Turning stock downturns into tax advantages
Turning stock downturns into tax advantages
Have you ever invested in a company only to see its stock value plummet? (This may become relevant in light of recent market volatility.) While such an investment might be something you’d rather forget, there’s a silver lining: you can claim a capital loss deduction on your tax return. Here are the rules when a stock you own is sold at a loss or is entirely worthless.
How capital losses work
As capital assets, stocks produce capital gains or losses when they’re sold. Your capital gains and losses for the year must be netted against one another in a specific order based on whether they’re short-term (held one year or less) or long-term (held for more than one year).
If, after netting, you have short-term or long-term losses (or both), you can use them to offset up to $3,000 of ordinary income ($1,500 for married taxpayers filing separately). Any loss in excess of this limit is carried forward to later years until all of it is either offset against capital gains or deducted against ordinary income in those years, subject to the $3,000 limit. If you have both net short-term and net long-term losses, the net short-term losses are used to offset ordinary income before the net long-term losses.
If you’ve realized capital gains from stock or other asset sales during the year, consider selling some of your losing positions to offset the gains. A good tax strategy is to sell enough losing stock to shelter your earlier gains and generate a $3,000 loss since this is the maximum loss that can be used to offset ordinary income each year.
Implications of the wash sale rule
If you believe that a stock you own will recover but want to sell now to lock in a tax loss, be aware of the wash sale rule. Under it, if you sell stock at a loss and buy substantially identical stock within the 30-day period before or after the sale date, you can’t claim the loss for tax purposes. In order to claim the loss, 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.
When stock is worth nothing
In some cases, a stock you own may have become completely worthless. If so, you can claim a loss equal to your basis in the stock, which is generally what you paid for it. The stock is treated as though it had been sold on the last day of the tax year. This date is important because it affects whether your capital loss is short-term or long-term.
Stock shares become worthless when they have no liquidation value. That’s because the corporation’s liabilities exceed its assets and have no potential value and the business has no reasonable hope of becoming profitable. A stock can be worthless even if the corporation hasn’t declared bankruptcy. Conversely, a stock may still have value even after a bankruptcy filing, if the corporation continues operating and the stock continues trading.
You may not discover that a stock has become worthless until after you’ve filed your tax return for the year of worthlessness. In that case, you can amend your return for that year to claim a credit or refund due to the loss. You can do this for seven years from the date your original return was due, or two years from the date you paid the tax, whichever is later.
Maximize the tax benefits
As you can see, deducting stock losses or worthless stock on your tax return can be complex. Therefore, it’s important to maintain thorough documentation. We can help maximize the benefits. Keep in mind that other rules may apply. Let us know if you have any questions.
Weighing the pluses and minuses of HDHPs + HSAs for businesses
Weighing the pluses and minuses of HDHPs + HSAs for businesses
Will your company be ready to add a health insurance plan for next year, or change its current one? If so, now might be a good time to consider your options. These things take time.
A popular benefits model for many small to midsize businesses is sponsoring a high-deductible health plan (HDHP) accompanied by employee Health Savings Accounts (HSAs). Like any such strategy, however, this one has its pluses and minuses.
Ground rules
HSAs are participant-owned, tax-advantaged accounts that accumulate funds for eligible medical expenses. To own an HSA, participants must be enrolled in an HDHP, have no other health insurance and not qualify for Medicare.
In 2025, an HDHP is defined as a plan with at least a $1,650 deductible for self-only coverage or $3,300 for family coverage. Also in 2025, participants can contribute pretax income of up to $4,300 for self-only coverage or $8,550 for family coverage. (These amounts are inflation-adjusted annually, so they’ll likely change for 2026.) Those age 55 or older can make additional catch-up contributions of $1,000.
Companies may choose to make tax-deductible contributions to employees’ HSAs. However, the aforementioned limits still apply to combined participant and employer contributions.
Participants can make tax-free HSA withdrawals to cover qualified out-of-pocket medical expenses, such as physician and dentist visits. They may also use their account funds for copays and deductibles, though not to pay many types of insurance premiums.
Pluses to ponder
For businesses, the “HDHP + HSAs” model offers several pluses. First, HDHPs generally have lower premiums than other health insurance plans — making them more cost-effective. Plus, as mentioned, your contributions to participants’ HSAs are tax deductible if you choose to make them. And, overall, sponsoring health insurance can strengthen your fringe benefits package.
