Proactive Accounting & Tax Services Small Business Owners, Tax Reduction

Be Sure to Know the Tax-Home Rule

When you travel out of town overnight, you need to know the tax-home rule. The IRS defines your tax home, and it’s not necessarily in the same town where you have your personal residence.

If you have more than one business location, one of the locations will be your tax home. It’s generally your main place of business.

In determining your main place of business, the IRS takes into account three factors:

  1. the length of time you spend at each location for business purposes;
  2. the degree of business activity in each area; and
  3. the relative financial return from each area.

Here’s a recent court case that illustrates this rule.

Akeem Soboyede, an immigration attorney, was licensed to practice law in both Minnesota and Washington, D.C., and he maintained solo law practices in both Minneapolis and Washington, D.C. 

Although Mr. Soboyede’s primary personal residence was in Minneapolis, he divided his time between his office in Minneapolis and his office in Washington, D.C.

Get ready for a chuckle: in court, Mr. Soboyede admitted in his testimony that he did not keep the necessary documentation because he “did not know . . . [he] was going to get audited.”

Due to the lack of records, the IRS disallowed most of the deductions. The remaining issue for the court was the travel expenses for lodging for which Mr. Soboyede had the records.

The court noted that Mr. Soboyede’s lodging expenses were only deductible if he was “away from home” as required by Section 162(a)(2).

In deciding whether Mr. Soboyede’s tax home was in Minneapolis or Washington, D.C., the court used the following two factors:

  • Where did he spend more of his time?
  • Where did he derive a greater proportion of his income?

Answer: Washington, D.C. Think about this: He had his home in Minneapolis, but the court ruled that his “tax home” was in Washington, D.C. As a result, he lost his travel deductions.

Proactive Accounting & Tax Services Small Business Owners, Tax Deduction

How to Deal with the New $142,800 Base for Self-Employment Taxes

What happens when lawmakers enact a new tax?

It starts small.

It looks easy.

In 1935, the self-employment tax topped out at $60. Those 1935 lawmakers must be twirling in their graves with the new rules for 2021, which levy the following taxes:

  • A self-employment tax of up to $21,848, which comes from the 15.3 percent rate that applies to self-employment income of up to $142,800.
  • A 2.9 percent tax that applies to all self-employment income in excess of the base amount.

Beware

You know the expression “Don’t let the camel’s nose get under the tent”? It applies here.

Look at what has happened to self-employment taxes since they first came into being in 1935, assuming you earn at the base amount:

  • $60 in 1935
  • $60 in 1949
  • $3,175 in 1980
  • $7,849 in 1990
  • $14,413 in 2006
  • $21,848 in 2021

To put the rates in perspective, say you are single and earn $150,000. On the last dollar you earned—dollar number $150,000—how much federal tax did you pay? The answer in round numbers—39 cents (14 cents in self-employment and 24 cents in federal income taxes).

Wow! That’s a lot. Then, if you live in a state with an income tax, add the state income tax on top of that.

Tax Planning

Two things to know about tax planning:

  1. Your new deductions give you benefits starting at your highest tax rates.
  2. In most cases, the return on your planning is not a one-time event. Once your plan is in place, you reap the benefits year after year. Thus, good tax planning is like an annuity.

Checklist

Here is a short checklist of some tax-planning ideas. Review these ideas so you can identify new business deductions for your tax return. You want business deductions because business deductions reduce both your income and your self-employment taxes.

