In previous posts (BUSINESS ENTITIES PARTS II AND III) we concluded that a Limited Liability Company (LLC) is usually the best choice of entity to conduct a business at least for a start up. If this is true for a start up, should existing businesses convert to an LLC? The advantage for an existing C Corp is of course lower taxes. The advantage for an existing S Corp is lower taxes without the strict S Corp eligibility rules. C and S Corps converting to an LLC would do so without sacrificing the personal liability protection of their owners. The conversion of a Sole Proprietorship or Partnership to an LLC would result in liability protection for the business owner without sacrificing the benefit of lower taxes. However, conversion of an existing Corporation to an LLC is treated as a liquidation of the existing entity and a recontribution of the converting entity’s assets to a new entity (the LLC) and may come at a tax cost. The question then for business owners is whether the advantages of an LLC are worth the tax cost.
Conversion of a C Corp to an LLC.
Upon such a conversion, the corporation is deemed to have sold all of its assets at fair market value usually resulting in a gain to the corporation taxed at corporate tax rates of approximately 35% and a liquidating distribution to its shareholders of the fair market value of the corporate assets also usually resulting in a taxable gain to the shareholders taxed at 15%. This is probably too high a tax cost for the benefit, but not in all cases. To the extent the corporate assets have not appreciated in value or to the extent the company or shareholder have unused tax benefits, the tax cost may not be prohibitive.
Conversion of an S Corp to an LLC
A converting S Corp is also deemed to have sold all of its assets at fair market value which usually results in a gain recognized at the corporate level, but in this case passed on to the shareholders to pay tax personally on the gain. There is usually no second level of tax (except in rare cases where the Built-In-Gain tax applies) reducing the cost of conversion significantly, but not eliminating it.
Conversion of a Partnership or Proprietorship to an LLC.
Unlike shareholders and Corporations, Proprietors, Partners and Partnerships have no tax cost when converting their businesses to LLCs. Upon conversion then, the Proprietors and Partners are no longer subject to personal liability for post conversion debts of the entity without a cost. There are issues though that should be considered before conversion. Proprietors and General Partners remain liable though for entity level debts incurred before conversion.
The conversion of a Limited Partnership can result in a reduction of tax basis (and a taxable distribution) for General Partners for non recourse liabilities. The conversion of a General Partnership may result in the former General Partners recognizing income due to the at risk recapture rules unless the entity has no recourse debt or as is usually the case, state law requires the former General Partners to remain liable for pre conversion debt.
Corporations and their shareholders should at least “run the numbers” to see whether conversion is feasible. Proprietors and Partners should probably convert to an LLC absent extenuating circumstances. Every entity (Corporation, Partnership or LLC) should have an agreement among their fellow owners for among other things, restricting ownership to those the current owners can comfortably deal with and to delineate exit strategies.
March 23, 2010
March 17, 2010
Business Entities (Part III)
In the last two posts, we described the various types of entities available to conduct a business and examined the taxation issues in detail. We concluded that in most cases, a pass through entity such as a Sole Proprietorship, Partnership or Limited Liability Company (LLC) is more advantageous than a Corporation for tax purposes and an S Corp is generally more advantageous than a C Corp. Besides keeping taxes to a minimum, business owners also want to keep their personal liability for the businesses debts to a minimum. This post will examine the personal liability issue in detail
There are four potential situations in which owners can be personally liable for their business’s debts. We will compare Corporations and LLCs (C Corp and S Corp shareholders and LLC members generally have the same potential liability) with Partnerships and Sole Proprietorships. General Partners have joint and several liability which means that regardless of a General Partner’s percentage of ownership of the Partnership, he or she is personally liable to a creditor for the full amount of the debt just like a Sole Proprietor who is of course personally liable for all of the business’s debts. Limited Partners that do not participate in the management and control of their business are treated more like shareholders than General Partners.
1. Personal liability for entity level debt. Corporate shareholders, LLC owners (members) and Limited Partners are not personally liable for debts incurred by the Corporation, LLC or Partnership unless they personally guarantee the debt. General partners and Proprietors are each liable for the full amount of entity debt whether or not such owners personally guaranteed the debt.
2. Personal liability for co-workers torts. The second area in which an owner can be personally liable is for the torts (wrongs such as negligence) caused by a co owner or employee. Shareholders, Members and Limited Partners are not liable unless they supervised or controlled the co worker committing the tort. General Partners and Proprietors are liable for all torts created by anyone in the organization. In some states though there is an exception for Partners in a “Limited Liability Partnership” or “LLP”, which is a type of partnership favored by professional practices before LLCs became operative.
3. Piercing the veil. In limited circumstances, creditors can ignore the corporate or company “veil” of protection. This happens only when the owners misuse their entity to deceive creditors. In such a case, shareholders and LLC members can be held personally liable for their business’s debts. Similarly, a Limited Partner who manages and/or controls the Partnership can be treated like a General Partner and be held personally liable. This common law doctrine has no relevance to true General Partners and Proprietors since they are personally liable anyway.
4. Responsible Party. Federal and state statutes can hold owners deemed the “responsible party” personally liable for certain business debts. For example if employment taxes are not remitted by the entity, the person responsible to remit these taxes can be personally liable even if they are a shareholder or member. There can be similar personal liability for owners responsible for paying sales tax and wages.
In BUSINESS ENTITIES (PART II) we concluded that for tax purposes a pass through entity such as a Partnership or LLC is the most advantageous choice. Here we conclude that for liability purposes, a Corporation (C or S) or LLC is the most advantageous choice. It should be obvious that at least when starting a business, an LLC would generally be the preferred entity. The next question for some business owners is should they change from a Corporation or Partnership to an LLC. This issue will be addressed in the next post (BUSINESS ENTITIES PART IV).
There are four potential situations in which owners can be personally liable for their business’s debts. We will compare Corporations and LLCs (C Corp and S Corp shareholders and LLC members generally have the same potential liability) with Partnerships and Sole Proprietorships. General Partners have joint and several liability which means that regardless of a General Partner’s percentage of ownership of the Partnership, he or she is personally liable to a creditor for the full amount of the debt just like a Sole Proprietor who is of course personally liable for all of the business’s debts. Limited Partners that do not participate in the management and control of their business are treated more like shareholders than General Partners.
