation agreements. It may be wise to finalize your agreements before the end of the year.

Alternative Minimum Tax (AMT)

For many taxpayers, particularly those with higher incomes, there is currently a limit to the benefit you can get from certain deductible expenses. There are phase-outs as your income rises, but another very important consideration is the Alternative Minimum Tax (AMT). The expenses most likely to be affected are state and local income taxes (especially in California, New York and other high-tax states) and office and employment expenses. If you are subject to the AMT, accelerating payment of these expenses will not do you any good. You should speak with your tax advisor about other possible strategies for 2017.

The AMT will be eliminated under both the House and Senate proposals. This will reduce the complexity of your return, and very possibly result in a lower tax bill. Important – if you plan to exercise Incentive Stock Options (ISOs) and you do not plan to sell them immediately, you may be wise to wait until next year, when they will not result in an AMT expense.

Take Losses Before Year-End

If you have losses on taxable investments, think about selling them this year. They will offset any capital gains you may have, but even if your losses are more than your gains, you can use up to $3,000 to reduce other income, and you can carry any excess losses forward to future years.

Retirement Plans

Make the maximum contributions to your retirement plans.
You can deduct contributions of $18,000 (more if you’re over 50) to your 401(k) plan – but at least make sure you contribute enough to get the full amount of your employer’s matching program.

You may be able to deduct up to $5,500 (more if you’re over 50) to a traditional IRA. If you don’t make a contribution before the end of the year, you have until April 15th. Contributions to a ROTH IRA are not deductible, but penalties are much less severe if you have to withdraw funds early.
If you’re self-employed or have an S Corporation, you can contribute to a SEP IRA or a similar plan. You can deduct approximately 20% of your self-employment income, up to $54,000. The good news is that you can make your contribution all the way up to the filing deadline, including extensions, which gives you plenty of time to calculate your income. If you have an S Corp, you can also take advantage of a SEP IRA.

Don’t take money out of your traditional IRA or 401(k) plan if you are under 59 ½ years old. There is a 10% penalty on top of the regular tax, and some states have an additional penalty. Before you take an early withdrawal, though, remember that you may be able to borrow from your 401(k). There are also penalties for early withdrawal from a ROTH, but your original contributions are not taxed a second time.

You can take a distribution from your IRA without a penalty if you are a first-time home buyer, if you make qualified tuition payments, and several other special situations. Remember that if you have a 401(k), and plan to make tuition payments, roll the 401(k) over into a traditional IRA first.

Consider rolling over your traditional IRA into a ROTH IRA. You will pay tax on the full amount when you roll it over, but if you expect to be in a low tax bracket this year, for any reason, this might be a good time to do it. Also, there is no required minimum distribution from a ROTH IRA after age 70 ½.
Start taking minimum required distributions from your traditional IRA if you turn 70 ½. There is a 50% tax if you don’t.

Charitable Donations

Charitable donations are a nice deduction, assuming your total deductions exceed the Standard Deduction. As suggested above, the standard deduction will probably increase next year, so it may be wise to make your 2018 donations this year to get a larger benefit from the deduction.

If you have shares of stock that have appreciated in value, consider donating the stock to charity. If you have owned the stock for more than one year, you can deduct the entire appreciated value of the stock, and avoid capital gains tax or Net Investment Income Tax (NIIT).

Gifts

You can make tax-free gifts of up to $14,000 ($28,000 for a married couple) per recipient. (Remember that gifts are not taxed to the recipient, but to the giver). Gifts in excess of this amount require filing a gift tax return, but you won’t actually pay tax until you go over your lifetime limit of $5,490,000.
Qualified payments for tuition or medical expenses are not considered a gift, as long as they are paid directly to the educational institution or the medical provider.

Avoid the “Kiddie Tax”

If your dependent children (under 19, or under 24 if they are full time students) have investment income over $2,100, it will be included in your income, and taxed at your full rate, including NIIT. So think carefully before you give them stocks to sell to pay for college.

Depreciation Opportunities

You can deduct 100% of qualifying asset purchases up to $500,000 (with phase-outs if your total purchases exceed $2 million) under Section 179. This is a tremendous incentive to buy capital assets which you would otherwise have to expense over several years. There are exclusions, but many of the excluded items are eligible for a 50% special depreciation allowance in the year of purchase.
These are terrific deductions. If you are planning to buy assets, buy them before year-end, and reduce your taxes for 2017.

Filing Deadlines

Individual tax returns for 2017 are due on April 17, 2018, or may be extended to October 15. Remember that it is an extension to file only, but taxes are still due on April 17. Form 1065 Partnership (including LLC) Returns are due on March 15, as are Form 1120S subchapter S corporation returns. Single member LLCs do not file Form 1065, so they are due with individual returns on April 17.

Form 1099-Misc and Form W-2 must be issued to employees and contractors, as well as to the IRS or Social Security Administration, by January 31. It’s a good idea to confirm all employee information and W-9 information before the end of the year. Remember that Form 1099-MISC must be issued to all individuals and partnerships to whom you paid over $600 during the year. There are penalties for not filing these forms.

Corporations and Partnerships

The proposed tax changes include a significant reduction in tax rates on business income. This includes income from C Corporations as well as S Corporations and partnerships. As the rules become clear, there will be a need to map out strategies to get the best benefit from the changes.
There are very specific rules related to S Corps and Partnerships, and now is a perfect time to be sure you in compliance before year-end. It would be a shame to lose out on the tax benefits of these business entities.

S Corp Salary – If you have a Subchapter S Corporation, don’t forget that you are required to pay yourself a reasonable salary. A major benefit of having an S Corp is that not all of your profits need to be subject to employment taxes, but you do need to pay yourself a salary, and issue yourself a W-2 as an employee. Issuing yourself a 1099 is not a substitute. Setting up W-2 payments after year-end is annoying, and there are stiff penalties for late payment of employment taxes, so take care of it before the end of the year.

Retirement plans – As discussed above, there are opportunities for S Corp shareholders and partners in partnerships and LLCs to make very substantial tax-deferred contributions to SEP and other retirement plans. The contributions are a percentage of your partnership income or your S Corp salary. It is important to remember that the retirement plans MUST be in the name of the S Corp or the partnership. Individual shareholders and partners cannot have their own SEP plans.

