Christian Block CPA, Author at Evergreen Small Business

One Big Beautiful Bill’s New R&D Deductions

Christian Block CPA — Mon, 03 Nov 2025 16:16:05 +0000

The OBBB, also known as the One Big Beautiful Bill, also known as the American Innovation and Growth Act of 2025, makes a useful change to the R&D deduction rules.

That change? Businesses may again deduct research and development costs, or R&D costs, as incurred.

Note: The current law says firms must capitalize R&D costs and then amortize the costs over a number of years.

But this change is trickier than you might at first guess. Some complexities exist. Also you have some tax planning opportunities related to any existing, capitalized R&D costs your tax return shows.

In this post, I walk you through the newly restored R&D deduction rules. And then I’ll explain not just how to recover deductions from prior years, but also how to maximize the tax savings you enjoy when you do this.

But let’s review how we got here.

R&D Deductions Pre-2022, The Golden Era

Prior to January 1, 2022, taxpayers had two primary options for handling R&D expenses:

Taxpayers could deduct R&D expenses in the year incurred. This applied to in-house R&D costs and certain contract expenses, and was the most common treatment.
Alternatively, businesses could elect under §174(b) to amortize R&D over at least 60 months.

The ability to expense R&D immediately had two tax accounting benefits. First, it reduced a taxpayer’s income which meant it also reduced a taxpayer’s tax burden. Second, it simplified the accounting by avoiding complex capitalization and amortization tracking. Then the rule changed.

R&D Deductions 2022 – 2024, The Dark Era

From 12/31/2021 through 12/31/2024, tax law required taxpayers to capitalize R&D costs. Those costs were amortized over 60 months if domestic R&D and over 180 months if foreign R&D.

That all sounds reasonable enough. But some practical observations about the capitalization policy. The policy:

Increased the tax burden for tax payers involved in R&D activities
Reduced cash flow reinvested in R&D activities, thereby hindering innovation
Burdened firms with complex accounting treatment
Boosted tax return preparation fees
Increased chance of tax return errors due to limited IRS guidance

The good news is R&D expenses are, potentially, immediately deductible again.

The American Innovation and Growth Act of 2025

The American Innovation and Growth Act of 2025, also known as the “One Big Beautiful Bill,” or “OBBB” for short, ends the capitalization policy of TCJA. Further, it allows taxpayers the ability to deduct still capitalized R&D costs from 2022 – 2024.

Domestic R&D

Domestic R&D costs, generally, qualify for immediate expensing if they meet the definition of R&D expenditures, which include:

Wages paid to employees directly engaged in qualified research
Supplies used in the conduct of research
Contracted research
Software development costs
Cloud computing and data hosting costs

Activities must be performed in the United States or a US territory, including contractor work, for immediate expensing.

Foreign R&D

Foreign R&D costs are still required to be capitalized and amortized over 180 months. Some foreign R&D examples include:

Wages paid to employees outside of the United States (frequently in Canada, India, UK, and other EU countries)
Third party vendors or contractors located outside of the United States
Foreign software development costs
Materials and supplies used in foreign R&D activities

Note, too, foreign R&D costs no longer qualify for R&D credits beginning 1/1/2025.

Reversing 2022 – 2024 Capitalization

The OBBB introduced two methods to claim R&D deductions that were missed during the capitalization period.

Method 1, Small Business Amendment Option

This allows small taxpayers (average 3-year revenue under $31 million) to file an amended return for any of the open 2022 – 2024 tax years to expense previously capitalized R&D expenses.

This method results in the fastest cash recovery, however, there is some preparation cost for amending previously filed tax returns, and possibly greater IRS examination risk.

Our recommendation is to look at the taxpayer’s marginal tax rate in the year in question to see if it makes sense to amend. You probably don’t want to do this if the taxpayer’s marginal rate is low. If the marginal rate is high, 35 or 37%, for example, amending may make the most sense.

Method 2, Catch-Up Deduction Election

This method allows any taxpayer, big or small, to either:

Deduct 100% of the unamortized basis of capitalized R&D in 2025, or
Deduct 50% of the unamortized basis in 2025, and 50% in 2026

The taxpayer must make the election on their originally filed 2025 tax return, making this likely the least expensive option with a lower amount of examination risk.

With this method, however, the taxpayer won’t realize the tax benefit until they file their 2025 or 2026 tax returns, which will occur in 2026 or 2027.

You will want to do some forecasting to optimize this. It probably doesn’t make sense to spread the deduction over two years if you anticipate 2025 to be a big income year and 2026 to be a small income year, for example. And you will want to analyze the tax benefits between the catch-up deduction and small business amendment options.

An Example to Illustrate

Say a taxpayer’s tax return capitalized $500,000 of R&D wages in 2024, and then amortized $100,000 of this spending. That leaves $400,000 of yet-to-be-amortized R&D costs at the start of 2025.

This taxpayer chooses between four options:

Continue amortizing the capitalized R&D wages at the rate of $100,000 a year.
Amend the 2024 tax return and adding the $400,000 of capitalized 2024 R&D wages to the 2024 tax return.
Take the $400,000 of still capitalized R&D wages as a deduction all on the 2025 tax return.
Split the $400,000 of capitalized R&D wages evenly across the 2025 and 2026 tax returns thereby putting a $200,000 deduction onto each return.

Taxpayers, probably with the help of their tax accountants, will want to “run the numbers” to see which option delivers the best savings. But the two general rules to consider are, first, sooner is better than later. (This is the ol’ time value of money.) But the second thing to consider is, if a firm can, it wants to use its deductions on the years where the marginal tax rates are highest.

Next Steps

Here is a small checklist of things to check if you are involved with R&D activities:

How much unamortized basis is left in capitalized R&D after 2024?
Try to estimate 2025 and 2026 income
Compare the income in the period of capitalization to estimated 2025 and 2026 income
Estimate the tax savings of each period and choose the one with the largest benefit.

I should also mention that deducting R&D does not prohibit or limit your ability to claim R&D credits.

As you can see, the change to R&D expensing is hugely consequential. Tens of thousands of small and mid-size business will be affected by this change.

This is one of the most tax-payer friendly developments we’ve seen in years. If you are a tax practitioner, you want to be looking closely at your R&D clients. If you are a taxpayer involved in R&D activities, you want to be discussing this with your tax preparer.

Want to know how R&D tax credits work? Click on this link.

The post One Big Beautiful Bill’s New R&D Deductions appeared first on Evergreen Small Business.

Trump Savings Accounts – Free Money from the Government

Christian Block CPA — Wed, 01 Oct 2025 17:59:58 +0000

Child focused tax benefits have taken on many forms over the years. We’ve had child tax credits, dependent care credits, education credits, 529 accounts, UTMA & UGMA accounts, and more. But, the recently passed One Big Beautiful Bill (OBBB) introduced something completely new: a federally seeded, tax deferred savings product for children known as Trump Savings Accounts.

This is a big deal that parents, grand parents, legal guardians, and even employers should pay attention to. The federal government is giving $1,000 to eligible new born babies. This isn’t a tax credit, a tax deduction, or anything else. It is actual cash the government deposits into a bank account. And that is just the beginning.

We’ll unpack what these new Trump Savings Accounts are, who qualifies, how to maximize contributions, and what they can be used for. We’ll also compare these to other accounts designed for children and see how they differ from what is already available.

What is a Trump Savings Account?

A Trump Savings Accounts is a tax-deferred custodial account that is structured like a Roth IRA. Qualifying children will receive a seed deposit of $1,000 from the federal government, beginning 1/1/2026.

To be absolutely clear, this is FREE money from the government! To qualify, a child only needs to:

Be a United States Citizen
Be born between 1/1/2025 and 12/31/2028
Have a Social Security number

No income limits for the parents or guardians exist. Every single qualifying child receives the seed deposit. However, parents and guardians can make additional deposits into the account as well. Lets dig into the details.

Contribution Rules and Limits

In addition to the government seed money, parents, relatives, friends, and even employers can make contributions into the savings account until the child reaches age 18.

The annual contribution limit is $5,000/child, indexed for inflation in future years. Employer’s can also contribute up to $2,500 per child, which counts towards the $5,000 contribution cap. Ignoring the inflation adjustments, it’s possible for a child to have $90,000 deposited into their account by the time they reach 18! That is serious money.

