How would you like to squeeze more time out of your busy week, cut down on record-keeping duties, and reduce piles of paperwork and old receipts? The optional standard mileage rates for business vehicles can help you do just that. Businesses that operate up to four vehicles at the same time can deduct this standard mileage rate rather than keeping track of depreciation, gas, and repairs.

The business standard mileage rate for 2013 is 56.5 cents-per-mile. The business rate reflects, among other things, gasoline, depreciation and maintenance costs each year. The business standard mileage rate for 2012 has been 55.5 cents-per-mile (the same as for the second half of 2011 and up from 51 cents-per-mile for the first half of 2011).

Four or more vehicles

Businesses using no more than four vehicles for business purposes can use the business standard mileage rate. Generally, the IRS prohibits taxpayers from using the business standard mileage rate to compute the deductible expenses of five or more vehicles the taxpayer owns or leases and uses simultaneously, such as in a fleet operation.

Depreciation

The depreciation component of the business standard mileage rate is 23 cents-per-mile for 2013, the same as for 2012. In 2011 the rate was 22 cents-per-mile. Businesses that use the standard mileage rate are not allowed to take actual depreciation deduction amounts, even if they are higher than the depreciation component. Before deciding to use the standard mileage rate, a look at whether you will do better under the actual expense method, which includes actual depreciation, should be considered. Especially for circumstances in which Code Section 179 expensing and/or bonus depreciation is available; taking actual expenses, including actual depreciation, may be worth the effort.

Luxury vehicle caps. If actual depreciation is taken on a business vehicle, Congress wanted to be sure that vehicles selling above a certain price point did not enable their owners to take a larger write-off because of that premium cost. The “luxury vehicle” limits are designed to do just that, although taxpayers may debate the price points above which Congress set the “luxury” level. For example, using the standard mileage rate to value an employee’s personal use of a business vehicle is not allowed if the vehicle is valued at more than $15,900 for 2012 (projected to rise to $16,000 in 2013); Light trucks or vans are governed by a slightly higher level of $16,700 for 2012 (and $17,000 for 2013). This value also translates into the cap allowed on depreciation taken each year on the vehicle. For example, the maximum depreciation deduction for passenger automobiles first placed in service by the taxpayer in the 2012 calendar year is $3,160 for the first year (in addition to $8,000 for bonus depreciation, if applicable). For light trucks and vans, the first year cap is slightly higher: $3,360 (but with the same additional $8,000 deduction for bonus depreciation).

Special rules for heavy SUVs. For many years, SUV owners enjoyed a special tax break, often referred to as the “SUV loophole.” As explained, the “luxury car” rules place strict limits on the maximum amount of depreciation that may be claimed on passenger automobiles, including trucks and vans, during each year of a vehicle’s recovery (depreciation) period. Generally, however, the luxury vehicle limits only apply to vehicles primarily used on public streets with an unloaded gross weight of 6,000 pounds or less. A truck or van, including an SUV built on a truck chassis, is not subject to the annual vehicle depreciation limitations if its gross vehicle weight rating (maximum loaded weight) is in excess of 6,000 pounds. This “loophole” treatment had allowed many taxpayers who purchased an SUV with a gross weight in excess of 6,000 pounds to write off the entire cost in the year of purchase under the Code Sec. 179 expensing deduction.

Congress started to crack down on the so-called “SUV loophole” when, in the American Jobs Creation Act of 2004, it put the brakes on the cost of any SUV that may be expensed under Code Sec. 179 to $25,000, in addition to being counted toward the total caps on deductions for Code Sec. 179 property of all types. For example, a $139,000/$560,000 overall Section 179 expensing limits apply for 2012 (this is scheduled to drop to $25,000 for 2013, with a $200,000 investment ceiling, unless Congress takes further action). If the SUV is not built on a truck chassis or if it does not have a gross vehicle weight of more than 6,000 pounds, however, the “luxury vehicle” limit puts an even lower cap on those deductions. Nevertheless, heavy SUVs continue to benefit from a “bonus depreciation” loophole in the law in which a deduction for bonus depreciation is not capped for those vehicles not falling under the luxury-vehicle depreciation caps (that is, heavy SUVs). Although bonus depreciation applies to 2012, Congress may not extend it into 2013, or it may do so but without retaining what some have termed an unintended benefit for heavy SUV owners.

