Tax law (and especially Section 469 of the Internal Revenue Code) mostly eliminates your ability to save big on taxes using real estate. That said, you do have a bunch of clever tricks available to deduct real estate losses on your tax return.

You just need to to plan ahead. And carefully structure your investing. But with little effort? You’d be surprised at the results.

Quick Review of Why Real Estate Produces Big Deductions

Let’s quickly review, though, how you can use real estate to generate big tax deductions.

Say you own a $1,000,000 property that generates $50,000 in rent. Further, suppose the property expenses, including the interest on the mortgage used to fund a part of the purchase, run $50,000.

You might assume such an investment breaks even for tax return purposes.

However, tax accounting rules will typically show a property like that described as losing money. Why? Because the investor depreciates the property.

Tax laws say investors can depreciate, or write off, the purchase price of a residential building over 27.5 years. And those same laws say a taxpayer can depreciate the purchase price of a commercial building over 39 years. (You only get to depreciate the building, not the land, by the way.)

And then the other wrinkle: Some of the bits and pieces of a residential property or commercial property can be written off much faster. Maybe in the year of your purchase.

A $1,000,000 rental property that breaks even, for example, might result in you putting a $100,000 or $200,000 deduction on the tax return you file the first year of ownership.

Which is why tax law includes the Section 469 passive loss limitation rules. In most situations, these rules say you don’t get to use big real estate deductions to shelter other income.

Exceptions exist for all rules, however. And more than a dozen exceptions allow you to deduct real estate losses or use real estate to shelter your other taxable income.

Real Estate Deduction Trick #1: Active Real Estate Participant

The first and easiest to use exception: The active participant exception (provided by Section 469(i)).

Specifically, if your modified adjusted gross income equals $100,000 or less, you can deduct real estate losses of up to $25,000 each year. The only two rules to make this deduction work are:

1. You or your spouse need to own at least ten percent of the property.
2. You or your spouse need to be actively participating in managing the property by doing things like picking the property manager, approving tenants and expenditures, and making rental agreement decisions.

By the way, if your modified adjusted gross income exceeds $100,000 but falls below $150,000, tax law proportionally phases out the $25,000 allowance. Someone with a modified adjusted gross income halfway between $100,000 and $150,000, for example, loses half of the $25,000 allowance.

The active real estate participant exception works for middle class taxpayers and for most upper-class taxpayers.

Note: Modified adjusted gross income equals a taxpayer’s adjusted gross income plus retirement deductions, passive losses such as on real estate, deductions for self-employment taxes, student loan interest, tuition deductions, and some foreign income deductions.

Real Estate Deduction Trick #2: The Section 280A(g) Exception

A weird trick works for property owners who also own a business structured as a corporation or a partnership.

A taxpayer in this situation can sometimes direct the corporation or partnership they own to pay rent to them for the use of a personally-owned real property.

If the rent counts as an ordinary and necessary expense, the rent payments get deducted on the corporation or partnership return. Which makes sense.

But here’s what’s weird. If the property owner rents the property for fourteen days or less, and then the property owner also personally uses the property for more than two weeks, the rent payments the taxpayer receives from their business don’t count as income.

An example shows how this works. You own a condo in Florida. When you attend a two-week industry conference in Orlando, rather than pay some hotel for lodging, your corporation pays you for using the condo for two weeks. (Say the corporation pays you $10,000.)

On the corporation’s tax return, the corporation counts the $10,000 as a valid deduction.

But on your individual tax return, the $10,000 rent received doesn’t count as income. Because of the Section 280A(g) rule.

By the way, the rental rate needs to be the market rate. (Accordingly, if the market rate is high, the rent amount can and must also be high.)

Real Estate Deduction Trick #3: Self-Rental

A related gambit works to deduct real estate losses, too.

If you buy property to rent to another trade or business you own, you can group the rental property trade or business with the operating trade or business on your tax return. That self-rental grouping lets you sidestep the passive loss limitation.

For example, if you run a professional practice (perhaps as an S corporation) and then you personally buy the building you use for the business, you get to deduct the real estate losses from the building on your personal return.

The one key bit of this rule to be alert to: The ownership of the rental property and the ownership of the operating trade or business need to match. Perfectly.

Note: We’ve got a longer and rather detailed discussion of how the self-rental trick works here: The Self-Rental Loophole.

Real Estate Deduction Trick #4: Real Estate Professional

Here’s a really powerful strategy to deduct real estate losses.

A real estate professional gets to deduct real estate losses if she or he materially participates in the rental operation.

To be a real estate professional, someone needs to spend more than 750 hours and more than 50% of their work day in a real estate trade or business they own (Section 469(c)(7)). Real estate trades or businesses include property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, property management, learning, or brokerage.

And then, as noted, either the taxpayer or the spouse needs to materially participate in the rental business by spending enough time. (The standard, clean way to materially participate is to spend more than 500 hours on the investment property or properties in a year. But you can achieve material participation in other ways, too. Like by spending more than 100 hours a year if no one spends more time.)

An example shows the power of this strategy. Say a high income professional or executive earns $400,000 annually. Suppose his or her spouse manages a family real estate portfolio and in that role as a property manager qualifies as a real estate professional. Further suppose that the real estate portfolio produces real estate losses equal to $150,000. This married couple pays taxes on the net $250,000 in this situation. In other words, $150,000 of the household’s $400,000 annual income gets sheltered by the paper real estate losses.

Note: A longer discussion of how the real estate professional strategy appears here: How the Real Estate Professional Tax Strategy Works  Also note that California prevents a taxpayer from using the real estate professional strategy for its state income tax returns. (A Californian still can use the real estate professional loophole to shelter federal income taxes.)

Real Estate Deduction Trick #5: Short-term Weekly-or-less Rentals

Here’s another strategy to deduct giant real estate losses.

If your average rental interval equals seven days or less, tax law (specifically Reg. Sec. 1.469-1T(e)(ii)(A)) says you’re not in the real estate rental business. Rather, you’re in a non-real-estate business. That means you get to deduct any of the non-real-estate losses if you materially participate.

Note: A longer discussion of how this real estate deduction exception works appears here: How the Vacation Rental Tax Strategy Works.  But know that short-term rentals work really well as long as you carefully follow the rules.

Real Estate Deduction Trick #6: Short-term More-than-a-Week Rentals

Another similar, but less well-known, short-term rental exception applies, too.

If a taxpayer rents property for, on average, thirty days or less but more than a week and she or he provides significant personal services, tax law (in this case, Reg. Sec. 1.469-1T(e)(ii)(B)), says they’re also not in the real estate rental business. Rather, they’re in a non-real-estate business. If a taxpayer materially participates in the non-real-estate business? Bingo. They get to deduct real estate losses.

So for example, if someone operates a hotel and the hotel provides daily maid service, a front desk with bellhops, and then maybe a concierge, that’s not a real estate business. And the taxpayer gets to deduct any of the non-real-estate losses if she or he materially participates.

Sidebar: The IRS Definition of “Significant”

One caution here: The IRS says “significant personal services” means really significant. Here’s the example the Treasury regulations give for when personal services provided by a residential apartment hotel fail to reach the level of “significant:”

Example 4:

The taxpayer is engaged in an activity of owning and operating a residential apartment hotel. For the taxable year, the average period of customer use for apartments exceeds seven days but does not exceed 30 days. In addition to cleaning public entrances, exists (sic), stairways, and lobbies, and collecting and removing trash, the taxpayer provides a daily maid and linen service at no additional charge. All of the services other than maid and linen service are excluded services (within the meaning of paragraph (e)(3)(iv)(B) of this section), because such services are similar to those commonly provided in connection with long-term rentals of high-grade residential real property.

The value of the maid and linen services (measured by the cost to the taxpayer of employees performing such services) is less than 10 percent of the amount charged to tenants for occupancy of apartments. Under these facts, neither significant personal services (within the meaning of paragraph (e)(3)(iv) of this section) nor extraordinary personal services (within the meaning of paragraph (e)(3)(v) of this section) are provided in connection with making apartments available for use by customers. Accordingly, the activity is a rental activity.

So, daily maid service isn’t enough. A taxpayer needs more than that.

Real Estate Deduction Trick #7: Rental Incidental to Extraordinary Personal Services

Sometimes, the owner of a residential property or commercial building lets customers use the residential facilities or commercial property just as part the customer receiving some other service.

For example, a hospital or nursing home may in effect “rent” hospital rooms to patients. But the rental activity pales in comparison to the medical or nursing care the people receive.

Another example: A college or boarding school provides (so in effect “rents”) rooms in on-campus dormitories to students attending classes. But the real activity is education.

In these settings where extraordinary personal services are provided, tax law (specifically Reg. Sec. 1.469-1T(e)(ii)(C)) considers the activity a non-real-estate activity. And the taxpayer may deduct the non-real-estate deductions and losses if they materially participate.

Probably not an idea many people will use. But you never know.

Real Estate Deduction Trick #8: Rental Activity Incidental to Nonrental Activity

Another way exists to deduct real estate losses based on the incidental nature of the real estate, too.

Specifically, if a trade or business owns and rents property, but that rental activity is only incidental relative to the main trade or business? The losses connected to the rental property don’t get limited by the Section 469 passive loss limitation rules.

The current Section 469 regulations (at Reg Sec. 1.469-1T(e)(vi)) provide three examples of this sort of incidental rental activity. One example says that if the taxpayer holds the property for appreciation and the gross rental income is less than the lesser of two percent of either the unadjusted basis or the fair market value of the property, that counts as incidental. Another example says that renting property to an employee counts as incidental. Finally, a third example says that if a property is used in a trade or business the taxpayer owns an interest in and the gross rental income falls less than two percent of the lesser of property’s unadjusted basis or fair market value, that minuscule rental income counts as incidental.

This approach to deducting real estate losses probably won’t result in giant tax savings. But might produce some.

Real Estate Deduction Trick #9: Nonexclusive Rental Activity

Nonexclusive use of property doesn’t count as a real estate rental activity (per Reg. Sec. 1.469-1T(e)(ii)(E)).

Examples of this situation? The Treasury’s regulations talk about a golf course where, in one sense, the property owner rents the use of the course to golfers. But not exclusive use. So that works.

And then a crazy idea which I also think works. Suppose you decide to get into the amusement park business. And you set up a haunted house attraction that charges people an admission fee. Again in this example, the property owner in effect rents the use of the house through an admission fee. But again not exclusive use. So that should work.

In these nonexclusive-use situations, as long as the owner materially participates in the activity, she or he can deduct real-estate-y losses.

