Two Correct Ways to Deduct Your Home Office with a Partnership

With the COVID-19 experience, you and your partners may be
doing a lot of work from home or even working from home primarily. Is the
home-office deduction in the mix?

If you operate your business as a partnership, you have two
ways to correctly deduct your home-office expenses.

If you have a tax-deductible home office and operate as a
partner in a partnership, you have two ways to get a tax benefit from the home
office:

1. Deduct the cost as an unreimbursed partner expense (UPE),
   or
2. Get reimbursement from your partnership via an accountable
   plan (think expense report).

Unreimbursed Partner
Expense

As a partner in a partnership, you generally can’t deduct
any of the partnership expenses on your individual tax return—the partnership
should pay for and deduct its own business expenses.

But if your partnership agreement or business policy forces
you to pay for the expense out of pocket with no reimbursement available, then
you can deduct the business expense in full on your individual tax return as a
UPE.

Because the UPE is a trade or business expense, it also
reduces your self-employment tax.

Deducting UPE is even better than taking a typical Schedule
C home-office deduction because you can deduct your full home-office expense even
when the partnership has a tax loss for the year.

Here are the two steps to claiming your UPE deduction:

1. Find your deduction amount using Form 8829 (but don’t
   include it with your tax return).
2. On a separate line on Schedule E, line 28, enter “UPE” in
   column (a) and the expense amount in column (i).

Accountable Reimbursement
Plan

The other option for realizing your home-office deduction is
to have your partnership reimburse you for your home-office expenses under an
accountable plan.

When your partnership does this, the reimbursement is

• tax-free to you, the partner, and
• tax deductible to the partnership, which reduces your
  share of the taxable net income from the partnership.

Here are the three steps to obtaining the reimbursement:

1. Find the reimbursement amount using Form 8829 (including
   depreciation).
2. Submit your reimbursement request with appropriate
   documentation within the time frames required by your partnership’s
   accountable plan policy.
3. Receive a reimbursement check from your partnership.

Why Reimbursement Is Best—Example

John is a 20 percent partner in Rainbow, LLC, which is a
partnership for federal tax purposes. He’s in the 24 percent federal tax
bracket (for this example, we’ll ignore the self-employment tax).

Let’s assume John uses Form 8829 and calculates his home-office
deduction as $4,000.

If John deducts the $4,000 as UPE, it puts $960 in his
pocket (24 percent of $4,000).

But if John receives an accountable plan reimbursement from
the partnership, it puts $4,192 in his pocket:

• $4,000 as a tax-free reimbursement, and
• $192 from reduced pass-through income (24 percent of $800,
  which is 20 percent of the $4,000 partnership expense).

If you are a candidate for the home-office deduction and
want to pursue this deduction, please call me on my direct line at 408-778-9651.

Raise Hell: Help Lawmakers Make PPP Expenses Tax Deductible

As you read this, it’s likely that your lawmakers are
working on the next Payroll Protection Program (PPP) package.

And hopefully, in this next package they will include a
provision that allows you to deduct business expenses that you pay with your
PPP money.

Let’s explain. In the CARES Act, Congress said:

For purposes of the Internal Revenue Code of 1986, any
amount which (but for this subsection) would be includible in gross income of
the eligible recipient by reason of forgiveness described in subsection (b)
shall be excluded from gross income.

From what we know, lawmakers thought this meant that the PPP
loan forgiveness was tax-free for you. You probably thought that too. We did.

But then in late April, the IRS issued Notice 2020-32 that
prevents PPP loan recipients from deducting business expenses that were paid
using the PPP monies that gave rise to forgiveness (defined payroll, rent,
utilities, and interest).

Two things to know here:

1. The PPP loan and forgiveness is a good deal even if the
   expenses are not deductible.
2. When the CARES Act was passed, it appears that lawmakers
   thought the PPP monies were tax-free and had not considered that the
   expenses paid with the loan proceeds would not be deductible.

Good-Deal Example

ABC Inc., an S corporation, receives a $100,000 PPP loan,
spends it all on defined payroll, and the lender forgives the $100,000.

On its 2020 tax return, ABC reports no PPP income (remember,
it was tax-free), but it may not deduct $100,000 of payroll expenses. The non-deduction
creates $100,000 of net taxable income that ABC, the S corporation, passes on
to its sole shareholder, Bob.

Let’s say Bob is in the 45 percent tax bracket when you
consider both his federal and state income taxes. Bob pays taxes of $45,000 on
this income.

And let’s say that ABC passes to Bob the $100,000 of
tax-exempt income. This puts Bob ahead by $55,000 ($100,000 – $45,000).

A good deal—sure!

