When starting a business, one of the most important decisions you’ll need to make is choosing the right tax structure. Two common options for entities are S Corporations (S Corps) and C Corporations (C Corps). Understanding the differences between these tax structures is crucial as it can have a significant impact on your business’s tax liability and overall financial health. In this article, we will provide a comprehensive analysis of S Corp and C Corp tax structures to help you make an informed decision for your business.

 Factors to Consider: Evaluating the Right Tax Structure

Before diving into the specifics of S Corp and C Corp tax structures, it is essential to evaluate the factors that should be considered when choosing the right tax structure for your business. One of the key factors is the number of shareholders your business will have. S Corps have a limitation of 100 shareholders, while C Corps have no such restrictions. Additionally, if you plan to raise capital through venture capitalists or public offerings, a C Corp may be more suitable due to its flexibility in issuing different classes of stock.

Another crucial factor is the treatment of profits and losses. S Corps are pass-through entities, meaning that profits and losses are passed through to the shareholders’ personal tax returns. This can be advantageous as it avoids double taxation. On the other hand, C Corps are subject to double taxation, where the corporation is taxed on its profits, and shareholders are taxed on any dividends received.

Additionally, the ability to deduct certain expenses can vary between S Corps and C Corps. While both structures allow for ordinary and necessary business expenses, C Corps may have more flexibility in deducting fringe benefits such as health insurance premiums and retirement plan contributions.

 Comparative Analysis: S Corp vs. C Corp Election for Entities 

Now let’s delve into a comparative analysis of S Corp and C Corp tax structures. As mentioned earlier, S Corps are pass-through entities, meaning they are not subject to federal income tax at the corporate level. Instead, profits and losses are passed through to shareholders, who report them on their individual tax returns. This can be beneficial for small businesses as it avoids the double taxation that C Corps face.

C Corps, on the other hand, are separate taxable entities. They are subject to federal income tax at the corporate level, and any dividends distributed to shareholders are also taxed at the individual level. While this may seem like a disadvantage, C Corps have the advantage of being able to retain earnings within the corporation, allowing for potential reinvestment and growth.

Another important consideration is the flexibility in ownership and shareholder requirements. S Corps have restrictions on the number and type of shareholders, limiting the potential for outside investment. C Corps, on the other hand, have no such limitations, making them more attractive for businesses seeking significant capital investments.

 Conclusion: Making an Informed Decision for Your Business 

Choosing the right tax structure for your business is a critical decision that can have long-term implications on your financial success. By understanding the differences between S Corp and C Corp tax structures, you can make an informed decision that aligns with your business goals and objectives.

If your business is small and you anticipate having a limited number of shareholders, an S Corp may be a suitable choice. The pass-through taxation and avoidance of double taxation can provide tax advantages. However, if you plan to raise capital through venture capitalists or public offerings, or if you anticipate significant growth and want to retain earnings within the corporation, a C Corp may be the better option.

Ultimately, it is crucial to consult with a tax professional or an attorney who specializes in business taxation to evaluate your specific circumstances and make the best decision for your business. By carefully considering the factors discussed in this article, you can choose the right tax structure that will optimize your business’s financial success.

Annual Exclusion for Gifts: Under U.S. law, each individual is permitted to make gifts up to a certain amount per recipient per year, free of gift tax. As of 2021, this annual exclusion amount is $15,000 per recipient or $30,000 per recipient for gifts made jointly by a married couple. It is thus possible to reduce the size of one’s taxable estate gradually, without incurring any gift tax liability. Gifts that exceed these amounts will count against one’s lifetime exemption.

If a taxpayer gifts properties which value is lower than the life time exemption, he/she can refer to the article “Tax Consequences for Gifting Properties – Gift Tax and Income Tax”

Unified Federal Gift and Estate Tax Exemption: This represents the total amount that an individual can gift during their lifetime or bequeath upon their death without incurring federal gift or estate tax. As of 2021, the unified exemption amount is $11.7 million per individual or $23.4 million for a married couple. This provision enables substantial wealth to be transferred tax-free.

Unlimited Marital Deduction: Transfers of assets between spouses, whether made during one’s lifetime or at death, are generally exempt from federal gift and estate tax under the unlimited marital deduction. The assets transferred to the surviving spouse will, however, be included in their taxable estate.

Life Insurance Proceeds: Life insurance can provide liquidity to an estate for the payment of any estate tax and other expenses upon death. Beneficiaries typically do not have to pay income tax on life insurance proceeds. However, if the policy is owned by the decedent, the proceeds will be included in their taxable estate for estate tax purposes. To avoid this, the policy can be structured under an Irrevocable Life Insurance Trust (ILIT), thus excluding the proceeds from the decedent’s taxable estate.

Use of Trusts: Various types of trusts can be established for the management and protection of assets, provision for beneficiaries, and minimization of taxes.

• Bypass Trusts (or AB Trusts or Credit Shelter Trusts): These allow married couples to fully utilize their individual estate tax exemptions. When one spouse dies, a portion of their estate (up to the exemption amount) funds the Bypass Trust. The remainder of the estate transfers to the surviving spouse, exempt from tax under the unlimited marital deduction.

• Irrevocable Life Insurance Trusts (ILITs): These can own a life insurance policy on the life of the grantor. The death benefit from the policy is excluded from the grantor’s estate and can be used to provide estate liquidity or income to beneficiaries.

• Dynasty Trusts: These allow wealth to be passed down across multiple generations while minimizing estate taxes.  Dynasty Trust takes advantage of the Generation-Skipping Transfer Tax (GSTT) exemption, which allows assets to pass to skip-person beneficiaries (typically grandchildren or more remote descendants) without incurring additional estate or gift tax. As of 2021, the GSTT exemption amount is the same as the federal estate tax exemption ($11.7 million per individual).

Charitable Donations: Assets donated to qualifying charities are deducted from the taxable estate, reducing its size. Moreover, these charitable contributions can be claimed as deductions on the individual’s income tax return if they itemize deductions.

Family Business Exemptions: Special provisions under the Internal Revenue Code may allow the deferral of estate taxes or the installment payment of such taxes over an extended period for qualified, closely-held family businesses.  If a large portion of an estate consists of a family-owned business, the heirs may have the option to defer estate taxes, pay the tax in installments over a period of up to 14 years, or qualify for a special use valuation to decrease the taxable value of the business. However, these options are subject to complex rules and not all businesses qualify.

Limited Partnership is one of important methods to lower gift tax and estate tax for generations.  

What is Limited Partnership? ”A California LP may provide limited liability for some partners. There must be at least one general partner that acts as the controlling partner and one limited partner whose liability is normally limited to the amount of control or participation of the limited partner. General partners of an LP have unlimited personal liability for the LP’s debts and obligation”

 I will have a separate post on why limited partnership can be used in estate planning as a method to lower potential gift and estate tax burdens

In conclusion, the strategic transfer of assets to heirs while minimizing tax liability is an intricate process that demands careful planning. Techniques such as lifetime gifting, strategic use of federal estate and gift tax exemptions, utilizing trusts, making charitable donations, and employing family business exemptions, when used effectively, can substantially reduce the estate’s tax burden.

References

Starting a Business – Entity Types

https://www.sos.ca.gov/business-programs/business-entities/starting-business/types

In previous post part 1, I’ve talked about when a person collects Social Security earlier than his/her full retirement age which is from 65 to 67, depending on the year of birth, he/she will get a reduction in benefits up 30%. In addition, if the person who is younger than full retirement age works while collecting the benefits, $1 in benefits will be withheld for every $2 or $3 he/she earns above the maximum earnings limit.

Care should be taken to avoid unnecessarily increasing the amount of Social Security benefits subject to tax

Tax Computation for Social Security Benefits

If social security benefit is only the source of income, most likely the taxpayer doesn’t have to pay income tax on any portion of social security benefits. In addition, the taxpayer may not even have to file the tax return in this situation.

However, if the taxpayer has other income, he/she may be required to file the tax return. Moreover, depending on income level, the maximum of 85% of social security benefits to be included in the adjusted gross income for tax purpose.

Head of Household (HOH), Qualified Widower (QW), Married Filing Separate (MFS)

* MFS (and lived with spouse at any time during the year): Base Income is $0 and up to 85% of the benefit will be taxable

Computation

The taxable portion of Social Security benefits is taxed as ordinary income on Form 1040. In general, depending on the income levels, a tax payer’s social security benefit can be 0%, 50% or 85% taxable income depending on the provisional income. I just want to clarify that it’s not 50% or 85% tax on the social security benefits but 50% or 85% of the benefit will be added to total taxable income for income tax. It means that the taxable portion of the social security benefits will never exceed 85% of the total benefits. The math formula to determine how much of the social security benefits will be added into adjusted gross income for tax purpose is rather complicated; so I won’t show the calculation in this post.

Provisional Income

Provisional Income is calculated to determine the percent of social security benefit to be taxable

• 1/2 of social security benefits (Box 5 from SSA-1099 and RRB-1099 form) (1)

• Total taxable income (excluding social security benefits), such as pensions, wages, interest, ordinary dividends, and capital gain distributions. Do not reduce income by any deductions, exclusions, or exemptions (2)

• Tax-exempt interest income such as interest on municipal bonds (3)

Provisional income = (1) + (2) + (3)

The provisional income is now to compare with the base income in the above table to determine the percent of the benefit to be taxable income. So now, let’s go through few examples to understand the computation.

Example 1

Michael who is 65 years old files tax using Single filing status with standard deduction. His income includes taxable 401k distribution of $14,000 and social security benefits of $20,000. Michael’s provisional income for 2020 is calculated as below:

401k distribution: = $14,000

1/2 of social security benefit: $20,000/2 = $10,000

Provisional income = $14,000 + $10,000 = $24,000 which is lower than the base income of $25,000 for single filing status. So, all of his $20,000 social security benefit is not taxable

Because Michel’s social security benefit is not taxable, Michael’s income includes only 401k distribution of $14,000. Therefore, the taxable income after standard deduction is $1,600 ($14,000 – $12,400). Federal tax is $161 and if Michael is California resident, there’s also $0 CA tax with this income.

Example 2

Same example 1 except that Michael decided to distribute another $20,000 from 401k to purchase a new car. The provisional income now is calculated as:

401k distribution ($14,000 + $20,000) = $34,000

1/2 of social security benefit: $20,000/2 = $10,000

Provisional income = $34,000 + $10,000 = $44,000 which is higher than the base income of $25,000 for single filing status. So, $13,000 (the calculation is not shown here) of social security benefit will be taxable

• Income Tax Calculation

  • 401k distribution ($14,000 + $20,000) = $34,000

  • Taxable Social Security benefit = $13,000

  • Adjusted Gross Income (AGI) = ($29,000 + $8,750) = $47,000

  • Standard Deduction = ($12,400)

  • Taxable Income ($37,750 – $12,400) = $34,600

  • Tax = $3,958

  • CA tax = $539

Compared to example 1, $20,000 increase in income results in an addition of $4,336 in tax ($3,958 federal tax + $539 CA tax – $161 federal tax from the example 1)

Example 3

Same as the example 2; however, if Michael takes out a car loan of $20,000 rather than take an additional $20,000 of 401k distribution, his provision income won’t change from the example 1. Therefore, none of his $20,000 social security benefit is taxable. Michael’s federal tax is still $161 and $0 CA tax.

State Taxes impact

In addition to federal taxes, some states levy on Social Security benefits. State tax is also important as it impacts the take home benefits. Depending on the states where a taxpayer lives, some states don’t collect income tax or don’t consider social security income into tax consideration. However, some states comply with federal which taxes up to 85% of benefits while others tax on social security benefits and having some tax breaks based on ages and income level.

At the time of this article, most states don’t tax social security benefits. However, these below states tax on social security benefits. Please check with local tax professionals for state tax planning.

Colorado, Connecticut, Kansas, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont, West Virginia.

Tax Planning for Social Security Benefits

In order to minimize the taxable amount, care should be taken to avoid unnecessarily increasing the amount of Social Security benefits subject to tax. Few recommendation for different types of investment to reduce tax and improve the bottom line.

Dividend paying stocks.

Dividend paying stocks usually pay qualified dividends which have a maximum of 20% tax rate rather than at ordinary tax rates (maximum of 39%). The income from dividends won’t change the taxable portion of the social security benefits but it will bring lower tax on the same amount of total income.

Investments that produce capital gains.

Invest into real estate or stock/mutual funds which produce capital gains. If the taxpayer does not need current income, he or she may realize current year tax savings and defer taxes until the assets are sold. In addition, when the taxpayer sells the asset, he or she will pay taxes at the capital gains tax rate (maximum of 20% for long term capital gain for assets being hold for more than 1 year) versus the ordinary income tax rate (a maximum of 39%). By investing in assets that produce capital gains, taxpayers can lower the overall tax and control when to sell assets to optimize tax savings.

Non-qualified annuities

Non-qualified annuities are backed by the assets of the insurance company. Many states regulate insurance companies that offer annuity contracts which guarantee principal; states also require insurance companies to maintain certain funding levels to help prevent them from defaulting on the investment. So non-qualified annuities can guarantee principal and reduce overall taxes until the investment is distributed.

References

• Retirement Benefits

  • https://www.ssa.gov/benefits/retirement/

The GIFT

Kevin bought a home 10 years ago with his daughter, Rachel for $900,000, each person has 50% ownership on the home. Kevin now wants to gift his 50% ownership which is now worth $750,000 (the house market value is about $1,500,000) to Rachel. The question he has is whether he will end up owing any taxes if he makes the transfer.

The answer is “it depends”

The property has no mortgage

If there’s no mortgage remaining on the home, when Kevin transfers his 50% to Rachel, Kevin is making a gift to Rachel of 50% of the current fair market value at $750,000.

Gift Tax Consequences.

Currently the annual gift tax exemption is $15,000. Kevin is deemed to make a taxable gift of $735,000 ($750,000 – $15,000). Therefore, Kevin would need to file a gift tax return and elect to use $735,000 of his lifetime exemption. For 2021, the estate and lifetime gift tax exemption is $11.7 million per individual. By doing this way allows Kevin to transfer his ownership to his daughter without incurring any current tax liability and $735,000 will be deducted from his lifetime gift tax exemption.