1. Personal liability for entity level debt. Corporate shareholders, LLC owners (members) and Limited Partners are not personally liable for debts incurred by the Corporation, LLC or Partnership unless they personally guarantee the debt. General partners and Proprietors are each liable for the full amount of entity debt whether or not such owners personally guaranteed the debt.
2. Personal liability for co-workers torts. The second area in which an owner can be personally liable is for the torts (wrongs such as negligence) caused by a co owner or employee. Shareholders, Members and Limited Partners are not liable unless they supervised or controlled the co worker committing the tort. General Partners and Proprietors are liable for all torts created by anyone in the organization. In some states though there is an exception for Partners in a “Limited Liability Partnership” or “LLP”, which is a type of partnership favored by professional practices before LLCs became operative.
3. Piercing the veil. In limited circumstances, creditors can ignore the corporate or company “veil” of protection. This happens only when the owners misuse their entity to deceive creditors. In such a case, shareholders and LLC members can be held personally liable for their business’s debts. Similarly, a Limited Partner who manages and/or controls the Partnership can be treated like a General Partner and be held personally liable. This common law doctrine has no relevance to true General Partners and Proprietors since they are personally liable anyway.
4. Responsible Party. Federal and state statutes can hold owners deemed the “responsible party” personally liable for certain business debts. For example if employment taxes are not remitted by the entity, the person responsible to remit these taxes can be personally liable even if they are a shareholder or member. There can be similar personal liability for owners responsible for paying sales tax and wages.
In BUSINESS ENTITIES (PART II) we concluded that for tax purposes a pass through entity such as a Partnership or LLC is the most advantageous choice. Here we conclude that for liability purposes, a Corporation (C or S) or LLC is the most advantageous choice. It should be obvious that at least when starting a business, an LLC would generally be the preferred entity. The next question for some business owners is should they change from a Corporation or Partnership to an LLC. This issue will be addressed in the next post (BUSINESS ENTITIES PART IV).
Business Entities (Part II)
In the last post, BUSINESS ENTITIES (PART I) we described the different types of entities available to conduct a business. We concluded that in choosing a business entity, an entrepreneur would most likely choose the entity that would keep taxes to a minimum while providing the maximum personal liability protection. This post will examine the taxation issues in more detail.
There are six potential areas in which one entity can be taxed differently than another entity. In these six areas, we will compare a regular or C Corporation (which includes an LLC that elects to be taxed as a C Corporation), an S Corporation (which is a regular Corporation for all purposes except that the entity and it’s owners elect to pay tax personally on the Corporate income) with other pass through entities (which includes a Sole Proprietorship, Partnership and LLC which does not elect to be taxed as a Corporation.
1. Multiple Taxes On Income From Operations. The ordinary business income of a C Corp is taxed to the Corporation at corporate tax rates. If and when this income is distributed to shareholders, it is taxed again to the shareholders as a dividend. The income from the business operations of an S Corp or other pass through entity is taxed only on the owner’s personal income tax return.
2. Multiple Taxes Upon Sale Or Liquidation. Income from the sale or liquidation of the business assets will result in corporate income to a C Corp as well as personal income to its shareholders when ultimately distributed to them. It should be noted that while multiple taxation of the income from operations of a closely held C Corp can often be avoided by distributing the cash to shareholders in the form of deductible compensation rather than dividends, this technique will not usually work with income from the sale or liquidation of the business assets. The income from the sale or liquidation of an S Corp’s assets will generally not result in multiple levels of taxation except to the extent it is attributable to gain from the assets existing when the Corp elected S Corp status and the election was made by a C Corp within ten years of the disposition of the corporate assets(the Built-In-Gains Tax). A Corporation that either has always been an S Corp or was a C Corp but made the S election more than ten years prior to the sale or liquidation would not be subject to the Built-In-Gains Tax. The income from the sale or liquidation of the assets of other pass through entities (Sole Proprietorship, Partnership or LLC) is never subject to multiple taxes.
3. Penalty Taxes. The earnings of certain Corporations can also be subject to penalty taxes in addition to the Corp’s regular income tax. The Accumulated Earnings Tax is imposed (although rarely) on certain C Corps that are formed or used to accumulate rather than distribute its earnings as taxable dividends to its shareholders. The Personal Holding Company Tax is imposed on closely held C Corps (5 or fewer shareholders) with at least 60% of its income from passive sources (dividends, interest, royalties and certain rents) that also fail to distribute earnings to shareholders. The corporate Alternative Minimum Tax is a tax designed to ensure that high income C Corps utilizing certain tax benefits pay a minimum amount of tax. S Corps are not subject to any of these taxes although there is an Excess Passive Income Tax on former C Corps with income from passive sources greater than 25% of the S Corp’s total income. There are no penalty taxes imposed on other pass through entities.
4. Pass Through of Business Tax Losses. If the business suffers a tax loss, which is common for start-up businesses, S Corps, Partnerships, Sole Proprietorships and LLC’s can pass this loss to their owners, potentially reducing such owners’ personal taxes. C Corps cannot pass through losses to their shareholders.
5. Basis in Retained Earnings. Basis is a very important tax concept. To the extent an owner of a business entity has tax basis, distribution of previously taxed income is tax free, losses are deductible and gain upon sale of the ownership interest in the entity is tax free. C Corp shareholders can not increase basis in their stock by the Corp’s retained earnings. S Corp shareholders and owners of other pass through entities increase their tax basis in their respective ownership interests by their share of the entity’s undistributed earnings.
6. Basis for Entity Level Debt. C Corp and S Corp shareholders cannot increase tax basis in their stock by their proportionate share of money borrowed by the Corporation, even if as is usually the case in closely held businesses, the shareholders personally guarantee the debt. The tax basis of Partners and LLC members in their respective entities is usually increased by their proportionate share of the entity’s borrowings.
It should be obvious that Sole Proprietorships, Partnerships and LLC s enjoy an advantage over C and S Corps with respect to the goal of paying the least amount of tax. The next post, BUSINESS ENTITIES ( PART III), will examine the choice of entity decision with respect to the goal of protecting the business owner’s personal assets from business liabilities.