Contributions aren’t tax-deductible for the donor and aren’t treated as income to the child. The money grows tax deferred, however, until the child starts withdrawing the funds.

The IRS determines the tax rate on a distribution based on how the recipient uses the funds. The tax rate is the same as long term capital gains tax rates on qualified withdrawals. A qualified withdrawal includes the following:

Education, including tuition, supplies, & room and board.
Expanded definition of education to include certified trade and vocational programs
First time home purchase
Starting a business

If the recipient uses the money for anything else before turning 59½, they must pay ordinary income taxes and a 10% penalty on the amount withdrawn. These are the same consequences as taking a nonqualified distribution from a retirement account.

Account Investment Vehicles

The money must be invested within specific eligible investments as detailed in the OBBB. Eligible investment means any mutual fund or exchange traded fund which:

Tracks the returns of a qualified index
Does not use leverage
Does not have annual fees and expenses of more than 0.1% of the balance of the investment fund

The term “qualified index” means:

The S&P 500 market index, or
Any other index which is
- comprised of equity investments in primarily United States companies, and
- for which regulated futures contracts are traded on a qualified board or exchange

So how do you open an account?

Opening a Trump Savings Account

First, as previously discussed, you must have a qualifying child born between 1/1/2025 – 12/31/2028 to open an account. If qualified, there are two ways to establish an account:

Eligible custodians can manually open accounts after 12/31/2025 with an authorized financial institution.
If no eligible custodian establishes an account on behalf of a qualified child within 12 months of the child’s date of birth, the Secretary of Treasury shall cause an account to be opened in the name of such child and held by a designated institutional custodian.

The treasury hasn’t issued guidance or an approved list of authorized financial institutions at the time of this writing. But most likely, a majority of the major financial institutions (Fidelity, Vanguard, Ascensus, JP Morgan Chase etc.) will support the accounts.

Trump Savings Account Alternatives

Now let’s see how Trump Savings Accounts stack up against more familiar options like 529 plans and custodial accounts, and explore which might be the best fit for your financial goals.

As compared to Trump Savings accounts, Section 529 plans

Are designed to help families save for education-related expenses
Contributions are not federally deductible but are deductible in some states
No contribution limits and considered as gifts to minor
Can change beneficiary
Funds grow inside of the account tax free
Qualified withdrawals are not taxed, if used to pay for
- College tuition and fees
- K-12 tuition
- Room and board
- Books, supplies, and required technology
Non-qualified distributions are taxed at ordinary rates and subject to a 10% penalty

A Section 529 plan has the advantage over a Trump Savings Account IF the funds are used for college expenses. If flexibility is a priority, the advantage goes to the Trump Savings Account.

As compared to Trump Savings accounts, custodial Accounts (UTMA, UGMA)

Are designed to allow an adult custodian to manage assets of a minor child
Contributions are not federally or state deductible
No contribution limits and considered as gifts to minor
Cannot change beneficiary
Funds can be used for anything that benefits the child
No tax shelter treatment, income is subject to kiddie tax annually

A custodial account has the advantage over a Trump Savings Account when spending flexibility is the priority. However, there is little to no tax advantage like a Trump Savings Account provides. Verdict? Max out Trump Savings Account contributions first, fund a custodian account second.

Are Trump Savings Accounts a Good Deal?

For eligible families (those with children born between 2025 and 2028) they present a rare opportunity: a $1,000 head start, tax-deferred investment growth, and potential employer contributions.

While they don’t replace the role of Section 529s for education savings or offer the flexibility of UGMA/UTMA custodial accounts, they fill a new niche by helping families build long-term wealth for their children with minimal upfront cost. Like any financial tool, the value depends on your goals, but for many, opening one is a low-risk, high-upside way to diversify a child’s financial future.

The post Trump Savings Accounts – Free Money from the Government appeared first on Evergreen Small Business.

April 15, 2025 ERC Deadline Approaches

Christian Block CPA — Thu, 16 Jan 2025 16:23:14 +0000

If your small business got beat up during the pandemic? And you didn’t get an employee retention credit, or ERC, refund? You should know two things. First, you can still apply for ERC refunds. Second, the final ERC deadline is getting close. April 15, 2025 is the actual date.

But let me dig into the details here so you know whether your firm qualified. And so you know what your firm needs to do to get any refund you missed. One comment here too: The refunds get big fast. If you qualified you’re probably talking tens or even hundreds of thousands of dollars of refunds.

First Some Background About the ERC

The Coronavirus Aid, Relief, and Economic Security Act (Cares Act), enacted in March of 2020, provided several aid packages for employers and employees. The primary goals were to keep businesses afloat and prevent employee furloughs.

Initially, employers had to choose between two programs, the Paycheck Protection Program or Employer Retention Credits. You could not participate in both.

The PPP program generally provided more money to business owners, and, not surprisingly, became the more popular choice.

In December of 2020, however, Congress passed the Consolidated Appropriations Act (CAA). And the CAA allowed businesses to participate in both the PPP and the ERC. Tax practitioners and employers then scrambled to learn about the ERC program in early 2021. And as we all learned, there was serious aid money available to qualified employers.

A final thing to know up front. Employers potentially got ERC funds, or employee retention credit refunds, for wages paid in 2020 and in 2021. But the ERC deadline for refunds based on 2020 wages ended roughly a year ago. What I’m talking about here then are ERC refunds for 2021 wages. But that’s okay. That’s where the big money is.

How to Qualify for ERC?

To qualify for the ERC, businesses must generally meet one of three criteria:

Significant decline in gross receipts, or
Full or partial suspension of operations due to a government closure order, or
Start a new trade or business after February 15, 2020 and before the end of 2021.

From a practitioner’s perspective (and based on experience with many ERC claims), qualifying via a significant decline in gross receipts is usually easiest to substantiate and prove to the IRS. For 2021, an employer needed a decline of more than 20% in gross receipts compared to the same quarter in 2019.

Government shutdown orders, the second way to qualify, introduce nuances that can complicate qualification and implementation. If you’re interested, you can read more about ERC and government shutdown orders here. But you probably want to know that much of the ERC fraud appears to have involved employers alledgedly qualifying based on government orders.

The third way to qualify is to start a new trade or business. To qualify for an ERC refund based on starting a new trade or business, you need to be a small business with average gross receipts over three previous years equal to $1,000,000 or less. This revenue limit looks at the total revenues from all your businesses. And you get the ERC refund based on the wages paid in any of the businesses.

Qualified Wages for ERC

Not all wages qualify for employee retention credits. Some do. Some don’t.

Qualified wages for ERC in 2021 include the following:

Wages subject to FICA taxes
Certain health plan expenses allocable to wages
Employers had to have 500 or fewer employees

Non-Qualified wages for ERC include:

Wages that were used for PPP
Greater than 50% owner wages
Greater than 50% owner family member wages (spouse, children, grandchildren, parents, siblings, in-laws etc.)

How is ERC Calculated

The 2021 ERC formula works differently depending on the credit.

If you qualify based on either a substantial decline in gross receipts or a goverment order, the ERC equals 70% of qualified wages, up to $10,000 per employee per quarter for the first, second and third quarters of 2021.

Example: Suppose in 2021 you have three employees earning $12,000 each quarter throughout the year. Qualified wages in this case equal $10,000 per employee per quarter for quarter 1, quarter 2 and quarter 3. The ERC in this case equals $10,000 × 70% × 3 employees or $21,000 per quarter. So $63,000 in total.

The startup business employee retention credit only applies to the third and fourth quarter of 2021. And the startup business employee retention credit tops out at $50,000 per quarter.

Example: A small construction company enjoys roughly $800,000 of average annual gross receipts. The owner invests in a rental property in late 2020 (so, a new trade or business.) The aggregated business doesn’t qualify for ERC refunds on the basis of either a substantial decline in gross receipts or a government closure order. But it does qualify because a new business started: the rental property. Say the construction company employed ten employees earning $12,000 each in quarter 3 and quarter 4 of 2021. The ERC in this case equals the greater of either $10,000 x 70% x 10 employees, or $70,000 for quarter 3 and $70,000 again for quarter 4., or $50,000 a quarter. In this case, the actual credit equals $50,000 a quarter for the third and fourth quarter, or $100,000 in total

ERC Deadline Depends on Year

The deadline to amend returns and claim the refund depends on the year.

