Thinking about converting your home into a rental property?

In some cases, homeowners decide to move to new residences, but keep their present homes and rent them out. If you’re thinking of doing this, you’re probably aware of the financial risks and rewards. However, you also should know that renting out your home carries potential tax benefits and pitfalls.

You’re generally treated as a regular real estate landlord once you begin renting your home. That means you must report rental income on your tax return, but also are entitled to offsetting landlord deductions for the money you spend on utilities, operating expenses, incidental repairs and maintenance (for example, fixing a leak in the roof). Additionally, you can claim depreciation deductions for the home. You can fully offset rental income with otherwise allowable landlord deductions.

Passive activity rules

However, under the passive activity loss (PAL) rules, you may not be able to currently claim the rent-related deductions that exceed your rental income unless an exception applies. Under the most widely applicable exception, the PAL rules won’t affect your converted property for a tax year in which your adjusted gross income doesn’t exceed $100,000, you actively participate in running the home-rental business, and your losses from all rental real estate activities in which you actively participate don’t exceed $25,000.

You should also be aware that potential tax pitfalls may arise from renting your residence. Unless your rentals are strictly temporary and are made necessary by adverse market conditions, you could forfeit an important tax break for home sellers if you finally sell the home at a profit. In general, you can escape tax on up to $250,000 ($500,000 for married couples filing jointly) of gain on the sale of your principal home. However, this tax-free treatment is conditioned on your having used the residence as your principal residence for at least two of the five years preceding the sale. So renting your home out for an extended time could jeopardize a big tax break.

Even if you don’t rent out your home so long as to jeopardize your principal residence exclusion, the tax break you would have gotten on the sale (the $250,000/$500,000 exclusion) won’t apply to the extent of any depreciation allowable with respect to the rental or business use of the home for periods after May 6, 1997, or to any gain allocable to a period of nonqualified use (any period during which the property isn’t used as the principal residence of the taxpayer or the taxpayer’s spouse or former spouse) after December 31, 2008. A maximum tax rate of 25% will apply to this gain (attributable to depreciation deductions).

Selling at a loss

Some homeowners who bought at the height of a market may ultimately sell at a loss someday. In such situations, the loss is available for tax purposes only if the owner can establish that the home was in fact converted permanently into income-producing property. Here, a longer lease period helps an owner. However, if you’re in this situation, be aware that you may not wind up with much of a loss for tax purposes. That’s because basis (the cost for tax purposes) is equal to the lesser of actual cost or the property’s fair market value when it’s converted to rental property. So if a home was bought for $300,000, converted to a rental when it’s worth $250,000, and ultimately sold for $225,000, the loss would be only $25,000. The question of whether to turn a principal residence into rental property isn’t easy. Contact us to review your situation and help you make a decision.

Fully deduct business meals this year

The federal government is helping to pick up the tab for certain business meals. Under a provision that’s part of one of the COVID-19 relief laws, the usual deduction for 50% of the cost of business meals is doubled to 100% for food and beverages provided by restaurants in 2022 (and 2021).

So, you can take a customer out for a business meal or order take-out for your team and temporarily write off the entire cost — including the tip, sales tax and any delivery charges.

Basic rules

Despite eliminating deductions for business entertainment expenses in the Tax Cuts and Jobs Act (TCJA), a business taxpayer could still deduct 50% of the cost of qualified business meals, including meals incurred while traveling away from home on business. (The TCJA generally eliminated the 50% deduction for business entertainment expenses incurred after 2017 on a permanent basis.)

To help struggling restaurants during the pandemic, the Consolidated Appropriations Act doubled the business meal deduction temporarily for 2021 and 2022. Unless Congress acts to extend this tax break, it will expire on December 31, 2022.

