Author: dsauder

Preface: Charitable contributions require you need to be very careful and rely on professional help, to keep in compliance the IRS when giving more than say 25 dollars. The IRS is becoming increasingly aware of questionable practices and is cracking down on taxpayers who use them. If a charitable giving scheme sounds too good to be true, it probably is! 

Charitable Giving – Permissible Tax Benefits for Charitable Giving

You probably know that you can get an income tax deduction for a gift to a charity if you itemize your deductions. But there is a lot more to charitable giving. For example, you may be able to indirectly benefit a family member and a charity at the same time and still get a tax break. Or you may be able give appreciated property to a charity without being taxed on the appreciation. These benefits can be achieved, though, only if you meet various requirements including substantiation requirements, percentage limitations and other restrictions. We would like to take the opportunity to introduce you to some of these requirements and tax saving techniques.

 

First, let’s take a look at the basics: Your charitable contributions can help minimize your tax bill only if you itemize your deductions. Once you do, the amount of your savings varies depending on your tax bracket and will be greater for contributions that are also deductible for state and local income tax purposes. To get a current deduction, the charitable gift must be to a qualified organization and must not exceed certain percentage limitations.

 

You also need to substantiate your donations. Generally, a bank record or written communication from the charity indicating its name, the date of the contribution and the amount of the contribution is adequate. If these records are not kept for each donation made, no deduction is allowed. Remember, these rules apply no matter how small the donation. However, there are stricter requirements for donations of $250 or more and for donations of cars, trucks, boats, and aircraft. Additionally, appraisals are required for large gifts of property other than cash. Finally, donations of clothing and household gifts must be in good used condition or better to be deductible.

 

The amount of otherwise allowable itemized deductions is reduced for higher income taxpayers whose adjusted gross income exceeds certain threshold amounts. For 2017, the threshold amounts are $313,800 in the case of married taxpayers filing a joint return or a surviving spouse, $287,650 in the case of a head of household taxpayer, $261,500 in the case of an unmarried individual, and $156,900 in the case of married taxpayers filing separate returns. A taxpayer with AGI over the threshold amount must reduce their otherwise allowable itemized deductions by the lesser of: three percent of the amount of the taxpayer’s AGI in excess of the applicable threshold amount, as adjusted for inflation, or 80 percent of the itemized deductions otherwise allowable for the tax year.

 

Now a word about special gift-giving techniques: There are some strategies that can help minimize your tax liability. Making a gift to another individual outside of the umbrella of a charitable organization is one. For example, you can give up to $14,000 in 2017 tax-free to another individual or $28,000 for married couples making joint gifts. If larger gifts are made, use of a lifetime gift and estate tax exclusion, set at $5.49 million for 2017, might be considered. However, you need to be very careful and rely on professional help. There are a lot of scams and schemes that really push the envelope. The IRS is aware of these abusive practices and is cracking down on taxpayers who use them. If a scheme sounds too good to be true, it probably is!

 

There are other special charitable giving techniques beyond the usual gifts of cash. These include, among others, a bargain sale to a charity, a gift of a remainder interest in your residence and a transfer to a charity in exchange for an annuity.  

Please do not hesitate to contact us if you have any questions regarding the planning of charitable gift of money or property.

Preface: Tax groupings of business activities can solidify tax positions in certain instances. What is a grouping, and when may it may be applicable?

To Group or not to Group

Credits: Jacob Dietz, CPA — jdietz@saudercpa.com

Lancaster, PA

The IRS considers a business activity to be passive if the taxpayer does not “materially participate.” The full complexities and the details of passive activities are beyond the scope of this blog, but generally the IRS will not allow the deduction of passive losses unless there is offsetting passive income of an equal or greater amount, or the activity is entirely disposed.

There are exceptions, however. For an example of how the passive activity rules could work, let’s imagine John owns two businesses. Business A is a restaurant, and John works full-time in the restaurant. Business B is a bakery across the street from the restaurant, and the bakery provides the restaurant with food. John hired an able manager for the baker, so he hardly does any work in that business.

If the bakery and the restaurant are treated as separate activities, then John would be active in the restaurant but may be passive in the bakery. If the restaurant made money and the bakery lost money, then John might not be able to deduct the bakery’s loss until future years if he had no other passive income.

The IRS, however, does allow grouping of activities that form an “appropriate economic unit.” If the bakery and the restaurant had been grouped, then John’s work in the restaurant would count as material participation for the entire activity, thereby making the bakery’s loss nonpassive.

