Month: June 2017

Preface: Dependent exemptions are not always addend, addend = sum. This blog presents ideas to minimize taxes for certain individual taxpayer situations.

Who Is my Dependent?

Credits: Jake Dietz, CPA

Whom can I claim on my tax return as a dependent? Perhaps you find yourself asking this question when preparing your tax information to give to your accountant. Some situations are very clear and common, but other situations take more work and research to determine. The IRS has detailed instructions, and this article will examine generally some of the qualifications but will not delve into all the complexities. To claim someone as a dependent on your tax return, they must either be your qualifying child or qualifying relative.

Qualifying Child

A qualifying child is generally your child or sibling, or a descendant of your child or sibling. The qualifying child must have been either under age 19, under age 24 and a student, or disabled. The child cannot have paid more than half the cost to support themselves. Generally, the child must have lived with you more than half the year. There are also some other considerations before the child can be considered your dependent, including if you could be claimed by another person, and if the child were married.

There is no income limitation for a qualifying child. You could have a 17-year-old child living at home making more money than his parents, but the child could still qualify if he did not pay more than half the cost to support himself.

Qualifying Relative

Someone who does not fit the requirements to be a qualifying child might be your qualifying relative. Qualifying relatives could be your children along with their descendants, your siblings along with their children, your parents along with their siblings and ancestors, in-laws, stepparents, stepsiblings, or an unrelated person who lived with you all year. Generally, you must provide more than half their support. The qualifying relative also must have made less than $4,050 in most situations.

First, let’s look at housing for these relatives that might qualify. They do not have to live with you, although they may live with you. For example, let’s suppose your elderly aunt lives in a house rent-free on your second farm. If she makes less than $4,050 and you provide over half her support, then you may be able to include her as a dependent.

Another scenario that you may encounter is an elderly father who would be a qualifying relative, except 3 of his children take turns providing for him. No one provides over half his support. In this case, there can be an agreement signed where one of the children can claim him.

Another interesting example of a qualifying relative would be someone who is not related to you but lives with you all year if you provide over half her support. Suppose there is an elderly lady in the community who has no income and no family to provide for her. You invite her into your home to live, and you provide for her. If she lives with you all year, then she may be your qualifying relative.

There is also an exception to the $4,050 rule for people with disabilities. If the person has a disability but earns more than $4,050 at a workplace for people with disabilities, then the $4,050 income test may be waived for that income.

As we examine scenarios and some of the rules that go into determining who is a dependent on your tax return, it may become obvious that this decision can take some careful analysis. This article is general in nature and only explores some of the qualifications. Please consult with an accountant about your specific circumstances before making a final decision.

 

Preface: An LLC with more than one member can be taxed as a partnership, but this brings up an interesting question regarding self-employment tax. Who is a limited partner in an LLC for purposes of the SE tax exemption? The Internal Revenue Code and related regulations do not say.

LLCs and Limited Partner SE Classification Taxation

Credits: Jake Dietz, CPA

Do you get a K-1 from an LLC every year that lists various types of income? Perhaps it also lists self-employment income, which may or may not include all the income on the K-1. This article looks specifically at reporting self-employment income on the distributive share of income for LLC’s taxed as a partnership.

First, let’s look at how partners in a partnership get taxed. Partnerships are pass-through entities for federal tax purposes. The partners of the partnership receive a K-1 allocating to them a share of the partnership’s activity, and then the partner files their personal tax return using information on the K-1. Because partnership items pass-through to the partners, a partner may pay tax on income he never personally received. For example, suppose Samuel is a 50% general partner and received $45,000 for his services to the partnership, which he helps manage. These payments are called guaranteed payments and can be deducted by the partnership. After all expenses were deducted, including the guaranteed payments, the partnership made $20,000 of net income, which it kept in the partnership for future use. Samuel would be subject to income tax on the $45,000 he received as guaranteed payments plus the 50% distributive share of the $20,000 partnership net income, or $10,000. If Samuel is not exempt from self-employment (SE) tax, then he must pay SE tax on the $45,000 guaranteed payments and the $10,000 distributive share.

