This week, I discuss a second way to qualify for big deductions. The real estate professional tax strategy.

If you’re a high-income taxpayer who wants to put big real-estate-related tax deductions onto a tax return? Yeah, this is an option you want to consider. Further, now, at the very beginning of a new year, is the time you want to start using this strategy.

But let’s dig into the details…

Note: We been blogging every Tuesday about tax strategies. Click here to see the complete list: Tax Strategy Tuesday.

Real Estate Professional Tax Strategy in Nutshell

The real estate professional tax strategy works mostly because of the depreciation deduction an investor enjoys.

Suppose you purchase a rental property for $1,000,000. Perhaps using a $100,000 down payment and a $900,000 mortgage. Say the tenants pay you $60,000 of annual rent. Suppose that amount covers the operating expenses and even pays the mortgage payment.

In economic terms, this arrangement may work beautifully. The property may be appreciating. The steady mortgage payments may over time pay off the loan. Probably, you’re making money.

But tax accounting rules allow you to add a large depreciation deduction to your return. In other words, even though your investment may slowly be growing in value, you can write off a loss each year on the property. Maybe, in fact, around $30,000 annually for a property like the one just described?

The problem is, most high-income investors don’t get to use that large depreciation-derived tax deduction. (Middle-class investors do by the way.)

Example: George and Martha earn $200,000 from jobs and own an investment property that generates a $30,000 loss due to depreciation. They would like to use the $30,000 loss to shelter some of their earned income. But they cannot. Tax laws limit their passive loss deductions.

Tax laws allow some taxpayers to use these passive losses, however. And one group who can? Real estate professionals.

Example: John and Abigail also earn $200,000 from jobs and also own an investment property that generates a $30,000 loss. John and Abigail can use the $30,000 loss to shelter some of the income they earn in their jobs. And the reason? Because John qualifies as a real estate professional.

Tricks that Make Real Estate Professional Tax Strategy Work

The trick to making the real estate professional tax strategy work? Qualifying as a real estate professional.

Essentially, tax law looks at two things.

First, does a taxpayer or one of the taxpayers on a married joint tax return work in  “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”

Tip: By the way? The key word to pay attention to in the quoted language (which comes from the statute)? The word “any.”

Second, to qualify as a real estate professional, an individual must:

1. Spend more than fifty percent of their work time and more than 750 hours working in one or more real estate trades or businesses in which they materially participate.
2. Materially participate in the real estate investment generating the passive loss.

One final note about working in a real property trade or business. An individual qualifies as working in a real property trade or business if she or he owns a sole proprietorship or is a partner in a partnership that, for example, does development, construction, rental, management, or brokerage. And an individual qualifies as working in a real property trade or business if she or he works as an employee of a corporation and owns five percent or more of the business. But the work might rise to the level of material participation.

Example: John and Abigail, the married couple mentioned in the preceding example, show $200,000 of income from jobs on their tax return and a $30,000 real estate loss. They get to deduct the $30,000 loss because John qualifies as a real estate professional. One way John might qualifiy? If he owns more than five percent of a corporation that operates a construction trade or business and he materially participates by working more than 500 hours.

Possible Tax Savings from Real Estate Professional Tax Strategy

Structured correctly, a large depreciation deduction or a collection of deductions often shelters other highly taxed income a taxpayer earns.

Example: A single, self-employed real estate broker earns $300,000 working full-time at his business. He also invests in real estate properties and materially participates in their operation. As result, any loss generated by the investments shelter his income. If an investment breaks even in terms of cash flows but generates a $100,000 loss due to depreciation, for example? He nets the $300,000 of broker earnings with the $100,000 of the rental losses. The result? He pays income taxes on $200,000 and so probably annually saves $30,000 to $40,000 in federal and state income taxes.

If a married couple files a joint tax return and combines a high-earner with a real estate professional, the tax return can use real estate losses to shelter the non-real-estate-professional’s income.

Example: A married couple includes a high-earning spouse who makes $1,000,000 in a W-2 job and a spouse who works half time (so roughly 1,000 hours a year) managing the family’s rental property portfolio. The rental portfolio generates a small positive cash flow but on paper due to depreciation shows a $400,000 loss each year. The couple pays taxes on the $600,000 net income and probably saves about $150,000 in federal and state income taxes.

Turbocharging the Real Estate Professional Strategy

Typically real estate investors depreciate commercial property over 39 years and residential property over 27.5 half years.

If an investor buys a $1,000,000 property that represents $200,000 of land and $800,000 of building, the investor depreciates just the $800,000 of building.

To calculate the annual depreciation for an $800,000 commercial building, the investor divides the $800,000 by 39 years. So nearly a $20,000 annual depreciation deduction.

To calculate the annual depreciation for an $800,000 residential property, the investor divides the $800,000 by 27.5 years. So roughly a $30,000 annual depreciation deduction.

Taxpayers interested in larger deductions, therefore, may wish to focus on residential properties.

Further, tax laws do provide real estate investors with a trick to load more depreciation into the early years of ownership: cost segregation.

Cost segregation breaks down the building part of the property’s cost—so $800,000 in the preceding paragraph—into real property (depreciated typically over 27.5 or 39 years) and personal property (depreciated very quickly and maybe even mostly in the first year or two of ownership).

A $800,000 apartment building for example might be cost segregated into $600,000 of real property that the taxpayer depreciates over 27.5 years and $200,000 of personal property depreciated mostly over the first year or two of ownership.

Limits to Strategy

Starting in 2021, however, tax laws limit the excess business losses a taxpayer deducts in any one year to the amount of trade or business income shown on the tax return plus another $262,000 in 2021 and $270,000 in 2022 if unmarried or $524,000 in 2021 and $540,000 in 2022 if married.

This limitation means that the highest income taxpayers can’t always shelter all their W-2 income via the real estate professional tax strategy.

Example: A married couple includes an executive earning $2 million annually in W-2 wages and a spouse who manages the family’s real estate rentals. The property manager spouse qualifies as a real estate professional. And the rental portfolio loses (on paper) $1 million annually. For 2022, the couple however can only use $540,000 of real estate losses to shelter the W-2 income.

How This Strategy Can Blow Up

When it fails, the real estate professional tax strategy fails for one of two reasons. First, it fails because careless or poorly informed taxpayers lose some of their hours. Those lost hours? Investor activity hours when a taxpayer isn’t involved in daily operations. And property manager hours when a taxpayer hires an outside property manager.

Example: Thomas spends 1000 hours working in his real estate trade or business. That amounts to more than fifty percent of the time he works in a trade or business. And that time would appear to count as material participation. Accordingly, Thomas assumes he qualifies for the real estate professional tax strategy. Unfortunately, because he doesn’t get involved in daily operations of the properties, he cannot count 150 hours of investor-type activity. Further, because he hired an outside property manager, he cannot count 150 hours of property-management-type activity. With only 700 hours counting toward the 750-hour minimum threshold, he fails to qualify for real estate professional status.