  • Eliminate the word “friend” from your vocabulary. From now on, these people are sources of business, so start talking business and asking for referrals over meals and beverages.
  • Hire your children. This creates tax deductions for you, and it creates non-taxable or very low taxed income for the children. Also, wages paid by parents to children are exempt from payroll taxes.
  • Learn how to combine business and personal trips so that the personal side of your trip becomes part of your business deduction under the travel rules (for example, traveling by cruise ship to a convention on St. Thomas).
  • Properly classify business expansion expenses as immediate tax deductions rather than depreciable, amortizable, or (ouch!) non-deductible capital costs.
  • Properly identify deductible start-up expenses ($5,000 up-front and the balance amortized) rather than letting them fall by the wayside (a common oversight).
  • Correctly classify business meals that qualify for the 100 percent deduction rather than the 50 percent deduction.
  • Know the entertainment facility rules so your vacation home can become a tax deduction.
  • Identify the vehicle deduction method that gives you the best deductions (choosing between the IRS mileage method and the actual expense method).
  • Correctly identify your maximum business miles, so you deduct the largest possible percentage of your vehicles.
  • Use a 1031 exchange to defer taxes (perhaps until death, when the tax code marks up your assets to fair market value and the income taxes disappear).
  • Qualify your office in your home as an administrative office.
  • Use allocation methods that make your home-office deductions larger.
  • If you are married with no employees, hire your spouse and install a Section 105 medical plan (Health Reimbursement Arrangements) to move your medical deductions to Schedule C for maximum benefits.
  • Operate as a one-person S corporation to save self-employment taxes.
  • If you are single with no employees, operate as a C corporation and install a Section 105 medical plan so you can deduct all your medical expenses.

If you would like my help implementing any of the ideas above, please don’t hesitate to contact us.

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Proactive Accounting & Tax Services Small Business Owners, Tax Deduction

Deduct 100 Percent of Your Business Meals under New Rules

Since 1986, lawmakers have limited business meal deductions: first to 80 percent, and then to 50 percent (unless an exception applies).

But on December 27, 2020, in an effort to help the restaurant industry due to the COVID-19 pandemic, lawmakers enacted a new, temporary 100 percent business meal deduction for calendar years 2021 and 2022.

To qualify for the 100 percent deduction, you need a restaurant to provide you with the food or beverages.

The law requires only that the restaurant provide the food and beverages. You don’t have to pay the money directly to the restaurant. For example, you qualify for the 100 percent deduction if you order a restaurant meal that’s delivered by Uber Eats or Grubhub.

Your deductible business meals must be tax code Section 162 ordinary and necessary business expenses, and they must not be subject to disallowance under tax code Section 274.

You must be present at the business meal, and you must provide the business meal to a person with whom you could reasonably expect to engage or deal with in the active conduct of your business, such as a customer, client, supplier, employee, agent, partner, or professional advisor, whether established or prospective.

Remember, to qualify for the 100 percent deduction, you need a restaurant. The IRS recently provided definitions and examples of what is and is not a restaurant.

A restaurant is “a business that prepares and sells food or beverages to retail customers for immediate consumption, regardless of whether the food or beverages are consumed on the business’s premises.” It is not any of the following:

  • Grocery stores
  • Specialty food stores
  • Beer, wine, or liquor stores
  • Drug stores
  • Convenience stores
  • Newsstands
  • Vending machines or kiosks

In general, the 50 percent limitation applies to business meals from the sources listed above.

The restaurant creates the 100 percent deduction.

To help you get ready, check the table below for what you can do in 2021 and 2022 as the law stands now:

Description (Deductible for Tax Years 2021-2022)100% Deductible50% DeductibleZero Deductible
Restaurant meals with clients and prospectsX  
Entertainment such as baseball and football games with clients and prospects  X
Employee meals for convenience of employer, served by in-house cafeteria X 
Employee meals for required business meeting, purchased from a restaurantX  
Meal served at chamber of commerce meeting held in a hotel meeting roomX  
Meal consumed in a fancy restaurant while in overnight business travel statusX  
Meals cooked by you in your hotel room kitchen while traveling away from home overnight X 
Year-end party for employees and spousesX  
Golf outing for employees and spousesX  
Year-end party for customers classified as entertainment  X
Meals made on premises for general public at marketing presentationX  
Team-building recreational event for all employeesX  
Golf, theater, or football game with your best customer  X
Meal with a prospective customer at the country club following your non-deductible round of golfX  
Proactive Accounting & Tax Services Small Business Owners

Starting a New Business? Get Up to $100,000 in Tax-Free Money

You likely already know that the employee retention credit (ERC) is a good deal—if you qualify.

Now, thanks to the recently enacted American Rescue Plan Act of 2021 (ARPA), you can qualify for up to $100,000 of ERC in the third and fourth quarters of 2021 if you

  • begin the business after February 15, 2020 (you could start today),
  • have average annual gross receipts of $1 million or less, and
  • do not meet either of the ERC tests—the suspended operations test or the gross receipts test—in place before ARPA was passed.

