Skip to main content
Category

Closely Held Businesses

What companies with retirement plans must do to comply with the SECURE Act

By Closely Held Businesses

On December 20, 2019, the Setting Every Community Up for Retirement Enhancement Act (SECURE Act) became law. The SECURE Act is landmark legislation that affects the rules for creating and maintaining workplace retirement plans for all employers.  Whether you currently offer your employees a retirement plan (or are planning to do so), you should consider how these new rules may affect your current retirement plan (or your decision to create a new one).

Some of the SECURE Act provisions are required to be (or can be) operationally implemented immediately by employers who sponsor and maintain tax-qualified retirement plans, such as 401(k) plans, cash balance plans or traditional defined benefit (DB) pension plans, and 403(b) plans. This article focuses attention on those more immediate provisions.

  • Credit card loans prohibited. Effective December 20, 2019, making new plan loans through any credit card or similar arrangement is prohibited. Any such loans will be treated as taxable distribution.
  • Increased age for required minimum distributions (RMDs). Under prior law, RMDs from tax-qualified retirement plans, 403(b) and 457(b) plans generally had to start no later than April 1 of the calendar year following the later of (i) the year in which an employee attains age 70 ½ or the calendar year in which the employee retires (but 5-percent owners could not use this retirement rule). SECURE changed age 70 ½ to age 72 for RMDs for individuals who attain age 70 ½ after December 31, 2019.

If an individual attained age 70 ½ in 2019 and if they have terminated employment or are a 5-percent owner, RMDs must still begin by April 1, 2020, (and continue annually thereafter) in accordance with prior law.  Similar changes apply to traditional IRAs (without regard to employment status).

Employers should confirm that their plan administrator will immediately update all retirement plan distribution paperwork describing the RMD rules to reflect the new law.

Employees who were expecting to begin RMDs when they reached age 70 ½ in 2020 or later may want to reconsider their options.

  • “Stretch” beneficiaries eliminated for defined contribution (DC) plans. Under prior law, if payments to a non-spouse designated beneficiary under a DC plan (including 403(b) plans) began within one year after the participant’s death, such payments could be made ratably over the beneficiary’s life expectancy (i.e., potentially stretched out over decades), but if the payments did not begin by that time, they had to be paid out in full within five years after the participant’s death.

Under the new law, for participant deaths that occur after December 31, 2019, all distributions generally must be paid within 10 years from the date of death. But the new 10-year payout rule does not apply to payments made to the participant’s surviving spouse, a child who has not reached the age of majority, a disabled or chronically ill individual (or trusts for the benefit of such individuals), or any individual who is not more than 10 years younger than the deceased participant, so long as the payments begin within one year after the participant’s death (but for surviving spouses, the payments are not required to begin until the deceased participant would have attained age 72). In addition, if such “eligible designated beneficiary” dies before receiving all payments owed to them, the remaining amount must be paid out within 10 years after the eligible designated beneficiary’s death.

  • Fiduciary safe harbor. Effective December 20, 2019, DC plan fiduciaries can use a new ERISA fiduciary safe harbor to reduce uncertainties when offering an annuity to plan participants. If plan fiduciaries satisfy the safe harbor, they are deemed to have met ERISA’s prudence standard for selecting an insurance carrier for the DC plan’s annuity option and will not be liable for losses if the insurer cannot satisfy its obligations under the annuity contract.

When an employer selects an annuity provider for its retirement plan, the employer is an ERISA fiduciary, which means that the employer must act solely in the best interests of plan participants and beneficiaries when making its decision.

For DC plans, the new safe harbor clarifies that employers are not required to select the lowest cost contract. Rather, the employer can consider the value, features and benefits of the contract and attributes of the insurer (such as its financial strength) in considering the cost of the annuity contract.

The safe harbor also clarifies that employers are not required to review the appropriateness of the annuity after the contract has been purchased.

The new safe harbor does not apply to cash balance or other DB plans.

  • Nondiscrimination testing relief for closed DB plans. The SECURE Act included long-awaited nondiscrimination testing relief for DB plans that are closed to new participants. The relief applies to plans that were closed as of April 5, 2017, or that have been in operation but have not made any increases to the coverage or value of benefits for the closed class for five years before the freeze can now meet nondiscrimination, minimum coverage, and minimum participation rules by cross-testing the benefits with the employer’s DC plans.

