Tax credits help business owners recover the cost of providing Coronavirus-related leave

If you’re a small and medium size business owner, this one’s for you. The IRS announced important refundable payroll tax credits that are much less talked about in the shuffle of COVID-19 relief efforts. These credits will continue to be important to businesses especially after states fully reopen, and employees may continue to find themselves to be sick with COVID-19, need to care for family members who are sick with Covid-19, and/or cannot come to work due to lack of childcare due to Covid-19.

Chris Strand, managing accountant at Ballast Tax and Business Services breaks down what small business owners need to know about this plan which has the goal to swiftly recover the cost of providing Coronavirus-related leave.

“There are two pieces to this tax credit which is available only to small and medium size business owners,” says Strand. “The paid sick leave credit and the paid family leave credit reimburses employers who provide up to 80 hours of sick leave for employees who are sick with Covid 19 or who must care for a family member with Covid 19. Secondly, it also reimburses employers who pay employees up to 10 weeks who must miss work due to the lack of available child care due to COVID-19.”

According to the IRS, not only does this cover wages, but It also covers health care costs for the employee, and employers are not required to pay FICA taxes on those wages.

“This is also available to self employed individuals,” says Strand. “The credit is refundable and the funds can be obtained quickly.”

In order to take advantage of the credit, the IRS states, employers simply deduct the credit amount from their payroll tax deposits for the current period. If there are more credits than payroll tax deposits, they can file to receive a check right away, not wait until the end of the year by submitting Form 7200, Advance Payment of Employer Credits Due to COVID-19.

“To be clear, this only applies to wages paid to employees who come down with, or care family members who come down with, Covid 19. Or to wages paid to employees who lose their child care due to Covid 19,” Strand adds. “This pandemic has brought about challenges never before seen and rarely even foreseen in our business community. This tax credit can potentially provide a significant aid to those business owners striving to meet these challenges.”

For details about these credits and other relief, contact Ballast Tax and Business Services.

 

The Economic Injury Disaster Loan (EIDL) program

SBA disaster loan application form on the wooden surface.

The SBA’s Economic Injury Disaster Loan (EIDL) program provides vital economic support to small businesses to help overcome the temporary loss of revenue they are experiencing as a result of the COVID-19 pandemic. Federal Disaster Loans are available for Businesses, Private Nonprofits, Homeowners, and Renters. This isn’t new – it’s a similar program to other loans available to declared victims of disasters such as hurricanes, tornados, earthquakes, fires, etc. However, for COVID-19, the program has been expanded and provides emergency grants of up to $10,000 – theoretically within three days – and low-interest loans up to $2 million.  

Who qualifies?

This program is for any small business with less than 500 employees (including sole proprietorships, independent contractors and self-employed persons), private non-profit organization or 501(c)(19) veterans organizations affected by COVID-19.

Businesses in certain industries may have more than 500 employees if they meet the SBA’s size standards for those industries.

What are the Loan terms?

According to the SBA, no matter the amount you apply for, the Economic Injury Disaster Loan advances funds (up to $10,000) and will be made available within days of a successful application.  This loan advance will not have to be repaid, so in other words, the first $10k of the loan is effectively a grant. 

The amount of your grant (up to $10,000), which you request when you fill out your EIDL application, is determined by the number of employees you have at $1,000 per employee with a maximum grant of $10,000. For example: If you have three employees, you will receive $3,000. That amount will be deducted from the loan forgiveness amount of any PPP loan you receive and should arrive within days of your EIDL loan application, according to the SBA.

You can apply for an EIDL of up to $2 million to provide working capital for expenses such as fixed debt and payroll costs. The interest rate is 3.75% and the loan term can be as long as 30 years. The COVID-19 EIDL includes an automatic one-year deferral on repayment, though interest begins to accrue when the loan is disbursed.

How to Apply

Unlike the Paycheck Protection Program, which requires you apply with a local lender, for an EIDL loan, you don’t have to go through a bank. You can apply through the SBA on their website.

The application process has been streamlined and the SBA says it should take you two hours and ten minutes or less to complete.

The application can be found on the SBA Disaster Assistance web page. You must apply no later than Dec. 16, 2020 in most states. A few have extended the deadline to Dec. 21.

You Can Apply for a PPP Loan Too

SBA guidance allows you to apply for a PPP loan in addition to an EIDL, so long as you don’t use the funds from each loan for the same expenses.