What constitutes an “appropriate economic unit?” There is some discretion in making this determination, but below are some factors from IRS Reg. 1.469-4 detailing some of the considerations.

“(i) Similarities and differences in types of trades or businesses;

(ii) The extent of common control;

(iii) The extent of common ownership;

(iv) Geographical location; and

(v) Interdependencies between or among the activities (for example, the extent to which the activities purchase or sell goods between or among themselves, involve products or services that are normally provided together, have the same customers, have the same employees, or are accounted for with a single set of books and records).”

These groupings are then permanent per the IRS regulations unless “a taxpayer’s original grouping was clearly inappropriate or a material change in the facts and circumstances has occurred that makes the original grouping clearly inappropriate.” If you are starting a new business, and you already have a business, then consult with your accountant regarding whether the businesses should be grouped. If you fail to group them now, and later try to group them, the IRS might disallow that grouping. There is an exception to the regrouping rule which allows taxpayers to regroup the first time the taxpayer is subject to the net investment income tax.

In Rev. Proc. 2010-13, the IRS lists disclosure requirements regarding tax groupings. If the original grouping was made before 1/25/2010, then no disclosure is required until a change is made. New groupings or regroupings after that date must be disclosed. If there is no disclosure, the IRS can generally treat them as separate activities. What if it is discovered that a grouping has not been disclosed? If the taxpayer discloses the grouping in the first year the omission is discovered, and all previous returns were consistent with that grouping, then the IRS considers it a timely disclosure.

If the IRS discovers the omission of the disclosure, then the taxpayer must have “reasonable cause” for omitting the disclosure. Contact our office if you think you may have some undisclosed groupings on your tax return which should be disclosed.

Even when the disclosure has already been made, the taxpayer may want to continue to disclose that grouping in each tax return. If done correctly, this may help inform the taxpayer and IRS and future accountants that there is a grouping in effect.

This blog is not tax advice. If you would like help walking through your options, please contact our office.

 

 

Preface:  Courts are finding that minority partners, are in an employment relationship for purposes of Unemployment Compensation tax assessments. Therefore, if a business has minority partners who receive K-1 income statements, they may be in danger of audits, citations, and penalties.

Is Your Partnership Legal?

Converting a General Partnership to a Limited Liability Company (LLC)

Credits: Tyler W. Hochstetler, Esq

For many years, Anabaptist business owners have often chosen the General Partnership as their business model of choice. The primary incentive for choosing the General Partnership is avoiding employee payroll, and thereby avoiding regulations, taxes, and workman’s compensation premiums.

After enjoying many years of relatively few legal challenges, some partnerships are now facing withering attacks. Pennsylvania regulatory agencies have charged Anabaptist partnerships with stretching the definition of “partnership” too far, and have imposed staggering penalties on these businesses.

In an effort to be wise stewards of business resources, many business owners have operated with 1% partners or minority partners instead of employees. These minority partners have typically been young men, sometimes minors, who exercise very little discretion and control over the activities of the business. They are often added to the partnership at a low capital investment amount, such as $100. They are often paid based on an hourly wage, and are rarely given a significant profit-sharing check.

These minority partners tend to view their work much like employment, and there is often a revolving door of turnover in these businesses. As minority partners exit, they are often repaid at the same or similar rates as when they “bought into” the partnership, rather than receiving a share of the fair market value of the company.

In many cases, one or two majority partners own the majority of the business, and the remaining partners have low ownership interests and low capital investments in the company. The majority partners often make partnership decisions without input from the minority partners, and they often set the compensation rates for everyone, including themselves. In some cases, these partnerships do not hold regular partnership meetings with all partners, they do not allow equal voting rights among partners, and they do not maintain adequate documentation of partnership activities.

As a result of these practices and government budget deficits, certain regulatory authorities have begun to challenge the validity of these partnerships. The Pennsylvania Department of Labor & Industry and Pennsylvania OSHA offices are examples of agencies which have begun to enforce a more liberal interpretation of what constitutes “employment.” These authorities have evaluated the relationship between majority and minority partners, and have often determined that the relationship is more like an employment relationship than a legitimate partnership. Fines and penalties are assessed accordingly.

Frustratingly, these authorities rarely give concrete guidance as to the definition of who is a legitimate “partner.” These authorities determine who is an “employee” based on vague standards such as a “totality of the circumstances.” They enjoy nearly unfettered discretion in determining who should be classified as an employee.

