Employer-provided life insurance? Here are the tax consequences
Employer-provided life insurance is a coveted fringe benefit. However, if group term life insurance is part of your benefit package, and the coverage is higher than $50,000, there may be undesirable income tax implications.
Tax on income you don’t receive
The first $50,000 of group term life insurance coverage that your employer provides is excluded from taxable income and doesn’t add anything to your income tax bill. But the employer-paid cost of group term coverage in excess of $50,000 is taxable income to you. It’s included in the taxable wages reported on your Form W-2 — even though you never actually receive it. In other words, it’s “phantom income.”
What’s worse, the cost of group term insurance must be determined under a table prepared by the IRS even if the employer’s actual cost is less than the cost figured under the table. With these determinations, the amount of taxable phantom income attributed to an older employee is often higher than the premium the employee would pay for comparable coverage under an individual term policy. This tax trap gets worse as an employee gets older and as the amount of his or her compensation increases.
Your W-2 has answers
What should you do if you think the tax cost of employer-provided group term life insurance is higher than you’d like? First, you should establish if this is actually the case. If a specific dollar amount appears in Box 12 of your Form W-2 (with code “C”), that dollar amount represents your employer’s cost of providing you with group term life insurance coverage in excess of $50,000, less any amount you paid for the coverage. You’re responsible for federal, state and local taxes on the amount that appears in Box 12 and for the associated Social Security and Medicare taxes as well.
But keep in mind that the amount in Box 12 is already included as part of your total “Wages, tips and other compensation” in Box 1 of the W-2, and it’s the Box 1 amount that’s reported on your tax return
Possible options
If you decide that the tax cost is too high for the benefit you’re getting in return, find out whether your employer has a “carve-out” plan (a plan that carves out selected employees from group term coverage) or, if not, whether it would be willing to create one. There are different types of carve-out plans that employers can offer to their employees.
For example, the employer can continue to provide $50,000 of group term insurance (since there’s no tax cost for the first $50,000 of coverage). Then, the employer can either provide the employee with an individual policy for the balance of the coverage, or give the employee the amount the employer would have spent for the excess coverage as a cash bonus that the employee can use to pay the premiums on an individual policy.
Contact Dukhon if you have questions about group term coverage or whether it’s adding to your tax bill.
Getting a divorce? Be aware of tax implications if you own a business
If you’re a business owner and you’re getting a divorce, tax issues can complicate matters. 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.
Tax-free property transfers
You can generally 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).
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 periods 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.
More tax issues
Later on, 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 that 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.
Plan ahead to avoid surprises
Like many major life events, divorce can have major 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. We can help you minimize the adverse tax consequences of settling your divorce.
Scholarships are usually tax free but they may result in taxable income
If your child is fortunate enough to be awarded a scholarship, you may wonder about the tax implications. Fortunately, scholarships (and fellowships) are generally tax-free for students at the elementary, middle, and high schools, as well as those attending college, graduate school or accredited vocational schools. It doesn’t matter if the scholarship makes a direct payment to the individual or reduces tuition.
Requirements for tax-free treatment
However, scholarships are not always tax-free. Certain conditions must be satisfied. A scholarship is tax-free only to the extent it’s used to pay for:
- Tuition and fees are required to attend the school and
- Fees, books, supplies, and equipment are required of all students in a particular course.
For example, expenses that don’t qualify include the cost of room and board, travel, research, and clerical help.
To the extent a scholarship award isn’t used for qualifying items, it’s taxable. The recipient is responsible for establishing how much of an award is used to pay for tuition and eligible expenses. Maintain records (such as copies of bills, receipts, and canceled checks) that reflect the use of the scholarship money.
Payment for services doesn’t qualify
Subject to limited exceptions, a scholarship isn’t tax-free if the payments are linked to services that your child performs as a condition for receiving the award, even if the services are required of all degree candidates. Therefore, a stipend your child receives for required teaching, research, or other services is taxable, even if the child uses the money for tuition or related expenses.
