Q:

Subject: Vacation Home Investment

 

Hi Kerry,

 

I plan to build a vacation rental in a couple of years.  The house will be used exclusively for business purposes and rented out by the day , weekend or week.  I will manage the property myself.  My question is . . . . is this activity a small business which I report out on Schedule C or a passive rental activity which I report out on Schedule E?  What is the determining factor(s).  If I have a choice as to how to report, what should I consider in making my decision?  My own research of IRS pubs seems to indicate that this should be treated as a small business but I keep seeing material on the web which seems to indicate otherwise.  Thanks.  You are the best.

 

Regards,

A:

That would be reported on Schedule C.  The break point is either that the average use of the property by renters is seven days or less, or 30 days or less and you (the owner) provide significant personal services along with the rental, such as cleaning and maintenance work.

As I constantly stress, trying to navigate the tax world without the assistance of at least one competent professional tax advisor is extremely dangerous. Your question, which any experienced tax pro could help you with, proves that you need to start working with one ASAP.   Any experienced tax pro can help you with that, as well as with maximizing all of the other kinds of deductions that are available for rental properties.

Good luck.  I hope this helps.

Kerry Kerstetter

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/30/2006 12:43:00 PM Send this post:

Q-1:

Subject: Section 179 expensing

 

Mr. Kerstetter,

 

I am writing to see if you may be able to help me with my confused state.  In 2004 I purchased an airplane with the plan of placing it into service at a local airport as a rental for student pilots.  I was advised, by my accountant, to form an S Corp and purchase the airplane.  I placed the airplane into service in the 1^st quarter of 2005 and kept it in service during all 4 quarters.  As it turns out it was not a profitable venture and I was negative approximately $15,000 (Profit/loss).  I had planned on taking a 179 expense however due to the business income limitation I cannot take the expense however I can carry it over to 2006.  As an aside a business venture such as this has no hope of ever being significantly profitable.

 

My question is would I be in the same situation if I had set up my company as an LLC?  As an LLC entity would my ordinary income be included in the business income limitation?  Is the business income limitation handled a little differently from an S Corp and a LLC?  Is there anything I can do to remedy this situation?

 

Thank you in advance for your assistance.

A-1:

Multi-member LLCs are treated essentially the same as S corps tax-wise, including with Section 179.

If you had set up a single member LLC and elected to treat it as a Schedule C sole proprietorship for tax purposes, the Section 179  expense would have been matched up against all of the earned income on your 1040, including from W-2s, most likely increasing the actual usable deduction.

Did you go over these different options with your accountant beforehand, or was he the kind who believes in a "one size fits all" S corp for everyone approach, without adequately analyzing the various factors first?

Kerry Kerstetter

Q-2:

I guess my accountant was the "one size fits all mentality."  I thought I was doing the right thing by going to him BEFORE I set up any business entity and even told him specifically (in 2004) I wanted to be able to take advantage of section 179.  I also spoke with an "aviation specialist" tax attorney who also recommended incorporation as an S Corp.

Without the 179 expense I owe $14,500 in Federal taxes, if I could (magically) be able to take advantage of the 179 expense I would have a $25,000 refund.

I have filed an extension and not have filed any returns as yet.  Do I have any options?

Best regards,

A-2:

With no income expected, it does seem rather careless to use an S corp if your goal was to maximize the Sec. 179 deduction.

What I have seen in cases just like this that I have worked on is that it often comes out okay by forgoing the Sec. 179 and just claiming normal or accelerated depreciation, which can be used to create a net loss that can flow through to your 1040 via the K-1.  If your preparer enters for Sec. 179 in his tax prep program, that will create a carry-forward for that amount and reduce the depreciable basis, resulting in much lower depreciation deduction.  While you won't get the huge Sec. 179 deduction all in one year, you will still get large losses for the depreciable life of the plane.

Good luck.

Kerry

Q-3:

Kerry,

 

Thank you. I am not sure careless is a strong enough word, as I said I was specific with my accountant that I wished to take advantage of the 179 expense.  Since the business was not profitable I "retired" the aircraft from service.  At present I am only looking at a deduction for 2005.

 

I will also be looking for a new accountant.  Can you make any referrals in the Denver area?

 

Again, thank you for your assistance.

 

Best regards,

Q-4:

Unfortunately, we don't have anyone to whom we could refer you. If you haven't already done so, you should check out my tips on how to select the right tax preparer for you.:

Good luck.

Kerry Kerstetter

Follow-Up:

Kerry,

 

This has been an expensive lesson for me.  My accountant has become a friend and I hope to keep him as a friend but he has proven to me that he can no longer be my accountant.  This misstep in tax planning impacted a commercial investment which hinged on the tax savings from the 179 expense; a plan I have discussed in detail with my accountant.

 

I would like to thank you again for you kind and thoughtful advice.  I can't tell you how much I appreciate it.  I have lost some sleep over my situation

but I realize I have many other blessings in my life and I am thankful for them.

Best regards,

 

Labels: 179

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/30/2006 12:40:00 PM Send this post:

Q:

Subject: Lease from Self

I am part owner of several corporate entities, Health Care Facilities,  Fast Food stores and Real Estate.  We have owned these properties for several years, consequently the majority have been depreciated ou,t specifically the equipment.  My question is, is it possible to use a corporation to buy the equipment from the entities and lease the equipment back to them and thus re-establishing depreciation on that equipment.  Be aware that there is common ownership among these entities.  What would be the benefits of this and what would be the drawbacks or negatives.

