Why do partners sometimes report more income on tax returns than they receive in cash?

If you’re a partner in a business, you may have come across a
situation that gave you pause. In a given year, you may be taxed on more
partnership income than was distributed to you from the partnership in which
you’re a partner.

Why is this? The answer lies in the way partnerships and
partners are taxed. Unlike regular corporations, partnerships aren’t subject to
income tax. Instead, each partner is taxed on the partnership’s earnings —
whether or not they’re distributed. Similarly, if a partnership has a loss, the
loss is passed through to the partners. (However, various rules may prevent a
partner from currently using his share of a partnership’s loss to offset other

Separate entity

While a partnership isn’t subject to income tax, it’s treated as
a separate entity for purposes of determining its income, gains, losses,
deductions and credits. This makes it possible to pass through to partners
their share of these items.

A partnership must file an information return, which is IRS Form
1065. On Schedule K of Form 1065, the partnership separately identifies
income, deductions, credits and other items. This is so that each partner can
properly treat items that are subject to limits or other rules that could
affect their correct treatment at the partner’s level. Examples of such items
include capital gains and losses, interest expense on investment debts and
charitable contributions. Each partner gets a Schedule K-1 showing his or her
share of partnership items.

Basis and distribution rules ensure that partners aren’t taxed
twice. A partner’s initial basis in his partnership interest (the determination
of which varies depending on how the interest was acquired) is increased by his
share of partnership taxable income. When that income is paid out to partners
in cash, they aren’t taxed on the cash if they have sufficient basis. Instead,
partners just reduce their basis by the amount of the distribution. If a cash
distribution exceeds a partner’s basis, then the excess is taxed to the partner
as a gain, which often is a capital gain.

Here’s an example

Two individuals each contribute $10,000 to form a partnership.
The partnership has $80,000 of taxable income in the first year, during which
it makes no cash distributions to the two partners. Each of them reports
$40,000 of taxable income from the partnership as shown on their K-1s. Each has
a starting basis of $10,000, which is increased by $40,000 to $50,000. In the
second year, the partnership breaks even (has zero taxable income) and
distributes $40,000 to each of the two partners. The cash distributed to them
is received tax-free. Each of them, however, must reduce the basis in his
partnership interest from $50,000 to $10,000.

Other rules and limitations

The example and details above are an overview and, therefore,
don’t cover all the rules. For example, many other events require basis
adjustments and there are a host of special rules covering noncash
distributions, distributions of securities, liquidating distributions and other

© 2020

Reopening concepts: What business owners should consider

A widely circulated article about the COVID-19 pandemic, written
by author Tomas Pueyo in March, described efforts to cope with the crisis as
“the hammer and the dance.” The hammer was the abrupt shutdown of most
businesses and institutions; the dance is the slow reopening of them —
figuratively tiptoeing out to see whether day-to-day life can return to some semblance
of normality without a dangerous uptick in infections.

Many business owners are now engaged in the dance. “Reopening” a
company, even if it was never completely closed, involves grappling with a
variety of concepts. This is a new kind of strategic planning that will test
your patience and savvy but may also lead to a safer, leaner and
better-informed business.

When to move forward

The first question, of course, is when. That is, what are the
circumstances and criteria that will determine when you can safely reopen or
further reopen your business. Most experts agree that you should base this
decision on scientific data and official guidance from agencies such as the
U.S. Department of Health and Human Services and Centers for Disease Control
and Prevention (CDC).

But don’t stop there. Although the pandemic is, by definition, a
worldwide issue, the specific situation on the ground in your locality should
drive your decision-making. Keep tabs on state, county and municipal news,
rules and guidance. Plug into your industry’s experts as well. Establish
strategies for expanding operations or, if necessary, contracting them, based
on the latest information.

Testing and working safely

Running a company in today’s environment entails refocusing on
people. If employees are unsafe, your business will likely suffer at some point
soon. Every company that must or chooses to have workers on-site (as opposed to
working remotely) needs to consider the concept of COVID-19 testing.