A second reason the real estate professional tax strategy fails? Because an investor fails to create a time log that an auditor accepts. This is a sort of an unfair trigger to failure. The tax laws suggest a reasonable approach to the recordkeeping works and that estimates are okay. Auditors, however, often seem to want extremely high quality contemporaneous time records as well as third-party proof.

The Real Estate Professional Strategy Works Best for These Taxpayers

The real estate professional tax strategy works well for full-time real estate agents, brokers, and property managers who want to also directly invest in real estate.

The strategy also works well for individuals who own and operate real estate trades or businesses. So, like construction company owners.

Finally, high-income married couples can often make the strategy work extremely well. If one spouse earns a large income (say $1,000,000) and the other spouse manages the couple’s rental portfolio and generates large paper losses due to depreciation deductions (say $500,000 a year), the spouses can dramatically reduce their income taxes by netting the W-2 wages with real estate losses.

Other Information Sources

The passive loss limitation rules and the material participation rules get covered in depth in the Treasury Regulations for Section 469. That information merits close scrutiny.

We’ve also got some blog post that discuss in more detail how the real estate professional trick works, how investors count real estate hours, and how the IRS audits real estate professionals. That information should also be useful to people learning more about this gambit.

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.

The post Tax Strategy Tuesday: Real Estate Professional Tax Strategy appeared first on Evergreen Small Business.

I thought that might be the case. Which brings me to the point of this blog post. You should explore whether you can avoid net investment income tax on your real estate rental income and gains.

The net investment income tax—you may think of it as the Obamacare tax or NIIT—runs roughly 3.8 percent on your real estate profits. So 3.8 percent of your net rental income. And 3.8 percent of your gains when you sell property.

And then the reason for bringing this strategy up now, at the very start of the year. If you are going to avoid net investment income tax? You want to adopt the tax strategy discussed here now. At the very start of a year. That works best. It works easiest.

Note: We’ve been posting a new tax strategy for high income taxpayers every Tuesday for several weeks now: See here for the complete list: Tax Strategy Tuesday.

The Avoid Real Estate Net Investment Income Tax Strategy in a Nutshell

You maybe already know this. But if a single individual’s modified adjusted gross income exceeds $200,000 or married taxpayers’ joint return shows modified adjusted gross income that exceeds $250,000? The taxpayer or taxpayers pay a 3.8 percent net investment income tax on some or all of their real estate profits.

Note: Modified adjusted gross income essentially equals adjusted gross income. In most cases.

Many real estate investors, however, can sidestep the net investment income tax. The U.S. Treasury’s regulations describe a handful of ways to do this. But the easiest and cleanest way? Qualify as a real estate professional who materially participates in your investment properties.

The rules for being a real estate professional work pretty simply, fortunately. The taxpayer (if single) or one spouse (if a married couple files a joint return) needs to meet a material participation threshold and then also needs to spend more than fifty percent of work time and more than 750 hours a on something real-estate-y. Like being the family’s property manager.

A variety of material participation rules work. But the IRS provides a safe harbor formula for these folks that suggests 500 hours a year of participation. (The safe harbor appears in Reg. Sec. 1.1411-4 paragraph (g)(7) near the end of the page.)

Possible Tax Savings from the Avoid Real Estate NIIT Strategy

The savings from avoiding net investment income tax on real estate? Substantial for high-income real estate investors.

Say a married couple earns $200,000 in non-real-estate income. Maybe the income comes from a job. Or from retirement benefits. Further, say the investor also earns another $400,000 in real estate profits. This money might be from rental income. It might be from selling a property for gain.

If the married couple can’t avoid NIIT, they pay the 3.8 percent tax on $350,000. (The tax applies to the lesser of their real estate income or the amount their modified adjusted gross income exceeds $250,000.) That means roughly a $13,000 annual NIIT tax bill.

If they qualify as a real estate professional and meet the material participation requirement, however, bingo. They avoid the roughly $13,000 tax.

Turbocharging the Avoid Real Estate NIIT Strategy

First, and sadly, we regularly see returns for taxpayers who paid NIIT even though they clearly qualified as real estate professionals and should not have paid NIIT. Probably this error stems from either someone self-preparing their return or someone working with a low-skilled preparer who didn’t know enough to handle NIIT. The good news if you happen to be in this situation? You should be able to amend the last two or three years of tax returns. (Discuss this as soon as you can with your accountant.)

A second comment: If there’s a year in which you know you’ll report a big profit from your real estate investing—perhaps a property sale—that’s the year to work hard to qualify as a real estate professional.

One other thing to mention someplace in this blog post: At least a couple of other techniques for avoiding real estate net investment income tax appear in the Treasury regulations. Self-rental situations should often let someone avoid NIIT on real estate income, for example. And real estate developers who rent a property they’ve developed also have an easy way to at least temporarily avoid NIIT on rental income.

And then the regulations hint at some other possibilities. Like short-term rentals. And loopholes for farmers and ranchers.

The bottom line here: If you can’t get the real estate professional designation to work, don’t give up. Ask your tax advisor if one of the other loopholes let you avoid paying NIIT.

Limits to Avoid Real Estate Net Investment Income Tax Strategy

You, or your spouse if you’re married, needs to not only qualify as a real estate professional. You also need to meet material participation thresholds. That means you can’t use this tax strategy to avoid NIIT on passive real estate investments. Sorry.

Further, as we write this, the status of the Build Back Better Act is unclear. But the version of the legislation circulating right now (which may differ from the version that passes) closes this loophole for real estate investors who enjoy a taxable income of more than $400,000 if single and more than $500,000 if married.

We discuss how this proposal works here: Build Back Better Hits S Corporations and Active Real Estate Investors. But in a nutshell, someone with a taxable income that exceeds $400,000 or $500,000 begins losing their ability to avoid NIIT on real estate income, and these folks completely lose the ability to avoid NIIT once taxable income rises to $500,000 or $600,000.

The Avoid NIIT Strategy Works Best for These Taxpayers

The avoid real estate net investment income tax strategy only practically works for taxpayers with direct real estate investments. (Only these folks can usually pass the material participation test.)

It also works most easily for situations where the taxpayer or a spouse qualifies as a real estate professional because they already work 750 hours a year or more in a real estate trade or business. So, for example, someone already self-employed as developer, redeveloper, construction contractor, rental agent, property manager, real estate broker or agent. Or someone who already owns five percent or more of a firm engaged in these activities.

Note: Tax law provides this definition of a real estate business. “…the term ‘real property trade or business’ means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”

Other Information Sources

The IRS’s treasury regulations for passive losses and net investment income tax should be read thoroughly and referenced by the tax accountants using this strategy.

The taxpayer who runs this strategy probably also wants to get a good grasp of the rules for real estate professionals and particularly the mechanics of counting real estate hours. A person might also want to peek at the earlier Tax Strategy Tuesday post on real estate professionals.

Finally, confirm with your tax advisor about whether this strategy even makes sense. You might not want to go to the work of being a real estate professional if the savings amount to only a few hundred dollars a year, for example. And then, as always, if you have not yet found a tax advisor, please consider becoming a client of our CPA firm.