There are six potential areas in which one entity can be taxed differently than another entity. In these six areas, we will compare a regular or C Corporation (which includes an LLC that elects to be taxed as a C Corporation), an S Corporation (which is a regular Corporation for all purposes except that the entity and it’s owners elect to pay tax personally on the Corporate income) with other pass through entities (which includes a Sole Proprietorship, Partnership and LLC which does not elect to be taxed as a Corporation.
1. Multiple Taxes On Income From Operations. The ordinary business income of a C Corp is taxed to the Corporation at corporate tax rates. If and when this income is distributed to shareholders, it is taxed again to the shareholders as a dividend. The income from the business operations of an S Corp or other pass through entity is taxed only on the owner’s personal income tax return.
2. Multiple Taxes Upon Sale Or Liquidation. Income from the sale or liquidation of the business assets will result in corporate income to a C Corp as well as personal income to its shareholders when ultimately distributed to them. It should be noted that while multiple taxation of the income from operations of a closely held C Corp can often be avoided by distributing the cash to shareholders in the form of deductible compensation rather than dividends, this technique will not usually work with income from the sale or liquidation of the business assets. The income from the sale or liquidation of an S Corp’s assets will generally not result in multiple levels of taxation except to the extent it is attributable to gain from the assets existing when the Corp elected S Corp status and the election was made by a C Corp within ten years of the disposition of the corporate assets(the Built-In-Gains Tax). A Corporation that either has always been an S Corp or was a C Corp but made the S election more than ten years prior to the sale or liquidation would not be subject to the Built-In-Gains Tax. The income from the sale or liquidation of the assets of other pass through entities (Sole Proprietorship, Partnership or LLC) is never subject to multiple taxes.
3. Penalty Taxes. The earnings of certain Corporations can also be subject to penalty taxes in addition to the Corp’s regular income tax. The Accumulated Earnings Tax is imposed (although rarely) on certain C Corps that are formed or used to accumulate rather than distribute its earnings as taxable dividends to its shareholders. The Personal Holding Company Tax is imposed on closely held C Corps (5 or fewer shareholders) with at least 60% of its income from passive sources (dividends, interest, royalties and certain rents) that also fail to distribute earnings to shareholders. The corporate Alternative Minimum Tax is a tax designed to ensure that high income C Corps utilizing certain tax benefits pay a minimum amount of tax. S Corps are not subject to any of these taxes although there is an Excess Passive Income Tax on former C Corps with income from passive sources greater than 25% of the S Corp’s total income. There are no penalty taxes imposed on other pass through entities.
4. Pass Through of Business Tax Losses. If the business suffers a tax loss, which is common for start-up businesses, S Corps, Partnerships, Sole Proprietorships and LLC’s can pass this loss to their owners, potentially reducing such owners’ personal taxes. C Corps cannot pass through losses to their shareholders.
5. Basis in Retained Earnings. Basis is a very important tax concept. To the extent an owner of a business entity has tax basis, distribution of previously taxed income is tax free, losses are deductible and gain upon sale of the ownership interest in the entity is tax free. C Corp shareholders can not increase basis in their stock by the Corp’s retained earnings. S Corp shareholders and owners of other pass through entities increase their tax basis in their respective ownership interests by their share of the entity’s undistributed earnings.
6. Basis for Entity Level Debt. C Corp and S Corp shareholders cannot increase tax basis in their stock by their proportionate share of money borrowed by the Corporation, even if as is usually the case in closely held businesses, the shareholders personally guarantee the debt. The tax basis of Partners and LLC members in their respective entities is usually increased by their proportionate share of the entity’s borrowings.
It should be obvious that Sole Proprietorships, Partnerships and LLC s enjoy an advantage over C and S Corps with respect to the goal of paying the least amount of tax. The next post, BUSINESS ENTITIES ( PART III), will examine the choice of entity decision with respect to the goal of protecting the business owner’s personal assets from business liabilities.
March 15, 2010
Business Entities (Part I)
Starting a business? Choosing which type of entity to conduct your business (Partnership, Corporation, Limited Liability Company etc.) is a critical decision which should be made as early as possible. Do you already own a business? Perhaps the type of entity already chosen by or for you may not be in your best interest. Should you change? At what cost? Regardless of the entity, do you have an agreement among your co-owners in writing? If not, you should. These issues will be discussed in this and succeeding posts.
The first question is why should you care. The most important reasons are that you want to pay as little tax as possible and you want to keep your personal liability for business debts to a minimum. Different entities provide varying levels of tax and liability protection. There are other factors to be considered in selecting a business entity such as continuity of a business’s life, centralization of its management and free transferability of an owner’s interest in the business, but taxes and liability protection generally take precedence.
The possible entities that can be used to conduct a business are as follows.
SOLE PROPRIETORSHIP
This is an unincorporated single owner business. The sole proprietor is personally liable for all of the business’s debts. The income of the business though is taxed only once, on the owner’s personal income tax return. There are no penalty taxes. The business terminates upon the owner’s death, so there is no continuity of life. The authority to manage the business is held by its owner. Transferability of the owner’s interest is difficult.
PARTNERSHIP
This is an unincorporated multi-owner business. All General Partners are personally jointly and severally liable for all of the business’s debts. Jointly and severally means that each General Partner can be liable to a creditor for the entire amount of the debt, not just for their proportionate share. Limited Partners though are not personally liable unless they participate in the management and control of the business. Like a sole proprietorship, the income of the business is taxed only on each Partner’s personal income tax return and there is no possibility of penalty taxes. There is no centralization of management at least in a General Partnership because as a matter of law, every General Partner is entitled to manage the Partnership. There is also no continuity of life of the business or free transferability of a General Partner’s ownership interest because again as a matter of law, the Partnership terminates upon the death of a General Partner. Limited partnership interests are sometimes freely transferable.
