Welcome to CPA at Law, helping individuals and small businesses plan for the future and keep what they have.

This is the personal blog of Sterling Olander, Certified Public Accountant and Attorney at Law. For over five years, I have worked as a tax professional helping clients with tax mitigation strategies, tax controversies, business transactions, wealth preservation structures, tax-exempt organiations, and estate plans.

I write about any legal, tax, or technological information that I find interesting or useful in serving my clients. All ideas expressed herein are my own and don't constitute legal or tax advice.

Federal Tax Classifications for Business Entities

For federal tax classification purposes, a business is classified as either a "business entity," which is any entity recognized for federal tax purposes; or a "disregarded entity," which is any entity not recognized or treated separate from its owner for tax purposes. The most common federal tax business entities include a C-Corporation, S-Corporation, and Partnership. Various rules under the Internal Revenue Code determine how a business is treated for federal tax purposes.

The default tax classification for a corporate entity is a C-Corporation. Alternatively, a corporation can elect to be taxed as an S-Corporation by filing Form 2553 with the IRS and meeting certain requirements.

A single-member limited liability company is the only state-formed entity eligible to be classified as a disregarded entity; this is the default classification. The one exception is where a business is owned equally by a husband and wife in a community property state; this business can also be treated as a disregarded entity. A single-member LLC can also elect to be taxed as a C-Corporation by filing Form 8832 with the IRS; alternatively, it can elect to be taxed as an S-Corporation by filing Form 2553.

The default tax classification for non-corporate, multi-member legal entities (including LLCs and state-law partnerships) is a partnership. A multi-member business may elect to be taxed as a C-Corporation or an S-Corporation in the same manner as a single-member LLC. One of the prerequisites for S-Corporation status is a single class of interest, disregarding differences in voting rights; multi-member LLCs with one class of interest or general partnerships can meet the requirements to be treated as an S-Corporation.

The following chart summarizes these rules:

               State-Law Entity
 Corporation  Single-Member LLC Multi-Member Eligible Entity
 Disregarded   No   Yes   No* 
 Partnership (Form 1065)   No   No   Yes 
 C-Corporation (Form 1120)   Yes  Yes   Yes 
 S-Corporation (Form 1120S)   Yes   Yes   Yes**

*A business owned equally by a husband and wife in a community property state can be treated as a disregarded entity.
**Only certain entities, such as multi-member LLCs with one class of interest and general partnerships, can qualify for S-Corporation status.

Self-Employment Tax Avoidance for LLC Members

In addition to the income tax, sole proprietors and partners in a partnership must pay self-employment tax on net self-employment earnings. This tax is imposed on "active" trade or business income, as opposed to "passive" income from rents, interest, dividends, capital gains, and income of a limited partner in a partnership.

Corporations pay tax at the corporate level and accordingly, corporate net income is not subject to self-employment tax. As I wrote previously, S-Corporation earnings flow through to the individual shareholders' personal income tax returns and also avoids self-employment tax. A special set of rules applies to income generated by LLCs taxed as partnerships.

These rules come from Prop. Reg. 1.1402(a)-2(h)(2). Technically, these regulations are not binding since the IRS has not issued final regulations, but they are the only administrative guidance available, "they can be relied on to avoid a penalty under IRC section 6406(f), and there is judicial precedence, in Elkins [81 T.C. 669 (1983)], [to] reasonably conclude that the courts will sustain the position of a taxpayer who relies on proposed regulations." Janet Meade, Minimizing Self-Employment Tax of LLC Managing Members, The CPA Journal, June 2006.

Under the proposed regulations, an individual will be treated as a limited partner (and thus avoid self-employment tax) unless "the individual (1) has personal liability for the debts of or claims against the partnership by reason of being a partner; (2) has authority to contract on behalf of the partnership under the statute or law pursuant to which the partnership is organized; or, (3) participates in the partnership's trade or business for more than 500 hours during the taxable year." Individuals who provide health, law, engineering, architecture, accounting, actuarial science, or consulting services cannot take advantage of this rule.

Even if members of the LLC don't meet all of the above tests, self-employment taxes can still be avoided with respect to "amounts that are demonstrably returns on capital invested in the partnership." In general, in order to take advantage of the exceptions to the general rule, the LLC should be manager-managed and the operating agreement should provide for two classes of members, a managing class and an investor class.

The investor class will be treated as limited partners and the managing class will be treated as general partners for self-employment tax purposes. Members of the managing class can avoid self-employment tax on a portion of their share of the partnership's net income if their interests are bifurcated between the managing class and investor class interests. In other words, the "application of the SE tax to LLC members under the proposed regulations depends not only upon their formal status as members or managing-members but also on their level of participation in the entity" (Meade).

Paying Gift Tax Now vs. Estate Tax Later

In addition to the annual exclusion, which allows individuals to make annual gifts of up to $14,000 per donee without implicating any taxes, there is another way to utilize gifting to family members to minimize estate taxes upon death.

This strategy applies to estates with a value in excess of the federal estate and gift tax exemption. In 2014, this exemption will be $5,340,000, up from $5,250,000 in 2013. Spouses can generally combine their credit amounts, resulting in the passing of estates worth two times the individual estate and gift tax exemption upon the death of the second spouse. Any estates that are worth less will not be subject to any estate or gift tax.