The post Tax Strategy Tuesday: Avoid Real Estate Net Investment Income Tax appeared first on Evergreen Small Business.

For example, if you know you’ll shortly liquidate some investment (cryptocurrency?) that results in very large taxable gains?

Maybe, just maybe, you ought to move. Before the gain gets realized. So, to Alaska, Florida, Nevada, South Dakota, Tennessee, Texas or Wyoming… (That’s the list of states that don’t tax income.)

Note: Washington state used to be a no-income-tax state and an attractive one to move to in some situations. However, Washington state starting on January 1, 2022 levies a 7 percent capital gains tax on the sorts of windfalls that would push someone to move.

Move to a ‘No Tax State’ Strategy in a Nutshell

This strategy? Well, you can already guess how it works. You clearly sever residency with the old state. And you also clearly establish residency in the new state.

You want to check the residency rules for the states you’ll move from and to. Especially the high-tax state. But in most cases, the stuff that determines residency reflects common sense.

Your state of residency probably is the state where you and your family work and live. Where your children, if they’re young, go to school. Where you vote. Where you procure medical or dental or other professional services. Where you bank.

It’s probably the state that issued your driver’s license, issued you any professional licenses, and that registers your vehicles. All of this stuff shows a permanent or indefinite connection to a state. And it suggests residency. Accordingly, to establish residency in some new no-tax state, you move all of this stuff from the old state to the new state. That’s the strategy in a nutshell.

And once you do that? Bingo. You should be able to save on state income taxes. Because you won’t have income earned in the old state.

Possible Tax Savings from Moving to a No Tax State Strategy

The tax savings you get from employing this strategy? Pretty significant in some situations. By moving from a high-tax to a no-tax state, a taxpayer roughly saves an amount equal to the income the original state loses the chance to tax.

Example: Rutherford, a long-time California resident, wants to sell cryptocurrency that will result in a $10 million gain. To avoid state taxes, he relocates from California to Texas, severing all connections to California. He sells his home in San Francisco and buys a new replacement home in Austin. He registers to vote in Texas and gets a Texas driver’s license. And then cancels his California voter registration and driver’s license.  And then, after all this, he sells the cryptocurrency. He should in this scenario avoid California’s 13.3% tax on the $10 million.

One obvious thing to keep in mind: Relocation and moving costs add up. The economics sometimes don’t support moving. Even for rather large gains.

Example: Rutherford’s good friend, Grover, is also a long-time Californian. He wants to sell cryptocurrency that will result in a $1 million gain. Though he would love to avoid the large California state tax on the cryptocurrency gains, he holds a great job in California. One where he earns probably $25,000 more a year that he would earn at a similar job in Texas. Further, to sell his California home and buy a replacement Texas home? That would probably cost him $50,000 in commissions. Grover therefore should probably not move for tax avoidance reasons.

Turbocharging the ‘No Tax State’ Strategy

I don’t see any obvious ways to turbocharge the strategy of moving from a high tax state.  But a couple of comments. First, tax deductions become less valuable in a no tax state. For this reason, someone moving from a high tax state may want to use deductions when they also save state income taxes. So maybe before they move? And maybe before they file the part-year-resident tax return?

And then one related comment. If someone currently resides in a low-tax or no-tax state and she or he plans to move to a high-tax state, that person may want to intentionally realize taxable income and gains before ending residency in the low- or no-tax state.

Example: Rutherford and Grover have a friend, William, who also sits on large cryptocurrency gains.  Roughly $5 million of gains, in fact. He currently lives in Texas but wants to move to California to be closer to family there. He probably should consider realizing his cryptocurrency gains before he moves from his current no-tax state to a high-tax state.

Limits to ‘No Tax State’ Strategy

As a practical matter, timing of residency ending in one state, beginning in another state, and then of  realizing some gain may prove tricky. You may not get the sequencing to work.

Also the more time between residency ending in the high-tax state and the point when income or gain is realized, the better.

Keep in mind that if residency ends during a tax year, a taxpayer files a part-year-resident tax return with the high-tax state… And that return? It surely includes the federal income tax for the full year.

Ideally, you would like that federal return to not show the income you’re trying to move out of the high-tax state. That might trigger trouble. Possibly seeing a large income item on the federal tax return for some part-year resident might trigger queries from alert state revenue agents.

Example: Rutherford moved from California on June 30 and files a part-year resident tax return for the year. That return includes the federal return for the year. Rutherford therefore delays selling the cryptocurrency and realizing the $10 million gain until the following year. The following year, he won’t file a part-year-resident California tax return.

Who This Strategy Works Best For

The “Move to a No Tax or Low Tax State” strategy works best for taxpayers who have only loose connections to their current high-tax state of residency and who also have really large taxable income windfalls and gains.

Other Resources

California is probably the most common high-tax folks want to leave. Any Californian who wants to consider establishing residency someplace else wants to carefully read this resource: Publication 1031.

The New York State Society of CPAs published a good discussion of how a taxpayer ends residency in that state worth reading–especially for New Yorkers: A Spotlight on New York State Residency Requirements.

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, onboarding info appears here and you can contact us here: Nelson CPA.

The post Tax Strategy Tuesday: Move to a No Tax State Strategy appeared first on Evergreen Small Business.

The Strategy in a Nutshell

To explain the tax benefit of accelerated depreciation, it’s important to first understand what accountants mean when we use the word “depreciation”—because it’s probably not what you think.

What is “depreciation”?

So, here’s a weird thing: when accountants talk about “depreciation,” we’re talking about a number that has nothing to do with an asset losing value. I know, this sounds like nonsense. But let me explain.

If a taxpayer purchases an expensive asset that they’ll (1) use over several years to (2) generate revenue (such as a building purchased to rent to tenants), accountants don’t subtract the cost of the asset from income the year the purchase is made. Instead, we break up the cost of that asset into pieces and subtract a piece from income each year over the several years the taxpayer uses the asset to generate revenue.

The number of pieces the cost gets broken into depends on the type of asset the taxpayer invested in and how long the IRS thinks the asset is likely to last. For example, residential real estate is broken up over 27.5 years. Nonresidential real estate is broken up over 39 years. And the cost of other assets (e.g., appliances, cars, computers) is broken up into larger pieces over fewer years.

For reasons that aren’t really clear (at least to me), the convention is to label this expense as “depreciation” on the profit and loss statement. But that’s not really right—the accounting department did nothing to determine whether the asset in question lost value. Instead, this expense should really be labelled something like, “this year’s fraction of the cost of assets we bought some number of years ago.” It’s clunky, but it would be a much less confusing label.

Why Accelerate Depreciation?

So, why would a taxpayer want to accelerate depreciation deductions? Well, two reasons.

First, you can sometimes time an accelerated depreciation deduction to occur in a year with a big spike in ordinary income, thus avoiding a higher-than-normal tax rate.

