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IRS Provides Tax Relief to California Storm Victims

by Amber Stevenson

The IRS has provided disaster tax relief to victims of California storms that began on January 8, 2023. According to the IRS, storm victims who live or have a business in the disaster area now have until May 15, 2023, to file various federal individual and business tax returns and to make tax payments. The full notice can be read at (IR 2023-03, 1/10/2023)

Disaster area. The disaster area includes the following counties: Alameda, Colusa, Contra Costa, El Dorado, Fresno, Glenn, Humboldt, Kings, Lake, Los Angeles, Madera, Marin, Mariposa, Mendocino, Merced, Mono, Monterey, Napa, Orange, Placer, Riverside, Sacramento, San Benito, San Bernardino, San Diego, San Francisco, San Joaquin, San Luis Obispo, San Mateo, Santa Barbara, Santa Clara, Santa Cruz, Solano, Sonoma, Stanislaus, Sutter, Tehama, Tulare, Ventura, Yolo, and Yuba.

Postponed deadlines. The IRS has postponed various tax filing and payment deadlines that occurred beginning on January 8, 2023. As a result, individuals and households who live or have a business in the disaster area will have until May 15, 2023, to file returns and pay taxes that were originally due during this period.

This tax relief includes business returns due on March 15 and business and individual returns due on April 18, 2023. In addition, farmers who forgo making an estimated tax payment in January and normally file their returns by March 1, now have until May 15, 2023, to file their 2022 return and pay any tax due.
The May 15, 2023, deadline also applies to:

  1. The quarterly estimated tax payments normally due on January 17, 2023, and April 18, 2023.
  2. The quarterly payroll and excise tax returns normally due on January 31 and April 30, 2023.

In addition, penalties on payroll and excise tax deposits due on or after January 8, 2023, and before January 23, 2023, will be abated if the tax deposits are made by January 23, 2023.

Relief is automatic. The IRS will automatically apply this tax relief to any taxpayer with an address in the disaster area (“affected taxpayers”). However, affected taxpayers that receive a penalty notice from the IRS for a return that has a due date falling within the postponement period (January 8, 2023, to May 15, 2023) should call the phone number on the notice to have the penalty abated.

In addition, taxpayers who live or have a business outside the disaster area but whose tax records are in the disaster area and workers assisting in disaster relief activities should call the IRS at 866-562-5227 to ask for this tax relief.

Disaster losses. Victims in the disaster area who suffered uninsured or unreimbursed disaster-related losses can choose to claim them on either the current year (2023) or prior year 2022 return. Taxpayers claiming disaster losses should write the FEMA declaration number—3691-EM—on any return claiming such a loss.

As of this posting, California has not conformed to this relief but we expect they will shortly.

Please keep in mind that this relief doesn’t apply to information returns such as Forms W-2, 1094, 1095, 1097, 1098 or 1099 series; to Forms 1042-S, 3921, 3922 or 8027. These forms still have their normal due dates.

When Married Couples Should File Separate Returns

by Amanda Domitrowich

Trying to figure out whether you and your spouse should file a joint tax return or separate returns? As is often the case with tax questions, the answer depends on your particular tax picture.

In general, your decision will depend upon which filing status results in the lowest tax. But bear in mind that, if you and your spouse file a joint return, each of you is jointly and severally liable for the tax on your combined income, including any additional tax that IRS assesses, plus interest and most penalties. This means that IRS can come after either of you to collect the full amount. Although there are provisions in the law that offer relief from joint and several liability, each of those provisions has its limitations. Thus, even if a joint return results in less tax, you may choose to file a separate return if you want to be certain of being responsible only for your own tax.

In most cases, filing jointly offers the most tax savings, particularly where the spouses have different income levels. The “averaging” effect of combining the two incomes can bring some of it out of a higher tax bracket. For example, if one spouse has $75,000 of taxable income and the other has just $25,000, filing jointly instead of separately for 2023 can save $1,972.50 in taxes.

Note that filing separately doesn’t mean you go back to using the “single” rates that applied before you were married. Instead, each spouse must use the “married filing separately” rates. These rates are based on brackets that are exactly half of the married filing joint brackets but are still less favorable than the “single” rates. This means the “marriage penalty” (which requires some marrieds to pay at a higher tax rate on the same total income than they would pay if each filed as a single) isn’t eliminated by filing separate returns. Although Congress has provided relief from the marriage penalty in the tax rates, those changes don’t provide a complete solution.

There is a potential for tax savings from filing separately, however, where one spouse has significant amounts of medical expenses. Medical expenses are deductible only to the extent they exceed 7.5% of adjusted gross income (AGI).

If a medical expense deduction is isolated on the separate return of a spouse, that spouse’s lower (separate) AGI, as compared to the higher joint AGI, can result in larger total deductions. For example, if one spouse has $19,500 in medical expenses and the spouses’ joint income is $260,000, then the jointly filing spouses can’t deduct any of the medical expenses, because 7.5% of $260,000 is $19,500 (and $19,500 − $19,500 = $0). But if the separate income of the spouse with the medical expenses is $140,000, the deduction increases to $9,000 on a separate return, because 7.5% of $140,000 is only $10,500, and $19,500 − $10,500 equals $9,000.

Other tax factors may point to the advisability of filing a joint return. For example, the child and dependent care credit, adoption expense credit, American Opportunity tax credit, and Lifetime learning credit are available to a married couple only on a joint return. And you can’t take the credit for the elderly or the disabled if you file separate returns unless you and your spouse lived apart for the entire year. Nor can you deduct qualified education loan interest unless a joint return is filed. You may also not be able to deduct contributions to your IRA if either you or your spouse was covered by an employer retirement plan and you file separate returns. Nor can you exclude adoption assistance payments or any interest income from series EE or Series I savings bonds that you used for higher education expenses if you file separate returns.

In addition, social security benefits may be more heavily taxed to a couple that files separately. The benefits are tax-free if your “provisional income” (your AGI with certain modifications plus half of your social security benefits) doesn’t exceed a “base amount.” The base amount is $32,000 on a joint return, but zero on separate return (or $25,000 if the spouses didn’t live together for the entire year).

The decision you make for federal income tax purposes may have an impact on your state or local income tax bill, so the total tax impact has to be compared. For example, an overall federal tax saving by filing separately might be offset by an overall state tax increase, or a state tax saving might offset a federal tax increase.

Unfortunately, we can’t give you any hard and fast rules of thumb for when it pays to file separately. The tax laws have grown so complex over the years that there are often a number of different factors at play for any given situation. However, there is one approach guaranteed to come up with the correct decision. We can simply calculate your tax bill both ways: jointly and separately. Then the approach that leads to overall tax savings could be used. We are happy to run the numbers for you to make sure you pay the minimum amount of taxes possible. Call us to arrange for a consultation or if you have any additional questions.

