The Process of Selling A Business - Pitfalls To Avoid

For business owners, selling the business is often the single most important financial transaction in their lifetime.  Since this is such an important event, we created a video series that will guide business owners through the selling process. Dave Wojeski, a partner at Greenbush Financial, has spent years in the merger acquisition space, focusing on business transaction between $5M and $100M in value.  Over the course of these 3 videos, Dave will share the following information about the sell side of these business transactions: 

Video 1: Valuation & Prepping Your Business For Sale

• Knowing when it’s the right time to sell your business

• How to determine the value of your business

• The returns that buyers typical expect from the acquisition of your business

• Prepping your business for sale to command a higher valuation

Video 2:  The Process of Selling Your Business

• The steps associated with selling your business

• Professionals involved in the selling process

• Letter of Intent (LOI), Due Diligence, and Purchase Agreement Terms

• Special considerations when selling the business to your children

Video 3:  Pitfalls To Avoid When Selling Your Business

• Common pitfalls to avoid when selling your business

• Employment agreements post sale

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

The New PPP Loan Forgiveness Application & Early Submission

It just keeps getting better for small business owners.  On June 17, 2020, the SBA released the updated PPP Forgiveness Application.   In addition to making the forgiveness application easier to complete, the new application also provided additional guidance on a number of questions that arose when the SBA extended the forgiveness period to 24 weeks. 

But it gets better. On June 22nd, the SBA issued additional guidance allowing borrowers to apply for forgiveness prior to the end of the 8 week or 24 week covered period if the borrowers had already spent their full PPP loan amount. 

With so much that has happened since the Paycheck Protection Program was first launched. Here is a quick recap of the events leading up to the release of the new PPP Forgiveness Application and the new guidance: 

March 27, 2020:  Congress passed the CARES Act which created the PPP Loan Program

April 2020:  The SBA opens the window for companies to access the PPP Loans

May 15, 2020:  The SBA released the first version of the PPP Loan Forgiveness Application

June 5, 2020:  Congress passed the PPP Flexibility Act

• Extended Covered Period to 24 Weeks

• Reduced payroll cost requirement from 75% to 60%

• Extended rehire safe harbor from June 30th to December 31st

June 17, 2020:  SBA releases the updated PPP Forgiveness Application

June 22, 2020: SBA allows companies to apply for forgiveness prior to the end of the covered period 

In this article we are going to address: 

• How to complete the new PPP Forgiveness Application

• The EZ Forgiveness Application vs the Long Form PPP Forgiveness Application

• Which companies are eligible to submit the PPP EZ Forgiveness Application

• The new max comp limits of $20,833 and $46,154

• Ability to apply for forgiveness prior to the end of the covered period

PPP EZ Forgiveness Application – Form 3508EZ

Instead of releasing just one forgiveness application, the SBA actually released two separate PPP Forgiveness applications: 

• PPP Loan Forgiveness EZ - Form 3508EZ

• PPP Loan Forgiveness Revised – Form 3508

The good news is both applications are much shorter than the initial 12 page Forgiveness Application that was released on May 15th, but making it even better, we now also have an EZ application which will make the Paycheck Protection Program Forgiveness Application process even easier for many companies. The EZ application is only 3 pages long. giving companies access to a shorter forgiveness application made sense to us because the PPP loan amount was calculated based on 10 weeks of payroll and with the extension of the covered period to 24 weeks, companies now have 24 weeks of payroll to cover a loan amount based on 10 weeks. The result, most companies will most likely be able to reach the full PPP forgiveness amount on Payroll Costs alone without having to take into account rent, utilities, and other qualified expenses. 

Who Is Eligible To Use The PPP EZ Forgiveness Application? 

Companies will only be able to utilize the PPP EZ Forgiveness Application if they satisfy one of the following three criteria. I will give you the short and sweet version first followed by the long technical version of the criteria.  Short and sweet: 

• You have no employees (Sole Proprietors or Owner Only Entities)

• You did not reduce employee HEADCOUNT (FTE’s) and did not reduce WAGES by more than 25% for employees making less than $100,000 in 2019 during the covered period compared to January 1, 2020 – March 31, 2020

• You did not reduce employee WAGES by more than 25% for employees making less than $100,000 in 2019 but you reduced the number of FTE’s during the covered period. However, the reduction in FTE’s was because CDC, OSHA, or other government agencies limited the capacity that the business could operate at during the covered period.

Here is the long technical version of the three criteria: 

• The borrower is a self-employed individual, independent contractor, or sole proprietor who had no employees at the time of the PPP loan application and did not include any employee salaries in the computation of the average monthly payroll in the PPP Application Form (SBA Form 2483).

• The borrower did not reduce annual salary or hourly wages of any employee by more than 25% during the covered period compared to January 1, 2020 and March 31, 2020 AND The borrower did not reduce the number of employees or the average paid hours of employees between January 1, 2020 and the end of the covered period.

• The borrower did not reduce annual salary or hourly wages of any employee by more than 25% during the covered period compared to January 1, 2020 – March 31, 2020 AND the borrower was unable to operate during the covered period at the same level of business activity as before February 15, 2020, due to compliance with requirements established or guidelines issued between March 1, 2020 and December 31, 2020 by the Secretary of Health, CDC, or OSHA, related to the maintenance of standards of sanitation, social distancing, or any other work or customer safety requirement related to COVID-19.

Again, you just have to be able to satisfy ONE of the three criteria listed above. You do not need to satisfy all three. 

Reduction In Wages of Employees

Per the criteria mentioned above, if you reduced wages by more than 25% during the covered period for employees that made under $100,000 in 2019, you would not be able to complete the PPP EZ Application. 

At first look this seems pretty self-explanatory but it’s really not. If you just read that statement for what it is, it would lead you to look at just your year-end payroll report for 2019, determine who had an annual compensation of $100,000 or less, and then you would look to see if any of those employees had wage reductions of greater than 25% during the covered period. 

However, the way the guidance was written, it would imply that the $100,000 annualized compensation  applies on a per pay period basis, meaning if in ANY pay period in 2019, you paid an employee higher than a $100,000 annualized wage, that employee would not be subject to the wage reduction calculation.  It’s best to illustrate this in an example. 

Let’s say Jim is one of your employees and in 2019 you paid Jim a total of $80,000.  His $80,000 in compensation included $75,000 in base pay plus his $5,000 annual bonus that was paid to him in the final pay period in December.  Your payroll is run on a biweekly basis meaning for purposes of assessing the $100,000 annual compensation limit, any employee that received more than $3,846.15 in any bi-weekly pay period in 2019, would not be subject to the wage reduction calculation.  Since in Jim’s last paycheck of 2019, he received his regular bi-weekly wage of $2,884.15 plus his annual bonus of $5,000, his final paycheck in December was for $7,884.15.  Thus Jim is excluded from the wage reduction calculation and can be ignored for purposes of assessing whether or not you are eligible to complete the PPP EZ Forgiveness Application even though his total compensation for 2019 was under $100,000. 

Whether or not it was the SBA’s intention to assess the $100,000 limit in this manner, we cannot be 100% certain, but as of today, that’s how it reads. 

Now that we have all of that fun stuff out of the way, let’s get to completing the PPP Forgiveness EZ Application. For the purpose of this article we are focusing on the EZ application because given the new 24 week covered period, the new safe harbor exceptions, and the ability to submit the application early, we expect that a lot of companies will qualify to submit the EZ Forgiveness application. 

How To Complete the PPP Loan Forgiveness EZ Application

Here is what the first page of the PPP Loan Forgiveness Application Form 3508EZ looks like:  

SBA PPP Loan Forgiveness Application

There are no worksheets that need to be completed!! It’s just this page and a second page that has a bunch of lines that Borrower has to initial certifying that they followed all of the rules associated with the PPP Loan Program.  

Top Section: The top section of the form is just general information on your company, your PPP loan, and your payroll schedule. 

Covered Period:  If your PPP loan was issued prior to June 5th, you have the option to either select the 8 week covered period or 24 week covered period.   The covered period beings on the date that you received the PPP loan.  One might ask, why would anyone choose the 8 week covered period?  There are actually a few reasons. 

Reason 1: The company has already spent all of the PPP loan money within the 8 week period. 

Reason 2:  By electing the 24 week covered period, it also potentially creates a 24 week covered period for the FTE (full time equivalent employee) calculation and the 25% wage reduction calculation.  But the guidance that we just received from the SBA on June 22nd which allows companies to file the forgiveness application prior to the end of the covered period could change this.  The SBA issued guidance allowing companies to file the forgiveness application early but they did clarify what happens if the company receives full forgiveness but then reduces wages or FTE’s prior the end of the full 24 week covered period.  We are flying blind right now until we get more guidance from the SBA on this. 

For companies that have not spent 100% of their PPP loan amount, it think this new guidance creates a wait and see approach, as to whether the company should select the 8 week covered period or select the 24 week covered period with the ability to apply for forgiveness early. 

For companies that have been able to spend 80%  to 90% of their PPP loan during the 8 week covered period, that were planning on reducing employees or wages after the covered period was complete, depending on the guidance that the SBA issues, it may be advantageous for those companies to stick with the 8 week period, as opposed to being subject to the 24 week covered period calculations that could reduce the forgiveness amount. 

The only other downside to selecting the 8 week period is the compensation limit for each owner and each employee is capped at a lower level compared to the 24 week covered period.  We will cover this when we get to the Payroll Cost portion of the forgiveness application. 

What is the “End Date” of your Covered Period?