For estates with a fair market value in excess of the exemption amounts, a tax will apply. The estate tax and gift tax statutes are designed so that the estate tax cannot be avoided by gifting assets before death. If assets in the estate in excess of the exemption amount are gifted during the lifetime of the donor, a gift tax will need to be paid at the same rate as the estate tax.

However, paying gift tax is less expensive than paying the estate tax because paying the gift tax permanently removes the tax paid from the donor's taxable estate. If the taxable gift were not made, the amount that would have been paid in gift tax remains in the taxable estate and is itself subject to the estate tax.

For example, assume the current gift and estate tax rate of 40% and a donor who has previously gifted his or her entire exemption amount. In order to gift $1 million to a donee, the donor will make the gift of $1 million and pay a $400,000 gift tax for a total of $1,400,000.

If the donor had not made the gift before he or she passed away, the estate would include the $1,400,000 and be subject to the 40% tax rate. The donee would only receive $840,000 after the estate tax of $560,000 is paid ($1,400,000 * 40%). In other words, the estate would save and the beneficiary would receive $160,000 more simply because the donor made a gift before death instead of waiting to pass his or her estate afterwards.

Timing is key to the success of this planning technique. Under IRC 2035(b), the taxable estate of the donor includes any gift tax paid on transfers made within three years before the donor's death; accordingly, if the donor dies less than three years after making the taxable gift, the strategy fails. On the other hand, the donor is choosing to accelerate the payment of taxes and give up the use of the money paid as tax. "The donor must survive for three years to avoid the §2035 gross up, but must not survive for so long that the value of the loss of use of the money paid as gift taxes exceeds the value of the estate tax savings." Lischer, 846-2nd T.M., Gifts to Minors

The Net Investment Income Tax

A new tax on investment income is in effect as of the start of the year. This "Net Investment Income Tax," or NIIT, is equal to 3.8% multiplied by the lesser of (1) the taxpayer's net investment income and (2) the amount that the taxpayer's modified adjusted gross income exceeds a certain threshold. The threshold amounts are $200,000 for single filers and heads of households, $250,000 for joint filers, and $125,000 for married individuals filing separate returns.

Investment income generally includes interest, dividends, capital gains, rental and royalty income, nonqualified annuities, and passive activity income. Expenses attributable to the investment income are subtracted to arrive at net investment income. The NIIT does not apply to wages, unemployment compensation, nonpassive business income, social security benefits, tax exempt interest, self-employment income, and distributions from qualified retirement plans. However, such amounts are included in the calculation of the modified AGI threshold amount.

For example, if a married taxpayer filing a joint return receives a $25,000 royalty with $5,000 worth of costs attributable to that royalty and has an AGI of $260,000, $10,000 will be subject to the NIIT. This is the lesser of the taxpayers net investment income and the amount the taxpayer's modified AGI of $260,000 exceeds the applicable threshold of $250,000. The taxpayer will owe a NIIT of $380.

One planning mechanism that can ameliorate the NIIT is for taxpayers to increase their participation in business activities that would otherwise be considered passive activities so that the income is not subject to the NIIT. Material participation generally means that the taxpayer be involved in the business operations on a regular, continuous, and substantial basis.

Another planning opportunity arises in the context of trusts for the benefit of a taxpayer's beneficiaries in lower income brackets. The NIIT applies to trusts at a much lower income threshold than it does for individuals. Accordingly, trusts that have the option of passing their income to the beneficiaries to be taxed on the individual level or retaining the income and paying any resulting tax at the trust level should opt for the former.

Other planning strategies focus not on reducing net investment income but on reducing adjusted gross income. For example, taxpayers should maximize contributions to retirement accounts such as 401(k)s, IRAs, and SEP accounts. As with any tax planning strategy, early implementation is key.

Examples of Self-Directed IRA Prohibited Transactions

In a previous post, I described the basics of self-directed IRAs; in this post, I provide some examples of prohibited transactions with disqualified people. The following are the transactions that are specifically prohibited by the Internal Revenue Code and an example of each:

Selling, Exchanging, or Leasing Property

The owner of an IRA intends to invest in real property with his IRA, but before the self-directed IRA account is properly funded, the owner learns of an opportunity that he needs to act on quickly. He purchases a property from an unrelated party with his own funds and the next day transfers the property to his IRA at the same price. This is a prohibited transaction between the IRA and the IRA owner even if the IRA would have been allowed to make the exact same purchase directly from the unrelated party.

Lending Money or Extending Credit

The owner of an IRA wishes to invest her IRA in an asset but does not have enough cash in the IRA for an outright purchase. The bank agrees to a loan but only if the IRA owner agrees to personally guarantee the debt. This is treated as an extension of credit from the IRA owner to the IRA and as such is a prohibited transaction.

Furnishing Goods or Services

The owner of an IRA that leases a piece of rental property hires her son to repair a broken window on the property and the son does so for a fair market price. This is a prohibited furnishing of services by a disqualified person (the son) to his mother's IRA.

Use of IRA Assets by a Disqualified Person

An IRA owner decides to purchase a vacation home and have a management company lease it to third parties throughout the year. If the vacation home is owned by the IRA and the IRA owner allows his in-laws to stay in the home for a weekend, this is a prohibited transaction even if fair market rent is paid to the IRA.