Currently, the deduction for business meals is allowed if the following requirements are met:

  • The expense is an ordinary and necessary business expense paid or incurred during the tax year in carrying on any trade or business.
  • The expense isn’t lavish or extravagant under the circumstances.
  • The taxpayer (or an employee of the taxpayer) is present when the food or beverages are furnished.
  • The food and beverages are provided to a current or potential business customer, client, consultant or similar business contact.

In the event that food and beverages are provided during an entertainment activity, the food and beverages must be purchased separately from the entertainment. Alternatively, the cost can be stated separately from the cost of the entertainment on one or more bills.

So, if you treat a client to a meal and the expense is properly substantiated, you may qualify for a business meal deduction as long as there’s a business purpose to the meal or a reasonable expectation that a benefit to the business will result.

Provided by a restaurant

IRS Notice 2021-25 explains the main rules for qualifying for the 100% deduction for food and beverages provided by a restaurant. Under this guidance, the deduction is available if the restaurant prepares and sells food or beverages to retail customers for immediate consumption on or off the premises. As a result, it applies to both on-site dining and take-out and delivery meals.

However, a “restaurant” doesn’t include a business that mainly sells pre-packaged goods not intended for immediate consumption. So, food and beverage sales are excluded from businesses including:

  • Grocery stores,
  • Convenience stores,
  • Beer, wine or liquor stores, and
  • Vending machines or kiosks.

The restriction also applies to an eating facility located on the employer’s business premises that provides meals excluded from an employee’s taxable income. Business meals purchased from such facilities are limited to a 50% deduction. It doesn’t matter if a third party is operating the facility under a contract with the business.

Keep good records

It’s important to keep track of expenses to maximize tax benefits for business meal expenses.

You should record the:

  • Date,
  • Cost of each expense,
  • Name and location of the establishment,
  • Business purpose, and
  • Business relationship of the person(s) fed.

In addition, ask establishments to divvy up the tab between any entertainment costs and food/ beverages. For additional information, please contact us.

Tax considerations when adding a new partner at your business

Adding a new partner in a partnership has several financial and legal implications. Let’s say you and your partners are planning to admit a new partner. The new partner will acquire a one-third interest in the partnership by making a cash contribution to it. Let’s further assume that your bases in your partnership interests are sufficient so that the decrease in your portions of the partnership’s liabilities because of the new partner’s entry won’t reduce your bases to zero.

Not as simple as it seems

Although the entry of a new partner appears to be a simple matter, it’s necessary to plan the new person’s entry properly in order to avoid various tax problems. Here are two issues to consider:

First, if there’s a change in the partners’ interests in unrealized receivables and substantially appreciated inventory items, the change is treated as a sale of those items, with the result that the current partners will recognize gain. For this purpose, unrealized receivables include not only accounts receivable, but also depreciation recapture and certain other ordinary income items. In order to avoid gain recognition on those items, it’s necessary that they be allocated to the current partners even after the entry of the new partner.

Second, the tax code requires that the “built-in gain or loss” on assets that were held by the partnership before the new partner was admitted be allocated to the current partners and not to the entering partner. Generally speaking, “built-in gain or loss” is the difference between the fair market value and basis of the partnership property at the time the new partner is admitted.

The most important effect of these rules is that the new partner must be allocated a portion of the depreciation equal to his share of the depreciable property based on current fair market value. This will reduce the amount of depreciation that can be taken by the current partners. The other effect is that the built-in gain or loss on the partnership assets must be allocated to the current partners when partnership assets are sold. The rules that apply here are complex and the partnership may have to adopt special accounting procedures to cope with the relevant requirements. 

Keep track of your basis 

When adding a partner or making other changes, a partner’s basis in his or her interest can undergo frequent adjustment. It’s imperative to keep proper track of your basis because it can have an impact in several areas: gain or loss on the sale of your interest, how partnership distributions to you are taxed and the maximum amount of partnership loss you can deduct.

Contact us if you’d like help in dealing with these issues or any other issues that may arise in connection with your partnership.

