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Elective Pass-Through Entity Tax
Business vs. Hobby – Key Differences You Need to Know
IRS Dirty Dozen (2022)
General Business Tax Credit Compliance
Articles
Elective Pass-Through Entity Tax
By Travis Moffett, Tax Manager
With the enactment of the Tax Cuts and Jobs Act of 2017, there was a $10,000 cap on the deduction of state and local taxes (SALT) for individuals beginning with the 2018 tax year. In response to this, some states have enacted an optional pass-through entity tax as a workaround to the cap. This election allows passthrough entities to deduct state taxes at the entity level on their federal income tax returns, while providing a credit or income exclusion to the entity owners for state income tax purposes.
What is the Elective PTE Tax?
Owners of pass-through entities are typically responsible for paying the taxes on the entity’s taxable income. This election allows pass-through entities to pay state income taxes on the owners’ behalf. PTE tax is calculated based on tax rates determined at the entity level regardless of the individual partners’ effective state tax rates. The payments of these taxes are fully deductible by the entity for federal income tax purposes and are passed through to the owners’ form 1040 Schedule E. Regarding the PTE owners’ state tax calculations, some states, such as Louisiana and Wisconsin, allow the owners of PTEs to obtain an income exclusion for the amount of pass-through income that has been taxed at the pass-through entity level. While other states allow a dollar-for-dollar state tax credit on the K-1 in the amount of state taxes paid by the PTE.
Please note that PTE tax is different from composite tax, which only covers non-resident PTE owners.
Things to consider before making an election:
Along with making the election to be taxed at the entity level come issues that should be addressed before making such an election including:
- Legal and accounting costs of making the election.
- Determining whether some owners might benefit disproportionately from others.
- Tax consequences to PTE owners for their resident state where the credit for their share of taxes paid to another state is not allowed.
- The aggregate additional state tax burdens might exceed the federal tax savings.
- The election should be evaluated on a year-to-year basis as a number of states continue to amend their original workarounds.
These are just some of the things to consider which could ultimately make the election undesirable. Especially for large, multi-state entities, the workaround may provide tax savings for some members while also increasing the tax burden for other owners leading to an unintended result.
Key Takeaways
Pass-through entities must exercise care when considering whether to make the optional election to make sure that all members will benefit. This can be done by performing detailed analyses of all the risks and opportunities involved on an ongoing basis to ensure that the owners are benefiting by having their state tax liabilities reduced. We recommend that clients consult their tax advisors to come to a solution that would benefit all parties involved.
For additional information, please contact Nicole Zhao, Tax Partner, at nzhao@malonebailey.com.
Business vs. Hobby – Key Differences You Need to Know
Written by Travis Moffett, Tax Manager
There are many of us that have been engaged in various hobbies throughout the years. We live during a time when anyone can make a little side money in addition to their primary job. Although not every activity that generates revenue is considered a business. Let’s walk through the differences and how they’re treated for tax purposes.
How is a hobby different from a business?
To some, any activity that you engage in which makes income would be considered a business. However, the IRS takes a more objective approach to determine the difference between a hobby and a business. The IRS has created a nine-point hobby vs. business test to determine whether your activity is a hobby or business:
1. Do you treat the activity like a business by maintaining accounting records?
2. Do you put in the time and effort appropriate to turn a profit?
3. Do you depend on the activity’s income for your livelihood?
4. Are the losses sustained in the activity beyond your control?
5. Did the losses happen during the activity’s startup phase?
6. Have you changed your operations to try to achieve or improve profitability?
7. Do you or your advisors have the knowledge to run a successful business?
8. Have you profited from running similar businesses in the past?
9. Has the activity ever made a profit and, if so, how much?
10. Can you reasonably expect the activity to earn a profit from the appreciation of assets used in the activity?
If the answers to most, if not all, of these questions are “yes”, then you are most likely running a business. Otherwise, you should seek advice from a tax accountant as businesses and hobbies receive different tax treatment.
Can you take tax deductions for a hobby?