Income Tax Consequences

In the future when Rachel sells the property, she may be subject to income taxes on the difference between the sale price and her basis in the property. However, Rachel will be eligible for the $250,000 capital gains exclusion at the time of sale.

Donee’s Basis

Since the transfer is a gift, the donee (Rachel) will take Kevin’s basis which is the 1/2 of purchase price ($450,000) and her own basis ($450,000) which is also the 1/2 of purchase price. Rachel’s basis is $900,000 and if she sells the house for $1,500,000, she has to pay the income tax on the gain of $600,000 ($1,500,000 – $900,000) unless she qualifies for $250,000 exemption (lives in the house as her primary residence for 2 years). See How to Minimize Tax on the Sale of Your Primary Residence for more information on how to qualify for $250,000 capital gain exemption.

What happens if the home is encumbered by a mortgage?

In this case, Rachel assumes 1/2 of the mortgage whether she signs the note to the lender or not. Moreover, Kevin is relieved from the portion of debt. As the result, the equity portion is considered as a gift; it is subject to gift tax and the mortgage assumption is considered as a sale.

Let’s use the same example as above except the home has a mortgage of $500,000

Gift Tax

When Kevin transfers 1/2 of his ownership in the property to Rachel, he makes a gift tax of as follows.

• Fair market value of his ownership: $750,000

(Less) 1/2 of the mortgage: $250,000

(Less) $15,000 annual gift tax exemption

Taxable Gift = $485,000

Although the taxable gift is $485,000, Kevin can file the gift tax return and elect to use $485,000 of his lifetime gift exemption to offset the tax liability.

Income tax from the sale part (mortgage assumption by donee)

Besides the gift tax issue, the donor (Kevin) realizes a gain for income tax purposes to the extent that the amount he “earns” in the “sale” exceeds his adjusted basis in the property. However, Kevin does not realize a loss if the amount he earns is less than his adjusted basis in the property.

Kevin’s adjusted basis equals 1/2 purchase price plus 1/2 of home improvement. To make it simple, there is no improvement made to the property. Kevin’s adjusted basis is $450,000 (1/2 of the purchase price). The sale price of his 1/2 ownership is 1/2 of the mortgage which is $250,000. Since Kevin’s basis is higher than the sale price, no loss is realized and no tax liability is incurred.

Donee’s Basis in the property

When a transaction is deemed to be both gift and sale, the basis equals

• (1) the larger of the donor’s basis or the amount paid by the donee for the property plus

• (2) a fractional amount of any gift taxes actually paid by the donor.

Back to the example,

(1) the donor’s (Kevin’s) basis = $450,000

The amount paid by the donee (Rachel) = $250,000

The larger amount of the two = $450,000

The donor didn’t actually paid any gift tax.

So Rachel’s basis in the house = $900,000 ($450,00 of her 1/2 ownership + $450,000 from Kevin’s gift)

Conclusion

Making a gift of property, such a transfer can have real and significant tax consequences. Be Cautious! Check with a Tax lawyer or Tax professional before making any property transfer to minimize the tax impact.

Social Security Benefits Introduction

Before deciding at what age a taxpayer should start collecting social benefits, taxpayers should understand the benefits differences between collecting the benefits at the age 62 and 70. This post shows how to calculate the benefits for the worker and his/her spouse and benefits for widower and children.

Most of us may have heard that a person needs a minimum of 10 years of work which equals to 40 credits to be eligible for Social Security retirement benefits.

Social Security benefits are computed by using average indexed monthly earnings up to 35 years of a worker’s earning.  A worker can receive full retirement social security benefits if he/she waits until full-retirement age.  For persons who were born between 1943 and 1954, the full retirement age is 66, at which the age the person is eligible to receive 100% of his/her benefits. See the below table for a full list of birth date and its corresponding full retirement age.

How to calculate the benefits if an individual decides to take the benefits before he/she reaches full retirement age?

Formula

The worker’s retirement benefit will be reduced by 5/9 of one percent for each month before full retirement age for up to 36 months. For each month in excess of 36 months, the benefit is reduced by 5/12 of one percent per month.

A spousal’s benefit is reduced by 25/36 of one percent for each month before full retirement age for up to 36 months. If the number of months exceeds 36, the benefit is further reduced 5/12 of one percent per month.

A worker will receive an 8% per year increase (until age 70) in benefits for every year of Social  Security delayed beyond full retirement age. Delaying the retirement age beyond age 70 will not result in additional benefits.

Spousal Benefits

A spousal insurance benefit is one-half of the worker’s primary insurance amount.

• The spouse is either at least 62 yrs old or disabled in order to qualify for the benefits on the worker’s social security record and the spouse has been married to the worker for at least one continuous year before filing for the application. The benefits will get reduced if the spouse starts collecting the benefit before his/her full-retirement age.

• If the spouse is under 62 yrs old and spouse is responsible for children under 16 or mentally/physically disabled child at age 16 or over.

Examples

Below is an example to illustrate the different amounts of benefits for both a worker and his/her spouse based on the age when the worker starts collecting social security benefits. In this example, the full-retirement age for both worker and his/her spouse is age 67, and the full-benefit is $1,000/month at age 67.

Benefit Calculation

If the worker and spouse start collecting the retirement benefits at age 62 which is 5 years earlier than his/her full-retirement age (67) or 60 months before 67 years old.

Reduction percent (Worker) = 36 x (5/9) + (5/12) x (60 -36) x 1% = 30%

Amount of benefit to receive (Worker) = $1,000 x (100% -30%) = $700/month

Reduction percent (Spouse) = 36 x (25/36) + (5/12) x (60 – 36) x 1% = 35%

Amount of benefit to receive (Spouse) = ($1,000 x (100% – 35%))/2 = $325/month ( Spousal benefit equals 50% of the worker benefit)

From the above table, spousal benefits will not increase even if the spouse delays collecting his/her spousal benefit. Moreover, the worker won’t get any additional benefits if he/she delayed collecting his/her benefit beyond age 70. Therefore, DO NOT delay collecting your social security benefits beyond age 70 and spouse should start collecting his/her spousal benefit at 67 to get the full benefits.

Can a divorced spouse be eligible for spousal social security benefits?

The good news is if an individual is divorced and if the previous marriage lasted 10 years or longer, he/she is still eligible for spousal benefits on his/her ex-spouse’s record (Regardless whether the ex-spouse remarries or not) as long as the individual meets following conditions:

• The individual is unmarried.  If the individual remarries, he/she may not be eligible to collect benefits on the former spouse’s record (some exceptions) unless the later marriage ends.

• The divorced spouse is 62 years old or more.

• Worker is qualified for the benefits and marriage has ended for at least two years.

If the divorced spouse is eligible for his/her own benefits and spousal benefits, the individual will get the higher amount of both benefits. Remarriage before age 50 may end the benefits unless the subsequent marriage ends.

A divorced spouse receives 50% of the ex-spouse’s full-retirement amount. And that does NOT effect the benefits of the worker or his/her current spouse benefits.

Widower (Surviving Spouse) Social Security Benefits

A widower can claim benefits on a worker’s Social Security Record if he/she meets the following conditions:

• The widower is age 60 or more.

• The surviving spouse is between 50 and 60 years old and disabled.

• The widower is not married.

• The surviving souse was married to the worker for at least 9 months before the worker died.

What will happen if the widower or the surviving divorced spouse remarries?

 Surviving spouse can claim benefits if he/she meets one of the following:

• Remarriage after age 60.

• Surviving divorced spouse or widower is at least 50 yrs old and is disabled prior to the remarriage.

How much social security benefits will a widower receive?

The widower receives 100% of the deceased worker’s benefits, and in addition to any of the worker’s delayed benefits.  However, the widower’s benefit will be reduced depending on the family’s maximum benefits.

How about the social security benefits for children?

An unmarried child can get up to half of the parent’s full benefits or 75% of the deceased parent’s benefits which is subjected to family maximum if he/she is:

• Younger than age 18.

• Age 18-19 and a full-time student (no higher than grade 12).

• 18 or older with a disability that began before age 22.

Other things to consider for Social Security Benefits

If a person begins to receive Social Security benefits before full retirement age, $1 in benefits will be withheld for every $2 the taxpayer earns above the maximum earnings limit. For 2021, the maximum earnings limit is $18,960. This earnings limit applies to earned income such as W-2 wages and self-employment income. It does not apply to investment income such as interest,  dividends,  and pension benefits.

If a person begins to receive Social Security benefits before full retirement age,  $1  in benefits is withheld for every $3 the taxpayer earns above the maximum earnings limit for the year the taxpayer turns full retirement age. The limit only applies to earnings for months prior to attaining full retirement age. For 2021, the maximum earnings limit for the year of full retirement is $50,520

A worker can keep all social security benefits regardless of how much they earn when they reach full retirement age. Therefore, it’s also important to pick the time to collect retirement benefits. I will discuss about tax impact and tax planning for social security benefits in the follow-up POST.

References

• Retirement Benefits

https://www.ssa.gov/benefits/retirement/

With the work-from-home policy becoming popular, more and more people move from one state to other states. Some move and settle with a new state; however, others just move temporarily to other states and move back after COVID-19. Moving permanently to a new state has a different state tax impact from temporary move to other states.

Just recall income tax-free states are:

• Alaska

• Florida

• Nevada

• New Hampshire

• South Dakota

• Texas

• Washington

• Wyoming

If the taxpayer just temporarily moves to different state for remote work and intends to go back to the resident state, he/she can check out my post
Where Do You Pay Tax if You Reside in One State and Work from Other States?

Establish domicile to avoid double taxes.

The first thing to move permanently to a new state is to establish domicile if the taxpayer wants to escape from state having a higher state tax. Each state has a different definition of domicile. In general, domicile is the taxpayer’s permanent location. In addition, domicile is the place where the taxpayer plans to return after a period of residing elsewhere.

Once the domicile location is settled, the domiciled state becomes the resident state; taxpayers can start paying the lower state tax. However, during the period of transitioning from one state to another state, both old and new states may claim the taxpayer state tax. Therefore, establishing the domicile to the new state is an important task.  The more evidence showing a taxpayer establishes domicile to the new state, the better chance for shortening the transition period. During transition period, the taxpayer may pay double taxes despite of some credits back from one to another state tax.

Ways to establish the domicile to the new state

• Buy or lease a home in the new state

• Sell the home in the old state. If the taxpayer doesn’t want to sell the home, be sure to rent it out at market rates to an unrelated party.

• Get a driver’s license and register vehicles in the new state. Register to vote in the new state.

• Enroll kids to the new state school system.

• Change mailing address with the U.S. Postal Service to the new state

• Change address on passports, insurance policies, will or living trust documents, and other important documents.

• Open and use bank accounts in the new state and close bank accounts in the old state. If the taxpayer doesn’t want to close bank accounts in the old state, he/she also needs to change the address to the new state.

When a taxpayer successfully establishes the new resident state, all taxpayer’s income is taxable by the resident state.

For example: If a taxpayer moves from California to Texas and keeps California bank accounts. Texas is now the taxpayer’s resident state. Because Texas has no income state tax, the taxpayer doesn’t have to pay Texas income tax on the interest and dividend income from California banks. California also doesn’t tax the taxpayer on the interest and dividend income from California banks for the same period.

Considerations

Business income

For business income a taxpayer receives in the old state, the taxpayer may face higher state tax impact. Both states may tax on the same income; so the taxpayer may need to apply for a credit on the new state’s tax return. For example, if the taxpayer receives interest on the accounts receivable in his/her business which operates in California, and he/she now is a permanent resident of North Carolina, the taxpayer may pay tax on the interest on the business accounts receivable to California and apply for a credit on the North Carolina tax.

Tax-exempt state investments from the old state

Tax-exempt state investments in one state may be taxable in another state.  Therefore, a taxpayer should review his/her investment portfolio as a part of the move preparation to avoid a big state tax impact when filling the tax return.  For example, holding tax-exempt California municipal bonds and being a California resident, the taxpayer won’t pay tax on that income including dividend, capital gains, etc.  However, if he/she owns the same California bonds and is Indiana’s permanent resident, he/she must pay Indiana income tax on the income

Retirement income

Most states that collect income tax will also tax your retirement income.  If a taxpayer is receiving retirement income but moves to a new state, the new state can tax the retirement income, but the old state can’t.

Restricted Stock Units (RSUs)

Majority states tax on the income to the extend the taxpayer performed services in the state.  Worst case, both resident and non-resident states may tax on the same income.  Fortunately, to avoid double taxation from state tax impact, the taxpayer will get credits back from one state.

Example 1

If a taxpayer receives an RSU grant in California. The RSU grant is vested when he/she is Washington resident. 

The income attributable to the difference between the fair market value of the stock on the vesting date and the price the taxpayer paid for the stock has a source in California where the taxpayer performed the services.  RSUs are free stock from the corporation; therefore, California will tax the whole amount of market price of the RSUs on the vesting date if 100% taxpayer service performed in California. 

On the other hand, if the taxpayer still works for the same company which grants the RSU and 50% of the service performed in California, the tax paid may be allocated between California and Washington (no income tax for Washington) This amount will show up on the taxpayer W2.  The taxpayer subsequently sold the RSUs, any difference between the market price of the RSUs on the vesting date and the market price on the selling date will become Washington capital gains (no income tax for Washington).

Example 2

Since Washington has no income tax, the taxpayer won’t get into a situation of being taxed twice.  However, for example if it’s Massachusetts rather than Washington, Massachusetts may also tax on the same income that California already taxed because the taxpayer is Massachusetts resident when the RSU is vested.  This causes the double taxation situation; Fortunately, one state will allow a credit against its taxes paid to the other state on this double-taxed income.

Before moving to a new state and start a new life, the taxpayer should find out the state tax laws from the current state and the new state as a part of preparation for the move. Understand the state tax laws can greatly help to minimize the state tax impact especially stocks which are parts of corporation’s benefits.