When are plan amendments needed? Generally, conforming plan amendments (retroactive to the first day as of which the new rules apply) will not be required any earlier than the last day of the first plan year beginning in 2022 (or later for certain collectively bargained and governmental plans). Additional guidance from the IRS is expected on plan amendment deadlines.

If you have questions about how to bring your company’s retirement plan into compliance with the SECURE Act, please give us a call at (858) 558-9200.

Employee vs. Contractor – California Requirements

By Closely Held Businesses

Welcome to a new year and new decade!  With the turning of the year comes the resetting of tax filing deadlines.  First up are 2019 W-2s for employees and 1099s for independent contractor services, both due January 31, 2020.  California recently created a new test to differentiate independent contractors from employees.  In this article we will discuss this test and why it is important to make sure the people you pay for services are properly classified.

Based on a 2018 California Supreme Court ruling, Assembly Bill 5 was signed into California law in September 2019.  Effective January 1, 2020, the law requires use of the “ABC test” to determine who is an independent contractor and who is an employee of your business.

This distinction is important for several reasons, including who is responsible for employer payroll taxes and unemployment & disability insurance, as well as the worker’s eligibility for unemployment and company provided benefits like health insurance, retirement plan contributions, overtime, paid time off, and sick leave.

Under the ABC test, a worker is considered an employee, and not an independent contractor, unless all three of the following conditions are satisfied:

  • The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact.

Do you control the worker’s schedule, circumstances, performance, location, hours, pay rate or pay schedule?  Do you reimburse for expenses, provide tools/supplies?  Do you provide the worker any benefits?

  • The worker performs work that is outside the usual course of the hiring entity’s business.

Does the individual perform tasks on your behalf that you, or your employees, normally would undertake, or is the work directly related to your business’ services or products?

  • The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.

Do they perform services for a variety of different customers/clients?

Meeting all three conditions to establish independent contractor status can be more challenging than under prior law.  It is presumed that workers are employees unless proven otherwise through application of the ABC test.

If it is determined that the company has improperly classified a worker as an independent contractor, an arduous compliance process may follow.  The company may be required to amend payroll reports and W-2s, corrective payroll tax payments may need to be made, and penalties and interest could be assessed.

If your company is subject to the new law, it is important to carefully identify workers that may fail any of the three conditions of the ABC test.  For those workers, consider discussing with your attorney whether service contracts can be adjusted to better reflect independent contractor status or whether the worker should be classified as an employee.  Once determined, the relevant factors of the relationship driving the decision should be well documented.

Please note that the ABC test, as described above, is not used to determine employment vs. contractor status for all industries and individuals.  Certain licensed insurance agents, medical professionals, attorneys, architects, engineers, and accountants are permitted to use other tests.

If you have questions regarding independent contractors and/or employees, please give us a call at (858) 558-9200.

2019 Year-End Planning For Businesses

By Closely Held Businesses

It’s that time of year again! Time to execute on planning opportunities these final weeks of the year to minimize your business’s tax liabilities.

We are closing in on the end of 2019, year two, under The Tax Cuts and Jobs Act.  Time to execute on planning opportunities these final weeks of the year to minimize your business’s tax liabilities.

Tax Due Dates

We encourage business clients to close their books as soon as possible after December 31, 2019. This enables the business to provide financial information to their L&B professional in a

timely manner, keeping the following due dates in mind:

  • Due March 16, 2020
    • Partnerships – filing calendar year Form 1065
    • S corporations – filing calendar year Form 1120S
  • Due April 15, 2020
    • C corporations – filing calendar year Form 1120
    • Single Member LLCs, Sole Proprietorships – filing Form 1040 Sch C, Sch E, or Sch F

Tax Rates

C corporations: For 2019 and 2020 tax years, the tax rate remains a flat 21%.

Partnerships, S-Corporations, LLCs, Sole Proprietorships: “Pass-through” entities are taxed at individual rates.  While the tax rates are not changing from 2019 to 2020—the top rate remains 37%—the income brackets are increased for inflation.  2019 & 2020 tax tables can be found here.

