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.
Claiming Expanded NOL Carrybacks for 2008 and 2009
Prior to the 2008 tax year, net operating losses (NOLs) could generally be carried back two years and forward 20 years. In February 2009, the American Recovery and Reinvestment Tax Act (the “February Act”) extended the carryback period to a maximum of five years—but only for “eligible small businesses” (ESBs) and in most cases only for the 2008 loss. ESBs are defined under a $15 million gross receipts test discussed below. As a further stimulus measure, in November 2009 Congress passed the Worker, Homeownership & Business Assistance Act of 2009 (the “November Act”), extending five-year carryback relief to most businesses including those that are not ESBs. Even after the November Act, however, ESBs still enjoy two important advantages—discussed below—over non-ESBs. On November 20, 2009, IRS issued Rev.Proc. 2009-52, 2009-49 IRB 744, which spells out the timing and procedure involved in claiming carrybacks under the November Act. This article refers to a taxpayer’s ability to elect a 3, 4 or 5 year carryback period under Code Section 172(b)(1)(H), whether under the February Act or the November Act, as “expanded carryback relief”.
Certain recipients of federal emergency assistance (TARP funds) and their affiliates are ineligible for expanded carryback relief under the November Act. Additionally, special rules—not covered here—apply to NOLs of life insurance companies and corporations filing consolidated returns.
An ESB is a corporation, partnership, or sole proprietorship that has $15,000,000 or less in average annual gross receipts over a three-year period, determined after aggregating gross receipts of certain related persons and applying other special rules adopted from the gross receipts test of Code Section 448(c)(1) (which relates to restrictions on use of the cash method of accounting). In the case of a partnership or S corporation, although the election to use expanded carryback relief is made at the partner or shareholder level, the gross receipts test itself is applied at the partnership or S corporation level. In Rev.Proc. 2009-26, 2009-19 IRB 935 (April 24, 2009), IRS ruled that for purposes of expanded carryback relief the three-year period for averaging gross receipts includes the year in which the NOL arises (the loss year). The gross receipts test is applied by aggregating gross receipts of all persons treated as a single employer under Code Sections 52(a) or (b) or 414(m) or (o), and by eliminating gross receipts from transactions between the persons being aggregated. “Gross receipts” are reduced by returns and allowances and, where capital or Section 1231 assets are sold, by the adjusted basis of the property sold (per Temp.Treas.Reg.Sec. 1.448-1T(f)(iv)). Special rules apply to short taxable years, entities with less than a three-year history, and predecessor businesses.
The most important difference in treatment between ESBs and non-ESBs is that “applicable net operating losses” from two tax years of an ESB—but only one tax year of a non-ESB—can qualify for expanded carryback relief. An “applicable net operating loss” is the NOL for a tax year that ends after December 31, 2007, and begins before January 1, 2010. Thus a calendar year taxpayer with 2008 and 2009 NOLs attributable to an ESB may carry back each NOL to a period of up to five years (subject to different filing deadlines as explained below). In contrast, a calendar year taxpayer with 2008 and 2009 NOLs from a non-ESB who elects expanded carryback relief must choose between the two years. Under the first example, a further difference is that the 2008 ESB NOL that is carried back to the fifth preceding tax year (under the February Act) is not subject to the limitation under the November Act that prevents an applicable NOL from offsetting more than 50% of taxable income in the fifth preceding year.
Not surprisingly, an election to use expanded carryback relief applies for purposes of both the regular tax and the alternative minimum tax (AMT). An important benefit of expanded carryback relief under the November Act, however, is that it is not subject to the rule that would otherwise prevent an AMT NOL from offsetting more than 90% of AMT income in a carryback year.
An election to use expanded carryback relief pursuant to the November Act is normally made by attaching to the taxpayer’s original or amended return for the loss year a statement that includes the following information:
That the taxpayer is electing to apply Section 172(b)(1)(H) of the Internal Revenue Code under Rev. Proc. 2009-52;
That the taxpayer is not a TARP recipient nor, in 2008 or 2009, an affiliate of a TARP recipient; and
The length of the NOL carryback period that the taxpayer elects (3, 4 or 5 years).
The taxpayer must also file a copy of the election statement with the return that applies the NOL to the carryback year (e.g., the Form 1045, Application for a Tentative Refund, for the carryback year). The election must be made by the due date (including extensions) for filing the return for the taxpayer’s last tax year that begins in 2009; the same deadline applies to the applicable Form 1045. Once made, the election is irrevocable. If the election amends a previous carryback claim or application (e.g., the taxpayer carried back the applicable NOL on a previously-filed Form 1045), the election must so state. Note, however, that the prior carryback of an ESB NOL pursuant to the February Act cannot be amended. Section 4.01(4) of Rev.Proc. 2009-52 provides an alternate procedure for making the Section 172(b)(1)(H) election, which is similar to the primary procedure but does not require that the election statement be filed with the return for the loss year.
If a taxpayer has previously waived carrybacks from the loss year under Code Section 172(b)(3) and is now revoking that waiver, the taxpayer must also file a statement indicating that it is revoking the NOL carryback waiver and is electing to apply Section 172(b)(1)(H). The November Act permits such a revocation for a tax year that ended before the November 6, 2009, date of enactment. Filing of the revocation election involves much the same procedure, information, and time limits as those that apply to the election of expanded carryback relief. The revocation applies for both regular tax and AMT purposes.
A carryback election under the February Act may be made by filing Form 1045, Application for a Tentative Refund (or other applicable form applying the extended carryback), within six months of the extended due date for filing the taxpayer’s return for the year of the “applicable 2008 net operating loss”. Under the February Act, a fiscal year taxpayer may elect to treat as its “applicable 2008 net operating loss” the NOL for its tax year that begins in 2008 (rather than its tax year that ends in 2008). In this regard, see Rev.Proc. 2009-26, 2009-19 IRB 935 (April 25, 2009), which continues to provide procedures for electing carrybacks under the February Act. Making a timely election under the February Act for an ESB NOL preserves the possibility of claiming expanded carryback relief for two loss years—one under the February Act and one under the November Act.
Contributed by Glenn Madere, Esq. Glenn Madere is the Editor of The Readable Code and Regs: Partnerships (Blue Bell, PA: Readable Press, 2009) Readable Press Website
Prepare Now For Next April 15th?
I know 2009 has not ended. Obviously you have not received your W-2, 1099s or mortgage interest and real estate tax statement. Over the holidays, though, there some things you can do beyond the normal gathering and organizing to make your 2009 tax return preparation a little easier. If you are one of the few and brave who prepare their own tax return, now is the time to line up your tax return preparation software. There are plenty of efficient, cost effective options available. All you need to do is find the right one for you. Whether you self prepare or use a paid preparer, consider whether any of the following issues should be addressed now rather than later.
