The extended federal income tax deadline is coming up fast. As you know, the IRS postponed until July 15 the payment and filing deadlines that otherwise would have fallen on or after April 1, 2020, and before July 15.
Retroactive COVID-19 business relief
The Coronavirus Aid, Relief and Economic Security (CARES) Act, which passed earlier in 2020, includes some retroactive tax relief for business taxpayers. The following four provisions may affect a still-unfiled tax return — or you may be able to take advantage of them on an amended return if you already filed.
Liberalized net operating losses (NOLs). The CARES Act allows a five-year carryback for a business NOL that arises in a tax year beginning in 2018 through 2020. Claiming 100% first-year bonus depreciation on an affected year’s return can potentially create or increase an NOL for that year. If so, the NOL can be carried back, and you can recover some or all of the income tax paid for the carryback year. This factor could cause you to favor claiming 100% first-year bonus depreciation on an unfiled return.
Since NOLs that arise in tax years beginning in 2018 through 2020 can be carried back five years, an NOL that’s reported on a still-unfiled return can be carried back to an earlier tax year and allow you to recover income tax paid in the carry-back year. Because federal income tax rates were generally higher in years before the Tax Cuts and Jobs Act (TCJA) took effect, NOLs carried back to those years can be especially beneficial.
Qualified improvement property (QIP) technical corrections. QIP is generally defined as an improvement to an interior portion of a nonresidential building that’s placed in service after the date the building was first placed in service. The CARES Act includes a retroactive correction to the TCJA. The correction allows much faster depreciation for real estate QIP that’s placed in service after the TCJA became law.
Specifically, the correction allows 100% first-year bonus depreciation for QIP that’s placed in service in 2018 through 2022. Alternatively, you can depreciate QIP placed in service in 2018 and beyond over 15 years using the straight-line method.
Suspension of excess business loss disallowance. An “excess business loss” is a loss that exceeds $250,000 or $500,000 for a married couple filing a joint tax return. An unfavorable TCJA provision disallowed current deductions for excess business losses incurred by individuals in tax years beginning in 2018 through 2025. The CARES Act suspends the excess business loss disallowance rule for losses that arise in tax years beginning in 2018 through 2020.
Liberalized business interest deductions. Another unfavorable TCJA provision generally limited a taxpayer’s deduction for business interest expense to 30% of adjusted taxable income (ATI) for tax years beginning in 2018 and later. Business interest expense that’s disallowed under this limitation is carried over to the following tax year.
In general, the CARES Act temporarily and retroactively increases the limitation from 30% to 50% of ATI for tax years beginning in 2019 and 2020. (Special rules apply to partnerships and LLCs that are treated as partnerships for tax purposes.)
Assessing the opportunities
These are just some of the possible tax opportunities that may be available if you haven’t yet filed your 2019 tax return. Other rules and limitations may apply. Contact us for help determining how to proceed in your situation.
© 2020 Covenant CPA
New technologies, including artificial intelligence and machine learning, increasingly are being applied to the old problem of occupational fraud. But in most circumstances, common accounting tools — “variance analysis” and “contribution margin” — remain effective in uncovering possible evidence of theft.
Gaps and absences
After your organization finalizes its annual budget, you may perform a variance analysis, reviewing differences between actual and budgeted performance. If, for example, actual wages significantly exceed budgeted wages, the difference could be due to such factors as wage increases, productivity declines or greater downtime. But it could also signal phantom employees on the payroll.
Fraud experts pay particular attention to variances related to inventory and purchase pricing. Supply-related variances could indicate the existence of kickbacks. Or they might suggest fictitious vendors — where payments go to the perpetrator and no inventory is received in exchange.
The absence of variances when they’re expected can also be cause for concern. If the cost of a critical production component has unexpectedly increased, then the actual numbers should show a variance. If no such variance is found, it could be a sign of financial reporting fraud.
Difference between price and costs
The term contribution margin generally refers to the difference between a unit’s sale price and its variable costs. It’s often used to make pricing decisions, calculate the breakeven point and evaluate profitability. But it can also be used to detect fraud.
In general, the contribution margin as a percentage of revenue should remain fairly consistent over time. If the contribution margin is dramatically lower than usual, skimming or inventory theft could be to blame. Just keep in mind that one discrepancy doesn’t equal solid evidence of fraud. It simply indicates that further investigation is warranted.