Tax Credit for Buying a Plug-in Electric Vehicle

by Amanda Domitrowich

The recently passed Inflation Reduction Act of 2022 includes changes to the credit available for electric vehicles. The changes are complex, and phase in over time. If you are in the market for an electric vehicle, we should review the new rules to help you maximize the credit you are allowed.

North American assembly requirement. One of the new rules is in effect right now. To qualify for the electric vehicle credit, final assembly of the vehicle must take place in North America. You can check whether a particular vehicle meets this requirement by entering its vehicle identification number (VIN) into the VIN decoder at https://afdc.energy.gov/laws/inflation-reduction-act or https://www.nhtsa.gov/vin-decoder. There is also a list of makes and models that generally should meet the requirement at https://afdc.energy.gov/laws/inflation-reduction-act, but you should double-check for any particular vehicle by using the VIN decoder.

Manufacturer limitation. The good news is that, effective as of January 1, 2023, the manufacturer limitation is going away. Under the manufacturer limitation, once a manufacturer had sold 200,000 electric vehicles, a taxpayer’s ability to take a tax credit for vehicles produced by that manufacturer began to phase out. Taxpayers are currently prevented from taking the electric vehicle credit for automobiles manufactured by General Motors and Tesla. Starting at the beginning of 2023, taxpayers will be able to take the credit for GM vehicles and Teslas once again, but see the manufacturer’s suggested retail price (MSRP) limits below.

Calculation of the credit. The way the credit is calculated is changing later this year. We do not know when the rules are changing yet, but it will be as soon as the IRS issues regulations implementing the new rules. Under the previous rules, the base amount of the electric vehicle credit is $2,500 per vehicle. The allowable credit increases to $7,500 per vehicle based on a formula which increases the credit by $417 for every kilowatt hour of battery capacity in excess of five.

Under the new rules, the amount of the credit will be based on two separate requirements, each one based on where the vehicle’s battery is sourced:

  • Taxpayers get a $3,750 credit for meeting the critical minerals requirement (which requires that a minimum percentage of the minerals contained in the battery be sourced in the United States or a country with which the United States has a free trade agreement in effect).

Taxpayers also can get a $3,750 credit for satisfying the battery component requirement (which requires that a minimum percentage of the value of the components of the battery be manufactured or assembled in North America.

Taxpayers can satisfy either or both requirements, for either a $3,750 credit (if only one requirement is satisfied) or a $7,500 credit (if both requirements are satisfied).

The new rules are designed to encourage electric vehicle manufacturers to move their battery supply chains from China to North America or countries with which the United States has better relations than China.

New qualified fuel cell motor vehicle. Effective January 1, 2023, the credit will also be available for new qualified fuel cell motor vehicles. New qualified fuel cell motor vehicles are vehicles propelled by power derived from one or more cells that convert chemical energy directly into electricity by combining oxygen with hydrogen fuel, and that meets certain additional requirements. New qualified fuel cell motor vehicles have to meet the North American final assembly requirement. They can qualify for either a $3,750 or $7,500 credit based on whether they satisfy one or both of the critical minerals requirement and battery components requirements.

Modified adjusted gross income limitation. Starting on January 1, 2023, your ability to take the electric vehicle credit will be limited based on your modified adjusted gross income (MAGI). MAGI is adjusted gross income (AGI) with adjustments for income received from U.S. territories. For most taxpayers, MAGI will be equal to AGI. You may not take the credit if your MAGI exceeds the threshold amount. The threshold amount is:

  • For married taxpayers filing a joint return or a surviving spouse, $300,000.
  • For taxpayers filing as head of household, $225,000.
  • For all other taxpayers (single, married filing separately), $150,000.

These amounts are not adjusted for inflation. If your MAGI exceeds this amount, you should buy the electric car before the first of the year.

MSRP limitation. Also starting on January 1, 2023, vehicles will not be eligible for the credit if they exceed an MSRP limit: $80,000 for vans, pickup trucks, and sport utility vehicles; $55,000 for other vehicles. This means that if you are looking at a higher-end electric vehicle, you need to act by the end of December.

Unfortunately, the manufacturer limitation (see above) will not go away until January 1, so you will not be able to claim the credit for higher-end GM and Tesla vehicles that exceed the MSRP limits.

Transition rule. Finally, if you had a binding contract to purchase an electric vehicle as of August 15, 2022, or earlier, you can choose to apply the old rules.

Call us today with any questions you might have about your electric vehicle purchase.

Avoiding Inadvertent Termination of S Corporation Status

By Amanda Domitrowich

If you have chosen the S corporation form for your business, you should be aware of certain steps that you should take to avoid an inadvertent termination of its S corporation status.

  • Avoid transfers to ineligible shareholders. In general, only individual U.S. citizens or residents, decedent estates, certain types of trusts, and certain exempt organizations may be S corporation shareholders. Therefore, it is important that you confirm that all the shareholders are eligible shareholders, i.e., (i) that no shareholder is a nonresident alien, a partnership, or a corporation; (ii) that all trusts are properly structured to be eligible shareholders, and (iii) that any election required for a trust shareholder is made.

    Even if a corporation’s initial shareholders are all eligible shareholders, its S corporation status will terminate if any shares are transferred to a nonresident alien individual, a corporation, a partnership, or a trust (other than the specific types of trusts which may be S corporation shareholders).

    In order to prevent a shareholder from terminating an S corporation’s status by transferring his shares to an ineligible shareholder, a shareholders’ agreement should prohibit transfers of any shares to any person other than a permitted S corporation shareholder and require a similar undertaking on the part of any transferee as a condition to any transfer. In addition, if permitted by local law, a restriction should be imposed in the corporation’s charter or by-laws that would void a purported transfer to an ineligible shareholder.
  • Avoid violating the shareholder limitation. An S corporation cannot have more than 100 shareholders at any time. Even if this limit is not exceeded at organization, the S status will terminate if the limit is exceeded at any time in the future, whether as a result of new issuances or transfers of shares.

    New issuances of stock require corporate action. You should keep this in mind when considering future issuances of stock to avoid exceeding the 100 shareholder limit.

