August 2016

Tread Lightly Around the Issue of Reasonable Owner Compensation

Posted on August 5, 2016 by Debra Barcuch

Are you drawing too much salary from your construction company — or perhaps not enough? Be careful: The IRS may challenge deductions for wages it thinks are unreasonable.

In a recent case, the co-owners of a cement contracting business chose to pay themselves a certain amount of compensation, contested the IRS’s refusal to allow part of the compensation as deductible and eventually won the case (H. W. Johnson, Inc., TC Memo 2016-95). The U.S. Tax Court’s decision revolved around the “independent investor” test.

Separate Divisions

The company was owned by the retired founder’s wife (51% interest) and his two sons (24.5% each). It grew to become one of the largest concrete contractors in Arizona, with more than 200 employees. Annual revenue rose rapidly after the sons assumed control of daily operations. When they took over in 1993, the company showed revenue of $4 million. That mushroomed to $23.87 million in 2003 and $38 million in 2004, the two tax years questioned by the IRS.

Each brother supervised a division of the company, overseeing all operations including:

Contract bidding and negotiation,
Project scheduling and management,
Equipment purchase and modification,
Personnel management, and
Customer relations.

Working 10 to 12 hours a day, five to six days a week, the brothers were at job sites daily and regularly operated equipment. They each were readily available if problems arose and were known locally for their responsive and hands-on management style.

The concrete work that the brothers supervised required considerable technical skill. Over the years, their business built an excellent reputation with developers, inspectors and other contractors for timely, quality performance. As a result, the company routinely won contracts even when it wasn’t the lowest bidder.

During the two years in dispute, the brothers personally guaranteed loans allowing the business to buy materials and supplies. In 2003, faced with the possible disruptions in their concrete supply, the brothers partnered with investors to start a concrete supply business — despite their mother’s objections about the risks. This move allowed the company to prosper when others were suffering.

The board of directors voted to pay the brothers $4,025,039 and $7,300,916 in 2003 and 2004, respectively. But the IRS partially denied the company’s deductions for this compensation, finding that $811,039 for 2003 and $768,916 for 2004 wasn’t reasonable.

Tax Court Outcome

The Tax Court applied the five factor test used by the U.S. Court of Appeals for the Ninth Circuit, to which an appeal in this case would have gone. Based on the appeals court’s landmark ruling in Elliotts v. Commissioner (716 F.2d at 1245-1247), five factors are used to determine reasonable compensation:

The employee’s role in the company,
A comparison with other businesses,
The character and condition of the company,
Potential conflicts of interest, and
Internal consistency in compensation.

According to the court opinion, the IRS argued that the current case hinged on the “fourth Elliotts factor; namely, whether a hypothetical independent investor would receive an adequate return on equity after accounting for [the brothers’] compensation.”

Responding to that argument, the Tax Court said that the annual return after payment of the compensation closely approximated the return generated by comparable companies. Accordingly, it said that an independent investor would have been satisfied with the return.

After examining all the factors, the Tax Court concluded that the compensation paid to the brothers was reasonable under the circumstances and, thus, deductible. Each brother was integral to the success of the business — including performance that resulted in remarkable growth in revenue, assets and gross profit margins during the years at issue.

Takeaway for Contractors

For contractors, the takeaway from this Tax Court ruling is to be sure you’re familiar with the independent investor test and how it applies to IRS challenges of compensation arrangements for shareholder-employees. Although there’s no definitive bright line test on what constitutes “reasonable,” the courts have historically cited several factors that vary by jurisdiction. These include:

Amounts similar businesses pay their shareholder-employees,
Reasons for paying high compensation (spell them out in your corporate minutes),
The nature, extent and scope of the taxpayer’s work,
The taxpayer’s qualifications and experience,
The size and complexity of the business,
General economic conditions,
The employer’s financial condition,
The employer’s salary policy for all employees,
Compensation paid in previous years,
Whether the employer and employee are dealing on an arm’s-length basis, and
Whether the employee guaranteed the employer’s debts.

No single factor is greater than the other. The decision generally comes down to the number of factors weighing for or against reasonable compensation.

Remember to pay reasonable amounts for services actually rendered. These actions should help protect you if the IRS ever comes calling,

Also, it makes a big tax difference whether amounts paid to owners and other high-income employees are treated as compensation or dividends. Compensation is deductible from the employer’s taxable income; dividends aren’t and effectively represent a second level of taxation on corporate income.