Real Estate Deduction Trick #10: Insubstantial Rental Activity

The Regulations for Section 469 describe rules taxpayers can use to group activities. For example, a barber with two barber shops might treat the two shops as two activities. Or he might group the two barber shops into a single activity.

Normally, though, taxpayers can’t group rental activities with a nonrental activity.

But except for that special rule, most grouping rules apply common sense. Stuff a taxpayer would logically think of as one trade or business can be grouped. (The specific rules appear at Reg. Sec 1.469-4 but talk about similarities and differences in the businesses, the extent of common control and ownership, geographical locations, and then interdependencies between the activities.)

However, these grouping rules also flag a couple of other interesting possibilities that effectively allow a taxpayer to deduct real estate losses by clever grouping. For example, a taxpayer might (per Reg. Sec. 1.469-4(d)(1)(i)(A)) group an insubstantial rental activity with another trade or business. And then in effect deduct real estate losses.

The now-expired former Reg. Sec 1.469-4T provided a less than “20 percent of the activity’s income” threshold for determining insubstantial-ness. In an example the regulations provided, a law firm earned 90 percent of its gross income from practicing law and 10 percent from renting out two floors in the ten-story office building it owned and operated out of. That example said the two floors of rental activity counted as insubstantial.

But note what happens in this case: The taxpayer probably does get to deduct real estate losses in situations where an insubstantial rental occurs.

Tip: If you need to explore this possibility in more detail, read the Technical Advice Memorandum 200014010. It describes why the less than 20 percent approach shouldn’t be considered a “bright line” test.

Real Estate Deduction Trick #11: Insubstantial Nonrental Activity

The other example of insubstantial-ness occurs when an insubstantial non-rental activity gets grouped with a rental activity. In that situation, income from the insubstantial non-rental activity might allow a taxpayer to deduct real estate losses equal to the income from the insubstantial non-real-estate activity.

For example, a building owner starts a small coffee shop in the lobby of an apartment house she owns. Those two activities might be group-able based on georgraphy, common ownership and control, and then interdependencies. Further, if they are group-able and the coffee shop activity is insubstantial, it’s income may be netted with the apartment house losses. That means the taxpayer shelters active trade or busienss income using real estate losses.

Tip: Another tip for taxpayers or tax accountants who want to explore in more detail grouping real estate with insubstantial non-real estate activities: look at the Glick v. United States federal district court case.

Real Estate Deduction Trick #12: Other Passive Income

A twelfth way to deduct real estate losses: You get to deduct the passive losses you incur on an investment property to the extent you have passive income. And you may unlock past suspended passive losses.

For example, if your tax return will report a large $1,000,000 passive gain on the sale of one rental property, Section 469(d), so the actual law, essentially says that gain can be sheltered by $1,000,000 of suspended passive losses you’ve incurred in the past. And it can be sheltered by large passive losses you intentionally orchestrate for the current year. So that’s another way to deduct real estate losses on your return.

Real Estate Deduction Trick #13: Disposition of the Activity Generating Passive Losses

A final way to deduct real estate losses exists: You do get to deduct passive losses generated in some activity when you dispose of the activity.

For example, if over the years your tax returns have shown passive losses accumulating on a rental property, selling the property will typically unlock those losses.

Say you bought a property for $1,000,000, for example, wrote off $500,000 of the purchase price through depreciation deductions, and will now sell the property for $500,000. And say the rental income and rental expenses equaled each other. So, the property essentially broke even before considering the depreciation deductions.

A sale in this situation will unlock the previously suspended losses.

Closing Thought

As always, taxpayers want to discuss a strategy like this with their tax advisor.

But this plug for our CPA firm: If you don’t have a tax advisor who can help? Please consider contacting us: Nelson CPA.

The post A Dozen Ways to Deduct Real Estate Losses appeared first on Evergreen Small Business.

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

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

Passive Loss History

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

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

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

Example 1 of the Self-rental Loophole

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

Year One

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

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

Year Two

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

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

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

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

Grouping your Active Trade or Business with your Self-rental

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

1. Similarities and differences in types of trades or businesses;
2. The extent of common control;
3. The extent of common ownership;
4. Geographical location;
5. Interdependencies between or among activities

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

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

Grouping Statment

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

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

Example 2 of Self-rental Loophole

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

Year One

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

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

Year Two

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

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

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

A Trick for Bigger Rental Losses

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

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

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

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

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

Tax increases in the bill

Here’s some good news: if you’re a small business owner or real estate investor, the Inflation Reduction Act probably doesn’t raise your taxes.

The major revenue raisers in this bill are:

• A new book minimum tax for large ($1 billion+ average book income) C corporations
• A new excise tax on stock buybacks (only applies to publicly-traded corporations)
• Extension of excess business loss limitation rules from 2026 to 2028
• Increased money for IRS enforcement

The extension of the excess business loss limitation rules will hit some real estate investors. But for most folks in this category, we think the increased money for the IRS will be the most visible and meaningful change to our tax system due to this law. As we’ve frequently noted on this blog, keeping good records and staying on top of your bookkeeping are the two most important ways to protect yourself in an audit.

Tax increases not in the bill

Back in the autumn of 2021, Democrats had proposed significant changes to the federal income tax code. In response to these proposals we wrote a blog post last September on the slow death of the S corporation, had the ideas become law.

Well, it turns out reports of the S corporation’s death were greatly exaggerated; the Inflation Reduction Act contains no changes to the net investment income tax, or NIIT. It also contains no changes to the basis step-up rules for inherited assets, no change to the unified gift/estate tax credit, and no changes to IRA contribution or distribution rules. In fact, we could write a whole laundry list of proposed changes that never found their way into the Inflation Reduction Act—and we have:

• No change to top marginal rate for individuals
• No changes to capital gains tax rates
• No “billionaire tax”
• No changes to SALT
• No changes to 199A
• No change to carried interest loophole
• No change to 21% C corporation rate
• No new limits on deductibility of interest expense for C corporations
• No changes to limit 1202 exclusions
• No changes to expand wash sale rules
• No changes to foreign tax credit
• No changes to GILTI, FDII, or BEAT

So, what else is in this bill? Well, a lot of climate change-related stuff.

Green tax incentives for real estate investors

Real estate investors may be interested in the bill’s tax incentives for green retrofits—especially if your building is in Washington State and subject to the Clean Buildings law.

For multifamily and commercial buildings: a 179D revamp

Section 13303 of the Inflation Reduction Act dusts the cobwebs off Section 179D of the tax code. The 179D deduction is, in essence, a depreciation acceleration trick similar to the Section 179 deduction small business owners are familiar with. The basic idea is if a real estate investor either (1) purchases a new energy efficient building or (2) makes a deep energy retrofit to an existing building, the investor can deduct a large chunk of the cost of that asset in the first year instead of waiting several years to deduct the cost as “depreciation expense.”

The amount a taxpayer can deduct up front is the lesser of either (1) the cost of the retrofit or (2) the result of a complex formula built around an efficiency engineering standard, ASHRAE Standard 90.1. Predictably, then, one of the rules for claiming a 179D deduction is that an independent licensed engineer (or in some cases, an architect) must certify the energy savings targets before the taxpayer can claim the deduction.

We’re not going to go into the nuts and bolts of the formula here, because really the way to claim this deduction is to hire a consulting firm staffed with tax professionals and engineers to design the retrofit to maximize the deduction for you. They’ll calculate your deduction and prepare a report for your regular tax accountant as part of that process. But here are a few key things to understand about Section 179D if you’re interested in this tax savings opportunity.

First, know that this deduction is for larger buildings: think commercial buildings, 4+ story apartment buildings, schools, hospitals, etc.

Second, know that a 179D deduction isn’t something to start thinking about when it’s time to prepare your tax return for the year. You need to decide whether you’ll claim this deduction before you begin the project. That’s because you’ll want to choose a design firm that really knows Section 179D and the ASHRAE standard it rests on, to make sure their design meets the tax law’s requirements. And if you want to claim the full deduction, not just part of it, you’ll need to be sure the building contractor you select for the construction work understands and complies with the Inflation Reduction Act’s new prevailing wage and apprenticeship rules.

Third, for the sake of my own conscience, I feel I ought to point out that the consulting fees for calculating 179D deductions can be very expensive. And some big players have gotten into hot water after being fairly aggressive with this stuff.

Finally, this may be an odd thing for a tax accountant to admit, but there are options for funding deep energy retrofits that go beyond tax deductions and credits. For example, some sophisticated real estate investors in Seattle are experimenting with a novel transaction structure called the “metered energy efficiency transaction structure,” or “MEETS” for short. And King County recently launched a PACE loan program. Of course, we can’t endorse any particular financing idea for you if we don’t know your situation. But we want to acknowledge that there are many options to consider.

For buildings with a sunny roof: the commercial solar panel credit

Section 13102 of the Inflation Reduction Act extends the commercial tax credit for solar panels (in Section 48 of the IRC) to 2034, with a phase-out beginning in 2032. Starting January 1, 2022, your maximum tax savings will be 30% of whatever the panels cost your business or real estate activity.

Example: You install a $20,000 solar panel system on a duplex you own and lease to tenants. If you qualify for the credit and meet the wage and apprenticeship rules, the IRS will pay for 30% of the cost of the system—so, $6,000.

That probably already sounds pretty good. But here’s where the numbers get silly. In addition to getting a (usually 30%) tax credit, Section 48 “energy property” also gets a 5-year asset life under MACRS. What’s more, the section 48 credit reduces the basis for depreciation by only half the credit amount. And while you can’t use the Section 179 deduction on any property you’ve claimed the Section 48 energy credit on, for the next few years you can likely use bonus depreciation to achieve a similar result.

So, just to put this all together: if a landlord installs a solar energy system on a building it owns and rents to tenants, or a small business installs a solar energy system on a building it owns and uses for business, not only will the IRS pay for up to 30% of the cost of the solar panels, but the panels get depreciated over just 5 years (even though in reality the panels will likely last for 25-30 years). What’s more, even though you might think the depreciable basis would be the 70% of the cost of the panel the landlord or business owner paid themselves, really the basis for depreciation is 85% of the total cost of the panels (because only ½ of the credit is subtracted from the depreciable basis). And remember, just like any other 5-year property, the depreciable basis can be (at least partially) expensed using the bonus depreciation rules, depending on what year you install and start using the property.

Now, of course Congress has attached some strings to all of this free money. The panel system must be new, not used, and it needs to be located in the United States. You’ll also need to comply with the Inflation Reduction Act’s new prevailing wage and apprenticeship rules, or the credit is only 6%. And you must hold the property at least 5 years or the IRS will recapture the credit.

