Month: January 2023

The type of business that you’re running has major implications in virtually all areas of your operations, especially when it comes to federal taxes. An S Corporation (or S Corp for short) is one that passes corporate income, losses, deductions, and credits to its shareholders. A C Corporation (or C Corp for short) is one where the owners are taxed separately from the business itself.

Having said that, just because you chose one type of legal structure at the outset of your business doesn’t mean that you have to live with that decision for the remainder of your career. Converting from an S Corp to a C Corp is possible, but it’s a process that requires you to keep a few key things in mind along the way.

The S Corp and C Corp Conversion Process: Breaking Things Down

Generally speaking, converting from an S Corp to a C Corp is something that happens for a few key reasons. Sometimes, it’s voluntary. Maybe a corporation wants to broaden its investor base, or its leaders have their eyes set on going public in the future. Sometimes, an S Corp is terminated by law, causing it to automatically transition into a C Corp. In this context, the corporation may have failed to meet its eligibility requirements, or it has earnings, profits, and passive investment income that is greater than 25% of its gross income for three consecutive years.

If yours is a business that falls into the former category, know that you need to start this process by March 15 of the current tax year. Once shareholders agree to the change, things will move along fairly quickly.

For starters, you need to file what is called a “Revocation of S Corporation Status” with the IRS Service Center. You’ll need to do this where you filed for an S Corp in the first place. On the document, you’ll give critical information like the name of the corporation, the tax ID number that you’re currently using, the total number of outstanding shares that you have, and more.

Once the document is completed, it needs to be signed by the same individual who is authorized to sign the corporate tax returns for the company. In most situations, this will be the president. In some contexts, it may be a corporate officer.

Note that the filing of this document will also need to include what is known as a statement of consent. This document needs to be signed by any shareholder that has more than 50% stock in the company. This includes people who have nonvoting shares, too.

During this time, you should make a copy of all documentation to store with your records. Most experts recommend that you store them with all of your other tax documents should you need to refer to them in the future.

There’s not much more to the actual process itself than that – but there are some potential consequences that you need to be aware of. Chief among them is the fact that a business only has a specific amount of time to distribute any earnings to shareholders when this process is complete. Once you’re outside of that window, all distributions will then be taxed as dividends.

Likewise, if you happen to convert halfway through the year, your business will need to file two tax returns. This can greatly complicate things, which is why it’s always important to make sure that everything is finalized by that March 15 date.

Finally, know that when you convert from an S Corp to a C Corp, you won’t be able to go back again for at least five years. The only exception to this is if you get approval to do so from the IRS itself. So be absolutely certain that this is the best move to take for your corporation before you go through the process.

In the end, converting from an S Corp to a C Corp is a decision that can definitely have its benefits – but there are also long-term implications that you need to be aware of. Before you go through the process of changing the tax status of your company, it is always recommended that you speak with a financial professional so that they can shed insight and help you avoid potentially costly mistakes in the future.

If you’d like to find out more information about how to convert from an S Corp to a C Corp, or if you have any additional questions, you’d like to go over with someone in a bit more detail, please don’t delay – contact us today.

Married taxpayers generally have the option to file a joint tax return or separate returns, a filing status commonly referred to as married filing separate (MFS). If you are married and you and your spouse are filing separate returns, or are considering doing so, you should read this article before making that decision.Depending on whether the taxpayers are residents of a separate or community property state, their separate returns may include just the income and eligible expenses of each filer or a percentage of their combined income and expenses.

Couples choose the MFS option for a variety of reasons:

• They want to avoid the joint and several liability for the tax from a joint tax return.Joint and several liability is a legal term for a responsibility that is shared by two or more parties to a lawsuit. A wronged party may sue any or all of them, and collect the total damages awarded by a court from any or all of them.
• They have children from a prior marriage and want to keep finances separate.
• They only want to keep their taxes separate.
• The marriage is tenuous.
• The taxpayers are separated and don’t want to cooperate in filing a joint return.
• One spouse might get a larger refund by filing separately (the other will pay more).
• They think they can save money by filing separate returns, and a variety of other reasons.

