How To Pay 0% Tax On Capital Gains Income

When you sell a stock, mutual fund, investment property, or a business, if you have made money on that investment, the IRS is kindly waiting for a piece of that gain in the form of capital gains tax.  Capital gains are taxed differently than the ordinary income that you received via your paycheck or pass-through income from your business.   Unlike ordinary income, which has a series of tax brackets that range from 10% to 37% in 2022, capital gains income is taxed at a flat rate at the federal level.   Most taxpayers are aware of the 15% long term capital gains tax rate but very few know about the 0% capital gains tax rate and how to properly time the sale of your invest to escape having to pay tax on the gain. 

Short-term vs Long-Term Gains

Before I get into this tax strategy, you first have to understand the difference between “short-term” and “long-term” capital gains.  Short-term capital gains apply to any investment that you bought and sold in less than a 12 month period.  Example, if I buy a stock today for $1,000 and I sell it three months later for $3,000, I would have a $2,000 short-term capital gain.  Short-term capital gains are taxed as ordinary income like your paycheck. There is no special tax treatment for short-term capital gains and the 0% tax strategy does not apply.

Long-term capital gains on the other hand are for investments that you bought and then sold more than 12 months later.  When I say “investments” I’m using that in broad terms. It could be a business, investment property, stock, etc.   When you sell these investments at a gain and you have satisfied the 1 year holding period, you receive the benefit of paying tax on the gain at the preferential “long-term capital gains rate”.

What Are The Long Term Capital Gains Rates?

For federal tax purposes, there are 3 long term capital gains rates:  0%, 15%, and 20%.  What rate you pay is determined by your filing status and your level of taxable income in the year that you sold the investment subject to the long term capital gains tax. For 2022, below are the capital gains brackets for single filers and joint filers.

As you will see on the chart, if you are a single filer and your taxable income is below $41,675 or a joint filer with taxable income below $83,350, all or a portion of your long term capital gains income may qualify for the federal 0% capital gains rate.

An important note about state taxes on capital gains income is that each state has a different way of handling capital gains income. New York state is a “no mercy state” meaning they do not offer a special tax rate for long term capital gains. For NYS income tax purposes, your long term capital gains are taxed as ordinary income.  But let’s continue our story with the fed tax rules which are typically the lion share of the tax liability.

In a straight forward example, assume you live in New York, you are married, and your total taxable income for the year is $50,000.  If you realize $25,000 in long term capital gains, you will not pay any federal tax on the $25,000 in capital gain income but you will have to pay NYS income tax on the $25,000.

Don’t Stop Reading This Article If Your Taxable Income Is Above The Thresholds

For many taxpayers, their income is well above these income thresholds.  But I have good news, with some maneuvering, there are legit strategies that may allow you to take advantage of the 0% long term capital gains tax rate even if your taxable income is above the $41,675 single filer and $83,350 joint filer thresholds.  I will include multiple examples below as to how our high net worth clients are able to access the 0% long term capital gains rate but I first have to build the foundation as to how it all works. 

Using 401(k) Contributions To Lower Your Taxable Income

In years that you will have long term capital gains, there are strategies that you can use to reduce your taxable income to get under the 0% thresholds.  Here is an example, I had a client sell a rental property this year and the sale triggered a long term capital gain for $40,000.  They were married and had a combined income of $110,000.  If they did nothing, at the federal level they would just have to pay the 15% long term capital gains tax which results in a $6,000 tax liability.  Instead, we implemented the following strategy to move the $40,000 of capital gains into the 0% tax rate.

Once they received the sale proceeds from the house, we had them deposit that money to their checking account, and then go to their employer and instruct them to max out their 401(k) pre-tax contributions for the remainder of the year.  Since they were both over 50, they were each able to defer $27,000 (total of $54,000). They used the proceeds from the house sale to supplement the income that they were losing in their paychecks due to the higher pre-tax 401(k) deferrals.  Not only did they reduce their taxable income for the year by $54,000, saving a bunch in taxes, but they also were able to move the full $40,000 in long term capital gain income into the 0% tax bracket.  Here’s how the numbers work:

Adjusted Gross Income (AGI):      $110,000

Pre-tax 401(k) Contributions:         ($54,000)

Less Standard Deduction:              ($25,900)

Total Taxable Income:                     $30,100

In their case, they would be able to realize $53,250 in long term capital gains before they would have to start paying the 15% fed tax on that income ($83,350 – $30,100 = $53,250). Since they were below that threshold, they paid no federal income tax on the $40,000 saving them $6,000 in fed taxes.

“Filling The Bracket”

The strategy that I just described is called “filling the bracket”.  We find ways to reduce an individuals taxable income in the year that long term capital gains are realized to “fill up” as much of that 0% long-term capital gains tax rate that we can before it spills over into the 15% long-term capital gains rate.