What if you, or a family member, are an employee of an educational institution that provides reduced or free tuition? A reduction in tuition provided to you, your spouse, or your dependents by the school at which you work isn’t included in your income and isn’t subject to tax.
What is reported on a tax return?
If a scholarship is tax-free and your child has no other income, the award doesn’t have to be reported on a tax return. However, any portion of an award that’s taxable as payment for services is treated as wages. Estimated tax payments may have to be made if the payor doesn’t withhold enough tax. Your child should receive a Form W-2 showing the amount of these “wages” and the amount of tax withheld, and any portion of the award that’s taxable must be reported, even if no Form W-2 is received.
These are just the basic rules. Other rules and limitations may apply. For example, if your child’s scholarship is taxable, it may limit other higher education tax benefits to which you or your child are entitled. As we approach the new academic year, best wishes for your child’s success in school. Contact us if you’d like to discuss these or other tax matters further.
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Is an LLC the right choice for your small business?
Perhaps you operate your small business as a sole proprietorship and want to form a limited liability company (LLC) to protect your assets. Or maybe you are launching a new business and want to know your options for setting it up. Here are the basics of operating as an LLC and why it might be appropriate for your business.
An LLC is somewhat of a hybrid entity because it can be structured to resemble a corporation for owner liability purposes and a partnership for federal tax purposes. This duality may provide the owners with the best of both worlds.
Personal asset protection
Like the shareholders of a corporation, the owners of an LLC (called “members” rather than shareholders or partners) generally aren’t liable for the debts of the business except to the extent of their investment. Thus, the owners can operate the business with the security of knowing that their personal assets are protected from the entity’s creditors. This protection is far greater than that afforded by partnerships. In a partnership, the general partners are personally liable for the debts of the business. Even limited partners, if they actively participate in managing the business, can have personal liability.
Tax implications
The owners of an LLC can elect under the “check-the-box” rules to have the entity treated as a partnership for federal tax purposes. This can provide a number of important benefits to the owners. For example, partnership earnings aren’t subject to an entity-level tax. Instead, they “flow through” to the owners, in proportion to the owners’ respective interests in profits, and are reported on the owners’ individual returns and are taxed only once.
To the extent the income passed through to you is qualified business income, you’ll be eligible to take the Code Section 199A pass-through deduction, subject to various limitations. In addition, since you’re actively managing the business, you can deduct on your individual tax return your ratable shares of any losses the business generates. This, in effect, allows you to shelter other income that you and your spouse may have.
An LLC that’s taxable as a partnership can provide special allocations of tax benefits to specific partners. This can be an important reason for using an LLC over an S corporation (a form of business that provides tax treatment that’s similar to a partnership). Another reason for using an LLC over an S corporation is that LLCs aren’t subject to the restrictions the federal tax code imposes on S corporations regarding the number of owners and the types of ownership interests that may be issued.
Review your situation
In summary, an LLC can give you corporate-like protection from creditors while providing the benefits of taxation as a partnership. For these reasons, you should consider operating your business as an LLC. Contact us to discuss in more detail how an LLC might benefit you and the other owners.
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Can taxpayers who manage their own investment portfolios deduct related expenses? It depends
Do you have significant investment-related expenses, including the cost of subscriptions to financial services, home office expenses, and clerical costs? Under current tax law, these expenses aren’t deductible through 2025 if they’re considered investment expenses for the production of income. But they’re deductible if they’re considered trade or business expenses.
For years before 2018, production-of-income expenses were deductible, but they were included in miscellaneous itemized deductions, subject to a 2%-of-adjusted-gross-income floor. (These rules are scheduled to return after 2025.) If you do a significant amount of trading, you should know which category your investment expenses fall into because qualifying for trade or business expense treatment is more advantageous now.
To deduct your investment-related expenses as business expenses, you must be engaged in a trade or business. The U.S. Supreme Court held many years ago that an individual taxpayer isn’t engaged in a trade or business merely because the individual manages their own securities investments — regardless of the amount or the extent of the work required.
