Article by: Jeff Skolnick, CPA, M.S. Taxation

Whether incurred by individuals, estates, trusts or corporations, net operating losses (NOLs) have almost the same definition and treatment. In almost all cases these are caused by losses in a trade or business (including rental real estate). NOLs can be caused by other factors such as casualty and theft losses but these causes are not as common and I therefore will not be focusing on these. Business losses can be generated by your sole proprietorship (or single member LLC), rental real estate property, partnership (or multi member LLC) or S corporation.

Net operating losses occur when your business losses exceed your items of income. Unfortunately, this is not a straightforward calculation as certain deductions such as capital losses in excess of capital gains, the NOL deduction and the section 199A deduction for Qualified Business Income are not counted when figuring an NOL. Each of these types of deductions have their own rules on how they are calculated. The Qualified Business Income deduction is the 20% deduction applicable to individuals with business income from their sole proprietorship, partnership, S corporation, LLC or rental property. Additionally when calculating an NOL for an individual income tax return there are adjustments made for what are considered to be Nonbusiness income (Retirement benefits, social security benefits and certain investment income) and Nonbusiness deductions (Alimony paid, retirement plan deductions, certain health savings deductions, the standard deduction and most itemized deductions).

If you have a business or businesses that generate enough losses to reduce your income to a negative amount, then you have an NOL. 

The 2018 Tax Cuts & Jobs Act placed additional restrictions on how NOLs are applied to income tax returns.  

• On the individual side of things a net operating loss generated by all of the taxpayer(s) businesses may not exceed $250,000 ($500,000 for married taxpayers filing jointly).  The rule before this change was a net operating loss was allowed to offset taxable income. An example should help clarify. Let’s say a single taxpayer has wages of $500,000 and a business loss from his/her business of $350,000. Prior to 2018 the law allowed the full $350,000 loss to be used to offset $500,000 of income and therefore the taxpayer paid tax on $150,000 of income. The $150,000 would then be decreased by the adjustments to income such as retirement plans, self-employed health insurance and the standard or itemized deductions. In years after 2017 the $350,000 loss would be limited to $250,000 (again this would have been a $500,000 limit if the example was a for a married couple filing a joint return), therefore leaving the taxpayer gross income at $250,000 before adjustments and deductions.  The remaining $100,000 (difference between $350,000 total NOL and the $250,000 limit) is carried forward to subsequent years. This $250,000 (or $500,000) limit does not apply to C corporarations.
• An NOL can only offset 80% of taxable income in a future year. An example would be a taxpayer incurring a $100,000 loss in 2018. In 2019 the taxpayer has $100,000 of taxable income. Under the rules that existed prior to 2018 the NOL of $100,000 would offset the income of $100,000. Under the new law only 80% of the 2019 taxable income is eligible to be offset. The taxpayer will use $80,000 to reduce taxable income to $20,000 with the remaining $20,000 of the NOL that was not used being carried forward to 2020.
• Prior to the new law net operating losses were generally carried back 2 years and any unused NOLs were then carried forward for 20 years. The new law eliminates carrybacks and requires all losses to be carried forward. Carryback allowed taxpayers with NOLs to amend prior year returns, lower their income and receive refunds immediately vs. carrying them forward and offsetting future income. Taxpayers also had the option of foregoing the carryback to carry the loss forward if they felt they would be in a higher income tax bracket in the future. Carrybacks are still allowed for farming losses. On the bright side, the new law eliminates the loss of NOLs if not used within 20 years after they are incurred. The new law allows losses to be carried forward indefinitely.

I want to also point out that there are rules for when a taxpayer(s) have a change in marital status. I am not going to discuss the technicalities here, but please be aware that if your marital status has changed between the time an NOL was incurred and when it is applied, then there is another layer added to the calculation.

While the concept is simple, “if you have losses from a business or businesses, then you can use these losses to offset future income”, there are a number of regulations that can complicate matters.  If you have an NOL consult with a tax professional. Proper use of the NOL regulations can save valuable tax dollars but misapplication of these rules can cause aggravation, penalties and interest.

Article By: Jeff Skolnick, CPA, M.S. Taxation

The purpose of a buy-sell agreement is to facilitate a change in ownership upon the occurrence of certain events.  These events can either be voluntary, such as retirement or involuntary, such as death, disability, or the inability of a partner/shareholder/owner to meet his/her financial obligations.

Buy-sell agreements set a market for a Company. These agreements are generally used by privately held businesses which do not have a readily available market. In other words, selling shares in your business is not going to be quite as easy as selling shares of Microsoft or Facebook. It is not always practical to try to sell a privately held business and virtually impossible to sell a portion of a privately held business. How many people do you think will want to buy into a business where they become partners or shareholders with people they do not even know?

The buy-sell agreement either sets the price of the business or lays out the mechanism to determine such a value. Typically, these agreements will use one or more of a variety of methods to determine value. Value can be based on book value of the Company, some type of multiples of either revenue or earnings or through the use of a valuation expert. 

Details are needed in the agreement even when using a valuation expert. Both the departing and remaining owner(s) may hire their own valuation experts, or they may mutually agree on a third party. It is important to remember that valuation is not an exact science and different experts may come up with different values.  There must be a determination of how these potentially differing values will be utilized. Being able to determine the correct value of a Company is a major focus of a buy-sell agreement.