With this change, I’m not really sure what is considered the new “end date” for the Covered Period.  Being able to apply for forgiveness prior to the end of the covered period makes the end date of the covered period seem irrelevant.   Maybe the new end date of the covered period is the day that you submit the forgiveness application.  That makes more sense to me because that would be the time period that you would be submitting payroll data for and the nonpayroll expenses that have either been paid or incurred, but it’s not clear at this point. 

Alternative Payroll Covered Period:  As mentioned above, the covered period begins the day the PPP loan hit your business checking account.  However, companies are allowed to elect to begin their covered period at the beginning of their next payroll period following the receipt of the PPP Loan. 

Example: Company XYZ has a bi-weekly payroll schedule.  They receive their PPP loan on April 26th in the middle of one of their payroll periods.  The company could voluntarily elect an alternative payroll covered period beginning on May 5th with would be the first day of the next payroll period.  This could make the calculations a little easier since the payroll dates will match up with a covered period. 

The extension of the covered period to 24 weeks and the ability to file for forgiveness early may render the Payroll Covered Period feature irrelevant for many companies.  It was more relevant when companies had to make sure they could fit in their 8 weeks of payroll into their 8 week covered period to maximize their forgiveness amount. 

Line 1: Payroll Costs: The new PPP Forgiveness Application came with different compensation limits for owner-employees and regular employees. 

Sole Proprietors & Owner Only Entities

If you are a sole proprietor or owner only entity, the Payroll Cost calculation is going to be very easy.  For each owner, the payroll cost is the LESSER OF $20,833 or 2.5 months of compensation from 2019.  If you are a sole proprietor that made more than $100,000 in 2019, you can just enter $20,833 on that line and move on.  For companies with multiple owners with no employees, you would just total up the compensation amounts with the cap for each owner and enter it on that line. 

For Companies With Employees

If your company has employees and satisfies one of the three criteria making you eligible to complete the PPP Forgiveness EZ Application, using your own personal excel spreadsheet, you can total up the Payroll Costs for the owners and employees as follows: 

Different Max Compensation Limits For Owner-Employees & Employees

The new forgiveness application provided updated guidance on the maximum compensation allowed for both owners and employees during the covered period.  Under the old 8 week covered period, compensation was capped at $15,385 for both owners and employees.   With the new 24 week covered period, compensation is capped at the following: 

• Owner-employees: $20,833

• Employees: $46,154

The math makes sense because it’s the $100,000 compensation cap, dividend by 52 weeks, multiplied by a 24 week forgiveness period.  Unfortunately for owners, the cap was only increased to $20,833 and there is an additional restriction.  The compensation cap for owner-employees will be the LESSER OF: 

• $20,833; or

• 5 months of the owners 2019 compensation

But also using the same math, it would seem prudent that the $46,154 compensation cap for each employee would be reduced if you submit your PPP Forgiveness application prior to the end of the covered period.  Example: If you file your forgiveness application after 15 weeks it would seem prudent that each employee's compensation would be limited to $28,846 which is the $100,000 cap, divided by 52 weeks, multiplied by 15 weeks, but the SBA has yet to issue guidance on this. 

So column 1 of your excel spreadsheet is compensation paid during the covered period to owner-employees and employees with these compensation caps imposed. 

For Employees: Health & Retirement Contributions Are In Addition To Comp Limit

The next two columns in your excel spreadsheet should be “Health Insurance Costs” and “Employer Retirement Contributions”. 

For employees, the maximum compensation for any single non-owner employee during the 24 week covered period is $46,154, but that cap just applies to their compensation.  In addition to the $46,154 cap, the company can also include the following amounts in “Payroll Costs” for each employee: 

• Employer contributions for employee health insurance

• Employer contributions to employee retirement plans

For sole proprietors and partners, these amounts are not counted in addition to the $20,833 for owner employees. It’s not 100% clear how retirement contributions will work for owner-employees of S-corp and C-corp, but as of today, I would guess that they are going to be limited as well to the $20,833 for compensation, health insurance, and employer contributions to retirement plans. Guidance needed from the SBA on this. 

But again, we expect this to be irrelevant for many companies because most companies will be able to meet the full forgiveness amount on just the 24 weeks of payroll without having to factor in these other “Payroll Costs”. 

Total up all of those columns on your excel spreadsheet and you have reached your Line 1: Payroll Cost for the forgiveness application. 

Line 2:  Business Mortgage Interest:  Any interest payments on a covered mortgage obligation that was in place prior to February 15, 2020.  As of right now the definition is either PAID or INCURRED during the covered period. 

Line 3:  Rent or Lease Payments:  Payments of rent during the covered period for a lease that was in place prior to February 15, 2020.  Similar to mortgage interest, the cost can either be PAID or INCURRED during the covered period. 

Line 4:  Business Utility Payments:  The payment of utilities during the covered period include electricity, gas, water, transportation, telephone , and internet services that were in place prior to February 15, 2020. 

The Forgiveness Calculation

The rest of the form, Lines 5 – 8,  are fairly self explanatory.  You are adding up your total qualified costs in comparing that to your loan amount to determine the percentage of your forgiveness. 

Page 2: PPP Loan Forgiveness EZ Application

Page 2 of the PPP EZ Loan Application looks like this:

New PPP Forgiveness Application

The Borrower just has to initial on each line, sign the bottom of the form, and the application is complete.  The next step is to gather all the supporting documentation for the expenses that are listed on the PPP application and submit the forgiveness application with those supporting documents to your bank to formally begin the forgiveness process. the bank has 60 days from the date you submit your forgiveness application to either accept the application or reject it. 

The PPP Loan Forgiveness Application - Form 3508 ("Long Form")

If you don't qualify to submit the EZ Loan Forgiveness Application, then you would have to complete what I call the PPP Loan Forgiveness Long Form.  Now even though I call it the long form it's still shorter then the 12 page loan forgiveness application that was released by the SBA on May 15th.  The long form requires you to: 

• Complete the PPP Application Worksheets

• Run the FTE Calculations

• Run the Wage Reduction Calculation

• Determine if you satisfy any of the Safe Harbors

We will cover the long form in a separate article. 

Michael Ruger

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

SBA PPP Loan New 24 Week Covered Period & Additional Changes

ppp loan 24 week covered period

On June 3, 2020, Congress passed the Paycheck Protection Program (PPP) Flexibility Act which provided much needed relief to many businesses that were trying to qualify for full forgiveness of their SBA PPP Loan within the 8 week covered period.   This bill changed the Covered Period from 8 weeks to 24 weeks which will provide companies with more time to spend their PPP loan. But there were also other changes that were made to PPP program that we will cover in this article including: 

• Covered Period extended to 24 weeks

• Non-payroll cost increased from 25% to 40% of the loan amount

• Max Employee Comp may increase from $15,385 to $46,153

• Companies will have until December 31st to restore FTE’s (full time equivalents)

• Additional safe harbors for FTE calculation

• Companies can defer employer payroll taxes in addition to the PPP loan

• Loan duration extended from 2 years to 5 years

• New questions that the PPP Flexibility Act creates

New 24 Week Covered Period

This is probably the most important change that was made to the Paycheck Protection Program.  Companies will now have a 24 week covered period to spend their PPP loan Instead of the original 8 week period and qualify for full forgiveness of the loan amount. Since the SBA PPP Loans were calculated based on 10 weeks of payroll, companies were finding it challenging to spend the full loan amount within an 8 week period.  The new bill did not change the definition of qualified expenses. They are still: 

• Payroll

• Employee health insurance

• Employer contributions to retirement plans

• Mortgage interest

• Rent payments

• Utilities

But a lot of small businesses didn't have enough “non-payroll costs” within the 8 week period to reach the full amount of their PPP loan.  Also, many companies weren't able to hire their employees back until a few weeks into their Covered Period, so they did not have 8 weeks worth of payroll for many of their employees. 

Changing the Covered Period to 24 weeks will make qualifying for full forgiveness of the PPP loan very easy for many companies.  They now have a loan that was calculated based on 10 weeks of payroll but have 24 week of payroll to spend it on.  While there are still grey areas regarding some of the non-payroll costs associated with the PPP, the change to a 24 week Covered Period for most employers, will make them irrelevant because most employers will be able to spend the full loan amount on straight payroll costs. 

24 Week Covered Period Is Optional

The new PPP Flexibility Act does not require companies that received PPP loans to adopt a 24 week Covered Period. If the company received their PPP loan prior to the signing of the new PPP Flexibility Act, they can elect to continue to use their original 8 week Covered Period.  This is a favorable option for companies that have already spent their full PPP loan and have not had a reduction in employee headcount or reduced wages. 

However, companies that have spent the full PPP loan amount but have experienced a reduction in employee headcount or reduced wages, may want to consider adhering to the new 24 week covered period because it will provide them with more time to bring employees back and make the company eligible for full forgiveness of the loan. 

Ability To Apply For Forgiveness Early

This raises a question that we will hopefully get guidance on from the SBA or Treasury soon.  If a company is 15 weeks into their 24 week covered period, they have already spent the full PPP loan amount on qualified expenses, and they have restored FTE’s and wages, can they apply for forgiveness prior to the end of their 24 week period or do they have to wait? 

We don't know the answer to this one yet but a lot of companies are going to be asking this question. It seems like adding the ability to apply early for forgiveness would benefit both the borrower and the banks.  The banks do not want to be servicing a 1% loan any longer than they have to.  But allowing this also creates some issues.  All of the forgiveness calculations are based on a set Covered Period, if you have some companies applying for forgiveness after 12 weeks, others at 18 weeks, and some at 24 weeks, it could definitely complicate the forgiveness calculations. 