For this reason, some employers choose to maximize the tax benefits by increasing the compensation. However, if a company simply pays its employees whatever it wants, it could find itself in hot water with the IRS. Typically, when the IRS successfully challenges an amount as “unreasonable,” the difference between the payment and a reasonable amount attributable to services provided can’t be deducted.

Best Defense

Of course, reasonable compensation issues don’t always involve excessive amounts. In some cases business owners may arrange for low or even no wage payments to reduce payroll taxes. As a result, the owners must argue with the IRS that they should be paid less, not more. If you find yourself in such a situation, you can bolster your position by spelling out the reasons for a low salary — including plans to use funds for expansion — in your corporate minutes.

The IRS may re-characterize compensation even if the business is running a loss — for an example, see Glass Blocks Unlimited (TC Memo 2013-180, 8/7/13). But, whatever the reason for the agency’s scrutiny, your construction company’s best first response to an IRS compensation challenge is to contact your CPA for professional guidance in building your defense.

Three Income Taxes People Love to Hate

Posted on August 3, 2016 by Debra Barcuch

Income Tax Monopoly Blog

Few people enjoy giving money to the IRS, but some types of taxes are viewed more unfavorably than others. Here are three worthy candidates vying for the title of most-hated tax.

Penalty Tax on Individuals without Health Insurance

As you probably know, the Affordable Care Act (ACA) imposes a penalty on individuals who fail to have so-called minimum essential health insurance coverage for any month of the year. This requirement is commonly called the “individual mandate,” and individuals must pay a penalty for noncompliance with the mandate.

You may be exempt from paying the penalty, however, if you fit into one of these categories for 2016:

Your household income is below the federal income tax return filing threshold, which is generally $10,350 for singles, $20,700 for married joint-filing couples and $13,350 for heads of households.
You lack access to affordable minimum essential coverage.
You suffered a hardship in obtaining coverage.
You have only a short-term coverage gap.
You qualify for an exception on religious grounds or have coverage through a health care sharing ministry.
You’re not a U.S. citizen or national.
You’re incarcerated.
You’re a member of a Native American tribe.

How much can the penalty cost? That’s a tricky question. If you owe the penalty, the tentative amount equals the greater of the following two prongs:

The applicable percentage of your household income above the applicable federal income tax return filing threshold, or
The applicable dollar amount times the number of uninsured individuals in your household, limited to 300% of the applicable dollar amount.

In terms of the percentage-of-income prong of the penalty, the applicable percentage of income is 2.5% for 2016 and beyond.

In terms of the dollar-amount prong of the penalty, the applicable dollar amount for each uninsured household member is $695 for 2016. This amount will be adjusted for inflation for 2017 and beyond. For a household member who’s under age 18, the applicable dollar amounts are cut by 50%.

The final penalty amount can’t exceed the national average cost of “bronze coverage” (the cheapest category of ACA-compliant coverage) for your household. For 2015, the national average cost for bronze coverage was $207 per person, per month or $1,035 per month for a family of five or more. Numbers currently aren’t available for 2016, but they’ll probably be somewhat higher. Meanwhile, the important thing to know is that a high-income person or household could owe more than 300% of the applicable dollar amount but not more than the cost of bronze coverage.

Important note: If you have minimum essential coverage for only part of the year, the final penalty is calculated on a monthly basis using pro-rated annual figures.

Example: You’re unmarried and live alone. During all of 2016, you have no health coverage. Your income for the year is $100,000. Your tax return filing threshold for the year is $10,350. Assume the monthly national average premium for bronze coverage for one person is $215 for 2016, which amounts to $2,580 for the entire year (12 × $215).

In this example, the percentage-of-income prong for 2016 is $2,241. That’s 2.5% of the difference between $100,000 and $10,350.

The dollar-amount prong is $695.

The tentative penalty amount is $2,241 (the greater of $2,241 or $695).

In this example, the annual national average cost of bronze coverage is assumed to be $2,580 for one person who’s uncovered for all of 2016. Therefore, the final penalty amount for failing to comply with the individual mandate is $2,241 (the lesser of $2,241 or $2,580).