Discrepancies are just a start
You may have the in-house expertise to expose potential fraud schemes using common accounting tools. But you should take suspicious results to a financial expert. Contact us. We use everything from modern analytic techniques to old-school witness interviews to get to the bottom of financial irregularities.
© 2020 Covenant CPA
The annual gift tax exclusion allows you to transfer up to $15,000 per beneficiary gift-tax-free for 2020, without tapping your lifetime gift and estate tax exemption. And you can double the exclusion to $30,000 per beneficiary if you elect to split the gifts with your spouse.
It’s important to understand the rules surrounding gift-splitting to avoid unintended — and potentially costly — consequences.
Understanding the pitfalls
Common mistakes made when splitting gifts include:
Failing to make the election. To elect to split gifts, the donor must file a gift tax return and the nondonor must consent by checking a box on the return and signing it or, if a gift exceeds $30,000, filing his or her own gift tax return. Once you make the election, you must split all gifts to third parties for the year.
Splitting gifts with a noncitizen. To be eligible for gift-splitting, one spouse must be a U.S. citizen.
Divorcing and remarrying. To split gifts, you must be married at the time of the gift. You’re ineligible for gift-splitting if you divorce and either spouse remarries during the calendar year in which the gift was made.
Gifting a future interest. Gift-splitting can be used only for present interests. So, a gift in trust qualifies only if the beneficiary receives a present interest — for example, by providing the beneficiary with so-called Crummeywithdrawal rights.
Benefiting your spouse. Gift-splitting is ineffective if you make the gift to your spouse, rather than a third party; if you give your spouse a general power of appointment over the gifted property; or if your spouse is a potential beneficiary of the gift. For example, if you make a gift to a trust of which your spouse is a beneficiary, gift-splitting is prohibited unless the chances your spouse will benefit are extremely remote.
Be aware that, if you die within three years of splitting a gift, some of the tax benefits may be lost.
Extended gift tax return deadline is approaching
Remember that when you elect to split gifts with your spouse, you, the donor, must file a gift tax return and your spouse, the nondonor, must consent by checking a box on the return and signing it. Bear in mind that because of the COVID-19 pandemic, the IRS extended the gift tax filing deadline to July 15, 2020, so now is the time to act. Contact us with any questions regarding making gifts.
© 2020 Covenant CPA
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.
© 2020 Covenant CPA
While the COVID-19 crisis has devastated many existing businesses, the pandemic has also created opportunities for entrepreneurs to launch new businesses. For example, some businesses are being launched online to provide products and services to people staying at home.
Entrepreneurs often don’t know that many expenses incurred by start-ups can’t be currently deducted. You should be aware that the way you handle some of your initial expenses can make a large difference in your tax bill.
How expenses must be handled
If you’re starting or planning a new enterprise, keep these key points in mind:
- Start-up costs include those incurred or paid while creating an active trade or business — or investigating the creation or acquisition of one.
- Under the Internal Revenue Code, taxpayers can elect to deduct up to $5,000 of business start-up and $5,000 of organizational costs in the year the business begins. As you know, $5,000 doesn’t get you very far today! And the $5,000 deduction is reduced dollar-for-dollar by the amount by which your total start-up or organizational costs exceed $50,000. Any remaining costs must be amortized over 180 months on a straight-line basis.
- No deductions or amortization deductions are allowed until the year when “active conduct” of your new business begins. Generally, that means the year when the business has all the pieces in place to begin earning revenue. To determine if a taxpayer meets this test, the IRS and courts generally ask questions such as: Did the taxpayer undertake the activity intending to earn a profit? Was the taxpayer regularly and actively involved? Did the activity actually begin?
Expenses that qualify
In general, start-up expenses include all amounts you spend to:
- Investigate the creation or acquisition of a business,
- Create a business, or
- Engage in a for-profit activity in anticipation of that activity becoming an active business.
To be eligible for the election, an expense also must be one that would be deductible if it were incurred after a business began. One example is money you spend analyzing potential markets for a new product or service.
To qualify as an “organization expense,” the expenditure must be related to creating a corporation or partnership. Some examples of organization expenses are legal and accounting fees for services related to organizing a new business and filing fees paid to the state of incorporation.
