Your CPA said what?

Section 529 Plans May be Here to Stay

Section 529 Plans (often referred to as tax advantaged college savings plans) got a big boost last week when a sweeping pension bill was approved by Congress. The President is expected to sign the bill into law giving Section 529 Plan investors a sigh of relief. As it stands now the rules allowing tax free distributions from Section 529 plans for education expenses will expire after 2010. That would mean that the investment earnings in such plans would accumulate tax free, but once the money is pulled out (for education purposes or otherwise) the earnings on the portion distributed would be included in the gross income of the beneficiary (usually the college student). The new legislation makes the tax free distribution for education expenses permanent.

Probably the best summary I've seen of the differenty 529 plan types is from the Motley Fool. It does a good job of highlighting the differences between 529 savings plans, 529 prepaid tuition plans and Coverdell education savings accounts.

Section 529 Savings Plans are probably the most popular today. Because the plans are setup and administered by the states there are a tremendous variety available. And just becuase you live in Florida doesn't mean you can't invest in a 529 plan in say, Virginia. One of the biggest differences between various state plans is the contribution limit. Unlike IRA's or other retirement plans 529 savings limits are based on the total account balance, not the amount contributed in a single year. For instance, you can make contributions to a Florida 529 savings plan until the balance reaches $341,000. You can write one check or several. It doesn't matter. Iowa limits it's plan balances to $239,000. You can also transfer balances from one state to another so the student is limited to picking a school in the state where the account was setup.

When choosing a state savings plan also note the fees and whether there are requirements for residents vs. non-residents. Some states with a state income tax allow 529 contributions to be used as a deduction so you'll want to take that into account as well. One very good resource for comparing the features of various state plans is Savingforcollege.com. Kiplinger's also has a very good article on 529 Plan FAQs.

One final note. Some plans, many in fact, are sold by brokers. Just as when purchasing other products from people paid to sell them you should be on your toes and bring a healthy level of scepticism with you before making a commitment. Both the NASD and the SEC have launched inquiries into questionable sales practices related to 529 plans.

 

Tax Benefits of Rental Real Estate

While real estate activity has slowed down in recent months the current market climate has caused some people to examine the prospect of buying rental properties. If the "buyer's market" trend continues we can expect more clients to ask about the tax benefits of renting real estate. Here are a few rules you should be aware of.

1. If you use the property for personal purposes more than 14 days or 10% of the total days rented you will be required to pro rate all expenses between personal use and rental use. This can result in a significant reduction in tax deductible expenses, including depreciation. However, days you spend at the property performing maintenance or other tasks required for its rental are not counted as personal days.
2. Residential rental property obtains a depreciation period of 27.5 years but in order to qualify the property must meet the IRS definition of residential rental. "This class includes any real property that is a rental building or structure (including a mobile home) for which 80% or more of the gross rental income for the tax year is from dwelling units. It does not include a unit in a hotel, motel, inn, or other establishment where more than half of the units are used on a transient basis," IRS Publication 527 (2005). If you don't meet this definition the property is commercial real estate and must be depreciated over 39 years.
3. Losses from rental property up to $25,000 can be used to offset other income. This is a great tax planning strategy but if adjusted gross income is too high ($150,000 for married couples) the losses are suspended.
4. Favorable tax treatment requires active participation. Even if your AGI is low enough to qualify for the above deduction of losses you may not be able to take them if you just place the rental with a property manager and do not actively participate in its management. IRS has definitions and guidelines for active participation that you should take the time to understand with your CPA.
5. Check with the locals. Much of our focus here has been on the federal tax treatment of rental properties. The local county, municipalities, even the neighborhood homeowners' association may impose additional fees, taxes, reporting requirements or restrictions that could affect your decision to buy. Make sure you ask the real estate agent for information regarding these issues before you get to closing.

With interest rates rising, more restrictive lending policies and a softening housing market the residential rental arena may become more and more attractive in coming months. For investors looking to add properties to their portfolio or jump into their first rental house it makes sense to take some time to understand both the before and after tax economics of a potential investment.

Joey Brannon is the founder of Axiom Professional Group, a tax, consulting and accounting firm in Bradenton, Florida. Mr. Brannon is both a CPA and an EA. You can find out more about Axiom by visiting www.axiomcpa.com.

Treatment of Closing Costs and Other Fees

The most frequently asked question when people buy and sell property is "Which closing costs are deductible?". If you look at a closing statement, commonly called a HUD-1, you will see plenty of itemized costs. Unfortunately the only items that are currently deductible are property taxes (but only those actually paid/credited, escrow doesn't count), mortgage interest, and in the case of a rental or business property association dues or other fees that would normally be deductible if invoiced and paid apart from closing.