During COVID-19 period, many employers implement work-from-home policy which becomes more and more popular. Which state tax does a remote employee have to pay if he/she lives in one state and works from other states?

Unless the taxpayer lives in tax-free states, a taxpayer needs to report all income to the resident state tax return regardless where the income is earned. These tax-free states are:

• Alaska

• Florida

• Nevada

• New Hampshire

• South Dakota

• Texas

• Washington

• Wyoming

Let’s look at these few scenarios.  These scenarios are for taxpayers who temporarily move to different states; the taxpayers also have an intention to move back to their resident state. For the state tax impact when moving and settling with a new state, please visit the post: Where Do You Pay Tax if You Reside in One State and Work from Other States?

Employer is located in one State, Employee works remotely from another State

Majority states levy on the income generated in the states where the employee is physically located.  However, there are 7 states (Arkansas, Connecticut, Delaware, Massachusetts, Nebraska, New York, and Pennsylvania) tax remote employees based on where the employer’s office is located.

Example

If an employee lives and works in California for a New Mexico company, California is the employee’s resident state. The employee needs to report all income from the remote work to California. As the time of writing this post, no income should be reported to New Mexico because the employee hasn’t physically worked in New Mexico during the tax year. However, if the employee travels to the head quarter and works, he/she may need to file New Mexico tax return.

Employee resides in one state and remotely works from other state(s)

If the employee earns money in a state where he/she is not a resident, the employee may have to file multiple state tax returns.  The first tax return is filed with the resident state to report income from all states – no matter where the income is earned.  The employee also needs to file the non-resident tax returns to report income earned from the non-resident states.  To avoid double taxation from resident and non-resident states, most resident states provide credits for the tax paid to non-resident states.  However, the credit is only up to the tax paid to the resident state; therefore, if resident state has lower tax rate than that of the non-resident state, the employee will end up paying double-tax on some portions of his/her income.

In general, taxpayers need to file the tax return and pay tax to non-resident states where the taxpayer earns income during the tax year. However, requirements vary from states to states.  Some states like Arizona don’t require employers to withhold tax if the remote employee is in Arizona for less than 60 days; however, remote employees who work in New York for even one day are required to file a tax return.

Example

Same as the above example, the employee resides still resides in California; however, he/she temporarily moves to his/her friend house in Indiana during the pandemic. The employee intends to move back to California when the pandemic is over. In this case, since California is still the employee’s resident state. Therefore he/she needs to report all income which includes income from both California and Indiana to California. The remote employee also needs to report the income earned and pay tax to Indiana for the time he/she physically works from Indiana.   California may give the employee some credits back to offset the tax paid. 

Author’s recommendations

To avoid a big surprise in April, the taxpayer should update the tax withholding by letting the employer know the new locations where he/she remotely works from.  If there is no withholding for non-resident states, the taxpayer may owe tax money; this may cause a big payment and penalty for not withholding.

States have their ways to find out taxpayers who don’t pay taxes if the taxpayers don’t report his/her work location.  States could audit the taxpayer. To find out where the taxpayer generated earned income, states can ask for all bills like utility bills, rental payments, kid school records, etc.

Multi-state tax filling and to get the right offset credits is complex.  Recordkeeping is important especially if the taxpayer work remote in multiple states during the tax year.   Tracking the time that the taxpayer spent in the state and be specific about the location, cities, counties; some counties and cities may levy taxes as well.

What if the taxpayer decides to move permanently to different a different state and remotely work from the new location?  I will have another post for state tax for employees who permanently move to different states.

One way to reduce taxes and build for your future is to put money into retirement accounts. Most people may be familiar with regular retirement accounts like IRA, Roth IRA, and 401(k) . Regular retirement accounts are usually open with financial institutions or banks. Once the account is open, there is a list of mutual funds and stocks that taxpayers can choose to invest in. However, self- directed retirement account is open with a self-directed custodian. For self-directed accounts, taxpayers can invest in almost anything; moreover, the investment decision is up to the taxpayers rather than being restricted with few of mutual funds and stock choices. Self-Directed Retirement Account is one of good strategies to maximize your retirement. I also have a blog post Tax-Efficient Strategies for Investments to Consider; the post provides investment strategies for both pre-tax and post-tax money.

Self-Directed Account Eligibility

In general, almost everyone is eligible for a self-directed retirement account. If a taxpayer is eligible for a traditional IRA or Roth IRA, he/she is eligible for a self-directed IRA or Roth IRA. If a taxpayer has a small business, he/she is eligible to open a SEP-IRA or Solo 401(k). So keep in mind that almost all retirement accounts can be self-directed retirement accounts

When I mentioned about having a small business to be eligible for SEP-IRA or Solo 401(k), it doesn’t mean that taxpayers need to have a legal entity. A home-based business selling a product or service and operating as a sole proprietor could allow the owner to be eligible for these retirement accounts.

What types of investments a self-directed retirement account can invest in?

A self-directed retirement account can invest in almost anything that you can think of. However, there are some exceptions

• S Corporation Stock: IRS tax code for S corporation doesn’t allow a retirement account to be a shareholder of a S corporation. However, a retirement can invest in LCCs, partnerships and C corporations

• Life insurance: In general, a retirement account can’t be on the title or the owner of a life insurance policy; however, it can be a beneficiary of a life insurance policy

• Collectibles: Retirement accounts can’t invest in collectibles except for certain coins and precious metals.

Besides above exceptions, a self-directed retirement accounts can invest in many categories such as real estates, promissory notes, business, cryptocurrency, REITs, etc.

Cautious for retirement investing tax traps

In general, self-directed retirement account is subject to both UBIT (Unrelated Business Income Tax) and UDFI (Unrelated Debt Finance Income) Tax. You read it right, retirement accounts are subject to these 2 tax traps. In addition, later when taxpayers reach the retirement age, distribution is also subject to income tax. To maximize your retirement, strategies to avoid UBIT and UDFI are essential

Unrelated Debt Finance Income Tax (UDFI) and strategies to avoid

UDFI is assessed when a retirement accounts invest in assets that use leverage. In another word, if a retirement accounts have to borrow money to invest, it will be subject to UDFI tax on profit that is related to debt. Most of real-estate investors fall into this category because leverage is a part of the deal for them to get a maximum return on investments. For example, if a retirement account purchases a $1,000,000 rental property. Out of $1,000,000 of the purchase price, $600,000 is the cash down payment and $400,000 is financed with mortgage. In this case, the debt ratio is 40% ($400,000/$1,000,000). If the property has $15,000 income during a particular tax year, 40% of $15,000 may be assessed for UDFI tax.

Strategies to avoid UDFI

• Avoid Debt – consider to invest into assets without any financing

• Partner with another retirement account: Same example as above but if the taxpayer can find another taxpayer to partner with to make the purchase. The partner also use cash in his/her retirement accounts to fund $400,000 to purchase the property. This way there is no leverage on the investment, so the UDI would not apply.

• Use solo 401(k) for investment: one great benefit of solo 401(k) which will be discussed below over other retirement accounts is that IRS allows solo 401(k) to invest into leverage assets without UDFI tax. Please keep in-mind, this only applies to loan incurred with respect to purchase the property. Same example as above, if the taxpayer uses solo 401(k) to purchase the rental property with the debt ratio of 40%, the taxpayer is tax-free from UDFI

Unrelated Business Income Tax (UBIT) and strategies to avoid

This tax is imposed on ordinary income of retirement accounts. So if a taxpayer uses his/her retirement money to open a restaurant, income generated from the restaurant is considered as ordinary income which could be subject to UBIT. However, UBIT is not applicable to investment income (rent, interest, dividends).   This is ideal for real estate investment because rental income, or capital gains from selling real estate properties won’t be subject to UBIT.  Unfortunately, income from flipping a house is ordinary and UBIT might apply.

Strategies to avoid UBIT

• Avoid investing in businesses that generate business income.

• Invest in non-ordinary investments like rental real-estate properties or lending the money out to others to get interest income (be aware of disqualified persons)

• For real-estate investors: Don’t “flip” out as flipping will generate business income which is subject to UBIT. Other options for real-estate investors to consider

  • Rent the property and hold it for long-term

  • Rent the property, then sell the property after 1 year. The gain from the property sold is capital gain, not ordinary gain and escape UBIT.

One of strategies to maximize retirement benefit is not to avoid UBIT. If the return on investments for the ordinary income is higher than UBIT that the taxpayer has to pay, then UBIT may not necessarily be a bad thing. Please check with your tax advisor for more information on UBIT.

Solo 401(k)

Once a taxpayer owns a business, he/she is eligible to open solo 401(k) account which allows they to contribute more to the retirement accounts each year. As mentioned above, a business doesn’t need to be a legal entity; in fact, sole propriety owners can also qualify for solo 401 (k). A solo 401(k) is an individual 401(k) designed for a business owner with no employees. However, if the business has W-2 staff, the business can still maintain solo 401(k) plan if the employee is under 21 or if the employee is over 21 and he/she works under 1,000 hours per year. So if the business owner has few independent contractors worked under, the owner is eligible for solo 401(k). However, it doesn’t mean taxpayers try to make their employees independent contractors which may violate employment rules.

Why Solo 401(k)?

Higher Contribution

Higher contribution limit is one of advantages of solo 401(k) over IRA or Roth IRA. Small business owners with solo 401(k) can contribute $19,500 (2020 tax-year), another $6,500 for catchup contribution for those who are older than 50. This is the same type of 401(k) contribution that almost everyone who works can contribute. In addition, the business can make a contribution into owner’s and spouse’s retirement accounts.

Owner’s spouse can also have the same contributions if the spouse also works for the business. Depending on how much income the spouse earns from business, the spouse may be able to maximize the solo 401(k) contribution. A sole proprietorship can contribute a 20% of the business net profits while it’s 25% of the owner’s W2 receiving from S corporation for S corporation’s case. The total of maximum contribution for each of the owners and their spouse is $57,000 for 2020. Therefore, a married couple can contribute $57,000 x 2 = $114,000 per year.

Other Advantages

Taxpayers can borrow against 401(k) up to the lesser of 50% of the account balance or $50,000. Taxpayers can use the loan amount for any purposes like purchasing a new car or having a vacation. Be sure to have the loan document in place and make loan repayment at least once every quarter which includes principal and interest. The maximum loan period is 5 years.

Another advantage of solo 401(k) over IRA or Roth IRA is that taxpayers have additional time to contribute in solo 401(k). For IRA or Roth IRA, the deadline for contribution is April 15 of the year following the tax year. However, the deadline for solo 401(k) contribution is when the business files the tax return. So if the business files the tax return (with extension) on September 15, the deadline for solo 401(k) contribution is also September 15.

My favorite advantage of solo 401(k) over IRA or Roth IRA is its ability to avoid UDFI tax which was discussed above.

Large deferred tax contribution and avoiding UDFI can make solo 401(k) one of best strategies to maximize retirement benefits

Limitation of investing with retirement accounts

Self-directed retirement accounts provide a lot of flexibility; however, there are some restrictions that taxpayers should understand before making an investment using self-directed retirement accounts

The main idea is that IRS doesn’t want taxpayers to use retirement money to have transactions or business with are disqualified persons such as yourself, your relatives or your business. Therefore, IRS defines a list of disqualified persons and prohibited transactions

Disqualified Persons and Disqualified Transactions

Below is the list of disqualified persons who can’t do the business or transactions with the retirement investment

• Retirement account owner and his/her spouse

• Brother and Sisters

• Aunts and Uncles

• Nephews and Nieces

• Spouse’s Siblings

• In-laws

In addition to the above list, anyone who provides services to the retirement accounts is also disqualified persons such as CPA, lawyer, financial advisor and their employees. Entities which disqualified persons own more than 50% are also disqualified persons

• If a taxpayer invests into a rental property using his/her self-directed retirement accounts, he/she and disqualified persons can’t rent the property nor purchase the property. In addition, if the property needs repairs, he/she can’t repair the property. Someone who is not under disqualified persons list can repair the property; however, the service fees need to be paid from the retirement account. Hint, cousins are not on the disqualified persons list

Please note that it’s not worth to violate the rule because the penalty is large for the violation. For example, if a taxpayer has $200,000 invested in stocks and lends out $50,000 to his/her sister. IRS could close the whole retirement accounts and assess tax/penalties on the whole $250,000. Understanding these restrictions can help taxpayers to avoid disqualified transactions with disqualified persons; hence it helps with strategies to maximize the retirement income

Author’s Recommendations

• Self-directed retirement accounts provide taxpayers investment flexibilities compared to regular retirement accounts. Taxpayers can invest in rental properties, stocks, lend money to others, invest in start-up business, etc. Taxpayers can open self-directed retirement accounts with self-directed custodian; then roll over the retirement money from regular retirement accounts to self-direct retirement accounts. For rolling regular 401(k) to self-directed retirement accounts, you should check with your financial institution and current employer. Taxpayers may not be permitted to rollover a 401(k) with the current employer.

Be aware of UDFI and UBIT which are levied on ordinary income and leveraged assets

• If you own a business, solo 401(k) is the best choice for self-directed retirement accounts; it can void UDFI tax, higher contribution ($114,000 in 2020 for husband and wife who work in the business). If your company has a define benefit plan (not discussed in this post), the contribution is much more. You can borrow a maximum of $50,000 from solo 401(k) for use without any reasons.

Reducing taxes, investment choice flexibility and avoiding UDFI, solo 401(k) is considered one of good strategies to maximize your retirement.

Estimated Tax Rules

Taxpayers have to pay the federal income tax throughout the year either through withholding in W2 or/and estimated tax.  People who are an employee and have multiple sources of income such as stocks, pensions, commission, bonuses, etc. may need to pay tax through both withholding and estimated tax payments. The main point is IRS wants to collect taxes on the go quarterly rather than at once by April of the following year.  On the other hand, if a taxpayer gets a refund from IRS, he/she may also get an interest on the late refund as well.  Therefore, taxpayers are required to make quarterly estimated tax payments, else underpayments will result penalties.  However, underpayment penalties for estimated tax are avoided if taxpayers satisfy one of the following conditions

Small tax liability due

If the tax balance due after federal income tax withholding or estimated tax payments is less than $1,000, no penalties are assessed.