How would Samuel be taxed if he were a 25% limited partner? Assume Samuel is a limited partner, and he worked for a few days to earn $500 in guaranteed payments. His distributive share of the partnership net income is $5,000. In this scenario, the full $5,500 would be subject to income tax, but only the $500 of guaranteed payments would be subject to SE tax. Why is the $5,000 not subject to SE tax? The Internal Revenue Code in §1402(a)(13) specifically exempts the distributive share (in this example $5,000) of a limited partner’s income from SE tax.

An LLC with more than one member can be taxed as a partnership, but this brings up an interesting question regarding self-employment tax. Who is a limited partner in an LLC for purposes of the SE tax exemption? The Internal Revenue Code and related regulations do not say.

The tax court, however, ruled in Castigliola, T.C. Memo. 2017-62. We can look to this court ruling for guidance. The court considered whether the LLC members were “functionally equivalent to that of a limited partner in a limited partnership.” The court noted that “limited partners typically lack management power but enjoy immunity from liability for debts of the partnership.” The court also noted that the LLC in the case was member-managed. No LLC operating agreement existed that limited the members’ management. Furthermore, the facts indicated that the LLC members participated in management. They were therefore not functionally equivalent to limited partners. The court also noted that “Because there must be at least one partner who is in control of the business, there must be at least one general partner.”

What can we learn from this ruling? If all the LLC members participate in management, then the LLC should probably report the distributive share of income as subject to SE tax, as well as the guaranteed payments. Although the LLC members may enjoy immunity from partnership debts, they should not expect to enjoy SE tax exemption on their distributive share of income if they help manage the LLC.

If the equivalent of limited partners exist in the LLC, then there should be documentation to substantiate the facts. Is there a written operating agreement that supports the argument that they function as limited partners? Is there any other evidence to support or contradict the limited partner claim? There should also be evidence indicating that at least one other member functions as a general partner.

This article is general in nature and should not be considered tax or legal advice. If you have questions on the specifics of an LLC of which you are a member, please contact this office.

Preface: Form 4029 Exemptions from FICA taxes can result in a tax landmine of penalties and back tax assessments in certain circumstances. Appropriate application of the tax code can minimize risks. What is permitted and what is not according to the IRS tax code?

What Affect Does Form 4029 Have on Partnerships and Sole Proprietorships?

Credits: Jake Dietz, CPA

Do you want to avoid paying Social Security and Medicare taxes by taking advantage of your form 4029 exemption? If so, entity type and ownership play important roles in avoiding these taxes. Even valid exemptions do not apply in certain situations. This blog addresses how form 4029 affects payroll taxes for sole proprietorships, partnerships, LLCs taxed as one of the previous two options, and corporations. Entity type and ownership play important roles in Social Security and Medicare tax avoidance.

First, here is a little information on Form 4029. It is the “Application for Exemption From Social Security and Medicare Taxes and Waiver of Benefits.” Approved forms allow both the employer and employee to avoid Social Security and Medicare taxes if certain conditions are met.

Sole Proprietorships and Single-Member LLC Disregarded Entities

A sole proprietorship is owned by one person and unincorporated. A single-member LLC (SMLLC) is an LLC owned by one member. It is a disregarded entity for federal tax purposes, unless an election is made to be taxed as a corporation. An SMLLC may therefore have the same federal tax treatment as its owner. Sole proprietorships and SMLLCs not taxed as corporations do not need to pay Social Security and Medicare payroll taxes for each employee with a valid form 4029 if the owner also has a valid form 4029.

For example, suppose Reuben is the sole owner of Silver Maple Furniture & Ice Cream Shop, LLC. The LLC never elected to be taxed as a corporation. The LLC hired Amos and George. Both the owner Reuben and employee Amos have form 4029s, but George does not. In the above scenario, the employer would be exempt from paying the employer portion of Social Security and Medical payroll taxes on Amos, but would have to pay those taxes on George. Amos would be exempt from paying the employee portion of Social Security and Medicare payroll taxes, but George would have to pay those taxes on his wages.

If the owner does not have a valid form 4029, then Social Security and Medicare payroll taxes are paid on all employees. This rule applies even if each employee obtained a valid form 4029.

Let’s take the example above and change the facts slightly. George (no 4029) buys the SMLLC from Reuben, and George employs Reuben (valid form 4029) and Amos (valid form 4029). In this situation, all Social Security and Medicare payroll taxes are due, since the employer does not have a valid form 4029.

Partnerships and LLCs Taxed as Partnerships

Form 4029 applies to a partnership or LLC taxed as a partnership if each member has a valid form 4029. If one member has a valid form 4029 and another member does not, then the exemption does not apply to partnership wages.

