Are you Interested in Generating Some Extra Cash?


Business Pursuits

  1. Deductions are still available if you conduct your hobby as a part-time business. The IRS will argue that you are not trying to make a profit, so the activity really is a hobby. Then your deductions will be limited to your income from the activity. But you can take all the deductions by qualifying for the "safe harbor" provision. Tax reform made the safe harbor more difficult to reach. You now have to make a profit in three out of any five consecutive years. If you don't meet the standard, you still can take the deductions by showing that you really want to make a profit. You do this by conducting the business in a professional manner. Keep good books and records. Hire experts and advisors when necessary. Be sure all your practices conform to generally accepted industry standards. Take courses or some other form of instruction to improve your skills in the field. You also must devote enough time and skill to the activity on a regular basis to indicate that you are serious about it. If you're an 80-hour-a-week professional, you probably cannot deduct losses from a sideline business. An activity can be considered for profit if you don't expect to generate much current income but believe that assets used in the activity will appreciate and produce significant capital gains in the long term. By following these guidelines you can deduct the costs as business expenses even if the activity never turns a profit.
  2. Don't improve rental properties, repair them. An improvement to a property is considered a capital expenditure. You cannot deduct the expense, but have to add it to the property's basis and depreciate it. A repair expense, however, can be deducted immediately. The difference between a repair and an improvement is a fine one, and often requires careful planning. A repair maintains the current value or useful life, while an improvement increases value or lengthens useful life. The key is to avoid bunching repairs together. When a large number of repairs are done at one time, even if they are unrelated, all the work will be lumped together and called a major renovation. You can avoid this treatment by having work done over a period of more than one year, using different contractors for the work, and not drawing up a single bid, blueprint, or contract for the combined work. Treat each job as a separate repair, and do all you can to make outsiders (such as the IRS) think they are separate projects. A file of tenant complaint letters requesting specific repairs can be very helpful -- don't through such notes away after the repairs are completed.
  3. You might not be saving money by doing repair and renovation work yourself. Usually these costs can be added to a property's basis. This increases your depreciation deductions and later decreases your gain on the property's sale. But the value of any personal labor you put into the work cannot be added to the basis. This is true even if you do that type of work for a living and can establish what the fair market value of your labor is.
  4. Believe it or not, there are ways to "depreciate" land. Generally only wasting assets can be depreciated, and land is not considered a wasting asset. It doesn't wear out over time. So when you buy business or investment property, the cost of the land and buildings must be separated. The buildings are depreciated, and the land is not. But one way to get the same result as depreciating land is to buy the buildings and lease the underlying land. The rent payments you make on the land will be deductible. If the property seller doesn't want to lease land, that's no problem. Many banks are happy to step in and buy the land and immediately lease it to you. Of course, you will want a long-term lease on the land to ensure that you won't lose the lease when you still want to use the buildings. You'll also want the rent to be adjusted according to some fixed standard, because you would be at the landlord's mercy otherwise.
  5. Another option is to buy an "estate for years" in the land. The owner of an estate for years essentially is the owner of a piece of property but only for the number of years stated in the deed. After that, the property reverts to the original owner. Under the tax law, the cost of an estate for years can be written off over the life of the estate. It's possible that your bank or a corporation formed by you can buy the remainder interest in the land so that the property will not revert to an unrelated third party when the estate for years expires. The estate for years can be tricky to execute. Your tax advisor should read the case of Lomas Santa Fe, Inc., 74 TC 662, before the deal is set up.
  6. Real estate sellers should consider leasing instead of selling their properties. Instead of an installment sale, make a long-term lease with an option to buy. The difference in your cash flow from the "buyer" will be nominal, if anything, but the difference in your tax situation could be dramatic. The lease income will be considered passive income if things are structured properly. That means losses from your other properties will offset the lease income. Instead of capital gain, you have ordinary income that is sheltered by the other properties. The distinction between a lease and a sale is a technical one, and depends on many fine distinctions. You should not attempt this on your own. Instead, your tax advisor should read Frank Lyon & Co. v. U.S. (435 US 561 (1978)) and structure the deal for you.
  7. Business start-up expenses are deductible if you play it smart. The key is that you must actually be in the business and ready to serve customers or clients before the expenses can be deductible. Any expenses you incur while preparing to enter a business must be capitalized. So you should delay significant expenses for as long as possible. If feasible, hold yourself out as ready to serve customers before all the expenses have been incurred. There is another option for unincorporated businesses that cannot wait to incur their start-up expenses. The proprietors can try deducting the start-up expenses as miscellaneous itemized deductions incurred for the production of income. There haven't been many cases on this treatment yet, but some tax advisors and the Tax Court believe the deduction is proper.
  8. Your business's income goes up, but the tax rate drops. All it takes is a little planning. Suppose you are ready to introduce a new product or expand the scope of your business. You could do what most people do, and simply grow normally through your own corporation. Or you could form another corporation, being sure that more than 20% of the stock is transferred to a third party who does not own stock in the old corporation. You'll want to do this when the corporation is financed by a new investor or when one or more employees will be key to its success. Give them stock in the corporation. When you do this, the corporation will be taxed separately. It will not be grouped with the other corporation for tax purposes the way it would if the same people owned more than 80% of both corporations. The result is lower taxes and more money for everyone. Corporate income under $75,000 is taxed at less than the maximum rate.
  9. Business owners should have their businesses pay the medical expenses. The best way to do this probably is by establishing a medical reimbursement plan. The firm sets a policy under which it will reimburse employees for medical expenses. You can set limits on the amount that will be reimbursed and the types of care that will be covered. The key is that full-time employees must be treated equally. When an employee incurs an expense, documentation is given to the firm and the expense is reimbursed according to the plan. The firm can buy a health insurance policy that will cover all or most of the expenses, and use its own cash to cover any expenses not paid for by the policy. The medical reimbursements are not taxable to the employees as long as the plan is nondiscriminatory and reimbursements do not exceed expenses.
  10. Sometimes it makes sense to put different business operations in separate corporations. In the 1970s multiple corporations allowed the owner many tax advantages, including multiple pension plans. But now corporations that are 85% or more owned by related individuals are grouped into one corporation in most cases. But at times it still pays to place business operations in separate corporations. When the businesses are in different states, multiple corporations ensure that profits are not hit with taxes from more than one state. Multiple corporations give the owner more flexibility in estate planning or when trying to sell one operation with a minimal tax bite. Splitting operations also qualifies each business for several advantages that are available only to small businesses, such as the section 1244 ordinary loss deduction for corporate stock that becomes worthless. Also the different businesses generally can select different accounting methods and tax years.