Penalty Tax on Employers that Pay Employee Health Insurance Premiums

The ACA also established a number of so-called “market reform restrictions” on employer-provided group health plans. These restrictions generally apply to all employer-provided group health plans, including those furnished by small employers with fewer than 50 workers.

The penalty for running afoul of the market reform restrictions is $100 per employee, per day. This penalty can amount to $36,500 per employee over the course of a full year. Even worse, the penalty can be assessed on employers who offer an employer payment arrangement in which the company’s health plan simply reimburses employees for premiums paid for individual health insurance policies or pays premiums directly on behalf of employees.

This penalty doesn’t apply to employer payment arrangements that have only one participating employee. Therefore, a business can still use such an arrangement to reimburse or pay for individual health policy premiums for one employee (such as the owner’s spouse) without triggering this expensive penalty.

Many S corporations have set up employer payment arrangements to cover individual health policy premiums for employees who also own more than 2% of the company stock. Under long-standing IRS rules, amounts paid under such plans are treated as additional wages that are subject to federal income tax but exempt from Social Security and Medicare taxes. Qualifying shareholder-employees can deduct the premiums on their individual federal income tax returns under the provision for self-employed health premiums. These plans are also exempt from the $100 per-employee-per-day penalty. But S corporation employer payment arrangements that benefit other employees are still exposed to the penalty.

Medicare Surtax on Net Investment Income

The 3.8% Medicare surtax on net investment income was also enacted as part of the ACA. Taxpayers who are hit with the net investment income tax (NIIT) can have a marginal federal tax rate as high as 43.4% (39.6% top federal income tax rate plus 3.8% NIIT). The NIIT can potentially affect anyone with consistently high income or anyone with a major one-time shot of income or gain, say, from selling some highly appreciated company stock or a highly appreciated personal residence. For purposes of the NIIT, net investment income includes the following after subtracting related expenses:

Capital gains, including the taxable portion of gain from selling a personal residence and capital gains distributions from mutual funds,
Dividends,
Interest, excluding tax-free interest (such as municipal bond interest),
Most royalties,
The taxable portion of annuity payments,
Income and gains from passive business activities (in other words, activities in which you don’t spend a significant amount of time),
Rental income,
Gain from selling a passive ownership interest in a partnership, limited liability company, or S corporation, and
Income and gains from the business of trading in financial instruments or commodities.

You’re exposed to the NIIT only if your modified adjusted gross income (MAGI) exceeds the applicable threshold of:

$200,000 if you are unmarried,
$250,000 if you are a married joint-filer, or
$125,000 if you use married filing separate status.

The amount hit by the NIIT is the lesser of: 1) your net investment income, or 2) the amount by which MAGI exceeds the applicable threshold. MAGI is defined as regular adjusted gross income plus certain excluded foreign-source income net of certain deductions and exclusions. (Most individuals are unaffected by this addback, however.)

Focus on the Positive

There’s some good news about these three most-hated taxes: With thoughtful advance planning, they can often be avoided or significantly reduced. For more information about these taxes, consult your tax adviser.

10 Tax Planning Tips for Filing 2016 Returns

Posted on August 2, 2016 by Debra Barcuch

Tax Planning Tips

For some reason, tax time always seems to be lurking around the corner, worrying business owners and individuals alike. While it is true that you shouldn’t take your tax obligation lightly, planning in advance will help ease the stress of tax time from your life.

Don’t Wait to Start Tax Planning

Procrastination is the downfall of any personal project. If you wait until the last minute, the stress will hurt your personal health and business. Everyone knows that April 15^th is Tax Day. By getting on top of your return early, you will have more time to check over your work and in turn will make fewer mistakes. Unlike others who will be rushing to figure out all the required paperwork, you’ll be spending Tax Day worry free.

Look Back

Review your previous year’s return. It is helpful to see how you filed last year so that any necessary changes or improvements can be made the upcoming year. Reviewing your previously filed documents will also help offer a lot of insight into what you accomplished last year and where you are heading in terms of income.

Fund a Qualified Retirement Plan

The ultimate goal for anyone is to retire, with no sense of worry. If you’re going to have enough saved, then a plan is a necessity. There are many ways to go about accomplishing that but a main one is to make sure you invest in your 401(K). Try to maximize the amount allowed to contribute to your companies 401(K). Talk to an expert to fund a continual plan. The earlier you start the easier it is later in the year.

