Are Disability Insurance Proceeds Taxable?

In a July 2013 article, the Council for Disability Awareness published a statistic stating that over 1 in 4 people currently in their 20s will become disabled before they retire, and that 6% of working-age Americans are currently disabled.

According to the Insurance Journal's June 2011 article, only 49% of US workers have short-term disability insurance and only 44% have long-term disability insurance.

What are the tax consequences if you become disabled and receive disability insurance proceeds?

It all depends on who paid for the disability insurance policy.

The proceeds from a disability insurance plan will not be taxable if:

1. You pay all the premiums for the policy;
2. The disability insurance is provided through your employer, but the premiums are paid with after-tax dollars (effectively, you pay the premiums through your paycheck);
3. The disability insurance is provided through your employer's cafeteria plan; or
4. The proceeds are a reimbursement for actual medical expenses, permanent loss or loss of use of part of the body, or permanent disfigurement.

The proceeds from a disability insurance plan are taxable if your employer paid the premiums and the premiums were not taxable to you.

If you have any questions about this, please feel free to send me an e-mail.

Can You Do a 1031 Exchange With a Relative?

Are you allowed to do a 1031 exchange with a relative? Yes, you are. However, special rules do apply.

Image from firstnationaltitle.net

There is a 2 year test that applies when you perform a 1031 exchange with a related party (a term defined for this context in the Internal Revenue Code). Under this test, if either you or your related party disposes of the property received in the exchange, then the 1031 non-recognition of gain or losses is disallowed.

However, if that occurs the gain or loss would be recognized in the year in which the disposition occurred, not when the exchange took place.

For example, in March 2015 you performed a 1031 exchange with your brother. You traded your brother your Chula Vista rental property for his Escondido rental property. Then, in August 2016 (without your knowledge) your brother sold the Chula Vista property. Even though you had no control over the fact that he sold the property, you did not satisfy the 2 year test so your exchange would be treated as a sale and would be taxable in 2016.

Exceptions

There are 3 exceptions to what otherwise could be a very harsh rule.  These exceptions are:

1. Dispositions that occur after the death of the taxpayer or the related person; 
2. Compulsory or involuntary conversions, if the exchange occurred before the threat or imminence of such conversion; or
3. Dispositions with respect to which it is established to the satisfaction of the Treasury Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.

If you have questions about 1031 exchanges, please feel free to send me an e-mail.

Deferred 1031 Exchanges

All the 1031 exchanges that we have discussed so far have had the exchange of property occur simultaneously. However, it is possible, and in fact very common, for a property owner to relinquish his or her property and then subsequently receive a replacement property- even weeks or months later.

Two important requirements must be met in order for a deferred like-kind exchange to qualify for 1031 treatment:

   1) The replacement property must be identified within 45 days after the closing of the sale of the initial (relinquished) property; and

   2) The replacement property must be received within the earlier of 180 days of the closing of the sale of the initial (relinquished) property, or the extended due date of the taxpayer's tax return for the year in which the initial sale occurred.

In order to meet the 45-day identification requirement, you must identify and describe in an unambiguous manner the replacement property in a written document.  The written document must then be delivered to either the person obligated to transfer the replacement property or to any other person involved in the exchange.

As a precaution against identifying a property that is subsequently unable to be delivered to you (and thus not qualifying for Section 1031 treatment), you are allowed to identified more than one replacement property.  In fact, you are allowed to identify up to 3 replacement properties (without regard to their value) or any number of potential replacement properties as long as their aggregate fair market value does not exceed 200% of the aggregate fair market value of the relinquished property.

In order to meet the 180-day receipt requirement, you must actually receive the replacement property within the time period and it must be substantially the same property identified.

A significant potential problem is when people intend to do a deferred 1031 exchange and sell their property, receive the funds, and then use those funds to purchase a replacement property. Unfortunately, that is not a 1031 exchange and will be treated as a sale.

If you or a disqualified person receives, or constructively receives, any cash or non-like-kind property prior to receiving the replacement property it transforms the transaction into a taxable event or partially taxable event depending on the amount received.  If the amount was equal to the full consideration of the relinquished property, then the transaction is treated as a sale.  If the amount received is less than full consideration, then the transaction is treated as a partially taxable exchange.

There are a group of people who are considered disqualified persons because they are viewed as your agent or as related-parties. This group includes your employees, attorney, accountant, banker, and real estate agent/broker.

There are a number of qualifying arrangements that can be made to work around this limitation. One of which is the use a qualified intermediary.  A qualified intermediary is someone who is not a disqualified person and enters into a written agreement with you.  Under that agreement, the qualified intermediary acquires the relinquished property from you and then transfers the relinquished property to a 3rd party.  The qualified intermediary will then acquire the replacement property and transfer it to you.

Here is an example of how a deferred 1031 exchange may look.

You own a rental property in Santee with a fair market value of $550,000, but you would like a rental property closer to your home in Vista. You find a qualified intermediary and enter into an exchange agreement to perform a 1031 exchange. You then find a buyer for your property in Santee. Instead of selling the property directly to the buyer, you transfer the property to the qualified intermediary. The qualified intermediary then sells the property to the buyer.

Within 45 days, you find 3 properties that you may be interested in, and your provide their addresses to the qualified intermediary in a written document. After some negotiations with the sellers, you agree upon a purchase price of $600,000 for one of the properties. The qualified intermediary then goes into escrow with the seller to acquire the property, with you contributing an additional $50,000 cash to make the purchase as well as any exchange fees the qualified intermediary is charging you. After the qualified intermediary acquires the replacement property, it transfers the property to you completing the 1031 exchange.

