Tax-wise ways to take cash from your corporation while avoiding dividend treatment

If you want to withdraw cash from your closely held corporation at a low tax cost, the easiest way is to distribute cash as a dividend. However, a dividend distribution isn’t tax efficient since it’s taxable to you to the extent of your corporation’s “earnings and profits,” but it’s not deductible by the corporation.

5 different approaches

Thankfully, there are some alternative methods that may allow you to withdraw cash from a corporation while avoiding dividend treatment. Here are five possible options:

1. Salary. Reasonable compensation that you, or family members, receive for services rendered to the corporation is deductible by the business. However, it’s also taxable to the recipient(s). The same rule applies to any compensation (in the form of rent) that you receive from the corporation for the use of property. In either case, the amount of compensation must be reasonable in relation to the services rendered or the value of the property provided. If it’s excessive, the excess will be nondeductible and treated as a corporate distribution.

2. Fringe benefits. Consider obtaining the equivalent of a cash withdrawal in fringe benefits that are deductible by the corporation and not taxable to you. Examples are life insurance, certain medical benefits, disability insurance and dependent care. Most of these benefits are tax-free only if provided on a nondiscriminatory basis to other employees of the corporation. You can also establish a salary reduction plan that allows you (and other employees) to take a portion of your compensation as nontaxable benefits, rather than as taxable compensation.

3. Capital repayments. To the extent that you’ve capitalized the corporation with debt, including amounts that you’ve advanced to the business, the corporation can repay the debt without the repayment being treated as a dividend. Additionally, interest paid on the debt can be deducted by the corporation. This assumes that the debt has been properly documented with terms that characterize debt and that the corporation doesn’t have an excessively high debt-to-equity ratio. If not, the “debt” repayment may be taxed as a dividend. If you make cash contributions to the corporation in the future, consider structuring them as debt to facilitate later withdrawals on a tax-advantaged basis.

4. Loans. You may withdraw cash from the corporation tax-free by borrowing money from it. However, to avoid having the loan characterized as a corporate distribution, it should be properly documented in a loan agreement or a note and be made on terms that are comparable to those on which an unrelated third party would lend money to you. This should include a provision for interest and principal. All interest and principal payments should be made when required under the loan terms. Also, consider the effect of the corporation’s receipt of interest income.

5. Property sales. You can withdraw cash from the corporation by selling property to it. However, certain sales should be avoided. For example, you shouldn’t sell property to a more than 50% owned corporation at a loss, since the loss will be disallowed. And you shouldn’t sell depreciable property to a more than 50% owned corporation at a gain, since the gain will be treated as ordinary income, rather than capital gain. A sale should be on terms that are comparable to those on which an unrelated third party would purchase the property. You may need to obtain an independent appraisal to establish the property’s value.

Minimize taxes

If you’re interested in discussing any of these ideas, contact us. We can help you get the maximum out of your corporation at the minimum tax cost.

Taking your spouse on a business trip? Can you write off the costs?

A recent report shows that post-pandemic global business travel is going strong. The market reached $665.3 billion in 2022 and is estimated to hit $928.4 billion by 2030, according to a report from Research and Markets. If you own your own company and travel for business, you may wonder whether you can deduct the costs of having your spouse accompany you on trips.

Is your spouse an employee?

The rules for deducting a spouse’s travel costs are very restrictive. First of all, to qualify for the deduction, your spouse must be your employee. This means you can’t deduct the travel costs of a spouse, even if his or her presence has a bona fide business purpose, unless the spouse is an employee of your business. This requirement prevents tax deductibility in most cases.

If your spouse is your employee, you can deduct his or her travel costs if his or her presence on the trip serves a bona fide business purpose. Merely having your spouse perform some incidental business service, such as typing up notes from a meeting, isn’t enough to establish a business purpose. In general, it isn’t enough for his or her presence to be “helpful” to your business pursuits — it must be necessary.