A:

This is the exact kind of thing that you should be discussing with your personal professional tax advisor.

What you will probably find out, if your tax pro runs some numbers for you, is that your plan would end up costing you more than it saves.  In order to inflate the values of the assets for higher depreciation, the selling entities will have to report gains, including depreciation recapture, which would be immediately taxable.  The higher depreciation deductions would be spread out over the next several years of the assets' lives.  Paying lump sum higher taxes now for higher deductions over the next five plus years seems to be counter-productive.

However, your entities may have large net operating losses, or other large deductions that could offset the sale profits.  Your personal tax advisor can help you see if that is the case.  However, if s/he does decide that such a sale makes sense, you will nee to be extra diligent in documenting the values you place on the assets.  IRS automatically regards such sales (aka churning) between related parties with suspicion, especially when there will be a tax savings opportunities.

Good luck.  I hope this helps.

Kerry Kerstetter

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/30/2006 12:28:00 PM Send this post:

Q:

Subject: small question

 

Hi, I am 20 years old and i am trying to figure something out. I noticed you posted on google groups, so I thought you cold help.

SO, I am in college and I have had 4 jobs last year. Two on campus jobs and two jobs in the summer. For one of the on campus jobs i am paid from an off campus firm. I am paid $40 a week. I have never met the people who pay me, and they do not submit a w2 form. I noticed this when dealing with finical aid. Am I going to jail? Or doing something illegal?

A:

All income you receive is taxable, whether or not the payer submitted a W-2 or 1099.

Get with a professional tax preparer ASAP to calculate your taxes for 2005.  You probably won't owe any actual income tax, but if no tax was being withheld from your paychecks, there is a good chance you will at least owe the 15.3% self employment (SE) tax.

Good luck.  I hope this helps.

Kerry Kerstetter

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/30/2006 12:23:00 PM Send this post:

Q:

Subject: Rental property

 

LOve reading your blog!!!

 

i inherited my mothers house when she died.   now renting it out.   how do i figure out the depreciation on it for my taxes?   mother bought it for 61,000 in 1987 but city has it assessed for 135,000.

keep up the posts!!!

A:

Your cost basis of the inherited property is its fair market value at the time your mother passed away.  If an estate tax return was filed for her, you would use the value shown on the 706.  If the estate was small enough not to require a 706, you should ask a local Realtor or appraiser to give you a value.  Most Realtors will run a CMA (competitive market analysis) for you for free, hoping that you will remember that when you decide to sell the property.

I'm glad that you like my blog; but it seems that you are missing one of the main themes that I thought I was stressing; that trying to navigate the tax world without the assistance of at least one competent professional tax advisor is extremely dangerous. Your question, which any experienced tax pro could help you with, proves that you need to start working with one ASAP. 

Just establishing the overall fair market value of the property is just the first step.  Next, you will need to allocate that between the values for the non-depreciable land and the depreciable building and components (appliances, fixtures and other separately identifiable items).  Any experienced tax pro can help you with that, as well as with maximizing all of the other kinds of deductions that are available for rental properties.

Good luck.  I hope this helps.

Kerry Kerstetter

Follow-Up:

thanks for the quick response. i guess i should get a tax pro like you said. you know what they say -- an ounce of prevention is worth a pound of cure!!!!

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/28/2006 01:47:00 PM Send this post:

Q:

Subject: 2008 Long Term Capital Gain

I understand that the 2008 LT CG tax rate for filers in the 10 % 15% bracket is to be 0% on the LT CG.

Assume the following:
Filing status Married, filing jointly
Taxable income of $30,000 (before LT CG)
LT CG (held over 15 years) $700,000

Is the entire $700,000 LTCG at 0% tax

             OR

is it just the amount from $30,000 up to the (approx) $62,000 taxed at 0%, then at the 15% rate for LTCG for filers in the brackets above 15%

If the filer could arrange to keep their 2008 taxable income in the 10 or 15% bracket(before LT CG) this would seem to be an outstanding opportunity to sell highly appreciated capital assets in 2008.

OR, am I missing the real facts here?

A:

It is a common misconception that the special low tax rates for LTCGs apply to the full amount of gain.  A you can see in the Schedule D tax worksheet, that isn't the case.  The various tax rates are applied sequentially, to the income in the different lower tax rate brackets.

In their divine wisdom, and as part of their smoke and mirrors style of budgeting, our imperial rulers in DC have given a special deal for only 2008 LTCGs, where the gain that would normally be subject to a 5% rate will be given a zero percent rate.  This means that you would use the worksheet and substitute 0% wherever it shows 5%.  The thresholds would also need to be adjusted for guesstimated inflation over the next few years. 

It's always possible that this one year special deal will be either repealed or even extended.  it is difficult to predict what our rulers will do.

Assuming it is in place when 2008 rolls around,  the best way to really exploit this break would be to do what you can to get your non-LTCG taxable income as low as possible.  A good professional tax advisor can help you with the many ways in which to accomplish this.

I hope this clears up your confusion.

Good luck.

Kerry Kerstetter

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/28/2006 01:38:00 PM Send this post:

Q:

Subject: Sale of sec 179

 

Is the below comment true (specifically the 'not subject to the self-employment tax')? I want to know the penalties of a Section 179 that I made for 2005 for $32,000 and a business truck.