Fiduciary Self-Dealing with the IRA

An IRA owner loans IRA funds to a corporation in which the IRA owner is a 35% shareholder. This is likely to result in a prohibited transaction even though the corporation is owned less than 50% by the IRA owner and is technically not a disqualified person. This is because the IRA owner is a fiduciary of the IRA and will likely be deemed to be dealing in his or her own interest.

Receipt of Consideration by a Fiduciary from Transacting with the IRA

An IRA owner, who is a licensed real estate agent, purchases real estate for his IRA from an unrelated party and receives a commission from the sale. Because the IRA owner is a fiduciary of the IRA and received consideration from transacting with the IRA, this is a prohibited transaction.

For further discussion and examples of prohibited transactions, please see Warren L. Baker's article on WealthCounsel's blog and this article by Strategic Property Exchanges, LLC.

Savings Incentive Match Plan for Employees

A Savings Incentive Match Plan for Employees (SIMPLE Plan) is a written salary-reduction arrangement that allows small businesses that meet certain requirements to make retirement contributions on behalf of eligible employees. A SIMPLE Plan "is ideally suited as a start-up retirement savings plan for small employers not currently sponsoring a retirement plan." A SIMPLE Plan is established by a written agreement and setting up Individual Retirement Accounts for employees.

In order to be eligible to establish and maintain a SIMPLE Plan, a business can not maintain or sponsor another retirement plan and must have 100 or fewer employees who earned $5,000 or more in the prior year. All of the employees in this category are eligible to participate in the plan and the employer may not impose more restrictive eligibility requirements. The employer is required to make either a non-elective contribution of 2% of each eligible employee’s compensation or a match of the employee’s elective salary reduction of up to 3% of the employee’s compensation.

Employees can make salary reduction contributions up to $12,000 in 2013, plus catch-up contributions of $2,500 for individuals 50 or older. Elective deferrals of an employee’s wages are included in Form W-2 wages for social security and Medicare purposes only. Employer contributions to a SIMPLE Plan are excluded from the gross income of the employee and deductible by the employer.

While the contribution limits of a SIMPLE Plan are lower than some other small employer retirement plan options, SIMPLE IRA Plans do not have the start-up and operating costs of other plans, nor is there any filing requirement for the employer. Furthermore, because SIMPLE Plan contributions can reduce salary, they can be used to reduce payroll or self-employment tax when compared to some other retirement plans.

Excel's Sumproduct Function

Excel's SUMPRODUCT function is more useful than it appears.  On its surface, SUMPRODUCT simply "returns the sum of the products of corresponding ranges or arrays." The easiest way to demonstrate this is to use the following table:

 A   B 
 1   5   3 
 2   2   6 
 3   0   10 
 4   1   8 

The formula =SUMPRODUCT(A1:A4,B1:B4) yields 35, which is the sum of the products of columns A and B, calculated as follows: (5*3)+(2*6)+(0*10)+(1*8).

While this functionality alone can be useful in some contexts, the real power of SUMPRODUCT comes from utilizing criteria. The values in any column can be logically tested as TRUE or FALSE in Excel. The logical value TRUE is represented by the number one and the logical value FALSE is represented by zero.

With that in mind, we can analyze a larger table that lists a client's name, the business entities associated with that client, and the due date and fee amount of the annual renewal filing required by the state the entity is formed in:

 A   B   C   D   E   F 
 1   Client   Entity Name   Entity Type   State   Month Due   Amount 
 2   John Doe   ABC Corporation   Corp   UT   Apr   15 
 3   John Doe   Doe Family Partnership   LP   UT   Dec   15 
 4   John Doe   Doe Rental Property, LLC   LLC   DE   Jun   250 
 5   John Doe   Doe Equipment, LLC   LLC   DE   Jun   250 
 6   Bill Smith   Bill Smith, DDS, Inc.   Corp   NV   Jan   325 
 7   Bill Smith   Smith Family Partnership   LP   WY   Dec   50 
 8   Bill Smith   Smith Equipment, LLC   LLC   DE   Jun   250 
 9   Bill Smith   Smith Business Property, LLC   LLC   NV   Oct   325 
 10   Bill Smith   Smith Rental Property, LLC   LLC   NV   Oct   325 
 11   Bill Smith   Smith Vacation Home, LLC   LLC   WY   Feb   50 

Suppose that Bill Smith is wondering what he will be paying each year for all his annual state renewal filings. This can be easily calculated with the following formula: =SUMPRODUCT(--(A2:A11="Bill Smith"),F2:F11). The result is 1,325.

The array in column A must equal "Bill Smith" in order for the figure in column F to be included in the total. The first four rows do not equal Bill Smith so they return FALSE, and the remaining rows do equal Bill Smith so they return TRUE. The "--" turns the Boolean values TRUE and FALSE into the integer value 1 and 0 respectively. The products of the values from column A and the values in column F added together equal 1,325.

Of course, the above result is also possible with the following SUMIF formula: =SUMIF(A2:A11,"Bill Smith",F2:F11). However, SUMIF does a poor job of handling multiple criteria, while SUMPRODUCT can. Following are some additional examples of SUMPRODUCT formulas and the information they return.

