Massachusetts has joined other states which have attempted to reduce the gap between taxes due and taxes collected by requiring most partnerships, Subchapter S corporations, and multi-member limited liability companies which are classified as partnerships under federal income tax laws (“Pass-through Entities”) to withhold tax on the income taxable to their members. The new Pass-through Entity withholding requirements are effective for tax years beginning after 2008 and will require that almost all Pass-through Entities which maintain an office in or do business in Massachusetts take some action. Failure to comply may subject a Pass-through Entity to penalties and, in the case of willful failure, fines of up to $100,000 and imprisonment. Read the rest of this entry »

TLB has issued a year-end tax letter for individuals covering recent changes in tax rules and regulations and covering simple strategies for minimizing your 2007 tax obligation.

The IRS has issued final regulations (T.D. 9356) on employment and excise taxes for disregarded entities, including single member LLC’s, and Qualified Subchapter S Subsidiaries (QSUB’s). These final regulations provide that a disregarded entity is treated as a separate entity (a corporation) for purposes of employment taxes and the related reporting requirements. The new regulations were effective August 16, 2007 and are applicable to wages paid on or after January 1, 2009.

Practically speaking these regulations mean that the business entity is responsible for filing and paying for employment taxes, as opposed to the owner at the individual level. With this treatment, owners of single member LLC’s are not responsible for the employment tax obligations of the entity. However, TLB cautions the owner may still have exposure under other rules, such as the responsible party provisions.

The IRS will still allow a single member LLC to calculate, report and pay all employment tax obligations as though the employees of the LLC were employed directly by the owner – and under the owner’s name and taxpayer identification number.

Alternatively, the single member LLC may calculate, report and pay all employment tax obligations under the entities name and taxpayer identification number.

Effective January 1, 2009, those who report employment taxes under the owner method are required to continue to use this method ongoing unless and until otherwise permitted by the IRS Commissioner. However, a taxpayer may take the opportunity now to convert from the owner method to the entity method of reporting without seeking permission – as long as it is done before January 1, 2009. Taxpayers who switch methods may consider wages paid by the owner to employees during the calendar year of the switch as having been paid by the entity for purposes of determining the various wage and benefit bases used in calculating employment taxes.

Please contact TLB if we can help you evaluate which option is the best for your facts and circumstances. Posted by Rich Bienvenue

When choosing the type entity to operate your business there are several legal and financial aspects to consider. These considerations vary, and carry different weight, depending upon each set of facts and circumstances. However, if you operate your business entity as a corporation - TLB recommends you recheck your reasons for not making the so-called “S” election. Some of the reasons why the S-election is advantageous are as follows:

1. Your selling your business - Upon the sale or distribution of corporate assets or business, tax is paid at both the corporate and shareholder level. If you are thinking of retiring or selling your small business in the future, you should seriously consider the advantages of making an S-election.

2. Unreasonably high compensation issues - C-Corporations have to worry about paying unreasonably high compensation. In order to get money out of a C-Corporation most taxpayers take out cash in the form of compensation bonuses. On an IRS examination, agents consider these unreasonable high compensation issues to determine if taxpayers are trying to avoid paying a corporate level tax and tax at the individual level for the receipt of dividends. If raised during examination the service will hit you for the tax and for substantial penalties. This issue doesn’t exist for the S-Corp, as all the corporate income flows through to the shareholder and is taxed only at that level.

3. Accumulated Earnings - O.K. if you avoid the unreasonable compensation issue noted in number 2 above, perhaps you will run into too high a level of accumulated earnings. In this scenario, the IRS may try to assert that the C-Corporation is not paying this cash out because of a desire on the part of the taxpayer to avoid paying taxes on the dividends. Again, this issue just doesn’t apply to the S-Corp, because all income flows through each year.

4. Personal expenses - lets face it many taxpayers try to funnel personal expenses through the business, or perhaps something that every body thought was legitimately a business expense is disallowed upon IRS examination. In a C-Corporation environment this could be disaster. Most likely the IRS will consider the payment of the personal expenses a dividend - so the taxpayer has to pickup the tax on that. In addition, now that the corporation loses the expense, its taxable income is increased and the corporation has to pickup the tax on its level. Add on penalties and something as innocuos as disallowed auto expenses totaling, lets say $10,000, will now cost the taxpayer an additional $7,000 - $9,000 in tax and penalties. Lets hope tax preparers out there are encouraging their clients to play it straight when it comes to personal expenses - especially with their C-Corp clients.

