Renting Your Home or Vacation Home for Short Periods

Article Highlights: 

  • Airbnb, VRBO, and HomeAway 
  • Rented for Fewer than 15 Days During the Year 
  • The 7-day and 30-day Rules 
  • Exceptions to the 30-Day Rule 
  • Schedule C Reporting 

Many taxpayers rent out their first or second homes without considering tax consequences. Some of these rules can be beneficial, while others can be very detrimental. If you rent your home to others, you should be aware of some special tax rules that apply to you. 

Even if you rent out your property using rental agents or online rental services that match property owners with prospective renters (such as Airbnb, VRBO, or HomeAway), it is still your responsibility to properly report the rental income and expenses on your tax return. 

Special (and sometimes complicated) taxation rules can make the rents that you charge tax-free. However, other situations may force your rental income and expenses to be treated as a business reported on Schedule C, as opposed to a rental activity reported on Schedule E. 

The following is a synopsis of the rules governing short-term rentals. 

Rented for Fewer than 15 Days During the Year – When a property is rented for fewer than 15 days during the tax year, the rental income is not reportable. The expenses associated with that rental are not deductible. Interest and property taxes are not prorated. The full amounts of the qualified mortgage interest and property taxes are reported as itemized deductions (as usual) on the taxpayer’s Schedule A. 

The 7-Day and 30-Day Rules – Rentals are generally passive activities, which means that losses from these activities are usually the only deductible up to the number of gains from other passive activities. However, an activity is not treated as a rental if either of these statements applies: 

A. The average customer use of the property is for seven days or fewer—or 30 days or fewer if the owner (or someone on the owner’s behalf) provides significant personal services. 

B. The owner (or someone on the owner’s behalf) provides extraordinary personal services without regard to the property’s average period of customer use.

If the activity is not treated as a rental, it will be treated as a trade or business. The income and expenses, including prorated mortgage interest and real property taxes, will be reported on Schedule C. IRS Publication 527 states: “If you provide substantial services that are primarily for your tenant’s convenience, such as regular cleaning, changing linen, or maid service, you report your rental income and expenses on Schedule C.” Substantial services do not include the furnishing of heat and light, the cleaning of public areas, the collecting of trash, or other such general amenities. 

The exception to the 30-Day Rule – If the personal services provided are similar to those that generally are provided in connection with long-term rentals of high-grade commercial or residential real property (such as public area cleaning and trash collection). If the rental also includes maid and linen services that cost less than 10% of the rental fee, then the personal services are neither significant nor extraordinary for the 30-day Rule. 

Profits and Losses on Schedule C – Typically, if you own and operate a business that isn’t set up as a corporation, your business’s income and expenses would be reported on Schedule C as part of your income tax return. You would pay self-employment tax (Social Security and Medicare taxes), as well as income tax, on the profit. However, suppose you have a profit from a rental activity. In that case, it is not subject to self-employment tax even when reported as self-employment income unless you are a real estate dealer. Suppose you have a loss from this type of activity. In that case, it is still treated as a passive activity loss unless you meet a material participation test—generally by providing 500 or more hours of personal services during the year related to the rental or qualifying as a real estate professional. Losses from passive activities are deductible only up to the passive income amount, but unused losses can be carried forward to future years. A special allowance for real estate rental activities with active participation permits a loss against nonpassive income of up to $25,000. This phases out when modified adjusted gross income is between $100K and $150K. However, this allowance does not apply when the activity is reported on Schedule C.

These rules can be complicated; please contact us to determine how they apply to your particular circumstances and what actions you can take to minimize tax liability and maximize tax benefits from your rental activities.

Preparing for 2021: Tax Planning Strategies for Small Business Owners

If you are a small business owner, every penny of your income counts. This means that you want to optimize your revenue and minimize your expenses and your tax liability. Unfortunately, far too many entrepreneurs are not well-versed in the tricks and tools available to them and end up paying far more than they need to. You don’t need an accounting degree to take advantage of tax-cutting tips. Here are a few of our favorites. 

Think About Changing to a Different Type of Tax Structure 

When you started your business, one of the first decisions you needed to make was whether you wanted to operate as a sole proprietor, partnership, LLC, S corporation, or C corporation. But as more time goes by, the initial reasons for structuring your business the way that you did may no longer be applicable or in your best interest from a tax perspective. There is no requirement that you stick with the business structure you initially chose. 

Ever since the Tax Cuts and Jobs Act of 2017 (TCJA) changed the highest corporate income tax rate from 35% to 21%, sole proprietorships, LLCs, partnerships, and S corporations can realize significant tax savings by electing to be taxed as a C corporation. This simple change can make sense if these pass-through businesses’ owner is taxed at a high tax bracket. If so, all you need to do is fill out and file Form 8832. Before doing so, make sure that the tax savings you can realize are a reasonable tradeoff for the other reasons that you may have initially selected the structure you are currently in. 

Pass-Through Businesses Can Get a 20% 

One of the most impactful changes that the TCJA made for pass-through businesses whose income is passed-through for taxation as their owners’ income is a valuable tax break known as the qualified business income (QBI) deduction. For eligible recipients, this deduction is worth a maximum 20% tax break on the income they receive from the business – but determining whether or not you qualify can be a challenge. 

There are several restrictions on taking advantage of the deduction, particularly regarding specified service trade or businesses (SSTBs) whose owners either earn too much income or rely specifically on their employees’ or owners’ reputation or skill. Though architecture and engineering firms escape this limitation, other business models – including medical practices, law firms, professional athletes and performing artists, financial advisors, investment managers, consulting firms, and accountants – fall into the category that loses out of their income is too high. In 2019 single business owners of SSTBs began phasing out at $160,700 and are excluded once their income exceeds $210,700, while those who are married filing a joint return phase out at $321,400 and are excluded at $421,400. To calculate the deduction, use Part II of Form 8995-A

Businesses that are not SSTBs are eligible to take the deduction even when they pass the upper limits of the thresholds, but only for either half of the business owners’ share of the W-2 wages paid by the business or a quarter of those wages plus 2.5% of their share of qualified property. 

These limitations and specifications for what type of business is and is not eligible are head-spinning. Though it is tempting to take the deduction simply, it’s a good idea to confirm whether you qualify and how to claim it with our office before moving forward. 