These agreements also allow the current owners to maintain control. In many situations, the remaining owner or owners would love to buy out a departed owner but may not have the wherewithal to do so. Additionally, there are very good reasons why a remaining owner wants to purchase the interest of a departed owner. Let’s take an example where two siblings are partners (Jack and Jill), and each is married. If one of the siblings passes away (Jack) and his interest passes to his spouse now Jill has become a partner with Jack’s spouse. They may or may not get along as well as the two siblings did, but what if Jack’s former spouse gets remarried? In this situation although Jill is not  partners with this new spouse, that spouse may be chirping in the ear of Jack’s former spouse which can cause many complications.

Once the terms of the buy-sell agreement are determined very often, the owners will purchase life insurance policies on each other. These policies help to provide funds if one owner passes away. The policy will pay the remaining owner or owners who can then use these funds to purchase the interest of the diseased owner from his/her family.

Let’s look at an example. If there are two partners, Nancy and Jim that each own 50% of a Company valued at $1,000,000, then how would life insurance be used to finance a buy-sell agreement? Each partner would have a $500,000 policy on the life of the other partner. Let’s move forward here and assume that Jim dies. Nancy will collect $500,000 from the insurance policy on Jim’s life which she would then use to purchase Jim’s interest from his beneficiaries.

In the case of an owner who has the left the Company but not passed away, payment methods aside from using life insurance proceeds are necessary. The agreement should spell out the terms if the buyout is to be financed. Terms would be similar to those determined in any financing situation, amount of down payment, amount of years for the payout, method to determine an applicable interest rate and consequences of not abiding by the payment terms.

It is also important to review buy-sell agreements on a regular basis. Owners want to make sure from time to time that the terms of the agreement still make sense. If you entered into a buy-sell agreement when your business first opened but haven’t looked at the agreement in 25 years things may have changed. Remember my earlier example? You don’t want a situation where each partner has taken out a $500,00 life insurance policy on the other partner but now the business is worth $5,000,000 and not $1,000,000. I encourage at least a quick review every few years to make sure everyone is happy with the way things will transpire if the agreement is invoked.

While not the sexiest of all business agreements, a well-crafted buy-sell agreement that is drafted with some effort and foresight will allow remaining owners to maintain their ownership and allow departed members or their families to be reasonably compensated when relinquishing their ownership. I believe that when drafting a buy-sell agreement that the assistance of professionals (attorneys and possibly accountants and valuation experts) is essential.

INITIAL STEPS TO OPENING YOUR BUSINESS

By: Jeffrey Skolnick, CPA, M.S. Taxation

This blog is meant to start you out on the right path when you open your business. I will cover the basic steps that should be followed.

The steps are shown below:

Write a business plan. This is a blueprint of the way you will run your business. Although not the sexiest of things to do (most new business owners are passionate about their products and services), however writing a business plan will force you to consider many areas in a more structured way which will increase your chances of success. A business plan will include a description of your products/services, the type of entity structure you are operating under (i.e., sole proprietorship, partnership, S or C corporation), market analysis, funding requirements and projections among other things. For more information on business, plans see my podcast on business plans or go to my website www.jeffcpaworld.com and check out my blog.

Determine and entity type. Before you begin your business, you must determine whether you will operate as a sole proprietorship, partnership, LLC, S or C corporation.  There are advantages and disadvantages to each, and you must decide which entity form is most beneficial to your situation. This is an area where you no doubt should work with a tax professional. Some things to consider are your overall tax liability, legal liability, and complexity of each entity type.  For more information on entity structure, see my podcast on choosing an entity structure or go to my website www.jeffcpaworld.com and check out my blog.

Form with the appropriate state or states. Once you’ve determined the entity structure type that you would like for your business you must register with your state.  Most states require you to perform a name search before you open. This is to avoid two businesses with the same name or having names so close that it confuses the public. Upon formation, you will receive some type of Certificate of Formation or Articles of Incorporation.  This is a step that sole proprietorships can typically avoid. I would also include filing a DBA (Doing Business As) or Alternative Name as well. These are used when the entity is formed under one name (possibly the name of the owners), but the business operates under a different name. Once your entity is formed, you will now be recorded with the Secretary of State.  You will form in only one state, but if you do business in multiple state you will most likely have to register in each state.

Register with the Federal government and the appropriate state or states. Once you’ve legally formed your organization, you must obtain an Employer Identification Number (EIN) from the IRS (this step is not a requirement of sole proprietors unless they have payroll). This can be done online and typically only takes under 15 minutes. You must also register for taxes with the state. This is a separate step from forming your organization. Every business should register for tax purposes, including sole proprietorships.  The most common types of taxes you will register for are income, payroll, and sales, and use taxes. There can be other taxes as well, but again these are the most common. I want to mention again that it is possible that you may be required to register with several states aside from your state of organization.

Order a corporate book. You must order a corporate book if you form as a corporation or an LLC. Partnerships and sole proprietors are not required to maintain a corporate book. A corporate book will contain your Articles of Incorporation or Certificate of Formation, by-laws, operating agreement, minutes and certificates issued to shareholders or members.  The reason for a corporate book is that since there is legal protection offered by your entity structure if you are a corporation or an LLC, you must treat your company as a separate entity. In other words, when you spend money from your corporation or LLC you should document that your members or shareholders (even if it’s only you) consent to you spending this money. Corporations are required to have annual shareholder meetings. The corporate book is where you would record the minutes of such meetings. If legally it can be proven that although your company was incorporated or formed as an LLC but you are treating the organization as your own personal piggy bank then if you are sued, the plaintiff my be able to “pierce the corporate veil” meaning you lose the liability protection normally offered by these entity types. The reason sole proprietorships and partnerships are not required to have a corporate book is there is no legal liability protection in these entities, to begin with.