In most cases, a spouse’s participation in social functions, for example as a host or hostess, isn’t enough to establish a business purpose. That is, if his or her purpose is to establish general goodwill for customers or associates, this is usually insufficient. Further, if there’s a vacation element to the trip (for example, if your spouse spends time sightseeing), it will be more difficult to establish a business purpose for his or her presence on the trip. On the other hand, a bona fide business purpose exists if your spouse’s presence is necessary to care for a serious medical condition that you have.

If your spouse’s travel satisfies these requirements, the normal deductions for business travel away from home can be claimed. These include the costs of transportation, meals, lodging, and incidental costs such as dry cleaning, phone calls, etc.

What if your spouse isn’t an employee?

Even if your spouse’s travel doesn’t satisfy the requirements, however, you may still be able to deduct a substantial portion of the trip’s costs. This is because the rules don’t require you to allocate 50% of your travel costs to your spouse. You need only allocate any additional costs you incur for him or her. For example, in many hotels the cost of a single room isn’t that much lower than the cost of a double. If a single would cost you $150 a night and a double would cost you and your spouse $200, the disallowed portion of the cost allocable to your spouse would only be $50. In other words, you can write off the cost of what you would have paid traveling alone. To prove your deduction, ask the hotel for a room rate schedule showing single rates for the days you’re staying.

And if you drive your own car or rent one, the whole cost will be fully deductible even if your spouse is along. Of course, if public transportation is used, and for meals, any separate costs incurred by your spouse aren’t deductible.

Have questions?

You want to maximize all the tax breaks you can claim for your small business. Contact us if you have questions or need assistance with this or other tax-related issues.

Stay Safe and Informed During Southern CA Winter Storms

Dear Valued Clients and Colleagues,

I hope you’re doing well and staying dry amidst the severe winter storms sweeping through Southern California. We understand that these weather conditions can bring unexpected challenges, not least of which may include delays or difficulties in gathering necessary tax documents.

Please know that during this turbulent time, our primary concern is for the safety and well-being of our clients. We recognize that the storms may impact your ability to meet certain deadlines or gather documents required for tax preparation. We want to assure you that we are here to assist and support you through these challenges.

Should you find yourself in need of additional time, have questions regarding your tax preparation or services, or if there are any specific issues you’re facing due to the weather, please feel free to reach out to us. Our team is prepared to offer the flexibility and support needed to navigate this period, including extending deadlines where possible or assisting in document retrieval and tax filing procedures.

Furthermore, if you have any immediate concerns or questions, whether tax-related or pertaining to how the storms might affect your financial planning, our lines are open. We’re committed to providing the guidance and assistance you require to manage your tax obligations and ensure your financial well-being during such challenging times.

Your safety is important to us, so please take all necessary precautions to protect yourself and your loved ones during the storms. We look forward to continuing to serve you and are ready to help in any way we can.

Stay safe and take care!!

Betty Kim, CPA

Managing Partner

A cost segregation study may cut taxes and boost cash flow

Is your business depreciating over 30 years the entire cost of constructing the building that houses your enterprise? If so, you should consider a cost segregation study. It may allow you to accelerate depreciation deductions on certain items, thereby reducing taxes and boosting cash flow.

Depreciation basics

Business buildings generally have a 39-year depreciation period (27.5 years for residential rental properties). In most cases, a business depreciates a building’s structural components, including walls, windows, HVAC systems, elevators, plumbing and wiring, along with the building. Personal property — including equipment, machinery, furniture and fixtures — is eligible for accelerated depreciation, usually over five or seven years. And land improvements, such as fences, outdoor lighting and parking lots, are depreciable over 15 years.

Frequently, businesses allocate all or most of their buildings’ acquisition or construction costs to real property, overlooking opportunities to allocate costs to shorter-lived personal property or land improvements. In some cases, the distinction between real and personal property is obvious. For example, computers and furniture are personal property. But the line between real and personal property is not always clear. Items that appear to be “part of a building” may in fact be personal property. Examples are removable wall and floor coverings, removable partitions, awnings and canopies, window treatments, decorative lighting and signs.

