Does your business receive large amounts of cash or cash equivalents? If so, you’re generally required to report these transactions to the IRS — and not just on your tax return.

The requirements

Each person who, in the course of operating a trade or business, receives more than $10,000 in cash in one transaction (or two or more related transactions), must file Form 8300. Who is a “person”? It can be an individual, company, corporation, partnership, association, trust or estate. What are considered “related transactions”? Any transactions conducted in a 24-hour period. Transactions can also be considered related even if they occur over a period of more than 24 hours if the recipient knows, or has reason to know, that each transaction is one of a series of connected transactions.

In order to complete a Form 8300, you’ll need personal information about the person making the cash payment, including a Social Security or taxpayer identification number.

The definition of “cash” and “cash equivalents”

For Form 8300 reporting purposes, cash includes U.S. currency and coins, as well as foreign money. It also includes cash equivalents such as cashier’s checks (sometimes called bank checks), bank drafts, traveler’s checks and money orders.

Money orders and cashier’s checks under $10,000, when used in combination with other forms of cash for a single transaction that exceeds $10,000, are defined as cash for Form 8300 reporting purposes.

Note: Under a separate reporting requirement, banks and other financial institutions report cash purchases of cashier’s checks, treasurer’s checks and/or bank checks, bank drafts, traveler’s checks and money orders with a face value of more than $10,000 by filing currency transaction reports.

The reasons for reporting

Although many cash transactions are legitimate, the IRS explains that the information reported on Form 8300 “can help stop those who evade taxes, profit from the drug trade, engage in terrorist financing and conduct other criminal activities. The government can often trace money from these illegal activities through the payments reported on Form 8300 and other cash reporting forms.”

Failing to comply with the law can result in fines and even jail time. In one case, a Niagara Falls, NY, business owner was convicted of willful failure to file Form 8300 after receiving cash transactions of more than $10,000. In a U.S. District Court, he pled guilty and was recently sentenced to five months home detention, fined $10,000 and he agreed to pay restitution to the IRS. He had received cash rent payments in connection with a building in which he had an ownership interest.

Forms can be sent electronically

Businesses required to file reports of large cash transactions on Forms 8300 should know that in addition to filing on paper, e-filing is an option. The form is due 15 days after a transaction and there’s no charge for the e-file option. Businesses that file electronically get an automatic confirmation of receipt when they file.

Effective January 1, 2024, you may have to e-file Forms 8300 if you’re required to e-file other information returns, such as 1099 and W-2 forms. You must e-file if you’re required to file at least 10 information returns other than Form 8300 during a calendar year.

The IRS also reminds businesses that they can “batch file” their reports, which is especially helpful to those required to file many forms.

Record retention

You should keep a copy of each Form 8300 for five years from the date you file it, according to the IRS. “Confirmation receipts don’t meet the recordkeeping requirement,” the tax agency added.

Contact us with any questions or for assistance.

© 2023

The airwaves and internet are inundated these days with advertisements claiming that businesses are missing out on the lucrative Employee Retention Tax Credit (ERTC). While some employers do indeed remain eligible if they meet certain criteria, the IRS continues to caution businesses about third-party scams related to the credit.

While there’s nothing wrong with claiming credits you’re entitled to, those that claim the ERTC improperly could find themselves in hot water with the IRS and face cash-flow problems as a result. Here’s what you need to know to reduce your risks.

ERTC in a nutshell

The ERTC is a refundable tax credit intended for businesses that 1) continued paying employees while they were shut down due to the pandemic in 2020 and 2021, or 2) suffered significant declines in gross receipts from March 13, 2020, to December 31, 2021. Eligible employers could receive credits worth up to $26,000 per retained employee. The credit may still be available on an amended tax return.

The requirements are strict, though. Specifically, you must have:

• Sustained a full or partial suspension of operations due to orders from a governmental authority that limited commerce, travel or group meetings due to COVID-19 during 2020 or the first three quarters of 2021,
• Experienced a significant decline in gross receipts during 2020 or in the first three quarters of 2021, or
• Qualified as a recovery startup business — which can claim the credit for up to $50,000 total per quarter without showing suspended operations or reduced receipts — for the third or fourth quarters of 2021. (Qualified recovery startups are those that began operating after February 15, 2020, and have annual gross receipts of less than or equal to $1 million for the three tax years preceding the quarter for which they are claiming the ERTC.)