The election to apply the research tax credit against payroll taxes

The credit for increasing research activities, often referred to as the research and development (R&D) credit, is a valuable tax break available to eligible businesses. Claiming the credit involves complex calculations, which we can take care of for you. But in addition to the credit itself, be aware that the credit also has two features that are especially favorable to small businesses:

  1. Eligible small businesses ($50 million or less in gross receipts) may claim the credit against alternative minimum tax (AMT) liability.
  2. The credit can be used by certain even smaller startup businesses against the employer’s Social Security payroll tax liability.

Let’s take a look at the second feature. Subject to limits, you can elect to apply all or some of any research tax credit that you earn against your payroll taxes instead of your income tax. This payroll tax election may influence you to undertake or increase your research activities. On the other hand, if you’re engaged in — or are planning to undertake — research activities without regard to tax consequences, be aware that you could receive some tax relief.

Why the election is important 

Many new businesses, even if they have some cash flow, or even net positive cash flow and/or a book profit, pay no income taxes and won’t for some time. Thus, there’s no amount against which business credits, including the research credit, can be applied. On the other hand, any wage-paying business, even a new one, has payroll tax liabilities. Therefore, the payroll tax election is an opportunity to get immediate use out of the research credits that you earn. Because every dollar of credit-eligible expenditure can result in as much as a 10-cent tax credit, that’s a big help in the start-up phase of a business — the time when help is most needed.

Eligible businesses

To qualify for the election a taxpayer must:

  • Have gross receipts for the election year of less than $5 million and
  • Be no more than five years past the period for which it had no receipts (the start-up period).

In making these determinations, the only gross receipts that an individual taxpayer takes into account are from the individual’s businesses. An individual’s salary, investment income or other income aren’t taken into account. Also, note that an entity or individual can’t make the election for more than six years in a row.

Limits on the election

The research credit for which the taxpayer makes the payroll tax election can be applied only against the Social Security portion of FICA taxes. It can’t be used to lower the employer’s lability for the “Medicare” portion of FICA taxes or any FICA taxes that the employer withholds and remits to the government on behalf of employees.

The amount of research credit for which the election can be made can’t annually exceed $250,000. Note, too, that an individual or C corporation can make the election only for those research credits which, in the absence of an election, would have to be carried forward. In other words, a C corporation can’t make the election for the research credit that the taxpayer can use to reduce current or past income tax liabilities.

The above are just the basics of the payroll tax election. Keep in mind that identifying and substantiating expenses eligible for the research credit itself is a complex area. Contact us about whether you can benefit from the payroll tax election and the research tax credit. 

Making withdrawals from your closely held corporation that aren’t taxed as dividends

Do you want to withdraw cash from your closely held corporation at a minimum tax cost? The simplest 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.” It’s also not deductible by the corporation.

Five alternatives

Fortunately, there are several alternative methods that may allow you to withdraw cash from a corporation while avoiding dividend treatment. Here are five areas where you may want to take action:

1. Capital repayments. To the extent that you’ve capitalized the corporation with debt, including amounts 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 future cash contributions to the corporation, consider structuring them as debt to facilitate later withdrawals on a tax-advantaged basis.

2. 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. The same rule applies to any compensation in the form of rent that you receive from the corporation for the use of property. In both cases, 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.

3. Loans. You may withdraw cash from the corporation tax-free by borrowing 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.

4. 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.

5. Property sales.  Another way to withdraw cash from the corporation is to sell 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.

Keep taxes low 

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

Married couples filing separate tax returns: Why would they do it?

If you’re married, you may wonder whether you should file joint or separate tax returns. The answer depends on your individual tax situation.

In general, it depends on which filing status results in the lowest tax. But keep in mind that, if you and your spouse file a joint return, each of you is “jointly and severally” liable for the tax on your combined income. And you’re both equally liable for any additional tax the IRS assesses, plus interest and most penalties. That means that the IRS can come after either of you to collect the full amount.