Bonus depreciation. Bonus depreciation for 2012 may be added to the available first-year deductions allowed on the purchase of a vehicle used for business if certain criteria are met. For most vehicles (those that are not fully depreciated in their first-year after applying the cap), business taxpayers claiming 50 percent bonus depreciation in 2012 are allowed an additional $8,000 in first year depreciation over and above the $3,160 first-year limit, for a total of $11,160 in the first tax year. Bonus depreciation, however, is for new vehicles only, and only if placed in service within the tax year. The section 179 expensing deduction, on the other hand, is available for both used and new vehicles.

Personal and business use

If you use your business vehicle for personal trips (including commuting back and forth from home and your principle business location) you must pro-rate your deduction to exclude the percentage of personal use. The magic number here is 50 percent. As long as you use your vehicle more than 50 percent for business during the year, you can pro-rate your deduction. You also have the option of using the standard mileage rate, based on miles of business use for the year times the prescribed rate.

After weeks, indeed months of proposals and counter-proposals, seemingly endless negotiations and down-to-the-wire drama, Congress has passed legislation to avert the tax side of the so-called “fiscal cliff.” The American Taxpayer Relief Act permanently extends the Bush-era tax cuts for lower and moderate income taxpayers, permanently “patches” the alternative minimum tax (AMT), provides for a permanent 40 percent federal estate tax rate, renews many individual, business and energy tax extenders, and more. In one immediately noticeable effect, the American Taxpayer Relief Act does not extend the 2012 employee-side payroll tax holiday.

The American Taxpayer Relief Act is intended to bring some certainty to the Tax Code. At the same time, it sets stage for comprehensive tax reform, possibly in 2013. Moreover, it creates important planning opportunities for taxpayers, which we can discuss in detail.

Individuals:

Unlike the two-year extension of the Bush-era tax cuts enacted in 2010, the debate in 2012 took place in a very different political and economic climate. If Congress did nothing, tax rates were scheduled to increase for all taxpayers at all income levels after 2012.  President Obama made it clear that he would veto any bill that extended the Bush-era tax cuts for higher income individuals. The President’s veto threat gained weight after his re-election.  Both the White House and the GOP realized that going over the fiscal cliff would jeopardize the economic recovery, and the American Taxpayer Relief Act is, for the moment, their best compromise.

Tax rates.  The American Taxpayer Relief Act extends permanently the Bush-era income tax rates for all taxpayers except for taxpayers with taxable income above certain thresholds:

$400,000 for single individuals, $450,000 for married couples filing joint returns, and $425,000 for heads of households.  For 2013 and beyond, the federal income tax rates are 10, 15, 25, 28, 33, 35, and 39.6 percent.  In comparison, the top rate before 2013 was 35 percent.  The IRS is expected to issue revised income tax withholding tables to reflect the 2013 rates as quickly as possible and provide guidance to employers and self-employed individuals.

Additionally, the new law revives the Pease limitation on itemized deductions and personal exemption phaseout (PEP) after 2012 for higher income individuals but at revised thresholds. The new thresholds for being subject to both the Pease limitation and PEP after 2012 are $300,000 for married couples and surviving spouses, $275,000 for heads of households, $250,000 for unmarried taxpayers; and $150,000 for married couples filing separate returns.

Capital gains.  The taxpayer-friendly Bush-era capital gains and dividend tax rates are modified by the American Taxpayer Relief Act. Generally, the new law increases the top rate for qualified capital gains and dividends to 20 percent (the Bush-era top rate was 15 percent). The 20 percent rate will apply to the extent that a taxpayer’s income exceeds the $400,000/$425,000/$450,000 thresholds discussed above. The 15 percent Bush-era tax rate will continue to apply to all other taxpayers (in some cases zero percent for qualified taxpayers within the 15-percent-or-lower income tax bracket).