In addition, a business can’t claim the ERTC on wages that it reported as payroll costs when it applied for Paycheck Protection Program (PPP) loan forgiveness or it used to claim certain other tax credits. Also, a business must reduce the wage deductions claimed on its federal income tax return by the amount of credits.

Prevalence of scams

The potentially high value of the ERTC, combined with the fact that employers can file claims for it on amended returns until April 15, 2025, has led to a cottage industry of fraudulent promoters offering to help businesses claim the credit. These fraudsters wield inaccurate information and inflated promises to generate business from innocent clients. In return, they reap excessive upfront fees in the thousands of dollars or commissions as high as 25% of the refund received.

The IRS has called the amount of misleading marketing around the credit “staggering.” For example, in recent guidance, the tax agency explained that, contrary to advice given by some promoters, supply chain disruptions generally don’t qualify an employer for the credit unless the disruptions were due to a government order. It’s not enough that an employer suspended operations because of disruptions — the credit applies only if the employer had to suspend operations because a government order caused the supplier to suspend its operations.

ERTC fraud has grown so serious that the IRS has included it in its annual “Dirty Dozen” list of the worst tax scams in the country. In Utah, for example, the U.S. Department of Justice has charged two promoters, who did business as “1099 Tax Pros,” with participating in a fraudulent tax scheme by preparing and submitting more than 1,000 forms to the IRS. They claimed more than $11 million in false ERTCs and COVID-related sick and family leave wage credits for their clients.

Fraudsters have been able to monopolize on the general confusion and uncertainty around the ERTC. A recent congressional hearing found that some of the problems can be traced back to the entirely paper application process created for the credit. This has contributed to a backlog of nearly 500,000 unprocessed claims, out of more than 2.5 million claims that have been submitted.

Although it’s unclear how much progress the IRS has made on the backlog, the agency has announced that it has entered a new phase of intensified scrutiny of ERTC claims. It’s stepping up its compliance work and establishing additional procedures to deal with fraud in the program. The IRS already has increased its audit and criminal investigation work on ERTC claims, focusing on both the promoters and the businesses filing dubious claims.

If you fell into the trap and are among those businesses, you could end up on the hook for repayment of the credit, along with penalties and interest, on top of the fees you paid the promoter. That could make a substantial dent in your cash flow.

Even if you’re eligible for the credit, you could run into trouble if you failed to reduce your wage deductions accordingly or claimed it on wages that you also used to claim other credits. As the IRS has noted, promoters may leave out key details, unleashing a “domino effect of tax problems” for unsuspecting businesses.

Moreover, providing your business and tax documents to an unscrupulous promoter could put you at risk of identity theft.

Red flags to watch for

The IRS has identified several warning signs of illegitimate promoters, including:

• Unsolicited phone calls, text messages, direct mail or ads highlighting an “easy application process” or a short eligibility checklist (the rules for eligibility and computation of credit amounts are actually quite complicated),
• Statements that the promoter can determine your ERTC eligibility within minutes,
• Hefty upfront fees,
• Fees based on a percentage of the refund amount claimed,
• Preparers who refuse to sign the amended tax return filed to claim a refund of the credit,
• Aggressive claims from the promoter that you qualify before you’ve discussed your individual tax situation (the credit isn’t available to all employers), or
• Refusal to provide detailed documentation of how your credit was calculated.

The IRS also warns that some ERTC “mills” are sending out fake letters from nonexistent government entities such as the “Department of Employee Retention Credit.” The letters are designed to look like official IRS or government correspondence and typically include urgent language pushing immediate action.

Protect yourself

Taking several simple steps can help you cut your risk of being victimized by scammers. First, if you think you may qualify for the credit, work with a trusted professional — one who isn’t proactively soliciting ERTC work. Those who are aggressively marketing the credit (and in some cases, only the credit) are more interested in making money themselves and are unlikely to prioritize or protect your best interests.