When you meet the three requirements above, you qualify as a recovery start-up business and, as such, can claim an ERC of up to $50,000 in both the third and fourth quarters of 2021.

It works like this: your recovery start-up business ERC is equal to 70 percent of the qualified wages paid to each employee (up to $10,000 per employee per quarter), with an overall maximum credit of $50,000 per quarter.

The big deal with the two quarters of 2021 is that your business has to be new, but it does not have to suffer from COVID-19 stresses. In fact, it can’t qualify for the recovery start-up business special deal if it otherwise qualifies under the suspended operations test or the gross receipts test.

Proactive Accounting & Tax Services Small Business Owners

New PPP Forgiveness Rules for Past, Current, and New PPP Money

Good news.

The new Paycheck Protection Program (PPP) law enacted with the stimulus package adds dollars to your pockets if you have or had PPP money.

Before we go further, please note the PPP money comes to you in what appears to be a loan. We say “appears” because you typically pay back a loan.

Done right, however, the PPP loan is 100 percent forgiven. The word “loan” makes some businesses leery of this arrangement. Don’t be. The PPP monetary arrangement is a true “have your cake and eat it too” deal.

And this remarkable deal applies to your past PPP loan, the PPP loan you have outstanding, and the PPP loan you are about to get if you have not had one before. Here are the details.

Loan Proceeds Are Not Taxable

The COVID-related Tax Relief Act of 2020 reiterates that your PPP loan forgiveness amount is not taxable income to you.

Expenses Paid with Forgiven Loan Money Are Tax-Deductible

As you may remember, the IRS took the position that expenses paid with PPP loan forgiveness monies were not deductible.

Lawmakers disagreed but were unable to get the IRS to change its position. The IRS essentially told lawmakers, “If you want the expenses paid with a PPP loan to be deductible, change the law.”

And that’s precisely what lawmakers did. The COVID-related Tax Relief Act of 2020 states that “no deduction shall be denied, no tax attribute shall be reduced, and no basis increase shall be denied, by reason of the exclusion from gross income.”

In plain English, the expenses paid with monies from a forgiven PPP loan are now tax-deductible, and this change goes back to March 27, 2020, the date the Coronavirus Aid, Relief, and Economic Security (CARES) Act was enacted.

Proactive Accounting & Tax Services S Corporation, Small Business Owners

Avoid Trouble: Don’t Let the IRS Set Your S Corporation Salary

You likely formed an S corporation to save on self-employment taxes.

If so, is your S corporation salary

  • nonexistent?
  • too low?
  • too high?
  • just right?

Getting the S corporation salary right is important. First, if it’s too low and you get caught by the IRS, you will pay not only income taxes and self-employment taxes on the too-low amount, but also both payroll and income tax penalties that can cost plenty.

Second, in most cases, the IRS is going to expand the audit to cover three years and then add the income and penalties for those three years.

Third, after being found out, you likely are now stuck with this higher salary, defeating your original purpose of saving on self-employment taxes.

Getting to the Number

The IRS did you a big favor when it released its “Reasonable Compensation Job Aid for IRS Valuation Professionals.”

The IRS states that the job aid is not an official IRS position and that it does not represent official authority. That said, the document is a huge help because it gives you some clearly defined valuation rules of the road to follow and takes away some of the gray areas.

Market Approach

The market approach to reasonable compensation compares the S corporation’s business with others and then looks at the compensation being paid by those businesses to employees who look like you, the shareholder-employee who is likely the CEO.

The question to be answered is, how much compensation would be paid for this same position, held by a nonowner in an arm’s-length employment relationship, at a similar company?

In its job aid, the IRS states that the courts favor the market approach, but because of challenges in matching employees at comparable companies, the IRS developed other approaches.

Cost Approach

The cost approach breaks your employee activities into their components, such as management, accounting, finance, marketing, advertising, engineering, purchasing, janitorial, bookkeeping, clerking, etc.