No tax liability for the prior year

A taxpayer can avoid the underpayment penalty if  he/she has no tax liability for the prior tax year. In order to qualify for this condition, the taxpayer was a U.S citizen or resident for the entire year. The taxpayer if required must file the prior-year return for the whole 12-month tax year showing tax liability

Estimated tax payments

Generally,  if the combination of withholding and estimated tax at least 90% of the tax for the current year or 100% (for those with income less than $75,000 or $150,000 for married couples) or 110% (for those with income higher than $75,000 or $150,000 for married couples) of the tax shown on the return for the prior year, whichever is smaller.

 Payment  Income Earned Period  1st Payment  January 1 to March 31  2nd Payment  April 1 to May 31  3rd Payment  June 1 to August 31  4th Payment  September 1 to December 31

The payment due date is usually 15 days after the income earned period.  For example, the 1st payment deadline which income earned period from 01/01 to 03/31 is April 15th.   Specific deadlines vary from year to year.  Please check IRS website for payment due dates

To pay for estimated tax online, taxpayers can open an account with IRS and pay via  https://www.irs.gov/payments

Taxpayer should minimize the estimated tax payments to the amount no greater than required to avoid underpayment penalties.   There are 3 accepted methods of estimated tax payments.  IRS doesn’t require taxpayers to use the same method for each quarter.  Therefore, taxpayers can use whatever methods that yield the minimum required payments each quarter.

100% or 110% prior-year tax

The combination of the tax paid through withholding or/and through estimated payments equal 100% of the prior-year tax for individuals having income less than $75,000 or married couples having income less than $75,000.  However, this combination is increased to 110% for individuals who make more than $75,000 or married couples who make more than $150,000.

90% of current year tax

The tax paid through withholding or/and through estimated tax payments equal 90% of the current-year tax.

Example 1: A & B, a married couple on 20X1 tax return, has AGI (adjusted gross income) in 20X1 is $250,000,  the federal tax is $47,897 (19.16% marginal tax rate).  In 20X2, the couple expects an income of $350,000.   A & B source of income is from W2.  

Since the A&B couple’s income is $250,000 which is higher than $150,000 for married couple, then 110% of the prior-year tax is used for the estimate tax payment.  The estimated tax for 20X2 would $52,687 ($47,897 x 110%).  Quarterly payments would be $13,172 ($52,687/4)

In 20X2, $350,000 income for married couple would most likely result a marginal tax rate at 23.48% or $82,184. If the taxpayers use 90% of current year tax, the estimated tax payment for 20X2 would be  $73,966 ($82,184 x 90%) .  Quarterly payments would be $18,491 ($73,966 /4)

Using 110% of prior-year tax would result a lower estimated payment ($52,687) than that of using 90% of current year tax (at least $82,184, for simplicity the calculation ignore additional Additional Medicare Tax).

Annualization method

Annualization method allows taxpayers to annualize income and estimate the amount of tax payments depending on actual year-to-date income for each quarter of the year.  This method is ideal for those who have unstable flows of income such as bonus, stocks, commission, real estate sale, or people who don’t control over when the income is received. 

Taxpayers pay through withholding and/or timely estimates an amount equal to 90% of the current-year tax computed based on annualization of actual year-to-date income for each quarter of the year.

Step 1: Estimated Taxable Income = (actual income for all the months prior quarterly payment due x 12)/(number of months that represent the income) (1)

Step 2: Calculate Income Tax based on the Estimated Taxable Income from (1)

Step 3: Estimated Tax Payment = 90% x Income Tax 

Examples 2: 

Similar to example 1, A & B, a married couple on 20X1 tax return, has AGI (adjusted gross income) in 20X1 is $250,000,  the federal tax is $47,897 (19.16% marginal tax rate). In 20X2, A & B anticipate that their income will be much less than 20X1 as A quits her job to open her own company, and the new company won’t generate much income.  However, In November, A & B realized a $100,000 short-term capital gain from selling their short-term stocks.  The income break-down is as below

 January 1 to March 31: $48,000

 April 1 to May 31:          $37,000

 June 1 to August 31:     $56,000

September 1 to December 31: $67,000 + $100,000 short-term gain from stocks

Following the above formula to figure out the estimated tax payment using Annualization method                              

 1st Payment  January 1 to March 31 Estimated Taxable Income $48,000 x 12 months/ 3 months = $192,000 Estimated Tax After Standard Deduction ($24,000) $31,657 (16.49% marginal tax rate) 1st quarter estimate payment  $31,657 x 90% /4 = $7,123

 2nd Payment  April 1 to May 31 Estimated Taxable Income ($48,000 +37,000) x 12 months/ 5 months = $204,000 Estimated Tax After Standard Deduction ($24,000) $35,017 (17.16 % marginal tax rate) Estimate Tax per quarter $35,017 x 90% /4 = $7,879 2nd quarter estimate payment $7,879 x 2 – $7,123= $8,635(payments for 2 quarters – amount paid for the 1st quarter)

 3rd Payment  June 1 to August 31 Estimated Taxable Income ($48,000 +$37,000 + $56,000) x 12 months/ 8 months = $211,500 Estimated Tax After Standard Deduction ($24,000) $37,117 (17.55 % marginal tax rate) Estimate Tax per quarter $37,117 x 90% /4 = $8,351 3rd quarter estimate payment $8,351 x 3 – ($7,123+ $8,635) = $9,295(payments for 3 quarters – amount paid for the 1st and 2nd  quarters)

 4th Payment  September 1 to December 31 Estimated Taxable Income ($48,000 +$37,000 + $56,000 + $167,000)  = $308,000 Estimated Tax After Standard Deduction ($24,000) $66,786 (21.68 % marginal tax rate) 4th quarter estimate payment $66,786 x 90%  – ($7,123+ $8,635+$9,295) = $35,054(payments for 4 quarters – amount paid for the 1st, 2nd  and 3rd quarters)

Please note that the calculation doesn’t account for self-employment tax and additional Medicare taxes

Choosing the right methods for minimizing estimated tax payments

Taxpayers should minimize the required estimated tax payments to maximize the cash flow and to avoid underpayment penalties .  Taxpayers can choose the same estimated tax method throughout the tax year.  In addition, taxpayers can also choose different estimated tax methods which can produce the smallest required  payment for each quarter.

Let’s use the example 2 above to compare different results for prior-year tax, current-year tax, annualization methods and combination of different methods for each quarter.  

Period 100% or 110% prior-year tax 90% current-year tax Annualization Method Combination methods to yield the smallest required payments 1st Payment 110% x $45,629/4 = $12,548 90% x $66,786/4 =  $15,027 $7,123 $7,123 2nd Payment $12,548 $15,027 $8,635 $8,635 3rd Payment $12,548 $15,027 $9,295 $9,295 4th Payment $12,548 $15,027 $35,054 $12,548 20X2 estimated payments $50,192 $60,108 $60,107 $37,601

             As a result, if the taxpayers use the annualization method for 1st, 2nd and 3rd quarters and use 100% or 110% prior-year tax method (110% is required in this example because the AGI is greater than $150,000), the total 20X2 estimated payments are smallest ($37,601) compared to other three standard methods. 

Year-end strategies to avoid penalties for estimated tax

By December, what if taxpayers discover that they are most likely to get penalties for underpayments, there are different strategies which can avoid the penalties for underpaid estimated tax at the end of the year.  

• Increase withholding at the end of the year.

  • The strategy is for individuals who has W2 withholding.  Income taxes withheld from wages are considered to spread out evenly throughout the tax year if taxpayers don’t specify exact dates for amounts to be withheld.  Therefore, additional withheld tax at year end is still deemed to spread out throughout the year.  Taxpayers can increase withholding at year end such as 100% withholding on year-end bonus, commission to avoid the underpaid penalties for estimated tax.

    • Example: Taxpayer A who discovers at the end of the year that he is $10,000 underpaid payment, he can increase $10,000 withheld tax through wages or bonus, commission.  The withheld amount is deemed to spread throughout the year which is $2,500/quarter. 

• Use actual dates for tax withheld 

   The  strategy helps taxpayers who have an unstable income flow.  If a taxpayer sells his/her stock and has a large capital gain, use actual dates for tax withheld to avoid underpayment penalties for a specific quarter when the actual income occurs 

• IRA distribution:

  • If a taxpayer owns traditional IRA accounts, this strategy can be used to reduce penalties.  Taxpayers can distribute their IRA and choose to withhold 100% of the distribution for federal income tax purpose.  If the taxpayer can redeposit the withdrawn IRA within the 60-day tax-free rollover period, she/he can avoid underpaid penalties.  The withheld tax is spread evenly throughout the tax year with an equal amount paid on each estimated tax installment due date.

    • Example:  Taxpayer A who discovers at the end of the year that he is $10,000 underpaid payment, he can distribute a $10,000 from IRA with 100% tax withholding.  In another word, A chooses to withhold $10,000 tax.  The withheld amount is deemed to spread throughout the year which is $2,500/quarter. As long as A redeposits $10,000 back to the same account within 60-day period, there’s no tax nor 10% early withdrawal penalty to be assessed on the transaction.  

Minimize Underpayment penalties during filling tax return

Most tax software assumes that taxpayers had the income throughout the year and calculates underpaid estimated tax. This calculation may cause large penalties.  For those taxpayers who have fluctuated in income or have large amount of income in a particular quarter should file the tax form 2210.   Form 2210 shows particular estimated tax payment based on specific income during specific time of the year.  It will allow Schedule AI to select the smaller required payments of the annualized income method or the regular method which leads to lower penalties.

For Turbotax software,  here is the instruction how to add Form 2210

References

“Topic No. 306 Penalty for Underpayment of Estimated Tax | Internal Revenue Service.”, www.irs.gov/taxtopics/tc306. Accessed 15 Oct. 2020.

This blog post will focus on the tax-efficient strategies on the federal income tax for investments including stocks, bonds, and rental investments.   Understanding tax implication will have a big impact on the return on investments (ROI)

Types of Investment Income

Before going to the details of tax-efficient strategies, taxpayers should understand the types of investment income and its tax implications.

• Assets (stocks and bonds) held for more than one year, qualified dividends :  taxed at long term capital gain rates which are 0 % for those who are in the 10-12% tax brackets (including the gain), 15% for singles who earns up $434,550  and married filling jointly who earns up $488,850 (2019) and a maximum of 20% for those who earns more than these amounts.  Depending on the income, there may be an additional  3.8% medicate surcharge.

• Assets held for less than one year, corporate bond interest: taxed at ordinary income tax rates  which have a maximum tax rate of 37% depending on the income. 

• Gain of collectible sale: taxed at ordinary tax rates, up to 28%

• Gain on real estate sale when depreciation was taken previously:  taxed at 25% up to the depreciation taken previously on the property

• Capital losses for individuals:  deductible against capital gains.  After that, only $3,000 of the excess loss can be used against any other types of income (W2 or Dividend income, etc.)  The remaining unused loss can be carried over to future years until it’s used up.

         Putnam Investments has a nice summary on  2019 tax rates, schedules, and contribution limits

Tax-Efficient Strategies for investments

Tax rates and rules may change from year-to-year.  However, keep in mind that taxes can reduce your investment returns from year-to-year, potentially impact your long-term goals. For those individuals who are in the high marginal federal income tax rate, tax impact may change your  investment decisions.

Followings are some tax-efficient strategies for investments that can help: 

Strategy 1: Tax-loss harvest to improve the return

The first tax-efficient strategy to consider is to harvest tax-loss.  Taxpayers should review their investment profiles around December of each year to determine what strategy and how to apply tax-loss harvest.

Tax-loss harvest is a practice to sell some stocks or bonds that generate a loss at year’s end.  This practice can help to offset the capital gains with the losses to lower taxes on the gain.   At year’s end, if a taxpayer has some capitals gains, the taxpayer should consider selling some investments that generate losses. This strategy can apply to the mix of stocks/securities and real estate investments.

These steps will help taxpayers to figure out whether the gain or loss is long-term or short-term before using tax-loss harvest

•            Keep track all capital gains and loss into short-term and long-term categories

•            Combine short-term gains and short-term losses together for net short-term gains or net short-term losses

•            Net long-term gains and long-term losses together for net long-term gains or net long-term losses

    Illustrations

            Example 1: 

Nicholas has a net short-term loss of $25,000 and a net long-term gain of $30,0000.  By netting them out, Nicholas would  have a $5,000 long-term capital gain which would result a 15% or 20% tax rate

           Example 2: 

Rachel has a net short-term gain of $25,000 and a net long-term loss of $30,0000.   By netting these numbers out, Rachel would have a $5,000 long-term loss.  If Rachel has a W2 income, Rachel can deduct $3,000 from the W2 income, the remaining $2,000 loss can carry forward to the future tax years until exhausted.    Looking at this example, if Rachel doesn’t use the tax-loss harvest strategy by harvesting $30,000 long-term loss, she would have to pay her short-term tax rate (same as ordinary tax rate) on $25,000 short-term gains.  If she’s in the 37% tax bracket, she would have to pay $9,250 for federal tax and state tax (rates vary by states).    Rachel can buy back the same loss stocks after 31 days of the sale to avoid wash-sale rule               

Tax-Efficient Strategies for wash-sale rule

Taxpayers can buy back loss stocks after 31 days of the sale.  Buy back loss stocks within the first 30 days of the sale will trigger wash-sale rule.  According to the rule, a realized loss on the sale or exchange of stock or securities is not recognized.  The wash-sale rule applies if a taxpayer sells or exchanges stock or securities at a loss and within 30 days before or after the date of the sale or exchange acquires substantially identical stock or securities.