A trader vs. an investor
However, if you can show that your investment activities rise to the level of carrying on a trade or business, you may be considered a trader, who is engaged in a trade or business, rather than an investor who isn’t. As a trader, you’re entitled to deduct your investment-related expenses as business expenses. A trader is also entitled to deduct home office expenses if the home office is used exclusively regularly as the trader’s principal place of business. On the other hand, an investor isn’t entitled to home office deductions since the investment activities aren’t traded or business.
Since the Supreme Court decision, there has been extensive litigation on whether a taxpayer is a trader or investor. The U.S. Tax Court has developed a two-part test that must satisfy a taxpayer to be a trader. Under this test, a taxpayer’s investment activities are considered a trade or business only where both of the following are true:
- The taxpayer’s trading is substantial (in other words, sporadic trading isn’t considered a trade or business), and
- The taxpayer seeks to profit from short-term market swings rather than from long-term holding of investments.
Profit in the short term
So, the fact that a taxpayer’s investment activities are regular, extensive, and continuous isn’t in itself sufficient for determining that a taxpayer is a trader. To be considered a trader, you must show that you buy and sell securities with reasonable frequency to profit on a short-term basis. In one case, a taxpayer who made more than 1,000 trades a year with trading activities averaging about $16 million annually was held to be an investor rather than a trader because the holding periods for stocks sold averaged about one year.
Contact us if you have questions or would like to figure out whether you’re an investor or a trader for tax purposes.
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Don’t assume your profitable company has strong cash flow
Most of us are taught from a young age never to assume anything. Why? Well, when you assume you make an … you probably know how the rest of the expression goes.
Many business owners make a dangerous assumption that if their companies are profitable, their cash flow must also be strong. But this isn’t always the case. Taking a closer look at the accounting involved can explain.
Investing in the business
What are profits, really? In accounting terms, they’re closely related to taxable income. Reported at the bottom of your company’s income statement, profits are essentially the result of revenue less the cost of goods sold and other operating expenses incurred in the accounting period.
Generally Accepted Accounting Principles (GAAP) require companies to “match” costs and expenses to the period in which revenue is recognized. Under accrual-basis accounting, it doesn’t necessarily matter when you receive payments from customers or pay expenses.
For example, inventory sitting in a warehouse or retail store can’t be deducted — even though it may have been long paid for (or financed). The expense hits your income statement only when an item is sold or used. Your inventory account contains many cash outflows that are waiting to be expensed.
Other working capital accounts — such as accounts receivable, accrued expenses, and trade payables — also represent a difference between the timing of cash flows. As your business grows and strives to increase future sales, you invest more in working capital, which temporarily depletes cash.
However, the reverse also may be true. That is, a mature business may be a “cash cow” that generates ample dollars, despite reporting lackluster profits.
Accounting for expenses
The difference between profits and cash flow doesn’t begin and end with working capital. Your income statement also includes depreciation and amortization, which are non-cash expenses. And it excludes changes in fixed assets, bank financing, and owners’ capital accounts, which affect cash on hand.
Suppose your company uses tax depreciation schedules for book purposes. Let say, in 2020; you bought new equipment to take advantage of the expanded Section 179 and bonus depreciation allowances. Then you deducted the purchase price of these items from profits in 2020. However, because these purchases were financed with debt, the actual cash outflows from the investments in 2020 were minimal.
In 2021, your business will make loan payments to reduce the amount of cash in your checking account. But your profits will be hit with only the interest expense (not the amount of principal that’s being repaid). Plus, there will be no “basis” left in the 2020 purchases to depreciate in 2021. These circumstances will artificially boost profits in 2021 without a proportionate increase in cash.
Keeping your eye on the ball
It’s dangerous to assume that your cash position is strong—cash flow warrants careful monitoring just because you're turning a profit. Our firm can help you generate accurate financial statements and glean the most important insights from them.
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Tax-favored ways to build up a college fund
If you’re a parent with a college-bound child, you may be concerned about being able to fund future tuition and other higher education costs. You want to take maximum advantage of tax benefits to minimize your expenses. Here are some possible options.