Year-End Tax Planning Strategies

Below are excellent tax strategies designed especially for businesses that report tax on cash basis and anticipate being subject to the same tax rate or lower in 2020.

  • Defer taxable income to 2020 by sending customer invoices in January instead of December.
  • To accelerate deductions, make December purchases by credit card. This allows for a 2019 tax deduction even when you pay the credit card company in 2020.
  • Purchase fixed assets eligible for 100% immediate deduction by December 31st. See our article here to learn how businesses can take advantage of bonus depreciation, Section 179 asset expensing, and de minimis safe harbor strategies.
  • Pay 2019 bonuses before year-end.
  • Prepay expenses. For example, consider paying a portion of next year’s insurance coverage before year-end.  Note that the tax rules on deducting prepayments can be complex, so please call your L&B professional to discuss.
  • Mail checks to vendors by December 31st. If your A/P department has scheduled check disbursements for early January, consider a December mailing to obtain 2019 tax deductions.
  • 20% Qualified Business Income (QBI) deduction strategies. See our article here for further discussion.
    • Increase 2019 wages/bonuses or fixed asset purchases to increase the QBI deduction limit.
    • Specified service businesses whose owners are at or around the QBI taxable income thresholds can increase retirement plan contributions to lower income below the thresholds to allow the deduction.
    • For partnerships that report significant guaranteed payments, review your partnership agreement to determine if guaranteed payment allocations can be reduced, as they are ineligible for the QBI deduction. Income thresholds still apply when considering the possible deduction when the income can be moved away from a guaranteed payment.
  • For businesses with average gross receipts under $25 million, consider the following accounting method changes:
    • Use the cash method of accounting for tax purposes instead of accrual. This creates an advantage when your receivables outweigh payables.
    • For inventory accounting, change from uniform capitalization (“UNICAP”) to a simplified or more tax-favorable inventory method.
    • For long-term construction contracts using the percentage-of-completion method of accounting, consider changing to another method such as completed-contract.
  • Establish a tax-advantaged retirement plan for your business in time to make 2019 deductible contributions. 401(k)’s and defined benefit plans generally must be established by December 31. SEP IRAs must be established by the tax return due date including extensions.  Employee deferrals into these plans will be required by December 31st but employer match contributions are allowed until the due date of the return including extensions in most cases.

Strategies may be different for accrual basis taxpayers or businesses anticipating a higher tax rate in 2020.  Before implementing any tax strategy, please ensure that it makes business sense independent of the tax outcome.

To discuss these or any other year-end tax planning strategies with an L&B professional, please give us a call at (858) 558-9200.

Check Out These Improvements! New Rules For Deducting The Costs of Business Property.

By Closely Held Businesses

The 2017 Tax Cuts and Jobs Act enhanced federal tax deductions for the purchase or improvement of certain assets used in a business.  This article discusses changes to bonus depreciation and Section 179 asset expensing, as well as a refresher on repair capitalization, that will generate tax savings for many of our business clients!

The 2017 Tax Cuts and Jobs Act significantly enhanced federal tax deductions for business assets like furniture, fixtures, equipment, software, land improvements, and certain real property improvements.  This is great news that will translate to tax savings for many of our clients!  Among the most important enhancements are changes to bonus and Sec. 179 depreciation, discussed below.

Note the content here is for federal tax purposes only.  California treats these rules differently, and therefore requires separate analysis.

Bonus depreciation:

Effective September 28, 2017, bonus depreciation now allows for a 100% immediate deduction of eligible property, up from 50%.  Property that qualifies for bonus depreciation includes tangible personal property like furniture, fixtures, equipment, land improvements, and off-the-shelf software used in a trade or business.  Additionally, used property is now bonus eligible, previously only new property qualified.  There is no annual limit on the amount of bonus depreciation a business can deduct.

Section 179 expensing:

Effective January 1, 2018, the new annual limit for Sec. 179 expense is $1,000,000, up from $510,000.  Assets eligible for immediate expensing under Sec. 179 include tangible personal property like furniture, fixtures, equipment, etc., off-the-shelf software, and qualified real property (QRP).  QRP is any improvement to an interior portion of a nonresidential building—not including building enlargement, elevators, escalators, or structural framework.  QRP also includes roofs, HVAC, fire protection and alarm systems, and security systems.

