Author: Leon Clinton

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

When it comes to taxes, your ownership of a timeshare comes with some tax implications, and they depend on how you use the timeshare:

• Personal use only
• Rental use only
• Both personal and rental use

Business use is a separate subject because you treat it separately under the business rules. You first deduct business use and then consider timeshare personal and rental use.

Mortgage Interest Deduction

You can deduct mortgage interest on your main home and one additional home. Your timeshare can qualify as a second home if

• it is used solely for personal purposes, or
• it has rental use, but your personal use qualifies it as a second home.

Co-Owners and Rental Complications

When you don’t rent your timeshare, you can disregard the co-owners and consider it your second home. But if you rent it out, the rental rules become complex, and you must account for the co-owners’ activities as well.

Passive Loss Rules

If your timeshare is classified as a rental property and shows a tax loss, it will be subject to passive loss rules, which can limit your deductions unless certain conditions are met.

Key Thoughts

• Avoid renting. This simplifies your tax situation, allowing you to focus on business and personal uses.
• Use the property for business and personal reasons instead. This avoids the complicated vacation home rules and allows for potential mortgage interest deductions.
• Consider the tax implications of renting. While rental income offsets costs, this addition of cash flow introduces complex tax rules and may not provide tax shelter benefits.

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

• By Leon Clinton
• June 25, 2024

The IRS allows you to write off the old roof or component when you replace it on your rental property. The write-off of the old component creates three major tax benefits for you:

• Immediate ordinary loss write-off. You can claim an immediate deduction for the loss, provided the passive loss rules do not delay it.
• Conversion to capital gain. You convert otherwise unrecaptured Section 1250 gain to capital gain.
• Time value of money. Investing the tax savings from the write-off can generate additional revenue over time.

Example

Consider a building purchased for $4 million seven years ago. You replace the roof and other components. The replacements create a $660,000 ordinary loss. If you’re in the 40 percent tax bracket, your immediate cash savings by claiming the deduction is $264,000.

If the passive loss rules delay your deduction until you sell the building, the $660,000 deduction remains available and continues as an ordinary loss at the time of sale.

Time Value of Money

Investing the $264,000 savings at 5 percent after taxes can significantly increase your earnings over time. For example, in 30 years, this grows to $1,086,660.

Additional Savings upon Sale

When you sell this building, the partial disposition election to write off the replacements helps you avoid the 25 percent tax on unrecaptured Section 1250 gain for the disposed assets. This results in additional tax savings at the time of sale.

Making the Election

The process to make this partial disposition election is simple. Calculate the write-off, claim depreciation on the new asset, and deduct your loss on the old asset in your timely filed tax return.

If you want to discuss repairs to your rental property and how they can increase your cash benefits, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• June 19, 2024