5. Utilization of losses - As a C-corporation any losses generated by the business, stay with the corporation, but may be carried forward. This is nice, but isn’t particularly useful if you are generating income otherwise (other businesses, earned compensation, etc.) The S-Corp allows losses to flow through to the shareholders, which can then utilize these losses to offset other income.

6. Save on payroll taxes - As noted in number 2 above, many taxpayers pay themselves a salary higher than they normally would in order to get the cash out of their C-Corporation and to avoid having to pay the corporate level tax. In this scenario, the taxpayer is paying 12.4% (6.2 employee, 6.2 employer) for social security on approximately the first $95,000 of wages plus 2.9% medicare on the total wages paid. If you were an S-Corp you might pay yourself a more reasonable wage, say comparable what you might pay an outsider and save yourself up to 15.3% in employment taxes by taking the resulting corporate profits as flow through income.

7. Keep the cash basis of accounting - C-Corporations that exceed $5million when applying the average annual gross receipts test (Is your accountant monitoring this every year for you?) are required to convert to the accrual basis of accounting. This could result in a huge change in taxable income, expecially in the first year. In this scenario, an S-election could save you and the use of the cash basis of accounting, particularly in light of IRS Revenue Procedure 2002-28, which provides for safe harbor provisions.

8. Is your C-Corporation a QPSC or a PSC? If so an S-Corp may be for you.

In many small businesses TLB has found that the S-Corporation is the preferred corporate entity and just seems to make the most sense. Of course there may be reasons one would want to operate as a C-Corporation - sounds like a future post. As always, please consult with TLB on any and all of these issues, before taking action, to determine the ramifications of an “S” election (i.e. the built in gains tax) and to plan accordingly.

Real estate agents, developers and investors must be careful in how they report income from the sale of subdivided real property. Many taxpayers and preparers assume the sale of real estate is eligible for capital gains treatment (capital gains are currently taxed at 15% for federal purposes) as opposed to ordinary income (current maximum federal rate of 35%). Needless to say an IRS adjustment relating to these issues and the addition of penalties and interest oftentimes results in a large liability that perhaps could have been minimized or avoided with proper planning.

In determining the proper tax treatment on the sale of subdivided property one has to consider whether the property constitutes investment property, which is eligible for capital gains treatment, or property held primarily for sale in the ordinary course of the taxpayers trade or business (taxpayer is deemed a dealer in property), which is treated as ordinary income. Of course, most disputes between a taxpayer and the IRS relate to the determination and definition of a trade or business and therefore whether a property is an investment activity or held primarily for sale.

Whether property is held primarily for sale in the ordinary course of business or for investment depends upon the facts and circumstances present. Perhaps the circumstances indicate a property is held primarily for sale, but other facts and circumstances may indicate the taxpayer is not engaged in a trade or business. Some of the relevant facts considered by the IRS and Courts include:

1. The nature and purpose of the acquisition of the property and the duration of ownership;2. The extent and nature of sales efforts;3. The number, continuity, and regularity of sales;4. The extent to which the taxpayer attempts to increase sale by improving the property and advertising;5. The use of a business office to facilitate sales; and 6. The time and effort devoted to sales by the taxpayer.

The purpose for which the taxpayer acquired the property is an important consideration in determining the characterization of the property. However, it is not uncommon for property acquired for investment to later be characterized as property held for sale, if the facts and circumstances of the scenario change, sometimes over the course of many years.

The extent and nature of sales efforts is another consideration in properly characterizing these types of transactions. If the taxpayer engages in advertising, hires agents, maintains a sales office, has a real estate license or represents to the public himself as a dealer in property, it is likely the IRS would consider the taxpayer a dealer.

Another significant consideration is the number, continuity, and regularity of sales. Obviously, the more sales the taxpayer engages in , the greater the chance the IRS would consider the taxpayer a dealer. In addition, substantial development or improvement of a property, such as land improvements, grading, subdividing and installing roads or utilities indicate the taxpayer is a dealer.