    Multiple corporations do have nontax advantages as well. The debts and other legal liabilities of one business will have no effect on the assets of another business. This is important when you have a prosperous business and plan to start a riskier one. When a large number of employees are involved, separate corporations make stock ownership incentive plans more effective. Employees feel that their individual efforts will have a more direct effect on the bottom line. If there are labor problems, such as strikes, multiple corporations ensure that the dissatisfaction of one group of employees won't affect the other business. When considering multiple corporations, be sure to balance these advantages against the disadvantages of additional bookkeeping, tax returns, and other administrative work.

    For information on a highly-recommended national service that can form a corporation for you in any state, write to Incorporation Information Package, 818 Washington Street, Wilmington DE 19801.

  11. It's smart business to pay yourself a bigger salary than the business can afford. Maybe business is a little slow right now and you're thinking of cutting your salary or eliminating the usual year-end bonus. That might be good right now, but it could hurt you in the long run. When business improves you will no doubt want to increase your compensation significantly. Then the IRS would step in with a claim of unreasonable compensation. The IRS will deny the salary deduction and claim that the increase is a dividend that's income to you but not deductible by the corporation. It can do this because salary is supposed to be tied to your individual performance, not to the company's performance and cash flow. The solution is not to cut your salary. But you also have to establish arguments that demonstrate the high salary during the down year is not itself unreasonable compensation. You do this by listing the adverse factors that were not your fault such as high turnover which brought an increased workload for you. You should also cite specific problems that were caused by the downturn and forced you to spend a long time solving them. If your company is doing better than competitors, that is evidence that you are worth the high salary.

    There should also be corporate board minutes that approve the salary and give reasons for it. In addition, there should be a clause stating that you cannot draw the salary if the corporation needs the cash for operating expenses. This means that in a bad year you do not have to take cash out of the company, and it also puts you in a strong position if the IRS forces you to go to court.