Know How You’re Going to Pay Your Taxes

It is gratifying to live the dream of owning your own small business, but the hard work required to generate revenue makes paying taxes extra painful. This is especially true because of the “pay as you go” tax system that the United States uses, asking business owners to make estimated quarterly payments. While employees pay their taxes ahead via payroll deductions withheld by their employers, no such automatic system is set up for small business owners. That leaves many with the temptation of delaying making payments to maintain liquidity. 

Unfortunately, failing to pay taxes quarterly can put you in the uncomfortable position of still having to pay at one point, with the additional burden of penalties and interest resulting from your delay. Though setting aside the money to pay taxes requires discipline, doing so will save you from the penalties charged by the IRS. These are calculated based on the amount you should have paid each quarter multiplied by your shortfall and the effective interest rate during the specific quarter (established as 3 percent over the federal short-term rate – C corporations pay a different rate). Even if you don’t calculate your quarterly estimated rates correctly, the safe harbor rule allows small businesses to pay the lower amount, which is either 90% of the tax due on your current year return or 100% of the tax shown on your last filed tax return. For those whose AGI was over $150,000 in the previous tax year, the safe harbor percentage is 110% of the previous year’s taxes. 

It is always a good idea to increase the amount you send in if you have a higher-income year. By doing a simple calculation of your safe harbor number and dividing it by four, you have a reasonable quarterly payment that you can safely send in on the due dates (April 15th, June 15th, September 15th, and January 15th of the following year). By setting aside the appropriate percentage that you will owe from each payment you receive, you can easily set aside the money you will need to pay and entirely avoid concerns about penalties or interest. Payment is most easily submitted using the online link for IRS Direct Pay, though many people opt for sending in the paper vouchers for IRS Form 1040-ES, along with a check. There is also an EFTPS system available for C Corporations’ use. 

Choose Your Accounting Method Carefully

Each small business owner calculates their income and revenue differently, with many using a method of accounting that is based on when money is received rather than when an order is placed and counts expenses when they are paid rather than the item or service ordered. This is known as the cash method of accounting. 

Whatever method of accounting you use, smart business owners can strategically adjust their approach—reporting their annual income based on cash receipts to reduce their end-of-year revenues, especially if there is reason to believe that next year’s income will be lower or they anticipate being in a lower tax bracket. 

An example of how this approach would be helpful can be seen in a business that expects to add new employees in the new year. Between that expense and other improvements planned, it makes sense to anticipate that net income will be down. The tax bracket for the business will be lower, so any work is done or orders placed towards the end of the current tax year should be accounted for when payments arrive so that the income can be taxed at a lower rate. The contrast to this is if you anticipate your business revenue to increase and be forced into a higher tax bracket in the new year. In that case, it makes sense to try to collect monies for work done in the current year early so that you can take advantage of your current, lower tax rate. This can be done for business expenses such as office supplies and equipment, which can be deferred and accelerated in the same way so that you can take advantage of tax deductions in the most advantageous way. 

Establish and Make Deposits Into a 401(k) or SEP 

One of the smartest ways to lower your taxable income is to contribute to a retirement account. Not only does doing so reduce your business’ tax liability, but it also ensures a more secure future. As a small business owner, either a 401(K) plan or a Simplified Employee Pension (SEP) plan will do the trick while benefiting both you and those who work for you in the future. 

While a 401(k) that is established before year-end will let you deduct any contributions you make (with contributions limited to the lower of $57,000 or the employee’s total compensation), business owners who fail to set up this type of plan by December 31st can still turn to the SEP as an alternative. Though SEP contributions are restricted to 25% of the business owner’s net profit, less the SEP contribution itself (technically 20%), a SEP can be established, and contributions made up until the extended due date of your return. Suppose you obtain an extension for filing your tax return. In that case, you have until the end of that extension period to deposit the contribution, regardless of when you file the return.

If You Took Out a PPP Loan, Plan on it Being Forgiven 

Many small businesses took advantage of the PPP loans that were offered by the government in the face of the COVID-19 crisis. While these loans were attractive because they are forgivable and gave businesses a chance to survive the dire circumstances, in April of 2020, the IRS issued Notice 2020-32, which indicated that even though the forgivable loans can be excluded from gross income, the expenses associated with the money received cannot be deducted. This effectively erases the tax benefit initially offered because losing the employee and expense deduction increases the business’ income and profitability. 

There is some chance that this issue will be resolved by Congress, as it contradicts the original intent of the tax benefit that accompanied the PPP funds, but that action has not yet been taken. It’s a good idea to talk to our office about this as soon as possible. Having to pay taxes on expenses incurred may be particularly challenging in the face of the difficulties the pandemic has imposed. Being financially prepared to pay more taxes than you originally intended may be a bitter pill to swallow. However, it will still be better than paying penalties and interest if you fail to pay what the government says that you owe. 

Though all of these strategies can be helpful, they may not all be appropriate for your situation. Keep them in mind as you go into the end of the year, and be prepared to ask questions to determine which apply to you when you speak with our office. Contact us to discuss tax planning for your business today.

How States are Reshaping Nexus Laws for Remote Employees Due to COVID-19

Ever since the coronavirus pandemic began impacting the United States, businesses around the country have responded by instituting work-from-home policies. While it is unclear how much longer the nation will be in the grips of the crisis, social distancing is likely to remain in place for many organizations. Some of the country’s most recognizable brands, including Facebook and Google, have already announced a work-from-home option that will extend through July 2021 for all of their employees, while others have made the ability to work remotely permanent.

As more organizations implement permanent or long-term work from home policies, they may need to review how nexus will be addressed. Especially now that several state governments are beginning to address work-from-home employees in terms of nexus and on tax revenue.

Traditionally, a state tax obligation is established when a business has a physical presence within its borders. That is what creates nexus. If a Floridian goes to New York for a temporary job placement, they have an income tax obligation in New York for the money that they earn there. If a California company places employees in Texas, then the company would have a responsibility to follow Texas laws and pay Texas sales tax. New York’s Governor Andrew Cuomo explicitly continued that practice when COVID-19 struck, making temporarily remote employees in New York liable for state income tax. However, several other states, including Massachusetts and Pennsylvania, made clear that the virus-related remote work would not trigger nexus obligations, at least until official work-from-home orders or states of emergency lasted. As mandates are being lifted while companies continue to allow or enforce work from home, those states are beginning to reconsider their position.

