If you own a business, would it make sense to hire your child? There are different facets to this question, and the one we will discuss today are the tax consequences.
Income Taxes
You can pay your child up to $5,800 without either of you incurring an income tax liability. As long as the wages are reasonable for the work performed, the wages are deductible to your business and taxable to your child. The child’s standard deduction of $5,800 can reduce the child’s taxable income to zero, effectively sheltering the wages.
Is the “kiddie tax” a consideration? The answer is no, as the kiddie tax applies to the transfer of passive income, such as interest and dividends. The income we are discussing is earned income, and the kiddie tax does not penalize earned income.
How much can you save? Well, that depends on your tax rate. If you are in the 35% tax bracket, then you are saving $2,030 in federal income taxes alone ($5,800 times 35%). This amount may be less if there is social security or you as employer have to pay federal unemployment tax. What are the rules for those taxes?
Social Security Tax
The social security consequence will vary depending on the age of the child and whether you are self-employed.
The first requirement is that the child must be under the age of 18.
If you are self employed (which is to say, you are unincorporated and file a Schedule C), you do not have to withhold or pay FICA taxes on a child under the age of 18. If you are under the FICA limit for 2011, this may be an immediate tax savings of 14.13% (15.3% times .9235). If you are over, then the FICA savings reduce to 2.68% (2.9% times .9235).
If you are incorporated, then there are no social security savings, as a different rule applies.
What if you are a partner in a partnership (or a member in an LLC)? If the only partners (or members) are the parents, then you do not have to withhold or pay FICA. Otherwise the corporate rule applies.
Federal Unemployment Tax
The same rule as for FICA applies here, with one exception. If the child works for your unincorporated business, or in a partnership (or LLC) where you and your spouse are the only partners (or members), then the wages will not be subject to FUTA. Otherwise, FUTA will apply.
The exception is the age cutoff. For FUTA, the child must be under age 21.
Income Tax Withholding
Usually, an employee who had no income tax liability for the prior year and expects none for the current year can claim exempt status and have no federal income tax withholding. There is a different rule for children who can be claimed as dependents on their parents’ return. That child cannot claim exempt status if his/her income will exceed $950 AND include more than $300 of interest, dividends and passive income of that nature.
Mind you, it is possible that you will get back the withholding when your child files his/her individual income tax return.
Tuesday, June 21, 2011
275,000 Charities Have Lost Tax Exempt Status
You may remember that charities, even small ones which previously had been exempt from IRS reporting, were required last year to file with the IRS. There was a “postcard’ filing (990N) for the smallest, but nonetheless everyone had to report.
What prompted this was a change in the tax law in 2006. The Pension Protection Act made it mandatory for most tax-exempts to file, irrespective of their gross receipts. This was a seismic change from prior law. If an organization failed to file for three consecutive years, then the PPA required it to lose its exempt status.
Counting off three years, many of these organizations had to file for the first time last year (2010). The IRS yesterday announced that approximately 275,000 organizations did not comply and have therefore automatically lost their exempt status. In addition, procedures have been announced for these organizations to regain their exempt status, in some cases by paying as little as a $100 fee.
Note that the revocation of status does not affect charitable deductions for amounts donated to these charities before 2011. However, deductions going forward will be disallowed because the organization names have been published - unless the charity reinstates its exempt status.
What prompted this was a change in the tax law in 2006. The Pension Protection Act made it mandatory for most tax-exempts to file, irrespective of their gross receipts. This was a seismic change from prior law. If an organization failed to file for three consecutive years, then the PPA required it to lose its exempt status.
Counting off three years, many of these organizations had to file for the first time last year (2010). The IRS yesterday announced that approximately 275,000 organizations did not comply and have therefore automatically lost their exempt status. In addition, procedures have been announced for these organizations to regain their exempt status, in some cases by paying as little as a $100 fee.
Note that the revocation of status does not affect charitable deductions for amounts donated to these charities before 2011. However, deductions going forward will be disallowed because the organization names have been published - unless the charity reinstates its exempt status.