In addition, certain items that otherwise would be treated as real property may qualify as personal property if they serve more of a business function than a structural purpose. These include reinforced flooring that supports heavy manufacturing equipment, electrical or plumbing installations required to operate specialized equipment and dedicated cooling systems for data processing rooms.

Identifying and substantiating costs

A cost segregation study combines accounting and engineering techniques to identify building costs that are properly allocable to tangible personal property rather than real property. Although the relative costs and benefits of a cost segregation study depend on your particular facts and circumstances, it can be a valuable investment.

Speedier depreciation tax breaks

The Tax Cuts and Jobs Act (TCJA) enhanced certain depreciation-related tax breaks, which may also enhance the benefits of a cost segregation study. Among other changes, the law permanently increased limits on Section 179 expensing, which allows you to immediately deduct the entire cost of qualifying equipment or other fixed assets up to specified thresholds.

In addition, the TCJA expanded 15-year-property treatment to apply to qualified improvement property. Previously, this tax break was limited to qualified leasehold-improvement, retail-improvement and restaurant property. And the law temporarily increased first-year bonus depreciation from 50% to 100% in 2022, 80% in 2023 and 60% in 2024. After that, it will continue to decrease until it is 0% in 2027, unless Congress acts.

Making favorable depreciation changes

It isn’t too late to get the benefit of faster depreciation for items that were incorrectly assumed to be part of your building for depreciation purposes. You don’t have to amend your past returns (or meet a deadline for claiming tax refunds) to claim the depreciation that you could have already claimed. Instead, you can claim that depreciation by following procedures, in connection with the next tax return you file, that will result in automatic IRS consent to a change in your accounting for depreciation.

Cost segregation studies can yield substantial benefits, but they’re not the best move for every business. Contact us to determine whether this strategy would work for your business. We’ll judge whether a study will result in tax savings that are greater than the costs of the study itself.

Tax Return Red Flags for Schedule C Filers

In the complex landscape of business taxes, Schedule C expenses and entity optimization hold significant weight. Proper documentation and reconciliation, guided by a trusted accounting professional, are more than just best practices – they are vital for audit prevention and ensuring a successful financial trajectory.

Why Is This So Important?

  1. Audit Triggers for Schedule C Filers: The IRS closely examines Schedule C filers to ensure the accuracy of reported income and deductions.

Specific scenarios increase the likelihood of triggering an audit:

  • Income exceeding $100,000
  • Taking disproportionately large deductions to offset income
  • Multiple-year hobby loss write-offs
  • Claiming 100% business use of a vehicle
  • Large deductions for meals, travel, and entertainment
  • Home office deductions
  • Claiming rental losses
  • Opting for the Research and Development Credit
  • Receipt of significant cash income (especially without filing Form 8300 for amounts over $10,000)
  1. Entity Optimization: Choosing the right business entity affects your liability and how much you pay in taxes. For instance, an LLC might benefit a sole proprietor more than remaining a Schedule C filer. Making the right decision in entity selection can lead to tax savings.

The Role of Accounting Professionals

  1. Documentation: Accurate and timely documentation of expenses ensures that you take advantage of all legitimate deductions, reducing the chance of errors that might trigger an audit.
  2. Reconciliation: Regular reconciliation of business accounts helps in early detection of discrepancies, ensuring that income and expenses align with bank and credit card statements.
  3. Guidance: Professionals can offer advice on structuring your business, potential deductions, and best practices to remain compliant with IRS regulations.
  4. Audit Support: In the unlikely event of an audit, having a professional by your side provides a sense of security. They can guide you through the process, answer questions, and ensure all paperwork is in order.

Proper handling of Schedule C expenses and entity optimization is not just about keeping the IRS at bay; it’s about ensuring that your business is on a secure and profitable path. Leveraging the expertise of an accounting professional can be a game-changer for your business’s financial health and success.

Stay informed, stay compliant, and remember – we’re here to help.

What types of expenses can’t be written off by your business?