Employers are generally allowed to test employees, but there are
dangers in violating privacy laws or inadvertently exposing the company to
discrimination claims. The CDC has said that routine testing will likely pass
muster “if these goals are consistent with employer-based occupational medical
surveillance programs” and “have a reasonable likelihood of benefitting
workers.” Consult your attorney, however, before implementing any testing

There’s also the matter of working safely. If you haven’t
already, look closely at the layout of your offices or facilities to determine
the feasibility of social distancing. Re-evaluate sanitation procedures and
ventilation infrastructure, too. You may need to invest, or continue investing,
in additional personal protective equipment and items such as plastic screens
to separate workers from customers or each other. It might also be necessary or
advisable to procure or upgrade the technology that enables employees to work

Move forward cautiously

No one wanted to do this dance, but business owners must
continue moving forward as cautiously and prudently as possible. While you do
so, don’t overlook the opportunity to identify long-term strategies to run your
company more efficiently and profitably. We can help you make well-informed
decisions based on sound financial analyses and realistic projections.

© 2020

Conduct a “paycheck checkup” to make sure your withholding is adequate

Did you recently file your federal tax return and were surprised
to find you owed money? You might want to change your withholding so that this
doesn’t happen next year. You might even want to do that if you got a big
refund. Receiving a tax refund essentially means you’re giving the government
an interest-free loan.

Withholding changes

In 2018, the IRS updated the withholding tables that indicate
how much employers should hold back from their employees’ paychecks. In
general, the amount withheld was reduced. This was done to reflect changes
under the Tax Cuts and Jobs Act — including an increase in the standard
deduction, suspension of personal exemptions and changes in tax rates.

The tables may have provided the correct amount of tax
withholding for some individuals, but they might have caused other taxpayers to
not have enough money withheld to pay their ultimate tax liabilities.

Review and possibly adjust

The IRS is advising taxpayers to review their tax situations for
this year and adjust withholding, if appropriate.

The tax agency has a withholding calculator to assist you in
conducting a paycheck checkup. The calculator reflects tax law changes in areas
such as available itemized deductions, the increased child credit, the new
dependent credit and the repeal of dependent exemptions. You can access the IRS
calculator here: https://bit.ly/2OqnUod.

Changes may be needed if…

There are some situations when you should check your
withholding. In addition to tax law changes, the IRS recommends that you
perform a checkup if you:

  • Adjusted your withholding in 2019, especially in the
    middle or later part of the year,
  • Owed additional tax when you filed your 2019 return,
  • Received a refund that was smaller or larger than
  • Got married or divorced, had a child or adopted one,
  • Purchased a home, or
  • Had changes in income.

You can modify your withholding at any time during the year, or
even multiple times within a year. To do so, you simply submit a new Form W-4
to your employer. Changes typically go into effect several weeks after a new
Form W-4 is submitted. (For estimated tax payments, you can make adjustments
each time quarterly estimated payments are due. The next payments are due on
July 15 and September 15.)

Good time to plan ahead

There’s still time to remedy any shortfalls to minimize taxes
due for 2020, as well as any penalties and interest. Contact us if you have any
questions or need assistance. We can help you determine if you need to adjust
your withholding.

© 2020

Steer clear of the Trust Fund Recovery Penalty

If you own or manage a business with employees, you may be at
risk for a severe tax penalty. It’s called the “Trust Fund Recovery Penalty”
because it applies to the Social Security and income taxes required to be
withheld by a business from its employees’ wages.

Because the taxes are considered property of the government, the
employer holds them in “trust” on the government’s behalf until they’re paid
over. The penalty is also sometimes called the “100% penalty” because the
person liable and responsible for the taxes will be penalized 100% of the taxes
due. Accordingly, the amounts IRS seeks when the penalty is applied are usually
substantial, and IRS is very aggressive in enforcing the penalty.

Far-reaching penalty

The Trust Fund Recovery Penalty is among the more dangerous tax
penalties 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 so you can
safely stay clear of it.

Which actions are penalized? The Trust
Fund Recovery Penalty applies to any willful failure to collect, or truthfully
account for, and pay over Social Security and income taxes required to be
withheld from employees’ wages.