United States v. Michael F. Schiavo
Let’s look at the matter of Michael Schiavo (United States v. Michael F. Schiavo). He was a bank director in Boston and had invested in a medical device partnership. This partnership had monies overseas. Schiavo decided to tuck the money (approximately $100,000) away and not tell anyone. He did not report the income and certainly did not file the Foreign Bank and Financial Accounts report (FBAR) with the Treasury on or before June 30 every year.
The partnership gave him about $100,000 in Bermuda to play with. He failed to file the FBARs for 2003 through 2008, so he was playing for a while.
He notices what the government was doing with UBS, meets with his advisor and decides to do a “quiet disclosure.” This means that he either amends his income tax return, files the FBAR, or both, without otherwise bringing attention to it. That is, it’s “quiet.”
The IRS had offered an amnesty program for foreign-account taxpayers back in 2009. The advantage was that the government would not prosecute. The downside was that there would be income taxes, penalties and a special 20% penalty for not having reported the monies originally. This program expired in October, 2009. Schiavo decided this was not for him.
The IRS has introduced another amnesty program in 2011, again allowing foreign-account taxpayers to come clean. This time the program covers two more years, and the penalties have been increased to 25% (with some exceptions). The IRS wants to increase the burden to the taxpayer so as not to reward the earlier act of noncompliance.
So Schiavo prepares and files FBARs for 2003 through 2008 but does not participate in the amnesty. That is, he is “quiet.” An IRS special agent then contacts him, whereupon Schiavo amends his income tax return to include the unreported income he just reported to the IRS via the FBAR.
You read this right. He made a quiet disclosure to the IRS but did not amend his income tax return to include the income he had just alerted them to.
The IRS estimates that the taxes at play were about $40,000.
Schiavo was convicted. He now faces a fine and possible jail time.
You are going to take this kind of risk for $40,000 in tax? Are you kidding me? You cannot retire on $40,000. Heck, one can barely send a kid to two years of college for $40,000. What was this guy thinking?
The partnership gave him about $100,000 in Bermuda to play with. He failed to file the FBARs for 2003 through 2008, so he was playing for a while.
He notices what the government was doing with UBS, meets with his advisor and decides to do a “quiet disclosure.” This means that he either amends his income tax return, files the FBAR, or both, without otherwise bringing attention to it. That is, it’s “quiet.”
The IRS had offered an amnesty program for foreign-account taxpayers back in 2009. The advantage was that the government would not prosecute. The downside was that there would be income taxes, penalties and a special 20% penalty for not having reported the monies originally. This program expired in October, 2009. Schiavo decided this was not for him.
The IRS has introduced another amnesty program in 2011, again allowing foreign-account taxpayers to come clean. This time the program covers two more years, and the penalties have been increased to 25% (with some exceptions). The IRS wants to increase the burden to the taxpayer so as not to reward the earlier act of noncompliance.
So Schiavo prepares and files FBARs for 2003 through 2008 but does not participate in the amnesty. That is, he is “quiet.” An IRS special agent then contacts him, whereupon Schiavo amends his income tax return to include the unreported income he just reported to the IRS via the FBAR.
You read this right. He made a quiet disclosure to the IRS but did not amend his income tax return to include the income he had just alerted them to.
The IRS estimates that the taxes at play were about $40,000.
Schiavo was convicted. He now faces a fine and possible jail time.
You are going to take this kind of risk for $40,000 in tax? Are you kidding me? You cannot retire on $40,000. Heck, one can barely send a kid to two years of college for $40,000. What was this guy thinking?
Appeal of Destino Properties, LLC
Here is a June addition to our ongoing discussion of questionable state tax laws.
This one takes us to California.
Destino Properties LLC (“LLC”) was organized in Nevada. It had one asset: a single family home in Nevada. The LLC had four members, three of which lived in California. One of the California members received the rental checks and deposited them to a California bank account. The LLC argued that the majority of its management activities, to the extent there were any, took place outside California.
Let’s add one more fact. California charges an $800 annual fee for LLCs and disregarded entities doing business or registered in the state. The LLC was not registered in California.
Question: does Destino have to pay the $800 fee to California?
The Franchise Tax Board (FTB) contended that Destino was doing business in California because actions by members are attributable to the LLC. Therefore, if the member performed activities in California, those activities could be imputed as LLC activities.