“If a taxpayer disposes of property on which the taxpayer has claimed the Section 179 deduction, the Section 179 deduction is subject to recapture in the same manner as depreciation. A taxpayer reports the sale of such property on Form 4797. The recapture of depreciation and the recapture of the Section 179 deduction on a sale of the property are not subject to the self-employment tax (Section 1402(a)(3)(C)).”

Found on the web here.

A:

That is true; but it nothing new.  Gains from sales of business equipment, including depreciation recapture, have always been reported on Form 4797, which is not counted as self employment income.  Section 179 is really just a form of very accelerated depreciation.

Your personal professional tax advisor can explain how this affects you in more detail.

Good luck.

Kerry Kerstetter

 

Labels: 179

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/28/2006 01:29:00 PM Send this post:

Q:

Kerry,

 I think I have asked you before and apologise if you have already answered me.  I'm involved in a couple LLC and a couple Sub S Corporations. Currently they are all loosing money. ie interest, dev costs, etc. 06 will produce a big profit from one of the sub s's. I am about to enter into another partnership. My attorney tells me he see's absolutely no difference in the two from a liability point of view.  Do you feel there is a difference from a tax point of view?

A:

If the LLC chooses to be taxed as either a partnership or S corp, it is treated exactly the same for tax purposes as a regular S corp is.

Kerry

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/28/2006 01:23:00 PM Send this post:

Q:

I  came across your website when looking for Tips on Quicken and there they were -

Can you answer a question possibly for me?  years ago I set up Quicken incorrectly and set it up literally by "Accounts" - meaning my various bank accounts !!!  since incorporating 2 years ago, now a nightmare for reports -

If I set up all the accounts correctly now, will I lose all the account info now already set up for years???

Thanks for any help you might send to this accounting-inept mind !!!

A:

I'm not really sure what you mean in regard to setting up your Quicken "By Accounts." 

To clean things up properly, there are some very basic things you need to do.  First is to import all of your Quicken data into QuickBooks and use that program instead.  I have a lot of info on my website as to why QB is vastly superior.

Next, you should be coordinating your QB chart of accounts and reports with your professional tax preparer and what s/he uses for the business tax returns.  You should be able to modify the pre-existing accounts to the proper types, including merging redundant accounts, without losing any historical data.

Any accounting pro who has experience with QB should be able to help you do this.

Good luck.

Kerry Kerstetter

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/27/2006 02:01:00 PM Send this post:

Q-1:

Subject: help :)

 

Hi

 

I am so happy I found your site. A bit too late to help me with 2005 taxes but live and learn. My husband and I have been incorporated in the state of Florida as an s-corp. since 1997. Our business subcontracts home framing crews to other builders (we have 4-5 crews depending on demand) we also have a cabinet shop that manufactures cabinets for builders and designers. In prior years after paying ourselves and the workers...tools etc. We would generally show a loss or a very small profit. In 2004 we had 34,000 profit that got tacked on to our taxes. Well, in 2005 109,000 got added to our 1040. We had income from W-2's of 131,000. We use a payroll leasing company to run all our payroll and had paid 16483 in taxes on that income. When our accountant told us we owed 37000 something dollars on money we had not received we weren't to happy. We did manage to put 8000 in an IRA before the filing deadline and reduced that to 34,000 something. We were not advised to do that we just were trying to reduce it anyway we could. I have at various times asked my accountant if now that we are making money wouldn't it be best to switch to a regular c-corp and he always advises against it. We take home a salary and occasional bonuses which are all run through payroll. We have had to take a draw to pay the taxes!!!. Please if you have some time could you advise me where I should go for help. My husband has a friend who's brother is a tax attorney and he was thinking of going to him. I would like to start looking into some retirement planning for the company...Roth ira.. etc but I don't know if I should first change to a regular corp.

 

Thank you for your time in reading this

A-1:

It is very frustrating that so many so called tax pros have blinders on and consider S corps the perfect solution for everyone, without doing the analysis that is required to determine the best entity for a particular situation.  Everyone's circumstances are unique.  I receive at least one email just like yours every single day.

It does sound as if you need to find a tax pro who is more open minded and not stuck in his/her ways.  Unfortunately, we don't have anyone to whom we could refer you. If you haven't already done so, you should check out my tips on how to select the right tax preparer for you.

Something to keep in mind is that it's not an all or nothing situation, where you have to run all of your business operations through one C corp or one S corp.  There are many reason to use multiple entities, and an experienced tax pro can help you with that. 

For example, if you've seen my article comparing C and S corps, you will know that employee benefits for owners are much more lucrative with C corps, including the ability to have an unlimited medical reimbursement plan.  This can get dangerous if you also have non-family employees; so a technique that has been around longer than I have, is to set up a separate corp with just the family members as employees that can offer them the lucrative benefits, while the non-family employees are employed by the other corp, which doesn't offer the same expensive benefits.  Doctors have been doing this for decades, so as not to have to cover all of their staff.

Having both an S and a C corp also allows excellent opportunities for income smoothing, when the C corp has a fiscal year ending in a month other than December.

None of these ideas are new or very difficult.  An experienced tax advisor can help you save thousands of time his/her fee by utilizing the proper combination of entities for your situation.

Good luck.

Kerry Kerstetter

Q-2:

Kerry,

 

Thank you for your prompt reply. I will be shopping for a new tax preparer. Thank you also for the advise on multiple companies. We do have a corporation set-up that is in-active and never been used (we do pay the corp. fees each year). We were going to separate the cabinets from framing when we organized it but never did since separating the books at that time involved separate general liability, workers comp, and payroll. Also at that time we needed to have credit on our payables and most people want a few years history. I guess we should revisit that idea. If you at some later date think of someone in my area that is a good preparer please let me know. We are located in Pensacola, Florida. I will continue to visit your site. I hope one day soon to lower my taxes. One more question. Are there any good books on this subject that you could recommend?