Payroll tax cut.  The employee-side payroll tax holiday is not extended. Before 2013, the employee-share of OASDI taxes was reduced by two percentage points from 6.2 percent to 4.2 percent up the Social Security wage base (with a similar tax break for self-employed individuals).  For 2013, two percent reduction is no longer available and the employee-share of OASDI taxes reverts to 6.2 percent. The employer-share of OASDI taxes remains at 6.2 percent. In 2012, the payroll tax holiday could save a taxpayer up to $2,202 (taxpayers earning at or above the Social Security wage base for 2012).  As a result of the expiration of the payroll tax holiday, everyone who receives a paycheck or self-employment income will see an increase in taxes in 2013.

AMT. In recent years, Congress routinely “patched” the AMT to prevent its encroachment on middle income taxpayers. The American Taxpayer Relief Act patches permanently the AMT by giving taxpayers higher exemption amounts and other targeted relief. This relief is available beginning in 2012 and going forward. The permanent patch is expected to provide some certainty to planning for the AMT. No single factor automatically triggers AMT liability but some common factors are itemized deductions for state and local income taxes; itemized deductions for miscellaneous expenditures, itemized deductions on home equity loan interest (not including interest on a loan to build, buy or improve a residence); and changes in income from installment sales. Our office can help you gauge if you may be liable for the AMT in 2013 or future years.

Child tax credit and related incentives.  The popular $1,000 child tax credit was scheduled to revert to $500 per qualifying child after 2012.  Additional enhancements to the child tax credit also were scheduled to expire after 2012.  The American Taxpayer Relief Act makes permanent the $1,000 child tax credit. Most of the Bush-era enhancements are also made permanent or extended. Along with the child tax credit, the new law makes permanent the enhanced adoption credit/and income exclusion; the enhanced child and dependent care credit and the Bush-era credit for employer-provided child care facilities and services.

Education incentives.  A number of popular education tax incentives are extended or made permanent by the American Taxpayer Relief Act.  The American Opportunity Tax Credit (an enhanced version of the Hope education credit) is extended through 2017.  Enhancements to Coverdell education savings accounts, such as the $2,000 maximum contribution, are made permanent.  The student loan interest deduction is made more attractive by the permanent suspension of its 60-month rules (which had been scheduled to return after 2012). The new law also extends permanently the exclusion from income and employment taxes of employer-provided education assistance up to $5,250 and the exclusion from income for certain military scholarship programs.  Additionally, the above-the-line higher education tuition deduction is extended through 2013 as is the teachers’ classroom expense deduction.

Charitable giving.  Congress has long used the tax laws to encourage charitable giving.  The American Taxpayer Relief Act extends a popular charitable giving incentive through 2013:  tax-free IRA distributions to charity by individuals age 70 ½ and older up to maximum of $100,000 for qualified taxpayer per year.  A special transition rule allows individuals to recharacterize distributions made in January 2013 as made on December 31, 2012.  The new law also extends for businesses the enhanced deduction for charitable contributions of food inventory.

Federal estate tax.  Few issues have complicated family wealth planning in recent years as has the federal estate tax.  Recent laws have changed the maximum estate tax rate multiple times. Most recently, the 2010 Taxpayer Relief Act set the maximum estate tax rate at 35 percent with an inflation-adjusted exclusion of $5 million for estates of decedents dying before 2013. Effective January 1, 2013, the maximum federal estate tax will rise to 40 percent, but will continue to apply an inflation-adjusted exclusion of $5 million. The new law also makes permanent portability between spouses and some Bush-era technical enhancements to the estate tax.

Businesses:

The business tax incentives in the new law, while not receiving as much press as the individual tax provisions, are valuable. Two very popular incentives, bonus depreciation and small business expensing, are extended as are many business tax “extenders.”

Bonus depreciation/small business expensing.  The new law renews 50 percent bonus depreciation through 2013 (2014 in the case of certain longer period production property and transportation property). Code Sec. 179 small business expensing is also extended through 2013 with a generous $500,000 expensing allowance and a $2 million investment limit.  Without the new law, the expensing allowance was scheduled to plummet to $25,000 with a $200,000 investment limit.

Small business stock.  To encourage investment in small businesses, the tax laws in recent years have allowed noncorporate taxpayers to exclude a percentage of the gain realized from the sale or exchange of small business stock held for more than five years.  The American Taxpayer Relief Act extends the 100 percent exclusion from the sale or exchange of small business stock through 2013.