Example: A high-income taxpayer has nonqualified employee stock options he wants to exercise before they expire. But he’s leery of recognizing so much ordinary income in one year due to the progressive rate structure of the U.S. income tax code. What’s more, he may predict that tax rates on ordinary income will be lower in the future than they are now. One idea for this taxpayer? Invest in a new real estate activity or small business and use a depreciation acceleration strategy to add a large deduction to his tax return in a year when his income and tax rate are otherwise very high.

A second, more abstract, but similarly lucrative benefit? If you can get out of having to wait several years to subtract the full cost of your investment from your income—in other words, if you can subtract the entire cost in the first year, or first few years, you use the asset—you end up with more money in your pocket than you would have otherwise.

Why? Because of the time value of money.

Assuming your tax rate stays constant over the life of your real estate investment, accelerating when you claim the deduction for the cost of the investment won’t lower your lifetime tax bill on paper. But remember that for the years you delay paying the tax, you can instead keep the money that would have gone to the IRS in an investment that earns you a return. Maybe you reinvest that money into your business, and so support additional growth in your firm. Maybe you invest it in an index fund. Or perhaps you just pay down a loan more quickly than you would have otherwise.

Possible Tax Savings

Taxpayers see an immediate reduction in income taxes in the year they deduct depreciation.

For example, if a taxpayer’s return includes a $100,000 deduction and her marginal tax rate equals 40 percent, the depreciation deduction likely lowers that year’s tax bill by $40,000.

Calculating the true savings of the accelerated depreciation, however, requires more work. The calculations also require additional information.

To keep the numbers simple, however, if a taxpayer saves $40,000 in taxes all at once rather than, say, $4,000 a year over ten years, that might deliver a time value of money benefit somewhere between $15,000 and $20,000. (I use a 15 percent annual discount rate to make this calculation.)

And then if a taxpayer can use a $100,000 deduction when the tax rate equals 40% rather than 20%, that obviously saves a large amount, too. In this simple example, it saves $20,000.

Turbocharging the Strategy

For much of the property a taxpayer depreciates, tax laws already allow for accelerated depreciation that frontloads depreciation in the early years of an investment.

Often taxpayers, for example, can use a Section 179 election to expense as much as roughly $1,000,000 of the cost of the personal property in the year the asset goes into service. (That million-dollar limit adjusts annually for inflation. In 2021, for example, the Section 179 limit is $1,050,000. Also note that a taxpayer’s income and other asset purchases factor into the maximum Section 179 deduction.)

Most taxpayers can also use bonus depreciation to immediately expense 100 percent of the cost of assets placed into service in 2021 or 2022 if the assets’ recovery period equals 20 years or less.

Finally, for situations where Section 179 and bonus depreciation don’t give a taxpayer a highly accelerated depreciation deduction? No problem. Three other big tricks exist for turbocharging depreciation deductions. One is to take advantage of the qualified improvement property rules, which relax the rules for when someone can use bonus depreciation. Another is to do something called a “cost segregation study,” which essentially transforms real property into personal property. And a third strategy is to use something called the “179D deduction,” a green building incentive that might be revamped in the Build Back Better bill (i.e., the reconciliation bill).

You’ll want to confer with your tax accountant. You likely need their help to assemble the right depreciation choices that save you taxes and generate time value of money benefits.

But know that these tricks all achieve the same fundamental thing: more of an asset’s cost is subtracted from taxable income earlier in the asset’s life. And possibly more of the asset’s cost is deducted in higher-income years.

Limits to the Strategy

The big caution taxpayers need to be aware of is that Congress has put complex rules into the tax code that limit taxpayers’ ability to deduct large losses from real estate and similar investments. Specifically, four loss limitation regimes to be aware of are the outside basis limitation rules (relevant for investors in partnerships and S corporations), the at-risk rules, the passive activity rules, and the excess business loss rules.

One can often sidestep these rules, but most taxpayers need the help of a skilled tax adviser to do so. And the taxpayer will need to have good recordkeeping to support claiming the loss. For example, if a taxpayer’s ability to claim a large loss rests on meeting the definition of a “real estate professional,” she ought to keep a detailed log of the hours she spends on the activity to prove she really meets that definition.

Another thing to keep in mind? A taxpayer should exercise caution when using accelerated depreciation for cars, boats, and planes or for property that is of a type often used for entertainment, recreation, or amusement. The reason? This property, called “listed property,” creates trouble for taxpayers if they happen to later convert the property from business use to personal use.

Which Taxpayers the Strategy Works Best For

Accelerated depreciation works best as a tax saving strategy for landlords and small businesses considering a large investment in real estate or significant capital assets (like vehicles, equipment, and machinery) and for taxpayers with an unusually high-income year.

Accelerated depreciation works best as a time-value-of-money strategy for investors and entrepreneurs able to invest tax savings in a venture that delivers a high rate of return. So small business. Or a leveraged real estate investment.

Other Information Sources

The IRS provides a great publication about how current depreciation rules work here: Publication 946: How to Depreciate Property.

If you’re interested in an example of how to avoid the loss limitation rules I mentioned earlier, we published an earlier post about the vacation rental strategy in November. We also have a post on the real estate professional rules, another strategy to allow losses.

Finally, taxpayers likely need a tax accountant’s help to maximize the benefits of accelerating depreciation. So do ask your tax advisor to consider these issues. And do give them both the time and the information they need to come up with smart recommendations. Finally, this plug for our accounting firm: If you don’t have a tax advisor who can help with this sort of stuff? You can contact us here: Nelson CPA.

The post Tax Strategy Tuesday: Accelerate Depreciation Strategy appeared first on Evergreen Small Business.

In other words, if you run your own business, even a sideline or part-time venture, you can possibly save significant income taxes by setting up a pension plan for yourself.

Note: To see a complete list of our tax strategy blog posts click here: Tax Strategy Tuesday.

Pension Plan Tax Strategy in a Nutshell

To show the details, let’s look at two situations: One where someone with a regular W-2 job earns $20,000 from a side hustle.

And then, another one where someone works full-time in their own business and earns $200,000. To keep the math simple, I assume this full-time business owner works as a sole proprietor. Also, that she or he employs no other workers.

In both of these situations, the business owner can probably setup one of three attractive pension plan options.

SEP-IRAs Allow for Easy Contributions

A first option to consider: A SEP-IRA plan that will allow the business owner to contribute roughly 20 percent of her or his profit to the pension.

SEP stands for simplified employee pension. With a SEP plan, an employer contributes a set percentage of a person’s compensation to the employee’s IRA. Or to the business owner’s IRA.

The contribution limit? Up to 25 percent of an employee’s compensation. Roughly up to 20 percent of the proprietor’s income.

Example: Someone who earns $20,000 annually in their own small business can probably make a SEP-IRA contribution equal to roughly $4,000. Someone who earns $200,000 annually can probably make roughly a $40,000 SEP-IRA contribution.

401(k) Plans Allow for Larger Contributions

A second option to consider: A 401(k) plan.

A 401(k) plan allows the business owner to contribute as much as 20 percent of her or his profit to the pension plus an elective deferral. An elective deferral equals as much as another $19,500 in 2021 and then as much as $20,500 in 2022. For business owners and employers aged 50 or more, those limits bump up to $26,000 in 2021 and $27,000 in 2022.