HSAs also have pluses for participants that can help you “sell” the model when rolling it out. These include:
- Participants can lower their taxable income by making pretax contributions through payroll deductions,
- HSAs can include an investment component that may include mutual funds, stocks and bonds,
- Account earnings accumulate tax-free,
- Withdrawals for qualified medical expenses aren’t subject to tax, and the list of eligible expenses is extensive,
- HSA funds roll over from year to year (unlike Flexible Spending Account funds), and
- HSAs are portable; participants maintain ownership and control of their accounts if they change jobs or even during retirement.
In fact, HSAs are sometimes referred to as “medical IRAs” because these potentially valuable accounts are helpful for retirement planning and have estate planning implications as well.
Minuses to mind
The HDHP + HSAs model has its minuses, too. Some employees may strongly object to the “high deductible” aspect of HDHPs.
Also, if not trained thoroughly, participants can misuse their accounts. Funds used for nonqualified expenses are subject to income taxes. Moreover, the IRS will add a 20% penalty if an account holder is younger than 65. After age 65, participants can withdraw funds for any reason without penalty, though withdrawals for nonqualified expenses will be taxed as ordinary income.
Expenses are another potential concern. HSA providers (typically banks and investment firms) may charge monthly maintenance fees, transaction fees and investment fees (for accounts with an investment component). Many companies cover these fees under their benefits package to enhance the appeal of HSAs to employees.
Finally, HSAs can have unexpected tax consequences for account beneficiaries. Generally, if a participant dies, account funds pass tax-free to a spouse beneficiary. However, for other types of beneficiaries, account funds will be considered income and immediately subject to taxation.
Powerful savings vehicle
The HDHP + HSAs model helps businesses manage insurance costs, shifts more of medical expense management to participants, and creates a powerful savings vehicle that may attract job candidates and retain employees. But that doesn’t mean it’s right for every company. Please contact us for help assessing its feasibility, as well as identifying the cost and tax impact.
6 essential tips for small business payroll tax compliance
6 essential tips for small business payroll tax compliance
Staying compliant with payroll tax laws is crucial for small businesses. Mistakes can lead to fines, strained employee relationships and even legal consequences. Below are six quick tips to help you stay on track.
1. Maintain organized records
Accurate recordkeeping is the backbone of payroll tax compliance. Track the hours worked, wages paid and all taxes withheld. Organizing your documentation makes it easier to verify that you’re withholding and remitting the correct amounts. If you ever face an IRS or state tax inquiry, having clear, detailed records will save time and reduce stress.
2. Understand federal withholding
- Federal income tax. Employees complete Form W-4 so you can determine how much federal income tax to withhold. The amounts can be calculated using IRS tax tables.
- FICA taxes (Social Security and Medicare). Your business is responsible for withholding a set percentage from each employee’s wages for Social Security and Medicare, and you must match that amount as an employer. The current tax rate for Social Security is 6.2% for the employer and 6.2% for the employee (12.4% total). Taxpayers only pay Social Security tax up to a wage base limit. For 2025, the wage base limit is $176,100. The current rate for Medicare tax is 1.45% for the employer and 1.45% for the employee (2.9% total). There’s no wage base limit for Medicare tax. All wages are subject to it.
3. Don’t overlook employer contributions
Depending on your state and industry, you may need to contribute additional taxes beyond those withheld from employee paychecks.
- Federal Unemployment Tax Act (FUTA) tax. Employers pay FUTA tax to fund unemployment benefits.
- State unemployment insurance. Requirements vary by state, so consult your state’s labor department for details. You can also find more resources at the U.S. Department of Labor.
4. Adhere to filing and deposit deadlines
- Deposit schedules. Your deposit frequency for federal taxes (monthly or semi-weekly) depends on the total amount of taxes withheld. Missing a deadline can lead to penalties and interest charges.
- Quarterly and annual filings. You must submit forms like the 941 (filed quarterly) and the 940 (filed annually for FUTA tax) on time, with any tax due.
Under the Trust Fund Recovery Penalty, a “responsible person” who willfully fails to withhold or deposit employment taxes can be held personally liable for a steep penalty. The penalty is equal to the full amount of the unpaid trust fund tax, plus interest. For this purpose, a responsible person can be an owner, officer, partner or employee with authority over the funds of the business.