Plan Charitable Contribution

Americans are actually giving more money in recent years to charity. Giving to charities is a good way to help your community and simultaneously find tax breaks. However, make sure you give to a qualified charity, and remember that donations to individuals don’t count as deductions. When donating, make sure you receive a receipt to include in your tax organizer. Lastly, there are limits to charitable giving deductions ratio so double check your deduction limit before writing the check.

Defer your income

Deferring income makes sense only if you’re going to be in the same or lower tax bracket as the previous tax year. Don’t get hit with a higher tax bill next year by receiving additional income. This option might also help if your employer gives out bonuses at year-end.

Record keep

It’s tedious, but the IRS won’t doesn’t allow estimates, so it is vital to make sure and keep track of your expenses. Keeping a record of appointments, emails and summaries will only help in dealing with the IRS and also keep organized on activities throughout the year. Most small businesses struggle with record keeping and it leads to substantial losses. Don’t let you or your company fall behind. Always stay on course with record keeping.

“Green” Tax Breaks

The new popular lifestyle is to go “green”. To make it seem more enticing, the government has put in place a system to reward individuals and businesses for putting cleaner and more environmentally friendly devices in your workplace and home. The government will provide tax incentives for putting up solar panels and renewable energy systems. This will help save the planet as well as putting some more green in your pocket.

Keep up with Tax Law changes (In Congress)

Every year, congress makes changes that affect the daily lives of Americans. Be sure to stay attuned to all decisions that could potentially affect your finances. Watch local and national news to see if there have been any changes to when and how to file taxes or major reforms that may potentially affect the tax bill year to year.

Remember your State and Local Tax duties

The national timeline is often parallel with the local timeline in terms of taxes. However, local governments have different filing and payment responsibilities with various income, property, and sales taxes. Make sure you are keeping up with out of state expenses and that your business is in tune with what your local responsibilities as well.

Avoid the “kid” tax

There are many tax breaks that parents receive. To learn more – check out our blog article: Ten Tax Breaks Available for Parents.

What to Do If You Haven’t Filed Last Year’s Tax Return or Can’t Pay the Bill

Posted on August 1, 2016July 22, 2024 by Debra Barcuch

Tax forms 1065

Unless you’ve extended the due date for filing last year’s individual federal income tax return to October 17, the filing deadline passed you by in April. What if you didn’t extend and you haven’t yet filed your Form 1040? And what if you can’t pay your tax bill? This article explains how to handle these situations.

“I Didn’t File but I Don’t Owe”

Let’s say you’re certain that you don’t owe any federal income tax for last year. Maybe you had negative taxable income or paid your fair share via withholding or estimated tax payments. But you didn’t file or extend the deadline because you were missing some records, were too busy, or had some other convincing reason (to you) for not meeting the deadline.

No problem, since you don’t owe — right? Wrong.

While it’s true there won’t be IRS interest or penalties (these are based on your unpaid liability, which you don’t have), blowing off filing is still a bad idea. For example:

You may be due a refund. Filing a return gets your money back. Without a return, there is no refund.Until a return is filed, the three-year statute-of-limitations period for the commencement of an IRS audit never gets started. The IRS could then decide to audit your 2015 tax situation five years (or more) from now and hit you with a tax bill plus interest and penalties. By then, you may not be able to prove that you actually owed nothing. In contrast, when you do the smart thing and file a 2015 return showing zero tax due, the government must generally begin any audit within three years. Once the three-year window closes, your 2015 tax year is generally safe from audit, even if the return had problems. If you had a tax loss in 2015, you may be able to carry it back as far as your 2013 tax year and claim refunds for taxes paid in 2013 and/or 2014. However, until you file a 2015 return, your tax loss doesn’t officially exist, and no loss carryback refund claims are possible. There are other more esoteric reasons that apply to taxpayers in specific situations.

The bottom line is, you should file a 2015 return, even though you’ve missed the deadline and believe you don’t owe.

“I Owe but Don’t Have the Dough”

In this situation, there’s no excuse for not filing your 2015 return, especially if you obtained a filing extension to October 17.