Having receipts to prove your tax deductions is obviously very important. Certain expenses such as charitable contributions greater than $250 and meals and lodging greater than $25 must be supported by receipts in order to be deductible. Now may be a good time to gather these receipts and if not available, request duplicates. You can also use this time to determine and finalize capital gains and losses for the year. You may want to call your broker before the end of 2009. Once an employee receives their final pay stub, he or she should review it first of all to make sure it is understood. In case there are any errors, your employer will have time before form W-2 is issued to correct these errors.
Inevitably, for some people there are certain issues that must be addressed before they can file their tax returns. It may be possible to reduce the April 15th stress by attempting to resolve these issues now.. Your filing status may be one of these issues. Married taxpayers may have to decide whether they want to file a joint return with their spouse or use the status of married filing separately. This involves many issues and April 15th is no time to make this decision. Similarly, if the dependency exemption between spouses and ex spouses has not been determined there is no advantage in delaying this discussion.
Another way to reduce stress is to decide now whether to make an IRA contribution. While the contribution does not have to be made until April 15th, you can avoid last minute potential problems by making the deposit now. If you employ at home domestic help, depending on the amount, you may be required to withhold and pay federal income and employment taxes. If you have not done so already, you need to discuss this with your employee now rather than later.
Finally, if your withholding and estimates for 2009 are not enough you can catch up somewhat with a January 15th estimate. State taxes paid by December 31, 2009 are deductible for 2009 even if due when filing your state return.
Having receipts to prove your tax deductions is obviously very important. Certain expenses such as charitable contributions greater than $250 and meals and lodging greater than $25 must be supported by receipts in order to be deductible. Now may be a good time to gather these receipts and if not available, request duplicates. You can also use this time to determine and finalize capital gains and losses for the year. You may want to call your broker before the end of 2009. Once an employee receives their final pay stub, he or she should review it first of all to make sure it is understood. In case there are any errors, your employer will have time before form W-2 is issued to correct these errors.
Inevitably, for some people there are certain issues that must be addressed before they can file their tax returns. It may be possible to reduce the April 15th stress by attempting to resolve these issues now.. Your filing status may be one of these issues. Married taxpayers may have to decide whether they want to file a joint return with their spouse or use the status of married filing separately. This involves many issues and April 15th is no time to make this decision. Similarly, if the dependency exemption between spouses and ex spouses has not been determined there is no advantage in delaying this discussion.
Another way to reduce stress is to decide now whether to make an IRA contribution. While the contribution does not have to be made until April 15th, you can avoid last minute potential problems by making the deposit now. If you employ at home domestic help, depending on the amount, you may be required to withhold and pay federal income and employment taxes. If you have not done so already, you need to discuss this with your employee now rather than later.
Finally, if your withholding and estimates for 2009 are not enough you can catch up somewhat with a January 15th estimate. State taxes paid by December 31, 2009 are deductible for 2009 even if due when filing your state return.
December 3, 2009
Deducting Fraudulent Investment Losses
If you did not know what a Ponzi scheme was prior to last year, you probably know by now thanks to Bernie Madoff. While Ponzi and Ponzi-like schemes have been going on for years, last year's economic downturn has brought the losses suffered by investors into focus.
There is no question that innocent investors have lost money in these schemes. For tax purposes though, it is sometimes unclear how and when to deduct these losses. Fortunately, in March 2009, the IRS issued Revenue Ruling 2009-9 which attempts to guide individual taxpayer victims of fraudulent investment schemes.
This ruling addressed a situation where the investor/taxpayer invested money with an investment advisor who perpetrated a criminal Ponzi scheme fraud on the investor. When the fraud was discovered, there was no money left in the fictitious account.
The first question that needed to be answered is whether the loss is capital in nature or a theft deduction. Taxpayers generally do not want capital loss treatment because such losses are limited to capital gains plus $3,000. IRS answered that if the loss resulted from illegal activity, then it is not a capital but a theft loss.
The next question is whether the theft loss was the result of a transaction entered into for profit. If not, the loss is deductible only to the extent it exceeds 10% of Adjusted Gross Income. Fortunately, the IRS decided that such fraudulent investment losses are the result of transactions entered into for profit and thus not so limited.
In this Revenue Ruling, the IRS concluded that the theft loss deduction for fraudulent investment schemes is a miscellaneous itemized deduction not limited by the 2% of Adjusted Gross Income or any other rule, therefore reported in full without limitation.
The IRS also addressed the timing of the theft loss. This is an issue because the loss was incurred in part in years that were closed by the Statue of Limitations. The IRS concluded that since a theft loss is deductible in full in the year the theft is discovered, losses incurred in previous years are not closed by the Statute of Limitations.
The amount of a deductible loss is the taxpayer's basis (contributions plus income reported as taxable less distributions). The deductible loss should be reduced by any amount for which in the year of discovery there is a reasonable prospect for recovery. Finally the IRS concluded that such a theft loss can create a net operating loss which can be carried back 3 years and carried forward 15 years.
This Revenue Ruling assumed certain important facts which helped the IRS reach its favorable opinion. It assumed the taxpayer's loss was from a theft discovered in the year a deduction was claimed. The amount was easy to determine because it was assumed that there was no reasonable prospect for recovery. These clear cut facts are not always the case, so the IRS went one step further and provided a safe harbor for taxpayers. If the provisions of Revenue Procedure 2009-20 are followed the IRS will not contest the taxpayer's treatment as a theft loss.
For this Revenue Procedure to apply, the loss must be connected with the commission of a crime which the investor had no knowledge of until it became public. If so, in the year in which the criminal indictment or complaint is filed the investor can deduct 95% of the loss if he or she does not pursue any avenue of recovery or 75% if the investor intends to pursue potential third party recovery. Please consult this Revenue Procedure (Rev. Proc. 2009-20, 2009-14 I.R.B. 749) for further details.
There is no question that innocent investors have lost money in these schemes. For tax purposes though, it is sometimes unclear how and when to deduct these losses. Fortunately, in March 2009, the IRS issued Revenue Ruling 2009-9 which attempts to guide individual taxpayer victims of fraudulent investment schemes.
This ruling addressed a situation where the investor/taxpayer invested money with an investment advisor who perpetrated a criminal Ponzi scheme fraud on the investor. When the fraud was discovered, there was no money left in the fictitious account.
The first question that needed to be answered is whether the loss is capital in nature or a theft deduction. Taxpayers generally do not want capital loss treatment because such losses are limited to capital gains plus $3,000. IRS answered that if the loss resulted from illegal activity, then it is not a capital but a theft loss.
The next question is whether the theft loss was the result of a transaction entered into for profit. If not, the loss is deductible only to the extent it exceeds 10% of Adjusted Gross Income. Fortunately, the IRS decided that such fraudulent investment losses are the result of transactions entered into for profit and thus not so limited.