With the implementation of the Tax Cuts and Jobs Act (TCJA) of 2017, hobby expenses are no longer deductible to offset hobby income. For this reason, there is no tax incentive for pursuing revenue-generating hobbies. The TCJA discontinued miscellaneous itemized deductions for individuals which is where hobby expenses would be previously reported. On the other hand, businesses are allowed to deduct any ordinary and necessary expenses which can result in a loss to offset other taxable income.
Keep accurate records
If you want your activity to be recognized as a business, you must ensure that you keep accurate records. Keep track of expenses, log transactions, make a business plan, keep separate business accounts, and send out invoices. These are some of the key factors which can be used to show the IRS you are operating a legitimate business.
IRS Dirty Dozen (2022)
Summary - The Internal Revenue Service wrapped up its “Dirty Dozen” warning list on June 10, 2022. "Dirty Dozen" is a list of various common tax scams that taxpayers may encounter.
The "Dirty Dozen" list is described as follows:
1. Use of Charitable Remainder Annuity Trust (CRAT) to Eliminate Taxable Gain.
Taxpayers inappropriately claim the transfer of appreciated assets to a CRAT which gives the assets a step-up in basis to fair market value as if they had been sold to the trust. The CRAT them sells the property and does not recognize gain.
2. Maltese (or Other Foreign) Pension Arrangements Misusing Treaty.
Taxpayers attempt to avoid U.S. tax by making contributions to certain foreign individual retirement arrangements in Malta (or possibly other foreign countries)
3. Puerto Rican and Other Foreign Captive Insurance.
U.S owners of closely held entities participate in a purported insurance arrangement with a Puerto Rican or other foreign corporation with cell arrangements or segregated asset plans.
4. Monetized Installment Sales
These transactions involve the inappropriate use of the installment sale rules by a seller who, in the year of a sale of property, effectively receives the sales proceeds through purported loans. Taxpayers who have engaged in any of these transactions should carefully review the underlying legal requirements and consult an advisor before claiming any tax benefits.
5. Economic Impact Payment and tax refund scams
Taxpayers should be on the lookout for any text messages, random incoming phone calls or emails inquiring about bank account information, requesting recipients to click a link or verify data. The IRS won’t initiate contact by phone, email, text or social media asking for sensitive information, such as social security numbers or other personal financial information.
6. Unemployment fraud leading to inaccurate taxpayer 1099-Gs
Scammers have taken advantage of the pandemic by filing fraudulent claims for unemployment compensation using stolen personal information of individuals who have not filed claims. Taxpayers should be on the lookout for a Form 1099-G reporting unemployment compensation they did not receive.
7. Fake employment offers posted on social media
There have been many reports of fake job postings on social media and these posts entice people to provide their personal financial information.
8. Fake charities that steal your money
These have always been a problem and donors should take time to do their research. Potential donors should ask the fundraisers for the charity’s exact name, web address and mailing address so this information can be confirmed later.
9. Identity theft
These scams remain a common threat to taxpayers and tax professionals who don’t adequately protect their personal information. People frequently don’t know they are a victim of identity theft until they are notified by the IRS of a possible issue with their tax return or their return is rejected because their SSN appears on a return already filed.
a. Text message scams
b. Email phishing scams
c. Phone scams
10. Bogus tax avoidance strategies
These schemes typically target high-net-worth individuals who are looking for ways to avoid paying taxes. The IRS warns anyone thinking about using one of these schemes that the agency continues to improve work in these areas thanks to evolving data analytic tools and enhanced document matching.
a. Concealing Assets in Offshore Accounts and Improper Reporting of Digital Assets
b. High-income individuals who don't file tax returns
c. Abusive Syndicated Conservation Easements
d. Abusive Micro-Captive Insurance Arrangements
11. Dangerous spear phishing attacks
Spear phishing is an email scam that attempts to steal a tax professional's software preparation credentials. These thieves try to steal client data and tax preparers' identities in an attempt to file fraudulent tax returns for refunds.
12. Offer in Compromise mills
Taxpayers should be caution to anyone claiming they can settle tax debt for pennies on the dollar. OIC mills are one example of unscrupulous tax preparers. Taxpayers should be wary of unscrupulous "ghost" preparers and aggressive promises of manufacturing a bigger refund.