The beginning of the phaseout window for 179 eligibility has increased to $2,500,000, up from $2,030,000.  This means that your Sec. 179 deduction is reduced dollar for dollar once your business acquires $2,500,000 or more of 179-eligible assets during the year.

“BAR” rules for capitalizing repairs and improvements:

The tax law requires that repairs and improvements to business property must be capitalized under certain conditions.  To capitalize means the expenditure is not deducted in full immediately, but is depreciated over time.

To determine when a repair or improvement must be capitalized, a handy trick is to remember the phrase “the BAR isn’t so high.”  If an expenditure is a Betterment, Adaptation, or Restoration (“BAR”) of business property then it generally must be capitalized.  The “BAR” rules apply to any tangible property used in a business, both personal and real property.

Betterments include material additions (i.e. physical enlargement) to the property, or expenditures that materially increase an asset’s productivity, efficiency, strength, quality, or output.  Adaptations are amounts paid to adapt the property to a new or different use.  Restorations include replacement of a major component or substantial structural part of the property, or returning the property to operating condition when no longer functional.

Special rules such as bonus depreciation and Sec. 179 allow for full expensing regardless of capitalization.  Expenditures below $2,500 that would otherwise be capitalized under the “BAR” criteria may be expensed in full immediately under a de minimis safe harbor if elected.

While these concepts—bonus, Sec. 179, repair capitalization, de minimis safe harbor—are foundational to tax planning for asset expenditures, they are just the tip of the iceberg.  Every situation must be analyzed separately to consider the myriad rules and caveats that exist in this area of tax law.

If you have any questions regarding these or any other tax matters, please do not hesitate to contact your L&B professional at (858) 558-9200.

Business owners: Want to deduct 20% of company income?

By Closely Held Businesses

Do you own a business organized as an LLC, sole proprietorship, partnership, S corporation, or any structure other than a C corporation?  If so, you may be able to claim a tax deduction of up to 20% of the business’s income.

The 2017 tax law known as the Tax Cuts and Jobs Act included a new deduction for owners of pass-through businesses, effective for tax years 2018 through 2025.  The deduction goes by several names: 199A deduction, 20% pass-through deduction, and qualified business income (QBI) deduction.

The QBI deduction is equal to 20% of your share of qualified business income, subject to certain limits.  For example, if your share of QBI is $100,000, you may be able to claim a deduction of up to $20,000 on your Form 1040.

Qualified business income includes domestic business taxable income from any qualified trade or business that is not structured as a C corporation.  LLCs, sole proprietorships (think 1040 Schedule C), partnerships, S corporations, and trusts are eligible entities.

Qualified business income is generally the operating taxable income (not revenue) of the business.  It does not include investment income such as dividends, interest, capital gains, and similar items.  It also does not include W-2 wages received by S corporation shareholders or guaranteed payments received by partners or LLC members.

The amount of your QBI deduction depends not only on business income, but also on your overall personal taxable income and capital gains.

If your 2019 personal taxable income is below $321,400 married filing jointly ($160,700 single), your QBI deduction is subject to only one limitation.  If the QBI deduction is less than 20% of personal taxable income minus capital gains, you may take it in full.

If your 2019 personal taxable income is above $421,400 married filing jointly ($210,700 single), you are subject to several limitations.  First, income from a specified service trade or business does not qualify for the deduction.  Specified trades and businesses include services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, trading, dealing in securities (including partnership interests or commodities), and any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.  Second, your QBI deduction is limited to the greater of 50% of your share of W-2 wages from the business, or 25% of W-2 wages plus 2.5% of business property.  Third, the deduction is limited to 20% of your personal taxable income minus capital gains.

If your 2019 personal taxable income is between $321,400-$421,400 married filing jointly ($160,700-$210,700 single), the specified service business and wage & property limits discussed above are phased-in.  Your deduction will be partially allowed, subject to the 20% of taxable income minus capital gains limit.

If you think you might qualify for the qualified business income deduction, please contact your L&B professional at 858-558-9200 to discuss.

Does California Conform or Not?