Below is our guidance regarding Congress’ stated position thus far regarding nexus, as well as the stance of other states. Please contact us if you have any questions.

Congress’s Position

While not every state has begun to address the tax ramifications of working-from-home due to COVID-19, Congress has started to address the issue. On July 27th, 2020, new legislation was introduced to limit the amount of state income tax that could be charged on income earned in the state to residents of another state. The proposal revises Section 403 of the American Workers, Families, and Employers Assistance Act (S. 4318), which says in part:

“No part of the wages or other remuneration earned by an employee who is a resident of a taxing jurisdiction and performs employment duties in more than one taxing jurisdiction shall be subject to income tax in any taxing jurisdiction other than: (A) The taxing jurisdiction of the employee’s residence (B) Any taxing jurisdiction within which the employee is present and performing employment duties for more than 30 days during the calendar year in which the wages or other remuneration is earned.”

The revision would extend the 30 days in part (B) to 90 days for the calendar year 2020 “in the case of any employee who performs employment duties in any taxing jurisdiction other than the taxing jurisdiction of the employee’s residence during such year as a result of the COVID-19 public health emergency.”

Indiana Addresses Nexus Rules Following COVID-19

The Indiana Department of Revenue recently posted information regarding the intersection of nexus and COVID-19 on its website. Their post indicated that they would “not use someone’s relocation, that is the direct result of temporary remote work requirements arising from and during the COVID-19 pandemic health crisis, as the basis for establishing Indiana nexus or for exceeding the protections provided by P.L. 86-272 for the employer of the temporary relocated employee.” Despite this assurance, the department went on to explain that nexus could be established for an out-of-state employer if their employee “remains in Indiana after the temporary remote work requirement has ended,” and that the employer could not “assert that solely having a temporarily relocated employee in Indiana [due to an official work-from-home order or a physician’s order related to a COVID-19 outbreak or diagnosis] creates nexus for the business or exceeds the protections of P.L. 86-272 for the employer.”

If your clients do business or have employees in Indiana and you need more information, visit the website of the Indiana Department of Revenue for more details.

Massachusetts Addresses Nexus Rules Following COVID-19

The Massachusetts Department of Revenue proactively announced new rules regarding nexus well before the full weight of the COVID-19 crisis was felt, and their anticipation of the changing landscape has led to them again issuing a statement to preempt any questions regarding taxation. The department issued rule TIR 20-05 with the intent of minimizing the impact of the COVID-19 state of emergency on employers and employees alike. It read in part:

“One or more employees working from home solely due to the COVID-19 pandemic will not subject a business to a sales and use tax collection obligation or to the corporate excise by reason of that fact” from March 10 until the conclusion of the state of emergency. That rule has now been revised with the intent of ensuring “that businesses have sufficient time to prepare for the cessation of these temporary rules.”

Revised Guidance on the Massachusetts Tax Implications of an Employee Working Remotely due to the COVID-19 Pandemic makes clear that TIR 20-05 will be in effect “until the earlier of December 31, 2020, or 90 days after the state of emergency in Massachusetts is lifted. As of that date, the rules outlined in this TIR will cease to be in effect, and the presence of an employee in Massachusetts, even if due solely to a Pandemic-Related Circumstance… will trigger the same tax consequences as under Massachusetts law more generally.”

The new guidelines go on to define a pandemic-related circumstance as including:

  • A COVID-19-related government order
  • A COVID-19-related remote work policy adopted by an employer in good faith compliance with federal or state government guidance or public health recommendations
  • A worker’s COVID-19-related compliance with quarantine, isolation directions relating to a COVID-19 diagnosis or suspected diagnosis, or a physician’s advice.

The new guidance indicates that any business asserting that it qualifies for an exemption based on these definitions will be responsible for substantiating and documenting any evidence supporting their claim and that without that verification, the nexus exemption may be denied. If your clients do business or have employees in Massachusetts and you need more information, visit the website of the Massachusetts Department of Revenue for more details.

Oregon Addresses Nexus Rules Following COVID-19

While the state of Oregon’s Department of Revenue has provided an exemption of corporate excise/income tax for COVID-19-related teleworking employees between March 8, 2020, and November 1, 2020, the explicit indication of the exemption ending on November 1st makes plain that traditional imposition of nexus will resume on November 2, 2020.

The Oregon Department of Revenue has also clarified how employees temporarily based in the state because of COVID-19 may affect nexus. The department explains:

“For Oregon corporate excise/income tax, the presence of teleworking employees … in Oregon between March 8, 2020, and November 1, 2020, won’t be treated by the department as a relevant factor when making a nexus determination if the employee(s) in question are regularly based outside Oregon.”

If your clients do business or have employees in Oregon and you need more information, visit the website of the Oregon Department of Revenue for more details.

South Carolina Addresses Nexus Rules Following COVID-19

Much like the finite time that the Oregon Department of Revenue has provided for the suspension of standard nexus rules, the South Carolina Department of Revenue issued its Letter #20-11, which outlines its suspension of establishing nexus, with the southern state’s expiration falling on September 30th, 2020.

If your clients do business or have employees in Indiana and you need more information, visit the website of the South Carolina Department of Revenue for more details.

If you need assistance or would like to schedule a consultation with your Tarlow advisor, please contact us.

Repairing Your Business’s Bad Credit Score

The creditworthiness of your business is measured by its credit score. This number is issued by Dun & Bradstreet, Experian, Equifax, and FICO SBSS, and is an essential reflection of your company’s payment reliability and timeliness.

Why is Your Business Credit Score Important?

Your company’s overall financial health is of key importance to any lenders, creditors, and trade partners with whom you wish to do business. Those partners need to be able to trust in your ability to provide the goods or services that you are promising: to pay back any loans you may apply for. Your financial health can also be a determination of the terms that you are able to negotiate with lenders.

Ultimately, your business credit score is the main way third parties can measure your company’s financial health. It’s typically used by lenders, creditors, and trade partners during various business transactions, such as applying for business loans, leasing, winning contracts, doing business with vendors or suppliers, obtaining net terms with trade partners, and even getting better interest and payment rates for instruments such as business contracts and mortgages.

