A Closer Look Archives - Page 2 of 4

Taxation of Alimony

The 2017 Tax Cuts and Jobs Act brought major changes to how alimony payments are taxed.

Under previous law, alimony (also known as maintenance or spousal support) was tax-deductible for the payer and considered taxable income to the receiver.

The new law flipped the structure. For couples divorced after Dec. 31, 2018, payers do not receive a tax deduction for payments and recipients do not have to claim alimony as income.

This is a complete reversal of how alimony has been taxed for decades.

Changes to alimony payments Could Make New Rules Apply

Anyone who finalized their divorce before Dec. 31, 2018, is subject to the previous tax laws when it comes to alimony payments and financial agreements.

But these grandfathered individuals should be cautious if they need to make changes to their spousal support as changes could mean that the new tax rules would apply.

The IRS says that if alimony is modified after December 31, 2018, the new rules apply if the modification:

changes the terms of the alimony payments; AND
states that the alimony payments are not deductible by the payer or includable in the income of the receiver.

If these changes are unavoidable, it’s important to consider the potential tax impact.

For individuals paying the alimony, losing the deduction could increase their taxable income which could disqualify them from contributing to a Roth IRA, cause more of their Social Security payments to be taxed if they are receiving any, Medicare premiums to increase, and more.

Tax Efficient LLC

I have a friend that is starting a business and they asked for my advice on the most tax-efficient way to set it up (i.e. how to pay the least amount of taxes possible).

After some discussion about what the business is and how much they expect to make, we landed on establishing a Limited Liability Company (LLC) and to elect filing taxes as an S-corporation. In short, here’s why.

Key points:

S Corporations have some tax planning unavailable to your run-of-the-mill LLC. The FICA tax for Social Security and Medicare (also known as self-employment taxes) only applies to wages paid to owner-employees. The remainder of the net earnings passes through as dividend income.
S-Corps avoid double taxation by reporting the gains and losses on the shareholders’ individual tax returns.
For tax years 2018-2025, a deduction equal to 20% of the share of an S-corporation’s profit can be claimed, subject to limitations.

Self-employment tax savings

Technically, S-corporation status is a federal tax status, while an LLC is a type of legal entity created under state corporate law.

LLCs almost always stick with the default tax rules, under which they are treated either as a sole proprietorship or a partnership, depending upon the number of owners. As your income from your LLC increases, so does the self-employment tax. You earn more, you pay more tax.

An S-Corp lets you split your profits into “shareholder wages” (subject to 15.3% Social Security, Medicare, and self-employment taxes) and “distributive share” (NOT subject to 15.3% Social Security, Medicare, and self-employment taxes).

An owner of an LLC with pass-through taxation pays 15.3% on the entire profits. Active owners in an S-Corp must pay themselves a reasonable salary (more on this down below), but realize a 15.3% savings on the rest of their retained profits.

avoid double taxation

Usually, corporations are taxed as its own entity. The corporation files IRS Form 1120 each year to report its income, deductions, and credits, and profits are typically taxed at corporate income tax rates.

That’s pretty cut and dry, but where small business owners can run into trouble is through something called double taxation. That’s because when the corporation distributes dividends to the stockholders (the business owner), these dividends are taxed on their personal tax returns.

If you’re a small business owner and expect to put some of the profit into your own wallet, the money could end up being taxed twice: first, the corporate profits are taxed at the corporate level and then the distributions are taxed on an individual level.

When filing as an S Corporation, the company itself no longer pays taxes on the profits. Instead, any profit or loss is passed to the owner and they report it on their personal tax return.

QBI deduction

In 2017, the Tax Cuts and Jobs Act established IRS Code Section 199A, which provides a 20 percent deduction for eligible pass-through entities with qualifying business income (“QBI”). This new provision has the ability to reduce the maximum individual tax rate of 37% on pass-through income to approximately 29.6%, making it more equitable to the C corporation tax rate of 21%.

The QBI offers a way to lower the effective tax rate on the profits of owners of pass-through entities. These include sole proprietorships (including independent contractors), partnerships, limited liability companies, and S corporations.

Salary amount

As the owner of an S Corp, you take a salary and only this portion is subject to FICA and Medicare taxes. Any remaining profit that is distributed is treated as a dividend and taxed as ordinary income, but not subject to payroll taxes.

Obviously, this creates an incentive for owners who work for an S-corporation to pay themselves the least amount possible. The IRS is aware of this incentive and requires shareholders to pay themselves a reasonable salary.

What is considered a reasonable salary depends on the net income and industry, so it is difficult to give a target dollar figure. You may hear the general rule of that salary can be two-thirds of net income. However, take this with a grain of salt. The salary number is very subjective relative to industry standards and should be supportable.

It’s advisable to work with a Certified Public Accountant to determine how much is a reasonable salary for the field you are in.

Disaster Relief Funds Run Dry

Yesterday, less than 2 weeks after launching recovery programs for small businesses, the Small Business Administration (SBA) has announced that the $349 Billion dollar relief fund has run dry.