If you read the Internal Revenue Code (and you probably don’t want to!), you may be surprised to find that most business deductions aren’t specifically listed. For example, the tax law doesn’t explicitly state that you can deduct office supplies and certain other expenses. Some expenses are detailed in the tax code, but the general rule is contained in the first sentence of Section 162, which states you can write off “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”

Basic definitions

In general, an expense is ordinary if it’s considered common or customary in the particular trade or business. For example, insurance premiums to protect a store would be an ordinary business expense in the retail industry.

A necessary expense is defined as one that’s helpful or appropriate. For example, let’s say a car dealership purchases an automated external defibrillator. It may not be necessary for the operation of the business, but it might be helpful and appropriate if an employee or customer suffers cardiac arrest.

It’s possible for an ordinary expense to be unnecessary — but, in order to be deductible, an expense must be ordinary and necessary.

In addition, a deductible amount must be reasonable in relation to the benefit expected. For example, if you’re attempting to land a $3,000 deal, a $65 lunch with a potential client should be OK with the IRS. (Keep in mind that the Tax Cuts and Jobs Act eliminated most deductions for entertainment expenses but retained the 50% deduction for business meals.)

Examples of taxpayers who lost deductions in court

Not surprisingly, the IRS and courts don’t always agree with taxpayers about what qualifies as ordinary and necessary expenditures. Here are three 2023 cases to illustrate some of the issues:

  1. A married couple owned an engineering firm. For two tax years, they claimed depreciation of $76,264 on three vehicles, but didn’t provide required details including each vehicle’s ownership, cost and useful life. They claimed $34,197 in mileage deductions and provided receipts and mileage logs, but the U.S. Tax Court found they didn’t show any related business purposes. The court also found the mileage claimed included commuting costs, which can’t be written off. The court disallowed these deductions and assessed taxes and penalties. (TC Memo 2023-39)
  1. The Tax Court ruled that a married couple wasn’t entitled to business tax deductions because the husband’s consulting company failed to show that it was engaged in a trade or business. In fact, invoices produced by the consulting company predated its incorporation. And the court ruled that even if the expenses were legitimate, they weren’t properly substantiated. (TC Memo 2023-80)
  1. A physician specializing in gene therapy had multiple legal issues and deducted legal expenses of $360,295 for two years on joint Schedule C business tax returns. The Tax Court found that most of the legal fees were to defend the husband against personal conduct issues. The court denied the deduction for personal legal expenses but allowed a deduction for $13,000 for business-related legal expenses. (TC Memo 2023-42)

Proceed with caution

The deductibility of some expenses is clear. But for other expenses, it can get more complicated. Generally, if an expense seems like it’s not normal in your industry — or if it could be considered fun, personal or extravagant in nature — you should proceed with caution. And keep careful records to substantiate the expenses you’re deducting.

Consult with us for guidance.

Important Update: IRS Focus on High-Net-Worth Individuals and Pass-Throughs

We wanted to bring your attention to a recent development that may be of interest to you as a high-net-worth individual or a pass-through entity.

The IRS has shifted its focus towards high-net-worth individuals and pass-through entities, aiming to enhance compliance and enforcement in this area. This change in focus may have implications for your tax planning and financial strategies.

I want to inform you that I currently have an ongoing audit case with the IRS concerning high-net-worth individuals and pass-through entities. Through this experience, I’ve observed that the IRS is still in the process of fine-tuning their approach to auditing these cases. Their primary focus continues to be on small businesses and Schedule C filers, particularly concerning tax compliance and deductions categories.

For those of you who operate Schedule C businesses, this could be an opportune time to consider revisiting your business structure. Making informed choices about your business structure can help you navigate these evolving IRS priorities and ensure compliance while optimizing your tax position.

To gain a deeper understanding of the IRS’s new focus and its potential implications, we encourage you to read the recent IRS announcement available on the following link.

IR-2023-176

As always, we are here to assist you in navigating any changes or challenges that may arise as a result of this shift in IRS priorities. Please feel free to reach out to us if you have any questions or concerns or if you would like to discuss how this development might affect your specific financial circumstances.