For example, if you decide to apply for a PPP loan and use those funds strictly for payroll, you cannot subsequently use funds from an EIDL for payroll, as well. If your EIDL loan was used for payroll costs, your PPP loan must be used to refinance your EIDL loan. Proceeds from any advance up to $10,000 on the EIDL loan will be deducted from the loan forgiveness amount on the PPP loan.

Sources: https://www.sba.gov/funding-programs/loans/coronavirus-relief-options/economic-injury-disaster-loan-emergency-advance, https://www.congress.gov/bill/116th-congress/house-bill/748/text

Please Note:Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized tax advice from Ballast Tax Services.   To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Ballast Tax Services is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice.  

Ballast Tax and Business Services does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to Ballast Tax’s  website or blog or incorporated herein, and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.

PPP (Paycheck Protection Program) Loans Summary

Paycheck Protection Program PPP Loan. Wooden cubes on the desk.

Paycheck Protection Program (PPP) is part of the $349 billion Federal stimulus package designed to provide access to cash so that businesses can keep paying their employees and other expenses such as health insurance premiums, rent or mortgage payments and utilities.

Paycheck Protection Program PPP Loan. Wooden cubes on the desk.

Who qualifies?

If you own a business, 501(c)(3) non-profit organization, 501(c)(19) veterans organization, or Tribal business concern with under 500 employees and have been affected by Coronavirus (COVID-19) you may be eligible. Also, if you’re a sole proprietor, independent contractor, or self-employed you also may be eligible for these loans. You also had to be in business as of February 15, 2020. 

How do you apply?

Since the program opened, April 3, there have been a flood of applications, the SBA recommends that you first consult with a local lender with whom you already have an existing lending relationship, as to whether it is participating in the program.

However, you can apply through any existing SBA 7(a) lender or through any federally insured depository institution, federally insured credit union, and Farm Credit System institution that is participating.

You only can apply once, so if you try and apply with multiple banks, ask for a guarantee that the lenders will contact you before submitting your file, so you are not triggered for fraud.

If you wish to begin preparing your application, you can download a copy of the PPP borrower application form to see the information that will be requested from you when you apply with a lender. The program is available now through June 30, 2020.

Loan Details and Forgiveness

According to the SBA, Individual businesses may be eligible for up to $10 million in forgivable loans if employees are kept on the payroll for eight weeks and the money is used for payroll, rent, mortgage interest, or utilities.

The loan will be fully forgiven if the funds are used for payroll costs, interest on mortgages, rent, and utilities (due to likely high subscription, at least 75% of the forgiven amount must have been used for payroll). Loan payments will also be deferred for six months. No collateral or personal guarantees are required. Neither the government nor lenders will charge small businesses any fees.

Loan forgiveness is based on the employer maintaining or quickly rehiring employees and maintaining salary levels.  Forgiveness will be reduced if full-time headcount declines, or if salaries and wages decrease. When calculating your loan, salaries will be capped at $100,000.

Otherwise this loan has a maturity of 2 years and an interest rate of 1%.

Tracking 8-Week payroll

According to guidance issued by the Department of Treasury on April 2, 2020, the eight-week period begins on the first day lenders disperse funds to businesses. This regulation also noted lenders should issue funds no later than 10 calendar days from the date of loan approval.

Beware of Scams

It’s as important as ever to be vigilant about consumer protection.

Make sure you never provide private information – social security numbers, credit card details, or banking information – to anyone calling, emailing or some other way claiming to be from the Treasury Department or the SBA offering you grants or stimulus payments. Scammers could use this information to apply for a loan on your behalf.

Be wary of any false promises for quicker loans and faster processing. It is best to go through a federally backed credit union or traditional SBA lender, as they’ll be the most familiar with the program and as such get up to speed on new processes sooner.

 

Source: These summaries are based on interpretations of the CARES Act; U.STreasury guidance released March 31, 2020U.S. Treasury guidance released April 2, 2020; and FAQs released April 7, 2020.

 

Please Note:Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized tax advice from Ballast Tax Services.   To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Ballast Tax Services is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice.  

Ballast Tax and Business Services does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to Ballast Tax’s  website or blog or incorporated herein, and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.

 

COVID-19 Update

We want you to know that Ballast Tax and Business Services is taking all the necessary precautions to keep business running as usual while our communities deal with the spread of the Coronavirus (COVID 19). We’ve issued a protocol to all our Ballast Tax staff for keeping the workplace clean and safe and for the best interest of employee and client health.