Non-Payroll Costs Increased from 25% to 40%

Prior to the passing of the PPP Flexibility Act, companies were required to spend at least 75% of the PPP loan amount on payroll cost in order to qualify for full forgiveness.  The new bill changed that.  Now companies only need to spend a minimum of 60% of the PPP loan amount on payroll costs to be eligible for full forgiveness. But arguably, not that many companies will need this now since they have 24 weeks of payroll costs to work with; but it adds some additional flexibility.

The 60% Cliff

While Congress may have loosened their restrictions on the minimum amount that needs to be used toward payroll costs it seems like it comes with a cliff.  While the old rules carried a 75% payroll cost threshold, it was assumed that for companies that fell short of the threshold, they would still qualify for partial forgiveness of the PPP loan amount.  Under this new 60% payroll threshold, as of today, it seems that if companies are unable to meet the 60% threshold, that none of the loan will qualify for forgiveness.  This will be an important feature to pay attention to for businesses like restaurants and bars that have been completely shut down and are only now starting to hire back employees.  Even with 24 weeks to work with, companies need to be aware of this possible 60% “all or none” forgiveness threshold that now seems to exist. Again, hopefully this is something that they will address in future guidance. 

Max Employee Comp $15,385 to $46,153

The PPP Flexibility Act did not change the $100,000 annual compensation limit for employees and owners. However, under the old 8 week covered period, each employee was limited to $15,385 in compensation during the covered period. 

$100,000 / 52 weeks x 8 weeks = $15,385 

Now that companies have a 24 week Covered Period, it would seem that the maximum compensation for each employee would naturally increase from $15,385 to $46,153. 

$100 / 52 weeks x 24 weeks = $46,153 

This has not been 100% confirmed yet but it will hopefully be addressed in the future guidance. 

You Cannot Increase Your PPP Loan Amount

This potential increase in the per employee compensation amount raises the question from employers, “Can I go back and ask for more money from the SBA for my PPP loan?” The short answer to that is “no”.  The PPP Flexibility Act did not change the calculation of the PPP loan amount, just other features of the program. They also specifically stated in the new bill, that the ability to apply for a PPP loan would not extend beyond June 30th.  As of today, there is a still about $100 Billion dollars allocated to the PPP loan program that is available to companies that have not yet applied for a PPP loan. 

For companies that would have qualified for the PPP loan but originally opted not to take it because they were completely shut down and doubted their ability to meet the 75% threshold of payroll within the 8 week Covered Period, this 24 week extension may now change their minds.  

FTE Rehired Date Extended to December 31, 2020

They also provided companies with a lot more time to bring back employees to avoid being penalized on the forgiveness amount of their loan.  Many companies are just now starting to open up but are by no means back to 100% of their staff and that was hurting them during the loan forgiveness process. Under the old rules, the FTE (full time equivalent) calculation was based on the last day of the borrower’s 8 week covered period but there was a safe harbor that stated as long as the employee headcount and wages were restored by June 30th, no FTE penalty would be assessed. 

Under the new PPP Flexibility Act, with a 24 week Covered Period, Employers will have more time to bring back employees and restore wages to their pre COVID-19 levels. The new act also extended the safe harbor FTE provision from June 30th to December 31, 2020, so companies will have until the end of the year to restore their employee headcount and wages to their February 15, 2020 level in order to avoid FTE penalties during the forgiveness process. 

Additional FTE Safe Harbors

The new bill enhanced some of the FTE safe harbor provisions. These safe harbors were in place to protect companies that had a reduction in their FTE’s but restored them by a specific date and based the calculations on alternative comparison periods. The new PPP Flexibility Act added to this list of FTE safe harbors which will now include: 

• There was an inability to rehire individuals who were employees of the eligible recipient on February 15th,

• There was an inability to hire similarly qualified employees for unfilled positions on or before December 31, 2020, or

• There was an inability to return to the same level of business activity as such business was operating at before February 15th due to compliance with requirements established or guidance issued by the Secretary of Health and Human Services, the Director of the Center for Disease Control and Prevention, or the Occupational Safety and Health Administration During the period beginning March 2020 and ending December 2020.

To further clarify this new safe harbor language, if you are a restaurant owner and for the remainder of the year you are required to operate at a limited capacity due to restrictions set forth by these public health organizations, you can access these safe harbors, and your loan forgiveness amount will not be reduced due to the inability to restore your FTE headcount. 

Companies Can Defer Employer Payroll Taxes & Get PPP Forgiveness

One of the relief provisions within the CARES Act was providing companies with the option to defer their employer’s 6.2% share of Social Security Taxes until 2021 and 2022.  This provision allowed companies to avoid having to pay those taxes now and they had to repay those amounts 50% in 2021 and 50% in 2022.   The taxes are still due but the payments are delayed so it's essentially an interest free loan for companies. 

Under the old PPP provisions, companies were able to elect this up until the point that they receive forgiveness of their PPP loan. Once the loan was forgiven, they were no longer able to defer these employer taxes. The PPP Flexibility Act changed this.  Now companies will be able to have their PPP loan completely forgiven and will also be able to continue to defer the employer’s share of the FICA taxes until 2021 and 2022. 

Loan Duration Extended from 2 Years to 5 Years

For companies that do not receive full forgiveness of their PPP loan, it then operates as a traditional SBA loan subject to the term of the loan.  Originally the PPP loans were amortized for 2 years and carried a 1% interest rate.  With only a 2 year amortization, once the 6 month deferment to payments was up, companies could have had sizable loan payments given the short duration of the amortization schedule.  The PPP Flexibility Act now allows those loans to be amortized over 5 years. 

But we need guidance on this feature. It seems like all PPP loans issued after the passage of this Flexibility Act will adhere to the 5 year amortization schedule, but for PPP loans issued prior to the passing of this bill is it an optional provision on the part of the banks?  They will hopefully address this in the Q&A document. If borrowers have to negotiate with their bank to extend the duration of their loan, they could have a tough time doing so because again, the banks do not want to be servicing loans with a 1% interest rate for 5 years. The banks want those loans forgiven as soon as possible so they can get reimbursed by the SBA and then make new loans at higher interest rates. 

Extension of Loan Payments

The original Paycheck Protection Program allowed borrowers to defer loan payments for a 6 month period. This in most cases would prevent companies from ever having to make a payment on their PPP loan before it was forgiven.  With the new 24 week Covered Period (6 months), they extended the payment deferral for these PPP Loans to “the date the lender receives the forgiveness amount from the SBA”, which in many cases will now be longer than the 6 month period. 

This Creates New Questions

The other positive of this PPP Covered Period extension is it gives the SBA and Treasury more time to issue much needed guidance on some of these grey areas that exist within the PPP program.  We already covered a number of these unanswered questions earlier in the article but there is a big one that remains unanswered.  With the Covered Period being extended to 24 weeks, most companies will reach the end of their covered period in October and November, and the forgiveness process could take over 60 days bringing the actual forgiveness event in 2021.  Since, as of right now, companies cannot take a deduction for expenses paid with the forgiven PPP loan, accountants will be challenged on how to account for those expenses if forgiveness is still pending.  Which is probably something that needs to be addressed as some point in the Q&A. 

New Forgiveness Application

The first version of the SBA PPP Forgiveness Application was released a few weeks ago but given these changes to the PPP Program, I would be greatly surprised if they don't go back and create a revised Forgiveness Application.   Hopefully, the next application is a lot shorter than 11 pages and it should be. Since many companies will be able to satisfy the full PPP loan amount with just payroll cost for their employees, it seems like that should be an option on a single page, certifying the amount that was spent on straight payroll, that employee headcount and wages have been restored by a given date, in turn making the forgiveness process much easier for everyone.  After all of the madness that everyone has been through with this everchanging PPP program, a one-page PPP forgiveness application would be a welcomed gift for business owners, bankers, and financial professionals. 

Michael Ruger

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Coronavirus Relief: $100K 401(k) Loans & Penalty Free Distributions

With the passing of the CARES Act, Congress made new distribution and loan options available within 401(k) plans, IRA’s, and other types of employer sponsored plans. These new distribution options will provide employees and business owners with access to their retirement accounts with the: 

• 10% early withdrawal penalty waived

• Option to spread the income tax liability over a 3-year period

• Option to repay the distribution and avoid taxes altogether

• 401(k) loans up to $100,000 with loan payments deferred for 1 year

Many individuals and small businesses are in a cash crunch. Individuals are waiting for their IRS Stimulus Checks and many small business owners are in the process of applying for the new SBA Disaster Loans and SBA Paycheck Protection Loans.  Since no one knows at this point how long it will take the IRS checks to arrive or how long it will take to process these new SBA loans, people are looking for access to cash now to help bridge the gap.  The CARES Act opened up options within pre-tax retirement accounts to provide that bridge. 

10% Early Withdrawal Penalty Waived

Under the CARES Act, “Coronavirus Related Distributions” up to $100,000 are not subject the 10% early withdrawal penalty for individuals under the age of 59½. The exception will apply to distributions from: 

• IRA’s

• 401(K)

• 403(b)

• Simple IRA

• SEP IRA

• Other types of Employer Sponsored Plans

To qualify for the waiver of the 10% early withdrawal penalty, you must meet one of the following criteria: 

• You, your spouse, or a dependent was diagnosed with the COVID-19

• You are unable to work due to lack of childcare resulting from COVID-19

• You own a business that has closed or is operating under reduced hours due to COVID-19

• You have experienced adverse financial consequences as a result of being quarantined, furloughed, laid off, or having work hours reduced because of COVID-19

They obviously made the definition very broad and it’s anticipated that a lot of taxpayers will qualify under one of the four criteria listed above.  The IRS may also take a similar broad approach in the application of these new qualifying circumstances. 