In this Revenue Ruling, the IRS concluded that the theft loss deduction for fraudulent investment schemes is a miscellaneous itemized deduction not limited by the 2% of Adjusted Gross Income or any other rule, therefore reported in full without limitation.
The IRS also addressed the timing of the theft loss. This is an issue because the loss was incurred in part in years that were closed by the Statue of Limitations. The IRS concluded that since a theft loss is deductible in full in the year the theft is discovered, losses incurred in previous years are not closed by the Statute of Limitations.
The amount of a deductible loss is the taxpayer's basis (contributions plus income reported as taxable less distributions). The deductible loss should be reduced by any amount for which in the year of discovery there is a reasonable prospect for recovery. Finally the IRS concluded that such a theft loss can create a net operating loss which can be carried back 3 years and carried forward 15 years.
This Revenue Ruling assumed certain important facts which helped the IRS reach its favorable opinion. It assumed the taxpayer's loss was from a theft discovered in the year a deduction was claimed. The amount was easy to determine because it was assumed that there was no reasonable prospect for recovery. These clear cut facts are not always the case, so the IRS went one step further and provided a safe harbor for taxpayers. If the provisions of Revenue Procedure 2009-20 are followed the IRS will not contest the taxpayer's treatment as a theft loss.
For this Revenue Procedure to apply, the loss must be connected with the commission of a crime which the investor had no knowledge of until it became public. If so, in the year in which the criminal indictment or complaint is filed the investor can deduct 95% of the loss if he or she does not pursue any avenue of recovery or 75% if the investor intends to pursue potential third party recovery. Please consult this Revenue Procedure (Rev. Proc. 2009-20, 2009-14 I.R.B. 749) for further details.
When To Take Social Security Retirement
Baby boomers are fast approaching their entitlement to Social Security retirement benefits. Many face an important decision as to whether to begin receiving these benefits at age 62, normal retirement age or to delay receipt until after normal retirement age.
Normal retirement age depends upon the year you were born. If you were born between 1943 and 1954, normal retirement age is 66. If you were born in or after 1960, normal retirement age is 67. Those born between these years have a graduated normal retirement age between ages 66 and 67.
Regardless of your normal retirement age, you may elect to receive your Social Security retirement benefits as early as age 62. For those facing this decision in the next 10 years, monthly benefits are permanently reduced by 5/9 of 1% for the first 36 months and 5/12 of 1% for any remaining months of benefits taken before normal retirement age. You can also decide to defer receiving your benefits past normal retirement age. If so, your monthly benefit will be permanently increased by 2/3 of 1% for each month you wait (up to age 70).
Social Security is designed, considering the population as a whole, to provide the same lifetime benefit whether received early, late or at normal retirement age. Your personal decision will depend upon a number of factors. The initial question is whether you have the flexibility to choose when to receive your benefits or because of economics, you need the cash as soon as possible. You may also want to consider your health and life expectancy.
Assuming you have the flexibility, most if not all actuarial studies show that in most cases, you would be better off electing to receive your benefits at age 62. There are several scenarios though where you may want to delay receiving your benefits.
If you intend to work after age 62. Social Security retirement benefits are reduced by $1 for every $2 of earnings greater than $14,160 in 2009 ($1 for every $3 of earnings greater than $37,680 if 2009 is the year you reach normal retirement age).
If you have not maximized your Social Security retirement benefit If you work after attaining age 62, you may increase your benefit to the extent your earnings in these years are greater than previous year earnings.
You should visit http://www.ssa.gov/. to see how these rules affect you personally. The retirement planning option will give dollars and cents options applicable to you.. Regardless of when you decide to receive retirement benefits, be sure to apply for Medicare benefits at age 65 since there is no advantage in delaying this benefit.
Normal retirement age depends upon the year you were born. If you were born between 1943 and 1954, normal retirement age is 66. If you were born in or after 1960, normal retirement age is 67. Those born between these years have a graduated normal retirement age between ages 66 and 67.
Regardless of your normal retirement age, you may elect to receive your Social Security retirement benefits as early as age 62. For those facing this decision in the next 10 years, monthly benefits are permanently reduced by 5/9 of 1% for the first 36 months and 5/12 of 1% for any remaining months of benefits taken before normal retirement age. You can also decide to defer receiving your benefits past normal retirement age. If so, your monthly benefit will be permanently increased by 2/3 of 1% for each month you wait (up to age 70).
Social Security is designed, considering the population as a whole, to provide the same lifetime benefit whether received early, late or at normal retirement age. Your personal decision will depend upon a number of factors. The initial question is whether you have the flexibility to choose when to receive your benefits or because of economics, you need the cash as soon as possible. You may also want to consider your health and life expectancy.
Assuming you have the flexibility, most if not all actuarial studies show that in most cases, you would be better off electing to receive your benefits at age 62. There are several scenarios though where you may want to delay receiving your benefits.
If you intend to work after age 62. Social Security retirement benefits are reduced by $1 for every $2 of earnings greater than $14,160 in 2009 ($1 for every $3 of earnings greater than $37,680 if 2009 is the year you reach normal retirement age).
If you have not maximized your Social Security retirement benefit If you work after attaining age 62, you may increase your benefit to the extent your earnings in these years are greater than previous year earnings.
You should visit http://www.ssa.gov/. to see how these rules affect you personally. The retirement planning option will give dollars and cents options applicable to you.. Regardless of when you decide to receive retirement benefits, be sure to apply for Medicare benefits at age 65 since there is no advantage in delaying this benefit.
Want to Reduce Your 2009 Taxes?
Every Thanksgiving many people look for ways to reduce their taxes by year end. Reducing your taxes is accomplished by minimizing taxable income (deferring income and/or accelerating deductions) and maximizing tax credits. Taxpayers who believe an increase in rates for 2010 is inevitable may want to maximize 2009 income and minimize 2010 income to the extent possible. Assuming though you wish to employ traditional tax planning techniques and reduce your 2009 taxes, there are some options you may want to consider before year end.
Legally deferring income to 2010 can result in a double benefit. Not only do you delay paying tax on the deferred income, a lesser Adjusted Gross Income (AGI) means exclusions like IRA contributions, deductions limited by AGI, like medical expenses and credits, like education credits also limited by AGI can be greater. One cannot simply tell their employer to delay salary until 2010, nor can self employed individuals unilaterally wait until 2010 to deposit receipts. There are though legal ways to reduce AGI.
Self employed individuals can legally reduce their AGI by doing such things as accelerating purchases necessary to their business. They should seek to time the purchase of equipment such as computers in order to maximize the section 179 deduction which allows immediate expensing of otherwise depreciable assets. The self employed should also consider maximizing retirement plan contributions, which may require adopting a profit sharing, 401 (k) or SEP plan by year end. Wage earners should also plan to maximize their 401 (k) contributions by year end.