CORPORATION
This is an incorporated legal entity separate and distinct from its owners. The owners (shareholders) are responsible for the business’s debts only under rare and unique circumstances. The income of the business is taxed to the corporation at corporate tax rates. Distributions to shareholders are taxed on the shareholders’ personal income tax returns, thus resulting in a double tax. There is also a potential for penalty taxes such as the Personal Holding Company Tax, the Accumulated Earnings Tax and the Corporate Alternative Minimum Tax. The shareholders of certain “Small Business Corporations” though can elect to pay tax personally on the Corporation’s business income, effectively eliminating the double tax. Such a Corporation is called an S Corporation. If no such election is made, the entity is termed a C Corporation. Because a Corporation is a separate entity, there is centralization of management and continuity of life. While there is no legal prohibition on transferring an owner’s interest, most closely held Corporations would be well advised to consider such a prohibition in their shareholder agreements..
LIMITED LIABILITY COMPANY (LLC)
This is an unincorporated legal entity separate and distinct from its owners. It is not a Corporation. The owners (members) are generally responsible for the business’s debts only to the extent corporate shareholders would be so liable. The owners can actually choose how the LLC’s business income will be taxed. The income would normally be taxed only once at the personal level although an election can be made to treat the LLC as a Corporation in which case the possibilities of double taxation and penalty taxes exist. Such an election would rarely be made by an entrepreneur. By law, there is neither centralization of management, continuity of life nor free transferability of the owner’s interest unless the members decide otherwise.
It seems rather obvious that in the vast majority of circumstances an entrepreneur would prefer an LLC over the other choices. The next post(s) will explore the advantages of each entity in more detail and raise the question whether an existing entity should convert to an LLC and if so, at what cost.
The first question is why should you care. The most important reasons are that you want to pay as little tax as possible and you want to keep your personal liability for business debts to a minimum. Different entities provide varying levels of tax and liability protection. There are other factors to be considered in selecting a business entity such as continuity of a business’s life, centralization of its management and free transferability of an owner’s interest in the business, but taxes and liability protection generally take precedence.
The possible entities that can be used to conduct a business are as follows.
SOLE PROPRIETORSHIP
This is an unincorporated single owner business. The sole proprietor is personally liable for all of the business’s debts. The income of the business though is taxed only once, on the owner’s personal income tax return. There are no penalty taxes. The business terminates upon the owner’s death, so there is no continuity of life. The authority to manage the business is held by its owner. Transferability of the owner’s interest is difficult.
PARTNERSHIP
This is an unincorporated multi-owner business. All General Partners are personally jointly and severally liable for all of the business’s debts. Jointly and severally means that each General Partner can be liable to a creditor for the entire amount of the debt, not just for their proportionate share. Limited Partners though are not personally liable unless they participate in the management and control of the business. Like a sole proprietorship, the income of the business is taxed only on each Partner’s personal income tax return and there is no possibility of penalty taxes. There is no centralization of management at least in a General Partnership because as a matter of law, every General Partner is entitled to manage the Partnership. There is also no continuity of life of the business or free transferability of a General Partner’s ownership interest because again as a matter of law, the Partnership terminates upon the death of a General Partner. Limited partnership interests are sometimes freely transferable.
CORPORATION
This is an incorporated legal entity separate and distinct from its owners. The owners (shareholders) are responsible for the business’s debts only under rare and unique circumstances. The income of the business is taxed to the corporation at corporate tax rates. Distributions to shareholders are taxed on the shareholders’ personal income tax returns, thus resulting in a double tax. There is also a potential for penalty taxes such as the Personal Holding Company Tax, the Accumulated Earnings Tax and the Corporate Alternative Minimum Tax. The shareholders of certain “Small Business Corporations” though can elect to pay tax personally on the Corporation’s business income, effectively eliminating the double tax. Such a Corporation is called an S Corporation. If no such election is made, the entity is termed a C Corporation. Because a Corporation is a separate entity, there is centralization of management and continuity of life. While there is no legal prohibition on transferring an owner’s interest, most closely held Corporations would be well advised to consider such a prohibition in their shareholder agreements..
LIMITED LIABILITY COMPANY (LLC)
This is an unincorporated legal entity separate and distinct from its owners. It is not a Corporation. The owners (members) are generally responsible for the business’s debts only to the extent corporate shareholders would be so liable. The owners can actually choose how the LLC’s business income will be taxed. The income would normally be taxed only once at the personal level although an election can be made to treat the LLC as a Corporation in which case the possibilities of double taxation and penalty taxes exist. Such an election would rarely be made by an entrepreneur. By law, there is neither centralization of management, continuity of life nor free transferability of the owner’s interest unless the members decide otherwise.
It seems rather obvious that in the vast majority of circumstances an entrepreneur would prefer an LLC over the other choices. The next post(s) will explore the advantages of each entity in more detail and raise the question whether an existing entity should convert to an LLC and if so, at what cost.
March 5, 2010
New 2009 Tax Breaks For Spending Your Hard Earned Money
Sometimes when you sit down to do your tax return you are surprised as to how much money you have to pay tax on. If you are like many others, you wonder where all this taxable income went. This year you may want to closely examine what you spent your money on because there are tax breaks new for 2009 that may be applicable to some of these expenditures. The IRS has recently announced that they expect larger refunds this year due to these new tax incentives. Look carefully at the following.
The largest new tax break is the first time homebuyer credit. This is probably not news to anyone who may qualify because realtors and others have effectively communicated this provision to prospective purchasers. This tax credit is equal to 10% of the cost of the home up to $8,000, although the credit is phased out for higher income individuals. You are a first time homebuyer if you or your spouse did not own a home for at least 3 years prior to your 2009 purchase.
Existing home owners would agree that a significant portion of their income is spent on home improvements. Certain expenditures made in 2009 to make your principal residence more energy efficient are eligible for a tax credit regardless of income. This credit is equal to 30% of eligible expenses up to a maximum credit of $1500. Eligible expenses include the cost of purchasing and installing certain high efficiency heating and cooling systems, water heaters and stoves. The cost to purchase (but not to install) energy efficient windows, doors, skylights and insulation also qualify. The cost of acquiring and installing alternative energy equipment for a new or existing home qualifies for another energy credit equal to 30%of such costs, but with no cap on the amount of such credit. Alternative energy equipment includes solar and geothermal systems as well as wind turbines.