For 2020 ERC claims, the ERC deadline was April 15, 2024. Accordingly, employers cannot still make claims based on 2020 wages.

For 2021 ERC claims, however, the ERC deadline is April 15, 2025. Employers can therefore make claims based on 2021 wages.

Thus, if you operated a small business in 2021, had employees, and never took advantage of the ERC program, reach out to your CPA or tax preparer now. You potentially have large ERC refund claims that will shortly expire.

Also if you started a new trade or business in 2020 or 2021, check in with your CPA or tax advisor. Many small business employers will also qualify for ERC refunds based on this lesser known method.

Tip: If your tax advisor wasn’t able to help you? Or if you’re a tax professional who didn’t gear up to provide this service? We’d be happy to talk about providing you or your client with help. The ERC refund program has restarted. You should have time to apply before the deadline. Contact us here: Nelson CPA inquiry form.

Two Final Words of Caution on ERC Claims

First, carefully vet anyone you engage for ERC work. Unfortunately, the program has been exploited by some (many?) unqualified ERC “mills” that have prepared allegedly fraudulent claims, often leading to significant consequences for businesses. Also if you believe you may have been a victim of ERC fraud, address the issue promptly. (The IRS has a voluntary disclosure program that allows businesses to rectify improper claims and potentially mitigate penalties. You can find more information about this process on the IRS Voluntary Disclosure Program webpage.)

But another caution or suggestion: Don’t not apply for ERC refunds if you legitimately qualify. The ERC has provided life-changing financial relief for many businesses. The window to claim these credits is still open. Therefore don’t miss your chance to file before the April 15, 2025 ERC deadline.

Other Resources

The rules for determining whether you had a substantial decline in gross receipts provide you more flexibility and wiggle room that I describe in the paragraphs above. This blog post gives more detail: 16 Ways of Qualifying for Employee Retention Credits.

More information about the startup business employee retention credit appears here: Startup Business Employee Retention Credit and here: The $100,000 Real Estate Employee Retention Credit Windfall.

Many houses of worship qualified for employee retention credits. If you participate in a faith community where your group was affected by government closure orders, you may want to research this more specialized situation. This blog post provides more details about what went on in Washington state and should be applicable to many other states as well: Washington State Houses of Worship All Qualify for Employee Retention Credits.

The post April 15, 2025 ERC Deadline Approaches appeared first on Evergreen Small Business.

The Section 183 Schedule C Problem

Christian Block CPA — Tue, 03 Sep 2024 19:25:40 +0000

Last month we blogged about potential issues with short-term rentals and Section 183. Section 183 is part of the tax law that says you cannot deduct expenses of activities you’re not engaging in for profit.

But that blog post got me thinking about the Section 183 Schedule C problem. Which is similar.

But before we dig into the details, let’s discuss briefly what Schedule C is. And then I’ll move on to discussing the Section 183 connection to Schedule C.

What is Schedule C?

Schedule C is a profit and loss schedule that is filed on the individual level to report business income. When you file Schedule C, you are telling the IRS you “engaged in an activity for profit.” An activity must be “engaged in for profit” in order to be considered a business.

Positive net income from Schedule C is ordinary income subject to self-employment and income tax. Negative net income from Schedule C offsets, or reduces, your other ordinary income. It also reduces the income taxes you pay.

What is the Section 183 Schedule C problem? Many of the Schedule C losses filed every year with the IRS do not rise to the level of an activity engaged in for profit. The activities, in other words, are hobbies. You do not want to report a loss from a hobby, receive a tax benefit, and end up under examination with the IRS.

If you are unsure whether your activity is a hobby or a business, the IRS lays out nine factors to help you decide. These factors will help clarify whether you operate an “engaged in for profit” business or a hobby. Whether you have a Section 183 Schedule C problem.

Let’s take a closer look at each factor.

1. Manner in Which a Taxpayer Carries on the Activity

This is the first factor detailed in the Section 183 Audit Technique Guide, and unsurprisingly, is very important. You want to operate your activity in a business like manner. Here are several business-y things you ought to consider implementing if you are not doing so already:

Separate personal and business finances. Use a dedicated business checking account and credit cards.
Use a real accounting system to track your income and expenses.
Write a business plan to show, specifically, how your business will make a profit.
If your business is not making a profit, change your operating methods to reach profitability.
Register your business and pay appropriate state level taxes and file all appropriate forms.

Again, running your activity like a legitimate business is very important to support the engaged in for profit intent. An activity run like a hobby, is probably a hobby.

2. Expertise of the Taxpayer or Their Advisors

You want to be an expert in your activity or listen to or hire experts that are. This doesn’t mean you need a Ph.D. or master’s degree, but you need to have knowledge of your activity and industry.

This makes intuitive sense. It would be impossible (or nearly) to make a profit operating an activity, or operating in an industry, you know nothing about.

Substantiate the steps you took to acquire knowledge. It might be reading books written by experts. Or taking seminars or classes. Maybe you really went to school and earned a Ph.D..

Relying on (and probably paying for) advice from experts like CPAs, attorneys, and consultants also help support your activity qualifying as an engaged in for profit business.

3. Time and Effort Expended in the Activity

The time expended in the activity should be consistent with an intent to make a profit. This is vague because there is no bright-line “time” test. And time doesn’t need to be exclusive or significant if competent management or employees are hired.

An examiner will look at the total time spent in the activity, plus time the taxpayer spends in other business activities and employment when weighing this factor.

The point is you want good documentation of time spent on the activity, whether it is you or someone else doing the work. The more time spent, the greater chance of your activity qualifying as an engaged in for profit business.

4. Expectation Assets Used in Activity May Appreciate in Value

The title sounds self explanatory but there is a bit of nuance. Appreciating assets, like property used in rental real estate, help to qualify an activity as an engaged in for profit business.

The nuance? The IRS is okay with your activity realizing losses year after year, as long as there is the expectation that, eventually, the activity pays off and generates positive income. The regulations even indicate a “reasonable expectation of profit is not required.”

I mentioned real estate earlier; this is also common in intellectual property. The goal is to hold the asset long enough to realize substantial appreciation.

In an examination, you want to point to supporting documents like appraisals or comparables. Something that helps substantiate the appreciation in value.

Note: Different rules apply for farming, as discussed a bit later

5. Success of Taxpayer in Carrying on Other Similar or Dissimilar Activities

A history of successful entrepreneurship helps to qualify your activity as an engaged for profit business. I think a history of unsuccessful entrepreneurship helps support this too. Not every business venture ends up being profitable.

If your activity isn’t doing well? Course correct and change things up to try and make it successful. And document the changes you make.

6. Taxpayer’s History of Income or Losses with Respect to the Activity

I’m going to paraphrase the regulations here. They say, basically, that losses during the start-up stage of an activity may not necessarily indicate the activity is not engaged in for profit. But, continued losses beyond the start-up stage, if not explainable, may indicate the activity is not being engaged in for profit.

If your activity is losing money year after year, you want to explain why. Market conditions, disease, theft, natural disaster, fire, etc. are all good explanations of why a business might not be profitable.

7. Amount of any Occasional Profits that are Earned

Section 183 gives a taxpayer a presumption of profit intent if gross income from an activity exceeds the deductions from the activity for at least three out of five taxable years. Most new activities will struggle to meet this.

As I said above, the expectation of profit is not required for your activity to be considered an engaged in for profit business. And occasional profits, especially in highly speculative ventures, indicate the activity is engaged in for profit.

You absolutely should not manipulate income or expense numbers to artificially show a profit to meet the safe harbor (more on the safe harbor below). An IRS examiner will almost surely catch this.

An IRS examiner will compare income and expenses between periods to find deviations. They will also substantiate the income and expenses reported on the tax return. Phantom income, or reduced or non-reported expenses, will be easy for an examiner to find.

8. Financial Status of the Taxpayer

A lack of income or capital from other sources indicates an activity is an engaged in for profit business. If your Schedule C activity is your only source of income, most likely you have an engaged in for profit business and not a hobby.

If you have other major sources of ordinary income, you want to carefully go through each of these factors to determine how to accurately report your activity on your tax return.