Businesses in possession of strong credit scores have a much better chance of obtaining the capital that they need to grow compared to those with weak credit scores. Many lenders have minimum credit score requirements in place, and businesses that cannot meet that threshold will be unable to secure the loan that they seek. Even if your business has a credit score that exceeds that threshold, the stronger your credit score, the more advantageous the interest rate or repayment terms you are likely to have extended to you.

Business credit scores are also used as a gauge by suppliers and others who will need to rely on you to pay them in a timely manner. Vendors, landlords, and other stakeholders with whom you will have a financial relationship will look to your past performance with others as an indication of how you are likely to treat them. Have a weak credit score? Even if these trade partners agree to do business with you, they are likely to include terms that will protect their own interests and be less advantageous to you.

How to Interpret Business Credit Scores

Unlike personal FICO credit scores which can reach as high as 850, business credit scores generally only go as high as 100 and can fall as low as 0. As is true in so many other types of grading systems, the higher the score, the better the credit rating is considered to be, though different credit rating agencies have different levels at which they bestow the value judgment of being “good.” For Equifax, a credit score of 90 or above is considered good while Experian considers 7 or above good. Dun & Broadstreet bestows the term “good” on scores of 80 or above, while FICO SBSS (whose highest scoring ranges well above 100) considers a score of 140 or more a good rating.

The higher a business’s credit score, the better their chance of obtaining loans or positive trade terms with vendors and suppliers. This is because the high score reflects a history of making payments on a timely basis rather than being late or delinquent.

Can You Fix A Bad/Thin Business Credit Score?

Having a low business credit score can be a reflection of several possible factors, including having filed for bankruptcy, having liens against your business, having a poor repayment history filled with delinquent payments or non-payments. In addition to having a bad score, businesses that don’t have a significant history of payments have credit scores that are termed “thin.”

When you’re applying for a loan, having either a bad business credit score or a thin credit score can work against you. Lenders are unlikely to provide advantageous terms to businesses with a poor history of repayment. Even if your business is new and doesn’t have much of a record of timely payments or delinquencies, many lenders will be reluctant to lend money to your business. Whichever situation you find yourself in, it will be well worth your time to either build a credit history or repair your poor credit. There are ways to do both. Here are several steps you can take that can have a significant impact.

  1. Keep your Business and Personal Finances Separate

You are not your business and your business is not you. Therefore, you should keep separate accounts for your company and for your personal use. Doing so will not only help you keep track of transactions and obligations for each, but will also help prevent any mistakes that you make (i.e. delinquent payments) from affecting either your business credit score or your personal credit score.

  1. Don’t Fall Behind On Your Bills

When your business makes a purchase or agrees to pay for a service, holding up your end of the bargain and paying in full (and on time) reflects on your business in a number of ways. Early payments will boost your credit score and be welcomed by trade partners, while delinquent payments will negatively impact your business’s credit score and have a negative impact on your reputation in general.

  1. Develop A Strong Relationship With Your Vendors

Keep in mind that your vendors and suppliers are the ones who report on-time or early payments to the credit bureaus as well as late payments. The better your business relationship with those partners, the more likely that they will report your positive actions and the less likely that they will report delinquencies.

  1. Maintain a Low Credit Utilization Ratio

Building credit as a business is done in much the same way as building personal credit: by establishing a history. One of the fastest ways to build a positive business credit report and score is to obtain a business credit card; however, use it sparingly and stay below 33% of your available credit.

  1. Keep Your Eye on Your Numbers

Credit reports change constantly, and it is essential that you keep your eye on it to make sure that it is an accurate reflection of your payment history. If you find a mistake you should act quickly to dispute the error within the framework provided by the bureau that is publishing the mistake.

  1. Add More Credit Options

Businesses that have either thin or bad credit can build their reputation by establishing additional lines of credit through a secured business credit card. These vehicles are backed by a deposit, making them easy to get and an excellent way to improve your business’s history (as long as you make your payments promptly).

Positive Credit Scores for Future Success

Having a solid, positive credit score for your business is more than just a report card. It is what can make a difference in your company’s future opportunities for growth. A business’s credit report should be nurtured, and this can be done by remaining organized and dedicated to making on-time or early payments, but for those who have made mistakes, it is not too late to repair and rebuild. Please contact us if you have any questions.

Receiving Tips Can Be Taxing

Article Highlights:

  • Collecting Tips
  • Tip Splitting
  • Service Charges
  • Record Keeping
  • Employer Reporting
  • Allocated Tips

Anyone who collects gratuities must include them in their taxable income. This requirement applies to restaurant servers, rideshare drivers, beauticians, concierges, porters, baristas, and delivery people.

Gratuities, or ‘tips’ are amounts freely given by a customer to a person providing a service. They are generally given as cash, but also include tips made on a credit or debit card or as part of a tip-sharing arrangement. Tips can also be in the form of non-traditional gifts such as tickets to events, wine, and other items of value. If you receive $20 or more in tips in any month, you should report all of your tips to your employer. However, there are a few exceptions:

  • Tip-splitting – Tips you give to others under a tip-splitting arrangement are not subject to the reporting requirement. You should only report the net gratuities you receive to your employer.
  • Service (cover) charges – These are charges arbitrarily added by the business establishment (employer). For example, a specific percentage of the bill for parties exceeding a certain number. These are excluded from the tip-reporting requirements. If your employer collects service charges from customers, your share of these charges as determined by your employer, is taxable to you and should already be included as part of your wages.

Keep a running daily log of tip income – It is good practice to keep a daily log of your tips, as gratuities are often audited. The IRS provides a log in Publication 1244 that includes the Employee’s Daily Record of Tips and the Report to Employer for recording your tip income.

Report tips to your employer – If you receive $20 or more in tips in any month, you should report all of your tips to your employer. Your employer is required to withhold federal income, Social Security, and Medicare taxes. State taxes may have to be withheld as well. If the tips received are less than $20 in any month, they are still taxable, although they do not need to be reported to your employer. Gratuities should always be reported on your tax return, and are subject to income, Medicare, and Social Security taxes.

