You searched for roth - 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.

The Washington Estate Tax Income in Respect of Decedent Problem

Stephen Nelson CPA — Mon, 11 Aug 2025 15:20:51 +0000

Washington state’s estate tax hits only a small percentage of the state’s decedents. (The threshold for paying tax is $3,000,000, and though the data is scarce, it looks like less than one percent of estates trip over this amount.)

But when taxpayer estates do the pay the tax? Ouch. Rates start at 20%. And rise ultimately to 35%.

Further, as bad as that may sound if your estate or the estate of someone in your family pays this tax? The situation may be far worse because of the way “income in respect of a decedent” is taxed.

The problem in a nutshell: State estate taxes may fully tax the “pre-tax” income in respect of a decedent.

What is Income in Respect of a Decedent?!

Good and important question. And one we can best answer with a simple example. The most common form of income in respect of a decedent are the wages someone earned but hadn’t yet been paid when they died. That income hasn’t yet been subjected to income taxes. Thus, federal tax laws tax it.

Example: Someone dies with $10,000 of accrued wages. Those wages paid after death represent income in respect of a decedent. The estate or heirs pay the income taxes the decedent would have paid on the $10,000. Maybe $3,000 to $4,000 in most cases. Thus the estate or heirs may only receive $6,000 or $7,000. But Washington state may tax the full $10,000.

Now a single payroll? Probably not that big a deal. A family that’s just lost a breadwinner has far bigger issues and concerns. And most estates don’t pay the Washington state estate tax.

But if an estate does pay Washington state estate taxes, the IRD issue grows in significance. And here’s why.

IRD includes a bunch of stuff. It includes most retirement account balances like traditional deductible IRA, 401(k), 403(b) and 457(b) and cash balance retirement plans. IRD includes some of the common equity compensation income provided to technology company employees including nonqualified stock options, restricted stock units, restricted stock awards and then other deferred compensation or stock deferral plans. IRD can also include large windfall amounts—lottery winnings, composer and author royalties, and SEC and IRS whistleblower awards—which won’t be collected until years or decades after the estate taxes are due. (More on this in few paragraphs.)

How Washington State Handles IRD

The problem here? The Washington estate tax is imposed on the full value of income in respect of a decedent (IRD) without regard to the income taxes that will later be owed.

Example: A Washington decedent’s estate includes $10,000,000 of IRD and is subject to the top 35% Washington estate tax rate. The resulting state estate tax equals $3,500,000.

When the IRD is later received, the estate or beneficiaries receive an income-tax deduction under IRC §691(c) equal to the estate tax attributable to the IRD. As a result, only $6,500,000 of the IRD is subject to federal income tax. At a combined 37% federal rate plus 3.8% net investment income tax, that produces an additional $2,652,000 of federal income tax.

In total, the combined Washington estate tax and federal income tax equal $6,152,000 — an effective tax rate of roughly 62%

How Federal Estate Taxes Handle IRD and State Estate Taxes

The tax situation becomes even worse when federal estate tax applies because the decedent’s estate exceeds the basic exclusion amount. In that case, income in respect of a decedent (IRD) can be subjected to Washington estate tax, federal estate tax, and federal income tax.

Example: A Washington decedent’s estate includes $10,000,000 of IRD. Washington estate tax at 35% produces a $3,500,000 tax. Because Washington estate tax is deductible for federal estate tax purposes, the federal taxable estate attributable to the IRD equals $6,500,000, resulting in $2,600,000 of federal estate tax at a 40% rate.

The total estate tax attributable to the IRD is therefore $6,100,000. Under IRC §691(c), that amount becomes an income-tax deduction when the IRD is later received. As a result, only $3,900,000 of the IRD is subject to federal income tax. At a combined 37% federal rate plus 3.8% net investment income tax, this produces an additional $1,591,200 of income tax.

In total, combined Washington estate tax, federal estate tax, and federal income tax equal $7,691,200 — an effective tax rate of nearly 77% on the $10,000,000 of IRD.

And believe it or not, the situation can in a handful of situations get even worse. There is a nightmare scenario.

The Liquidity Nightmare: Estate Taxes Due Before IRD Pid

Here’s the true nightmare scenario: a decedent’s estate includes substantial income in respect of a decedent (IRD), but the estate will not actually receive the income for many years.

This can occur, for example, when IRD consists of a long-term payout stream such as a lottery annuity, structured settlement, or deferred compensation arrangement. In these cases, the estate tax is due shortly after death—even though the cash needed to pay that tax may not arrive for decades.

Example: Suppose a Washington decedent dies owning the right to receive $1,000,000 per year from a lottery annuity, with 15 annual payments remaining. For estate-tax purposes, the annuity is valued at $10,000,000. Washington estate tax at the top 35% rate produces a $3,500,000 estate tax liability attributable to the IRD.

The problem is timing. The Washington estate tax is generally due within nine months of death, but the estate does not receive its next $1,000,000 lottery payment until a year later. As a result, the estate must either borrow to pay the tax or request extensions while interest accrues.

When the first $1,000,000 annuity payment is eventually received, a substantial portion is immediately consumed by federal income taxes. Even after accounting for the §691(c) deduction, roughly $250,000 to $300,000 of the payment may go to federal income tax and net investment income tax. The remaining cash is then applied toward interest and principal on the estate tax obligation, leaving only a fraction of each annual payment to reduce the underlying estate tax balance.

Because the annuity payments are relatively small compared to the upfront estate tax liability, it can take many years for the estate to fully retire the tax debt. During that period, interest continues to accrue, and heirs may receive little or no net benefit from the IRD for a long time.

In extreme cases, the estate may be forced to borrow repeatedly or even liquidate non-IRD assets simply to service the estate tax obligation created by the IRD itself.

Some Quick Final Comments

What do you do about this? You’ve already taken the first step (maybe) which is recognizing the potential size of the problem if your estate includes substantial IRD.

As far as remedies or palliative measures? Your first step is probably to confer with a good estate planner. All the usual federal estate planning techniques and methods probably get turbocharged if you’re talking about IRD potentially subject to Washington state’s estate tax. (Here’s a primer of basic techniques: Washington state estate tax planning techniques. But if you’re potentially taxed on a lot of IRD? You’re going to want to look at the more sophisticated techniques available too.)

Thus, three closing remarks and ideas to discuss with your attorney or accountant.

First, an interesting feature of Washington’s estate tax regime is, the state doesn’t tax gifts. Thus, while a large gift to heirs might trigger federal gift taxes or use up the federal basic exclusion amount, those gifts typically don’t result in additional Washington state estate taxes.

Note: Starting in 2026, you can gift up to $15,000,000 without triggering gift taxes. Married? The amount doubles: You and your spouse can together gift up to $30,000,000.

Second, I’m usually not a big Roth account fan. (See here for a list of all blog posts that discuss the reasons here.) But paying the taxes now to convert a big $10,000,000 tax-deferred IRA (and IRD) to a smaller but equivalent after-tax $5,900,200 Roth account (which is not IRD)? That often makes good sense if it saves Washington state estate taxes. If a $10,000,000 traditional IRA gets converted and you’re avoiding the top estate tax rate, for example, the tax savings roughly equal $1.6 million.

And then, third, the other obvious option to at least consider: Someone with a lot of IRD in their estate may want to consider changing their domicile.

Additional Resources

Need more background information on the state’s new estate tax? Check out this blog post: Planning for the New 35% Washington State Estate Tax.

Want to estimate what state taxes an estate might pay? This calculator makes a good estimate for estates created after July 1, 2025: Washington State Estate Tax Calculator.

The post The Washington Estate Tax Income in Respect of Decedent Problem appeared first on Evergreen Small Business.

Using ChatGPT in a Small Business

Stephen Nelson CPA — Thu, 13 Feb 2025 16:46:51 +0000

I’ve been learning about artificial intelligence, or AI, over about the last year or year and a half. Most days, and this is a little embarrassing, I’ve probably spent two to three hours using or learning about AI. And especially ChatGPT.

Given the questions I get from friends and colleagues about this, especially about using ChatGPT in a small business, I thought it’d make sense to share how I’ve or we’ve been using this new tool.

Organizing This Discussion

Using ChatGPT in a small business though? A big topic. Thus, I’m going to break this discussion into two parts.

In this part, which I consider part 1, I’m going to list and briefly describe all the examples of how we’re probably productively been using ChatGPT in our small business. (The CPA firm in other words.) But I’m hoping you can use my ideas to begin incorporating something like ChatGPT into your work.

In the second part, “Small Business ChatGPT Tips and Tricks,” I share some basic tips and techniques I found work well and get you or me good or better results.

And one other comment as I start: This is going to be a bit of a laundry list. But that’s not just because lists provide an easy structure for writing. I think you and I approach an AI like ChatGPT with the idea that we’re going to build a laundry list of tasks it can help us do better. That, I think, should be our immediate goal.

So, here’s my current laundry list…

General Help with Writing Emails

A quick first task. And this is pretty general. But if you need some help getting your emails “just right?” ChatGPT is your friend. And in a potpourri of ways. Some examples.

If you need to write emails in other than your native language? That’s obviously often a struggle. But here’s what you can do. Write in your native language—and then have ChatGPT translate that message into the appropriate language for the email. This works great.

Another example: If you need to, let me just say this politely, if you need to be a little less angry and a little more composed? Have ChatGPT soften the language of your first draft.

Finally, another example: If you’re struggling with grammar, punctuation, typos or other silly mistakes for whatever reason? Get ChatGPT to proof your writing.

By the way, a possible side effect of this approach? I’m guessing it will over time allow the people to polish their writing skills.