Prepare your by-laws or operating agreement. Whether you’ve formed a corporation and are writing your by-laws or a partnership or LLC writing an operating agreement, this is one of the most important documents you can have. These are the rules by which your organization is to be run. This will explain titles, responsibilities, and requirements for the shareholders, partners, or members. These will cover items such as what happens if additional capital is required, how to deal with the death of a shareholder or member, and how to dissolve the organization.  Very often, lenders may ask for an operating agreement. It is also vital that these agreements are written when the entity is formed. Far too often, I run into individuals that did not want to spend the time on this when they formed their entity, and it is too late to write them once a dispute has arisen.

Establish a bank account. Once you’ve received your EIN, open a bank account in the name of your business. Sole proprietorships that do not obtain an EIN (they are operating under the taxpayer’s social security number) should still have a separate bank account for their business.

Check on other miscellaneous items that affect your business. Don’t be fooled by the fact that I use the term miscellaneous. These can be very important. The areas I am thinking of here are insurance needs and licensing or permit requirements.  I believe you should speak with an insurance professional to determine your needs and be careful to make sure you are aware of all licensing and permit requirements for each jurisdiction in which you operate.

Consider your funding sources. Most start-up businesses will require cash infusions in their early stages while building their organization. Make sure you have considered where this money will come from; savings, home equity line of credit, business line of credit, family or friends, and last resort credit cards.  Please keep in mind if you are going to borrow the money you will be required to show financial statements and will almost certainly have to personally guarantee the loan.

Establish a proper system for accounting. Now you’ve formed your business and performed each of the steps I’ve outlined, the next area you need to address is a bookkeeping system. I always tell my clients to use a system like QuickBooks. It is by far the most widely used small business program; all small business accountants are familiar with it, it’s user-friendly and relatively inexpensive.  I also tell my clients that the main reason for keeping your records on QuickBooks is not to give me information in February or March, but it is to assist you in managing your business. A proper set of books will show you trends of your busy and slow periods and help you analyze items of income and expense in order to make informed decisions. A proper accounting system, in my opinion, should also include a system to file sales invoices, paid bills, bank reconciliations, tax filings, insurance policies, employee personnel files, subcontractor files, and any contracts entered into by the business.

Conclusion.  I will repeat myself here. The steps required to setup a business are not the most exciting part of starting your business. I am very aware of this.  I do believe, however, that taking the time to set your business up correctly will make you say more than once, “I’m glad I took care of that.”

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Why write a business plan?

Article By: Jeffrey Skolnick, CPA, M.S. Taxation

A business plan is going to serve as a blueprint to the way you run your business. By far the biggest mistake I see individuals make when they decide to open their own business is they do it without enough thought. Let’s face it, writing a business plan is not fun, and most people go into business because they have a passion for something and very few people have a passion for anything as tedious as a business plan.

One reason you should do one, even if it is not a long plan is that it will require you to think about some things that are vital to your existence and should help you map out your future strategy.  Another reason may be if you are looking to raise capital, either through investors or borrowing, then you will need to provide information to the potential investors or lenders so that they are comfortable with going forward with you.  Keep in mind most startup businesses do not make it, and while I don’t know the statistical data, I can guarantee you those that plan will vastly increase their chances of success.

Where can I find out more about business plans?

There are some very good resources to choose from that can help you write a business plan. There are software packages that can walk you through the process and guide you to what information you require, and it will also require some research on your part. I believe the initial research is one of the biggest keys to your success, and I will explain a little more as we move along. While there are a lot of software packages, I also recommend searching the U.S. Small Business Administration website www.sba.gov.  This is a great free resource, everything is written in easy to understand language (as opposed to legalese), and there is some great information. I believe by spending just a little time there; you can gain some clarity on what you are trying to accomplish.

What is included in a business plan?

A traditional business plan will contain the following key elements:

Executive summary. This is going to a brief description ofwhat your business is, what need you are going to fulfill, and why you believe you will be successful. This is a summary of the overall plan. The details will be put forth in the remaining sections. Think of this as your elevator pitch or 30-second story. In other words, you want to explain what you do, how you do it, and why you do it very briefly.  

Company description. As the title suggests, this is information about your company. You will explain:

• Your products and services
• Your target market
• Your ownership, both from the type of legal entity you are (i.e., sole proprietor, partnership or corporation) and who you owners are as well as their experience
• Any advantages you may have in the market

This is going to be a detailed explanation of who you are and why you will succeed. I stress that even if you are not currently looking for investors or lenders that you approach this section as if you were seeking one or both of these groups. This will force you to think about your business in a more structured manner.

Market analysis. In my opinion, one of the most important areas you can think about. I am reminded of the old Honeymooners episode where Alice is scolding Ralph on some of his past ventures, and she asks about the time he invested in a parking lot near the new movie theater? He answers with, “How did I know they were building a drive-in theater?” While that is funny, you want to look at the market and see who your competition is. How will you compete and what will you need to do to be successful.

Organization and management. This area will explain the type of entity structure you will have (sole proprietorship, partnership, LLC, S or C corporation) and an organizational chart. This is also the area where you would explain the major players and possibly their qualifications.

Service or product line. Think of this as if you were going to appear on shark tank. You will explain either what your services are or what products you sell. Make sure you are thinking about the benefits to your customers/clients. Nobody spends money to benefit you. People spend money because they see value to themselves.

