Avoid being a target for the IRS. Business Loses.

Avoid Being an IRS Target When Your Business Loses Money

If you operate what you think is a business, but that business loses money, it may not be a business at all under the tax code. Such a money-losing activity can look like a tax shelter to the IRS, and that substantially increases your chances of an IRS audit.

The tax code contains a business loss safe harbor that’s known as a presumption of profit. You meet this safe harbor when your activity produces a profit in three of five years (two of seven for breeding, training, showing, or racing horses). When you meet the safe harbor, you are presumed a business unless the IRS establishes to the contrary.

We know this for-profit tax code section as the hobby loss section. But you can see that this tax code section creates trouble for much more than what you would consider a simple hobby. Here’s an example of how badly the recent tax reform under the Tax Cuts and Jobs Act can treat a business that loses money.

Example. Henry has an activity that fails the business test and loses money. Last year, he had $70,000 of income and $100,000 of expenses. Under pre-tax-reform law, Henry could claim the hobby-related business deductions up to the amount of his income. So Henry deducted $70,000 (subject to some minor adjustments) and reported close to zero taxable income.

Not this year. Tax reform is going to make Henry suffer. With the same facts, Henry’s business deductions are zero. His taxable income is $70,000. Think about that. Henry lost $30,000 ($70,000 – $100,000) in real money. He now pays taxes on $70,000 of phantom income.

What can Henry do to make this problem go away? He has two choices.

  • First, he could create a “for profit” business defense in the hope that he would defeat the IRS in an audit.
  • Alternatively, he could stop the taxation on his phantom income by operating his activity as a C corporation.

Tax Planning for Snow Birds

Tax Planning for Snowbirds

You can plan your tax-deductible business life to avoid cold winters and hot summers. Spend a moment examining the following four short paragraphs that contain the basic facts from the Andrews case.

For six months of the year, from May through October, Edward Andrews lived in Lynnfield, Massachusetts, where he owned and operated Andrews Gunite Co., Inc., a successful pool construction business. During the other six months, Mr. Andrews lived in Lighthouse Point, Florida, where he owned and operated a sole proprietorship engaged in successful horse racing and breeding operations. In addition, he, his brother, and his son owned a successful Florida-based pool construction corporation from which Mr. Andrews took no salary, but where he did assist with operations.

Instead of renting hotel rooms while in Florida, Mr. Andrews purchased a home, claimed 100 percent business use of the Florida home, and depreciated the house and furniture as business expenses on his Schedule C for his horse racing and breeding business. Mr. Andrews then allocated his other travel expenses and costs of owning and operating this house in Florida on his individual income tax return as

  • personal deductions on his Schedule A for a portion of the mortgage interest and taxes,
  • business deductions on his Schedule C for the horse racing and breeding business, and
  • employee business expenses on IRS Form 2106 for the pool construction business.

(Tax reform under the Tax Cuts and Jobs Act eliminates employee business expense deductions for tax years 2018 through 2025—so Mr. Andrews would replace his old strategy with a corporate reimbursement of employee business expenses strategy.)

Just as Mr. Andrews did, you can tax plan your life to spend your winters in one state and your summers in a different state. In this scenario, your tax-deductible home takes the place of your staying in hotels. The other home is likely your principal residence located near your tax home.

Your travel expenses between the homes are deductible because you do business in both places. You also deduct your meals and other living costs while at the deductible travel destination. You can have separate businesses in each state or a branch business in the second state.

TCJA for Partnerships and LLCs

Tax Reform Changes Affecting Partnerships and LLCs and Their Owners

The Tax Cuts and Jobs Act (TCJA) includes several changes that affect partnerships and their partners, and LLCs that are treated as partnerships for tax purposes and their members. Most of the changes are good news. Here are some highlights:

Technical Termination Rule Repealed (Good)

Under prior law, a partnership or an LLC treated as a partnership for tax purposes was considered terminated for federal income tax purposes if, within a 12-month period, there was a sale or exchange of 50 percent or more of the partnership’s or LLC’s capital and profits interests. Fortunately, the TCJA repealed the technical termination rule, effective for partnership or LLC tax years beginning in 2018 and beyond. This is a permanent change.

Lower Tax Rates for Individual Partners and LLC Members (Good)

For 2018 through 2025, the TCJA retains seven tax rate brackets for ordinary income and net short-term capital gains recognized by individual taxpayers, including income and gains passed through to individual partners and LLC members. Six of the rates are lower than before. In 2026, the rates and brackets that were in place for 2017 are scheduled to return, but skeptics doubt that will happen.