If you would like to discuss deferred 1031 exchanges further, please send me an e-mail.

Whats Your Basis After a 1031 Exchange?

Over the past few weeks we have been discussing 1031 exchanges and the requirements that must be met in order to have a tax-deferred exchange of property. We also discussed boot, the taxable benefits that are received as part of a 1031 exchange.

So what happens when you sell the property you received in a 1031 exchange? How do you calculate your gain?

The gain is calculated by taking the sales price and subtracting from that amount your basis and the selling expenses (gain = proceeds - (basis + selling costs).

Generally, basis is your original purchase price plus the cost of capitalized improvements less the depreciation allowable over the years. But is it the original purchase price of the relinquished property or the replacement property? Do you factor in the capital improvements and depreciation on the relinquished property?

In order to determine what your basis is in the replacement property, you start with your adjusted basis in the relinquished property at the time of the exchange. By adjusted basis, I mean you start with the original purchase price and adjust that by any capital improvement and depreciation allowed.

Next, you increase your basis by: 

1. The amount of cash you paid to the other party;
2. The value of any other property given to the other party;
3. Any liabilities you assumed in the exchange; and
4. Any gain you recognize.

Finally, you decrease your basis by:

1. The amount of cash you are paid;
2. The value of any other property you receive;
3. Any liabilities assumed by the other party (that you are relieved of); and 
4. Any loss you recognize.

As you may have noticed, the adjustments to the basis is primarily boot.

Lets look at an example of how to calculate the basis of the replacement property.

Several years ago you purchased a property for $200,000. You paid $40,000 cash and financed the rest. Over the years you made $50,000 of capital improvements and have taken $30,000 of depreciation. You have also paid off $10,000 of the mortgage. Your property now has a fair market value of $500,000, and you enter into a 1031 exchange to acquire a property with a fair market value of $600,000. That property is subject to a mortgage of $200,000. You also agree to pay the other party $50,000 cash.

First, we have to determine what your basis in the relinquished property was. You purchased it for $200,000. We add to that amount the $50,000 of improvements and subtract the $30,000 of depreciation. That means your relinquished property had a basis of $220,000.

Next, we have to increase that basis by the cash you are paying to the other party and the debt you agreed to assume. That means you will be increasing the basis by $250,000 ($50,000 cash plus $200,000 liability assumed).

Finally, there was debt relief of $150,000. That means you decrease the basis by $150,000. That means your basis in the replacement property is $320,000.

If you have questions about this formula or about 1031 exchanges in general, please send me an e-mail.

What is Boot? Why Do I Have to Pay Taxes On It?

Over the last few posts, we discussed 1031 exchanges and how, if the requirements are met, they allow for tax-deferred exchanges of one property for another. I mentioned that even though the exchange of the property itself is tax-deferred, there may be other elements to the exchange that are taxable. Taxable benefits received as part of a 1031 exchange are referred to as boot.

Image from www.atlas1031.com

There are essentially two forms of boot. The first is any property received in the exchange that is not like-kind to the property relinquished. The most common form of this type of boot is cash, but it can be any type of property that is not like-kind.

For example, you own a rental property with a fair market value of $1.2 million. You are willing to exchange it for another rental property with a fair market value of $1 million, but you probably want to be compensated for the difference in values by receiving cash for $200,000. That cash is boot.

The second form of boot is debt relief. If the relinquished property is subject to debt and as part of the exchange you are relieved of that debt, you are treated as having received cash.

Lets say you own a commercial building with a fair market value of $1.5 million, but it has a mortgage of $500,000 attached to it. You exchange it for another property with a fair market value of $1.5 million. At first glance, it may look like there is no boot because nothing except for the rental properties were exchanged. However, you were relieved of $500,000 of debt and that is treated the same as if you had received that much in cash.

Of course, there could be boot going both ways in the transaction. In that case, there are rules that allows certain types of boot to be offset by other boot, leaving you with "net boot." These offsetting rules are:

1. Cash paid to the other party offsets cash received.
2. Cash paid to the other party offsets any mortgage (debt) relief.
3. Mortgage (debt) assumption offsets mortgage (debt) relief.
4. Exchange expenses offsets cash received.
5. Mortgage (debt) assumption does not offset cash received.

Furthermore, just because you have boot does not necessarily mean that it will be subject to tax. Boot is only taxable to the extent that there is gain. For 1031 exchanges, the amount of gain recognized is equal to the lesser of: 1) the amount of gain realized in the exchange; or 2) the value of the boot received.

Lets look at another example. Several years ago you purchased a rental property in San Diego for $700,000. The property now has a fair market value of $800,000 with a mortgage of $200,000. You enter into a 1031 exchange and receive a property with a fair market value of $500,000 with no debt and cash of $100,000.

If you had sold the original property in a traditional sale, you would have had a gain of $100,000 ($800,000 value less $700,000 purchase price). Because you did a 1031 exchange instead, you received a like-kind property with a fair market value of $500,000 and boot of $300,000 ($200,000 of debt relief and $100,000 cash). In this case, you would not be required to recognize all $300,000 of boot, only the $100,000 of gain that you would have recognized in a traditional sale.

Lets look at the same scenario, except that you had purchased the property for only $200,000. In this case, if you had sold the property you would realize a gain of $600,000. However, in a 1031 exchange you only have to recognize $300,000 of gain because that is the amount of boot you received.

If you have any questions about 1031 exchanges and boot, please feel free to send me an e-mail.

Can I Take Advantage of a 1031 Exchange?