Strategies to avoid wash sale:

•  Wait for at least 31 days either before or after the sale of any securities before purchasing the same securities in order to use the loss 

• If taxpayers can’t wait for 31 days before purchasing the same stocks, taxpayers should consider buying similar stocks from a different corporation to avoid wash-sale rule

  • Example 3

If a taxpayer takes a loss on the sale of Bank of America stocks, the taxpayer can’t buy Bank of America stocks within 30 days to avoid wash-sale rule.  However, the taxpayer can purchase Wells Fargo stocks within 30 days and the wash-sale rule won’t apply

• • Example 4

    • Adam owns 100 shares of A stocks with a basis of ($30,000).  He sold 50 shares for $10,000.  Fifteen days later, he purchased the same stock for $9,000.

    • Adam realizes loss of $5,000 from 50 sold shares ($10,000 realized – $15,000 cost basis) is not recognized because it results from a wash sale.  Adam’s basis in the newly acquired stock is $14,000 ($9,000 from the purchase price + $5,000 from the wash sale which is not recognized).  Remember to keep the record of the new basis ($14,000) of the newly acquired stock; most brokerages only report the purchase price which is $9,000).  This is a potential mistake which may cost taxpayers thousands of dollars in tax for not adding the wash sale amount to the basis of the stock when the stock is sold.

• Wash-sale rule is applicable to losses but not applicable to gains.  This leads to another tax strategy

  • At year’s end, if a taxpayer has a big loss from securities, the taxpayer can sell a stock with low basis to offset the loss and purchase the same stock the next day at a higher price in order to increase the cost basis for lower gain (lower tax) in future years

    • Example 5

      • December 2019, Z incurred a loss of $50,000 from B stock.  He/she also owns Apple stocks which he/she bought a long time ago at $50/share and the current price is $100/share.  Z can sell 1,000 Apple shares to offset $50,000 from the loss of B stock.  

      • Gain from selling 1,000 Apple shares = 1,000 x ($100 – $50) = $50,000.  This $50,000 gain can offset $50,000 loss from B stock which result 0 tax for the current year.

      • Z believes that Apple stock will continue to increase.  He can buy back 1,000 Apple shares the next day at $101/share.  So, the cost basis of 1,000 Apple shares now is $101/share rather than at $50/share.  When Z sells these 1,000 Apple stock at the end of 2020 at $125/share, the gain for tax purpose is $24,000 or 1000 x ($125 – $101) rather than at $75,000 (1000 x ($150 – $50)) if he doesn’t use this strategy.

Strategy 2:  Hold investments longer than 1 year and specify shares sold.

The second tax-efficient strategy to consider is to hold investments for more than one year.  Hold investments longer than 1 year (at least 1 year and 1 day) to avoid short-term capital gains which is at higher tax rates (up to 37% rate) than the rates of long-term capital gains (15% or 20% rate).  Investments, even missing one day (for example, holding period for 1 year rather than 1 year and 1 day) will subject to short-term gain tax rates.

• Taxpayers are allowed to specify shares to be sold for tax purposes.  Rules recommended as below:

  • If there is a loss, sell shares with the highest basis to maximum the loss 

  • If there is a gain, sell shares which produce long-term gain and with highest basis for lower taxes

• If the shares sold are not specified,  “first-in-first-out” (FIFO) rule will apply to shares sold. 

• For Employment Stock Purchase Plans strategy, please visit the post All You Need To Know About Employment Stock Purchase Plans – ESPP

Example 4:

               May 2017, Sam purchased 500 shares of A stocks at $50 per share

               August 2017,  bought another 500 shares of the same A stocks at $70 per share

               If in 2020, Sam sells 400 shares at $80 per share.  Unless Sam specifies to sell shares from a specific lot, the FIFO rule will be applied and Sam will pay tax on ($80 – $50) x 400 = $12,000 gain.  If Sam follows the above rules and he/she specify to sell shares from highest basis lot ($70), she will pay lower tax on ($80 – $70) x 4000 = $4,000 gain

• In general, some taxpayers may find it’s not worth holding the stock just simply to avoid taxes.  Holding the stock/investments longer than 1 year will result lower tax rate to a 15% or 20% rate rather than at ordinate tax rates (up to 37%) if holding the investment for less than 1 year.  Before making the decision whether to keep the investments longer to qualify for long-term capital tax rate, you may need to take into an account of many aspects:

  1. 1. 1. Whether you’re ready to sell the investment?

        2. Do you believe the investment will go up by the time you sell the investment (few months or 1 year from now)?

        3. Is the tax saving worth for the wait?

Strategy 3:  Choose tax-efficient investments

Investing in tax-efficient funds can increase the rate of return and result in fewer tax hassles.  There are several types of tax-efficient funds

• Completely tax exempt: the whole investment is exempt from tax for both federal and state taxes.  Municipal bonds issued by the state are an example of this type

• Partially tax exempt: The investment is tax free for either the state or federal but not both.  Treasury bonds which are tax exempt from the state is an example of this type 

Google search for “tax efficient investments”, a lot of recommended funds will return from the search

Strategy 4: Investments with the right account types 

•      Place high tax-rate investments into tax-deferred accounts

  • Put investments that produce ordinary income or short-term capital gains into tax-deferred accounts like traditional 401(k) and traditional IRA accounts.  Place investments with long-term capital gains or investments that pay high dividends into nontax-deferred accounts (normal accounts that taxpayers own under their name or joint names).

  • The distribution from tax-deferred accounts will be taxed at ordinary income tax rates.  Placing investments that produce long-term capital gains (15% or 20%) into tax-differed accounts will convert a 15% or 20% rate into ordinary income tax rates (maximum of 37%).  Therefore, placing wrong investments into wrong account types can cost thousands of dollars every year.

• Avoid placing real estate, tax-exempt bonds and annuities in tax-deferred accounts.

  • • In fact, all money distributed from tax-deferred accounts is taxed as ordinary income tax rates.  Placing tax-exempt bonds or annuities into 401(k) or IRA would convert tax-free interests or tax-deferred to fully taxable amount. 

    • There are tax benefits of real-estate investments with nontax-advantage accounts

      • Leverage:  borrow most of purchase price from lenders

      • Reduce tax by deducting property tax, interest, depreciation, and other expenses from rental income

      • Long-term capital gains on sale (if the property is hold for more than 1 year)

      • Ordinary losses if there’s a loss on sale (a loss can offset against the ordinary income)

    • If a taxpayer uses tax-advantage accounts to own real estate, above benefits will go away.  All distribution from the funds, including real-estate investments, will be taxed as ordinary income.  Another tax trap which impacts real estate investors is UDFI tax (unrelated debt finance income tax).  The UDFI is taxed when a retirement account invests in assets that use leverage.  In other words, to avoid UDFI tax, taxpayers can’t borrow money to purchase real-estate investments in tax-advantage accounts.    However, there’s a tax strategy to avoid this UDFI tax and it is potentially ideal for house flippers using tax-deferred accounts.  Please the blog post Hidden Strategies to Maximize Your Retirement That You May Not Know for strategies to avoid UDFI tax

• REIT stocks are ideal for tax-advantage investments

With REIT, investors can get the benefit of owning real-restate without dealing with UDFI tax and other hassles

References

Putnam Investments, 2019 tax rates, schedules, and contribution limits

 https://www.putnam.com/literature/pdf/II985-1c8a682ed561733a32008b46dd84b79f.pdf

There is a  misconception about the tax strategy for 2nd or rental homes. Tax payer can move to rental home, live in it for two years before selling it  in order to get full exclusion for the gain of $250,000 for single filer or $500,000 for married jointly couple. Reducing the capital gain tax on rental or 2nd home sale requires a right strategy to take the advantage of IRC §121 and its exception.

Many of you may hear about IRC §121 exclusion which the taxpayer can exclude the gain up to $250,000 or $500,000 for married filing jointly.  I also discuss about this provision in the another post.  You can read How to Minimize Tax on the Sale of Your Primary Residence

This is one of good strategies; however, this is a big misconception that many people don’t know.  The fact is  taxpayer will NOT get the full $500,000 exclusion

New 2008 requirement

Before 2008, one strategy is to convert the 2nd home or rental home to primary residence for two years prior to selling and take the full $250,000 or $500,000 gain exclusion. In 2008, congress introduces a requirement to prevent people from  abusing the IRC §121.  

After 2008, the strategy is still working but it is not as lucrative as before.  For individuals who own more than one home, the primary residence is where they spend most of their time and there is only one primary residence during a particular year.  under the new law, the time that the taxpayer is not using the home as his/her primary residence  is non-qualified use and the gain of the non-qualified used is treated as the capital gain.  In other words, if the taxpayer has some periods of time when  he/she is not using the home as the primary residence, he/she will never get the maximum of $250,000 or $500,000 exclusion.

One of the requirements of IRC §121 is to use the home as primary residence 2 out of 5 years leading to the home sell.  This requirement is to determine whether a taxpayer is eligible for the exclusion.  If he/she is not eligible, the entire gain will be taxed as capital gain.  Therefore, it’s very crucial to understand the new requirement to reduce the gain tax for rental home sale. 

What is Non-qualified Use?

Non-qualified use refers to any periods during which the home was used as a rental,  investment property, or 2nd home and not as primary residence by a taxpayer.  However, there are exceptions to the period of non-qualified use:

• Any period after the last day home was used as the primary residence by a taxpayer until the date of sale. Also, such period should be within 5 years before the date of sale.
• Any period (not more than 10 years) during which a taxpayer served on qualified official extended duty.
• Any other period of temporary absence (not more than 2 years) due to health conditions, change of employment, or other unforeseen circumstances (as provided in law)

Non-qualified Use Formula

As for the new tax rule, a taxpayer cannot exclude the portion of gain which belongs to non-qualified use of primary residence from the gross income for tax purpose.

A = Total numbers of days after 2008  the taxpayer does not use the home as the primary residence

B = Total number of days the taxpayer owned the home (counting all days, not just days after 2008)

Non-qualified Use = A/B

Gain allocable to non-qualified use = non-qualified use x Gain on the sale of  property

Gain exclusion = (1 – Non-qualified Use) x Gain on the sale of property

Illustrations

Taxpayers X and Y, a married filing jointly couple, bought a home on January 1, 2003 for $450,000.

• Lived in the home until December 31, 2005.

• January 1, 2006 to December 31, 2012, moved out and rented the home

• From January 1, 2012 to December 31, 2016, moved back and lived in the home

• January 1, 2017 to December 2018, moved out and rented the home

• On January 2019, the couple sold the house for $1,500,000

• The depreciation claimed on the home when rented was  $150,000

How much X and Y will recognize on sale of the home? and How much they can exclude on their gross income per IRC §121? How to reduce capital gain tax on 2nd or rental home sale?

Gain Computation

Depreciation Recapture: $150,000. No exclusion considered for depreciation and depreciation recapture of $150,000 tax at preferential rate of 25%

Gain to be considered for exclusion: $1,050,000

X and Y meet the requirement for IRC §121 because they owned and used the home as their primary residence for 2 out of 5 years prior to the sale. So the remaining gain is $1,050,000

Gain Allocable to Non-qualified Use

The next step is to determine how much gain belongs to the period of non-qualified use and cannot be excluded from the gross income.

The non-qualified use is the total number of days after 2008 when X &Y don’t used the home as a main residence.

• From January 1, 2003 to December 31, 2005 lived in the home: Qualified Use, 3 years

• From January 1, 2006 to December 31, 2012, moved out and rented the home:

  • Qualified use (before 2009): 4 years

  • Non-qualified use (after 2008): from January 1, 2009 to December 31, 2012: 4 years

• From January 1, 2012 to December 31, 2016, moved back and lived in the home: Qualified Use, 5 years

• From January 1, 2017 to December 2018, moved out and rented the home. This period is not considered non-qualified use because of the exception that it is the period after the home was last used as the primary residence but before the date of sale

A = Total numbers of days after 2008  the taxpayer does not use the home as the primary residence = 5 years

B = Total number of days the taxpayer owned the home (counting all days, not just days after 2008) = 16 years (from January 1, 2003 to January 1, 2019)

Non-qualified Use = A/B

Non-qualified Use = 4/16

Since the maximum exclusion for a married filling jointly couple is $500,000, $500,000 is used to calculate non-qualified use gain

Gain allocable to non-qualified use = 4 x $500,000/16 = $125,000

Results

In summary, there is a $150,000 depreciation recapture tax, $125,000 of gain allocated to non-qualified use and $375,000 of gain excluded from the gross income

For simplification, assume the taxpayers long-term capital gain tax rate and depreciation recapture tax rate are 15% and 25% respectively. Please see the below table which will illustrate the comparison between old and new law

Under the old law, X and Y would have excluded $500,00 from their gross income. However, under the new law, X & Y will now be able to exclude a gain of only $375,00 . As per the new law, the non-qualified use period starts only from January 1, 2009. Therefore, X and Y could exclude gain from January 1, 2006 to December 31, 2008.

Author’s Recommendations

In summary, non-qualified use causes the reduction of the $250,000 or $500,000 (married filling jointly) exclusion or taxpayers pay more taxes.

Many taxpayers have multiple homes. Taxpayers may hit a big tax bill without proper planning. Below is one of strategies to reduce the capital gain tax on the sales of 2nd or rental homes that I often advise my clients to take the advantage of IRC §121 by meeting the residence requirement and minimize the non-qualified use

• Live in Home 1 as the primary residence for > 2 years (1)

• Sell Home 1 immediately OR rent it our or make it as the 2nd home for < 3 years (2)

• Live in Home 2 as the primary residence for > 2 years after (1) period (3)

• Sell Home 2 immediately OR rent it our or make it as the 2nd home for < 3 years (4)

• Continue all these steps for the 3rd, 4th home, and so on

Following these steps, taxpayers meet the residence requirement of IRC §121 which is 2 years as primary residence out of the last 5 years to the closing date. Taxpayers can also meet the exception of being non-qualified use for the last 3 years ((2) and (4)) in which all five-year period will become qualified use for gain exclusion calculation. So the maximum of $250,000 or $500,000 (married filling jointly) gain exclusion from the gross income can be achieved.

Please note that, besides the last 3-year period which meets non-qualified use exception, other periods that the taxpayer doesn’t live in the home as primary residence will be considered as non-qualified use.