Think about this for a second. The one activity of the LLC was to rent property. It did this in Nevada. The title was in Nevada. The insurance was in Nevada. The real estate taxes were in Nevada. Last time anyone looked, Nevada was not a county of California. Did the managerial activities of the LLC (three-fourths of which were in California) outweigh THE SOLE operational activity of the LLC (which was ALL in Nevada)? What if the LLC was a plastic fabricator with a workforce of 200 employees? Would it still be pulled in by California? At which point would the operational activities of the LLC outweigh the managerial activities of its members?
California reasoned that receiving rental checks, authorizing repairs and hiring a California tax preparer all constituted “doing business” in California. Here is tax planning: hire K&C as your CPAs. We are in Ohio, which is not California. We might recommend that the rental checks also come here, and we could deposit them on your behalf. You could choose an Ohio or a Kentucky bank, as Kentucky is just across the river. That would be two less activities for California to claim.
What is going on, of course, is that California was going find nexus, no matter what.
This one takes us to California.
Destino Properties LLC (“LLC”) was organized in Nevada. It had one asset: a single family home in Nevada. The LLC had four members, three of which lived in California. One of the California members received the rental checks and deposited them to a California bank account. The LLC argued that the majority of its management activities, to the extent there were any, took place outside California.
Let’s add one more fact. California charges an $800 annual fee for LLCs and disregarded entities doing business or registered in the state. The LLC was not registered in California.
Question: does Destino have to pay the $800 fee to California?
The Franchise Tax Board (FTB) contended that Destino was doing business in California because actions by members are attributable to the LLC. Therefore, if the member performed activities in California, those activities could be imputed as LLC activities.
Think about this for a second. The one activity of the LLC was to rent property. It did this in Nevada. The title was in Nevada. The insurance was in Nevada. The real estate taxes were in Nevada. Last time anyone looked, Nevada was not a county of California. Did the managerial activities of the LLC (three-fourths of which were in California) outweigh THE SOLE operational activity of the LLC (which was ALL in Nevada)? What if the LLC was a plastic fabricator with a workforce of 200 employees? Would it still be pulled in by California? At which point would the operational activities of the LLC outweigh the managerial activities of its members?
California reasoned that receiving rental checks, authorizing repairs and hiring a California tax preparer all constituted “doing business” in California. Here is tax planning: hire K&C as your CPAs. We are in Ohio, which is not California. We might recommend that the rental checks also come here, and we could deposit them on your behalf. You could choose an Ohio or a Kentucky bank, as Kentucky is just across the river. That would be two less activities for California to claim.
What is going on, of course, is that California was going find nexus, no matter what.
The IRS is Pursuing 501(c)(4)s
The 2011 Workplan of the IRS Exempt Organizations Division states:
"[i]n recent years, our examination program has concentrated on section 501(c)(3) organizations. Beginning in FY 2011, we are increasing our focus on section 501(c)(4), (5) and (6) organizations."
The (c)(3) is the classic charity – Muscular Dystrophy or March of Dimes, for example. The purpose of a (c)(4) is to pursue a near-endless range of public policy goals through action and advocacy. Many of these entities are barred from (c)(3) status because they express their advocacy through political activity. It is quite common to couple a (c)(3) with a (c)(4). You already know some of the big (c)(4) players, organizations such as AARP and the National Rifle Association.
Now let’s carve-out the meaning of “political activities”:
* Promoting legislation germane to the (c)(4)s purpose is considered a permissible social welfare purpose. Therefore an organization can qualify as tax-exempt under( c)(4) even if the organization’s only activity is lobbying, as long as the lobbying is related to its exempt purpose.
* A social welfare purpose does not include participating in an election in order to advance or defeat a given candidate. Candidate-related activity cannot be the (c)(4)s primary activity. The IRS does not tell us what “primary” means, and advisors differ. Some advisors s feel comfortable with electioneering approaching (but always remaining below) 50% of the organization’s total activities. It is unclear how to even measure activities. What is the measure: dollars spent, time spent by staff and volunteers, a percentage of fixed expenses (such as rent)?