  • Our accountants will be replacing all in-person meetings for the foreseeable future with either a web meeting (via Join.me) or conference call. We would be happy to provide further instructions for this type of meeting.  
  • While we traditionally still receive some tax forms via hardcopy in the mail, we are asking that all clients who are able, please scan your return and electronically submit paperwork through our secure portal.

  • If you are unable to scan your documents, please note that we will delay processing any hand-mailed paperwork we receive for at least a week, to avoid potential virus transmission on surfaces.

  • We will be suspending our receipt of cash payments, but will continue to accept payment by check, money order, and all major credit cards.

  • We will be automatically filing extensions for all individual returns as we away a formal tax deadline extension from the IRS.

  • In the event that our offices were to close, Ballast Tax and Business Services can meet your service needs under many different circumstances. Our accountants have the ability to work remotely using our secure access technology to continue to serve you.
  •  
  • We have technology that shifts our main phone service line to cellphones, so you should continue to call Ballast Tax and Business as usual.
  • We will keep you informed of any changes and potential extensions the IRS may make as things develop.

If you need any additional information on some best practices to reduce the spread, please read best practices issued by the CDC.

Thank you for your cooperation.

Tax Calculation

What is tax calculation?

Tax calculation is the process by which you figure out how much you owe in income tax. If you file federal income tax Form 1040, you must compute your adjusted gross income (AGI) and your taxable income before you can calculate your tax. Essentially, your AGI is your total income minus certain adjustments. Your taxable income is your AGI minus your itemized deductions (or your standard deduction) and your exemptions. (Personal exemptions have been suspended for 2018 to 2025.)

After finding your taxable income, you need to determine your income tax liability from the tax table or the tax rate schedules. This tax amount is then reduced by certain credits you may be entitled to and increased by any other taxes you may owe. In terms of tax calculation and tax planning, certain taxes deserve particular note: the alternative minimum tax, the capital gains tax, and the self-employment tax.

How do you determine your adjusted gross income (AGI)?

AGI is your total income minus any adjustments, including the following:

  • Educator expenses (up to $250 in qualified expenses for eligible educators)
  • IRA deduction for you and for your spouse
  • Deduction for moving expenses (generally suspended for 2018 to 2025)
  • Deduction for employer portion of your self-employment tax
  • Self-employed health insurance deduction
  • Deduction for Keogh, SEP, and SIMPLE retirement plan contributions
  • Penalty on early withdrawal of savings
  • Alimony paid (pre-2019 divorce, unless divorce agreement provides otherwise)
  • Student loan interest deduction
  • Health savings account (HSA) deduction
  • Tuition and fees (qualified tuition deduction)*

Other less common adjustments are also available, including:

  • Archer MSA deduction
  • Certain expenses of qualified performing artists
  • Jury duty pay given to your employer
  • Reforestation amortization and expenses
  • Certain required repayments of supplemental unemployment benefits
  • Contributions to a Section 501(c)(18)(D) pension plan
  • Certain expenses from the rental of personal property
  • Contributions by certain chaplains to Section 403(b) plans
  • Attorney fees and court costs for actions involving certain unlawful discrimination claims

*Not available after 2017 unless extended by Congress.

How do you determine your taxable income?

To figure the amount of your taxable income, you must first subtract either your itemized deductions or your standard deduction from your adjusted gross income (AGI). Next, you subtract your exemptions. (Personal exemptions have been suspended for 2018 to 2025.) Whether or not you itemize deductions, you may also subtract a qualified business income deduction from your AGI.

Deductions

You can choose to itemize your deductions on Schedule A (Form 1040) or take the standard deduction.

  • Itemized deductions: You can itemize your deductions (such as medical expenses, taxes, mortgage interest, and casualty losses) on Schedule A (Form 1040). You can benefit from itemizing your deductions on Schedule A if you have total itemized deductions that are more than the highest standard deduction amount to which you otherwise are entitled. Note, however, that in years 2013 to 2017, itemized deductions may be limited for taxpayers with high AGIs.
  • Standard deduction: The standard deduction is based on your filing status and whether you are 65 or older or blind. If you were 65 or older or blind during this tax year, you’re entitled to a higher standard deduction than taxpayers under 65 and/or not blind. There are special rules that may eliminate or reduce your standard deduction, such as when your filing status is married filing separate and your spouse itemizes deductions.