9. Elements of Personal Pleasure

We have reached the final factor, and this one is quite subjective. What is pleasurable to one person might be a chore for someone else.

You want to minimize the amount of personal pleasure in your activity as much as possible. Let me explain.

An activity will not be treated as not engaged in for profit merely because the taxpayer has motivations other than solely making profits. There will always be other activities which yield higher returns. And those activities might make you miserable. There should be a balance of enjoyment and financial success, not a narrow focus on one or the other.

There are a handful of other points I want to discuss before we wrap up.

Farming Activities

This blog post is tailored for Schedule C activities, but Section 183 is particularly consequential for farming activities that are reported on Schedule F. Section 183’s intent is to prevent taxpayer’s engaged in farming activities from offsetting farming losses with land appreciation.

Remember factor 4? It doesn’t apply here, at least with land. The regulations say the farming and holding the land for appreciation constitute one activity, but only if the farming activity reduces the net cost of carrying the land. In other words, the farming itself needs to be profitable. Land appreciation has no weight in the determination of a farming activity being an engaged in for profit business.

Safe Harbor

Most of Section 183 is subjective, requiring taxpayers and examiners to look at the facts and circumstances of each activity. But, fortunately, there is one quantitative way of determining if your activity rises to the level of an engaged in for profit business.

There is a presumption an activity is engaged in for profit if:

The activity has net profits for three out of five consecutive tax years, or
In the case of breeding, training, showing or racing horses, the activity has net profits for two out of seven consecutive tax years.

The IRS can still dispute your activity is really a hobby and not a business, but the burden rests on the IRS to prove it.

This safe harbor is difficult to meet for business that are still in their “start up” phase. Fortunately, there is a an election to postpone the determination, which I cover next.

Election to Postpone Determination

Form 5213, Election to Postpone Determination, can be filed to delay an IRS determination as to whether an activity is engaged in for profit. You can find the form here.

You want to file this form in the first year or two after beginning your activity if you expect to realize losses. When filed, the IRS will postpone their determination until after the end of the 4th consecutive tax year, or 6th year if your activity is farming.

The form must be filed within three years of the due date of the first tax return. If you receive a Statutory Notice of Deficiency from the IRS (the notice disallows hobby loss deductions) you must file within 60 days.

Final Thoughts on the Section 183 Schedule C Problem

The IRS estimates roughly 70-80% of Schedule C filers with losses are really hobbies. This means Schedule C’s with losses are exceptionally vulnerable to IRS examinations.

You want to be confident your activity rises to the level of “engaged in for profit” before you claim a Schedule C loss. And be ready to defend your position with the IRS. If you are unsure after reading this, you may consider reaching out to a tax professional for help.

The post The Section 183 Schedule C Problem appeared first on Evergreen Small Business.

How EV Credits Work

Christian Block CPA — Mon, 02 Oct 2023 14:59:52 +0000

Do you plan on purchasing a new vehicle within the next ten years? If the answer is yes, and good chance it is, you want to know how EV credits work.

Really, the correct term is “Qualified Plug-In Electric Drive Motor Vehicle Credits,” which is quite a mouthful. For purposes of this blog post, I’m going to call them EV credits.

Admittedly, I have not personally owned an EV or seriously shopped for one. However, electric motor and battery technology is improving rapidly, the charging network is growing, and the incentives are great, if you can make them work.

I’m going to discuss how EV credits work and how they can benefit, and possibly influence, your next vehicle purchase.

What is an EV Credit?

Put simply, the US government gives you money, in the form of a tax credit, for purchasing a qualified electric vehicle. The credit has been around for a while. Maybe you’ve already gotten one.

But, the rules changed in the summer of 2022 with the passing of the Inflation Reduction Act (IRA). And the changes make the credit less accessible to many taxpayers.

So let’s briefly discuss how EV credits worked before the IRA (pre 2023), and how EV credits work starting in 2023.

EV Credits 2022 and earlier:

If you purchased a qualified electric vehicle, you could claim a non-refundable credit of $2,917 for a vehicle with a battery capacity of at least 5 kilowatt hours, plus $417 for each kilowatt over 5 kilowatts, up to a maximum of $7,500. (Note that “non-refundable” means you can’t get a credit for more than the income taxes you otherwise owe.)

Criteria for EV to qualify:

purchased brand new
have an external charging source
used in the United States primarily
have a gross weight rating of less than 14,000 lbs
not purchased to resell
manufacturer can’t sell more than 200,000 EV’s in the U.S.

BTW, GM sold 200,000 EV’s by Q4 2018, with Tesla reaching 200,000 by Q1 2020 and Toyota reaching 200,000 by Q2 2022. These brands were ineligible for any more credits under the old rules.

EV Credits 2023 and later:

The maximum credit is still a non-refundable $7,500, but the EV credits work differently with the passing of the IRA. The IRA broadened the range of vehicles that qualify, but restricted the amount of taxpayers able to take them (more on this later).

First, lets break down the new rules for brand new EV’s.

Criteria for new EV to qualify:

purchased brand new
have an external charging source
used in the United States primarily
have a gross weight rating of less than 14,000 lbs
not purchased to resell
two components; $3,750 credit for critical mineral requirements (critical minerals extracted or processed in the US) and $3,750 for battery component requirements (battery produced or assembled in US)
produced by qualified manufacturer
final assembly in North America

Number of units sold is no longer a limitation, and, in an effort to stimulate US manufacturing, the final assembly of a qualified EV must be completed in North America.

The website fueleconomy.gov has a neat search engine to look up qualified EV’s. You just input year/make/model to check eligibility. You can also find a list of manufacturers and qualified models on the IRS website here. The selling dealer is also required to provide you with a written statement detailing, under penalties of perjury, the maximum allowable EV credit for the vehicle you are buying.

The IRA also opened up the EV credit to used vehicles, and is limited to $4,000.

Criteria for a used EV to qualify:

must be the first sale other than to the original owner
vehicle must be at least two years old
had to be a qualified EV when sold new
must be sold by a dealer
have a gross weight rating of less than 14,000 lbs
purchased in the United States
credit is limited to 30% of purchase price
purchase price must be less than $25,000
can be claimed once every three years

Limitations

Earlier I mentioned EV credits will be more restrictive for a lot of taxpayers. Gone are the days of trading in your top of the line, six figure Tesla Model S every year for the newest latest and greatest, and subsidizing the initial cash outlay with a nice big $7,500 credit at tax time.

There are now MSRP restrictions and adjusted gross income (AGI) restrictions we need to cover. Let’s begin with the MSRP restrictions.

MSRP Limits:

You cannot claim an EV credit if MSRP exceeds the following amounts:

Vans – $80,000
Sport Utility Vehicles – $80,000
Pickup Trucks – $80,000
Other – $55,000

These prices might seem high, but it is easy to cross the threshold when you start adding options to the base price.

For fun, I went to Ford’s website to build a new Lightning truck. The base price of the Lariat model starts at $69,995. Add in the extended range battery option and a tonneau cover, and the MSRP jumps to $81,040, making this EV ineligible for any credits. I guess you’d want to wait on the tonneau cover and buy one with your $7,500 tax credit the following year.

Please note, MSRP does not include tax, title, license, or dealer mark-up fees. So good news there.

Now let’s cover the new AGI limitations:

AGI Limits:

You cannot claim an EV credit if your AGI exceeds the following amounts:

Married Filing Jointly – $300,000
Head of Household – $225,000
All other taxpayers – $150,000

These are respectable income levels, yes. But I don’t think it is a stretch to assume most (or at least many) people purchasing brand new EV’s likely have an AGI above the threshold. And there is no phase out, you either qualify or you don’t.

Final Thoughts:

Hopefully no one purchases a new EV and gets surprised they don’t qualify for EV Credits when they file their tax return the following year. This is especially true for the early EV adopters that have already taken EV credits and are not aware the rules have changed, substantially, for 2023.

If the EV credit is a major deciding factor in your car purchasing process, you want to to know how EV credits work. If you follow the rules and don’t make too much money, you should get a nice big tax credit.

Make sure to read our post “Inflation Reduction Act: Tax Credits for Homeowners” for information on additional clean energy property credits.