The numbers are pretty staggering. The SBA says that is has processed more than 14 years worth of loans in 14 days and approximately 1.5 million businesses have been approved for $350,000 in forgivable PPP loans. View some stats on the PPP here.

So what if you’ve already applied and haven’t received funds yet? It doesn’t necessarily mean that you won’t receive funding at all.

If you have an E-Tran number than your lender has already sent your application into the Capital Access Financial System (CAFS) and it’s possible that your loan has been account for and being processed, you just haven’t received the funds yet.

If your lender hasn’t submitted your loan application to the SBA through the system, and you don’t have an E-Tran number, then it is unlikely that your application will be processed at this time. Here is what the SBA website states:

Lapse in Appropriations Notice: SBA is unable to accept new applications at this time for the Paycheck Protection Program or the Economic Injury Disaster Loan (EIDL)-COVID-19 related assistance program (including EIDL Advances) based on available appropriations funding. EIDL applicants who have already submitted their applications will continue to be processed on a first-come, first-served basis.

Don’t lose hope yet though. I suspect that there will get more funding in the next few weeks as the government has already mentioned that another $250 billion could be added to the CARES Act to help fund these programs.

If your bank is still taking applications, go ahead and apply in case more funds become available. You don’t want to lose your spot in the queue.

COVID-19 and the CARES Act

Last Friday Congress passed the Coronavirus Aid, Relief, and Economic Security (CARES) Act, a $2 trillion emergency fiscal stimulus package, which includes a wide range of provisions aimed at helping ease the economic damage that this global pandemic is causing on families and small businesses.

It’ll be some time before I’m done reviewing all of the content within the bill but there are a few key provisions that I wanted to let you know about as they will likely have an immediate effect on you. These include:

Direct payments to individuals

This is probably the most talked-about provision in this bill which provides every adult a recovery rebate of $1,200 and $500 per child (subject to income limitations) for 2020. They are basing the rebate credit on your most current Federal tax return, either 2018 or 2019, so if you had less income in 2019 and haven’t filed your taxes yet, you may want to do that as quickly as possible.

Here is a link to a calculator to estimate how much your check might be https://www.omnicalculator.com/finance/stimulus-payment.

The funds might be best utilized by boosting your cash reserves or paying off debts if you don’t have an immediate need for the cash.

2020 RMDs are suspended

The CARES Act waives any required minimum distributions (RMD) that were to be taken in 2020. This applies to Traditional IRAs, SEP IRAs, SIMPLE IRAs, 401(k)s, 403(b), and Governmental 457(b) plans.

If you’ve already taken your RMD for 2020 within the last 60 days, it is possible to roll it back into the account and defer paying taxes. You’ll just need to transfer an amount equal to your RMD back into your retirement account before the end of the 60-day window.

Student loan payments are deferred

There are no payments due on Federal loans until 9/30/2020 and interest will not accrue during this time.

Payments will continue by default so you must contact your loan provider, or go online, to request the payments be stopped.

If you are on track for a loan forgiveness program, like Public Service Loan Forgiveness, the months of April through September will continue to count toward meeting the requirements even if you aren’t making payments. You are essentially getting 6 free months toward qualifying for whatever loan forgiveness program you are in so be sure to take advantage of it.

Some ideas for the freed up cash flow is to pay off other debts that can not be temporarily paused or to maximize contributions to your retirement accounts.

Help for small businesses

The Coronavirus pandemic has severely impacted small businesses with issues such as loss of revenue, incapacity to make payroll, employee layoffs, inability to maintain inventory, supply chain interruptions, and other unforeseen circumstances.

A significant provision included in the CARES Act for small business owners is the Paycheck Protection Program, a (partially) forgivable loan program offered through the Small Business Administration (SBA). Such loans must be applied for by June 30, 2020, and can have a maximum maturity of 10 years. They may be provided via existing approved SBA lenders, as well as lenders who are otherwise certified by the SBA to offer such loans.

Under the Paycheck Protection Program, lenders will generally be able to issue SBA 7(a) small business loans up to the lesser of $10 million, or 2.5 times the average monthly payroll costs over the previous year. In order to qualify for loan forgiveness, the business must maintain the same number of employees during the period Feb 15 – Jun 30 as it did previously. This forgiveness of debt is not considered taxable income for the business. Be aware that it’s not possible to formally apply for this program quite yet because the applications do not exist at the moment. However, if you do plan to apply for this program, you can get a head start by pulling together all of your documents around payroll for the trailing 12- to 18-month periods.

If you are in immediate need of financial assistance, the CARES Act now permits businesses to take an Economic Injury Disaster Loan (EIDL) for up to $2 million. The EIDL is now available in all 50 states and can be used by any small business that has fewer than 500 employees. Self-employed individuals and non-profits are also eligible for this program. For self-employed individuals, you’ll need a copy of your Schedule C or proof of income and expenses as well as potentially 1099-MISCs.