If you spent some of your money on a new car, you may also get a tax break also new for 2009. The sales tax paid on the purchase of a new vehicle after February 16, 2009 may be deductible even if you do not itemize your deductions. The deduction is limited to the tax paid on the purchase price of a new car, light truck, motorcycle or motor home up to a cost of $49,500 for each vehicle purchased. Like most tax breaks, this deduction is phased out for higher income taxpayers. It starts to phase out when your income reaches $125,000 ($250,000 for joint filers) and is completely phased out at $135,000 ($260,000 for joint filers).
Finally, if some of your money went to pay college expenses, the new American Opportunity Credit (AOC) may give you a better tax break for 2009 than the older education tax credits and deductions. The maximum $2500 AOC may be available to taxpayers who spent at least $4,000 for tuition, fees and books in 2009 for themselves, their spouses and children. The older Lifetime Learning Credit of $2,000 and $4,000 tuition and fees deduction is still available, but less attractive. For example 40% of the AOC is refundable whereas none of the older education credits were or are refundable. The AOC phases out for higher income individuals. It starts to phase out when your income reaches $80,000 ($160,000 for joint returns) and is completely phased out at $90,000 ($180,000 for joint filers). These income levels are higher than the older education tax credits. The older credits though continue to be viable options. The AOC is only available for the first 4 years of college. The older Lifetime Learning Credit is not so limited. For those living in the 7 Midwestern states ravaged by the 2008 floods the older Hope Credit (available for the first 2 years of undergraduate study) has been increased for 2009 to $3600 per student, in these cases a better option than the AOC.
The largest new tax break is the first time homebuyer credit. This is probably not news to anyone who may qualify because realtors and others have effectively communicated this provision to prospective purchasers. This tax credit is equal to 10% of the cost of the home up to $8,000, although the credit is phased out for higher income individuals. You are a first time homebuyer if you or your spouse did not own a home for at least 3 years prior to your 2009 purchase.
Existing home owners would agree that a significant portion of their income is spent on home improvements. Certain expenditures made in 2009 to make your principal residence more energy efficient are eligible for a tax credit regardless of income. This credit is equal to 30% of eligible expenses up to a maximum credit of $1500. Eligible expenses include the cost of purchasing and installing certain high efficiency heating and cooling systems, water heaters and stoves. The cost to purchase (but not to install) energy efficient windows, doors, skylights and insulation also qualify. The cost of acquiring and installing alternative energy equipment for a new or existing home qualifies for another energy credit equal to 30%of such costs, but with no cap on the amount of such credit. Alternative energy equipment includes solar and geothermal systems as well as wind turbines.
If you spent some of your money on a new car, you may also get a tax break also new for 2009. The sales tax paid on the purchase of a new vehicle after February 16, 2009 may be deductible even if you do not itemize your deductions. The deduction is limited to the tax paid on the purchase price of a new car, light truck, motorcycle or motor home up to a cost of $49,500 for each vehicle purchased. Like most tax breaks, this deduction is phased out for higher income taxpayers. It starts to phase out when your income reaches $125,000 ($250,000 for joint filers) and is completely phased out at $135,000 ($260,000 for joint filers).
Finally, if some of your money went to pay college expenses, the new American Opportunity Credit (AOC) may give you a better tax break for 2009 than the older education tax credits and deductions. The maximum $2500 AOC may be available to taxpayers who spent at least $4,000 for tuition, fees and books in 2009 for themselves, their spouses and children. The older Lifetime Learning Credit of $2,000 and $4,000 tuition and fees deduction is still available, but less attractive. For example 40% of the AOC is refundable whereas none of the older education credits were or are refundable. The AOC phases out for higher income individuals. It starts to phase out when your income reaches $80,000 ($160,000 for joint returns) and is completely phased out at $90,000 ($180,000 for joint filers). These income levels are higher than the older education tax credits. The older credits though continue to be viable options. The AOC is only available for the first 4 years of college. The older Lifetime Learning Credit is not so limited. For those living in the 7 Midwestern states ravaged by the 2008 floods the older Hope Credit (available for the first 2 years of undergraduate study) has been increased for 2009 to $3600 per student, in these cases a better option than the AOC.
Should You Convert to a Roth IRA?
Beginning January1, 2010 anyone can convert their Traditional IRA or in many cases their balance in an employer plan, such as a 401 (k), 403 (b) and 457 plan to a Roth IRA. Previously, only those with income less than $100,000 could do so. Is this a good idea? While conversion can be an important part of one’s financial and estate planning, it is a complex decision based upon many factors and assumptions. Only certain taxpayers will benefit from such a conversion. Furthermore, the decision to convert goes against the tried and true strategy of deferring income taxes as long as possible.
A Traditional IRA and employer plan usually consist of untaxed contributions and earnings thereon although after-tax contributions can also be made. The earnings always grow tax deferred. Distributions generally must begin when the owner attains age 701/2 (the required minimum distribution). Distributions of pre tax contributions and of earnings are taxed at ordinary income tax rates.
A Roth IRA consists of contributions that have already been taxed. Distributions of contributions and income are tax free provided they are made after the fifth anniversary of opening the account. There is no required minimum distribution from the Roth IRA prior to the death of the owner.
Conversion to a Roth IRA requires the owner to pay tax currently (not when distributed) at ordinary income tax rates on the untaxed portion of their Traditional IRA or employer plan. A 10% penalty would also be due on the taxable amount if the owner was less than 59 1/2 years old and had established the Roth IRA within the past 5 years. Why would one in essence prepay this tax? They would do so in order to have future earnings distributed tax free and perhaps to avoid required minimum distributions. They could also be counting on the income tax rates being higher in the future. This may not be a bad assumption due to the growing federal deficit. In fact if Congress does nothing, the top federal rate will rise automatically from 36% to 39.6% in 2011 and thereafter.
The ideal candidate for conversion is a wealthy individual who will not need and does not plan to use the IRA or employer plan funds during his or her lifetime. They would like to leave as much of these funds as possible to their descendents. Because there is no required minimum distribution for the owner, over time the tax free buildup of Roth earnings should more than offset the current tax on conversion. The ideal candidate would also be concerned about the federal estate tax. The ultimate beneficiary pays no income taxes because this ideal candidate has paid it for them when converting to the Roth IRA. The tax payable at conversion reduces one’s taxable estate with no estate or gift tax consideration.