There are many reasons for people to sell primary homes during their lifetime.  People move to different locations due to work-related move. People may also have to sell their home, upgrade to a bigger home when the family has more members or downgrade the home when kids go to college, out of the home.  Deciding to sell the homes which is not easy for many people due to the tax the tax they have to pay for selling the home. Therefore, to minimize tax on the sale of primary residence is the ultimate goal for home seller to achieve.

Most people may hear about IRC §121 exclusion which the taxpayer can exclude the gain up to $250,000 or $500,000 for married filing jointly from the gross income.  In the past 15 years, house price has increased at a rapid pace. Many people have a large equity in their home and they hesitate to sell/downgrade to a smaller home because of the tax on the gain they have to pay.  We can go to the details how to take the full exclusion of $500,000 gain. Better than that, a taxpayer can even take more than $500,000 gain exclusion if he/she has proper planning before selling the primary house.

This post won’t go to the details of the primary residence definition during a tax year. In general, for individuals who own more than one home, the primary residence is where they spend most of their time. There is only one primary residence during a given year.

To take advantages of IRC §121 exclusion for second and rental homes, please refer to How to Reduce Capital Gain Tax on The Sale of The Second and Rental Homes

 Primary requirements 

To minimize tax on the sale of a primary residence, a taxpayer needs to satisfy three main requirements

 1.  Ownership

If the tax payer owns the home for at least 24 months out of the last 5 years to the closing date, the taxpayer meets the ownership requirement. For a married couple filling jointly, one one spouse has to meet the ownership requirement 

 2.  Residence  

  This requirement is similar to the ownership requirement which the taxpayer resides in the home as the primary home for at least 24 months out of the last 5 years to the closing date.  However, there are few differences:

• 24 months (730 days) of residence does not have to be consecutive, as long as the taxpayer resides in the home as his/her primary resident for 730 days within the last 5-year period

• Each spouse must meet residence requirement for a married couple filling jointly . Temporarily away from home like a short vacation still meets residence requirement

If the taxpayer becomes physically or mentally unable to care for himself/herself, and he primary home has been used for 12 months in the last 5 years, time for staying in a licensed care facility still counts toward the residence requirement. 

3.   Look-back Period

• The taxpayer can only take this tax advantage once every 2 years.  So if the taxpayer sold any primary home and take the exclusion during the 2-year period before the closing date, the taxpayer doesn’t qualify for the gain exclusion

If a taxpayer meets the ownership, residence, and look-back period and taking exceptions into account (discussed later), the home sale qualifies for the maximum exclusion of the gain ($250,000 for single taxpayer and $500,000 for a married couple filing jointly)
If the taxpayer doesn’t meet one of these 3 requirements nor exceptions to these requirements (to be discussed below),  the taxpayer is most likely to pay tax on the whole gain whether it’s a long term or short term capital gains unless the home is qualified for a partial exclusion of the gain.

Exceptions to primary requirements

    I will have a different blog post on these exceptions to the requirements and how to plan to take the advantage of the exceptions of the exclusion. 

• Divorced or separated:         

• Become widower

• Vacant land sale

• Home destroyed or condemned

• Service, Intelligence, and Peace Corps personnel.

• Remainder interest

• The home was acquired in like-kind/1031 exchange

Partial exclusion of gains

If a taxpayer doesn’t qualify for the full gain exclusion, the partial exclusion is only available if the taxpayer can prove that there are unforeseeable events causing the sale arose during the time the taxpayer owned and used your property as your residence.  Some examples of the events:

• Work-related move

• Health-related move:  the move to obtain medical care for yourself or for family members 

Author’s Recommendations

• Taxpayers can take the advantage of the $250,000 or $500,000 exclusion by purchasing a home and make it primary residence once every 2 years to get tax free (up to $500,000) on the gain given with the assumption that the housing market price keeps going up

• Widower and divorced taxpayer are in the exception category; hence they can also plan to take the advantage of this exclusion.   Will be discussed in a different blog post

• It appears that the maximum for full gain exclusion is $500,000 for a married filling couple.  However, there’s a way to exclude more than $500,000 gain to minimize tax on the sale of the primary residence. That is if there are 2 or more home-owners who own the home. To simplify, each home owner is married and file joint return, the gain exclusion can be a maximum of $1,000,000 rather than $500,000.

                For example:  A and B are co-owners of their primary resident home.  The home was purchased in 2010 for $500,000.  A got married in 2015 and B got married in 2017; both A and B have married jointly tax filling status .  A, A’s spouse and B, B’s spouse have lived in the home until it’s sold in 2020 for $1.5 Millions.  In this case, A and B can exclude all $1 Million gain and pay no tax on the home gain.  How does it work?

              By the end of the tax year of the home sold, both A and B will receive  a 1099-S  from the title company.  A and B should request the 1099-S if they don’t receive this tax form.  The 1099-S will show the sold price ($750,000 for A and $750,000 for B, assume that A and B have 50% ownership).  The basis of the home which is $500,000 will be split into $250,000 for A and $250,000 for B.  Since A his/her spouse and B and his/her spouse are married couples and meet the both residence and ownership requirements, A and B would get the maximum of $500,000 gain exclusion.

In general, IRA (Individual Retirement Account) is a tax-advantage vehicle toward retirement savings.  There are different types of IRAs; however, this blog post will focus on Traditional IRA and Roth IRA as they are related to the Backdoor Roth IRA

1. Traditional IRA

2. Roth IRA

Traditional IRA and Roth IRA are tax-advantage retirement savings.  

• In general, a taxpayer can withdraw any types of IRAs before the age of 59 ½.  However, the withdrawal amount will be subjected to an individual income tax and an early-withdrawal penalty of 10%

• Income limits and maximum contributions for IRAs change every year. For 2020 and 2019, the contribution limit is $6,00 ($7,000 if you’re age 50 or older)

• There is Income limitation for contributing to Roth IRA and deduction to traditional IRAs

• An individual can contribute to both IRA and Roth IRA (if eligible).  However, the total contribution will subject to the maximum contribution

The main difference between Roth and traditional IRAs lies in the timing of their tax advantages. For traditional IRAs, the contributions can be deducted (pre-tax) in the same year of the contribution made and the withdrawals will get taxed later; However, for Roth IRAs the contribution can’t be deducted (post-tax) in the year of contribution made and withdrawals will get tax-free later.

Why Roth IRA?

Often Roth IRA is preferred over the transitional IRAs 

• Roth IRA is not subjected to required minimum distributions (RMD) starting the age of 72 while traditional IRA is subjected to this rule.  

  • RMD:  a minimum amount of money needs to be withdrawn from retirement accounts.  The minimum amount is specified by IRS each year.  The distribution is taxed based on the tax rate in the distribution year and a 50% penalty is imposed on the rule violation.

• For Roth IRA, since the contribution is post tax amount, the contribution (not the earnings) can be withdrawn any time at any age without penalty nor tax.

• For Roth IRA, a qualified distribution (age of 59 ½ or over), the withdrawals (both contribution and earnings) will be tax-free and penalty-free  while the traditional IRA qualified distribution will be penalty-free but taxed based on the tax rate of the year of distribution.

Why Backdoor Roth IRA?

Backdoor Roth IRA is a legal technique to contribute to Roth IRA for high-income individuals who are not allowed to contribute to traditional IRAs or Roth IRA.  American IRA’s expert has a nice summary table for the 2019 Roth IRA eligibility as below.

From the table, a married couple whose income over $203,000 (2019) is not eligible to contribute to Roth IRA.  Therefore, backdoor Roth IRA technique can be used to contribute to Roth IRA.

Easy Steps for Backdoor Roth IRA

1. Make a nondeductible contribution (post-tax money) to a traditional IRA

2. Convert the traditional IRA to a Roth IRA.  The conversion from the contribution  will not result in any taxable income, only the earnings during the time from contribution to conversion period will result in taxable income

I have found Vanguard make it easy for backdoor Roth IRA procedure as the whole process can be done online.  A steps-by-steps captures are shown below:

Step 1: Open a traditional IRA and contribute $6,000 of post-tax money to the account.

Please follow the instruction on the screen to complete the process of opening a tradition IRA account.  Below is the screen capture for the last funding step.

Now the transitional IRA account is open and funded with a nondeductible of $6,000 (maximum 2020 contribution for under 50 year-old individuals

It will take few days for the new traditional IRA account with $6,000 showing up on Vanguard.  After that, a conversion can happen.

Step 2: Convert the traditional IRA to a Roth IRA 

• If you don’t have an existing Roth IRA account, you can open a new Roth IRA account then convert $6,000 from the IRA to Roth IRA

Follow the instruction on the screen to continue the process

Congratulations !!!  Backdoor Roth IRA process is now completed.  Since both traditional IRA and Roth IRA accounts are already open,  the existing accounts for traditional IRA contribution and Roth IRA conversion can be used for future years, no need to open new accounts. 

Cautions

• Step 1 is for contribution to a traditional IRA.  Traditional IRA is subjected to RMD; therefore, an individual needs to be younger than 70 ½ by the end of the contribution year.

• The nondeductible contribution for the current year can be made by April 15th or the tax filling deadline of the following year.  The conversion can take place anytime after contribution is processed.     

• December 31st of the tax year is the deadline for the backdoor Roth IRA conversion to dispose of other traditional IRAs which are still in balance.  If there is still any traditional IRA balances on December 31st, then the pro-rata rule will apply to the conversion.

  • Traditional IRAs can be rolled to Roth IRA, 401(k) or 403(b) at work if it takes the rollover.

  • Pro-rata Rule example:  if an individual makes a backdoor Roth IRA contribution of $6,000 and having a traditional IRA with a pre-tax balance of $20,000, then only 23.1%  or $1,385 ($6,000 / ($20,000 + $6,000)) of the conversion will be tax-free and the remainder of  $4,615 ($6,000 * (1 – 23.1%)) will be taxable income.  

Tax Filling 

The nondeductible contribution is reported on the form 8606 for the tax year of contribution, but no tax impact. The conversion will be reported for the year in which it happened (along with the carried-forward basis). 

To report a backdoor Roth IRA in the tax software, navigate to the IRA contribution first.  Please do not choose Roth IRA contribution but choose traditional IRA contribution.  Once traditional IRA contribution is complete, navigate to income section and choose 1099-R distribution .  Be careful to enter exact information from 1099-R form (1099-R is provided by the IRA brokerage).  This step is to convert traditional IRA to Roth IRA.  After that, form 8606 will be generated, you can review if the information on 8606 form is correct.

References

• 2019 Roth IRA Eligibility

https://www.irahelp.com/printable/2019-roth-ira-eligibility

• 2019 Traditional IRA Deduction

https://www.irahelp.com/printable/2019-traditional-ira-deductions

Many of you may hear about IRC §121 exclusion which the taxpayer can exclude the gain up to $250,000 or $500,000 for married filing jointly.  I also discuss about this provision in the another post.  You can read the post How to Minimize Tax on the Sale of Your Primary Residence.  One of the most tax traps taxpayer should avoid is that many people purchase the home from ex-spouses during divorce settlement.  This tax trap which many people are not ware of, causes the cost basis of the home stay the same though the home price increases.   According to the carryover basis rule, any payments made to ex-spouses don’t increase the original joint cost basis of the home.  As the result, the cost basis when the couple purchased the property (long time ago) is used against the selling price for tax gain calculation.

Illustration

Example:  Kevin sold his 50% share of the home to his ex-wife, Nancy for $350,000 as a part of divorce settlement.  Nancy and Kevin bought the home 20 years ago for $200,000.  Few years later, Nancy had sold the home for $900,000, Nancy would have to pay tax on the entire gain of $700,000 ($900,000 selling price – $200,000 original basis).  After $250,000 gain exclusion, she still has to pay tax on $450,000 gain.

Rather than buying the home from her ex-husband, the home should be sold to the third person for $700,000, and with $500,000 gain exclusion neither Kevin nor Nancy pays any taxes.  Nancy can use the tax-free gain to purchase a different home for $700,00 as her primary residence.  She can sell the home 3 years later for $900,000, and she wouldn’t pay any taxes after $250,000 gain exclusion.

Recommendations

As a part of divorce settlement, neither spouse should purchase the home from the other spouse.  To avoid the tax trap, the home should be sold to different persons so that each spouse can take the advantage of $250,000 gain exclusion (assumed that ownership and residence test met).

Before discussing about the factors for choice of business entity, we should have a good understanding of options that a business can choose from

There are some differences between legal entities and tax purpose entities.

1. Federal Tax – Sole Proprietorship, Partnerships, C Corporations and S Corporations

2. Legal Entities –

• • Sole Proprietorship –

  •  Partnerships (various types)

  •  Corporations will be treated on the federal income tax as C Corporation by default.  However, a corporation can choose to be taxed as S Corporation (if others qualifications are satisfied)

  • Limited Liability Companies (LLC) are normally treated on the federal income tax purpose either as:

    • Partnership (more than 1 member)

    • Sole Proprietorship (single member)

    • C Corporation ( Form 8832, entity classification election to be taxed as a corporation)

    • S Corporation ( to be taxed as S corporation on federal tax, file both form 8832 and form 2553, small business corporation election)

Business Entities are created at the State level, not created with the IRS.  For example, for California, business entities are created and filed with the California Secretary of the State’s Office
https://www.sos.ca.gov/business-programs/

Primary factors for choice of business entity

There are many factors that determine the type of entity for a business.  However, these are primary factors for business

• Liability protection

• Tax burden for the business and its owners (including compliance costs)

• The number and type of business owners.

AICPA has a good comparison of business entities which include general tax rules and non-tax aspects applicable to each of the business entity type.  The below table is referenced from AICPA website

Federal Tax Factors

• Sole Proprietorship – income and expenses of the proprietorship retain the character when reported.  For example, ordinary income of the proprietorship is treated as ordinary income while capital gain is treated as capital gain when reported by sole proprietor.  In general, proprietors can take a deduction for qualified business income (QBI – section 199A) which is 20% of proprietorship net income.

• Partnerships are not subject to a Federal income tax. Partnership ordinary business income (loss) and other items are allocated to partners according to the ownership interests.