Example: If someone earns $20,000 annually in a small business, they can probably make a 401(k) plan contribution equal to roughly $20,000. (The amount someone contributes can’t exceed what they earn.) If someone earns $200,000 annually, they can probably make roughly a $40,000 contribution plus an elective deferral of $19,500 to $27,000 depending on their age.

The maximum 401(k) plan contribution for employees and shareholder-employees equals 25 percent of wages.

Example: Say a business owner makes $200,000 in his business. Further say he operates as an S corporation and that the S corporation pays him $100,000 in wages. In this case, the maximum 401(k) contribution equals $25,000 plus the elective deferral.

Defined Benefit Plans Allow for Giant Contributions

A third option for some taxpayers to consider—especially older taxpayers: A defined benefit plan which allows a taxpayer to contribute amounts unconnected to their current year income. Instead, the defined benefit plan looks at someone’s historical income and what that person needs to accumulate by retirement in order to enjoy some set retirement income amount (or “defined benefit.”)

This may be a helpful bit of information to know: When you hear about some pension plan that promises to pay 50 percent or 75 percent of someone’s average earnings if they’ve worked X number of years? Yeah. That’s a defined benefit plan. And that amount the employer needs to pay into the plan in order to deliver the promised benefit? Subject to certain tax law limitations, that amount equals the contribution.

Example: Say someone earns $20,000 annually in their small sideline business. Further assume they’ve earned this amount for decades and will retire a short ways down the road. The business may be able to setup a defined benefit pension plan and contribute $50,000 a year to a defined benefit pension plan.

Example: Say someone who earns $200,000 annually. And has for decades. A business owner in this situation, if close to retirement, may be able to contribute $150,000 annually. Or $200,000.

A final note: Neither you nor your accountant calculates the defined benefit plan contribution amount. An actuary calculates the pension plan contribution required to fund the retirement income stream.

Possible Tax Savings from Pension Plan Strategy

A big pension plan contribution substantially reduces your income taxes for the year you make the contribution.

If you make a $20,000 contribution and your marginal income tax rate equals 25 percent, for example, the savings equal $5,000.

If you make a $60,000 contribution and your marginal income tax rate equals 30 percent, the savings equal $18,000.

Make a $200,000 contribution if your marginal tax rate equals 50 percent? The savings equal $100,000.

But an important point to remember: The amounts given above represent deferrals. When a taxpayer withdraws the money from a pension plan, she or he will probably pay income taxes then. But probably at much lower tax rates. Most people enjoy higher incomes while they work as compared to during retirement.

Turbocharging the Pension Plan Tax Strategy

You turbocharge your pension plan tax strategy by contributing the most money possible to your retirement nest-egg for as long as you can. That’s the basic optimization technique. And three turbocharging tactics for doing this should often be considered.

Multiple Pension Plans?

First, an individual may be able to start multiple pension plans.

A business that already runs a 401(k) plan may be able to set-up a defined benefit plan, for example.

Or, an entrepreneur who is a partner in a ten-employee software company and who owns a one-person consultancy may be able to add a second pension plan for the second business. If the software company already provides a 401(k) plan, for example, the business owner may be able to setup a SEP-IRA or defined benefit pension plan for the one-person consultancy.

Note: An employer’s pension plan or plans need to not discriminate in favor of owners and highly-compensated employees. Further note that tax laws group employers or businesses with the same or nearly identically ownership into a single employer. In the case where an entrepreneur operates a one-person consultancy and owns 100 percent of a software company, tax laws say the employer for pension purposes is the combination of the two businesses. Also tax laws can group businesses that don’t share ownership if the firms represent an affiliated service group. Given these complexities, you want to get your tax advisor’s help in situations where a business owner operates or controls multiple entities.

Adding Family Members to Plan?

A second idea to turbocharge a pension option. In some cases, an employer may be able to double, triple or quadruple pension plan contributions by adding (legitimately) a spouse or other family members to the pension plan. If a business owner’s spouse works in the business, for example, he or she should be paid wages. And if a pension plan exists, he or she should probably participate.

Caution: A business owner usually doesn’t save money by adding family members to the payroll only to get a bigger pension deduction. The reason? The extra payroll taxes triggered usually more than eat up any tax savings from the extra pension deductions.

Plans for Last Wind-down Years?

A third tactic for situations where an owner winds down a small business. In some situations, the wind-down of a business creates a unique opportunity. If the last few years of a business’s life require only the owner to work—maybe a sale occurred, for example—that may be a perfect time to setup a new hyper-generous pension plan for just the owner.

Example: A small business owner sells his firm’s assets in a transaction that results in the owner receiving large payments over the years following the sale of the firm. Very possibly, the seller can set up a pension plan at that point and make large annual pension plan contributions.

Limits to Strategy

Some limits exist for the pension plan strategy.

Costs Matter

First, firms should consider the costs.

Employee matching contributions paid to non-owners become very significant.

Fortunately, most SEP-IRA and single participant as well as owner-and-spouse 401(k) plans don’t burden a business with additional administrative costs.

But most small business 401(k) plans and single-participant defined benefit plans cost a few thousand dollars a year. Maybe $1,000 to $2,000 for a small business 401(k), for example, if the plan handles multiple participants? Maybe $2,000 to $4,000 annually for a single-participant defined benefit pension plan?

Elective Deferrals Per Individual

Second, note that tax law limits most individuals’ elective deferrals across all of her or his pension plans to $19,500 in 2021 and $20,500 in 2022. For taxpayers aged 50 or older, the limits equal $26,000 in 2021 and $27,000 in 2022. But the point here: Obviously if an individual works at a full time W-2 job and uses fully uses the elective deferral for that job’s 401(k) plan, she or he can’t also use an elective deferral for a second pension plan.

Non-discriminatory Matching Percentages Required

Third, note that in general the matching percentage used for a business owner needs to, for practical purposes, equal the matching percentage used for any employees who work at the business.

A business however often can set the percentage to zero or some other low amount as long as that percentage gets used for everyone. Also note that some employees can often be excluded from a an employer’s pension. Children for example.

Note: A minor complexity exists with regard to sole proprietor and partner pension amounts: The equivalent owner pension percentage equals the employee percentage divided by one plus the  employee percentage. A 25 percent employee contribution equates to a 20 percent owner contribution, for example, because .25/(1.25) equals .2.

SEP-IRA and 401(k) Limits

Fourth, tax law limits the pension plan deductions a business can make to a SEP-IRA or 401(k).

The limit for a SEP-IRA contribution equals $61,000 for 2022 and $58,000 for 2021, and then not more than 25 percent of an employee’s compensation or more than roughly 20 percent of a sole proprietor’s or partner’s compensation.

Higher limits exist for 401(k) plans. The total 401(k) contribution for an individual can’t exceed 100 percent of the person’s compensation. Further, the deduction can’t exceed $58,000 in 2021 and can’t exceed $61,000 in 2022 for folks under age 50. Folks aged 50 or older get limited to $64,500 in 2021 and $67,500 in 2022.