Who is at risk? The
penalty can be imposed on anyone “responsible” for collection and payment of
the tax. This has been broadly defined to include a corporation’s officers,
directors and shareholders under a duty to collect and pay the tax as well as a
partnership’s partners, or any employee of the business with such a duty. Even
voluntary board members of tax-exempt organizations, who are generally excepted
from responsibility, can be subject to this penalty under certain
circumstances. In addition, in some cases, responsibility has been extended to
family members close to the business, and to attorneys and accountants.

IRS says responsibility is a matter of status, duty and
authority. Anyone with the power to see that the 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. Although a taxpayer held liable can
sue other responsible people for contribution, this is an action he or she must
take entirely on his or her own after he or she pays the penalty. It isn’t part
of the IRS collection process.

Here’s how broadly the net can be cast: You may not be directly
involved with the payroll tax withholding process in your business. But if you
learn of a failure to pay over withheld taxes and have the power to pay them
but instead make payments to creditors and others, you become a responsible

What’s considered “willful?” For
actions to be willful, they don’t have to include an overt intent to evade
taxes. Simply bending to business pressures and paying bills or obtaining supplies
instead of paying over withheld taxes that are due the government is willful
behavior. And just because you delegate responsibilities to someone else
doesn’t necessarily mean you’re off the hook. Your failure to take care of the
job yourself can be treated as the willful element.

Avoiding the penalty

You should never allow any failure to withhold and any
“borrowing” from withheld amounts — regardless of the circumstances. All funds
withheld must also be paid over to the government. Contact us for information
about the penalty and making tax payments.

© 2020

PPP Flexibility Act eases rules for borrowers coping with COVID-19

As you may recall, the Small Business Administration (SBA)
launched the Paycheck Protection Program (PPP) back in April to help companies
reeling from the economic impact of the COVID-19 pandemic. Created under a
provision of the Coronavirus Aid, Relief and Economic Security (CARES) Act, the
PPP is available to U.S. businesses with fewer than 500 employees.

In its initial incarnation, the PPP offered eligible
participants loans determined by eight weeks of previously established average
payroll. If the recipient maintained its workforce, up to 100% of the loan was
forgivable if the loan proceeds were used to cover payroll expenses, certain
employee health care benefits, mortgage interest, rent, utilities and interest
on any other existing debt during the “covered period” — that is, for eight
weeks after loan origination.

On June 5, the president signed into law the PPP Flexibility
Act. The new law makes a variety of important adjustments that ease the rules
for borrowers. Highlights include:

Extension of covered period. As
mentioned, under the CARES Act and subsequent guidance, the covered period
originally ran for eight weeks after loan origination. The PPP Flexibility Act
extends this period to the earlier of 24 weeks after the origination date or
December 31, 2020.

Adjustment of nonpayroll cost threshold. Previous
regulations issued by the U.S. Treasury Department indicated that eligible
nonpayroll costs couldn’t exceed 25% of the total forgiveness amount for a
borrower to qualify for 100% forgiveness. The PPP Flexibility Act raises this
threshold to 40%. (At least 60% of the loan must still be spent on payroll

Lengthening of period to reestablish
Under the original PPP, borrowers faced a June 30, 2020
deadline to restore full-time employment and salary levels from reductions made
between February 15, 2020, and April 26, 2020. Failure to do so would mean a
reduction in the forgivable amount. The PPP Flexibility Act extends this
deadline to December 31, 2020.

Reassurance of access to payroll tax
The new law reassures borrowers that delayed payment of
employer payroll taxes, which is offered under a provision of the CARES Act, is
still available to businesses that receive PPP loans. It won’t be considered
impermissible double dipping.

Important note: The SBA
has announced that, to ensure PPP loans are issued only to eligible borrowers,
all loans exceeding $2 million will be subject to an audit. The government
may still audit smaller PPP loans, if there is suspicion that funds were

This is just a “quick look” at some of the important aspects of
the PPP Flexibility Act. There are many other details involved that could
affect your company’s ability to qualify for a PPP loan or to achieve 100%
forgiveness. Also, new guidance is being issued regularly and further
legislation is possible. We can help you assess your eligibility and navigate
the loan application and forgiveness processes.

