Archive for the ‘material participation’ Tag

Back to Basics Part XXXV – Form 8959 Additional Medicare Tax and Form 8960 – Net Investment Income Tax

Originally published in the Cedar Street Times

March 25, 2016

Forms 8959 and 8960 are two relatively new forms that started with the 2014 tax year.  These are two of quite a number of tax increases that are being used to help fund ObamaCare.  Both of these forms affect people with income in excess of $200,000 for Single filers or 250,000 for Married Filing Jointly.

Form 8959 is the Additional Medicare Tax.  It is an additional 0.9% Medicare Part A tax on combined W-2 and self-employment wages in excess of the above stated thresholds.  Note that it is not based on  W-2 box 1 taxable wages, but on Medicare wages which are often higher for most people.  Pretax deductions such as contributions to retirement plans are included in Medicare wages, whereas they are not included in box 1 taxable wages.

Employers have to start collecting this additional tax once your wages hit the thresholds.  However, if you changed jobs during the year, the second employer will not withhold until the wages your earn with that employer reaches the thresholds.  This means that you could owe additional tax when you file your tax returns for the shortfall, since the new employer and old employer do not communicate to coordinate this tax.  For self-employed people, you would of course be sending in quarterly estimates of your income and self-employment tax liability, and the calculation of this new tax would be made on your income tax returns at year-end.

The Form 8960 is the Net Investment Income Tax (NIIT).  Once your income meets the thresholds previously discussed, you will also have an additional 3.8% tax on all investment related income.  This would include income sources such as interest income, dividend income, annuities, rents, royalties, capital gains distributions from mutual funds and capital gains from the sale of investments such as stocks and bonds.  Even real estate professionals would be subject to NIIT on their own rental real estate activities, unless they meet the material participation test specifically in rental real estate, which is a separate test from time spent in real estate sales activities, for instance.

If you own an interest in a business and you are not materially participating in the business, this income will also be subject to the net investment income tax.  Material participation generally means 500 hours or more during the year.  The sale of rental property and even second homes are also subject to NIIT.  If you sell an interest in a partnership or s-corporation and do not materially participate in the business, you will also be subject to NIIT on any gains from those sales.  Investment income from your children that are taxed on your returns through Form 8814 are also subject to NIIT.

Wages, unemployment compensation, alimony, Social Security benefits, tax-exempt interest income, income subject to self-employment taxes, and income from qualified retirement plan distributions are specifically excluded from the tax.

There are also some deductions that can be used to offset NIIT.  These expenses included investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, tax preparation fees, fiduciary expenses (in the case of an estate or trust) and state and local income taxes.

Regarding trusts and estate, it is important to note that the thresholds for NIIT are much lower.  Due to the compressed income tax bracket structure, NIIT kicks in when the trust or estate reaches the highest income tax bracket at only $12,300 of income (2015).  This provides additional incentive for trustees to push income out to the beneficiaries since many trusts will be subject to NIIT, but the beneficiaries are often not subject due to the much higher thresholds for individuals.

Planning can be an important tool to lower the impact of NIIT.

If you have questions about other schedules or forms in your tax returns, prior articles in our Back to Basics series on personal tax returns are republished on my website at www.tlongcpa.com/blog .

Travis H. Long, CPA, Inc. is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. Travis can be reached at 831-333-1041. This article is for educational purposes.  Although believed to be accurate in most situations, it does not constitute professional advice or establish a client relationship.

Back to Basics Part XXV – Form 8582 – Passive Activity Loss Limitations

Originally published in the Cedar Street Times

October 16, 2015

 

Prior to the Tax Reform Act of 1986, both the nation and Congress were gripped with the ideas that the rich were not paying any taxes and that the tax code was overly complex.  Sound familiar?  The Tax Reform Act of 1986 was heralded as the biggest change to the income tax system since World War II.  It did have sweeping changes and drastic effects.  In the nearly 30 years since its enactment, all kinds of new exceptions and complexities have entered the code.  That said, there are still a lot of landmark changes that affect our tax system today.  One of these is in the area of passive losses.