So lobbying is acceptable but electioneering is not.
Donations to (c)(4)s are not afforded the same protection as a (c)(3), and the IRS has held its powder for almost 30 years on whether it would consider (c)(4) donations to be subject to the gift tax.
That has changed.
How would the IRS know who donated to a (c)(4)? A (c)(4) has to disclose to the IRS on its 990 filing contributors who donated $5,000 or more. This list however does not have to be publicly disclosed. Therefore, you and I might not know, but the IRS would. It would not be a difficult task for the IRS to identify donors for audit.
And they have. The IRS has recently sent letters that read as follows:
"Your 2008 gift tax return (Form 709) has been assigned to me for examination. The Internal Revenue Service has received information that you donated cash to [REDACTED], an IRC Section 501(c)(4) organization. Donations to 501(c)(4) organizations are taxable gifts and your contribution in 2008 should have been reported on your 2008 Federal Gift Tax Return (Form 709)."
The federal gift tax applies to a gratuitous transfer of property by an individual. The gift tax is separate from the individual income tax. Not all gratuitous transfers are subject to the gift tax. Transfers between spouses are not considered gifts, for example. An individual can give away $13,000 per year to anyone for any reason without involving the gift tax. Donations to (c)(3)s are not considered gifts, irrespective of the amount. Donations to a 527 organization (that is, a PAC) are not considered gifts. Donations to a (c)(4) are considered gifts.
At least they are considered gifts by the IRS. The IRS pulled out almost 30 years ago, and the limited guidance and cases in this area leaves doubt that the IRS is correct. If one focuses in on the political nature of the contribution, then one has to consider Stern and Carson, for example. In Stern (CA-5, 1971), the IRS lost its argument that campaign contributions were taxable gifts. In Carson (CA-10, 1981) the Tax Court held that Congress did not intend for gift tax to apply to campaign contributions, and the Tenth Circuit affirmed on this point.
We almost undoubtedly will see this matter litigated.
"[i]n recent years, our examination program has concentrated on section 501(c)(3) organizations. Beginning in FY 2011, we are increasing our focus on section 501(c)(4), (5) and (6) organizations."
The (c)(3) is the classic charity – Muscular Dystrophy or March of Dimes, for example. The purpose of a (c)(4) is to pursue a near-endless range of public policy goals through action and advocacy. Many of these entities are barred from (c)(3) status because they express their advocacy through political activity. It is quite common to couple a (c)(3) with a (c)(4). You already know some of the big (c)(4) players, organizations such as AARP and the National Rifle Association.
Now let’s carve-out the meaning of “political activities”:
* Promoting legislation germane to the (c)(4)s purpose is considered a permissible social welfare purpose. Therefore an organization can qualify as tax-exempt under( c)(4) even if the organization’s only activity is lobbying, as long as the lobbying is related to its exempt purpose.
* A social welfare purpose does not include participating in an election in order to advance or defeat a given candidate. Candidate-related activity cannot be the (c)(4)s primary activity. The IRS does not tell us what “primary” means, and advisors differ. Some advisors s feel comfortable with electioneering approaching (but always remaining below) 50% of the organization’s total activities. It is unclear how to even measure activities. What is the measure: dollars spent, time spent by staff and volunteers, a percentage of fixed expenses (such as rent)?
So lobbying is acceptable but electioneering is not.
Donations to (c)(4)s are not afforded the same protection as a (c)(3), and the IRS has held its powder for almost 30 years on whether it would consider (c)(4) donations to be subject to the gift tax.
That has changed.
How would the IRS know who donated to a (c)(4)? A (c)(4) has to disclose to the IRS on its 990 filing contributors who donated $5,000 or more. This list however does not have to be publicly disclosed. Therefore, you and I might not know, but the IRS would. It would not be a difficult task for the IRS to identify donors for audit.
And they have. The IRS has recently sent letters that read as follows:
"Your 2008 gift tax return (Form 709) has been assigned to me for examination. The Internal Revenue Service has received information that you donated cash to [REDACTED], an IRC Section 501(c)(4) organization. Donations to 501(c)(4) organizations are taxable gifts and your contribution in 2008 should have been reported on your 2008 Federal Gift Tax Return (Form 709)."