The post How EV Credits Work appeared first on Evergreen Small Business.

How IRS Audits Work

Christian Block CPA — Wed, 01 Feb 2023 16:35:44 +0000

Audit anxiety is something nearly every taxpayer has in common. But, have you ever considered how IRS audits actually work?

The IRS processes millions of tax returns each year that are never subject to additional examination or audit. Obviously, it is in your best interest to report things accurately and hope to stay off the IRS’s radar. Unfortunately, that isn’t always possible. Being selected for an audit does not inherently imply guilt or deception, and can happen to anyone that files a tax return.

I thought this would be a good topic of discussion as we go into the 2023 tax year. The IRS announced they are hiring 5,000 new agents in 2023, so this is especially relevant. Therefore, I will discuss how audits work, how returns are selected for audit, different types of audits, and ways to keep yourself protected if you are audited.

First, let’s go over some interesting statistics found in the 2021 IRS Service Data Book.

Statistics

The chances of being audited are pretty low. The IRS had 78,661 full time employees in 2021, and IRS employees dedicated to enforcement are only around 45%. Contrast this with the 167,915,264 individual 1040 tax returns filed in 2021. Consequently, the IRS has an estimated one IRS enforcement agent for every 4,800 individual 1040 returns filed, an extremely low ratio of agents to returns.

These enforcement agents don’t just look at 1040’s, either. Let’s add the 12,209,623 business entity returns filed in 2021 to our numerator. That equals roughly one IRS enforcement agent for every 5,200 returns. I won’t bother factoring estate, excise, payroll, tax exempt, and trust tax returns into the calculation, you get the idea.

Return Selection

Most tax returns go through an automated, electronic system called the “Discriminant Function,” or “DIF” for short. The IRS calculates the DIF score by weighting and adding together return characteristics. The higher the DIF score, the higher the potential for audit. Every 1040 return gets a DIF score. Additionally, S Corp and C Corp returns with assets less than $10,000,000 get DIF scores. The IRS uses other techniques to select returns for audits as well.

The IRS matches information in their files to information reported on your tax return. For example, a taxpayer receives a 1099-INT after cashing in a savings bond. If the taxpayer fails to report the interest or reports a different amount than what the 1099-INT shows, chances are this return will get selected for an audit.

Confidential informants can tip off the IRS, resulting in return selection. So can related party transactions with a taxpayer already under examination.

Certain schedules are high risk and can trigger scrutiny from the IRS. Form 8283 Non-cash Contributions, Form 8275 Disclosure statement, and Form 8082 Notice of Inconsistent Treatment are a few examples that can trigger a closer look at your return.

Per the 2021 IRS Data Book, here are some current trends the IRS is looking closely into:

Too many round numbers and deductions that offset large income items
FBAR reporting issues related to perceived under-reporting of foreign income
Virtual currency
Passive vs. non-passive flow through income
Real estate professional positions on rental real estate
Worker classification – employee vs. contractor
Matching source documents to returns, as mentioned above

But not all audits are equal. The intensity varies. So lets discuss the different types and cover some details of how IRS audits work.

Correspondence Examination/Audit

Correspondence audits are the most common, and there is a good chance you may have already had one. Have you ever received an IRS notice for your tax return? Maybe you failed to make estimated tax payments and received a notice asking you to pay interest. That is a correspondence audit, and usually not a big deal.

The IRS conducts these audits entirely through the mail. The IRS will make an adjustment or correction to a return, indicate the change, and calculate additional tax or refund due. Then, the taxpayer can either pay the additional tax or collect their additional refund if they agree with the adjustment.

Taxpayers can request more information or disagree with the change or correction and propose their own. The taxpayer should support their position with additional supporting documentation in their IRS response letter.

Sometimes taxpayers avoid these letters and take no action; not a recommended strategy. The IRS will send a second notice of deficiency letter, often referred to as a 30 day letter, requesting payment, when no action is taken by the taxpayer.

If no response is sent within 30 days, the IRS issues a Statutory Notice of Deficiency, and if the taxpayer still disagrees, they can file an appeal with the tax court.

Office Examination/Audit

A Tax Compliance Officer (TCO) conducts this type of audit in person at an IRS office to resolve issues too complex to resolve by mail. Typical issues include large itemized deductions, travel expenses, and misclassified income from rents and royalties.

The TCO will send the taxpayer a letter requesting an appointment and the type of documentation they need to bring to substantiate data reported on the tax return.

At the appointment, the TCO will collect oral testimony and physical documentation and will make one of three determinations; 1.) No change 2.) Deficiency 3.) Over-assessment.

Finally, lets discuss the third type of audit, the Field Audit.

Field Examination/Audit

A TCO conducts this type of audit at the location where the original books, records, and source documents are maintained, generally the taxpayer’s home or place of business. As you can probably guess, they are the least common type of audit. 21% of 2021 audits were field audits, per the 2021 IRS Service Data Book.

Spending the day in an office with an IRS agent is nobody’s idea of fun, however, these audits can produce more favorable results for the taxpayer than the other audit types.

Markedly, here are a few tips if you find yourself in a field audit:

Be polite and friendly
Know your taxpayer rights
Avoid offering more information than needed
Be honest
Have your records organized and easily accessible
Never leave the examiner alone
Negotiate your positions

Appeals

A taxpayer can appeal if no agreement is reached. You must submit a formal written protest if the total amount owed exceeds $25,000, or the appeal is for a partnership, S Corp, or tax exempt organization.

There is no IRS form for a written appeal, but, it needs to include the following information:

Statement the taxpayer wants to appeal the examiner’s findings to the appeals office
Taxpayer’s name, address, and phone number
A copy of the letter showing the proposed changes
Tax periods involved
Schedule of adjustments the taxpayer disagrees with
Statement of fact supporting the taxpayer’s position
Statement outlining the law the taxpayer relies on
Declaration under penalties of perjury attesting the statement of facts as true and accurate

Protection

Now lets discuss some different expenses and how to ensure they are substantiated.

Trade or Business Expenses

Before taking a deduction, you want to ensure your activity rises to the level of a trade or business. 26 U.S. Code § 162 allows a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. A taxpayer must continuously and regularly be involved in the activity for the primary purpose of making a profit.

The regulations provide a list of relevant factors when considering if the activity rises to the level of a trade or business, including:

Expertise of the taxpayer
Time and effort expended on the activity
History of income and losses with respect to the activity
Whether elements of personal pleasure or recreation are involved in the activity
Manner in which the taxpayer carried on the activity

Example

Lets explore this a bit more and use myself as an example. I like fixing up cars, which inevitably ends up with me having more money in them than I can sell them for. I also have a job as a CPA and know this car hobby is not a money making endeavor. There is no profit motive, no history of success, and is done purely for personal pleasure. It surely does not rise to the level of a trade or business, therefore I cannot report the activity on my 1040 tax return and claim a loss that offsets my CPA income.

The scenario is probably different if I am working on other people’s cars for money on the side. I would need to report the income, and I would certainly have expenses (tools, supplies, etc.) that are legitimate business deductions.

In summary, be careful not to take losses and deductions on an activity the IRS would classify as a hobby and not a business.

Travel Expenses

You need to substantiate business expenses, clearly, but this is especially true with travel expenses. Travel expenses aren’t as straight forward as say, a rent payment to the landlord of a retail store, so extra diligence must be used when deducting travel.

To qualify for a deduction, travel expenses must be:

Reasonable and necessary
Incurred while traveling “away from home”
Directly related to the conduct of the taxpayer’s trade or business

Three factors are used to determine a taxpayer’s “tax home:”

Whether there existed a business connection to the location of the home
Were duplicate living expenses incurred while traveling and while maintaining the tax home?
Whether personal connections exist to the tax home

Commuting to the office is not a qualified travel expense. And if your place of employment is somewhere other than your residence, and you decide not to move your residence to your work location, living and travel expenses getting to your job are not deductible either.

Mixed purpose travel gets murky too. It must be primarily related to the taxpayer’s trade or business to be deductible, with time spent on business being the most relevant factor. If you have business seminars in Hawaii for four days, and you stay for two additional vacation days, that probably counts. Reverse the business and personal time, that probably doesn’t count. And there must be a bona-fide business purpose for a spouse’s travel expenses to be deductible.