Here’s an example of how the cost approach works to support a $71,019 salary as reasonable compensation for this S corporation owner whose corporation had $3.5 million in revenue and 19 employees:

TaskHoursWageAmount
Taxi driver and chauffeur104$12.75$1,326
General manager624$58.32$36,392
Wholesale buyer166$27.59$4,575
Collections clerk146$15.32$2,237
Sales representative624$30.96$19,149
Order clerk416$18.56$7,340
Totals2,080N/A$71,019

Health Insurance

The S corporation’s payment or reimbursement of health insurance for the shareholder-employee and his or her family goes on the shareholder-employee’s W-2 and counts as compensation, but it’s not subject to payroll taxes, so it fits nicely into the payroll tax savings strategy for the S corporation owner.

Pension

The S corporation’s employer contributions on behalf of the owner-employee to a defined benefit plan, simplified employee pension (SEP) plan, or 401(k) count as compensation but don’t trigger payroll taxes. Such contributions further enable the savings on payroll taxes while adding to the dollar amount that’s considered reasonable compensation.

Planning note. Your S corporation compensation determines the amount that your S corporation can contribute to your SEP or 401(k) retirement plan. The defined benefit plan likely allows the corporation to make a larger contribution on your behalf.

Section 199A Deduction

The S corporation’s net income that is passed through to you, the shareholder, can qualify for the 20 percent Section 199A tax deduction on your Form 1040.

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Proactive Accounting & Tax Services Small Business Owners, Tax Deduction

How Many Whole or Partial Rooms Can You Use for Your Home Office?

With the COVID-19 pandemic still going on, you may be spending more time working from your home office.

You may have taken some extra rooms for your business use. Is that okay?

Section 280A(c) states that you may claim a home office based on the portion of the dwelling that you use exclusively and regularly for business. Thus, the law dictates no specific number of rooms or particulars regarding the size of the office.

The courts make this rule clear, as you can see in the Mills (less than one room) and Hefti (lots of rooms) cases described below.

The Mills Case

Albert Victor Mills maintained an office in his apartment from which he conducted his rental property management business. The apartment was small, totaling only 422 square feet. In the office area of the apartment where Mr. Mills had his desk, he also kept tools, equipment, paint supplies, and a filing cabinet.

The court agreed with Mr. Mills’s allocations and awarded the home-office deduction based on his claimed 23 percent business use of the 422-square-foot apartment.

Planning note. Mr. Mills did not have a single room dedicated to a home office. He had only an area of the apartment where he grouped his office furnishings, equipment, and supplies. If you have a similar situation, make sure your business assets are located in a group.

The Hefti Case

Charles R. Hefti lived in a big house, totaling 9,142 square feet. He claimed that more than 90 percent of his home was used regularly and exclusively for business.

Based on its review of the rooms, the court concluded that 13 rooms, totaling 19 percent of the home, were used exclusively and regularly for business.

Insights

The deductible portion of your home for an office includes the area used exclusively and regularly for business.

Let’s say you have an office in one room and your files in a second room, and you never use these rooms for personal purposes. Further, let’s say you use the office area on a daily basis and the file area in connection with that daily work.

Both rooms would meet the exclusive and regular use requirements, just as Mr. Mills’s and Mr. Hefti’s offices met these rules.

But Not This

“Exclusive use” means that you must use a specific portion of the home only for business purposes. You must make no other use of the space.

Exception. One exception to the exclusive use rule is storage of inventory or product samples if the home is the sole fixed location of a trade or business selling products at retail or wholesale.

Example 1. Your home is the only fixed location of your business, which involves selling mechanics’ tools at retail. You regularly use half of your basement for storage of inventory and product samples. You sometimes use the area for personal purposes. The expenses for the storage space are deductible even though you do not use this part of your basement exclusively for business.

Example 2. In Pearson, Dr. Pearson practiced orthodontics in a downtown medical building but retained the dental records of more than 3,000 patients in 36 file drawers (each measuring 26 inches by 14 inches by 12 inches) and had 1,461 boxes containing orthodontic models (each box measuring 10 inches by 6 inches by 2 1/2 inches).

He stored the records in the attic and basement of his home. The areas used for such storage were not separate rooms, and the remaining portions of the attic and basement were used by Dr. Pearson and his family for personal purposes.

The court ruled that Dr. Pearson may not treat the storage areas as home-office expenses because the records were not inventory or samples and Dr. Pearson did not operate a wholesale or retail trade or business from his home.

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Proactive Accounting & Tax Services S Corporation, Small Business Owners

PPP Update: Two New Rules for Owners of S and C Corporations

The Payroll Protection Program (PPP) rules—they keep a-changin’.