5. Stay current with regulatory changes
Tax laws are never static. The IRS and state agencies update requirements frequently, and new legislation can introduce additional obligations. A proactive approach helps you adjust payroll systems or processes in anticipation of changes, rather than scrambling at the last minute.
6. Seek professional advice
No matter how meticulous your business is, payroll taxes can be complex. We can provide guidance specific to your industry and location. We can help you select the right payroll system, calculate employee tax withholding, navigate multi-state filing requirements and more. In short, we can help ensure that every aspect of your payroll is set up correctly.
Deduct a loss from making a personal loan to a relative or friend
Deduct a loss from making a personal loan to a relative or friend
Suppose your adult child or friend needs to borrow money. Maybe it’s to buy a first home or address a cash flow problem. You may want to help by making a personal loan. That’s a nice thought, but there are tax implications that you should understand and take into account.
Get it in writing
You want to be able to prove that you intended for the transaction to be a loan rather than an outright gift. That way, if the loan goes bad, you can claim a non-business bad debt deduction for the year the loan becomes worthless.
For federal income tax purposes, losses from personal loans are classified as short-term capital losses. You can use the losses to first offset short-term capital gains that would otherwise be taxed at high rates. Any remaining net short-term capital losses will offset any net long-term capital gains. After that, any remaining net capital losses can offset up to $3,000 of high-taxed ordinary income ($1,500 if you use married filing separate status).
To pass muster with the IRS, your loan should be evidenced by a written promissory note that includes:
- The interest rate, if any,
- A schedule showing dates and amounts for interest and principal payments, and
- The security or collateral, if any.
Set the interest rate
Applicable federal rates (AFRs) are the minimum short-term, mid-term and long-term rates that you can charge without creating any unwanted tax side effects. AFRs are set by the IRS, and they can potentially change every month.
For a term loan (meaning one with a specified final repayment date), the relevant AFR is the rate in effect for loans of that duration for the month you make the loan. Here are the AFRs for term loans made in April of 2025:
- For a loan with a term of three years or less, the AFR is 4.09%, assuming monthly compounding of interest.
- For a loan with a term of more than three years but not more than nine years, the AFR is 4.13%.
- For a loan with a term of more than nine years, the AFR is 4.52%.
Key point: These are lower than commercial loan rates, and the same AFR applies for the life of the loan.
For example, in April of 2025, you make a $300,000 loan with an eight-year term to your daughter so she can buy her first home. You charge an interest rate of exactly 4.13% with monthly compounding (the AFR for a mid-term loan made in April). This is a good deal for your daughter!
Interest rate and the AFR
The federal income tax results are straightforward if your loan charges an interest rate that equals or exceeds the AFR. You must report the interest income on your Form 1040. If the loan is used to buy a home, your borrower can potentially treat the interest as deductible qualified residence interest if you secure the loan with the home.
What if you make a below-market loan (one that charges an interest rate below the AFR)? The Internal Revenue Code treats you as making an imputed gift to the borrower. This imaginary gift equals the difference between the AFR interest you “should have” charged and the interest you charged, if any. The borrower is then deemed to pay these phantom dollars back to you as imputed interest income. You must report the imputed interest income on your Form 1040. A couple of loopholes can potentially get you out of this imputed interest trap. We can explain the details.
Plan in advance
As you can see, you can help a relative or friend by lending money and still protect yourself in case the personal loan goes bad. Just make sure to have written terms and charge an interest rate at least equal to the AFR. If you charge a lower rate, the tax implications are not so simple. If you have questions or want more information about this issue, contact us.
Business owners should get comfortable with their financial statements
Business owners should get comfortable with their financial statements
Financial statements can fascinate accountants, investors and lenders. However, for business owners, they may not be real page-turners.
The truth is each of the three parts of your financial statements is a valuable tool that can guide you toward reasonable, beneficial business decisions. For this reason, it’s important to get comfortable with their respective purposes.
The balance sheet
The primary purpose of the balance sheet is to tally your assets, liabilities and net worth, thereby creating a snapshot of your business’s financial health during the statement period.
Net worth (or owners’ equity) is particularly critical. It’s defined as the extent to which assets exceed liabilities. Because the balance sheet must balance, assets need to equal liabilities plus net worth. If the value of your company’s liabilities exceeds the value of its assets, net worth will be negative.
In terms of operations, just a couple of balance sheet ratios worth monitoring, among many, are:
Growth in accounts receivable compared with growth in sales. If outstanding receivables grow faster than the rate at which sales increase, customers may be taking longer to pay. They may be facing financial trouble or growing dissatisfied with your products or services.