 

Thanks again!

A-2:

Nolo Press has several good books on this kind of thing.

Kerry

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/27/2006 01:54:00 PM Send this post:

Q:

Subject: Exchange Question

 

Hello,

 

I’m actually curious about guidelines in Oregon.  My parents use their home as a primary residence and as their place of business.  They have lived in the home for one year and now have some changes that may require them to sell it and relocate.  (My father was just diagnosed with depression.)  I am wondering if they would be able to sell it and not pay capital gain taxes for either of those reasons: using it for business or the health diagnosis.

 

Thank you so much!  Your website has been incredibly helpful.   

A:

Using the home for business won't allow a tax free sale.

The medical condition, if unforeseen when the home was purchased,  would allow them to use the pro-rated exclusion of  $714.28 profit per day the home was owned and used as a primary residence.

I have this all explained on my website.

Your parents should definitely consult with their personal professional tax advisor to both calculate the actual potential gain and verify whether they would qualify for the pro-rated exclusion.

Good luck.  I hope this helps.

Kerry Kerstetter

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/27/2006 01:45:00 PM Send this post:

Q:

Subject: question...I saw your site and thought you might be able to answer question...sorry to bother you!

I love your site. True entrepreneur----ialism...:-)

 

Listen...hope you don't mind the note here....but Quick Books support drives me out of my mind. Rather pluck my eyes out than call them or try to sift through the community...so I am taking a chance and going to ask you ...if you mind..just delete...I am sure I will muddle through for another week or two in the dark...haha...

 

anyway..

 

I have made a couple of loans to another one of my own companies from my company. Seems quickbooks makes it easy to take a loan but not give one. I read your part on that....and setting a Shareholder Loan Liability account.

 

But not sure how to do it when I make a loan....pray tell...I am thinking this is an easy answer that is why I chanced asking you.

 

Can you help me with a response. I apologize for popping in!

 

With my Regards,

A:

I don't think you would get any help from QuickBooks on this because it's a basic accounting question, and nothing really to do with the software.

Setting up a loan payable or receivable is a simple task in QB.  What you should be doing is coordinating your QB chart of accounts with your professional tax preparer and what s/he uses for the business tax returns because loans between companies, as well as loans from shareholders, can have either debit or credit balances and be show in either the asset or liability sections of the balance sheet..  The critical thing is to periodically reconcile the balances between the different company QB files to ensure they are in synch with each other.

If you aren't working with a professional tax preparer and are trying to do all of the tax returns on your own, you are crazy and will get yourself into serious trouble.

Good luck. I hope this helps.

Kerry Kerstetter

Follow-Up:

Yes..i have a CPA....but I am so grateful for your response. It helped me a lot! It helped me formulate what I was trying to ask...I am glad you understood so well....Thanks and Thanks!

I will go to that site on reforms....I am with you on that subject I think! (have not read it yet..thats why I say that:-)

With my Regards,

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/23/2006 06:24:00 PM Send this post:

Q-1:

Subject: Tax question

Dear Sir,

I was wondering if there is any way I can reject some income. If for some reason, I don't want $200 of income from a part time source, because this $200 cancels some other benefit of higher value, how can I reject this income. My part time employer has issued a W2 for this amount and given me a check. But I have not cashed this check as yet and will tear it up if needed.

One possibility is that they make a correction in their returns to the IRS when reporting their taxes collected. But if they are not willing to do this, what options do I have.

Thanks,

A-1:

It depends on when you received the paycheck.  Did you receive it in 2005 or 2006? 

Kerry Kerstetter

Q-2:

Kerry,

 

Thank you so much for this timely response. I received the first check in November 2005 but I lost it and so received another check (reissued/replacement) in February 2006.

 

The check is for $200 but the incremental taxes due to the loss of a deduction is over $200 and so I am trying to find if the tax laws or practice will in any way allow me to nullify this income. If there is no legal way I can forego this income I will file my returns on Monday. Do you think it is worth filing for an extension so I can further research this issue or have you come across similar issues earlier?

 

If there is any way I can help you please do not hesitate to contact me. Best and thank you once again for your timely response.

A-2:

You're correct that the best thing to do right now is to file for an automatic six month extension.  Rushing to meet the April 17 deadline, while there are still questionable issues, is crazy.

You should then find yourself a good professional tax preparer who can take a look at your 2005 info and see if there is a way around the problem you claim to have.  While the situation you describe is entirely possible, there are also usually ways around it by moving things around on your tax return.

If it is determined that the $200 of income will actually cost you more than $200 in extra taxes, and you did in fact lose the check during 2005, there is a way to give yourself another year's grace.  You could show the full W-2 amount on the appropriate line on your 1040 so that IRS doesn't assume that you overlooked it.  You could then deduct the $200 down in the Adjustments To Gross income section, attaching an explanation of the lost check and repayment in 2006.

On your 2006 1040, you would then have to report that $200 as W-2 income.  However, you have plenty of time to spend the money before 12/31/06 on something that is deductible and will effectively cancel out that income, such as depositing it into an IRA or donating it to charity. 

You should obviously work with your professional tax advisor to see what is the best way to go.

Good luck.

Kerry Kerstetter

Q-3:

Kerry,

 

Thank you so much for this quick reply once again. This is potentially a solution! I should have been more detailed when I asked you the question.