The federal gift tax applies to a gratuitous transfer of property by an individual. The gift tax is separate from the individual income tax. Not all gratuitous transfers are subject to the gift tax. Transfers between spouses are not considered gifts, for example. An individual can give away $13,000 per year to anyone for any reason without involving the gift tax. Donations to (c)(3)s are not considered gifts, irrespective of the amount. Donations to a 527 organization (that is, a PAC) are not considered gifts. Donations to a (c)(4) are considered gifts.
At least they are considered gifts by the IRS. The IRS pulled out almost 30 years ago, and the limited guidance and cases in this area leaves doubt that the IRS is correct. If one focuses in on the political nature of the contribution, then one has to consider Stern and Carson, for example. In Stern (CA-5, 1971), the IRS lost its argument that campaign contributions were taxable gifts. In Carson (CA-10, 1981) the Tax Court held that Congress did not intend for gift tax to apply to campaign contributions, and the Tenth Circuit affirmed on this point.
We almost undoubtedly will see this matter litigated.
The Mobile Workforce State Income Tax Simplification Act of 2011
Kudos to US Representative Hank Johnson (GA) for cosponsoring the Mobile Workforce State Income Tax Simplification Act of 2011. This bill was proposed in a previous session of Congress. At the end of each session, all bills and resolutions that haven’t passed are cleared. Rep Johnson has reintroduced the bill with Rep Coble (NC).
The concept is simple: if an employer sends employees temporarily across state lines, the employer will not have to register with and withhold taxes for the other state. Temporary is defined as 30 days or less.
Rep Johnson comments:
The tax system is already too burdensome and complicated as it is. This simplifies the code and would prevent Americans who work in multiple jurisdictions from being taxed by state and local governments other than the places in which they live or perform duties over an extended period.”
The hearing was May 25, 2011 before the Subcommittee on Courts, Commercial and Administrative Law.
As someone who has had to worry about this very same issue, I am pleased that someone up in Washington “gets it.”
Perhaps they should include sales taxes and also call in bureaucrats from Texas to explain their position on trade shows. Consider this gem. The Texas Comptroller determined that an out-of-state seller of dental equipment was required to collect sales taxes because it attended an annual trade show in Texas. Mind you, the orders were filled, shipped and billed from outside Texas, but the company did send a person to attend that trade show. Yipes!
The concept is simple: if an employer sends employees temporarily across state lines, the employer will not have to register with and withhold taxes for the other state. Temporary is defined as 30 days or less.
Rep Johnson comments:
The tax system is already too burdensome and complicated as it is. This simplifies the code and would prevent Americans who work in multiple jurisdictions from being taxed by state and local governments other than the places in which they live or perform duties over an extended period.”
The hearing was May 25, 2011 before the Subcommittee on Courts, Commercial and Administrative Law.
As someone who has had to worry about this very same issue, I am pleased that someone up in Washington “gets it.”
Perhaps they should include sales taxes and also call in bureaucrats from Texas to explain their position on trade shows. Consider this gem. The Texas Comptroller determined that an out-of-state seller of dental equipment was required to collect sales taxes because it attended an annual trade show in Texas. Mind you, the orders were filled, shipped and billed from outside Texas, but the company did send a person to attend that trade show. Yipes!
Taxes on IRS-Prepared Returns Are Not Discharged in Bankruptcy
A recent bankruptcy case gave me pause. The case is Cannon v U.S.
The Cannons did not file tax returns for 1999 through 2001. The IRS audited and made income tax assessments based on the audit. This is known as a substitute return.
The Cannons later filed for bankruptcy. The IRS said that their taxes for 1999 through 2001 were nondischargeable.