Inventory growth vs. sales growth. If your business maintains inventory, watch it closely. When inventory levels increase faster than sales, the company produces or stocks products faster than they’re being sold. This can tie up cash. Moreover, the longer inventory remains unsold, the greater the likelihood it will become obsolete.
Growing companies often must invest in inventory and allow for increases in accounts receivable, so upswings in these areas don’t always signal problems. However, jumps in inventory or receivables should typically correlate with rising sales.
Income statement
The purpose of the income statement is to assess profitability, revenue generation and operational efficiency. It shows sales, expenses, and the income or profits earned after expenses during the statement period.
One term that’s commonly associated with the income statement is “gross profit,” or the income earned after subtracting cost of goods sold (COGS) from revenue. COGS includes the cost of labor and materials required to make a product or provide a service. Another important term is “net income,” which is the income remaining after all expenses — including taxes — have been paid.
The income statement can also reveal potential problems. It may show a decline in gross profits, which, among other things, could mean production expenses are rising more quickly than sales. It may also indicate excessive interest expenses, which could mean the business is carrying too much debt.
Statement of cash flows
The purpose of the statement of cash flows is to track all the sources (inflows) and recipients (outflows) of your company’s cash. For example, along with inflows from selling its products or services, your business may have inflows from borrowing money or selling stock. Meanwhile, it undoubtedly has outflows from paying expenses, and perhaps from repaying debt or investing in capital equipment.
Although the statement of cash flows may seem similar to the income statement, its focus is solely on cash. For instance, a product sale might appear on the income statement even though the customer won’t pay for it for another month. But the money from the sale won’t appear as a cash inflow until it’s collected.
By analyzing your statement of cash flows, you can assess your company’s ability to meet its short-term obligations and manage its liquidity. Perhaps most importantly, you can differentiate profit from cash flow. A business can be profitable on paper but still encounter cash flow issues that leave it unable to pay its bills or even continue operating.
Critical insights
You can probably find more exciting things to read than your financial statements. However, you won’t likely find anything more insightful regarding how your company is performing financially. We can help you not only generate best-in-class financial statements, but also glean the most valuable information from them.
Are you a tax-favored real estate professional?
Are you a tax-favored real estate professional?
For federal income tax purposes, the general rule is that rental real estate losses are passive activity losses (PALs). An individual taxpayer can generally deduct PALs only to the extent of passive income from other sources, if any. For example, if you have positive taxable income from other rental properties, that generally counts as passive income. You can use PALs to offset passive income from other sources, which amounts to being able to currently deduct them.
Unfortunately, many rental property owners have little or no passive income in most years. Excess rental real estate PALs for the year (PALs that you cannot currently deduct because you don’t have enough passive income) are suspended and carried forward to future years. You can deduct suspended PALs when you finally have enough passive income or when you sell the properties that generated the PALs.
Exception for professionals
Thankfully, there’s a big exception to the general rule that you must have positive passive income to currently deduct rental losses. If you qualify for the exception, a rental real estate loss can be classified as a non-passive loss that can usually be deducted currently.
This exception allows qualifying individual taxpayers to currently deduct rental losses even if they have no passive income. To be eligible for the real estate professional exception:
- You must spend more than 750 hours during the year delivering personal services in real estate activities in which you materially participate, and
- Those hours must be more than half the time you spend delivering personal services (in other words, working) during the year.
If you can clear these hurdles, you qualify as a real estate professional. The next step is determining if you have one or more rental properties in which you materially participate. If you do, losses from those properties are treated as non-passive losses that you can generally deduct in the current year. Here’s how to pass the three easiest material participation tests for a rental real estate activity:
- Spend more than 500 hours on the activity during the year.
- Spend more than 100 hours on the activity during the year and make sure no other individual spends more time than you.
- Make sure the time you spend on the activity during the year constitutes substantially all the time spent by all individuals.
If you don’t qualify
Obviously, not everyone can pass the tests to be a real estate professional. Thankfully, some other exceptions may potentially allow you to treat rental real estate losses as currently deductible non-passive losses. These include the:
Small landlord exception. If you qualify for this exception, you can treat up to $25,000 of rental real estate loses as non-passive. You must own at least 10% of the property generating the loss and actively participate with respect to that property. Properties owned via limited partnerships don’t qualify for this exception. To pass the active participation test, you don’t need to do anything more than exercise management control over the property in question. This could include approving tenants and leases or authorizing maintenance and repairs. Be aware that this exception is phased out between adjusted gross incomes (AGIs) of $100,000 and $150,000.
