Author: Leon Clinton

You have read horror stories about how the IRS audits business owners and deems their 1099 independent contractors W-2 employees—and then assesses tens (or hundreds) of thousands of dollars in back payroll taxes, interest, and penalties.

Are you one of those horror stories?

Okay, let’s say you are one of them. You know that you are an IRS target because you have workers who really should be employees, but you treat them as independent contractors. And you are afraid that if you change now, the IRS will see that change, audit your prior years, and charge big bucks for your mistake.

What should you do? Keep the workers as independent contractors and hope the IRS doesn’t catch on? Or amend your past returns to show the misclassified workers as employees?

Depending on how many workers you have misclassified, and the number of years involved, that amendment process could be cost prohibitive.

The Pennies-on-the-Dollar Come-Clean Program

The come-clean program, which should have you paying just pennies on the dollar, is the IRS Voluntary Classification Settlement Program (VCSP) for business owners who want to change their worker classification on a going-forward basis.

Not everybody qualifies for the VCSP. To be eligible to participate in the VCSP, you must meet the following requirements:

1. Reporting consistency. You must have timely filed the previous three years’ federal tax returns for your workers (that is, 1099s) consistent with your treatment of the workers as independent contractors.
2. Not currently under audit. You cannot currently be under employment tax audit by the IRS, or under worker classification audit by the Department of Labor or by any state government agency.

Benefits of the VCSP Settlement Agreement

If you decide to participate in the VCSP, you must agree to treat the class or classes of workers covered by the agreement as employees for future tax periods. In exchange, you will receive the following most-favorable benefits:

• Reduced employment tax liability. You pay only 10 percent of the employment tax liability that would have been due on compensation paid to the workers for the most recent tax year. (Pennies on the dollar for one year—about 3.3 percent of what that likely would have been for the past three years.)
• No interest or penalties. You will not be liable for any interest and penalties. (Okay, knock that 3.3 percent down to something like 0.93 percent.)
• Audit protection for misclassifications in prior years. You will not be subject to an employment tax audit for prior years with respect to the workers covered by the VCSP. (Priceless.)

If you have misclassified workers, there is very little downside to participating in the VCSP—except, of course, that you will have to treat the workers covered by the VCSP agreement as employees on a going-forward basis.

If you would like to discuss your 1099 workers, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• July 8, 2022

Making gifts to promote your business is complicated by time, inflation, and poor tax legislation.

For example, a client recently brought this up: “To stay in touch and promote my business, I buy dozens and dozens of Starbucks $5 gift cards and send them monthly to my prospects and referral sources. Can I write off the $5 cards?”

You’ve probably heard the expression “between a rock and a hard place.” That’s where this client’s Starbucks gift cards fall. The law is going to treat her $5 Starbucks cards as business gifts.

Thus, if she gives a card to a referral source every month, her cost is $60 for the year ($5 x 12), but she may not deduct more than $25 for business gifts made to the same person. Ouch!

There’s a ridiculous $4 exception to the gift rules. The law exempts from the business gift rules and calls it advertising when you give to a customer or a prospect an item

• that costs you $4 or less,
• on which you have your name clearly and permanently imprinted, and
• that is one of a number of identical items distributed generally by you.

Here’s why this is ridiculous: The $4 rule was enacted in 1962, many years before Starbucks came into being. Further, if you applied the consumer price index calculator to that $4 amount, it would inflate to $39 today. The $25 total gift amount inflates to $241.

If you have questions about the gift rule, please don’t hesitate to call me on my direct line at 408-778-9651.

• By Leon Clinton
• July 6, 2022

It is getting increasingly popular for individuals to use self-directed IRAs to invest in alternative investments—that is, investments in things other than stocks, bonds, CDs and the like.

The single most popular alternative investment for self-directed IRAs is real estate.

With real estate values continuing to climb, you may be thinking about establishing your own self-directed IRA to purchase residential rental property, commercial property, or other real estate investments.

But before you do so, you should be aware of some potential downsides of using self-directed IRAs for real estate. These aren’t necessarily dealbreakers, but they can be big obstacles.

Debt Financing

First, it is more difficult to get debt financing for real estate held in a self-directed IRA.

You, the self-directed IRA owner, are not allowed to lend any money to your self-directed IRA. Your close relatives are also barred from making loans. Nor can you personally guarantee a loan taken out by your self-directed IRA.

Instead, your self-directed IRA must obtain a non-recourse loan. With a non-recourse loan, the lender’s sole recourse in the event of default is to foreclose on the property. Such loans are more difficult to obtain than regular loans. Typically, the lenders that make these loans require your self-directed IRA to furnish a 30 percent to 50 percent down payment.

Unrelated Business Income Tax

If you obtain such debt financing, your self-directed IRA could become subject to the unrelated business income tax. This is a tax imposed on tax-exempt entities, including IRAs, that earn money from businesses unrelated to their tax-exempt purposes.

The unrelated business income tax is based on the percentage of the property that is debt-financed. For example, if your self-directed IRA buys a rental property worth $500,000 with $250,000 of non-recourse financing, 50 percent of the rental income from the property is subject to the unrelated business income tax.

The unrelated business income tax most often poses a problem when your self-directed IRA sells debt-financed real property. It pays the unrelated business income tax on any profit at capital gains rates. If the property has substantially increased in value, the tax could be large.

Key point. Your self-directed IRA can avoid paying the tax if the debt on the property is paid off more than 12 months before the sale.

RMDs

Finally, if you’re at or near 72 years of age, you need to consider how holding real estate in a traditional IRA will impact the requirement that you take annual required minimum distributions (RMDs). (No RMDs are required for Roth IRAs.).

Once you hit the RMD age, you must distribute a percentage of your IRA’s value to yourself each year, based on your life expectancy, or face an enormous 50 percent penalty.

If all or most of the assets in your traditional IRA consist of real estate, the property may not generate enough cash to pay your RMD. This is not an unsolvable problem, but it is a problem.

If you have questions about self-directed IRAs or RMDs, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• July 5, 2022