Writing Awkward Emails

A related example: writing those awkward emails that take too much time. Often because the subject matter is potentially hurtful or emotionally charged: declining to interview a job applicant, rejecting a candidate for some position, or disengaging from a client. Also any other communication where you or I may struggle with writer’s block. Or where we may procrastinate as we worry about the wording.

ChatGPT suffers from no emotional block about writing, for example, an awkward email. What it writes? Surely good enough. Always nice enough. Almost surely “legally” safe. And absolutely massively faster at this work than you or I are.

Thus, use ChatGPT to write an adequate email. Then click Send. Done.

The “Quick Question” Emails

You know what I’m talking about here if you’re in a service business. The “I just have a quick question” trap: So, your or my client or customer has a question or set of questions, wants a quick, free answer, and assumes you or I can dash off a quick response. Ideally this afternoon.

Reality: Rarely do these “quick questions” take only a minute or two to draft and then send. It’s a half hour. Or longer.

Thus, I think, if you or I attribute the email to ChatGPT, we have ChatGPT write these. This approach converts a maybe 45-minute task into that five-minute task. One you or I can provide for free.

And two subtle benefits of this approach. First, when you’re sharing bad news or awkward truths, you may find it useful to be quoting something ChatGPT says. (You aren’t the one telling them some idea doesn’t work. ChatGPT tells them.) Second, and maybe unfairly, ChatGPT can be a more authoritative source than you or I are delivering personalized information. (If you want another source? Here’s what ChatGPT says…)

A sidebar comment about all these email-related tasks: I don’t think this stuff is merely nibbling around the edges. CPAs for example basically get paid for half the hours they work. Your business may experience something similar. Thus, if you or I can dial down the minutes we spend here and there communicating with clients and vendors, colleagues and coworkers, we should save hours each week.

Writing Software Code

I want to talk now about some of the new work an AI like ChatGPT can do. And the obvious first example here? Programming. You and I, even if we’re not experienced or trained programmers, can use ChatGPT to write source code. And at extremely low cost.

We can then use this software to automate bits of our businesses. Or to increase the value of the products or services we provide. Or to cut the costs of those products and services.

This should make sense, right? Because you and I have work we do where some software would help… Software that no software development company will ever produce. So, the answer: We do it ourselves.

This step requires a bit of set-up time. It took me about a day to figure out what to do with the JavaScript ChatGPT has been writing for our blog posts recently. Getting Python running on my computer? That took a few hours too. (I had not really programmed for decades.) Roughly speaking, I can now write a blog post that includes a JavaScript calculator in about the same time as a blog post that doesn’t.

This has been a meaningful improvement for us. One example to illustrate. We use our blog to market our niche services across the US. And ChatGPT gives me the ability to bump the value of our blog’s posts by adding JavaScript calculators to some of those posts.

We’ve got “calculators” that estimate the tax savings from an S corporation, that estimate reasonable S corporation shareholder-employee compensation, that calculate the depreciation deductions from cost segregation studies, that answer some of those perennial Roth IRA questions, and a bunch more.

You may be able to do something similar in your operation. Or even something identical.

One-on-one Mentoring and Personalized Education

Another example and in a sense something the programming stuff I just mentioned illustrates. ChatGPT will teach you and me stuff. Complicated stuff.

You can start by having it write a short overview of some subject you in your job or people in your industry struggle with. You can then ask detailed questions. Repeatedly. You can provide examples that explain your current understanding throughout this process using specific client details. (“So let me get this straight, ChatGPT. For my client named Steve, in this situation, it works like this?”) ChatGPT shows endless patience. It works day or night. You can in effect torture it with dumb questions. The sort no one would ever ask in a classroom or seminar.

Seriously, the next time you have a question in the past you’d ask a knowledgeable colleague or mentor? Ask ChatGPT. (I participate as an admin in a couple of online social media networks for CPAs. And most of the questions folks ask? They should probably ask ChatGPT.)

Reasonable-cost Research Reports and Management Consultant Studies

Small businesses often don’t get to do the same sorts of research that larger firms do. Or get to regularly consult with industry or management experts.

For example, the big guys may have economists on staff who look at the likely scenarios the near future holds. They may also either employ or engage with true experts to plan for and think about the challenges and opportunities their business and industry face.

And then what about pursuing or ignoring the strategy or tactic de jour? (In public accounting right now, firms of all sizes wonder whether private equity funds owning a firm makes sense.) The small guys don’t have people (typically) they can ask about stuff like this.

However, now? With ChatGPT? In all of the above cases, you and I can get lengthy written analyses customized to our firm’s specific situation. Concerned about how new tariffs will affect your business or your clients? Or about how inflation may affect you or your clients? Worried about the compensation levels needed to fully staff your firm with great talent? Struggling to understand how something like private equity ownership of firms in your industry impacts your business plan?

ChatGPT will do all this research and analysis for you. And extremely quickly. You can get insights and commentary about the range of economic outcomes from new government policy for your firm this morning as you have your coffee. Actionable insights about current and future salary levels and labor shortages within the profession tomorrow morning–again with your coffee. The private equity thing? Again, with your morning coffee. But maybe two cups for that.

By the way this thought: Will these ChatGPT reports and analysis be perfect? Full of bulletproof analysis? Will the actions they suggest be guaranteed to deliver great or at least good results?

I think not. But getting pretty good research and pretty good analysis surely beats the option of not looking at and considering this stuff. (And I’m not sure what you’d get from an expensive expert is that much better.)

Monte Carlo Simulations and Scenario Planning

A quick thing to point out. You and I can get ChatGPT to do Monte Carlo analysis for our investment planning. And scenario planning for our business plans and forecasts.

I think ChatGPT is particularly useful for doing Monte Carlo simulations. To start, get ChatGPT to explain what a Monte Carlo is and how it works. You can then get its help to collect the handful of inputs needed. And you can then ask it to make the calculations. And then ask it redo the calculations for an alternative set of assumptions.

The same reality occurs with scenario planning. Say you were thinking about selling out to a private equity firm. You can easily get ChatGPT to model the financial outcomes of continuing to operate independently, selling out to a private equity, and any other option too.

For what it’s worth? When I asked ChatGPT to analyze for fun our firm selling out to a private equity firm, it estimated we would simply be converting ordinary income to capital gains and would probably, even if CPA firm valuations deflated, end up with much better outcomes by staying “partner owned.” That analysis also acknowledged but didn’t quantify the benefits of autonomy by working for ourselves versus (and here I quote ChatGPT) working for “MBAs with spreadsheets.” I intuitively knew in our situation all this was true. But I found it interesting and useful to get another, neutral, objective point of view.

Critiquing Business Strategies and Tactics

Okay, a subtle point but an important one. I don’t feel like a ChatGPT-style AI does a good job at business planning, strategy, or tactics. For one thing, it “thinks” or “does what it does” too linearly. For another thing, probably you and I can’t prompt it with enough of the right information to come out with innovative, highly personalized strategies and tactics.

But you know what ChatGPT is really good at? Looking at some plan, strategy or tactic that you or I or a consultant or client develops and then critiquing it. There? It often will spot errors or bugs or holes.

Sorry for falling down the rabbit hole for a paragraph. (Just this paragraph.) And I’m not sure about exact error rate percentages here. But here’s what I think happens when you have ChatGPT “check your work.” If when we’re on our game our error rate is five percent and ChatGPT’s error rate is twenty percent? (And those percentages feel about right actually.) A compounding benefit occurs. And the overall effective error rate drops to maybe one percent. (The actual math maybe looks like this: 20% times 5% equals 1%.)

Three Final Thoughts

Let me close with three final thoughts.

First, I don’t think something like ChatGPT replaces a good knowledge worker any more than a nail gun and air compressor replace a master carpenter. After more than a year, though, I do think you and I will use ChatGPT for work we can’t affordably or efficiently do now. For a reasonable price.

Tip: To put this into dollars? I think we pay OpenAI $20 a month per person right now for a subscription to ChatGPT 4o. Paying $200 a month per person for ChatGPT o1? Yeah, that’s probably okay. But at some point, say the price was $2,000 a month per person, I don’t know if that would make economic sense. At least not given how we’re able to use the technology.

Second thought: I feel like ChatGPT amplifies worker productivity and performance. You boost someone’s performance by maybe—this is a fermi number guess—by maybe 20 to 30 percent. That means a couple of things, I suggest. First, you and I don’t become less valuable with AI we become more valuable. (For $20 a month, you or I maybe become like 20 percent smarter.) Second, the most important people to get up to speed with an AI tool like ChatGPT? Your most skilled and experienced team members.

Here’s my third and final thought. An AI like ChatGPT should allow you or me to dramatically boost the performance of our small businesses rather quickly. So not at some point in the future like three years from now. But today. Or maybe tomorrow. The trick though? And this gets back to the laundry list comment I made earlier. We need to experiment and explore and ultimately build a list of tasks where ChatGPT lets us do more work and new useful work.

The post Using ChatGPT in a Small Business appeared first on Evergreen Small Business.

Section 199A(i) Fiscal Year Change Extends Deduction

Stephen Nelson CPA — Wed, 23 Oct 2024 12:11:53 +0000

A short, technical post: You can possibly use a fiscal year and even a fiscal year change to get one additional year of Section 199A deduction. Even if the law does expire as scheduled at the end of 2025.

For example, if you’re anticipating a big Section 199A deduction on your return? Like a $1,000,000 deduction say? Or even bigger? You can maybe save any extra $400,000, $500,000 or more in federal taxes by starting a new business using a fiscal year or by changing the fiscal year of your existing business.