All taxpayers potentially can reduce AGI by making sure they recognize realized capital losses. Capital losses can offset capital gains in full. In addition, losses greater than gains up to $3,000 can offset any other type of income. Retired taxpayers over age 70 ½ do not have to take (and pay tax on) required minimum distributions in 2009. Despite the publicity concerning this issue, it is surprising many taxpayers are unaware of this opportunity.
This may also be the time to revisit your flexible spending account, especially if your employer requires you to spend your account by year end. You may also want to consider increasing your contribution for next year at this time. You may also want to examine your medical expenses at this time in order to maximize the 7.5% of AGI threshold either in 2009 or 2010.
The timing of charitable contributions can result in a tax planning opportunity. You may be able to satisfy a pledge early, or prepay contributions you would normally make in 2010 before year end. As always, consider donating appreciated stock to your charity and avoid the capital gains tax. To the extent you have a significant state tax liability for 2009, but due on 4/15/2010, consider paying by year end to get a 2009 tax deduction. Be careful to consider the alternative minimum tax implications.
At this point in the year, the first time home buyers tax credit is probably not available. However, if you were planning to buy a car soon, you still have time to purchase a new car before year end and perhaps deduct the sales tax. Finally, make sure you tax advantage of tax credits before year end, especially credits available to make your home more energy efficient.
Legally deferring income to 2010 can result in a double benefit. Not only do you delay paying tax on the deferred income, a lesser Adjusted Gross Income (AGI) means exclusions like IRA contributions, deductions limited by AGI, like medical expenses and credits, like education credits also limited by AGI can be greater. One cannot simply tell their employer to delay salary until 2010, nor can self employed individuals unilaterally wait until 2010 to deposit receipts. There are though legal ways to reduce AGI.
Self employed individuals can legally reduce their AGI by doing such things as accelerating purchases necessary to their business. They should seek to time the purchase of equipment such as computers in order to maximize the section 179 deduction which allows immediate expensing of otherwise depreciable assets. The self employed should also consider maximizing retirement plan contributions, which may require adopting a profit sharing, 401 (k) or SEP plan by year end. Wage earners should also plan to maximize their 401 (k) contributions by year end.
All taxpayers potentially can reduce AGI by making sure they recognize realized capital losses. Capital losses can offset capital gains in full. In addition, losses greater than gains up to $3,000 can offset any other type of income. Retired taxpayers over age 70 ½ do not have to take (and pay tax on) required minimum distributions in 2009. Despite the publicity concerning this issue, it is surprising many taxpayers are unaware of this opportunity.
This may also be the time to revisit your flexible spending account, especially if your employer requires you to spend your account by year end. You may also want to consider increasing your contribution for next year at this time. You may also want to examine your medical expenses at this time in order to maximize the 7.5% of AGI threshold either in 2009 or 2010.
The timing of charitable contributions can result in a tax planning opportunity. You may be able to satisfy a pledge early, or prepay contributions you would normally make in 2010 before year end. As always, consider donating appreciated stock to your charity and avoid the capital gains tax. To the extent you have a significant state tax liability for 2009, but due on 4/15/2010, consider paying by year end to get a 2009 tax deduction. Be careful to consider the alternative minimum tax implications.
At this point in the year, the first time home buyers tax credit is probably not available. However, if you were planning to buy a car soon, you still have time to purchase a new car before year end and perhaps deduct the sales tax. Finally, make sure you tax advantage of tax credits before year end, especially credits available to make your home more energy efficient.
Social Security Retirement
The Social Security Program was initially enacted to benefit senior citizens impoverished by the Great Depression. While many people think of Social Security in terms of retirement, today’s Social Security provides much more than benefits to retired workers. It also provides retirement benefits to spouses, ex spouses and minor children of retired workers as well as disability benefits to the worker, and his or her spouse and children.
This discussion though is limited to Social Security retirement benefits. While Social Security was never designed to be one’s sole source of retirement income, law changes through 1981 and automatic cost of living adjustments through 2009 have grown Social Security retirement benefits to a significant sum. The Social Security Administration though has recently announced that for the first time, there will be no cost of living adjustment for 2010 because there was no increase in the Consumer Price Index for the relevant period.
For 2009, the average Social Security benefit paid to a retired worker is $1,153 per month or $13,836 annually. The average monthly payment to a retired married couple is $1,876 or $22,512 annually. The maximum Social Security benefit in 2009 is $2,323 per month or $27,876 annually. To qualify for the maximum benefit, one must have worked for 35 years, earning at or above the maximum wage base applicable to each of the 35 years.
Your Social Security benefits are financed by payroll taxes paid equally by you and by your employer. Self employed workers pay the entire tax. The tax rate and taxable wage base have grown significantly. For 2009 (and 2010) the rate is 7.65% each on the first $106,800 of taxable wages. In 1937, the rate was 1% of the first $3,000 of taxable wages. In 1974, the rate was 4.95% each on the first $13,200 of wages.
This dramatic increase in payroll tax has caused many, especially higher earners, to ask whether these payroll taxes could have provided them a larger retirement benefit if invested privately. Social Security provides a monthly annuity for life. For the sake of comparison, let us see how much of a commercial monthly annuity could be purchased with these payroll taxes.
Assume an individual retiring in 2009 at full retirement age has worked for 35 years earning exactly one half of the maximum social security wage base in each of those 35 years. This person’s social security benefit would be $1652 per month increased each year for cost of living adjustments measured by the increase (if any) in the consumer price index. Over his or her earnings years, they would have paid $56,834 in payroll taxes. Invested at 3%, these taxes would buy a comparable annuity of $437.45 per month. Invested at 6%, the comparable annuity would be $695.05 per month. Considering that the employer contributes an equal amount, even doubling these commercial annuities would not beat Social Security.
Social Security benefits are weighted more for the first dollars of earnings than the last dollars of earnings. One would then expect a higher earning worker to receive a lesser return on their “investment”. An individual retiring in 2009 again at full retirement age but earning (and paying tax on) the maximum social security wage base for 35 years would receive the maximum retirement benefit of $2,323 per month. This individual would have paid $ 113,668 in payroll taxes. Invested at 3%, a comparable commercial annuity would pay $875.43 per month, $1390.74 per month if the payroll taxes were invested at 6%. Counting the equal employer contribution, if the total employer and employee payroll taxes were invested at 3%, the equivalent commercial annuity would be $1751.39 per month, far less than the monthly social security retirement benefit of $2323.
If both employer and employee taxes were invested at 6% a commercial annuity could be purchased paying $2782.01 per month. While this is slightly greater than the Social Security benefit, the Social Security program offers additional benefits to workers. For example, the Social Security retirement benefit is more like a 100% joint and survivor annuity in certain cases. The spouse of a deceased worker would receive the deceased worker’s benefit if greater than the surviving spouse’s own benefit. A worker retiring in 2009, having paid the maximum payroll tax for 35 years and invested both the employer and employee contributions at 6% could purchase a 100% joint and survivor annuity paying $2163.72 per month with the funds, less than the Social Security benefit of $2323.