© 2020

If you’re selling your home, don’t forget about taxes

Traditionally, spring and summer are popular times for selling a
home. Unfortunately, the COVID-19 crisis has resulted in a slowdown in sales.
The National Association of Realtors (NAR) reports that existing home sales in
April decreased year-over-year, 17.2% from a year ago. One bit of good news is
that home prices are up. The median existing-home price in April was $286,800,
up 7.4% from April 2019, according to the NAR.

If you’re planning to sell your home this year, it’s a good time
to review the tax considerations.

Some gain is excluded

If you’re selling your principal
residence, and you meet certain requirements, you can exclude up to
$250,000 ($500,000 for joint filers) of gain. Gain that qualifies for the
exclusion is also excluded from the 3.8% net investment income tax.

To be eligible for the exclusion, you must meet these tests:

  • The ownership test. You must have owned the property for at least two years
    during the five-year period ending on the sale date.
  • The use test. You
    must have used the property as a principal residence for at least two
    years during the same five-year period. (Periods of ownership and use
    don’t need to overlap.)

In addition, you can’t use the exclusion more than once every
two years.

Larger gains

What if you have more than $250,000/$500,000 of profit when
selling your home? Any gain that doesn’t qualify for the exclusion generally
will be taxed at your long-term capital gains rate, provided you owned the home
for at least a year. If you didn’t, the gain will be considered short term and
subject to your ordinary-income rate, which could be more than double your
long-term rate.

Here are two other tax considerations when selling a home:

  1. Keep track of your basis. To support an accurate tax basis, be sure to maintain
    complete records, including information on your original cost and
    subsequent improvements, reduced by any casualty losses and depreciation
    claimed based on business use.
  2. Be aware that you can’t deduct a loss. If you sell your principal residence at a loss, it
    generally isn’t deductible. But if a portion of your home is rented out or
    used exclusively for your business, the loss attributable to that part may
    be deductible.

If you’re selling a second
home (for example, a beach house), it won’t be eligible for the gain exclusion.
But if it qualifies as a rental property, it can be considered a business
asset, and you may be able to defer tax on any gains through an installment
sale or a Section 1031 like-kind exchange. In addition, you may be able to
deduct a loss.

For many people, their homes are their most valuable asset. So
before selling yours, make sure you understand the tax implications. We can
help you plan ahead to minimize taxes and answer any questions you have about
your home sale.

© 2020

Good records are the key to tax deductions and trouble-free IRS audits

If you operate a small business, or you’re starting a new one,
you probably know you need to keep records of your income and expenses. In
particular, you should carefully record your expenses in order to claim the
full amount of the tax deductions to which you’re entitled. And you want to
make sure you can defend the amounts reported on your tax returns if you’re
ever audited by the IRS or state tax agencies.

Certain types of expenses, such as automobile, travel, meals and
office-at-home expenses, require special attention because they’re subject to
special recordkeeping requirements or limitations on deductibility.

It’s interesting to note that there’s not one way to keep
business records. In its publication “Starting a Business and Keeping Records,”
the IRS states: “Except in a few cases, the law does not require any specific
kind of records. You can choose any recordkeeping system suited to your
business that clearly shows your income and expenses.”

That being said, many taxpayers don’t make the grade when it comes
to recordkeeping. Here are three court cases to illustrate some of the issues.

Case 1: Without records, the IRS can
reconstruct your income

If a taxpayer is audited and doesn’t have good records, the IRS
can perform a “bank-deposits analysis” to reconstruct income. It assumes that
all money deposited in accounts during a given period is taxable income. That’s
what happened in the case of the business owner of a coin shop and precious
metals business. The owner didn’t agree with the amount of income the IRS
attributed to him after it conducted a bank-deposits analysis.

But the U.S. Tax Court noted that if the taxpayer kept adequate
records, “he could have avoided the bank-deposits analysis altogether.” Because
he didn’t, the court found the bank analysis was appropriate and the owner
underreported his business income for the year. (TC Memo 2020-4)

Case 2: Expenses must be business related

In another case, an independent insurance agent’s claims for a
variety of business deductions were largely denied. The Tax Court found that he
had documentation in the form of cancelled checks and credit card statements
that showed expenses were paid. But there was no proof of a business purpose.