As we discussed in the last blog post, a 1031 exchange is a tax-deferred, like-kind exchange of property held for productive use or investment for another property held for productive use or investment. In English, it allows you to trade one property for another property without paying income taxes at that time.

Image from www.kolotv.com

As you can imagine, this is a major benefit to taxpayers because it means that you can defer paying thousands of dollars (or far more) in taxes for years. Obviously, such a beneficial tax code provision is going to have very strict requirements that must be met in order to utilize it.

The first requirement is that the property that you are disposing of must have been held for productive use in a trade or business or for investment.  This means that it cannot be personal use property, such as your principal residence or a vacation home.

The second requirement is that the property that you are acquiring must be used either in a trade or business or for investment. How the other party used the property is irrelevant, the test is how you will use the property. The basic idea is that if you are going to be allowed to defer taxes from the "sale" of the relinquished property, you have to use the replacement property in a similar manner.

The next requirement is that the property cannot be: inventory, stock, bonds, notes or other evidence of indebtedness, interests in a partnership, certificates of trusts or beneficial interests, or choses in action.

Finally, the replacement property must be of a "like kind" to the property relinquished. All real estate located in the United States, whether it is improved or unimproved, is considered to be like-kind to other real estate located in the United States. However, real estate located in the United States is not like-kind to real estate outside of the United States.

Unlike with real estate, not all personal property (e.g., equipment, furniture, etc.) is considered to be like-kind to other personal property.  In order to be like-kind, the personal property must be in the same asset class (and if livestock, must be the same gender).  In addition, as with real estate, personal property located in the United States is not like-kind to personal property outside of the United States.

There are additional timing requirements that must be met if the property exchange does not occur simultaneously, but we will discuss that further in a future blog post.

If you would like to know if your transaction would qualify under Section 1031, please send me an e-mail.

What is a 1031 Exchange?

If you own rental real estate, you are probably concerned about the tax hit you will take when you sell one property to invest in another property. If you talk to realtors or tax professionals about it, they would probably suggest that you consider a Section 1031 exchange.

So, what then is a 1031 exchange? It is a tax-deferred, like-kind exchange of one investment for another investment.

The Hasbro game Monopoly actually provides a great conceptual basis for how a 1031 exchange is intended to work.

Early in the game, you will use your cash to buy various properties. Eventually, one of the other players will acquire a property that you need and is not willing to sell it to you for cash (or you may not have enough cash on hand to buy it). Instead, the other player suggests trading his property for one of yours.

When this trade happens, you do not have to pay the bank for the difference in value between your property and the other player's property. It is simply a trade between the two players.

In the real world, you may acquire various investment properties throughout your life. At some point in your life, you may reach a point where you want to sell one of your investment properties and purchase another investment property. Without Section 1031, the owner of each property would have to pay income taxes on their individual gains from the sale of the properties. However, Section 1031 allows each landowner to simply trade their properties like they would in a game of Monopoly while deferring paying any taxes until the eventual sale (not 1031 exchange) of a property occurs.

Of course, few trades are this easy either in Monopoly or real life. In Monopoly, if the two properties do not have exactly the same value to both players, then the player with the more valuable property may demand money in addition to the property. While there are no consequences to that in the game, in real life the receipt of cash in a 1031 exchange is referred to as "boot" and is taxable. Even beyond the difference in values between the properties, few trades in the real world are as simple as they are in a game of Monopoly because many properties are burdened with mortgages which can have tax consequences. Furthermore, in the real world it can be difficult to find two landowners who are willing to trade properties, so to make a 1031 exchange work a qualified intermediary may have to be used to work around this problem.

Over the next few posts, we will discuss the formal requirements of a Section 1031 exchange, taxable transactions connected to a 1031 exchange, your basis in the new property, and transactions involving qualified intermediaries. In the meantime, if you would like to discuss 1031 exchanges or any other tax issue please send me an e-mail.

What Happens When You Sell a Passive Activity Business or Real Estate?

As you now know, if the passive activity rules apply to your business or real estate then you may not be able to deduct all your losses.  Passive activity losses can only be used to offset passive activity income (they cannot be used as a deduction against your ordinary income).  If you do not have any passive activity income, the loss is suspended and carries forward to the next year until you eventually have passive activity income.  But what happens if you dispose of the passive activity business or real estate before you are entitled to use all of the passive activity losses?

If that is the case, and it is the entire activity that is being disposed of, then special rules apply.  If the disposition is part of a fully taxable transaction (such as a sale), then the losses are recognized in the following order:

1) The current year passive activity losses are first used to offset all passive activity income from other activities for the year;

2) Then, the passive activity losses are deducted against ordinary income.

Lets look at an example to get a better understanding of what this means.

Joe is a limited partner in a small business, and owns one rental property.  Joe is not a real estate professional and does not actively participate in the management of his rental properties. In 2015, the small business will have income of $5,000.  The rental property has a loss of $3,000 prior to its sale during the year.  The property had a tax loss for a number of years prior, and had unused passive activities losses of $30,000.

Because the sale of the property is a taxable event and represents the complete disposition of his ownership interest in that property, Joe is allowed to recognize his prior unused passive activity losses.  First, though, he must offset the current year passive losses of $3,000 against the $5,000 of passive activity income from the small business.  After that, he is entitled to deduct the previously unused passive activity losses of $30,000.

However, the rules are different if the disposition of the business or real estate is instead the result of the owner's death.  In that case, the current year passive losses are still used to offset the current year passive activity income, but only to a certain extent.  They will only be allowed to be used to the extent that the losses exceed the "step-up" in basis that occurs when property is transferred through inheritance.  In other words, the losses are reduced by the amount of basis step-up.  Any unused passive activity losses then disappear- they cannot be used as a deduction against ordinary income.