Exemptions

Whether you itemize your deductions or use the standard deduction, currently, you can generally deduct $4,050 (for 2016 and 2017) for each exemption you are allowed to claim. However, if your AGI exceeds a specified dollar amount for your filing status, the amount of your deductions and exemptions may be limited or phased out (the phaseout did not apply in 2012). Personal exemptions have been suspended for 2018 to 2025.

How do you determine your tax?

After finding your taxable income, the next step is to figure your income tax liability. This tax amount is then reduced by certain credits to which you may be entitled and increased by any other taxes you owe. Finally, you apply any payments or other credits against your liability to determine whether you owe additional tax or whether you are entitled to a refund.

Tax tables and tax rate schedules are used to ascertain tax. The tax table must be used for taxable income of less than $100,000 (unless Form 8615 or Schedule D is used to calculate tax). The tax rate schedule, however, must be used for taxable income of $100,000 or more (unless Form 8615 or Schedule D is used to calculate tax). Form 8615 is used to calculate the tax for a child’s unearned income that is subject to the kiddie tax rules. Regardless of whether you use the tax table or the tax rate schedule, the amount of tax you pay depends on your tax bracket.

A tax bracket is, generally, the income tax rate at which you are taxed for a certain range of income. Brackets are expressed by their marginal tax rate. Currently, there are seven marginal tax rates: 10, 12, 22, 24, 32, 35, and 37 percent. The income levels at which each rate applies vary depending upon your filing status: married filing separately, married filing jointly, head of household, or single.

What are the current tax rates?

The tax rate schedules for 2019 are as follows:

Single:

 

If Taxable Income Is:

Your Tax Is:

Not over $9,700

10% of taxable income

Over $9,700 to $39,475

$970 + 12% of the excess over $9,700

Over $39,475 to $84,200

$4,543 + 22% of the excess over $39,475

Over $84,200 to $160,725

$14,382.50 + 24% of the excess over $84,200

Over $160,725 to $204,100

$32,748.50 + 32% of the excess over $160,725

Over $204,100 to $510,300

$46,628.50 + 35% of the excess over $204,100

Over $510,300

$155,798.50 + 37% of the excess over $510,300

Married filing jointly and surviving spouses:

 

If Taxable Income Is:

Your Tax Is:

Not over $19,400

10% of taxable income

Over $19,400 to $78,950

$1,940 + 12% of the excess over $19,400

Over $78,950 to $168,400

$9,086 + 22% of the excess over $78,950

Over $168,400 to $321,450

$28,765 + 24% of the excess over $168,400

Over $321,450 to $408,200

$65,497 + 32% of the excess over $321,450

Over $408,200 to $612,350

$93,257 + 35% of the excess over $408,200

Over $612,350

$164,709.50 + 37.6% of the excess over $612,350

Married individuals filing separately:

 

If Taxable Income Is:

Your Tax Is:

Not over $9,700

10% of taxable income

Over $9,700 to $39,475

$970 + 12% of the excess over $9,700

Over $39,475 to $84,200

$4,543 + 22% of the excess over $39,475

Over $84,200 to $160,725

$14,382.50 + 24% of the excess over $84,200

Over $160,725 to $204,100

$32,748.50 + 32% of the excess over $160,725

Over $204,100 to $306,175

$46,628.50 + 35% of the excess over $204,100

Over $306,175

$82,354.75 + 37% of the excess over $306,175

Heads of household:

 

If Taxable Income Is:

Your Tax Is:

Not over $13,850

10% of taxable income

Over $13,850 to $52,850

$1,385 + 12% of the excess over $13,850

Over $52,850 to $84,200

$6,065 + 22% of the excess over $52,850

Over $84,200 to $160,700

$12,962 + 24% of the excess over $84,200

Over $160,700 to $204,100

$31,322 + 32% of the excess over $160,700

Over $204,100 to $510,300

$45,210 + 35% of the excess over $204,100

Over $510,300

$152,380 + 37% of the excess over $510,300

Trusts and estates:

 

If Taxable Income Is:

Your Tax Is:

Not over $2,600

10% of taxable income

Over $2,600 to $9,300

$260 + 24% of the excess over $2,600

Over $9,300 to $12,750

$1,868 + 35% of the excess over $9,300

Over $12,750

$3,075.50 + 37% of the excess over $12,750

How do the long-term capital gains tax rates come into play?