One final comment: the Inflation Reduction Act adds 10% to your solar panel credit if you install the panels in a low-income community, and 20% if you install the panels on a qualified low-income residential building project. There are also bonus credits for using domestic content and for installing panels in an “energy community” (think West Virginia coal country).

For parking lots in low income or rural areas: the EV charger credit

Section 13404 of the Inflation Reduction Act extends and modifies the Alternative Fuel Refueling Property Credit. “Alternative refueling property” includes electric vehicle charging stations, so this credit is relevant for any building owner who would like to install EV chargers in their parking garage or parking lot.

The new EV charger credit rules apply to property placed in service after December 31, 2022, and the credit expires December 31, 2032. One notable difference between the Senate Finance Committee proposal and what passed the Senate last Sunday: this credit is now only available to EV chargers installed in low income communities and rural areas. It’s also worth noting that the Inflation Reduction Act modifies section 30C to make bidirectional charging equipment and charging equipment for 2- and 3-wheelers eligible for the credit.

Example: You own a small office building in a low-income community and install 10 level 2 EV chargers in the building’s parking lot for $3,500 each (including parts and labor). If you qualify for the credit and meet the wage and apprenticeship rules, the IRS will pay for 30% of the cost of the chargers—so, $10,500.

Predictably, there are some strings attached. The charger must be new, not used, and it needs to be located in the United States. To get the full 30% credit, you’ll need to comply with the Inflation Reduction Act’s new prevailing wage and apprenticeship rules; otherwise, the credit is only 6%. And the credit is limited to $100,000 per item of property (that limit used to be $30,000 and it used to apply per location, not per item).

The Inflation Reduction Act keeps language in the old statute which says recapture rules “similar to” the rules of 179A apply to the credit. Section 179A has since been repealed, and the IRS never actually put out formal guidance on how the recapture rules work. All we have is an 11-page notice, IRS Notice 2007-43.

For housing developers: the Energy Efficient Home Credit

If you’re a housing developer who specializes in building energy efficient homes, you’ve probably been watching this provision in Build Ba—er, the Inflation Reduction Act—for months. But for the sake of thoroughness, we’ll note that section 13304 extended the Energy Efficient Home Credit (in section 45L of the Internal Revenue Code) to 2032, increased the credit’s size, and modified the eligibility requirements.

The old version of the credit provided $2,000 to eligible contractors for each newly constructed or “substantially reconstructed” home if the home consumed 50% less energy than a comparable dwelling unit and had a building envelope that accounted for at least 1/5 of the energy reductions. The Inflation Reduction Act increases this amount to $2,500 for homes meeting Energy Star requirements and $5,000 for zero energy ready homes, assuming the project meets new prevailing wage and apprenticeship requirements.

The new credit rules apply to dwelling units acquired after December 31, 2022.

How the credits interact with utility rebates

One final thing I’ll mention is how the tax code treats utility rebates, and how those rebates interact with the tax credits I’ve described in this blog post.

In general, utility rebates are taxable income. But section 136 of the Internal Revenue Code says a taxpayer’s gross income doesn’t include “any subsidy provided (directly or indirectly) by a public utility to a customer for the purchase or installation of any energy conservation measure.” This section also says taxpayers can’t claim a tax credit or deduction for any amount paid for with this sort of utility rebate.

So, if you claim a rebate from your local utility for a purchase that meets the statute’s definition of an “energy conservation measure,” you won’t need to pay income tax on the amount, which is good. But you’ll also need to subtract that amount from the purchase price first before calculating any tax deductions or credits. For example, if you install solar panels on an apartment building you own and claim a utility rebate for the panels, and the rebate counts as an “energy conservation measure” under Section 136, you’ll need to subtract the rebate from the cost of the panels before calculating the credit.

The post Inflation Reduction Act: What Every Real Estate Investor Should Know appeared first on Evergreen Small Business.

In some cases, a small business may still be able to treat their business as an S corporation for the year ending soon. And in most  cases, a small business can begin operating as an S corporation next year.

Reminder: Get the complete list of tax strategy posts here: Tax Strategy Tuesday.

One Person S Corporation Tax Strategy in Nutshell

The best way to showcase the power of the one person S corporation is by comparing the payroll taxes a sole proprietor pays with the payroll taxes a one person S corporation pays.

Let’s use the simple round-number example where a small business earns $100,000.

If this entrepreneur operates as an sole proprietorship, he or she pays not only income taxes but a 15.3 percent self-employment payroll tax on 92.35 percent of the $100,000.

Do the math, in fact, and the formula calculates roughly $14,000 of payroll taxes.

If this business operates an an S corporation, however, and she or he earns $100,000 in profits, the taxes work differently.

In a nutshell, the business owner decides what portion of the $100,000 to call out as wages. And then he or she pays the 15.3% payroll tax on just that portion. (The business owner will pay essentially the same income taxes.)

If a business says, for example, that $40,000 of the $100,000 should be wages—and then does the payroll tax accounting correctly—the business owner pays roughly $6,000 in payroll taxes.

And that’s where the S corporation tax savings show up: $6,000 in payroll taxes instead of $14,000 in payroll taxes.

One key, key issue here won’t surprise you: Tax law requires the business to pay the owner reasonable wages.

Tip: Use our free calculator to estimate S corporation tax savings for your specific situation: S Corporation Tax Savings Calculator.

Tricks that Make One Person S Corporation Tax Strategy Work

Many one person S corporations deliver generous tax savings to their owners by setting the owner wages too low. But you don’t want to do that. Further, knowledgeable, reputable tax accountants never condone that approach. And usually, they refuse to knowingly enable that approach.

But two tricks often allow a business to safely set a very modest salary that saves big amounts.

One trick: Load up the S corporation’s tax return with tax-free fringe benefits for the shareholder-employee. Essentially, these count as compensation but don’t trigger payroll taxes.

Example: James used to operate a sole proprietorship that generated $100,000 in business profits and paid roughly $14,000 in self-employment taxes. He now operates as an S corporation and pays himself $40,000 in wages. That means he pays roughly $6,000 in Social Security and Medicare taxes, thereby saving roughly $8,000 annually in payroll taxes. He and his accountant consider this approach reasonable because of the extremely generous tax-free fringe benefits the S corporation provides: $12,000 of health insurance, an $8,000 health savings account, and a $15,000 employer pension fund contribution.

A second trick: If an S corporation retains earnings for business purposes, the business owner sidesteps paying payroll taxes on that money.

Example: James from the preceding example shows $25,000 of leftover S corporation profit after paying modest wages and generous fringe benefits to him. He pays income taxes on the $25,000 but not payroll taxes due to the S corporation. Probably that’s very safe if he retains that $25,000 as working capital in the business. For example, as cash in the company checking account. Or dollars invested in inventory.

Possible Tax Savings from One Person S Corporation Tax Strategy

Operating a business as an S corporation rather than as a sole proprietorship often saves a one-person business owner many thousand dollars annually. Further, unlike many tax reduction schemes, S corporation tax savings often count as permanent tax savings that roll on for years and years.

Someone who reduces their taxes by, say, $8,000 a year via a $25,000 or $30,000 pension fund contribution probably pays that tax back—or some of it anyway—later on when the taxpayer withdraws the funds.

Example: John reduces his tax bill by $8,000 annually through a pension plan to which he contributes $25,000 each year. Over his working years, he hopes to accumulate $1,000,000 in his retirement account. At that point, though, he’ll begin drawing $40,000 a year. And he’ll probably at that point pay $6,000 or $8,000 in taxes annually.

With an S corporation, in comparison, the taxpayer never pays back the annual payroll tax savings. If the tax payer saves $8,000 a year, for example, she or he gets to keep that money.

Turbocharging the One Person S Corporation Strategy

Higher income one person S corporations need to carefully check the math. But if a taxpayer’s income rises high enough, an S corporation may generate additional savings. Those savings? The Section 199A deduction.

If a taxpayer’s taxable income, for example, equals $500,000, a taxpayer’s business needs W-2 wages in order to qualify for the Section 199A deduction.

Example: Rutherford and Calvin both operate one person businesses that generate $500,000 in taxable profits. Rutherford’s business operates as a sole proprietorship and so pays zero wages. As a result, he receives no Section 199A deduction. Calvin, in comparison, operates as a one person S corporation and pays himself $150,000 in wages and $50,000 in fringe benefits. That leaves $300,000 of leftover S corporation profit. And he gets a $60,000 Section 199A deduction.

Note: The simple version of the Section 199A formula says a taxpayer gets the lesser of 50 percent of the $150,000 of wages or 20 percent of the $300,000 of business profit.

Limits to Tax Strategy

Small business owners have used the one person S corporation gambit for nearly seventy years. And often with great results. But several limits exist to using the strategy.

First, relatively high fixed costs mean the strategy often fails to generate net savings for the smallest small businesses. Especially for part-time or sideline ventures operated by someone who works full-time at a regular W-2 job. Note that extra accounting costs often run $2,000 annually. So, the first couple of thousand dollars a small business saves in payroll taxes go right back out the door to pay for accountants and payroll services.

Second, not every business qualifies to be an S corporation owner. As a simplified rule of thumb, only U.S. individual taxpayers qualify to own shares in an S corporation. (Some wiggle room exists with regard to eligible shareholders so talk with your tax advisor about the detailed rules.)

Third, as incomes rise, the payroll tax rates change: Payroll tax rates start at 15.3 earnings (up to $147,000 in 2022). Ratchet up to 3.8 percent at $200,000 of earnings. And then, between the 15.3 and 3.8 percent tax brackets, a 2.9 percent bracket exists. (That bracket is shrinking every year due to inflation adjustments in the 15.3 percent limit.) And the point here: One person S corporations fairly easily generate payroll tax savings when the taxpayer avoids the 15.3 percent tax rate. But not so much when the taxpayer avoids the 2.9 percent or 3.8 percent tax rate.

How This One Person S Corporation Strategy Can Blow Up

The IRS rarely audits S corporations and so rarely challenges one person S corporation salaries. Ironically, then, small business owners probably don’t need to worry too much about that. (This is not the same thing as saying you can ignore the rules, by the way. Don’t ignore the rules.)

But the one person S corporation strategy easily can “blow up” for other reasons.

For example, some small businesses lack the organizational aptitude to operate the accounting system and the formal payroll system required. (If someone can’t do a regular payroll or run bookkeeping software like QuickBooks, Xero or FreshBooks, that’s a signal the one person S corporation thing may not work well.)

Another factor to consider: A small business needs basically either a corporation or limited liability company to function as the foundation for the S corporation. In effect, the whole S corporation thing is just a bookkeeping approach these types of legal entities use. Accordingly, the one person S corporation needs to be willing to deal with her or his state’s legal red tape.