Marketing and sales. This section, while it will vary greatly depending on several variables such as business type or geographic region to name a couple, lays out how you will attract clients/customers.  Marketing is an area that is a constantly changing trial and error pathway. How many times have you seen or heard companies asking how you heard about them? These companies are spending money on advertising and attempting to determine the effectiveness of such advertising.

Funding requirements. Another key area that I see that causes business owners huge headaches. It is key that you understand how much money your business will require and how you are going to use it. Again, let’s go back to the show shark tank. The panelists will almost always ask, “What will you use the money for?” No lender or investor wants to give his or her hard-earned money to someone who is “winging it.”  If you’re a brick and mortar store, you may require funding for equipment, advertising, personnel, etc. 

You will also look at your business to determine your slow and busy times during the year. In my business, for example, I have much greater cash flow February through May then I have in August and September.  It is important to think of all the money you will need for funding capital expenditures and operations. Very few thing will make you less prepared then asking for money and then six months later asking for more because you didn’t anticipate correctly.

Financial projections. You will want to show projections to potential investors or lenders to give them a reason to give you their money. If your business is established you will use your current financial statements (balance sheet, income statement and cash flows statement). You will also show your projections over the next five years or so. New businesses will obviously only show projected numbers. When making financial projections you can should be more detailed and more accurate with the near term (next year or two).

These are the  basic areas of a business plan.  The SBA also lists an Appendix section for additional materials requested but I’m not going to cover that here.  The SBA also mentions a “lean startup format” which is a much simpler version of what I just discussed. Theses are sometimes referred to as a Business Model Canvas.

Conclusion. Although not typically the first thought on a new owners mind (these individuals are usually focused on their products or services), having a business plan will increase your odds of success greatly. If the venture is worthwhile, then please spend the time to make sure your foundation is solid before you build your house.

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Article by: Jeff Skolnick, CPA, M.S. Taxation

This question is one of the most popular ones that I receive from clients.  Usually when this question is posed it is actually code for “I want to throw some paperwork out and I want you to tell me its okay”.

The most common answer

If you consult the IRS website or speak with tax preparers they tell you to retain most records for 7 years.  

The general rule for an audit is that you may be audited for 3 years after the later of the due date of the return or the date the return is actually filed.  This would mean that if you filed your 2018 tax return before April 15, 2019, then you could be audited until April 15, 2022.

Another part of the statute for audits allows the IRS to go back 6 years if you do not report income that should have been reported and it is more than 25% of the gross income shown on your return.

The answers that you may not like now, but may save you later

I suggest that my clients retain copies of all tax returns indefinitely.  They can be useful even once the most common 3 or 6 year statute of limitations have passed.

If you have not filed your return, then the statute of limitations does not start to run.  If you receive a notice from the IRS about a return from 10 years ago that they claim was never filed, the easiest way to answer them is by providing a copy of the return.  In the age of electronically filed returns this problem has been greatly reduced as the IRS sends confirmation once electronically filed returns are received.  Although the risk has certainly been reduced, I still advise clients to retain all tax returns. If you prefer not to take up the space with actual hard copies (paper) of your return, then I suggest keeping them in electronic format.

In addition, if the IRS suspects fraud, the statute of limitations is indefinite.

The retention time for financial records pertaining to investments is much longer.  For example records of stocks purchased would have to be kept from the day the stock was purchased until 7 years after the security was sold. This is even more important if you have dividend reinvestment plans as each year you are adding to the basis of the security.  Keep in mind that if a security is gifted, then the person receiving the gift generally has the same basis as the person giving the gift and therefore should be given proof of basis along with the gift. In addition, you should retain the closing statement from the purchase of your home as well as records for any improvements you made over the years until your home is sold.

If you have received property through an inheritance, such as real estate or portfolio instruments such as stocks, bonds or mutual funds then you would want to keep the proof of the basis.  The reason for this is the tax code allows for a “step-up” in basis of assets received from a decedent.  In other words let’s say a parent purchased a home for $100,000 and over the years spent another $60,000 in improvements.  I will also say that the home was worth $500,000 at the date of death of the owner.  Although the owner had a basis of $160,000 because it was conveyed to you through an inheritance your basis would be $500,000.  Proof of this basis would come from tax returns or appraisals and would have to be retained for 7 years following your sale of the property.

Certain paperwork such as tax returns (previously mentioned), formation papers, bylaws, minutes and partnership agreements should be kept indefinitely.

Please keep in mind that I have only been discussing the IRS, however your state taxing authority could also audit your return.

Conclusion

I know there are many rules as to which records should be kept and for how long.  The good news is that most people have computers today and records can be scanned to save space.  Once again if you’re not sure, then check with a tax professional before discarding any records. 

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Deducting Automobile Expenses

Article by: Jeff Skolnick, CPA, M.S. Taxation

Who can deduct automobile expenses?

Any business may reimburse individuals who use their automobiles for business purposes and deduct those expenses.  This includes self-employed individuals as well as small or large businesses.  You must keep in mind; however, that commuting mileage does not count as business mileage. Additionally, the automobile should be owned by the business entity and not the individual.

There are special rules if you are an employee.  For many years you were able to deduct your expenses; however, your deduction was reduced by any reimbursements received from your employer.  Your overall deduction was reported on your tax return as a “miscellaneous” deduction on Schedule A. These expenses when added together with other miscellaneous deductions such as other unreimbursed employee expenses, union dues, investment fees and tax preparation fees were deductible to the extent that they exceeded 2% of your adjusted gross income (AGI). 