In an Unemployment Compensation audit, the agency will often audit a partnership for multiple years of business activities. These audits are stressful and expensive. Auditors sometimes paint with a broad brush in ruling that one or two partners are the “employers” and everyone else is an “employee.” They then assess unemployment taxes for several years at once, and add on penalties and interest payments. Subcontractors can also become entangled in the web of the auditor’s review, adding another layer of complexity. The burden of proof then tends to shift onto the partnership to prove that the auditor erred in classifying everyone as employees.

In an OSHA examination, roofing partnerships are especially vulnerable. Often a competing contractor or concerned citizen complains to OSHA when young men are roofing without harnesses and safety equipment. OSHA seizes the opportunity to interview young, minority partners. When those partners do not answer questions to their satisfaction, OSHA can levy punitive penalties on the partnership. Many minority partners are not prepared to answer questions regarding their ownership interests or the partnership structure.

Several partnerships have challenged the assessments by Unemployment Compensation and OSHA. Several recent Anabaptist cases which were appealed in Pennsylvania courts (by other attorneys) have failed. Courts are finding that minority partners, as described above, are in an employment relationship for purposes of Unemployment Compensation tax assessments. The Pennsylvania legislature has also contributed to this discussion with the 2011 passage of the Construction Workplace Misclassification Act (Act 72). This law addresses the misclassification of independent contractors, but it appears to have emboldened regulators in evaluating partnerships.

It is important to note that both General Partnerships and LLC’s taxed as partnerships are affected by these changing interpretations to partnership law. Consequently, if a business has minority partners who receive K-1 income statements, they may be in danger of audits, citations, and penalties. As one solution, some General Partnerships and LLC partnerships have elected to place all of their minority partners on payroll to protect themselves from audits and assessments.

When making this conversion, partnerships may begin looking for an alternative business structure. The LLC is a recommended option because of its protection from legal liability, its pass-through tax status, and the low amount of legal paperwork required. There are several steps involved in converting a General Partnership to an LLC.

In Pennsylvania, converting a General Partnership to an LLC requires filing a Statement of Conversion (Form DSCB: 15-355) with the Pennsylvania Department of State. A Docketing Statement must also accompany this form. A registered address will be required, which should match any existing registered address that the partnership may have filed with the state in order to conduct business under a fictitious name.

Further, when converting from a General Partnership to an LLC, a corporate designator is required. This means that your business name must include the letters “LLC” or a similar designator in the name.

After you have filed the appropriate forms with the state, and they are approved and returned to you, your entity should consider several other steps to effectuate the conversion. Depending on the circumstances, the business may also want to consider updating its vehicle titling, transportation licenses, sales tax registrations, real property deeds, bank accounts, and other paperwork which remains in the old partnership name.

Every LLC should generally have an LLC Operating Agreement. You should consult with legal counsel in drafting an LLC Operating Agreement for the converted partnership. This Operating Agreement will contain information such as who will manage the LLC, who owns the LLC, and how the LLC will continue or cease if one member passes away or withdraws.

The LLC should also consult with a competent accountant throughout the conversion process to ensure that the appropriate tax paperwork and payroll information is established and filed in a timely manner. Workman’s compensation coverage should be purchased in most cases, although some states (including Pennsylvania) have religious exemptions for certain employees. Unemployment compensation registration should be completed with the state as well.

Partnerships should also recognize that employee tax withholdings will increase the tax burden of the business. Compensation adjustments should be considered in order to reconcile the cost increase. Once employees understand that the employer is now paying a portion of their tax burden, and withholding and remitting the remainder of their tax burden, they will often be appreciative.

One of the biggest liabilities for a partnership is an unhappy minority partner that files a workman’s compensation claim or unemployment compensation claim. Having employees on payroll can result in happier employees, more peace of mind, and a better testimony of compliance and living in peace with our authorities. May God grant you wisdom in discerning the best course of action for your business in this changing legal climate.

 

Tyler W. Hochstetler, Esq. is an Anabaptist attorney who is licensed in Pennsylvania and Virginia. He serves as in-house counsel for Anabaptist Financial, and also has a private law practice, representing Amish and Mennonite clients.

 

 

Partner or Employee – Taxes in Pennsylvania On Employees

Preface: Abner owns 1%, has an LLC capital account of $100, and works 50 hours per week at a $9.95 per hour rate. Is Abner a partner or employee? Abner owns 1%, has an LLC capital account of $100, and works 50 hours per week at a $19.75 per hour rate + OT. Is Abner a partner or employee?