A caution for existing businesses with debt: When an LLC elects to be treated as an S corporation, that triggers a deemed incorporation of the small business. Usually for a one person S corporation, that deemed incorporation triggers zero income taxes. But if the LLC owes liabilities (such as a vehicle loan), the deemed incorporation can trigger a large tax bill. Taxpayers in this situation should consult their tax advisors.

Finally, this caution: The Build Back Better Act proposes eliminating the S corporation gambit for high income taxpayers. (We’ve got a longer blog post here that explains how that works: Build Back Better Hits High-income S Corporations.)

The One Person S corporation Strategy Works Best for These Taxpayers

The one person S corporation works best when someone makes either a high five or low six figure profit and then can pay a reasonably low salary. As suggested in the earlier, the approach also works best when the business tax return shows lots of tax-free fringe benefits.

Accordingly, many independent contractors working as skilled tradespeople, consultants and professionals can make the strategy work well.

Through 2025, an S corporation can also work with very high income taxpayers if the taxpayer qualifies for the Section 199A deduction by having the business pay wages. Big income real estate brokers, some doctors, software engineers, and a handful of other special case situations fall into this category.

Timing of Strategy

Regarding timing, by the way, a small business operating as an LLC throughout the past year—so the LLC existed on January 1 of the current year—can elect to be treated as an S corporation for year. Even rather late in the year. To do that the business owner or his accountant files a 2553 form with the IRS. And the business owner needs to pay a reasonable amount of shareholder-employee compensation before December 31.

Note: Technically, in order to elect S corporation status as of January 1 for some year, the IRS needs the 2553 form by March 15 of that year. The IRS allows late elections, however, if the business provides a good excuse.

Other small businesses practically want to wait until the start of the next year. And they want an LLC or corporation already formed by January 1 of that next year.

Example: Martha wants to operate her small business as an S corporation as soon as possible. But she doesn’t yet operate the business as a corporation or limited liability company. Accordingly, what she does is form an LLC late in the year and then elect to use S corporation status starting January 1 of the next new year.

Other Information Sources

If a small business wants to set up a limited liability company, we have free downloadable kits you can access at his page: downloadable limited liability company kits.

Over the years, we’ve accumulated quite a bit of background information about S corporations. If you’re just starting your research, you may find these blog posts useful: The Million Dollar S corporation Mistake, S Corporation Reasonable Compensation, and IRS S Corporation Shareholder Salary Data.

Finally, and as always, taxpayers want to discuss a strategy like this with their tax advisor. He or she knows the details of your specific situation. And this plug for our CPA firm: If you don’t have a tax advisor who can help, please consider contacting us: Nelson CPA.

Tip: If some accountant or consultant suggests that you can form a corporation or LLC late in the year (so say December of the current year) and then retroactively elect S corporation status as of January 1 of the current year. So months earlier than the corporation or LLC even exists? That person doesn’t understand enough about S corporations to be providing you with professional advice. Sorry.

The post Tax Strategy Tuesday:  One Person S Corporation appeared first on Evergreen Small Business.

The Build Back Better Act hits S corporation owners and active real estate investors a bit harder than some of us guessed.

In a nutshell? It subjects high income S corporation owners and active real estate investers to the net investment income tax. (Something they avoided to date.)

If you’re impacted, therefore, you want to understand the new law. And then you maybe also want to take steps to minimize the tax increase.

But let’s dig into the details…

How S Corporations and Active Real Estate Investors Taxed Prior to Build Back Better

To start, let me review how the net investment income tax (also known as the Obamacare tax) works today.

In the case of an S corporation earning $200,000 in profits, the business owner splits the profit into wages and a leftover amount called a distributive share. For example, an S corporation owner might split $200,000 of profit into $80,000 in wages and $120,000 in distributive share.

The business owner pays Social Security and Medicare taxes on the $80,000. But not on the $120,000.

Further, if she or he materially participates in the business? The owner pays no net investment income tax either.

Active real estate investors often, for purposes of net investment income taxes, enjoy a similar tax treatment. A high income taxpayer would usually pay net investment income tax on $100,000 of real estate investment income. But she or he probably sidesteps paying that tax if materially participating in an active real estate investment.

Build Back Better changes this, however. Starting in 2022, Build Back Better makes a high income taxpayer treat the S corporation or active real estate income as net investment income. That treatment potentially triggers the 3.8% net investment income tax on the S corporation distributive share or the active real estate investment income.

Net Investment Income Tax in a Nutshell

The 3.8% net investment income tax hits single taxpayers who earn more than $200,000 in modified adjusted gross income. It hits married taxpayers who earn more than $250,000 in modified adjusted gross income.

If some taxpayer pays the tax, the 3.8% tax gets levied against the lesser of the net investment income or the amount by which the taxpayer’s modified adjusted gross income exceeds those $200,000 and $250,000 thresholds.

For example, a single person who earns $210,000 in investment income pays the 3.8% tax on $10,000. Not on $210,000.

Most taxpayers can think about the net investment income “modified adjusted gross income” as equivalent to regular old adjusted gross income. But at the bottom of this blog post, I link to an example of what the new Section 1411 statute will look like if the version of the Build Back Better Act available when I wrote this blog post on November 15, 2021 is what Congress passes and the President signs.

And now lets talk about how Build Back Better impacts S corporation owners and active real estate investors. It’s a little bit tricky…

Which High Income Taxpayers Pay Tax

A single taxpayer treats her or his S corporation or active real estate investment income as net investment income and so potentially subject to net investment income tax if her or his modified adjusted gross income exceeds $400,000.

Married taxpayers treat their S corporation or active real estate investment income as net investment income and so potentially subject to net investment income tax if their modified adjusted gross income exceeds $500,000.

A married taxpayer filing a separate return treats her or his S corporation or active real estate investment income as net investment income and so potentially subject to net investment income tax if her or his modified gross income exceeds $250,000.

Let me give an example so you see how this works.

Say a single person earns $410,000 in S corporation income and $90,000 in W-2 wages and therefore enjoys $500,000 of modified adjusted gross income. Build Back Better treats the $410,000 of S corporation income as net investment income. And therefore this taxpayer will pay the 3.8% tax on $300,000 of that $410,000 of S corporation income. Note that the taxpayer pays the 3.8% on the lesser of the $410,000 of net investment income or the amount by which the taxpayer’s $500,000 of modified adjusted gross income exceeds $200,000–which equals $300,000.

A Phase-In Range Applies for Build Back Better S Corporation Tax

And then another wrinkle to be aware of: A phase-in range applies.

Single taxpayers see the tax phase in as the modified adjusted gross income rises from $400,000 to $500,000.

Married taxpayers filing joint tax returns see the tax phase in as the modified adjusted gross income rises from $500,000 to $600,000.

Finally, married taxpayers filing a separate tax return see the tax phase in as modified adjusted gross income rises from $250,000 to $300,000.

For example, say a single taxpayer earns $450,000 from an S corporation she or he materially participates in. Say that $450,000 equals the taxpayer’s modified adjusted gross income. With Build Back Better, this taxpayer treats that $450,000 as net investment income. But she or he doesn’t pay the 3.8% tax on the full $250,000 in excess of the $200,000 threshold for net investment income tax. Rather, because $450,000 is half way through the $100,000 phase-in range, she or he pays the 3.8% tax on half of the $250,000, or $125,000.

Some Initial Tax Planning Thoughts and Comments

Right now? We don’t even know if the Build Back Better Act will pass. And we don’t know what the final bill will say. But a handful of tax planning thoughts merit consideration…

Wait to Elect S Status?

First, this suggestion: An entrepreneur starting a new trade or business probably wants to wait on making any Subchapter S election until the dust settles on the Build Back Better legislative process. It seems very likely that applying the net investment income tax to S corporation income changes the attractiveness the S corporation option for some high income taxpayers and for some high potential ventures.

Consider Converting to Partnership?

A second thought: High income taxpayers with existing S corporations probably want to explore the mechanics of converting S corporations into partnerships.

As compared to an S corporation, a partnership (including a limited liability company) might mean that a high income taxpayer pays self-employment taxes on all the business income rather than net investment income taxes on a chunk of the business income.

But that treatment however should result in a new self-employment tax deduction. And it might also result in larger Section 199A and pension plan deductions.

Further, a partnership allows more flexibility in the tax accounting. And in the ownership. These tradeoffs might make the partnership option attractive…

No Do-it-yourself Corporate Liquidations

A third thought: Liquidating a corporation, including an S corporation, and reforming as a partnership probably triggers a bunch of taxable events. Accordingly, most high income taxpayers should work with their tax advisors to assess the costs and benefits of liquidating an S corporation to reform as a partnership.

This would not be a do-it-yourself project, in other words. Well, unless you’re a tax attorney, CPA or enrolled agent with corporate tax knowledge.

Smooth Income to Avoid Tax

A fourth general comment: High income taxpayers whose adjusted gross incomes bounce around the phase-in range–probably the usual case for affected S corporation owners? Yeah, these folks will really want to smooth their income going forward.

For example, a single person with modified adjusted gross income that holds steady at $400,000 annually avoids the Build Back Better tax.

But a single person who sees her or his income bounce between $300,000 one year and then $500,000 the next year, gets whacked with about $10,000 of net investment income tax every other year.

Work Harder to Find Deductions

A fifth comment related to scavenging more deductions. The marginal federal tax rates for some affected taxpayers get very high.

Affected taxpayers might be paying a base federal income tax rate of 35% for example. Another 10% to 12% due to the phase-out of the Section 199A deduction (if they are a specified service trade or business). Then another maybe 8% to 10% due to the phase-in of the net investment income tax.

A 50% or higher federal rate may mean taxpayers want to reexamine all the usual tax sheltering tactics. So bigger pension deductions. Or de-passified real estate losses. Stuff like that.

Remember Section 199A May Require S Corporation

Finally, a sixth comment: Even with the new tax, an S corporation may still make sense for some high income non-specified-service-trade-or-business taxpayers. Why? Due to the Section 199A deduction. Accordingly, don’t automatically assume an S corporation no longer makes sense. (Note though the Section 199A deduction expires after 2025.)

Other Resources You May Find Useful

First, here’s the government web page where you can get downloadable copies of the Build Back Better bill and related official documents.

Second, just in case you’re not used to mashing up new legislation with old existing statutes, here’s a Microsoft Word document that shows how Section 1411 looks if the Build Back Better Act passes. Note that the new bits appear in green.

A third small point worth mentioning: If you’re an active real estate investor, you may want to verify you’ve been sidestepping the net investment income tax in the past. Details here about how you do that correctly: Real Estate Investors and the Net Investment Income Tax. By the way? If you’ve been paying net investment income tax on your real estate investment income but should not have been, amend your open old tax returns. And get the refunds.