By Closely Held Businesses

While everyone is talking about the changes to federal tax law, what about California? California conforms to certain provisions of the Internal Revenue Code (IRC), and its most recent conformity date is January 1, 2015. After the enactment of the Tax Cuts and Jobs Act (TCJA), what are some of the differences between federal law and California law?

2% Miscellaneous Itemized Deductions

New federal law has eliminated miscellaneous itemized deductions. The most common miscellaneous itemized deductions include investment fees from brokerage accounts, tax preparation fees, and unreimbursed employee expenses. California does not conform to this federal law, and continues to allow these deductions.

Section 199A Deduction

The Section 199A deduction is a new 20-percent deduction of certain businesses’ qualified business income (QBI) and is taken on an individual’s or trust’s tax return. Most QBI is reported on a taxpayer’s schedule C where they report business income or schedule E, which reports rental income and income from K-1s. Individuals may be eligible to take this deduction regardless of whether they itemize deductions reported on schedule A or take the standard deduction (Note: The standard deduction increased significantly under the new tax law). However, this is only a federal deduction for those that qualify. California does not conform to Section 199A, and therefore the 20-percent QBI deduction cannot be taken against California income.

Section 179 Expense

Under IRC section 179, businesses that purchase qualifying equipment are typically able to write off the entire amount of that purchase in the year of acquisition. The TCJA provides an increase to the maximum section 179 expense amount from $500,000 to $1 million, subject to limitations if you put large amounts of qualifying assets into service. The new law also allows non-residential real property such as roofs, HVAC, fire protection and alarm systems, and security systems that are placed in service after December 31, 2017 to be eligible for the deduction.

California does not conform to the changes to section 179. Instead, California allows a corporate or personal taxpayer to deduct up to $25,000. It is important to be aware of these differences when doing year-end tax planning.

Bonus Depreciation

The TCJA provides a 100 percent first-year depreciation deduction, an increase from 50 percent under prior law, for certain property placed in service after September 27, 2017. This provision also modifies the type of property that qualifies for this deduction to include the purchases of used equipment, so long as it was purchased in an arm’s-length transaction.

California does not conform to the rules regarding bonus depreciation.  Instead, California depreciation is generally deducted under regular tax depreciation methods, or accelerated under section 179 up to $25,000 as discussed above.

Like-Kind Exchanges (Section 1031)

Under IRC section 1031, no taxable gain or loss is recognized if qualifying property held in a business or investment is exchanged solely for similar (“like kind”) property.  Before the TCJA, section 1031 could be used to defer tax on exchanges of many types of business & investment property.  These include real estate (buildings and land), furniture, fixtures, equipment, vehicles, trademarks, patents, and copyrights, among others.  The TCJA restricted the use of section 1031 to real estate only for federal tax purposes, effective January 1, 2018.

California does not conform for the 2018 tax year.  Therefore like-kind exchanges completed in 2018 are not limited to real estate for California tax purposes, regardless of income level.

However, California does conform on exchanges completed after January 10, 2019, subject to income thresholds.  Starting January 10, 2019, section 1031 conformity applies, and therefore is limited to real estate only, when adjusted gross income is more than $250,000 for single taxpayers ($500,000 married filing jointly).

If you have any questions regarding these differences or any other tax matters, please do not hesitate to contact your L&B professional at (858) 558-9200.

Understanding the Basics of Basis

By Closely Held Businesses

If you own any investment, you’ve likely heard the word basis. It can be a complicated concept, but it boils down to one simple idea, namely what your economic interest is in an investment. For example, if you purchase stock in a C Corporation for $10 and later sell that stock for $15, your basis is the original $10, which brings the recognized gain to $5. This example helps to illustrate the overall concept of basis. However, it becomes muddied with more complicated investment structures.

Partnerships:

There are two distinct concepts of basis that apply to partnerships and their partners. First, the partnership has an adjusted basis in its assets. This basis is sometimes referred to as “inside basis.” Second, each partner has an adjusted basis in its partnership interest. This basis is sometimes referred to as “outside basis.” The amount of a partner’s adjusted basis in its partnership interest is significant in several circumstances, including the determination of the amount of gain or loss recognized by the partner upon a distribution of property by the partnership, the deductibility of partnership losses by the partner, and the determination of gain or loss on the sale or exchange of the partnership interest. The calculation of a partner’s outside basis is done by adding and subtracting certain items.