As of 2018 miscellaneous itemized deductions subject to 2% of your adjusted income were all eliminated.  2017, therefore is the last year these expenses were allowed as a deduction on a personal income tax return. These new rules force employees to request reimbursement from their employer, otherwise the employee will be out the money.

What automobile expenses are deductible?

When deducting automobile expenses, you have a choice of one of two methods.  The first method is to use actual expenses.  Actual expenses would include gasoline, oil, repairs, registration fees, insurance, depreciation and lease payments.

The second method would be to use the standard mileage rate published by the IRS.  Using the standard mileage rate eliminates the need to keep track of all of the above expenses.  You simply track the amount of business mileage driven and multiply those miles by the appropriate rate.  The standard mileage rate for 2019 is 58 cents per mile.   

Parking fees and tolls can be taken as additional expenses whether you elect to use actual expenses or the standard mileage rate.

In this blog I am concentrating on business mileage. Keep in mind the mileage rate for those who itemize and use their vehicle for medical reasons may use a standard mileage rate of 20 cents per mile as a medical expense deduction also 14 cents per mile if the vehicle was used for charitable purposes.  Keep in mind that the medical mileage increases medical expenses, however, medical expenses must exceed 10% of Adjusted Gross Income (AGI) in order to count as an itemized deduction.

Additionally, charitable mileage counts as an itemized deduction but in order to benefit from either medical mileage or charitable mileage you must itemize on your tax return.  Please keep in mind with the new higher standard deductions (ie $24,000 for married individuals filing jointly) far fewer individuals will itemize than used to be the case.

Can I switch from one method to the other in later years?

You are not allowed to switch from the actual expense method to the standard mileage method in a later year.  You are allowed to switch from the standard mileage method to the actual expense method in a later year although there are some special rules concerning depreciation expense.

It is therefore very important to plan your expected benefits under each method before you report the expenses of a vehicle placed in service during the year as your first year of reporting has an impact on all future years.

Special rules for Luxury Automobile Depreciation

Long ago tax law carved out a special deduction for luxury automobiles. This was done to stop the very wealthy from deducting what were determined to be luxury automobiles as an ordinary and necessary business expense.  Think about from a standpoint that the IRS does not want to see a business depreciating a $300,000 Ferrari over five years.  Almost everybody would agree that a write off of that nature is over the top. 

The problem was the IRS for years was using a figure that was far too low.  For 2017 the luxury automobile depreciation limitations were $11,160 in year 1, $5,100 in year 2, $3,050 in year 3 and $1,875 in each subsequent year until the automobile is either fully depreciated or disposed of.  These limitation figures allowed taxpayers a write off of only $23,060 after five years.  It would be difficult to find anyone that would classify an automobile with a price tag of $23,060 a luxury automobile. 

Luckily the new tax law made changes to these figures and beginning in 2018 the new luxury automobile limitations are $10,000 in year 1, $16,000 in year 2, $9,600 in year 3 and $5,760 in each subsequent year.  These new limitations allow for $47,120 of depreciation on a luxury vehicle over the first five years.  I feel this adjustment was long overdue and makes much more sense in today’s world.

Recordkeeping Requirement

In order to deduct automobile expense, you should keep a log in which you record the date, where you traveled, the business purpose, the mileage and any expenses incurred such as gas or tolls.  Nowadays this has become much easier with the use of telephone apps that can track this for you.  Keep in mind if you do not meet the substantiation requirements, then your automobile deduction may be disallowed.

Conclusion

This blog gives only the very basics concerning automobile expense deductions. Once again if you’re not sure of the rules, then check with a tax professional before taking these deductions. 

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Article by: Jeff Skolnick, CPA, M.S. Taxation

There is always a great deal of discussion on capital gains and losses, including special tax rates and short term and long term holding periods.

This article addresses some of the basic questions.

What Transactions Are Considered Capital Transactions?

Gains or losses resulting from the sales of capital assets are capital transactions. The Internal Revenue Code defines a capital asset as any property except:

1. inventory;

2. depreciable or real property used in the taxpayer’s trade or business;

3. specified literary or artistic property;

4. business accounts or notes receivable; or

5. certain U.S. publications.

The most common types of capital assets would include stocks, bonds, mutual funds, and land held for investment.

What Are The Current Tax Rates on Capital Gains?

Short term capital gains are taxed at the same rates as ordinary income (somewhere between 10% and 37% depending on your tax bracket).

Long term capital gains also have different rates. The long term capital gains tax rates are 0%,15% or 20% depending on your taxable income and filing status.

There are also long term capital gains taxed at 25%. These occur in certain sales of depreciable real estate.

There is also a 28% tax rate used for collectibles and certain corporate stock sales.

What Is The Difference Between Long Term And Short Term Capital Gains?

Assets held for one year or less are considered short term while assets held for more than one year are considered long term.

Can Capital Losses Be Used To Offset Capital Gains?

Although short term and long term capital gains are taxed at different rates, losses from one category can offset income in the other. For example, if you have a $10,000 short term capital gain and a $5,000 long term loss, then you would be taxed on $5,000 of gain at ordinary income tax rates.

If the situation was reversed (a $10,000 long term gain and a $5,000 short term loss) then you would be taxed on $5,000 at long term capital gain rates.