Fourth, this tangential remark: Partnership entities face both risks and opportunities related to maximizing their Section 199A deductions. More details here about this subject: Salvaging Partnership Section 199A Deductions.

Finally, this plug for our CPA firm: If you own an S corporation and need tax planning help with the new net investment income taxes on S corporations, know that we are available to help taxpayers with this analysis. Contact information appears here: Nelson CPA.

The post Build Back Better S Corporation Tax Hits High Income Taxpayers appeared first on Evergreen Small Business.

People have complained about the loophole, gosh, probably since President Eisenhower’s administration created it.

The triggering event? President Biden and the House Democrats’ tax proposal to subject working S corporation shareholders to the net investment income tax. But the situation is complicated. Messy.

So, I’m going to talk here about the slow death of the S corporation. Why it occurs. And what you can do if the death matters to your business. Or to the businesses of your clients.

One other thing to say as we start. I’m going to use rounded, really simplified examples here. That’ll make this discussion shorter. Easier to digest.

And then one high level point to start with? The death occurs because the new tax on S corporations ignores inflation. But let’s dig into the details.

How S Corporations Save Tax

To start, you need to understand how S corporations save entrepreneurs payroll taxes, including Social Security taxes, Medicare taxes, and then the Medicare surtax and net investment income tax (which are more commonly known as the Obamacare taxes).

Say an entrepreneur pays him or herself a fair salary. On that income, she or he pays Social Security taxes, and possibly Medicare and Obamacare taxes.

But say the business the entrepreneur runs generates another $100,000 of business profit in addition to those wages

On that additional non-wage income, the entrepreneur still pays income taxes.

But with an S corporation she or he doesn’t pay payroll taxes. And that is how S corporations save business owners taxes.

In comparison? If the entrepreneur operates as a sole proprietorship and makes the exact same amount of money? She or he essentially pays both income and payroll taxes on all the profit.

Furthermore, the same basic accounting occurs if an entrepreneur works as a partner in a partnership. In that situation, the partner pays both income and payroll taxes on all the profit.

Note: We have a long discussion about how S corporations save taxes here: The Million Dollar S Corporation Mistake.

How Biden Tax Plan Starts the Slow Death of S Corporation

What President Biden proposes? And what the House Ways and Means Committee puts into writing? A rule that says an entrepreneur pays the 3.8 percent Obamacare tax if the entrepreneur’s income rises high enough.

Specifically, the rule says that if an entrepreneur files as a single person, she or he pays the 3.8 percent Obamacare tax once modified adjusted gross income hits $400,000. And if an entrepreneur files as a married person, she or he pays the 3.8 percent Obamacare tax once modified adjusted gross income hits $500,000.

A clarification: A taxpayer pays the Obamacare tax on the amount by which modified adjusted gross income exceeds the threshold. A single person with a modified adjusted gross income of, say, $410,000, pays no 3.8 percent tax on that first $400,000. Only on a part of that last $10,000.

Who Gets Hit Initially with New S Corporation Tax

Very correctly, Mr. Biden and House Democrats point out that in 2021, those modified adjusted gross income thresholds mean basically only taxpayers in the top one percent get hit.

For the record, I double-checked. The Democrats are absolutely right.

Today? The new tax on S corporations ignores roughly 99 percent of the taxpayers in the country.

Note: A great paper that discusses and coincidently profiles who the Biden tax plan targets appears here: Capitalists in the Twenty-first Century.

The thing that people miss? And something, frankly, entrepreneurs, business owners and professional advisors need to pay attention to?

Slowly but efficiently, inflation expands the number of people subject to the Obamacare tax over time.

Why? Because tax law fails to adjust those $400,000 and $500,000 thresholds for inflation.

And what that means is, more quickly than you might guess? A larger and larger group of S corporation shareholders pay the Obamacare tax.

Furthermore, eventually, inflation will eliminate the payroll tax savings an S corporation has traditionally delivered.

Specifically, once inflation pushes up a shareholder-employee’s reasonable wages to the Social Security maximum taxable earnings limit and pushes up that person’s household taxable income to the Biden net investment income tax trigger? The S Corporation no longer saves business owners payroll taxes.

The process takes time. But the effect shows up sooner than you might guess.

The Original Obamacare Tax Example

To give you a concrete example, you only need to look at the original Obamacare tax formula.

The original flavor of the Obamacare tax formula hit single taxpayers earning more than $200,000 of modified adjusted gross income. And it hit married taxpayers earning more than $250,000 of modified adjusted gross income.

In 2010 when Obamacare passed, people talked about those income thresholds representing top one percent situations. That sounds about right.

And note that in 2010 when Obamacare passed, the Social Security tax applied only on the first $106,800 of earnings.

Above that earnings level, any additional wages got hit with either the standard 2.9 percent Medicare tax or the 3.8 percent Obamacare tax.

The 2.9 percent tax applied to earnings over the $106,800 maximum taxable earnings threshold but under the $200,000 threshold.

Then above $200,000? That 3.8 percent Obamacare tax rate kicked in.

But the thing is? That bit of tax law also doesn’t adjust that $200,000 or $250,000 value for inflation. And that means the 2.9 percent bracket has shrunk in size due to inflation.

With a dozen years of inflation since the Obamacare law passed, many more people pay the Obamacare tax. Next year, the Social Security maximum taxable earnings limit will probably equal roughly $147,000. That’s my guess. That means the 2.9 percent payroll tax bracket shrinks to roughly $53,000. So almost half the size of the $93,000 bracket that existed when Obamacare passed.

All that income previously taxed at 2.9 percent? Tax law now levies instead either a 15.3 percent Social Security tax or the 3.8 percent Obamacare tax. And in a few years? Well, very possibly by the time Mr. Biden leaves office? The 2.9 percent Medicare bracket won’t even exist.

In a few years, in other words, the 15.3 percent tax may apply to the first $200,000 or more of income a person earns. And the 3.8 percent Obamacare tax will apply to any amounts in excess of that $200,000.

The Slow-Motion Death of the S Corporation

Now let’s return to the slow-motion death of the S corporation…

And a first point just so nobody overreacts: The death of the S corporation? It will take time. Lots of it.

I’m talking, and we’re worrying, about something that occurs incrementally over the next couple of decades or longer.

But it’s certainly worth noting that in coming years the S corporation tax savings steadily shrink. Especially for successful entrepreneurs.

Specifically, as inflation requires shareholder-employees to bump their salaries and so pay more and more of the 15.3 percent Social Security tax? And as more and more shareholder-employees pay the 3.8 percent Obamacare tax? Well, yeah, you need to think about all this. And probably starting as soon as the law passes. If it passes.

Note: Nonworking S corporations may already be subject to Obamacare taxes on their shares of S corporation profits as explained here: Avoiding Net Investment Income Tax.

Actionable Insights for Bid Tax Plan S Corporation

In fact, if you’re an entrepreneur or business owner, I think you want to consider three issues:

First,  if your business needs wages to qualify for the still generous Section 199A deduction Congress plans to provide through 2025? The S corporation option may still save you tax. The current Congressional Democrats’ tax proposal, which could easily change between the time I write this and the time you read it, gives business owners up to a $400,000 or $500,000 Section 199A deduction. So, a 199A deduction on roughly $2 million to $2.5 million of income. An S corporation may therefore make sense temporarily if only to create wages for the Section 199A deduction. (That deduction allows taxpayers to avoid paying tax on the last 20 percent of their business income.)

Second—and this is an however—if your situation revolves around a business or venture that may or will run decades? Yeah, you probably want to revisit your entity choice. Something else may make more sense. Let’s be honest. The historical reason to be an S corporation? So you save payroll taxes. The historical problems with an S corporation? You also lose flexibility and give up other tax benefits. Accordingly, if you lose or will lose payroll tax savings as compared to what you planned or hoped? Yeah, you need to consider other options. Like a limited liability company treated as a partnership. Or a traditional C corporation.

Third, and I am not going to go into details here, but you of course do have other ways to mitigate or sidestep the taxes Congressional Democrats and Mr. Biden propose hitting S corporations with. Your tax advisor, in fact, has a long list of planning techniques she or he can dust off and then use to dial down the taxes you ultimately pay. You may just need to be a bit more proactive. And go to a little more work.

The post Biden Tax Plan Starts Long Slow Death of the S Corporation appeared first on Evergreen Small Business.

The only problem? You need to move quickly. Thus, this blog post where I’ll talk about boosting the size of the credits you calculate.

But let’s make sure you’re up to speed on how the employee retention credit works. And then we’ll talk about how you can increase the size of the employee retention credits you calculate.

And by the way, one other note: These credits? They nearly instantly become refunds. Starting next time you do payroll. And in some cases, gigantic refunds.

Employee Retention Credits in a Nutshell

In effect, the federal government will pay an employer, such as a small business, up to a $5,000 credit for wages paid and group health insurance provided to each employee in 2020.

In 2021, the deal gets even better. The federal government will pay up to a $28,000 credit for wages paid and group health insurance provided to each employee in 2021.

Example 1: A small business employs ten workers who each earn $40,000 annually and it qualifies for employee retention credits for both 2020 and 2021. In 2020, the firm receives $50,000 of credits ($5,000 for each employee). In 2021, the firm receives $280,000 of credits ($28,000 for each employee).

The credit formula, by the way, works differently in 2020 and 2021.

In 2020, the employee retention credit formula equals fifty percent of the wages and group health insurance paid but not more than $5,000 per employee. (The 2020 credit formula looks only at the first $10,000 of wages and group health insurance paid for the year.)

In 2021, the employee retention credit formula equals seventy percent of the wages and group health insurance paid but not more than $7,000 a quarter. (The 2021 credit formula looks at the first $10,000 of wages and group health insurance paid during each quarter.)

Unbelievable, right? I agree. The numbers, especially for 2021, get huge. Even for a small business.

Five Basic Employee Retention Credit Rules

Five basic rules apply to the employee retention credit.

The first rule? The credit works, potentially, for wages and group health insurance paid after March 12, 2020 and through December 31, 2021.

The second rule: A firm needs its operations either fully or partially suspended by federal, state or local government restrictions… or a firm needs to suffer a significant contraction in quarterly revenues as compared to 2019. (I’ll talk more about this in a minute, but a firm only gets the credit on wages and group health insurance paid during a full or partial suspension or during a down quarter.)

A third rule says that you can’t “double dip” and thereby get a credit and refund if some other federal government program already provided you money to pay the wages. For example, you don’t get employee retention credits for wages you paid using Paycheck Protection Program funds. Or using an EIDL grant. Or if you received other payroll tax credits that, in effect, funded employee wages.