Although there are “innocent spouse” provisions in the law that may offer relief, they have limitations. Therefore, even if a joint return results in less tax, you may want to file separately if you want to only be responsible for your own tax.

In most cases, filing jointly offers the most tax savings, especially when the spouses have different income levels. Combining two incomes can bring some of it out of a higher tax bracket. For example, if one spouse has $75,000 of taxable income and the other has just $15,000, filing jointly instead of separately can save $2,499 on their 2021 taxes, when they file this year.

Filing separately doesn’t mean you go back to using the “single” rates that applied before you were married. Instead, each spouse must use “married filing separately” rates. They’re less favorable than the single rates.

However, there are cases when people save tax by filing separately. For example:

One spouse has significant medical expenses. Medical expenses are deductible only to the extent they exceed 7.5% of adjusted gross income (AGI). If a medical expense deduction is claimed on a spouse’s separate return, that spouse’s lower separate AGI, as compared to the higher joint AGI, can result in larger total deductions.

Some tax breaks are only available on a joint return. The child and dependent care credit, adoption expense credit, American Opportunity tax credit and Lifetime Learning credit are only available to married couples on joint returns. And you can’t take the credit for the elderly or the disabled if you file separately unless you and your spouse lived apart for the entire year. You also may not be able to deduct IRA contributions if you or your spouse were covered by an employer retirement plan and you file separate returns. And you can’t exclude adoption assistance payments or interest income from series EE or Series I savings bonds used for higher education expenses.

Social Security benefits may be taxed more. Benefits are tax-free if your “provisional income” (AGI with certain modifications plus half of your Social Security benefits) doesn’t exceed a “base amount.” The base amount is $32,000 on a joint return, but zero on separate returns (or $25,000 if the spouses didn’t live together for the whole year).

Circumstances matter

The decision you make on filing your federal tax return may affect your state or local income tax bill, so the total tax impact should be compared. There’s often no simple answer to whether a couple should file separate returns. A number of factors must be examined. We can look at your tax bill jointly and separately. Contact us to prepare your return or if you have any questions.

Keeping meticulous records is the key to tax deductions and painless IRS audits

If you operate a business, or you’re starting a new one, you know you need to keep records of your income and expenses. Specifically, you should carefully record your expenses in order to claim all of the tax deductions to which you’re entitled. And you want to make sure you can defend the amounts reported on your tax returns in case you’re ever audited by the IRS.

Be aware that there’s no one way to keep business records. But there are strict rules when it comes to keeping records and proving expenses are legitimate for tax purposes. Certain types of expenses, such as automobile, travel, meals and home office costs, require special attention because they’re subject to special recordkeeping requirements or limitations.

Here are two recent court cases to illustrate some of the issues.

Case 1: To claim deductions, an activity must be engaged in for profit 

A business expense can be deducted if a taxpayer can establish that the primary objective of the activity is making a profit. The expense must also be substantiated and be an ordinary and necessary business expense. In one case, a taxpayer claimed deductions that created a loss, which she used to shelter other income from tax.

She engaged in various activities including acting in the entertainment industry and selling jewelry. The IRS found her activities weren’t engaged in for profit and it disallowed her deductions.

The taxpayer took her case to the U.S. Tax Court, where she found some success. The court found that she was engaged in the business of acting during the years in issue. However, she didn’t prove that all claimed expenses were ordinary and necessary business expenses. The court did allow deductions for expenses including headshots, casting agency fees, lessons to enhance the taxpayer’s acting skills and part of the compensation for a personal assistant. But the court disallowed other deductions because it found insufficient evidence “to firmly establish a connection” between the expenses and the business.