Charitable Contributions

If you generally have enough deductions to itemize, chances are you have probably taken a charitable contribution deduction. And you want to have very good records to substantiation the contribution.

For cash contributions of $250 or less, you need to have one of the following:

Canceled check
Bank or credit card statement
Receipt from the organization
Paystub if contributed through a payroll deduction

Cash contributions greater than $250 should, ideally, be substantiated with a receipt from the organization detailing the dollar amount, date, and whether any goods or services were provided to the donor.

Worker Classification Audits

The last topic I want to discuss is worker classification audits. Employers have a financial incentive to misclassify employees as independent contractors because costs and record keeping is lower. Workers have an incentive to be classified as independent contractors because they can deduct expenses not available to employees.

The IRS uses a three-factor test to determine if a person is an employee or a contractor:

Behavior Control – Does the employer provide training to the worker? The more training provided, the more control the employer exerts over the worker.
Financial Control – Key factors include the workers investment in the services they provide, other services they make available to the market, and the opportunity for their own profit with respect to their services.
Relationship of Parties – Relationship factors include the extent to which either party can terminate the relationship, the party’s contractual relationship, and the employer providing, or not providing, benefits typically provided to an employee.

Misclassification of a worker as an independent contractor can have large consequences to the employer. The employer may end up liable for payroll taxes on all open tax years, federal income tax that should have been withheld from the workers paychecks, and any state income taxes that should have been paid on the worker. Consequently, only one or two worker misclassifications could lead to thousands of dollars of tax owed.

Final Thoughts

The goal of this blogpost was to (hopefully) relieve some anxiety by covering how IRS audits work and what you can expect if you ever find yourself in an audit situation. You should not feel bad if it happens to you. But, you want to be smart and methodical on how your respond to and deal with the IRS.

Good record keeping, honesty, and a little bit of knowledge will go along way on keeping yourself protected.

We have some additional posts on IRS audit prevention tips, real estate professional audit troubles, and surviving short term rental audits that contain great information if you want even more detail.

The post How IRS Audits Work appeared first on Evergreen Small Business.

The Self-Rental Loophole

Christian Block CPA — Thu, 01 Sep 2022 22:33:32 +0000

Long ago, there was no tax code that differentiated ordinary income from passive income or ordinary losses from passive losses. Life was good for taxpayer’s and their CPA’s in the know. People freely set up tax shelters to reduce their taxable income while still navigating within the laws of the IRS. Primarily by reducing their ordinary income with passive losses.

Most of the CPA’s practicing back then have probably long since retired, and tax law has since changed considerably. And not for the benefit of the taxpayer.

Fortunately, one of these tax shelters still exists. One that lets you turn a passive loss into an ordinary loss by utilizing a self-rental property. But before we fall down the rabbit hole, lets brush up on some history for more context.

Passive Loss History

When I said long ago, I meant 1986. This is when US Code § 469, Passive Activity Losses and Credits Limited, was passed. The statute defines passive income as rental real estate and any activity in which a taxpayer doesn’t materially participate in. They closed the loop hole, sort of.

There was still no statutory rule for self-rental real estate, and taxpayers were using self-rental income to absorb other passive losses. And owners could optimize their self-rental income either up or down to take 100% of their passive losses that otherwise would be unutilized and carry forward. This carried on until 1992.

Regulation 1.469-2 came out and stipulated rental income is not passive if it comes from an activity a taxpayer materially participates in. This is known as the self-rental trap. Income from a self-rental now becomes ordinary income and rental losses remain passive. And this makes using a self-rental as a tax shelter very difficult.

Example 1 of the Self-rental Loophole

Lets go through a simple example to show why this can be so problematic.

Year One

Jennifer owns 100% of her own law firm, taxed as an S Corporation. She also co-owns a building and rents the whole building to her law firm. At the end of the year, her law practice has $200,000 of net income and her portion of the rental loss is $50,000.

You would assume she can net the two amounts and pay tax on $150,000, but that’s not how it works. She has a passive loss of $50,000 that she cannot take because she has no other passive income. Ultimately, she has $200,000 of taxable income.

Year Two

Jennifer has net income from the law firm of $250,000, her portion of the self-rental loss is $50,000, and she purchased a single family residence she rented out with net income of $20,000.

She is able to net the $20,000 of rental income with $20,000 of loss from her self-rental (because self-rental losses are passive). She still cannot take a self-rental loss because she has extinguished her passive income.

Her net income is equal to the $250,000 from the law firm, and her loss carryforward is now equal to $80,000; $50,000 from year 1 and $30,000 from year 2.

As you can see, Jennifer isn’t benefiting from her self-rental since she cannot take the losses. But lets look at another way she can do this.

Grouping your Active Trade or Business with your Self-rental

Regulation 1.469-4 that allows similar activities that constitute an appropriate economic unit to be grouped as a single activity for purposes of the passive activity loss rules. The taxpayer may use any reasonable method in grouping activities by applying the relevant facts and circumstances, and the regulation gives the most weight to these 5 factors:

Similarities and differences in types of trades or businesses;
The extent of common control;
The extent of common ownership;
Geographical location;
Interdependencies between or among activities

Typically you are not able to group rental activities with other trade or business activities. However, you can if the rental activity and business activity constitute an appropriate economic activity, AND:

The rental activity is insubstantial in relation to the trade or business activity;
The trade or business activity is insubstantial in relation to the rental activity; or
Each owner of the trade or business activity has the same proportionate ownership interest in the rental activity, in which case the portion of the rental activity that involves the rental of items of property for use in the trade or business activity may be grouped with the trade or business activity.

Grouping Statment

Once you have determined you can group your rental activity with your business activity, Rev Proc 2010-13 says you need to file a grouping statement with your tax return.

In summary, the statement must identify the names, addresses, and employer identification numbers (if applicable) for the trade or business activities or rental activities that are being grouped as a single activity. You must declare the grouped activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of Section 469.

Example 2 of Self-rental Loophole

In our example earlier, Jennifer wasn’t a 100% owner in her law firm AND her self-rental property. Lets go back to that example assuming she owns 100% of both and makes a grouping election on her tax return.

Year One

Jennifer owns 100% of her own law firm, taxed as an S Corporation. She also owns 100% of a building and rents the whole building to her law firm. At the end of the year, her law practice has $200,000 of net income and her rental loss is $50,000.

Now she gets to net the rental loss with her business income and has taxable income of $150,000. Assuming her marginal tax rate is 32%, this saves her $16,000 in taxes compared to our earlier example!

Year Two

Jennifer has net income from the law firm of $250,000, self-rental loss of $50,000, and she purchased a single family residence she rented out with net income of $20,000.

First, she nets the rental loss with her business income, for a total of $200,000. Assuming she doesn’t have any passive losses, she picks up another $20,000 of taxable income from the new rental, for total taxable income of $230,000.

The increased income in year 2 puts her marginal rate at 35%. Since her taxable income is $20,000 less than the previous example, her tax savings equal $7,000!

A Trick for Bigger Rental Losses

Your business is doing well and you know you will have record net income, and also record income taxes. Fortunately, you already have a self-rental and have been converting the losses from passive to ordinary because you made a grouping election. Now this idea, do a cost segregation.

A cost segregation breaks down real property, which is depreciated over 39 years, into personal property, which is often depreciated entirely in one year.

A building with a depreciable basis of $500,000 might accelerate up to $150,000 of depreciation in one year. That is adding a $150,000 deduction to a return, and a tax savings of probably more than $50,000!

It is a great way to load up deductions and offset business income in a windfall year.

The post The Self-Rental Loophole appeared first on Evergreen Small Business.

Don’t Forget About The Work Opportunity Tax Credit!

Christian Block CPA — Wed, 01 Jun 2022 15:45:10 +0000

The Work Opportunity Tax Credit, or WOTC for short, gets little attention these days. COVID relief programs such as the Paycheck Protection Program and Employee Retention Credits allowed businesses to claim huge amounts of money, much larger than the WOTC.

But those programs have now ended. While the WOTC is still around. Accordingly, small business owners should be aware of it. So, let’s run through what the WOTC is and how it works.

Work Opportunity Tax Credit Background

The WOTC is a tax benefit to encourage employers to hire targeted groups that face barriers to employment. Once set to expire after 2019, the Taxpayer Certainty and Disaster Tax Relief Act of 2020 extended the WOTC through 2025.