Keep in mind that although your losses can exceed your gains, you may only deduct $3,000 of losses in excess of gains in any year. If we change the example above to a $10,000 short term capital gain and a $30,000 long term capital loss, then you would offset all of the $10,000 short term gain plus an additional $3,000 with the long term loss. Since your long term loss was $30,000 and only $13,000 was used, then the remaining $17,000 is carried over to the next year’s tax return.

Although capital losses can be carried forward indefinitely, they may never be carried back against prior year capital gains. This can have a profound impact on your return. 

Let’s say that you have a $1,000,000 capital loss one year and a $1,000,000 capital gain the next year. For this example, ignore the rule about allowing $3,000 of capital losses in excess of capital gains as it is immaterial and makes the example a little easier to understand. In the situation I just outlined clearly the $1,000,000 of unused capital loss can be carried forward to offset the capital gain in the next year resulting in $0 of taxable income.

If I change this scenario around and have the $1,000,000 capital gain occur in year one and the $1,000,000 capital loss in year two the result is the $1,000,000 is taxed as a capital gain (long or short term based on the amount of time the item had been owned) in year one and the $1,000,000 loss in year two cannot be used to offset this gain. It can only be used to offset future capital gains plus an additional $3,000 per year. If in year two the taxpayer had a $20,000 capital gain then $23,000 of the loss would be used (enough to offset all of the gain plus an additional $3,000) and $977,000 would be carried forward.

The reason I point this out is it is a rule that I believe to be unfair. In both scenarios, there was a $1,000,000 gain and a $1,000,000 loss which should net to $0. Unfortunately, because of the way the law is written if you incur a gain before a loss you will pay taxes even though economically you were not any better off than if you incurred the loss initially and then the gain.

Net Investment Tax

There is a net investment income tax of 3.8% which is levied on taxpayers with Modified Adjusted Gross Income over $250,000 for married individuals filing jointly, $125,000 for married individuals filing separately and $200,000 for everyone else. This tax is on the lesser of the investment income or the income in excess of the aforementioned limits. Capital gains and losses are considered to be investment income. This tax is in addition to any income tax levied whether at ordinary rates or more preferential long term rates.

Tax planning

As a general rule, I would like tax consequences to be a factor in your investing strategy, but by no means the only factor. For example, if you are thinking of selling a real estate investment property and you are planning to buy another, then, by all means, see if you can take advantage of the tax-free exchange provision or even move in for a few years to then get the sale of home residence exclusion. I also, like many accountants, advise my clients to search for items in their portfolio that may have losses and you no longer like. If you like a stock and it is just down, I don’t advise selling it to take a loss and buying back later. First, if all if you do this too quickly (within 30 days) this is called a wash sale and the loss is disallowed.

Conclusion

This article discusses capital gains and losses. While I have given a quick overview, this area can be quite complex. I would encourage anyone with significant capital transactions to contact a tax professional.

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Article By: Jeff Skolnick, CPA, M.S. Taxation

There are a number of items available in the tax code to assist taxpayers paying for qualified education expenses. These include tax credits, deductions and even a way to eliminate penalties on IRA distributions before age 59 ½.

I will start with the two different credits available for higher education tuition and fee expenses.  They are the American Opportunity Credit and the Lifetime Learning Credit. You are only able to use one of these credits per student in any tax year.

American Opportunity Credit

The American Opportunity Credit is available for any student within his/her first four years of post secondary education. The maximum credit allowed is $2,500. In addition, 40% of the credit is a refundable credit. This means it would be allowed even if income tax was reduced to zero. An example of this would be where a taxpayer has an income tax liability before any credits of $1,500. If the taxpayer had 1 child eligible for the maximum credit of $2,500, then the first 60% or $1,500 would offset the income tax, bringing it down to zero. The refundable portion of $1,000 would be allowed as a refund. 

The $2,500 limit is calculated as 100% of the first $2,000 of tuition and required fees and 25% of the next $2,000 of such fees. Qualified fees include tuition, required student activity fees, books, supplies and equipment. Room and board do not qualify.

Eligible students must also be enrolled in a program that leads to a degree, must be taking at least 50% of the course load needed to be considered full–time and not have any felony conviction for possessing or distributing a controlled substance.

There are also income phaseouts for this credit. This credit begins to phase out for individuals with income between $80,000 and $90,000 ($160,000 to $180,000 for joint filers). Married taxpayers filing separately do not qualify for the American Opportunity Credit.

Lifetime Learning Credit

This is a nonrefundable credit. The credit is a 20% credit on the first $10,000 of qualified tuition and fees paid for the taxpayer, spouse or dependents.  The maximum credit is therefore $2,000. This credit is per taxpayer, not per student. There is no degree or workload requirement. This credit is also not limited to the first four years of post secondary education.

There are also income phaseouts for the lifetime learning credit. This credit begins to phase out for individuals with income between $57,000 and $67,000 ($114,000 to $134,000 for joint filers). Married taxpayers filing separately do not qualify for the Lifetime Learning Credit.

In addition to the two credits discussed there are a few more programs available to assist taxpayers with the heavy burden of education expenses.