More good news, it’s not an “all or none” calculation.  If you are married, have $60,000 in taxable income, and $100,000 in long term capital gains, a portion of your $100,000 in capital gains will be taxed at the 0% rate with the majority taxed at the 15% tax rate.  As you might have guessed the IRS is not going to let you get away with paying 0% on a $100,000 in long term capital gains because you maneuvered your taxable income into the 0% cap gain range. But in this case, $23,350 would be taxed at the 0% long term cap gain rate, and the reminder would be taxed at the 15% long term cap gain rate.

Do Capital Gains Bump Your Ordinary Income Into A Higher Bracket?

When explaining this “filling up the bracket” strategy to clients, the most common question I get is: “If long term capital gains count as taxable income, does that push my ordinary income into a higher tax bracket?”   The answer is “no”.  In the eyes of the IRS, capital gains income is determined to be earned “after” all of your other income sources.

In an extreme example, let’s say you have $70,000 in ordinary income and $200,000 in capital gains. If your total ordinary income was $70,000 and you file a joint tax return, your top fed tax bracket in 2022 would be 12%.  However, if the IRS decided to look at the $200,000 in capital gain income first and then put your ordinary income on top of that, your top federal tax bracket would now be 24%.  That would hurt tax wise. Luckily, it does not work that way.  Even if you realized $1M in long term capital gains, the $70,000 in ordinary income would be taxed at the same lower tax brackets since it was earned first in the eyes of the IRS.

Work With Your Accountant

Before I get into the more advanced strategies for how this filling up the brackets strategy is used, I cannot stress enough the importance of working with your tax advisor when executing these more complex tax strategies.  The tax system is complex and making a shift in one area could hurt you in another area.

Even though these strategies may lower the federal tax rate on your long-term capital gain income, capital gains will increase your AGI (adjusted gross income) for the year which could phase you out of certain deductions, tax credits, increase your Medicare premiums, reduce college financial aid, etc. Your accountant should be able to run tax projections for you in their software to play with the numbers to determine the ideal amount of long-term capital gains that can be realized in a given year without hurting the other aspects of your financial picture.

Strategy #1:  I’m Retiring

When people retire, in many cases, their taxable income drops because they no longer have their paycheck and they are typically supplementing their income with social security and distributions from their investment accounts.  This creates a tax planning opportunity because these taxpayers sometimes find themselves in the lowest tax bracket that they have been in over the past 30+ years.  Here are some of the common examples.

Example 1: The First Year Of Retirement

If you retire at the beginning of the calendar year, you may only have had a few months of paychecks, so your income may be lower in that year.  If you have built up cash in your savings account or if you have an after tax investment account that you can use to supplement your income for the remainder of the year to meet your expenses, this may create the opportunity to “fill up the bracket” and realize some long-term capital gains at a 0% federal tax rate in that year.

Example 2:  Lower Expenses In Retirement

We have had clients that were making $150,000 per year and then when they retire they only need $40,000 per year to live off of.  When you retire, the kids are typically through college, the mortgage is paid off, and your expenses drop so you need less income to supplement those expenses.   A portion of your social security will most likely be counted as taxable income but if you do not have a pension, you may have some wiggle room to realize a portion of your long-term capital gains as a 0% rate each year.

Assume this is a single filer. Here is how the numbers would work:

Social Security & IRA Taxable Income:     $40,000

Less Standard Deduction:                          ($12,000)

Total Taxable Income:                                $28,000

This individual would be able to realize $13,675 in long term capital gains each year at the 0% fed tax tax because the threshold is $41,675 and they are only showing $28,000 in taxable income.  Saving $2,051 in fed taxes.

Strategy #2:  Business Owner Experiences A Low Income Year

If you have been running a business for 5+ years, you have probably been through those one or two tough years where either revenue drops dramatically or the business incurs a lot of expenses in a single year, lowering your net profits.  Do not let these low taxable income years go to waste.  If you typically make $250,000+ per year and you have one of these low income years, start planning as soon as possible because once you cross that December 31st threshold, you have wasted a tax planning opportunity.  If you are showing no income for that year, you may want to talk to your accountant about realizing some long term capital gains in your brokerage account to realize those gains at a 0% tax rate.  Or you may want to consider processing a Roth conversion in that low tax year. There are a number of tax strategies that will allow you to make the most of that “bad year” income wise. 

Strategy #3: Leverage Cash Reserves and Brokerage Accounts

If you have been building up cash reserves or you have a brokerage account that you could sell some holdings without incurring big taxable gains, you may be able to use that as your income source for the year which could result in little to no taxable income showing for that tax year.  We have seen both retirees and business owners use this strategy.

Business owners have control over when expenses will be realized which influences how much taxable income is being passed through to the business owner.  If you can overload expenses into a single tax year instead of splitting it evenly between two separate tax years, that could create some tax planning opportunities.

Strategy #4: Moving To Another State

It’s common for individuals to move to more tax friendly states in retirement. If you live in a state now, like New York, that makes you pay tax on long term capital gain income, and you plan to move to Florida next year and change your state of domicile, you may want to wait to realize your capital gains until you are resident of Florida to avoid having to pay state tax on that income. This has nothing to do with the 0% Fed tax strategy but it might reduce your state income tax bill on those capital gains.