Prior to 1986, wealthy individuals could invest in tax shelters which combined borrowed money and depreciation expense, while taking advantage of tax subsidies and tax preferences on certain types of investments to push out massive losses well in advance of their current, real economic investment and loss.  Some of the tax subsidies and preferences were true reductions in tax, and the tax deferral parts of these plans essentially created interest-free loans from the government.  The losses would then be used to offset income generating activities from wages, profitable business activities, and portfolio activities, virtually eliminating income tax for a lot of wealthy people.  Tax shelters were popping up faster than Starbucks coffee houses, and draining capital which could have otherwise been invested in productive activities in America.  There was also a lot of legal and accounting brain power being siphoned off to tax shelter creation.

The Tax Reform Act of 1986 (among many other things) setup three buckets for income, 1) earned income – such as from working for someone else or running a business yourself, 2) portfolio income – such as interest, dividends and capital gains from the sale of stocks, bonds, mutual funds, etc., and 3) passive income – such as investments in rental real estate properties and ownership interests of businesses in which you do not really work.  The basic tenant, is that the three buckets are generally kept separate, and in order to deduct losses in one bucket, you have to have offsetting income in that same bucket, otherwise the losses get suspended to be used at a future time.  Prior to 1986, there was just one bucket – income.  After this three bucket concept was introduced, most of these tax shelters became useless.  For some that managed to survive in other ways, another arm of the Tax Reform of Act of 1986 had to be reckoned with –  Alternative Minimum Tax (I discussed AMT in a prior article which is posted on my website at  www.tlongcpa.com/blog).

The passive activity rules are laid out in Section 469 of the Internal Revenue Code.  There are a lot of rules in Section 469, but the short of it is that you usually need to work at least 500 hours a year in a business you own to be considered a material participant and keep the income or losses in the earned income bucket.  So, if you own part of a business, but do not materially participate, any losses will be stuck in the passive activity bucket and get suspended until you have some passive activity income to offset, or until you liquidate your interest in the business.

For rental real estate activities, you generally have to spend 750 hours a year and have no other activity in which you spend more than 750 hours to throw the income or losses in the earned income bucket.  People meeting this rule are considered “real estate professionals.”  Rental real estate losses are a huge issue for California rental property owners, since massive losses accrue in the early years due to high mortgage interest and depreciation stemming from high purchase prices.  Real estate professionals are allowed to deduct all their losses from rental properties against their other earned income.  All other people are limited to using 0-$25,000 of losses per year against earned income depending on their modified adjusted gross income and whether or not they “actively participate.”  Active participation is a pretty easy standard to meet.  If you make managerial decisions, you are an active participant, and are eligible for the special $25,000 loss deduction.  (The act of simply choosing a property manager to handle everything for you is a managerial decision, for instance.)  If your modified adjusted gross income is over $125,000, however, the $25,000 active participation loss deduction starts to phase out.  By the time you reach $150,000, it is gone.

All of this bring us to the point of today’s article – the Form 8582 – Passive Activity Loss Limitations.  The Form 8582 is simply the vehicle used to track the activities in the passive income bucket and show which ones have suspended losses from year to year.  The form is three pages long.  The first page is the summary, and the second two pages are the detailed worksheets supporting page one.  Rental real estate activities are separated on the form from all other passive activities, since they have the special $25,000 active participation rule that must be applied.  Part I summarizes the items within those two categories and further breaks them down into activities with income, activities with losses, and prior year losses that have been suspended.  You then net everything within each of the two categories.  The rental real estate category then runs through Part II to see if you qualify for all or a portion of the special $25,000 loss allowance against earned income.  Part III deals with Commercial Revitalization Deductions, which are just a favorable twist on the $25,000 rule for people who are rehabilitating certain buildings in distressed communities.  Part IV sums the total losses that are allowed for the year.

The next two pages are the details for each business activity or rental property you own.  This is where you would look to see how much suspended losses you may have on each property.  Although you might not like the idea of having your losses limited each year, you will certainly enjoy the benefits down the road when you sell a property or business for a gain, and all those suspended passive losses come to your rescue!  And it is also nice to know that if you sell one property for a large gain and the losses freed up from that particular property are not enough to offset its gain, then the suspended losses from all other properties are drawn from on a pro-rata basis until exhausted to help offset the gain as well.

If you have questions about other schedules or forms in your tax returns, prior articles in our Back to Basics series on personal tax returns are republished on my website at www.tlongcpa.com/blog .