If you have any questions, please send me an e-mail.

Are Real Estate Professional Affected by the Passive Loss Rules?

Over the past few blog posts we have been discussing what passive activities are, and how they can affect your taxes. Specifically, we discussed how all real estate investments are automatically considered to be passive activities, and that passive activity losses cannot be deducted against ordinary income. Instead, passive activity losses can only be used to offset passive activity income (which is taxed like ordinary income). We also discussed that certain investors who actively participate in the real estate activity are allowed to deduct up to $25,000 of losses as a special allowance, but that the special allowance begins to phase out if the investor has more than $100,000 of income from all sources. But what about real estate professionals? Real estate professionals are not simply investors who may own one or two rental properties, they spend most of their time involved in real estate and their income is typically very dependent on their real estate activities. Are real estate professionals limited to the same $25,000 special allowance that other real estate investors are limited to?

No, the Internal Revenue Code specifies that real estate professionals are exempt from the passive activity rules (for their real estate investments).

Who is a Real Estate Professional?

There are two requirements that must be met in order to qualify as a real estate professional for tax purposes:

1) More than one half (1/2) of the personal services you perform in all trades or businesses must be performed in real estate trades or businesses in which you materially participate (see the material participation rules here). The purpose of this rule is to ensure that only people who spend more time with real estate than other trades or businesses qualify.

2) You must perform more than 750 hours of services during the year in real estate trades or businesses in which you materially participate. This rule prevents casual investors who are not involved in other trades or businesses from claiming to be real estate professionals.

To be clear, there are a number of real estate activities that can qualify- it is not simply limited to rental activities. The Internal Revenue Code specifically lists the following activities that qualify as a real estate trade or business:

• Real property development;
• Redevelopment;
• Construction;
• Reconstruction;
• Acquisition;
• Conversion;
• Rental;
• Operation;
• Management;
• Leasing; and
• Brokerage.

Therefore, if you are a real estate professional, the passive activity rules do not apply to your real estate activities.  You are entitled to deduct those any losses from those activities against your ordinary income.

If you have questions about whether you qualify as a real estate professional, how the passive activity rules operate, or any other tax question please send me an e-mail.

Can Real Estate Investors Deduct Any Losses?

If you are a real estate investor or considering investing in real estate, you probably did not like the news that by default all real estate investments are considered to be passive activities.  As we previously discussed, you cannot deduct passive activity losses against "active" income, you can only use it to offset passive activity income if there is any.  However, there are exceptions to this general rule.  The first exception is for active participation in real estate investments.  If you qualify for this exception, you can deduct up to $25,000 of losses.

Only individuals, an individual's estate, or an individual's qualified revocable trust can actively participate in a rental activity.  You must also own at least 10% by value of all the interests in the activity throughout the year.

What does it mean to actively participate in the real estate activity?

Active participation is a fairly relaxed standard that can be met simply by making significant management decisions.  For example, this standard can be met by:

• Approving new tenants;
• Determining the rental terms; or
• Approving expenditures.

This is not an exhaustive list, so other similar decisions could be enough to qualify as active participation.

However, even if you actively participate in a real estate activity you may not be able to deduct the $25,000.  The $25,000 "special allowance" phases out based upon your income.  For every dollar of income you earn over $100,000 the special allowance decreases by $0.50 until it is completely phased out at $150,000 of income. 

If you would like to know more about the active participation exception to the passive activity rules, please feel free to send me an e-mail.

How Do I Know If My Business is a Passive Activity?

In the last post, I discussed the consequences of having your business be classified as a passive activity.  As I mentioned, any trade or business activity in which you do not materially participate is a passive activity to you.  But how do you know if you have materially participated?

Image borrowed from www.123rf.com

Luckily for you, there are 7 tests that answer this question, and you only need to "pass" one of them to avoid the "passive activity" treatment.

The material participation tests are:

1) You participated in the activity for more than 500 hours.  In general, any work you do for the business counts, unless it is the type of work not customarily done by the owner of that type of activity or your main reason for doing that work is simply to reach 500 hours.

2) Your participation was substantially all the participation in the activity of all individuals for the year, including participation of employees.  In other words, if you essentially run the business by yourself you do not have to worry about the number of hours you actually worked.

3) You participated in the activity for more than 100 hours during the year, and you participated at least as much as any other individual.

4) You participate in multiple trade or business activities, each for at least 100 hours, and combined they add up to more than 500 hours.  However, each activity in this grouping must be (if looked at individually) a passive activity.

5) You materially participated in the activity for at least 5 of the last 10 years.

6) You materially participated in a personal service activity for at least 3 years (regardless of how many years ago that was).  For these purposes, personal service activities include activities in the fields of health, law, accounting, or consulting, or any other activity for which your personal skills/services (not capital) is the primary income-producing factor.

7) An evaluation of the "facts and circumstances".  This is the least certain of all the material participation tests because you have to evaluate your situation and make a decision as to whether you materially participated, and hope that the IRS agrees.

If you satisfy any one of these tests, then you materially participated in your trade or business and are entitled to deduct the losses against your other income.

Please keep in mind that your real-estate related activities are considered to be passive activities regardless of whether your materially participated in them.  However, there are two exceptions that we will be discussing in the next blog posts.

If you have any questions about the passive activity rules and how they affect you, please send me an e-mail.

What Do You Mean My Investment is a Passive Activity?

Has anyone ever told you that your investment in a business or in real estate is a passive activity?  Do you know what that means?  Don't worry, most people don't.