Health Insurance – Your health insurance payments may be deductible on your personal return if you are a shareholder in an S Corp or a partner in a partnership or LLC, and you meet certain requirements. Remember, though, that the payments must be made by the corporation or LLC – or reimbursed if you make the payments yourself.

Payments made by your S Corp must be included as compensation on your W-2, but are not subject to payroll taxes. Make this clear to your payroll processing company.

Payments by your partnership or LLC are treated as distributions.

If you have a single member LLC, you can make payments from your business or personal account.

Do you need your LLC or S Corp? – Are you getting any real benefit from it? If you are in a state that has a minimum LLC or S Corp tax, you may be paying for something you don’t really need. California’s minimum tax is $800, and you’re also paying for a relatively expensive tax return. If limited liability is a big concern, consider buying insurance that offers appropriate protection. Closing the LLC or S Corp before year-end won’t reduce your 2017 tax bill, but it will cut future costs… See the article I wrote earlier on this website.

Corporation and pass-through tax rates will be much lower under the proposed tax legislation, so it may be wise to revisit the decision to operate as an S Corp or a C Corp.

I would be pleased to discuss your tax planning issues.

YOUR S CORPORATION – A CHECK-UP

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In my experience, a lot of people don’t pay enough attention to their Subchapter S Corporations until tax time, when it’s sometimes too late to correct errors or oversights.

You formed the S Corp because of the benefits you would get from it, so it would be a shame to operate it in such a sloppy way that you could miss out on some of those benefits. Please take a moment to be sure you are following these guidelines, and make any necessary changes before the end of the year.

Reasons for forming an S Corp generally include:

  • Reducing payroll taxes on a portion of your income
  • Retirement contributions in excess of the limits on IRAs and 401(k) plans
  • Deduction of health insurance costs
  • Limited liability

I will discuss these items briefly below, then move on to some other relevant thoughts.

W-2s and Payroll Taxes

Generally speaking, your S Corp does not pay tax, but rather the income “passes through” to your personal tax return. This pass-through income is taxed at your regular rates, but it is not subject to the federal and state payroll taxes you would pay if you were an employee.

It is important to note that a shareholder of an S Corp is not self-employed, but is actually an employee of the company. As such, you are required to pay yourself a reasonable salary, a term that is not clearly defined, but is intended to prevent shareholders from entirely avoiding Social Security, Medicare and other payroll taxes. One way to look at it is that you should pay yourself what it would cost to hire someone to do your job.

Your salary is treated as a deduction by the company, so you aren’t taxed twice. You pay payroll taxes on your salary, but you don’t pay payroll taxes on the remainder of the S Corp’s income after deducting your salary. That’s one of the benefits of an S Corp.

Action required:  Pay yourself a salary, and issue a W-2 at the end of the year. I suggest you use a payroll service to be sure you are in full compliance with the complex rules and regulations surrounding payroll. Do this before the end of the year.

Retirement Contributions

As an S Corp owner, you have a choice of retirement plans that you can establish. One of the most popular plans is a Simplified Employee Pension, or SEP. An advantage of a SEP plan is that the company can contribute a percentage of your salary, up to a maximum contribution of $54,000. This is substantially higher than the limits for IRAs and 401(k) plans. Do be aware, though, that you also have to offer the plan to your other eligible employees, and contribute the same percentage on their behalf. This is a specialized and complex area, so you should speak with a knowledgeable professional on the subject.

It is important to note again that as an S Corp shareholder, you are not self-employed, but rather an employee of the company. The retirement plan must be created in the name of the company, not yourself, and the contributions are made by the company. Contributions are deductible from the company’s income of course.

Action required: You can establish a SEP retirement plan any time during the year, or up to the date when the company’s tax return is due (even if you file for an extension). Other types of retirement plans may have different rules, so be sure to investigate before the end of the year.

Health Insurance

As an S Corp shareholder, you can deduct health insurance costs for yourself and your family directly on your tax return. But there is a special process for doing so, and it is important that you follow it. The company must pay for your health insurance. It is acceptable to have the insurance in your own name and make the payments yourself, but you need to have the company reimburse you, and deduct the expense.

Health insurance paid by the company is considered compensation to you, and must be added to your salary on your W-2 at the end of the year. You will not pay payroll tax on this amount, but it must be included in gross earnings. You then deduct the amount directly on your personal tax return.

It seems a bit convoluted, but those are the rules.

Action required:  Be sure to have the company reimburse you for medical insurance payments before the end of the year, and be sure to instruct your payroll service to include it on your W-2. If the payroll service gives you trouble, ask to speak to a supervisor… they do this for thousands of people every year.

Limited Liability

To ensure that your S Corp offers limited liability you need to be disciplined in the way you operate it. Without going into depth, you need to establish that it is a separate entity, and not just an extension of your own personal finances. That includes keeping a separate bank account and credit cards, maintaining careful accounting records and keeping up to date with your state’s filing requirements.

Action required: Check that you are following the appropriate discipline to ensure your company is a separate entity.

Estimated Tax Payments

We are required to make payments during the year of the amount of tax we estimate owing for the whole year. This is easy for the salary you pay yourself, because you are expected to withhold and pay federal and state tax from each paycheck.

The issue here is the tax you expect to pay on the company’s earnings that pass through to your personal return. Depending on your situation, these amounts can be substantial, and to add insult to injury, there are penalties for underpayment of estimated tax.

Action required:  Speak with your tax professional at least once during the year, to be sure you are making appropriate estimated tax payments.

State and Local Tax Registration

Many cities have tax filing requirements, and it can be annoying and expensive if you haven’t met their requirements. Los Angeles, for example, assesses tax on income above a specified level, but also has a requirement to register for a business license and renew it every year.

If you are operating outside the state in which you registered the company, you need to check on filing requirements. California, for example, is very aggressive about finding and taxing out-of-state businesses that do business there.

Action required: Learn the filing requirements, and follow them. They will find you if you don’t.

Auto Expense and Home Office

The S Corp can own a car, and deduct any allowable business expenses, but you may find it easier to keep the car in your own name, and submit for reimbursement any business mileage, documenting the locations, distances and business purpose of each trip. You would complete form 2106 on your personal return, and deduct the reimbursement. I often find it convenient and preferable to use the IRS standard mileage rate where eligible – it’s 53.5 cents per mile in 2017.