Let me quickly go into the details. You can see if you agree. One comment to make up front. I didn’t always think this. When I wrote my book “Maximizing Section 199A Deductions” in 2017, I thought what I’m about to describe did not work. Now? Yeah, I do. But let’s step into the weeds.

The Statutory Language of Section 199A(i)

The first thing to look at is what the Section 199A(i) applicability “end” date language says in the actual statute. That language appears below:

(i)Termination

This section shall not apply to taxable years beginning after December 31, 2025.

You and I want to pay attention to the precise language. Section 199A doesn’t apply to taxable years that begin after December 31, 2025. So, obviously, a calendar taxable year that begins on January 1, 2025 works. We all agree on that.

And it’s no big jump to realize, “Okay. Yeah. Starting on February 1, 2025? Or March 1, 2025? Or any other date within 2025? That works too. None of those dates begin after December 31, 2025.”

One other comment: If Congress, the writer of the law, wanted to prevent someone taking a Section 199A deduction on a fiscal year tax return that starts in 2025 but ends in 2026? It seems like it could and should have written Section 199A(i) differently. Something like this, to my mind, does the trick:

(i)Termination

This section shall not apply to taxable years beginning ending after December 31, 2025.

If you agree with what I’ve said or maybe always thought what I describe in the earlier paragraphs? You can stop reading. You know what you need to know. And you don’t need to spend any more time on this.

For people who vaguely remember reading something different? For accountants who maybe recall a training session where the presenter described things differently? Let me keep going. Because I maybe know where things went off the rails.

The Applicability Date Language of Regulation 1.199A-1(f)

The source of my initial confusion? And possibly your confusion too if you’re part of the brotherhood or sisterhood who fell down this rabbit hole? The applicability “starting” date language from the regulations works differently. And that language really triggered the fog here. That language says this:

(f) Applicability date—(1) General rule. Except as provided in paragraph (f)(2) of this section, the provisions of this section apply to taxable years ending after February 8, 2019.

(2) Exception for non-calendar year RPE. For purposes of determining QBI, W-2 wages, UBIA of qualified property, and the aggregate amount of qualified REIT dividends and qualified PTP income, if an individual receives any of these items from an RPE with a taxable year that begins before January 1, 2018, and ends after December 31, 2017, such items are treated as having been incurred by the individual during the individual’s taxable year in which or with which such RPE taxable year ends.

To summarize the general rule? The regulations apply to taxable years ending after February 8, 2019. (Not very relevant here. We’re only talking years ending after February 8, 2019 anyway.) But then the tweak that benefits taxpayers. For a non-calendar year RPE, or “relevant pass-through entity,” so a partnership or S corporation? If the fiscal year started in 2017 and ended in 2018? The Treasury gave the taxpayer a Section 199A deduction on his or her 2018 tax return.

In effect, even though the Section 199A only became effective for tax years beginning after December 31, 2017? Yeah. Christmas came early for fiscal year pass-through entities. They enjoyed the Section 199A deduction on qualified business income earned in calendar year 2017 but reported by the pass-through entity on the tax return that ended its fiscal year in 2018.

What a number of people did—me included—is apply this special rule about how Section 199A started in 2018 to how things work when it ends after 2025. Awkwardly, that reading is wrong.

A tangential note: Section 11011(e) of the Tax Cuts and Jobs Act set the applicable date of Section 199A as “taxable years beginning after December 31, 2017.”

The Obvious First Section 199A(i) Question

Let’s jump to the obvious first question: Can a relevant pass-through entity use a fiscal year or change its fiscal year and enjoy an extra year of Section 199A deduction? Answer: Maybe.

You just read what Section 199A(i) says. The section shall not apply to taxable years beginning after December 31, 2025. So that’s not a problem. But you need a way to wriggle into using a fiscal year. And two possible wriggles exist.

Wriggle #1: Section 442 says a partnership or S corporation—the two relevant pass-through entities that Section 199A applies to—can change from a calendar year to a natural year. (A natural year exists when a business generates at least 25 percent of its gross receipts in a two-month interval.)

Wriggle #2: Section 444 says a new partnership or S corporation can adopt a fiscal year that ends September 30, October 31, or November 30. (An existing calendar year partnership or S corporation probably cannot use Section 444 to change its fiscal year.)

Thus, theoretically any partnership or S corporation might be able to change its taxable year from a calendar year to a fiscal year that begins before December 31, 2025 using Section 442. New partnerships or S corporations can make a Section 444 election that begins their fiscal year on October 1, November 1, or December 1 of 2024 or 2025.

To adopt a fiscal year or make a fiscal year change, predictably, the entity must comply with requirements of Section 442 or 444. Some entities will surely fail to qualify for technical reasons. (Again, for example, note that it is not possible to move from an established calendar year S corporation to fiscal year using a Section 444 election.)

But assuming an entity does get a fiscal year to work, if an entity calculates and reports a Section 199A deduction to its owners on its fiscal year tax return that starts in 2025 but ends in 2026? Owners include a Section 199A deduction on their 2026 1040 tax return.

The Obvious Second Section 199A(i) Question

Next question: Should new pass-through entities adopt a fiscal year and should existing entities change their fiscal year (when possible) to get an extra year of Section 199A deduction?

This question seems trickier. Sure, you probably can do this in many situations. But should you? My sense is the cost of adopting a fiscal year (for a new business) or of making a fiscal year change (for an existing business) exceeds the benefit for most pass-through entities.

I think our CPA firm’s rule of thumb might be something like “you need to anticipate getting a Section 199A deduction well into six figures to adopt a fiscal year or to make changing to a fiscal year worth considering.”

Someone who enjoys a $100,000 Section 199A deduction in 2025 might possibly save $30,000 to $40,000 in federal income taxes by getting one more year. Someone who enjoys a $200,000 Section 199A deduction in 2025 might save $80,000 with one more year. Grabbing that additional savings probably makes sense.

Furthermore, someone who makes ten times that much and enjoys a $1,000,000 or larger Section 199A deduction? They maybe save $400,000 or more in federal income taxes by getting one more year of Section 199A treatment. Grabbing that additional savings absolutely makes sense.

But the typical successful small business owner who makes, say, $100,00o? So, that guy who currently gets a $20,000 Section 199A deduction? That size deduction may save $4000 or $5000. Which sounds good and is good. But that amount may not be enough to justify the fiddling. Or the costs of the accountants.

The Timeclock is Running Out

One other factor to consider here is timing. CPA firms and pass-through entities do not have much time to prepare and file the paperwork that effects a change in the accounting year assuming they even want to do so.

To change to a Section 442 natural year that ends on, for example, April 30, 2025 (if that’s possible), one files a Form 1128. That form’s due date would typically be July 15, 2025. But you probably want to file sooner. You can and probably should file the Form 1128 on January 1, 2025

To make a Section 444 election that adopts a taxable year ending on November 30, 2025 (if that’s possible), one files a Form 8716. That form’s due date would typically be February 15, 2025. But again, you can and probably should file the Form 8716 earlier on in that first fiscal year.

All in all, then, not much time considering that most of the time between now and then is tax season.

Not Everyone Agrees Yet

A final point. Some tax practitioners probably still think you in effect look at the Section 199A regulations’ instructions about how one handles fiscal year entities that start their taxable year in 2017 to determine how you should handle fiscal year entitites that start their taxable year in 2025. (This is the stuff I talked about in the preceding discussion of Regulation Section 1.199A-1(f).)

For example, here’s the relevant blurb from the Bloomberg BNA Tax Management Portfolio, “Portfolio 537-1st: Qualified Business Income Deduction,” that talks about how the fiscal year thing affects the Section 199A deduction:

However, the regulations do not provide a similarly favorable “mirror image” rule in the case of an RPE with a taxable year beginning on or before December 31, 2025, and ending after such date. As a result, a taxpayer that is a partner or shareholder in such an RPE would not be able to take a §199A deduction with respect to amounts allocable to such taxpayer even if realized by the RPE during 2025.

The authors then provide this example:

Example 9: Assume the same facts as Example 8, except that the S corporation’s taxable year begins on November 1, 2025, and ends on October 31, 2026. A is not entitled to a §199A deduction with respect to any portion of A’s share of QBI, W-2 wages, UBIA of qualified property, and the aggregate amount of qualified REIT dividends and qualified PTP income from the S corporation for the months of November and December 2025.

But I think that’s wrong.

Again, for the record, I was originally saying the same thing (and long before the BNA tax management portfolio said it.) But now? Now I think you don’t expand the regulation’s language that tweaks the applicability start date and then apply that language to the applicability end date. Rather you look at the statute’s termination date language. The rule Congress wrote.

Other Resources about Section 199A(i) Fiscal Year Charges

For an overview of changing an accounting year of a partnership or S corporation, you may want to refer to Revenue Procedure 2006-46. (It describes the mechanics of using Form 1128 to request an accounting year change based on a natural business year.)

For instructions for making a Section 444 election, you want to refer to the Form 8716 and its instructions as well as the Form 8752 and its instructions.

We also have a Section 199A(i) Fiscal Year Change FAQ available at our CPA firm website. That appears here: Section 199A(i) Fiscal Year Change FAQ.

The post Section 199A(i) Fiscal Year Change Extends Deduction appeared first on Evergreen Small Business.

Roth Calculator

Stephen Nelson CPA — Wed, 25 Sep 2024 16:15:54 +0000

The Roth Calculator below helps you determine whether you end up with more retirement income using a Roth IRA or 401(k). Or using a traditional IRA or 401(k).