Tax extenders.  A host of business tax incentives are extended through 2013.  These include:

  • Research tax credit or R&D credit
  • Work Opportunity Tax Credit (WOTC)
  • New Markets Tax Credit
  • Employer wage credit for military reservists
  • Tax incentives for empowerment zones
  • Indian employment credit
  • Railroad track maintenance credit
  • Subpart F exceptions for active financing income
  • Look through rules for related controlled foreign corporation payments

Energy:

For individuals and businesses, the new law extends some energy tax incentives.  The Code Sec. 25C, which rewards homeowners who make energy efficient improvements, with a tax credit is extended through 2013.  Businesses benefit from the extension of the Code Sec. 45 production tax credit for wind energy, credits for biofuels, credits for energy-efficient appliances, and many more.

Looking ahead

The negotiations and passage of the new law are likely a dress rehearsal for comprehensive tax reform during President Obama’s second term.  Both the President and the GOP have called for making the Tax Code more simple and fair for individuals and businesses.  The many proposals for tax reform include consolidation of the current individual income tax brackets, repeal of the AMT, moving the U.S. from a worldwide to territorial system of taxation, and a reduction in the corporate tax rate. Congress and the Obama administration also must tackle sequestration, which the American Taxpayer Relief Act delayed for two months. All this and more is expected to keep federal tax policy in the news in 2013. Our office will keep you posted of developments.

If you have any questions about the American Taxpayer Relief Act, please contact Azran Financial at (310) 691-5040 or (818) 691-1234 or via e-mail at info@www.azranfinancial.com.  We can schedule an appointment to discuss how the changes in the new law may be able to maximize your tax savings.

Planning Opportunities for New 3.8-Percent Medicare Tax Using S Corporations

The Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act implemented Code Sec. 1411, which imposes a new 3.8-percent Medicare tax on unearned income of higher-income individuals. The tax will take effect January 1, 2013, and applies to the net investment income of individuals, estates, and trusts that exceeds specified thresholds. Although the tax does not apply to corporations, it will apply to dividends and other passive income derived from corporations.

Because the tax on net investment income applies to individuals, it may apply to amounts received by individuals from passthrough entities, such as partnerships, limited liability companies, and S corporations. Under general principles, items of income that flow through a partnership, S corporation, or limited liability company (LLC) to partners, shareholders, or members retain their character. Thus, for example, interest income earned by a partnership is still characterized as interest when it passes through to a partner.

Net Investment Income

The tax, known as the Medicare contribution tax, equals 3.8 percent of the lesser of (1) an individual’s net investment income or (2) the excess of the individual’s modified adjusted gross income (AGI) over the threshold amount. The thresholds are $250,000 for married taxpayers filing a joint return; $125,000 for married taxpayers filing a separate return; and $200,000 for all other taxpayers.

Trusts and estates are subject to a much lower threshold. They should strive to distribute their income to their individual beneficiaries to minimize the tax.

The tax does not apply to non-resident aliens, charitable trusts, or corporations.

Net investment income includes gross income from interest, dividends, royalties, and rents, as well as net gain from the disposition of property, unless such income is derived from a passive activity. The tax also applies to other gross income from a trade or business that is a passive activity. Thus, the application of the tax depends on the character of the amounts and the treatment of amounts received from these entities.

Passive Activities

The tax applies to passive income, which is income from a trade or business that is a passive activity under Code Sec. 469. An activity is passive if it involves the conduct of a trade or business in which the taxpayer does not materially participate. Very generally, material participation exists if the taxpayer is involved in the operations of the activity on a regular, continuous, and substantial basis. Accordingly, if the individual materially participates in the entity’s business, the tax on net investment income does not apply to income from the entity. If the individual does not materially participate, the income is characterized as passive and may be subject to the tax under Code Sec. 1411(c)(2).

A sole proprietor by definition manages his or her business. Thus, the sole proprietor materially participates in his or her business and would not have to pay the 3.8-percent tax on income of the proprietorship.