The fact of the matter is that tax laws are carefully written to keep married taxpayers from filing separately to manipulate the tax laws to their benefit. The following is a list of the more commonly encountered tax disadvantages – some might call them tax penalties –when filing as MFS. Unless otherwise noted the amounts shown are for 2023:

Filing Threshold – For all filing statuses except MFS the income threshold where a return must be filed is equal to the standard deduction for that filing status. For an MFS return the filing threshold is $5.

Community Property State Income – Unlike most states where each spouse claims their own earned income on an MFS return, in community property states the earned income is evenly split between the spouses. However, FICA payroll withholding, self-employment tax, and IRA contributions apply separately to the spouse who earned the income.

Joint & Several Liability – On a joint return both spouses can be held responsible for payment of the tax, while the spouses filing as MFS are only responsible for payment of the tax on their individual MFS returns.

Social Security Benefits Taxation Threshold – Social Security (SS) income is not taxable until taxpayers filing married joint have modified AGI (MAGI) that exceeds a threshold of $32,000. MAGI is regular AGI (without Social Security income) plus 50% of their Social Security income plus tax-exempt interest income, and plus certain other infrequently encountered additions. However, the threshold is zero for taxpayers filing as MFS. Thus taxpayers filing as MFS are taxed on 85% of every dollar of SS income.

Capital Loss Limitation –Where married couples filing jointly can annually deduct up to $3,000 of capital losses, those filing as MFS can only deduct up to $1,500.

Sec 179 Limitation – Taxpayers can elect to expense the cost of qualifying property used in the active conduct of a trade or business. The portion of the cost not expensed under Sec 179 is depreciable. The maximum amount that can be expensed is inflation adjusted annually and is $1,160,000 for 2023 (up from 1,080,000 in 2022). For MFS taxpayers the annual maximum amount must be allocated between the spouses.

Rental Loss Limitation – Generally, most taxpayers cannot deduct rental losses. However, there is aspecial rule that allows a deduction of aggregate losses from rental real estate activities up to $25,000 per year for taxpayers who are an active participant in the activity. It means that the taxpayer must participate in management decisions, and at least arrange for others to provide the necessary services such as repairs.

However, this special allowance only applies to lower income taxpayers with an AGI, without regard to passive losses, of $150,000 or less. In addition the $25,000 loss allowance begins to phase out 50 cents for each $1 of income over $100,000. Thus the allowance is fully phased out for joint filers when the AGI exceeds $150,000.

Phase out applies to gross income without considering passives, taxable Social Security benefits, or deductions for IRA.

Taxpayers filing as MFS must live apart the entire year or they get no relief under this rule. If they lived apart all year, the allowance is $12,500, and phase out begins at income of $50,000.

Traditional IRA – For taxpayers filing joint returns, a Traditional IRA is tax deductible except that the deductibility is phased out for higher income taxpayers who are active participants in an employer retirement plan. Where both spouses are active participants in an employer retirement plan the deductibility of IRA contribution in 2023 phases out for AGIs between $116,000 and $136,000. Where only one spouse is an active participant the phase out is between $218,000 and $228,000. However, for those filing MFS the phaseout is between $0 and $9,999.

Roth IRA – The ability to contribute to a Roth IRA phases out for those couples filing jointly between $218,000 – $228,000. However, for those living together and filing MFS the phase-out is range is $0 and $9,999.

Savings Bond Interest Exclusion – An individual who pays qualified higher education expenses with redemption proceeds from Series EE or I bonds issued after ’89 can potentially exclude from income the bond interest. No exclusion is available to a taxpayer filing married separate.

Higher Education Interest – An “above-the-line” deduction is allowed for interest payments due and paid on any “qualified student loan,” regardless of when a taxpayer first incurred the loan. The maximum deduction per year is $2,500. However, for those filing MFS, no deduction is allowed.