If you have start-up expenses that you’d like to deduct this year, you need to decide whether to take the elections described above. Recordkeeping is critical. Contact us about your start-up plans. We can help with the tax and other aspects of your new business.
© 2020 Covenant CPA
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.
© 2020 Covenant CPA
If you operate a small business, or you’re starting a new one, you probably know you need to keep records of your income and expenses. In particular, you should carefully record your expenses in order to claim the full amount of the tax deductions to which you’re entitled. And you want to make sure you can defend the amounts reported on your tax returns if you’re ever audited by the IRS or state tax agencies.
Certain types of expenses, such as automobile, travel, meals and office-at-home expenses, require special attention because they’re subject to special recordkeeping requirements or limitations on deductibility.
It’s interesting to note that there’s not one way to keep business records. In its publication “Starting a Business and Keeping Records,” the IRS states: “Except in a few cases, the law does not require any specific kind of records. You can choose any recordkeeping system suited to your business that clearly shows your income and expenses.”
That being said, many taxpayers don’t make the grade when it comes to recordkeeping. Here are three court cases to illustrate some of the issues.
Case 1: Without records, the IRS can reconstruct your income
If a taxpayer is audited and doesn’t have good records, the IRS can perform a “bank-deposits analysis” to reconstruct income. It assumes that all money deposited in accounts during a given period is taxable income. That’s what happened in the case of the business owner of a coin shop and precious metals business. The owner didn’t agree with the amount of income the IRS attributed to him after it conducted a bank-deposits analysis.
But the U.S. Tax Court noted that if the taxpayer kept adequate records, “he could have avoided the bank-deposits analysis altogether.” Because he didn’t, the court found the bank analysis was appropriate and the owner underreported his business income for the year. (TC Memo 2020-4)
Case 2: Expenses must be business related
In another case, an independent insurance agent’s claims for a variety of business deductions were largely denied. The Tax Court found that he had documentation in the form of cancelled checks and credit card statements that showed expenses were paid. But there was no proof of a business purpose.
For example, he made utility payments for natural gas, electricity, water and sewer, but the records didn’t show whether the services were for his business or his home. (TC Memo 2020-25)
Case number 3: No records could mean no deductions
In this case, married taxpayers were partners in a travel agency and owners of a marketing company. The IRS denied their deductions involving auto expenses, gifts, meals and travel because of insufficient documentation. The couple produced no evidence about the business purpose of gifts they had given. In addition, their credit card statements and other information didn’t detail the time, place, and business relationship for meal expenses or indicate that travel was conducted for business purposes.
“The disallowed deductions in this case are directly attributable to (the taxpayer’s) failure to maintain adequate records,“ the court stated. (TC Memo 2020-7)
We can help
Contact us if you need assistance retaining adequate business records. Taking a meticulous, proactive approach to how you keep records can protect your deductions and help make an audit much less painful.
© 2020 Covenant CPA
Machine learning increasingly is being used to discover fraud schemes. With this type of artificial intelligence (AI), the technology learns or improves in accuracy through experience, rather than through additional programming. If you already use AI in your business, you’re probably somewhat familiar with how machine learning works. But here’s a quick overview of its application in fraud detection.
New approaches needed
More and more, businesses rely on digitization to deliver the goods and services their customers want. Unfortunately, digitization also makes it easier both for cybercriminals and stakeholders, such as employees, vendors and customers, to steal. Preventing fraud in the digital age requires new approaches.
Machine learning is one such approach. Traditional rules-based fraud detection software flags transactions — such as purchase orders of a certain type or over a certain amount — that are suspicious according to static rules. On the other hand, fraud detection software that includes machine learning uses large sets of historical data to “learn,” or create algorithms about the patterns associated with new fraud schemes, enabling it to detect fraud in the future.
Step by step
For a machine to learn, its users must follow certain procedures. After the software is enabled to capture historical transaction data — and the more data, the better — the company using it reviews the data to ensure it presents an accurate picture of transactions. The software then applies algorithms to identify potentially suspicious items. This process creates the first fraud detection model. The software analyzes the same set of data repeatedly and produces new models for the company to review. The company provides feedback on each model to help the software develop better algorithms.