Before 1986, investors would create tax shelters for themselves by putting their money into investments that would generate tax losses but no actual economic losses. For example, they may invest in a rental property and then would rent the property to a tenant for an amount equal to the monthly expenses. The investors would then have no net cash inflow or outflow, but would be able to depreciate the property and claim a tax loss.


Congress eventually caught on to the games that investors were playing with the Tax Code as it existed back then, and as a response invented the passive activity rules.

Under the passive activity rules, there are two types of passive activities.  The first type of passive activity are trade or business activities in which you do not materially participate.  In the next blog post we will discuss how this is determined.  The second type of passive activity are rental activities (although there are two exceptions that will be discussed in future blog posts).

The income and gains on passive activities will continue to be taxed just like any other ordinary income and gains. However, the losses on passive activities are not deductible but instead can only be used to offset passive activity income.  The passive activities losses are deferred until they can either offset passive activity income or the underlying investment is completely disposed of (e.g., sold).

In addition to not being able to deduct passive activity losses against your active income, the passive activity income is subject to the 3.8% Medicare Surtax.

Do you think you might have a "passive activity" investment?  If you would like to discuss whether it truly is a passive activity and how that affects your taxes, please send me an e-mail.

S-corp vs. LLC: Allocation of income and losses

As you have now discovered, there are a number of differences between S-corporations and LLCs. S-corporations have to follow the traditional corporate formalities, while the formalities that LLCs have to follow are far more relaxed.  There are also differences in the taxes and fees that they have to pay to California, and the types of compensation that the owners of each can take. The amount of flexibility you have in allocating income and losses between the owners is also a key difference.

The shareholders (owners) of an S-corporation must divide all income, gains, losses, and deductions in proportion to their ownership percentage.  Therefore, if you own 30% of an S-corporation then you will pick up 30% of the corporation's taxable net income on your tax return, and you are entitled to 30% of all the distributions made.

The members (owners) of an LLC, on the other hand, are allowed to have unequal allocation of income, gains, losses, and deductions as long as certain criteria are met. For example, you and your co-owner each own 50% of the LLC. You may have decided among yourselves that all of the depreciation deductions will be allocated to you, while all of the other items of income, gain, losses, and deductions will be split 50:50. You are allowed to do that as long as several requirements are met.  Those requirements are too complex to discuss in this blog, so I strongly recommend talking to a CPA if you are considering establishing an LLC whose operating agreement authorizes non-proportional allocation of income, gains, losses, and deductions.

If you have questions about the tax differences between S-corporations and LLCs, or if you would to talk about the requirements necessary in order to have non-proportional allocations in your LLC, please send me an e-mail.

S-corp vs. LLC: Income

In last week's blog, we discussed how California taxes S-corporations and LLCs differently.  In this blog, we will be discussing the differences in how the owner's compensation is classified.

Image borrowed from
www.nanohealthtechnology.com

The owner of an LLC will likely spend countless hours working for the business. However, the owner is not treated as an employee, so the owner does not receive wages or a salary. Instead, for tax purposes, the owner is treated as receiving the entire profits of the LLC as compensation regardless of whether or not any money is taken out of the business. These profits are treated as self-employment income, and therefore are subject to self-employment taxes. While they will be discussed in more detail in a future post, it is important to understand that self-employment taxes are an additional tax assessed on your normal income tax return that is designed to imitate payroll taxes.

On the other hand, the owner of an S-corporation can be compensated by the corporation in two different ways.  The first, like LLC members (owners), is through ownership distributions.  These are withdrawals of the business' profits.  The second method, which is not available to LLC members, is through a salary.  In fact, an owner-employee of an S-corporation is required to take a "reasonable salary" before taking distributions from the business. What is a reasonable salary varies from business to business, so I would recommend talking to a corporate attorney to determine what is a reasonable salary for your business.  The factors that helps to determine what is a reasonable salary include: your position (title) in the business, the compensation of those with a similar position within your field, and the number of employees a business has. However, you are not required to take any money out of the business, whether through salary or distributions.  This means that even if you should have a reasonable salary of $50,000, you do not have to take $50,000 out of the business.  You could, for example, take out $20,000.  However, up to that hypothetical $50,000 everything should be taken through payroll as a salary.

An S-corporation's net profits is reduced by the amount of salary paid to the owners- the same as it would be by the salary of any other employee.

Regardless of whether your business is structured as an LLC or as an S-corporation, the business's profits are passed through to the owners and subject  to income taxes.  They are subject to income taxes regardless of whether the profits are retained by the business or distributed to the owners. However, only LLC owners pay self-employment taxes on the net profits of the business.

If you would like to know more about the differences between S-corporations and LLCs and how it can affect your taxes, please send me an e-mail.

S-corp vs. LLC: CA Minimum Taxes

Besides the formalities that S-corporations have to observe, there are a few other differences between S-corporations and LLCs.  One difference that will affect your bank account is how California assesses taxes.

Image borrowed from www.alliancetrustcompany.com

The amount of California taxes that an S-corporation will pay is based upon its net income.  An S-corporation pays the greater of $800 or 1.5% of its net income.

An LLC, on the other hand, pays $800 of California taxes and may be assessed an LLC fee based upon its revenue.  The table below shows the LLC fee for the various revenue ranges.

Revenue	LLC Fee
$0 - $249,999	$0
$250,000 - $499,999	$900
$500,000 - $999,999	$2,500
$1,000,000 - $4,999,999	$6,000
$5,000,000 +	$11,790

Therefore, whether an S-corporation or an LLC makes more sense for your business (based purely on the amount of taxes you will pay to California) depends on what you expect you revenues to look like compared to your net income.  Lets look at a few examples.