Common items that increase a partner’s outside basis are:

  • Any contribution of cash, property, or services
  • The increased share of partnership liabilities in the year
  • Any recognition of income, including tax exempt income

Common items that decrease a partner’s outside basis are:

  • Any distribution of cash or property
  • The decreased share of partnership liabilities in the year
  • Any recognition of losses or deductions, including nondeductible expenses

The new instructions for 2018 Form 1065 institute a new requirement for the disclosure of each partner’s tax basis capital account. The requirement applies if the partnership reports on a basis other than tax (shown on Part II Line L of the K-1) and the tax basis capital would be negative either at the beginning or ending of the current tax year. If any of these situations apply, the partnership is required to disclose the beginning and ending tax basis capital for the current reporting tax year on each partner’s Schedule K-1 under box 20, line AH. Tax basis capital is defined a little differently from above, calculated as the addition of all contributions to the partnership, less any distributions, plus all taxable and tax-exempt income, less taxable losses and nondeductible expenses. The new requirement means that many partnerships will now need to calculate the tax basis capital accounts of all the partners going back to inception, which can be a very time-consuming process for 2018.

S Corporations:

A shareholder’s basis in an S Corporation is based on the same basic concepts as a partnership, with a caveat in the treatment of liabilities. A partnership, as described above, takes the partnership’s liabilities into account when determining outside basis. An S Corporation, on the other hand, does not consider labilities of the corporation as a part of basis. Only loans directly from a shareholder to the corporation are included in the shareholder’s basis.

The new instructions for 2018 Form 1040 Schedule E require S-Corporation shareholders to attach a tax basis calculation if any of the following events occurs: the shareholder reports a loss from the corporation, disposes of stock, or receives a loan repayment or distribution. This calculation is done on a worksheet which will take into account all of the taxable income, losses, contributions, distributions, and loans. This also will need to be calculated from inception of the S Corporation.

Basis can be complicated both in theory and in practice, but understanding the basics can be very helpful in knowing when analysis must be done, especially in the wake of new tax law. If you have any questions regarding these concepts or any other tax matters, please do not hesitate to contact your L&B professional at (858) 558-9200.

Business Accounting 101

By Closely Held Businesses

Properly accounting for your business activities can be just as confusing as it is important. The financial statements that you provide to us each year serve as our map to completing your business tax returns. Read on for tips on what to look out for in preparing financial statements to help us streamline the preparation of your returns.

The financials provided for your business are our starting point and main resource in the preparation of your business tax returns. Accurate, detailed financial statements will result in a more accurate and efficiently produced tax return. Below are some common pitfalls we find on business financials and how to avoid them.

Not Enough Accounts
The income and expenses on your profit and loss statement should be broken out into clearly labeled accounts.

Pitfall: Having one generic account such as “Business Expenses” which contains several different types of expenses including taxes, insurance, rents, repairs, supplies, and reimbursements.
Improvement: Create separate accounts for each different type of expense, similar those listed above, for a better overall picture of your business.

Too Many Accounts
On the other hand, creating too many accounts can lead to overly-complicated financials. It will be more difficult for you to understand how your business is doing and will take us more time to organize your accounts for tax return purposes.

Pitfall: A business with multiple business activities or locations may be tempted to create individual accounts for each activity and each type of income or expense.
Improvement: Try using the classification field in your accounting software to specify which business activity each income or expense item is related to. For example, repairs from activities A and B will both be recorded to the same ‘Repairs’ account. Simply include “Activity A” or “Activity B” in the classification field. This will allow you to produce clear financial statements while maintaining the ability to run reports showing the detail of either activity.

Capital Assets
One of the most common analyses we do when preparing your business tax return is determining whether a purchase should be capitalized or expensed. If there are material transactions on your financials for items such as supplies, furniture, equipment, or payments for repairs, it is likely that more information will be needed. This most commonly applies to transactions over the $2,500 de minimis expensing safe harbor.

Pitfall: Recording a transaction over $2,500 with the memo ‘Supplies/Equipment’ or no memo at all.
Improvement: In your memo, include specific details regarding the type of equipment purchased, purpose of any repairs, and whether the transaction was for multiple items below the capitalization threshold. Proactively providing these details can prevent unnecessary follow-up questions, saving time for everyone.