Standard Deduction – The deduction for those filing as MFS is ½ of the standard deduction for married filing joint taxpayers plus the age 65 and blind add-on amounts.

Standard Deduction vs Itemized Deductions – Generally taxpayers can choose between taking the standard deduction or itemizing deductions. However, where both spouses are filing as MFS if one itemizes, then both must itemize, a tax trap often overlooked by MFS filers.

Medicare Premiums – For taxpayers who qualify forMedicare, the premiums are based upon their modified adjusted gross income (MAGI) and filing status from the tax return two years prior. The rates for individuals filing MFS are substantially higher than for other Medicare participants.

Home Mortgage Interest – MFS spouses are treated as if they are one taxpayer and must split between them the amount of mortgage interest deduction they would be entitled to jointly. If two homes are involved, each spouse can only claim interest on one home unless they agree one can claim both.

State and Local Taxes Deduction – When itemizing deductions, the tax code limits (referred to as the SALT limitation) the deduction for state and local taxes, such as state income or sales tax and property tax, to $10,000 for all filing statuses except MFS, which is limited to $5,000.

Alternative Minimum Tax (AMT) – For MFS taxpayers the AMT exemption amount is only half of the amount for those filing jointly and the income threshold for the 28% tax rate is half of what it is joint filers.

Tax Rates – The marginal rates for MFS are twice that of married taxpayers filing jointly.

Child & Dependent Care Credit – MFS taxpayers cannot claim this credit unless legally separated. Where it can be claimed, the AGI credit phaseout threshold is $75,000 (half of that allowed for joint filers).  

Earned Income Tax Credit (EITC) – The EITC is a tax credit for low-income taxpayers. Where one spouse can file as head of household (HH) instead of MFS and lives in a community property state, earned income for the credit does not include amounts earned by the other spouse. For a spouse to claim HH instead of MFS, he or she must have lived apart from their spouse at least the last six months of the year and paid more than one-half of the cost of maintaining a household which is the principal place of abode for more than one-half the year of a child, stepchild, or eligible foster child for whom the taxpayer may claim a dependency exemption.

Adoption Tax Credit – Allowed for an MFS taxpayer only if the spouses lived apart for the last 6 months of the year and the child lived with taxpayer more than half the year and the taxpayer provided over half the cost of maintaining the home.

Elderly & Disabled Tax Credit – Not allowed for those filing as MFS.

Retirement (Saver’s) Credit – The maximum AGI to be eligible for any Saver’s Credit for those filing jointly in 2023 is $54,750 while for those filing MFS it is $36,500.

Tax Withholding – MFS taxpayers only claim their own income tax withheld unless they are residents of a community property state where they each claim half.

Estimated Tax Allocation – When taxpayers make joint estimated tax payments, they can allocate the payments between themselves in any amounts they can agree upon. If they cannot agree, they must divide the payments in proportion to each spouse’s individual tax as shown on their separate returns for the year.

Estimated Tax High Income Safe Harbor – Taxpayers are subject to an underpayment penalty when their tax liability less the sum of their withholding and estimated tax payments is more than $1,000. However, there is a high income exception to the penalty when the AGI for the previous year is over $150,000, in which case the required estimated payments are the smaller of 90% of the current year’s tax, or 110% of the previous year’s tax. If filing MFS the AGI for the previous year need only be over $75,000.

Premium Tax Credit – The premium tax credit is a refundable credit available to lower income taxpayers to help them offset the cost of purchasing their health insurance from a government marketplace. Taxpayers filing MFS cannot claim this substantial credit unless they are a victim of spousal abuse or abandonment.

Automatic 2-month Extension When Out of the Country – Taxpayers who are out of the U.S. on the tax filing due date are granted an automatic 2-month extension to file their tax return. This provision applies to both spouses when filing a joint return even if only one spouse is out of the country. When filing MFS, the extension will only apply to the spouse that is out of the country.

Many of the consequences listed interact with others and generally require professional tax software to account for all of interactions and to accurately compare the results for a couple filing jointly or each filing separately.