You also should request a detailed worksheet that explains how you’re eligible for the credit. The worksheet should “show the math” for the credit amount as well.

If you’re claiming you suspended business due to a government order, ensure that you have legitimate documentation of the order. Don’t accept a generic document about a government order from a third party. Rather, you should acquire a copy of the actual government order and review it to confirm that it applies to your business.

Proceed with caution

No taxpayer ever wants to leave money on the IRS’s table, but skepticism is warranted whenever something seems too good to be true. If you believe your business might be eligible for the ERTC, we can help you verify eligibility, compute your credit and file your refund claim. We can also help you determine how to proceed if you claimed the ERTC improperly.

© 2023  

Let’s say you own highly appreciated land that’s now ripe for development. If you subdivide it, develop the resulting parcels and sell them off for a hefty profit, it could trigger a large tax bill.

In this scenario, the tax rules generally treat you as a real estate dealer. That means your entire profit — including the portion from pre-development appreciation in the value of the land — will be treated as high-taxed ordinary income subject to a federal rate of up to 37%. You may also owe the 3.8% net investment income tax (NIIT) for a combined federal rate of up to 40.8%. And you may owe state income tax too.

It would be better if you could arrange to pay lower long-term capital gain (LTCG) tax rates on at least part of the profit. The current maximum federal income tax rate on LTCGs is 20% or 23.8% if you owe the NIIT.

Potential tax-saving solution

Thankfully, there’s a strategy that allows favorable LTCG tax treatment for all pre-development appreciation in the land value. You must have held the land for more than one year for investment (as opposed to holding it as a real estate dealer).

The portion of your profit attributable to subsequent subdividing, development and marketing activities will still be considered high-taxed ordinary income, because you’ll be considered a real estate dealer for that part of the process.

But if you can manage to pay a 20% or 23.8% federal income tax rate on a big chunk of your profit (the pre-development appreciation part), that’s something to celebrate.

Three-step strategy

Here’s the three-step strategy that could result in paying a smaller tax bill on your real estate development profits.

1. Establish an S corporation

If you individually own the appreciated land, you can establish an S corporation owned solely by you to function as the developer. If you own the land via a partnership, or via an LLC treated as a partnership for federal tax purposes, you and the other partners (LLC members) can form the S corp and receive corporate stock in proportion to your percentage partnership (LLC) interests.

2. Sell the land to the S corp

Sell the appreciated land to the S corp for a price equal to the land’s pre-development fair market value. If necessary, you can arrange a sale that involves only a little cash and a big installment note the S corp owes you. The business will pay off the note with cash generated by selling off parcels after development. The sale to the S corp will trigger a LTCG eligible for the 20% or 23.8% rate as long as you held the land for investment and owned it for over one year.

3. Develop the property and sell it off

The S corp will subdivide and develop the property, market it and sell it off. The profit from these activities will be higher-taxed ordinary income passed through to you as an S corp shareholder. If the profit is big, you’ll probably pay the maximum 37% federal rate (or 40.8% percent with the NIIT. However, the average tax rate on your total profit will be much lower, because a big part will be lower-taxed LTCG from pre-development appreciation.

Favorable treatment

Thanks to the tax treatment created by this S corp developer strategy, you can lock in favorable treatment for the land’s pre-development appreciation. That’s a huge tax-saving advantage if the land has gone up in value. Consult with us if you have questions or want more information.

© 2023

While the value of virtual currency continues to fluctuate, the IRS’s interest in it has only increased. In 2021, for example, the agency launched Operation Hidden Treasure to root out taxpayers who don’t report income from cryptocurrency transactions on their federal income tax returns.

Moreover, the Inflation Reduction Act, enacted in 2022, allocated $80 billion to the IRS, with much of it designated for enforcement activities. However, the Fiscal Responsibility Act, enacted in May 2023, will claw back $21.39 billion of that amount by the end of 2025. The IRS’s strategic operating plan for 2023 through 2031 lays out the agency’s intention to ramp up enforcement related to digital assets. If you buy, sell or otherwise engage in transactions involving virtual currency, you need to stay up to date with the latest tax developments.