Employer allocation of tips – If you work for a large restaurant, you may find tips you didn’t know about on your W-2 form. Restaurants with a large serving staff report a total called “allocated tips” to the IRS. Here is what allocated tips are all about:

Tip allocation applies to “large food and beverage establishments” (i.e., food service businesses where tipping is customary and that have 10 or more employees). These establishments must allocate a portion of their gross receipts as tip income to employees who “underreport,” which happens if an employee reports tips that are less than 8% of that employee’s share of the employer’s gross sales. The employer must allocate the difference between what the employee reported and the 8% amount to those underreported employees.

If this situation applies to you, the allocation amount will be noted in a separate box on your W-2, and these allocated tips won’t be included in the total wages shown on your W-2 form. You will need to report the allocated tip amount as additional income on your tax return unless you have adequate records to show that the amount is incorrect. The IRS frequently issues inquiries if the taxpayer’s W-2 shows an allocation of tips and a lesser amount is reported on his or her tax return.

Self-Employed Individuals – If you are self-employed, you don’t have an employer to report tips to, and you simply include the tips you received in your self-employed income on your tax return for the year when you received the tips.

Because they are usually paid in cash, tips are a frequent audit item. If you are receiving tips and have any questions about their taxability, please contact us.

Do You Own a Specified Service Trade or Business? If So, Your 20% Pass-Through Tax Deduction May Be Limited

As part of its recent tax reform, Congress included a new 20% deduction of pass-through income for trades or businesses other than C-corporations. This pass-through income is referred to as qualified business income (QBI); for trades or businesses, it generally includes bottom-line profits, and for S-corporations and partnerships, it includes K-1 flow-through income. This new law was added as tax code section 199A, so the deduction is often referred to as the 199A deduction.

Congress added this deduction to benefit sole proprietors, partners, and S-corporation shareholders (among others); the goal is to allow for benefits equivalent to the substantial tax-rate cut that the same reform provided to C-corporations. However, this new deduction is not applied uniformly to all types of trades and businesses, for which there are two categories:

  • qualified trades or businesses (QTBs) and
  • specified service trades or businesses (SSTBs).

This deduction is limited by the taxpayer’s filing status and 1040 taxable income, and it differs depending on whether the business is a QTB or a SSTB. Although the main purposes of this article are to define SSTBs and to describe how they are taxed differently from QTBs, if one is to understand why an SSTB may not qualify for the deduction, whereas a QTB might qualify, it is necessary to first understand the basic differences between the deductions for SSTBs and QTBs.

Apparently, Congress considered the income from service businesses to be akin to wages and didn’t want taxpayers who provide services to have the benefit of the 20% deduction instead of paying taxes on that income as ordinary wages. This change was primarily aimed at deterring high-income people from becoming independent contractors or setting up pass-through businesses so that they could turn their wages into business income and get the 20% deduction. The result is a phase-out of the deduction for high-income taxpayers who have income from SSTBs.

The table below provides an overview of the tax treatment for each type of business. As you will note, the SSTB deduction phases out for higher levels of 1040 taxable income, but the QTB deduction does not. This type of phase-out is called a wage limitation.

Example of How to Use the Table: Two married people who are filing jointly have 1040 taxable income (before the 199A deduction) of $469,000; they also have a SSTB. They would first select the box with their filing status (“Married Filing a Joint Return”), then move to the right to the correct range of 1040 taxable income (which is the adjusted gross income after removing either the standard deduction or the itemized deductions; in this case, “Greater than $415,000”), and finally follow that column down to the cell aligned with the correct type of business (“SSTB”). In this case, the trade or business does not qualify for the 199A deduction.

Taxpayer’s Filing Status

Taxable Income
(Before the 199A deduction)

Married Filing a Joint Return
Less Than $315,000
Between $315,000 and $415,000

Greater than $415,000

Other filing Statuses
Less Than $157,500
Between $157,500 and $207,500

Greater than $207,500

Type of Business
The 199A Deduction
SSTB
20% of QBI
Deduction phased out
No deduction allowed
QTB
20% of QBI
Wage limitation phased in
Deduction equal to the lesser of 20% of QBI or the wage limitation

Specified Service Trades or Businesses (SSTBs)
The IRS describes SSTBs as being in the following fields:

  • Health – The health category includes the provision of services by physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and similar health care professionals who provide medical services directly to patients. However, this excludes the provision of services that are not directly related to a medical field, even when those services purportedly relate to the health of the service recipient. For example, this category excludes the operation of health clubs or spas that provide physical exercise or conditioning; health-related payment processing; or the research, testing, manufacture, and/or sales of pharmaceuticals or medical devices.
  • Law – The law category refers to the provision of services by lawyers, paralegals, legal arbitrators, mediators, and similar professionals in their capacities as such. The category excludes the provision of services that do not require skills unique to the field of law, such as the printing, delivery, and stenography services provided to lawyers.
  • Accounting – The accounting category includes the provision of services by accountants, enrolled agents, tax-return preparers, financial auditors, and similar professionals in their capacities as such. This category is not limited to services that require state licensure as a certified public accountant. This category also excludes payment processing and billing analysis.
  • Actuarial Science – The actuarial science category refers to the provision of services by actuaries and similar professionals in their capacities as such. This category only includes the services provided by analysts, economists, mathematicians, and statisticians if they are engaged in analyzing or assessing financial costs due to risk or uncertainty.
  • Performing Arts – The performing arts category includes the performance of services by individuals who participate in the creation of the performing arts, including actors, singers, musicians, entertainers, directors, and similar professionals in their capacities as such. It excludes services that do not require skills that are unique to the creation of performing arts, such as the maintenance and operation of equipment or facilities. Similarly, the dissemination of video or audio of performing-arts events to the public is not considered to be a service in the performing arts.
  • Athletics – The athletics category refers to the performance of services by individuals who participate in athletic competitions, including athletes, coaches, and team managers in sports such as baseball, basketball, football, soccer, hockey, martial arts, boxing, bowling, tennis, golf, skiing, snowboarding, track and field, billiards, and racing. This category excludes the provision of services that do not require skills that are unique to athletic competition, such as the maintenance and operation of equipment or facilities for use in athletic events. It also excludes the provision of services by persons who disseminate video or audio of athletic events to the public.
  • Consulting – The consulting category refers to the provision of professional advice and counsel to clients to assist them in achieving goals and solving problems. Consulting professionals include lobbyists and similar professionals, but this category focuses on their capacities as such and excludes the minor consulting that accompanies the sale of a product. A trade or businesses cannot be an SSTP if less than 10% of its gross receipts are from consulting (or 5% if the company’s gross receipts are greater than $25 million).
  • Financial services – The category of financial services applies to services that are typically performed by financial advisors and investment bankers, including the following financial services: managing wealth; advising clients with respect to their finances; developing retirement and wealth-transition plans; providing advisory and other services regarding valuations, mergers, acquisitions, dispositions, and restructurings (including in title 11 bankruptcies and similar cases); and raising financial capital through underwriting or by acting as a client’s agent in the issuance of securities. This includes the services provided by financial advisors, investment bankers, wealth planners, retirement advisors, and similar professionals but excludes banking services such as deposit-taking or loan-making.
  • Brokerage Services – The brokerage services category includes services in which a person arranges transactions between a buyer and a seller with respect to securities and in exchange for a commission or fee. This includes services provided by stock brokers and similar professionals but excludes services provided by real estate or insurance agents and brokers.
  • Reputation or Skill – The original legislation’s list of SSTBs included trades or businesses for which the principal asset was the reputation or skill of one or more of employees or owners. However, it was unclear if this meant, for example, that a self-employed plumber who provided his skill to the business would be eligible for the 199A deduction. The taxpayer-friendly interpretation of these tax regulations has generally defined “reputation and skill” to mean:(1) The receipt of income in exchange for endorsing products or services for which the individual provides endorsement services;
    (2) The receipt of licensing income in exchange for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbol associated with that individual’s identity; or
    (3) The receipt of appearance fees or income (including fees or income paid to reality performers who appear as themselves on television, social media, or other forums; radio, television, and other media hosts; and video game players).