  12. Lodging provided by your employer can be tax free income. You must be required to live in the employer-provided lodging as a condition of employment, and the lodging must be provided on the employer's place of business. This provision is often used to provide tax-free lodging for motel managers, but there are other possibilities. In one case, a farmer incorporated his farming business and contributed the entire farmžincluding the personal residencežto the corporation. He then signed an employment contract with the corporation. One of the conditions of employment was that the farmer had to live in the residence provided on the farm. The corporation depreciated the house and deducted all taxes, maintenance, and utilities. The farmer did not include the value of the housing in taxable income. The IRS objected to this treatment, but the Tax Court agreed with the farmer. The IRS's own witnesses at trial admitted that they did not know of a farm of that type that was run by a non-resident farmer and agreed that the farm would have to be run by someone on the premises. (J. Grant Farms, 49 TCM 1197 (1985). The courts also have broadly defined an employer's premises. Two forest watchmen were required to live in lodging provided in the forest area they patrolled. The IRS said the lodging was not tax free since the area they patrolled was quite large and the lodging was on only a small part of it. But the Tax Court said that the lodging was an integral part of the employer's premises, so it was tax free. (Vanicek, 85 TC 731 (1985)).
  13. Buying small businesses is cheaper and more attractive under the new rules. Previously the cost of goodwill (the most valuable asset of many small businesses) could not be deducted by a purchaser. It simply sat on the books at cost. Other intangible assets arguably could be written off over their estimated useful lives, but the IRS fought such deductions routinely on audits. The 1993 law provides uniform rules under which acquired intangible assets can be deducted. In general the cost of these assets, including goodwill, can be written off over a 15-year period that begins with the month of acquisition. This applies to intangibles that were acquired after August 10, 1993, and that are held in connection with a trade or business or an activity for the production of income. You can elect to have the rules apply to intangibles acquired after July 25, 1991. Intangibles that get these new rules are: goodwill; going-concern value; workforce in place; information base; know-how; any customer-based intangible; any supplier-based intangible; any license, permit, or other right granted by a government or agency; any covenant not to compete; and any franchise, trademark, or trade name. The rules and definitions are lengthy. So do not go into a deal without good tax advice on the details. There will be winners and losers under this provision. In some industries, certain intangibles were being written off over less than 15 years without strong opposition from the IRS. Customer lists, for example, are often considered to lose value in much less than 15 years. Another downside is that you only get the benefit by purchasing the assets of a business. If you purchase the stock of a corporation, for example, you do not get to write off the intangibles acquired. But overall the provision should improve the cash flow of small business buyers and should make the businesses more valuable to potential buyers.
  14. There are times when a home office will increase your tax bill. Suppose you've had a home office and have been properly taking related deductions. Now you want to sell the home. You plan to either defer the gain on the home by investing it in another home or exclude the gain from income by using the $125,000 exclusion for those over age 55. The problem is that the home office is not considered a personal residence and will not qualify for either of these treatments. You will be considered to have sold two buildings -- your residence and your office. There will be capital gains to pay on the sale of the office. The way to avoid this treatment is to stop using the home office before the year in which you sell the home. Be sure you do not qualify for the home office deductions and do not take them on the tax return during that year.
  15. Are S corporations still the best deal for business owners? In the Tax Reform Act of 1986, the top individual tax rate was lower than the top corporate tax rate for the first time ever. This provided a great incentive for profitable small business owners to convert their businesses to S corporations. Also known as "small business corporations," these corporations generally paid no taxes. Instead, all income and deductions were passed through to the owners and taxed at the owners' top tax rate.

    The main disadvantage of this strategy was that a 2% or greater owner lost some fringe benefit advantages that are available to owners of regular corporations. But when a corporation was generating substantial taxable income, the income tax savings more than made up for the lost tax-free benefits. Does the Clinton plan mean abandoning S corporations?

    Not necessarily. You want to consider more than the tax rates. The main case for revoking S status is when: you would end up in the highest individual tax bracket as an S corporation shareholder, you plan to reinvest most of the corporation's earnings to fund its growth, and the corporation does not have appreciated assets (including goodwill) that would be subject to double taxation if they were sold by a regular corporation. In many other cases, S status still makes sense despite the higher rates.

    A good reason to retain S corporation status is that the tax basis of your stock rises as you pay income taxes on the corporation's undistributed income. The increasing stock basis reduces the taxable gain incurred when you eventually sell the stock. An S corporation also can sell appreciated assets without paying double taxes on the gain in most cases. A regular corporation cannot. The S corporation also cannot be penalized by the IRS for unreasonably accumulating earnings and is less likely to be challenged for paying unreasonably high salaries. You can revoke S status for a calendar year anytime up to March 15 of that year by filing a statement with the IRS along with consent agreements signed by shareholders owning at least 50% of the stock. But if you revoke S status, it cannot be reelected for five years without permission from the IRS. What about having an existing regular corporation elect S status? The main disadvantage, after the higher individual tax rates, is that any gain from the sale of appreciated assets within 10 years after the conversion will be subject to double taxation. You can revoke S status for a calendar year anytime up to March 15 of that year by filing a statement with the IRS along with consent agreements signed by shareholders owning at least 50% of the stock. But if you revoke S status, it cannot be reelected for five years without permission from the IRS. What about having an existing regular corporation elect S status? The main disadvantage, after the higher individual tax rates, is that any gain from the sale of appreciated assets within 10 years after the conversion will be subject to double taxation.

