Tax Tips and Alerts
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 income.)
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 matters.
COVID-19 is changing the landscape for many schools this fall. But many children and young adults are going back, even if it’s just for online learning, and some parents will be facing tuition bills. If your child has been awarded a scholarship, that’s cause for celebration! But be aware that there may be tax implications.
Scholarships (and fellowships) are generally tax-free for students at 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.
Tuition and related expenses
However, for a scholarship to be 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 required to attend the school and
- Fees, books, supplies and equipment required of all students in a particular course.
For example, if a computer is recommended but not required, buying one wouldn’t qualify. Other 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 for tuition and eligible expenses. Maintain records (such as copies of bills, receipts and cancelled checks) that reflect the use of the scholarship money.
Award can’t be payment for services
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, is an employee of an education 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.
Returns and recordkeeping
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 school year, best wishes for your child’s success in school. And please contact us if you wish to discuss these or other tax matters further.
During the COVID-19 pandemic, many small businesses are strapped for cash. They may find it beneficial to barter for goods and services instead of paying cash for them. If your business gets involved in bartering, remember that the fair market value of goods that you receive in bartering is taxable income. And if you exchange services with another business, the transaction results in taxable income for both parties.
For example, if a computer consultant agrees to exchange services with an advertising agency, both parties are taxed on the fair market value of the services received. This is the amount they would normally charge for the same services. If the parties agree to the value of the services in advance, that will be considered the fair market value unless there is contrary evidence.
In addition, if services are exchanged for property, income is realized. For example, if a construction firm does work for a retail business in exchange for unsold inventory, it will have income equal to the fair market value of the inventory. Another example: If an architectural firm does work for a corporation in exchange for shares of the corporation’s stock, it will have income equal to the fair market value of the stock.
Joining a club
Many businesses join barter clubs that facilitate barter exchanges. In general, these clubs use a system of “credit units” that are awarded to members who provide goods and services. The credits can be redeemed for goods and services from other members.
Bartering is generally taxable in the year it occurs. But if you participate in a barter club, you may be taxed on the value of credit units at the time they’re added to your account, even if you don’t redeem them for actual goods and services until a later year. For example, let’s say that you earn 2,000 credit units one year, and that each unit is redeemable for $1 in goods and services. In that year, you’ll have $2,000 of income. You won’t pay additional tax if you redeem the units the next year, since you’ve already been taxed once on that income.
If you join a barter club, you’ll be asked to provide your Social Security number or employer identification number. You’ll also be asked to certify that you aren’t subject to backup withholding. Unless you make this certification, the club will withhold tax from your bartering income at a 24% rate.
Forms to file
By January 31 of each year, a barter club will send participants a Form 1099-B, “Proceeds from Broker and Barter Exchange Transactions,” which shows the value of cash, property, services and credits that you received from exchanges during the previous year. This information will also be reported to the IRS.
By bartering, you can trade away excess inventory or provide services during slow times, all while hanging onto your cash. You may also find yourself bartering when a customer doesn’t have the money on hand to complete a transaction. As long as you’re aware of the federal and state tax consequences, these transactions can benefit all parties. Contact us if you need assistance or would like more information.
If you’re planning your estate, or you’ve recently inherited assets, you may be unsure of the “cost” (or “basis”) for tax purposes.
Fair market value rules
Under the fair market value basis rules (also known as the “step-up and step-down” rules), an heir receives a basis in inherited property equal to its date-of-death value. So, for example, if your grandfather bought ABC Corp. stock in 1935 for $500 and it’s worth $5 million at his death, the basis is stepped up to $5 million in the hands of your grandfather’s heirs — and all of that gain escapes federal income tax forever.
The fair market value basis rules apply to inherited property that’s includible in the deceased’s gross estate, and those rules also apply to property inherited from foreign persons who aren’t subject to U.S. estate tax. It doesn’t matter if a federal estate tax return is filed. The rules apply to the inherited portion of property owned by the inheriting taxpayer jointly with the deceased, but not the portion of jointly held property that the inheriting taxpayer owned before his or her inheritance. The fair market value basis rules also don’t apply to reinvestments of estate assets by fiduciaries.
Step up, step down or carryover
It’s crucial for you to understand the fair market value basis rules so that you don’t pay more tax than you’re legally required to.
For example, in the above example, if your grandfather decides to make a gift of the stock during his lifetime (rather than passing it on when he dies), the “step-up” in basis (from $500 to $5 million) would be lost. Property that has gone up in value acquired by gift is subject to the “carryover” basis rules. That means the person receiving the gift takes the same basis the donor had in it (just $500), plus a portion of any gift tax the donor pays on the gift.
A “step-down” occurs if someone dies owning property that has declined in value. In that case, the basis is lowered to the date-of-death value. Proper planning calls for seeking to avoid this loss of basis. Giving the property away before death won’t preserve the basis. That’s because when property that has gone down in value is the subject of a gift, the person receiving the gift must take the date of gift value as his basis (for purposes of determining his or her loss on a later sale). Therefore, a good strategy for property that has declined in value is for the owner to sell it before death so he or she can enjoy the tax benefits of the loss.
These are the basic rules. Other rules and limits may apply. For example, in some cases, a deceased person’s executor may be able to make an alternate valuation election.
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.
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: target=”_blank”>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 expected,
- 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.
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.
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 person.
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.
The tax filing deadline for 2019 tax returns has been extended until July 15 this year, due to the COVID-19 pandemic. After your 2019 tax return has been successfully filed with the IRS, there may still be some issues to bear in mind. Here are three considerations.