Terminology

The IRS defines a “virtual asset” as any virtual representation of value that’s recorded on a cryptographically secured distributed ledger or similar technology. The term includes:

• Convertible virtual currency (meaning it has an equivalent value in real currency or acts as a substitute for real currency) such as Bitcoin,
• Stablecoins (a type of currency whose value is tied to the value of another asset, such as the U.S. dollar), and
• Non-fungible tokens (NFTs).

According to the IRS, cryptocurrency is an example of a convertible virtual currency that can be used as a payment for goods and services, digitally traded between users, and exchanged for or into real currencies or digital assets. Cryptocurrency uses cryptography to secure transactions that are digitally recorded on a distributed ledger (for example, blockchain).

Taxation of transactions

For federal tax purposes, digital assets are treated as property. Thus, transactions involving virtual currency are subject to the same general tax rules that apply to property transactions, such as purchases and sales of stock or real estate.

Several types of virtual currency transactions can trigger reporting obligations, including:

Sales. If you sell virtual currency, you must recognize any capital gain or loss on the sale, subject to any limitations on the deductibility of capital losses. The gain or loss equals the difference between your adjusted tax basis in the currency and the amount you receive for it. You should report the amount you receive on your federal income tax return in U.S. dollars (see below for more information on reporting obligations).

Your basis is the amount you spent to acquire the virtual currency, including fees, commissions and other costs. Your adjusted basis is your basis increased by certain expenditures and reduced by certain deductions or credits.

Property exchanges. If you exchange virtual currency that you hold as a capital asset for other property (including goods or other digital assets), you must recognize a capital gain or loss. The gain or loss is the difference between the fair market value (FMV) of the property you receive and your adjusted tax basis in the virtual currency. If, as part of an arm’s length transaction, you transfer a digital asset and receive other property in exchange, your tax basis in the property you receive is its FMV at the time of the exchange.

Payment for services. If you receive virtual currency for performing services — regardless of whether you perform the services as an employee or an independent contractor — you recognize the FMV of the currency when received as ordinary income. The FMV will also be your tax basis in that asset.

On the flip side, if you pay for a service using virtual currency that you hold as a capital asset, you’ve exchanged a capital asset for the service and will have a capital gain or loss. In addition, the FMV of virtual currency that’s paid as wages, at the date of receipt, is subject to federal income tax withholding, Federal Insurance Contributions Act (FICA) tax and Federal Unemployment Tax Act (FUTA) tax. It also must be reported on Form W-2, “Wage and Tax Statement.”

Reporting obligations

You may have noticed a new line on your individual federal income tax return in recent years. The 2022 version asks:

“At any time during 2022, did you: (a) receive (as a reward, award or payment for property or services); or (b) sell, exchange, gift or otherwise dispose of a digital asset (or a financial interest in a digital asset)?”

If you answer “yes,” you must report all related income, whether as income, a capital gain or loss, or otherwise (for example, as a gift).

The Infrastructure Investment and Jobs Act (IIJA), enacted in late 2021, created additional new reporting requirements for digital asset transactions. These provisions were enacted with an eye toward generating additional tax revenues to help fund infrastructure projects. The requirements provide the IRS with more information to work from and establish more potential compliance tripwires for taxpayers who engage in virtual currency transactions.

The IIJA expanded the definition of brokers that are required to report their customers’ gains and losses on the sale of securities during the tax year to the IRS on Form 1099-B, “Proceeds from Broker and Barter Exchange Transactions.” The form generally requires a description of each sale, the cost basis, the acquisition date and price, the sale date and price, and the resulting short- or long-term gain or loss.

Under the IIJA, operators of trading platforms for digital assets, such as cryptocurrency exchanges, are subject to the same reporting requirements as traditional securities brokers. The effective date remains to be seen, though, as the IRS hasn’t yet issued final regulations with instructions. After the new rules take effect, cryptocurrency platforms will need to collect Form W-9, “Request for Taxpayer Identification Number and Certification,” from their customers.