    Transfers by shareholders can be somewhat more problematic, since they can occur without any action on the part of the corporation. Therefore, a shareholders’ agreement should prohibit any transfer of shares to a person who is not already a shareholder or if the transfer would cause the 100 shareholder limit to be exceeded and transfers should be conditioned on the transferee being subject to the same restriction. If permitted by local law, an appropriate restriction should also be imposed in the corporation’s charter or by-laws so that a purported transfer that caused the limit to be exceeded would be void.
  • Don’t issue more than one class of stock. An S corporation can only have one class of stock. Be sure to keep this requirement in mind when considering future changes to the capital structure of the corporation, including purported debt owed by the corporation that may be recharacterized as equity. The IRS allows S corporations to use various equity incentive compensation arrangements without violating the one class of stock restriction. If you want to create an equity incentive compensation plan, we would be happy to discuss with you how to structure the plan.
  • Avoid excess passive investment income. If an S corporation has accumulated earnings and profits (because it was once a C corporation or is a transferee of a C corporation), its S election will terminate if, for a period of three consecutive tax years, its “passive investment income ” exceeds 25% of its gross receipts.

    The first step in avoiding an inadvertent termination under this rule is to keep track of the corporation’s passive investment income to determine whether the 25% limitation may be exceeded. Although excess passive income is subject to a special tax, S corporation status will terminate only if the limit is exceeded for three consecutive years.

    If a corporation is in danger of exceeding the 25% passive income limitation for three consecutive years, there are two basic approaches to avoid termination of S corporation status. Since termination will only occur if the corporation has accumulated earnings and profits from C corporation years, termination can be avoided by stripping out those earnings and profits by way of a dividend. Ordinarily, distributions by an S corporation reduce pre-S corporation earnings and profits only after the accumulated income from all S corporation years has been distributed. However, it is possible to elect to treat distributions as coming from pre-S corporation earnings and profits first. Moreover, if it desired to strip out earnings and profits without actually depleting the corporation’s cash or other liquid assets, a “deemed” dividend election can be made. Be aware, however, that a distribution out of pre-S corporation earnings and profits (whether actual or under the deemed dividend election) is generally taxable to shareholders as a dividend (unlike a distribution from accumulated S corporation income which is generally a return of capital).

    A second approach to avoiding termination under the passive income rules is to tailor the corporation’s operations so that the 25% passive income limit is not exceeded. Since termination will occur only after the limit is exceeded for three consecutive years, if you are willing to incur the tax on excess passive income, there should be sufficient time to take action to avoid a termination.

    This can be done by reducing the amount of passive investment income, or by increasing the amount of other income. Since the test is applied to gross receipts, acquiring a business that produces receipts that are not passive investment income, even if it does not produce much in the way of net income, is one possible solution. It may also be possible to restructure certain operations so that passive income (e.g., certain rental income) becomes active income. (Unfortunately, an investment in municipal bonds producing tax -exempt interest is not a solution under these rules.)

If, despite appropriate precautions, S corporation status is nevertheless terminated, all is not lost. It is possible to apply to IRS for a “waiver” of an inadvertent termination of S status. Naturally, the safest course of action is to avoid a termination in the first place.

If you have any further questions, or if you’d like to go into the appropriate provisions to avoid transfers of stock which would cause a termination, please contact us!

2022 Year-end Tax Planning Ideas

With year-end approaching, it is time to start thinking about moves that may help lower your taxes for this year and next. We have compiled a list of actions based on current tax rules that may help you save tax dollars if you ACT BEFORE YEAR-END. Not all of them will apply to you, but you (or a family member) may benefit from many of them. Upon your request, we can narrow down specific actions to tailor a particular plan for you. In the meantime, please review the following list and contact us at your earliest convenience so that we can advise you on which tax-saving moves might be beneficial. We have broken out the potential actions into the following sections:

Individuals

Many taxpayers won’t need to itemize because of the high basic standard deduction amounts that apply for 2022 ($25,900 for joint filers, $12,950 for singles and for married filing separately, $19,400 for heads of household), and because many itemized deductions have been reduced or abolished, including the $10,000 limit on state and local taxes; miscellaneous itemized deductions; and non-disaster related personal casualty losses. You can still itemize medical expenses that exceed 7.5% of your adjusted gross income (AGI), state and local taxes up to $10,000, your charitable contributions subject to various limitations, plus mortgage interest deductions on a restricted amount of debt. However, these deductions won’t save taxes unless they total more than your standard deduction.

  • Some taxpayers may be able to work around these deduction restrictions by applying a bunching strategy to pull or push discretionary medical expenses and charitable contributions into the year where they will do some tax good. For example, a taxpayer who will be able to itemize deductions this year but not next will benefit by making two years’ worth of charitable contributions this year.
  • Postpone income until 2023 and accelerate deductions into 2022 if doing so will enable you to claim larger deductions, credits, and other tax breaks for 2022 that are phased out over varying levels of AGI. These include deductible IRA contributions, child tax credits, higher education tax credits, and deductions for student loan interest. Postponing income also is desirable for taxpayers who anticipate being in a lower tax bracket next year due to changed financial circumstances. Note, however, that in some cases, it may actually pay to accelerate income into 2022. For example, that may be the case for a person who will have a more favorable filing status this year than next (e.g., head of household versus individual filing status), or who expects to be in a higher tax bracket next year. That is especially a consideration for high income taxpayers who may be subject to higher rates next year under proposed legislation.
  • Consider donating appreciated publicly traded stock to get a two-fold benefit of the donation at fair market value without having to pick up the capital gains.
  • It may be advantageous to try to arrange with your employer to defer, until early 2023, a bonus that may be coming your way. This might cut as well as defer your tax. Again, considerations may be different for the highest income individuals.
  • Consider using a credit card to pay deductible expenses before the end of the year. Doing so will increase your 2022 deductions even if you don’t pay your credit card bill until after the end of the year.
  • If you expect to owe state and local income taxes when you file your return next year and you will be itemizing in 2022, consider asking your employer to increase withholding of state and local taxes (or make estimated tax payments of state and local taxes) before year-end to pull the deduction of those taxes into 2022. However, this strategy is not good to the extent it causes your 2022 state and local tax payments to exceed $10,000.
  • Higher-income individuals must be wary of the 3.8% surtax on certain unearned income. The surtax is 3.8% of the lesser of: (1) net investment income (NII), or (2) the excess of MAGI over a threshold amount ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 in any other case).

As year-end nears, the approach taken to minimize or eliminate the 3.8% surtax will depend on the taxpayer s estimated modified adjusted gross income (MAGI) and NII for the year. Some taxpayers should consider ways to minimize (e.g., through deferral) additional NII for the balance of the year, others should try to reduce MAGI other than NII, and some individuals will need to consider ways to minimize both NII and other types of MAGI. An important exception is that NII does not include distributions from IRAs or most other retirement plans.