The remaining costs are split into three groups: land, building and loan costs. The building is depreciated (27.5 years for residential rental, 39 years for other commercial property) and the loan costs are amortized over the expected life of the loan (we usually use five years). You get no deduction for the land on the theory that it does not deteriorate in value so it's cost should not be recovered as a tax deduction. Here are some areas you should be aware of when trying to optimize tax deductions.

1. The allocation between building and land. If the property is a rental or commercial real estate you will get a depreciation deduction on the building. However, your allocation of the purchase price must be reasonable. If you buy a beach front property with a 50 year old bungalow on it allocating 80% of the cost to the house is a stretch. Property tax records, appraisals and insured values can all point you in the direction of a sound allocation.
2. Classification of loan costs as closing costs. There are many costs required by the lender apart from doc stamps and title fees. If these are not classified as loan costs they will be allocated to the building with a much longer depreciation period or land with no depreciation deduction at all.
3. Identification of intangible taxes paid on the mortgage. These are deductible when paid (at closing). Failure to pull them out most often results in their classification as loan or closing costs.
4. Failure to treat property tax credits properly. A seller in a county that taxes in arrears will often be charged an amount for property tax through the date of sale. This is a tax deductible expense. The buyer will receive a property tax credit at closing and must deduct this from the amount of taxes actually paid during the year to arrive at the proper tax deduction.
5. Failure to seperately account for included goods and furnishings. There are several reasons to write furnishings up as a seperate bill of sale, but one of the biggest it quicker write-offs for furnishings vs. the building itself.
6. Failure to properly amortize or deduct points. Depending on the type of loan and the use of the property you may be able to immediately deduct an points paid. Alternatively they should be amortized over the actual life of the loan. If you refinance make sure any unamortized points are deducted in the same way loan interest is accounted for.

Closing statements can get confusing when it comes to segregating tax deductible items from those that should be capitalized. If you have questions don't be afraid to ask someone who has experience optimizing these transactions to bring the greatest tax benefit.

Joey Brannon is the founder of Axiom Professional Group, a tax, consulting and accounting firm in Bradenton, Florida. Mr. Brannon is both a CPA and an EA. You can find out more about Axiom by visiting www.axiomcpa.com.

Payroll: How to pay yourself, legally.

May has been a busy month as we catch our breath from tax season while also trying to get out of the office and spend a little more time with our families. That hasn't left much time for blogging, but we're back in the swing of things now. Recently we've taken on some new clients who have used some pretty creative accounting techniques for payroll in the past. One of our goals is to help small businesses become big businesses and toward that end we try to bring some sophistication to their accounting practices as well as bring them into compliance with the tax laws.

The simplest type of business entity is a sole proprietorship. However, most people don't understand that these business profits are taxed twice: once for ordinary income tax and once for self employment tax. Self employment tax is nothing more than social security and medicare taxes. When you work for someone else 7.65% of your pay is withheld for social security and medicare in addition to the amounts withheld for income tax (commonly called federal withholding).The employer is also taxed 7.65% on your wages. When you go into business for yourself you get to pay both sides and the tax rate is 15.3%. Owner's of sole proprietorships don't cut themselves a paycheck. Instead they take draws from excess cash. No matter how much or how little they take out they are charged both self employment tax and income tax on the profits...even if they leave all the money in the business and take nothing for themselves.

Corporations are somewhat different. Where a sole proprietorship is not legally distinct from its owner a corporation is. Therefor a corporation must decide how much to pay those working for it and it must go through the formality of cutting a payroll check, filing payroll tax returns and depositing the corresponding payroll tax liability. If a corporation chooses to pay its employees relatively little then it will pay less payroll tax. If it pays them a lot it will expect to have a bigger payroll tax bill. IRS is wise to this and they realized a long time ago that if given the opportunity many small corporation owners wouldn't pay themselves a salary at all; they would just take dividend distributions. That is why IRS requires corporations to pay officers and owners a reasonable amount of salary. They don't give us many guidelines to determine what is reasonable, but generally we can look at the market and determine what we would need to pay an unrelated party to perform the same services and base our compensation on that.

What we have been seeing lately are corporations (specifically S corporations) where the owners are not taking any salary at all. Instead they are continuing to take draws as if they were a sole proprietor. From a federal standpoint their tax rate will be about the same if they claim these draws as self employment income on their tax return. However, because there has been no payroll they have not paid any associated state unemployment taxes. Nor have they paid any federal unemployment taxes. As quickly as possible we try to transition these owners from a 'draw' mentality to a 'payroll' mentality.