These loans may be used to pay fixed debts, payroll, accounts payable and other bills that can’t be paid because of the disaster’s impact. The interest rate is 3.75% for small businesses. The interest rate for non-profits is 2.75%. SBA offers loans with long-term repayments in order to keep payments affordable, up to a maximum of 30 years. Terms are determined on a case-by-case basis, based upon each borrower’s ability to repay.

The CARES Act also allows for a $10,000 emergency grant to be issued to anyone who applies for the EIDL. The $10,000 emergency grant is given to business owners within three days of their application, and they’re allowed to keep that money even if your loan is denied. The application process is simple, completely online, and should only take about 15 minutes to complete. Follow this link to get started: https://covid19relief.sba.gov/#/

Expanded unemployment insurance (UI)

If you have lost your job or are experiencing reduced hours due to COVID-19, it is encouraged to file for unemployment insurance benefits as soon as possible as there are extended benefits available.

This includes a $600 per week increase in benefits for up to four (4) months and federal funding of UI benefits provided to those not usually eligible such as those who are self-employed, independent contractors, and those with limited work history.

Visit Indiana’s Department of Workforce Development’s website for more information https://www.in.gov/dwd/3474.htm

I hope you and your family are staying safe during this time. We have been through difficult times before and I am confident we’ll get through it this time too.

Did You Contribute Too Much to a Roth IRA?

For the 2019 tax year, a single filer can contribute up to $6,000 to a Roth IRA ($7,000 for age 50 and older) if their modified adjusted gross income (MAGI) is less than $122,000.

As their income goes above that, the allowed contribution amount begins to decrease until they become totally ineligible at $137,000. The limits for those who are married and filing jointly are $193,000 and $203,000 respectively.

So what can you do if you saved diligently to your Roth IRA last year but as you are gathering all of the documents to file your taxes you find that your income was too high to actually contribute to a Roth IRA?

There are three fairly straightforward options to remedy this problem.

Withdraw the Excess Contribution

The first solution is to simply withdraw the excess contribution so it doesn’t count toward that year’s contributions.

According to the IRS:

“For purposes of determining excess contributions, any contribution that is withdrawn on or before the due date (including extensions) for filing your tax return for the year is treated as an amount not contributed. This treatment only applies if any earnings on the contributions are also withdrawn. The earnings are considered earned and received in the year the excess contribution was made.”

What this means is that withdrawals are not treated as distributions — it’s as though the contributions were never made. But earnings on the contributions will be counted as income and you’ll owe taxes on that amount (you’ll also owe the 10% tax for an early withdrawal if you are under the age of 59 1/2).

For example, if you contributed $6,000 and that $6,000 earned $100 you will need to withdraw $6,100 when removing the excess contribution. Only the $100 of earnings will be considered income though.

You can withdraw contributions from a Roth IRA up until the Oct. 15 extended deadline if you’ve requested an extension of time to file your return. If you already filed your tax return, you can still withdraw contributions, but you’ll need to file an amended tax return after withdrawing the funds.

Move the Money to a Traditional IRA

Another option is to “re-characterize” the Roth IRA contribution to a Traditional IRA contribution.

According to the IRS:

“You may be able to treat a contribution made to one type of IRA as having been made to a different type of IRA. This is called re-characterizing the contribution. To recharacterize a contribution, you generally must have the contribution transferred from the first IRA (the one to which it was made) to the second IRA in a trustee-to-trustee transfer. If the transfer is made by the due date (including extensions) for your tax return for the tax year during which the contribution was made, you can elect to treat the contribution as having been originally made to the second IRA instead of to the first IRA.”

The IRS says that you must also:

“Include in the transfer any net income allocable to the contribution. If there was a loss, the net income you must transfer may be a negative amount. Report the recharacterization on your tax return for the year during which the contribution was made. Treat the contribution as having been made to the second IRA on the date that it was actually made to the first IRA.”

Apply the Roth Contribution to the Following Tax Year

If you expect your income will be low enough that you can contribute to a Roth IRA going forward, you also have the option of applying the excess contributions to the next tax year. This allows you to keep the funds invested in the Roth IRA.

The IRS says:

“If contributions to your Roth IRA for a year were more than the limit, you can apply the excess contribution in one year to a later year if the contributions for that later year are less than the maximum allowed for that year.”

what if you don’t take action

If you don’t take any of the actions above, the IRS is going to determine that you made excess contributions and assess an excise tax of 6% to the amount that exceeds your limit for the year. This amount is calculated and reported on Form 5329.

You might say to yourself, “6% doesn’t seem so bad”. But the tax doesn’t just apply to one year, it will continue to be assessed each year for as long as the excess contributions remain in the Roth IRA.

It can be easy to inadvertently contribute too much to your Roth IRA. Luckily, there are a number of easy to administer solutions to fix the problem. Just make sure you take the necessary action so you don’t end up paying the government more money than you need to!