The amount of pass-through deduction that is ultimately available due to an SSTB is entirely dependent upon the taxpayer’s 1040 taxable income. Thus, in some cases, pension contributions and the expensing of business assets can lower a taxpayer’s taxable income enough that he or she benefits from an increase in the pass-through deduction. In this scenario, married couples who are not living in community-property states could benefit from filing separately rather than jointly.

If you have questions related to whether your business qualifies for this new deduction, whether it is classified as an SSTB, or how SSTB income fits into your overall tax picture, please give us a call.

After Tax Reform, Which Is Right for You: S Corp or C Corp?

The Tax Cuts and Jobs Act has left many of today’s businesses with big questions. Incorporation remains a hot topic, but this law is shaking things up. It’s quick to assume your company should be one or the other, but without careful consideration of the facts, your organization may end up facing financial loss, hefty tax penalties or missed tax savings.

The goal of this type of incorporation is to minimize tax burdens, but the wrong decision can be costly. In a C Corp, the company pays corporate taxes to the Internal Revenue Service. But, in an S Corp, there’s no entity tax. Rather, taxes are paid through an individual return.

The New Law Changes
The new law, which went into effect for the 2018 tax year, brought changes to both S Corp and C Corp businesses. In fact, both types of corporations benefited here. For C Corps, the tax rate was dropped from 35 percent down to just 21 percent. For an S Corp the new law provides a deduction equal to 20% of the pass-through income from the corp subject to limitations for higher-income taxpayers. At best, this reduces the effective tax rate to 29.6 percent from 37 percent. In both cases, there are specific restrictions here to know.

One thing to remember about these tax changes is that there are many components to determining which method is right for your business. Don’t make a quick judgment here. Rather, invest in some one-on-one time with your tax professional to determine the best possible scenario for your individual company. To help, consider these key areas.

S Corp and C Corp Ownership
A key component in deciding how to incorporate your business relates to ownership. In the S Corp, there is a limit of 100 shareholders within the company. These must be domestic organizations operated in the United States where all of the company’s shareholders are also living in the United States. Additionally, this structure allows for a single stock classification. As a business, you cannot offer common stocks as well as preferred shares, for example.

Comparatively, C Corps allow for fewer restrictions. There is no limit on ownership at all. There is no limit on the number of shareholders the company can have. Any small- to a medium-sized company planning an IPO or simply obtain investors outside of the traditional domestic structure will find C Corps offer far more flexibility.

Another key factor about C Corps relates to the differences within your shareholders. These corporations can issue several types of stock. As a result, it is not uncommon for some shareholder votes to be more important than others. This, too, can influence the decision you make in choosing one or the other model.

Corporation Taxation – Choosing the Best Taxation Structure
Most companies will focus most of their decision on S Corp or C Corp options based on ownership as a starting point. However, every company also wants to keep costs low. Taxation is one of the most expensive hurdles any organization must manage. And, each type of structure offers a different look.

For example, consider how a C Corp is taxed. It is commonly referred to as a “double taxation structure.” This is because the company (the entity itself) will pay a corporate tax. Then, the stockholders pay taxes on their income from the business. While this has long been a concern for any business owner using the C Corp structure (paying taxes twice on income is very costly), the new tax law changes this a bit. As noted previously, the tax rate for C Corp has changed from 35 percent to just 21 percent. However, the dividends will still be faced with double taxation.

The slashing to 21 percent means every company is paying the same rate, neither the size of the company nor the type of organization matters. That’s an important consideration when choosing which type of structure is right for your company.

With the help of a tax professional, it is also important to consider other tax strategies available. For example, an S Corp shareholder pays taxes every year on the money the company earns during that year. This is a simpler, straightforward scenario. But, in a C Corp, the taxes are only paid when the company decides to distribute dividends. It can also occur if a shareholder realizes capital gains (such as when selling ownership). This provides the C Corp with an ability to minimize taxes just by timing dividends properly.

Making the Right Decision for Your Needs
This is only the very top edge of considerations for which is best for your company. However, there are a few things that can influence your decision.

Stable Small Businesses
If you own a smaller company, you’ll benefit from an S Corporation for various reasons. First, the income passes through and is taxable to the stockholders on their 1040s, thereby eliminating double taxation. Plus the lower tax rate and the 20% pass-through deduction are very beneficial to an S-Corporation structure.