In general, the WOTC is equal to 40% of up to $6,000 of wages paid to an individual who is in their first year of employment, performs at least 400 hours of services, and falls into one of these ten qualifying groups:

Temporary Assistance for Needy Families (TANF) recipients,
Unemployed veterans, including disabled veterans,
Formerly incarcerated individuals,
Designated community residents living in Empowerment Zones or Rural Renewal Counties,
Vocational rehabilitation referrals,
Summer youth employees living in Empowerment Zones
Supplemental Nutrition Assistance Program (SNAP) recipients,
Supplemental Security Income (SSI) recipients,
Long-term family assistance recipients and
Long-term unemployment recipients.

The last group is interesting since so many people have been out of work due to the Covid pandemic. A long-term unemployment recipient is someone out of work for 27 consecutive weeks who collected unemployment benefits at least part of the time. Many people rejoining the workface are probably in this group.

Qualified Wages

Wages subject to Social Security and Medicare taxes are qualified wages for the WOTC. But qualified wages can be zero if:

The employee worked less than 120 hours,
The wages were used for another employment credit (ERC, Qualified Sick and Family Leave, etc.)
The employee worked for you previously (be careful if you furloughed employees during the pandemic and rehired them),
The employee is your dependent,
The person is a replacement employee during a strike or lockout,

Now let’s discuss the mechanics of how to claim the credit.

State Paperwork

The first step to claiming the credit is filling out Form 8850, Pre-Screening Notice and Certification Request for the Work Opportunity Credit. You have 28 days from the hire date to file this with your state. The form asks the employee if they fit into one of the ten groups mentioned above, along with their name, address, and social security number. Consider making this form part of your standard onboarding process so you don’t forget about the work opportunity credit!

If the employee fits into one of the qualifying categories, the next step is to complete ETA 9061, Individual Characteristics Form. It is similar to Form 8850 with a bit more detail.

When both forms are completed they are sent to the state. We send the forms to the Employment Security Department in Washington State, for example.

The state then makes a determination if that employee qualifies. A couple points on that…

First, the state may require additional documentation. To qualify a veteran in Washington you need to submit the applicant’s DD214 or a letter from the Department of Defense or National Personnel Records that show active duty start and ends dates. For a disabled veteran in Washington you must also submit a Veterans Administration Disability Letter.

Second (at least in Washington), you can file an appeal if your claim is denied. Probably you will need to supply additional supporting documentation. You may need to include a copy of the applicant’s SNAP benefits letter, for example.

Claiming the Work Opportunity Tax Credit

Assuming the state approves your applicant, the credit is claimed when you file your annual income tax return on Form 5884, Work Opportunity Credit. Corporations claim the credit at the entity level and pass-through entities claim the credit at the individual level.

The credit is non-refundable, meaning you cannot claim it in a year without sufficient tax liability. However, the IRS lets you carry any unused credits forward for 20 years. Chances are, you will get to utilize it at some point if you find yourself unable to claim it in year one.

Higher Limits for Veteran Employees

Earlier I mentioned the credit is generally equal to 40% of up to $6,000 of qualified wages per employee, or $2,400. Certain qualified veterans have considerably higher limits as follows:

$12,000 of wages ($4,800 credit) if the veteran is entitled to compensation for a service-connected disability and hired not more than 1 year after being discharged or released for active duty
$14,000 of wages ($5,600 credit) if the veteran is unemployed for a period(s) totaling at least 6 months in the 1-year period ending on the hiring date
$24,000 of wages ($9,600 credit) if the veteran is entitled to compensation for a service-connected disability and has been unemployed for a period(s) totaling at least 6 months in the 1-year period ending on the hiring date.

Final Thoughts

The WOTC has been easy to forget about lately. It was going to end in 2019. Then the PPP and ERC programs overshadowed it.

Those bigger programs ended in 2021, but the WOTC is still soldiering on. It might not be as sexy, but saving $2,400 or $4,800 per year is nothing to sneeze at.

This fairly straight forward credit should not be forgotten. So I will say it one more time: Don’t forget about the Work Opportunity Tax Credit!

The post Don’t Forget About The Work Opportunity Tax Credit! appeared first on Evergreen Small Business.

Why Profit Distributions Usually Don’t Get Taxed

Christian Block CPA — Tue, 01 Mar 2022 22:39:39 +0000

We encounter a common misconception from flow-through business owner clients every year and I want to try and clear the air.

That misconception? That distributions from partnerships, S corporations and other pass-through entities get taxed. (They usually don’t, by the way.)

The misconception regularly leads to a minor financial tragedy. Because often times a business owner sits on a huge cash balance in their business checking account. That money, they actually need to use on, you know, life things like rent or mortgage payments, insurance, taxes, day care, food, clothing, vacations and so forth.

But the business owner doesn’t want to distribute the profits. Because she or he fears paying tax on the money. Which is ironic. And wrong.

So this article explains what’s going on here. I’ll discuss what you get taxed on. When you get taxed. I’ll explain how the mysterious thing the accountants call “basis”works. And then I’ll end with a warning about a common error you want to avoid because it unnecessarily triggers additional taxes.

To start, a quick discussion about taxable income and basis…

Taxable Income from Your Business

Each business entity type calculates taxable income in basically the same way. Taxable income equals taxable revenues minus deductible expenses. This number gets reported in box 1 of the K-1 form you receive from the business, which in turn gets plugged into and taxed on your individual 1040.

For example, you start a business at the beginning of the year and collect $100,000 of revenues and pay $50,000 of deductible expenses. Your business’s taxable net income at the end of the year equals $50,000. Suppose you only used the revenue you collected to pay the business expenses and now have $50,000 in your business checking account.

Money left over in the bank is the confusing part. Because you might think you avoid taxes on this money if you leave it in the business. And that you only pay taxes on the money when you take it out of the partnership or S corporation or sole proprietorship.

But that’s not the way the accounting works. You pay taxes on the business profit. Not, usually, on the distributions of profit paid to an owner.

Now let’s have a quick chat about basis.

Basis and Why It Matters

I want this discussion to remain as simple as possible. (If you would like to dive deeper, you can read the statute for S Corporations here and the statute for Partnerships here.) But to generalize, a business owner’s basis consists of the cash and adjusted-for-depreciation cost of property contributed to a business, adjusted for certain items that increase and decrease said basis.

Let’s look at the common increases and decreases…

Increases to Basis:

Contributions of cash and property into the business
Taxable income from the business
Sale of appreciated property the business owns
Non-taxable income (think PPP and EIDL grants)
Recourse and qualified non-recourse debt for partnerships
Partner loans to the business
Credit cards used for business issued personally to the shareholder for S Corporations

Decreases to Basis:

Distribution of cash and property from the business
Loss from the sale of property the business owns
Non-deductible expenses (meals, entertainment, etc.)
Decreases in partner loans and decreases in recourse and qualified recourse debt
Payments made by the business to pay off S Corporation owner owned credit cards

The general rule: As long as you have basis, you pay no taxes on distributions. Which is why basis matters.

Examples Show How Mechanics Work

But the problem here? Basis constantly fluctuates from year to year. That reality means you or your accountant need to carefully track the basis each tax year in order to know whether distributions trigger tax.

Let me show you some examples so you see how this works.

Example 1

Let’s circle back to our example where you earned $50,000. Pretend you spent no money funding the startup for this business because there is little to no overhead.

Your basis at the beginning of the year is $0.00. The $50,000 of net income increases your basis by $50,000. Now what?

You can take the total $50,000 as a distribution and pay $0.00 in taxes. In this case, your basis at the beginning of year 2 is $0.00. Remember, your basis increased by the net income of $50,000 (what you paid tax on), and decreased by the distribution of $50,000.

Alternatively, you decide to leave the whole $50,000 in the business in year 1. Maybe you are living off of savings.

But remember, you are still taxed on $50,000 of income, regardless of where the money goes.

By the way? If in year 2 the business loses $25,000 and you never extracted any profits from year 1? You can still distribute $25,000 to yourself tax free at the end of the year, so year two, ending year 2 with $0.00 basis.