The danger in not treating your compensation properly is two fold. First, you are not adhering to the IRS rules regarding fair compensation and you are not paying the proper amount of federal or state payroll tax. Second, by treating your corporation as a sole proprietorship you may be giving up certain liability protections that are often important reasons for incorporating to begin with.

Joey Brannon is the founder of Axiom Professional Group, a tax, consulting and accounting firm in Bradenton, Florida. Mr. Brannon is both a CPA and an EA. You can find out more about Axiom by visiting www.axiomcpa.com.

New Tax Legislation Moving Forward

I'm back from vacation and while I was out Congress passed a new tax bill that the President is expected to sign on Wednesday of this week. Highlights of the new bill include...

1. An extension of the reduced capital gains and dividend tax rates. The rates were set to increase after 2008. The new bill extends the reduced rates through 2010.
2. There's a small provision allowing musical artists to treat the sale of compositions or copyrights as sales of capital assets (subject to reduced tax rates).
3. The AMT exemption is increased to 62,550 for married couples for 2006 (42,500 for others).
4. An extension of the increased section 179 deduction amount through the end of 2009.

In addition to the above cuts the bill also adds several 'revenue raisers' to keep the bill's cost below $70 billion. These include requiring taxpayers to make up-front payments when submitting offers in compromise to IRS and allowing taxpayers with higher incomes to convert their traditional IRA's to Roth's.

The most controversial aspect of the bill (besides the extension of the reduced capital gains and dividend rates) is the requirement for withholding on federal contracts. Beginning in 2011 contractors will have 3% of their contract proceeds withheld. Several lawmakers have vowed to repeal this provision before it has a chance to take effect, but it is an interesting approach to closing the $345 billion tax gap that results from non-compliance. Some estimate that two thirds of the tax gap results from under reporting income associated with 1099 earnings. Withholding at the source of payment of this type of income is seen as a logical enforcement step. It will be interesting to see how it plays out over the next several years.

Tax Treatment of Incentive Stock Options

In 2000 I was working with several dot-com companies and incentive stock options (ISO's) were a hot topic. ISO's were used to lure in new recruits, poach executives from other companies and make up for the mediocre compensation most tech start-ups offered. With the internet bust ISO's fell out of favor, or at least out of the news. That is, unless you follow tax law. Over the last several years there have been a steady stream of tax court cases and news reports about taxpayers racking up huge tax liabilities as the result of option exercises. These cases play well in the press because the tax liability can come due when the taxpayer has no cash to pay it and only a pile of worthless stock certificates to show for their efforts.

Recently ISO's seem to be making a come back. Well established companies have started offering ISO's to offer as additional compensation in today's tight labor market. The resurgence of tech companies and pure internet plays is also driving the ISO rebound. Here's what you need to know to understand how these little gems cause so much trouble for taxpayers.

A stock option is the ability to buy a stock at a predetermined price (the strike price). If the market value of the stock is above the strike price then the option has a value equal to the difference. If the fair market value is below the strike price the option is said to be 'under water' and is worthless.

Normally when you exercise an option the difference between the strike price and the option price is deemed compensation and subject to ordinary income taxation (as well as payroll tax in some cases). If the company sets up the plan in a certain way it becomes a qualified incentive stock option plan (ISO) and the tax treatment is deferred until the underlying stock is sold. Not only is the tax deferred, but it gets capital gains treatment if the buyer holds the stock for one year after the option is exercised.

But here's the rub. The alternative minimum tax (AMT) does not recognize ISO's. As far as the AMT is concerned you have realized income equal to the difference between the strike price and the stock's fair market value on the date of exercise. This can create a huge AMT tax liability. If the story ended there it might not be such a problem. After all, you have stock worth millions so you ought to pay the tax on it, right? And you should be able to eventually get a credit for the AMT tax you pay.

Here's the problem. Since you exercised ISO's you can't sell them for a year. If the stock tanks during that year you are left with worthless securities, and a huge tax bill. Further, limitations on the AMT credit mean it can take a lifetime to recoup the AMT paid in the year of exercise. This all adds up to a tax situation that seems ill conceived at best and horribly inequitable at worst. The problem is that the AMT was enacted before ISO's became common place and it has not evolved to address them. Different groups continue to lobby congress but there is still no substantive AMT reform forthcoming.