Example 1

You expect your business to have $600,000 of revenue but only $60,000 of net profit.  In this case, it makes more sense to operate as an S-corporation.  As an S-corporation you would be paying $900 in taxes to California ($60,000 x 1.5%).  However, as an LLC you would pay $3,300 ($800 of taxes plus a $2,500 LLC fee).

Example 2

You expect your business to have $900,000 of revenue and $300,000 of net profit.  In this example, it makes more sense to operate your business as an LLC.  As an LLC, you will be paying $3,300 to California ($800 of taxes play a $2,500 LLC fee).  However, as an S-corporation you would be paying $4,500 in California taxes ($300,000 x 1.5%).

If you would like a further understanding of the tax differences between LLCs and S-corporations, please send me an e-mail.

Can You Own an LLC By Yourself?

Sometimes the number of owners a business has affects what types of entities it is allowed to operate as.  While a corporation can have one or more owners (shareholders), a partnership by definition must have two or more owners.  An LLC can be thought of as a hybrid between corporations and partnerships, so can it have only a single owner (member)?  It depends.

Image borrowed from www.corporatedirect.com

The federal government's position changes depending upon how an LLC elects to be taxed.  LLCs have the option to be taxed as either a corporation or a partnership, but the default rule is that LLCs are taxed as partnerships.  If a single-member LLC elects to be taxed as a corporation, then the federal government will recognize the LLC as a corporation. However, if a single-member LLC elects to be taxed as a partnership, then the federal government will treat the LLC as a "disregarded entity".

The federal government essentially creates a legal fiction that the disregarded entity does not exist. It looks through the disregarded entity and attributes all of the entity's actions to its owner.  The owner is required to report the entity's income on its own tax return.

California, however, does not treat a single-member LLC any differently than any other LLC.  The LLC is required to file its own tax return for California.  In addition, because LLCs are created under state law, a single-member LLC has all of the same legal protections that any other LLC would have, such as limited liability protection.  If you would like a better understanding of a single-member LLC's legal rights, I would recommend talking to a business law attorney.

If you have any questions regarding how a sigle-member LLC is taxed, please send me an e-mail.

Is an LLC the Right Choice for You?

Your business has reached the point where you are no longer comfortable operating it as a sole proprietor and you know that you need to form a business entity, but which structure is right for you? You thought about a C-corporation, but you do not the double taxation or all of the corporate formalities that would have to be observed. A general partnership does not work for you because you want to have limited liability protection.  A limited partnership sounds great, but you and your partners all want to be actively involved in the management of the business and each partner who is involved in management decisions is then a general partner who does not have limited liability protection.  An S-corporation sounds great because you still have all the protections that C-corporations have, including limited liability, and there is only a single level of taxation.  However, you would still have to follow all of the corporate formalities and that is not appealing to you. What option is left to you?

Image borrowed from bluemavenlaw.com

You could form a Limited Liability Company (LLC).  An LLC can be thought of as a hybrid between a corporation and a partnership.  Like a corporation, an LLC has limited liability protection, can enter into contracts, purchase assets, loan and borrow money, and sue and be sued. However, like a partnership, the taxable income and losses of the LLC flows through to the owners so that the LLC does not have to pay income taxes itself.   (Note: California assesses a "minimum tax" and an LLC fee, as we will discuss in detail in a future post). LLCs also do not have to follow the same corporate formalities that C-corporations and S-corporations do.

To form an LLC in California, you will have to file Form LLC-1 "Articles of Organization of a Limited Liability Company (LLC)".  I would also recommend talking to a business attorney and having that attorney help draft an Operating Agreement between the members (owners) of the LLC.

Unlike an S-corporation, there are no restrictions on the number of owners that an LLC can have. Also, unlike S-corporations, corporations, partnerships, and foreign residents are allowed to be owners in an LLC.

As I previously mentioned, an LLC does not have to follow the same corporate formalities that a corporation does.  However, this does not mean that an LLC does not have any formalities that it has to follow- it is just very relaxed in comparison to a corporation.  A California LLC still has to file Articles of Organization with the Secretary of State, pay taxes and fees assessed by California, maintain adequate business records, and maintain separate bank accounts for the business. However, because the corporate formalities required of an LLC are so relaxed, one of the main factors that will be considered if a litigant is attempting to "pierce the corporate veil" and remove your LLC's limited liability protection is whether the LLC is adequately capitalized.  You will want to speak to a business attorney to determine what is adequate capitalization for your business.

One drawback of LLCs is that not everyone is allowed to form them.  Doctors, lawyers, and accountants are just a few examples of professions that cannot operate their business through an LLC.

There are a number of differences that exist between S-corporations and LLCs that are not addressed here that may affect your tax situation.  We will be discussing them in detail in future posts.  In the meantime, if you have any questions about LLCs please send me an e-mail.

Built-in Gains Tax

If you have been operating your business as a corporation but are now contemplating making the S Election, make sure you speak to a tax advisor about how the Built-in Gains Tax could potentially impact you.

As I discussed in the blog post "Is an S-Corporation Right for You?", an S corporation has all the traditional benefits of a C-Corporation (or what you typically think of as a corporation) including limited liability protection, but like a partnership the owners only have to pay income taxes on the distributed profits once.

The S Election could be made right after the business is incorporated, in which case you do not have to worry about the Built-in Gains Tax. However, the election can also be made years after the corporation has been formed.  In that event, it is important that you understand when the Built-in Gains Tax is triggered and how it operates because it could impact the business decisions you would otherwise make.