If you did extend, filing your return by October 17 will avoid the 5%-per-month “failure-to-file” penalty. The only cost for failing to pay what you owe is an interest charge. The current rate is a relatively reasonable 0.83% per month, which amounts to a 10% annual rate. This rate can change quarterly, and you’ll continue to incur it until you pay up. If you still can’t pay when you file by the extended October 17 due date, relax. You can arrange for an installment arrangement (see below).

If you didn’t extend, you’ll continue to incur the 5%-per-month failure-to-file penalty until it cuts off:

Five months after the April 19 due date for filing your 2015 return or When you file, whichever occurs sooner. While the penalty can’t be assessed for more than five months, it can amount to up to 25% of your unpaid tax bill (5 times 5% per month equals 25%). So you can still save some money by filing your 2015 return as soon as possible to cut off the 5%-per-month penalty. Then you’ll continue to be charged only the IRS interest rate — currently 0.83% per month — until you pay.

If you still don’t file your 2015 return, the IRS will collect the resulting penalty and interest. You’ll be charged the failure-to-file penalty until it hits 25% of what you owe. For example, if your unpaid balance is $10,000, you’ll rack up monthly failure-to-file penalties of $500 until you max out at $2,500. After that, you’ll be charged interest until you settle your account (at the current monthly rate of 0.83%).

Save Money with an Installment Agreement

By now you understand why filing your 2015 return is crucial even if you don’t have the money to pay what you owe. But you may ask: When do I have to come up with the balance due? The answer: As soon as possible, if you want to halt the IRS interest charge. If you can borrow at a reasonable rate, you may want to do so and pay off the government, hopefully at the same time you file your return or even sooner if possible.

Alternatively, you can usually request permission from the IRS to pay off your bill in installments. This is done by filing a form with your 2015 return. On the form, you suggest your own terms. For example, if you owe $5,000, you might offer to pay $250 on the first of each month. You’re supposed to get an answer to your installment payment application within 31 days of filing the form, but it sometimes takes a bit longer. Upon approval, you’ll be charged a $120 setup fee or $52 if you agree to automatic withdrawals from your bank account.

As long as you have an unpaid balance, you’ll be charged interest (currently at 0.583% a month, which equates to a 7% annual rate), but this may be much lower than you could arrange with a commercial lender. Other details:

Approval of your installment payment request is automatic if you owe $10,000 or less (not counting interest or penalties), propose a repayment period of 36 months or less, haven’t entered into an earlier installment agreement within the preceding five years, and have filed returns and paid taxes for the preceding five tax years. A streamlined installment payment approval process is available if you owe between $10,001 and $25,000 (including any assessed interest and penalties) and propose a repayment period of 72 months or less. Another streamlined process is available if you owe between $25,001 and $50,000 and propose a repayment period of 72 months or less. However, you must agree to automatic bank withdrawals, and you may have to supply financial information. If you owe $50,000 or less, you can apply for an installment payment arrangement online instead of filing an IRS form. Finally, if you can pay what you owe within 120 days, you can arrange for an agreement with the IRS and avoid any setup fee. Warning: When you enter into an installment agreement, you must pledge to stay current on your future taxes. The government is willing to help with your 2015 unpaid liability, but it won’t agree to defer payments for later years while you’re still paying the 2015 tab.

Pay With a Credit Card

You can also pay your federal tax bill with Visa, MasterCard, Discover or American Express. But before pursuing this option, ask about the one-time fee your credit card company will charge and the interest rate. You may find the IRS installment payment program is a better deal.

Act Soon

Filing a 2015 federal income return is important even if you believe you don’t owe anything or can’t pay right now. If you need assistance or want more information, contact your tax adviser.

No Sale on Section 199 Deduction for Retailer’s Marketing Materials

Posted on August 1, 2016 by Debra Barcuch

Section 199

Despite its name, the Section 199 deduction — also referred to as the domestic manufacturing deduction — isn’t necessarily limited to traditional manufacturing activities within the United States.

The IRS has issued guidance addressing situations where this valuable tax break can — and can’t — be used. A recent Chief Counsel Advice (CCA) answers the question of whether a retailer could take the deduction for marketing materials that ostensibly are made in the United States and generate revenue for products that are manufactured abroad (CCA 201626024).