So what should you do if you end up with a load of ISO's? In some ways you are rolling the dice. If you exercise the options and wait the year to get favorable capital gains treatment you run the risk of generating an AMT bill you will have no way to repay if the stock collapses. The alternative is to ignore the ISO's favorable tax treatment, sell the stock, pay ordinary income tax and use the remaining proceeds as you wish.

Unfortunately, the options are not always clear cut to the employees who receive ISO's. Many believe the stock is restricted or are misinformed by unknowing managers who hold a different class of shares or who participate in a non-qualified stock option plan. If you have access to an ISO make sure you get a complete copy of the plan document and your option vesting schedule. Then review both with your CPA or tax attorney to determine the best course of action.

Joey Brannon is the founder of Axiom Professional Group, a tax, consulting and accounting firm in Bradenton, Florida. Mr. Brannon is both a CPA and an EA. You can find out more about Axiom by visiting www.axiomcpa.com.

LLC's - Hybrid's for Business

Mention 'hybrids' these days and people will assume your are talking about cars that get great mileage. Business owner's have long had access to hybrids in another form when it comes to entity selection. LLC's or limited liability companies can be just about anything you want them to be and in business flexibility is generally a good thing. Here is how they work.

LLC's are corporations and must be chartered by the state just like regular corporations. In fact, from the local standpoint there is not so much difference between an LLC and a traditional corporation when it comes to registering to do business in the state. The big difference is in the eyes of IRS. Owners can choose to accept the 'default' IRS classification or they can make an election to be treated in a certain manner for tax purposes.

First the default classifications... an LLC with a single owner (commonly called a single member LLC) will be treated as a sole proprietorship by IRS. In effect the corporation is a "disregarded entity" for tax purposes and the business is treated as if it were unincorporated. This is a good thing for business owners who want the greater measure of personal liability protection provided by a corporation but who are less than thrilled with the increased administrative burden created by a separate taxpaying entity. The state and courts will treat them as a corporation and the IRS will treat them as a sole proprietor.

If the LLC has more than one owner the IRS will automatically treat it as a partnership. Again this provides greater liability protection than a general partnership, without creating the double taxation standard typical of regular corporations. The owners will need to file a partnership tax return and report their respective share of partnership profits on their individual income tax returns.

The above two scenarios explain what happens under the IRS 'default' rules. However, the owners can choose to be taxed differently. For instance a single or multi-member LLC can choose to be taxed as a corporation. Further, after choosing to be taxed as a corporation the LLC can elect S corporation status if it qualifies.

These are the most basic scenarios for LLC use. More advanced situations occur where subsidiaries are incorporated as LLC's that are wholly owned by the parent corporation. This is great from a tax standpoint because the LLC is disregarded as far as IRS is concerned meaning the parent does not have to incur the expense and administrative burden of filing separate tax returns. At the same time the subsidiary is legally distinguishable from the parent and it is much easier to sell or spin-off the subsidiary than if it were unincorporated. Additionally, while IRS may treat the LLC as disregarded the states may consider them separate entities allowing segregation for unemployment and sales tax purposes.

Another arena where LLC's are very popular is international corporate tax planning. Foreign corporations often setup U.S. domestic LLC's to transact business here. Since the LLC's are wholly owned by the foreign parent they are disregarded for US tax purposes allowing the foreign parent to file as a foreign corporation here in the US. At the same time vendors and suppliers are more comfortable dealing with a domestic US corporation and do not have the same withholding requirements that might apply when they do business with foreigners.

We have seen LLC's used in all of these scenarios and we continue to find situations where this unique form of hybrid entity suites business owners better than traditional corporations or partnerships. While LLC's have their advantages there are just as many situations where they are not the best choice. It takes an examination of all the facts as well as the owner's future plans to make the right decision.

Joey Brannon is the founder of Axiom Professional Group, a tax, consulting and accounting firm in Bradenton, Florida. Mr. Brannon is both a CPA and an EA. You can find out more about Axiom by visiting www.axiomcpa.com.

The Real Cost of Paying Late

Today is the deadline for paying individual income taxes. While you can get an extension to file your income tax return you cannot get an extension to pay your tax. If you don't pay the total amount due you will be charged penalties and interest on the shortfall. It's never good to have your IRS record reflect that you paid penalties, but sometimes it can't be avoided. Unexpected changes in your tax situation or last minute cash shortfalls happen. However, many times the inability to pay is due to poor planning or budgeting. In these cases liabilities can go outstanding for several months and the addition to your tax bill can be substantial. So what does it cost to pay late? Here is how IRS calculates the amount of penalties and interest.