But with passage of the CARES Act, Congress was not making a
good deal—it was providing ABC with money for it to remain afloat and continue
paying its employees during the COVID-19 pandemic.

What If It’s Like We
Thought It Was?

If the payroll were deductible, ABC would be ahead by both
the $100,000 and the tax benefit of the payroll being deductible—giving the
company a better chance of continuing to pay its employees after the PPP loan
and its forgiveness.

Since the S corporation doesn’t pay income taxes, let’s look
at Bob. He would have the $100,000 plus the tax benefit of the payroll
deduction ($45,000).

Here’s the comparison:

• $145,000 if the PPP is as we thought it was
• $55,000 as the IRS has it now

Unfair—Schedule C Taxpayer
Suffers No Tax Bite

To add one more reason to why the business expenses paid
from PPP loan forgiveness monies should be tax deductible, consider this: the
self-employed taxpayer with no employees has his or her loan forgiven based on
his or her 2019 net income.

There’s no spend on payroll.

The self-employed person does not have to spend any PPP
monies on interest, rent, or utilities. He or she can achieve full forgiveness
in 10.8 weeks based solely on the 2019 tax return.

In its “you can’t deduct it” notice (IRS Notice 2020-32),
the IRS invokes IRC Section 265, but Section 265 does not consider how the PPP
treats forgiveness for the self-employed. It applies to expenses incurred for
the purpose of earning or otherwise producing tax-exempt income.

For the Schedule C taxpayer, no such expenses to produce
tax-exempt income need to be paid to achieve 100 percent forgiveness.

Lawmakers Upset with the
IRS

Let’s start with the fact that the IRS has a tough job. In
many cases, the IRS is nothing more than a referee. If lawmakers fumble the tax
law, the IRS has to call it. No choice.

In a letter to Secretary of the Treasury Mnuchin, Senator Chuck
Grassley, chairman of the committee on finance; Senator Ron Wyden, ranking
member on the committee on finance; and Richard E. Neal, chairman of the
committee on ways and means, jointly stated that the IRS got this wrong and
that the intent of the CARES Act was for the PPP to be a tax-free grant.

The IRS has held firm. That puts the ball back into
lawmakers’ hands, and now it’s their turn. This is where you come in.

Give Them a Nudge

Congress is working on additional COVID-19 legislation. And
we suspect that you will see the new legislation enacted into law before
Congress recesses for its summer break on August 8, 2020.

That means things are moving quickly, and if you want your
voice to be heard, you need to speak now.

To help create the action you desire, do this:

• S. 3612 is the Senate bill to make the PPP forgiveness
  money used to pay business expenses tax deductible. To express your yea or
  nay on S. 3612, contact your senators. You can find them at this link: https://www.senate.gov/senators/contact
• H.R. 6821 is the House bill to make the PPP forgiveness
  money used to pay business expenses tax deductible. To express your yea or
  nay on H.R. 6821, contact your representative. You can find him or her at
  this link: https://www.house.gov/representatives

You don’t need to be big and formal about your yea or nay.
You can fax, email, or phone and simply say you support or oppose the bill.
It’s that easy—and it’s effective. Do it.

Over the past few decades, federal taxes have generally
trended lower.

That era may be coming to an end, especially for well-off
individuals.

The major factor to consider is that our country might
finally be forced to confront the issue of ongoing huge federal budget
deficits—which have been made that much bigger by costly federal COVID-19
relief measures.

Can you protect what you currently possess from a possible
oncoming federal estate and gift tax threat? Maybe.

Before suggesting a strategy to (hopefully) dodge the
threat, let’s first cover the necessary background information. Here
goes.

Today’s Federal Estate and
Gift Tax Picture

The Tax Cuts and Jobs Act (TCJA) drastically increased the
unified federal estate and gift tax exemption from $5.49 million for 2017 to
$11.58 million for 2020—with inflation adjustments scheduled for 2021-2025. If
you’re married, your spouse is entitled to a separate exemption in the same
amount.

If you make cumulative lifetime taxable gifts in
excess of the exemption amount, the excess is taxed at a flat 40 percent rate.
If you pass away with an estate valued at more than the exemption amount, the
excess is taxed at the same flat 40 percent rate.

Taxable gifts mean gifts made in one year to one individual
that exceed the annual federal gift tax exclusion. The exclusion for 2020 is
$15,000, and it will probably stay at that number for the next few years
(unless our duly-elected politicians reshuffle the deck).

If you make taxable gifts during your lifetime, you won’t actually
owe any federal gift tax until the cumulative amount of such gifts exceeds the
unified federal estate and gift tax exemption. Excess gifts reduce your unified
exemption dollar-for-dollar, but only a few very generous individuals ever
actually owe federal gift tax.

