Author: Leon Clinton

Early withdrawals from a traditional IRA before age 59 1/2 generally incur a 10 percent penalty tax on the taxable portion of the withdrawal. There are several exceptions to this rule that can help you avoid the penalty under specific circumstances. Below, I have outlined the key exceptions that may apply to your situation.

Substantially equal periodic payments. You can arrange for a series of substantially equal periodic payments. This method requires careful calculation and adherence to strict rules but allows penalty-free withdrawals.

Medical expenses. Withdrawals for medical expenses exceeding 7.5 percent of your adjusted gross income, or AGI, are exempt from the penalty.

Higher education expenses. You can use penalty-free withdrawals for qualified higher education expenses for you, your spouse, and your children.

First-time home purchase. You can withdraw up to $10,000 (lifetime limit) for qualified home acquisition costs without penalty.

Birth or adoption. You can withdraw up to $5,000 for expenses related to the birth or adoption of a child.

Emergency expenses. Starting January 1, 2024, you can withdraw up to $1,000 annually for emergency personal expenses without penalty.

Disaster recovery. Withdrawals for qualified disaster recovery expenses are exempt from the penalty, up to an aggregate limit of $22,000.

Disability. If you are disabled and cannot engage in substantial gainful activity, you can withdraw funds without penalty.

Long-term care. Beginning December 29, 2025, you can take penalty-free withdrawals for qualified long-term care expenses.

Terminal illness. Withdrawals due to terminal illness are exempt from the penalty.

Post-death withdrawals. Amounts withdrawn after the IRA owner’s death are not subject to the penalty.

Military reservists. Active-duty military reservists called to duty for at least 180 days can withdraw funds without penalty.

Health insurance premiums during unemployment. If you receive unemployment compensation for 12 consecutive weeks, you can withdraw funds to pay for health insurance premiums without penalty.

Domestic abuse victims. Starting January 1, 2024, you can take penalty-free withdrawals of up to $10,000 if you are a victim of domestic abuse.

IRS levies. Withdrawals to pay IRS levies on the IRA account are not subject to the penalty.

It’s important to note that SIMPLE IRAs incur a 25 percent penalty for early withdrawals within the first two years of participation. Additionally, Roth IRAs have different rules, allowing penalty-free access to contributions but potentially taxing and penalizing withdrawals of earnings.

If you want to discuss your IRA, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• July 8, 2024

One significant tax benefit of owning residential rental property or non-residential commercial or investment property is depreciation—a deduction you get without spending any additional money.

But regular depreciation for real property is slow. Residential rental property is depreciated over 27.5 years and non-residential property over 39 years, providing a relatively small deduction each year.

Fortunately, there is a way you can speed up your depreciation deductions—especially during the first year or years you own the property: cost segregation.

“Cost segregation” is the technical term for separately depreciating the elements of property that are not real property. These are elements other than land, buildings, and building components. They include

• improvements made to the land, such as landscaping, swimming pools, paved parking areas, and fences; and
• personal property items inside a building that are not building components—for example, refrigerators, stoves, dishwashers, and carpeting in residential rentals.

Using cost segregation does not increase a property owner’s total depreciation deductions, but it does accelerate them over the first few years because personal property has a five- or seven-year depreciation period and land improvements a 15-year period.

In addition, by using bonus depreciation and/or Section 179 expensing, owners can deduct all or most of the cost of personal property and land improvements the first year they own the property—providing a potentially enormous first-year deduction.

A cost segregation study must be conducted to identify which building elements are personal property and land improvements and then to determine their depreciable basis. Studies can be conducted by engineers or done more cheaply with other methods that the IRS views as less reliable.

Cost segregation may not be advisable for every property owner—for example, where it results in a loss that can’t be deducted due to the passive loss rules, or where the owner intends to sell the property within a few years and has to recapture as ordinary income the cost-segregated depreciation deductions.

The best time to perform a cost segregation study is the same year you buy, build, or remodel your real property. But you can wait until a future year—perhaps when you have enough rental or other passive income to use the speeded-up depreciation deductions.

If you want to discuss cost segregation, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• July 3, 2024

Self-employment taxes are substantial, and most people want to minimize them. Self-employed taxpayers often avoid self-employment taxes by operating as an S corporation.

The distributions from the S corporation are not subject to self-employment tax. But Social Security and Medicare tax must be paid on the shareholders’ employee compensation (which must be reasonable based on the services they provide). S corporations are also subject to various legal restrictions that can be inconvenient.

How about using the partnership form to avoid self-employment tax? This doesn’t work for general partnerships because general partners always have to pay self-employment taxes on their distributive share of the ordinary income earned from the partnership’s business.

But what about limited partnerships? These are partnerships that contain two classes of partners:

1. General partners who are personally liable for partnership debts and manage the business
2. Limited partners whose personal liability for partnership debts is limited to the amount of money or other property they contribute

The tax law provides that limited partners “as such” don’t have to pay self-employment tax on their distributive share of partnership income.

Moreover, in about half the states, limited partnership laws have been revised to permit limited partners to work for the partnership without losing their limited liability.

Does this mean limited partners in many states can work for the partnership and avoid paying self-employment tax on their share of the partnership income? High-earning limited partners—hedge fund managers, for example—could save substantial tax if this were the case.

Unfortunately, in Soroban, a recent precedential decision involving a highly successful hedge fund and well-paid limited partners, the U.S. Tax Court held that the answer to this question is “no.”

The court held that the limited partner exception to self-employment taxes applies only to limited partners who are passive investors, not to those actively involved in the partnership business.

Soroban is the latest in a series of cases involving self-employment taxes for partnership-like entities that the IRS has won. The other cases involved active participants in a state limited liability partnership, a limited liability company taxed as a partnership, and a professional limited liability company. Only passive investors in these entities can avoid self-employment tax.

Encouraged by these victories, the IRS is writing regulations requiring a functional analysis to determine whether a person is a limited partner. The IRS is also likely to conduct more self-employment audits of limited partnerships.

If you want to discuss limited partnerships, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• June 28, 2024