If you have questions or would like to schedule an appointment to see how the consequences of filing separate returns might apply to your situation, please give the office a call.  

Individuals are always looking for tax deductions that can reduce their tax liability. But what is the actual tax benefit derived from a tax deduction? There is no straightforward answer because some deductions are “above the line”, others must be itemized, some must exceed a threshold amount before being deductible, and certain ones are not deductible for alternative minimum tax purposes, while business deductions can offset both income and self-employment tax. In other words, there are many factors to consider, and the tax benefits differ for everyone, depending on their particular situation and tax bracket.

For most non-business deductions, the savings are based upon your tax bracket. For example, if you are in the 12% tax bracket, a $1,000 deduction would save you $120 in taxes. On the other hand, if you are in the 32% tax bracket, the $1,000 deduction will save you $320 in taxes. Even so, if your taxable income is close to transitioning into the next-lower tax bracket, the benefit will be lower.

You also need to consider whether the deduction is allowed on your state return and what your state tax bracket is to determine the total tax savings. Currently, the maximum federal tax bracket is 37%, meaning the most benefit that can be derived from a $1,000 income tax deduction is $370. Some individuals justify making discretionary purchases just because they are tax-deductible. Even in the highest tax bracket, you are still paying $630 out of pocket ($1,000 − $370), so it does not make sense to incur a tax-deductible expense just for the tax deduction.

Some deductions, such as IRA and self-employed retirement plan contributions, alimony, and student loan interest, are adjustments to income or what we call above-the-line deductions. These deductions, to the extent permitted by law, provide a dollar deduction for every dollar claimed. On the other hand, deductions that fall into the itemized category must exceed the standard deduction for your filing status before any benefit can be derived. In addition, medical deductions are reduced by 7.5% of your adjusted gross income (AGI), and most cash charitable deductions are limited to a maximum of 60% of your AGI. Under the tax reform that became effective in 2018, the deduction for state and local taxes is currently capped at $10,000 per year.

The most beneficial deductions are business deductions that offset both income tax and, depending upon the circumstances, self-employment tax. For 2023, the self-employment tax rate is 12.4% of the first annually inflation adjusted $160,200 of net self-employment income plus 2.9% for the Medicare tax, with no cap. Contact this office for rates applicable to other years. Some high-income taxpayers may pay an additional 0.9% Medicare tax. For self-employed businesses with less than $160,200 of net income, the self-employment tax rate is 15.3%. Thus, for small businesses with profits of less than $160,200, the benefit derived from deductions generally will include the taxpayer’s tax bracket plus 15.3%. For example, for a taxpayer in the 24% tax bracket, the benefit could be as much as 39.3% (24% + 15.3%) of the deduction. If the deduction were $2,000, the tax savings could be as much as $806 or more, when the taxpayer’s state income tax bracket is included.

In addition to deductions, taxpayers also benefit from tax credits. Tax credits reduce the tax, not the taxable income, dollar for dollar. These credits come in different varieties. Some, referred to as non-refundable will only reduce a taxpayer’s tax liability to zero while refundable credits will reduce the tax liability to zero and any balance is refunded. In addition, some unused non-refundable credits can be carried to other years. The following are examples of 2023 tax credits:

• Earned Income Tax Credit (EITC) – This inflation adjusted credit is for lower income taxpayers based on their earned income and overall income for the year. The credit can be as much as $7,430, and is a refundable credit.
• Home Solar Credit – Is 30% of the cost of a home solar electric system put into service in 2023. The credit is non-refundable, but unused credit carries over to future years.
• Credit for Energy Efficient Home Modifications – This credit is 30% of the cost ofmaking qualifying energy saving improvements to your existing home. The costs, and thus the credit, is limited by the type of home improvement and the annual maximum credit is $1,200. However, this is a non-refundable credit and there is no carryover.

So when evaluating the tax benefit of a tax credit one must consider whether it is a refundable credit; if any unused amounts carry over to be used in other years; and whether there are any limits on the dollar amount of the credits.