We remain committed to providing you with expert guidance and support to help you achieve your financial goals and maintain compliance with tax regulations.

Thank you for entrusting us with your financial needs, and we look forward to assisting you further.

Update on depreciating business assets

The Tax Cuts and Jobs Act liberalized the rules for depreciating business assets. However, the amounts change every year due to inflation adjustments. And due to high inflation, the adjustments for 2023 were big.

We have been advising our clients on these changes, but we wanted to send out a summary of the updates.

Here are the numbers that small business owners need to know.

Section 179 deductions

For qualifying assets placed in service in tax years beginning in 2023, the maximum Sec. 179 deduction is $1.16 million. But if your business puts in service more than $2.89 million of qualified assets, the maximum Sec. 179 deduction begins to be phased out.

Eligible assets include depreciable personal property such as equipment, computer hardware and peripherals, vehicles and commercially available software.

Sec. 179 deductions can also be claimed for real estate qualified improvement property (QIP), up to the maximum allowance of $1.16 million. QIP is defined as an improvement to an interior portion of a nonresidential building placed in service after the date the building was placed in service. However, expenditures attributable to the enlargement of a building, elevators or escalators, or the internal structural framework of a building don’t count as QIP and usually must be depreciated over 39 years. There’s no separate Sec. 179 deduction limit for QIP, so deductions reduce your maximum allowance dollar for dollar.

For nonresidential real property, Sec. 179 deductions are also allowed for qualified expenditures for roofs, HVAC equipment, fire protection and alarm systems, and security systems.

Finally, eligible assets include depreciable personal property used predominantly in connection with furnishing lodging, such as furniture and appliances in a property rented to transients.

Deduction for heavy SUVs

There’s a special limitation on Sec. 179 deductions for heavy SUVs, meaning those with gross vehicle weight ratings (GVWR) between 6,001 and 14,000 pounds. For tax years beginning in 2023, the maximum Sec. 179 deduction for heavy SUVs is $28,900.

First-year bonus depreciation has been cut

For qualified new and used assets that were placed in service in calendar year 2022, 100% first-year bonus depreciation percentage could be claimed.

However, for qualified assets placed in service in 2023, the first-year bonus depreciation percentage dropped to 80%. In 2024, it’s scheduled to drop to 60% (40% in 2025, 20% in 2026 and 0% in 2027 and beyond).

Eligible assets include depreciable personal property such as equipment, computer hardware and peripherals, vehicles and commercially available software. First-year bonus depreciation can also be claimed for real estate QIP.

Exception: For certain assets with longer production periods, these percentage cutbacks are delayed by one year. For example, the 80% depreciation rate will apply to long-production-period property placed in service in 2024.

Passenger auto limitations

For federal income tax depreciation purposes, passenger autos are defined as cars, light trucks and light vans. These vehicles are subject to special depreciation limits under the so-called luxury auto depreciation rules. For new and used passenger autos placed in service in 2023, the maximum luxury auto deductions are as follows:

  • $12,200 for Year 1 ($20,200 if bonus depreciation is claimed),
  • $19,500 for Year 2,
  • $11,700 for Year 3, and
  • $6,960 for Year 4 and thereafter until fully depreciated.

These allowances assume 100% business use. They’ll be further adjusted for inflation in future years.

Advantage for heavy vehicles

Heavy SUVs, pickups, and vans (those with GVWRs above 6,000 pounds) are exempt from the luxury auto depreciation limitations because they’re considered transportation equipment. As such, heavy vehicles are eligible for Sec. 179 deductions (subject to the special deduction limit explained earlier) and first-year bonus depreciation.

Here’s the catch: Heavy vehicles must be used over 50% for business. Otherwise, the business-use percentage of the vehicle’s cost must be depreciated using the straight-line method and it’ll take six tax years to fully depreciate the cost.

Consult with us for the maximum depreciation tax breaks in your situation.