The IIJA also amended existing anti-money laundering laws to treat digital assets as cash for purposes of those laws. As a result, beginning in 2023, businesses must report to the IRS when they receive more than $10,000 in digital assets in one transaction or multiple related transactions.

Such transactions should be reported on IRS Form 8300, “Report of Cash Payments Over $10,000 Received in a Trade or Business.” To complete the form, a business will need to gather the name, address and taxpayer identification number, among other information, from the payer. Failure to comply may lead to significant civil and criminal penalties.

Enforcement tool

One way the IRS may uncover digital assets is through the use of a “John Doe summons.” The U.S. Department of Justice notes that “because transactions in cryptocurrencies can be difficult to trace and have an inherently pseudo-anonymous aspect, taxpayers may be using them to hide taxable income from the IRS.” By asking a court to serve a John Doe summons on a crypto dealer or exchange, the IRS can find out information about a person’s account.

In one recent case, an individual challenged the IRS’s use of a summons to obtain his account information from a virtual currency exchange. He argued it was unconstitutional. A U.S. District Court disagreed and ruled that the IRS’s actions “fall squarely” within its powers to pursue unpaid taxes. (Harper, DC NH, 5/26/23)

An evolving area

With its new infusion of enforcement funding, the IRS’s focus on virtual currency transactions is likely to intensify. We’ll help you stay in compliance with the applicable rules and requirements.

© 2023  

For years, life insurance has played a critical role in estate planning, providing a source of liquidity to pay estate taxes and other expenses. It’s been particularly valuable for business owners, whose families might not have the liquid assets they need to pay estate taxes without selling the business.

Because the federal gift and estate tax exemption has climbed to $12.92 million (for 2023), estate tax liability generally is no longer a concern for the vast majority of families. But even for nontaxable estates, life insurance continues to offer significant estate planning benefits.

Replacing income and wealth

If you die unexpectedly, life insurance can protect your family by replacing your lost income. It can also be used to replace wealth in a variety of contexts. For example, suppose you own highly appreciated real estate or other assets and wish to dispose of them without generating current capital gains tax liability. One option is to contribute the assets to a charitable remainder trust (CRT).

CRTs are irrevocable trusts that work like this: You contribute property to a CRT during your life or upon your death and the trust makes annual distributions to you or your beneficiary (typically, your spouse) for a specified period of time. When that period ends, the remainder goes to a charity of your choice.

These instruments are particularly useful when you contribute highly appreciated assets and want to reduce capital gains tax exposure. Because the CRT is tax-exempt, it can sell the assets and reinvest the proceeds without currently triggering the entire capital gain.

Here’s where life insurance comes in. Because CRT assets eventually go to charity — usually after both you and your spouse have died — you won’t have as much to leave to your children or other heirs. A life insurance policy can replace that “lost” wealth in a tax advantaged way.

Treating your children equally

If much of your wealth is tied up in a family business, treating your children fairly can be a challenge. It makes sense to leave the business to those children who work in it, but what if your remaining assets are insufficient to provide an equal inheritance to children who don’t? For many families, the answer is to purchase a life insurance policy to make up the difference.

Protecting your assets

Depending on applicable state law, a life insurance policy’s cash surrender value and death benefit may be shielded from creditors’ claims. For additional protection, consider setting up an irrevocable life insurance trust to hold your policy.

Finding the right policy

These are just a few examples of the many benefits provided by life insurance. We can help determine which type of life insurance policy is right for your situation.

© 2023

If you own or manage a business with employees, there’s a harsh tax penalty that you could be at risk for paying personally. The Trust Fund Recovery Penalty (TFRP) applies to Social Security and income taxes that are withheld by a business from its employees’ wages.

Sweeping penalty

The TFRP is dangerous because it applies to a broad range of actions and to a wide range of people involved in a business.

Here are some answers to questions about the penalty:

What actions are penalized? The TFRP applies to any willful failure to collect, or truthfully account for, and pay over taxes required to be withheld from employees’ wages.

Why is it so harsh? Taxes are considered the government’s property. The IRS explains that Social Security and income taxes “are called trust fund taxes because you actually hold the employee’s money in trust until you make a federal tax deposit in that amount.”