In considering these factors it is important to note that not any one consideration is a determining factor – all considerations need to be weighed together in order to support a proper determination. In addition, the Internal Revenue Code provides for safe harbor provisions that allow investors to subdivide unimproved land into parcels and to sell the parcels without being deemed to have held the property primarily for sale in the ordinary course of a trade or business. However, these safe harbor provisions are limited and are not applicable if the taxpayer makes improvements to the property that substantially increase its value. Also, the safe harbor provisions are not available to dealers in real estate who hold property primarily for sale in the ordinary course of their trade or business.

The case of Hospital Corp. of America v. Commissioner of Revenue established the right of taxpayers to utilize cost segregation studies for computing depreciation and provides guidance in identifying tangible personal property in a building, which is eligible for accelerated methods of depreciation over fewer years as compared to the traditional 27.5 year recovery period for residential rental property and the 39.5 year recovery period for commercial real estate.The result of cost segregation analysis is significant savings to the taxpayer, and an incentive for investment, particularly when the taxpayer has the ability to elect the provisions of code section 179, which allows expensing (to a limit) of certain depreciable items all in one year.

The determination of whether an item is personal property or real property (ie: a structural component), as usual, depends upon the facts and circumstances, however, the IRS position is that the following items, if used in the operation and maintenance of a building are examples of structural components (ie: real property): bathtubs, boilers, ceilings, central air conditioning and heating systems, chimneys, doors, electrical and wiring, fire escapes, floors, hot water heaters, HVAC units, lighting fixtures, paneling, partitions – if not readily removable, plumbing, roofs, sinks, sprinkler systems, stairs, tiling, walls, and windows (Reg. Section 1.48-1(e)(2))

Sorry lottery fans – except for the fact that you just hit the big one – you just can’t win, at least not with the IRS. As you probably know if you ever do hit the big one and win $100 million – you don’t always actually receive $100 million. Instead, you receive an annual annuity from the lottery commission, which I might add isn’t chump change, but after paying for taxes, lawyers, investment management, not to mention the new house, new spouse and an Escalade (I would get a Bentley – it holds its value better), a couple million a year just doesn’t go as far as it used to.One option available to lottery winners from outside third parties is to exchange your newly won stream of payments for a lump-sum payment that you could totally blow – I mean invest – now. As you might suspect, the IRS has treated these lump-sum payments as ordinary income, and therefore subject to the individual income tax rates (probably at the current top rate of 35%) and not at capital gain rates (15%). So not only did you cash out your winnings at less than 100 cents on the dollar, 35% of whatever is left is gone to the federal government (we haven’t even mentioned the state).The Second Circuit recently upheld the IRS position in this regard, which was previously upheld by the Third, Ninth and Tenth Circuits and by the Tax Court in Prebola v. Comissioner, (No. 05-6953-ag – 3/27/2007). In upholding the IRS position the courts have been applying the “substitute for income doctrine,” which holds that lump-sum payments received in exchange for what would otherwise be received as ordinary income are treated as ordinary income.Sorry Ms. Prebola.

The IRS announced in a June 6, 2007 news release that it is undertaking a National Research Project with a goal of designing, and implementing a successful strategy to collect data that will be used to measure payment, filing and tax law compliance. In undertaking this project, the IRS is attempting to take advantage of the auditing capacity created by undertaking a National Research Project on approximately 5,000 S-Corporations, which will be concluding. The project will begin in October, 2007 and will initially audit approximately 13,000 individuals for tax year 2006. The focus will be on those parts of an individual return that cannot be verified through third-party information reporting, according to an IRS spokesman. The IRS is hoping to extend the program several years so that it may refine the data collected in order to assist in determining the so-called “tax gap” which was previously estimated by the IRS at $345 billion for tax year 2001.

Obviously, if a taxpayer can recover the cost of acquiring an asset sooner rather then later, it is to her benefit.  There are several instances I can think of where the life of an asset is not defined or particularly clear in the tax code.  Well in the case of Trentadue v. Comissioner (128T.C. No. 8 – 4/3/2007), the Tax Court provides us with some guidance as these issues relate to the classification and depreciable life of wine grape trellises, irrigation systems, and a well used in the taxpayers’ wine production activity. Read the rest of this entry »