Remember Permanency Requirement

Finally, fifth, an employer needs to run its pension plan for a few years. Here’s why: Pension laws require that pensions be “permanent.”

Therefore, you cannot run one plan for a year, shut it down, start up some new plan a little while later, shut it down, and so on. That behavior probably violates a permanency requirement.

Ask your tax advisor or pension administrator for details. Usually if you operate the pension for a few years, that counts as permanent enough.

Other Information Resources

The Internal Revenue Service provides rich, easy-to-read information about retirement plans at its website (click here.)

Any of the big financial services firms will help you set up a pension plan. Mutual fund giant Vanguard.com works well for SEP-IRA plans and for one participant 401(k) plans because they offer such low-cost investment options. We like (and ourselves use) Guideline.com for small business 401(k) plans with multiple employees because they offer pretty economical, pretty convenient solutions for most small employees. Finally, to get the names of good defined benefit plan providers, ask your tax advisor. He or she will probably know of several vendors in your area or who serve firms your firm’s size.

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

The post Tax Strategy Tuesday: Start a Pension Plan for Yourself appeared first on Evergreen Small Business.

That tax strategy—and yes you still have time barely—gives you a tax credit that equals as much as $50,000 for the fourth quarter of 2021.

And just to make this point crystal clear. Yes. The federal government may give you $50,000. Cash. All you need to do? Start a trade or business before the year ends.

Tip: We discuss a tax strategies every Tuesday here at the Evergreen Small Business blog. Click here to see the full list: Tax Strategy Tuesday.

Employee Startup Business Employee Retention Credit in Nutshell

The rules for the recovery startup business employee retention credit work simply.

A small business employer needs to begin carrying a trade or business sometime after February 15, 2020 and before December 31, 2021.

The recovery startup business employee retention credit equals 70 percent of the wages and health insurance paid to any non-family-member employee but not more than $7,000 per employee for a quarter.

And then the rules limit you to $50,000 a quarter.

Example: You own a construction company and then start a sideline consulting gig during the quarter. The construction company employs five workers who each make $12,000 a quarter. The consulting gig employs a part-time employee who makes $5,000 a quarter. Assuming none of these employees is family? The recovery startup business employee retention credit equals $38,500: 70 percent of the first $10,000 paid to each of the five construction company employees plus 70 percent of the $5,000 paid to the consulting business’s part-time worker.

The Two Tricks that Make Tax Strategy Work

Two tricks make the recovery startup business employee retention credit super-attractive as a tax strategy.

First? All you need to do is begin carrying on a trade or business. (If you’re already in one business, that means beginning to carry on a new or a different trade or business.)

This caution: A trade or business needs to something you do in pursuit of profits. So, a real business. Not a hobby. Not a faux business. And you need to engage in the trade or business with regularity and continuity. (We’ve pointed out elsewhere that buying a rental property and placing that property into service qualifies under the rules.)

And then the second trick that makes this tax strategy really attractive: An employer aggregates all its trades or businesses. An entrepreneur who owns and operates a construction company and a rental property, for example, aggregates those two ventures into a single employer. Which produces a really interesting result…

Example: A construction company owned by a single entrepreneur employs workers. She buys a rental property after February 15, 2020 and that rental property qualifies as a trade or business. That new rental then counts as beginning to carry on a trade or business. And then the wages paid by the construction company create up to $50,000 of employee retention credits.

Possible Tax Savings from Startup Business Credit Tax Strategy

Because the tax strategy we’re talking about here is a credit, the tax savings equal the credit.

A $25,000 credit means you get $25,000 of tax savings. A $50,000 credit means you get $50,000 of savings.

To claim the employee retention credit, an employer uses the quarterly 941 federal payroll tax return. Essentially, you (or your accountant) uses the employee retention credit to reduce the payroll tax deposits required. Or if you’ve already made the payroll tax deposits, you use the employee retention credit to get a refund of overpaid deposits.

Turbocharging the Startup Business Employee Retention Credit Strategy

Just to point again to something mentioned earlier. You can claim a recovery startup business credit if you started a new trade or business after February 15, 2020 and before December 31, 2021.

Someone who starts a business after February 15 2020 and before September 30, 2021 gets the credit for the third and fourth quarters of 2021. Someone who starts a business during the fourth quarter of 2021, gets the credit only for the fourth quarter.

Accordingly, you want to think about whether or not you’ve already started a trade or business and so already triggered eligibility.

Example: In the summer of 2020, you bought a rental property. If you’re attempting to maximize profits and engaging in that rental trade or business with regularity and continuity? Bingo. You already qualify. You should have added an employee retention credit to your third quarter 941 filed in 2021. And then you should add an employee retention credit to your fourth quarter 941 you’ll file in early 2022.

If you haven’t yet started a new trade or business, you need to find something else—something real of course—to start as soon as you can.

Limits to Strategy

Only small business employers qualify for recovery startup business employee retention credits.

The definition of “small business?” An employer that averages $1,000,000 or less in gross receipts over the three previous tax years. Usually that means the 2018, 2019 and 2020 calendar years. Note that some special rules apply if an employer didn’t operate in those years.

Also the strategy only works for two quarters: The third quarter of 2021 and the fourth quarter of 2021.

Note: The other flavors of the employee retention credit terminated at the end of the third quarter of 2021. Only the recovery startup business employee retention credit program works in the fourth quarter 2021.

Also this important bit: For any employee retention credit, only wages and health insurance paid to non-family-members count.

How This Tax Strategy Can Blow Up

Taxpayers and their advisors want to carefully assess whether some new activity rises to the level of a separate trade or business.

We’ve got a discussion that digs into this issue in our book, Maximizing Employee Retention Credits, but the general rules say you apply the Section 162, need to have separate or separable books and financial records, and want to have begun carrying that identifiable new activity by December 31, 2021.

The Startup Business Credit Strategy Works Best for These Taxpayers

The startup business employee retention credit works best, in a sense, for qualifying small business owners who start a new trade or business or invest in rental  property but who already have employees in another existing business.

Other Information Sources

Section 3134 is the bit of law that creates the recovery startup busines employee retention credit (available here.) That statute provides useful detail. Further, the IRS published Notice 2021-49 and it gives detailed guidance on the recovery startup business employee retention credit (available here.)

For taxpayers and tax advisors who want to dig into the details of the recovery startup business credit, we’ve got a series of longer blog posts: Recovery Startup Business Employee Retention Credit, the $100,000 Real Estate Employee Retention Credit Windfall, and Nine Awkward Questions about the Startup Business Employee Retention Credit.

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.

The post Tax Strategy Tuesday:  Startup Business Employee Retention Credit appeared first on Evergreen Small Business.

The strategy? Convert guaranteed payments to qualified business income, or QBI. Which should cut someone’s income taxes by about a quarter.

Accordingly, this week, the Tax Strategy Tuesday blog post discusses this gambit. And its mechanics. And note that at the end of this post, additional information resources appear.