Similarly, assuming you meet the rigorous and very specific requirements, you can deduct an expense for the business use of your home office. Again, submit expense reports for reimbursement, detailing the square footage of your office space and the total size of your home, in addition to specific allocated costs such as rent, mortgage, utilities, etc.

Action required: Submit detailed expense reports, and have the company reimburse you. Do this before the end of the year.

An S Corporation can be a very useful business format, but there are rules that need to be followed to ensure you get all the appropriate benefits. And remember that an S Corp is not necessarily the best entity for you, depending on your situation and your objectives.

As always, speak to a tax professional before acting… and after!

Looking at a Real Estate Deal

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A client recently asked me to look at an investment proposal he was considering. He isn’t familiar with real estate deals, so his basic questions were:

  • Is it a good project?
  • Is it a good deal?
  • What are the risk factors?
  • Please explain the deal structure. Is it a common structure for similar deals?

Here are some thoughts on how to evaluate this sort of a deal:

This Project

In this case the project involved purchasing land in a Southern California town, building a senior living facility, and operating it for a period before selling it. They were looking for a $10 million investment.

Land acquisition, permits and other pre-construction were to take 7 months, construction 12 months and lease-up (the time it takes to lease all units) another 12 months. The proposal was to hold and operate the facility for 10 years, but vaguely suggested the possibility of selling at the end of the lease-up period.

Is This Your Kind of Deal?

This is a passive deal in which the investor has no control over the property or decision process. Are you ok with that? And are you willing to let someone hold your money for 13 years?

This isn’t to suggest that it’s a bad deal. A lot of people have made good money on investments like this. You just have to be sure it fits your needs and expectations.

Who is the Sponsor?

The sponsor is the person or organization that conceived of the project, put together the plan, and is now looking for equity financing. This is a long-term strictly passive investment, so you need to have full confidence in the sponsor. His (or her, or their) experience, reputation and integrity are critical to the project’s outcome. Questions to ask include:

  • Has the sponsor completed similar projects in the area? This is especially important in Southern California, where local governments can make you jump through hoops before they approve a project.
    • Does he have experience with land entitlements in the region? How about his experience with the local municipality?
    • Does he have experience with construction management and budgets? Has he selected reputable engineers and contractors?
    • What is his expertise in operating senior living facilities, or whatever else the project may involve? Does he have a reputable management company on board?
  • How much is the sponsor investing? Do you want to be a limited partner when the person controlling the project doesn’t have anything at risk?
  • If the sponsor has previous successful experience, why isn’t he using previous investors?

Risk Factors

The first big risk has already been discussed. You’re letting somebody control your money for 13 years. First, is the sponsor trustworthy? Next, the longer your money is outside your control, the more chance there is that something will go wrong. That’s a main reason why long term projects need to have a significantly higher return than short term projects.

That whopper of a consideration aside, here are some specifics:

  • General business risk. Is this the right project in the right place at the right time? The sponsor should have comprehensive, convincing information to help you make this decision. Senior living facilities sound like a pretty good bet these days, but is it the right time and place? Clearly, you should do your own due diligence.
  • What happens if cash flow projections are bad, or something unexpected happens, and more funding is required? Are you required to invest more? Will you have to give up a big part of your return to attract a new investor who knows you can’t complete the project?
  • Land entitlements (permits, approvals, etc.) require expertise and knowledge of the local government process, and VERY often take a lot longer than expected, running up costs and dragging down financial returns. The fewer permits required, the more likely the project will move ahead on schedule. That will make the land more expensive, though, because someone else took the entitlement risk.
  • In my experience, the land development phase almost always goes over budget. Is there enough contingency? Again, the less land development required, the better chance of staying on plan. But it will also make the land more expensive.
  • Assumptions used in projecting revenues and costs.
    • Are the unit rental rates in the projections achievable? This particular proposal used a 3% annual increase in rental rates over the entire 10 year operating period. This sounds aggressive to me, but maybe the sponsor has data from other projects to support it.
    • Expense assumptions need to be examined closely, too. Having done hundreds of budgets and projections in my career, I can promise that expenses are always projected on a “best case” basis.
  • Are there holes or errors in the cash flow projections? Something I noticed in this specific proposal is that there were no operating costs budgeted for the 12 month lease-up period. I also didn’t see the sponsor’s fees deducted from the cash flow projections.

Is it a Good Project?

Over and above your due diligence regarding the risk factors, attention turns to the financial returns. How you view the proposal is important:

  • This project is really two separate projects – 1) acquisition, construction and lease-up of a senior living facility, and 2) investment in an operating facility. These are very different projects with very different risks and expected returns, so they need to be analyzed separately.

This proposal did not separate the two phases, but when I applied the sponsor’s valuation assumptions (a 7% cap rate) at the end of the construction and lease-up phase, there was no profit whatsoever, even though this is the phase with the greatest risk. Did the sponsor even bother to check whether he was overpaying for the land? Any suggestion of selling at a profit at that point has flown out the window.

  • It is common for investment proposals to show project returns on a leveraged basis, maybe even applying tax assumptions that may or may not fit your situation. Not unreasonable, because the project is probably using debt financing, and this would be the actual return on your equity investment.

The problem is that it makes it difficult to compare the quality of this project against other similar projects. The only way to compare one project with another is to take out the variables, and show the pretax unleveraged return. Of course, this proposal did nothing of the kind.

  • This project seemed to be projecting a 23% annual after-tax return to the investor, but the financial analysis didn’t feel reliable. Anyway, that’s a heck of a return, and you would really want to ask if it’s too good to be true.

The Deal Structure

Once the investment is made, then the deal is all about who takes out cash – when and how much. This deal was fairly typical.

  • Sponsor fees –
    • The sponsor typically takes an up-front fee based on funds under management. In this situation, it was 1.0%, probably about enough to recoup the sponsor’s start-up costs.
    • He also typically also takes a percentage of the selling price when the project is sold, 1.0% in this case. This is his bonus.
    • The sponsor will also take a fee for the duration of the project, often measured as a percentage of assets. It seems reasonable that the sponsor have some cash flow. In this case it was 2.5%, or $250,000 a year.
  • The “waterfall” – This is a detailed agreement outlining where and when free cash flow is distributed among the investors and sponsor.
    • This particular agreement was unclear as to how the monthly cash flow would be distributed, but it would generally be based on a percentage formula, and the investors’ share divided according to their relative investment.
    • There is often a “preferred return” when the project is sold. That is, the investor gets his entire investment back, plus an amount that brings him up to an agreed rate of return (7.0% in this case) before the sponsor gets to share in the profits.
    • After the investor gets his preferred return, then the remaining cash flow is shared according to any simple or complicated formula agreed to in the partnership agreement.