Background Information

During the past decade, the Sec. 199 deduction was gradually increased from 3% of “qualified production activities income” (QPAI) to 9% for 2010 and thereafter. That means that if your firm is in the 34% federal tax bracket for 2016, a 9% deduction effectively will amount to a tax cut of more than 3%.

Detailed calculations are required to arrive at your company’s QPAI. Basically, you take your domestic production gross receipts and subtract:

The cost of goods sold allocated to such gross receipts,
Direct expenses allocated to such receipts,
A ratable portion of other indirect expenses (such as certain overhead items)

For this purpose, DPGR includes gross receipts derived from the sale, exchange, lease, rental, licensing or other disposition of qualified production property. Significantly, the property also must be “manufactured, produced, grown or extracted” (MPGE) in whole or in significant part within the United States. In other words, this is a home-grown tax break.

Other limits may also come into play. For instance, if your firm’s taxable income is lower than its QPAI before the Sec. 199 deduction is calculated, the deduction is claimed as a percentage of taxable income. Furthermore, the annual deduction is limited to 50% of the W-2 wages paid by your company.

Overall, the IRS guidance for the deduction is favorable to taxpayers, often extending the tax break for DPGR in borderline situations. For example, gross receipts derived from a qualified disposition of Sec. 199 property generally don’t include advertising income and product placement income. However, they do if that income is included in gross receipts from the lease, rental, license, sale, exchange or other disposition of newspapers, magazines, telephone directories, periodicals or similar printed publications that are manufactured or produced in whole or significantly within the United States when the ads were placed in those media.

Important note: This special exception applies only if the gross receipts, if any, derived from the qualified disposition of the printed materials are or would be treated as DPGR.

The IRS provides the following example: Assume that a taxpayer produces and manufactures a newspaper in the United States. Gross receipts from the newspaper include receipts from newsstand sales, subscriptions and advertising placed in the paper. Gross receipts from the ads are then treated as “derived from” newspaper sales and qualify as DPGR.

Facts of the Recent Case

The taxpayer in the Chief Counsel Advice is a specialty retailer of clothing, intimates, accessories and non-clothing gift items distributed under various brand names. Its products are available to U.S. and international customers through the retailer’s website and telephone call centers for its catalogs.

Although manufacturing and producing its physical products happens outside the country, the retailer claimed to be the manufacturer of its catalogs, mailers and other similar printed publications. The materials are distributed for free to existing customers and no advertising space is sold. The advertising in the print materials is only for the retailer’s brands.

The price the retailer charges for its branded clothing includes a component to cover the cost of producing the printed materials, including a profit markup. The retailer claimed that it was entitled to a Sec. 199 deduction for the print materials because advertising is a key component of the clothing and accessories it sells.

It argued that the print media is responsible for generating the majority of the company’s sales. As a result, the retailer claims it qualifies for the Sec. 199 deduction because advertising was a component of the clothing and accessories sold.

IRS Advice

The IRS didn’t buy the argument. It published a CCA, concluding that the taxpayer can’t characterize any gross receipts derived from the sale of its products as DPGR from advertising income.

The retailer’s products are manufactured outside the United States. Accordingly, gross receipts from their sale aren’t DPGR.

The CCA points out that the exception in the regulations for tangible personal property is limited to certain printed publications and applies only to advertising income from ads placed in those media. The Sec. 199 deduction isn’t available just because the taxpayer derives gross receipts from the sale of a tangible product it advertises. In this case, the taxpayer wasn’t paid by a third party for advertisements in its printed media. The ads were solely for the retailer’s own brands.

The fact that advertising taxpayer’s products increases sales has no bearing on the result. Thus, the IRS rang up a no sale on the retailer’s deduction claim.

Key Takeaway

Although this ruling didn’t go the taxpayer’s way, don’t make any broad assumptions concerning eligibility for the Sec. 199 deduction. Notably, an activity that falls outside mainstream manufacturing may still qualify as MPGE in the United States under an exception. Review your company’s situation with a tax adviser who can provide the necessary guidance.

Section 199 Covers a Broad Range of Activities

The Section 199 deduction specifically allows a tax break for many activities that fall outside traditional manufacturing, including:

Construction of real property,
Services provided by architects and engineers,
Production of electricity, natural gas or water,
Production of computer software,
Production of qualified film and videotape, and
Processing agricultural products.

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