What is the issue here? To be dischargeable in bankruptcy, a debtor’s taxes must meet several tests:
* The returns are due more than three years before bankruptcy
* The tax must be assessed more than 240 days before bankruptcy
* A return must have been filed more than 2 years prior to bankruptcy
* The return must not be fraudulent
* The taxpayer must not have attempted to evade tax
The issue is the definition of “return.” In 2005 the Bankruptcy Code was amended to include the following gem of wordsmithing:
...the term ‘return’ means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements.) Such term includes a return prepared pursuant to § 6020(a) of the Internal Revenue Code of 1986, or similar State or local law, or a written stipulation to a judgment or a final order entered by a nonbankruptcy tribunal, but does not include a return made pursuant to § 6020(b) of the Internal Revenue Code of 1986, or a similar State or local law.”
So a return under IRC Section 6020(a) will qualify. What does Sec 6020(a) say?
6020(a) Preparation of Return by Secretary.—
If any person shall fail to make a return required by this title or by regulations prescribed thereunder, but shall consent to disclose all information necessary for the preparation thereof, then, and in that case, the Secretary may prepare such return, which, being signed by such person, may be received by the Secretary as the return of such person.
The Bankruptcy Code will accept the above but will not accept the following under Sec 6020(b):
6020(b)(1)Authority of secretary to execute return.—
If any person fails to make any return required by any internal revenue law or regulation made thereunder at the time prescribed therefor, or makes, willfully or otherwise, a false or fraudulent return, the Secretary shall make such return from his own knowledge and from such information as he can obtain through testimony or otherwise.
The problem is that a substitute return is a Sec 6020(b) return. If you owe tax with this IRS-prepared substitute return, you are facing the possibility that this tax is nondischargeable, even if the 2-year period has expired.
The question I have is whether amending an IRS-prepared Sec 6020(b) return will constitute filing a tax return and thereby begin the 2-year period. I am looking at Judge Easterbrook’s language in Payne, and Payne’s descendants, such as Creekmore and Links. I must admit, it as clear as mud.
The tax planning for this is pretty straightforward however: file your returns before the IRS catches you.
The Cannons did not file tax returns for 1999 through 2001. The IRS audited and made income tax assessments based on the audit. This is known as a substitute return.
The Cannons later filed for bankruptcy. The IRS said that their taxes for 1999 through 2001 were nondischargeable.
What is the issue here? To be dischargeable in bankruptcy, a debtor’s taxes must meet several tests:
* The returns are due more than three years before bankruptcy
* The tax must be assessed more than 240 days before bankruptcy
* A return must have been filed more than 2 years prior to bankruptcy
* The return must not be fraudulent
* The taxpayer must not have attempted to evade tax
The issue is the definition of “return.” In 2005 the Bankruptcy Code was amended to include the following gem of wordsmithing:
...the term ‘return’ means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements.) Such term includes a return prepared pursuant to § 6020(a) of the Internal Revenue Code of 1986, or similar State or local law, or a written stipulation to a judgment or a final order entered by a nonbankruptcy tribunal, but does not include a return made pursuant to § 6020(b) of the Internal Revenue Code of 1986, or a similar State or local law.”
So a return under IRC Section 6020(a) will qualify. What does Sec 6020(a) say?
6020(a) Preparation of Return by Secretary.—
If any person shall fail to make a return required by this title or by regulations prescribed thereunder, but shall consent to disclose all information necessary for the preparation thereof, then, and in that case, the Secretary may prepare such return, which, being signed by such person, may be received by the Secretary as the return of such person.
The Bankruptcy Code will accept the above but will not accept the following under Sec 6020(b):
6020(b)(1)Authority of secretary to execute return.—
If any person fails to make any return required by any internal revenue law or regulation made thereunder at the time prescribed therefor, or makes, willfully or otherwise, a false or fraudulent return, the Secretary shall make such return from his own knowledge and from such information as he can obtain through testimony or otherwise.
The problem is that a substitute return is a Sec 6020(b) return. If you owe tax with this IRS-prepared substitute return, you are facing the possibility that this tax is nondischargeable, even if the 2-year period has expired.
The question I have is whether amending an IRS-prepared Sec 6020(b) return will constitute filing a tax return and thereby begin the 2-year period. I am looking at Judge Easterbrook’s language in Payne, and Payne’s descendants, such as Creekmore and Links. I must admit, it as clear as mud.
The tax planning for this is pretty straightforward however: file your returns before the IRS catches you.
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