The great thing about deals is that they are negotiable, or you can walk away. You don’t have to accept any terms you can’t live with.

Are You Getting a Good Deal?

A good deal is in the eye of the beholder…

  • Is the projected return better than your other investment opportunities, given the risk factors involved?
  • Are you getting as good a return as you would on a similar project?
  • Are you satisfied that the sponsor is being rewarded reasonably?
  • Are you satisfied that you are getting as good a deal as other investors in the project?

My Recommendation

You’re probably not surprised that I recommended against this particular deal. I did recommend, though, that my client keep an eye out for other deals to educate himself. You never know when the right deal might present itself.

 

 

 

 

 

 

 

DO I NEED AN LLC?

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Whenever a client tells me they’ve formed, or plan to form an LLC, I ask…

Why?

Especially if they don’t have partners in their business.

The question takes a lot of people by surprise, because they just assume they need a company to start a business, or they think it’s the only way to achieve liability protection. They often haven’t considered the costs of forming and maintaining an LLC, and even more often don’t know how to operate it prudently.

An LLC (Limited Liability Company) can be a useful structure under certain circumstances, but they aren’t for everyone. Here are some thoughts:

– LLCs are kind of cool. I had an LLC myself, and it felt pretty cool, until I added up all the other factors and costs

– You don’t need an LLC to operate a business

– Limited liability may give you some protection against creditors or liability claims, but it’s not a sure thing

– A single-member LLC doesn’t even exist for federal tax purposes, so it’s exactly the same as operating as a sole proprietor

– Maybe an S Corp would serve your needs better

– There may be a state tax or filing fees for your LLC – the California minimum tax is $800

– You need to stay current with all LLC filing requirements for your state, or you may lose the benefits of the LLC

– Forming an LLC in another state may not save you tax in your home state

– Tax rates are higher on self-employment earnings – with or without an LLC – so you need to make estimated tax payments

– You can make much larger deductible retirement contributions if you are self-employed – with or without an LLC

– You can deduct your health insurance if you’re self-employed – with or without an LLC

Sole Proprietorship

There is nothing to stop you from starting a business without an LLC. When you operate a business in your own name or a DBA, it’s called a Sole Proprietorship. You can buy and sell products or services, buy equipment, rent space and incur operating expenses for your business. If you keep careful records and maintain separate bank accounts, the business can be accounted for separately from your personal activities.

For tax purposes, your business is reported on Schedule C of your personal tax return – Profit or Loss from Business. Your net income is taxed as ordinary income, and is subject to an additional Self-Employment Tax. This is basically your social security and medicare tax that you would pay if you received a paycheck from an employer. The difference is that you pay the employer share of these taxes, too. The calculation is complicated, but it comes to a little under 15%. You need to keep this in mind when making estimated tax payments during the year.

In a sole proprietorship, there is no built-in protection against creditors or liability claims.

Single Member LLC

If you are the only member of your LLC, you are taxed exactly the same as if you were a sole proprietor. A single member LLC is called a Disregarded Entity for tax purposes, which means that the IRS doesn’t even recognize its existence. Your business income is reported on Schedule C of your personal tax return, and you pay the Self-Employment Tax.

The only difference is that, depending on which state you are in, you may have to file a separate LLC tax return or information return, and/or pay an LLC tax or filing fee.

And oh, yeah… there is theoretically some protection against creditors and liability claims.

Limited Liability

Yes, limited liability means that the company is a separate entity for legal purposes, and creditors or legal claimants can only go after the company’s assets. You are only liable to lose any amounts you have invested or lent to the company, and your home and other personal assets are protected. That’s the theory, anyway.

Let’s look at it practically… Is anybody really going to lend money, lease property or give credit to your single member LLC without a personal guarantee from you? I didn’t think so. So what is the benefit of limited liability against creditors if all the LLC debts are your personal responsibility?

And what about liability claims? Sure, you have limited liability, as long as you operate the LLC in a disciplined fashion… and if you aren’t crooked. If a claimant or creditor is determined to go after your personal assets, they may try to “pierce the corporate veil.” That is, if they can demonstrate that you didn’t use separate bank accounts or separate credit cards, and generally didn’t operate the business as an entity completely separate from your personal affairs, they may get past the limited liability protection offered by the LLC. The same goes if they can demonstrate that you behaved fraudulently.

Insurance

How much liability do you expect to have? Most businesses don’t have that much to worry about – how much liability can your IT consulting business or online retail operation really generate? Liability insurance should cover most situations at a reasonable cost, and umbrella insurance would be an added layer of protection. A lot easier than operating and paying for an LLC.

Of course, there are businesses with potentially greater liability. It is common to see LLCs formed for day care facilities and rental properties. This is typically in addition to liability insurance. Just remember to be disciplined in keeping the business separate, and keep up to date on your state filings and payments.

Subchapter S Corporation (S Corp)

Depending on the size of your business, you might be better off forming an S Corp. One of the features of an S Corp is that not all of your income is subject to Self-Employment Tax, as it is in an LLC. There are a lot of issues that need to be weighed in going this route, but there are even more rules that need to be followed to the letter in order to realize the ongoing benefits. I’ve seen many S Corps formed by people who were never taught how to operate them, and left them exposed to unfavorable tax and legal consequences.

Out-of-State LLCs

Some states have high taxes and fees for LLCs. California, for example, has a minimum tax of $800. This gives some people the bright idea of forming their LLC in a state with lower costs. Don’t do it. Your home state – especially California – will catch you, and they will claim that you are conducting business in that state. You will then be required to pay tax and penalties.

Delaware is a very popular state in which to form an LLC, for a variety of reasons. Depending on your home state, you will probably want to register the LLC as a foreign LLC doing business in your state. That is certainly the case in California.