By the way? Most people probably end up with a better outcome using a traditional IRA or 401(k). But you want to “run the numbers”

Click the Calculate button to see example calculations using the default inputs. To get actionable insights for your own “Roth or not” decision, replace the default inputs with your own. Detailed instructions and additional information appear below the calculator.

Collect the Roth Calculator Inputs

Contribution:
Years of Saving:
Years of Spending:
Rate of Return:
Inflation Rate:
Saving Years Tax Rate:
Spending Years Tax Rate:
Qual Dividends Tax Rate:
Qual Dividends Yield:

Simple Strategy Withdrawals

Simple Strategy	Traditional	Roth
Accumulation
Withdrawal
Less: Taxes
Net Amount

Hybrid Strategy Withdrawals

Hybrid Strategy	Traditional	Roth
IRA Balance		0
Taxable Acct		0
Accumulation
Withdrawal
Less: Taxes		0
Net Amount

Collecting the Inputs

You need to collect a handful of inputs. Most make intuitive sense. You enter the annual contribution you will make, the years you’ll save and the years you’ll spend, and then the nominal return and inflation rate you expect.

You need to enter at least two tax rates: your saving years “marginal” tax rate and the spending years tax rate on the withdrawals. The saving years marginal tax rate allows the calculator to estimate the taxes you save by making a deductible contribution to a tax-deferred IRA or 401(k). The spending years tax rate allows the calculator to estimate that taxes you’ll pay on the withdrawals from your tax-deferred IRA or 401(k).

Note: Your saving years tax rate usually is higher than your spending years tax rate. Your saving years tax rate equals your top marginal tax rate. The spending years tax rate, in comparison, blends low tax rates and higher tax rates. Also many people, and probably most people, report higher incomes during their working years than during their retirement years.

Understanding the Simple Strategy Results

The Roth Calculator lets you look at simple Roth strategies where you start with a set amount of pre-tax income. (Like $7,000.) And then either you use all of that pre-tax income to contribute to a traditional IRA or 401(k). Or you can first pay the taxes on that income and then contribute the leftover, after-tax amount (like maybe $5,320) to a Roth IRA or Roth 401(k).

Obviously, when you contribute smaller amounts to a Roth account with the simple strategy, you end up with a smaller future value. But that smaller future value represents after-tax savings. Thus, as you draw from the Roth account, you avoid paying income taxes again.

The calculator then assumes you annuitize the IRA balances over the specified years of spending. And that you pay income taxes only on the withdrawals from the traditional IRA or 401(k) at the spending years tax rate.

Obviously, you want to replace the default entries with your own personalized inputs. But the 22% tax rate is what a single filer reporting taxable income between roughly $47,000 and $100,000 might pay in 2024. Or what a married couple reporting taxable income between roughly $94,000 and $200,000 might pay in 2024. The 11% tax rate is what somone might pay by drawing from a roughly $500,000 IRA account and receiving typical Social Security benefits.

Understanding the Hybrid Strategy Results

The Roth Calculator also lets you look at a hybrid strategy where you contribute the same amount to both accounts. (Probably the maximum contribution allowed? So a number like $7,000.) But then you also save the extra tax savings you get from the traditional IRA contribution. In other words, if you save $1700 in income taxes by contributing to a traditional IRA or 401(k), the calculator looks at what happens if you save that money in a tax efficient stock index fund. The calculator assumes you pay qualified dividend tax rates on the dividends during your saving years. Thus, to model the hybrid strategy, you may want to replace the qualified dividends tax rate and the qualified dividends yield with your own numbers.

One other note: The hybrid strategy formulas assume you pay the qualified dividend rate on half of the money withdrawn from the taxable account. That’s probably conservative. Many retirees might pay less tax. (If paying taxes on only half of the money sounds wrong, remember that you’ve already been taxed on the contributions over the years. And on the dividends.)

Additional Resources

If your modeling suggests a Roth IRA or Roth 401(k) doesn’t make sense and that’s a surprise? You might find this old blog post useful: Are Roth-IRAs and Roth-401(k)s Really a Good Deal?

To get up-to-date IRA and Roth-IRA contribution limits refer to the IRS’s “Retirement Topics – IRA Contributions Limits” web page.

The post Roth Calculator appeared first on Evergreen Small Business.

Backdoor Roth IRAs Really a Smart Idea?

Stephen Nelson CPA — Tue, 02 Apr 2024 15:12:19 +0000

Maybe the last ten individual tax returns I’ve signed? They all included a backdoor Roth IRA.

That got me thinking: How much tax do you really save with a backdoor Roth? And the answer: Probably not as much as you hope.

But let’s start with an overview of how Roth IRAs work. And then I’ll show you how a tax accountant calculates the tax benefits of a Roth IRA conversion, aka a “backdoor Roth.”

First a Quick Explanation

A Roth IRA lets you contribute money to a special version of an IRA, or individual retirement account. You don’t get a tax deduction in the year you make a contribution to a Roth IRA. But as long as you follow the rules, you don’t ever pay income taxes on your Roth IRA’s earnings. Or when you draw money from the account.

You do not, for example, pay income taxes when/if your Roth IRA earns dividends and capital gains that first year, the second year, and so on.

Even better? In retirement, so maybe two or three decades from now, you do not pay income taxes as you draw the money you contributed. Or draw the profits your investment earned over the years.

That all sounds good. But not every taxpayer gets to make regular contributions to a Roth IRA. For 2023, a single taxpayer can’t earn more than $138,000 and a married couple can’t earn more than $218,000 and make a full Roth IRA contribution. (In 2024, those limits rise to $146,000 and $230,000.) Also as you cross those income limits, the amount you can contribute to a Roth IRA phases out. (More details here.)

Which is where the backdoor Roth IRA comes in…

How Backdoor Roth IRA Works

If high income taxpayers can’t contribute directly to a Roth IRA, they usually can contribute money to a nondeductible IRA. Even if they have a regular retirement plan at their job.

They then can convert that non-deductible, non-Roth-IRA account to a Roth-IRA account. And that two-step dance allows a higher-income taxpayer to get money into a Roth IRA. Thereby dodging the income limits I mentioned earlier.

A final important point: As long as the person doesn’t hold other traditional non-Roth-IRA IRA balances? She or he moves the money into a Roth-IRA account without paying any income taxes.

Calculating the Front-end Annual Tax Savings

But the idea doesn’t work as well as you might hope. Most people don’t save much tax during the years they work using a Roth IRA. Or using a backdoor Roth IRA.

Let’s look at the numbers for 2023 for a typical taxpayer aged 49 or younger who can “backdoor” $6,500 into a Roth IRA and then avoid income taxes on the earnings.

While the $6,500 might earn, say, five percent or $325 the first year? An investor investing outside of a Roth IRA wouldn’t have gotten taxed on the full $325. Rather, she or he gets taxed on just the dividends and realized capital gains. And probably that fraction of the return? Only lightly taxed.

Note: I use five percent as the rate of return because after rounding the Vanguard Group expects that return over the next decade.

The taxed dividend yield on a US stock market index fund like Vanguard’s Total Stock Market, probably runs roughly 1.8%. On a $6,500 Roth IRA, that means taxable income of maybe $117 the first year.

Most taxpayers won’t even pay taxes on that income. But at a 15% qualified dividend tax rate—so for example married people making more than $123,500 adjusted gross income in 2024—the first year savings equal about $18.

That annual savings amount grows over time if someone keeps on “backdooring”: $36 in year two, $55 in year three, $75 in year four, and so on.

After two decades of steady backdoor Roth IRA contributions, the annual tax savings might be $500 to $600 annually. Which is pretty good. But maybe not great.

You would not want to pay an accountant $200, $300 or $400 an hour or pay a financial planner 1/2% or 1% fee to help you harvest these sorts of modest savings.

Calculating Back-end Roth IRA Tax Savings in Retirement

Fortunately, the back-end tax savings of a Roth IRA look better. Use a Roth IRA and in retirement, you won’t pay income taxes when drawing down the money.

An example illustrates this: Say someone saving $6,500 annually faces two choices: Invest money using a backdoor Roth IRA or invest money using a regular old taxable account. To keep this all apples-to-apples, assume something like the Vanguard Group’s Total Stock Market Fund.

If the investor earns five percent return annually and pays a 15% tax rate, they end up with almost identical balances after two decades. The Roth-IRA balance equals $226,000 and the taxable account balance equals $219,000. (The $7000 difference reflects that annual income tax bill. And, yes, I’m rounding.)

But here’s the thing: The Roth-IRA investor can draw the entire $227,000 balance without paying income taxes.

In comparison, if the “taxable account” investor draws the $219,000? She or he may trigger long-term capital gains taxes on the unrealized gains, or appreciation, in the account. Those unrealized gains which may get taxed equal roughly $53,000 using the assumptions provided earlier.

How much tax would someone pay on $53,000 of long-term capital gains in retirement? You have to do the accounting carefully.

A middle-class taxpayer and even some upper-class taxpayers might pay zero taxes, as noted earlier. And so most people, especially in retirement, could draw down a large taxable account without paying income taxes. Especially if they drain the account over multiple years.

A high-income taxpayer, in contrast, might potentially pay a 15% or even 20% capital gains tax. She or he probably also will pay the 3.8% Obamacare tax. That would mean an $8,000-ish to $13,000-ish total tax bill.

But often even these folks have good ways to dodge this tax bill. Spreading realization of the gain over a few years. Using some of these funds for charitable contributions. Leaving the money for their heirs which would let them entirely avoid paying taxes on the gain.