Tip: If you’re interested in other tax strategies, click here: Tax Strategy Tuesday.

But let’s start by giving a nutshell description of the strategy…

Convert Guaranteed Payments into QBI Tax Strategy in Nutshell

You perhaps know this, but if a partnership pays a partner some amount and calls that disbursement a guaranteed payment, the partner pays income taxes on the full amount.

Example: Dolly works as a physician in a group medical practice operating as a partnership. As a partner, she receives a $300,000 guaranteed payment for her work. Dolly pays income taxes on the $300,000.

The tax accounting works differently, however, if the partnership allocates and then pays out profit shares to partners.

Why? Because tax law (through 2025) gives partners in partnerships a special “qualified business income” deduction equal to twenty percent of the qualified business income, or QBI. And a profit allocation counts as qualified business income. Guaranteed payments don’t count.

Example: James, a physician in a different group medical practice, also earns $300,000. But his partnership doesn’t use guaranteed payments in its accounting. Rather, the partnership allocates profits to James and then pays out profits as distributions. James therefore pays income taxes on only eighty percent of the $300,000, or $240,000. His taxable income drops from $300,000 to $240,000 due to the $60,000 QBI deduction.

A final quick point about this tax strategy. Partly the problem this blog post describes reflects a legacy of accountants taking shortcuts. Before 2018? It didn’t matter that bookkeepers and accountants incorrectly labeled payments to partners as guaranteed payments. That made the accounting easy. But often the partnership didn’t really have guaranteed payments.

Tricks that Convert Guaranteed Payments into Qualified Business Income Tax Strategy Work

Okay, the obvious basic trick for making the convert-guaranteed-payments-to-QBI strategy work? Not using guaranteed payments.

That means, per tax law, saying partners get paid out of profits. And not saying some amount gets paid to a partner regardless of profits.

Also, all the internal documentation that describes and controls and documents how partner profits get allocated? And then paid out to partners? That stuff all needs to tell the same story. (A partnership’s attorney quarterbacks this process, including the key step of updating the partnership agreement.)

But get the mechanics right, and the results work wonderfully. And get sloppy and cut corners? Ouch.

Referencing the earlier examples, if Dolly’s partnership says she gets that $300,000 no matter what happens, no matter the firm’s profitability, that $300,000 is a guaranteed payment.

But if the partnership updates its partner compensation agreements to say that partners can plan on a $25,000 month distribution (so $300,000 for the year but subject to partnership cash flows and profits) and then people get allocated profits based on the management committee’s allocation of profits at year-end, that subtle difference converts the guaranteed payments into profit allocations.

Voila. The partner gets a twenty percent qualified business income deduction, or QBI deduction.

Possible Tax Savings from Convert Guaranteed Payments Tax Strategy

The savings a taxpayer enjoys from this strategy? Equal to the new QBI deduction times the taxpayer marginal federal tax rate.

For example, if a taxpayer earns about $330,000 in qualified business income and gets a $65,000 QBI deduction—that’s about as large as someone in a specified service trade or business can get—that saves the taxpayer about $16,000 in federal taxes each year.

Note: A specified service trade or business is basically a white collar or white coat professional. The QBI deduction for these taxpayers phases out once the taxpayers income reaches a threshold amount. For married taxpayers in 2021, the phase-out threshold begins at roughly $330,000 of taxable income.

Partners in non-specified-service-trades-or-businesses may get a larger deduction. For example, a partner in a non-specified-service-trade-or-business with $2 million of qualified business income may get a $400,000 QBI deduction. That $400,000 QBI deduction probably saves the partner around $150,000 in taxes.

Most partners earn five figure or low six figure incomes, however. In these more typical cases, the savings generated by the QBI deduction drop. For example, on $50,000 of QBI, the deduction equals $10,000. And if the marginal tax return equals 12 percent, the tax savings run $1,200 annually.

Turbocharging the Convert Guaranteed Payments into QBI Strategy

Most often, a taxpayer really shouldn’t have to “do” anything to get this strategy to work. Or to work better. Though in a few cases, and as noted earlier, working the strategy sometimes requires the partnership agreement to be updated.

Example: A twenty-partner law firm pays equal shares of the profit to partners. Usually, that share runs roughly $450,000 a year. The partnership K-1 that goes to partners shows about $80,000 of deductions for pension, self-employed health insurance and self-employment taxes. Partners all average another $40,000 in itemized deductions. Which means even though the law firm surely is a specified service trade or business, each partner (at least in this example) should annually get roughly a $65,000 tax deduction and save roughly $16,000 in taxes.

By the way, if a partnership has bungled the accounting for profit allocations, a solution exists. The partnership just amends its 2018, 2019 and 2020 1065 tax returns. And then the partners amend their 1040 tax returns for the same years. (This error, sadly, happens more often that you would guess.)

Limits to Strategy

Typically, high income partners working in a specified service trade or business (basically a white-collar or white-coat profession) lose their ability to easily use the qualified business income once their adjusted gross income rises above, say, $225,000 if single and above $450,000 if married.

Note: The specified service trade or business label only matters as married taxpayers’ taxable income rises above $329,000 and as a single taxpayer’s taxable income rises above $164,900. These taxable income thresholds probably roughly equate to adjusted gross incomes that are at least $50,000 to $100,000 higher due to common tax deductions.

These specified-service-trade-or-business partners can still get the deduction onto their returns. But the deduction requires more work either in the partnership’s accounting. Or on the partners’ individual tax returns.

Example: Dolly the physician mentioned earlier sees her partnership profit triple to $900,000. Her spouse, however, manages the family’s rental property portfolio and creates roughly a $400,000 annual business loss using depreciation. When the couple adds their other adjustments and deductions to their federal return, the taxable income drops below the threshold where specified service trade or business status matters.

How This Tax Strategy Can Blow Up

Bad bookkeeping and internal documentation that mislabels distributions as guaranteed payments surely undermines the strategy.

And then if a partnership agreement historically made use of guaranteed payments? Obviously, the partnership and its partners need to update that agreement.

One other practical matter may torpedo this tax strategy. Partners may find it unacceptable to explicitly bear the risk of fluctuating incomes. Or their families may find it unacceptable.

Example: Three engineers named Hillary, Laura, Michelle consistently generate $1,500,000 in profits from their engineering services partnership. And the agreement between these three women? They evenly share the profits as they evenly share the work. Thus each partner earns $500,000 annually. On its face, this arrangement does not use guaranteed payments and so generates potentially as much as $500,000 a year of qualified business income and possibly a $100,000 QBI deduction. However, it may be that one of the partners or one of the partner’s spouses wants to call the distributions “guaranteed.” Even though of course, they probably aren’t really guaranteed. But that label just, well, “feels” safer.

The Convert Guaranteed Payments into Qualified Business Strategy Works Best for These Taxpayers

The convert guaranteed payments into QBI tax strategy works well for high-income partners. Especially when the partnership doesn’t operate a specified service trade or business.