The Built-in Gains Tax may also apply if an S-corporation ever acquires assets from a C-corporation in a tax-free transaction.

The purpose of the Built-in Gains Tax is to prevent the shareholders of a C-corporation from converting to an S-corporation with the intend of avoid the tax consequences that would otherwise apply in a liquidation.  In other words, the Built-In Gains Tax is intended to prevent owners of a C-corporation from avoiding the taxes they would otherwise have to pay when shutting down or selling off all or part of their business by converting to an S-corporation.

Essentially, when converting to an S-corporation, the corporation must look at the assets it owned prior to the S Election taking effect and determine if those assets have appreciated in value (a formal appraisal is highly recommended).  If they have, the amount of appreciation on each asset will be known as the net unrealized built-in gain.  If the S-corporation then, within the applicable time period, sells that asset, the corporation (not the shareholders) must pay the Built-in Gains Tax, which is equal to the top marginal corporate tax rate (currently 35%), on the net unrealized built-in gain.

The applicable time period is currently 10 years, but shorter time periods apply to conversions that occurred in prior years.  If the S Election took effect in 2009 or 2010, then the applicable time period is 7 years.  If the S Election took effect in 2011, 2012, or 2013, the applicable time period is 5 years. It is always possible that new legislation will be enacted shortening the applicable time period again, so please talk to a trusted advisor if you are concerned about how the Built-in Gains Tax might affect you.

If you have questions about the Built-in Gains Tax, please send me an e-mail.

Is an S-Corporation Right for You?

You like the idea of forming a corporation because you want the limited liability protection, but the high cost of being taxed twice on the same income is very unappealing.  So then you thought about operating your business as a partnership so that your share of the business income will flow through to you, but the risk of being sued due to the actions of others is just too great.  A limited partnership doesn't work for you either because you want to be the one actively managing your business, not just an investor.  What other options are available to you?  One option is an S-corporation.

Image borrowed from Pacific
Associates Corporation

Every S corporation starts off as a C corporation, or what you may think of as a "regular corporation."  Then, the corporation will make an election, commonly referred to as an S Election, to be taxed under Subchapter S of the Internal Revenue Code. Basically, what this means to you is that taxes are paid at the owner-level rather than at the business-entity level, just like with partnerships.  But unlike partnerships, because an S-corporation is still a corporation it has the benefit of limited liability protection.

The S Election is made by filing Form 2553 with the Internal Revenue Service.  Once the election is made with the IRS, S corporation status is automatically recognized by California.  The election may be filed anytime during the year prior to when the election is to take effect, or within the first 2 months and 15 days of the year in which the election is to take effect.

However, there are restrictions on what corporations can be S-corporations.  First, the corporation must be incorporated within the United States.  Next, all the shareholders (owners) must be either individuals, estates, and certain types of trusts.  An S corporation may not have partnerships, corporations, or non-resident aliens as shareholders.  Additionally, an S corporation may not have more than 100 shareholders, and there can only be one type of stock issued.  The reason there can only be one class of stock issued is that all the shareholders must have the same rights in the corporation.  Finally, an S-corporation is not allowed to engage in certain types of business, such as finance or insurance.  If any of these restrictions are violated, the S-corporation status will be revoked.

S corporations have to comply with the same formalities that their C corporation counterparts do. Some of these formalities are:

• Filing Articles of Incorporation with the California Secretary of State;
• Electing a Board of Directors;
• Enacting Corporate Bylaws;
• Holding Board meetings at least once a year;
• Holding shareholder meetings at least once a year;
• Maintaining separate bank accounts for the corporation; and
• Maintaining corporate records.

However, this is not an exhaustive list and you should talk to a corporate law attorney to see what other formalities have to be observed.

In future blog posts, we will discuss in more detail the distinctive characteristics of S-corporations and specifically how they differ from other types of entities.

If you would like to talk about the unique tax rules that govern S-corporations and how they may impact your business, please send me an e-mail.

What is a Limited Partnership?

How is a limited partnership different from a general partnership?

In the last blog post, What is a Partnership?, I gave you an overview of general partnerships and some of the advantages and disadvantages of using that type of business entity.  In an attempt to make partnerships a more beneficial business structure, limited partnerships were created.

In a general partnership, every partner is a "general partner."  That means that each partner can be held personally liable for not only his or her own actions, but for the actions of the partnership as a whole, the other partners, and the partnership's employees.

In a limited partnership, there must be at least one general partner but there are also limited partners.  Limited partners have limited liability (see Limited Liability Protection) so they can only be held personally liable for their own actions.

In exchange for having limited liability protection, the limited partners are not allowed to take any active role in the management of the partnership.  I would advise talking to a business attorney about what activities specifically qualify as management activities.

Why would a General Partner want to be in a Limited Partnership?

At first, it does not seem like there would be any advantages to a general partner to being in a limited partnership.  The general partner is still fully liable for the actions of the others, just as in a general partnership.

However, there are two main benefits to this arrangement for general partners.  The first is that it makes it easier for general partners to raise funds for the business through investors.  Many investors would not be interested in becoming a partner with full personal liability for the actions of the other partners.  The second benefit is that this arrangement leaves the general partners in full control of the daily operations of the business and all major business-related decisions.

What are the other benefits of Limited Partnerships?

Limited partnerships, like general partnerships, are pass-through entities for tax purposes meaning that they are not subject to double taxation (see Would You Rather Be Taxed Once or Twice?).  Also, the limited partners only have the amount that they invested in the business at risk.  Creditors cannot attempt to seize their personal assets, and as previously mentioned they are not personally liable for the actions of others in the business.