Closing Comments and Caveats

Given the above? I don’t find backdoor Roth IRAs particularly compelling. Sorry. But, three final thoughts:

First, if you expect higher returns? Or if inflation runs hot? (The inflation rate embedded in that five percent return from Vanguard runs between two and three percent, by the way.) In those scenarios, the tax savings from a Roth IRA get better.

Second, I think you don’t do this for only a year or two. Rather, you do something like this over decades. That’s the way to snowball the benefits. You’re working the compound interest engine when you do this.

Third, finally, this awkward acknowledgement. Most people don’t earn enough or accumulate enough to pay the sorts of taxes a Roth-IRA account saves. Especially in retirement. Therefore, backdoor Roth IRAs really only make sense for high-income taxpayers who can confidently look forward to high-income lifestyles in the final chapters of their lives.

Note: We’ve got several blog posts that describe the economics of what one might label, ‘”Frontdoor” Roth IRAs and Roth 401(k)s: Are Roth IRAs and 401(k)s Really a Good Deal?, Worst-case Scenarios for Roth-style Accounts, and The Only Times You Want to Use a Roth-style Account. If you found this blog post interesting, you might also find those interesting too.

The post Backdoor Roth IRAs Really a Smart Idea? appeared first on Evergreen Small Business.

A CPA Explains Moore v. United States

Stephen Nelson CPA — Mon, 04 Dec 2023 14:59:52 +0000

I want to talk about the Moore v. United States tax case. The U.S. Supreme Court hears oral arguments this week. And to date, the media coverage of the pending case? Mostly political. And mostly missing the giant impact the case’s issues have on small businesses and entrepreneurs.

But let’s quickly get into the details. Because not only is the case groundbreaking, it produces actionable insights both for small business owners and individual taxpayers.

Issue #1: Due Process Violations

The Moores’ case, if you’re a layperson and you read their petition, brings up three issues related to a tax that appeared in 2017, the Section 965 transition tax. One of the easiest to understand is the “Due Process” clause in the U.S. Constitution.

You can read the Wikipedia definition here, but a quick analogy comparing your own taxes with the Moores’ makes the point clearest.

You probably have saved a bit of money using a 401(k) account. Or a traditional or Roth Individual Retirement Account. Hopefully you’ve been doing that for years. Maybe decades. And partly you’ve done that because tax law says (and has said for decades) you don’t pay income taxes on your profits until you withdraw the money.

That was the deal, right? And so, it would be really crummy, and pretty unfair, if Congress retroactively decided at this point to change the rules. In other words, to now say you need to pay—today—income taxes on the money earned inside your IRA or 401(k) account in the 1990s or the 2000s using a new tax law we cooked up last month.

And yet, that’s basically what the Section 965 transition tax did. It retroactively changed the tax law and rules. And it made previously earned income from earlier years and decades taxable in 2017.

The Moores explain the situation in their petition. They invested $40,000 in a friend’s small business in India. That decision reflected the fact that any income earned by the corporation would not be taxed as earned. But only later as it was distributed. Or when they sold shares. And then on December 22, 2017, President Trump signed the new law which said, ”Okay. Change of rules. Now we want to tax the income as far back as 1986.” The Moores’ resulting tax, apparently paid in 2018, but for an earlier decade’s worth of earnings, equaled $14,729.

Anyway, that’s the first issue—and one that’s largely been missed or ignored or misunderstood by journalists discussing the Moores’ case: Was this retroactive tax law a violation of due process?

Issue #2: Measurement of Income

A second issue the Moore v. United States case examines? When and how a taxpayer measures income.

This bit of the argument gets a little more complicated. As the news coverage of the case shows.

The common-sense income measurement method used for centuries looks at transactions summarized in income statements. That’s been the approach in the Western world since at least the Renaissance (as documented by the Italian monk, Luca Paccioli). And Indian and Arabic cultures have similar accounting traditions that predate the Europeans.

To illustrate how this works for investors, take the example of you owning stock in some U.S. corporation. Like Microsoft. Or Apple Computer.

You don’t owe taxes on the money the Microsoft or Apple shows on their income statements. And on which they pay taxes. You only owe taxes on dividend income you receive from Microsoft or Apple. Or on the capital gain you enjoy if you sell shares of Microsoft or Apple Computer. In other words, the income shown on your income statement. That’s the way the accounting works. Or always used to.

What the Section 965 “transition” tax, and then a related chunk of tax law the Section 951A “global intangible low-taxed income” tax, do? They say you pay taxes on a chunk of the income earned by a foreign corporation you’ve invested in. Even though you haven’t received, or realized, any income. Even though you wouldn’t show that income on your personal income statement. And even if you really don’t have a clean way to measure the income.

Note: Congress and IRS refer to the Section 951A “Global Intangible Low-Taxed Income” tax as the GILTI tax. And, yes, they pronounce it “guilty.”

A quick sidebar for any tax professionals in the audience. Because I want to make two technical points. First, GILTI and other sections of Subpart F do work similarly to how U.S. partnership accounting works. But one noteworthy difference between typical partnership accounting and the Section 965 transition tax is, with a partnership, the income attributed to the partners is earned in the same year the income is attributed—and notably, the attributed partnership income is earned after Congress enacted the law imposing the tax.

A second technical point: Some critics of the Moores’ petition say Subchapter S corporations already force shareholders to report and pay income taxes on corporation income. Thus, Sections 965 and 951A aren’t really a new way of doing the tax accounting. What those folks miss though? With an S corporation, shareholders unanimously consent to this tax accounting treatment before it occurs. Often because the tax accounting both simplifies a small business’s accounting and saves tax.

Summing up, the measurement issue seems more complicated to me. Presumably the Court will consider a bunch of issues as they look closely at how the mechanics need to work. Furthermore, the issue raises more unanswered questions than casual analysis might predict. One issue connected to the complexity, in fact, I discuss next.

Issue #3: Compliance Costs of the Section 965 and 951A Taxes

A third issue is missed in most of the reporting I’ve seen or read: The compliance costs. So let me explain.

In their petition, the Moores note that the Section 965 transition tax equaled, as noted, $14,729. That was the tax per their petition on a $40,000 investment made a decade or so earlier.

The Moores didn’t disclose what the tax accounting costs for determining this tax bill were. Mr. Moore said in an interview said the accountants were costly.

But know this: The costs to calculate Section 965 and 951A taxes in general? Astronomical for a small business investor.

The IRS Form 5471 forms used to calculate these taxes, for example, take roughly a week to prepare according to the IRS. That’s not counting the time to learn the law. Or the time to collect the needed data.

Furthermore, the preparer? She or he needs to be a tax specialist who understands both the federal tax laws for international taxpayers. And she or he needs to understand generally accepted accounting principles since the form incorporates GAAP financial statements.

Rough numbers, you’re probably talking $300 or $400 an hour for roughly 40 hours. That’s $12,000 to $16,000 for just a part of the annual 1040 tax return.

People haven’t thought or talked much about this issue. But it’s an important part of the story. And one small business owners and managers should understand.

Three Closing Comments

Our CPA firm publishes this blog to share actionable insights for small business entrepreneurs and investors. So, let me try to do that regarding the Moore v. United States tax law case.

First, a specific tactical insight. If you’ve invested in a small corporation or LLC in another country? Maybe a family business where your people came from? Or some friend’s foreign venture? Or, heaven forbid, you used a corporation or LLC to hold some foreign rental property? Oh my gosh. You need to see if you should have been filing 5471s. And then if you should have been but haven’t? You want to get with a CPA firm who handles this to see how to bring yourself into compliance. The penalties for bungling the Section 965 and 951A taxes are brutal. (In general, the penalties are assessed in $10,000 increments.)

A second, more general insight. Whatever you or I may think of these sorts of increased regulatory burdens and compliance costs? The increases appear to reflect a trend or pattern entrepreneurs should plan for. And stay alert to.

As just another example, next year the Financial Crimes Enforcement Network (aka “FinCEN”) will require 30 to 40 million small businesses to file “Business Ownership Information” or BOI reports. Failing to file potentially triggers financial penalties that rise as high as $10,000 and, in a worst-case, results in up to two years in prison. (We blog on this topic next month, by the way.) The only practical response to this sort of stuff? Plan ahead. And budget time and dollars.

Finally, a third important takeaway from the Moores’ case for taxpayers. We all want to allow for the possibility that tax law changes—possibly even retroactive changes—may upset carefully laid plans.

Some Related Resources

We’ve got quite a bit of information about international taxes available here at the blog. And you might find other posts useful. For example, if you need to understand the basics of how one handles foreign business tax reporting? Check out this earlier blog post: Reporting Foreign Business Investment

And this related comment: The Section 965 transition tax is what the Moores’ case looks at but a companion tax is the Section 951A GILTI tax. Small businesses facing or dealing with that tax might be interested in either of these two posts too: Section 951A GILTI Tax Avoidance: Ten Tricks and Section 962 Election: An Answer to GILTI?.

The post A CPA Explains Moore v. United States appeared first on Evergreen Small Business.

If You Got Conned in ERC Scam

Stephen Nelson CPA — Fri, 20 Oct 2023 17:30:15 +0000

You wondered at the time whether it was a scam, right? And now you regularly see news reports about ERC scams. Employee retention credit scams, that is.

And so two questions. Did you get scammed? And if so, what should you do at this point? Fortunately, you can probably answer these two questions pretty easily.

Note: This blog post has been updated for the additional guidance the IRS provided on October 19, 2023.

Did You Get Conned or Scammed?