Snapshots of Earlier
Federal Estate and Gift Tax Regimes

Today’s federal estate and gift tax regime is far more
taxpayer friendly than the regimes that existed earlier in this century.

• For 2000, the federal estate
  tax exemption was $675,000, and the maximum tax rate was 55 percent.
• For 2005, the exemption was
  $1.5 million, and the maximum tax rate was 47 percent.
• For 2009, the exemption was
  $3.5 million, and the maximum tax rate was 45 percent.
• For 2010, but just for that
  one year, estate executors could opt for a zero federal estate tax bill in
  exchange for giving up tax-basis step-ups for certain assets inherited by
  beneficiaries of the deceased individual.
• For 2015, the unified federal
  estate and gift tax exemption was $5.43 million. The tax rate on
  cumulative lifetime gifts in excess of the exemption and estates valued in
  excess of the exemption was a flat 40 percent.
• For 2020, the unified federal estate and gift tax
  exemption is $11.58 million. The tax rate on cumulative lifetime gifts in
  excess of the exemption is a flat 40 percent. The tax rate on the estate
  of an individual who passes away this year with an estate valued in excess
  of the exemption is a flat 40 percent.

The Portable Exemption
Privilege

Since 2011, we’ve had so-called federal estate and gift tax exemption
portability for married couples. If one spouse dies without using his or
her exemption, the surviving spouse is allowed to inherit the deceased spouse’s
unused exemption.

Scheduled Federal Estate
and Gift Tax Regime for 2021-2025 and Sunset Provision Scheduled for 2026

For 2021-2025, today’s version of the Internal Revenue Code
stipulates that the unified federal estate and gift tax exemption (currently
$11.58 million) will be adjusted annually for inflation.

The flat tax rate on excess lifetime gifts and excess estate
values will remain at 40 percent.

So far, so good. But a so-called sunset provision stipulates
that the exemption for 2026 will revert back to the 2017 amount of $5.49
million, with a cumulative inflation adjustment for 2018-2025. About $6.5
million is a good guess for the 2026 exemption amount if the sunset provision
takes effect for that year.

The flat tax rate on cumulative lifetime gifts in excess of
that number and estate values in excess of that number would remain at 40
percent.

The Looming Federal Estate
and Gift Tax Threat

There’s no guarantee that today’s super-favorable federal
estate and gift tax regime will survive beyond this year.

What actually happens to the federal estate and gift tax
regime (if anything) will depend on events. The current regime might survive,
or it might be trashed and replaced with something not nearly so taxpayer friendly.
Possible outcomes could include:

• The existing taxpayer-friendly
  regime stays in place through at least 2024 (the next general election
  year).
• The portable exemption
  privilege is repealed, and the effective date of the aforementioned sunset
  provision is accelerated to January 1, 2021. The 2021 exemption would be
  about $6 million.
• Starting next year, we go back
  to the 2009 regime with its much-smaller $3.5 million exemption, 45
  percent maximum tax rate, and no portable exemption.
• Starting next year, we get
  something much worse. For instance, we could go all the way back to the
  2000 regime with its skimpy $675,000 exemption, confiscatory 55 percent
  maximum tax rate, and no portable exemption. Ugh!

What to Do?

Very good question. Here’s one idea. If you have an estate
in the large-to-very-large category, put yourself in position to make large-to-very-large
gifts before year-end to reduce the value of your taxable estate.

You can shelter the gifts from the federal gift tax with
this year’s unified federal estate and gift tax exemption. Remember, it’s that
hefty $11.58 million.

Considerations

1. Depending on the assets on your personal balance sheet,
it could be easy or hard to position yourself to make large-to-very-large gifts
before year-end. You may need to make some moves to get into position.

2. Depending on who would receive your large-to-very-large
gifts, you may need to take some extra steps, such as setting up trusts for
some or all of your intended gift recipients.

3. If you’re married, remember that both you and your spouse
are entitled to separate unified federal estate and gift tax exemptions.

4. If your spouse passed away after 2010, we hope the
executor of your spouse’s estate filed Form 706 (the federal estate tax return)
to elect to take advantage of the portable exemption privilege. If so, your
exemption is that much bigger. If not, consult a good estate planning pro to
see if the election can still be made. If so, it could make a big difference in
your favor.

5. If you make gifts to someone who is more than one
generation beneath you (like a grandchild or great-grandchild), the federal
generation-skipping transfer tax (GSTT) can become a factor. The GSTT is
sneaky. It can come into play with gifts to a trust that will eventually
benefit someone who is more than one generation beneath you. Talk to your estate planning pro about the GSTT, especially
if you’re considering making a gift to a trust.

If you or a loved one is giving this a good look and would
like my input, please call me on my direct line at 408-778-9651.