Retirement Plans

You can deduct much larger retirement contributions if you are self-employed. While a regular IRA contribution is limited to $5,500, a SEP IRA contribution can be 20% of your self-employment income, up to a total contribution of $54,000. You don’t need to have an LLC to be eligible for a SEP IRA. The same goes for deducting your health insurance.

Am I saying you probably don’t need a single member LLC? I like to joke that the average life of an LLC among my clients is a year and a half. They don’t mind paying the $800 California tax the first time, because they are full of hope and ambition, but the second time it comes up, it’s pretty hard to see what they are getting for their money… So yeah, I’m saying you probably don’t need an LLC.

Last Minute Tax Planning for 2016

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My clients often ask me if I can help them reduce their tax bill. The answer is yes… but for most tax saving opportunities, you have to take action before the end of the year.

Here are some things you can do before December 31 that may have a big impact on your tax bill when April 15th comes around.

Itemized Deductions vs Standard Deduction

There is a long list of expenses that are deductible for tax purposes. They include medical expenses, charitable donations, mortgage interest, state and local income taxes, employment expenses, etc. Some of these expenses are subject to limitations, of course.

Most taxpayers are entitled to the Standard Deduction, though, so unless your deductible items add up to more than the Standard Deduction there is no need to keep track of them. A single person, for example, gets an automatic deduction of $6,300, and a married couple filing jointly gets $12,600.

Sometimes, you may find yourself with deductions that are close to exceeding the Standard Deduction, and accelerating payment of some of the deductible expenses could result in claiming additional itemized deductions. This strategy could result in making it difficult or impossible to itemize next year, but you will come out ahead if you can itemize every second year.

Keep this strategy in mind when you read the rest of my comments.

Defer Income / Accelerate Deductions

There are opportunities to defer income items that would be taxable this year, and move them into next year. You may also be able to pay certain deductible expenses this year that you might have waited to pay next year. This strategy only makes sense, of course, if you are not expecting to be in a higher tax bracket next year.

If you have business income – self-employed, partnership, etc. – you can delay billing your customers or clients, so you don’t receive payment until after December 31. Similarly, you can speed up payment of some of your expenses to get a deduction this year.

If you have a rental property, and your income is under $100,000, you may be eligible to deduct up to $25,000 of rental losses against your regular income. The deduction phases out completely when your income goes over $150,000. It is a good incentive to defer income or accelerate expenses if you are in this range.

Talk to your employer about receiving any year-end bonus after December 31, so you don’t pay tax on it until next year.

Pay your January 15 estimated state tax payment before December 31. Make your mortgage payment at the end of December, instead of January 1. If your medical bills for the year are likely to be more than 10% of your income (7.5% if you’re over 65) then pay as many outstanding medical and dental bills as you can before year-end. Same thing for alimony payments and other deductible items due in January.

Property taxes are typically paid twice a year. In Los Angeles, they are due on November 1st and February 1st. Consider paying both installments this year.

An important note… For many taxpayers, particularly those with higher incomes, there is a limit to the benefit you can get from certain deductible expenses. There are phase-outs as your income rises, but another very important consideration is the Alternative Minimum Tax (AMT). The expenses most likely to be affected are state and local income taxes (especially in California and other high-tax states) and office and employment expenses. If you are subject to the AMT, accelerating payment of these expenses will not do you any good. You should speak with your tax advisor about other possible strategies.

Take Losses Before Year-End

If you have losses on taxable investments, think about selling them this year. They will offset any capital gains you may have, but even if your losses are more than your gains, you can use up to $3,000 to reduce other income, and you can carry any excess losses forward to future years.

Retirement Plans

Make the maximum contributions to your retirement plans.

You can deduct contributions of $18,000 (more if you’re over 50) to your 401(k) plan – but at least make sure you contribute enough to get the full amount of your employer’s matching program.

You may be able to deduct up to $5,500 (more if you’re over 50) to a traditional IRA. If you don’t make a contribution before the end of the year, you have until April 15th. Contributions to a ROTH IRA are not deductible, but penalties are much less severe if you have to withdraw funds early.

If you’re self-employed, you can contribute to a SEP IRA or a similar plan. You can deduct approximately 20% of your self-employment income, up to $53,000. The good news is that you can make your contribution all the way up to the filing deadline, including extensions, which gives you plenty of time to calculate your income. If you have an S Corp, you can also take advantage of a SEP IRA.

Don’t take money out of your traditional IRA or 401(k) plan if you are under 59 ½ years old. There is a 10% penalty on top of the regular tax, and some states have an additional penalty. Before you take an early withdrawal, though, remember that you may be able to borrow from your 401(k). There are also penalties for early withdrawal from a ROTH, but your original contributions are not taxed a second time.

You can take a distribution from your IRA without a penalty if you are a first-time home buyer, if you make qualified tuition payments, and several other special situations. Remember that if you have a 401(k), and plan to make tuition payments, roll the 401(k) over into a traditional IRA first.

Consider rolling over your traditional IRA into a ROTH IRA. You will pay tax on the full amount when you roll it over, but if you expect to be in a low tax bracket this year, for any reason, this might be a good time to do it. Also, there is no required minimum distribution from a ROTH IRA after age 70 ½.

Start taking minimum required distributions from your traditional IRA if you turn 70 ½. There is a 50% tax if you don’t.

Charitable Donations

Charitable donations are a nice deduction, assuming your total deductions exceed the Standard Deduction.

If you have shares of stock that have appreciated in value, consider donating the stock to charity. If you have owned the stock for more than one year, you can deduct the entire appreciated value of the stock, and avoid capital gains tax or Net Investment Income Tax (NIIT).

Gifts

You can make tax-free gifts of up to $14,000 ($28,000 for a married couple) per recipient. (Remember that gifts are not taxed to the recipient, but to the giver). Gifts in excess of this amount require filing a gift tax return, but you won’t actually pay tax until you go over your lifetime limit of $5,450,000.

Qualified payments for tuition or medical expenses are not considered a gift, as long as they are paid directly to the educational institution or the medical provider.

Avoid the “Kiddie Tax”

If your dependent children (under 19, or under 24 if they are full time students) have investment income over $2,100, it will be included in your income, and taxed at your full rate, including NIIT. So think carefully before you give them stocks to sell to pay for college.

Depreciation Opportunities

You can deduct 100% of qualifying asset purchases up to $500,000 (with phase-outs if your total purchases exceed $2 million) under Section 179. This is a tremendous incentive to buy capital assets which you would otherwise have to expense over several years. There are exclusions, but many of the excluded items are eligible for a 50% special depreciation allowance in the year of purchase.