  • The 0.9% additional Medicare tax also may require higher-income earners to take year-end action. It applies to individuals whose employment wages and self-employment income total more than an amount equal to the NIIT thresholds, above. Employers must withhold the additional Medicare tax from wages in excess of $200,000 regardless of filing status or other income. Self-employed persons must take it into account in figuring estimated tax. There could be situations where an employee may need to have more withheld toward the end of the year to cover the tax. This would be the case, for example, if an employee earns less than $200,000 from multiple employers but more than that amount in total. Such an employee would owe the additional Medicare tax, but nothing would have been withheld by any employer.
  • If you believe a Roth IRA is better for you than a traditional IRA, consider converting traditional-IRA money invested in any beaten-down stocks (or mutual funds) into a Roth IRA in 2022 if eligible to do so. Keep in mind that the conversion will increase your income for 2022, possibly reducing tax breaks subject to phaseout at higher AGI levels. This may be desirable, however, for those potentially subject to higher tax rates under pending legislation or for those projected to be in a lower tax bracket this year.
  • Required minimum distributions RMDs from an IRA or 401(k) plan (or other employer-sponsored retirement plan) have not been waived for 2022. If you were 72 or older in 2021 you must take an RMD during 2022. Those who turn 72 this year have until April 1 of 2023 to take their first RMD but may want to take it by the end of 2022 to avoid having to double up on RMDs next year.
  • If you are age 70½ or older by the end of 2022, and especially if you are unable to itemize your deductions, consider making 2021 charitable donations via direct qualified charitable distributions from your traditional IRAs. These distributions are made directly to charities from your IRAs, and the amount of the contribution is neither included in your gross income nor deductible on as an itemized deduction. However, you are still entitled to claim the entire standard deduction. (The qualified charitable distribution amount is reduced by any deductible contributions to an IRA made for any year in which you were age 70½ or older, unless it reduced a previous qualified charitable distribution exclusion.)
  • Take an eligible rollover distribution from a qualified retirement plan before the end of 2022 if you are facing a penalty for underpayment of estimated tax and increasing your wage withholding won’t sufficiently address the problem. Income tax will be withheld from the distribution and will be applied toward the taxes owed for 2022. You can then timely roll over the gross amount of the distribution, i.e., the net amount you received plus the amount of withheld tax, to a traditional IRA. No part of the distribution will be includible in income for 2022, but the withheld tax will be applied pro rata over the full 2022 tax year to reduce previous underpayments of estimated tax.
  • Consider increasing the amount you set aside for next year in your employer’s FSA if you set aside too little for this year and anticipate similar medical costs next year or if you anticipate more medical costs next year.
  • If you become eligible in December of 2022 to make HSA contributions, you can make a full year’s worth of deductible HSA contributions for 2022.
  • Make gifts sheltered by the annual gift tax exclusion before the end of the year if doing so may save gift and estate taxes. The exclusion applies to gifts of up to $16,000 made in 2022 to each of an unlimited number of individuals. You can’t carry over unused exclusions to another year. These transfers may save family income taxes where income-earning property is given to family members in lower income tax brackets who are not subject to the kiddie tax.
  • If you were in federally declared disaster area, and you suffered uninsured or unreimbursed disaster related losses, keep in mind you can choose to claim them either on the return for the year the loss occurred (in this instance, the 2022 return normally filed next year), or on the return for the prior year (2021), generating a quicker refund.
  • If you were in a federally declared disaster area, you may want to settle an insurance or damage claim in 2022 to maximize your casualty loss deduction this year.

Stock Market Investor Strategies

As year-end approaches, you should consider the following moves to make the best tax use of paper losses and actual losses from your stock market investments:

  • Sell at a loss to offset earlier gains. If you have realized gains earlier in the year from sales of stock held for more than one year (long-term capital gains) or from sales of stock held for one year or less (short-term capital gains), take a close look at your portfolio with a view to selling some of the losers—those shares that now show a paper loss. The best tax strategy is to sell enough of the losers to generate losses to offset your earlier gains plus an additional $3,000 loss. Selling to produce this amount of loss is a good idea from the tax viewpoint because a $3,000 capital loss (but no more) can offset the same amount of ordinary income each year.

Suppose that you believe that the shares showing a paper loss still have the potential to turn around and eventually generate a profit. In order to sell and then repurchase the shares without forfeiting the loss deduction, you must avoid the wash-sale rules. This means that you must buy the new shares outside of the period that begins 30 days before and ends 30 days after the sale of the loss stock. However, note that if you expect the price of the shares showing a paper loss to rise quickly, your tax savings from taking the loss may not be worth the potential investment gain you may lose by waiting more than 30 days to repurchase the shares.

  • Use earlier-in-the-year losses to offset gains you would benefit from taking. If you have capital losses on sales earlier in the year, consider whether you should take capital gains on some stocks that you still hold. For example, if you have appreciated stocks that you would like to sell, but don’t want to sell if it will cause you to have taxable gain this year, consider selling just enough shares to offset your earlier-in-the-year capital losses (except for $3,000 of those which can be used to offset ordinary income). You should consider selling appreciated stocks now if you believe those stocks have reached (or are close to) the peak price and you also believe that you can invest the proceeds from the sale in other property that will give you a better rate of return in the future.

If this strategy applies to you, and your holdings showing a paper gain consist of stocks you haven’t held for more than one year, as well as stocks you have held for more than one year, you should consider selling those stocks on which you will have short-term gain first, and then stocks that would yield long-term gain. This way, you’ll be in a better position to wind up with gain taxed at favorable rates when you sell other stocks with paper gains. To the extent possible, you should also try to use long-term capital losses to offset short-term capital gains. This can be done, however, only if the total of your long-term capital losses is more than your long-term capital gains. Deferring long-term capital gains until next year is one way of achieving this goal.

  • Long-term capital gain from sales of assets held for over one year is taxed at 0%, 15% or 20%, depending on the taxpayer’s taxable income. If you hold long-term appreciated-in-value assets, consider selling enough of them to generate long-term capital gains that can be sheltered by the 0% rate. The 0% rate generally applies to net long-term capital gain to the extent that, when added to regular taxable income, it is not more than the maximum zero rate amount (e.g., $83,350 for a married couple). If, say, $5,000 of long-term capital gains you took earlier this year qualifies for the zero rate then try not to sell assets yielding a capital loss before year-end, because the first $5,000 of those losses will offset $5,000 of capital gain that is already tax-free.
  • Since individual taxpayers may carry over capital losses indefinitely, there is no reason to sell appreciated stocks just to have offsetting gains. If you don’t have a better investment for the proceeds of a sale of these stocks, don’t sell them. You can carry over your capital losses to next year when you may have a better opportunity to make use of those losses. You can even offset another $3,000 of the carried over losses against ordinary income next year (and in succeeding years if the full amount of the capital loss carryover is not used next year).
  • If selling an investment in a qualified small business stock, consider the tax savings and rollover provisions.
  • Review your ISO, NQ, and RSU holdings to determine strategies to minimize tax.