Unchanged Rates for Long-Term Gains and Qualified Dividends (Not Good)

The TCJA retains the 0, 15, and 20 percent tax rates on long-term capital gains and qualified dividends recognized by individual taxpayers, including gains and dividends passed through to individual partners and LLC members. After 2018, these brackets will be indexed for inflation.

New Pass-Through Business Deduction (Good)

For tax years beginning in 2018-2025, the TCJA establishes a new deduction based on your share of qualified business income (QBI) passed through from a partnership or LLC. The deduction generally equals 20 percent of QBI, subject to restrictions that can apply at higher income levels.

New Limits on Deducting Business Losses (Not Good)

For 2018-2025, the TCJA made two changes to the rules for deducting an individual taxpayer’s business losses. Unfortunately, the changes are not in your favor.

For tax years beginning in 2018-2025, you cannot deduct an excess business loss in the current year. An excess business loss means the amount of a loss in excess of $250,000, or $500,000 if you are a married joint-filer. The excess business loss is carried over to the following tax year, and you can then deduct it under new rules for deducting net operating loss (NOL) carryforwards, explained below.

Key Point: This new loss disallowance rule applies after applying the passive activity loss (PAL) rules. So if the PAL rules disallow your business loss, you don’t get to use the new loss disallowance rule.

For NOLs arising in tax years beginning in 2018 and beyond, the TCJA stipulates that you generally cannot use an NOL carryover to shelter more than 80 percent of taxable income in the carryover year. Under prior law, you could generally use an NOL carryover to shelter up to 100 percent of your taxable income in the carryover year.

Another TCJA change stipulates that NOLs arising in tax years ending after 2017 generally cannot be carried back to an earlier tax year. You can carry such losses forward only. But you can carry them forward indefinitely. Under prior law, you could carry an NOL forward for no more than 20 years.

90 Day Mileage Log

How the 90-Day Mileage Log Rule Works for You

Often in an IRS audit, the examiner will ask for your mileage log at the beginning of the audit. If you do not have a mileage log, then you are in danger of losing more than just vehicle deductions. Think about it. If you don’t have a log for mileage, what is the IRS examiner going to think about your other records? Right—he or she is going to think you are a bad taxpayer with bad tax records who needs extra scrutiny.

The IRS says that you may keep an adequate record for part of a tax year and use that part-year record to substantiate your vehicle’s business use for the entire year. To use a sample record, you need to prove that your sample is representative of your use for the year.

By using your appointment book as the basis for your mileage, you not only build great business-use proof, but you also do a great job of showing that your sample vehicle record mirrors your general appointments during the year. (If you are using a mileage app, synchronize the app results with the appointment book.)

The IRS illustrates two possible sampling methods:

  • One identical week each month (for example, the third week of each month)
  • Three consecutive months

We don’t recommend the one-same-week-each-month method because it is difficult to start and stop a record-keeping process. (Think about how hard it would be to create a habit, undo it, and then create it again—every month.)

The three-consecutive-months log requires only one start and one stop, and you are rewarded with nine months of mileage-log freedom. For this reason, the three-month log is the superior alternative. Before getting into the three-month method, we should note that once you have done three months, you are in the habit. You might find it easier to continue all year, rather than stop this year and then have to start again next year.

Here are the basics of how the IRS describes the three-month test:

  • The taxpayer uses her vehicle for business use.
  • She and other members of her family use the vehicle for personal use.
  • The taxpayer keeps a mileage log for the first three months of the taxable year, and that log shows that 75 percent of the vehicle’s use is for her business.
  • Invoices and paid bills show that her vehicle use is about the same throughout the year.

According to this IRS regulation, this three-month sample is adequate to prove 75 percent business use.

Convert your personal vehicle to a business asset for a juicy deduction.

Convert Your Personal Vehicle to Business and Deduct up to 100 Percent

You probably like your personal vehicle just as it is. But wouldn’t you like it far better if it were producing tax deductions? Perhaps big deductions, immediately. And the Tax Cuts and Jobs Act gives you the tax reform roadmap on how to do this.

Of course, to make this happen, you need to strip your personal vehicle of its personal status and re-dress it as a business vehicle. This is not difficult. In its new business dress, your former personal vehicle can qualify for up to 100 percent bonus depreciation.

Example. Sam has a personal vehicle with a tax basis for depreciation of $31,000. With 70 percent business use on this 100 percent bonus depreciation–qualifying vehicle, Sam has a new $21,700 tax deduction for this year ($31,000 x 70 percent).

Losing your Supper money becuase of TCJA?

TL;DR

Supper Money – TCJA reduces all meals to 50% deductible. Need to get it classified as a fringe benefit to deduct 100%.