The fourth rule? Large eligible employers only take the credit only on wages paid to employees for not working. For 2020 employee retention credits, a large eligible employer is a firm employing more than 100 full-time employees in 2019. For 2021 employee retention credits, a large eligible employer is a firm employing more than 500 full-time employees in 2019. For small eligible employers, in comparison, the employer takes the full credit, potentially, on all their workers’ wages (subject to the third rule just mentioned).

The fifth rule: A business owner aggregates the businesses she or he or they own. For example, if you own a restaurant (maybe operated as a sole proprietorship), 100 percent of a consulting business (maybe operated as an S corporation), and a majority interest in a partnership, you aggregate all of these businesses to determine whether your operations qualify (according to rule #2 above), what the wages total and so forth.

And now let’s look at the three big opportunities to maximize employee retention credits. Because for two of these opportunities, time may be running out.

Bigger Employee Retention Credit Tip #1: Savvy PPP Forgiveness Application

Here’s the first technique you may be able to use to maximize your employee retention credits: How you complete the PPP forgiveness application. But let me explain.

Whatever wages you report on your PPP loan forgiveness application? The employee retention credit formula ignores those wages, as mentioned earlier, for purposes of the employee retention credit.

Example 2: Say a small business potentially qualifies for $50,000 of employee retention credits on $100,000 of wages and qualified health expenses due to partial suspension. If this small business received a $100,000 PPP loan, the borrower might get full forgiveness for using the funds for $100,000 of W-2 wages. And it might, just to be efficient, show that same $100,000 of W-2 wages on its PPP forgiveness application. But in that case, it receives no employee retention tax credit on those wages. The business can’t use the same wages for PPP forgiveness and employee tax credits.

Example 3: Say another nearly identical, partially suspended small business also potentially qualifies for up to $50,000 of employee retention credits on some portion of a $100,000 of wages and qualified health expenses. Further, say this PPP borrower also received a $100,000 PPP loan and could have gotten full forgiveness simply by claiming that full $100,000 of W-2 wages and health expenses. But say it instead applied for forgiveness by showing it used the PPP money for $50,000 of W-2 wages and health expenses, $10,000 of other payroll costs including payroll taxes and pension contributions, and then $40,000 of rent, utilities and mortgage interest. In this case, the business should still get employee retention credits on half of the wages. So roughly $25,000 of employee retention credits.

You see the big point here: How you complete the PPP loan forgiveness application affects the leftover wages and qualified health insurance you or your accountant plug into the employee retention credit formula. (The basic trick is, try to get forgiveness for spending other than wages and group health insurance, if that approach protects your ability to get employee retention credits.)

Finally, this bit of bad news: If you already applied for forgiveness, you can’t undo your application. But some first-round PPP borrowers haven’t yet applied for forgiveness. Some borrowers also received a second-round PPP loan. Many of these firms still have the opportunity to apply for forgiveness in a way that maximizes employee retention credits.

Bigger Employee Retention Credit Tip #2: Look at Every Qualification Possibility

A firm qualifies for employee retention credits in two basic ways.

Maybe the most talked about way? Suffering a significant contraction in revenues. Specifically, a greater-than-fifty-percent contraction in 2020 or a greater-than-twenty-percent contraction in 2021.

Note: If a firm suffers a greater-than-fifty-percent contraction in 2020, it continues to qualify for employee retention credits until the quarter after the first quarter its revenues equal eighty percent or more of the same quarter’s revenues from 2019.

Example 4: Say a firm generated exactly $100,000 in revenue each quarter of 2019. If its revenues in 2020 equaled $80,000 in quarter 1, $40,000 in quarter 2, $80,000 in quarter 3, and $100,000 in quarter 4, it qualifies for employee retention credits in quarters 2 and 3.

Example 5: Say the firm from example 4 experienced another contraction in 2021. If revenues for quarter 1 and quarter 2 of 2021 equal $75,000—so seventy-five percent of what the firm experienced in 2019—it qualifies for employee retention credits in quarters 1 and 2 of 2021.

A firm may also qualify if federal, state or local government mandates, directives or proclamations fully or partially suspend its operations.

Example 6: On April 1, 2020, a restaurant reduces the number of tables for diners by fifty percent due to a state government public health directive that stays in effect for the rest of 2020. Say the firm usually generates $100,000 a month of revenues but through the closure generates $70,000 a month of revenues. The restaurant fails to qualify for employee retention credits based on reduced revenues. Revenues “only” decline by thirty percent. However, the restaurant does qualify for employee retention credits based on state public health restrictions that partially suspend operations.

The obvious trick here to maximize the employee retention credit: Look at both qualification rules: the one based on the reduction revenues… and the one based on the federal, state or local government restrictions on activity.

And then the less obvious trick for maximizing the credit and the resulting refund. Be sure to explore whether a firm can stretch out the time frame it qualifies for employee retention credits by looking both at restrictions and revenue reductions.

Example 7: Say a firm that enjoyed $100,000 a quarter of revenues throughout 2019 sees operations restricted on March 15 due to local government directives that continued through June 30. Assume that revenues “only” sag in the second quarter to $60,000 as compared to 2019, then sag in the third and fourth quarters to $40,000. The firm qualifies as partially suspended from March 15 through June based on local government directives. The firm qualifies due to substantial revenue declines for the third and fourth quarter. Accordingly, wages and group health expenses paid between March 15, 2020 and December 31, 2020 potentially produce an employee retention credit.

Bigger Employee Retention Credit Tip #3: Acquiring to Aggregate

One other powerful tax planning opportunity bears mentioning. As noted earlier, the rules for employee retention credits require employers to aggregate businesses. An entrepreneur who owns, for example, two or three (or more) separate businesses aggregates those businesses into a single employer for the purposes of the employer retention credit.

Example 8: An entrepreneur owns a restaurant, an online ecommerce website, and a consultancy. All three businesses generated a $100,000 quarter of revenues in 2019. The employee retention credit formula combines these three businesses. If the aggregated firm experienced a full or partial suspension in any one of the three businesses through the entire second quarter, the entire consolidated operation potentially qualifies for employee retention credits for the second quarter. For example, if local public health officials directed the restaurant to close from April 1 through June 30, but the other two businesses continued to chug along? The entire three-business aggregation counts as partially suspended from April 1 through June 30. That “partially suspended” status means all three businesses qualify potentially for employee retention credits.

And then here’s the planning opportunity related to aggregation. If a business acquires a firm, it can aggregate that firm’s data from before the acquisition date if the acquirer possesses the information needed to calculate the formulas. A couple of examples show how this technique might work.

Example 9: A consultant operates a firm that generates $100,000 a quarter in 2019 but due to Covid-19 only $80,000 a quarter in 2020. Because no government restriction fully or partially suspends the consultancy operation, the consultancy fails to qualify for employee retention credits due to government restrictions. Further with a twenty-percent reduction in revenues, the firm fails to qualify for employee retention credits due to a significant decline in revenues.

However, if the consultant acquires another business, that may result in qualification for employee retention credits.

Example 10:  The consultant from example 9 acquires a restaurant on April 1, 2021. If that restaurant enjoyed $100,000 a quarter of revenues in 2019 but only books $70,000 a quarter of revenue in 2020 and 2021, then the consultant’s aggregated businesses qualify for the employee retention credit for the quarter that starts on April 1, 2021. For that quarter, the combined revenues, $80,000 for the consultancy and $70,000 for the restaurant, equal seventy-five percent of the aggregated 2019 revenues. Seventy-five percent falls under that eighty-percent threshold therefore qualifying the aggregated businesses for employee retention credits in the second quarter.

Show Me the Money

A quick comment in case you’re new to this employee retention credit topic. You get the refund created by the employee retention credit using the quarterly 941 payroll tax form.

If you should have claimed a credit on some past 941 forms from 2020? Or on the first or second quarter 941 for 2021? You need to go back and amend those. Or maybe better yet, have your tax accountant do the calculations and prepare the form. (If you didn’t know to include the credit in the first place, maybe you ought to have the accountant take care of this for you.)

Note: Our CPA firm will amend 941 forms for small businesses if you use a outside payroll service (like ADP, Paychex, or Gusto) and if you have an accounting system that supplies quarterly revenue data (so like QuickBooks Online, Xero Accounting, or QuickBooks Desktop). Use our CPA firm’s contact form to reach out.

If you can claim a credit on your original second, third or fourth quarter 941, you just calculate the amount and enter it on the 941 form. (You do need to have workpapers which backup and explain your calculations.) Further, if you know for a fact you’re getting a credit, you can and should reduce your payroll tax deposits immediately so you don’t have to wait a month or two or three for the refund.)

Closing Comments

Three quick comments in closing. First, you may unfortunately find you’re too late to boost your employee retention credits by more thoughtfully preparing the PPP loan forgiveness application. Don’t beat yourself up for that. Initially you could not qualify for employee retention credits if you also borrowed PPP money. So probably you or your accountant prioritized getting the PPP loan money. And then prioritized getting that loan forgiven. All that made sense. You want to remember all that if you inadvertently missed that opportunity.

And a second comment: As mentioned earlier, time is running out your ability to maximize your credits. If you want to use aggregation, for example, you need to finish an acquisition as soon as possible. Further, with regard to the PPP loan forgiveness, you probably need to apply soon for forgiveness if you haven’t already. The bottom-line in all this? You probably need to move fast to maximize employee retention credits.

A third comment which may be helpful to some readers trying to make sense of this crazy, new tidal wave of free money supplied by the federal government. Accept the free money element of this. Don’t try to make sense of what may not, once the dust settles, make much sense. The Congressional rationale here? Well, the Covid-19 pandemic restrictions coupled with reductions in consumer demand destroyed millions of small businesses. As I write this in July 2021, one source is reporting that nearly fifty percent of small businesses open in January of 2020 have now closed. And so what Congress did with programs like the Paycheck Protection Program and employee retention credits is shower small businesses with money to keep people on the payroll.

Need More Information or ERC Training for Staff?

If you realize some of your staff need more training about how the employee retention credits work, no problem.

We’ve got economical $14.95 paperback book that represents a great way for staff, managers and partners to learn how employee retention credits work: Maximizing Employee Retention Credits.

We’ve also got a number of related articles and blog posts about the employee retention credit and many may be useful for folks still getting up to speed.

The post Three Tips for Bigger Employee Retention Credits appeared first on Evergreen Small Business.

Accordingly, in this third blog post about how Mr. Biden’s proposals affect small business, I talk about these parts of the Biden real estate tax proposals.

But let me make a couple of quick comments to provide context.