The penalty is sometimes called the “100% penalty” because the person found liable is personally penalized 100% of the taxes due. The amounts the IRS seeks are usually substantial and the IRS is aggressive in enforcing the penalty.

Who’s at risk? The penalty can be imposed on anyone “responsible” for collecting and paying tax. This has been broadly defined to include a corporation’s officers, directors and shareholders, a partnership’s partners and any employee with related duties. In some circumstances, voluntary board members of tax-exempt organizations have been subject to this penalty. In other cases, responsibility has been extended to professional advisors and family members close to the business.

According to the IRS, responsibility is a matter of status, duty and authority. Anyone with the power to see that taxes are (or aren’t) paid may be responsible. There’s often more than one responsible person in a business, but each is at risk for the entire penalty. You may not be directly involved with the payroll tax withholding process in your business. But if you learn of a failure to pay withheld taxes and have the power to pay them, you become a responsible person. Although taxpayers held liable can sue other responsible people for contribution, this action must be taken entirely on their own after the TFRP is paid.

What’s considered willful? There doesn’t have to be an overt intent to evade taxes. Simply paying bills or obtaining supplies instead of paying over withheld taxes is willful behavior. And just because you delegate responsibilities to someone else doesn’t necessarily mean you’re off the hook. Failing to do the job yourself can be treated as willful.

Recent cases

Here are two cases that illustrate the risks.

1. A U.S. Appeals Court held a hospital administrator liable for the TFRP. The administrator was responsible for payroll, as well as signing and reviewing checks. She also knew that the financially troubled hospital wasn’t paying withheld taxes to the IRS. Instead of prioritizing paying taxes, she paid vendors and employees’ wages. (Cashaw, CA 5, 5/31/23)
2. A corporation owner’s daughter/corporate officer was assessed a $680,472 TFRP for unpaid payroll taxes. She argued that she wasn’t a responsible party. She owned no stock and couldn’t hire and fire employees. But she did have the power to write checks and pay vendors and was aware of the unpaid taxes. A U.S. Appeals Court found the “great weight of evidence” indicated she was a responsible party and the TFRP was upheld. (Scott, CA 11, 10/31/22)

Best advice

Under no circumstances should you “borrow” from withheld amounts. All funds withheld should be paid over to the government on time. Contact us with any questions.

© 2023

An estimated 190 million Americans have recently been under heat advisory alerts, according to the National Weather Service. That may have spurred you to think about making your home more energy efficient — and there’s a cool tax break that may apply. Thanks to the Inflation Reduction Act of 2022, you may be able to benefit from an enhanced residential energy tax credit to help defray the cost.

Eligibility rules

If you make eligible energy-efficient improvements to your home on or after January 1, 2023, you may qualify for a tax credit up to $3,200. You can claim the credit for improvements made through 2032.

The credit equals 30% of certain qualified expenses for energy improvements to a home located in the United States, including:

• Qualified energy-efficient improvements installed during the year,
• Residential “energy property” expenses, and
• Home energy audits.

There are limits on the allowable annual credit and on the amount of credit for certain types of expenses.

The maximum credit you can claim each year is:

• $1,200 for energy property costs and certain energy-efficient home improvements, with limits on doors ($250 per door and $500 total), windows ($600 total) and home energy audits ($150), as well as
• $2,000 per year for qualified heat pumps, biomass stoves or biomass boilers.

In addition to windows and doors, other energy property includes central air conditioners and hot water heaters.

Before the 2022 law was enacted, there was a $500 lifetime credit limit. Now, the credit has no lifetime dollar limit. You can claim the maximum annual amount every year that you make eligible improvements until 2033. For example, you can make some improvements this year and take a $1,200 credit for 2023 — and then make more improvements next year and claim another $1,200 credit for 2024.

The credit is claimed in the year in which the installation is completed.

Other limits and rules

In general, the credit is available for your main home, although certain improvements made to second homes may qualify. If a property is used exclusively for business, you can’t claim the credit. If your home is used partly for business, the credit amount varies. For business use up to 20%, you can claim a full credit. But if you use more than 20% of your home for business, you only get a partial credit.