Travis H. Long, CPA, Inc. is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Back To Basics Part VII – Schedule C

Originally published in the Cedar Street Times

January 9, 2015

In this issue, we are discussing Schedule C -Profit or Loss from Business.  Prior articles are republished on my website at www.tlongcpa.com/blog if you would like to catch up on our Back to Basics series on personal tax returns.

Schedule C is generally used to report income and expenses for your self-employment activities for which no partnership exists or no entity has been established (such as a C or S-Corporation or LLC) – in other words, it is used for a sole proprietorship.  Of course there are exceptions and wrinkles to the rules.  Here are a few common ones.  In most states, a husband and wife which own and operate a business together would file a partnership return instead of a Schedule C.  However, since California is a community property state, a husband and wife should generally file two Schedule Cs and split the income and deductions based on their distributive shares, even if filing a joint return.

One important reason for doing this is that two Schedule SEs would also be filed reporting the Social Security and Medicare taxes separately for each spouse.  They would each be subject to the full taxable wage base for Social Security, but they would also each receive credit for their earnings which would figure into their Social Security checks in retirement.

An LLC with only one member that is operating a business would also report the business activity on a Schedule C instead of a 1065 Partnership return.  Since you can’t have a partnership between you and yourself, the formal entity structure is disregarded for federal tax purposes and reported like a sole proprietorship.  In community property states such as California, a husband and wife that both own and operate the business are actually considered one member for LLC purposes.  If they were the only two owners, the entity would be disregarded, but they would then report on two Schedule Cs as discussed above.

Now that we have discussed who uses the form, let’s move to the form itself.  The initial section of Schedule C asks for identifying information – the name of the business, the type of business, address, etc.  If you have an employer identification number you can enter that as well.  This would be required if you have employees on payroll.  You can also obtain one if you simply do not want to hand out your Social Security number whenever a formal taxpayer identification number is needed – such as for filing 1099-Misc forms for independent contractors.

There are also some other direct questions regarding your basis of accounting, level of participation, and filing compliance.  Most small businesses under $10 million in annual revenues operate by the cash method of accounting as it has many advantages.  Material participation is a tightly defined standard  by the IRS which can affect your ability to take losses in a down year.  The questions on 1099 filings are loaded questions designed to help the IRS easily identify businesses that are not filing required 1099s for payments to independent contractors, for interest received, etc.

In Part I Income, you list your gross receipts, subtract sales returns and allowances, subtract cost of goods sold (which are detailed in Part III) and then add other income such as interest income or certain credits.  Part III Cost of Goods Sold is mainly geared towards retailers, wholesalers, and manufacturers.  It provides a place to detail beginning and ending inventory and any associated labor and material costs associated with production of the goods.  Even taxpayers on a cash basis are generally required to track inventory.  Cash basis typically means you get the deduction when you spend the cash, and you record the income when you get the cash.  But with inventory, you do not get the deduction until the inventory is sold or disposed.

In Part II you detail all your expenses.  The instructions to Schedule C do a pretty good job of explaining what types of expenses they want on each line.  Some of the lines are supported by additional forms such Form 4562 Depreciation and Amortization feeding into Schedule C line 13 for Depreciation.  Line 24b for Meals and Entertainment is unique as most qualified meals and entertainment are allowed only a 50 percent deduction.  Another unique aspect is that preset per diem rate deductions are allowed for self-employed individuals (and employees) for meals, entertainment, and incidental expenses in lieu of tracking actual receipts.  Some of these per diems are quite generous depending on the location of travel, and taxpayers can sometimes get a much larger deduction than the amount they actually spend.

Line 30 for expenses for business use of your home is another example where an entirely separate form (Form 8829) is used to calculate the deduction.  There is also an alternative simplified method introduced with the 2013 returns that gives you $5 square foot for business space (up to $1,500) without having to track actual expenses on Form 8829.

Line 32 contains a few questions about whether your investment in the business is “at-risk” or not.  Basically they are asking if you are financially liable if things go south, and could you lose the money you have injected into the business in the past.  This affects your ability to take losses in down years.

Part IV details your vehicle deduction for standard mileage rate users.  For 2014, this amount is 56 cents a mile.  If you track actual expenses instead, you would not fill out this part.

Part V is for any additional expenses not discussed in Part II.

In two weeks we will continue our Back to Basics series with Schedule D – Capital Gains and Losses

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.