 

Both me and my wife are Indian students and so I use the 1040 NR. In the India-US tax treaty we can count our spouses as dependents and get the second deduction of $3200 per head.

 

It was my wife who received the $200 in November 2005, lost the check and received a reissued check in March 2006. This is all her income for the year and so she will have zero taxes if she files separately.

 

Since we (non residents) don't have the option of filing as married filing jointly in the 1040 NR, I will have to file my taxes separately but could claim the $3200 as an additional deduction of my spouse (tax treaty benefit).

 

My understanding is that if my spouse files another return I may not be able to get the second deduction of $3200. The additional taxes due to losing this deduction is much higher than than the $200 income my spouse will have to report.

 

Could we follow your idea and file the $200 as income for her as 2006 income on a separate 1040NR. For 2005 could we claim no income and I file a return with her as my dependent?

 

Thanks again for the quick reply. If I can be of any help please do not hesitate to contact me.

A-3:

Now you've gotten beyond my level of expertise.  I haven't prepared a 1040NR since my days in the Bay Area so I don't want to steer you in the wrong direction. 

Yours is a perfect example of why you should work with a tax pro who is familiar with 1040NRs rather than try to stumble through it on your own.

Good luck.

Kerry

Follow-Up:

Kerry,

 

Thank you once again. I really appreciate your time. I have filed for an extension and will research this deeper with a professional. Please feel free to contact me if I can help in any way.

 

Best,

 

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/23/2006 06:16:00 PM Send this post:

Q-1:

Subject: Advice on inheritance law

I am looking for a tax form number that has to do with estate and inheritance law.

 

I know I have a $2mm lifetime exemption, meaning that my heirs can inherit up to $2million dollars from me and not pay inheritance taxes on it when I die.

 

Let say I want to give my child $500,000 now and have it count as part of my $2,000,000.00 therefore reducing the amount that can be sheltered to $1,500,000 at the time of my death.  Also this shelters my child from paying gift taxes even though it's above the annual gift limit of $12,000.00.

 

What is the tax form number and where is my understanding wrong?

 

Thanks

A-1:

While it is good that you are trying to educate yourself on matters such as this, you are venturing into dangerous territory if you think you can set up an estate or gifting plan without the counsel of experienced professionals.

I have a very brief summary of the estate tax rates and exclusion amounts on my website.  As you can see, it changes every year, making it necessary to constantly revise estate and gifting plans.

You do have some basic misunderstandings of how these taxes work.  First is the fact that they are not levied on the recipient.  Gift taxes are payable by the giver and are tax free to the recipient.  Estate taxes are payable from the decedent's estate, with the remaining assets distributed tax free to the heirs, except for some kinds of assets, such as pre-tax retirement accounts.

There are many twists that can screw up an amateur gifting plan.  First is the fact that, while the lifetime gift tax exclusion used to be the same as the estate tax exclusion, that is no longer the case.  The lifetime gift tax exclusion is only one million dollars, half of the estate tax exclusion.

The process of gifting can be tricky, depending on what kinds of actual assets are being transferred.  While after-tax cash is easy to value, it's more tenuous with other kinds of assets.  There is also the issue of how the asset's current market value compares to its cost basis.

You can download the actual Gift Tax (709) and Estate (aka Death or Inheritance) Tax (706) forms and their instructions from the IRS.gov website.  Glance over them and you should realize that you are in over your head without the services of a qualified tax pro.

Good luck.

Kerry Kerstetter

Q-2:

Dear Kerry,

Thank you for your kind response.
First, I wholeheartedly agree with you that when I get ready to act, I will only do so with the aid of an experienced estate attorney. Not just an attorney, but one who deals heavily in estate planning.  Yet, at the same time, I also know that there is still the conflict of interest on the part of someone is both advising me on a course of action AND selling me a product to allow that course of action. 

For example, an attorney has a conflict of interest when advising a client on whether to go the route of a will or an AB Trust.  The trust is more costly for the client up front, but often the fees upon executing the trust at the time of death are much, much lower, possibly even nonexistent.  The cost of a will is minimal, but the cost to probate the will and settle the estate is often quite high.  The AARP says that probating a will and settling the estate often costs 5% of the estate value.

So even a most trusted advisor has a conflict of interest.  And as altruistic as a person can be, the conflict remains.  So it's my job to educate myself so I can intelligently listen and ask questions.

Here's the actual situation I am investigating.

My wife owns 10% of a family business that may soon be sold for $40,000,000.  Her portion will be about $4,000,000.  Since the company was worth $0 when she acquired her piece of the company, the entire $4mm is taxable at long term capital gains rate of 15% or $600,000.  That's a huge hunk of cash to just hand over without exploring other options.

Here's the option I'm investigating, and here's where my thinking and knowledge are suspect.
Let's say that on September 1, my wife dies and leaves me all of her estate.
1.  I would then receive her 10% ownership at current market value or step up in value.
2.  Say on September 30, I sold the 10% at current market value, which has not changed since September 1.  In my understanding, I would not owe any capital gains taxes since I inherited them at the same value that I sold them.

Of course, in this scenario, I owe inheritance taxes on the excess $2mm dollars above the life time exemption. At the rate of about 47% or so.

My question is this, could my wife take advantage of that $2mm lifetime exemption NOW?  Could she give me the $2mm of her company NOW and completely use up her lifetime exemption?  If so, I would now own 5% of the business, I would "inherit" it while she is alive, sell it and owe no long term captial gains since I receive step up in value.