Bottom Line

There are few strategies that allow you to pay 0% in federal taxes on any type of gain.  If you are a high income earner, this strategy may not work for you every year but there may be opportunities to use them at some point if income drops or when you enter the retirement years.  Again, don’t let those lower income years go to waste. Work with your accountant and determine if “filling the bracket” is the right move for you. 

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.

Can I Open A Roth IRA For My Child?

Parents will often ask us: “What type of account can I setup for my kids that will help them to get a head start financially in life"?”.  One of the most powerful wealth building tools that you can setup for your children is a Roth IRA because all of accumulation between now and when they withdrawal it in retirement will be all tax free. If your child has $10,000 in their Roth IRA today, assuming they never make another deposit to the account, and it earns 8% per year, 40 years from now the account balance would be $217,000.

Contribution Limits

The maximum contribution that an individual under that age of 50 can make to a Roth IRA in 2022 is the LESSER of:

• $6,000

• 100% of earned income

For most children between the age of 15 and 21, their Roth IRA contributions tend to be capped by the amount of their earned income. The most common sources of earned income for young adults within this age range are:

• Part-time employment

• Summer jobs

• Paid internships

• Wages from parent owned company

If they add up all of their W-2's at the end of the year and they total $3,000, the maximum contribution that you can make to their Roth IRA for that tax year is $3,000.

Roth IRA's for Minors

If you child is under the age of 18, you can still establish a Roth IRA for them. However, it will be considered a "custodial IRA". Since minors cannot enter into contracts, you as the parent serve as the custodian to their account. You will need to sign all of the forms to setup the account and select the investment allocation for the IRA. It's important to understand that even though you are listed as a custodian on the account, all contributions made to the account belong 100% to the child. Once the child turns age 18, they have full control over the account.

Age 18+

If the child is age 18 or older, they will be required to sign the forms to setup the Roth IRA and it's usually a good opportunity to introduce them to the investing world. We encourage our clients to bring their children to the meeting to establish the account so they can learn about investing, stocks, bonds, the benefits of compounded interest, and the stock market in general. It's a great learning experience.

Contribution Deadline & Tax Filing

The deadline to make a Roth IRA contribution is April 15th following the end of the calendar year. We often get the question: "Does my child need to file a tax return to make a Roth IRA contribution?" The answer is "no". If their taxable income is below the threshold that would otherwise require them to file a tax return, they are not required to file a tax return just because a Roth IRA was funded in their name.

Distribution Options

While many of parents establish Roth IRA’s for their children to give them a head start on saving for retirement, these accounts can be used to support other financial goals as well. Roth contributions are made with after tax dollars. The main benefit of having a Roth IRA is if withdrawals are made after the account has been established for 5 years and the IRA owner has obtained age 59½, there is no tax paid on the investment earnings distributed from the account.

If you distribute the investment earnings from a Roth IRA before reaching age 59½, the account owner has to pay income tax and a 10% early withdrawal penalty on the amount distributed. However, income taxes and penalties only apply to the “earnings” portion of the account. The contributions, since they were made with after tax dollar, can be withdrawal from the Roth IRA at any time without having to pay income taxes or penalties.

Example: I deposit $5,000 to my daughters Roth IRA and four years from now the account balance is $9,000. My daughter wants to buy a house but is having trouble coming up with the money for the down payment. She can withdrawal $5,000 out of her Roth IRA without having to pay taxes or penalties since that amount represents the after tax contributions that were made to the account. The $4,000 that represents the earnings portion of the account can remain in the account and continue to accumulate tax-free. Not only did I provide my daughter with a head start on her retirement savings but I was also able to help her with the purchase of her first house.

We have seen clients use this flexible withdrawal strategy to help their children pay for their wedding, pay for college, pay off student loans, and to purchase their first house.

Not Limited To Just Your Children

This wealth accumulate strategy is not limited to just your children. We have had grandparents fund Roth IRA's for their grandchildren and aunts fund Roth IRA's for their nephews. They do not have to be listed as a dependent on your tax return to establish a custodial IRA. If you are funded a Roth IRA for a minor or a college student that is not your child, you may have to obtain the total amount of wages on their W-2 form from their parents or the student because the contribution could be capped based on what they made for the year.

Business Owners

Sometime we see business owners put their kids on payroll for the sole purpose of providing them with enough income to make the $6,000 contribution to their Roth IRA. Also, the child is usually in a lower tax bracket than their parents, so the wages earned by the child are typically taxed at a lower tax rate. A special note with this strategy, you have to be able to justify the wages being paid to your kids if the IRS or DOL comes knocking at your door.

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.