Social Security taxes also fund a disability program for workers suffering total disability prior to attaining retirement age. This is a potential cost that would have to be added to the cost of the commercial annuity for comparison purposes.
Workers close to retirement should also consider whether they are better off receiving their Social Security benefits either before or after normal retirement age. This will be the subject of the next posting.
This discussion though is limited to Social Security retirement benefits. While Social Security was never designed to be one’s sole source of retirement income, law changes through 1981 and automatic cost of living adjustments through 2009 have grown Social Security retirement benefits to a significant sum. The Social Security Administration though has recently announced that for the first time, there will be no cost of living adjustment for 2010 because there was no increase in the Consumer Price Index for the relevant period.
For 2009, the average Social Security benefit paid to a retired worker is $1,153 per month or $13,836 annually. The average monthly payment to a retired married couple is $1,876 or $22,512 annually. The maximum Social Security benefit in 2009 is $2,323 per month or $27,876 annually. To qualify for the maximum benefit, one must have worked for 35 years, earning at or above the maximum wage base applicable to each of the 35 years.
Your Social Security benefits are financed by payroll taxes paid equally by you and by your employer. Self employed workers pay the entire tax. The tax rate and taxable wage base have grown significantly. For 2009 (and 2010) the rate is 7.65% each on the first $106,800 of taxable wages. In 1937, the rate was 1% of the first $3,000 of taxable wages. In 1974, the rate was 4.95% each on the first $13,200 of wages.
This dramatic increase in payroll tax has caused many, especially higher earners, to ask whether these payroll taxes could have provided them a larger retirement benefit if invested privately. Social Security provides a monthly annuity for life. For the sake of comparison, let us see how much of a commercial monthly annuity could be purchased with these payroll taxes.
Assume an individual retiring in 2009 at full retirement age has worked for 35 years earning exactly one half of the maximum social security wage base in each of those 35 years. This person’s social security benefit would be $1652 per month increased each year for cost of living adjustments measured by the increase (if any) in the consumer price index. Over his or her earnings years, they would have paid $56,834 in payroll taxes. Invested at 3%, these taxes would buy a comparable annuity of $437.45 per month. Invested at 6%, the comparable annuity would be $695.05 per month. Considering that the employer contributes an equal amount, even doubling these commercial annuities would not beat Social Security.
Social Security benefits are weighted more for the first dollars of earnings than the last dollars of earnings. One would then expect a higher earning worker to receive a lesser return on their “investment”. An individual retiring in 2009 again at full retirement age but earning (and paying tax on) the maximum social security wage base for 35 years would receive the maximum retirement benefit of $2,323 per month. This individual would have paid $ 113,668 in payroll taxes. Invested at 3%, a comparable commercial annuity would pay $875.43 per month, $1390.74 per month if the payroll taxes were invested at 6%. Counting the equal employer contribution, if the total employer and employee payroll taxes were invested at 3%, the equivalent commercial annuity would be $1751.39 per month, far less than the monthly social security retirement benefit of $2323.
If both employer and employee taxes were invested at 6% a commercial annuity could be purchased paying $2782.01 per month. While this is slightly greater than the Social Security benefit, the Social Security program offers additional benefits to workers. For example, the Social Security retirement benefit is more like a 100% joint and survivor annuity in certain cases. The spouse of a deceased worker would receive the deceased worker’s benefit if greater than the surviving spouse’s own benefit. A worker retiring in 2009, having paid the maximum payroll tax for 35 years and invested both the employer and employee contributions at 6% could purchase a 100% joint and survivor annuity paying $2163.72 per month with the funds, less than the Social Security benefit of $2323.
Social Security taxes also fund a disability program for workers suffering total disability prior to attaining retirement age. This is a potential cost that would have to be added to the cost of the commercial annuity for comparison purposes.
Workers close to retirement should also consider whether they are better off receiving their Social Security benefits either before or after normal retirement age. This will be the subject of the next posting.
October 19, 2009
Charitable Trusts
The wealthy have long utilized charitable trusts to meet their philanthropic goals. In 1969, Congress provided tax benefits in the form of income tax deductions and income and estate tax exclusions for the transfer of assets to charitable trusts. Since then, these trusts have steadily gained popularity.
You can use one of several types of charitable trusts depending upon your goals. These trusts can be formed during your lifetime or after death, but all trusts must be irrevocable. Assuming you want to take advantage of these tax benefits during your lifetime, once you are comfortable with not being able to take back the assets, you must decide which type of trust meets your goals.
All types of charitable trusts have two classes of beneficiaries, one class entitled to periodic payments from the trust and the second class receiving the principal. The Charitable Remainder Trust (CRT) is designed to provide you or your designated beneficiaries (for example your children) with income from the trust either for your lifetime or a fixed period of time after which your designated charity receives the remaining principal. A Charitable Lead Trust (CLT) operates in reverse of the CRT in that your beneficiaries receive the remaining principal at your death, while your designated charity receives periodic payments from the trust.
Charitable trusts are further defined by how the periodic payments are determined. You can require the trust to distribute a fixed amount each year (a Charitable Remainder Annuity Trust or a Charitable Lead Annuity Trust). You can also require that the Trust distribute each year a fixed percentage of the trust principal (a Charitable Remainder Unitrust or Charitable Lead Unitrust).
Since Charitable Remainder Trusts (CRT) provide income to the donor or the donor’s beneficiaries, they are much more popular than Charitable Lead Trusts. The following is an example of how a typical CRT might work. Assume you are age 65 and have assets such as marketable securities or real estate worth $500,000 with a tax basis of $200,000. Once you decide which charity to receive the remaining principal, you must decide how much income you or your beneficiaries would like to receive and for what period of time. The unitrust, which pays a percentage of trust assets each year, is usually preferred by relatively young (age 65) donors because of its flexibility.
Assume you decide to receive 5% of the trust’s assets each year. (5% is the minimum). At age 65, you would receive $25,000 (5% of the fair market value of the trust or $500,000). For the rest of your life, you will receive 5% of the value of the trust. Your charitable tax deduction is $225460. If you cannot use all of it in the year you contribute the asset to the trust, you can carry forward the unused deduction for 5 years. Remember, you do not have to pay tax on the $300,000 appreciation in the donated asset and the asset is not included in your taxable estate.
The amount of your charitable tax deduction is directly related to the income you choose to receive. For example, if you chose to receive 8% of the trust’s assets ($40000) in year one, the charitable deduction is only $150,490. The amount of your charitable deduction is also a function of your age. If you wait until age 70 to make the contribution, assuming the minimum 5% payout is selected, your deduction would be $262,565.