These are terrific deductions. If you are planning to buy assets, buy them before year-end, and reduce your taxes for 2016.

Filing Deadline Changes

A number of changes have been made to filing deadlines this year, including:

Form 1065 Partnership (including LLC) Returns are now due on March 15. Previously, the deadline was April 15, which was inconvenient for the partners, who had to wait for their K-1s in order to meet their own April 15 deadlines. This change is logical, but you need to be aware of it. The extension filing date for partnerships has also changed – from October 15 to September 15. Single member LLCs do not file Form 1065, so there is no change.

Form 1099-Misc and Form W-2 must now be issued to employees and contractors, as well as to the IRS or Social Security Administration, by January 31. It’s a good idea to confirm all employee information and W-9 information before the end of the year.

Subchapter S Corporations and LLCs

If you have a Subchapter S Corporation, don’t forget that you are required to pay yourself a reasonable salary. A major benefit of having an S Corp is that not all of your profits need to be subject to employment taxes, but you do need to pay yourself a salary, and issue yourself a W-2 as an employee. Issuing yourself a 1099 is not a substitute. Setting up W-2 payments after year-end is annoying, and there are stiff penalties for late payment of employment taxes, so take care of it before the end of the year. Also, remember that your health insurance premiums should be added to your W-2 wages (exempt from payroll taxes) and deducted on your personal return.

Do you have an LLC or an S Corporation? Are you getting any real benefit from it? If you are in a state that has a minimum LLC or S Corp tax, you may be paying for something you don’t really need. California’s minimum tax is $800, and you’re also paying for a relatively expensive tax return. If limited liability is a big concern, consider buying insurance that offers appropriate protection. Closing the LLC or S Corp before year-end won’t reduce your 2016 tax bill, but it will cut future costs.

I would be pleased to discuss your tax planning issues.

Buying a House … Residence vs Rental Property

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A common question my clients ask is “Should I buy a house?” A logical extension of the question is “Should I live in the house, or would I be better off renting it out?”

Actually, the question is more often phrased “What are the tax benefits of buying a house?” This can result in a barrage of technical information that doesn’t answer the real question.

THE TAX STUFF

Let’s get the technical tax stuff out of the way:

–  The interest portion of your mortgage payment and your property taxes are tax deductible
–  If you rent out the property, you can also deduct operating expenses like repairs, utilities and management fees
–  If you rent out the property, you can also deduct depreciation. The house itself is depreciated over 27.5 years. Improvements, furnishings and appliances are depreciated at faster rates
–  If you live in the house for more than 2 years, you don’t have to pay tax on the first $250,000 of capital appreciation – the exemption is $500,000 if you’re married and file a joint return
–  If you make under $100,000 you can deduct rental losses on your tax return. But if you make between $100,000 and $150,000, the deduction phases out to zero. The good news is you can deduct the disallowed losses when you sell the house
–  If you rent the property, your gain on sale is taxed at capital gains rates, which are lower than regular rates. Depreciation you deducted is recaptured at regular rates
–  If you pay Alternative Minimum Tax, all bets are off…but if you live in the house, your mortgage interest is a deduction for AMT purposes

There’s the barrage of information. Do you know what you want to do now? I don’t think so.

WHAT YOU”RE TRYING TO ACCOMPLISH

Living in your house accomplishes three main objectives:

– You stop paying rent to somebody else
– Tax deductions for mortgage interest and property taxes make your monthly payments more affordable
– With a relatively small down payment, you get the benefit of the full amount of any gain on sale. It’s not unusual to make a gain as big as your down payment. That’s a 100% return on your investment – and $250,000 or $500,000 of the gain is tax-free

When you rent out your house, the objective is to bring in enough rental income to cover your cash payments for mortgage, property tax and operating expenses. Depreciation doesn’t affect your cash flow, but it can be used to create losses for tax purposes if you are in an income range to benefit from the deduction. I’m sure there are places where you can generate positive cash flow from a rental home, while paying no tax because of the depreciation deduction. A few years ago I worked with a Midwest homebuilder where we marketed houses for exactly that business model, but I now live in Southern California, and positive cash flow is only a dream.

Your income mostly comes from the gain you make when you sell the house. This gain is taxable, but it’s taxed at a lower rate than your regular income.

The downside of renting out your house is that you still have to live somewhere. Any profit you make will be reduced by the rent you pay. If you already own your home, of course, that’s not an issue.

RESIDENCE OR RENTAL – WHICH IS BETTER?

Here’s an example that compares the results of living in your home and renting it out.

I made a number of assumptions as the starting point. I’m sure you can poke holes in some of them, but bear with me.

– You are currently paying rent of $2,500 a month
– You have $150,000 for a down payment
– You buy a house for $600,000 and sell it 5 years later for $700,000
– You take a $450,000 mortgage at 4.0% interest, and pay 2.0% a year for property taxes
– You can rent the house to tenants for $3,600 a month
– Operating costs are $3,600 a year for your residence, and $5,000 for the rental
– Your selling costs are 6% when you sell the house
– Your regular tax rate is 30%

Option 1 – Don’t Buy the House

If you don’t buy the house, you continue to pay $2,500 a month in rent. After 5 years, you have spent $150,000. End of story.

Option 2 – Live in the House

Your mortgage payment is $2,170 a month, and your taxes are another $1,000. You’re now paying for repairs and maintenance, but the tax benefit of the interest and tax deduction means you’re only paying about $200 a month more than when you were renting.

You make $100,000 in profit when you sell the house (less $42,000 in closing costs) but you don’t pay tax on the gain. You also get your down payment back, plus you paid off $43,000 on your mortgage.

Over all, your total cost after 5 years is $63,000. This compares with $150,000 you would have spent on rent. Congratulations – by buying the house you saved $87,000.

Option 3 – Rent the House

You rent the house out for $3,600 a month, which is pretty much exactly the amount you pay out for mortgage payments, property taxes and operating costs. You get a tax deduction of $16,000 a year for depreciation, but if you make more than $150,000 it just adds to your deferred loss.

You make the same $100,000 profit when you sell the house. This is taxable at capital gains rates, but the $42,000 closing costs are deductible. As above, you get back your down payment and the $43,000 you paid down on your mortgage.