If you are underpaid on April 15th IRS charges interest on the unpaid liability. The rate of interest is currently at 7% and goes up and down with the market. IRS adjusts the rate each quarter. Also, interest is calculated daily so filing the return even one day later than the date your CPA has used to calculate interest owed could result in a tax notice from IRS.

IRS also charges a penalty of .5% per month for paying late up to a maximum of 25%. This .5% per month penalty equates to a 6% annual rate so the total cost of not paying your tax when due is equal to a 13% annual rate (7% interest + 6% penalty). That's not low, but it gets worse. IRS calculates interest using the compound method which works great if you're on the receiving end but not so good if you're the one having to pay up. Additionally, IRS charges interest on the amount of the penalty as well. So the effective rate you pay on your unpaid tax liability is somewhere north of 13%.

A bigger penalty is reserved for those who fail to file a tax return. That penalty is 5% of the tax due for each month the return is late, up to a maximum of 25%. You will also pay interest on this unpaid amount as well. For this reason it is imperative that you file an extension if you can't file your tax return by the due date. On the flip side if you owe nothing and don't file your tax return on time you will not pay a penalty for late filing.

Joey Brannon is the founder of Axiom Professional Group, a tax, consulting and accounting firm in Bradenton, Florida. Mr. Brannon is both a CPA and an EA. You can find out more about Axiom by visiting www.axiomcpa.com.

Tangible Personal Property Tax in Florida

Today is the deadline for 2006 tangible personal property taxes. Most small business owners aren’t even aware this tax exists until they receive the form in the mail from their local property tax assessor. The forms are very simple and most of our clients with a limited amount of tangible assets choose to complete the returns on their own. So here’s the short version on what you need to know about tangible tax.

Many people assume the property appraiser’s activities are limited to valuing real estate for property tax purposes. However, Florida statutes direct the appraiser to value all property in the county including tangible personal property used by businesses. This means that desks, chairs, filing cabinets, computers, manufacturing equipment, and virtually anything else used by your business in its activities is subject to property tax. One important exception, however, is inventory. Inventory held for resale to customers is not taxed.

The Florida Department of Revenue produces form DR-405 that can be used to report the tangible personal property held by a business, but each county seems to have its own variation of the form. Manatee County for instance has taxpayers list all the assets on one master list regardless of their asset type. Sarasota County on the other hand uses the generic state form where assets of like type must be grouped together and summarized on page 1.

If you receive a pre-printed form from the county you must return it even if you are out of business or have sold all of your assets. If you do not file a form the county is likely to assess you a minimum amount of tax that in many cases is higher than the tax you would pay if you reported all of your assets at their fair market values.

Returns are due to the county April 1st or the first business day thereafter if the 1st falls on a weekend or holiday. The assessor updates the tangible tax rolls and submits them to the tax collector who issues a property tax bill later in the year. Tax rates are the same as for real property in the same jurisdiction. There is nothing equivalent to the homestead exemption for businesses, however, in Manatee County if the tax turns out to be less than $15 the tax collector won’t bother sending you a bill.

Here are a few other points you should be aware of.

• Tangible property you lease (copy machines, equipment, etc) must be reported and taxed.
• Property located in a rental unit (washers, dryers, appliances, furnishings) is taxable.
• Vehicles or trailers subject to registration in the county are not taxable.
• Some counties grant extensions to file the tangible return but you must often apply for an extension before the filing deadline. Extensions tend to be for only 30 days.
• The assessment is made at January 1 and you must report property you removed from the business during the previous year.
• If you sell your business you need to provide a copy of the bill of sale to your local property appraiser so they can remove you from the rolls and follow up with the new owner.
• Penalties for failure to file start at 5% per month and go as high as 25%.

Like I said initially, the tangible tax return is definitely something business owners can prepare themselves and many of our clients choose to go through the exercise as a practical way of updating their asset list each year. However, if you need help don't be afraid to give us a call.

Axiom Professional Group is a public accounting and consulting firm started by Joey Brannon in Bradenton, Florida. For more information you can view the Axiom Professional Group, P.A. home page   or visit the Axiom web site articles page (both links will exit the blog site).

Fractional Gifts of Art Work

Ric Gregoria of the Sarasota based law firm Williams Parker has written an interesting article on fractional interest gifts of artwork. This is a great technique for managing the limitations applied to charitable gifting and we've seen it produce much greater tax savings than if the piece of art were gifted outright to a musuem or university. Ric does a really nice job of concisely laying out the strategy.