August 2014 Tax Newsletter

What’s Inside:

Tax Collections:
IRS Expands Offer in Compromise Program

Planning:
College Bound Students:
* Financial Aid Starts with the FAFSA
* Grandparent Aid for College Costs

Tax Disputes/Controversy:
Reasonable Compensation for S Corporation Owners

Criminal Corner:
Offshore Bank Account Sentencing Order – Northern California

Tax Calendar

TAX COLLECTIONS:

IRS Expands Offer in Compromise Program
For those who have a tax bill they cannot pay, the IRS has expanded its Offer in Compromise Program to allow for greater acceptance.  For instance, the IRS has revised its calculation on future income, allows student loan repayments, and has expanded the allowable living expenses.  Therefore, if you have a tax bill that you cannot pay, we ask that you contact Moskowitz LLP so that we can review your particular circumstances and see if you would now likely qualify for an offer in compromise.

For years, our firm has taken a more conservative approach when advising clients regarding Offer in Compromise due to the rigid IRS standards, length of time and amount of energy involved in the process, and the low likelihood of success.  However, in light of program changes, we are recommending that our clients take another look at the program.

Here is why:

Offers in Compromise are analyzed based upon one’s equity in assets and future net income.  In the past, taxpayers had to include as part of their offer an amount equal to 48-60 months of future net income.  Now, the amount is reduced to a multiple of 12-24 months.  This is an extraordinary reduction and could result in Offer in Compromise becoming a viable strategy.

 

How this reduction will work:

Example 1:

• Taxpayer owes $125,000 to the IRS
• Taxpayer earns $80,000 per year.
• According to the national and local standards, the Taxpayer can afford to pay $750 per month to the IRS.
• The Taxpayer has $40,000 in realizable value of his/her assets.

Under the old rules the acceptable offer would have been $76,000, computed by multiplying the $750 by 48 ($36,000) and adding the $40,000.

Under the new rules, the acceptable offer would be $9000 ($750 by 12) and the value of the assets for a total of $49,000.

Example 2:

• Taxpayer owes $400,000 to the IRS.
•  Taxpayer earns $250,000 per year.
•  According to the national and local standards, the Taxpayer can afford to pay $4,000 per month to the IRS.
•  The taxpayer has $5,000 in realizable value of his/her assets.

Under the old rules the acceptable offer would have been $197,000, computed by multiplying the $4,000 by 48 ($192,000) and adding the $5,000.

Under the new rules the acceptable offer will be $53,000, computed by multiplying the $4,000 by 12 ($48,000) and adding the $5,000.

It should be noted, if full payment of the tax can be made within the statute of limitations to collect tax (usually ten years from the filing of the return), then the offer will be rejected.  But, even in these cases, with proper planning, an Offer in Compromise may be successful.

There are also other major changes to the Offer in Compromise analysis.  For instance, the calculation of the fair market value of assets utilized in business is one such change.  The equity in income producing assets will no longer be added to the value of an ongoing business, unless such assets are not critical to the business operations.

Example: A real estate salesman has a vehicle with $30,000 in equity.  The vehicle is used to transport clients and assists in the production of income.  The equity in the vehicle will generally no longer be included in the value of the Offer in Compromise.

PLANNING:

College Bound Students: Financial Aid Starts with the FAFSA
College-bound students and their families have more work to complete beyond submitting applications and (hopefully) deciding which school to attend.  Students should file the Free Application for Federal Student Aid (FAFSA) before starting college and in succeeding years.  As the cost of higher education soars, filing the FAFSA may provide some valuable relief.

Why it’s important
Using the FAFSA to apply for aid opens the door to various forms of assistance, including need-based grants, merit-based scholarships, education loans, and work opportunities.  Funds may come from federal or state governments or from individual colleges.

Essentially, aid applicants use the FAFSA to report the student’s assets, student’s income, parents’ assets, and parents’ income.  This data is placed into a formula to determine the expected family contribution (EFC) for the coming academic year.  If the cost of attending a given college exceeds the EFC, the student may be offered some form of financial aid.

Some parents may choose not to have their children file the FAFSA, either because they doubt they’ll receive need-based aid or because they don’t want to deprive more deserving applicants of limited aid dollars.  While it’s for each family to decide, not filing the FAFSA may have repercussions.  Some merit scholarships require the FAFSA, as do federal education loans.  What’s more, some colleges are so expensive that relatively affluent parents can qualify for aid, especially if more than one child will be attending college.

Application assistance
You and your student can fill out the FAFSA online at www.fafsa.ed.gov.  Please be aware, some colleges require additional financial aid forms, and the entire process can be time-consuming.  Our office is available to help college students and their families in the preparation and submission of tax returns as part of the documents required for submission of the application.