Meals & Entertainment
The recent tax reform act included a number of changes to the deductibility of expenses for meals and entertainment. Updating your financials to include classifications for each of these expenses will enable us to properly calculate your deduction.

Pitfall: Recording transactions to a singular “Meals & Entertainment” account without a memo or classification.
Improvement: Begin using the following classifications for these expenses: Office Parties, Client Entertainment, Client Meals, Employee Entertainment, Employee Meals, and Employer Convenience.

For more information on how to determine the proper classification and tax implications of meals and entertainment please see our past article which can be found here.

Reconciling Accounts
It is important to confirm that your financial statements accurately reflect all assets and activity by preparing a reconciliation of your bank accounts.

Pitfall: Waiting until the end of the year to reconcile your accounts and having to search for any discrepancies throughout a year’s worth of activity.
Improvement: Reconcile your cash accounts to the bank statements at the close of each month to ensure that any mistakes are caught and corrected.

Accounting for your business activities can be complicated but avoiding these common pitfalls is a great start to creating accurate and informative financial statements. This will help ensure the smooth preparation of your returns, and will leave you with more reliable records of your business activities. If you are considering implementing any of the above methodologies, please contact your L&B professional at 858-558-9200.

Starting a Business? Make Sure You Stay Compliant Once You’ve Cut the Ribbon.

By Closely Held Businesses

Starting a new business is exciting, but understanding what comes next and staying on top of your “regulatory to-do list” can be challenging. Read on for a sample checklist and description of each task you should be aware of to remain in compliance with federal and state laws.

Starting a new business isn’t as simple as coming up with an idea, name, and logo. Depending on your choice of entity (sole proprietorship, limited liability company, partnership, C corporation, or S corporation), each state has different requirements to begin and continue conducting business. In this article, we focus on California’s requirements.  If you are interested in setting up a business in another state, please contact our office and we will be happy to assist you.

  1. Draft your operating agreement – Whether or not you will be in business alone or with other partners/investors, it is important to have an operating agreement that will define and govern your business activities. This agreement must be tailored to your particular business and entity type, so it is a good idea to consult an attorney to help you draft this document. The same attorney will be a helpful resource as you navigate the law when operating your business.
  2. Obtain an EIN (Employer Identification Number) – An EIN is the unique identifying number (similar to an individual’s social security number) that you will use to conduct business. It is the number that will be associated with any bank accounts or credit cards that you open for the business, and it will also be used on any federal tax forms that you file. An EIN can be obtained online here or by filing Form SS-4.
  3. Register with the California Secretary of State (SOS) – To operate a business in California, you must register with the SOS. You will file different forms depending on your type of entity. A list of these forms can be found by visiting the Secretary of State’s website here. Once registered, the SOS will provide you with an entity number (similar to an EIN but for use in CA only). Once that number is received, you have 90 days to file a Statement of Information which outlines the entity’s address, officers/members, agent for service of process, and type of business activity the entity conducts. This statement is then filed either annually or biannually depending on the entity type.
  4. Apply for a Business Tax Certificate – Many cities require a business tax certificate or business license to conduct business activity. A business planning to operate in the City of San Diego can register for a Business Tax Certificate  here.
  5. Pay any initial filing fees or estimated taxes – Business entity types, except for C corporations, are generally considered “pass-through entities.” This means that the income and deductions generated by the business are passed through to the owners who will pay the federal and state income tax associated with that business on their individual returns. Unfortunately, that doesn’t mean that the entity is exempt from all taxes. California imposes a minimum $800 franchise tax on most forms of business entities. Depending on how much income the business makes, the tax can increase significantly. Consult with your tax advisor regarding payment requirements and due dates.
  6. If you are going to be hiring employees, register with the Employment Development Department (EDD) – To pay employees and file payroll tax forms, you must be registered with the EDD. Depending on how many employees you have, your tax advisor may be able to help with this. Otherwise, there are numerous payroll service providers that can manage your payroll and related compliance.
  7. If you are going to be selling a product that will be subject to sales tax, register with the California Department of Tax and Fee Administration (CDTFA) – This is the division of the CA government where you will remit sales tax collected from customers. This is also how you will obtain a Seller’s Permit (or other licenses you may need) to conduct your business activity. Depending on your level of sales, you may be required to remit the sales tax collected annually, quarterly, or monthly. We recommend consulting with your tax advisor regarding your specific due dates.
  8. If you expect to acquire more than $100,000 in non-real estate business property, alert your County Assessor that you have begun conducting business – notifying the Assessor will ensure that you are sent Form 571-L to declare your assessable business property. We recommend that you contact your County Assessor to determine if there is a form to file, or if a simple letter will suffice.
  9. Consult with your tax advisor – Once your business is up and running, it is important to stay in frequent communication with your tax advisor regarding your business activities so that they can help you remain compliant throughout the years. Different tax forms are due at different times of the year and missing the deadlines could subject your business to hefty fines and penalties.