Charitable Trusts are by no means for everyone. If you are otherwise charitable minded though,this may be a way to meet your goals with the help of the IRS. As always an attorney familiar with Charitable Trusts should be consulted.
You can use one of several types of charitable trusts depending upon your goals. These trusts can be formed during your lifetime or after death, but all trusts must be irrevocable. Assuming you want to take advantage of these tax benefits during your lifetime, once you are comfortable with not being able to take back the assets, you must decide which type of trust meets your goals.
All types of charitable trusts have two classes of beneficiaries, one class entitled to periodic payments from the trust and the second class receiving the principal. The Charitable Remainder Trust (CRT) is designed to provide you or your designated beneficiaries (for example your children) with income from the trust either for your lifetime or a fixed period of time after which your designated charity receives the remaining principal. A Charitable Lead Trust (CLT) operates in reverse of the CRT in that your beneficiaries receive the remaining principal at your death, while your designated charity receives periodic payments from the trust.
Charitable trusts are further defined by how the periodic payments are determined. You can require the trust to distribute a fixed amount each year (a Charitable Remainder Annuity Trust or a Charitable Lead Annuity Trust). You can also require that the Trust distribute each year a fixed percentage of the trust principal (a Charitable Remainder Unitrust or Charitable Lead Unitrust).
Since Charitable Remainder Trusts (CRT) provide income to the donor or the donor’s beneficiaries, they are much more popular than Charitable Lead Trusts. The following is an example of how a typical CRT might work. Assume you are age 65 and have assets such as marketable securities or real estate worth $500,000 with a tax basis of $200,000. Once you decide which charity to receive the remaining principal, you must decide how much income you or your beneficiaries would like to receive and for what period of time. The unitrust, which pays a percentage of trust assets each year, is usually preferred by relatively young (age 65) donors because of its flexibility.
Assume you decide to receive 5% of the trust’s assets each year. (5% is the minimum). At age 65, you would receive $25,000 (5% of the fair market value of the trust or $500,000). For the rest of your life, you will receive 5% of the value of the trust. Your charitable tax deduction is $225460. If you cannot use all of it in the year you contribute the asset to the trust, you can carry forward the unused deduction for 5 years. Remember, you do not have to pay tax on the $300,000 appreciation in the donated asset and the asset is not included in your taxable estate.
The amount of your charitable tax deduction is directly related to the income you choose to receive. For example, if you chose to receive 8% of the trust’s assets ($40000) in year one, the charitable deduction is only $150,490. The amount of your charitable deduction is also a function of your age. If you wait until age 70 to make the contribution, assuming the minimum 5% payout is selected, your deduction would be $262,565.
Charitable Trusts are by no means for everyone. If you are otherwise charitable minded though,this may be a way to meet your goals with the help of the IRS. As always an attorney familiar with Charitable Trusts should be consulted.
September 23, 2009
Saving Estate Tax with a Family Limited Partnership
In order to reduce your potential estate tax you must reduce your taxable estate. One customary way to reduce your estate is to make gifts to your ultimate beneficiaries such as your children and grandchildren. Removing an asset from your taxable estate by gift though, will generally require you to part with all dominion and control of the gifted asset. Gifting interests in a Family Limited Partnership which owns the assets that you wish to transfer to your beneficiaries when, properly structured, will remove the assets including appreciation (at a discounted value) from your taxable estate while allowing you to retain control of the assets.
A Family Limited Partnership (FLP) is nothing more than a traditional limited partnership with the donor and the donor’s family members as the general and limited partners. A Limited Liability Company (LLC) is synonymous with a partnership for this purpose since an LLC can be taxed as if it were a partnership. Limited partners by law have no say in the operation and management of any limited partnership which accounts for the discount in value of their partnership interest. General partners control the operation of a limited partnership regardless of their percentage of ownership.
A typical FLP might be organized and operated in the following manner. Donor transfers an asset worth $1,000,000 to a newly created FLP in exchange for a 1% general partnership interest and a 99% limited partnership interest. Donor immediately gifts the 99% limited partnership interest to his children, retaining the 1% general partnership interest. Donor dies 10 years later when the asset is worth $2,000,000. Had Donor gifted 99% of the asset directly to his children, the value of the gift would have been $999,000. Since the children have no control over the asset, the value of the gifted limited partnership interest can be discounted for gift tax purposes. Properly structured and operated it is reasonable to assume the IRS would accept a discount for lack of control and marketability of at least 35%. The value for gift tax purposes of the limited partnership interest assuming a 35% discount would be $643,500. Assuming Donor retains control of the asset until death by retaining the 1% general partnership interest, he or she has removed $1,980,000 from his or her estate at a gift tax cost of only $643,500.
The IRS and Congress have been increasingly concerned with this estate tax saving opportunity. IRS has repeatedly challenged what it believes to be the abusive use of Family Limited Partnerships. The kind of asset transferred to the FLP can be an issue. If marketable securities are the only asset, one can expect IRS scrutiny. At this point though, funding the FLP with something like a rental property appears to be safe.An IRS challenge can also be expected if the FLP fails to operate as such. For example, if the 1% general partner in our example receives distributions in excess of his or her ownership percentage, IRS can be expected to object.
The amount of minority or lack of marketability discounts continues to be an issue. A review of the case law and my personal experience leads me to feel comfortable with a combined discount of 35% when indicated by a sufficient appraisal. The courts have delineated the factors which constitute a sufficient appraisal. A potential donor would be well advised to engage an appraiser conversant with these factors.
Certain members of Congress are interested in legislating away this tax saving opportunity. The “Certain Estate Tax Relief Act of 2009” would eliminate discounts to Family Limited Partnerships as a matter of course. Nevertheless, unless this bill is passed and made retroactive, properly formed and operated, transfers to and gifts of FLP interests are an effective way to reduce estate tax while retaining control of the transferred assets. As always, an attorney well versed in these provisions should be consulted.
A Family Limited Partnership (FLP) is nothing more than a traditional limited partnership with the donor and the donor’s family members as the general and limited partners. A Limited Liability Company (LLC) is synonymous with a partnership for this purpose since an LLC can be taxed as if it were a partnership. Limited partners by law have no say in the operation and management of any limited partnership which accounts for the discount in value of their partnership interest. General partners control the operation of a limited partnership regardless of their percentage of ownership.