Individuals not planning to use these funds for ten years or more also are a good candidate for conversion. The benefit of ten years of income compounding tax free would probably offset the detrimental present value of the income tax due on conversion. Conversely, an individual planning on using the funds in their near future would not have enough years of tax free compounding necessary to overcome the detriment of paying taxes on the conversion before the funds were distributed.
It is somewhat ironic that high income individuals (unmarried taxpayers with income greater than $120,000 and joint filers with income greater than $177,000) and married filing separate filers with income greater than $10,000 cannot contribute to but can now convert to a Roth IRA. These individuals by making annual non deductible contributions to a Traditional IRA (such contributions are not limited by income) and subsequently converting these contributions to a Roth would in essence be funding a Roth regardless of their income.
Taxes on the conversion are normally due for the year in which the conversion is made. For example, if you convert in 2011, your 2011 income will include the untaxed portion of your Traditional IRA and employer plan and the taxes due to the conversion will be due on April 15th, 2012. Taxpayers converting to a Roth IRA in the year 2010 though will have the option of including one-half of the conversion in their 2011 taxable income and one-half in their 2012 taxable income in addition to the option of including all of the conversion in their 2010 income.
Another favorable aspect of the conversion option is the ability to change one’s mind. This may happen if the market values of the assets drop significantly after conversion. In such a case, the owner can “re-characterize” the converted Roth assets as Traditional IRA assets. Re-characterization can occur as late as the extended due date of the tax return (October 15th of the year following the year of conversion). For this reason, one may want to convert a Traditional IRA or balance in an employer plan into multiple Roth accounts in order to be able to re-characterize only those investments that have depreciated in value. Finally one can elect to “reconvert” the “re-characterized” Traditional IRA back to the Roth IRA after 30 days.
Conversion to a Roth IRA may very well be an important part of your financial strategy. You should consult your financial advisor as soon as possible, because if it is the right strategy for you, the sooner in 2010 you convert, the less tax you will have to pay upon converting.
A Traditional IRA and employer plan usually consist of untaxed contributions and earnings thereon although after-tax contributions can also be made. The earnings always grow tax deferred. Distributions generally must begin when the owner attains age 701/2 (the required minimum distribution). Distributions of pre tax contributions and of earnings are taxed at ordinary income tax rates.
A Roth IRA consists of contributions that have already been taxed. Distributions of contributions and income are tax free provided they are made after the fifth anniversary of opening the account. There is no required minimum distribution from the Roth IRA prior to the death of the owner.
Conversion to a Roth IRA requires the owner to pay tax currently (not when distributed) at ordinary income tax rates on the untaxed portion of their Traditional IRA or employer plan. A 10% penalty would also be due on the taxable amount if the owner was less than 59 1/2 years old and had established the Roth IRA within the past 5 years. Why would one in essence prepay this tax? They would do so in order to have future earnings distributed tax free and perhaps to avoid required minimum distributions. They could also be counting on the income tax rates being higher in the future. This may not be a bad assumption due to the growing federal deficit. In fact if Congress does nothing, the top federal rate will rise automatically from 36% to 39.6% in 2011 and thereafter.
The ideal candidate for conversion is a wealthy individual who will not need and does not plan to use the IRA or employer plan funds during his or her lifetime. They would like to leave as much of these funds as possible to their descendents. Because there is no required minimum distribution for the owner, over time the tax free buildup of Roth earnings should more than offset the current tax on conversion. The ideal candidate would also be concerned about the federal estate tax. The ultimate beneficiary pays no income taxes because this ideal candidate has paid it for them when converting to the Roth IRA. The tax payable at conversion reduces one’s taxable estate with no estate or gift tax consideration.
Individuals not planning to use these funds for ten years or more also are a good candidate for conversion. The benefit of ten years of income compounding tax free would probably offset the detrimental present value of the income tax due on conversion. Conversely, an individual planning on using the funds in their near future would not have enough years of tax free compounding necessary to overcome the detriment of paying taxes on the conversion before the funds were distributed.
It is somewhat ironic that high income individuals (unmarried taxpayers with income greater than $120,000 and joint filers with income greater than $177,000) and married filing separate filers with income greater than $10,000 cannot contribute to but can now convert to a Roth IRA. These individuals by making annual non deductible contributions to a Traditional IRA (such contributions are not limited by income) and subsequently converting these contributions to a Roth would in essence be funding a Roth regardless of their income.
Taxes on the conversion are normally due for the year in which the conversion is made. For example, if you convert in 2011, your 2011 income will include the untaxed portion of your Traditional IRA and employer plan and the taxes due to the conversion will be due on April 15th, 2012. Taxpayers converting to a Roth IRA in the year 2010 though will have the option of including one-half of the conversion in their 2011 taxable income and one-half in their 2012 taxable income in addition to the option of including all of the conversion in their 2010 income.
Another favorable aspect of the conversion option is the ability to change one’s mind. This may happen if the market values of the assets drop significantly after conversion. In such a case, the owner can “re-characterize” the converted Roth assets as Traditional IRA assets. Re-characterization can occur as late as the extended due date of the tax return (October 15th of the year following the year of conversion). For this reason, one may want to convert a Traditional IRA or balance in an employer plan into multiple Roth accounts in order to be able to re-characterize only those investments that have depreciated in value. Finally one can elect to “reconvert” the “re-characterized” Traditional IRA back to the Roth IRA after 30 days.
Conversion to a Roth IRA may very well be an important part of your financial strategy. You should consult your financial advisor as soon as possible, because if it is the right strategy for you, the sooner in 2010 you convert, the less tax you will have to pay upon converting.
February 5, 2010
How Taxpayers Can Avoid Preparer Fraud
Paid tax return preparers are acutely aware of increased IRS scrutiny of their industry. The IRS has recently issued an announcement aimed at clients of return preparers enlisting their help in reducing tax return preparer fraud and warning them that they are responsible for what is submitted on their behalf to IRS.