Currently, the highest marginal tax rate applicable to ordinary income and short-term capital gains of individuals is 37 percent, whereas the top long-term capital gains rate for individuals is 20 percent for most long-term capital gains. Because of this difference, you need to complete a special capital gains tax worksheet to calculate your capital gains tax.

Long-term capital gains and qualified dividends are generally taxed at special capital gains tax rates of 0 percent, 15 percent, and 20 percent depending on your taxable income. The actual process of calculating tax on long-term capital gains and qualified dividends is extremely complicated and depends on the amount of your net capital gains and qualified dividends and your taxable income. These rates also generally apply to qualified dividends paid to individuals from domestic corporations and qualified foreign corporations.

What about the alternative minimum tax (AMT)?

The purpose of the alternative minimum tax (AMT) is to ensure that taxpayers with substantial income will not escape taxation entirely by employing certain exclusions, deductions, and credits. The tax law gives special treatment to some kinds of income and allows special deductions and credits for some kinds of expenses. Taxpayers who benefit from the law in these ways may have to pay at least a minimum amount of tax through an additional tax: the AMT.

What about the self-employment tax?

If you are self-employed, you must pay Social Security and Medicare taxes for yourself as part of your income tax. The self-employment tax is based on net earnings from self-employment, not on taxable income. The rate on net earnings is 15.3 percent; 12.4 percent is for Social Security and 2.9 percent is for Medicare. The maximum amount subject to the Social Security part is currently $132,900 (up from $128,400 in 2018). All of your net earnings of at least $400 are subject to the Medicare tax.

You generally must report and pay self-employment tax (Schedule SE of Form 1040) if either of the following applies to you (or to your spouse, if you file a joint return):

  • You were self-employed and your net earnings from self-employment were $400 or more
  • You had church employee income of $108.28 or more

For tax years after 2012, a 0.9 percent Medicare surtax also applies to wages and self-employment income in excess of $200,000 for single taxpayers and over $250,000 for married couples filing joint returns ($125,000 for married couples filing separate returns).

What are some other taxes that might affect you?

  • Social Security and Medicare tax on tips not reported to employer: If you received tips of $20 or more in any month while working for one employer but didn’t report all of them to your employer, you must figure your Social Security and Medicare tax on the tips not reported. Use Form 4137 and attach it to Form 1040.
  • Household employment taxes: If you have a household employee, you may need to pay state and federal household employment taxes. You generally must add your federal employment taxes to the income tax that you report on your federal income tax return. Household work is work done in or around your home by baby-sitters, nannies, health aides, private nurses, maids, caretakers, yard workers, and similar domestic workers. A household worker is your employee if you can control not only what work is done but also how it is done. If you have a household worker, you may need to withhold and pay Social Security and Medicare taxes, or you may need to pay federal unemployment tax, or you may need to do both. For more information, see IRS Publication 926, or Schedule H and its instructions.
  • Premature distribution tax: If you take a distribution from your qualified plan before you reach age 59½, you may have to pay a 10 percent premature distribution tax on that part of the distribution that is taxable (unless you meet an exception). This penalty tax can amount to a substantial sum if your distribution is large.
  • A 20 percent tax on excess (golden parachute) payments: If you received an excess parachute payment (EPP), you may have to pay a tax equal to 20 percent of this excess payment.
  • For tax years after 2012, an additional hospital insurance (Medicare) tax of 0.9 percent: This additional tax will be assessed on wages (as well as self-employment income) that exceed $200,000 ($250,000 for married couples filing joint returns, $125,000 for married couples filing separate returns). Employees will be liable for this amount to the extent that the additional tax has not been withheld from wages.
  • For tax years after 2012, a new unearned income Medicare contribution tax on the investment income of high earners: The 3.8 percent tax will apply to the lesser of (1) net investment income or (2) the amount by which adjusted gross income (AGI) exceeds the $200,000 or $250,000 for married couples filing jointly ($125,000 for married couples filing separate returns) threshold amounts. Net investment income generally includes interest, dividends, capital gains, annuity income, royalties, and rents. Tax-exempt interest won’t be included, nor will income or distributions from qualified retirement accounts.
  • Starting in 2014, a new tax on individuals who don’t have adequate health care coverage (this is often referred to as the individual insurance mandate): This tax will be phased in over three years, starting at the greater of $95, or 1 percent of gross income in 2014 (up to a family maximum of $285); increasing to the greater of $325, or 2 percent of gross income in 2015 (up to a family maximum of $975); and rising to the greater of $695, or 2.5 percent of gross income in 2016 and 2017 (up to a family maximum of $2,085). The individual insurance mandate has been eliminated for months beginning after December 31, 2018.