More information on 2022 “Dirty Dozen” list can be found on the IRS website.
If you have any additional question, please feel free to contact us at nzhao@malonebailey.com.
General Business Tax Credit Compliance
Summary - For most business owners, General Business Tax Credit (GBTC) offers great benefits by reducing their tax liabilities dollar by dollar. However, GBTC, comprised of over 30 individual business tax credits, is one of the least understood credits available to business owners. In this article, we highlight some the most frequently used credits under GBTC that may be helpful to your business.
Work Opportunity Credit
Employers may take a work opportunity credit for wages paid to employee who is certified as a member of ten targeted groups and begin work before January 1, 2026. The targeted groups for this credit are listed on the IRS website.
The amount of credit is calculated as 40% of up to $6,000 of wages paid to, or incurred on behalf of, an individual who:
Is in their first year of employment
Performs at least 400 hours of services of the employer
Therefore, the maximum tax credit is $2,500 per person. There is also a 25% rate applies to wages for individuals who works fewer than 400 hours but over 120 hours.
Paid Family and Medical Leave Credit
This credit is available for employers who provide paid leave to qualifying employees under Family and Medical Leave Act between in tax year 2018 through 2025.
The credit is equal to the applicable percentage of the amount of wages paid to qualifying employees while on family and medical leave. The applicable percentage is 12.5% increased by 0.25 percentage points for each percentage point by which the rate of payment exceeds 50%, up to a maximum applicable percentage of 25%.
Note that if the paid leave is made by state or local government or is required by state or local laws, it will not be included in qualified wages.
Research Credit
The research credit is calculated on Form 6765, Credit for Increasing Research Activities under section 280C. The eligibility of Research Tax Credit is much broader than we think. Companies and organizations that develop new or improved products, formulas, software, techniques, inventions, processes, etc. qualify for the Research Tax Credit.
The research credit is generally allowed for expenses paid or incurred for qualified research, which means:
The research for which expenses may be treated as section 174 expenses.
This research must be undertaken for discovering information that is technological in nature, and its application must be intended for use in developing a new or improved business component of the taxpayer.
In addition, substantially all of the activities of the research must be elements of a process of experimentation relating to a new or improved function, performance, reliability, or quality.
All of the research activities must be applied separately with respect to each business component of the taxpayer.
Small Business Health Care Tax Credit
The Affordable Care Act provides credit for qualifying small employers that provide insured health coverage to their employees. To be eligible, the employer must meet the following criteria:
- The employer has less than 25 full-time equivalent employees, calculated by adding up the total employee service hours and divide that amount by 2080
- The average salary is less than $50,000 per year
- The employer contribution is at least 50% of full-time employees’ premium cost
- The employer offers coverage to all full-time employees and the coverage is purchased through
Small Business Health Options Program (SHOP) Marketplace.
Although taxpayers cannot use GBTC when the credits exceed tax liabilities in a tax period, the IRS allows the taxpayer to carry the unused credits back one year and forward 20 years until exhausted. More information on GBTC can be found on the IRS website.
Sick and Family Leave Credits
Under the American Rescue Plan Act of 2021 (the "ARP"), employers with fewer than 500 employees ("Eligible Employers") for qualified sick and family leave wages ("qualified leave wages") paid with respect to leave taken by employees beginning on April 1, 2021, through September 30, 2021, as well as the equivalent credits available for certain self-employed individuals. Employees may receive up to ten days of paid sick leave and up to 12 weeks of paid family leave.
This credit is different from the above-mentioned Paid Family and Medical Leave Credit.
To be able to claim the credit, the Eligible Employer pays the employee qualified family leave wages in an amount equal to at least 2/3 the employee's regular rate of pay (as determined under section 7(e) of the FLSA), multiplied by the number of hours the employee otherwise would have been scheduled to work, not to exceed $200 per day and $12,000 in the aggregate for leave taken by employees beginning on April 1, 2021, through September 30, 2021.
If you have any additional question, please feel free to contact Nicole Zhao, Tax Partner, at nzhao@malonebailey.com.