To find the total fees due for Bill Smith's LLCs, use this formula: =SUMPRODUCT(--(A2:A11="Bill Smith"),--(C2:C11="LLC"),F2:F11), which results in 950.

To find the total fees due for Bill Smith's Nevada LLCs, use this formula: =SUMPRODUCT(--(A2:A11="Bill Smith"),--(C2:C11="LLC"),--(D2:D11="NV"),F2:F11), which results in 650.

To find what all clients will be paying for LLC fees in the month of June, use this formula: =SUMPRODUCT(--(C2:C11="LLC"),--(E2:E11="Jun"),F2:F11), which results in 750.

In summary, SUMPRODUCT simply returns the sum of the products of corresponding ranges or arrays. However, if multiple arrays are used as filters, its usefulness increases dramatically.

Charging Order Remedies

A charging order is a statutory provision of law that allows a creditor of a company’s owner to take distributions made to the owner by the company. It is a limited remedy designed to protect innocent owners by preventing a creditor from disrupting business activities by seizing or controlling company interests. Because the creditors cannot control the entity, they cannot control when distributions are made, meaning that the creditors get nothing if the business never makes a distribution. Limited partnerships and limited liability company statutes, but not corporation statutes, generally limit a creditor to a charging order.

As an example of how charging order protection works, assume that Jane forms a new Corporation and contributes $10,000. Jane is the Corporation’s 51% owner, and her husband John owns 49%. The Corporation prospers and is worth $10 million some years later. At that time, Jane is driving her personal car negligently and runs over and kills a doctor; she incurs a $10 million judgment. Because her business is formed as a corporation, the estate of the doctor can levy on Jane’s stock, thereby gaining control of the Corporation, and sell its assets in satisfaction of the judgment. This will result in Jane’s loss of employment and in the liquidation of the corporation at a substantially discounted price, with her husband receiving 49% of the discounted proceeds.

However, if Jane had initially organized her business as a limited liability company, the exclusive remedy for the estate of the doctor in most jurisdictions is a charging order. As such, the estate would be entitled to distributions that the LLC makes, but nothing more; it cannot levy on Jane’s LLC interest, fire her, or liquidate her company.

Because limiting a creditor to a charging order is designed to protect the innocent members in a business entity, this limitation may not apply where a limited liability company has only a single member. In fact, a number of courts have held that creditors of the sole member of an LLC are not limited to the charging order remedy and that they may seize the debtor’s LLC interest. Accordingly, a single member LLC by itself cannot be relied upon to provide meaningful asset protection.

File 1120S instead of Schedule C

Schedule C is part of Form 1040 and is used to report income or loss from a business. “Business” means any continuous activity engaged in for income or profit. Schedule C is also used to report statutory employee wages and expenses, income and deductions of certain qualified joint ventures, and certain income shown on Form 1099-K and Form 1099-MISC. There are two important reasons why reporting business income on Form 1120S is better than reporting business income on Schedule C.

First, is audit risk. The IRS continually tracks the “tax gap,” or the amount of tax liability faced by taxpayers that is not paid on time. A huge portion of the tax gap is attributable to Schedule C under-reporting; this is the reason why the IRS audit efforts focus so heavily on Schedule C. Additionally, claiming several years of losses in a row on Schedule C will increase audit risk with the IRS arguing that the “business” is really a “hobby” and that the losses should be disallowed.

Not only does filing Schedule C cause an audit risk, it also results in paying more self-employment taxes than necessary. On Schedule C, all of the net income from the business is subject to self-employment tax, which is normally around 15 percent. Self-employment tax is in addition to income tax.

By forming a business entity and electing to have that business entity taxed under Subchapter S of the Internal Revenue Code, self-employment tax liability can be reduced. A Subchapter S Corporation (S-Corp) is created when an eligible entity, such as a corporation or limited liability company, elects to be treated according to the rules of Subchapter S of the Code and its regulations.

S-Corp net income is reported on form 1120S and flows through to the personal tax return of its owners, avoiding Schedule C and self-employment tax all together. However, S-Corps must pay a reasonable salary to its owners. Salary is subject to payroll taxes, and payroll taxes are virtually identical in amount to self-employment taxes. However, S-Corps do not need to pay all net income as salary, and any net income not paid as salary avoids both self-employment tax and payroll tax.

In order to form an S-Corp and file Form 1120S, advance planning must be undertaken since a business entity should be formed and Form 2553 should be filed to make the S-Election near the beginning of the tax year. Doing so, however, is likely to result in a smaller overall tax liability at year end.

Defective Grantor Trust Overview

Irrevocable trusts are an essential part of sophisticated estate planning. Such trusts are normally used to hold assets that have been gifted or otherwise transferred by a grantor. Assets within irrevocable trusts, including future appreciation, are not included in the grantor’s estate for estate tax purposes.

A standard irrevocable trust is treated as a separate entity for income tax purposes and will be taxed on the income at the trust level. However, if an irrevocable trust is “defective,” the deemed grantor of the trust will be taxed on the income of the trust instead. This means the trust is disregarded for federal income tax purposes; such trusts are known as “grantor trusts.”

An intentionally defective grantor trust can be an effective planning technique for several important reasons. First, as with any irrevocable trust, the assets held within the trust are generally protected from creditors.