During the past month, the Small Business Administration (SBA) issued a new set of frequently asked questions (FAQs) and a new interim final rule, which in combination create the following good news for the Payroll Protection Program (PPP):

  • More forgiveness. The $20,833 cap on corporate owner-employee compensation applies to cash compensation only. It’s not an overall compensation limit as the SBA had stated in its prior interim guidance. Under this new rule, the owner-employee can add retirement benefits on top of the cash compensation, creating a new higher cap.
  • Escape owner status. You are not an owner-employee if you have less than a 5 percent ownership stake in a C or an S corporation. Therefore, the cap on forgiveness for this newly defined non-owner-employee is not $20,833 but rather $46,154.

The new rules override prior guidance and have significance for PPP loan forgiveness today—and perhaps for obtaining additional loan monies retroactively (if Congress reinstates the PPP along with a new second round for businesses that suffered a big drop in revenue).

Here’s one example of how the new rules benefit John, an S corporation owner.

Example. John, the sole owner and worker, operates his business as an S corporation. His 2019 W-2 shows $140,000 in Box 1, of which $20,000 is for health insurance. In addition, the S corporation pays state unemployment taxes of $500 on John’s income and contributes $20,000 to his pension plan.

Based on the facts in the example, the corporation is eligible for up to $25,000 of PPP loan forgiveness, as follows:

  • $20,833 on John’s salary (the cap), which the corporation pays to John at his regular rate in less than 10 weeks during the covered period;
  • $4,167 on John’s retirement ($20,000 x 20.83%); and
  • zero on the unemployment taxes because they were paid out in January, before the covered period began.

Advantage. Prior guidance limited forgiveness to $20,833. John’s S corporation gains $4,167 in additional forgiveness thanks to the new FAQs, assuming that the S corporation’s loan amount is $25,000 or more (which is possible).

The good news in the new guidance is that the corporate retirement contributions on behalf of owner-employees now count for additional forgiveness when the owner-employee has cash compensation greater than $100,000. And with the C corporation, the new guidance allows health insurance for the owner-employee.

Proactive Accounting & Tax Services Financing, Small Business Owners

7 Things To Know Before You Take Out an Economic Injury Disaster Loans (EIDLs)

Small Business Administration (SBA) Economic Injury Disaster Loans (EIDLs) can be a great source of low-interest funding for businesses struggling with the economic impact of the COVID-19 pandemic.

Unlike Payroll Protection Program (PPP) loans, EIDLs are not forgivable—borrowers have to pay them back. But they have a low 3.75 percent interest rate and a long 30-year repayment period. Borrowers can repay them at any time without penalty.

To obtain an EIDL, borrowers must sign a loan authorization and agreement, a note, and a security agreement filled with fine print. Many of these provisions could have a significant impact on the borrower’s business for the life of the loan—up to 30 years.

It is vital to understand the terms and conditions before taking out any loan, including an EIDL. Here are seven key provisions borrowers should be aware of.

1. No Changes to the Business

Without SBA approval, EIDL borrowers may not sell the business or change its ownership structure. This includes removing or adding a business partner.

2. No Distributions Outside the Usual Course of Business

The owners may not make distributions outside the usual course of business without SBA approval. This includes loans, advances, bonuses, or asset transfers to owners, employees, or other companies.

Distributions within the usual course of business are permitted. SBA officials have said this includes distributions of net income to owners of a pass-through business, such as an S corporation or a limited liability company.

3. Strict Record-Keeping Requirements

The SBA imposes strict record-keeping requirements on EIDL borrowers. They must keep itemized receipts showing how they spend the loan funds. Also required is a full set of financial and operating statements, which must be furnished to the SBA each year. The SBA also has the option of requiring an expensive review of the borrower’s records by an independent CPA.

4. Using Other COVID-19 Payments to Pay the SBA

EIDLs are intended to cover disaster losses not compensated by other sources. If an EIDL borrower obtains grants, loans, insurance proceeds, or lawsuit recoveries to help defray COVID-19-related losses, the borrower is required to notify the SBA. The SBA may require that such money be used to repay the EIDL.

But a business may obtain both a PPP loan and an EIDL so long as it doesn’t use them for the same expenses.