Avoiding Personal Holding Company Tax

What is a personal holding company?

A personal holding company (PHC) is a C corporation in which more than 50 percent of the value of its outstanding stock is owned (directly or indirectly) by five or fewer individuals and which receives at least 60 percent of its adjusted ordinary gross income from passive sources. Because the top corporate tax rates have historically been lower than the top individual tax brackets, some shareholders of closely held corporations have sought to retain earnings within the corporation as a strategy to avoid the higher individual tax rates. To prevent this, Congress enacted a penalty tax on certain C corporations–the personal holding company (PHC) tax.

The personal holding company tax is imposed on the undistributed income of those C corporations that serve as vehicles to shelter passive income. The rationale is that a corporation should be primarily an active business operation. The law targets those closely held corporations that derive substantial income from investments, such as royalties, interest, dividends, and rents. Avoiding PHC status is important because failure to do so could result in additional taxation. A PHC must pay a corporate tax equal to 20 percent. (From 2003 to 2012, the tax rate was 15 percent. The rate increased as of 2013 with passage of the American Taxpayer Relief Act of 2012). The tax is levied on undistributed PHC income.

To summarize, a personal holding company (PHC) is a C corporation in which:

  • At least 60 percent of the corporation’s adjusted ordinary gross income consists of PHC income
  • At any time during the last half of the tax year, more than 50 percent of the value of the corporation’s outstanding stock is owned, directly or indirectly, by (or for) five or fewer individuals

What is PHC income?

PHC income generally consists of the following sources of (primarily) passive income:

  • Dividends
  • Interest minus certain amounts excluded under Internal Revenue Code 543(a)(1) and Internal Revenue Code 543(b)(2)(C)
  • Royalties minus certain expenses allowed under Internal Revenue Code 543(b)(2)(B)
  • Annuities
  • Rents subject to specific income requirements
  • Compensation received for the use of corporate property from shareholders who own at least 25 percent of the value of the stock of the corporation, subject to limits
  • Amounts received under a personal service contract if someone other than the corporation designates the individual performing the services, and the person designated owns (directly or indirectly) at least 25 percent of the value of the corporation’s stock at least some time during the taxable year
  • Income from estates and trusts
  • Mineral, oil, gas, and copyright royalties subject to specific income requirements

What is PHC’s adjusted ordinary gross income?

In general, a PHC’s adjusted ordinary gross income is the corporation’s gross income, minus:

  • Gains from the sale or disposition of capital assets
  • Gains under Internal Revenue Code 1231(b)
  • Certain foreign income
  • Certain expenses allowed against rental income
  • Certain expenses allowed against royalty income
  • Certain interest income

See Internal Revenue Code 543(b) for more details.

Are there any exceptions to the definition of a personal holding company?

Some businesses that meet the general income and ownership tests for personal holding companies are statutorily excluded from PHC classification and taxation. These exceptions include the following:

  • Tax-exempt corporations
  • Banks
  • Domestic building and loan associations
  • Life insurance companies
  • Surety companies
  • Certain lending or finance companies
  • Certain foreign companies
  • Certain small business investment companies operating under the Small Business Investment Act of 1958
  • Corporations under the jurisdiction of the court in a Title 11 or similar bankruptcy case

What strategies can be used to avoid PHC taxation?

Throughout the year, corporations should monitor their accumulated earnings and the types of income they receive to detect potential exposure to the PHC tax. Certain strategies can be employed to avoid the tax.

Increase number of business owners

Since the PHC tax applies only to C corporations in which more than 50 percent of the value of stock is owned by five or fewer individuals during the last half of the tax year, you can avoid PHC status by ensuring that the top five owners in your closely held corporation own less than 50 percent of the value of the outstanding stock. Gifts of stock to relatives or friends can avoid potential problems in this area.

Bear in mind, though, the concept of “constructive ownership.” Stock owned directly or indirectly by your family members and certain other related individuals or entities could be treated as owned by you. Your family members include your brothers and sisters, your spouse, ancestors, and lineal descendants. You can, for instance, gift stock to the spouse of your brother or sister.

Increase adjusted ordinary income or decrease PHC income

Since you are only subject to the PHC tax if at least 60 percent of the corporation’s adjusted ordinary gross income consists of PHC income, you should change the relationship between your operating income and your passive investment income. More specifically, you can take steps to increase your adjusted ordinary income or to decrease PHC income.