TCJA Changes to Your Tax-Free Supper Money

Here’s how the TCJA applied its tax reform to your supper money meal allowances. Before tax reform, you deducted 100 percent of the supper money cost. Now, because of tax reform, your tax deduction for supper money is subject to a 50 percent cut for amounts paid during tax years 2018 through 2025.

The regulations allow supper money as an excludable fringe benefit when the benefit satisfies the following four conditions:

  1. You provide the benefit only occasionally.
  2. You pay no more than a reasonable amount.
  3. The meal enables you or the employee to work overtime.
  4. You do not calculate the benefit based on the number of hours worked. For example, a $20 allowance per hour of overtime is a no-no. You can’t do that. The way to provide the benefit is to give a discretionary meal allowance, such as $56.

If the payment of supper money does not meet the four rules, it is taxable compensation to the recipient, and if that’s an employee, the money is subject to withholding and payroll taxes.

Corporate owners and the self-employed qualify for the supper money allowance under the four rules explained above. The law does not discriminate. It makes supper money available to all who work in the business.

IRA Rollover Advice

TL;DR

IRA Rollover – Rollover your IRAs using direct (trustee to trustee) rollovers. If not you will need to make up the 20% withheld or face tax and penalties.

Retirement Plan and IRA Rollover Advice

When moving your retirement money to an IRA, you should follow this one rule of thumb. If you fail to follow the rule we’re about to reveal, you can face two big problems:

  • First, your check will be shorted by 20 percent.
  • Second, you will be on the search for replacement money.

Here is this very important rule of thumb that you need to follow: Move the money using a trustee-to-trustee transfer. Nothing else. There are two types of transfers that can be used to move qualified plan distributions into IRAs in a tax-free manner: (1) direct (trustee-to-trustee) rollovers and (2) what we will call traditional rollovers.

If you want to do a totally tax-free rollover, do nothing other than the direct (trustee-to-trustee) rollover of your qualified retirement plan distribution into the rollover IRA. This is easy to do.

Simply instruct the qualified plan trustee or administrator to (1) make a wire transfer into your rollover IRA or (2) cut a check payable to the trustee of your rollover IRA (this option is less preferable than a wire transfer). Your employee benefits department should have all the forms necessary to arrange for a direct rollover.

Roth IRA Penalty

TL;DR

ROTH IRA – You can take Contributions tax and penalty free. The law says Roth distributions come out in the following order: regular contributions, rollover contributions, and finally earnings.

Take Money Out of Your IRA at Any Age Penalty-Free

You probably think you can’t take money out of your IRAs before age 59 1/2 unless you meet a narrow exception to the unpleasant 10 percent penalty on early distributions. But that’s not true. We have a variety of planning opportunities here.

For example, you don’t pay taxes or the 10 percent penalty on amounts you withdraw that you previously contributed or converted to the Roth IRA. These amounts are your “basis” in the Roth IRA. (Remember, you funded your Roth IRA with after-tax money!)

The law says Roth distributions come out in the following order:

  • regular contributions,
  • rollover contributions, and finally
  • earnings

Example. Jane opened her Roth IRA in 2002. She contributed $30,000 over the life of the Roth IRA. Today, the account is worth $50,000. Jane can withdraw up to $30,000 tax-free and penalty-free regardless of her age.

If you made nondeductible contributions to a traditional IRA, then you have “basis” in all your traditional IRAs. With basis, you have some planning opportunities with your business’s qualified plans, such as your 401(k).

And then, on a totally different front, there’s a little-known escape from the 10 percent penalty, called the substantially equal periodic payment exception. It allows you to create a stream of penalty-free traditional IRA distributions starting at any age for any reason.

You have to continue the substantially equal periodic payments for at least five years or until you reach age 59 1/2, whichever is later. As you can see from the above, you can touch your IRA accounts before age 59 1/2 without a special reason.

Tax Savings Tips – Real Estate

TL;DR

Real Estate Loses – In order to take loses you need to have 750 hours in real estate activities. Taking the Home office deduction allow you to deduct mileage to and from properties. Drive time can be included in the calculation. Keep a time log for your Real Estate activities.

Drive Time Increases Odds of Deducting Rental Property Losses

Your rental properties provide tax shelter when you can deduct your losses against your other income. One step to deducting the losses is to pass the tax code’s 750-hour test. And one step to finding the hours you need to pass the time test may be your drive times.

Trzeciak Case

Mariam Trzeciak owned, managed, and rented 14 single-family homes in and near Columbus, Ohio. She and her husband, Marc, on their joint tax returns, claimed rental property losses of $126,376 and $151,884 in the two years that were subject to this IRS audit.