Seven-day average rental period exception. When the average rental period for a property is seven days or less, the activity is treated as a business activity. If you can pass one of the material participation tests, losses from the activity are non-passive.
30-day average rental period exception. The activity is treated as a business activity when the average rental period for a property is 30 days or less and significant personal services are provided to customers by or on behalf of you as the property owner. If you can pass one of the material participation tests, losses from the activity are non-passive.
Utilize all tax breaks
As you can see, various taxpayer-friendly rules apply to owners of rental real estate, including the exceptions to the PAL rules covered here. We can help you take advantage of all available rental real estate tax breaks.
Discover if you qualify for “head of household” tax filing status
Discover if you qualify for “head of household” tax filing status
When we prepare your tax return, we’ll check one of the following filing statuses: single, married filing jointly, married filing separately, head of household or qualifying widow(er). Only some people are eligible to file a return as a head of household. But if you’re one of them, it’s more favorable than filing as a single taxpayer.
To illustrate, the 2025 standard deduction for a single taxpayer is $15,000. However, it’s $22,500 for a head of household taxpayer. To be eligible, you must maintain a household that, for more than half the year, is the principal home of a “qualifying child” or other relative of yours whom you can claim as a dependent.
Tax law fundamentals
Who’s a qualifying child? This is one who:
- Lives in your home for more than half the year,
- Is your child, stepchild, adopted child, foster child, sibling, stepsibling (or a descendant of any of these),
- Is under age 19 (or a student under 24), and
- Doesn’t provide over half of his or her own support for the year.
If the parents are divorced, the child will qualify if he or she meets these tests for the custodial parent — even if that parent released his or her right to a dependency exemption for the child to the noncustodial parent.
Can both parents claim head of household status if they live together but aren’t married? According to the IRS, the answer is no. Only one parent can claim head of household status for a qualifying child. A person can’t be a “qualifying child” if he or she is married and can file a joint tax return with a spouse. Special “tie-breaker” rules apply if the individual can be a qualifying child of more than one taxpayer.
The IRS considers you to “maintain a household” if you live in the home for the tax year and pay over half the cost of running it. In measuring the cost, include house-related expenses incurred for the mutual benefit of household members, including property taxes, mortgage interest, rent, utilities, insurance on the property, repairs and upkeep, and food consumed in the home. Don’t include medical care, clothing, education, life insurance or transportation.
Providing your parent a home
Under a special rule, you can qualify as head of household if you maintain a home for your parent even if you don’t live with him or her. To qualify under this rule, you must be able to claim the parent as your dependent.
You can’t be married
You must be single to claim head of household status. Suppose you’re unmarried because you’re widowed. In that case, you can use the married filing jointly rates as a “surviving spouse” for two years after the year of your spouse’s death if your dependent child, stepchild, adopted child or foster child lives with you and you maintain the household. The joint rates are more favorable than the head of household rates.
If you’re married, you must file jointly or separately — not as head of household. However, if you’ve lived apart from your spouse for the last six months of the year and your dependent child, stepchild, adopted child, or foster child lives with you and you “maintain the household,” you’re treated as unmarried. If this is the case, you can qualify as head of household.
Contact us. We can answer questions about your situation.
Is your business on top of its tech stack?
Is your business on top of its tech stack?
Like many business owners, you’ve probably received a lot of technology advice. One term you may hear frequently is “tech stack.” Information technology (IT) folks love to throw this one around while sharing their bits and bytes of digital wisdom.
Well, they’re not wrong about its importance. Your tech stack is crucial to maintaining smooth operations, but it can be a major drain on cash flow if not managed carefully.
Everything you use
For the purpose of running a business, a tech stack can be defined as all the software and other digital tools used to support the company’s operations and IT infrastructure. It includes assets such as your:
- Accounting software,
- Customer relationship management platform,
- Project management tools,
- Cloud storage, and
- Communication apps.
Note: In a purely IT context, the term is widely defined as the set of technologies used to develop an application or website.
For businesses, a tech stack’s objective is to streamline workflows and promote productivity while maintaining strong cybersecurity. Unfortunately, as it grows, a tech stack can leave companies struggling with overspending, inefficiencies and employee apathy.