In addition, the court found that the taxpayer didn’t prove that she engaged in her jewelry sales activity for profit. She didn’t operate it in a businesslike manner, spend sufficient time on it or seek out expertise in the jewelry industry. Therefore, all deductions related to that activity were disallowed. (TC Memo 2021-107)

Case 2: A business must substantiate claimed deductions with records

A taxpayer worked as a contract emergency room doctor at a medical center. He also started a business to provide emergency room physicians overseas. On Schedule C of his tax return, he deducted expenses related to his home office, travel, driving, continuing education, cost of goods sold and interest. The IRS disallowed most of the deductions.

As evidence in Tax Court, the doctor showed charts listing his expenses but didn’t provide receipts or other substantiation showing the expenses were actually paid. He also failed to account for the portion of expenses attributable to personal activity.

The court disallowed the deductions stating that his charts weren’t enough and didn’t substantiate that the expenses were ordinary and necessary in his business. It noted that “even an otherwise deductible expense may be denied without sufficient substantiation.” The doctor also didn’t qualify to take home office deductions because he didn’t prove it was his principal place of business. (TC Memo 2022-1)

We can help

Contact us if you need assistance retaining adequate business records. Taking a meticulous, proactive approach can protect your deductions and help make an audit much less difficult.

Smooth sailing: Tips to speed processing and avoid hassles this tax season

The IRS began accepting 2021 individual tax returns on January 24. If you haven’t prepared yet for tax season, here are three quick tips to help speed processing and avoid hassles.

Tip 1. Contact us soon for an appointment to prepare your tax return.

Tip 2. Gather all documents needed to prepare an accurate return. This includes W-2 and 1099 forms. In addition, you may have received statements or letters in connection with Economic Impact Payments (EIPs) or advance Child Tax Credit (CTC) payments.

Letter 6419, 2021 Total Advance Child Tax Credit Payments, tells taxpayers who received CTC payments how much they received. Since the advance payments represented about one-half of the total credit, taxpayers who received CTC payments need to file a return to collect the rest of the credit. Letter 6475, Your Third Economic Impact Payment, tells taxpayers who received an EIP in 2021 the amount of that payment. Taxpayers need to know the amount to determine if they can claim an additional amount on their tax returns.

Taxpayers who received an EIP or CTC payments must include that information on their returns. Failure to include this information, according to the IRS, means a return is incomplete and will require additional processing, which may delay any refund owed to the taxpayer.

Tip 3. Check certain information on your prepared return. Each Social Security number on your tax return should appear exactly as printed on the Social Security card(s). Likewise, make sure that names aren’t misspelled. If you’re receiving your refund by direct deposit, check the bank account number.

Failure to file or pay on time

What if you don’t file on time or can’t pay your tax bill? Separate penalties apply for failing to pay and failing to file. The penalties imposed are a percentage of the taxes you didn’t pay or didn’t pay on time. If you obtain an extension for the filing due date (until October 17), you aren’t filing late unless you miss the extended due date. However, a filing extension doesn’t apply to your responsibility for payment. If you obtain an extension, you’re required to pay an estimate of any owed taxes by the regular deadline to avoid possible penalties.

The penalties for failing to file and failing to pay can be quite severe. (They may be excused by the IRS if your lateness is due to “reasonable cause,” such as illness or a death in the family.) Contact us for questions or concerns about how to proceed in your situation.

Entrepreneurs and taxes: How expenses are claimed on tax returns

While some businesses have closed since the start of the COVID-19 crisis, many new ventures have launched. Entrepreneurs have cited a number of reasons why they decided to start a business in the midst of a pandemic. For example, they had more time, wanted to take advantage of new opportunities or they needed money due to being laid off. Whatever the reason, if you’ve recently started a new business, or you’re contemplating starting one, be aware of the tax implications.

As you know, before you even open the doors in a start-up business, you generally have to spend a lot of money. You may have to train workers and pay for rent, utilities, marketing and more.

Entrepreneurs are often unaware that many expenses incurred by start-ups can’t be deducted right away. Keep in mind that the way you handle some of your initial expenses can make a large difference in your tax bill.