Starting a business can be an exciting but scary endeavor!  Be sure to contact our office at (858) 558-9200 if you have any questions about the tax or financial aspects of setting up and maintaining your investment.

Depreciation Recapture Madness

By Closely Held Businesses

Depreciation is a powerful tax deduction.  For personal property used in a business—think equipment, computers, furniture, machinery etc.—current tax law allows for depreciation to be claimed at a very accelerated pace.  In many cases 100% of an asset’s cost can be depreciated in the year of purchase.  For real property used in a business or investment, depreciation can reduce your tax bill even if the real estate value increases! However, the depreciation that reduces your tax bill today may increase your tax liability in the future.  This drawback, called “depreciation recapture,” is worth understanding and planning for.

Business assets held longer than a year generally must be capitalized in the year the asset is placed in service.  Rather than claiming an immediate expense on the income statement, capitalizing moves the asset to the balance sheet, from where it is expensed over time using depreciation.

Accumulated depreciation increases as depreciation expense is claimed each year.  As a result, the asset’s carrying value—cost less accumulated depreciation—decreases over time.  And as an asset’s carrying value decreases, its taxable gain upon sale increases.  In its basic form, taxable gain equals sale proceeds minus the asset’s tax carrying value (i.e. tax basis).

The tricky part about depreciation is that when the asset is sold at a gain, “depreciation recapture” can kick in.  Depreciation recapture generally refers to the portion of gain caused by accumulated depreciation.  The disadvantage is that depreciation recapture is taxed at higher rates than normal capital gains.

When personal property is sold, depreciation recapture is recognized to the extent of accumulated depreciation or total gain, whichever is less.  This is referred to as Sec. 1245 recapture, based on the applicable tax code section.  Gain in excess of accumulated depreciation is generally subject to the more favorable capital gains rates under Sec. 1231.

Real property is treated a little differently.  When straight-line depreciation is used, frequently the case with real estate, gain from straight-line depreciation is treated as “unrecaptured” Sec. 1250 gain.  When accelerated depreciation is used for real property—for example bonus depreciation taken on qualified improvement property—only the difference between accelerated and straight-line depreciation is subject to depreciation recapture.  And as with personal property, gain in excess of accumulated depreciation is subject to capital gains rates under Sec. 1231.

Depreciation recapture is taxed at ordinary rates, a maximum 37% for most business types (non-C corporations).  Unrecaptured Sec. 1250 gain is taxed at a maximum 25% rate.  Capital gains are taxed at a maximum 20% rate.  Therefore strategies to characterize gain as capital gain, rather than depreciation recapture, should be considered.

Cost of Real Property $100,000
Total Accumulated Depreciation $15,000
Depreciation Deducted Under an Accelerated Method Exceeding Straight-line Method $5,000
Sale Price $120,000
Adjusted Cost Basis (Original Cost Less Depreciation) $85,000
Total Gain Realized $35,000
Depreciation Recapture – 37% max ordinary rate (non-C corporation assets) $5,000
Unrecaptured Depreciation – 25% max capital gains rate $10,000
Capital Gain – 20% max capital gains rate $20,000

These are just the basics, as the rules in this area can be complex depending on your situation.  If you are considering selling business assets, please contact your L&B professional (858) 558-9200 with any questions.

 

SafeSend - a safe and easy solution for your tax engagements! Learn More >>
+