Case in point: For its 2025 State of Digital Adoption Report, software platform provider WalkMe surveyed nearly 4,000 enterprise leaders and employees worldwide. The data showed that about 43% of enterprise tech stacks are currently more complex than they were three years ago. Disturbingly, the report found the average large enterprise lost $104 million in 2024 because of underused technology, fragmented IT strategy and low employee adoption of tech tools.
Although these results focus on larger companies, small to midsize businesses face the same risks. Over time, companies often layer technologies upon technologies, sometimes introducing redundant or extraneous tools that are largely ignored.
5 factors to consider
Balancing functionality and innovation without overspending is the key to staying on top of your tech stack. Here are five factors to focus on:
1. Composition. Many business owners lose track of the many complex elements of their tech stacks. The best way to stay informed is to conduct regular IT audits. These are formal, systematic reviews of your IT infrastructure, which includes your tech stack. Audits often reveal redundant software subscriptions and underused or forgotten software licenses.
2. Integration/compatibility. When tech tools don’t play well together — or at all — data silos spring up and redundant work drags everyone down. This leads to more errors and less productivity. When managing your tech stack, choose solutions that integrate well across your operations. As feasible, replace those that don’t.
3. Price to value. Choosing IT tools primarily based on cost is risky. Although you should budget carefully, opting for cheaper solutions can ultimately increase technology expenses because of greater inefficiencies and the constant need to add tools to fill functionality gaps. Stay mindful of getting good value for the price and make choices that align with your strategic objectives.
4. Scalability. Generally, as a business grows, its technology needs expand and evolve. That doesn’t mean you always have to buy new software, however. Look for solutions that can scale up with growth or down during slower periods. Shop for assets that offer flexibility along with the right functionality.
5. Adoptability. Your company could have the most powerful software tool in existence, but if it sits unused, that item is just a wasted expense taking up space in your tech stack. Add new technology cautiously. Consult your leadership team, survey the employees who’ll be using it and ask for vendor references. When you do buy something, roll it out with an effective communication strategy and thorough training.
A technological tree
Like a tree, a tech stack can grow out of control and become a nuisance or even a danger to everyone around it. Properly pruned and otherwise well-maintained, however, it can be a powerful and functional business feature. Let us help you identify all your technology costs and assess the return on investment of every component of your tech stack.
Small business alert: Watch out for the 100% penalty
Small business alert: Watch out for the 100% penalty
Some tax sins are much worse than others. An example is failing to pay over federal income and employment taxes that have been withheld from employees’ paychecks. In this situation, the IRS can assess the trust fund recovery penalty, also called the 100% penalty, against any responsible person.
It’s called the 100% penalty because the entire unpaid federal income and payroll tax amounts can be assessed personally as a penalty against a responsible person, or several responsible persons.
Determining responsible person status
Since the 100% penalty can only be assessed against a so-called responsible person, who does that include? It could be a shareholder, director, officer or employee of a corporation; a partner or employee of a partnership; or a member (owner) or employee of an LLC. To be hit with the penalty, the individual must:
- Be responsible for collecting, accounting for, and paying over withheld federal income and payroll taxes, and
- Willfully fail to pay over those taxes.
Willful means intentional, deliberate, voluntary and knowing. The mere authority to sign checks when directed to do so by a person who is higher-up in a company doesn’t by itself establish responsible person status. There must also be knowledge of and control over the finances of the business. However, responsible person status can’t be deflected simply by assigning signature authority over bank accounts to another person in order to avoid exposure to the 100% penalty. As a practical matter, the IRS will look first and hard at individuals who have check-signing authority.
What courts examine
The courts have examined several factors beyond check-signing authority to determine responsible person status. These factors include whether the individual:
- Is an officer or director,
- Owns shares or possesses an entrepreneurial stake in the company,
- Is active in the management of day-to-day affairs of the company,
- Can hire and fire employees,
- Makes decisions regarding which, when and in what order outstanding debts or taxes will be paid, and
- Exercises daily control over bank accounts and disbursement records.
Real-life cases
The individuals who have been targets of the 100% penalty are sometimes surprising. Here are three real-life situations:
Case 1: The operators of an inn failed to pay over withheld taxes. The inn was an asset of an estate. The executor of the estate was found to be a responsible person.