Biden Real Estate Tax Proposals: The Big Picture

First, a theme appears in Mr. Biden’s proposals. That theme? Investors and entrepreneurs need to pay higher tax rates as their wealth and income grows. In most situations, for example, Mr. Biden proposes to rather substantially bump up the taxes on big investment windfalls and entrepreneurial profits.

A second comment, however: The proposed Biden taxes hit few taxpayers. Really only people with very high incomes. So, like, just the top one percent.

Finally, for those folks? Smart tax planning should often let them better manage the tax increase. At least in many situations. (The trick? Smooth profits and gains so more income gets taxed at low rates and less at the highest rates.)

And now let’s talk about the ways Mr. Biden proposes to raise taxes on real estate investors.

High Income Real Estate Investors Hit with Obamacare Tax

A first tax bump? Mr. Biden wants real estate investors with high incomes to pay either the 3.8 percent net investment income tax. Or the 3.8 percent self-employment contributions act tax.

In our blog post last week about how this same tax increase works for S corporation shareholders, we stepped through the bookkeeping. In a nutshell, some real estate investors currently avoid the Obamacare tax. (Details here.) But going forward? Mr. Biden wants those real estate investors with large adjusted gross incomes to pay the 3.8 percent tax on the chunk of their business income in excess of $400,000.

A simple example: A real estate investor earns $500,000 from her or his real estate investments. This investor pays a 3.8 percent tax on the last $100,000 of income. That amount equals $3800.

Mr. Biden proposes making this tax increase effective starting in 2022.

No Preferential Tax Rate for Capital Gains Taxes for High Income Investors

Another tax bump Mr. Biden proposes? He proposes that investors with seven figure taxable incomes pay ordinary income tax rates on at least some of their capital gains.

This reminder. Middle-class taxpayers usually pay a zero-percent long-term capital gains tax rate. Upper-class taxpayers usually pay a 15 percent long-term capital gains tax rate. And sometimes, if the taxpayer’s income gets high enough? A 20 percent long-term capital gains rate.

Mr. Biden proposes that all these taxpayers continue to pay the same zero, 15 or 20 percent long-term capital gains rate.

But the hitch? Once a taxpayer’s taxable income crosses the $1,000,000 threshold, he wants the taxpayer to pay the highest marginal tax rate. For 2021, that tax rate equals 37 percent. He proposes bumping up that rate to 39.6 percent after 2021.

An example using big but simple numbers: Say a taxpayer earns $500,000 in W-2 wages and then receives a $1,000,000 long-term capital gain from the sale of a real estate investment.

The first $500,000 of the real estate investment gains get taxed as long-term capital gains. Probably, the rate equals 20 percent. The last $500,000 of the real estate investment gains get taxed as, essentially, ordinary income. Mr. Biden wants that rate set at 39.6 percent.

Accordingly, this taxpayer doesn’t pay a 39.6 percent long-term capital gains tax on all their capital gain. The taxpayer pays a blended long-term capital gains tax rate. Roughly 30 percent with the example numbers given.

Note: Mr. Biden proposes making this change in tax laws effective retroactively to sometime in 2021. Accordingly, if you’re reading this? You may be too late to avoid the new tax on really large capital gains.

Section 1031 Like-kind Exchanges Limited

Under current tax law, real estate investors may be able to exchange one property for another and thereby delay paying taxes on the income or gain.

For example, if an investor buys a property for $100,000 and it appreciates in value to $1,000,000? She or he can probably exchange, or swap, that $1,000,000 property for another $1,000,000 property and avoid paying taxes.

Mr. Biden proposes dialing down this tax-deferral trick, however. He suggests tax law limit taxpayers to deferring no more than $500,000 annually using the Section 1031 like-kind exchange rules.

The bookkeeping and tax return arithmetic for like-kind exchanges gets tricky. But we guess that real estate investors who historically used a like-kind exchange to delay paying taxes may want to reconsider that tactic from this point forward.

Mr. Biden proposes making this tax increase effective starting in 2022.

Excess Business Losses Limited (Again)

Two other general tax law proposals from Mr. Biden may impact real estate investors, too. Though note that these changes affect only the highest income and highest net worth taxpayers. And the first of these changes isn’t really new from Mr. Biden. More of a tweak to an existing law…

That first change? It concerns Section 461(l) excess business loss limitations.

The legislative history on this code section? Complicated because of Covid-19. But basically up through 2020, a taxpayer could engineer situations where he or she used large business losses, including real estate losses, to shelter unlimited amounts of income. Including W-2 income and portfolio income.

For example, suppose a married couple includes a highly-paid executive earning $2,000,000 and the other spouse qualifies as a real estate professional by managing the family’s real estate portfolio. Further suppose through depreciation deductions, the real estate professional spouse loses $2,000,000 a year. In the past, this couple reported zero taxable income and paid no taxes.

Starting in 2021, however, the law limits the business losses that can be deducted to the sum of the business income a taxpayer recognizes plus in 2021 another $524,000 if married or another $262,000 if single. (The IRS adjusts these amounts annually for inflation.)

In the example provided here, then, the couple probably realizes no business income which can be sheltered. The couple can therefore probably shelter only $524,000 or roughly a quarter of the W-2 income.

And how this connects to Mr. Biden’s tax proposals. While Section 461(l) became effective (for the second time) starting in 2021, the law currently expires after 2026. Mr. Biden however proposes making the Section 461(l) excess business loss limitation permanent. Which means that the trick some high income taxpayers have used to rather permanently shelter income using real estate may go away permanently.

Step-up in Basis Eliminated

A final change some real estate investors face. Mr. Biden wants to eliminate the step-up in basis that currently occurs when a taxpayer dies.

We talked about the way the Section 1014 step-up in basis benefits real estate investors before. (See A Dozen Reasons for Direct Real Estate Investment.) So let me just provide a quick summary here of the way some real estate investing families work this tax planning gambit.

But a trigger warning first: This is a little morbid…

A real estate investor can bequest a property to her or his heirs. And when that happens under current law, the basis of the property gets reset, or “stepped up,” to the fair market value at or around the time the taxpayer died. The new owner can then sell the property without paying tax. Or restart the depreciation using the stepped-up basis.

For example, say your grandfather bought an apartment house for $100,000 decades ago and even enjoyed years of tax-free rental income from depreciation deductions. Then, say he died with the apartment part of this estate and he bequeathed the apartment house, now worth $1,000,000, to your mom. Neither the estate nor your mom owes taxes in this situation. In fact, your mom can sell the apartment building for $1,000,000. And pay zero income taxes. Or she can continue to hold the property and restart depreciation deductions based on the stepped-up $1,000,000 value.

Further, your family can continue this arrangement in future generations.

If your mom holds the property in her estate and then you inherit the apartment house when it’s worth $10,000,000, under current law, you can sell the property for $10,000,000 without paying income taxes. Or you can continue to hold the property and also restart the depreciation deductions based on that $10,000,000 valuation.

You can see the way the tax savings snowball.

Mr. Biden’s responds with two proposed tax law changes. First, he eliminates the step-up in basis. Second, he taxes the economic gain the decedent would have realized if she or he had sold the property on the date she or he died.

One other wrinkle to the proposal. Mr. Biden proposes excluding from this taxation $250,000 of gain related to a principal residence as well as another $1,000,000 for other assets. Further, gains on personal property (other than collectibles) get ignored. And a surviving spouse doubles the $250,000 and $1,000,000 exclusion amounts.

An example shows how this might work. You and your siblings inherit a fully depreciated apartment house worth $10,000,000 from your parents. Let’s say this is the only asset in the estate. To keep the example easy, let’s also say your parents’ cost basis of the apartment equals zero. In this case, the imputed gain when your last surviving parent passes away equals $10,000,000 and your surviving parent’s estate owes taxes on $8,000,000 after the two $1,000,000 exclusions. The first $1,000,000 of this gain? Taxed as regular long-term capital gains. The other $7,000,000? Taxed as ordinary income.

To deal with the liquidity issues inherent in taxing illiquid assets, Mr. Biden helpfully proposes letting the estate pay the tax over 15 years.

This change Mr. Biden apparently proposes making effective starting in 2022.

Closing Comments on Biden Real Estate Tax Proposals

Whether Mr. Biden’s tax proposals become law? Who knows. But clearly taxpayers emphasizing real estate investment want to carefully follow the discussion.

Further, if even some of the Biden real estate tax proposals do become law, many real estate investors will want to reassess their strategy and their tactics.

Other Resources

We discussed Mr. Biden’s proposals for small C corporations including the new higher capital gains tax rate here: Avoiding Biden Tax Increases on Small Corporations

We discussed Mr. Biden’s proposals for levying the Obamacare tax on S corporations here, Biden S Corporation Tax Proposal Caps Savings, but the same logic applies to active real estate investors.

David Wessel did a good article about reconciliation process which the U.S. Congress can use for tax law changes here: What is Reconciliation? If you don’t understand how Mr. Biden can change tax law given the roughly even split in the U.S. Senate, you may want to skim that article.

At the time, I’m writing this, little detailed guidance exists for Section 461(l) excess business loss limitations other than the statute and the 2019 Form 461 instructions. But Tax Advisor magazine published a useful summary in 2019 here.

Finally, the Treasury Green Book, which describes in detail the tax proposals, appears here.

The post Biden Real Estate Tax Proposals Scramble Planning for Investors appeared first on Evergreen Small Business.

And you hear lots of rules of thumb (including some at this website).

And then people talk… you know, about what you can really do. (Hey. We’ve all heard the stories…)

Which is why it’s useful and interesting to sift through actual IRS S corporation salary data. So I want to do that here.

A Quick Review of the Basic Rule

Before we start that sifting, though, let’s recognize and restate the basic rule for setting S corporation shareholder-employee salaries.

That basic rule goes like this: You need to set a salary that some other firm would pay someone for doing similar work.

Furthermore, here’s another good idea. It’s always wise and smart to dig up some real salary survey data for your area for jobs like you’re looking at. (We particularly like Bureau of Labor Statistics data which you can get to from here.)

So keep that in mind as you continue reading. And now let’s look at the data.

Average S Corporation Shareholder Salaries

The table that follows shows average revenues, officer compensation deductions and profits for S corporations operating in roughly a couple of dozen industry categories.

The data comes from the 2017 1120S tax returns S corporation owners filed with the Internal Revenue Service in 2018. (Source: SOI Tax Stats – S Corporation Statistics .)

Understanding the Table’s Salary Data

Let me quickly describe the table’s data so no confusion exists. We can do this by talking about the first row.

Row one in the table reports on the average revenue, officer salary deduction and net profit considering all 4.7 million S corporations.

Make sure you understand those numbers: On average, an S corporation generates roughly $1.7 million of revenue, deducts $62,046 of salaries expense for all its officers, and reports just over $100,000 of net income.