You or your business qualifies for an employee retention credit in one of three ways:

First way: You’re a small business and you started another, new business sometime after February 15, 2020 and before the end of 2021. (That’s easy, right? You know if you did this.)

Second way: Quarterly revenues, as compared to 2019, collapsed. To qualify for 2020, the collapse needs to exceed 50 percent. To qualify for 2021, the collapse needs to exceed 20 percent. (Your accounting system lets you make these determinations with roughly three or four clicks of a mouse.)

And then the third way you qualify: If a government order triggered either a full or partial suspension in your business. And this method? Where the nonsense seems to occur. The place where ERC scams show up.

Fortunately, you can easily determine your eligibility for an ERC based on a government order. You just need to pull out the actual government order that either fully closed your business for some period of time. Or you need to pull out the actual government order that partially closed your business for a period of time—and then show that the partial closure reduced the hours of service or revenues by at least 10 percent.

And now here’s the cold reality. Too often? We see situations where no government order actually exists. I kid you not. And when that’s case? Yeah, sorry. No easy way to say this. But I think you’ve very possibly gotten caught in an ERC scam.

Note: Here’s an example of an actual government order from Washington state: Proclamation by the governor: Stay Health Stay Home.

Real-life Example of ERC Scams

You see all sorts of sloppy thinking regarding government orders.

For example, in one case, a business owner prominent in his industry circulated an email that talked about a government order hitting a major supplier of his firm and similar firms. We understand numerous employers filed millions of dollars of ERC refund claims based on this email.

But when we checked? No government order existed. In fact the supplier, helpfully, said so on their website. Explicitly.

Note: A clarification: A government order “counts” for purposes of employee retention credits if it affects your business… or vendors you get supplies from… or vendors of vendors you get supplies from. A government order that affects your customers does not matter for purposes of your ERC eligibility however. (It might negatively impact your revenues of course–which is another way to qualify.)

Double-check You Got Caught in ERC Scam

So your first step is obvious, right? Find or see if the ERC consultant worked from a real government order. Get a copy. Read the copy and make sure it either closed your operation down. Or it closed down the operation of a vendor in your supply chain and the impact was more than nominal.

And if you can find this document? Count yourself lucky. Because many of your small-business-owning brothers and sisters appear to have claimed employee retention credits when no government order existed. You however should be fine. Not so for people who don’t have a government order.

Take These Steps If You Actually Were Scammed

If you did claim ERC refunds you were not entitled to? You need to take several steps to dial down the damage.

First, if the federal quarterly payroll tax returns—which is where an employer claims employee retention credits—have not yet been filed? I think you stop that process. This may mean instructing the “consultant” preparing the amended returns to stop. You probably want to tell them explicitly that you now believe no government order exists if that is case.

Second, if the federal quarterly payroll tax returns have been filed? But you haven’t received a refund? I think you withdraw your refund request using the procedure desrcibed here: Withdraw an Employee Retention Credit Claim. Note that the process works very simply in most cases: You make a copy of the 941-X form used to file the ERC refund claim, write “Withdrawn” into the left margin and then have an authorized person sign, give a title, and date the withdrawal using the right margin. You then, quoting from the IRS instructions, “Fax the signed copy of your return using your computer or mobile device to the IRS’s ERC claim withdrawal fax line at 855-738-7609.”

Third, if the IRS has already processed ERC refunds and you now know your firm was not eligible? You want to amend any tax returns that reflect the erroneous ERC refunds. For example, you want to amend the 941 quarterly payroll tax returns again and then repay the tax refund. That will get you square with the Internal Revenue Service and stop the compounding of penalties and interest.

Another example: If you amended your 2020 and 2021 income tax returns to report the refunds as income (which is required), you want to amend your income tax returns and remove that income. This will reduce your income tax liability for 2020 and 2021 and get you a refund while you still can.

Other Resources

We’ve got a bunch of blog posts about how employee retention credits work here. If you’re concerned you didn’t know enough or still don’t know enough about employee retention credits, check these out to provide yourself with the information you’ll need to get out of this mess.

If you’re a tax practitioner who now needs to do a deep dive into the law, pick up a copy of Maximizing Employee Retention Credits from Amazon.com. (You will have a number of clients who need help with this if your firm is anything like ours. Sorry.)

If you’re an employer who got into trouble on this area? Check first with your CPA to see if he or she can help you get out of the mess. If that doesn’t work, we do have an ability to help a limited number of taxpayers. You can make contact with our firm here: Nelson CPA PLLC.

The post If You Got Conned in ERC Scam appeared first on Evergreen Small Business.

Grouping Activities to Achieve Material Participation

Stephen Nelson CPA — Mon, 07 Aug 2023 16:01:39 +0000

This week, a quick discussion of grouping activities as backdoor way to materially participate.

But first a bit of background about what material participation is and why it matters. And then I’ll talk about how grouping activities sometimes makes a giant difference on your tax return.

Why Material Participation Matters

Okay, so here’s the main thing: You can’t deduct losses from a business venture or hands-on investment except if you materially participate in the activity.

Example 1: Two brothers, Pete and Tom, invest in a new venture. Say a restaurant. The brothers agree to each invest $100,000 and will proportionally share the losses and the profits. Tom will also receive a salary from working in the business. Pete won’t work in the business. He’s keeping his regular job. If the first year, the business loses $100,000, each brother suffers a $50,000 loss. Tom, because he materially participates, can deduct that loss on this tax return. Pete, because he doesn’t participate at all, can’t.

That’s the basic concept.

The Seven Material Participation Recipes

Next question: How does someone materially participate? Well, tax law provides seven recipes:

You spent more than 500 hours on the activity.
You spent more than 100 hours but nobody else spends more time.
In essence? You were the only person who spent any time in the activity.
You spent more than 100 hours in the activity, also spent more than 100 hours in some other activities, somehow fail to materially participate in any of these activities using some other recipe, but in total, your hours spent in all of these “significant participation activities” exceed 500 hours.
For five of the last ten years, you materially participated (for example, using more than 500 hours recipe) .
You materially participated in a personal service activity for any three years. (Again, for example, by spending more than 500 hours those years.)
You’ve been involved in an activity on such a “regular, continuous and substantial basis” that you material participated even if one of the other six material participation recipes doesn’t work. (This is an impractical recipe. Too vague. Please don’t think you can use it.)

And one important wrinkle to this discussion for married people. Spouses combine hours to determine material participation. For example, if two spouses each spend 300 hours, the total material participation hours equals 600 hours.

Grouping Activities: Backdoor Material Participation

If you don’t materially participate using one of those seven recipes just listed, however? You have one other gambit you can maybe use: Grouping activities.

The best way to understand grouping is to copy and paste an example from the relevant Treasury regulations at 1.469-4(c)(3):

Example 2: Taxpayer C has a significant ownership interest in a bakery and a movie theater at a shopping mall in Baltimore and in a bakery and a movie theater in Philadelphia. In this case, after taking into account all the relevant facts and circumstances, there may be more than one reasonable method for grouping C‘s activities. For instance, depending on the relevant facts and circumstances, the following groupings may or may not be permissible: a single activity; a movie theater activity and a bakery activity; a Baltimore activity and a Philadelphia activity; or four separate activities. Moreover, once C groups these activities into appropriate economic units, paragraph (e) of this section requires C to continue using that grouping in subsequent taxable years unless a material change in the facts and circumstances makes it clearly inappropriate.

I boldfaced key part of the copied text above. But let me summarize how I think you read this. A taxpayer invested in and works in four activities. Possibly she or he doesn’t materially participate in an activity at least using one of the usual recipes. But the taxpayer can combine activities in any reasonable method. And once activities get aggregated? Probably, the taxpayer does materially participate.

For example, maybe the taxpayer in Example 2 doesn’t qualify as materially participating in the bakery in Philadelphia. And maybe she doesn’t qualify as materially participating in the bakery in Baltimore either. But if she or he combines the Philadelphia bakery with the Baltimore bakery? Maybe that works.

Rules for Grouping Activities

As noted earlier, you can use “any reasonable method.” The Treasury regulations flesh out what that means. And they provide some logical instructions.

You need to look at all the relevant facts and circumstances. Further, a logical handful of factors should be given the “greatest weight” in determining whether it’s reasonable to treat “more than one activity as a single activity:”

I’m going to again copy and paste the actual language from the regulations. (See the bulleted list below.) But think about how these apply to the fictional business owner with bakeries and movie theaters in Baltimore and Philadelphia.

Similarities and differences in types of trades or businesses
The extent of common control
The extent of common ownership
Geographical location; and
Interdependencies between or among the activities (for example, the extent to which the activities purchase or sell goods between or among themselves, involve products or services that are normally provided together, have the same customers, have the same employees, or are accounted for with a single set of books and records).

Limitations on Grouping Activities

Because grouping activities is so potentially powerful, limitations exist.

You can’t group a rental activity with a non-rental trade or business except in usual situations. (We’ve described those situations in another blog post here: A Dozen Ways to Deduct Passive Losses. But the common exception to this limitation: You can ignore this limitation when one of the activities is insubstantial in relation to the other. Another common exception: Self-rental situations.)

You can’t group real property rentals with personal property rentals.

You can’t group limited partner and limited entrepreneur activities except when the activities are in the same type of business. (This limitation applies to farming; movie and video production, distribution and holding; leasing Section 1245 property (so mostly depreciable personal property); oil and gas exploration; and geothermal exploration.)

But other than these limitations? In many cases, business owners should be able to group activities to achieve material participation. If they need to.

Grouping Activities Paperwork

You or your tax advisor need to add some paperwork to your tax return to group activities. For example, you include a grouping election with the first tax return you combine activities.