Second, since the trust is not a separate taxpayer, a sale to the trust by the grantor is not a recognizable transaction for income tax purposes and no gain will be recognized. Such a sale is often structured as an installment sale with a promissory note that has a self-cancelling feature effective upon the death of the grantor. This results in the balance of the note being excluded from the estate of the grantor; similarly, any increase in the value of the asset will also occur outside of the grantor’s taxable estate.

Third, since income generated by the irrevocable grantor trust is taxed to the grantor, the payment of that tax liability by the grantor is, in effect, a gift-tax free benefit to the trust and ultimately to the trust's beneficiaries. Since the trust is irrevocable, the trust principal will not be included in the taxable estate of the grantor. Therefore, the grantor can transfer assets into the trust by sale without the recognition of an income tax event, not have the trust assets included in his or her gross estate at death, and continue to reduce the value of his or her estate by the income tax payments on the trust income.

Although President Obama's current budget proposal would eliminate the value of using intentionally defective grantor trusts as an estate planning strategy, such trusts currently remain a useful tool.

Asset Protection for IRAs

What is the best way to ensure that an Individual Retirement Account (IRA) is protected from the claims of creditors? As with any asset, developing a protection plan should include considering the following questions: Is the asset already protected by state or federal statute? Can the asset be moved or the owner's residence changed so that the asset would be protected by the statutes of a different jurisdiction? Can an unprotected asset be converted to a protected asset? Can the asset be protected by incorporating a protective structure?

Applying this framework to IRAs, the first consideration is whether the IRA is already protected by state or federal statute. The 50 states and the federal government provide a patchwork of statutory protection for various types of assets in various scenarios. IRAs are protected up to $1 million under federal bankruptcy statutes.

However, states may "opt out" of the federal exemptions and require that debtors filing for bankruptcy in a district within that state be subject to the state exemptions instead. While some federal bankruptcy provisions will always trump state law, the IRA provisions do not. California, for example, has opted out of the federal exemptions and only offers limited protection for IRAs.

If an asset is not already statutorily protected, the next question is whether the asset can become statutorily protected by utilizing the laws of another state. For example, Florida has very liberal asset protection laws for real property, so purchasing a property in Florida can offer protection from creditors. However, since IRAs don't have a distinct physical location, they tend to be governed by the owner's state of residence; and the only alternative would be to move and establish residency in a state that protects IRAs, such as Washington state.

If changing domicile is not an option, another is to convert an asset that is not protected into an asset that is protected. Converting cash to real estate is one example mentioned previously. Given the special tax treatment of IRAs, any such strategy would need to avoid tax penalties. While IRAs may not be protected in a particular state, 401(k) and other ERISA-qualified retirement plans are under federal law that trumps any state law affording 401(k)s less protection. In Patterson v. Shumate, 504 U.S. 753 (1992), the United States Supreme Court confirmed that creditors may not reach an individual's interest in ERISA-qualified plans, whether in a bankruptcy, lawsuit, or otherwise.

However, only certain kinds of IRAs can be rolled into a 401(k). Inherited IRAs may not be rolled into a 401(k), neither can non-deductible IRA contributions. Only IRA funds that constitute tax-deductible contributions or a previous 401(k) rollover can be rolled over into a 401(k). Furthermore, the employer and the 401(k) plan administrator must approve the rollover.

If converting the non-protected asset into a protected asset is not an option, placing the asset into a protective structure such as an irrevocable trust or LLC should be considered. Almost without exception, income-producing property such as rental real estate should be owned by an entity, probably an LLC, for asset protection purposes. While the owner of an IRA must be the individual, an LLC can still be incorporated by changing the investment of an IRA to a limited liability company with a friendly manager. This will work to invoke the protections provided by LLC statutes. In order for this strategy to work, the IRA must be managed by a custodian that allows self-directed investments.

In summary, if an asset is not protected by state or federal statute, consider whether it can be moved or the owner's residence changed, whether the unprotected asset can be converted to a protected asset, or whether the asset can be protected by incorporating a protective structure.

Introduction to Self-Directed IRAs

An individual retirement account (IRA) is a tax advantaged, custodial account set up for the exclusive benefit of the owner. The account must meet the following requirements: First, the custodian must be a bank, a federally insured credit union, a savings and loan association, or another entity approved by the IRS to act as custodian. The custodian is responsible for receiving and holding IRA assets, maintaining accurate records, making distributions, and providing annual statements to the IRA owner.

Second, the custodian generally cannot accept contributions that exceed the IRA contribution limits, with the exception of rollover contributions. Contributions, except for rollovers, must be in cash. Third, the owner must have a nonforfeitable right to the account at all times. Fourth, assets in the account cannot be combined with other property, except in a common trust fund or common investment fund, and fifth, the rules on distributions must be followed.

Most IRA custodians only allow IRAs to select from investments that their company offers, such as stocks and bond portfolios. However, the Internal Revenue Code (IRC) only prohibits investing in life insurance contracts or collectibles under IRC § 408. Collectibles include works of art, rugs or antiques, any metal or gem, any stamp or coin, or any alcoholic beverage.