To increase adjusted ordinary income:

  • Accelerate sales and bill at year-end
  • Decrease cost of goods sold by deferral of purchases or other expenses at year-end
  • Invest in other business activities that result in additional gross receipts that are not PHC income

To decrease accumulated PHC income:

  • Cash in some securities and reinvest the funds in stocks that have growth potential but do not regularly pay dividends
  • Pay dividends to stockholders (dividends can even be paid 2½ months after year-end if you make a special election)
  • Limit your passive investments

Can converting from a C corporation to an S corporation help?

While the PHC tax is only imposed on C corporations, election of S status may not be an effective solution. An S corporation that has prior C corporation earnings and profits (E&P) and more than 25 percent of its gross receipts from PHC income sources is also exposed to a tax. A corporate level tax of 35 percent is levied on the excess net passive income.

Shifting Income/Timing Income: Tax Planning for the Self-Employed

What is shifting income/timing income?

Income shifting (also known as income splitting) may be defined as dividing income in a way that lowers overall taxes. Typically, income is shifted from higher-bracket taxpayers to lower ones. Income shifting can be a valuable tool for self-employed persons.

Although there are a number of ways to accomplish a shifting of income, the following methods are most popular: employing family members, family partnerships, interest-free and below-market loans, gifting, sale- or gift-leaseback, trusts, and life insurance/annuities. When using these methods to shift income to a child, it’s always important to bear in mind the kiddie tax.

Timing the receipt of your income can also help you lower your taxes. When tax rates are stable, it’s wise for you to defer as much income as possible from one year to a later year and to accelerate deductions so that you can postpone payment of the tax. When you eventually realize the income at some future point, it’s possible that you’ll be retired and/or in a lower tax bracket. Understanding the differences between the cash method and the accrual method of accounting can also help you to time your income most effectively.

What is the kiddie tax, and what is its relation to income splitting?

In the past, parents found that they could lower their taxes by shifting unearned income into their children’s names. This worked because the parents were in a higher tax bracket than their children. Congress closed this loophole by enacting certain rules known as the kiddie tax.

The kiddie tax rules apply when a child has unearned income (for example, investment income). Children subject to the kiddie tax are generally taxed using the trust and estate income tax brackets on any unearned income over a certain amount. Currently, this amount is $2,200 (the first $1,100 is tax free and the next $1,100 is taxed at the child’s rate). The kiddie tax rules apply to (1) those under age 18, (2) those age 18 whose earned income doesn’t exceed one-half of their support, and (3) those ages 19 to 23 who are full-time students and whose earned income doesn’t exceed one-half of their support.

How can employing your family members help you to shift income?

One method of income shifting is to hire your family members to work in your business. Paying salaries to family members reduces the amount of business income that you must pay yourself. In addition, the tax code provides a particular Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) tax exclusion for unincorporated businesses that employ an owner’s children. The earnings of a child under 18, who is employed by a parent owning a sole proprietorship or a partnership, are not subject to FICA (Social Security and Medicare taxes). Likewise, there is an exclusion from FUTA (unemployment tax) for a business paying the owner’s child who is under age 21. Of course, you’ll have to ensure that the type of work performed, the rate of pay, and the timing of payment are all appropriate.

How can income be split among family members in a family partnership to reduce overall taxes?

Limited partnerships can be used to split income taxes. A family limited partnership (FLP) is owned by family members and operates under the rules of limited partnerships. Typically, parents form an FLP and transfer their assets (e.g., an existing business) to this entity.

The FLP is used to shift present business income to lower-bracket family members. The children have no right to manage the business; rather, they are treated like investors who have an ownership interest only in the business. Each child can receive limited partnership interests worth $15,000 (the current annual gift tax exclusion amount) from each parent as gifts, without federal gift tax consequences. Thus, income generated by the business will pass through to a number of different family members. In addition, limited partners can work in the business and be compensated for their services. Be aware, however, that the IRS has expressed some concerns regarding the gifting of FLP interests.

How can gifts be used to shift income?