Credits: Jake Dietz, CPA

Have you ever wondered if your LLC should hire employees that receive W-2s, or instead use 1% members that receive K-1s and are treated as self-employed? In the past, Pennsylvania allowed LLC’s taxed as partnerships and general partnerships to avoid Unemployment Compensation (UC) taxes by treating workers as 1% or 2% partners instead of employers. PA has begun to crack down on this practice. PA will now treat most 1% partners or LLC members as employees if they receive compensation for services. Furthermore, PA can go back to previous years and reclassify the minority owners as employees.

On page 2 of “Controlling UC Costs for Contributory Employers”, REV 04-16, Pennsylvania states that

“The UC Law presumes that services performed for remuneration constitute “employment,” and that the individual performing the services is an “employee.” Accordingly, a member of an LLC performing services for the LLC is presumed to be an employee of the LLC. However, employee status will not apply if the independent contractor test in section 4(l)(2)(B) of the UC Law is satisfied. Under section 4(l)(2)(B), a member is an independent contractor if, with respect to work performed for the LLC, he or she is (a) free from direction and control and (b) customarily engaged in an independently established trade, occupation, profession or business.”

Pennsylvania law assumes that someone getting paid to work for an LLC is an employee, unless the independent contractor test can be successfully applied. There is not a set ownership percentage amount at which you are automatically a self-employed independent contractor, and below which you are automatically employed. Pennsylvania can exercise their judgment. Some factors PA may consider include capitalization and voting rights. If the LLC has equal ownership percentages, capital percentages and voting rights (such as 4 members with a 25% share) then they likely can avoid UC tax. Do all the members have voting rights, or does one member with the highest percentage make all the decisions? If minority members have no voting rights, it may be hard to argue that they are “free from direction and control.” Does one member have most of the capital?  For example, if the total capital accounts are $10,000, and four 20% members have capital accounts with only $100 each, and a fifth 20% member has a capital account of $9,600, then that could be a problem. If one member is making all the decisions and has most of the capital, then PA may say that the other workers are employees subject to direction and control whose compensation is subject to UC tax.

What should be done if you are the majority owner of an LLC with minority members that would likely be reclassified as employees if audited by PA? If it is just a few minority members, you could consider inviting them to purchase a greater interest in the LLC and to take part in management. Before making that decision, however, consider if you are willing to share management responsibilities with them. Also, are the minority members willing to take the financial risks of greater ownership, and are they willing to invest the capital? The ramifications for this decision extend beyond UC taxes.

Another option would be to switch the minority members over to employees. In that case, all employment taxes apply, unless there are exemptions for them. FICA employment taxes can be avoided with proper exemptions, but if the exemptions are not in place they must be paid. Other taxes cannot be avoided, including UC tax.

If the decision is made to switch from self-employed minority members to W-2 employees, then careful thought should go into structuring the compensation. For example, let’s look at hypothetical ABC, LLC, and its minority member, Abner. Abner owns 1%, has an LLC capital account of $100, and works 50 hours per week at a $20 per hour rate. Nobody in the LLC has filed Form 4029 to be exempt from self-employment or FICA taxes. Abner is not paid overtime. He pays, on his personal tax return, 15.3% of his earnings as self-employment tax. Abner therefore would get $1,000 per week for 50 hours at $20/hour. He needs to pay, when he files his taxes, $153 as self-employment tax. If the LLC switches Abner to an employee and continues pay him $20 an hour, then Abner would get $1,100 per week (40 hours at $20/hour and 10 overtime hours at $30/hour.) Furthermore, he would only need to pay his portion of FICA taxes, which would be 7.65%, or about $84. He would also have a small portion of Unemployment Compensation to pay, but most of that tax will be paid by the LLC. That sounds fantastic for Abner! The LLC, however, may not be as happy about the arrangement. Not only is the LLC now paying Abner $100 more than before, but the LLC is also paying half the FICA taxes, which comes to approximately $84, plus Unemployment Compensation, and possibly additional payroll tax or insurance. There are other factors to consider as well, including the increased administrative burden, the tax benefits of deducting payroll taxes for income tax purposes, and the possibility of now qualifying for the Domestic Production Activities Deduction, which requires W-2 wages.

Another option might be to continue treating Abner as a partner for income tax purposes, but to begin paying UC taxes on him as if he were an employee. There could still be some risk to this option, however.