The vast majority of preparers are good, honest professionals, but as usual, a few “bad apples” have forced the IRS to address the fraudulent and other illegal activities of unscrupulous members of the tax return preparer community. These activities involve the preparation of fraudulent returns generally by claiming false business and personal tax deductions and credits, such as the Earned Income Credit. Many times the taxpayer or client is not even aware of the fraud. Nevertheless, taxpayers and not the preparer are liable for the additional tax, interest and penalties. The taxpayer may also have to pay for professional assistance in representing him or her before the tax examiners. Tax fraud can also be a crime, punishable by imprisonment and hefty fines.
In its announcement, the IRS delineated numerous ways in which taxpayers can avoid tax preparer fraud. First of all, clients should review their tax returns and question entries they are not familiar with. They should never sign a blank return and never use a preparer who charges a fee based upon a percentage of the refund. Be especially wary of preparers who promise a larger refund than other tax return preparers. Make sure the preparer signs the tax return (as required by law) and provides a copy.
Clients should also do some research on their potential preparer. Only CPAs, Attorneys and Enrolled Agents can represent clients in all matters related to federal income taxes such as audits, appeals and collection issues. Other tax return preparers, which may be as competent as CPAs, Attorneys and Enrolled Agents, can only represent taxpayers for audits of returns prepared by them. Taxpayers should also take into consideration whether the preparer will be around to answer questions about the return several years after the return has been filed. The IRS can audit tax returns generally until three years after it has been filed
(Six years for potential fraudulent returns). Finally, clients should inquire as to what professional organizations their preparer is affiliated with. Most professional organizations require its members to obtain continuing education credits and to adhere to it’s code of ethics.
The vast majority of preparers are good, honest professionals, but as usual, a few “bad apples” have forced the IRS to address the fraudulent and other illegal activities of unscrupulous members of the tax return preparer community. These activities involve the preparation of fraudulent returns generally by claiming false business and personal tax deductions and credits, such as the Earned Income Credit. Many times the taxpayer or client is not even aware of the fraud. Nevertheless, taxpayers and not the preparer are liable for the additional tax, interest and penalties. The taxpayer may also have to pay for professional assistance in representing him or her before the tax examiners. Tax fraud can also be a crime, punishable by imprisonment and hefty fines.
In its announcement, the IRS delineated numerous ways in which taxpayers can avoid tax preparer fraud. First of all, clients should review their tax returns and question entries they are not familiar with. They should never sign a blank return and never use a preparer who charges a fee based upon a percentage of the refund. Be especially wary of preparers who promise a larger refund than other tax return preparers. Make sure the preparer signs the tax return (as required by law) and provides a copy.
Clients should also do some research on their potential preparer. Only CPAs, Attorneys and Enrolled Agents can represent clients in all matters related to federal income taxes such as audits, appeals and collection issues. Other tax return preparers, which may be as competent as CPAs, Attorneys and Enrolled Agents, can only represent taxpayers for audits of returns prepared by them. Taxpayers should also take into consideration whether the preparer will be around to answer questions about the return several years after the return has been filed. The IRS can audit tax returns generally until three years after it has been filed
(Six years for potential fraudulent returns). Finally, clients should inquire as to what professional organizations their preparer is affiliated with. Most professional organizations require its members to obtain continuing education credits and to adhere to it’s code of ethics.
Individual Retirement Accounts (IRAs)
The beginning of tax season is always a good time to review the rules applicable to IRAs. Early 2010 is an especially good time because for the first time anyone can change their Traditional IRA to a Roth IRA. IRAs are tax advantaged personal retirement vehicles legislated into existence several decades ago. Over the years, several different types have evolved. The original IRA is now termed “Traditional IRA” to which an individual may make either a deductible or non deductible contribution. Contributions to a “Roth IRA” are never deductible. The third type is a “Simplified Employee Pension or SEP” which is nothing more than an individual’s Traditional IRA to which the individual’s employer makes contributions on behalf of such individual.
There are several rules applicable to both Traditional and Roth IRAs. The maximum contribution that can be made to all IRAs is $5,000 for 2009 and 2010 ($6,000 if the individual is at least 50 years old). A contribution for 2009 can be made up to 4/15/2010. An individual (or spouse in certain cases) must have earned income or alimony at least equal to the contribution. Finally, deductible contributions to a Traditional IRA and contributions to a Roth can be limited or eliminated if certain income limitations are exceeded.
Most people make contributions to Traditional IRAs only if tax deductible. Earnings and appreciation are tax deferred until distributed at which point the full amount of any distribution is taxed at ordinary income tax rates. If non deductible contributions have been made, a prorated portion of any distribution is a tax free return of after tax dollars. One cannot contribute to a Traditional IRA once they reach 701/2 years of age. Distributions must begin the year after attaining age 70 1/2 (“Required Minimum Distributions or RMDs”). Distributions before age 59 1/2 are subject to a 10% premature distribution penalty, with certain exceptions.
Contributions to a Roth IRA are never tax deductible. Distributions of contributions, earnings and appreciation are tax free if made after the 5th anniversary of opening a Roth account when the individual either attains age 591/2 or certain other conditions are met. Contributions to a Roth can be made after reaching age 70 1/2. There is no Required Minimum Distribution for the owner of a Roth and generally no 10% premature distribution penalty.
As previously mentioned, deductible contributions to a Traditional IRA and contributions to a Roth IRA may be limited by income (“Modified Adjusted Gross Income” or “MAGI”). The amount of deductible contributions for unmarried individuals participating in their employer’s retirement plan begins to phase out for 2009 when MAGI equals $55,000 and is completely phased out at $65,000 ($56,000 and $66,000 respectively for 2010). For married individuals filing a joint return, if both spouses are covered by an employer plan, the deductible contribution for both 2009 and 2010 begins to phase out when MAGI equals $89,000 and is completely phased out at $99,000. If your spouse is covered but you are not, your deduction begins to phase out at $166,000 and is eliminated at $176,000 for 2009 ($167,000 and $177,000 respectively for 2010). For 2009 and 2010 the deductible contribution for married taxpayers filing separately begins to phase out at $0 and is totally phased out at $10,000 of MAGI if either the taxpayer or in some cases their spouse is a participant in an employer plan for both 2009 and 2010. Non-deductible contributions to a Traditional IRA are not limited by income.