529 Plan

Technically called Qualified Tuition Programs, these plans are better known as 529 plans which refers to the Internal Revenue Code section in which they are defined. These plans allow individuals to prepay or contribute to an account for paying a student’s qualified education expenses. While there are a number of parts to these plans the basics are the following:

• Contributions to these plans are not tax deductible however if used for eligible education expenses none of the income earned will be taxable.
• Eligible education expenses include tuition and fees, books, supplies, equipment and room and board (although there are certain rules to be closely followed in this area).
• Beginning in 2018 it is now possible to use up to $10,000 per year per beneficiary for either elementary or secondary education expenses. Helpful to those with children in private schools.
• Coordinating with the annual gift tax exclusion, taxpayers may contribute up to $15,000 per beneficiary per year. This means parents can contribute $30,000 per year per beneficiary. In addition, the law allows a contribution equivalent to five years of the gift tax exclusion, or $75,000. You are then not eligible to give any gifts for the next four years. Technically, you can give gifts you would just have to file a gift tax return.
• The same expenses may not be used for the American Opportunity or Lifetime Learning Credits and for 529 distributions or Coverdell ESA Distributions (these will be explained next).

Coverdell Educaion Savings Account

For beneficiaries under 18 years of age, $2,000 may be contributed to an Education Savings Account (sometimes referred to as Education IRAs or ESAs). Married taxpayers filing jointly making the contribution will have this $2,000 figure phased out when their Modified adjusted Gross Income (MAGI) is between $190,000 and $220,000, for everyone else (including those married filing separately) the phaseout occurs between $95,000 and $110,000. Like the 529 plan contributions, ESA contributions are not deductible however if used for eligible education expenses none of the income earned will be taxable. Eligible expenses are basically the same as those allowed for 529 plans.

Again keep in mind the same education expenses cannot be used more than once. They can be used for the American Opportunity Credit, Lifetime Learning Credit, 529 plan or Coverdell ESA but only one type in a year. You may be able to utilize more than one benefit type in a year. In other words,  vthe American Opportunity Credit and 529 plan but you could not use the same expenses for both.

Other Benefits Available with regards to Education

Student Loan Interest

Taxpayers can deduct up to $2,500 of interest paid on qualified education loans. This deduction begins to phase out for individuals with income between $65,000 and $80,000 ($130,000 to $160,000 for joint filers). Married taxpayers filing separately do not qualify for the Student Loan Interest deduction. In addition, this deduction is allowed for taxpayers whether they itemize or not.

Exception to 10% Penalty on IRA Withdrawals Before Age 59 ½

Money withdrawn from your IRA (not 401K or other retirement plan, IRA only) and used for qualified education expenses of a taxpayer, spouse, child or grandchild will be exempt from the 10% penalty normally levied on early withdrawals. Eligible expenses are basically the same as those allowed for 529 or Coverdell ESA plans.

Tax Planning Tip

If you are in a position where you are unable to receive any benefit from the education deductions/credits previously discussed, then it may make sense to employ your child (if you are self-employed) and not claim them as a dependent or not claim them if they have other employment. The child would then be able to offset his/her income if they’ve exceeded $12,000.

Conclusion

This article only highlights education credits.  I would encourage taxpayers to contact a tax professional that has complete knowledge of these credits if they feel they may be eligible.

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Article By: Jeffrey Skolnick, CPA, M.S. Taxation

Choosing an entity structure is very important. Although it is possible to change from one structure to another there may be unintended tax consequences, therefore it makes sense to get set up correctly from the start.

Sole Proprietorship:

This is the most basic and easiest business entity to create.  There is no paperwork required to file.  You don’t need an Employer Identification Number (EIN) unless you have employees.  This is the only entity that I will discuss where no EIN is required. The income and expenses of your business are reported on Schedule C of your Federal Income Tax Form 1040.  The downside to this type of an entity structure is that the owner is personally liable for the debts and potential lawsuits of the business.  In other words there is no legal protection for the owner as there is in other entities (such as a corporation).  Additionally certain items such as medical expenses are reported in separate parts of the personal income tax return and may not yield the same benefits as if they were allowed as a deduction in your business.  Lastly, this type of entity is subject to self-employment tax and most likely if you have a Schedule C you will be required to make Estimated Income Tax Payments.

Partnerships:

Think of a general partnership as a multi member sole proprietorship.  The reason I say this is because there once again is very little if any paperwork required to create a partnership.  As with a sole proprietorship the owners are personally liable for the debts and potential lawsuits of the business.  The legal language used is jointly and severally liable. This means the owners are liable but not necessarily for just their portion. If one of the partners cannot pay his/her fair share of a liability, a creditor may go after any other or all other partners. In other words there is no legal protection for the owner as there is in other entities (such as a corporation).  

A limited partnership is generally made up of at least one and possibly several general partners.  These partners would have all of the same benefits and disadvantages as discussed in the previous paragraph.  Limited partnerships also have limited partners which may have limited liability (similar to a corporation) depending on state law.

Partnerships are required to file a Partnership Form 1065; however no tax is paid at the entity level.  Instead, a partnership is considered a “flow through” entity meaning the income flows from the partnership to the individual partners who report this income on their individual Forms 1040.  As with sole praetorships this income is subject to self-employment tax and again the partners would most likely be required to make Estimated Tax Payments.

Corporations:

Certainly the most formal entity structure, corporations must be formed under State law. I am only going to touch on “C” corporations because for the most part this structure is for larger organizations and most small businesses if they incorporate will elect “S” corporation status.

“C” corporations are entities that pay their own income tax and is the only entity I am discussing where nothing flows through to the owners (called either shareholders or stockholders). Stockholders of corporations typically receive money in one of two ways; either through wages (deductible as an expense to the corporation) or as dividends (not deductible to the corporation).  Again since this is geared toward small businesses I am not going to expand on this definition at this time.