For example, he made utility payments for natural gas,
electricity, water and sewer, but the records didn’t show whether the services
were for his business or his home. (TC Memo 2020-25)

Case number 3: No records could mean no

In this case, married taxpayers were partners in a travel agency
and owners of a marketing company. The IRS denied their deductions involving
auto expenses, gifts, meals and travel because of insufficient documentation.
The couple produced no evidence about the business purpose of gifts they had
given. In addition, their credit card statements and other information didn’t
detail the time, place, and business relationship for meal expenses or indicate
that travel was conducted for business purposes.

“The disallowed deductions in this case are directly
attributable to (the taxpayer’s) failure to maintain adequate records,“ the
court stated. (TC Memo 2020-7)

We can help

Contact us if you need assistance retaining adequate business
records. Taking a meticulous, proactive approach to how you keep records can
protect your deductions and help make an audit much less painful.

© 2020

A nonworking spouse can still have an IRA

It’s often difficult for married couples to save as much as they
need for retirement when one spouse doesn’t work outside the home — perhaps so
that spouse can take care of children or elderly parents. In general, an IRA
contribution is allowed only if a taxpayer has compensation. However, an exception
involves a “spousal” IRA. It allows a contribution to be made for a nonworking

Under the spousal IRA rules, the amount that a married couple
can contribute to an IRA for a nonworking spouse in 2020 is $6,000, which is
the same limit that applies for the working spouse.

Two main benefits

As you may be aware, IRAs offer two types of benefits for
taxpayers who make contributions to them.

  1. Contributions of up to $6,000 a year to an IRA may be
    tax deductible.
  2. The earnings on funds within the IRA are not taxed
    until withdrawn. (Alternatively, you may make contributions to a Roth IRA.
    There’s no deduction for Roth IRA contributions, but, if certain requirements
    are met, distributions are tax-free.)

As long as the couple together has at least $12,000 of earned
income, $6,000 can be contributed to an IRA for each, for a total of $12,000.
(The contributions for both spouses can be made to either a regular IRA or a
Roth IRA, or split between them, as long as the combined contributions don’t
exceed the $12,000 limit.)

Catching up

In addition, individuals who are age 50 or older can make
“catch-up” contributions to an IRA or Roth IRA in the amount of $1,000. Therefore,
in 2020, for a taxpayer and his or her spouse, both of whom will have reached
age 50 by the end of the year, the combined limit of the deductible
contributions to an IRA for each spouse is $7,000, for a combined deductible
limit of $14,000.

There’s one catch, however. If, in 2020, the working spouse is
an active participant in either of several types of retirement plans, a
deductible contribution of up to $6,000 (or $7,000 for a spouse who will be 50
by the end of the year) can be made to the IRA of the non-participant spouse
only if the couple’s AGI doesn’t exceed $104,000. This limit is phased out for
AGI between $196,000 and $206,000.

Contact us if you’d like more information about IRAs or you’d
like to discuss retirement planning.

© 2020

Student loan interest: Can you deduct it on your tax return?

The economic impact of the novel coronavirus (COVID-19) is
unprecedented and many taxpayers with student loans have been hard hit.

The Coronavirus Aid, Relief and Economic Security (CARES) Act
contains some assistance to borrowers with federal student loans. Notably,
federal loans were automatically placed in an administrative forbearance, which
allows borrowers to temporarily stop making monthly payments. This payment
suspension is scheduled to last until September 30, 2020.

Tax deduction rules

Despite the suspension, borrowers can still make payments if
they choose. And borrowers in good standing made payments earlier in the year
and will likely make them later in 2020. So can you deduct the student loan
interest on your tax return?

The answer is yes, depending on your income and subject to
certain limits. The maximum amount of student loan interest you can deduct each
year is $2,500. The deduction is phased out if your adjusted gross income (AGI)
exceeds certain levels.