A typical FLP might be organized and operated in the following manner. Donor transfers an asset worth $1,000,000 to a newly created FLP in exchange for a 1% general partnership interest and a 99% limited partnership interest. Donor immediately gifts the 99% limited partnership interest to his children, retaining the 1% general partnership interest. Donor dies 10 years later when the asset is worth $2,000,000. Had Donor gifted 99% of the asset directly to his children, the value of the gift would have been $999,000. Since the children have no control over the asset, the value of the gifted limited partnership interest can be discounted for gift tax purposes. Properly structured and operated it is reasonable to assume the IRS would accept a discount for lack of control and marketability of at least 35%. The value for gift tax purposes of the limited partnership interest assuming a 35% discount would be $643,500. Assuming Donor retains control of the asset until death by retaining the 1% general partnership interest, he or she has removed $1,980,000 from his or her estate at a gift tax cost of only $643,500.
The IRS and Congress have been increasingly concerned with this estate tax saving opportunity. IRS has repeatedly challenged what it believes to be the abusive use of Family Limited Partnerships. The kind of asset transferred to the FLP can be an issue. If marketable securities are the only asset, one can expect IRS scrutiny. At this point though, funding the FLP with something like a rental property appears to be safe.An IRS challenge can also be expected if the FLP fails to operate as such. For example, if the 1% general partner in our example receives distributions in excess of his or her ownership percentage, IRS can be expected to object.
The amount of minority or lack of marketability discounts continues to be an issue. A review of the case law and my personal experience leads me to feel comfortable with a combined discount of 35% when indicated by a sufficient appraisal. The courts have delineated the factors which constitute a sufficient appraisal. A potential donor would be well advised to engage an appraiser conversant with these factors.
Certain members of Congress are interested in legislating away this tax saving opportunity. The “Certain Estate Tax Relief Act of 2009” would eliminate discounts to Family Limited Partnerships as a matter of course. Nevertheless, unless this bill is passed and made retroactive, properly formed and operated, transfers to and gifts of FLP interests are an effective way to reduce estate tax while retaining control of the transferred assets. As always, an attorney well versed in these provisions should be consulted.
Roth Conversions
The advantages of a Roth IRA over a Traditional IRA or 401(k) plan have been well documented. Withdrawals from Roth IRAs (including untaxed earnings) are generally not taxable. Furthermore, unlike other tax deferred arrangements, mandatory distributions upon attaining age 70 ½ are not required from a Roth IRA.
Unfortunately, many people have not been able to take advantage of this tax saving opportunity. If your income exceeds certain levels ($176,000 for joint filers, $10,000 for married filing separately filers and $120,000 for all others) you cannot make a direct contribution to a Roth IRA. You cannot convert a Traditional IRA or 401(k) to a Roth IRA before 2010 if your income exceeds $100,000 or you are married but file separately.
Beginning in 2010 though, you will be able to convert a traditional IRA or in some circumstances your balance in a 401(k) plan to a Roth IRA regardless of your income or filing status. Income tax will be due on the conversion of pre tax contributions and earnings, but for 2010 conversions only, one half of tax will be due on your 2011 return and one half on your 2012 return. Taxable income will be accelerated though to the extent you make distributions from the Roth IRA before 2012.
There are several planning opportunities available in 2009 for those who plan to convert in 2010 or later. As previously mentioned, higher income taxpayers are not eligible to make direct contributions to a Roth IRA. Such taxpayers can make non deductible contributions to a traditional IRA before converting this account to a Roth effectively avoiding the Roth income limitation. Please be advised though that you cannot roll over just after tax contributions. A partial rollover is deemed to be a proportionate amount of pre tax and after tax dollars. All traditional IRAs are considered one for this purpose regardless of which IRA is to be converted.
Another planning opportunity exists for participants in a 401(k) plan. Since 2008, otherwise eligible participants can directly roll 401(k) balances into a Roth IRA if the plan so allows. This opportunity also effectively avoids the Roth income limitation.
If you are planning to convert in 2010, you may also want to consider accelerating 2010 income to 2009 and deferring 2009 tax deductions to 2010 where possible in order to even tax brackets as much as possible.
Unfortunately, many people have not been able to take advantage of this tax saving opportunity. If your income exceeds certain levels ($176,000 for joint filers, $10,000 for married filing separately filers and $120,000 for all others) you cannot make a direct contribution to a Roth IRA. You cannot convert a Traditional IRA or 401(k) to a Roth IRA before 2010 if your income exceeds $100,000 or you are married but file separately.
Beginning in 2010 though, you will be able to convert a traditional IRA or in some circumstances your balance in a 401(k) plan to a Roth IRA regardless of your income or filing status. Income tax will be due on the conversion of pre tax contributions and earnings, but for 2010 conversions only, one half of tax will be due on your 2011 return and one half on your 2012 return. Taxable income will be accelerated though to the extent you make distributions from the Roth IRA before 2012.
There are several planning opportunities available in 2009 for those who plan to convert in 2010 or later. As previously mentioned, higher income taxpayers are not eligible to make direct contributions to a Roth IRA. Such taxpayers can make non deductible contributions to a traditional IRA before converting this account to a Roth effectively avoiding the Roth income limitation. Please be advised though that you cannot roll over just after tax contributions. A partial rollover is deemed to be a proportionate amount of pre tax and after tax dollars. All traditional IRAs are considered one for this purpose regardless of which IRA is to be converted.
Another planning opportunity exists for participants in a 401(k) plan. Since 2008, otherwise eligible participants can directly roll 401(k) balances into a Roth IRA if the plan so allows. This opportunity also effectively avoids the Roth income limitation.
If you are planning to convert in 2010, you may also want to consider accelerating 2010 income to 2009 and deferring 2009 tax deductions to 2010 where possible in order to even tax brackets as much as possible.
Whether a Roth conversion is beneficial depends upon a number of factors such as your post retirement income tax rate, your state income tax rules and the length of time your money will remain in the Roth IRA. While these considerations are complex, within certain time limits you may be able to reverse a Roth conversion. As always, you should consult your CPA, attorney or financial advisor to help you plan for this potential retirement savings opportunity.
September 3, 2009
Garnett Decision Rejects Treatment of Losses from LLC and LLP Interests as Presumptively Passive
The passive activity loss rules in general prevent individuals and certain other taxpayers from deducting passive activity losses against non-passive income. In most cases whether an activity is passive depends on whether the taxpayer materially participates in it. In the case of limited partnerships, Code Section 469(h)(2) treats a taxpayer with a limited partner interest as not materially participating in the partnership’s activity except as provided in regulations (the “per se rule”). Those regulations in turn allow a limited partner to establish material participation, but only by using one of three tests—the 500 hours-per-year test, the test that requires material participation during five of the preceding ten years, or the test that requires three prior years of material participation in the case of a personal service activity. Temp.Reg.Sec. 1.469-5T(e). Were it not for the per se rule, the taxpayer could establish material participation under any of those tests or any of four additional tests—one of which allows aggregation of “significant participation activities” to achieve 500 hours of participation. Garnett v. Commissioner, 132 T.C. No. 19 (June 30, 2009) holds, based on an analysis of state law governing the limited liability companies (“LLCs”) and limited liability partnerships (“LLPs”) at issue in the case, that interests in those entities are not subject to the per se rule. As a result, the taxpayers in the case are allowed to use any of the seven regulatory tests for material participation. The court reached the same conclusion with respect to certain interests of the taxpayers as tenants-in-common in rental properties.