College Bound Students: Grandparent Aid for College Costs
Many grandparents would like to help their grandchildren with the steep costs of higher education.  It is often a laudable goal, but some methods of providing this assistance can prove to be more effective than others.

Grand gifts
The simplest tactic is to gift money to grandchildren before or during their college years.  In 2014, the annual gift tax exclusion is $14,000 per recipient.

Example 1: Cora Smith has three grandchildren.  She can give each of them $14,000 this year for their college funds.  Cora’s husband, Rob, can make identical gifts to each of their grandchildren.  Such gifts will have no adverse tax consequences.  (Larger gifts may reduce this couple’s gift tax exemption and, ultimately, their estate tax exemption.)

In addition to all of these $14,000 gifts, the Smiths can pay the college tuition for any of their grandchildren.  No matter how large these outlays might be, Cora and Rob will not owe any tax or suffer any reduction in their transfer tax breaks.

Axing aid
Such grandparent gifts may have disadvantages.  They can result in the reduction financial aid.

Example 2: Over the years, Rob and Cora have made gifts to their grandson Doug.  Counting investment buildup, Doug has $50,000 worth of assets when he fills out the FAFSA (see the article “Financial Aid Starts with the FAFSA” in this issue) for his first year of college.  The FAFSA assesses Doug’s assets by 20%, when calculating the expected family contribution (EFC), so the $50,000 could reduce his financial aid by $10,000.  Tuition payments by Rob and Cora for Doug’s schooling could result in even larger aid cutbacks.

For some grandparents, this may not be a major concern.  The student’s immediate family could have such extensive assets and substantial income that need-based financial aid won’t be possible.  However, today’s college costs are so high that aid might be available, even to well-off families.  The possible impact on financial aid should be discussed with the student’s parents.

In addition, it should be considered that assets given to grandchildren will come under their control once they come of age, usually on or before the age of 21.  Grandparents need to be comfortable with the idea that the money in a grandchild’s account may or may not be used for education or other worthwhile purposes.

Grandparents to parents
Instead of making gifts directly to grandchildren, grandparents can give assets to their own children who are the student’s parents.  This plan will have less impact on financial aid.

Example 3: Assume that Cora and Rob have made gifts to their daughter Elly, Doug’s mother, rather than making gifts directly to Doug.  These gifts have increased Elly’s assets by $50,000.  A parent’s assets are assessed at no more than 5.64% on the FAFSA so the additional assets held in Elly’s name would reduce possible aid by $2,820.

Therefore, giving money to the student’s parent would be better than giving money to the student, if financial aid is a concern, assuming the parents are more financially prudent and less chance exists for the transferred assets to be squandered.

Focusing on 529 plans
If concerns about the security and intent of the gifted funds still exist, these may be addressed by contributing to a 529 college savings plan.  These plans have many advantages.

Example 4: Cora Smith creates three 529 accounts, naming a different grandchild as the beneficiary for each one.  Cora now has control over how the money will be invested and how it will be spent.  Any investment earnings will be tax-free and distributions will also be untaxed, if the money is used for the beneficiary’s college bills.  Cora can even reclaim the funds in the 529 if she needs money, by paying tax and (with some exceptions) a 10% penalty on any earnings.

What’s more, a 529 account owned by a grandparent isn’t reported on the grandchild’s FAFSA, and as such, will not have any initial impact on financial aid.  It’s true that eventual distributions from a grandparent’s 529 will be reported on subsequent FAFSA and will substantially reduce financial aid.  While this won’t be a concern for families who are not receiving need-based aid, if the student needs the aid, distributions from the grandparent’s 529 plan can be postponed until the last FAFSA has been filed.

Example 5: Doug Franklin will start college in the 2015-2016 school year, and he files his first FAFSA in January 2015.  Doug receives some need-based aid so his grandmother Cora lets the 529 account continue to grow, untaxed.  Doug files a new FAFSA every year until January 2018, when he submits the form for his senior year.  Subsequently, Cora can use the 529 account to pay Doug’s remaining college bills.  Doug won’t be filing any more FAFSAs for financial aid, so Cora’s 529 distributions won’t be reported.

The bottom line is that grandparents have many tactics available if they wish to give their grandchildren financial assistance on the path towards achieving a college degree.

 

TAX DISPUTES/CONTROVERSY:

Reasonable Compensation for S Corporation Owners
For regular C corporations, “reasonable compensation” can be a troublesome tax issue.  The IRS doesn’t want shareholder executives to inflate their deductible salaries while minimizing the corporation’s nondeductible dividend payouts.