In other words, the only restrictions on using an IRA to invest in real estate, notes, or any asset other than those listed above would come from the IRA custodians themselves, not any law or regulation. The IRS website states that IRA custodians “are permitted to impose additional restrictions on investments. For example, because of administrative burdens, many IRA trustees do not permit IRA owners to invest IRA funds in real estate. IRA law does not prohibit investing in real estate but trustees are not required to offer real estate as an option.”

The alternative is a self-directed IRA. A self-directed IRA is simply an IRA account in which the custodian agrees to allow the owner to exercise greater control over investment decisions. However, because there is so much more flexibility over a self-directed IRA, the owner must be aware of the rules regarding prohibited transactions with related parties. The IRS imposes significant tax penalties if any “disqualified person” engages in a “prohibited transaction” with a retirement plan. A “disqualified person” according to IRC § 4975 includes any of the following people or entities:

      The owner of the plan;
      A family member such as a spouse, ancestor, lineal descendant, and their spouses;
      The administrator of the plan;
      Any person providing services to the plan;
      Any corporation, partnership, trust, or estate in which the IRA owner owns, either directly or indirectly, 50% or more; or
      An officer, director, 10% or more shareholder, or highly compensated employee of any entity described above.

A prohibited transaction according to IRC § 4975 is any direct or indirect:

      Sale or exchange, or leasing of any property between a plan and a disqualified person; or a transfer of real or personal property by a disqualified person to a plan where the property is subject to a mortgage or similar lien placed on the property by the disqualified person within 10 years prior to the transfer, or the property transferred is subject to a mortgage or similar lien which the plan assumes;
      Lending of money or other extension of credit between a plan and a disqualified person;
      Furnishing of goods, services, or facilities between a plan and a disqualified person;
      Transfer to, or use by or for the benefit of, a disqualified person of income or assets of a plan;
      Act by a disqualified person who is a fiduciary whereby he or she deals with the income or assets of a plan in his or her own interest or account; or
      Receipt of any consideration for his or her own personal account by any disqualified person who is a fiduciary from any party dealing with the plan connected with a transaction involving the income or assets of the plan.

In short, a prohibited transaction is one that violates the purpose of IRA law, which is to benefit the owner in the future after retirement, when distributions are permitted. The owner has a fiduciary relationship with his or her self-directed IRA, and with these rules in mind, they can take use their IRA funds to make a wide range of of the investments.

In Excel, Use Index-Match Instead of Vlookup

While searching the web for help with a nested VLOOKUP formula I was attempting, I happened upon a post by Charley at ExcelUser Blog about the INDEX-MATCH function combination that has made working with spreadsheet data a little easier and faster for me. VLOOKUP searches a table for a value in the left-most column and can return a value in the same record from different column to the right. A number of times when using VLOOKUP, I've needed to search for a value in a column other than the left-most column and return a value from a record in a column to the right or left.

For example, the following state abbreviation table can be used with VLOOKUP to return the full state name by looking up the abbreviation, but not vice versa.

 A   B   C   D 
 1   AL   Alabama       1 
 2   AK   Alaska        Alabama 
 3   AZ   Arizona        AL 

Of course, I could copy column A and paste into column C and use the table B1:C3 to return the abbreviation by looking up the full state name, but that isn't very clean and becomes impractical with larger tables and more complicated data needs.

INDEX-MATCH uses two functions. The MATCH function returns the record number to the INDEX function, which returns the data actually being sought. The formula in D1 is =MATCH(A1,A1:A3,0). The first argument is the search term, "AL", the next argument specifies the table being searched, and third argument specifies that we want an exact match. The result of the formula is the row number on which the lookup value, "AL", appears.

The formula in D2 utilizes the INDEX function to return the actual value we want, the full state name. The first argument is the table or array, and the second argument is the record number, calculated by the same MATCH function from D1. The formula is =INDEX(B1:B3,MATCH(A1,A1:A3,0)). Note that the two table references need to start and stop on the same cells or else incorrect data could result.

The formula in D2 could just as easily be =VLOOKUP(A1,A1:B3,2,FALSE). However, INDEX-MATCH does not require the lookup value to be in the left most column. The formula in D3 looks up the value in B1 and returns the corresponding abbreviation: =INDEX(A1:A3,MATCH(B1,B1:B3,0)). VLOOKUP is unable to accomplish this with the current table.

These same principles apply with HLOOKUP, which is is the same as VLOOKUP except it utilizes a table turned on its side. INDEX-MATCH is more flexible and it apparently faster as well.

Fixing Problems with Online IRS EIN Applications

Having obtained hundreds of Employer Identification Numbers for clients over the past few years, I have learned a number of remedies for rejected online EIN applications submitted on the IRS's website. Consider the following potential causes:

Every EIN application requires a responsible party name and matching tax ID number. Often, this will be an individual and their social security number, but sometimes the responsible party is another business with another EIN number. The IRS will not process online EIN applications if the responsible party is an entity with an EIN previously obtained through the internet. In other words, unless the responsible party is an individual with a social security number or an entity with an EIN that was not obtained through the internet, the online EIN application will always return an error.

If the first two numbers of the entity's EIN Number begin with 20, 26, 27, 45, 46, or 47, that EIN number was obtained through the online EIN application. Accordingly, that entity can never be a responsible party for another online EIN application; you will have to apply over the phone or list another responsible party on the online application, such as the individual who owns the entity. If the responsible party's EIN begins with 30, 32, 35, 36, 37, 38, 61, 80, 90, or 91, that EIN number was not obtained through the online EIN application, and that entity should be able to be a responsible party on another online EIN application.