Although the credit is available for certain water heating equipment, you can’t claim it for equipment that’s used to heat a swimming pool or hot tub.

The credit is nonrefundable. That means you can’t get back more on the credit than you owe in taxes. You can’t apply any excess credit to future tax years. However, there’s no phaseout based on your income, so even high-income taxpayers can claim the credit.

Collecting green for going green

Contact us if you have questions about making energy-efficient improvements or purchasing energy-saving property for your home. The Inflation Reduction Act may have other tax breaks you can benefit from for making clean energy purchases, such as installing solar panels. We can help ensure you get the maximum tax savings for your expenditures. Stay cool!

© 2023

If you’re getting a divorce, you know the process is generally filled with stress. But if you’re a business owner, tax issues can complicate matters even more. Your business ownership interest is one of your biggest personal assets and in many cases, your marital property will include all or part of it.

Transferring property tax-free

In general, you can divide most assets, including cash and business ownership interests, between you and your soon-to-be ex-spouse without any federal income or gift tax consequences. When an asset falls under this tax-free transfer rule, the spouse who receives the asset takes over its existing tax basis (for tax gain or loss purposes) and its existing holding period (for short-term or long-term holding period purposes).

For example, let’s say that under the terms of your divorce agreement, you give your house to your spouse in exchange for keeping 100% of the stock in your business. That asset swap would be tax-free. And the existing basis and holding period for the home and the stock would carry over to the person who receives them.

Tax-free transfers can occur before a divorce or at the time it becomes final. Tax-free treatment also applies to post-divorce transfers as long as they’re made “incident to divorce.” This means transfers that occur within:

• A year after the date the marriage ends, or
• Six years after the date the marriage ends if the transfers are made pursuant to your divorce agreement.

Additional future tax issues

Eventually, there will be tax implications for assets received tax-free in a divorce settlement. The ex-spouse who winds up owning an appreciated asset — when the fair market value exceeds the tax basis — generally must recognize taxable gain when it’s sold (unless an exception applies).

What if your ex-spouse receives 49% of your highly appreciated small business stock? Thanks to the tax-free transfer rule, there’s no tax impact when the shares are transferred. Your ex will continue to apply the same tax rules as if you had continued to own the shares, including carryover basis and carryover holding period. When your ex-spouse ultimately sells the shares, he or she will owe any capital gains taxes. You will owe nothing.

Note: The person who winds up owning appreciated assets must pay the built-in tax liability that comes with them. From a net-of-tax perspective, appreciated assets are worth less than an equal amount of cash or other assets that haven’t appreciated. That’s why you should always take taxes into account when negotiating your divorce agreement.

In addition, the beneficial tax-free transfer rule is now extended to ordinary-income assets, not just to capital-gains assets. For example, if you transfer business receivables or inventory to your ex-spouse in a divorce, these types of ordinary-income assets can also be transferred tax-free. When the asset is later sold, converted to cash or exercised (in the case of nonqualified stock options), the person who owns the asset at that time must recognize the income and pay the tax liability.

Avoid surprises by planning ahead

Like many major life events, divorce can have significant tax implications. For example, you may receive an unexpected tax bill if you don’t carefully handle the splitting up of qualified retirement plan accounts (such as a 401(k) plan) and IRAs. And if you own a business, the stakes are higher. Contact us. We can help you minimize the adverse tax consequences of settling your divorce.

© 2023

If you own an unincorporated small business, you probably don’t like the size of your self-employment (SE) tax bills. No wonder!

For 2023, the SE tax is imposed at the painfully high rate of 15.3% on the first $160,200 of net SE income. This includes 12.4% for Social Security tax and 2.9% for Medicare tax. The $160,200 Social Security tax ceiling is up from the $147,000 ceiling for 2022, and it’s only going to get worse in future years, thanks to inflation. Above the Social Security tax ceiling, the Medicare tax component of the SE tax continues at a 2.9% rate before increasing to 3.8% at higher levels of net SE income thanks to the 0.9% additional Medicare tax, on all income.

The S corp advantage

For wages paid in 2023 to an S corporation employee, including an employee who also happens to be a shareholder, the FICA tax wage withholding rate is 7.65% on the first $160,200 of wages: 6.2% for Social Security tax and 1.45% for Medicare tax. Above $160,200, the FICA tax wage withholding rate drops to 1.45% because the Social Security tax component is no longer imposed. But the 1.45% Medicare tax wage withholding hits compensation no matter how much you earn, and the rate increases to 2.35% at higher compensation levels thanks to the 0.9% additional Medicare tax.

An S corporation employer makes matching payments except for the 0.9% Additional Medicare tax, which only falls on the employee. Therefore, the combined employee and employer FICA tax rate for the Social Security tax is 12.4%, and the combined rate for the Medicare tax is 2.9%, increasing to 3.8% at higher compensation levels — same as the corresponding SE tax rates.

Note: In this article, we’ll refer to the Social Security and Medicare taxes collectively as federal employment taxes whether paid as SE tax for self-employed folks or FICA tax for employees.

Strategy: Become an S corporation

While wages paid to an S corporation shareholder-employee get hit with federal employment taxes, any remaining S corp taxable income that’s passed through to the employee-shareholder is exempt from federal employment taxes. The same is true for cash distributions paid out to a shareholder-employee. Since passed-through S corporation taxable income increases the tax basis of a shareholder-employee’s stock, distributions of corporate cash flow are usually free from federal income tax.

In appropriate circumstances, an S corp can follow the tax-saving strategy of paying modest, but justifiable, salaries to shareholder-employees. At the same time, it can pay out most or all of the remaining corporate cash flow in the form of federal-employment-tax-free shareholder distributions. In contrast, an owner’s share of net taxable income from a sole proprietorship, partnership and LLC (treated as a partnership for tax purposes) is generally subject to the full ravages of the SE tax.

Potential negative side effect

Running your business as an S corporation and paying modest salaries to the shareholder-employee(s) may mean reduced capacity to make deductible contributions to tax-favored retirement accounts. For example, if an S corporation maintains a SEP, the maximum annual deductible contribution for a shareholder-employee is limited to 25% of salary. So the lower the salary, the lower the maximum contribution. However, if the S corp sets up a 401(k) plan, paying modest salaries generally won’t preclude generous contributions.

Other implications

Converting an unincorporated business into an S corporation has other legal and tax implications. It’s a big decision. We can explain all the issues.

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If philanthropy is an important part of your legacy, consider taking steps to ensure that your donations are used to fulfill your intended charitable purposes. Indeed, outright gifts can be risky, especially large donations that will benefit a charity over a long period of time.

Add restrictions to your gifts

Even if a charity is financially sound when you make a gift, there are no guarantees that it won’t suffer financial distress, file for bankruptcy protection or even cease operations down the road. The last thing you want is for a charity to use your gifts to pay off its creditors or for some other purpose unrelated to the mission that inspired you to give in the first place.

One way to help preserve your charitable legacy is to place restrictions on the use of your gifts. For example, you might limit the use of your funds to assisting a specific constituency or funding medical research. These restrictions can be documented in your will or charitable trust or in a written gift or endowment fund agreement.

Depending on applicable federal and state laws and other factors, carefully designed restrictions can prevent your funds from being used to satisfy creditors in the event of the charity’s bankruptcy. If these restrictions are successful, the funds will continue to be used according to your charitable intent, either by the original charity (in the case of a Chapter 11 reorganization) or by an alternate charity (in the case of a Chapter 7 liquidation).

Research potential charities

In addition to restricting your gifts, research the charities you’re considering to help ensure that they’re financially stable and use their funds efficiently and effectively. One powerful research tool is the IRS’s Tax Exempt Organization Search (TEOS), found at https://bit.ly/43MVQ3e. TEOS provides access to information about charitable organizations, including newly filed tax returns (Forms 990), IRS determination letters and eligibility to receive tax-deductible contributions.

If you’d like to incorporate charitable giving into your estate plan, please contact us. We can explain your options.

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