Inflation Reduction Act of 2022

The recently enacted Inflation Reduction Act of 2022 contains a multitude of new environmentally related tax credits that are of interest to individuals and small businesses. The Act also extends and modifies some pre-existing tax credits:

  • Extension, Increase, and Modifications of Nonbusiness Energy Property Credit. Before the Act, you were allowed a personal credit for specified nonbusiness energy property expenditures. The credit applied only to property placed in service before January 1, 2022. Now you may take the credit for energy-efficient property placed in service before January 1, 2033.

Increased credit: The Act increases the credit for a tax year to an amount equal to 30% of the sum of (a) the amount paid or incurred by you for qualified energy efficiency improvements installed during that year, and (b) the amount of the residential energy property expenditures paid or incurred by you during that year. The credit is further increased for amounts spent for a home energy audit. The amount of the increase due to a home energy audit can’t exceed $150.

Annual limitation in lieu of lifetime limitation: The Act also repeals the lifetime credit limitation, and instead limits the allowable credit to $1,200 per taxpayer per year. In addition, there are annual limits of $600 for credits with respect to residential energy property expenditures, windows, and skylights, and $250 for any exterior door ($500 total for all exterior doors). Notwithstanding these limitations, a $2,000 annual limit applies with respect to amounts paid or incurred for specified heat pumps, heat pump water heaters, and biomass stoves and boilers.

  • Extension and Modification of Residential Clean Energy Credit: Before the Act, you were allowed a personal tax credit, known as the residential energy efficient property (REEP) credit, for solar electric, solar hot water, fuel cell, small wind energy, geothermal heat pump, and biomass fuel property installed in homes in years before 2024.

The Act makes the credit available for property installed in years before 2035. The Act also makes the credit available for qualified battery storage technology expenditures.

  • Extension, Increase, and Modifications of New Energy Efficient Home Credit: Before the Act, a New Energy Efficient Home Credit (NEEHC) was available to eligible contractors for qualified new energy efficient homes acquired by a homeowner before Jan. 1, 2022. A home had to satisfy specified energy saving requirements to qualify for the credit. The credit was either $1,000 or $2,000, depending on which energy efficiency requirements the home satisfied.

The Act makes the credit available for qualified new energy efficient homes acquired before January 1, 2033. The amount of the credit is increased, and can be $500, $1,000, $2,500, or $5,000, depending on which energy efficiency requirements the home satisfies and whether the construction of the home meets prevailing wage requirements.

  • New Clean Vehicle Credit: Before the enactment of the Act, you could claim a credit for each new qualified plug-in electric drive motor vehicle (NQPEDMV) placed in service during the tax year.

The Act, among other things, retitles the NQPEDMV credit as the Clean Vehicle Credit and eliminates the limitation on the number of vehicles eligible for the credit. Also, final assembly of the vehicle must take place in North America.

No credit is allowed if the lesser of your modified adjusted gross income for the year of purchase or the preceding year exceeds $300,000 for a joint return or surviving spouse, $225,000 for a head of household, or $150,000 for others. In addition, no credit is allowed if the manufacturer’s suggested retail price for the vehicle is more than $55,000 ($80,000 for pickups, vans, or SUVs).

Finally, the way the credit is calculated is changing. The rules are complicated, but they place more emphasis on where the battery components (and critical minerals used in the battery) are sourced.

  • Credit for Previously-Owned Clean Vehicles: A qualified buyer who acquires and places in service a previously-owned clean vehicle after 2022 is allowed an income tax credit equal to the lesser of $4,000 or 30% of the vehicle’s sale price. No credit is allowed if the lesser of your modified adjusted gross income for the year of purchase or the preceding year exceeds $150,000 for a joint return or surviving spouse, $112,500 for a head of household, or $75,000 for others. In addition, the maximum price per vehicle is $25,000.
  • New Credit for Qualified Commercial Clean Vehicles: There is a new qualified commercial clean vehicle credit for qualified vehicles acquired and placed in service after December 31, 2022. The credit per vehicle is the lesser of: (1) 15% of the vehicle’s basis (30% for vehicles not powered by a gasoline or diesel engine) or (2) the “incremental cost” of the vehicle over the cost of a comparable vehicle powered solely by a gasoline or diesel engine. The maximum credit per vehicle is $7,500 for vehicles with gross vehicle weight ratings of less than 14,000 pounds, or $40,000 for heavier vehicles.
  • Increase in Qualified Small Business Payroll Tax Credit for Increasing Research Activities: Under pre-Act law, a “qualified small business” (QSB) with qualifying research expenses could elect to claim up to $250,000 of its credit for increasing research activities as a payroll tax credit against the employer’s share of Social Security tax.

Due to concerns that some small businesses may not have a large enough income tax liability to take advantage of the research credit, for tax years beginning after December 31, 2022, QSBs may apply an additional $250,000 in qualifying research expenses as a payroll tax credit against the employer share of Medicare. The credit cannot exceed the tax imposed for any calendar quarter, with unused amounts of the credit carried forward.

  • Extension of Incentives for Biodiesel, Renewable Diesel and Alternative Fuels: Under pre-Act law, you could claim a credit for sales and use of biodiesel and renewable diesel that you use in your trade or business or sold at retail and placed in the fuel tank of the buyer for such use and sales on or before December 31, 2022. Now you are permitted to claim a credit for sales and use of biodiesel and renewable diesel fuel, biodiesel fuel mixtures, alternative fuel, and alternative fuel mixtures on or before December 31, 2024.

You are also allowed now to claim a refund of excise tax for use of (1) biodiesel fuel mixtures for a purpose other than for which they were sold or for resale of biodiesel mixtures on or before December 31, 2024 and (2) alternative fuel as fuel in a motor vehicle or motorboat or as aviation fuel, for a purpose other than for which they were sold or for resale of such alternative fuel mixtures on or before December 31, 2024.

Business

This year’s business planning is more challenging than usual due to the uncertainty surrounding pending legislation that could increase corporate tax rates plus the top rates on both business owners ordinary income and capital gain starting next year.

Whether or not tax increases become effective next year, the standard year-end approach of deferring income and accelerating deductions to minimize taxes will continue to produce the best results for most small businesses, as will the bunching of deductible expenses into this year or next to maximize their tax value.

If proposed tax increases do pass, however, the highest income businesses and owners may find that the opposite strategies produce better results: Pulling income into 2022 to be taxed at currently lower rates, and deferring deductible expenses until 2023, when they can be taken to offset what would be higher-taxed income. This will require careful evaluation of all relevant factors.