Income from a partnership, S corporation, or LLC is often characterized as passive income if the individual does not materially participate in the business of the entity. In the past, passive income was seen as beneficial, because it could be used to offset passive losses. Thus, in the past, taxpayers have desired passive income and may even have planned for it. Now, because of the net investment income tax, certain taxpayers may prefer not to have income characterized as passive.

Social Security Taxes

Employees generally are subject to Social Security (FICA or SECA) taxes on their wage income, amounting to 7.65 percent contributed by the employee and the employer. This also applies to wages paid to partners. Self-employed individuals pay a similar tax (15.3 percent, which includes both the employee’s and the employer’s shares) on their business income. This income is characterized as net earnings from self employment.

The current payroll tax holiday has reduced an employee’s employment tax share to 5.65 percent (13.3 percent for self-employed). Absent further legislation, the rates will revert to their previous levels in 2013.

Net earnings from self-employment are specifically excluded from being characterized as net investment income (Code Sec. 1411(c)(6)). This eliminates the possibility of an individual being subject to Medicare taxes on both earnings and unearned income.

Partnership Income

Earnings or business income derived from a partnership, which flows through the entity to the general partners, is characterized as net earnings from self-employment. Therefore, it is subject to self-employment tax, and is not subject to the 3.8-percent tax on net investment income.

Income that flows through to the limited partners is not treated as net earnings from self-employment. It will be subject to the 3.8-percent net investment income tax, but not the Social Security tax.

If the same individual is both a general partner and a limited partner, the characterization of the income is not so clear and likely will be subject to greater examination by the IRS.

S Corporation Income

Unlike a partnership, an S corporation’s income that passes through to its owners (its shareholders) is not per se characterized as net earnings from self-employment, because dividends on shares of stock issued by the S corporation are excluded from this characterization. Similarly, normal distributions actually made by an S corporation to its shareholders are not treated as net earnings from self-employment. However, this contrasts with distributions that are payments of wages to shareholder-employees, which are subject to Social Security taxes.

Thus, shareholder-employees can avoid Social Security taxes by withdrawing funds from the S corporation as a distribution, rather than as wages. However, if the employee takes no salary or an unreasonably low salary, the courts generally have supported the IRS in recharacterizing at least a portion of the distributions as wages subject to Social Security taxes.

Income that passes through to S corporation shareholders, as well as distributions, will be subject to the 3.8-percent Medicare tax unless the shareholder materially participates in the business (i.e., the S corporation’s business is not a passive activity with respect to the shareholder). In the latter case, however, the income may successfully avoid both Social Security taxes and Medicare taxes. Furthermore, gain on the sale or redemption of the S corporation interest likewise should not be net investment income under this interpretation if the shareholder materially participates in the business.

Planning Strategies

With these consequences in mind, taxpayers may now be more inclined to establish an S corporation to run their business as long as they are materially involved in the operation of the business and pay reasonable salaries to shareholder-employees. This can be accomplished with a variety of structures.

The basic structure is to operate the business through an S corporation or through an LLC that elects to be taxed as an S corporation. The shareholder-owners must be materially involved in the business. Wages paid to shareholder-employees will be subject to Social Security taxes, but distributions, passthrough income, and net gains from the sale or redemption of the shareholder’s interest in the S corporation will not be subject to the net investment income tax.

If a shareholder does not materially participate in the business operations, the net investment income tax will apply to income items paid or distributed to the shareholder (other than wages).

Variations of this basic structure can be used, and the tax consequences should be the same. S corporations can only have one class of stock. An LLC with one class of interests and no preferred income allocations or distributions may elect S corporation treatment for tax purposes and secure this same treatment. Another variation can be used if there are varying interests. An S corporation owned by the business’s operators can become a member of an LLC with other investors who are not eligible to hold S corporation stock (e.g. foreign investors) becoming members of the LLC.

Another possible structure uses a corporation as the manager of an LLC. The corporate manager in this case would have the authority to bind the LLC. A member investing in the LLC as a limited partner would not be subject to self-employment taxes. If involved in the business, the limited partner would not be subject to the net investment income tax. It may not be so clear, however, how to treat an LLC member who is involved in the business for self-employment tax purposes. Finally, a limited partnership with an S corporation as the sole general partner could also obtain these benefits. Income would pass through and the limited partners would qualify for the limited partner exception to self-employment taxes.