It appears that this could work from an estate side, but now the gifting rules appear to be different.  So I don't think this could work.

If you have the time to comment on this situation or strategy I'd appreciate your input. If not, I understand and appreciate your earlier advice just the same.

A-2:

You have some good points; but are also still working under some misconceptions that would be cleared up if you were to work with an estate planning pro ASAP.

You are absolutely right that there are tons of conflicts of interest in the estate planning arena, especially with insurance salespeople who conveniently steer you into high commission policies and investments.

It is true that, for most people, probate costs are much higher than are actual estate taxes; especially when a living trust is not used.  Trusts do cost some money up front; but that is usually a tiny fraction of the savings down the road.

To address your issue with your wife, and if she were to die before you, you should know that on the 706, there is an unlimited (no maximum amount) deduction from the taxable estate for assets left to a surviving spouse.  This means that there is no estate tax actually payable after the first spouse's death if everything passes to you.

This means that the full estate tax burden falls on your estate, after you pass on.  For large estates, this creates another issue.  If your wife's 706 were to just pass everything to you, and then you die shortly after (in a few years), the total exclusion for the accumulated  estate would be just two million dollars, rather than the four million dollars two people should be able to claim.  What good estate planing attorneys do in situations like this is to make sure the first spouse to die utilizes her full exclusion by having two million dollars (or whatever the current amount is) worth of assets transfer into a spousal bypass trust at her death.  The trust will file income tax returns and generally pass its income through to the surviving spouse or whoever the designated beneficiaries are.  This means that two million dollars of wealth has been exempted from the estate tax.

Then, when you pass on, your estate will be able to claim its own two million dollar exemption.  If you have remarried in the meantime, you can set up a new spousal bypass trust, and so on.

You also seemed to miss my earlier point that the lifetime gift tax exclusion is only one million dollars, not two.

You and your wife really should start working with an estate planning pro right away to clear up these issues.

Good luck.

Kerry Kerstetter

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/23/2006 11:59:00 AM Send this post:

Q:

Subject: new truck

 

Kerry, My son turns 16 this winter.  I'm buying him a 2001 pickup.  I believe we hold our 2 vehicles in the company and pay most of their expense (gas, ins)  out of the company.  How should i buy his truck.  would it benefit me to put him on the payroll in some labor capacity?  looking for your input.

thanks

A:

I can only address this from the tax perspective.  You should also consult with your insurance agent because there are special rules and benefits for teen-age drivers that may influence your decision here.

For tax purposes, it depends on how many miles the truck will be used for business usage.  If most of the miles will be business related, the corp can own it and pay the expenses, and any purely personal miles will have to be shown as income to your son.

If most of the miles will be personal, it will be easier to own it personally and reimburse your son for any business miles driven.

Good luck.  I hope this helps.  

Kerry

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/23/2006 11:33:00 AM Send this post:

Q:

Subject: Tax information

I read your article S vs C corporations and want to thank you for clearing up some of the myths between these two type of corporations.

All my recommendations have been to setup as an S corporation without much clarification.  This information is very clear and to the

point for us new to starting up a business and I’d like to thank you for that.

 I was wondering if you would be willing to clarify a few points with me.

I started a side company up in 2005 and filed for an S corporation status.

From what I understand reading this article, since I have not filed my 2005 taxes I still have the option to convert back to a C corporation.

Am I understanding this correctly?  If so what is required to change this back?

Also on my net profits, which were $21K, under a C corporation are you saying I would pay only 15% taxes on this income?

Where as I would pay a higher tax rate with an S corporation by adding this $21K to my normal income from my job.

 I know this is a busy time of year and I appreciate any feedback you would have for me.

 Thank you

A:

You are a classic case of someone who is headed for tax disaster unless you start working with a professional tax advisor immediately.   This is not something that you can do on your own, regardless of what information you read on the internet, including anything I have written or posted.  

If IRS has approved your S election, they will be expecting an S Corporation income tax return (1120S) for the calendar year in which the S election was granted.  You cannot just change your mind and file a C corporation return (1120) instead.  When you submitted the 2553, you obligated yourself to include the corp's net income on your 1040.  You must honor that obligation, even though you obviously made it without understanding what it entailed.  That was your fault for not working with a tax pro before deciding to file for the S election.

There are procedures for revoking the S election, but that will not entitle you to change the fiscal year from 12/31.  You will need to set up a brand new C corp in order to do that.

Get with a tax pro ASAP to see what can be salvaged of your do-it-yourself mess.

Good luck.

Kerry Kerstetter

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/23/2006 11:29:00 AM Send this post:

Q:

Subject: Sec.179 on S.Corp - Income Limitations

Kerry,

I came across your website while searching the web for a question I had related to Section 179.

Can an S.Corp. (single shareholder), claim a Section 179 expense deduction and flow it through to its shareholder for an amount in excess of the amount of taxable income given the fact that the shareholder is also claiming a salary form the S .Corp?

Example:

Shareholder salary from S.Corp $60,000

S. Corp net income before Section 179 $50,000

Section 179 Qualifying Property $100,000

Is the max deduction $$50K or $100K?

Thank you in advance for any insight you may have.

A:

This is the kind of thing that you should be working with your personal professional tax advisor on.  If you are trying to handle S corp taxes on your own, you are asking for big problems and will most likely end up paying a tax pro more to straighten things up after the fact than if you were to use his/her services from the beginning.