  • Taxpayers other than corporations may be entitled to a deduction of up to 20% of their qualified business income. For 2022, if taxable income exceeds $340,100 for a married couple filing jointly, (approximately half that for others), the deduction may be limited based on whether the taxpayer is engaged in a service-type trade or business (such as law, accounting, health, or consulting), the amount of W-2 wages paid by the business, and/or the unadjusted basis of qualified property (such as machinery and equipment) held by the business. The limitations are phased in; for example, the phase-in applies to joint filers with taxable income up to $100,000 above the threshold, and to other filers with taxable income up to $50,000 above their threshold.

Taxpayers may be able to salvage some or all of this deduction, by deferring income or accelerating deductions to keep income under the dollar thresholds (or be subject to a smaller deduction phaseout) for 2022. Depending on their business model, taxpayers also may be able increase the deduction by increasing W-2 wages before year-end. The rules are quite complex, so don’t make a move in this area without consulting us.

  • More small businesses are able to use the cash (as opposed to accrual) method of accounting than were allowed to do so in earlier years. To qualify as a small business a taxpayer must, among other things, satisfy a gross receipts test, which is satisfied for 2022 if, during a three-year testing period, average annual gross receipts don’t exceed $27 million. Not that many years ago it was $1 million. Cash method taxpayers may find it a lot easier to shift income, for example by holding off billings until next year or by accelerating expenses, for example, paying bills early or by making certain prepayments.
  • Businesses should consider making expenditures that qualify for the liberalized business property expensing option. For tax years beginning in 2022, the expensing limit is $1,080,000, and the investment ceiling limit is $2,700,000. Expensing is generally available for most depreciable property (other than buildings) and off-the-shelf computer software. It is also available for interior improvements to a building (but not for its enlargement), elevators or escalators, or the internal structural framework), for roofs, and for HVAC, fire protection, alarm, and security systems.

The generous dollar ceilings mean that many small and medium sized businesses that make timely purchases will be able to currently deduct most if not all their outlays for machinery and equipment. What’s more, the expensing deduction is not prorated for the time that the asset is in service during the year. So expensing eligible items acquired and placed in service during the last days of 2022, rather than at the beginning of 2023, can result in a full expensing deduction for 2022.

  • Businesses also can claim a 100% bonus first year depreciation deduction for machinery and equipment bought used (with some exceptions) or new if purchased and placed in service this year, and for qualified improvement property, described above as related to the expensing deduction. The 100% write-off is permitted without any proration based on the length of time that an asset is in service during the tax year. As a result, the 100% bonus first-year write-off is available even if qualifying assets are in service for only a few days in 2022.
  • Businesses may be able to take advantage of the de minimis safe harbor election (also known as the book tax conformity election) to expense the costs of lower-cost assets and materials and supplies, assuming the costs aren’t required to be capitalized under the UNICAP rules. To qualify for the election, the cost of a unit of property can’t exceed $5,000 if the taxpayer has an applicable financial statement (AFS, e.g., a certified audited financial statement along with an independent CPA’s report). If there’s no AFS, the cost of a unit of property can’t exceed $2,500.
  • Plan for funding a qualified retirement plan / setting up a Simplified Employee Pension (SEP).
  • Consider having your flow through entity pay a portion of your state tax liability under the new Pass-Through Entity tax credit provisions.
  • A corporation (other than a large corporation) that anticipates a small net operating loss (NOL) for 2022 (and substantial taxable income in 2023) may find it worthwhile to accelerate just enough of its 2023 income (or to defer just enough of its 2022 deductions) to create a small amount of taxable income for 2022. This allows the corporation to base its 2023 estimated tax installments on the relatively small amount of income shown on its 2022 return, rather than having to pay estimated taxes based on 100% of its much larger 2023 taxable income.
  • Year-end bonuses can be timed for maximum tax effect by both cash- and accrual-basis employers. Cash basis employers deduct bonuses in the year paid, so they can time the payment for maximum tax effect. Accrual-basis employers deduct bonuses in the accrual year, when all events related to them are established with reasonable certainty. However, the bonus must be paid within two and a half months after the end of the employer’s tax year for the deduction to be allowed in the earlier accrual year as long as not paid to an over 50% owner of the corporation. Accrual employers looking to defer deductions to a higher-taxed future year should consider changing their bonus plans before year end to set the payment date later than the 2.5-month window or change the bonus plan terms to make the bonus amount not determinable at year end.
  • To reduce 2022 taxable income, consider deferring a debt-cancellation event until 2023 or to accelerate, consider finalizing a debt-cancellation event.
  • Take steps to utilize prior year suspended basis, at-risk or passive losses:

Suspended basis and at-risk losses can be freed up by contributing capital into the business.

Sometimes the disposition of a passive activity can be timed to make best use of its freed-up suspended losses. Where reduction of 2022 income is desired, consider disposing of a passive activity before year-end to take the suspended losses against 2022 income. If possible 2023 top rate increases are a concern, holding off on disposing of the activity until 2023 might save more in future taxes.

These are just some of the year-end steps that can be taken to save taxes. As you can tell from this letter, many provisions are quite complex and require some analysis based on individual facts. Even if you don’t believe any of these provisions will apply to your 2022 tax situation, you should consider contacting us so at a minimum, we can run a tax projection to help you avoid unnecessary surprises come April 2023. Again, by contacting us, we can tailor a particular plan that will work best for you.

Tax Aspects of Refinancing a Home Mortgage

by Amanda Domitrowich

Are you planning to refinance the mortgage on your home and wondering about the tax rules regarding the refinancing? This article will discuss whether you can deduct the interest you will pay on your new mortgage, the points that you pay, and other fees that you may pay in connection with the refinancing.

Interest deduction on refinanced mortgage. Interest on a refinanced mortgage will be deductible, within the limits discussed, if it falls into one of the following categories:

Your old mortgage was taken out after Dec. 15, 2017. Debt that results from the refinancing of debt that was incurred after Dec. 15, 2017 to buy, build, or substantially improve your main or second home, and that is secured by that home. But interest on this debt is deductible only to the extent that the amount of the debt from refinancing doesn’t exceed: (a) the amount of the original debt that has been refinanced, and (b) $750,000 ($375,000 for married taxpayers filing separately).

Your old mortgage was taken out after Oct. 13, 1987, but before Dec. 16, 2017. Debt that results from the refinancing of debt that was incurred after Oct. 13, 1987, but before Dec. 16, 2017, to buy, build, or substantially improve your main or second home, and that is secured by that home. But interest on this debt is deductible only to the extent that the amount of the debt from refinancing doesn’t exceed: (a) the amount of the original debt that has been refinanced, and (b) $1 million ($500,000 for married taxpayers filing separately). Note that for the $1 million ($500,000) limit to apply, the refinancing debt has to be incurred before the expiration of the term of the old debt.