The IRS has argued that LLCs should be treated as limited partnerships, but the courts generally have not accepted this analysis.

Under current law, it appears that investors may be able to use the S corporation structure to avoid most Social Security self-employment taxes and the net investment income tax. However, the IRS has yet to issue regulations on the 3.8-percent net investment income tax, and it remains to be seen whether potential IRS guidance on material participation in a business, or other interrelationships between the self-employment tax and net investment income tax provisions under the Code, will affect the use of these structures.

As a taxpayer, you are facing what is perhaps an unprecedented set of circumstances – the expiration of the tax rates enacted in 2001, the expiration of more than 150 tax provisions and a tax increase of more than $500 billion overall – that could result in a much higher tax liability when you file your next return.

As we edge nearer to the “fiscal cliff,” as it’s being called, several changes are looming, including (but not limited to) a possible increase on long-term capital gains, restrictions on  itemized deductions, reinstatement of the full payroll tax, and an increase in both the estate tax rate and the number of estates that will be subject to the estate tax. In addition, a new 3.8% surtax on some investment income will become effective Jan. 1, 2013.

Many of these changes will have an impact on small businesses and call for tax planning and possible actions now to soften the potential burden [particularly if you operate as a pass-through entity as many tax increases will affect individuals]. For example, if you are planning to sell appreciated business assets, doing so before the end of 2012 may help avoid the higher capital gains tax. Please come in at your earliest convenience so we can discuss your tax situation and develop a strategy that makes sense for you.

Deductible Business Expenses – How Will You be Affected?

Under Section 179 of the tax code, small businesses can deduct the total cost of some qualifying property in the year it is placed in service, within certain limits, rather than depreciating it over time. The limit on the cost of property (including real property) that can be expensed is now $139,000. The total value of the equipment purchased cannot be higher than $560,000.

As of Jan. 1, 2013, the expensing limit is set to drop and real property, some of which is allowed now, will no longer be included. As a result, businesses may want to consider making equipment or property purchases before year-end to take advantage of the higher expense amount. What may be critical to taking advantage of section 179 election is whether the equipment can be put into service before Jan. 1, 2013.

Also, with the expiration of current 50% first-year bonus depreciation allowance, businesses will have to revert to the modified accelerated cost recovery system to calculate depreciation, meaning that more costs will have to be deducted over time rather than immediately.

Pass-Through Entities

As a pass-through entity, there are several other issues to consider since you pay your business taxes as an individual, including:

  • The return of the phase-out for itemized deductions for a taxpayer who has adjusted gross income over roughly $175,000 as well as a phase-out of personal exemptions for taxpayers with income over a certain level. Each one would limit the amount of allowable deductions and raise the taxpayer’s net taxable income.
  • The lowest individual income tax rate will rise from 10% to 15% and all other individual rates will also edge up.
  • Due to an expiring Bush-era tax cut, a broader marriage penalty will mean higher tax bills for married couples. Instead of the current 200%, the standard deduction for married couples filing jointly will fall to 167% of the standard deduction for single taxpayers.
  • The alternative minimum tax (AMT) will apply to 2012 income for many more Americans if not indexed for inflation. At the end of 2011, the AMT exemption was $74,450 for married taxpayers and $48,450 for singles. It is set to fall to $45,000 for joint filers and $33,750 for single filers. Taxpayers are also set to lose the ability to offset their AMT bite with personal tax credits.
  • The credit for Research and Experimentation Expenses, worth up to 20% of qualified costs, expired at the end of 2011 and has not been extended.

We also want to remind you that business owners and self-employed individuals need to:

  • Obtain tax identification numbers for all the individuals to whom they send Forms 1099-Misc
  • Closely review their estimated tax calculations in light of any tax changes that occur

Azran Financial can help you review those calculations to understand the effect these possible increases could have on your tax situation. Please contact us today at (310) 691-5040 or (818) 691-1234, or e-mail us at info@www.azranfinancial.com to schedule an appointment to develop strategies to minimize the impact of this uncertain tax climate on your business.

The IRS has provided guidance which clarifies that an arrangement that recharacterizes taxable wages as nontaxable reimbursements or allowances does not satisfy the business connection requirement for accountable expense reimbursement plans.