This blog is not tax or employment law advice. It is solely for awareness on applicable employment and tax statutes with regards to entrepreneurship. If you would like help walking through your options, please contact our office.

Preface: Proper estate planning can save tax dollars. Here’s a rule applicable for family farms.

Special Use Valuation for Farmers

A special rule (special use valuation) applicable to farmers may allow the next generation of a family to continue to operate a farm rather than sell it to meet estate tax obligations. Because fair market value considers the property’s value at its highest and best use, estate tax that is based on fair market value could make it prohibitive to continue to operate the farm as a family enterprise. For example, a farm may be worth $1 million to a developer to construct townhouses and a shopping mall, but only $400,000 to the farmer who wishes to continue operating it as a farm.

Under special use valuation, an executor may elect to value real property used in farming at a value based on its use as a farm, rather than at its fair market value. The election is irrevocable, and the reduction in value is limited to a ceiling amount depending on your year of death: $1.1 million for 2015; $1.11 million for 2016; and $1.12 million for 2017.

To elect special use valuation, the property must be put to a qualified use. That is, it must be used as a farm for farming purposes. Qualified woodlands may also qualify for special use valuation. It must also pass to qualified heirs. These include the decedent’s ancestor, spouse, lineal descendants of the decedent, his spouse or his parent, or the spouse of any lineal descendant. All property, including personal property, used in the farm must comprise 50 percent of the adjusted value of the gross estate and the real property used in the farm must comprise 25 percent of the adjusted value of the gross estate.

In addition, material participation in the operation of the farm for a total of at least five years in the eight years immediately preceding the decedent’s death, disability or retirement is required. If the qualified heir ceases to use the farm property or sells the property within ten years of the decedent’s death, an additional recapture tax is due.

If you would like to discuss how special use valuation might affect your estate planning, please contact your estate specialist.

 

Preface: Automobile mileage in business is a tax deduction. What are the options and how can you apply this tax deduction?

 

Respectful Calculations For Expenses On Business Mileage  

Businesses generally can deduct the entire cost of operating a vehicle for business purposes. Alternatively, they can use the business standard mileage rate, subject to some exceptions. The deduction is calculated by multiplying the standard mileage rate by the number of business miles traveled. Self-employed individuals also may use the standard rate, as can employees whose employers do not reimburse, or only partially reimburse, them for business miles driven.

 

Many taxpayers use the business standard mileage rate in particular to help simplify their recordkeeping. Using the business standard mileage rate takes the place of deducting almost all of the costs of your vehicle. The business standard mileage rate takes into account costs such as maintenance and repairs, gas and oil, depreciation, insurance, and license and registration fees.

 

Beginning on Jan. 1, 2017, the standard mileage rates for the use of a car (also vans, pickups or panel like trucks) is:

• 53.5 cents per mile for business miles driven, down from 54 cents for 2016
• 17 cents per mile driven for medical or moving purposes, down from 19 cents for 2016
• 14 cents per mile driven in service of charitable organizations

 

The business mileage rate decreased half a cent per mile and the medical and moving expense rates each dropped 2 cents per mile from 2016. The charitable rate is set by statute and remains unchanged.

 

The standard mileage rate for business is based on an annual study of the fixed and variable costs of operating an automobile. The rate for medical and moving purposes is based on the variable costs.

 

Taxpayers always have the option of calculating the actual costs of using their vehicle rather than using the standard mileage rates. If instead of using the standard mileage rate you choose to use the actual expense method to calculate your vehicle deduction for business miles driven, you must maintain very careful records. You must keep track of the actual costs during the year to calculate your deductible vehicle expenses. One of the most important tools is a mileage log book. Fleets must use actual expense methods.

 

Our office can help you compare the benefits of using the business standard mileage rate or the actual expense method

Preface: A tax accountants has multiple roles for clients, 1. Provide tax compliant filings for the business, and 2, minimize the tax liability for the shareholders or partners. 3. Educate on what a tax compliant filing is, and how minimize the tax liabilities. This blog is untongue tied tax pertinent information for manufacturing businesses thinking about ways to reduce tax liabilities and maintain compliant tax filings.