For S corporation owners, the opposite is true.  If owner employees take what the IRS considers “unreasonably low” compensation, the IRS may recast the earnings to reflect higher payroll taxes, along with interest and penalties.  In our blog post, IRS Targets: Tax Audits of Partnerships, LLC, and other Pass through Entities, we discussed the increased likelihood of IRS audits – one particular area where we have seen an increase in scrutiny is the reasonable compensation of S-Corp owners.

One pocket to pick
Eligible corporations that elect S status avoid corporate income taxes.  Instead, all income flows through to the shareholders’ personal tax returns.

Example 1: Ivan Nelson owns a plumbing supply firm structured as an S corporation.  Ivan’s salary is $250,000 a year while the company’s profits are $400,000.  The $650,000 total is reported on Ivan’s personal tax return.

In 2014, Ivan pays 12.4% as the employer and employee shares of Social Security tax on $117,000 of earnings.  He also pays a 2.9% Medicare tax on his $250,000 salary.  As a result of recent tax legislation, Ivan-who is not married-owes an additional 0.9% Medicare tax on $50,000, the amount over the $200,000 earnings threshold (the threshold is $250,000 on a joint tax return).  Altogether, Ivan pays well over $20,000 in payroll taxes.

Going low
Often, S corporation owners have a great deal of leeway in determining their salary and any bonus.  Holding down these earnings may reduce payroll taxes.

Example 2: Jenny Maxwell owns an electrical supply firm across the street from Ivan’s business.  Jenny’s company also is an S corporation.  She reports the same $650,000 of income from the business but Jenny classes only $75,000 as salary and $575,000 as profits from the business.  Thus, she pays thousands of dollars less than Ivan pays for Social Security and Medicare taxes.

Proving your payout
As mentioned, the IRS might target S corporation owners who are suspected of low-balling earned income.  Therefore, all S corporation shareholders should take steps to justify the reasonableness of their compensation.

If you own an S corporation, consider spelling out your salary level in your corporate minutes.  Where possible, give examples and quote industry statistics that show your compensation is in line with the amounts paid to executives at similar firms.

Other explanations might also help.  Depending on the situation, you might say that business is slow, in the current economy, so the minutes will report that you are keeping your salary low to provide working capital for the company.  If your business is young, the minutes could explain that you’re holding fixed costs down, so the company can grow, but you expect to earn more in the future.  In still another scenario, you might say that you are nearing retirement and are making an effort to rely more on valued employees, so a modest level of earnings reflects the actual work you’re now contributing.

As illustrated above, holding down S corporation compensation can result in a sizable payroll tax savings.  Moskowitz LLP is here to help you in establishing a reasonable, tax-efficient plan for your salary and bonus.

Calculating coverage
Beyond compensation, health insurance may also affect the payroll tax paid by an S corporation owner.  Special rules apply to anyone owning more than 2% of the company’s stock.

If the company has a health plan and pays some or all of the costs for coverage of such a so-called “2% shareholder,” the payments will be reported to the IRS as taxable income.  However, that amount will not be subject to payroll taxes, including those for Medicare and Social Security.  The company can take a deduction for these payments, effectively reducing corporate profits passed through to the shareholder as taxable income.

In addition, the S corporation shareholder may be able to deduct the premiums paid by the company-this deduction can be taken on page 1 of his or her personal tax return, which may provide other tax benefits.  However, such an “above-the-line” deduction cannot be taken in any month when the shareholder or spouse is eligible to participate in another employer-sponsored health plan.  Also, this deduction cannot exceed the amount of the shareholder’s earned income for the year.

This can be a complicated issue, especially if your state law prevents a corporation from buying group health insurance for a single employee.  If you own an S corporation, our office is here to help you decide the best way to minimize payroll tax as well as income tax from your health plan.  Also, if you find the IRS is questioning the compensation, please contact our office to discuss the matter.

 

CRIMINAL CORNER:

Offshore Bank Account Sentencing Order – Northern California
An Offshore Bank Account Convicted by a Jury Trial was sentenced in the Northern District of California on July 12, 2014.  The jury found that the individual (Ashvin Desai) failed to report his family’s foreign bank account to the government on their tax returns and FBARs as well as failing to disclose over $1.2 million in interest income.  The Northern District sentenced him to six months in prison, plus six months and one day of home confinement.  Of course the civil tax penalties (which may be as much as $14,229,744) must be paid as well.  This represents a departure in sentencing for this offense and we are interested to see if the government will appeal the sentencing order, as they have recently done in a similar matter.