As noted, partners in specified service trades or businesses face some challenges if their tax returns show high incomes. But regularly, even these folks benefit from treating partnership profits as allocations of profit rather than guaranteed payments paid regardless of profits.

Other Information Sources

The Internal Revenue Code section that describes how guaranteed payments work appears here: Section 707. The related regulations start here: Reg. Sec. 1.707. Someone working with this tax strategy needs to know well what these bits of tax law say.

We’ve also got some blog posts that discuss in more detail how partnerships make the convert-guaranteed-payments-into-QBI tax strategy work: This blog post for example provides a backgrounder on the Section 199A deduction as well as discussion of common ways the Section 199A deduction gets bungled: Section 199A Rookie Mistakes.

This blog post explains the detailed mechanics: Salvaging Partnership Section 199A Deductions.

Finally, this blog post shows how the specified-service-trade-or-business rules sometimes work differently than one might guess: Physician Section 199A Deductions Can Work (If You Know The Rules). Note that this same sort of workaround commonly exists for firms in other categories that initially seem to be disqualified from Section 199A.

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, onboarding info appears here and you can contact us here: Nelson CPA.

The post Tax Strategy Tuesday:  Convert Guaranteed Payments to Qualified Business Income 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.

This blog post starts that series by talking about a first strategy that many taxpayers can use: vacation rental property.

Vacation Rental Tax Strategy in Nutshell

The vacation rental property tax strategy works like this. You buy a vacation property.  So, a cabin in the Rocky Mountains. Or a Florida beach house. Maybe a condo in Hawaii.

You then put the property into a rental pool. Maybe a local property management company. Maybe one of the big international web-based services like HomeAway.com or AirBnB.

You then do your tax accounting in a way that puts large paper losses on the tax returns you file in the early years of your ownership.

Example: You make a $50,000 down payment on a $500,000 vacation rental. On your first year’s tax return, you use depreciation to calculate a $100,000 loss. That $100,000 loss shelters $100,000 of other income showing on your return, including wages.

Tricks that Make Vacation Rental Tax Strategy Work

Tax laws typically limit the business loss deductions a taxpayer claims on a tax return.

And tax law really limits real estate business loss deductions because depreciation tricks allow taxpayers to show paper losses even for properties appreciating in value.

The general rule for real estate related losses? A taxpayer can’t use those losses to shelter ordinary income, such as from job.

However, this limitation doesn’t apply in special situations. And short-term rental property counts as a special situation.

The precise rule? If the average rental period equals seven days or less, the losses on the property don’t get limited automatically.

Example: Two vacation rental property owners hold Florida beach condos. One rented her property for ten times for a week each time. She qualifies for the short-term rental loophole. Her average rental period equals seven days. The other owner rents his condo for twenty times. Nineteen times, he rented the condo for a single week. The twentieth time, however? He rented the unit for two weeks. His average rental period therefore equals 7.35 days. He fails to qualify.

One other rule to be alert to? Even an investor who averages seven days or less for rental periods needs to meet the material participation rules. For example, an investor needs to spend more than 500 hours a year on the vacation rental business. Or an investor needs to spend more than 100 hours a year and no other party can spend more time than that. Other material participation rules exist too. And you’ll want to review those with your tax advisor.

Possible Tax Savings from Vacation Rental Tax Strategy

The depreciation deduction on a vacation rental creates the loss deduction that shelters other income a taxpayer receives.

Example: Married taxpayers use the vacation rental strategy to put a $15,000 loss deduction onto their tax return. If their combined federal and state marginal tax rate equals 40 percent, that deduction lowers their current year tax expense by $6,000.

Typically, residential rental depreciation annually equals 1/27.5^th of the building cost. Take the example of a $500,000 property that represents $100,000 of land and $400,000 of building. It probably generates at least an annual depreciation deduction equal to $400,000/27.5, or nearly $15,000 annually.

Turbocharging the Vacation Rental Strategy

Some investors use a technique called cost segregation to break down the building part of the rental cost—so that $400,000 mentioned in the preceding paragraph—into real property and personal property.

Personal property includes appliances and furniture. It can also be depreciated very quickly. Sometimes mostly or entirely on the first year’s tax return.

A $400,000 building for example might be cost segregated into $300,000 of real property that the investor depreciates over 27.5 years and $100,000 of personal property that she or he depreciates in one year or in a very few years.

Tip: Use our free Short-term rental depreciation deductions calculator to estimate the tax deductions your rental property might generate.

Note that an investor might execute this strategy each year to enjoy larger tax deductions. An investor might also buy larger properties or multiple properties to increase the size of any vacation rental losses.

Limits to Vacation Rental Strategy

Starting in 2021, however, tax laws limit business losses to the amount of trade or business income a taxpayer generates plus another $262,000 if unmarried or $524,000 if married. (The IRS adjusts these amounts each year for inflation.)

Example: A married couple where one spouse earns $1,000,000 and the other spouse earns $100,000 in a trade or business (like a sole proprietor) would only be able to use $624,000 of vacation rental loss deductions in a single year.

How This Tax Strategy Can Blow Up

While a vacation rental tax strategy generates big tax savings through large loss deductions, taxpayers bear risks using the strategy.

First, and at a practical level, investors need to understand the material participation rules to safely take the loss deduction. Investors also need to do good record-keeping of their participation and the average rental periods in case the IRS audits a tax return.

Second, the depreciation-generated losses created by the vacation rental tax strategy reverse themselves eventually. Usually. That reversal means taxable income when the taxpayer later sells the property. Accordingly, a vacation rental investor wants to be able to delay sale of the depreciated property until she or he sees their income drop.

The Vacation Rental Tax Strategy Works Best for These Taxpayers

The vacation rental tax gambit makes most sense for taxpayers who already maximize their contributions to retirement savings plans (like 401(k)s) yet still want to save additional money.

For example, many high-income professionals (doctors, attorneys, and other professionals), business owners, and even high-earning employees (like professional athletes) may want to make use of the technique. Essentially, using the vacation rental tax strategy allows a taxpayer a large increase in the amounts saved using pre-tax money.

Example: A family includes one spouse who earns $1,000,000 in a W-2 job and another spouse who manages the family’s short-term rental properties and loses (on paper) $400,000 annually. The family adjusted gross income, assuming no other income or adjustments, equals $600,000. And one way to look at these numbers is, that $400,000 of the W-2 income is getting invested, pre-tax, into the family’s rental portfolio if that money pays down mortgages or goes toward down payments or property improvements.

Other Information Sources

The passive loss limitation rules appear in Section 469 of the Internal Revenue Code and get elaborated on in the Treasury Regulations for Section 469. Taxpayers or their advisors need to become familiar with these details to safely execute the vacation rental strategy.

We’ve also got a blog post that discusses vacation rental tax accounting and the rules for tallying hours of participation.

As always, you’ll get great context by discussing a strategy like this in detail with your tax advisor since she or he knows your specific situation. And, finally, if you don’t have a tax advisor who can help, please consider contacting our firm: Nelson CPA.

The post Tax Strategy Tuesday:  Vacation Rental Property appeared first on Evergreen Small Business.