 

Tax Attributes Specifically Relevant To Manufacturing Businesses

 

An important tax benefit for manufacturers is the domestic production activities deduction (DPAD), also known as the manufacturing deduction. The deduction is equal to nine percent of the lesser of the taxable income or qualified production activities income (QPAI). The deduction is available if a business has income from the rental, sale or other disposition of tangible personal property, buildings (but not land), computer software, and other products. The products must have been manufactured, produced, grown or extracted primarily in the United States. The deduction is also available for income from certain services, such as engineering and architecture. The deduction is reported on Form 8903, Domestic Production Activities Deduction. The DPAD tax benefit is deduction from business income, for tax but not book. It reduces income on the taxed income only, yet requires no cash payments. The sole purpose of this tax benefit is encourage manufacturing enterprises and economic vibrancy. DPAD has numerous applications for beyond typical manufacturing revenue, and production activity revenue is key to the deduction amount.

Depreciation – the write-off of the cost of an asset – is an essential element of tax accounting for a business. Property is depreciable if it is used for business, has a useful life exceeding one year, and may wear out or lose value from natural causes. Property that appreciates in value can still be depreciated if they are subject to wear and tear. Depending on how much income is generated by the business, the general goal in taking depreciation is to be able to write off property over the shortest period available, based on the property’s useful life. Most property is depreciated under MACRS, the Modified Accelerated Cost Recovery System. However, rather than claiming depreciation deductions, intangible property is amortized under Code Sec. 197. Taxpayers can also use cost segregation studies to reduce the period over which specified assets must be depreciated.

Special tax provisions provide accelerated write-offs of assets. These include bonus depreciation and the Code Sec. 179 expensing election. Depending on the current state of the law, companies claiming first year bonus depreciation may be able to write off 50 percent or more of an asset’s cost, in addition to the deduction allowed under MACRS depreciation. The expensing election allows a company to write off the entire cost of an asset up to the limit in the tax code. For 2016, the limit is a total of $500,000, e.g. manufacturing businesses looking to automate floor production, the investment in substantial equipment can likely be realized in immediate tax savings.

To accelerate deductions and avoid having to depreciate asset costs over a period of years, companies may treat certain costs of maintaining its assets as repairs or maintenance, generally deductible in full in the year paid. In late 2013, the IRS issued so-called “repair regulations” that explain when taxpayers must capitalize costs and when they can deduct expenses for acquiring, maintaining, repairing and replacing tangible property. The regulations have many provisions that enable taxpayers to deduct their costs more easily and that reduce the need to maintain depreciation schedules. These provisions include the de minimis expensing rules of say up to $2,500 purchases, the write-off of expenses for materials and supplies, the deduction of recurring maintenance costs, and the replacement of building systems.

Taxpayers that produce merchandise and goods for sale are required to account for raw materials, supplies, work-in-progress and finished goods that comprise the items being manufactured. Taxpayers required to use inventories generally must use the accrual method of accounting. Accounting for inventories must reflect the best accounting practices of the taxpayer’s trade or business and must clearly reflect income. Permissible inventory accounting methods include FIFO (the first-in, first-out method); LIFE (last-in, first out) and average cost. Some taxpayers may also use the lower of cost or market (LCM) method.

Companies may claim the research tax credit for increased research expenditures in business-related activities. The credit generally is equal to 20 percent of the increase in qualified research expenses over a base amount, although there is an alternative simplified credit (ASC). The credit is not available for research activities conducted after the beginning of commercial production of a business component. Yet, if your company is developing a more powerful mic for gathering sound with waterfall noise level environments, the research credit would be applicable.

Summary: while the tax code optimizations highlighted are pertinent to minimizing taxes for manufacturing business, the content of this blog is only to provide an awareness of tax management strategies in say the manufacturing industry. Before making any tax decisions, talk with your trusted tax accountant.

Preface: Employee or subcontractor classification is often an ambiguous area of the tax code. In this blog, relationship factors relevant to the tax classifications are considered, e.g. should Eli be an employee or a subcontractor?

Credits: Jake Dietz

Help Wanted: Tax Considerations When Adding Workers

Has your business grown so much that you are ready to bring in more help? If so, consider if you should hire employees or get independent contractors to assist you. The IRS cares about how you classify workers. They do not want you to merely classify a worker as an independent contractor to save on taxes without first determining if the worker is truly an independent contractor.

Determining the classification of your new worker may take some thought, but the IRS provides some guidance and factors which should be considered. For some workers, certain factors might point towards the employee classification, while other factors point towards the independent contractor classification. Although it can be unclear at times, employers should make a good faith effort at classifying correctly.