Your question is a good one for educational purposes.  The S corp taxable income limit for Section 179 purposes is the net bottom line with several adjustments.  One of those adjustments is adding back the W-2 wages paid to shareholder employees.  With your example, and assuming none of the other adjustments apply, that would mean that the full $100,000 could be deducted on the 1120S, which is then passed through to the shareholder via K-1. 

Your tax pro's tax prep software should be able to make the appropriate calculations of the applicable taxable income limitations.  I also found a very handy worksheet for this on Page 5-4 in the 2005 Depreciation QuickFinder Handbook.

Good luck.

Kerry Kerstetter

 

Labels: 179

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/22/2006 11:32:00 AM Send this post:

Q:

Subject: Quick Question

I know the gifter doesn't have to file, but does the recipient have to file on a gift that is less than the $11000 limit?  Thank you.

A:

Gifts received are one of the few types of income that are not taxable to the recipient, nor do they have to be reported anywhere.  That applies to gifts of any size, including millions of dollars.

For practical purposes, when a client has received a very large gift or inheritance (another tax free type of income) I have found it useful as a self defense measure to attach a statement explaining the receipt of the gift or inheritance so that IRS will understand why some deductions, such as charitable contributions, are so high compared to the taxable income being reported on that 1040.  To not disclose that fact up front is to invite an audit of the full 1040 when the IRS's screening ratios kick out as suspicious.

FYI:  As of 1/1/06, the current maximum annual gifts before a Gift Tax return is required is $12,000.

I hope this helps.

Kerry Kerstetter

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/22/2006 11:21:00 AM Send this post:

Q:

Subject: Can you help with a question

Hello Kerry:

 

I read your very informative section on rates on the web.  I personally am the executor to my dads estate that has a monetary distribution every year ($500/month) to my brother for the next 8 years. 

 

Today I am filing a 1041 - can you please tell me what is the maximum deduction I can take against the estate (and on what line of the return does it go)?  I have included the tax preparers fee from last year.   Thank you.

A:

If you've read many of my blog posts, you should know that I consider it too dangerous for amateurs to prepare their own tax returns, especially in areas where there are a variety of possible twists, such as with trust fiduciary returns.  It is far too easy to screw things up and get yourself into serious trouble with the IRS and State tax agencies.

You need to have an experienced professional tax preparer handle this.

Good luck.

Kerry Kerstetter

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/22/2006 11:12:00 AM Send this post:

Q:

Subject: Multiple property sales

 

Tax guru,

 

This morning I thought I was a fairly savvy real estate investor…..until my accountant called.  

 

 My first home was purchased in the fall of 2000, I lived there two years and rented it for the last three when it was sold.  After moving out of that house I moved into a condo which I had lived in for two years refurbed and sold at the end of two years when I moved into my next house which I lived in exactly two years and sold. 

 

If you followed that you can see that I sold the condo first(in 2004) and paid no capital gains on my 2005 return.  I sold my first home next(in 2005) and wasn’t expecting to pay capital gains.  I sold my most recent primary residence this year Jan ’06 and didn’t expect to pay capital gains next year. 

I met all of the IRS conditions of a primary residence, and after purchasing nearly 25 properties in the last 5 years I had never hear anyone say that you could not sell a primary residence and use the exemption more than once every two years.  Is this true? Is there any way around this?  I feel betrayed…like I’m being penalized for keeping a property.

 

Please help!

A:

The current law for primary residence sales (Section 121) was enacted in 1997 and has always had a limit that the tax free exclusion couldn't be used more than once during any two year period, unless the second sale was for an unforeseen circumstance. 

That limit has been well publicized and I am amazed that your tax advisor didn't mention it to you earlier when you were considering selling the second home within the two year window.  If you didn't ask your accountant's advice before the second sale, you learned an expensive lesson.

We've all heard the maxim that "ignorance of the law is no excuse."  There are tons of examples in the tax arena where things are so muddy that that rule doesn't apply.  However, this allowance of the Section 121 exclusion for only one tax free home sale per two year period is not a gray area.

From IRS Pub 523:

"You cannot exclude gain on the sale of your home if, during the 2-year period ending on the date of the sale, you sold another home at a gain and excluded all or part of that gain. If you cannot exclude the gain, you must include it in your income."

Depending on which sale had the higher profit, you should work with your personal tax advisor to see if amending the return with the earlier sale to have it taxed and allow the exclusion for the second sale would be a good move for you.

Good luck.

Kerry Kerstetter

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/22/2006 11:08:00 AM Send this post:

Q:

Subject: Glossary Terms

 

I think you have to add :

 

C- company

 

S company

 

what does it mean?

 

Thanks

A:

Those terms aren't used.

You probably mean C and S corporations, which are explained here.

Kerry Kerstetter

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/21/2006 04:54:00 PM Send this post:

Q:

Subject: tax question - child care

 

Hello,

 

If possible, could you please answer the following question for me regarding paying someone for child care...

I would like to employ my Mom to take care of our future child; one benefit I saw from this I can maximize my employer's child care spending account to $5000, which is tax deductible.  I am in a higher tax bracket and my Mom is in a lower tax bracket. What IRS relatated items would I have to do to pay someone for services, ie: would I have to get a tax number, or pay into Social Security for her, or pay into worker's compensation, would I have to set up a company, etc

 

Thank you very much,

A:

The best thing would probably be if your mother set up her own child care business that could be paid for watching your kid, as well as others.  There are many different ways in which that business can be structured (sole proprietorship, C or S corporation); so your mother will need to consult with her personal professional tax advisor to determine the best strategy for her unique situation.  