Tax Impact

While the 10% early withdrawal penalty can be waived, in most cases, when you take a distribution from a pre-tax retirement account, you still have to pay income tax on the distribution.   That is still true of these Coronavirus Related Distributions but there are options to help either mitigate or completely eliminate the income tax liability associated with taking these distributions from your retirement accounts. 

Tax Liability Spread Over 3 Years

Normally when you take a distribution from a pre-tax retirement account, you have to pay income tax on the full amount of the distribution in the year that the distribution takes place. 

However, under these new rules, by default, if you take a Coronavirus-Related Distribution from your 401(k), IRA, or other type of employer sponsored plan, the income tax liability will be split evenly between 2020, 2021, and 2022 unless you make a different election.  This will help individuals by potentially lowering the income tax liability on these distributions by spreading the income across three separate tax years.  However, taxpayers do have the option to voluntarily elect to have the full distribution taxed in 2020.   If your income has dropped significantly in 2020, this may be an attractive option instead of deferring that additional income into a tax year where your income has returned to it’s higher level. 

1099R Issue

I admittedly have no idea how the tax reporting is going to work for these Coronavirus-Related Distributions. Normally when you take a distribution from a retirement account, the custodian issues you a 1099R Tax Form at the end of the year for the amount of the distribution which is how the IRS cross checks that you reported that income on your tax return.  If the default option is to split the distribution evenly between three separate tax years, it would seem logical that the custodians would now have to issue three separate 1099R tax forms for 2020, 2021, and 2022.    As of right now, we don’t have any guidance as to how this is going to work. 

Repayment Option

There is also a repayment option associated with these Coronavirus Related Distributions, that will provide taxpayers with the option to repay these distributions back into their retirement accounts within a 3-year period and avoid having to pay income tax on these distributions. If individuals elect this option, not only did they avoid the 10% early withdrawal penalty, but they also avoided having to pay tax on the distribution. The distribution essentially becomes an “interest free loan” that you made to yourself using your retirement account. 

The 3-year repayment period begins the day after the individual receives the Coronavirus Related Distribution.  The repayment is technically treated as a “rollover” similar to the 60 day rollover rule but instead of having only 60 days to process the rollover, taxpayers will have 3 years. 

The timing of the repayment is also flexible. You can either repay the distribution as a: 

• Single lump sum

• Partial payments over the course of the 3 year period

Even if you do not repay the full amount of the distribution, any amount that you do repay will avoid income taxation.   If you take a Coronavirus Related Distribution, whether you decide to have the distribution split into the three separate tax years or all in 2020, if you repay a portion or all of the distribution within that three year window, you can amend your tax return for the year that the taxes were paid on that distribution, and recoup the income taxes that you paid. 

Example: I take a $100,000 distribution from my IRA in April 2020.  Since my income is lower in 2020, I elect to have the full distribution taxed to me in 2020,  and remit that taxes with my 2020 tax return. The business has a good year in 2021, so in January 2022 I return the full $100,000 to my IRA.  I can now amend my 2020 tax return and recapture the income tax that I paid for that $100,000 distribution that qualified as a Coronavirus Related Distribution. 

No 20% Withholding Requirement

Normally when you take cash distributions from employee sponsored retirement plans, they are subject to a mandatory 20% federal tax withholding; that requirement has been waived for these Coronavirus Related Distributions up to the $100,000 threshold, so plan participants have access to their full account balance. 

Cash Bridge Strategy

Here are some examples as to how individuals and small business owners may be able to use these strategies. 

For small business owners that intend to apply for the new SBA Disaster Loan (EIDL) and/or SBA Paycheck Protection Program (PPP),  the underwriting process will most likely take a few weeks before the company actually receives the money for the loan.   Some businesses need cash sooner than that just to keep the lights on while they are waiting for the SBA money to arrive.  A business owner could take a $100,000 from the 401(K) plan, use that money to operate the business, and they have 3 years to return that money to 401(k) plan to avoid having to pay income tax on that distribution.  The risk of course, is if the business goes under, then the business owner may not have the cash to repay the loan. In that case, if the owner was under the age of 59½, they avoided the 10% early withdrawal penalty, but would have to pay income tax on the distribution amount. 

For individuals and families that are struggling to make ends meet due to the virus containment efforts, they could take a distribution from their retirement account to help subsidize their income while they are waiting for the IRS Stimulus checks to arrive.  When they receive the IRS stimulus checks or return to work full time, they can repay the money back into their retirement account prior to the end of the year to avoid the tax liability associated with the distribution for 2020. 

401(k) Plan Sponsors

I wanted to issue a special note the plan sponsors of these employer sponsored plans, these Coronavirus Related Distributions are an “optional” feature within the retirement plan. If you want to provide your employees with the opportunity to take these distributions from the plan, you will need to contact your third party administrator, and authorize them to make these distributions. This change will eventually require a plan amendment but companies have until 2022 to amend their plan to allow these Coronavirus Related Distributions to happen now, and the amendment will apply retroactively. 

$100,000 Loan Option

The CARES Act also opened up the option to take a $100,000 loan against your 401(k) or 403(b) balance.  Normally, the 401(k) maximum loan amount is the lesser of: 

50% of your vested balance  OR  $50,000 

The CARES Act includes a provision that will allow plan sponsors to amend their loan program to allow “Coronavirus Related Loans” which increases the maximum loan amount to the lesser of: 

100% of your vested balance  OR  $100,000 

To gain access to these higher loan amounts, plan participants have to self attest to the same criteria as the waiver of the 10% early withdrawal penalty.  But remember, loans are an optional plan provision within these retirement plans so your plan may or may not allow loans.  If the plan sponsors want to allow these high threshold loans, similar to the Coronavirus Related Distributions, they will need to contact their plan administrator authorizing them to do so and process the plan amendment by 2022. 

No Loan Payments For 1 Year

Normally when you take a 401(K) loan, the company begins the payroll deductions for your loan payment immediately after you receive the loan.  The CARES act will allow plan participants that qualify for these Coronavirus loans to defer loan payments for up to one year.  The loan just has to be taken prior to December 31, 2020. 

Caution

While the CARES ACT provides some new distribution and loan options for individuals impacted by the Coronavirus, there are always downsides to using money in your retirement account for purposes other than retirement.  The short list is: 

• The money is no longer invested

• If the distribution is not returned to the account within 3 years, you will have a tax liability

• If you use your retirement account to fund the business and the business fails, you could have to work a lot longer than you anticipated

• If you take a big 401(k) loan, even though you don’t have to make loan payments now, a year from the issuance of the loan, you will have big deductions from your paycheck as those loan payments are required to begin.

Michael Ruger

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future. 

Coronavirus SBA Loan Forgiveness Program

On March 27, 2020, Congress officially passed the CARES Act which includes the SBA Paycheck Protection Program.  This program offers loans to small businesses that can be forgiven if certain conditions are met.  A special note, this SBA program is separate from the SBA Disaster Loan Program called the Economic Injury Disaster Loan Program. 

In this article we will review: 

• The terms of the Paycheck Protection Program

• How the loan amount is calculated

• Deferred Payments for 6 to 12 months

• How to apply for the loans

• The loan forgiveness process

• Restrictions on what the loans can be used for

• Other loan programs available to small businesses

Paycheck Protection Program

This is a new loan program sponsored by the SBA that was put in place to provide small business owners with access to cash to sustain normal business operations over the course of the next 8 weeks.  While these are technically loans, if the guidelines of the program are followed, business owners will: 

• Never have to make a loan payment

• Have the full loan amount forgiven

• There are no fees to apply for the loan

• Higher and faster approval rates compared to other lending programs

Business Expenses Covered By These Loans

This program is very specific about what the money can be used for.  In order to qualify for forgiveness of the loan amount, the loan proceeds have to be used for: 

• Payroll & commission payments

• Mortgage or rent payments

• Group health benefits including insurance premiums

• Vacation, medical, or sick leave payments

• Utility payments

• Interest on debt obligations previous to February 15, 2020

More specifically, it’s to cover expenses incurred between February 15, 2020 and June 30, 2020. 

Who Qualifies For These SBA Loans?

Most small businesses will be eligible to apply for these loans. Here are the application requirements: 

• The business has been in operation since February 15, 2020

• The business has 500 or less employees

• The business has paid salaries, payroll taxes, or Form 1099 non-employee compensation

• Ability to demonstrate that your business was economically affected by COVID-19

Sole proprietors, independent contractors, and 501(c)(3) entities are also eligible to apply. 

Terms of the Loans

There are a number of unique features about this SBA loan program that will make it very appealing to small business owners: 

• No fees to apply for the loan

• No collateral required

• No personal guarantees

• Maximum interest rate of 4%

• Maximum 10-year amortization

• Ability to defer payments for 6 to 12 months (depending on your lender)

• No pre-payment penalty

• Loan forgiveness if program requirements are met

Loan Forgiveness

There are requirements that have to be met in order for all or a portion of the loan amount to be forgiven by the SBA. 

• The money has to be spent on qualified expenses (listed above)

• The expenses have to be incurred within 8 weeks after the loan is approved

• The business has to maintain the same number of employees between Feb 15th and June 30th that it did during same period in 2019 or from January 1, 2020 until February 15, 2020

• You cannot reduce employee wages by more than 25% for employee with less than $100K in compensation

Going outside of these requirements will either reduce or eliminate the amount of the loan that is forgiven by the SBA.   We are still waiting for clarification on a number of business scenarios concerning employee headcount and wage calculations. The CARES Act was over 800 pages long, but it does seem as of right now, that if you rehire employees that were previously laid off at the beginning of the period, or restore wages that were previously reduced, you will not be penalized as long as you do this by either the end the initial 8 week period or June 30th. We still need clarification as to which deadline will apply. 

Is The Loan Forgiveness Amount Taxable?

No.  Within this program, the amount that is forgiven is considered a tax-free grant from the U.S. government. 

How Is The Amount Of The SBA Loan Calculated?

Since this program was implemented to help businesses support payroll expenses, when you apply for the loan, you will need to submit payroll documentation for the previous 12 months.  The calculation for these loans is very simple: 

• Total payroll expenses for the previous 12 months

• DIVIDED by 12 months

• MULTIPLIED by 2.5

In the calculation of the total payroll expenses, any employees making more than $100,000, they cap their compensation at $100,000 for purposes of the maximum loan calculation.  Also, the amount available in the form this SBA loan is the LESSER of: 

2.5 times monthly payroll expenses  OR   $10 million dollars 

Here is a quick example: 

Company XYX has 1 owner and 3 employees with the following payroll expenses for the past 12 months: 

Owner:  $200,000

Employee 1:  $90,000

Employee 2:  $60,000

Employee 3:  $50,000 

Since the owner’s salary is capped at $100,000, it will result in the following maximum loan amount: 

$300,000 / 12 Months = $25,000

$25,000 x 2.5 =  $62,500 

If the company is approved for the $62,500 loan, depending on their bank, they may be able to defer making loan payments for 6 months, and as long as the company spends that money within the next 8 weeks on expenses outlined by the SBA program, maintains headcount and employee wages, they will be eligible for full forgiveness of the loan after that 8 week period without pre-payment penalty or a taxable event. 

How Do You Apply For These Loans?

For the Paycheck Protection Program, these loans will be issued through banks.  When you call your banker you will need to let them know that you are applying for an SBA Paycheck Protection Loan.  The SBA serves as a guarantor for these loans so if the borrower meets the SBA criteria, the bank issues the loan, but if the borrower defaults on the loan, the SBA reimburses the bank for those losses. 

Choose Your Bank Wisely

Not all banks will be participating in this loan program, so you first have to identify which banks in your area are participating in this SBA Paycheck Protection Program.  These loans are going to be in high demand so the banks are most likely going to be overwhelmed with loan applications which could slow down the turnaround time of these loans.  It is prudent to reach out to your professional network, like your accountant, investment advisor, or independent commercial broker, to determine which banks have the capacity to get these loans through quickly. 

It will be extremely important for business owners to submit all of the proper documentation for the loan on the first attempt.   If information is missing from the application or you submit the wrong supporting documentation, it could really slow down the process.  The banks receive a fee from the government for every loan that they process so they have a big incentive to focus on the loans that all of the proper documentation so they can approve them quickly. 

Start The Process Now

For our clients that we believe meet the criteria for this SBA Loan Program, our top recommendation is to start the process now otherwise you could end up in the back of a very long line.  But before you do, you should consult with you accountant, financial advisor, or commercial lender to make sure this is the right program for you.  There are multiple programs out there right now to help support small businesses due to the economic crisis caused by the Coronavirus.   If you take a loan from one program, it could disqualify you from access to other SBA loans or tax credits that are available that could be more beneficial for your business.  Here is our article on the SBA Disaster Loan Program which will be another popular option for businesses impacted by the Coronavirus containment efforts. 

Article:  Coronavirus SBA Disaster Loan Program

Michael Ruger

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Coronavirus SBA Disaster Loan Program

The Coronavirus containment efforts have put a lot of small businesses in a very difficult situation.  Some businesses have been forced to shut down altogether, while other businesses are working at a reduced capacity.  To help, Congress recently released billions of dollars to be used by the SBA to fund loans to small businesses.  In this article we are going to review: 

• Loan limits for SBA Disaster Loans

• Duration of SBA Disaster Loans

• How SBA Disaster Loans differ from traditional SBA Loans

• How long does it take to get an SBA loan

• The interest rate on SBA loans

• Collateral requirements for SBA Disaster Loans

• Other lending programs available to small businesses

Quick Overview of SBA Loans

For individuals that are new to SBA Loans just a quick note, the SBA can either lend money directly to businesses or it can require a bank to issue the loans.  When the banks issue the loans, the SBA serve as a guarantor for those loan, if the borrower defaults on the loan, the bank gets reimbursed by the SBA for the amount of the default.

There are SBA loans like the “Economic Injury Disaster Loan” that was just made available by Congress that is issued directly from the SBA.  It requires a completion of an online application, submission of documentation to the SBA, and then the loan is either approved or denied by the SBA.

SBA Disaster Loan Limits

The SBA Disaster Loan Program provides loans to businesses up to $2 million dollars. Businesses of course, can take loans for less than that amount. 

Interest Rate For SBA Disaster Loans

By law, SBA Disaster Loans have to be issued with an interest rate under 4% which is much lower than the interest charged for traditional SBA loans. 

Duration of SBA Disaster Loans

The SBA Disaster Loans can be amortized up to a maximum of 30 years.  The option to amortize the loan over 30 years provide small businesses with access to capital with lower monthly payments. 

Collateral for SBA Disaster Loans

For SBA Disaster Loans, collateral is typically required for loans over $25,000.  Due to the unprecedented nature of the Coronavirus crisis, this collateral requirement has been waived.  However, a business must pledge collateral to the extent that it is available. The CARES Act also waived the personal guarantee requirement for loans under $200,000. 

How Long Does It Take To Get An SBA Loan?

So what’s the turnaround time on an SBA loan?  You have to act quickly.  Given the high demand for these loans, the banks and SBA are most likely going to be overwhelmed with SBA loan applications.   Even though this money has been made available to small businesses, the loans can only be issued as quickly as they can be processed.  If you do not start the application now, it may be months before you actually receive the cash for the loan. Unfortunately, some business will not be able to wait that long before closing their doors so it’s important to start the process now.

SBA Disaster Loans between $350,000 and $1M will be considered “SBA Express Loans” and can often be issued within 30 days of the application but the ability to issue the loan within that window will greatly depend on how quickly you can submit the required documents to the bank to complete the underwriting process.  The bank or SBA is going to request:

• Complete Business Loan Application

• Form P-019: Economic Injury Disaster Loan Supporting Information

• IRS Form 4506-T: Request for Transcript of Tax Return

• List of all the owners of the business and the percentage of their ownership

• Most recent tax return for the business

• SBA Form 413: Personal financial statement (for each 20%+ owner of the business)

• SBA Form 2202: Schedule of liabilities listing all fixed debts

• Personal tax returns for each 20%+ owner

• Most recent profit & loss statement and balance sheet for the business

• Current YTD profit / loss statement

They may require some additional documentation but these are the most common items. 

SBA Disaster Loan Underwriting Process

Getting an SBA loan is not guaranteed by any means. Banks and SBA look at three main items: Cash, Credit, and Collateral.  One of the main differences between traditional SBA loans and Disaster SBA loans, is that Disaster Loans have more lax unwriting requirements. While a traditional SBA loans may require all three cash, credit, and collateral to be strong, a disaster loan may only require one of those three items to be in a strong position.

It is very important to apply for the SBA Disaster Loan sooner rather than later based on the cash position of the business. You want to apply for the loan while the cash position of the business is still in decent shape, it increases your chances of being approved.   If the business begins taking losses or revenue has stopped entirely, it will be much more difficult to get approved for the SBA Disaster Loan.

Even if your business does not need the money now, it may make sense to apply for the loan, and just keep the cash in the business checking account in case the business needs that capital a few months from now, it’s cheap capital.  There are no loan origination fees charged to the borrower to apply for these SBA Disaster Loans and with an interest rate of 3.75%, if the business takes out a loan for $300,000, it’s only costing the business $750 per month in interest expense to have that cash on hand.

$10,000 Grant

The CARES Act includes an emergency grant in the amount of $10,000 to any small business or nonprofit that applies for the Economic Injury Disaster Program.  When the business owner applies for this SBA Disaster loan, they can request for the grant amount to be advanced within 3 days of submitting the loan application. There are restrictions as to what the grant money can be used for such as payroll, paying a mortgage or rent, and other expenses specifically outlines by the EIDL. 

Other Business Loan Programs

As a result of the Coronavirus stimulus package, there are a number of other lending programs available to small businesses besides the SBA Disaster Loan Program. Some individual states have developed their own lending programs to give small businesses access to interest free loans quickly.  There is also the new Paycheck Protection Loan Program associated with the CARES Act that was recently passed, these loans have a loan forgiveness feature associated with them if certain terms are met.  The terms of these other loan programs may end up being more favorable than the SBA Disaster Loan Program but it will have to be assessed on a case by case basis. 

Michael Ruger

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

How To Use Your Retirement Accounts To Start A Business

One of the most challenging aspects of starting a new business is finding the capital that is needed to support your expenses as you begin to build up a revenue stream since it’s not always easy to ask friends and family for money to invest in a startup business.  Luckily, for new entrepreneurs, there are some little-known ways on how you can use retirement accounts as a funding source for your new business. However, before you cash out your 401(k) account to start a business, you have to fully understand the pros and cons of each option. 

ROBS Plans

ROBS stands for “Rollover for Business Startups”.   ROBS is a special program that allows you to use the balance in your 401(k) or IRA account to fund your new business while avoiding having to pay taxes and the 10% early withdrawal penalty for business owners under age 59.5.  Unlike a 401(k) loan that has limits, loan payments, and interest, ROBS plans allow you to use your full retirement account balance without having to enter into a repayment plan. 

Why do business owners use ROBS plans?

The benefits are fairly obvious.  First off, by using your own retirement assets to fund your new business, you don’t have to ask friends and family for money.  Secondly, if you were to embark on the traditional lending route from a bank for your start-up, most would require you to pledge personal assets, such as your house, as collateral for the loan. Doing this puts an added pressure on the new entrepreneur because if the business fails you not only lose the business, but potentially your house as well.  By using the ROBS plan, you are only risking your own assets, you have quick and easy access to those funds, and if the business fails, worst case scenario, you just have to work longer than you expected. 

Is this too good to be true?

When I explain this funding strategy to new business owners, the question I usually get is, “Why haven’t I heard of these plans before?”, and here are a few reasons why.  To begin, you are using retirement plan dollars and accessing the tax benefits, and in doing so there are a lot of complex rules surrounding these types of plans. It’s not uncommon for accountants, third-party administrators, and financial advisors to not know what a ROBS plan is, let alone understand the compliance rules surrounding these plans; thus, it’s rarely presented as a viable option. Over the course of this article we will cover the pros and cons of this funding mechanism. 

How do ROBS plans work?

The concept is fairly simple, your retirement account essentially buys shares of stock in your new business which provides the business with the cash needed to grow. You do not have to be a publicly traded company for your retirement account to buy shares, however, you are required to establish your new company as a C-Corp in order for this plan to work.

This process entails incorporating your new business, as well as establishing a new 401(k) plan within that business, that contains the special ROBS features. Then, you can transfer assets from your various retirement accounts into the new 401(k) plan allowing the 401(k) plan to then buy shares in your new company.  While this sounds easy, I cannot stress enough that you must work with a firm that fully understands these types of plans and the funding strategy.   These plans are perfectly legal, but there are a lot of rules to follow. Since this funding strategy allows you to access retirement account dollars without having to pay tax to the IRS, the IRS will sometimes audit these plans hoping that you did not fully understand or comply with the rules surrounding the establishment and operations of these ROBS plans.

The steps to set up a ROBS plan

Here are the steps for setting up the plan:

1) Establish your new business as a C-Corp.

2) Establish a new 401(k) plan for your new business

3) Process direct rollovers from your 401(k) accounts and IRA accounts into your new 401(k) plan

4) Use the balance in your 401(k) account to purchase shares of the corporation

5) Now you have cash in your business checking account to pay expenses

You must be a C-Corp

The only type of corporate structure that works for a ROBS plan is a C-Corp because only a C-Corp can sell shares of the business to a retirement account legally.  That means that LLCs, sole proprietorships, partnerships or even S-Corps will not work for this funding option. 

Establishing the new 401(k) plan

ROBS plans have all the same features and benefits of a traditional 401(k) plan, profit-sharing plan, or defined benefit plan, except they also have special features that allow the plan to invest plan assets in the privately held C-Corp.

You need to work with a firm that knows these plans well because not all custodians will allow you to hold shares of a privately held corporation in a qualified retirement account. For many investment firms and custodians, this is considered either a “private placement” or an “alternative investment”.  There is typically a special approval process that you must go through with the custodian before they allow your 401(k) account to purchase the shares of stock in your new company. Be ready, there are a lot of mainstream 401(k) providers that will not only not know what a ROBS plan is, but they often times limit the plan investment options to mutual funds; to avoid this, make sure you are aligning yourself with the right provider. 

Transferring funds from your retirement accounts to your new 401(k) plan

Your new investment provider should assist you with coordinating the rollovers into your 401(k) account to avoid paying taxes and penalties.  Also, if you have 401(K) Roth or after-tax money in your retirement accounts, special preparations need to be made prior to the rollover occurring for those sources. 

Purchasing stock in the business

It’s not as easy as simply transferring money into the business checking account since you have to go through the process of issuing shares to the 401(k) account. In most cases, the percentage of ownership attributed to the 401(k) plan is based upon your total funding picture to start up the company. If your retirement accounts are the sole resource to fund the business, then technically your 401(k) plan owns 100% of the company. It’s not uncommon for new business owners to use multiple funding sources including personal savings, funding from friends and family, or a home-equity loan.  In these instances, a ROBS plan is still allowed but the plan will own less than 100% of the business.

I don’t want to get too deep in the weeds with this point, but it’s usually advisable not to issue 100% of the shares of the business to your 401(k) plan. This could limit your ability to raise additional capital down the road because you don’t have any additional shares to issue to new investors or to share equity with a new partner.

Using the capital to grow your business

Once the share purchase is complete, the cash will be transferred from your retirement account into the business checking account allowing use those funds to start growing the business.

There is a very important rule when it comes to what you can use these funds for within the new business. First and foremost, you cannot use these funds to pay yourself compensation as the business owner. This is probably the biggest ‘no-no’ associated with these types of plans. The IRS does not want you circumnavigating income taxes and penalties just to pay yourself under a ROBS plan.  In order to pay yourself as the business owner, you have to be able to generate revenue from the business.  The assets from the stock purchase can be used to pay all of your expenses but before you’re able to take any money out of the business to pay yourself compensation you have to be showing revenue.

Once new business owners hear this, it’s often disheartening. It’s great that they have access to capital to build their business, but how do they pay their bills while they’re building up the revenue stream? Luckily, I have good news on this front. We have additional strategies that we can implement using your retirement accounts outside of the ROBS plan that will allow you to pay yourself compensation as the owner and it can work out better tax wise than paying yourself as a W2 income through the C-corp.

Requirements for ROBS plans

There are a few requirements you have to meet for this funding strategy to work.

1) The funds have to be held in a pre-tax retirement account. This means that money in Roth IRA’s and Roth 401(k)’s are not eligible for this funding strategy.

2) You typically need at least $50,000 in your new 401(k) account for the ROBS plan to make sense since there are special costs associated with establishing and maintaining a ROBS 401(k) plan.  If your balance is less than $50,000, the cost to establish and maintain the plan begins to outweigh the benefit of executing this funding strategy.

3) If you’re rolling over a 401(k) plan to fund your ROBS 401(k) plan, it cannot be from a current employer. In other words, if you are still working for a company and you’re running this new business on the side, you are not able to rollover your 401(k) balance into your newly established 401(k) plan and implement this ROBS strategy. The 401(k) account must be coming from a former employer that you no longer work for.

4) You have to be an active employee in the business

There are special IRS rules that define if an employee is actively or materially participating in a business. Since ROBS plans do not work for passive business owners, it is difficult to use these plans for real estate investments unless you can prove that you are an active employee of that real estate corporation. If your new business is your only employer, you work over 1000 hours per year, and it’s your primary source of revenue, then you should not have a problem qualifying as an active employee.  If you have multiple businesses however, you really need to consult your accountant and ROBS provider to make sure you satisfy the IRS definition of materially participating.

A ROBS plan can be used for more than just start-ups

While we have talked a lot about using ROBS plans to start up a business, they can also be used for other purposes. These plans can be a funding source to:

1) Buy an existing business

2) Recapitalize a business

3) Build a franchise

These plans can offer fast access to large amounts of capital without having to go through the traditional lending channels.

Cost of setting up and maintaining a ROBS plan

It typically costs $4,000 – $5,000 to set up a ROBS plan and you cannot use the balance in your retirement account to pay this fee. It must be paid with outside funds.

As for ongoing fees, you will have the regular administrative, recordkeeping, and investment advisory fees associated with sponsoring a 401(k) plan which vary from provider to provider. You may also have additional fees charged each year by the custodian for holding the privately held C-Corp shares in your retirement account.  Make sure you clearly understand what the custodian will require from you each year to value those shares.  If you wind up with a custodian that requires audited financial statements, this could easily run you an additional $8,000+ per year to obtain those audited financial statements from an accounting firm.  If you are sponsoring one of these plans, you probably want to try to avoid this large additional cost.

Complications if you have employees

For start-up companies or established companies that have employees that would otherwise be eligible for the 401(k) plan, there are special issues that need to be addressed. The rules within the 401(k) world state that all investment options available within the plan must be made available to all eligible employees.  That means if the business owner is able to purchase shares of the company within the retirement plan, the other eligible employees must also be given the same investment opportunity. You can see immediately where this would pose a challenge to the ROBS plan if you have eligible employees.

However, investment options can be changed which is why ROBS plans are the most common in start-ups where there are no employees yet, allowing the 401(k) plan to setup the only eligible plan participant, the business owner, allowing them to buy shares of the company.  Once the share purchases are complete, the business owner can then remove those shares as an investment option in the plan going forward.

The Cons of a ROBS plan

Up until now we have presented the advantages of the ROBS plan but there are some disadvantages.

1)  The first one is pretty obvious. You are risking your retirement account dollars in a start-up business. If the business fails, not only will you be looking for a new job, but you’ve depleted your retirement assets.

2)  You are required to sponsor a C-Corp which may not be the most advantageous corporate structure.

3) You are required to sponsor a 401(k) plan.  When running a start-up business, it’s sometimes more advantageous to sponsor a Simple IRA or SEP IRA which requires less cost and time to maintain, but you don’t have that option using this funding strategy.

4)  The business owners can’t pay themselves compensation from the stock purchase

5) The cost to setup and maintain the plan. Paying $5,000 just to establish the plan isn’t exactly cheap.  Plus, you’re looking at $2,000+ in annual maintenance costs for the plan.  Other options like taking a home-equity loan or establishing a Solo 401(K) plan and taking a $50,000 401(k) loan from the plan may be the better funding option.

6) Audit risk.  While it’s not the case that all these plans are audited, they do present an audit opportunity for the IRS given the compliance rules surrounding the operation of these plans. However, this risk can be managed with knowledgeable providers.

7) Asset sale of the business becomes complex.  If 10 years from now you sell your company, there are two ways to sell it. An asset sale or a stock sale. While a stock sale jives very easily with this ROBS funding strategy, an asset sale becomes more complex.

Summary

Finding the capital to start up a business is never easy.  Each funding option comes with its own set of pros and cons.  The ROBS plan is just another option for consideration. While I have greatly simplified how these plans work and how they operate, if you are strongly considering using this plan as a funding vehicle for your new business, please reach out to us so we can have an open discussion about what you are trying to accomplish, and how the ROBS plan stacks up against other funding options that you may have available. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

No Deduction For Entertainment Expenses In 2019. Ouch!!

There is a little known change that was included in tax reform that will potentially have a big impact on business owners.  The new tax laws that went into effect on January 1, 2018 placed stricter limits on the ability to deduct expenses associated with entertainment and business meals.  Many of the entertainment expenses that businesses were able to deduct in 2017 will no longer we allowed in 2018 and beyond.  A big ouch for business owners that spend a lot of money entertaining clients and prospects. 

A Quick Breakdown Of The Changes

new tax rules for entertainment expenses

No Deduction in 2019

Prior to 2018, if the business spent money to take a client out to a baseball game, meet a client for 18 holes of golf,  or to host a client event,  the business would be able to take a deduction equal to 50% of the total cost associated with the entertainment expense.  Starting in 2018, you get ZERO.  There is no deduction for those expenses. 

The new law specifically states that there is no deduction for: 

• Any activity generally considered to be entertainment, amusement, or recreation

• Membership dues to any club organization for recreation or social purpose

• A facility, or portion thereof, used in connection with the above items

This will inevitably cause business owners to ask their accountant: “If I spend the same amount on entertainment expenses in 2018 as I did in 2017, how much are the new tax rules going to cost me tax wise?” 

Impact On Sales Professionals

If you are in sales and big part of your job is entertaining prospects in hopes of winning their business, if your company can no longer deduct those expenses, are you going to find out at some point this year that the company is going to dramatic limit the resources available to entertain clients?  If they end up limiting these resources, how are you supposed to hit your sales numbers and how does that change the landscape of how you solicit clients? 

Impact On The Entertainment Industry

This has to be bad news for golf courses, casinos, theaters, and sports arena.  As the business owner, if you were paying $15,000 per year for your membership to the local country club and you justified spending that amount because you knew that you could take a tax deduction for $7,500, now what?  Now that you can’t deduct any of it, you may decide to cancel your membership or seek out a cheaper alternative. 

Impact On Charitable Organizations

How do most charities raise money?  Events.   As you may have noticed in the chart, in 2017 tickets to a qualified charitable event were 100% deductible.  In 2018, it goes from 100% deductible to Zero!!  It’s bad enough that the regular entertainment expenses went from 50% to zero but going from 100% to zero hurts so much more.  Also charitable events usually have high price tags because they have to cover the cost of event and raise money for the charity.  In 2018, it will be interesting to see how charitable organizations get over this hurdle. It may have to disclose right on the registration form for the event that the ticket cost is $500 but $200 of that amount is the cost of the event (non-deductible) and $300 is the charitable contribution. 

Exceptions To The New Rules

There are some unique exceptions to the new rules.  Many business owners will not find any help within these exceptions but here they are: 

• Entertainment, amusement, and recreation expenses you treat as compensation to your employees in their wages (In other words, the cost ends up in your employee’s W2)

• Expenses for recreation, social, or similar activities, including facilities, primarily for employees, and it can’t be highly compensation employees (“HCE”). In 2018 an HCE employee is an employee that makes more than $120,000 or is a 5%+ owners of the company.

• Expenses for entertainment goods, services, and facilities that you sell to customers

What’s The Deal With Meals?

Prior to 2018, employers could deduct 50% of expenses for business-related meals while traveling.  Also meals provided to an employee for the convenience of the employer on the employer’s business premises were 100% deductible by the employer and tax-free to the recipient employee.

Starting in 2018, meal expenses incurred while traveling on business remain 50% deductible to the business. However, meals provided via an on-premises cafeteria or otherwise on the employers premise for the convenience of the employer will now be limited to a 50% deduction.

There is also a large debate going on between tax professional as to which meals or drinks may fall into the “entertainment” category and will lose their deduction entirely.

Impact On Business

This is just one of the many “small changes” that was made to the new tax laws that will have a big impact on many businesses.   It may very well change the way that businesses spend money to attract new clients.  This in turn will most likely lead to unintended negative consequences for organizations that operate in the entertainment, catering, and charitable sectors of the U.S. economy.

Disclosure: For education purposes only. Please seek tax advice from your tax professional

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Business Owners: Strategies To Reduce Your Taxable Income To Qualify For The New 20% Qualified Business Income Deduction

Now that small business owners have the 20% deduction available for their pass-through income in 2018, as a business owner, you will need to begin to position your business to take full advantage of the new tax deduction. However, the Qualified Business Income ("QBI") deduction has taxable income thresholds. Once the owner's personal taxable income begins to exceed specific dollar amounts, the 20% deduction with either phase out or it will trigger an alternative calculation that could lower the deduction.

First: Understand The 20% Deduction

If you are not already familiar with how the new 20% deduction works, I encourage you to read our article:"How Pass-Through Income Will Be Taxes In 2018 For Small Business Owners"If you are already familiar with how the Qualified Business Income deduction works, please continue reading.

The Taxable Income Thresholds

Regardless of whether you are considered a “services business” or “non-services business” under the new tax law, you will need to be aware of the following income thresholds:

Individual: $157,500

Married: $315,000

These threshold amounts are based on the “total taxable income” listed on the tax return of the business owner. Not “AGI” and not just the pass-through income from the business. Total taxable income. For example, if I make $100,000 in net profit from my business and my wife makes $400,000 in W-2 income, our total taxable income on our married filing joint tax return is going to be way over the $315,000 threshold. So do we completely lose the 20% deduction on the $100,000 in pass-through income from the business? Maybe not!!

The Safe Zone

For many business owners, to maximize the new 20% deduction, they will do everything that they can to keep their total taxable income below the thresholds. This is what I call the “safe zone”. If you keep your total taxable income below these thresholds, you will be allowed to take your total qualified business income, multiply it by 20%, and you’re done. Once you get above these thresholds, the 20% deduction will either begin to phase out or it will trigger the alternative 50% of W-2 income calculation which may reduce the deduction.  The phase out ranges are listed below:

Inidividuals: $157,500 to $207,500

Married: $315,000 to $415,000

As you get closer to the top of the range the deduction begins to completely phase out for “services businesses” and for “non-services business” the “lesser of 20% of QBI or 50% of wages paid to employees” is fully phased in.

What Reduces "Total Taxable Income"?

There are four main tools that business owners can use to reduce their total taxable income:

• Standard Deduction or Itemized Deductions

• Self-Employment Tax

• Retirement Plan Contributions

• Timing Expenses

Standard & Itemized Deductions

Since tax reform eliminated many of the popular tax deductions that business owners have traditionally used to reduce their taxable income, for the first time in 2018, a larger percentage of business owners will elect taking the standard deduction instead of itemizing. You do not need to itemize to capture the 20% deduction for your qualified business income. This will allow business owners to take the higher standard deduction and still capture the 20% deduction on their pass-through income. Whether you take the standard deduction or continue to itemize, those deductions will reduce your taxable income for purposes of the QBI income thresholds.

Example: You are a business owner, you are married, and your only source of income is $335,000 from your single member LLC. At first look, it would seem that your total income is above the $315,000 threshold and you are subject to the phase out calculation. However, if you elect the standard deduction for a married couple filing joint, that will reduce your $335,000 in gross income by the $24,000 standard deduction which brings your total taxable income down to $311,000. Landing you below the threshold and making you eligible for the full 20% deduction on your qualified business income.

The point of this exercise is for business owners to understand that if your gross income is close to the beginning of the phase out threshold, somewhere within the phase out range, or even above the phase out range, there may be some relief in the form of the standard deduction or your itemized deductions.

Self-Employment Tax

Depending on how your business is incorporated, you may be able to deduct half of the self-employment tax that you pay on your pass-through income. Sole proprietors, LLCs, and partnership would be eligible for this deduction. Owners of S-corps receive W2 wages to satisfy the reasonable compensation requirement and receive pass-through income that is not subject to self-employment tax. So this deduction is not available for S-corps.

The self-employment tax deduction is an “above the line” deduction which means that you do not need to itemize to capture the deduction. The deduction is listed on the first page of your 1040 and it reduces your AGI.

Example: You are a partner at a law firm, not married, the entity is taxed as a partnership, and your gross income is $200,000. Like the previous example, it looks like your income is way over the $157,500 threshold for a single tax filer. But you have yet to factor in your tax deductions. For simplicity, let’s assume you take the standard deduction:

Total Pass-Through Income: $200,000

Less Standard Deduction: ($12,000)

Less 50% Self-Employ Tax: ($15,000) $200,000 x 7.5% = $15,000

Total Taxable Income: $173,000

While you total taxable income did not get you below the $157,500 threshold, you are now only mid-way through the phase out range so you will capture a portion of the 20% deduction on your pass-through income.

Retirement Plans – "The Golden Goose"

Retirement plans will be the undisputed Golden Goose for purposes of reducing your taxable income for purposes of the qualified business income deduction. Take the example that we just went through with the attorney in the previous section. Now, let’s assume that same attorney maxes out their pre-tax employee deferrals in the company’s 401(k) plan. The limit in 2018 for employees under the age of 50 is $18,500.

Total Pass-Through Income: $200,000

Less Standard Deduction: ($12,000)

Less 50% Self-Employ Tax: ($15,000)

Pre-Tax 401(k) Contribution: ($18,500)

Total Taxable Income: $154,500

Jackpot!! That attorney has now reduced their taxable income below the $157,500 QBI threshold and they will be eligible to take the full 20% deduction against their pass-through income.

Retirement plan contributions are going to be looked at in a new light starting in 2018. Not only are you reducing your tax liability by shelter your income from taxation but now, under the new rules, you are simultaneously increasing your QBI deduction amount.

When tax reform was in the making there were rumors that Congress may drastically reduce the contribution limits to retirement plans. Thankfully this did not happen. Long live the goose!!

Start Planning Now

Knowing that this Golden Goose exists, business owners will need to ask themselves the following questions:

• How much should I plan on contributing to my retirement accounts this year?

• Is the company sponsoring the right type of retirement plan?

• Should we be making changes to the plan design of our 401(k) plan?

• How much will the employer contribution amount to the employees increase if we try to max out the pre-tax contributions for the owners?

Business owners are going to need to engage investment firms and TPA firms that specialize in employer sponsored retirement plan. Up until now, sponsoring a Simple IRA, SEP IRA, or 401(K), as a way to defer some income from taxation has worked but tax reform will require a deeper dive into your retirement plan. The golden question:

“Is the type of retirement plan that I’m currently sponsoring through my company the right plan that will allow me to maximize my tax deductions under the new tax laws taking into account contribution limits, admin fees, and employer contributions to the employees.”

If you are not familiar with all of the different retirement plans that are available for small businesses, please read our article “Comparing Different Types Of Employer Sponsored Plans”.

DB / DC Combo Plans Take Center Stage

While DB/DC Combo plans have been around for a number of years, you will start to hear more about them beginning in 2018. A DB/DC Combo plan is a combination of a Defined Benefit Plan (Pension Plan) and a Defined Contribution Plan (401k Plan). While pension plans are usually only associated with state and government employers or large companies, small companies are eligible to sponsor pension plans as well. Why is this important? These plans will allow small business owners that have total taxable income well over the QBI thresholds to still qualify for the 20% deduction.

While defined contribution plans limit an owner’s aggregate pre-tax contribution to $55,000 per year in 2018 ($61,000 for owners age 50+), DB/DC Combo plans allow business owners to make annual pre-tax contributions ranging from $60,000 – $300,000 per year. Yes, per year!!

Example: A married business owner makes $600,000 per year and has less than 5 full time employees. Depending on their age, that business owner may be able to implement a DB/DC Combo plan prior to December 31, 2018, make a pre-tax contribution to the plan of $300,000, and reduce their total taxable income below the $315,000 QBI threshold.

Key items to make these plans work:

• You need to have the cash to make the larger contributions each year

• These DB/DC plan needs to stay in existence for at least 3 years

• This plan design usually works for smaller employers (less than 10 employees)

Shelter Your Spouse's W-2 Income

It's not uncommon for a business owner to have a spouse that earns W-2 wages from employment outside of the family business. Remember, the QBI thresholds are based on total taxable income on the joint tax return. If you think you are going to be close to the phase out threshold, you may want to encourage your spouse to start putting as much as they possibly can pre-tax into their employer's retirement plan. Unlike self-employment income, W-2 income is what it is. Whatever the number is on the W-2 form at the end of the year is what you have to report as income. By contrast, business owners can increase expenses in a given year, delay bonuses into the next tax year, and deploy other income/expense maneuvers to play with the amount of taxable income that they are showing for a given tax year.

Timing Expenses

One of the last tools that small business owners can use to reduce their taxable income is escalating expense. Now, it would be foolish for businesses to just start spending money for the sole purpose of reducing income. However, if you are a dental practice and you were planning on purchasing some new equipment in 2018 and purchasing a software system in 2019, depending on where your total taxable income falls, you may have a tax incentive to purchase both the equipment and the software system all in 2018. As you get toward the end of the tax year, it might be worth making that extra call to your accountant, before spending money on those big ticket items. The timing of those purchases could have big impact on your QBI deduction amount.

Disclosure: The information in this article is for educational purposes. For tax advice, please consult your tax advisor.

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

How Rental Income Will Be Taxed In Years 2019+

Tax reform will change the way rental income is taxed to landlords beginning in 2018. Under current law, rental income is classified as "passive income" and that income simply passes through to the owner's personal tax return and they pay ordinary income tax on it. Beginning in 2018, rental income will be eligible to receive the same preferential tax treatment as the "qualified business income" (QBI) for small business owners.

20% Deduction

Starting in 2018, taxpayers with qualified business income (including rental income), may be eligible to take a tax deduction up to 20% of their QBI. Determining whether or not you will be eligible to capture the full 20% deduction on your rental income will be based on your total taxable income for year. The taxable income thresholds are as follows:Single filers: $157,500Married filing joint: $315,000"Total taxable income" is not your AGI (adjusted gross income) and it's not just income from your real estate business or self-employment activities. It's your total taxable income less some deductions. The IRS has yet to provide us with full guidance on the definition of "total taxable income". For example, let's assume you have three rental properties owned by an LLC and you net $50,000 in income from the LLC each year. But your wife is a lawyer that makes $350,000 per year. Your total taxable income for the year would be $400,000 landing you above the $315,000 threshold.

Below The Income Threshold

If your total taxable income is below the income thresholds listed above, the calculation is very easy. Take your total QBI and multiply it by 20% and that's your tax deduction.

Above The Income Threshold

If your total taxable income is above the thresholds, the calculation gets more complex. If you exceed the income thresholds, your deduction is the LESSER of:

1. 20% of QBI

1. The GREATER OF:

• 50% of W-2 wages paid to employees

• 25% of W-2 wages paid to employees PLUS 2.5% of the unadjusted asset basis

The best way to explain the calculation is by using an example. Assume the following:

• I bought a commercial building 3 years ago for $1,000,000

• I have already captured $100,000 in depreciation on the building

• After expenses, I net $150,000 in income each year

• The LLC that owns the property has no employees

• I'm married

• I own a separate small business that makes $400,000 in income

Since I'm over the $315,000 total taxable income threshold for a married couple filing joint, I will calculate my deduction as follows:The LESSER of:

1. 20% of QBI = $30,000 ($150,000 x 20%)

1. The GREATER of:

• 50% of W-2 wage paid to employees = $0 (no employees)

• 25% of W-2 wages page to employees plus 2.5% of unadjusted basis

(25% of wages = $0) + (2.5% of unadjusted basis = $25,000) = $25KIn this example, my deduction would be limited to $25,000. Here are a few special notes about the calculation listed above. In the 11th hour, Congress added the "2.5% of unadjusted basis" to the calculation. Without it, it would have left most landlords with a $0 deduction. Why? Real estate owners typically do not have W-2 employees, so 50% of W-2 wages would equal $0. Some larger real estate investors have "property management companies" but they are usually set up as a separate entity. In which case, the W-2 income of the property management company would not be included in the calculation for the QBI deduction. If you are someone who owns a property or properties and is need of a Property management company to help you with organizing and operating your property, then doing research in your general area to find a real estate company that can help you with that is important.Another special note, 2.5% is based on an unadjusted basis and it's not reduced by depreciation. However, the tangible property has to be subject to depreciation on the last day of the year to be eligible for the deduction. Meaning, even though the 2.5% is not reduced for the amount of depreciation already taken on the property, the property must still be in the "depreciation period" on the last day of the year to be eligible for the QBI deduction.Tony Nitti, a writer for Forbes, also makes the following key points:

• The depreciable period starts on the date the property is placed in service and ends on the LATER of:

- 10 years, or- The last day of the last full year in the asset's "regular" (not ADS) depreciation periodMeaning, if you purchase a non-residential rental building that is depreciated over 39 years, the owner can continue to capture the depreciation on the building but that will not impact the 2.5% unadjusted basis number for the full 39 years of the depreciation period.

• Any asset that was fully depreciated prior to 2018, unless it was placed in service after 2008, will not count toward the basis.

• Shareholders or partners may only take into consideration for purposes of applying the limitation 2.5% his or her allocable share of the basis of the property. So if the total basis of commercial property is $1,000,000 and you are a 20% owner, you basis limitation is $1,000,000 x 20% x 2.5% = $5,000

Phase-In Of The Threshold

The questions I usually get next is: "If I'm married and our total taxable income is $320,000 which is only $5,000 over the threshold, do I automatically have to use the more complex calculation?" The special calculation "phases in" over the following total taxable income thresholds:Single filers: $157,500 - $207,500Married filing joint: $315,000 - $415,000I won't get into the special phase-in calculation because it's more complex than the special "above the income threshold" calculation that we already walked through but just know that it will be a blend of the straight 20% deduction and the W-2 & 2.5% adjusted basis calculation.

Qualified Trade or Business Requirement

In August 2018, the IRS came out with further clarification of how the QBI deduction would apply to real estate. In order to qualify for the QBI deduction for real estate income, your real estate holdings have to qualify as a "trade or business". The definition of a trade or business for QBI purposes deviates slightly from the traditional IRS definition. There is a safe harbor that states if you spend more than 250 hours a year working on that business it will qualify for the deduction.There are a few items to consider in the 250 hour calculation. So called "drive bys" where the owner is spending time driving by their properties to check on them does not count toward the 250 hours. If you have a property management company, the hours that they spend managing your propoerty can be credited toward your 250 hour requirement. However, the property management company has to provide you with proper documentation to qualify for those credited hours.

Consult Your Accountant

I'm a Certified Financial Planner®, not an accountant. I wrote this article to give real estate investors a broad view of what tax reform may have instore for them in 2018. If you own rental property, you should be actively consulting with our accountant through the year. As the IRS continues to release guidance regarding the QBI deduction throughout 2018, you will want to make sure that your real estate holdings are positioned properly to take full advantage of the new tax rules.

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.