Tax Credits for Paid Leave under FFCRA

The Families First Coronavirus Response Act (FFCRA) generally requires employers to provide up to two weeks of paid leave at regular pay rates for employees who can't work due to being sick with coronavirus, up to two weeks of paid leave at two-thirds of regular pay rates for employees who can't work due to a family member being sick with coronavirus, and up to ten weeks of paid leave at two-thirds of regular pay rates for employees who can't work because a child's school or child care provider is unavailable. Fortunately, all of an employer's costs for this qualified sick leave is designed to be offset by payroll tax credits.

By way of background, employers are required to withhold estimated employees' income taxes and payroll taxes (Social Security and Medicaid) from employees' paychecks and then match the payroll tax withholding and remit all of such funds to the IRS on (usually) a quarterly basis. The credit for paid leave under the FFCRA offsets the employer's portion of payroll taxes. However, the credits are refundable, meaning that if the qualified sick leave paid in respect of employees impacted by coronavirus exceeds the employer's portion of payroll tax for all employees, the employer will receive a refund from the IRS.

Regulations and forms for these new tax credits will be forthcoming. The most interesting aspect of these tax credits is that employers will apparently be able to retain income taxes withheld and both the employer's and the employees' share of payroll taxes up to the amount of qualified sick leave, rather than deposit such withholdings with the IRS and seek a refund. As I discussed in a prior post, these withholdings are considered to be held in trust for the IRS, and individuals who do not remit such taxes to the IRS will be personally liable for the entirety of such taxes. As such, employers should not utilize this method of reimbursement for qualified sick leave they pay without maintaining very careful records and waiting until final guidance is issued by the IRS. Trust fund taxes must never be used to cover any other expense.

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IRS Notice 784 - Trust Fund Recovery Penalty

As mentioned in a previous post, the IRS pays out tax refunds (often constituting amounts an employer has withheld from an employee's paycheck in excess of that employee's income tax liability) before verifying if the employer has actually withheld those amounts or paid them to the IRS. This is a flawed method and helps explain why the IRS is extremely concerned that employers remit these withheld taxes, as well as social security and Medicaid taxes, to the IRS.

One enforcement mechanism is the Trust Fund Recovery Penalty (TFRP), which is described IRS Notice 784, which is referenced in the IRS's website and current Internal Revenue Manual. Since Notice 784 effectively explains the TFRP but does not appear to be generally available on the web, I quote it here:

Could You be Personally Liable for Certain Unpaid Federal Taxes?

If you are an employer, you must withhold federal income, social security (or railroad retirement), and Medicare taxes from your employee’s wages or salaries. If you provide communication or air transportation services, you also may have to collect certain excise taxes from people who paid you for the services. (Get Pub. 510 for more information on excise taxes.) These taxes are called trust fund taxes and must be paid to the Internal Revenue Service through tax deposits or as payments made with the applicable returns.

The trust fund recovery penalty. – If trust fund taxes willfully aren’t collected, not truthfully accounted for and paid, or are evaded or defeated in any way, we may charge a trust fund recovery penalty. This penalty is equal to the amount of the trust fund taxes evaded, not collected, not accounted for, or not paid to IRS. We also charge interest on the penalty.

Who has to pay the penalty? – The trust fund recovery penalty may apply to a person or persons IRS decides is responsible for collecting, accounting for and paying the trust fund taxes and who acted willfully in not doing so. If IRS can’t immediately collect the taxes from the employer or business, we will decide who the responsible person or persons are and who acted willfully.

“Willfully” means voluntarily, consciously, and intentionally. A responsible persons acts “willfully” if this person knows that the required actions are not taking place for any reason. Paying other business expenses instead of trust fund taxes is considered willful behavior.

Any person who had responsibility for certain aspects of the business and financial affairs of the employer (or business) may be a responsible person. A responsible person may be an officer or employee of a corporation, or a partner or employee of a partnership. This category may include accountants, trustees in bankruptcy, members of a board, banks, insurance companies, or sureties. The responsible person can even be another corporation, a volunteer director/trustee, or employee of a sole proprietorship. Responsible persons may include those who direct or have authority to direct the spending of business funds.

If we charge you this penalty, we may take your assets (except exempt assets) to collect the amount owed.

Avoid the penalty. – You can avoid the trust fund recovery penalty by making sure that all taxes are collected, accounted for, and paid to IRS when required. Make your tax deposits and payments on time. IRS employees are available to assist you if you need information on tax deposits and payments. You may telephone the IRS tax information number in your area for help. Pub. 937, Employment Taxes and Information Returns, Pub. 15, Employer’s Tax Guide, and Form 941, Employer’s Quarterly Federal Tax Return, are also helpful and available from IRS.

Source: Bloomberg BNA, Tax and Accounting Center, links added by me.

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Self-Employment Taxes for LLC Members

In a previous post, I discussed how members of an LLC taxed as a partnership can avoid being liable for self-employment tax on the net income from the business. With the limited exception of Prop. Reg. 1.1402(a)-2, the subject of that post, clear guidance on this issue has been lacking for decades. This month, the IRS created a stir by taking on the issue anew with Chief Counsel Advice memorandum 201436049. Tony Nitti, writing at Forbes, has a great article that describes the backdrop for this new pronouncement in this way:

"IRC Section 1402, like many provisions of the Code, starts off by setting the general rule– i.e., all trade or business income, including a partner’s distributive share of partnership income, is included in self-employment income–before listing a host of exceptions to that general rule. Specific to this discussion, IRC Section 1402(a)(13) provides that the distributive share of partnership income of a limited partner – other than guaranteed payments – is NOT included in self-employment income."