Case 2: A volunteer member of a charitable organization’s board of trustees had knowledge of the organization’s tax delinquency. The individual also had authority to decide whether to pay the taxes. The IRS determined that the volunteer was a responsible person.
Case 3: A corporation’s newly hired CFO became aware that the company was several years behind in paying withheld federal income and payroll taxes. The CFO notified the company’s CEO of the situation. Then, the new CFO and the CEO informed the company’s board of directors of the problem. Although the company apparently had sufficient funds to pay the taxes in question, no payments were made. After the CFO and CEO were both fired, the IRS assessed the 100% penalty against both of them for withheld but unpaid taxes that accrued during their tenures. A federal appeals court upheld an earlier district court ruling that the two officers were responsible persons who acted willfully by paying other expenses instead of the withheld federal taxes. Therefore, they were both personally liable for the 100% penalty.
Don’t be tagged
If you participate in running a business or any entity that hasn’t paid over federal taxes that were withheld from employee paychecks, you run the risk of the IRS tagging you as a responsible person and assessing the 100% penalty. If this happens, you may ultimately be able to prove that you weren’t a responsible person. But that can be an expensive process. Consult your tax advisor about what records you should be keeping and other steps you should be taking to avoid exposure to the 100% penalty.
Businesses considering incorporation should beware of the reasonable compensation conundrum
Businesses considering incorporation should beware of the reasonable compensation conundrum
Small to midsize businesses have valid reasons for incorporating, not the least of which is putting that cool “Inc.” at the end of their names. Other reasons include separating owners’ personal assets from their business liabilities and offering stock options as an employee incentive.
If you’re considering incorporation for your company, however, it’s essential to be aware of the associated risks. One of them is the reasonable compensation conundrum.
How much is too much?
Let’s say you decide to convert your business to a C corporation. After completing the incorporation process, you can pay owners, executives and other highly compensated employees some combination of compensation and dividends.
More than likely, you’ll want to pay your highly compensated employees more in compensation and less in dividends because compensation is tax deductible and dividends aren’t. But be careful — the IRS may be watching. If it believes you’re excessively compensating a highly compensated employee for tax avoidance purposes, it may challenge your compensation approach.
Such challenges typically begin with an audit and may result in the IRS being allowed to reclassify compensation as dividends — with penalties and interest potentially tacked on. What’s worse, if the tax agency succeeds with its challenge, the difference between what you paid a highly compensated employee and what the tax agency considers a reasonable amount for the services rendered usually isn’t deductible.
Of course, you can contest an IRS challenge. However, doing so usually involves considerable legal expenses and time — and a positive outcome is far from guaranteed.
Note: S corporations are a different story. Under this entity type, income and losses usually “pass through” to business owners at the individual level and aren’t subject to payroll tax. Thus, S corporation owners usually prefer to receive distributions. As a result, the IRS may raise a reasonable compensation challenge when it believes a company’s owners receive too little salary.
What are the factors?
There’s no definitive bright-line test for determining reasonable compensation. However, over the years, courts have considered various factors, including:
- The nature, extent and scope of an employee’s work,
- The employee’s qualifications and experience,
- The size and complexity of the business,
- A comparison of salaries paid to the sales, gross income and net worth of the business,
- General economic conditions,
- The company’s financial status,
- The business’s salary policy for all employees,
- Salaries of similar positions at comparable companies, and
- Historical compensation of the position.
It’s also important to assess whether the business and employee are dealing at an “arm’s length,” and whether the employee has guaranteed the company’s debts.
Can you give me an example?
Just a few years ago, a case played out in the U.S. Tax Court illustrating the risks of an IRS challenge regarding reasonable compensation.
The owner of a construction business structured as a C corporation led his company through tough times and turned it into a profitable enterprise. When the business recorded large profits in 2015 and 2016, primarily because of the owner’s personal efforts and contacts, it paid him a bonus of $5 million each year in addition to his six-figure salary. The IRS claimed this was excessive.
The Tax Court relied heavily on expert witnesses to make its determination. Ultimately, it decided against the business, finding that reasonable amounts for the bonuses were $1.36 million in 2015 and $3.68 million in 2016, respectively. (TC Memo 2022-15)
Who can help?
As your business grows, incorporation may help your company guard against certain risks and achieve a greater sense of stature. However, there are tax complexities to consider. If you’re thinking about it, please contact us for help identifying the advantages and risks from both tax and strategic perspectives.