Kerry Kerstetter

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/21/2006 04:50:00 PM Send this post:

Q:

Subject: Exchange Question

Are there any special rules that pertain to a person who is not allowed to live in what they want to be their primary residence because they are required to rent government housing as part of the job.

We took a new job which does not have government housing, which means we have to buy a primary residence at the new location  with the money obtained from the sale of our house we were not allowed to live in.

there will be a profit from the house sale but all of it will be needed to purchase a house in the new location.

Seems that there should be some kind of exception as military people probably often fall into this category.

A:

There are some special rules for people in the military and Foreign Services, as mentioned here in IRS Publication 523.

You really need to work one on one with an experienced professional tax advisor to see if any of this applies to your unique situation.

Good luck.

Kerry Kerstetter

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/21/2006 04:45:00 PM Send this post:

Q:

Subject: C Corp estimated tax

Hiii

Wonderful blog!

 

How do u calculate c corp estimated tax?

A:

Technically, you should estimate what the net taxable income will be for the year, calculate the tax and divide that by four to figure your quarterly payments.

Your professional corporate tax accountant can help you with this, as well as how to best utilize the safe harbor methods that are available to possibly justify lower quarterly payments.

As with all corporate tax matters, this is not something that you should be handling on your own, without professional assistance.

Kerry Kerstetter

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/20/2006 05:42:00 PM Send this post:

Q-1:

Subject: Investment Property HARD & FAST RULE

 

Good Evening .....

I came across your website tonite while doing some searches for a real estate property question I have.   It is a question that I simply cannot find the answer to.

I apologize if you do not accept questions, but figured I would give it a shot....

The Big Question:

I own 2 condos. 

They are both rented.

I would like to buy a home and eventually live in it myself.  Right now I am living with and caring for a sick uncle.

I would prefer not to get hit with the Cap Gains Tax from selling investment property.

Could I sell the condos, buy the home, rent out the home  -- so it is basically selling investment property to purchase another investment property.

Then, after a year or so, move into the home (after the tenants are gone)  ---- would this allow me to avoid the Cap Gains Taxes ??

Thank you so much for your time and I would be deeply indebted for any help you could provide.....

A-1:

With 1031's it's investment property for investment property.  Not primary residence.  Here's the link on my website that explains about primary residences.

First of all you need to get with your tax person to figure your best avenue.  If he/she suggests a 1031 you need a1031 accommodator to do your paperwork.  You CAN NOT do this yourself.  Your tax returns have to show your acquisition/purchase property as investment property.

If you decide a year or two down the road you don't want to rent it out anymore, you can convert the acquisition/purchase property into a primary residence.

IRS can drop a deal if they feel your intent was to make the acquisition/purchase property a primary residence from the start & you'd have to pay the capital gains taxes.

Hope this helps.

Sherry Lee Kerstetter, President

Tax Free Exchange Corporation

Q-2:

Thank you Sherry Lee for your rapid response and information...
 
I guess what you're saying is the IRS does not have a hard and fast rule when it comes to turning an investment property into the owner's primary residence....??
 
I have to admit that surprises me.  So if a landlord were to decide he did not want to rent out his property anymore and moved in there is no way to know if the IRS will come looking for Cap Gains Taxes ?    What if the property had been rented for 10 years ?  Certainly the IRS would not say "we think this was your plan from the start and we want our $$"  or would they ?? 
 
I would think there would have to be some guidelines for this type of situation -- no ???
  
Thanks again Sherry Lee and any more info would be greatly appreciated....   :-)

A-2:

The issue of converting a 1031 replacement property into a personal use residence has been a gray area for decades.  We in the tax practitioner community have been begging IRS for decades to give us a definite time period after which a conversion won't be challenged.  IRS refuses to do so because they want to reserve the right to second guess anyone. 

There was a slight step in the direction of defining safe time periods in 2004, when our rulers in DC specifically required people living in converted 1031 property to own it for at least five full years prior to sale if they want to use the $250,000 per person tax free exclusion of gain, as I described in this blog post.

Obviously, the longer time that elapses between the exchange and the conversion to personal use, the less likely IRS will challenge it as pre-planned.  The cases that are most suspect are the conversions that occur in less than 12 months, as well as any that can be identified as preconceived.

They key is to have plenty of documentation of your intention to use the replacement property for rental, business or investment purposes.  Any plan to eventually convert it to personal use should be kept to yourself  If you blab that to a lot of people, there is a chance that one of them may be jealous of your 1031 tax savings and try to make trouble for you by telling IRS about your preconceived plans.  The culture of envy and hating anyone else who has more than you is widespread in this country.

I hope this helps.  You should also be working with a tax pro who understands these rules and they apply to real life people.

Good luck.

Kerry Kerstetter

Q-3:

Thank you Kerry and Sherry for the info and your expertise.

I can see how it can get very complicated....

I wonder , in your opinions, do you think if I purchase a home under the 1031 Replacement Property Rule, rent it out for 2 full years, and then moved in --- would this be fairly safe from IRS suspicions ??

I get the feeling that every case is different in this situation and there are certainly no "definites" ...

Thank you !!!

A-3:

We've been doing 1031's all over the USA for over 25 years & IRS has never challenged a case from us.

There is no guarantees & the laws can change from now until then.

We can just advise you on what we know to date.

Good Luck.
Sherry

 

Labels: 1031

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/20/2006 05:23:00 PM Send this post: