With all that’s been going on, it’s easy to forget that it’s Section 199A season again. Yes, we’re talking about that lovely 20 percent deduction.
Are you compensating yourself and your fellow partners or LLC members with so-called guaranteed payments? If so, you may benefit from the following information about those payments and the preferred return option.
What Is a Guaranteed Payment?
A guaranteed payment is a payment by a partnership to a partner that’s determined without regard to the partnership’s net income.
Guaranteed payments can be for services rendered by a partner to the partnership or for the partnership’s use of the partner’s capital. Guaranteed payments made in exchange for services to a partnership are often called “partner salaries,” which is a misnomer because partners are not considered employees for most federal tax purposes.
Guaranteed payments are treated as ordinary income. Guaranteed payments to an individual partner from a partnership that’s considered to be engaged in a trade or business count as self-employment income.
At the partnership level, guaranteed payments generally count as deductible expenditures in calculating the amount of the partnership’s ordinary net business income or loss. The net income or loss is then allocated under the partnership agreement to the partners, reported on their respective Schedules K-1, and ultimately reported on their individual personal returns.
What Is a Preferred Return?
Good question. There is no specific tax-law definition of what constitutes a preferred return paid by a partnership to a partner.
But for purposes of this analysis, we will define a preferred return as a preferential allocation of partnership net income to a service-providing partner before the remaining partnership net income is allocated to all partners via the standard allocation arrangement specified by the partnership agreement--which is usually based on the partners’ percentage ownership interests. Preferred returns that meet this definition may also be called “priority profit allocations.”
Whether it is called a “preferred return” or a “priority profit allocation,” the key point is that we are talking about a payment to a partner that
is based on a specific allocation of partnership net profit, and
is not based on the partner’s ownership percentage, and
comes before any allocation of partnership net profits based on ownership percentages.
Such payments will usually constitute ordinary income and will be subject to self-employment tax when received by an individual partner.
And such payments will effectively reduce the amount of partnership net income that remains to be allocated to the partners based on the standard allocation arrangement specified by the partnership agreement.
The QBI Deduction Factor
Here’s where it gets interesting. For 2018-2025, you as an individual partner can potentially deduct up to 20 percent of your share of a partnership’s qualified business income (QBI), subject to limitations based on your income level and the type of business.
Guaranteed payments don’t count as QBI. To add insult to injury, a partnership’s deductions for guaranteed payments reduce the partnership’s QBI, which in turn can reduce allowable QBI deductions for you and the other partners. Ugh!
In contrast, a preferred return of partnership net income that constitutes a share of the partnership’s QBI counts as QBI, as long as the preferred return is a not a disguised payment for services rendered to the partnership.
Tax-saving strategy. To maximize QBI deductions for you and the other partners, consider replacing guaranteed payments that don’t count as QBI with preferred return payments that do count as QBI.
If you would like to examine the possibility of using the preferred return strategy in your partnership, please contact us.
We seem to be living in an age of natural disasters. Floods, fires, hurricanes, tornados, and other disasters often dominate the news.
If a disaster strikes you, the tax law may help.
You may qualify to deduct a tax code-defined disaster loss from your taxable income. The rules for personal losses are complex and far more restrictive than for business losses.
Only Casualty Losses Are Deductible
Damage to personal property caused by a disaster is deductible only if it qualifies as a casualty loss. A casualty is damage to, destruction of, or loss of property from events such as fires and floods that are sudden, unexpected, or unusual.
The disaster must result in physical damage to property, so economic losses due to the COVID-19 pandemic do not qualify as a casualty loss.
Many, but not all, casualty losses are covered by insurance. You can’t deduct such losses to the extent they are insured. Moreover, suppose you have insured yourself against the loss. In that case, you must file a timely insurance claim, even if that insurance claim will result in the cancellation of your policy or an increase in premiums.
Your casualty loss (not your deduction) is equal to the lesser of
the decrease in the property’s fair market value after the disaster, or
the property’s adjusted basis before the disaster (usually its cost).
Subtract any insurance or other reimbursement from the lesser of (1) or (2).
To find the decline in the property’s fair market value, you can use appraisal or repair costs.
Limits on Casualty Losses
Unfortunately, you can’t deduct all your casualty losses. From 2018 through 2025, you can only deduct personal casualty losses due to a federally declared disaster or to the extent you have casualty gains.
For example, a homeowner can claim a casualty loss if a wildfire (declared a federal disaster) destroys his home. But he gets no deduction if a faulty fireplace caused the fire and destroys his home (no federal disaster).
The law imposes major limits on your casualty-loss deduction. The general rule says that you may not deduct the first $100 and then deduct your loss only to the extent that it exceeds 10 percent of your adjusted gross income. Your final hurdle is that you then deduct the loss as an
itemized deduction. These rules significantly reduce or even eliminate many casualty loss deductions.
Fortunately, some casualty losses are not subject to these limits, including disaster losses sustained due to a federally declared major disaster from January 1, 2020, to February 25, 2021. Instead, losses from such disasters are subject to a $500 floor with no 10 percent adjusted gross income reduction. Under this rule, you deduct the loss whether or not you itemize. If you don’t itemize, you add the deductible loss to your standard deduction.
You have a choice for losses from a federal disaster: claim the loss in the year of the disaster or on the prior year’s return if it’s before October 15. This can result in a quick refund of all or part of the tax you paid that year.
If all this is not complicated enough, there’s one further wrinkle. A casualty such as a fire can result in a casualty gain instead of a casualty loss when the insurance proceeds you receive exceed the property’s adjusted basis (cost).
A casualty gain is taxable. But you may deduct casualty losses from the gains. Here, you don’t need a federal disaster.
Also, you can postpone tax on a casualty gain by buying replacement property.
If you have any questions or need my assistance, please contact us.
When you operate a business, you have a variety of tax breaks available.
The recently enacted Consolidated Appropriations Act extends and expands some of the breaks. We bring the following selection of them to your attention as a tax-strategy buffet.
You can deduct 100 percent of your dine-in and take-out business meals that are provided by restaurants in 2021 and 2022.
For hiring members of 10 targeted groups, you can obtain the work opportunity tax credit for first-year wages through 2025.
You can now qualify for the 39 percent new markets tax credit for investments through 2025.
The empowerment zone tax breaks that were scheduled to expire on December 31, 2020, are extended through 2025, but the new law terminates, for 2021 and later, both (a) the enhanced first-year depreciation rules and (b) the capital gains tax deferral break.
Employers may continue through 2025 making Section 127 education plan payments that cover student loan principal and interest up to the plan maximum of $5,250.
For residential rental property that you placed in service before 2018 and were depreciating over 40 years under the straight-line method, you can now use 30 years if you elect out of the Tax Cuts and Jobs Act business interest expense limitations.
Farmers may elect a two-year net operating loss carryback rather than the five-year carryback retroactively, as if this change were in the original CARES Act.
The $1.80 per-square-foot or $0.60 per-square-foot deductions for energy-efficient improvements to commercial buildings are now permanent.
Small Business Administration Economic Injury Disaster Loan advances and loan repayment assistance are not taxable, and you suffer no tax attribute reductions as a result of the tax-free monies.
Manufacturers of residential homes can claim a credit of $1,000 or $2,000 for homes that meet applicable energy-efficiency standards through 2021.
Your business can claim a business federal income tax credit for up to 30 percent of the cost of installing non-hydrogen alternative-fuel vehicle refueling equipment (say, for your employees’ electric vehicles) through 2021.
Your business can claim a federal income tax credit for buying vehicles propelled by chemically combining oxygen with hydrogen to create electricity, through 2021 (credits range from $4,000 to $40,000).
The new law extends the seven-year recovery period to cover motorsports entertainment complex property placed in service through 2025.
You can elect to claim the first-year write-off for the cost of qualified film, television, and theatrical productions commencing before 2025, subject to a $15 million per-production
limit or a $20 million limit for productions in certain disadvantaged areas.
For racehorses that are no more than two years old that you place in service during 2021, you may use three-year depreciation.
You do have to admire the opportunities that the tax law contains to help businesses. If you would like my help with any of the above, please don’t hesitate to contact us.
For 2018-2025, you (and estates and trusts) can use your qualified business income (QBI) to create the 20 percent deduction under Section 199A.
While federal income tax losses from business activities are usually beneficial, losses from pass-through business entities can have the adverse side effect of reducing allowable QBI deductions for pass-through business entity owners--such as you.
In this context, pass-through entities are defined as sole proprietorships, single-member (one owner) LLCs treated as sole proprietorships for federal income tax purposes, partnerships, multimember LLCs treated as partnerships for federal income tax purposes, and S corporations.
These entities can pass through business losses that you can deduct in the current year. But a pass-through of a loss could harm your QBI for the current year.
Or you may have to suspend the losses and carry them forward to future years. The suspended losses can also result in negative QBI in the year you deduct them.
Negative QBI from one source offsets positive QBI from other sources.
If you have overall negative QBI for the year, you must carry forward the negative amount to future years to offset positive QBI in those years. That can result in lower QBI deductions in carry-forward years.
The negative QBI issue is especially relevant now, since COVID-19 economic fallout will cause many pass-through business entities to pass through negative QBI amounts to their owners for 2020 and possibly for 2021 as well.
You also may have suspended pass-through business entity losses from prior years that are now deductible, such as suspended passive losses from rental real estate properties that have been sold. Suspended passive losses can also be “freed up” when you have passive income. Previously suspended losses can cause negative QBI in the year they become deductible.
If you own multiple businesses and/or rental properties, the Section 199A deduction can get complicated. If you would like my help sorting this out for you, please don’t hesitate to contact us.
The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) made many temporary changes in the tax law. The new Consolidated Appropriations Act (CAA) adjusted some of these and left others to die on December 31, 2020.
With all the changes that took place in 2020, I thought you would like to be informed of the following insights.
Borrow $100,000 from Your IRA and Pay It Back within Three Years with No Tax Consequences
Thanks to the CARES Act, IRA owners who were adversely affected by the COVID-19 pandemic were eligible to take tax-favored coronavirus-related distributions (CRDs) from their IRAs during 2020—but only during 2020.
You could take as much as $100,000. You can then recontribute a CRD back into your IRA within three years of the withdrawal date and treat the withdrawal and later recontribution as a federal-income-tax-free rollover.
In effect, the CRD drill allowed you to borrow up to $100,000 from your IRA(s) and then recontribute (repay) the amount(s) at any time up to three years later, with no federal income tax consequences when all is said and done. There are no limitations on what you can use CRD funds for during the three years.
Status report. The CAA does not extend the CRD deal beyond 2020, but it clarifies that similar tax rules can apply to IRA distributions taken by folks who are affected by specified future disasters.
Suspension of Retirement Account Required Minimum Distributions
In normal times, you must begin taking annual required minimum distributions (RMDs) from traditional IRAs and tax-deferred retirement plan accounts after you reach age 72 (or age 70 1/2 if you turned 70 1/2 before 2020). The CARES Act suspended RMDs for calendar year 2020 as a COVID-19 tax relief measure, but only for that one year.
Status report. So far, lawmakers have not extended this deal.
Small-Employer Tax Credits to Cover Required COVID-19-Related Employee Paid Leave
The Families First Coronavirus Response Act (FFCRA) granted a federal tax credit to small employers to cover mandatory payments to employees who take time off under the FFCRA’s COVID-19-related emergency sick-leave and family-leave provisions.
Specifically, a small employer could collect a tax credit equal to 100 percent of qualified emergency sick-leave and family-leave payments made by the employer pursuant to the FFCRA. But the credit under the FFCRA covers only leave payments made between April 1, 2020, and December 31, 2020. Equivalent tax credit relief was available to self-employed individuals who took qualified leave between those dates.
Status report. The FFCRA expired by its terms on December 31, 2020. But the COVID-Related Tax Relief Act of 2020 (contained within the CAA) extends the small-employer credit to cover leave payments made between January 1, 2021, and March 31, 2021, that fall within the FFCRA framework.
There is no requirement for small employers to provide emergency sick-leave or family-leave payments after December 31, 2020. But between January 1, 2021, and March 31, 2021, employers can choose to make voluntary leave payments that fall within the FFCRA framework and can collect the credit if they do so.
Equivalent tax credit relief is available to self-employed individuals who take qualified leave between January 1, 2021, and March 31, 2021.
Liberalized Business Net Operating Loss Deduction Rules
Business activities that generate tax losses can cause you or your business entity to have a net operating loss (NOL) for the year. The CARES Act significantly loosened the NOL deduction rules and allows a five-year carryback for NOLs that arose in tax years 2018-2020.
So, an NOL that arose in 2020 can be carried back to 2015. NOL carrybacks allow you to claim refunds for taxes paid in the carryback years. Because tax rates were higher in pre-2018 years, NOLs carried back to those years can result in hefty tax refunds.
Status report. The CAA does nothing for NOLs that arise in tax years beginning in 2021—you can carry them forward only.
Suspension of Excess Business Loss Disallowance Rule
Before the CARES Act relief, the Tax Cuts and Jobs Act (TCJA) disallowed so-called excess business losses incurred by individuals in tax years beginning in 2018-2025. The TCJA defined an excess business loss as a loss that exceeds $250,000, or $500,000 for a married joint-filing couple. The $250,000 and $500,000 limits are adjusted annually for inflation.
The CARES Act suspended the excess business loss disallowance rule for losses that arose in tax years beginning in 2018-2020.
Status report. The CAA does nothing for excess business losses that arise in tax years beginning in 2021. As things stand, you effectively treat a 2021 excess business loss as an NOL that you can carry forward to future years.
As always, I’m here to be of service to you. If you need my help on any of the above or other tax issues, please don’t hesitate to contact us.
Disasters such as storms, fires, floods, and hurricanes damage or destroy property.
If property such as an office building, rental property, business vehicle, or business furniture is damaged or destroyed in a disaster, your business may qualify for a casualty loss deduction.
It’s easier to deduct business casualty losses than personal losses, but the rules are complex.
What Casualty Losses Are Deductible
Disasters such as fires and floods can result in a “casualty” because the damage, destruction, or property loss is from a sudden, unexpected, or unusual event.
Car accidents qualify as a casualty so long as they’re not caused by your willful act or willful negligence. Losses due to thefts and vandalism can also qualify.
Insurance covers many casualty losses. You must reduce your casualty loss by the amount of any insurance you receive or expect to receive. But unlike a personal loss, you are not required to file an insurance claim for a business casualty loss. You may wish to not do so if it will result in your policy’s cancellation or an increase in premiums.
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Spencer Accounting Group, LLC does not provide investment, tax, legal, or retirement advice or recommendations in these blogs. The information presented here is not specific to any individual's personal circumstances.
Keana Spencer is an Accountant, Entrepreneur, and Educator to her clients, with a strong passion. Keana has over 10 years of experience and through her practice, she is a source of knowledge and strategies to her clients.