Moving Expenses Are No Longer Deductible

If you were planning on moving this year to take a new position with a new company or even a new position within your current employer, the moving process just got a little more expensive. Not only is it expensive, but it can put you under an intense amount of stress as there will be lots of things that you need to have in place before packing up and moving. Even things like how you are going to transport your car over to your new home, can take up a lot of your time, and on top of that, you have to think about how much it's going to cost. Prior to the tax law changes that took effect January 1, 2018, companies would often offer new employees a "relocation package" or "moving expense reimbursements" to help subsidize the cost of making the move. From a tax standpoint, it was great benefit because those reimbursements were not taxable to the employee. Unfortunately that tax benefit has disappeared in 2018 as a result of tax reform.

Taxable To The Employee

Starting in 2018, moving expense reimbursements paid to employee will now represent taxable income. Due to the change in the tax treatment, employees may need to negotiate a higher expense reimbursement rate knowing that any amount paid to them from the company will represent taxable income.

For example, let’s say you plan to move from New York to California and you estimate that your moving expense will be around $5,000. In 2017, your new employer would have had to pay you $5,000 to fully reimburse you for the moving expense. In 2018, assuming you are in the 35% tax bracket, that same employer would need to provide you with $6,750 to fully reimburse you for your moving expenses because you are going to have to pay income tax on the reimbursement amount.

Increased Expense To The Employer

For companies that attract new talent from all over the United States, this will be an added expense for them in 2018. Many companies limit full moving expense reimbursement to executives. Coincidentally, employees at the executive level are usually that highest paid. Higher pay equals higher tax brackets. If you total up the company's moving expense reimbursements paid to key employees in 2017 and then add another 40% to that number to compensate your employees for the tax hit, it could be a good size number.

Eliminated From Miscellaneous Deductions

As an employee, if your employer did not reimburse you for your moving expenses and you had to move at least 50 miles to obtain that position, prior to 2018, you were allowed to deduct those expenses when you filed your taxes and you were not required to itemize to capture the deduction. However, this expense will no longer be deductible even for employees that are not reimbursed by their employer for the move starting in 2018.

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.

How Pass-Through Income Will Be Taxed For Small Business Owners

While one of the most significant changes incorporated in the new legislation was reducing the corporate tax rate from the current 35% rate to a 21% rate in 2018, the tax bill also contains a big tax break for small business owners. Unlike large corporations that are taxed at a flat rate, most small businesses, are "pass-through" entities, meaning that the profits from the business flow through to the business owner's personal tax return and then are taxed at ordinary income tax rates.While pass-through income will continue to be taxed at ordinary income tax rates, many small business owners will be eligible to deduct 20% of their "qualified business income" (QBI) starting in 2018. In other words, some pass-through entities will only be taxes on 80% of their pass-through income.

Pass-through entities include

Sole proprietorships

Partnerships

LLCs

S-Corps

Unanswered Questions

I wanted to write this article to give our readers the framework of what we know at this point about the treatment of the pass-through income in 2018. However, as many accountants will acknowledge, there seems to be more questions at this point then there are answers. The IRS will need to begin issuing guidance at the beginning of 2018 to clear up many of the unanswered questions as to who will be eligible and not eligible for the new 20% deduction.

Above or Below "The Line"

This 20% deduction will be a below-the-line deduction which is an important piece to understand. Tax lingo makes my head spin as well, so let's pause for a second to understand the difference between an "above-the-line deduction" and a "below-the-line deduction".The "line" refers to the AGI line on your tax return which is the bottom line on the first page of your Form 1040. While both above-the-line and below-the-line deductions reduce your taxable income, it's important to understand the difference between the two.

Above-The-Line Deductions

Above-the-line deductions happen on the first page of your tax return. These deductions reduce your gross income to eventually reach your AGI (adjusted gross income) for the year. Above-the-line deductions include:

• Contributions to health savings accounts

• Contributions to retirement plans

• Deduction for one-half of the self-employment taxes

• Health insurance premiums paid

• Alimony paid, student loan interest, and a few others

The AGI is important because the AGI is used to determine your eligibility for certain tax credits and it will also have an impact on which below-the-line deductions you are eligible for. In general, the lower your AGI is, the more deductions and credits you are eligible to receive.

Below-The-Line Deductions

Below-the-line deductions are reported on lines that come after the AGI calculation. They are comprised mainly of your “standard deduction” or “itemized deductions” and “personal exemptions” (most of which will be gone starting in 2018). The 20% deduction for qualified business income will fall into this below-the-line category. It will lower the income of small business owners but it will not lower their AGI.