The IRS will only issue an EIN to one responsible party per day. This limitation applies to all requests for EINs, whether through the online EIN application or by phone, fax, or mail. If an EIN has been issued to any entity by any application method on a particular day, the responsible party on that EIN application must wait until the next day before being the responsible party on another EIN application.

A rejected EIN application indicating Reference Number 101 has a name conflict. The IRS requires a unique entity name before it will issue an EIN, similar to how the secretary of state requires a unique entity name within that state before Articles or Certificates of Formation may be successfully filed. However, because the IRS is a federal agency issuing EINs for entities in all 50 states, it potentially checks for duplicate entity names across multiple states. There are numerous references to a state on the online EIN application, such as the physical location state, mailing address state, and the state where the Articles are or will be filed.

If all of these state references are the same, the IRS will only check for previously-issued EINs with that entity name in that one state. If multiple states are reported, for example, if the Articles were filed in a different state than the business's physical address, the IRS will check both states for name availability before issuing an EIN, even though filing the Articles only requires a unique entity name in the one state where the Articles are being filed. Applying for an EIN over the phone may be required in these name conflict situations; often, the IRS agent will ask to see a copy of the Articles before issuing an EIN.

Reference Numbers 109 and 110 indicate technical problems and an EIN may still be obtainable using the exact same information that resulted in the error. The error might result from too many people trying to obtain an EIN at the same time. Try again later, or try closing and reopening the browser, using a different browser, using a different computer, clearing cookies, restarting the computer, or adjusting your security settings. Or, feel free to contact me; I would be happy to try and help.

Section 179 Deductions for Non-Corporate Lessors

For asset protection purposes, business capital assets should normally be owned by a separate entity, as opposed to the business operating entity, and then leased back to the operating entity. A non-corporate leasing entity can still qualify for the favorable tax treatment of newly-purchased business assets under IRC § 179, which allows businesses to expense certain depreciable assets instead of depreciating them over a longer period of time. However, two additional requirements must be followed.

First, the term of the lease (including options to renew) must be less than 50 percent of the class life of the property. Second, for the 12 month period after the property is transferred to the lessee, the lessor's deductions attributable to the property (not including rents and reimbursed amounts) must exceed 15 percent of the rental income paid by the lessee.

In Ross P. Thomann v. Commissioner (TC Memo 2010-241), as discussed by Paul Bonner in the July 2011 Journal of Accountancy, the IRS disallowed a section 179 deduction for farm equipment primarily due to the lack of a written lease that clearly identified the property leased and the lease term. The taxpayer also presented no documentation of class life or a comparison of lease income with the lessor's deductions.

In order to avoid denial of the 179 deduction like the taxpayer in Thomann, documentation is the key. The lease agreement should clearly document each property being leased as well as the asset class life of each property so as to ensure that the term of the lease, taking into account options to renew, is less than half of the class life. Furthermore, the rent attributable to each property being leased should be documented, as well as the expenses, to ensure and demonstrate that deductions exceeding 15 percent of the rent income are taken by the lessor in the first 12 months. The lease agreement may need to specify that the lessor is responsible for expenses under the lease, and the lessor may need to frontload scheduled maintenance, insurance, etc. to ensure the 15 percent requirement is met.

By undertaking these steps, both asset protection and significant tax benefits can be realized.

Sample Form for S-Election Revocation

While entities taxed as S-Corps are the default recommendation of most business and tax planners, there are a number of benefits derived from being taxed as a C-Corp that should be carefully considered. C-Corps can deduct expenses that other tax entities cannot, such as 100% of the health insurance paid for employees, including shareholders in the corporation, as well as the costs of any medical reimbursement plan. While C-Corps do leave its shareholders open to the notorious double tax, this may not be a problem if profits are low.

If after careful consideration with your CPA, you decide that you would like to revoke the S-Corp status of your closely-held business, the following is a form letter that can be used:


_______________ ____, 20____
Department of the Treasury
Internal Revenue Service
_______________, ____ __________

Re: Revocation of S Corporation Election of _______________, Inc., Taxpayer Identification Number: ____-______________

To Whom It May Concern:

Notice is hereby given, pursuant to Section 1362(a) of the Internal Revenue Code, that _______________, Inc., a corporation incorporated in the State of _______________, with address of _______________, _______________, ____ __________, revokes its S corporation election filed with you on IRS Form 2553 dated _______________ ____, 20____.

The number of shares of the corporation’s stock (including non-voting stock) issued and outstanding at the time of this revocation is __________. The first taxable year for which this revocation is intended to be effective is the corporation’s taxable year beginning _______________ ____, 20____. Required shareholder consents to this revocation of election are attached.

Sincerely,


______________________
President of _______________, Inc.


Shareholders' Consent to Voluntary Revocation of
Election of S Corporation Status

The undersigned, being shareholder(s) of _______________, Inc., a corporation incorporated in the State of _______________, hereby consent to the revocation of its election under Section 1362(a) of the Internal Revenue Code to which this consent is attached. The address of the corporation is _______________, _______________, ____ __________. The corporation’s Taxpayer Identification Number is ____-______________. Each of the undersigned shareholders taxable year ends on December 31.