There are three factors that the IRS considers. These factors are behavior control, financial control, and type of relationship. We will drill down on each of these three categories.

Behavior Control

For the behavior consideration, the IRS looks at whether or not the employer may control what work is done and how it is done by the worker. The IRS asserts that a worker is an employee if the company has the right to tell the worker how to do the work, regardless of whether or not the company actually does tell the worker how to work.

Let’s look at an example. If you own a farm and hired a new employee, you can tell him exactly how to do the work. You may tell him to bale hay using a specific tractor with a certain baler, even in a certain gear. You may give detailed instructions on what to do, how to do it, and when to do it. Even if the new employee is experienced and you do not need to give as many instructions, you still have the right to give the instructions.

On the other hand, if a custom operator comes to your farm to bale hay, you may not have the right to give as many instructions to him. The custom operator may choose which tractor, which baler etc. to use. If the custom operator runs out of twine, then the custom operator, not the farm owner, gets to decide where to buy twine and how much to buy.

If your company is providing training to the worker, that indicates an employee. You don’t need to train the custom operator how to bale hay. If the custom operator needs training, it is the operator’s responsibility to get it.

Financial Control

The IRS also looks at financial control. How much investment does the worker need to do the job? If the worker needed a significant investment in tools, software, etc., then that is evidence pointing towards an independent contractor. Our hay baling employee had no investment in the equipment, but our custom baler operator had to purchase a tractor and baler and supplies. Certain jobs, however, may require investments of workers who are employees. Construction worker and mechanic are two such jobs.

Does the worker regularly incur expenses that you don’t reimburse? Is it possible that the worker will lose money on the job? Is the worker paid by the job instead of by the hour? If these questions can be answered “Yes” it points toward a contractor. If our custom operator has too many breakdowns, it could lead to a loss for the year. If the employee has breakdowns, they still receive the same hourly rate as if there were no breakdowns.

Type of Relationship

Does the relationship look like a long-term relationship between an employer and employee? If so, that points to an employee classification. If the relationship is a based on a contract to do a certain job, then that points to a contractor. Just because a contract is signed, however, does not guarantee that the worker is an independent contractor.

Another factor is if the work provided is a product or service of the business. For example, an accountant doing work for an accounting firm is likely an employee of that firm.

Unfortunately, there is no bright line rule for determining if someone is an employee or independent contractor, but fortunately the IRS does give guidance. For additional guidance, please contact our office.

 

 

Preface: Retirement planning or tax savings? Self-employed business owners can save on tax dollars, or more appropriately, defer the tax expense with the right plan.

Keogh or SEP for the Self-Employed Person?

If you’re self-employed and contemplating setting up an easy-to-administer retirement plan, you have a few options available. You can set up a Simplified Employee Pension plan (known as a SEP), or one of two different types of Keogh plans, either a profit-sharing plan or a money-purchase plan. Which is best for you depends upon your particular circumstances. To help get you started, we’re highlighting some of the differences among the different types of plans.

What’s the easiest plan to set up? There’s no question that the SEP wins hands down. A SEP can be set up easily at a bank or brokerage house, with separate accounts for each participant. A simple IRS form can be used to establish a model SEP. Setting up and administering a Keogh plan is a little more complicated, and in most cases returns have to be filed periodically.

How much can you contribute and deduct? If you’re looking to make the biggest deductible contributions possible, the money purchase Keogh has the edge. You can contribute as much as 100% of your earnings, up to a maximum of $53,000 for 2016 and 2015, as adjusted for inflation. With a profit-sharing Keogh or SEP, the percentage is lower. In either event, contributions can’t be based on annual earnings over $265,000 for 2016 and 2015 ($260,000 for 2014), as adjusted for inflation. The down side of the money-purchase plan is that you must make set contributions every year. With the profit-sharing Keogh or the SEP you can vary contributions from one year to the next, depending upon how the business is doing.

Do you have to cover employees? With any plan, you generally must if they are age 21 or older. However, with a Keogh plan, you don’t have to cover employees who haven’t completed at least one year of service (two years in some cases). Because of the way a year of service is defined, many part-timers don’t have to be covered at all. With a SEP the rules are a little different: You only have to cover employees who have worked for you during three of the past five years. But once that condition is met, even most part-timers have to be covered.

When do benefits vest? A Keogh plan can be set up so that employees aren’t entitled to their accrued benefits unless they have been plan members for a certain number of years (sometimes three, sometimes five). Or they can become entitled to their benefits gradually over a seven-year period. If the employee quits or is fired, he or she is only entitled to “vested” benefits. No such waiting period is allowed for SEP participants.