Savings bonds
Series EE U.S. savings bonds offer two tax-saving opportunities for eligible families when used to finance college:
- You don’t have to report the interest on the bonds for federal tax purposes until the bonds are cashed in, and
- Interest on “qualified” Series EE (and Series I) bonds may be exempt from federal tax if the bond proceeds are used for qualified education expenses.
To qualify for the tax exemption for college use, you must purchase the bonds in your name (not the child’s) or jointly with your spouse. The proceeds must be used for tuition, fees, and certain other expenses — not room and board. If only part of the proceeds is used for qualified expenses, only that part of the interest is exempt.
The exemption is phased out if your adjusted gross income (AGI) exceeds certain amounts.
529 plans
A qualified tuition program (also known as a 529 plan) allows you to buy tuition credits for a child or make contributions to an account set up to meet a child’s future higher education expenses. State governments or private education institutions establish qualified tuition programs.
Contributions aren’t deductible. The contributions are treated as taxable gifts to the child, but they’re eligible for the annual gift tax exclusion ($15,000 for 2021). A donor who contributes more than the annual exclusion limit for the year can elect to treat the gift as if it were spread out over a five-year period.
The earnings on the contributions accumulate tax-free until college costs are paid from the funds. Distributions from 529 plans are tax-free to the extent the funds are used to pay “qualified higher education expenses.” Distributions of earnings that aren’t used for qualified expenses will be subject to income tax plus a 10% penalty tax.
Coverdell education savings accounts (ESAs)
You can establish a Coverdell ESA and contribute up to $2,000 annually for each child under age 18.
The right to make contributions begins to phase out once your AGI is over a certain amount. If the income limitation is a problem, a child can contribute to his or her own account.
Although the contributions aren’t deductible, income in the account isn’t taxed, and distributions are tax-free if used on qualified education expenses. If the child doesn’t attend college, the money must be withdrawn when he or she turns 30, and any earnings will be subject to tax and penalty. But unused funds can be transferred tax-free to a Coverdell ESA of another member of the child’s family who hasn’t reached age 30. (Some ESA requirements don’t apply to individuals with special needs.)
Plan ahead
These are just some of the tax-favored ways to build up a college fund for your children. Once your child is in college, you may qualify for tax breaks such as the American Opportunity Tax Credit or the Lifetime Learning Credit. Contact us if you’d like to discuss any of the options.
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2021 Q3 tax calendar: Key deadlines for businesses and other employers
Here are some key tax-related deadlines affecting businesses and other employers during the third quarter of 2021. Keep in mind that this list isn’t all-inclusive, so that additional deadlines may apply to you. Contact us to ensure you’re meeting all applicable deadlines and to learn more about the filing requirements.
Monday, August 2
- Employers report income tax withholding and FICA taxes for the second quarter of 2021 (Form 941) and pay any tax due.
- Employers file a 2020 calendar-year retirement plan report (Form 5500 or Form 5500-EZ) or request an extension.
Tuesday, August 10
- Employers report income tax withholding and FICA taxes for the second quarter of 2021 (Form 941) if you deposited all associated taxes that were due in full and on time.
Wednesday, September 15
- Individuals pay the third installment of 2021 estimated taxes if not paying income tax through withholding (Form 1040-ES).
- If a calendar-year corporation, pay the third installment of 2021 estimated income taxes.
- If a calendar-year S corporation or partnership that filed an automatic extension:
- File a 2020 income tax return (Form the 1120S, Form 1065, or Form 1065-B) and pay any tax, interest, and penalties due.
- Make contributions for 2020 to certain employer-sponsored retirement plans.
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Still have questions after you file your tax return?
Still have questions after you file your tax return?
Even after your 2020 tax return has been successfully filed with the IRS, you may still have some questions about the return. Here are brief answers to three questions that we’re frequently asked at this time of year.
Are you wondering when you will receive your refund?
The IRS has an online tool that can tell you the status of your refund. Go to irs.gov and click on “Get Your Refund Status.” You’ll need your Social Security number, filing status and the exact refund amount.
Which tax records can you throw away now?