Your after-tax income from the rental property is $82,000. Nice, really nice. You’ve made a pretax return on investment of 11% a year. Compare that with the return on other investments.

BUT… not so fast.

You still have to live somewhere while you’re renting out the house. Right? Assuming you continue to pay $2,500 a month in rent, that turns your rental profit into a net cash cost of $68,000. The good news is that you’re still miles ahead of where you would have been if you hadn’t bought the house at all, and only about $5,000 behind using the house as your residence.

Do you think you could increase the rent on the house over 5 years? That would make the results of renting vs living in the house about the same, wouldn’t it?

CONCLUSION

Sorry, I’m not giving you a conclusion. This was just one example, and your situation is almost certainly going to be different. My assumptions are just assumptions, and you would have to do a careful analysis of the facts before you move forward.

There are a lot of subjective issues as well. Do you want the headache of being a landlord? And what about unforeseen problems like bad or unreliable tenants? But what about the upside gain if rents keep climbing the way they are in Los Angeles these days?

I would be happy to discuss your specific situation, and run my model with assumptions that apply to you.

Reduce Your 2015 Tax Bill

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My clients often ask me if I can help them reduce their tax bill. The answer is yes… but for most tax saving opportunities, you have to take action before the end of the year.

Here are some things you can do before December 31 that may have a big impact on your tax bill when April 15th comes around.

Itemized Deductions vs Standard Deduction

There is a long list of expenses that are deductible for tax purposes. They include medical expenses, charitable donations, mortgage interest, state and local income taxes, employment expenses, etc. Some of these expenses are subject to limitations, of course.

Most taxpayers are entitled to the Standard Deduction, though, so unless your deductible items add up to more than the Standard Deduction there is no need to keep track of them. A single person, for example, gets an automatic deduction of $6,300, and a married couple filing jointly gets $12,600.

Sometimes, you may find yourself with deductions that are close to exceeding the Standard Deduction, and accelerating payment of some of the deductible expenses could result in claiming additional itemized deductions. This strategy could result in making it difficult or impossible to itemize next year, but you will come out ahead if you can itemize every second year.

Keep this strategy in mind when you read the rest of my comments.

Defer Income / Accelerate Deductions

There are opportunities to defer income items that would be taxable this year, and move them into next year. You may also be able to pay certain deductible expenses this year that you might have waited to pay next year. This strategy only makes sense, of course, if you are not expecting to be in a higher tax bracket next year.

If you are self-employed, you can delay billing your customers or clients, so you don’t receive payment until after December 31. Similarly, you can speed up payment of some of your expenses, to get a deduction this year.

Talk to your employer about receiving any year-end bonus after December 31, so you don’t pay tax on it until next year.

Pay your January 15 state tax estimated payment before December 31. Make your mortgage payment at the end of December, instead of January 1. If your medical bills for the year are likely to be more than 10% of your income (7.5% if you’re over 65) then pay as many outstanding medical and dental bills as you can before year-end. Same thing for alimony payments and other deductible items due in January.

Property taxes are typically paid twice a year. In Los Angeles, they are due on November 1st and February 1st. Consider paying both installments this year.

An important note… For many taxpayers, particularly those with higher incomes, there is a limit to the benefit you can get from certain deductible expenses, and the Alternative Minimum Tax (AMT) comes into play. The expenses most likely to be affected are state and local income taxes (especially in California and other high-tax states) and office and employment expenses. If you are subject to the AMT, accelerating payment of these expenses will not do you any good. You should speak with your tax advisor about other possible strategies.

Take Losses Before Year-End

If you have losses on taxable investments, think about selling them this year. They will offset any capital gains you may have, but even if your losses are more than your gains, you can use up to $3,000 to reduce other income, and you can carry any excess losses forward to future years.

Retirement Plans

Make the maximum contributions to your retirement plans.

You can deduct $18,000 (more if you’re over 50) to your 401(k) plan – but make sure you contribute enough to get the full amount of your employer’s matching program.

You may be able to deduct up to $5,500 (more if you’re over 50) to a traditional IRA. If you don’t make a contribution before the end of the year, you have until April 15th.

If you’re self-employed, you can contribute to a SEP IRA or a similar plan. You can deduct approximately 20% of your self-employment income, up to $53,000. The good news is that you can make your contribution all the way up to the filing deadline, including extensions, which gives you time to calculate your income.

Don’t take money out of your IRA or 401(k) plan if you are under 59 ½ years old. There is a 10% penalty on top of the regular tax, and some states have an additional penalty.

You can take a distribution from your IRA without a penalty if you are a first-time home buyer, if you make qualified tuition payments, and several other special situations. Remember that if you have a 401(k), and plan to make tuition payments, roll the 401(k) over into a traditional IRA first.

Consider rolling over your traditional IRA into a ROTH IRA. You will pay tax on the full amount when you roll it over, but if you expect to be in a low tax bracket this year, for any reason, this might be a good time to do it. Also, there is no required minimum distribution from a ROTH IRA after age 70 ½.

Start taking minimum required distributions from your traditional IRA if you turn 70 ½. There is a 50% tax if you don’t.

Charitable Donations

Charitable donations are a nice deduction, assuming you do not claim the Standard Deduction.

If you have shares of stock that have appreciated in value, consider donating the stock to charity. If you have owned the stock for more than one year, you can deduct the entire appreciated value of the stock, and avoid capital gains tax or NIIT.

Gifts

You can make tax-free gifts of up to $14,000 ($28,000 for a married couple) per recipient. (Remember that gifts are not taxed to the recipient, but to the giver)

Qualified payments for tuition or medical expenses are not considered a gift, as long as they are paid directly to the educational institution or the medical provider.

Avoid the “Kiddie Tax”

If your dependent children (under 19, or under 24 if they are full time students) have investment income over $2,100, it will be included in your income, and taxed at your full rate, including NIIT. So think before you give them stocks to sell to pay for college.

Depreciation Opportunities

As the law stands right now, you may deduct up to $25,000 of qualifying assets purchased in 2015, under Section 179. This amount was $500,000 in 2014, and may be increased by Congress for 2015 before the end of the year. In 2014 there was also a bonus depreciation provision that allowed you to expense 50% of qualified asset purchases. This may or may not also be reinstated for 2015. Think about these provisions when purchasing equipment for your business.