• Corporations are governed by Subchapter C (C corporations) or Subchapter S (S corporations) of the Internal Revenue Code

  • C corporations are subject to an entity-level Federal income tax which is a flat rate of 21%.  When a C corporation distributes its income, the shareholders reports dividend income on the 1040 tax returns; however, there’s no deduction is allowed for the dividend paid.  This results to a double taxation (on the entity level and on the shareholder level)

  • S corporations generally are not subject to an entity-level Federal income tax like partnerships.  S corporation ordinary business income (loss) and other items are allocated to the shareholders according to the ownership interests.

Other State Considerations when choosing an Entity in California

The main focus of this article is for LLCs as LLC is a very popular type of entities for small businesses.

A Limited liability company (either single-member or multi-member LLC) which is organized in California must file an annual California LLC tax return (Form 568).  Annual California LLC taxes ($800) and potential annual LLC fees are imposed directly on the LLC (bases on the gross receipts).  Don’t confuse between LLC taxes and LLC fees as they are separate items.  LLCs are subject to pay both LLC taxes and LLC fees (if applicable)

• It’s very critical to understand that LLC tax ($800) is imposed even if LLC has no net income or does not conduct business in the state. The $800 LLC tax is due by the 15th day of the 4th month after the beginning of the tax year.  Please note that the $800 annual LLC tax will continue every year until all three of these conditions occur:

  • The LLC files the final Form 568 return and pays the $800 LLC tax for the final tax year

  • The LLC does not do business in California after the final taxable year

  • File cancellation documents with the California Secretary of State within 12 months of a timely filed the final Form 568

•  California LLC Fees are bases on California-based gross receipts (not the net income) of $250,000 or more.  LLC fees must estimate and pay the fee by the 15th day of the 6th month of the current tax year.  The below image is referenced from FTB website for the LLC fees

Other taxes that a business encounters

A business is subjected to pay these taxes if applicable.

• Property Tax

• Sales/Use Taxes

• Business License Taxes

• Payroll Tax including unemployment insurance

  • A sole proprietorship is subject to federal self-employment tax of 15.3% on net income as are some partnership allocation of income to partner.  Wages paid to a shareholder-employee of a corporation are also subject to payroll taxes.  Payroll tax burden should be taken into consideration of the choice of business entity.

Factors Choice of Business Entity

A business entity may face many taxes and fees.  Also nontax considerations may override tax considerations and lead owners to conclude that a business should be operated as a LLC, a corporation or a sole proprietors/general partners in partnerships.

Example:  Mr. Smith plans to start a business in the current tax year.  He expects operating losses for the first 3 years and highly profitable after 3 years.  Mr. Smith should operates as sole proprietorship if his business is not a high risk of liability as proprietorship is the cheapest entity to operate and he can also deduct the losses against any other type of income on his personal return.  On the other hand, if his business is a high risk of liability business he should choose S corporation because the losses will flow through and be deductible on his personal return and he also limits the business liability from his personal liability.    When the business becomes profitable, he should switch to C corporation status.

If a business has employees who are not the owner immediate family or if the business has substantial properties, to a void lawsuits and to protect properties a sole proprietorship may not be a good entity choice.

Recommendations

Factors for choice of business entity will depend on each entity’s situation

• An LLC with S corporation election usually results in lowest tax with the new 20% of qualified business income deduction (QBI) while limits its liability.  S corporation owners may be able to eliminate a substantial social security and medicate taxes by paying yourself as little as possible in salary, however, must be “reasonable” and the  remaining distribution as dividends to save tax.

• Personal service businesses like legal, medical, accounting, financial services, actuary, consulting, athletics, performing art, and possibly realtors, that make over $415,000 for married coupon or $207,500 for single earner (2020) should consider C corporation as it is not eligible for 20% QBI deduction.

 1. 401(k)

A 401(k) is a employer sponsor retirement plan for eligible employees. The employees can contribute to the plan and invest for their own retirement on a tax deferred basis.  The contribution is tax deferred, so there is a contribution limit set every year by the applicable law (contribution limits for 401(k) plan in 2020 is $19,500 for individuals who are younger than 50).  Depending the plan that the employer setup, usually the plan allows the owner to invest into stock, mutual funds and the in the long term, the fund grows.  The sooner you start, the longer your saving can build toward your retirement.

Keep in mind that in general, individuals may wait until they reach the age of 59 and 1/2 years old to start withdrawing money from retirement funds to avoid 10% penalty from early withdrawal.

Many employers provide a dollar to dollar match for  the first few percentage of employee 401(k) contribution.For example: If a person has a salary of $100,000, a  4.5% match means the company will contribute to the employee 401(k) fund a maximum of $4,500 if the employee also contributes $4,500 to his/her own 401(k) fund.

Salary     $90,000
Bonus     $10,000
Total Compensation   $100,000

Beginning of 2020 balance     $0
401 (k) contribution                $19,500
Employer matches                  $4,500

                Ending Balance                  $24,000
I have used the below 401(k) calculator to simulate hypothetical data for the sole purpose of showing a big difference of an individual 401(k) balance at the age of 65 when that person starts his/her 401(k) at  25 years old vs. at 50 years old.

https://www.calculator.net/401k-calculator.html

Per the above graph which is based on simulated data, the earlier a person contribute to the retirement plan, the more saving the person has toward the retirement funds.  The saving can be huge which individuals should not ignore.

On the hand, the retirement fund is tax deferred which meant you can save tax

Going back to the above example

• No contribution:

Income:                                                     $100,000
Standard Deduction for single:    $12,200
 Adjusted Gross Income                            $87,800
Federal Tax                                    $15,246
State Tax   *                                     $5,924
         * California Tax is used in this calculation

• $19,500 contribution to 401(k) 

Income:                                                     $100,000
401(k) contribution                      $19,500
Standard Deduction for single:    $12,200
Adjusted Gross Income                              $68,300
Federal Tax                                    $10,884
State Tax   *                                     $4,111
         * California Tax is used in this calculation

$19,500 of 401(k) contribution results a tax saving of $6,175 ($4,362 of federal tax saving + $1,813 of CA tax saving)

Author’s Note:   The contribution should be spreading out throughout the year in order to take the full “free-matching money” from the employer because the match is made on a per pay period basis rather than based on total contribution percentage at the end of the year.  Maximize the 401(k) benefit from the tax standpoint and from the “free-matching money” can be a big saving toward retirement years

Good news is that some companies have “true-up” contribution which means the company will review the whole amount of the employee contribution after the end of the year in order for employees to receive their full match based on the annual limit. You should check with your employer on the “true-up” contribution policy.

2.  HSA (Health Saving Account)

HSA is pre-tax money to pay for medical expenses like deductibles, co-payments and other qualified expenses.You can check eligible expenses for HSA at the link https://learn.healthequity.com/qme/

I personally love HSA as it is considered as “triple tax free” while I can invest my HSA into different types of mutual funds.

• Pre-tax income contribution

  • There is limitation on how much you can contribute per year.  Like 401(k), the limit changes every year.  Contribution limits for 2020 is $3,550 for individuals and $7,100 for family.  Some employers contribute certain amounts to employees HSA account if the employees qualify for  HSA contribution.  The employer contribution amount also counts toward the HSA contribution limit.

• Grow Tax-deferred

  • Depending on the brokerage that manages the fund, HSA money can be invested to buy stock, mutual funds and continue to grow

• Tax-Free withdrawn (to pay for qualified expenses)

  • Unlike 401(k) which is tax deferred, HSA is tax-free withdrawn if the withdrawn money pays for eligible expense (see above for the link to eligible expense).

• Unused amount automatically can be rolled over from year to year

  • Unlike Flexible Spending Account (FSA) which is owned by the employer, and only $500 of unused fund can be rolled over to the next year, HSA is owned by the employee and all unused fund will be rolled over from year to year.   As a human being, people will get sick and sooner or later the HSA will be used toward medical expenses.

There are many great benefits of HSA; however, an individual needs to enroll in a high deductible health plan (HDHP) to qualify for HSA contribution

3. Flexible Spending Account (FSA)

FSA is very similar to HSA in terms of pre-tax money to pay for medical expenses like deductibles, co-payment, etc.    However, there are few important differences between FSA and HSA

• FSA is owned by the employer whereas HSA is owned by the employee.  That means if you leave your employer during the year, the unused FSA balance  may go to the employer.

• FSA contribution limit is lower than HSA (2020 FSA contribution limit for individuals is $2,750 vs. $3,550 of HSA)

• Only $500 of the unused FSA fund can be rolled over to the next year while all unused HSA fund can be rolled over from year to year.

Eligible expenses for FSA –    https://learn.healthequity.com/qme/

4. Limited Purpose Flexible Spending Account (LP-FSA)

LP-FSA is very similar to HSA/FSA in terms of pre-tax money but the fund can be used to pay for dental and vision expenses only while HSA and regular FSA can be used for broader medical services.

LP-FSA can be used in conjunction with HSA.  Other characteristics are the same with FSA

• FSA is owned by the employer whereas HSA is owned by the employee.  That means if you leave the employer during the year, the unused FSA balance  may go to the employer.

• LP-FSA contribution limit for 2020 is $2,750

• Only $500 of the unused LP-FSA fund can be rolled over to the next year while unused HSA fund can be rolled over from year to year.

Eligible expenses for LP-FSA – https://www.benstrat.com/downloads/HU-FSA-LP-Eligible-Expenses.pdf

5. Dependent Flexible Spending Account (DCFSA)

DCFSA is a pre-tax benefit account used to pay for eligible dependent care services

• preschool

• summer day camp

• before and/or after school programs

• child daycare

Contribution limit for 2020 is $5,000

 DCFSA has a “use it or lose it” rule.  Qualified expenses which are incurred up until December 31st can be reimbursed.  However, unused amounts that are lost, are not deductible.  So, it’s very important to plan a head of time before enrolling in any FSA accounts.

6.  Health Insurance plans

There are many different health insurance plans offered by employers.  These plans usually fall into 2 buckets:  high deductible health plans and low deductible health plans.

• HDHP – If an employee enrolls in the high deductible health plan (HDHP), he/she usually pays a lower monthly premium but have high deductible.  The deductible is the amount to be met before the health insurance starts to pay.  Enrolling in a HDHP qualifies for HSA and LP-FSA contribution and HSA can be used to pay for these high deductibles.  I have enrolled in a HDHP for almost 10 years to maximize HSA benefit.

• LPHP – on the other hand, enrolling in low deductible health plan (LPHP), an employee pays a higher monthly premium but having a lower deductible.  LPHP doesn’t qualify for HSA contribution but can contribute to FSA

If you’re relatively healthy, I would recommend to enroll in a HDHP for the following reasons:

•  Pay lower monthly health insurance premium

•  Qualify HSA contribution.  HSA can grow overtime and having a lot of tax benefits as described above

• Eventually when you reach to the stage of having health issues (everyone will eventually get sick and have medical expenses), HSA can be used to pay for these expenses tax-free

7. Employment Stock Purchase Plan (ESPP)

Employment stock purchase plan is another great benefit to maximize.  In general, ESPPs allow employees to buy shares of employers’ stock at a discount by using after-tax payroll deductions

• Contribution and discount percentage limit may vary from employers.   However, IRS limits ESPP purchase of $25,000 per calendar year.

• Most companies allow its employees to contribute a maximum of 10% of the take-home pay and 15% discount of either the offering date or the purchase date, whichever is lower

• There are two-year offering period (look-back period), so the actual gain may be more than 15%

• Above is real examples showing the benefit of ESPP enrollment

  • The first example, the market price on the purchase date of 6/28/2019  was $54.73 and the ESPP purchase price was $33.03 which results around 40% discount rather than 15% discount

  • For the 2nd example, the cost of purchase on 12/31/2018 was $33.03 while the market price was $43.33 also resulting a discount of 24%

• Tax Treatment

  • No tax reports until the year of the sale

  • Qualifying dispositions

    • the discounted amount: Ordinary income tax rate

    • the remainder              : Long-term capital gain (lower tax rate)

  • Disqualifying dispositions

    • most of the sale proceeds as ordinary income

  • For more details about tax treatment for planning purpose.  Please visit my blog post Employment Stock Purchase Plan – ESPP

8. Education Assistance

Many employers offer tuition assistance for higher education if the employee is on the company payroll.  The assistance usually covers required textbooks, lab fees, registration fees, mandatory and recurring fees.

Some of these amounts are taxed and some are tax-free.  If the educational program is classified as job-related, the whole tuition assistance amount is tax-free.  If it’s classified as non-job related, the first $5,250 is tax-free, the remaining amount is added to your income for tax purpose.

Education assistance is mostly “free money”. Employees should maximize this benefit if they continue their education whether it’s training programs or graduate schools

9.  Backdoor Roth IRA

Backdoor Roth IRA is also another way to save toward retirement.  I myself maximize this benefit every year.  Please visit the blog post for more information:  Steps by Steps to Backdoor Roth IRA

Bottom Line

As an employee, you should take these advantages to maximize the benefits as  many of them are just free money or you may have to pay a little tax.  As the contributions is taken out from your take-home income, your take-home paycheck becomes smaller.   Smaller take-home paycheck means you have to stay within a tight budget for all living expenses and lifestyles .  However, you should at least at a minimum do the followings in the priority order

1. 401k contributions equal the company’s match to maximize its free money from your company.   Example, contribute only $4,500 to get the maximum match from the employer rather than contributing the maximum allowable amount which is $19,500

2. Education Assistance:  this is really a free money from your employer  for higher education.

3. ESPP

4. HSA – only qualify with high deductible health plans

5. FSA – qualify with low deductible health plans

6. LP-FSA – dental and vision with proper planning (braces, implant, eye laser surgery, etc.)

7. DC-FSA – for whom to send kids to schools, day care, etc.

Only $500 of the unused FSA funds can be rolled over to the next year and if you leave your company, unused amounts may go back to the employer.  So, it’s very important to plan a head of time before enrolling in any FSA accounts.