However, it was stated in the tax legislation that even though the 20% qualified business deduction will be a below –the-line deduction it will not be considered an “itemized deduction”. This is a huge win!!! Why? If it’s not an itemized deduction, then small business owners can claim the 20% qualified business income deduction and still claim the standard deduction. This is an important note because many small business owners may end up taking the standard deduction for the first time in 2018 due to all of the deductions and tax exemptions that were eliminated in the new tax bill. The tax bill took away a lot of big deductions:

• Capped state and local taxes at $10,000 (this includes state income taxes and property taxes)

• Eliminated personal exemptions ($4,050 for each individual) (Eliminated in 2018)

  • Family of 4 = $4,050 x 4 = $16,200 (Eliminated in 2018)

• Miscellaneous itemized deductions subject to 2% of AGI floor (Eliminated in 2018)

Restrictions On The 20% Deduction

If life were easy, you could just assume that I'm a sole proprietor, I make $100,000 all in pass-through income, so I will get a $20,000 deduction and only have to pay tax on $80,000 of my income. For many small business owners it may be that easy but what's a tax law without a list of restrictions.The restriction were put in place to prevent business owners from reclassifying their W2 wages into 100% pass-through income to take advantage of the 20% deduction . They also wanted to restrict employees from leaving their company as a W2 employee, starting a sole proprietorship, and entering into a sub-contractor relationship with their old employer just to reclassify their W2 wages into 100% pass-through income.

S-Corps

Qualified business income will specifically exclude "reasonable compensation" paid to the owner-employee of an S-corp. While it would seem like an obvious reaction by S-corp owners to reduce their W2 wages in 2018 to create more pass through income, they will still have to adhere to the "reasonable compensation" restriction that exists today.

Partnerships & LLCs

Qualified business income will specifically exclude guaranteed payments associated with partnerships and LLCs. This creates a grey area for these entities. Partnerships do not have a “reasonable compensation” requirement like S-corps since companies taxed as partnerships are not allowed to pay W2 wages to the owners. Also the owners of partnerships are not required to take guaranteed payments. My guess is, and this is only a guess, that as we get further into 2018, the IRS may require partnerships to classify a percentage of a owners total compensation as a “guaranteed payment” similar to the “reasonable compensation” restriction that S-corps currently adhere too. Otherwise, partnerships can voluntarily eliminate guaranteed payments and take the 20% deduction on 100% of the pass-through income.

This may also prompt some S-corps to look at changing their structure to a partnership or LLC. For high income earners, S-corps have an advantage over the partnership structure in that the owners do not pay self-employment tax on the pass-through income that is distribution to the owner over and above their W2 wages. However, S-corp owners will have to weigh the self-employment tax benefit against the option of changing their corporate structure to a partnership and potentially receiving a 20% deduction on 100% of their income.

Sole Proprietors

Sole proprietors do not have "reasonable compensation" requirement or "guaranteed payments" so it would seem that 100% of the income generated by sole proprietors will count as qualified business income. Unless the IRS decides to enact a "reasonable compensation" requirement for sole proprietors in 2018, similar to S-corps. Before everyone runs from a single member LLC to a sole proprietorship, remember, a sole proprietorship offers no liability barrier between the owner and liabilities that could arise from the business.

Income Restrictions

There are limits that are imposed on the 20% deduction based on how much the owner makes in “taxable income”. The thresholds are set at the following amounts:

Individual: $157,500

Married: $315,000

The thresholds are based on each business owner’s income level, not on the total taxable income of the business. We need help from the IRS to better define what is considered “taxable income” for purposes of this phase out threshold. As of right now, it seems that “taxable income” will be defined as the taxpayer’s own taxable income (not AGI) less deductions.

If the owner’s taxable income is below this threshold, then the calculation is a simple 20% deduction of the pass-through income. If the owner’s taxable income exceeds the threshold, the qualified business deduction is calculated as follows:

The LESSER of:

20% of its business income OR 50% of the total wages paid by the business to its employees

Let’s look at this in a real life situation. A manufacturing company has a net profit of $2M in 2018 and pays $500,000 in wages to its employees during the year. That company would only be able to take the qualified business income deduction for $250,000 since 50% of the total employee wages ($500,000 x 50% = $250,000) are less than 20% of the net income of the business ($2M x 20% = $400,000).

This creates another grey area because it seems that the additional calculation is triggered by the taxable income of each individual owner but the calculation is based on the total profitability and wages paid by the company. For the owners that required this special calculation for exceeding the threshold, how is their portion of the lower deduction amount allocated? Multiplying the lower total deduction amount by the percent of their ownership? Just more unanswered questions.:

Restrictions For "Service Business"

There will be restrictions on the 20% deduction for pass-through entities that are considered a "service business" under IRC Section 1202(e)(3)(A). The businesses specifically included in this definition as a services business are:

• Health

• Law

• Accounting

• Actuarial Sciences

• Performing Arts

• Consulting

• Athletics

• Financial Services

• Any other trade or business where the principal asset of the business is the reputation or skill of 1 or more of its employees

In a last minute change to the regulations, to their favor, engineers and architects were excluded from the definition of “service businesses”.

This is another grey area. Many small businesses that fall outside of the categories listed above will undoubtedly be asking the question: “Am I considered a service business or not?” Outside of the industries specifically listed in the tax bill, we really need more guidance from the IRS.