Essential tax points 

When starting or planning a new enterprise, keep these factors in mind:

  • Start-up costs include those incurred or paid while creating an active trade or business — or investigating the creation or acquisition of one.
  • Under the federal tax code, taxpayers can elect to deduct up to $5,000 of business start-up and $5,000 of organizational costs in the year the venture begins. Of course, $5,000 doesn’t go far these days! And the $5,000 deduction is reduced dollar-for-dollar by the amount by which your total start-up or organizational costs exceed $50,000. Any remaining costs must be amortized over 180 months on a straight-line basis.
  • No deductions or amortization write-offs are allowed until the year when “active conduct” of your new business commences. That usually means the year when the enterprise has all the pieces in place to begin earning revenue. To determine if a taxpayer meets this test, the IRS and courts generally ask questions such as: Did the taxpayer undertake the activity intending to earn a profit? Was the taxpayer regularly and actively involved? Has the activity actually begun?

Types of expenses

Start-up expenses generally include all expenses that are incurred to:

  • Investigate the creation or acquisition of a business,
  • Create a business, or
  • Engage in a for-profit activity in anticipation of that activity becoming an active business.

To be eligible for the election, an expense also must be one that would be deductible if it were incurred after a business began. One example would be the money you spend analyzing potential markets for a new product or service.

To qualify as an “organization expense,” the outlay must be related to the creation of a corporation or partnership. Some examples of organization expenses are legal and accounting fees for services related to organizing the new business and filing fees paid to the state of incorporation.

An important decision 

Time may be of the essence if you have start-up expenses that you’d like to deduct for this year. You need to decide whether to take the election described above. Recordkeeping is important. Contact us about your business start-up plans. We can help with the tax and other aspects of your new venture.

Numerous tax limits affecting businesses have increased for 2022

Many tax limits that affect businesses are annually indexed for inflation, and a number of them have increased for 2022. Here’s a rundown of those that may be important to you and your business.

Social Security tax

The amount of an employee’s earnings that is subject to Social Security tax is capped for 2022 at $147,000 (up from $142,800 in 2021).

Deductions 

  • Standard business mileage rate, per mile: 58.5 cents (up from 56 cents in 2021)
  • Section 179 expensing:
    • Limit: $1.08 million (up from $1.05 million in 2021)
    • Phaseout: $2.7 million (up from $2.62 million)
  • Income-based phase-out for certain limits on the Sec. 199A qualified business income deduction begins at:
    • Married filing jointly: $340,100 (up from $329,800 in 2021)
    • Single filers: $170,050 (up from $164,900)

Business meals

In 2022 and 2021, the deduction for eligible business-related food and beverage expenses provided by a restaurant is 100% (up from 50% in 2020).

Retirement plans 

  • Employee contributions to 401(k) plans: $20,500 (up from $19,500 in 2021)
  • Catch-up contributions to 401(k) plans: $6,500 (unchanged)
  • Employee contributions to SIMPLEs: $14,000 (up from $13,500)
  • Catch-up contributions to SIMPLEs: $3,000 (unchanged)
  • Combined employer/employee contributions to defined contribution plans: $61,000 (up from $58,000)
  • Maximum compensation used to determine contributions: $305,000 (up from $290,000)
  • Annual limit for defined benefit plans: $245,000 (up from $230,000)
  • Compensation defining a highly compensated employee: $135,000 (up from $130,000)
  • Compensation defining a “key” employee: $200,000 (up from $185,000) 

Other employee benefits

  • Qualified transportation fringe-benefits employee income exclusion: $280 per month (up from $270 per month)
  • Health Savings Account contributions:
    • Individual coverage: $3,650 (up from $3,600)
    • Family coverage: $7,300 (up from $7,200)
    • Catch-up contribution: $1,000 (unchanged)
  • Health care Flexible Spending Account contributions: $2,850 (up from $2,750)

These are only some of the tax limits that may affect your business and additional rules may apply. Contact us if you have questions.