Through this process, the model learns what constitutes fraud and the number of false positives should drop significantly. In the end, the company selects the most accurate fraud detection model to put into production.
If you have the technical capabilities, you may be able to develop a customized machine learning program for fraud detection in-house. We can help if you don’t. Contact us.
© 2020 Covenant CPA
You may have good intentions in keeping a trust a secret from its beneficiaries. Perhaps you have concerns that, if your children or other beneficiaries know about the trust, they might set aside educational or career pursuits. Be aware, however, that the law in many states forbids this practice by requiring a trust’s trustee to disclose a certain amount of information about the trust to the beneficiaries.
More states enforce the Uniform Trust Code
The Uniform Trust Code (UTC), which now 34 states (and the District of Columbia) have adopted, requires a trustee to provide trust details to any qualified beneficiary who makes a request. The UTC also requires the trustee to notify all qualified beneficiaries of their rights to information about the trust.
Qualified beneficiaries include primary beneficiaries, such as your children or others designated to receive distributions from the trust, as well as contingent beneficiaries, such as your grandchildren or others who would receive trust funds in the event a primary beneficiary’s interest terminates.
Consider a power of appointment
One way to avoid UTC disclosure requirements is by not naming your children as beneficiaries and, instead, granting your spouse or someone else a power of appointment over the trust. The power holder can direct trust funds to your children as needed, but because they’re not beneficiaries, the trustee isn’t required to inform them about the trust’s terms — or even its existence. The disadvantage of this approach is that the power holder is under no legal obligation to provide for your children.
Turn to us for help
Before taking action, it’s important to check the law in your state. Some states allow you to waive the trustee’s duty to disclose, while others allow you to name a third party to receive disclosures and look out for beneficiaries’ interests. In states where disclosure is unavoidable, you may want to explore alternative strategies. If you have questions regarding trusts in your estate plan, please contact us.
© 2020 Covenant CPA
Transferring a family business to the next generation requires a delicate balancing act. Estate and succession planning strategies aren’t always compatible, and family members often have conflicting interests. By starting early and planning carefully, however, it’s possible to resolve these conflicts and transfer the business in a tax-efficient manner.
Ownership vs. management succession
One reason transferring a family business is such a challenge is the distinction between ownership and management succession. From an estate planning perspective, transferring assets to the younger generation as early as possible allows you to remove future appreciation from your estate, minimizing estate taxes. However, you may not be ready to hand over the reins of your business or you may feel that your children aren’t yet ready to take over.
There are several ways owners can transfer ownership without immediately giving up control, including:
- Using a family limited partnership (FLP),
- Transferring nonvoting stock, or
- Establishing an employee stock ownership plan.
Another reason to separate ownership and management succession is to deal with family members who aren’t involved in the business. It’s not unusual for a family business owner to have substantially all of his or her wealth tied up in the business.
Providing heirs outside the business with nonvoting stock or other equity interests that don’t confer control can be an effective way to share the wealth with them while allowing those who work in the business to take over management.
Conflicting financial needs
Another challenge presented by family businesses is that the older and younger generations may have conflicting financial needs. Fortunately, strategies are available to generate cash flow for the owner while minimizing the burden on the next generation. They include:
An installment sale. This provides liquidity for the owner while improving the chances that the younger generation’s purchase can be funded by cash flows from the business. Plus, so long as the price and terms are comparable to arm’s-length transactions between unrelated parties, the sale shouldn’t trigger gift or estate taxes.
A grantor retained annuity trust (GRAT). By transferring business interests to a GRAT, the owner obtains a variety of gift and estate tax benefits (provided he or she survives the trust term) while enjoying a fixed income stream for a period of years. At the end of the term, the business is transferred to the owner’s children or other beneficiaries. GRATs are typically designed to be gift-tax-free.
An installment sale to an intentionally defective grantor trust (IDGT). Essentially a properly structured IDGT allows an owner to sell the business on a tax-advantaged basis while enjoying an income stream and retaining control during the trust term. Once the installment payments are complete, the business passes to the owner’s beneficiaries free of gift taxes.
Each family business is different, so it’s important to identify appropriate strategies in light of your objectives and resources. We’d be pleased to help.
© 2020 Covenant CPA