5. Strict Collateral Requirements

Businesses that borrow more than $25,000 are required to pledge all their business’s personal property as collateral. Such collateral includes present and future inventory, equipment, deposit accounts, promissory notes, negotiable instruments, and receivables.

The SBA obtains a security interest in all such collateral the borrower has at the time of the loan, or collateral it acquires or creates in the future. The borrower must

  • obtain hazard insurance for its collateral, and
  • ask the SBA for permission before selling or otherwise disposing of its collateral, other than selling inventory in the ordinary course of business.

6. Buy American

EIDL borrowers must promise to buy American-made equipment and products with the loan proceeds, to the extent feasible.

7. Penalties for Violations

Penalties for violations of the EIDL terms can be severe. The SBA can demand immediate repayment of the entire loan if the borrower breaches any of its terms. The SBA also reports defaults to credit reporting agencies.

Borrowers who misapply EIDL funds—for example, using them to pay personal expenses—are liable to the SBA for an amount equal to one-and-a-half times the original loan.

Proactive Accounting & Tax Services Small Business Owners, Tax Deduction

Working at Home? Don’t Overlook These Deductions

Whether you claim a business office in the home or are simply working at home, say because of COVID-19, you likely have some former personal assets that you now use for business.

Ah, new tax deductions!

Yep. Say you don’t claim a home-office deduction but now you are working at home and sitting in the fancy chair you inherited from your grandmother.

Let’s say you use the fancy chair 85 percent for business purposes. Can you depreciate 85 percent of that chair?

Yes.

Let’s say that grandma’s estate was appraised and this chair had a value of $10,000 when you inherited it about a year ago. It’s an antique, so it’s not gone down in value since you inherited it.

Depreciating a Formerly Personal Asset

When you convert the fancy chair to 85 percent business use, the law sees you as placing the item in service in your business at that time. That means you can begin depreciating the asset and claiming your tax deductions.

To determine the basis to use for depreciation, use the lesser of

  • fair market value on the date of conversion from personal to business use, or
  • adjusted basis of the property (generally the amount you paid for the asset plus the cost of any improvements).

With the fancy chair, your adjusted basis is the inherited value.

But say you bought the chair for $8,000. Suppose it was worth $10,000 when you converted it to personal use. You would use the $8,000 figure to determine your depreciation deductions.

Bonus Depreciation and Section 179 Expensing

Unfortunately, unlike assets directly purchased for your business, you may not use Section 179 to immediately expense assets that you convert from personal to business use.

Bonus Depreciation Is a Different Story

If you acquire bonus depreciation qualified property for personal use after September 27, 2017, and convert it to business use this year (or anytime before 2027), you must use 100 percent bonus depreciation if you don’t elect out of it.

Example. You purchased an antique clock for $9,300 in January 2018. Yesterday, you placed the clock in business service by moving the clock from your entryway to your home office. If you don’t make a formal election in your tax return to elect out of bonus depreciation, you must claim a $9,300 depreciation deduction on the antique clock this year.

Basis When You Sell

There’s a trick to basis when you sell converted property—you use a different rule for calculating losses than you do for calculating gains:

  • Losses. To calculate losses, use your adjusted basis (conversion basis as discussed above minus depreciation).
  • Gains. To calculate gains, use original cost basis minus post-conversion depreciation. In most cases, original cost gives you a higher basis and thus less tax. So don’t accidentally use adjusted basis.

Note. For inherited assets, your cost basis is the estate value (generally, the date of death value).

Clarifying Examples

Let’s say you bought a personal use desk/credenza/bookcase set for $8,000 and then converted it to business use when its fair market value had fallen to $6,000. Here are the tax consequences for three different sales scenarios (to make the examples clear, we ignored depreciation):

  • Loss. If you sell the desk/credenza/bookcase set for $4,000, you have a $2,000 deductible loss ($6,000 – $4,000). Note. This is much better than if you sold the desk/credenza/bookcase set as a personal asset, which would create a zero deductible loss.
  • Gain. If you sell the desk/credenza/bookcase set for $10,000, you have a $2,000 gain ($10,000 – $8,000).
  • Gray area. If you sell the set for $7,000, you have neither gain nor loss on the sale. That’s a decent result—it means no taxes for you (but no deductible losses either).