Example 2

Another example. You start your business with a personal contribution of $100,000. You use the money to buy some equipment, lease an office space, and hire an employee. Year 1 net income equals $200,000, and you distribute $100,000 to yourself to pay your personal expenses. Your basis looks like this:

Year 1

Capital Contribution	$ 100,000.00
Net Income	$ 200,000.00
Distributions	$ (100,000.00)
Year 1 ending basis:	$ 200,000.00

You pay tax on $200,000 of income, the distribution is tax free, and you end the year with $200,000 of basis.

Year 2 profits are down a bit, and net income equals $50,000 for the year. You took the same distribution of $100,000, and your basis at the end of the year is $150,000.

Year 2

Beginning Basis	$ 200,000.00
Net Income	$ 50,000.00
Distributions	$ (100,000.00)
Year 2 ending basis:	$ 150,000.00

Year 3 you try to aggressively expand and require more capital to do so. Your business secures a $500,000 loan to pay for more equipment, employees, advertising and general overhead. This year you are also purchasing an investment property to take advantage of the deductions offered by a short term rental.

The aggressive expansion is a success, and you end the year with $200,000 of net income. But you had to distribute $400,000 to yourself to put a down payment on your rental property and pay the same living expenses. Whoops, now part of your distribution is taxable. Lets break it down:

Year 3

Beginning Basis	$ 150,000.00
Net Income	$ 200,000.00
Distributions	$ (400,000.00)
Year 3 ending basis:	$ –

You probably noticed that doesn’t foot out. And it’s because basis can’t dip below $0.00.

In this third year, you are taxed on $200,000 of net income (taxed at ordinary income tax rates) and are left with $350,000 that can be distributed tax free.

But the additional $50,000 of distribution? This is called “a distribution in excess of basis.” The $50,000 of distribution which you do not have basis for becomes a capital gain and gets taxed at capital gains rates.

Guaranteed Payments or Distributions?

One final important point. I want to discuss a mistake we often see on partnership returns.

Distributions to partners are commonly but incorrectly coded as guaranteed payments. And this can have negative income tax consequences.

But first, a little background on guaranteed payments. A company uses guaranteed payments to incentivize a potential partner to join a partnership, most often in professional service firms. The partnership pays a specified amount to the partner each year, regardless of how the company performs. Their payment is “guaranteed,” kind of like a salary.

However, a majority of partnership agreements I read have no clause for guaranteed payments. And still, tax preparers frequently incorrectly code distributions as guaranteed payments. Why does this matter?

Reason #1

Guaranteed payment income is not eligible income for the Section 199A, Qualified Business Income Deduction (QBID). The partner forfeits a 20% deduction because their distribution is coded incorrectly.

Reason #2

Limited partners are not subject to self-employment taxes. But guaranteed payments are subject to self-employment taxes. A limited partner unnecessarily pays an additional 15.3% in taxes when their distribution is incorrectly coded as a guaranteed payment.

Pretend a tax preparer codes a $50,000 distribution as a guaranteed payment. The partner pays income tax on $50,000 instead of $40,000 by missing out on QBID. Assume a 25% tax rate and that’s an additional $2,500 they pay in income taxes.

Additionally, the partner pays $7,065 ((92.35% x 50,000) x 15.3%) of self employment tax on the $50,000!

The point I’m trying to make is you want to get this right for partners.

Final Thoughts

I hope this clears up some confusion on what actually gets taxed when a flow-through business generates profits. And also that the discussion not only eases your anxiety about taking distributions–but allows you to avoid the one or two bookkeeping blunders that trigger tax.

The post Why Profit Distributions Usually Don’t Get Taxed appeared first on Evergreen Small Business.

Biden Estate Tax Hikes

Christian Block CPA — Thu, 19 Aug 2021 22:33:02 +0000

The big news in the tax world lately has been the President Biden and the Biden administration’s tax proposals found in the “General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals,” or “Green Book,” for short. Steve has already written about how they might affect Real Estate Investors and S Corporation Savings.

In keeping with the current theme I want to discuss the new proposals and how they could affect the future of estate and legacy planning. The proposed rules in this blog post, if passed, would take effect January 1, 2022.

The 2020 Global Wealth Report from Credit Suisse details there are approximately 20.2 million millionaires in the United States; around 6% of the population’s households. Federal estate taxation, in recent times, has really only been an issue for the very wealthy. Mr. Biden’s estate tax hikes would make this an issue for a much greater portion of the population.

Current Estate & Gifting Rules

To start, let’s review how estate tax rules work now.

The Estate Exclusion

The Estate Exclusion is the total amount of your estate that is not subject to tax when you die. The exclusion amount in 2021 is $11,700,000. And married taxpayers double that.

A taxpayer can use this exclusion throughout their lifetime with gifting (the IRS keeps a running total) or pass this amount to their heirs at death, all tax free.

The tax rate on lifetime gifts over the exemption amount is a flat 40 percent. Unsurprisingly, the IRS taxes very few estates as a result.

Step Up Basis

You get to “step up” the basis of inherited or gifted assets to current market value.

Let’s pretend you inherit a house from your favorite relative, Great Aunt Agnes. Agnes purchased the house for $100,000 and it was worth $1,800,000 when she passed away. Your basis gets stepped up to the market value of $1,800,000. The $1,700,000 is completely excluded. You can sell the house immediately and not pay any tax.

And because Agnes’s estate was valued at less than $11,700,000, her estate doesn’t pay any taxes either.

Grandfathered Exclusion

Gifts made while the high exclusion amount is in effect will still apply even if congress later lowers the exclusion amount below $11,700,000. This is good news for people that have been gifting significant assets and have not yet used up their lifetime exclusion.

Biden’s Estate and Gift Tax Proposals

Now let’s contrast the old rules with the Mr. Biden and his Administration’s proposed new rules.

Transfers of Property by Gift or Death Treated as Realization Events

The donor or deceased owner of an appreciated asset would realize a capital gain at the time of the transfer and owe tax. But, there are some exclusions.

First, Mr. Biden’s proposal allows a $1,000,000 estate or gift exclusion. This is transferable to a surviving spouse making the total for a married couple $2,000,000.

Second, it allows US Code § 121 exclusion from sale of principal residence of $250,000 per person or $500,000 for a married couple.

Let’s go back to our Aunt Agnes example…

Agnes purchased her house for $100,000 and it was worth $1,800,000 when she passed away. The total gain is $1,700,000, less the $1,000,000 estate exclusion, less the $250,000 exclusion for selling a primary residency. This leaves you with $450,000 of capital gains that will be taxable, probably between 15%-20%, depending on your total income for the year. And Agnes didn’t leave you any money to pay the taxes.

But what if you intend to keep the house and don’t have the cash to pay the tax…

15-Year Fixed Payment Plan

The proposal allows a 15-year fixed-rate payment plan for the tax on appreciated assets transferred at death for “non-liquid” assets.

The IRS reserves the right to require security at any time when there is reasonable need for security to continue the deferral. The security can be provided from any person, and in any form, deemed acceptable by the IRS.

Gain Realization Events Every 90 Years

Unrealized gain would be recognized by trusts, partnerships, and other non-corporate entities if the property has not been the subject of a recognition event within the prior 90 years. The testing period would start January 1, 1940, making the first possible recognition event December 31, 2030.

This is bad news for wealthy families that have set up dynasty trusts to circumvent gift, estate, and generation skipping transfer (GST) taxes. This is equally bad for partnerships that hold significantly appreciated assets that have never been taxed.

A Few Final Points

The proposed estate tax hikes from Mr. Biden are more aggressive than we’ve seen in recent years, to say the least. And very much less favorable to higher net worth taxpayers.

Estate taxes may no longer pose problems for only very wealthy families. If the proposals go through, many families will be subject to estate and transfer taxes they would otherwise avoid completely under the current rules.

One note for Washington state residents: Remember, too, that Washington state’s estate taxes begin at $2,193,000. (That tax rate starts at 10 percent and eventually ratchets up to 20 percent.)

There is still time for planning, however. Take advantage of the high $11,700,000 before it is gone forever. You can gift assets to would be beneficiaries, or use an appropriately set up trust to remove assets from your estate. The point is, you want to take action now.

The post Biden Estate Tax Hikes appeared first on Evergreen Small Business.