Gifting assets to family members is another way to shift income. It might be advantageous for you to gift income-producing investment assets (such as stock in various companies) to your relatives. The initial distribution of shares to your relatives would be classified as a gift, and the annual income from the gift would be taxed to the relative. You can make federal gift tax-free gifts of up to $15,000 per year per recipient under the annual gift tax exclusion. Married couples can generally double that amount if they split the gifts. If your gift exceeds the annual exclusion amount, the excess may be subject to gift tax. However, gift tax due may be offset by your $11,400,000 (in 2019, $11,180,000 in 2018) basic (applicable) exclusion amount, if it is available.

You should also be aware of the Uniform Transfers to Minors Act (UTMA) and the Uniform Gifts to Minors Act (UGMA). Some states don’t allow securities to be registered in a minor’s name. Basically, if you want to transfer an income-producing asset to a minor child, you have two choices: to make the gift under UTMA or UGMA or to make the gift in trust.

How can interest-free and below-market loans be used to shift income?

Another way for a family to shift income is to use a no-interest or low-interest loan to a family member as an alternative to an outright gift. Low-interest means that the rate of interest charged is less than the applicable federal rate (AFR) set monthly by the IRS. In general, the IRS will impute interest (i.e., treat you as if you had received interest at the AFR) if you loan money without charging at least the AFR. However, there are some exceptions to this rule. In general, de minimis loans (those that are $10,000 or less) will not result in imputed interest or reclassification as a taxable gift. Also, if certain conditions are met, loans of less than $100,000 will not cause interest to be imputed.

How can trusts be used to shift income?

You can transfer income-producing assets or cash into a trust for the benefit of someone else. If the trust is set up properly, income that is paid out of the trust to a beneficiary will be taxed to the beneficiary rather than to you. Thus, the trust may be used as an income-shifting tool. Many different forms of trusts exist, and you must be careful to avoid grantor trust arrangements, whereby trust income is taxed to the grantor rather than to the beneficiary. Grantor trusts usually are not used for income shifting, although they have many other uses.

How can annuities and life insurance be used to reduce income taxes and shift income?

Rather than invest all of your cash in income-producing assets that create taxable income in the current year, you can purchase an annuity to reduce income taxes; this is because the income generated by the annuity will accumulate tax free until the funds are withdrawn. The interest is not taxable in the current year as long as no withdrawals are made. In addition, if the annuity payouts will begin when you are much older, you may be in a lower tax bracket at that time.

You can also invest some of your cash in a life insurance policy, naming a relative as the beneficiary and/or owner. In this way, you can also shift income, and the cash value of the policy grows tax deferred.

How can a sale- or gift-leaseback be used to shift income?

Another way to shift income is to transfer property (such as a vacation home) by using a sale- or gift-leaseback arrangement. Typically, you would sell the property to a relative and then rent it back from the relative. Potentially, the lessor would get depreciation benefits as well as rental income.

What about the timing of income?

Timing your income appropriately can also help you to lower your taxes. Self-employed persons should know the difference between the cash method of accounting and the accrual method of accounting. It is also useful to know about postponing (deferring) income and accelerating deductions.

Cash versus accrual method of accounting

Essentially, using the cash method of accounting means that your business will recognize revenues and expenses only when there is an actual inflow or outflow of cash with respect to your business.

Assume John Smith began a sole proprietorship, the Smith Barbershop, on December 31, 2018. His fiscal year also ends on December 31. Smith has three customers on December 31, and each receives a $20 haircut. Two of the customers pay Smith in cash, and one customer tells Smith he’ll be back with a $20 bill the next day. Smith hands the third customer a bill to remind him of the debt. Because Smith uses the cash method of accounting, he informs the IRS that he earned $40 for 2018.

If, however, John’s business used the accrual method of accounting, he would have to report $60 worth of income to the IRS for 2018. That’s because John completely performed his end of the haircutting contract and is owed an additional $20 for work performed during 2018.

The accrual method of accounting, then, may be defined as one that recognizes revenue at the point of sale and recognizes expenses when incurred (not simply when paid).

Postponing income and accelerating deductions

When tax rates are stable, it’s generally wise to lower your taxable income by postponing your income and accelerating your deductions. For instance, if you’re a self-employed taxpayer who uses the cash method of accounting in your business, you should consider delaying the billing of some of your customers until next year. It’s not taxable income until you have the cash (or a reasonable substitute) in hand.

If, however, you use the accrual method of accounting in your business, you should defer your right to receive payment for the goods or services you provide. You can accomplish this by waiting until next year to finish a job or by holding up your delivery of goods until next year.

You can accelerate deductions by incurring (or paying) deductible expenses late this year instead of early next year.