Profit-sharing Keoghs can have cash or deferred arrangements allowing employee pre-tax contributions, which can help keep employer costs down. The rules are slightly different for each type of plan.

If you find you haven’t made a decision by year-end there is a feature of a SEP that is useful. It can be set up and funded by the tax return due date. Contributions can be made after year-end to a Keogh plan only if the plan was actually set up by the end of the previous tax year.

After you’ve considered these points, you might want to consult with a CPA about some of the finer points; we would be happy to help you plan that decision, and the retirement expense that will work best for you.

Preface: Construction accounting – unbeknownst to many in the industry,  contains special accounting rules for long-term contracts. Businesses with annual construction contracts in excess of $10m are required to apply long-term contract accounting. What is it, and what should you know?

 

Accounting for Long-Term Contracts

Long-term contracts for tax law recognition-of-income purposes are contracts for manufacturing, building, installing or constructing property that are not completed in tax year in which they are entered into.  A contract is considered to be for building, installation or construction of property if it provides for the erection of a structure, such as a building, oil well or other improvement, bridge, railroad or highway, or large industrial machine.

 

Taxable income from long-term contracts generally must be determined using the percentage of completion method.   Under the percentage-of-completion method, gross income is reported annually according to the percentage of the contract completed in that year. The completion percentage must be determined by comparing costs allocated and incurred before the end of the tax year with the estimated total contract costs (cost-to-cost method or simplified cost-to-cost method).  A taxpayer who has entered into a small construction contract or home construction contract, however, may use an exempt contract method of accounting.

 

Direct-benefit services. Income and expenses attributable to engineering or architectural services are accounted for as part of the long-term contract if they enable the taxpayer to construct or manufacture the qualifying subject matter of the long-term contract.  Other income and expense items, such as investment income, expenses not attributable to such contracts, and costs incurred with respect to any guarantee, warranty, maintenance or other service agreement relating to the subject matter of such contracts, including engineering activity performed after the delivery and acceptance of the subject matter of the contract, must be accounted under the taxpayer’s normal accounting method.

 

Construction management contracts. One type of construction contract that primarily involves the performance of services is a construction management contract. In a typical construction management contract, the construction manager coordinates the construction project for the owner. The construction management firm does not have a contractual relationship with the contractors or subcontractors and is not at risk for defects in the materials or for mistakes in the construction. The construction management firm will oversee and coordinate the construction activity, may provide engineering and design services, may negotiate with contractors, subcontractors or suppliers on the owner’s behalf, and may perform some construction services.

 

The IRS has inferred in a number of private rulings that a taxpayer may be able to carve out a portion of the income from a construction management contract and report such portion using the percentage of completion method in limited circumstances. The taxpayer would need to show that the separate construction activities qualify as long-term contract activities, that a reasonable amount of revenue has been allocated to the construction portion of the contract as opposed to the construction management portion, and that the proper costing techniques have been utilized in determining the annual percentage of completion for the construction portion of the contract.

 

Real property construction contracts. The requirement that income be computed using the percentage of completion method or the percentage of completion-capitalized cost method and the requirements concerning the allocation of costs to long-term contracts do not apply to construction contracts entered into by a taxpayer:

1. who estimates, at the time the contract is entered into, that the contract will be completed within the two-year period beginning on the contract commencement date, and

2. whose average annual gross receipts for the three tax years preceding the tax year the contract is entered into do not exceed $10 million.

 

However, the rules for allocation of production period interest to long-term contracts apply to the long-term construction contracts. A construction contract for this purpose is any contract for the building, construction, reconstruction, or rehabilitation of, or the installation of any integral component to, or improvements of, real property.

 

Home construction contracts. Proposed IRS regulations provide that a contract for the construction of common improvements is considered a contract for the construction of improvements to real property directly related to and located on the site of the dwelling units, even if the contract is not for dwelling unit construction.  For example, a land developer that sells individual lots (and its contractors and subcontractors) might have long-term construction contracts that qualify for the home construction contract exemption.  These regulations also permit an individual condominium unit to be considered a “townhouse” or “rowhouse” under the exemption, so that each condominium unit can be treated as a separate building in determining whether the underlying contract qualifies.

 

If you have any questions about the tax rules related to long-term construction contracts or their application to your business, please  contact this office.