The taxpayers in Garnett owned direct or indirect interests in seven LLPs and two LLCs engaged in various agricultural businesses. Under applicable state law, they had no personal liability for obligations of the entities. The IRS argued that such limited liability made the taxpayers’ interests limited partner interests for purposes of the per se rule. The Tax Court, however, pointed to the “general partner exception” of Section 1.469-5T(e)(3)(ii) under which an individual’s partnership interest is not treated as a limited partner interest if the individual is a general partner at all times during the relevant tax year. While that provision is aimed primarily at situations where the individual is both a general and a limited partner in the same partnership, the court found that the exception by its own terms is not limited to such dual-status cases. Noting the lack of a statutory or regulatory definition of “general partner”, the court looked to the legislative history of Section 469, which justifies the per se rule on the basis of state law principles that preclude a limited partner from participating in a partnership’s business while retaining limited liability protection. The court therefore concluded that the state law prohibition against limited partner participation in the partnership’s business—rather than limited liability—is the defining characteristic of a limited partner interest for purposes of the per se rule. Turning to the law of the state of formation of the entities (Iowa), the court noted that—in contrast to restrictions on the activities of limited partners—members of LLCs and LLPs can participate in management. Accordingly, the court concluded that taxpayers held their interests in the LLPs and LLCs as general partners for purposes of the per se rule. While the court acknowledged that a factual inquiry into the authority of taxpayers to act on behalf of their LLCs and LLPs may be appropriate in the context of determining material participation, it found such an inquiry unnecessary to determine the application of Section 469(h)(2).
Less than a month after the Garnett decision, the U.S. Court of Federal Claims decided Thompson v. U.S., 2009 TNT 138-4 (July 20, 2009), which also holds that an interest in an LLC is not an interest as a limited partner for purposes of the per se rule. While the court acknowledged certain legislative history suggesting that Treasury may have regulatory authority to treat “substantially equivalent entities” as limited partnerships for purposes of the per se rule, it found that an LLC is not such an entity. Whereas the Thompson decision is a final judgment while the Garnett decision is for partial summary judgment, should the government decide to appeal both cases it is likely the Thompson case would be decided first on appeal.
The Garnett and Thompson decisions may also benefit a real estate professional who qualifies for the “real property business” exception to the general rule that treats rental activities as automatically passive (Code Section 469(c)(2) and (c)(7)). This is because a real estate professional who holds an interest as a limited partner must still apply the per se rule before determining material participation (subject to a narrow de minimis exception contained in Treas.Reg.Sec. 1.469-9(f)(2)).
It is unclear what effect, if any, Garnett and Thompson may have on application of the self-employment tax to members of LLCs and LLPs. In this regard Code Section 1402(a)(13) excludes from self-employment earnings the distributive share of income of a limited partner, subject to an exception for certain guaranteed payments. Complicating any inquiry into this area are longstanding proposed regulations that create a separate series of tests for determining whether a taxpayer is a limited partner for self-employment tax purposes—tests relied upon today by some practitioners despite their status as proposed regulations. See Prop.Treas.Reg.Sec. 1.1402(a)-2(h).
Contributed by Glenn Madere, Esq. Glenn Madere is the Editor of The Readable Code and Regs: Partnerships (Blue Bell, PA: Readable Press, 2009) Readable Press Website
The taxpayers in Garnett owned direct or indirect interests in seven LLPs and two LLCs engaged in various agricultural businesses. Under applicable state law, they had no personal liability for obligations of the entities. The IRS argued that such limited liability made the taxpayers’ interests limited partner interests for purposes of the per se rule. The Tax Court, however, pointed to the “general partner exception” of Section 1.469-5T(e)(3)(ii) under which an individual’s partnership interest is not treated as a limited partner interest if the individual is a general partner at all times during the relevant tax year. While that provision is aimed primarily at situations where the individual is both a general and a limited partner in the same partnership, the court found that the exception by its own terms is not limited to such dual-status cases. Noting the lack of a statutory or regulatory definition of “general partner”, the court looked to the legislative history of Section 469, which justifies the per se rule on the basis of state law principles that preclude a limited partner from participating in a partnership’s business while retaining limited liability protection. The court therefore concluded that the state law prohibition against limited partner participation in the partnership’s business—rather than limited liability—is the defining characteristic of a limited partner interest for purposes of the per se rule. Turning to the law of the state of formation of the entities (Iowa), the court noted that—in contrast to restrictions on the activities of limited partners—members of LLCs and LLPs can participate in management. Accordingly, the court concluded that taxpayers held their interests in the LLPs and LLCs as general partners for purposes of the per se rule. While the court acknowledged that a factual inquiry into the authority of taxpayers to act on behalf of their LLCs and LLPs may be appropriate in the context of determining material participation, it found such an inquiry unnecessary to determine the application of Section 469(h)(2).
Less than a month after the Garnett decision, the U.S. Court of Federal Claims decided Thompson v. U.S., 2009 TNT 138-4 (July 20, 2009), which also holds that an interest in an LLC is not an interest as a limited partner for purposes of the per se rule. While the court acknowledged certain legislative history suggesting that Treasury may have regulatory authority to treat “substantially equivalent entities” as limited partnerships for purposes of the per se rule, it found that an LLC is not such an entity. Whereas the Thompson decision is a final judgment while the Garnett decision is for partial summary judgment, should the government decide to appeal both cases it is likely the Thompson case would be decided first on appeal.
The Garnett and Thompson decisions may also benefit a real estate professional who qualifies for the “real property business” exception to the general rule that treats rental activities as automatically passive (Code Section 469(c)(2) and (c)(7)). This is because a real estate professional who holds an interest as a limited partner must still apply the per se rule before determining material participation (subject to a narrow de minimis exception contained in Treas.Reg.Sec. 1.469-9(f)(2)).
It is unclear what effect, if any, Garnett and Thompson may have on application of the self-employment tax to members of LLCs and LLPs. In this regard Code Section 1402(a)(13) excludes from self-employment earnings the distributive share of income of a limited partner, subject to an exception for certain guaranteed payments. Complicating any inquiry into this area are longstanding proposed regulations that create a separate series of tests for determining whether a taxpayer is a limited partner for self-employment tax purposes—tests relied upon today by some practitioners despite their status as proposed regulations. See Prop.Treas.Reg.Sec. 1.1402(a)-2(h).
Contributed by Glenn Madere, Esq. Glenn Madere is the Editor of The Readable Code and Regs: Partnerships (Blue Bell, PA: Readable Press, 2009) Readable Press Website
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