Your old mortgage was taken out before Oct. 14, 1987. Debt that results from the refinancing of debt that was incurred before Oct. 14, 1987-no matter how the proceeds of the mortgage were used-and that is secured by your first or second home. All of the interest you pay on this debt is fully deductible, as long as the term of the old mortgage hasn’t expired, and the amount of the debt resulting from the refinance doesn’t exceed the amount of principal remaining on the old debt immediately before the refinancing.

Interest on refinanced “home equity loans” isn’t deductible, 2018 – 2025. “Home equity debt,” as specially defined for purposes of the mortgage interest deduction, means debt that: (1) is secured by the taxpayer’s home, and (2) wasn’t incurred to acquire, construct, or substantially improve the home). From 2018 through 2025, there’s no deduction for the interest on home equity debt, no matter when the home equity debt was incurred. And interest on debt resulting from the refinancing of such home equity debt isn’t deductible.

Beginning with 2026, home equity debt will be deductible, as will the debt resulting from a refinancing of home equity debt. However, the interest that can be deducted will be limited to loan amounts of the lesser of $100,000 ($50,000 if your filing status is married filing separately) or your equity in the home.

Points. In general, points that you pay to refinance your home aren’t fully deductible in the year that you paid them. Instead, you can deduct a portion of the points each year over the life of the loan.

To figure your deduction for points, divide the total points by the number of payments to be made over the life of the loan. Then, multiply this result by the number of payments you made in the tax year.

For example, if you paid $3,000 in points and you will make 360 payments on a 30-year mortgage, you can deduct $8.33 per monthly payment. For a year in which you make 12 payments, you can deduct a total of $99.96 ($8.33 × 12).

However, you may be entitled to a larger first-year deduction for points if you used part of the proceeds of the refinancing to improve your home and you meet certain other requirements. In that case, the points associated with the home improvements may be fully deductible in the year they were paid.

For example, say that you refinance a high-rate mortgage that has an outstanding balance of $80,000 with a new lower-rate loan for $100,000. You use the proceeds of the new mortgage loan to pay off the old loan and to pay for $20,000 of improvements to your home. Since 20% of the new loan was incurred to pay for improvements, 20% of the points you paid can be deducted in the year of the refinancing.

If you’re refinancing your mortgage for the second time, the portion of the points on the first refinanced mortgage that you haven’t yet deducted may be deductible at the time of the second refinancing.

Penalties and fees. A prepayment penalty that you pay to terminate your old mortgage is deductible as interest in the year of payment.

However, fees paid to obtain the new mortgage aren’t deductible, nor can you add them to your basis in your home to reduce the gain when you sell it. Examples of such nondeductible fees are credit report fees, loan origination fees, and appraisal fees.

Give us a call today to go over these rules with you in greater detail!

Using S Corporations to Reduce Self-Employment Income

by Amanda Domitrowich

Income that you generate conducting your business as a sole proprietorship (or through a wholly-owned limited liability company (LLC)) is subject to both income tax and self-employment tax. The self-employment tax is imposed on 92.35% of self-employment income at a 12.4% rate for social security up to the social security maximum ($142,800 for 2021; $147,000 for 2022) and at a 2.9% rate for Medicare. An additional 0.9% Medicare tax is imposed on income exceeding $250,000 for married couples ($125,000 for married persons filing separately) and $200,000 in all other cases. No maximum tax limit applies to the Medicare tax. Similarly, if you conduct your business as a partnership in which you are a general partner, in addition to income tax you would be subject to the self-employment tax on your distributive share of the partnership’s income. On the other hand, if you conduct your business as an S corporation you will be subject to income tax, but not self-employment tax, on your share of the S corporation’s income.

An S corporation is not subject to tax at the corporate level. Instead, the corporation’s items of income, gain, loss, and deduction are passed through to the shareholders. However, the income passed through to the shareholder is not treated as self-employment income. Thus, by using an S corporation, you can avoid self-employment income tax.

There is a problem, however, in that IRS requires that the S corporation pay you reasonable compensation for your services to the S corporation. The compensation is treated as wages subject to employment tax (split evenly between the corporation and the employee), which is equivalent to the self-employment tax. If the S corporation does not pay you reasonable compensation for your services, IRS may treat a portion of the S corporation’s distributions to you as wages and impose social security taxes on the deemed wages. There is no simple formula regarding what is reasonable compensation. Presumably, reasonable compensation would be the amount that unrelated employers would pay for comparable services under like circumstances. There are many factors that would be taken into account in making this determination.

Give us a call today to discuss the practical aspects of conducting your business through an S corporation and how much the S corporation would have to pay you as compensation.

Computing a Net Operating Loss for an Individual

by Amanda Domitrowich

Speaking broadly, you may be able to benefit by carrying what is called a “net operating loss” (NOL) into a different year-a year in which you have taxable income-and taking a deduction (the “NOL deduction”) for the loss against that year’s income.

The NOL deduction equals the total of your NOL carryovers and NOL carrybacks to the particular tax year. But, for tax years after 2020, the deduction will be subject to an 80%-of-taxable income limitation.

Your NOLs for tax years 2018, 2019 and 2020 are carried back for five years. But, NOLs for 2021 and later tax years generally can’t be carried back (although farm losses can be carried back two years). And, NOLs for tax years after 2017 are generally carried forward indefinitely.

You must carry the NOL first to the earliest year allowed, and, then, successively, to the next earliest year, etc. until the loss is used up. But, if it would benefit you more to just carry a NOL forward, you can waive carryback of that loss.

To determine the amount of your NOL for a particular tax year, you don’t just use the negative taxable income reported on your tax return for that year. Instead, several modifications must be made to compute the amount of your NOL. These include the following:

  • (1) You cannot use your personal or dependency exemptions-for the years in which these are available (i.e., after 2025 and before 2018).
  • (2) You cannot use any NOL from a different year.
  • (3) “Nonbusiness” capital losses (those arising outside of your trade or business, or your employment) can only be used against “nonbusiness” capital gains. Excess capital losses cannot increase your NOL.
  • (4) “Nonbusiness” deductions (e.g., charitable donations, deductible medical expenses, mortgage interest, alimony, etc.) can only be used against “nonbusiness” income (interest, dividends, etc.). That is, they cannot directly increase your NOL. However, if you have nonbusiness capital gains in excess of nonbusiness capital losses (see (3), above), you can use your “excess” nonbusiness deductions against these gains. (Note that casualty losses are treated as fully usable “business deductions” for these purposes.)
  • (5) Finally, “business” capital losses can only be used against “business” capital gains, except that if you still have nonbusiness capital gains after netting nonbusiness capital losses and excess nonbusiness deductions against them, you can use your business capital losses against them.