At a minimum, keep tax records related to your return for as long as the IRS can audit your return or assess additional taxes. In general, the statute of limitations is three years after you file your return. So you can generally get rid of most records related to tax returns for 2017 and earlier years. (If you filed an extension for your 2017 return, hold on to your records until at least three years from when you filed the extended return.)
However, the statute of limitations extends to six years for taxpayers who understate their gross income by more than 25%.
You should hang on to certain tax-related records longer. For example, keep the actual tax returns indefinitely, so you can prove to the IRS that you filed legitimate returns. (There’s no statute of limitations for an audit if you didn’t file a return or you filed a fraudulent one.)
When it comes to retirement accounts, keep records associated with them until you’ve depleted the account and reported the last withdrawal on your tax return, plus three (or six) years. And retain records related to real estate or investments for as long as you own the asset, plus at least three years after you sell it and report the sale on your tax return. (You can keep these records for six years if you want to be extra safe.)
If you overlooked claiming a tax break, can you still collect a refund for it?
In general, you can file an amended tax return and claim a refund within three years after the date you filed your original return or within two years of the date you paid the tax, whichever is later.
However, there are a few opportunities when you have longer to file an amended return. For example, the statute of limitations for bad debts is longer than the usual three-year time limit for most items on your tax return. In general, you can amend your tax return to claim a bad debt for seven years from the due date of the tax return for the year that the debt became worthless.
Year-round tax help
Contact us if you have questions about retaining tax records, receiving your refund or filing an amended return. We’re not just here at tax filing time. We’re available all year long.
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Launching a small business? Here are some tax considerations
While many businesses have been forced to close due to the COVID-19 pandemic, some entrepreneurs have started new small businesses. Many of these people start out operating as sole proprietors. Here are some tax rules and considerations involved in operating with that entity.
The pass-through deduction
To the extent your business generates qualified business income (QBI), you’re eligible to claim the pass-through or QBI deduction, subject to limitations. For tax years through 2025, the deduction can be up to 20% of a pass-through entity owner’s QBI. You can take the deduction even if you don’t itemize deductions on your tax return and instead claim the standard deduction.
Reporting responsibilities
As a sole proprietor, you’ll file Schedule C with your Form 1040. Your business expenses are deductible against gross income. If you have losses, they’ll generally be deductible against your other income, subject to special rules related to hobby losses, passive activity losses and losses in activities in which you weren’t “at risk.”
If you hire employees, you need to get a taxpayer identification number and withhold and pay employment taxes.
Self-employment taxes
For 2021, you pay Social Security on your net self-employment earnings up to $142,800, and Medicare tax on all earnings. An additional 0.9% Medicare tax is imposed on self-employment income in excess of $250,000 on joint returns; $125,000 for married taxpayers filing separate returns; and $200,000 in all other cases. Self-employment tax is imposed in addition to income tax, but you can deduct half of your self-employment tax as an adjustment to income.
Quarterly estimated payments
As a sole proprietor, you generally have to make estimated tax payments. For 2021, these are due on April 15, June 15, September 15 and January 17, 2022.
Home office deductions
If you work from a home office, perform management or administrative tasks there, or store product samples or inventory at home, you may be entitled to deduct an allocable portion of some costs of maintaining your home.
Health insurance expenses
You can deduct 100% of your health insurance costs as a business expense. This means your deduction for medical care insurance won’t be subject to the rule that limits medical expense deductions.
Keeping records
Retain complete records of your income and expenses so you can claim all the tax breaks to which you’re entitled. Certain expenses, such as automobile, travel, meals, and office-at-home expenses, require special attention because they’re subject to special recordkeeping rules or deductibility limits.
Saving for retirement
Consider establishing a qualified retirement plan. The advantage is that amounts contributed to the plan are deductible at the time of the contribution and aren’t taken into income until they’re withdrawn. A SEP plan requires less paperwork than many qualified plans. A SIMPLE plan is also available to sole proprietors and offers tax advantages with fewer restrictions and administrative requirements. If you don’t establish a retirement plan, you may still be able to contribute to an IRA.
We can help
Contact us if you want additional information about the tax aspects of your new business, or if you have questions about reporting or recordkeeping requirements