References

401(k) Calculator – https://www.calculator.net/401k-calculator.html

HSA and FSA eligible expenses – https://learn.healthequity.com/qme/LP-FSA eligible expenses – https://www.benstrat.com/downloads/HU-FSA-LP-Eligible-Expenses.pdf

Espp How-to #1: Timeline the Esppstock Option Counsel®

Mary Russell – http://stockoptioncounsel.com/blog/espp-how-to-1-timeline-the-espp/2012/10/28

Dividends Received Deduction (DRD) is available to Corporations.  The purpose of the dividends received deduction is to mitigate multiple taxation of corporate income.  If a corporation owns a stock in another corporation and receives dividends,  then a portion of dividends may be deducted from income as a special deduction which is called Dividends Received Deductions (DRD).

An example of DRD

A Dividend Paying Corporation issues $10,000 dividends to the Dividend Receiving Corporation.
On the form of 1120, there is $10,000 Dividend Income but potentially the Dividend Receiving Corporation can claim deductions.

Percentage of Ownership by Corporate       Shareholder Deduction Percentage < 20% 50% >=20% but < 80% 65% >=80% and affiliated 100%

DRD is subjected to Modified Taxable Income limitation.  For this purpose, the taxable income is computed without regard:

1. The NOL

2. The Dividends Received Deduction

3. Any capital loss carryback to the current tax year

The following steps are used in applying the calculations for DRD

1. Multiply the dividends received by the deduction percentage

2. Multiply the taxable income (calculated above) by the deduction percentage

3. Limit the deduction to the lesser of step 1 or step 2.  If deducting the amount in step 1 results in an NOL, the amount in step 1 is used  (NOL rule)

Calculation

X Corporations Y Corporations Z Corporations Gross Income from operations $600,000 $480,000 $320,000 Expenses from operations ($490,000) ($490,000) ($490,000) Dividends received from domestic corporations (< 20% Ownership $300,000 $300,000 $300,000 Taxable Income before DRD $410,000 $290,000 $130,000 Three-step procedure for DRD Step 1: (50% x $300,000) $150,000 $150,000 $150,000 Step 2 50% x $410,000 $210,000 50% x $290,000 $145,000 50% x $130,000 $65,000 Step 3 Lesser of Step 1 or Step 2 $150,000 $145,000 $150,000 (*)

In the example, DRD for X and Y Corporations are straight forward which is  $150,000 for X Corporation and $145,000 for Y Corporation.

(*) Z Corporation qualifies for NOL rule treatment because subtracting $150,000 (step 1) from $130,000 taxable income before DRD results a negative number.  So Z Corporation can deduct $150,000, 

Important Notes 

Some important notes in order to qualify for DRD

1. Hold stock for 45 days under most situations (IRC section 246(c))

2. The standard rate of deduction (50%, 65% an 100% for  2018) applies for domestic corporations

For planning purposes, Corporations should consider the timing of income and deductions to qualify NOL rule.  This rule may result in a significant amount of a corporation’s DRD.

Cash method of tax accounting eligibility 

In general, a business recognizes income when actually or constructively received

Public Law 115-97 provides a guideline for businesses to be eligible to use the cash method:

• Businesses (excluding tax shelters) with average annual gross receipts that do not exceed $26 million  as of 2019 (over the prior three taxable years)

•  Businesses with average annual gross receipts in excess of $26 million (over the prior three taxable years) that are not required to maintain inventories and that are:

  • Qualified personal service corporations

  • S corporations

  • Partnerships that do not have a C corporation partner

  • Sole proprietorship

  • Farming businesses that are not a C corporation (or that do not have a C corporation partner)

All other businesses generally are required to use an accrual method

Why cash method or accrual method is important for businesses?

• Certain rules for each method that need to follow to calculate taxable income

• This is a common IRS examination area

• There are penalties if a business does not use a proper method

• Opportunities for tax planning

However, tax shelter is prohibited from using the cash method under section 448(a)(3) of the tax law for any tax year.

Section 1256(e)(3)(B) “any partnership or other entity (other than a corporation which is not an S corporation) if more than 35% of losses of such entity during the tax year are allocable to limited partners or limited entrepreneurs”

• So tax shelter could easily be an LLC with over 35% inactive owner which can’t use the cash method.

Why Cash method is a favorable method for businesses?

 Under cash method of tax accounting, income is deferred until collected and expense deduction is deferred until paid.

 If a business is a pass-through entity like partnership, sole proprietorship, or S-corp and the partners/owners are expected to be in a higher tax bracket in the future, tax strategy usually defers income. Cash method in this case is more favorable than accrual method

If a business has more receivables than payables, the cash method to defer the income until actually receiving the receivable payment is more favorable.

In contrast, if a business has more payables than receivable.  Cash method may accelerate more income as the business can’t deduct the payables until it actually pays the payable .

Choosing the right method of accounting for a business, a tax planning strategy needs to be developed.

What is the process to change the method of tax accounting?

If this is the first year tax return of the business,  checking the box on the first return as “cost” is enough to adopt the method of accounting.  Be careful, accrual method is always available but  the business has to be eligible to use cash method

In general,  a taxpayer can change the method of accounting once every five years.

Form 3115 filling is required for changing the method of accounting.  Computing income adjustment for previous years to the year of change as if the taxpayer has always been using the new method is usually required.

What happens to the adjustment – section 481(a) adjustment?

If the adjustment is positive or unfavorable adjustment, a 4-year spread which means a 25% of the adjustment added into the income each year for four years beginning with the year of change

If the adjustment is negative or favorable, it applies into the year of change.  This is a potential for a significant tax reduction

I’ve always had a credit score of 800 and above for so many years.  However, there was a silly mistake that costed me 90 points.  The lower credit score impacted my interest rate and closing cost when I purchased my home in 2019.

Automatic Payment is the key to keep up with billing deadlines

As a busy person like many of you, I have always use automatically payment from my Bank of America (BOA) checking account to pay for all my bills from mortgage to credit cards and utilities.   E-Bill, a feature which I love the most, allows billing companies to bill directly to my bank account.  My bank account  then pays the bill on due dates or other options (depending on the setting).  This feature is so convenient that I don’t even pay attention to any billing deadlines because I know that I won’t miss any payments.

However, some billing companies don’t have this feature available on BOA. In other words, I have to login to the credit card online to check for the balance, and then go to my BOA account online to pay the bill manually or pay the bill traditionally by sending the check in the mail.  Another payment method which I don’t like to use is to provide bank account information to billing company website, and it will automatically withdraw your money when it’s due.  Kohl’s credit card is one of these billing companies.  The only reason that I Kohl’s credit card because occasionally I can get 30% discount from Kohl’s if I use Kohl’s credit card.  I was very careful when I use the Kohl’s credit card.  So I always pay full balance after each transaction to ensure I don’t miss the bill payment in case I forget.

The mistake that hurt credit score

However, in 2018 I had a business trip to Taiwan, and I forgot to pay for the bill of around $17.  Two months later, the balance went up to ~ $35 by the time I checked for the balance.  Calling to Kohl’s customer service, explained the situation and then paid the balance in full right away.  I was shocked when the monthly credit reports show my credit score down to 729 points from 819 points. This score range has stayed on my record for a long time; it’s now in 2020 but my credit score is not improved much.

I usually don’t care much about credit score impact as I didn’t have any debts and didn’t borrow money.  However, Mid-2019, my husband and I have found our dream home and we decided to purchase the home.  Even with 50% down payment, we couldn’t get a good mortgage rate because brokers told us that we don’t have a perfect credit score.

Lessons learnt from the mistake

As you see, a small mistake which I forgot to pay for a bill of $17 costed my 90 points of my credit score. In addition, it also impacted my mortgage rate which also costed me thousands of dollars.  Here is my lessons learnt:

1. Limit number of credit cards that I use for easy billing management

2. Avoid credit cards that don’t have e-bill feature with BOA.  If I need to use these cards, I put the transaction balance into my task list to remind me for on-time payments

3. Avoid using cash for two reasons

• • Record keeping – credit card companies keep all transactions while I can’t keep track cash purchases

  • Rewards – most credit card companies pay rewards on the total amount of money spent.  My husband and I usually get around $400 to $500 per year in credit card rewards while I won’t get any money back with cash spending

For ESPP, if the company buys the stock on the employees’ behalf, nothing will happen as the taxpayer doesn’t owe any taxes.  However, if the taxpayer sells any ESPP stocks in any year, a W2 will be issued for that year which reflects the stock sale.

Depending of how long stock was hold, the box 14 of W2 may show ESPP-DD (qualifying disposition) or/and ESPP-QD (disqualifying disposition).  Please note that box 14 is for information only as these numbers are already included in box 1 of the W2

What are ESPP-DD and ESPP-QD?

Disqualifying disposition (ESPP-DD): 

If the stock is sold within two years after the offering date or less than one year from the purchase date, the bargain will be on W2 as a compensation which will be taxed at ordinary income tax rate. The bargain is the difference between the purchase price and market price on the purchase date.  Any additional gain is considered capital gain.  However, whether it’s long-term or short-term capital gain depends on the length of the stock was hold.

• Example 1:

Disqualifying disposition resulting in short-term capital gain Date Fair Market Value (FMV) Discount (15%) Actual cost Offering Date 1/2/2016 $38.86 $33.03 Purchase Date 06/29/2016 $43.03 $33.03 Transaction Date (Sale Date) 9/7/2016 $50 Number of Shares 225

The above example is a disqualifying disposition because the stock owner sold the stock in less than two year after the offering date and less than one year from the purchase date.

The box 14 of W2 may show ESPPDD $2,250.  Below is the formula to calculate the bargain.

  Number of shares sold x (market price on the purchase date – purchase price)

= 225 shares x ($43.03 – $33.03) = $2,250 .Schedule D of the 1040 tax return, the taxpayer needs to report the gain from the transaction.  Stock brokers will send Form 1099-B around February of the following year that reflects the sale but the Form 1099-B may include $2,250 as the broker may not keep track the discount from the company.  For this reason, the basis of the stock sold may need to be adjusted.  Many of taxpayers who file the return themselves or in-experienced tax preparers may make mistakes of not adjusting the basis which causes double-taxes.

The $2,250 which is already reported on the W2 needs to be adjusted to the cost basis on the schedule D, else it may cause double taxes.  How to adjust this?

   Number of shares sold x market price on the sold date – commission  paid to broker – cost basis 

    Cost Basis =  Number of shares sold x Purchase Price + the compensation income (which was reported on the W2)

Go back to the example – the short-term capital gain on your schedule D will be

   225 shares x $50 (sold price) – $10 (commission) – (225 shares x $33.03 (purchase price)  + $2,250 (adjustment for the cost basis))

   = $11,240 – ($7,431.75 + $2,250) = $1,558.25

• Example 2:

Disqualifying disposition resulting in long-term capital gain Date Fair Market Value (FMV) Discount (15%) Actual cost Offering Date 1/2/2016 $38.86 $33.03 Purchase Date 6/29/2016 $43.03 $33.03 Transaction Date (Sale Date) 7/1/2017 $50 Number of Shares 225

This example is pretty much the same with the example, except the sale date is in 07/2017 rather than 09/2016
This is a disqualifying disposition because the stock owner sold the stock less than two years after the offering date.  However, it would result in long-term capital gain as the stock was hold more than 1 year since the purchase date

Box 14 of the W2 will be the same as the example 1- $2,250

The amount reports on the schedule D is the same – $1,558.25.  The only difference is that this amount is long-term capital gain (lower tax rate – good) rather than short-term capital again (same as ordinary tax rate) in the example 1

Qualifying disposition (ESPP-QD)

 If the stock is sold at least two years after the offering date and at least one year after the purchase date, the bargain is also taxed at ordinary income tax rate.  The bargain is the difference between the purchase price and market price on the purchase date.  Any additional gain will be considered long-term capital gain which is taxed at lower rate than ordinary income tax rate.

• Example 3:  

Qualifying disposition with stock price increased between offering date and purchase date Date    Fair Market Value (FMV) Discount (15%) Actual cost Offering Date 1/2/2016 $38.86 $33.03 Purchase Date 06/29/2016 $43.03 $33.03 Transaction Date (Sale Date) 9/7/2018 $50 Number of Shares 225

This example is a qualifying disposition because the stock owner sold the stock more than 2 years after the offering date and more than one year from the purchase date.

The calculation for qualifying disposition a bit different than disqualified disposition

Box 14 of W2 is ESPPQD  $1,311.75   .  Here is how it is calculated

The lesser amount of

1.  Number of shares sold x market price on the sold date – commission  paid to broker – Number of shares sold x purchase price

          225 shares x $50 – $10 (commission) – 225 x $33.03 = $3,808

      2.  Number of shares sold x (offering date price – purchase price)   

          225 shares x ($38.86 – $33.03) = $1,311.75 

 Same formula on the previous examples for capital gain calculation.   Long-term capital gain report on schedule is calculated as below

225 shares x $50 (sold price) – $10 (commission) – (225 shares x $33.03 (purchase price)  + $1,311.75 (adjustment for the cost basis))

   = $11,240 – ($7,431.75 + $1,311.75) = $2,496.5

Bottom Line

Below is the summary of tax treatment for ESPP.

• No tax reports until the year of the sale

• Qualifying dispositions

  • the discounted amount: Ordinary income tax rate

  • the remainder              : Long-term capital gain (lower tax rate)

• Disqualifying dispositions

  • most of the sale proceeds as ordinary income

All three above examples are pretty much the same.,  just manipulating the sale date would result in reducing the tax as it would result long-term capital gain (lower tax rate: 0%, 15% and 20% depending on the income)

To make it simple:  Assumption  that the taxpayer is in 24% tax bracket for ordinary income and 15% for long-term capital gain

Example 1 would result in  ($2,250 + $1,558.25) x 24% = $913.98 of tax

Example 2 would result in $2,250 x 24% + $1,558.25 x 15% = $796.24 of tax

Example 3 would result in $1,311.75 x 24% + $2,496.5 x 15% = $689.30 of tax

For tax planning purpose, if the ESPP stock meet  Qualifying disposition (stock hold at least two years after the offering date and at least one year after the purchase date) would result the lowest tax.