In general, employee business expense reimbursements that are paid through an employer’s accountable expense reimbursement plan are excluded from the employee’s adjusted gross income. An accountable plan basically requires employees to submit receipts for expenses and repay any advances that exceed substantiated expenses. Amounts paid to employees through an accountable plan are not taxable compensation. Thus, they are not subject to federal or state income taxes or Social Security taxes, or employer payroll taxes and withholding.

On the other hand, business expense reimbursements paid through a system that does not meet the specific requirements for accountable plans are considered paid under a nonaccountable plan, and are treated as taxable compensation. An employer can have a reimbursement plan that is considered accountable in part and nonaccountable in part.

A reimbursement plan must meet three requirements in order to be considered an accountable expense allowance arrangement

  1. reimbursements must have a business connection;
  2. reimbursements must be substantiated; and
  3. employees must return reimbursements in excess of expenses incurred.

An arrangement satisfies the business connection requirement if it provides advances, allowances, or reimbursements only for business expenses that are allowable as deductions, and that are paid or incurred by the employee in connection with the performance of services as an employee of the employer. Therefore, not only must an employee actually pay or incur a deductible business expense, but the expense must arise in connection with the employment for that employer.

The business connection requirement will not be satisfied if a payor pays an amount to an employee regardless of whether the employee incurs or is reasonably expected to incur deductible business expenses. Failure to meet this reimbursement requirement of business connection is referred to as wage recharacterization because the amount being paid is not an expense reimbursement but rather a substitute for an amount that would otherwise be paid as wages.

The business connection requirement will not be satisfied if a payor pays an amount to an employee regardless of whether the employee incurs or is reasonably expected to incur deductible business expenses. Failure to meet this reimbursement requirement of business connection is referred to as wage recharacterization because the amount being paid is not an expense reimbursement but rather a substitute for an amount that would otherwise be paid as wages.

The IRS guidance includes four situations, three of which illustrate arrangements that impermissibly recharacterize wages such that the arrangements are not accountable plans. A fourth situation illustrates an arrangement that does not impermissibly recharacterize wages. In this arrangement, an employer prospectively altered its compensation structure to include a reimbursement arrangement.

Because of the difference in tax treatment of reimbursements under an accountable plan versus a nonaccountable plan, it is important to review your reimbursement policies. Please call our office for an appointment to discuss your options under this IRS guidance.

An S-corporation, such as yours, is a pass-through entity that is treated very much like a partnership for federal income tax purposes. As a result, all income is passed through to your shareholders and taxed at their individual tax rates. However, unlike a C corporation, an S corporation’s income is taxable to the shareholders when it is earned whether or not the corporation distributes the income. Because an S corporation has a unique tax structure that directly impacts shareholders, it is important for you to understand the S corporation distribution and loss limitations, as well as how and when items of income and expense are taxed, before developing your overall tax plan.

In addition, some S corporation income and expense items are subject to special rules and separate identification for tax purposes. Examples of separately stated items that could affect a shareholder’s tax liability include charitable contributions, capital gains, Sec. 179 expense deductions, foreign taxes, and net income or loss related to rental real estate activities.

These items, as well as income and losses, are passed through to the shareholder on a pro rata basis, which means that the amount passed through to each shareholder is dependent upon that shareholder’s stock ownership percentage. However, a shareholder’s portion of the losses and deductions may only be used to offset income from other sources to the extent that the total does not exceed the basis of the shareholder’s stock and the basis of any debt owed to the shareholder by the corporation. The S corporation losses and deductions are also subject to the passive-activity rules.

Other key points to consider when developing your comprehensive tax strategy include:

the availability of the Code Sec. 179 deduction at the corporate and shareholder level;

  1. reporting requirements for the domestic production activities deduction;
  2. the tax treatment of fringe benefits;
  3. below-market loans between shareholders and S corporations; and
  4. IRS scrutiny of distributions to shareholders who have not received compensation.

We can assist you in identifying and maximizing the potential tax savings. Please call our office at (310) 691-5040 or (818) 691-1234 or e-mail us at info@www.azranfinancial.com to arrange an appointment.