Welcome to ORBA’s first bi-monthly Tax Connections Newsletter. Here you will find useful information on timely tax and accounting issues. Please feel free to comment and leave any thoughts or feedback you have. Be sure to check back every two months for a new issue as well as subscribe to our blog for weekly articles!
Family Loans — Tax Considerations
Tighter lending standards have made it more difficult to obtain financing to start or expand small businesses and buy homes. If your child or grandchild is having a hard time getting a loan from a commercial lender, you may be willing to help out by lending the money yourself.
Have a Written Agreement
Start by putting the loan agreement in writing. This may seem like an unnecessary formality, but without a written loan document, the IRS could argue that the transaction was a gift instead of a loan, potentially creating gift-tax issues. Having written documentation is also important in case the borrower fails to repay all or part of the loan. In that situation, you’d want to be able to show you’re entitled to write off the unpaid amount as a non business bad debt.
Charge Adequate Interest
The second step is setting an interest rate. While there’s no rule against interest-free loans or loans that have below-market interest rates, in a family context they can lead to tax complications. If you don’t charge sufficient interest, the difference between the amount of interest you actually receive (if any) and the amount you should have received — referred to as “imputed” interest — is taxable to you. You can avoid the imputed interest rules by charging interest at the appropriate “applicable federal rate” (AFR). The IRS publishes AFRs monthly for loans of different maturities. These rates have been low recently, reflecting the current market interest rate environment. For example, in December 2011, the annual AFR (using a monthly compounding assumption) is:
- .20% for a short-term loan (three or fewer years)
- 1.27% for a mid-term loan (more than three but no more than nine years)
- 2.80% for a long-term loan (more than nine years)
These are the minimum rates for intra-family loans initiated in December 2011. For a term loan, the rate can remain fixed for the life of the loan. For a demand loan (one that gives you the right to demand full repayment at any time), you have to charge a floating AFR to avoid imputed interest issues.
When you loan your child or grandchild no more than $100,000, the amount that can be added to your taxable interest income under the below market interest rate rules generally can’t exceed the borrower’s net investment income. Even better, you won’t have to report any imputed interest if the borrower’s net investment income amounts to $1,000 or less. You can also sidestep imputed interest on small loans of no more than $10,000 (all outstanding principal) provided the borrowed funds aren’t used to buy or carry income-producing assets.
Business Start-up Costs — What’s Deductible?
Launching a new business takes hard work — and money. Costs for market surveys, travel to line up potential distributors and suppliers, advertising, hiring employees, training, and other expenses incurred before a business is officially launched can add up to a substantial amount. The tax law places certain limitations on tax deductions for start-up expenses.
- No deduction is available until the business becomes active.
- Up to $5,000 of accumulated start-up expenses may be deducted in the tax year in which the active business begins. This $5,000 limit is reduced (but not below zero) by the excess of total start-up costs over $50,000.*
- Any remaining start-up expenses may be deducted ratably over the 180- month period beginning with the month in which the active business begins.
Example: Gina spent $20,000 on start-up costs before her new business began on July 1, 2011. In 2011, she may deduct $5,000 and the portion of the remaining $15,000 allocable to July through December of 2011 ($15,000/180 × 6 = $500), a total of $5,500. The remaining $14,500 may be deducted ratably over the remaining 174 months.
Instead of deducting start-up costs, a business may elect to capitalize them (treat them as an asset on the balance sheet). Deductions for “organization expenses” — such as legal and accounting fees for services related to forming a corporation or partnership — are subject to similar rules.
* For tax years beginning in 2010, the maximum start-up deduction was $10,000, reduced by the excess over $60,000.
For investors in the higher income-tax brackets, tax-exempt municipal bonds (munis) can represent an attractive investment. Municipal bond interest is generally exempt from federal income tax and sometimes is exempt from state (and possibly local) income tax in the state of issuance.
Taxable Equivalent Yield
If you are looking at potential bond investments, you’ll want to figure out whether you will do better after taxes with a muni or a taxable security. Calculating the taxable equivalent yield — the interest rate in your tax bracket that is equivalent to the rate being paid on the tax-exempt bond you are considering — will help you make a useful comparison.
Example. Jay is in the 35% federal income-tax bracket. He wants to know how much a corporate bond would have to yield someone in his tax bracket to match the 3.8% yield on a tax-exempt muni investment he is considering. He subtracts .35 from one and divides the result (.65) into 3.8%. The answer: 5.85%. On an after tax basis, a taxable bond yield of 5.85% is equivalent to a 3.8% tax-exempt yield. (Only federal taxes are considered in this example.)
Is AMT a Factor?
State and local governments and their agencies issue the majority of municipal bonds. However, nonprofit organizations, airports, certain housing agencies, and other “private activity” issuers also issue munis. Although exempt from regular income tax, the interest on most private activity bonds is taxable for alternative minimum tax (AMT) purposes. You’ll want to assess your potential exposure to AMT before investing in private activity bonds.