Important IRS Enforcement Update – Let’s stay compliant together!

September is off to a strong start for us and as usual, we are staying busy with the upcoming tax deadline!

We wanted to bring to your attention a recent announcement from the IRS regarding their updated enforcement priorities. This information is crucial for all taxpayers, and we’re here to assist you in navigating these changes.

The IRS has outlined a “sweeping” shift in their enforcement focus, which includes the following key areas:

  1. Increased Audits: High-net worth taxpayers, large partnerships, and those with suspected nonreporting foreign bank accounts can expect heightened audit scrutiny.
  2. Aggressive Collection: The IRS is stepping up collection efforts against high-income individuals who owe tax debts.
  3. Artificial Intelligence: The use of Artificial Intelligence (AI) will play a significant role in detecting non-compliance.
  4. Digital Asset Reporting: The IRS continues to focus on digital asset reporting non-compliance, making it vital for those involved in the digital asset space to stay compliant.
  5. 1099 Fraud: The construction sector is under increased scrutiny for 1099 fraud, emphasizing the importance of accurate reporting.
  6. FBAR Violations: The IRS will continue to scrutinize Foreign Bank and Financial Accounts (FBAR) violations.

You can read the full IRS News Release here: IRS News Release Link.

In light of these changes, we strongly recommend that you work closely with us to ensure your tax compliance and reporting are up to date. Our team is well-equipped to help you navigate these evolving tax landscapes, and we’re here to provide guidance, answer questions, and assist you in staying compliant.

Our commitment to you is to make this process as smooth and stress-free as possible. Should you have any concerns or questions about your tax situation, please do not hesitate to reach out to us. We are here to support you and ensure that you remain in good standing with the IRS.

Thank you for entrusting us with your tax and financial needs. We look forward to working together to ensure your continued compliance and financial success.

Proactive Tax Planning & Organized Accounting for Strategic Decision Making

Encore Partners LLP wanted to bring to your attention the importance of proactive tax planning and maintaining organized accounting practices. By ensuring that your financial records are up to date and accurate, you can significantly enhance your ability to make informed decisions and optimize your tax position.

We understand that tax planning is a crucial aspect of financial management. With the ever-changing tax landscape and evolving regulations, it is essential to stay ahead of the curve. By proactively reviewing your financial situation and implementing effective tax planning strategies, we can help you minimize tax liabilities and maximize savings.

To achieve these goals, we highly recommend organizing your accounting systems and records in a meticulous manner. Having well-maintained and up-to-date financial information enables us to identify opportunities and devise customized tax strategies tailored to your specific needs. Some key benefits of maintaining organized accounting include:

  1. Accurate Financial Reporting: Timely and accurate financial reports provide a clear snapshot of your financial health. This information helps us identify areas where potential tax savings can be realized and allows for proactive decision making.
  2. Real-time Data for Strategic Planning: Organized accounting ensures that your financial data is readily available when needed. Having access to up-to-date information empowers us to analyze trends, anticipate tax implications, and develop effective tax strategies.
  3. Tax Returns & Compliance with Regulatory Requirements: Maintaining proper accounting records is essential for meeting regulatory obligations. By keeping your records organized, you can stay compliant with tax filing deadlines, avoid penalties, and streamline the audit process.
  4. Efficient Financial Management: Organized accounting practices enable efficient tracking and management of income, expenses, and cash flow. This information serves as a foundation for accurate budgeting, forecasting, and making informed business decisions.

To assist you in this process, we are ready to offer our expertise and guidance. Our team of experienced professionals can help you implement effective accounting systems, streamline your financial processes, and develop proactive tax planning strategies tailored to your unique circumstances.

Now is an ideal time to initiate discussions about proactive tax planning and organizing your accounting practices. We encourage you to reach out to us to schedule a consultation. Together, we can ensure that you have the most up-to-date information at your disposal to make strategic financial decisions and optimize your tax position.

Thank you for your continued trust in our services. We look forward to supporting you in achieving your financial goals.