    If you currently are operating as a regular corporation and want to elect S status, be sure to distribute any accumulated earnings and profits of the corporation. Failure to do this could result in a double taxation of some distributions in the future. To elect S, you must have no more than one class of stock (though you can have voting and nonvoting shares of that class), no more than 35 shareholders, and no shareholders who are nonresident aliens or nonhuman entities (though certain trusts and estates will qualify as shareholders). The election is made by filing Form 2553 along with the written consent of each shareholder. An election must be made by the 15th day of the third month of the year for which the election is to be effective. Thus, taxpayers wishing to make the election for calendar year 1990 must file the form by March 15, 1990. A corporation in its first year of existence must make the election by the 15th day of the third month of its existence. The election can be revoked by a majority of shareholders at any time. It is possible for an S corporation to inadvertently terminate its status, for instance by adding too many shareholders or acquiring a subsidiary. If this happens, the corporation can regain S status by correcting the mistake soon after it is discovered. In addition, the restrictions on passive income were revised in 1982 so that it is fairly difficult for a business to lose S status by earning too much passive income. Those corporations most at risk in this area are those that earn the bulk of their income from rentals or leasing.

    As in the past, the S corporation can be used to pass losses through to shareholders, provided the shareholders materially participate in the activity as required by the passive loss rules. Losses can be deducted only to the extent of a shareholder's basis in the stock. A major difference between a partnership and an S is that a partner's basis includes a pro rata share of debt owed by the partnership. That isn't so with an S. An S shareholder's basis includes only debt owed to the shareholder by the corporation. Shareholders expecting to pass through losses should keep this in mind when arranging financing for the business.

  16. Small businesses can write off more equipment each year. The amount of equipment purchases that you can elect to expense when the equipment is put in service is increased to $17,500 (from $10,000). The amount is reduced for each dollar that a business's equipment put in service during the year exceeds $200,000. And the write off cannot exceed the taxable income for the year. Any excess amount that is disallowed because of a lack of taxable income can be carried forward to a future year. You can expense any part of the basis of a particular piece of equipment. Any remaining cost that is not expensed is depreciated under the normal depreciation rules. This is effective for property put in service after Dec. 31, 1992.
  17. Small businesses might find financing more plentiful due to new write offs. Two provisions in the 1993 law make small business investments more attractive by offering investors new tax breaks. The first provision allows individuals and regular C corporations to defer capital gains on the sale of publicly traded securities if within 60 days the sale proceeds are used to purchase common stock or a partnership interest in a "specialized small business investment company." A SSBIC essentially is one that finances businesses owned by disadvantaged taxpayers. The SSBIC must be licensed under Section 301(d) of the Small Business Investment Act of 1958. The amount of gain that can be rolled over in a tax year is limited to the lesser of $50,000 or $500,000 minus any gain previously deferred in this way. For C corporations, the limits are $250,000 and $1 million.

    The second provision allows investors to exclude from income up to 50% of any gain they earn from the disposition of qualified small business stock that was held for at least five years. The stock must have been originally issued after the date the tax law was enacted (August 10, 1993) and must be issued in return for money, property, or compensation for services. The corporation also must conduct an active business. There are extensive rules covering this provision. For example, not all types of businesses qualify, so there are definitions of the businesses that qualify. In addition, there are rules that prevent an investor from excluding the gain if options or other hedging strategies are used to protect the investment. Another drawback is that one half of the excluded gain is a preference item for the alternative minimum tax. Investments through partnerships, S corporations, and common trust funds qualify for the exclusion.

  18. Leasing assets can create deductions where none existed before. Some assets cannot be depreciated, even when purchased for your business. This is particularly true of some office furnishings, for which the IRS periodically likes to deny deductions. If your office is furnished with antiques, art, oriental rugs, or other collectibles, an auditor might rule that the items do not deteriorate or depreciate, so they have an unlimited useful life. In this case, you cannot depreciate them or otherwise write off their cost. One way around this is to lease the furnishings instead of buying them. The lease payments are deductible. But some businesses get into trouble by entering into a lease with an option to buy or similar arrangement. The lease/purchase option can work, giving you deductions during the lease period and ownership of the items at the end of the lease. But you need to have a good tax expert carefully draw up or review your lease agreement so the IRS will not say that it actually is a disguised sale and deny all your deductions.

    The Tax Court analyzes what it thinks is the "economic reality" of the transaction. For example, if lease payments are substantially equal to what the purchase price would be, the transaction is considered a sale. The IRS has issued a series of rulings which give the factors it will consider. Factors that indicate you have a disguised sale include: you acquire title after making a certain number of payments; a portion of the lease payments give you equity; the rental payments materially exceed the fair market value; or the option purchase price at the end of the lease is nominal in relation to the value. If you avoid the pitfalls of a lease option, you can furnish your business with valuable items while deducting part of the cost.