A Look at Above-the-Line Deductions
When it comes to lowering your personal income-tax liability, one deduction is as effective as another deduction of the same amount. Or is it?
Actually, deductions you’re permitted to claim in arriving at your adjusted gross income (AGI) — “above the line” — can be more valuable to you than deductions that are subtracted from your AGI. Why? Because various tax benefits are reduced or eliminated once AGI (or AGI with various modifications) exceeds specified limits. In effect, above the- line deductions do double duty by lowering your AGI and your taxable income. And you don’t need to itemize your deductions to claim them. Here’s a rundown of some of the above the- line deductions available to individual taxpayers.
Alimony: The payments must be made in cash pursuant to a divorce or separation instrument and can’t be required to continue beyond the death of the recipient or be fixed as child support.
Educator expenses: Grade K through 12 teachers, instructors, counselors, principals, or aides who are in a school for at least 900 hours during the school year may deduct up to $250 paid for books, supplies (other than nonathletic supplies for health or physical education courses), supplementary materials, or equipment used in the classroom. This deduction is set to expire after 2011.
Traditional IRA contributions: For 2011, the maximum deductible contribution is $5,000 ($6,000 for individuals age 50 or older). The deduction is phased out for taxpayers who participate (or whose spouses participate) in employer sponsored retirement plans where modified AGI exceeds specified thresholds. (So the amount you can claim, if any, could depend on the level of your AGI without regard to the IRA deduction.)
Premature withdrawal penalties: The deduction is for any interest or principal forfeited to a bank or other financial institution as a penalty for premature withdrawal from a time savings account, certificate of deposit, or similar deposit.
Rental property/trade or business expenses: Expenses associated with property held for the production of rents — such as utilities, depreciation, repairs, and maintenance — are deductible above the line on Schedule E. Sole proprietors deduct their trade or business expenses above the line on Schedule C. The deductibility of net losses from Schedule C and E is subject to certain limitations.
Higher education expenses: Tuition and related expenses are potentially deductible. However, the deduction is capped at $4,000 or $2,000, depending on modified AGI, and isn’t available once modified AGI exceeds $80,000 ($160,000 on a joint return). This deduction is set to expire after 2011.
Student loan interest: Up to $2,500 of interest expense on qualified higher education loans is potentially deductible in 2011. The deduction phases out for taxpayers with modified AGI between $120,000 and $150,000 (joint filers) or between $60,000 and $75,000 (single filers).
Moving expenses: Costs associated with moving household goods and personal effects to a new residence and traveling from an old to a new residence are potentially deductible if the move is because of a change in principal work location. Certain requirements must be met.
HSA contributions: The maximum deductible contribution to a health savings account in 2011 is generally $3,050 for individuals with self-only coverage under a high deductible health plan and $6,150 for those with family coverage. An additional $1,000 deductible contribution is available to individuals age 55 or older who aren’t enrolled in Medicare.
Self-employed taxpayers: Retirement plan contributions, qualified health insurance premiums, and a portion of self-employment taxes are deductible above the line. Requirements and limits apply.
Payroll Taxes — Who’s Responsible?
Employers may not think of themselves as tax collectors, but essentially that’s the role they play under the federal payroll tax system. The income and FICA taxes employers withhold from employees’ pay are considered to be held in trust for the government and must be deposited with the IRS on a strict schedule.
When a business fails to make payroll tax deposits, the IRS may pursue not just the company but also so called “responsible persons.” Officers, employees, and anyone else who has the duty to collect, account for, or pay over the withheld taxes may be held personally liable for a “trust fund recovery penalty” equal to 100% of the unpaid taxes if they willfully fail to fulfill their responsibilities.
A Wide Reach
In a recent internal memo, the IRS makes clear that third-party payroll service providers, professional employer organizations, and employee leasing companies that have significant control over the payment of their clients’ employment taxes also can be considered responsible persons. However, designating a third party to take over some or all payroll tax functions does not relieve the common law employer from its tax responsibilities. The IRS can and often does attempt to collect unpaid payroll taxes from several sources.
Make Payroll Taxes a Priority
In tough economic times, companies may be tempted to use money that should go toward payroll taxes to pay other creditors and ongoing operating costs. But failure to pay over trust fund taxes can lead to serious problems with the IRS. If making full payment is impossible, voluntarily disclosing underpayments and making arrangements with the IRS to pay the taxes might forestall IRS action to collect the trust fund recovery penalty from responsible persons.
The general information in this publication is not intended to be nor should it be treated as tax, legal, or accounting advice. Additional issues could exist that would affect the tax treatment of a specific transaction and, therefore, taxpayers should seek advice from an independent tax advisor based on their particular circumstances before acting on any information presented. This information is not intended to be nor can it be used by any taxpayer for the purpose of avoiding tax penalties.