The IRS revenue agent assigned to examine the Trzeciaks’ returns disallowed the losses as passive losses, claiming that Mariam did not qualify as a real estate professional because she could not count her drive time from her home near Dayton to Columbus, where the properties were.

It took Mariam’s CPA, who prepared her returns and assisted with the audit, and then her lawyers almost three years to surface the home-office deduction as the savior. Once it surfaced, the IRS allowed the drive time, and that allowed Mariam to deduct her rental property losses of $126,376 for year 1 and $151,884 for year 2.

Leland Case

In Leland, Clarence McDonald Leland traveled 13 to 16 hours from Mississippi to Texas and back several times each year to perform necessary work on his 1,276-acre farm in Turkey, Texas.

The court noted that the IRS did not object to the inclusion of the travel time in determining Clarence’s participation in the farm. And the court went on to say: “The facts of this case establish that petitioner’s [Clarence’s] travel time was integral to the operation of the farming activity rather than incidental.”

Leyh Case

The Leyh case involved Richard Leyh and Ellen O’Neill. Ellen owned 12 rental properties in Austin, Texas, about 26 to 30 miles from her home at a ranch in Dipping Springs, Texas.

Ellen and Richard deducted a $69,531 loss from their rental operations. The IRS said no because Ellen, without inclusion of her drive time, failed the 750-hour test to establish herself as a real estate professional.

The sole question that the court had to address was whether Ellen could include her drive time from her home to the rentals as rental property time. Interestingly, she failed to include her travel time in her well-kept log of time and had to reconstruct that travel time for the court.

The court ruled that her reconstruction of the travel time to and from the properties was adequate and ruled that she and Richard could deduct her $69,531 in rental losses on their joint tax return.

What You Should Do

Take the steps necessary to make your rental property drive time count as material participation time. The first step is to keep an accurate log of the time that you spend on your rentals (yes, we know this is a pain—but suffer a little and just do it).

Audit-Proof Your Time Spent on Rental Properties

If you claim status as a tax law–defined real estate professional who can deduct his or her rental property losses, your time record for the year must prove that you spent

  1. more than one-half of your personal service time in real property trades or businesses in which you materially participate, and
  2. more than 750 hours of your personal and investor services time in real property trades or businesses in which you materially participate.

If you are married, either you or your spouse must individually qualify as a real estate professional. If one spouse qualifies, both spouses qualify.

Achieving real estate professional status is the first of two steps. You face one additional hurdle. To deduct tax losses on a rental, you also must prove that you materially participated in the rental activity. If you are married, you and your spouse may count your joint efforts toward passing the material participation tests.  Most of the tests for material participation are based on hours worked.

What Does This Mean to You?

In simple terms: keep a time log. In an audit of your real estate activity, the IRS tells its examiner:

Request and closely examine the taxpayer’s documentation regarding time. The taxpayer is required under Reg. Section 1.469-5T(f)(4) to provide proof of services performed and [of] the hours attributable to those services.

If you don’t have what the IRS wants, your odds of winning your rental property tax loss deductions are slim, if that. And don’t think you can create this log after the fact. Most everyone who spends the considerable time it takes to jump through the hoops to create an after-the-fact log of hours using the IRS spreadsheets loses the deductions.

Tax Law Changes – NOL Rules

TL;DR

NOL Changes –  No carrying back losses for immediate benefit. Can only offset 80% of taxable income in future years.

Changes to Net Operating Losses After Tax Reform

Tax reform made many good changes in the tax law for the small-business owner. But the changes to the net operating loss (NOL) deduction rules are not in the good-changes category. They are designed to hurt you and put money in the IRS’s pocket.

Now, if you have a bad year in your business, the new NOL rules are designed to stop you from using your business loss to find some immediate cash. The new (let’s call them bad-for-you) rules certainly differ from the prior beneficial rules.

Old NOL Rules

You have an NOL when your business deductions exceed your business income in a taxable year. Before tax reform, you could carry back the NOL to prior tax years and get refunds of taxes paid in those prior years.

Alternatively, you could have elected to waive the NOL carryback and instead carry forward the NOL to offset some or all of your taxable income in future tax years.

New NOL Rules

Tax reform made two key changes to the NOL rules:

  1. You can no longer carry back the NOL (except for certain qualified farming losses).
  2. Your NOL carryforward can offset only up to 80 percent of your taxable income in a tax year.

The changes put more money in the IRS’s pocket by

  • eliminating your ability to get an immediate tax benefit from your NOL carryback, and
  • delaying your ability to get tax benefits from future NOL carryforwards.

We are bringing the NOL rules to your attention in case you need to do some planning with us. We likely have some strategies that can help you realize some immediate benefits from your business loss.