If facts and circumstances change and the original grouping no longer makes sense? You regroup and disclose that action on the first affected tax return.

If you haven’t made a grouping election but should have? Yeah, you should talk to your tax advisor about that. Typically, you can make a “backdated” grouping election.

One predictable and fair caveat? The IRS may regroup activities if (1) a group is “not an appropriate economic unit” and (2) a “principal purpose” of the grouping was to “circumvent” Section 469’s passive loss limitation rules.

Crazy Grouping Activities Examples That Work

Let me share three example groupings that probably work.

Example 3: A contractor works full-time in his own construction business. His spouse spends 50 hours a year on a short-term rental business—which tax law doesn’t consider a rental activity. But the short-term rental housekeeper spends 80 hours a year. Thus, without grouping the businesses? The taxpayers can’t deduct short-term rental losses. However, if the couple groups the activities, they achieve material particpation. Note that it should be reasonable to group these activities. In addition to the common ownership and control, the husband maybe does construction and repair work in both activities. And then the wife may do the accounting in both activities.

Example 4: A real estate broker qualifies as a full-time real-estate professional, and also spends 75 hours per property per year managing two rental properties. But if he uses separate landscapers for each property and the two landscapers each spend 100 hours a year? He doesn’t materially participate and won’t be able to deduct rental losses. Unless he groups. And in that case, bingo, he material participates. Because his 150 hours exceeds the 100 hours spent by either of the landscsapers. (As mentioned earlier, you can’t group his real estate sales activity with the rental activity.)

Example 5: A taxpayer rides horses professionally (one activity) and operates an interior design business that specializes in equestrian-themed home interiors (another activity). Very possibly, she can group the horseriding with the interior design. Risk exists here that the IRS might see the horse business as a hobby, something I discussed here: What Ms. Topping Learned. But ignoring the hobby loss issue, if someone owns and operates two businesses that together create synergies? Grouping might be reasonable. (Be sure to consult your tax advisor if you want to try something like this.)

A Final Caution Here

And let me end with a caution. The IRS regularly rejects taxpayers grouping an airplane business with another business. Which maybe doesn’t seem to matter to you if you don’t own an airplane. But the rejected airplane activity groupings highlight a risk.

The pattern that seems to show up when the IRS removes an airplane business from grouping? Common ownership and control isn’t enough. You need more than that. You want interdependencies or similarities in the activities. Probably some synergy. And then you don’t want huge differences in the activities. (Grouping a doctor’s office with an airplane charter, for example? Yeah, that’s stretch.)

Other Related Resources:

Real Estate Professional Audits

Surviving Short-term Rental Audits

The post Grouping Activities to Achieve Material Participation appeared first on Evergreen Small Business.

The Qualified Family-Owned Small Business Deduction

Stephen Nelson CPA — Thu, 13 Jul 2023 14:22:39 +0000

If you own or invested in a Washington state small business, you want to know about the qualified family-owned small business deduction.

And here’s why: Washington state now levies a seven-percent capital gains tax on (1) the net long-term capital gains residents realize and (2) the Washington-state-y net long-term capital gains that nonresidents realize.

But if you’re a small business owner or entrepreneur? You can probably avoid the capital gains tax on the sale of a small business. Because the law includes a qualified family-owned small business deduction.

A warning though: Washington state’s new capital gains tax is complicated. And the most complicated bit? The small business loophole you may want to use.

The Washington Capital Gains Tax in a Nutshell

But let me briefly explain how the Washington capital gains tax works. And then I’ll get into the gritty details of the qualified family-owned small business deduction (aka, the “QFOSB” deduction.)

So the big picture on this Washington capital gains tax. The state levies a seven percent tax on the net long-term capital gains an individual taxpayer realizes.

However two wrinkles here: First, the law exempts a bunch of special-case capital gains, including most capital gains on real estate, gains from selling depreciable property, and for specific industry situations. (For a complete list of the exemptions, you can refer to a blog post over at our CPA firm website: Washington State Capital Gains Tax Planning.)

And then the second wrinkle. The law provides three deductions: A standard $250,000 deduction (so the first $250,000 of gain is never taxed). A charitable contribution deduction of up to $350,000, which is an alternative to the $250,000 standard deduction. (You would use the alternative charitable deduction only if it exceeds the standard deduction.) And then a qualified family-owned small business deduction.

Note: Those amounts in the preceding paragraph get adjusted annually for changes in the Seattle-area consumer price index. The actual standard deduction for 2023, for example, should be eight or nine percent higher.

So, that’s the big picture. But you’ll need to understand the gritty details of the QFOSB deduction.

Deduction Detail #1: Gross Revenues $10 Million or Less

A first thing to know about the QFOSB deduction: To be a small business, a firm’s worldwide revenues for the twelve-month period prior to the sale or exchange need to equal $10,000,000 or less. (This value also gets adjusted for inflation. So if you’re looking at a sale in 2023? The value might be closer to $11,000,000.)

But note that the tax doesn’t look at the capital gain, as the following two examples highlight:

Example 1: George developed and patented artificial intelligence software. After several years of development, annual revenues average less than $1,000,000 a year. But a large technology company buys his business for $100,000,000. He should qualify for the full qualified family-owned small business deduction on the $100,000,000.

Example 2: George’s wife Martha starts an ecommerce business and slowly grows the business to $12 million in revenues. After George sells his business, she sells her firm in 2022 for $500,000 based on the firm’s annual profits. (Profits roughly run $200,000 a year.) Probably half of her $500,000 of capital gains, or $250,000, gets taxed. Her business? Too big to use the QFOSB deduction on her tax return.

Deduction Detail #2: Three Families or Fewer Control

The next thing to know. The QFOSB deduction only works for an interest in a family-owned business that meets, and here I use the language of the statute, one of the following characteristics:

An interest as a proprietor in a business carried on as a sole proprietorship
An interest in a business if at least 50 percent of the business is owned, directly or indirectly, by any combination of the taxpayer or members of the taxpayer’s family.
An interest in a business if at least 30 percent of the business is owned, directly or indirectly, by any combination of the taxpayer or members of the taxpayer’s family and at least 70 percent of the business is owned, directly or indirectly, by the members of two families or at least 90 percent of the business is owned, directly or indirectly, by the members of three families.

The Washington capital gains tax law, by the way, says a taxpayer’s family members include ancestors (so parents and grandparents of the taxpayer, for example), spouses and state registered domestic partners, lineal descendants, lineal descendants of a taxpayer’s spouse or state registered domestic partner, and finally, the spouse or state registered domestic partner of a lineal descendant. (These definitions come from Revised Code of Washington Section 83.100.046.)

Example 3: George and his wife Martha along with their good friends John and his state registered domestic partner Abigail start a small business. Initially they each own half. Later on they sell a third of the company to a venture capital fund. If they subsequently sell the business, because their two families together own less than 70 percent, they won’t get to use the QFOSB deduction. Note that had they sold the firm before raising venture capital? Yeah, they would have qualified.

One thing to note here: The new law doesn’t define what a business is. But a reasonable guess is that the definition used for federal income taxes works. For example, the Section 162 standard established in a famous U.S. Supreme Court case, Commissioner v Groetzinger, says a business is an activity conducted in pursuit of profit and carried on with regularity and continuity. (Groetzinger was a professional gambler, by the way.)

One would think that all the common business forms “qualify” for the qualified small business interest deduction: sole proprietorships, partnerships, regular “C” corporations, S corporations, LLCs operating as a proprietorship, partnership or corporation, and so forth.

But an awkward reality: We don’t at this point know for sure how the state defines a “business.” (For example, federal income tax laws say a real estate rental activity may rise to the level of a trade or business. Yet who knows how the state sees this issue.)

Deduction Detail #3: Sell Substantially All of the Business or the Interest

Another detail you need to know to assure the deduction: The business owner needs to sell at least 90 percent of her or his interest or the owners need to sell at least 90 percent of the business’s real property, taxable personal property, and intangible personal property.

Example 4: Washington and Adams, a land surveying partnership with two owners, sells all of the assets of their business for a $1,000,000 capital gain. The two owners share the $1,000,000 equally. Assuming all the other requirements are met, each owner shelters their proportional $500,000 gains with the QFOSB deduction because they’ve sold 100 percent of the consulting business.

Example 5: Jefferson and Burr operate a law firm as equal partners. Burr wants to sell his 50 percent interest in the law firm to a young new partner, Clinton, and then retire. When Burr sells his 50 percent interest to Clinton, he realizes a $500,000 capital gains tax and he also avoids the Washington capital gains tax on the $500,000 gain. The reason? He sells 100% (so more than 90%) of his interest in the business.

Note: The statutory and administrative guidance available from Washington state provide no guidance on whether an existing business might be split into two or more separate businesses. For example, in Example 4, could Washington and Adams split the land survey firm into two businesses—say a Virginia operation and a Massachusetts operation—prior to the sale? And then they could possibly sell substantially all of one of those businesses? I would guess this does work. And here’s why: In the July 2023 administrative rules’ Example 11, the Department of Revenue describes how a real estate gain potentially subject to capital gains tax can be “moved” into another entity and so escape the tax.

Deduction Detail #4: Hold Interest for Five Years

The usual time frame required to receive long-term capital gain treatment on a federal and most other state income tax returns is more than one year. But to enjoy the qualified family-owned small business deduction, a taxpayer needs to have held her or his interest in the business, either directly or beneficially, for at least five years immediately preceding the sale. And while a mere change in the form of the business doesn’t necessarily restart the five year countdown, the change in form needs to not change the proportions of any beneficial ownership interest. (This last requirement comes from page 12 of the July 2023 administrative rules.)