What are the negatives of Limited Partnerships?

While the limited partners being barred from participating in the management of the business may be a benefit to the general partners, it can be frustrating for the limited partners.  The limited partners invested their money in the business and may have strong opinions about how the business should be run.  However, if they become involved in the management of the business they lose their limited partner status and their limited liability protection.

Another disadvantage to limited partnerships is that the passive activity rules may affect the limited partners ability to deduct business losses.  The passive activity rules will be the subject of a future blog post.

If you would like to learn more about the tax implications of using the limited partnership structure for your business, or the tax implications of any other business decisions, please send me an e-mail.

What is a Partnership?

A partnership is the easiest type of business entity to form.  So easy in fact that partnerships are occasionally unintentionally formed.

A partnership is formed when two or more people engage in a business enterprise for profit. Partnerships are the only type of business entity that do not require any form of paperwork to be filed as part of its formation.

For purposes of this post, when I refer to a "partnership" I mean a general partnership. Limited partnerships will be discussed in the next post.

Although not required to form a partnership, I would recommend talking to a business transactions attorney anytime you are considering going into business with another person.

In some ways, a partnership is the opposite of a corporation (see What is a Corporation?).  Whereas there is a legal fiction that a corporation is a separate and distinct person, a partnership can be viewed more as an aggregate of all the partners.  For example, property can be owned in the partnership's name but really that means that each partner owns a portion of that property.

Also, as previously mentioned, a partnership does not have to follow any type of formalities to be formed.  It is created simply by two or more people engaging in a business enterprise for profit.  It can be a very informal arrangement.  There are no requirements that even a partnership agreement be created, although for practical purposes it is very useful to have a partnership agreement in place.

While partnerships are required to file tax returns, it is simply an "informational" tax return.  The partnership itself does not pay any taxes, and thus unlike a corporation it is not subject to double taxation.  The partnership's taxable income instead flows through to its individual partners who are responsible for reporting the income on their individual tax returns and paying tax on their share of the partnership's income.  The purpose of the partnership tax return is simply to notify the IRS and the relevant state tax collection agencies of the amount of income that the individual partners should be reporting on their tax returns.

The informational tax return that a partnership files is Form 1065.  Form 1065 will show all of the business' revenue, expenses, gains, losses, and tax credits that get passed through to the partners. Each partner, and the relevant tax collection agencies, will then be provided with a Form K-1.  The purpose of the K-1 is to inform the partner of how much income, losses, and other tax attributes have to be reported on the partner's individual tax return and the nature of the income and losses.

There are several disadvantages to operating your business as a partnership.  The first is that your partners must consent to you transferring your ownership interests in the partnership to someone else. Because the defining characteristic of a partnership is that there are two or more people choosing to work together in a business enterprise, it is impossible to have a partnership if the other person refuses to be engaged in a business enterprise with another person.  Therefore, if you want to sell your ownership interest in a partnership to another person your partners have to agree to it.

Another disadvantage of partnerships is that you are jointly and severally liable for the actions of the partnership, yourself, your partners, and your employees.  Effectively, this means that your partner, while conducting business for the partnership, could cause injury to another person and you could end up being the one sued for it even though you had nothing to do with the situation other than being a partner in a partnership.

If you would like a referral to a business transactions attorney or would like more information on how partnerships and other forms of businesses entities are taxed, please send me an e-mail.

Triple Taxation?!?!

In the last blog post, Would You Rather Be Taxed Once or Twice?, we discussed that the major disadvantage of corporations is that its profits are taxed twice: once at the corporate level, and once at the shareholder level.   But what if a corporation owns another corporation?  Would the income from the second corporation be subject to triple taxation?

Image borrowed from hudsonvalleynewsnetwork.com

The answer is... maybe and to a certain extent.

Does that clarify things?

In order to lessen the potential impact of triple taxation, within the Internal Revenue Code there is a corporate tax deduction known as the "dividends received deduction."

What the dividends received deductions does is allow a corporate shareholder to deduct from its income a certain percentage of the dividends it receives from other corporations that it owns based upon its ownership percentage.

If a corporate shareholder owns less than 20% of another corporation, it is entitled to deduct from its income 70% of the dividends it receives from that corporation.  If the corporate shareholder owns between 20% and 80% of another corporation, then it is entitled to deduct 80% of the dividends it receives from that corporation.  Finally, it a corporation owns greater than 80% of another corporation, it is entitled to deduct 100% of the dividends it receives from that corporation.

There are several limitations placed upon the dividends received deduction, including the: taxable income limitation, the holding period limitation, and the debt-financed dividends received limitation.

Under the taxable income limitation, the amount of the dividend received deduction cannot exceed a certain percentage of the corporation's taxable income.  For corporations that would be entitled to a 70% dividends received deduction, the amount of the deduction cannot be greater than 70% of the corporation's taxable income.  Likewise, for corporations that would be entitled to an 80% dividends received deduction, the amount of the deduction cannot be greater than 80% of the corporation's income.  However, there is no such restriction for corporations that would be entitled to a 100% dividends received deduction.  Also, the taxable income limitation does not apply if the dividends received deduction either creates or increases a corporation's net operating loss.

Under the holding period limitation, a corporate shareholder must hold the shares of the distributing corporation's stock for a period of more than 45 days.

Under the debt-financed dividends received limitation, the deduction  is disallowed if debt was used to finance the purchase of the other corporation's stock.  Therefore, if a percentage of the stock was purchased using debt, then the dividends received deduction is reduced by that percentage.

If you would like to learn more about the dividend received deduction, please feel free to send me an e-mail.