If you are a “services business”, when the tax reform was being negotiated it looked like service businesses were going to be completely excluded from the 20% deduction. However, the final regulations were more kind and instead implemented a phase out of the 20% deduction for owners of service businesses over a specified income threshold. The restriction will only apply to those whose “taxable income” exceeds the following thresholds:

Individual: $157,500

Married: $315,000

If you are a consultant or owner of a services business and your taxable income is below these thresholds, it would seem at this point that you will be able to capture the 20% deduction for your pass-through income. As mentioned above, we need help from the IRS to clarify the definition of “taxable income”.

Phase Out For Service Businesses

The amounts listed above: $157,500 for individual and $315,000 for a married couple filing joint, are where the thresholds for the phase out begins. The service business owners whose income rises above those thresholds will phase out of the 20% deduction over the next $50,000 of taxable income for individual filers and $100,000 of taxable income for married filing joint. This means that the 20% pass-through deduction is completely gone by the following income levels:

Individual: $207,500

Married: $415,000

Any taxpayer’s falling in between the threshold and the phase out limit will receive a portion of the 20% deduction.

Since the thresholds are assessed based on the taxpayer’s own taxable income and not the total income of the business, a service business could be in a situation, like in an accounting firm, where the partners with the largest ownership percentage may not qualify for 20% deduction but the younger partners may qualify for the deduction because their income is lower.

Tax Planning For 2018

It's an understatement to say that most small business owners will need to spend a lot of time with their accountant in the first quarter of 2018 to determine the best of course of action for their company and their personal tax situation.While we are still waiting for clarification on a number of very important items associated with the 20% deduction for qualified business income, hopefully this article has provided our small business owners with a preview of things to come in 2018.

Disclosure: I'm a Certified Financial Planner® but not an accountant. The information contained in this article was generated from hours and hours of personal research on the topic. I advise each of our readers to consult with your personal tax advisor for tax advice.

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.

Tax Reform: Summary Of The Changes

The conference version of the tax bill was released on Friday. The House and the Senate will be voting to approve the updated tax bill this week with what seems to be wide spread support from the Republican party which is all they need to sign the bill into law before Christmas. Most of the changes will not take effect until 2018 with new tax rates for individuals set to expire in 2025. At which time the tax rates and brackets will return to their current state. Here is a run down of some of the main changes baked into the updated tax bill:

Individual Tax Rates

They are keeping 7 tax brackets with only minor changes to percentages in each bracket. The top tax bracket was reduced from 39.6% to 37%.

Capital Gains Rates

There were no changes to the capital gains rates and they threw out the controversial mandatory FIFO rule for calculating capital gains tax when selling securities.

Standard Deduction and Personal Exemptions

They did double the standard deduction limits. Single tax payers will receive a $12,000 standard deduction and married couples filing joint will receive a $24,000 standard deduction.The personal exemptions are eliminated.

Mortgage Interest Deduction

New mortgages would be capped at $750,000 for purposes of the home mortgage interest deduction.

State and Local Tax Deductions

State and local tax deduction will remain but will be capped at $10,000. An ouch for New York State. That $10,000 can be a combination of your property tax and either sales or income tax (whichever is larger or will get you to the cap of $10,000).Oh and you cannot prepay your 2018 state income taxes in 2017 to avoid the cap. They made it clear that if you prepay your 2018 state income taxes in 2017, you will not be able to deduct them in 2017.

Medical Expense Deductions

Medical expense deductions will remain for 2017 and 2018 and they lowered the AGI threshold to 7.5%. Beginning in 2019, the threshold will change back to the 10% threshold.

Miscellaneous Expense Deductions

Under the current rules, you are able to deduct miscellaneous expenses that exceed 2% of your AGI. That was eliminated. This includes unreimbursed business expenses and home office expenses.

A Few Quick Ones

Student Loan Interest: Still deductible

Teacher Out-of-Pocket Expenses: Still deductible

Tuition Waivers: Still not taxable

Fringe Benefits (including moving expenses): Will be taxable starting in 2018 (except for military)

Child Tax Credit: Doubled to $2,000 per child

Gain Exclusion On Sale Of Primary Residence: No Change

Obamacare Individual Mandate: Eliminated

Corporate AMT: Eliminated

Individual AMT: Remains but exemption is increased: Individuals: $70,300 Married: $109,400

Corporate Tax Rate: Drops to 21% in 2018

Federal Estate Tax: Remains but exemption limit doubles

Alimony

For divorce agreements signed after December 31, 2018, alimony will no longer be deducible. This only applies to divorce agreements executed or modified after December 31, 2018.

529 Plans

Under current tax law, you do not pay taxes on the earnings for distributions from 529 accounts for qualified college expenses. The new tax reform allows 529 account owners to distribute up to $10,000 per student for public, private and religious elementary and secondary schools, as well as home school students.

Pass-Through Income For Business

This is still a little cloudy but in general under the conference bill, owners of pass-through companies and sole proprietors will be taxed at their individual tax rates less a 20% deduction for business-related income, subject to certain wage limits and exceptions. The deduction would be disallowed for businesses offering "professional services" above a threshold amount; phase-ins begin at $157,500 for individual taxpayers and $315,000 for married taxpayers filing jointly.