Growing Small Businesses
If your company is growing – or you plan to go public and take on new ownership, the C Corporation offers the opportunity to do so. It allows for a larger number of investors, and international investments are possible. Additionally, as a smaller business, you may not be likely to issue dividends any time soon. As a result, this can reduce the amount of income reported to the IRS on an annual basis.

Larger Companies
For larger organizations, the C Corp tends to offer the best structure overall. Other options limit investor access and may create scenarios where the company cannot grow. The effective tax rate is significantly lower – competitive to any company no matter the size. The new tax reform provides the most advantages to this buyer in particular.

Making the Decision for Your Needs
Many organizations today have jumped on the new tax reform as an opportunity to incorporate more tax savings. However, a clear picture is important and we recommend slowing down before making any type of drastic decisions like this. They have far-reaching implications and can create a financial burden or limitations on an organization if the wrong decision occurs. With the assistance of a tax professional or attorney, it is possible to make better decisions based specifically on the type of business structure you have, the business’s short-term and long-term goals, as well as new laws and taxation rates. Before you make a change as an entrepreneur, know what you are really getting. Please contact us with any questions.

10 Mistakes Most Small Business Owners Miss When Starting Out

The process of starting a small business can be an arduous one; there are numerous steps that need to be taken — and often in a precise order — to legally establish a business. As a result, the process can be overwhelming. Unfortunately, it’s also easy to overlook some important details and steps along the way. By being aware of a few of the most common legal and compliance mistakes made by small business owners when starting out, you can be better prepared for future success.

1. Misclassifying Employees as Independent Contractors
Regulators are coming down hard on misclassifications. The IRS estimates that this problem includes millions of workers. It is best to talk this through with an expert, but you can get some background on the guidelines at the United States Department of Labor website.

2. Choosing the Wrong Business Structure
One of the first major decisions you’ll need to make in regards to your small business is the type of business structure you will select. This can range anywhere from a basic sole proprietorship (which doesn’t require any special forms or paperwork) to a more complex structure, such as a corporation or LLC. Keep in mind that different types of business structures offer different tax benefits and other protections, so it’s important to thoroughly explore your options and select the structure that’s best for your unique needs. You’ll also need to go through the legal process of establishing your business under your desired structure, which may require help from a legal or other type of professional.

3. Failing to Apply for an Employer Identification Number
Unless you plan on operating your business strictly as a sole proprietorship (in which case, you will use your personal Social Security number when filing taxes), you’ll also need to apply for a unique Employer Identification Number (EIN). This number will be specifically associated with your business, and it can be helpful to think of it as a business Social Security number of sorts; it’s used to file your business taxes, open up dedicated business bank accounts, and the like.

4. Overlooking Important Permits and Licenses
Depending on the specific industry in which your business will be operating and your location, you may also be required to obtain specialized licenses and/or permits in order to legally operate. Otherwise, you’ll run the risk of being shut down or finding yourself in serious legal trouble down the road. Take some time to research the specific types of permits or licenses that you may need to obtain, as well as the steps you’ll need to take in order to acquire them. Sometimes, this process can be time-consuming and even costly, so it’s not something you’ll want to put off until the last minute.

5. Not Knowing When to Speak to a Professional
When starting up a small business, it’s not uncommon to run a one-man (or woman) operation. After all, you may not have the cash flow or even the need to hire outside help in the early stages. Still, when it comes to making sure your business is squared away from a legal/compliance standpoint, it can certainly be worth the money to consult with tax and accounting professionals early in the game. You don’t necessarily need to onboard these experts full-time, but being able to turn to them for advice and guidance when you need it will help you avoid serious legal issues later on.

6. Putting Off Domain Name Registration
As soon as you have your business name picked out and registered, it’s also in your best interest to go ahead and register your website domain as soon as possible. Even if you don’t plan on setting up and launching your website any time soon, domain names are cheap, and having yours registered now will help you avoid a situation where the domain name you want is taken by somebody else later on.

7. Lack of a Comprehensive Business Plan
One of the biggest mistakes small business owners make when first starting out is that of not having a well thought-out and articulated business plan. A business plan is an important document that outlines in detail what your goals for your business are and how you will achieve them. This document is important not just for you and other members of your immediate team, but for potential investors as well. Should you seek financing for your company at any point, an investor is going to want to see and scrutinize your business plan — and it will likely have a major impact on the final decision.

8. Not Having Finances Squared Away
Another common mistake new business owners make is that of poor financial planning, which can lead to a lack of funding to get you through your first months successfully. Ideally, you’ll want to make sure your business plan accounts for all the company-related expenses you’ll incur during the first year of operation, as well as any personal expenses as well. Unfortunately, this is something that many small business owners overlook or miscalculate with disastrous results. The easiest way to avoid this mistake is to consult with a small business accountant during the early stages of drafting your business plan.

9. Failing to File Patents on Products or Ideas
It’s (hopefully) no surprise that you’ll want to be proactive about filing for patents for any unique products, prototypes or designs you may have. However, what many small business owners first starting out don’t realize is that they’ll also want to file patents on ideas, such as intellectual property, that could otherwise be stolen or copied and used by other entrepreneurs. After all, intellectual property can be just as valuable as a product prototype — so you’ll want to plan and protect these kinds of ideas accordingly.

Be careful to also avoid the mistake of waiting too long to file for relevant patents; the process can often be long and drawn out, so getting started as early as possible will be in your best interest.

10. Being Blind to Important Compliance Requirements
Last, but not least, make sure you’re aware of any and all compliance requirements that may apply to your business based on its structure, location, industry or other factors. For example, even if you’re keeping things “simple” by operating as a sole proprietorship, you’re going to be required to file and pay quarterly estimated taxes under that structure. Failing to meet compliance and other requirements can result in serious legal trouble, including fines and penalties, down the road.

When it comes to compliance requirements, such as annual reporting and tax filing, it’s always a good idea to keep a calendar of important dates, so you don’t forget anything. After all, you’ll have enough deadlines to worry about and remember on your own — especially during that first year of business operation. This is yet another situation where having a compliance expert, such as a tax or accounting professional, can really come in handy. He or she can assist you with annual compliance reviews, reminders on impending deadlines and the like.

From selecting a name and business structure to making sure your small business remains in compliance at all times, there are, unfortunately, a lot of opportunities to make mistakes as a new business owner. By keeping this information in mind and by working alongside the right types of professionals as you prepare to launch your new business, hopefully, you’ll be able to avoid these issues. From there, you can maximize your chances for success in the first year of operation and beyond.