Let’s assume that Reuben (valid form 4029) decides to bring Amos (valid form 4029) into Silver Maple Furniture & Ice Cream Shop, LLC as another member. Because all the members have valid form 4029s, then each employee that has a form 4029 would also be exempt. If the LLC wanted to hire Justin (valid form 4029), then no Social Security and Medicare taxes would be due on Justin. Both the employer and George, however, would have to pay Social Security and Medicare taxes on George’s wages because he does not have a valid form 4029.

Alternatively, let’s consider what would have happened if Reuben (valid form 4029) brought George (no 4029) into the LLC instead of Amos (valid form 4029). In that situation, all Social Security and Medicare payroll taxes are due because not all the members are exempt.

Corporations

The form 4029 exemption does not apply to corporations, or to its employees. Social Security and Medicare taxes are due even if the owner and all employees each possess a valid form 4029.

Summary

For a form 4029 to take effect, all owners must have valid form 4029s, and the entity must not be a corporation. Furthermore, the exemption only applies to employees that also have a valid form 4029.

Entity type and ownership can affect Social Security and Medicare taxes, and should therefore be factors in the decision-making process. Also, an employee with a form 4029 may want to ask potential employers before accepting a job if the employer is exempt. Contact your tax accountant if you would like help exploring how form 4029 is affected by entity type and ownership.

 

Preface: Proper planning can maximize the amount of compensation a company can pay in a way that will increase its chances of being able to withstand an IRS challenge.

Taking High Compensation Without Dividend Danger

Owners of a closely held C corporation know that the company’s earnings are theoretically exposed to a double tax. Principally, earnings are first taxed to the corporation and those that are distributed to as dividends are taxed on your individual income tax return, without the company getting a deduction for the payments.

On the other hand, the company can deduct the salary it pays you. While you have to pay tax on the salary, unlike dividends, salary is taxed only once. And while dividend income is taxed at net capital gains rates (at a maximum 20 percent rate if all income exceeds a $470,700 threshold for joint filers, $418,400 for single individuals in 2017), that is an additional 15 or 20 percent that you may not otherwise have to pay with proper compensation planning. What’s more, investment income is also subject to the 3.8 percent Net Investment Income (NII) surtax if an individual’s overall income exceeds a $250,000/$200,000 level.

Does this mean that the double tax can be avoided simply by increasing your salary rather than by paying dividends? No, there are two potential problems with that approach. First, the company can only deduct reasonable compensation. Second, if compensation is set at the high end of the scale and is later found to be unreasonable, the IRS can charge the owner with a constructive dividend on the unreasonable portion of the compensation.

What then can be done? Proper planning can maximize the amount of compensation the company can pay in a way that will increase its chances of being able to withstand an IRS challenge.

The basic test of reasonableness, as applied by the IRS and many courts, is whether the amount paid is analogous to that paid by employers in like businesses to equally qualified employees for similar services. In this respect, the total compensation package is examined including contributions to retirement plans and other employee benefits.

As a result, a showing of special skills may help to justify reasonableness. It also can be helpful if the individual performs different roles for the company (for example, chief executive officer and designer of a new product).

Another possible approach may be to set up a portion of an owner’s compensation to be paid as bonuses if profits meet certain levels. While the IRS has attacked such contingent compensation arrangements in family companies, some courts have upheld them where the agreement was set up when the business was started or when the amount of the future earnings was questionable, and the agreement was consistently followed during the ups and downs of the business.

Few businesses start out with the owners able or willing to pay themselves what they are really worth. Even after the business is successful, periods of economic slowdown, may force belt tightening. It is in these situations that an owner may have an opportunity to enter into a formal contract with the company calling for a share of the profits as added compensation when things improve.

If this is done it’s important to include in the corporate minutes the record showing that the owner was underpaid at the time the agreement was entered into. The minutes also should show that the contingent payment out of future profits is merely intended to provide an incentive for the owner to put forth his best efforts to build the business and to make up for the periods of underpayment.

Attention to such details when planning compensation arrangements should help the owner fend off or blunt future attacks on compensation when the business proves highly successful and substantial compensation is paid under the agreement.

Feel free to contact us if we can help you with the complex task of developing a proper compensation package for tax purposes.