Tip: Remember too to mentally adjust the numbers for inflation that’s occured since 2017.

And then reading down the rows of the able, look at the other averages for the industry categories listed: mining, construction, manufacturing and so on.

You can probably glean some insights from this information. But you’ll want to keep in mind a few facts.

The S Corporation Salaries Number is the Deduction

A first thing to note, for example, the S corporation salaries value the IRS data lets you calculate? The value represents the average deduction.

So, that $62,046 average just referenced? That’s the average deduction for officer compensation. The amount might represent one officer making $62,046. Or two officers making $31,023. Or three officers making–well, I don’t need to go on. You see how this works.

Officers Not Necessarily Shareholder Employees

A quick related note: An officer isn’t necessarily a shareholder.

Now most of the officer compensation deduction probably does go to shareholder-employees. But maybe not all.

In any case, that’s something else to keep in mind.

Means Probably Higher than Medians

One final thing to remember: The table above shows mean averages: mean total revenues, mean officer compensation deductions and mean net profit.

The reality to recognize about mean averages? A mean value probably exceeds by a large amount the median, or midpoint, value.

For example, suppose you or I calculate the mean and the median of the following ten officer compensation deductions:

• Three officers making $20,000 each
• Six officers making $40,000 each
• One officer making $300,000

The median, or midpoint, officer deduction equals $40,000 in this case.

The mean, or average, officer deduction in this case, however, equals $60,000.

I calculated this as ($20,000+$20,000+$20,000+$40,000+$40,000+$40,000+$40,000+$40,000+$40,000+$300,000)/10

You see what happens with the mean average. That big number–the $300,000–pulls up the average.

An Example of How to Use the Salaries Data

Given all of the above, then, how might you use this data?

Well, you can probably use the average officer deduction values as a benchmark for setting S corporation shareholder salaries for average-sized businesses within a category.

As an example, look at the the average S corporation that operates within the  “professional, scientific and technical services” category.

On average, firms within that category of S corporations per the table report revenues of just over $800,000. The officer compensation deduction equals about $72,000. And then the business profit roughly equals $92,000.

If you run similar sized professional services firm? One generating similar profits? You’re probably on pretty safe ground paying yourself around $70,000.

Again, remember that $70,000 represents a deduction amount–not a salary amount. Also it’s a mean not a median. Finally, it might represent not just shareholder-employees but non-shareholder officers. So don’t forget that.

Nevertheless, even given these factors, the value probably provides a pretty reasonable benchmark to consider when setting a salary for a firm in the same industry category.

Getting Additional S Corporation Average Salary Data

One final quick comment. In the past, the IRS published statistics that allowed for building a much longer list of average revenues, officer compensation and net profit by industry.

If you’re interested in a longer list, therefore, you may want to make the calculations yourself using some earlier years’ datasets. (We did calculate and show that longer dataset for 2013 at our S corporations Explained website. You may want to peek there.)

Other S Corporation Salary Resources

We provide some basic guidelines here: S Corporation Salary Rules

Firms wrestling with trading off Section 199A deductions with S corporation payroll tax savings may be interested in this discussion: S Corporation Sharehold Salaries adn the Section 199A Deduction

We’ve got some more tips and guidelines here for setting S Corporation Reasonable Compensation

Finally, here’s a quick overview of some rules for Safe Harbor S Corporation Salaries

The post IRS S Corporation Shareholder Salary Data appeared first on Evergreen Small Business.

The revised tax deadline for most small businesses, July 15th, is barely more than a week away. And that should mean you and I think about how to dial down the upcoming tax bills. The very topic we’ve been able to ignore–maybe had to ignore–given the pandemic.

The interesting thing? Small businesses and entrepreneurs get some of the very best tax breaks available.

But let’s step through these “killer” small business tax breaks. And you’ll quickly see what I mean.

Section 199A Deduction

The Section 199A small business tax break works simply for really small businesses.

A business owner gets to add a tax deduction to her or his return equal to 20 percent of the profit shown for a sole proprietorship, a partnership, an S corporation or rental property.

Example 1: An entrepreneur makes $100,000 in some venture. She may be able to add a $20,000 tax deduction to her return.

The thing to keep in mind about Section 199A? If a taxpayer’s 2019 income rises into above $160,700 (above $321,400 if married), special rules kick in that may limit or reduce the deduction. (A taxpayer may need a business to pay W-2 wages or own depreciable property.)

Furthermore, a taxpayer may want to do things which boost the so-called “qualified business income” which the Section 199A applies to. Most types of small business profit count as “qualified business income” including sole proprietorship profits, partnership and S corporation distributive shares, net rental income, and so on. But some types of “business income” don’t including guaranteed payments from a partnership and wages from an S corporation.

I’m not going to dig into those rules here. This blog supplies a bunch of detailed posts about Section 199A. But if you are not absolutely confident you’re maximizing your Section 199A deductions, spend some time learning the ropes.

Though the Section 199A expires after 2025, some successful small business owners will use this small business tax break to avoid paying taxes on six and seven figures of income.

Note: To learn more about the Section 199A deduction, you might want to start here: Section 199A Deduction Rookie Mistakes

Subchapter S Election

Eligible entities, including traditional corporations and limited liability companies, can elect to use the tax accounting rules from Subchapter S of the Internal Revenue Code.

These accounting rules sort of work like partnership accounting in that a business’s profit get allocated to its owners—and then they pay the income taxes.

But this tax accounting method produces an unusual result. It typically saves a business owner a chunk of self-employment taxes.

Example 2: An entrepreneur makes $100,000 as a sole proprietor. Or makes $100,000 as a partner in a partnership. He pays income taxes on the $100,000. And he pays the 15.3% self-employment taxes on almost all of the $100,000.

Example 3: Another entrepreneur operates a business that also makes $100,000 but which has been structured as an S corporation. Assume the S corporation pays out half of the profit, or $50,000, to the owner as W-2 wages. The other $50,000 of profit? The business pays that out to the owner as a “shareholder distribution.” In this case, the business owner only pays the 15.3% self-employment taxes on $50,000 rather than on nearly all of $100,000 of income.

Tip: You can use our free S Corporation Tax Savings Calculator to estimate S corporation tax savings for your specific situation.

By the way? The few thousand dollars of tax savings someone experiences annually with an S corporation don’t seem like that much savings. But over time, the savings can compound massively. We’ve observed in our practice that many small business owners can accumulate an extra $1,000,000 of retirement savings by operating as an S corporation. (We step a reader through our math behind this observation here: The Million Dollar S Corporation Mistake.)

Bonus Depreciation

The recent tax law changes let businesses immediately write off most non-real-estate property used in a business or as real estate investments.

Giant depreciation deductions don’t at first blush seem like that big a break… but taxpayers may be able to use them to fund growth of a business or of an investment portfolio using pretax income.

Some taxpayers may even be able to use bonus depreciation to withdraw money from a retirement plan without paying income taxes.

Example 4: A small business owner wants to buy the $1,000,000 building her firm rents. To make the building purchase, she needs a $250,000 down payment and a $750,000 mortgage. Though she doesn’t have $250,000 of cash for a down payment, she does have $250,000 of funds available in a retirement account. Further, bonus deprecation rules allow her to immediately depreciate $250,000 of the building price at time of purchase. Accordingly, she can withdraw the $250,000 from the retirement account and shelter this withdrawal from income taxes by deducting $250,000 of bonus depreciation.

This caution: Using bonus depreciation to shelter great gobs of income may require extra efforts and of course requires careful planning. To use bonus depreciation on a building, a business owner would need to use a cost segregation study, something we’ve talked more about here: Vacation Rental Tax Shelters.

Note: If you’re interested in more information about the new depreciation rules, my colleague Christian Block did a recent post: Maximizing Depreciation Deductions Under the Tax Cuts and Jobs Act.

Qualified Opportunity Zones

Qualified opportunity zones allow an investor or entrepreneur to reinvest “capital gain” profits in an economically distressed area.

The small business tax break available here? Well, three small business tax breaks actually. First, the taxpayer delays paying any capital gains taxes until 2026.

Second, probably the taxpayer pays only 85% to 90% of the capital gains tax they owed in the first place.

And then, third, if the new investment in the qualified opportunity zone increases in value, that increase isn’t subject to any capital gains.

Example 5: An entrepreneur reinvests $1,000,000 of capital gains into a qualified opportunity zone. As a result, he delays paying any tax on the gain. Probably, when in 2026 he does need to “pay the piper,” he will only pay taxes on $850,000 to $900,000 of the gain. Finally, if that $1,000,000 investment grows by $2,000,000 to $3,000,000 of value, he probably won’t have to pay capital gains taxes on the $2,000,000.

How to make sense of qualified opportunity zones? Well, Congress wanted to heavily incent small business owners to invest in economically distressed areas.

We think you need to be cautious about trying to take this small business tax break. But if you’re “entrepreneur-ing” in some communities, you want to know about this gambit.

Note: Interested in more detail? See here: Sobering Up About Qualified Opportunity Zones.

Qualified Small Business Stock

Qualified small business stock, also known as Section 1202 stock, represents potentially the biggest small business tax break available.

If an investor invests in a regular “C” corporation and the business the corporation operates qualifies, the investor avoids paying capital gains taxes on the later sale of the “C” corporation stock.

A note: If you pursue the “Qualified Small Business Stock” small business tax break, you lose the opportunity to use Section 199A deductions. And you lose the ability to avoid payroll taxes with a Subchapter S election. But you can save a bundle of capital gains taxes.

Example 6: An entrepreneur invests time and money into a software company. Five years later she sells her shares for $10,000,000. Because the software company stock counts as Section 1202 “Qualified small business stock,” she pays zero capital gains taxes.

Note: Two recent blog posts we’ve published here dig into the details of the Section 1202 “Qualified Small Business Stock” exclusion. One post discusses how Section 1202 Qualified Small Business Stock works and the other identifies some of the Section 1202 Qualified Small Business Stock pitfalls people need to stay alert to.

Two Closing Comments

This blog post describes small business tax breaks available this year and in one or more future years.

But if your firm has been hit by the Covid 19 pandemic, you want to know about a couple of other items.

First, Congress earlier in the year changed the net operating loss carry back rules. If your firm lost money this year, therefore, be sure you understand how the new carry back rules work. (See this blog post, Covid 19 Small Business Tax Relief, for more information.)

Second, over the weekend, Mr. Trump signed the short, five week extension in the Paycheck Protection Program. If you missed getting a paycheck protection program loan earlier, you ought to look again at that program. (More information on that here: Paycheck Protection Program Explained and Illustrated.)

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