Month: September 2024

You can plan your tax-deductible business life to avoid cold winters and hot summers.

Spend a moment examining the following four short paragraphs containing the Andrews case’s basic facts. 

For six months of the year, from May through October, Edward Andrews lived in Lynnfield, Massachusetts, where he owned and operated Andrews Gunite Co., Inc., a successful pool construction business. 

During the other six months, Mr. Andrews lived in Lighthouse Point, Florida, where he owned and operated a sole proprietorship engaged in successful horse racing and breeding operations. In addition, he, his brother, and his son owned a successful Florida-based pool construction corporation from which Mr. Andrews took no salary but where he did assist in its operations. 

Instead of renting hotel rooms in Florida, Mr. Andrews purchased a home, claimed 100 percent business use of the Florida home, and depreciated the house and furniture as business expenses on his Schedule C for his horse racing and breeding business. 

Mr. Andrews then allocated his other travel expenses and the costs of owning and operating this house in Florida on his individual income tax return as

• personal deductions on his Schedule A for a portion of the mortgage interest and taxes,
• business deductions on his Schedule C for the horse racing and breeding business, and
• employee business expenses on IRS Form 2106 for the pool construction business. 

(Tax reform under the Tax Cuts and Jobs Act eliminates employee business expense deductions for tax years 2018 through 2025—so Mr. Andrews would change his strategy to obtaining expense reimbursements from the pool business.)

As Mr. Andrews did, you can tax plan your life to spend your winters in one state and your summers in another. 

In this scenario, your tax-deductible home takes the place of hotels. The other home is likely your principal residence located near your tax home.

Your travel expenses between the homes are deductible because you do business in both places. You also deduct your meals and other living costs while at the deductible travel destination. 

You can have separate businesses in each state or a branch business in the second state.

If you want to discuss a business and personal living arrangement such as Andrews had, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• September 17, 2024

As you consider converting your C corporation into an S corporation, understand and plan for the built-in gains (BIG) tax. 

The tax code imposes the BIG tax on S corporations that recognize gains on assets that the C corporation held at the time of S corporation conversion. Some gains can surprise you because on the date of conversion, the law makes you convert your accounting to the accrual method. 

Example. Your C corporation operates on a cash basis and has receivables at the time of conversion. Your new S corporation operates on a cash basis. But as it collects the receivables, it faces the BIG tax.

Here’s a breakdown of the BIG tax: The first tax is 21 percent—the C corporation rate. The S corporation passes the remaining 71 percent of profits to you, where they are subject to individual income tax rates, which can be as high as 40.8 percent.

To help you navigate and potentially avoid the BIG tax, here are five strategic approaches:

1. Avoid selling the S corporation during the five-year BIG tax penalty period.
2. Identify personal goodwill, which is not a corporate asset, and get a proper appraisal to prove this to the IRS.
3. Reduce building appreciation with an accurate appraisal.
4. Give yourself a bonus.
5. Establish any unpaid compensation from previous years as a liability, and have the S corporation pay it within two and a half months after conversion. This creates a built-in loss to offset other built-in gains.

If you want to discuss the BIG tax, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• September 13, 2024

If you run your business through a regular “C” corporation, beware of the accumulated earnings tax (AET). 

The IRS can use the AET to penalize C corporations that retain earnings in the business rather than pay them to shareholders as taxable dividends. To retain earnings, the C corporation first pays the corporate tax of 21 percent on those earnings.

When the corporation distributes those already taxed earnings to shareholders, the shareholder includes those distributed earnings as dividends in taxable income, where they are taxed again at the shareholders’ capital gains rate.

The AET is a flat 20 percent tax. The AET is a penalty tax imposed after an audit in which the IRS concludes that the corporation paid out insufficient dividends compared to the amount of income accumulated by the corporation. 

You have AET exposure when your C corporation has large balances in retained earnings, cash, marketable securities, or loans to shareholders reported on a corporation’s balance sheet on IRS Form 1120, Schedule L.

The IRS can impose the AET on any C corporation, including public corporations. However, closely held C corporations are the most likely targets because their shareholders have more influence over dividend policy than public corporations’ shareholders.

Historically, IRS auditors have not prioritized the AET, but anecdotal evidence suggests this may change.

Fortunately, there are many ways to avoid problems with the AET—for example:

• Elect S corporation status
• Retain no more than $250,000 in earnings ($150,000 for corporations engaged in many types of personal services)—all C corporations are allowed to retain this much AET free.
• Establish that the corporation needs retained earnings above $250,000/$150,000 for its reasonable business needs—for example, to provide necessary working capital, fund expansion needs, pay debts, or redeem stock 

The key to avoiding the AET is to document the reasons for accumulating earnings beyond $250,000/$150,00 in corporate minutes, board resolutions, business plans, budget documents, or other contemporaneous documentation.

If you want to discuss the accumulated earnings tax, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• September 10, 2024