How Some High-Income Taxpayers Can Maximize the New 20% Pass-through Business Deduction

Taxpayers with higher 1040 taxable incomes who are self-employed but are not “specified service businesses” may find it beneficial to structure new businesses, or restructure an existing business, as an S corporation to avoid taxable income limitations that apply to the new 20% Sec. 199A pass-through deduction.

To make up for the tax reform’s reduction of the C corporation tax rate to 21%, from which other forms of business activities do not benefit, Congress created a new deduction and code section: 199A. The 199A deduction is for taxpayers with other business activities – such as sole proprietorships, rentals, partnerships and S corporations – since, unlike C corporations, which are directly taxed on their profits, the income from the other business activities flows through to the owner’s tax return and is taxed at the individual level, i.e., at the individual’s tax rate, which can be as high as 37%.

This new Sec. 199A deduction is 20% of the pass-through income from these business activities. But not every owner of these flow-through businesses will benefit from this deduction because, as in all things tax, there are limitations.

Whether or not a taxpayer will benefit from the deduction will depend in great part upon the taxpayer’s 1040 taxable income figured without the Sec. 199A deduction. Married taxpayers with a taxable income below $315,000 (or below $157,500, for others) will benefit from the full 20% deduction.

However, limitations begin to apply when a taxpayer’s 1040 taxable income exceeds those amounts. The most restrictive limitation is the one placed on “specified service businesses.” Once married taxpayers filing jointly have a 1040 taxable income exceeding $415,000 (or above $207,500, for others), they receive no Sec 199A deduction benefit from any pass-through income derived from a specified service business. Specified service businesses include trades or businesses involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services or any trade or business in which the principal asset of the trade or business is the reputation or skill of one or more of its employees or owners. Note that an engineering or architecture business is not a specified service business for this deduction.

On the other hand, a taxpayer can still benefit from pass-through income from other business activities, even when the taxpayer’s 1040 taxable income exceeds the $415,000/$207,500 limits, provided the business activity pays wages and/or has qualified business property, the combination of which make up what is referred to as the wage limitation. Without getting too complicated, the Sec. 199A deduction is the lesser of 20% of one’s pass-through income or the wage limitation. If the wage limit is zero, then the Sec. 199A deduction would also be zero for these high-income taxpayers. The wage limitation itself is the greater of 50% of the wages paid by the business activity or 25% of the wages paid plus 2.5% of the cost of qualified business property. Perhaps this is best explained by example.

Example #1: Peter and his wife have a 1040 taxable income of $475,000. Peter has a self-employed business (not a specified service business), from which he has a net profit of $300,000, and his tentative 199A deduction is $60,000 (20% of $300,000). However, because his taxable income exceeds $415,000, his Sec. 199A deduction is the lesser of $60,000 or the wage limit. Peter has no employees or qualified business property, so his wage limitation is zero; thus, his Sec. 199A deduction is also zero.

Example #2: Same as example #1, except Peter’s business is organized as an S corporation. Of his net profit of $300,000, it is determined that a reasonable compensation (wage) for the services Peter provides to the S corporation is $150,000, which the S Corporation pays as a salary to Peter. The other $150,000 is pass-through income. Now, Peter’s Sec. 199A deduction is the lesser of 20% of the pass-through income – $30,000 (20% of $150,000) – or the wage limitation, which is 50% of the wages paid by the S Corporation or $75,000 (50% of $150,000).

This demonstrates how a business activity can benefit from being organized as an S corporation, since S corporations are required to pay working shareholders a reasonable wage for their services provided in operating the business. They are able to divide the pass-through income between reasonable wages and pass-through income to enable a 199A deduction for a higher-income taxpayer. Other business entities do not provide this option, which is the reason why high-taxable-income taxpayers might explore the benefits of organizing new businesses as, or reorganizing their existing businesses into, an S corporation.

Of course, there are other issues involved as well, and some sole proprietors may not find it worth the expense or effort to switch to a different type of business entity. However, the higher the taxpayer’s income, the more beneficial it becomes. The same issues also apply to partnerships. To see if organizing or reorganizing your business activity into an S corporation can reduce your tax liability, call us for an appointment.


Tax Reform Puts a Cap on Deducting Business Losses

Note: This is one of a series of articles explaining how the various tax changes in the GOP’s Tax Cuts & Jobs Act (referred to as “the Act” in this article), which passed in late December of 2017, could affect you and your family, both in 2018 and future years. This series offers strategies that you can employ to reduce your tax liability under the new law.

Under the Act, deductible business losses of noncorporate taxpayers will be limited beginning in 2018. Many have misconstrued this new law to mean that no losses are allowed.

Fortunately, that is not the case. The Act does not allow “excess business losses” to be deducted. An “excess business loss” is the excess of the taxpayer’s aggregate trade or business deductions for the tax year (determined without regard to whether the deductions are disallowed for that tax year) over the sum of the taxpayer’s aggregate gross income or gain for the tax year from those trades or businesses, plus $250,000 (200% of that amount for a joint return (i.e., $500,000)). This amount will be adjusted for inflation after 2018.

More simply put, deductible losses for the year are generally limited to $250,000 ($500,000 for married couples filing jointly).

Example: A single taxpayer, in 2018, has two businesses. The combined deductions from the two businesses total $500,000. The taxpayer’s gross income from those two businesses is $200,000. After netting the income and deductions, there is a net loss of $300,000 ($200,000 – $500,000). Prior to the Act, the deductible loss would have been $300,000. However, under the Act the excess business loss is equal to $50,000 ($500,000 – ($200,000 + $250,000)). And since excess business losses are not deductible, the taxpayer can only deduct $250,000 ($300,000 – $50,000) in 2018.
On the bright side, the nondeductible excess business loss ($50,000 in our example) is treated as a net operating loss (NOL) carried forward to the next year’s return, where it is deductible from the taxpayer’s gross income, including nonbusiness income. Under the Act, an NOL is carried forward indefinitely until it is used up. The Act did, however, limit NOLs in the future to offsetting only 80% of a taxpayer’s income for any year.

If you have questions related to “excess business loss,” please give us a call.