In general, taxpayers who earn active income owe self employment tax on that income, while taxpayers who invest and earn passive income, such as limited partners in a limited partnership, do not pay self employment tax on those earnings. IRC 1402 was passed before LLCs came into existence, and LLCs have confused the issue because all LLC members are legally akin to limited partners.

Most tax practitioners agree that, similar to how S-Corps are treated, only part of the distributive share received by members from properly-structured LLCs ought to be subject to self-employment tax, not all of it. However, with CCA 201436049, the IRS took the position that individuals who were members of an LLC that served as a general partner of an investment limited partnership and received a management fee were subject to self employment tax on the entirety of their distributive share.

CCA 201436049 makes reference to Prop. Reg. 1.1402(a)-2 in a footnote, summarizing the three tests for limited partner treatment: "[A]n individual is treated as a limited partner 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; or (3) participates in the partnership's trade or business for more than 500 hours. [There are] exceptions for certain holders of classes of interest that are identical to those held by limited partners."

With respect to the exceptions: "If the LLC has two classes of members... [and if] at least 20% of the members of the Investor Class do meet all three tests and the managing member is a member of this class," the managing member is treated as a limited partner and his or her distributive share is not subject to self employment tax. John M. Cunningham, "Using LLCs to Protect Family Assets," WealthCounsel CLE, September 14, 2011. The key is to have a properly-drafted operating agreement that clearly creates these distinct classes of membership.

CCA 201436049 stands for the idea that the distributive shares of LLC members who provide services are not wholly exempt from self employment tax simply due to the LLC structure. The proposed regulation, even though not finalized, can probably still be relied upon as a safe harbor. Beyond that, be aware that the IRS appears prepared to argue that more or all of a partnership LLC's distributive shares ought to be subject to self-employment tax.

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Income Shifting to Children

A fundamental tax-mitigation technique is shifting income from taxpayers in high tax brackets to taxpayers in lower brackets. One of the ways this can be accomplished for business owners is by paying their children a salary for working for the business. Not only does this shift taxable income from the parent's higher-bracket to the children's lower-bracket while keeping everything within the family, this technique can also save payroll taxes compared to hiring non-family employees.

According to the IRS, "[p]ayments for the services of a child under age 18 who works for his or her parent in a trade or business are not subject to social security and Medicare taxes if the trade or business is a sole proprietorship or a partnership in which each partner is a parent of the child." Furthermore, children claimed as dependents on a parent's return and who make less than $6,200 for 2014 do not owe any income tax and are not required to file a tax return, although filing would be necessary in order to receive a refund of income tax withheld.

A parent can also match the child's wages up to $5,500 with a Roth IRA contribution in the child's name. This will reduce the parents' future tax on investment income by the amount of the return on the contribution, which would grow tax-free.

In addition to passing income in the form of "active" wages to children, "passive" income can also be passed to children. In order to take advantage of this opportunity, the "kiddie tax" must be avoided. If the tax applies, the income is taxed at the parent's highest rate instead of the child's, completely negating the strategy. However, parents can still transfer income-generating assets to children, and if the income for the tax year is under $2,000 in 2014, the child's lower rate applies. As children reach the age of majority and continue earning substantially less than their parents, the opportunities to shift passive income increases.

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Educational Assistance Programs

Companies who hire students or potential students can offer educational benefits that would be more beneficial to both employer and employee than a standard wage offer would be. This can be accomplished through the fringe benefit known as an Educational Assistance Program.

An Educational Assistance Program allows an employer to provide an employee assistance in paying for tuition, fees, books, and supplies for education. Benefits provided under this program will not be subject to income or employment taxes, and the first $5,250 will be excluded from the employee's income each year.

The requirements are as follows: (1) The program must benefit employees who qualify under rules set up by the employer but that do not favor 5%-or-more owners or employees earning more than $115,000; (2) the program may not provide more than 5% of its benefits during the year for shareholders or owners; (3) the program may not allow employees to choose to receive cash or other benefits that must be included in gross income instead of the educational assistance, (4) the employer must give reasonable notice of the program to eligible employees, and (5) the program must be in writing.

To illustrate how such a program can be better for both an employer and an employee who is indifferent about receiving wages or educational assistance as compensation, assume that an employer is contemplating offering an employee an annual raise of $5,000. Were this raise to come in the form of a salary increase, the employer would need to first deduct 6.2% for social security, 1.45% for medicare, and some amount for income tax withholding, say 5%, for a total of $632.50, leaving the employee with $4,367.50. The employer must pay out, in addition to the $5,000, an additional $382.50 for the employer portion of social security and medicare, for a total of $5,382.50.

In contrast, if the annual raise is in the form of educational assistance, neither the employee nor the employer is subject to any of the above taxes. If the employer offers a raise of $5,250.00, the total payout will be $5,250.00, a savings of $132.50. The employee will have $5,250.00 of his or her educational expenses paid for, a net benefit of $882.50 compared to receiving a salary and paying for tuition with after-tax dollars.

Certainly, an educational assistance program isn't appropriate in all cases, but it can provide savings and incentives to both the employer and employee for whom the situation is right.

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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).

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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.

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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.

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