For 2020, the deduction is phased out for taxpayers who are
married filing jointly with AGI between $140,000 and $170,000 ($70,000 and
$85,000 for single filers). The deduction is unavailable for taxpayers with AGI
of $170,000 ($85,000 for single filers) or more. Married taxpayers must file
jointly to claim the deduction.

Other requirements

The interest must be for a “qualified education loan,” which
means debt incurred to pay tuition, room and board, and related expenses to
attend a post-high school educational institution. Certain vocational schools
and post-graduate programs also may qualify.

The interest must be on funds borrowed to cover qualified
education costs of the taxpayer, his or her spouse or a dependent. The student
must be a degree candidate carrying at least half the normal full-time
workload. Also, the education expenses must be paid or incurred within a
reasonable time before or after the loan is taken out.

It doesn’t matter when the loan was taken out or whether
interest payments made in earlier years on the loan were deductible or not. And
no deduction is allowed to a taxpayer who can be claimed as a dependent on
another taxpayer’s return.

The deduction is taken “above the line.” In other words, it’s
subtracted from gross income to determine AGI. Thus, it’s available even to
taxpayers who don’t itemize deductions.

Document expenses

Taxpayers should keep records to verify eligible expenses.
Documenting tuition isn’t likely to pose a problem. However, take care to
document other qualifying expenditures for items such as books, equipment,
fees, and transportation. Documenting room and board expenses should be simple
if a student lives in a dormitory. Student who live off campus should maintain
records of room and board expenses, especially when there are complicating factors
such as roommates.

Contact us if you have questions about deducting student loan
interest or for information on other tax breaks related to paying for college.

© 2020

IRS releases 2021 amounts for Health Savings Accounts

The IRS recently released the 2021 inflation-adjusted amounts
for Health Savings Accounts (HSAs). 

HSA basics

An HSA is a trust created or organized exclusively for the
purpose of paying the “qualified medical expenses” of an “account beneficiary.”
An HSA can only be established for the benefit of an “eligible individual” who
is covered under a “high deductible health plan.” In addition, a participant
can’t be enrolled in Medicare or have other health coverage (exceptions include
dental, vision, long-term care, accident and specific disease insurance).

In general, a high deductible health plan (HDHP) is a plan that
has an annual deductible that isn’t less than $1,000 for self-only coverage and
$2,000 for family coverage. In addition, the sum of the annual deductible and
other annual out-of-pocket expenses required to be paid under the plan for
covered benefits (but not for premiums) cannot exceed $5,000 for self-only
coverage, and $10,000 for family coverage.

Within specified dollar limits, an above-the-line tax deduction
is allowed for an individual's contribution to an HSA. This annual contribution
limitation and the annual deductible and out-of-pocket expenses under the tax
code are adjusted annually for inflation.

Inflation adjustments for 2021 contributions

In Revenue Procedure 2020-32, the IRS released the 2021
inflation-adjusted figures for contributions to HSAs, which are as follows:

Annual contribution limitation. For
calendar year 2021, the annual contribution limitation for an individual with
self-only coverage under a HDHP is $3,600. For an individual with family
coverage, the amount is $7,200. This is up from $3,550 and $7,100,
respectively, for 2020.

High deductible health plan defined. For
calendar year 2021, an HDHP is a health plan with an annual deductible that
isn’t less than $1,400 for self-only coverage or $2,800 for family coverage
(these amounts are unchanged from 2020). In addition, annual out-of-pocket
expenses (deductibles, co-payments, and other amounts, but not premiums) can’t
exceed $7,000 for self-only coverage or $14,000 for family coverage (up from
$6,900 and $13,800, respectively, for 2020).

A variety of benefits

There are many advantages to HSAs. Contributions to the accounts
are made on a pre-tax basis. The money can accumulate year after year tax free
and be withdrawn tax free to pay for a variety of medical expenses such as
doctor visits, prescriptions, chiropractic care and premiums for long-term-care
insurance. In addition, an HSA is "portable." It stays with an
account holder if he or she changes employers or leaves the work force. For
more information about HSAs, contact your employee benefits and tax advisor.

© 2020