“S” corporations are entities that are either entities formed as corporations that elect to be treated as “S” corporations or LLCs (which I will discuss shortly) that elect to be taxed as an “S” corporation.  An “S” corporation is also a “flow through” entity and is required to file Federal Form 1120S.  As with partnerships income earned by an “S” corporation flows through to the individual owners who report this income on their respective income tax returns.  The difference between “S” corporations and other entities is that while a sole proprietor or partner of a partnership is precluded from paying themselves through wages, S corporation shareholders are required to pay themselves through salary.  “S” corporation owners pay income tax on their wages earned and on the profits reported to them on by the corporation. Once again if shareholders receive profits from the corporation then they will most likely be required to make Estimated Income Tax Payments.  One difference between “S” corporation profits and partnership profits is that “S” corporation profits are not subject to self-employment tax.

LLCs

I chose to address this entity structure last because, for tax purposes, an LLC is not really anything. It is considered a “disregarded entity” which means that it is looked through as if it were invisible.  In other words, the default position of a single member LLC is that for tax purposes this entity would report on Form Schedule C.  If an LLC is made up of multi members, then the default position is that the entity would be taxed as a Partnership.  I know you are probably asking why bother forming an LLC if the tax filings are the same as either a sole proprietorship or partnership?  The answer is the LLC structure does afford owners limited liability similar to a corporation.  LLCs are formed with the State, very similar to corporations. While an LLC has default positions as I’ve outlined also keep in mind that an LLC can choose to be taxed as an “S” corporation.

Conclusion:

Although it is possible to change entity structure after the initial formation of a Company some changes are easier than others (LLCs to “S” corporations), others are either not possible or could have other potential adverse tax consequences.  It is therefore very wise to consult with a tax professional and to be set up correctly from the start.

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Mortgage Interest Deduction Traps

Article By: Jeff Skolnick, CPA, M.S. Taxation

At a time when interest rates are at a very low level and many people contemplate whether or not to refinance to either take advantage of the low rates or to pull out some equity from their home, I thought it was a good time to point out some of the traps of the mortgage interest deduction.

What is deductible Home Mortgage Interest?

Home mortgage interest can be divided in to two basic categories.  The first is acquisition debt and the second is home equity loans.

The first rule to keep in mind is that for any acquisition or equity debt to be deductible it must be secured by your main or second home.  This rule is not normally a big deal if you are obtaining a loan through a bank, however it can be important if the borrowing is from a nontraditional source such as a friend or relative.  If the borrowing is done between friends or relatives, then it is important that the loan be recorded and be secured by the main or second home.

Acquisition debt is defined as loans used to buy, construct or improve first or second homes.  Taxpayers are allowed to have $750,000 in acquisition debt between their main and second homes ($375,000 if married filing separately).  If a taxpayer has loans exceeding $750,000 in principal, then a portion of the interest is nondeductible.  These figures came into play after 2017. Prior to 2018 this $750,000 was $1,000,000 ($500,000 if married filing separately).  If you had a loan that met the $1,000,000 threshold before 2018 you are still able to deduct the interest after 2017. These loans have been grandfathered in.

After 2017 home equity loans are no longer deductible unless the money was used to buy, construct or improve a first or second home. These loans are not grandfathered.

Refinancing – What’s the worry?

I’ve briefly outlined the basic rules of the mortgage interest deduction above.  I want to now try to explain how refinancing can and does cause unexpected issues when there is no planning.

A common example of how individual taxpayers run in to interest deduction issues is the following:

Taxpayers purchase a home for $300,000; they put down $60,000 and finance $240,000.  Clearly the $240,000 is home acquisition debt and fully deductible.  Ten years down the road the house is now worth $425,000, and the original loan is down to $200,000.

The first trap I will discuss is the taxpayer’s taking out a home equity loan of $150,000.  Based on the rules outlined above no  interest will be deductible because it is a home equity loan.  This of course assumes that the $150,000 was not used for additional improvements on the house.  If the proceeds were used for example on an addition to the home, then the portion of the proceeds related to the improvements would be considered additional acquisition debt and the remainder would be considered home equity debt.

A second example would be that the taxpayers decided to refinance the original mortgage with a new $350,000 loan. Only the first $200,000  used to pay off the original loan would be considered mortgage acquisition debt while the rest is considered home equity, once again unless substantial improvements are made.

One last thing to keep in mind regarding refinanced loans is that points paid are generally not deductible in the year paid and must be amortized over the life of the loan unless the new loan is used for home improvements.

Business Interest

I just wanted to mention that acquisition debt used to purchase or improve a rental property is a separate type of interest and is 100% deductible assuming the proceeds were used to buy, construct or improve the rental property. Keep in mind that just as with a home mortgage if a landlord refinances a property to take out equity, then this would be considered nondeductible.  Again the only deductible interest is onproceeds used to purchase, construct or improve the property.

Investment Interest

Investment is interest is interest charged on monies borrowed to purchase investment property. This includes margin interest.  Some examples of investment property are stocks, bonds and mutual funds. Investment interest is deductible up to the amount of investment income and any unused investment interest expense is carried over to be used against future investment income.

Conclusion

Although it can be the biggest deduction on many taxpayers’ returns, the home mortgage interest deduction is more complicated than most people think.  Always make sure to check with your tax professional before making any decisions regarding your mortgage debt.

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Listen to the most recent episode of my podcast: Episode 16: Mortgage Interest rules. https://anchor.fm/jeffrey-skolnick/episodes/Episode-16-Mortgage-Interest-rules–What-you-should-be-aware-of-e47lpb