Example 6: James starts a restaurant on January 1, 2020 and operates as a sole proprietor for two years. He then incorporates the restaurant and elects Subchapter S status two years later on January 1, 2022. He sells the restaurant on December 30, 2024 and realizes a $1,000,000 capital gain. Because he sells the business one day short of five years? He will pay the capital gains tax on a portion of the $1,000,000. (Partial days count as full days per the statute. So if he’d sold on December 31, 2024 or later, he could have taken the deduction.) Note that the change in the form of the business ownership—a sole proprietorship for two years and then an S corporation for almost three years—doesn’t matter because James’ ownership percentage doesn’t change when the form of the business changes.

Example 7: John, James’s brother, also started a restaurant on January 1, 2020 and then owned and operated it for a full five years, selling the restaurant on January 1, 2025. John operated the restaurant as a sole proprietorship for the first two years and then as an S corporation the remaining three years. When he elected Subchapter S status, however, he allowed his key employee to acquire a five percent interest in the S corporation. Unfortunately, he fails to qualify for the qualified family-owned small business deduction. Why? Because his changed ownership percentage in the S corporation “form” of the business restarts the five-year holding period.

Deduction Detail #5: Taxpayer or Family Materially Participates

A material participation rule exists for the QFOSB deduction: Either the individual or a family member owning the business needs to materially participate in the business for five of the ten years immediately preceding the sale unless the sale is to another member of your family.

To determine material participation, the Washington statute basically regurgitates Section 469 of the Internal Revenue Code, which says material participation means a taxpayer needs to be involved in the operations of the activity on a regular, continuous and substantial basis. And then the statute says material participation has the roughly same meaning as the Section 469 statute and its regulations. (The actual statute says, “materially participated must be interpreted consistently with the applicable treasury regulations for Title 26 U.S.C. Section 469 of the internal revenue code…” The administrative rules then soften the “consistently” requirement with a rule to “generally” apply the 469 regulations.)

But a note: The Section 469 temporary regulations provide seven methods of achieving material participation. And only the first three methods, which set time-spent thresholds (more than 500 hours a year or more than 100 hours when no one works more or substantially all of hours), appear to work well. The regulations’ other material participation methods appear not to work. Or not to work cleanly. (Two methods, for example, say a taxpayer has materially participated for federal income tax purposes even when she or he hasn’t spent any time working in the preceding five years.)

Deduction Detail #6: Document Material Participation

A related material participation thing. Material participation from any member of the family of the taxpayer apparently counts for the entire family. But surely many family-owned small business owners have not been documenting their participation.

And for a good reason: They haven’t needed to.

Internal Revenue Code Section 469 and the companion Treasury regulations use material participation to determine when individual taxpayers claim passive activity losses and use passive activity tax credits. That’s exactly the opposite of what Washington state wants. The state uses the passive loss material participation regulations to determine if individual taxpayers report taxable income.

The practical problem in this misapplication? Profitable “qualified family-owned small business” businesses probably won’t have been tracking their material participation at least before now. Because they didn’t need to. But now they should. Probably. So they can later prove material participation.

Deduction Detail #7: Consider (Reconsider?) Activity Groupings

One other wrinkle related to Section 469 material participation rules bears mentioning.

Section 469 and its companion regulations provide a way for taxpayers to aggregate their trade or business activities into larger grouped trades or businesses.

As a generalization, trades or businesses (which is what the Washington state statute appears to talk about) might qualify for the family-owned small business deduction if they meet the requirements and follow the rules described here.

But one probably needs to stay alert to the possibility that the state says activity groupings create trades or businesses for purposes of the Washington state capital gains tax.

Example 8: Years ago, for purposes of filing his federal income tax return, Andrew appropriately grouped a warehouse he owns (held in an LLC) with a distribution business he owns (in an S corporation) based on self-rental grouping rules embedded in the Section 469 regulations. Because the IRS sees these two activities as a single activity, one wonders if the Washington Department of Revenue would see them as a single trade or business. That unintended consequence would mean that Andrew would not get a qualified family-owned small-business deduction unless he sells both the warehouse and the distribution business to the same buyer.

A related thought: Even if Andrew sold both the warehouse and distribution business simultaneously, would two sales to different buyers count as a sale or exchange that disposes of substantially all of the assets? The language of the statue talks about the “sale of substantially all of the taxpayer’s interest in a qualified family-owned small business.” Not “sales” plural, then. But a singular “sale.”

And another related thought: If the Washington Department of Revenue would see an activity grouping consisting of a warehouse and a distribution business as a single trade or business, could the business owner first sell the warehouse? (That would presumably not trigger Washington capital gains because real estate gains are exempt from the tax.) Then later, but perhaps even in the same year, the business owner could sell substantially all of the remainder of the previously grouped activities—so just the distribution business. I would guess this works. For what it’s worth.

Deduction Detail #8: Use Smart Purchase Price Allocations

Some small businesses get sold as a collection of assets: the inventory, furniture and fixtures, maybe the real estate and then the intangible personal property like the goodwill. Because some of the assets fall into exempt income categories, a seller might want to sell assets rather than the entity.

Example 9: Martin owns a small business, Van Buren Inc., that he can sell his stock in for a $750,000 gain. However, he worries he will fail to qualify for the QFOSB deduction because he can’t confidently prove his material participation. Thus, by selling this stock, he might pay the seven percent tax on $500,000 of the gain (assuming the 2022 $250,000 standard deduction). Alternatively, in an asset sale, he can sell the inventory for a $100,000 gain (not taxed because inventory is not a capital asset), sell the depreciated furniture and fixtures for a $200,000 gain (statutorily exempt from the Washington capital gains tax), sell the real estate for a $200,000 again (again, statutorily exempt), and thus completely avoid the Washington capital gains tax.

Note: Some practitioners wondered how the Department of Revenue would handle purchase price allocations. And the July 2023 rule proposals provide helpful guidance. The proposed rules say that taxpayers can use full appraisal reports, assessor valuation if the assessment date closely matches the sale or exchange date, or the purchase price allocation the seller and buyer use to comply with IRC Section 1060. Predictably, the Department of Revenue reserves the right to change or modify what it views as an inappropriate allocation.

Deduction Detail #9: Consider Domicile of Owners

A Washington state domiciliary (basically what tax law usually thinks of as a resident) pays taxes on essentially all of her or his net long-term capital gains. (I’m ignoring the credit for taxes paid to another state if some net long-term capital gains get sourced outside Washington.)

For nonresidents, however, only tangible personal property sold or exchanged from a location in the state gets hit with the Washington capital gains tax.

Tangible personal property, per the administrative rules means “personal property that can be seen, weighed, measured, felt or touched”. Tangible personal property, then, does not include an interest in a partnership or shares of a corporation. Thus, an out-of-state small business owner might optimize by selling her or his interest in the partnership or the corporation instead of having the partnership or corporation sell its assets.

Example 10: Martin’s wife Hanna, also owns a small business, Hannah Hoes Corporation. After Martin sells his business, he and his wife move to Nevada. And then, after establishing residency there, Hannah sells her interest in her Washington corporation for a $1,000,000 gain. She avoids Washington capital gains tax.

Deduction Detail #10: Avoid Section 338(h)(10) Treatment

The modest guidance from the Department of Revenue, at least at the time we’re writing this, suggests to us that taxpayers might want to avoid common but more complex transaction structures.

As one example of this, I’d think a taxpayer wants to avoid applying Section 338(h)(10) to a qualified stock purchase transaction. Section 338(h)(10), by the way, treats a sale of stock as a sale of assets. The issue with Section 338(h)(10) is, one might not know how to handle the transaction on a Washington capital gains tax return.

Deduction Detail #11: Reconsider Section 754 Elections

A technical point.

I’m not necessarily a fan of making Section 754 elections. (The work required to make the election and then the resulting annual tax return adjustments often exceeds the tax savings.) However, taxpayers and their tax advisors probably want to reconsider Section 754 elections for appreciated property held inside a partnership at the time when a partner dies and receives a Section 1014 step-up in basis.

The reason? The step-up in basis may eliminate, or at least minimize, a taxpayer’s long-term capital gains. And that will probably eliminate or minimize Washington state’s taxation of long-term capital gains.

Deduction Detail #12: Consider Using Trust or Estate Ownership

A final, weird tangential comment: The list of pass-through entities which confer beneficial ownership for an individual excludes estates as well as trusts other than grantor trusts. That means if a nongrantor trust or estate realizes a long-term capital gain, the individuals who are beneficiaries of the estate or trust don’t pay the seven percent tax.

Thus, some small business owners may want to move an interest in a small business into a trust or sell an interest held in an estate before realizing the gain. (This gambit also works for capital assets other than interests in small businesses.)

Additional Resources for Qualified Family-Owned Small Business Deductions:

As noted earlier, we’ve got a “general” blog post over at the CPA firm website that discusses the mechanics of the Washington state capital gains tax including some common tax planning tactics: Washington State Capital Gains Tax Planning

The actual statute appears here: https://lawfilesext.leg.wa.gov/biennium/2021-22/Pdf/Bills/Senate%20Passed%20Legislature/5096-S.PL.pdf?q=20210426052154

The most recent July 2023 draft of the administrative regulation appears here: https://dor.wa.gov/sites/default/files/2023-06/20-XXXcr1frmdraftjune23.pdf?uid=64aac2f8dc5d9

The post The Qualified Family-Owned Small Business Deduction appeared first on Evergreen Small Business.