The undersigned shareholders’ name, address, taxpayer identification number, number of shares owned, and date acquired are as follows:

Shareholder Name:                Address:                         TIN:                      No. of Shares:   Date Acquired:

______________________ ____________________ ______________ ____________ __________________

______________________ ____________________ ______________ ____________ __________________

______________________ ____________________ ______________ ____________ __________________

______________________ ____________________ ______________ ____________ __________________

Signed: ____________________ Title: ____________________ Date: __________________

Signed: ____________________ Title: ____________________ Date: __________________

Signed: ____________________ Title: ____________________ Date: __________________

Signed: ____________________ Title: ____________________ Date: __________________

The Basics of the Tax Consequences of a Business Asset Sale

The sale of a business by a seller to a purchaser generally can take two forms: A sale of the business’s assets or a sale of equity interests in the business. As a general rule, the seller will favor a sale of equity and the purchaser will favor an asset sale. This is because with an equity sale, the seller will have capital gain whereas with an asset sale, the seller generally has some ordinary income. An asset purchase is more appealing to the purchaser because the tax basis of the assets will be equal to their purchase price and can be depreciated on that basis. The sale of a business via an asset sale is treated as if each of the assets of the business were sold separately for purposes of determining gain or loss.

All assets sold in an asset sale must be classified as capital assets, depreciable property used in the business, real property used in the business, or property held for sale to customers, such as inventory or stock in trade. The gain or loss on each asset is figured separately. The sale of capital assets results in capital gain or loss whereas the sale of real property or depreciable property used in the business and held longer than one year results in gain or loss under IRC § 1231. The sale of inventory results in ordinary income or loss to the seller.

In general, both the purchaser and seller of a business must use the “residual method” to allocate the consideration to each business asset transferred. The purchaser’s consideration is the cost of the assets acquired. The seller’s consideration is the amount realized (money plus the fair market value of property received) from the sale of assets. The residual method determines gain or loss from the transfer of each asset and how much of the consideration is for goodwill and certain other intangible property. It also determines the purchaser’s basis in the business assets.

The residual method requires the consideration to be reduced first by the cash and general deposit accounts (including checking and savings accounts but excluding certificates of deposits) and allocated among the various business assets in the following order:

Class I: Cash, demand deposits, and similar cash items.
Class II: Readily marketable stock and securities and certificates of deposit.
Class III: All other tangible and intangible assets not in any other class.
Class IV: IRC § 197 intangibles other than goodwill and going concern value.
Class V: Goodwill and going concern value.

In this way, gain and/or loss is allocated among all the assets of the business.

Probate Assets vs. Non-Probate Assets

Some people are under the mistaken impression that having a will means that the probate process will be avoided upon death. Having a will allows you to appoint who will handle your affairs and who will inherit assets, and it can provide for various methods to lower costs to the estate (such as waiving the bond required of a personal representative). However, a will does not avoid the probate process; it simply gives directions to the probate court, and it must be probated in order to be effective.

If an asset is held in joint tenancy and a joint tenant survives, that asset will be a non-probate asset and pass outside of the probate process. Life insurance, annuities, IRAs, pension plans, or accounts with a P.O.D. (payable on death) or T.O.D. (transfer on death) designation will avoid probate using beneficiary designations, if the beneficiary survives. Any property held in trust, such as a living trust, will be non-probate property. Nearly all other assets cannot be transferred upon death without passing through the probate process.

Personal Residence LLC and Trust Tax Considerations

Some asset protection attorneys recommend placing personal residences into entities, while others prefer trusts. While both have their pros and cons, no decision should be made without ensuring that the federal tax benefits of owning a personal residence are maintained.

The Internal Revenue Code provides a significant tax advantage to taxpayers who own a personal residence. First is the interest deduction of as much as $1 million of acquisition indebtedness and up to $100,000 of home equity indebtedness on a qualified personal residence. Taxpayers who do not hold legal title to a residence but who can establish they are the equitable owners of the property are entitled to deduct mortgage interest paid by them with respect to the property. Transferring a personal residence into an asset protected entity should not affect this deduction as long as the taxpayer remains the equitable owner of the property.

Second, and more important, IRC § 121 provides for an exclusion from taxable income of $250,000 ($500,000 for married couples) worth of gain on the sale of a personal residence. This exclusion may be claimed every two years as long as the taxpayers owned and used the property as their principal residence for two out of the previous five years prior to the sale.

Treas. Reg. § 1.121-1(c)(3)(i) provides that if a taxpayer owns his or her residence in a trust, as long as the taxpayer is treated as the owner of the trust, he or she is treated as owning the residence for purposes of satisfying the two-year ownership requirement. Treas. Reg. § 1.121-1(c)(3)(ii) provides that if an individual taxpayer owns his or her residence in an entity, as long as the entity has the taxpayer as its sole owner and is disregarded for federal tax purposes, he or she is treated as owning the residence for purposes of satisfying the two-year requirement.

One other possibility exists in community property states where a married couple owns the limited liability company 50-50, as the entity can elect to be taxed as a disregarded entity under Rev. Proc. 2002-69. The couple will be able to own their residence in the LLC and satisfy the two-year requirement.