If you are planning an expenditure and expect the tax deduction or tax credit to help cover the cost, please call before making the purchase to ensure that the tax benefit will be what you anticipate.

If your 2022 refund or balance due turns out not to be the desired amount, you may want to consider adjusting your withholding based on your projected tax for 2023. If you need assistance, please call this office.

W-9 Collection – If you are operating a business, then you are required to issue a Form 1099-NEC to each service provider to which you have paid at least $600 during a given year. It is a good practice to collect a completed W-9 form from every service provider (even if you are paying less than $600), as you may use that provider again later in the year and may have difficulty getting a W-9 after the fact—especially from providers that do not plan to report all of their income for the year.

Estimated Tax Payments – If you are self-employed, then you prepay each year’s taxes in quarterly estimated payments by sending 1040-ES payment vouchers or making electronic payments. For the 2023 tax year, the first three payments are due on April 18, June 15, and September 15, 2023, and the final payment is due on January 16, 2024. Generally, these payments are based on the prior year’s taxable income; if you expect any significant changes in either income or deductions relative to the previous year, please contact this office for help in adjusting your payments accordingly.

Charitable Contributions – If you marginally itemize your deductions, then you can employ the bunching strategy, which involves taking the standard deduction one year but itemizing your deductions in the next. However, you must make this decision early in the year so that you can make two years’ worth of charitable contributions in the bunching year.

Required Minimum Distributions – Each year, if you are 73 (a recent law change increased it from 72 in 2022) or older, you must take a required minimum distribution from each of your retirement accounts or face a substantial penalty. By taking this distribution early in the year, you can ensure that you do not forget and accidentally subject yourself to penalties.

Gifting – If you are looking to reduce your estate-tax exposure or if you just want to give some money to family members, know that each year, you can gift up to an inflation-adjusted amount, which for 2023 is $17,000, to each of an unlimited number of beneficiaries without affecting your lifetime estate-tax exclusion amount or paying a gift tax.

Retirement-Plan Contributions – Review your retirement-plan contributions to determine whether you can afford to increase your contribution amounts and to make sure that you are taking full advantage of your employer’s contributions to the plan.

Beneficiaries – Marriages, divorces, births, deaths, and even family clashes all affect whom you include as a beneficiary. It is good practice to periodically review not just your will or trust but also your retirement plans, insurance policies, property holdings, and other investments to be sure that your beneficiary designations are up to date.

Reasonable Compensation – With the advent a few years ago of the 20% pass-through deduction, which is available to most businesses other than C-corporations, the issue of reasonable compensation took on new importance, particularly for shareholders of S corporations. This has been a contentious issue in the past, as it has allowed shareholders who are not just investors but who are actually working in the business to take a minimum salary (or no salary at all) so that all their income passed through the K-1 as investment income. This strategy allows such shareholders and the S corporation to avoid payroll taxes on income that should be treated as W-2 compensation. A number of issues factor into a discussion of reasonable compensation, including comparisons to others working in similar businesses and to employees within the same business, as well as the cost of living in the business’s locale. This is a subjective amount, and it generally must be determined by a firm that specializes in making such determinations.

Business-Vehicle Mileage – Generally, vehicles with business use also have some amount of nondeductible personal use in a given year. It is always a good practice to record a vehicle’s mileage at the beginning and at the end of each year so as to determine its total mileage for that year. The total mileage figure is then used when prorating the personal- and business-use expenses related to that vehicle.

College-Tuition Plans – Contribute to your child’s Section 529 plan as soon as possible; the funds begin accumulating earnings as soon as they are in the account, which is important because the student will likely begin using that money at age 18 or 19.

Only a few of the tax-related actions that you take during a year will benefit yourself or others. The most important of these actions is keeping timely and accurate tax records; for businesses in particular, this is of the utmost importance. Those who have well-documented income and expense records generally come out on top when the IRS challenges them.

If you have any questions related to your taxes or if would like an appointment for tax projections or tax planning, please contact our office.