1. Some tax records can now be thrown away
You should 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 2016 and earlier years. (If you filed an extension for your 2016 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’ll need to 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 a legitimate return. (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.)
2. You can check up on 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” to find out about yours. You’ll need your Social Security number, filing status and the exact refund amount.
3. You can file an amended return if you forgot to report something
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. So for a 2019 tax return that you file on July 15, 2020, you can generally file an amended return until July 15, 2023.
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.
We can help
Contact us if you have questions about tax record retention, your refund or filing an amended return. We’re not just available at tax filing time — we’re here all year!
The IRS and the U.S. Treasury had disbursed 160.4 million Economic Impact Payments (EIPs) as of May 31, 2020, according to a new report. These are the payments being sent to eligible individuals in response to the economic threats caused by COVID-19. The U.S. Government Accountability Office (GAO) reports that $269.3 billion of EIPs have already been sent through a combination of electronic transfers to bank accounts, paper checks and prepaid debit cards.
Eligible individuals receive $1,200 or $2,400 for a married couple filing a joint return. Individuals may also receive up to an additional $500 for each qualifying child. Those with adjusted gross income over a threshold receive a reduced amount.
However, the IRS says some payments were sent erroneously and should be returned. For example, the tax agency says an EIP made to someone who died before receipt of the payment should be returned. Instructions for returning the payment can be found here: https://bit.ly/31ioZ8W
The entire EIP should be returned unless it was made to joint filers and one spouse hadn’t died before receipt. In that case, you only need to return the EIP portion made to the decedent. This amount is $1,200 unless your adjusted gross income exceeded $150,000. If you cannot deposit the payment because it was issued to both spouses and one spouse is deceased, return the check as described in the link above. Once the IRS receives and processes your returned payment, an EIP will be reissued.
The GAO report states that almost 1.1 million payments totaling nearly $1.4 billion had been sent to deceased individuals, as of April 30, 2020. However, these figures don’t “reflect returned checks or rejected direct deposits, the amount of which IRS and the Treasury are still determining.”
In addition, the IRS states that EIPs sent to incarcerated individuals should be returned.
Payments that don’t have to be returned
The IRS notes on its website that some people receiving an erroneous payment don’t have to return it. For example, if a child’s parents who aren’t married to each other both get an additional $500 for the same qualifying child, one of them isn’t required to pay it back.
But each parent should keep Notice 1444, which the IRS will mail to them within 15 days after the EIP is made, with their 2020 tax records.
Some individuals still waiting
Be aware that the government is still sending out EIPs. If you believe you’re eligible for one but haven’t received it, you will be able to claim your payment when you file your 2020 tax return.
If you need the payment sooner, you can call the IRS EIP line at 800-919-9835 but the Treasury Department notes that “call volumes are high, so call times may be longer than anticipated.”
As you may have heard, the Coronavirus Aid, Relief and Economic Security (CARES) Act allows “qualified” people to take certain “coronavirus-related distributions” from their retirement plans without paying tax.
So how do you qualify? In other words, what’s a coronavirus-related distribution?
Early distribution basics
In general, if you withdraw money from an IRA or eligible retirement plan before you reach age 59½, you must pay a 10% early withdrawal tax. This is in addition to any tax you may owe on the income from the withdrawal. There are several exceptions to the general rule. For example, you don’t owe the additional 10% tax if you become totally and permanently disabled or if you use the money to pay qualified higher education costs or medical expenses
Under the CARES Act, you can take up to $100,000 in coronavirus-related distributions made from an eligible retirement plan between January 1 and December 30, 2020. These coronavirus-related distributions aren’t subject to the 10% additional tax that otherwise generally applies to distributions made before you reach age 59½.
What’s more, a coronavirus-related distribution can be included in income in installments over a three-year period, and you have three years to repay it to an IRA or plan. If you recontribute the distribution back into your IRA or plan within three years of the withdrawal date, you can treat the withdrawal and later recontribution as a totally tax-free rollover.
In new guidance (Notice 2020-50) the IRS explains who qualifies to take a coronavirus-related distribution. A qualified individual is someone who:
- Is diagnosed (or whose spouse or dependent is diagnosed) with COVID-19 after taking a test approved by the Centers for Disease Control and Prevention (including a test authorized under the Federal Food, Drug, and Cosmetic Act); or
- Experiences adverse financial consequences as a result of certain events. To qualify under this test, the individual (or his or her spouse or member of his or her household sharing his or her principal residence) must:
- Be quarantined, be furloughed or laid off, or have work hours reduced due to COVID-19;
- Be unable to work due to a lack of childcare because of COVID-19;
- Experience a business that he or she owns or operates due to COVID-19 close or have reduced hours;
- Have pay or self-employment income reduced because of COVID-19; or
- Have a job offer rescinded or start date for a job delayed due to COVID-19.
As you can see, the rules allow many people — but not everyone — to take retirement plan distributions under the new exception. If you decide to take advantage of it, be sure to keep good records to show that you qualify. Be careful: You’ll be taxed on the coronavirus-related distribution amount that you don’t recontribute within the three-year window. But you won’t have to worry about owing the 10% early withdrawal penalty if you’re under 59½. Other rules and restrictions apply. Contact us if you have questions or need assistance.
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.
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:
- 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.
- 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.
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About Yuma, AZ
First incorporated as Arizona City in 1871, Yuma was renamed in 1873 and is now the largest city in Arizona outside the metro areas of Phoenix and Tucson.