The ability to make a contribution to a Roth IRA is phased out when MAGI exceeds certain levels irrespective of active participation in an employer retirement plan. For unmarried taxpayers, this ability begins to phase out when MAGI equals $105,000 and is completely phased out at $120,000 for both 2009 and 2010. For married taxpayers filing a joint return, the phase out amounts are $166,000 and $176,000 for 2009 ($167,000 and $177,000 respectively for 2010). The phases out amounts are $0 and $10,000 for married taxpayers filing separately for 2009 and 2010.
Many taxpayers think a Roth IRA would be favorable to a Traditional IRA considering the inevitable increase in income tax rates. Conversion to a Roth was previously available only to those with income less than $100,000. The tax law offers a window of opportunity to anyone, regardless of income, to convert to a Roth beginning in 2010. The next post will examine this opportunity.
Avoid These Mistakes When You File Your Tax Return
According to the IRS, taxpayers continue to make the same mistakes every year when they file their tax returns. These mistakes lead to at best a delay in receiving your refund and at worse, closer scrutiny of your return by the IRS examiners. All of the following common mistakes are easily avoidable by exercising due diligence.
Using and verifying one’s proper social security or taxpayer identification number seems to be more difficult than one would expect. While entering a taxpayer’s proper number on the return is easy enough, problems can and do arise when a third party reports income and deductions to IRS using the wrong number. Pay careful attention to 1099’s. For example, reporters sometimes use your number on your child’s account or vice versa. Divorced taxpayers sometimes have their home mortgage interest deduction reported on form 1098 under their ex-spouse’s social security number Also, be careful to enter the correct social security number of your dependent child or your return will bounce.
Some taxpayers, at least according to IRS, have difficulty in determining their proper filing status. This mistake is especially common among taxpayers whose marital status is in flux. With respect to the tax code, you are either married or not on the last day of the year. If you are married, you can choose between filing a joint return with your legal spouse or choose to file as married filing separately. You cannot file as a single taxpayer. For most taxpayers, filing a joint return will result in lower taxes, but can subject an “innocent” taxpayer to the tax liabilities of their spouse. When in doubt, use the married filing separately status because you can later amend your return and file jointly with your spouse. You cannot initially file a joint return and later amend to file married filing separately. Single and certain married but legally separated taxpayers who maintain the household of certain dependents may qualify for the head of household filing status, which is better than single or married filing separately. According to IRS, this option is either frequently overlooked or wrongfully used.
Failing to claim or wrongfully claiming the Earned Income Credit is another common error. The rules are extremely complex but if not addressed you can cost yourself a lot of money by failing to claim or subject yourself to substantial penalties by wrongfully claiming the credit.
The IRS seems to have developed a form for every issue and strongly prefers that you use their forms. For example, if you claim unreimbursed employee business expenses as a deduction, be sure to use form 2106 or you return may bounce. Similarly, non cash charitable contributions over $500 will be disallowed unless IRS Form 8283 is attached to the tax return.
An error that is increasingly becoming more common is the failure to compute and pay the Alternative Minimum TAX (AMT). The AMT is a tax that parallels the income tax and is payable to the extent it exceeds the regular income tax. Taxpayers with income greater than the AMT exemption of $46,700 ($70,950 for joint returns) must consider this tax or IRS may do it for them. As usual. IRS has a form (6251) to help compute this tax.
Finally, be sure to sign and date your tax return.
December 29, 2009
Reverse Mortgages: Good or Bad Idea?
Every time I see a certain celebrity talking about reverse mortgages on television, I wonder if they are a good or bad idea. Reverse mortgages have been around for a long time. The older products for a variety of reasons usually turned out to be a bad idea. The product Mr. Wagner is talking about though is very different from the older products and may be a good idea under the right circumstances. The rest of this article concerns only the newer, federally insured products.
A reverse mortgage is a way to access the equity in your home without selling it. You can receive a lump sum, periodic payments, a line of credit or any combination of the above. The cash you receive is not taxable, nor does it affect Social Security or Medicare. The federal government through HUD sets the terms, including interest rates, fees and payments. The note is a federally insured non recourse obligation. The result is that you never have to make a payment unless you sell your home and you will never owe more than your home is worth.
In order to be eligible for this product all borrowers must be at least 62 years old. The home must be the principal residence of the borrowers. The borrowers must consult with a HUD certified counselor before their application is approved.
The downside is that a reverse mortgage is an expensive alternative to more traditional ways to tap the equity in your home. Settlement costs are approximately 5%, including a 2% origination fee, a 2% insurance fee and approximately 1% for other settlement costs. The interest rate will be increased by .5% to help pay the cost of federal insurance and the bank will also charge a service fee. Most of these fees would not be charged if you were able to access your equity with a traditional line of credit or simply sell your home.
If your income is such that you cannot qualify for a line of credit or you cannot or do not want to sell, this product may just be a good idea for you. Take Mr. Wagner’s advice and consider this alternative. The AARP web site may be a good place to start.
A reverse mortgage is a way to access the equity in your home without selling it. You can receive a lump sum, periodic payments, a line of credit or any combination of the above. The cash you receive is not taxable, nor does it affect Social Security or Medicare. The federal government through HUD sets the terms, including interest rates, fees and payments. The note is a federally insured non recourse obligation. The result is that you never have to make a payment unless you sell your home and you will never owe more than your home is worth.
In order to be eligible for this product all borrowers must be at least 62 years old. The home must be the principal residence of the borrowers. The borrowers must consult with a HUD certified counselor before their application is approved.
The downside is that a reverse mortgage is an expensive alternative to more traditional ways to tap the equity in your home. Settlement costs are approximately 5%, including a 2% origination fee, a 2% insurance fee and approximately 1% for other settlement costs. The interest rate will be increased by .5% to help pay the cost of federal insurance and the bank will also charge a service fee. Most of these fees would not be charged if you were able to access your equity with a traditional line of credit or simply sell your home.
If your income is such that you cannot qualify for a line of credit or you cannot or do not want to sell, this product may just be a good idea for you. Take Mr. Wagner’s advice and consider this alternative. The AARP web site may be a good place to start.
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