Example. N has a loss of $20,000 from business operations for the year. N also has (i) nonbusiness capital gains of $9,000 and nonbusiness capital losses of $4,000, and (ii) nonbusiness income of $13,000 and nonbusiness deductions of $14,000 (not including personal or dependency exemptions). N has no business capital gains or losses.

N’s “starting point” for calculating N’s NOL is N’s $20,000 business loss. N’s capital losses reduce N’s capital gains to $5,000 ($9,000 − $4,000). N’s nonbusiness deductions wipe out N’s nonbusiness income ($13,000 − $14,000), leaving N with $1,000 “excess” nonbusiness deductions. N can use the $1,000 excess nonbusiness deductions to further reduce N’s capital gains to $4,000. But, the $4,000 of capital gains do reduce N’s NOL from $20,000 to $16,000. The final result: N incurs a $16,000 NOL for the tax year.

Note that N’s taxable income will show a loss that’s greater than N’s $16,000 NOL, because N’s taxable income includes items such as personal exemption that aren’t allowed in figuring N’s NOL. Only the $16,000 NOL, however, can be carried forward to other years for use as a deduction.

The above computations can grow quite complex, depending upon your circumstances.

In addition to the rules above, special rules allow farmers to retain a pre-2018, two-year NOL carryback election and then applicable 80%-of-taxable-income limitation, for farming losses arising in 2018, 2019 or 2020 tax years, and to revoke a previously made waiver of the two-year carryback for 2018 or 2019 farming losses, and apply the five-year carryback instead. Obviously, there’s a lot to consider in determining the amount of your NOL, and whether to claim an NOL deduction. Please contact us today and we will be happy to discuss further.

Individual Estimated Tax Payments – Who Should Pay Them and Why?

by Amanda Domitrowich

Individuals must pay 25% of a “required annual payment ” by Apr. 15, June 15, Sept. 15, and Jan. 15, to avoid an underpayment penalty. When that date falls on a weekend or holiday, the payment is due on the next business day.

The required annual payment for most individuals is the lower of 90% of the tax shown on the current year’s return or 100% of the tax shown on the return for the previous year. However, if the adjusted gross income on your previous year’s return was over $150,000 (over $75,000 if you are married filing separately), you must pay the lower of 90% of the tax shown on the current year’s return or 110% of the tax shown on the return for the previous year.

Most people who receive the bulk of their income in the form of wages satisfy these payment requirements through the tax withheld by their employer from their paycheck. Those who make estimated tax payments generally do so in four installments. After determining the required annual payment, they divide that number by four and make four equal payments by the due dates.

But you may be able to use the annualized income method to make smaller payments. This method is useful to people whose income flow is not uniform over the year, perhaps because of a seasonal business. For example, if your income comes exclusively from a business that you operate in a resort area during June, July, and August, no estimated payment is required before Sept. 15. You may also want to use the annualized income method if a significant portion of your income comes from sales of securities that are made at various times during the year.

If you fail to make the required payments, you may be subject to an underpayment penalty. The penalty equals the product of the interest rate charged by IRS on deficiencies, times the amount of the underpayment for the period of the underpayment.

However, the underpayment penalty doesn’t apply to you:

  • (1) if the total tax shown on your return is less than $1,000 after subtracting withholding tax paid;
  • (2) if you had no tax liability for the preceding year, you were a U.S. citizen or resident for that entire year, and that year was 12 months;
  • (3) for the fourth (Jan. 15) installment, if you file your return by that Jan. 31 and pay your tax in full; or
  • (4) if you are a farmer or fisherman and pay your entire estimated tax by Jan. 15, or pay your entire estimated tax and file your tax return by Mar. 1

In addition, IRS may waive the penalty if the failure was due to casualty, disaster, or other unusual circumstances and it would be inequitable or against good conscience to impose the penalty. The penalty can also be waived for reasonable cause during the first two years after you retire (after reaching age 62) or become disabled. Third quarter estimated taxes for 2022 are coming due on September 15th. If you think you may be eligible to determine your estimated tax payments under the annualized income method, or you have any other specific questions about how the estimated  tax rules apply to you, please contact our office today!

Simplified Employee Pensions (SEPs)

by Amanda Domitrowich

Are you thinking about setting up a retirement plan for yourself and your employees, but are concerned about the financial commitment and administrative burdens involved in providing a traditional pension or profit-sharing plan? An alternative program you may want to consider is a “simplified employee pension,” or SEP.

SEPs are intended as an alternative to “qualified” retirement plans, particularly for small businesses like yours. The relative ease of administration and the complete discretion you, as the employer, are permitted in deciding whether or not to make annual contributions, are features that are especially attractive. Here’s how these plans work.

If you don’t already have a qualified retirement plan, you can set up a SEP simply by using the IRS model SEP, Form 5305-SEP. By adopting and implementing this model SEP, which doesn’t have to be filed with the IRS, you will have satisfied the SEP requirements. This means that you, as the employer, will get a current income tax deduction for contributions you make on behalf of your employees. Your employees will be taxed not when the contributions are made, but at a later date when distributions are made, usually at retirement. Depending on your specific needs, an individually-designed SEP-instead of the model SEP-may be appropriate for you.

When you set up a SEP for yourself and your employees, you will make these deductible contributions to each employee’s IRA, called a SEP-IRA, which must be IRS-approved. The maximum amount of deductible contributions that you can make to an employee’s SEP-IRA, and that he or she can exclude from income, is the lesser of: (i) 25 percent of compensation, and (ii) $61,000 (for 2022). The deduction for your contributions to employees’ SEP-IRAs isn’t limited by the deduction ceiling applicable to an individual’s own contribution to a regular IRA. Your employees control their individual IRAs and IRA investments, the earnings on which are tax-free.

There are other requirements which you have to meet to be eligible to set up a SEP. Essentially, all regular employees must elect to participate in the program, and contributions can’t discriminate in favor of the highly compensated employees. But these requirements are minor compared to the bookkeeping and other administrative burdens connected with traditional qualified pension and profit-sharing plans. The detailed records that traditional plans must maintain to comply with the complex nondiscrimination regulations aren’t required for SEPs. And employers aren’t required to file annual reports with IRS-Forms 5500-which, for a pension plan, could require the services of an actuary. What record-keeping is required can be done by a trustee of the SEP-IRAs-usually a bank or mutual fund.

We are happy to meet with you to explain your SEP options in greater detail as well as answer any questions you may have. Give us a call today!

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