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.

M&A Activity: Make Sure You Address The Seller’s 401(k) Plan

Buying a company is an exciting experience.  However, many companies during a merger or acquisition fail to address the issues surrounding the seller’s retirement plan which can come back to haunt the buyer in a big way.   I completely understand why this happens.  Purchase price, valuations, tax issues, terms, holdbacks, and new employment agreements tend to dominate the conversations throughout the business transaction.   But lurking in the dark, below these main areas of focus, lives the seller’s 401(k) plan.  Welcome to the land of unintended consequences where unexpected liabilities, big dollar outlays, and transition issues live.

Asset Sale or Stock Sale

Whether the transaction is a stock sale or asset sale will greatly influence the series of decisions that the buyer will need to make regarding the seller’s 401(k) plan.  In an asset sale, it is common that employees of the seller’s company are terminated from employment and subsequently “rehired” by the buyer’s company.  With asset sales, as part of the purchase agreement, the seller will often times be required to terminate their retirement plan prior to the closing date.

Terminating the seller’s plan prior to the closing date has a few advantages from both the buyer’s standpoint and from the standpoint of the seller’s employees. Here are the advantages for the buyer:

Advantage 1:  The Seller Is Responsible For Terminating Their Plan

From the buyer’s standpoint, it’s much easier and cost effective to have the seller terminate their own plan.  The seller is the point of contact at the third party administration firm, they are listed as the trustee, they are the signer for the final 5500, and they typically have a good personal relationship with their service providers.  Once the transaction is complete, it can be a headache for the buyer to track down the authorized signers on the seller’s plan to get all of the contact information changed over and allows the buyer’s firm to file the final 5500.

The seller’s “good relationship” with their service providers is key. The seller has to call these companies and let them know that they are losing the plan since the plan is terminating.  There are a lot of steps that need to be completed by those 401(k) service providers after the closing date of the transaction.  If they are dealing with the seller, their “client”, they may be more helpful and accommodating in working through the termination process even though they losing the business. If they get a random call for the “new contact” for the plan, you risk getting put at the bottom of the pile

Part of the termination process involves getting all of the participant balances out of the plan. This includes terminated employees of the seller’s company that may be difficult for the buyer to get in contact with.   It’s typically easier for the seller to coordinate the distribution efforts for the terminated plan.

Advantage 2:  The Buyer Does Not Inherit Liability Issues From The Seller’s Plan

This is typically the main reason why the buyer will require the seller to terminate their plan prior to the closing date.  Employer sponsored retirement plans have a lot of moving parts.  If you take over a seller’s 401(k) plan to make the transition “easier”, you run the risk of inheriting all of the compliance issues associated with their plan. Maybe they forgot to file a 5500 a few years ago, maybe their TPA made a mistake on their year-end testing last year, or maybe they neglected to issues a required notice to their employees knowing that they were going to be selling the company that year.  By having the seller terminate their plan prior to the closing date, the buyer can better protect themselves from unexpected liabilities that could arise down the road from the seller’s 401(k) plan.

Now, let’s transition the conversation over to the advantages for the seller’s employees.

Advantage 1: Distribution Options

A common goal of the successor company is to make the transition for the seller’s employees as positive as possible right out of the gate.  Remember this rule:  “People like options”.  Having the seller terminate their retirement plan prior to the closing date of the transactions gives their employees some options. A plan termination is a “distributable event” meaning the employees have control over what they would like to do with their balance in the seller’s 401(k) plan.  This is also true for the employees that are “rehired” by the buyer.  The employees have the option to:

• Rollover their 401(k) balance in the buyer’s plan (if eligible)

• Rollover their 401(k) balance into a rollover IRA

• Take a cash distribution

• Some combination of options 1, 2, and 3

The employees retain the power of choice.

If instead of terminating the seller’s plan,  what happens if the buyer decides to “merge” the seller’s plan in their 401(k) plan?  With plan mergers, the employees lose all of the distribution options listed above. Since there was not a plan termination, the employees are forced to move their balances into the buyer’s plan.

Advantage 2:  Credit For Service With The Seller’s Company

In many acquisitions, again to keep the new employees happy, the buyer will allow the incoming employee to use their years of service with the seller’s company toward the eligibility requirements in the buyer’s plan.  This prevents the seller’s employees from coming in and having to satisfy the plan’s eligibility requirements as if they were a new employee without any prior service.  If the plan is terminated prior to the closing date of the transaction, the buyer can allow this by making an amendment to their 401(k) plan.

If the plan terminates after the closing date of the transaction, the plan technically belonged to the buyer when the plan terminated.  There is an ERISA rule, called the “successor plan rule”, that states when an employee is covered by a 401(k) plan and the plan terminates, that employee cannot be covered by another 401(k) plan sponsored by the same employer for a period of 12 months following the date of the plan termination.  If it was the buyer’s intent to allow the seller’s employees to use their years of service with the selling company for purposes of satisfy the eligibility requirement in the buyer’s plan, you now have a big issue. Those employees are excluded from participating in the buyer’s plan for a year.  This situation can be a speed bump for building rapport with the seller’s employees.

Loan Issue

If a company allows 401(k) loans and the plan terminates, it puts the employee in a very bad situation. If the employee is unable to come up with the cash to payoff their outstanding loan balance in full, they get taxed and possibly penalized on their outstanding loan balance in the plan.

Example: Jill takes a $30,000 loan from her 401(k) plan in May 2017.  In August 2017, her company Tough Love Inc., announces that it has sold the company to a private equity firm and it will be immediately terminating the plan.  Jill is 40 years old and has a $28,000 outstanding loan balance in the plan.  When the plan terminates, the loan will be processed as an early distribution, not eligible for rollover, and she will have to pay income tax and the 10% early withdrawal penalty on the $28,000 outstanding loan balance. Ouch!!!

From the seller’s standpoint, to soften the tax hit, we have seen companies provide employees with a severance package or final bonus to offset some of the tax hit from the loan distribution.

From the buyer’s standpoint, you can amend the plan to allow employees of the seller’s company to rollover their outstanding 401(k) loan balance into your plan.  While this seems like a great option, proceed with extreme caution.  These “loan rollovers” get complicated very quickly.  There is usually a window of time where the employee’s money is moving over from seller’s 401(k) plan over to the buyer’s 401(k) plan, and during that time period a loan payment may be missed.  This now becomes a compliance issue for the buyer’s plan because you have to work with the employee to make up those missed loan payments.  Otherwise the loan could go into default.

Example, Jill has her outstanding loan and the buyer amends the plan to allow the direct rollover of outstanding loan balances in the seller’s plan.  Payroll stopped from the seller’s company in August, so no loan payments have been made, but the seller’s 401(k) provider did not process the direct rollover until December.  When the loan balance rolls over, if the loan is not “current” as of the quarter end, the buyer’s plan will need to default her loan.

Our advice, handle this outstanding 401(k) loan issue with care.  It can have a large negative impact on the employees. If an employee owes $10,000 to the IRS in taxes and penalties due to a forced loan distribution, they may bring that stress to work with them.

Stock Sale

In a stock sale, the employees do not terminate and then get rehired like in an asset sale.  It’s a “transfer of ownership” as opposed to “a sale followed by a purchase”.  In an asset sale, employees go to sleep one night employed by Company A and then wake up the next morning employed by Company B.  In a stock sale, employees go to sleep employed by Company A, they wake up in the morning still employed by Company A, but ownership of Company A has been transferred to someone else.

With a stock sale, the seller’s plan typically merges into the buyer’s plan, assuming there is enough ownership to make them a “controlled group”.  If there are multiple buyers, the buyers should consult with the TPA of their retirement plans or an ERISA attorney to determine if a controlled group will exist after the transaction is completed.   If there is not enough common ownership to constitute a “controlled group”, the buyer can decide whether to continue to maintain the seller’s 401(k) plan as a standalone plan or create a multiple employer plan.    The basic definition of a “controlled group” is an entity or group of individuals that own 80% or more of another company.

Stock Sales: Do Your Due Diligence!!!

In a stock sale, since the buyer will either be merging the seller’s plan into their own or continuing to maintain the seller’s plan as a standalone, you are inheriting any and all compliance issues associated with that plan.  The seller’s issues become the buyer’s issues the day of the closing.   The buyer should have an ERISA attorney that performs a detailed information request and due diligence on the seller’s 401(k) plan prior the closing date.

Seller Uses A PEO

Last issue.  If the selling company uses a Professional Employer Organization (PEO) for their 401(k) services and the transaction is going to be a stock sale, make sure you get all of the information that you need to complete a mid-year valuation or the merged 5500 for the year PRIOR to the closing date.  We have found that it’s very difficult to get information from PEO firms after the acquisition has been completed.

The Transition Rule

There is some relief provided by ERISA for mergers and acquisitions.  If a control group exists, you have until the end of the year following the year of the acquisition to test the plans together.  This is called the “transition rule”.   However, if the buyer makes “significant” changes to the seller’s plan during the transition period, that may void the ability to delay combined testing.  Unfortunately, there is not clear guidance as to what is considered a “significant change” so the buyer should consult with their TPA firm or ERISA  attorney before making any changes to their own plan or the seller’s plan that could impact the rights, benefits, or features available to the plan participants.

Horror Stories

There are so many real life horror stories out there involving companies that go through the acquisition process without conducting the proper due diligence and transition planning with regard to the seller’s retirement plan.  It never ends well!!  As the buyer, it’s worth the time and the money to make sure your team of advisors have adequately addressed any issues surrounding the seller’s retirement plan prior to the closing date. 

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.