Subchapter S Corporations and LLCs

If you have a Subchapter S Corporation, don’t forget that you are required to pay yourself a reasonable salary. A major benefit of having an S Corp is that not all of your profits need to be subject to employment taxes, but you do need to pay yourself a salary, and issue yourself a W-2 as an employee. Issuing yourself a 1099 is not a substitute. Setting up W-2 payments after year-end is annoying, and there are stiff penalties for late payment of employment taxes, so take care of it before the end of the year.

Do you have an LLC? Are you getting any real benefit from it? If you are in a state that has a minimum LLC tax, you may be paying for something you don’t really need. California’s minimum tax is $800. You’re also paying for a relatively expensive tax return. If limited liability is a big concern, consider buying insurance that offers appropriate protection. Closing the LLC before year-end won’t reduce your 2015 tax bill, but it will cut future costs.

I would be pleased to discuss your tax planning issues.

The Quick Fix? … Or the Whole Enchilada?

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Managers need information; that’s one of the laws of nature. The uses of information are endless, and managers constantly come up with new needs for reports, analyses and procedures. But information comes at a cost. The cost may be easy to calculate, as in the case of development hours required, or it may be an opportunity cost trade-off with the company’s other priorities.

Weighing Priorities

Whenever you have a need for information, here are the questions you’ll be asked:

1. How badly do you need it?
2. How soon do you need it?
3. If we can’t give you everything you need, what can you live with?
4. What are the projected cost savings or revenue increases?
5. What is the cost of getting the information?

Large organizations have developed sophisticated processes to allocate information resources among competing priorities, often involving some sort of ROI analysis. People do tend to exaggerate, though, so the objectivity and precision of the process comes under suspicion. Smaller companies, in my experience, tend to admit that they use more subjective methods to evaluate priorities.

The result is pretty much the same, though. Unless you have a critical need, such as compliance with a new accounting policy, a new line of business or an actual system breakdown…

You’re going to have to wait. Maybe forever.

The Quick Fix

The alternative to waiting for an exciting new series of reports and procedures, reconciled, actionable and fully integrated with all existing systems is the Quick Fix. This may be a compromise resulting from the answer to Question 3 above, or you may have to take matters into your own hands.

The Quick Fix is usually inexpensive, fast and gives you most of what you need. It can be a viable alternative to waiting for an entire new application to emerge from the murky dungeons of the development process. Or it can get you started on a new initiative without waiting for months, even years, to get the Whole Enchilada.

The Quick Fix isn’t always the right answer, though. Here are some situations I’ve observed over the years.

A Retailer

As CFO of a retailer, we received systems support from the specialty stores division of the internationally known parent company. The problem was that the specialty stores division was a shoe company, and we were a fashion apparel company. Many important issues needed to be resolved to customize the systems so our merchandisers could conduct business. So it was no surprise that when the accountants had a serious problem calculating Gross Profit and Inventory, we were sent to the back of the line, and told to wait.

For a small fee, we hired a programmer to develop a custom report that not only gave us reliable Gross Profit and Inventory results, but also provided the merchandisers with a clear picture of their operating results. It only took an hour or two a month to update the program, so the Quick Fix became a satisfactory permanent solution.

Some years later, a senior executive of the parent company saw our report, and ordered it installed in all the other operating companies. The systems development people jumped on it, and rolled it out to the entire company with great fanfare. But we just shrugged our shoulders… there was no need for the Whole Enchilada.

Real Estate Services

A real estate services company had passed the level of revenues that required them to change their tax accounting from the cash method to the accrual method. They recently asked me to help them make the transition.

The company had grown rapidly, but was still using Quick Books as its accounting system. It was certainly time for an upgrade, and the accounting conversion made it a perfect time to make the change. The only problem was that it would take months of time, and a substantial cash investment to research, purchase and install a new accounting package, and to integrate it with the business operations system. Meanwhile, the tax filing deadline was coming up fast.

My first suggestion was the Quick Fix. I suggested they continue using the methods the accounting staff were used to, and just make journal entries at the end of each month to adjust to accrual accounting. The CEO, however, wanted a deeper change, including a daily reconciliation to the output of their highly sophisticated operating system.

The situation clearly called for the Whole Enchilada, but timing was such that we needed a transitional Quick Fix to meet reporting requirements, and to fill in the gaps while we studied a fully integrated system overhaul.

I reviewed the business operating system, and found it to be sufficiently reliable to use its output as the source of accounting entries. The problem was that there were no accounting cutoffs or similar checks and balances for reconciliation, so I worked with the programmers to develop daily reports that verified the integrity of the data.

As a result of the project, management realized they needed to increase the sophistication of their financial department, and hired an experienced controller. I’m looking forward to hearing how they ultimately proceed.

A Homebuilder

A homebuilder had developed an elaborate and sophisticated construction management system, and its reporting mechanism was tied to an accounting package. Oddly enough, they also continued to maintain the original general ledger system that dated back to the 1970s. The problem was that the two systems generated very different information, and the senior managers each had favorite reports that didn’t agree with those used by other managers. Massive amounts of time were wasted in meetings, and one vice president spent most of his time reconciling the divergent reports. Needless to say, accounting was a nightmare.

The CEO had been instrumental in developing both systems, and was unwilling to see the need for change. The Quick Fix was practiced on a daily basis, but by the time the results were available, it was often too late to act on the information. An irreverent senior executive used an automotive metaphor, suggesting that when you opened the hood, the engine was run by squirrels on a treadmill.

The situation was crying out for the Whole Enchilada, and the Quick Fix just wasn’t working. Yes, the company went bankrupt.

A Land Developer

When I arrived for my first day as CFO of a land developer, I asked the controller for the most recent financial statements. “What do you mean?” she asked. That was the first sign of trouble. I soon learned that we had land on the books that we didn’t own, just as we owned land that wasn’t on the books. It was the same thing with loans and other assets and liabilities. In an organization with over 60 different companies, each with its own separate equity and debt financing, this was intolerable.

There was no Quick Fix to be found, so we shortly purchased a well-known industry-specific accounting package, and herded the numbers into their proper places.

The Whole Enchilada was the only option.

How does your company weigh the costs and benefits of implementing the Quick Fix or the Whole Enchilada?