July Newsletter
24-Jun-2015 We hope you are enjoying your summer so far. You probably aren’t thinking about taxes right now but here are a couple articles we are sure you would like to read.
Have fun on your vacations and have a happy, healthy summer! Also, if you haven’t had a chance, go check out our Facebook and Twitter pages and see what we’ve been up to.
Sincerely,
Hanson & Co Staff
Succession Planning for a Family Business
If you intend to name a family member to succeed you in running your company, you have some advantages. The person you’ll name (probably your son or daughter, son- or daughter-in-law) is someone you can identify easily, without an extensive search. You know that person’s capabilities and shortcomings; he or she likely works for the company now, so you have a good idea of how well the future owner will do.
That said, passing on your company to a family member can pose problems. Intra-family dynamics should be considered, which may not be the case if your successor is an outsider. Moreover, there are several methods of relinquishing ownership, all of which may be closely scrutinized by the IRS.
Seeing things clearly
Designating a family member as your successor can raise emotional issues. Does your son really want to run your business, working the long hours you’ve always put in? Is your daughter truly eager to jump off the partner track at her law firm to take charge of your company? Be honest with yourself, even if it leads to painful conclusions.
Example: Donna Allen realized that her two sons did not get along with each other, but she thought that would change as they grew older. Instead, their mutual animosity continues, and they’re competing with each other to replace their mother as CEO of Allen Enterprises. Facing reality, Donna concluded that a 50-50 ownership solution would ruin her successful company. Thus, she is dividing the company into two firms, along product lines, so each son can be the sole owner of his own business in the future.
Playing fair
If you have more than one child, it’s often the case that one will be the obvious successor. Passing on ownership to all the children and leaving one to run the company can lead to strife: The operator may feel like he or she is working to enrich siblings, and the outside owners might second-guess business decisions.
Naming the child who will manage the company as the sole owner may make sense, from a business perspective, but it also can deprive the others of a valuable asset. In such cases, it may be desirable to equalize the inheritances. (If you’re married, your estate plan also should provide for a surviving spouse.)
Situations differ, but life insurance might offer a way to compensate family members who won’t wind up with your valuable business.
Transfer tactics
Your estate plan also should focus on the method you’ll use to keep your company in the family. Broadly, here are your options:
Sell it. This mode has the obvious benefit of providing you with income in retirement, enabling you to enjoy the fruits of building the business. Coming up with enough cash for the buyout may be difficult for your younger successor, so it might be necessary to arrange financing or an installment sale so payments will come from future company earnings, in some manner.
Give it. Another option is to transfer some shares to your successor during his or her lifetime. Gift tax may be avoided or minimized by using discounts for fractional interests in the company while ownership might be motivational. On the downside, such gifts can reduce the income you’ll get from the business and you should have a strategy for dealing with other children.
Leave it. You can simply hold onto the company until you die and bequeath it to your successor. This approach allows you to remain in control and perhaps receive income from dividends once you stop working. A lack of ownership, though, might discourage your chosen successor and lead to that person’s leaving for another opportunity.
No matter which of these methods you choose, the IRS may challenge the valuation involved. A below-market sale, for example, could be recast as part sale and part taxable gift. Thus, having a reliable valuation of the company should be part of your all-in-the-family succession plan.
A sophisticated approach might involve a mix of selling, giving, and leaving your business to a younger relative. Tactics such as retaining income-producing shares while transferring operational control may be appropriate. Our office can help you put together a tax-effective strategy.
Passive Activity Losses From Rental Property
In these times of high stock prices and low bond yields, investors might be thinking about rental property. Such investments can pay off, in the right situation. Before you make any decisions, though, you should be aware of the tax implications, especially the passive activity loss rules.
Despite the language, those rules don’t apply to familiar investments that might seem passive, such as buying corporate stocks or government bonds. Rental property is deemed to be a passive activity, so the passive activity rules typically apply to individual investors acting as landlords. Investing in real estate may deliver untaxed income, but deducting losses can be challenging. (The rules are different for individuals who are real estate professionals, but specific qualifications must be met.)
Depreciating while appreciating
Investment property owners can take depreciation deductions, even if the property is gaining value. What’s more, this deduction requires no cash outlay.
Example 1: Brett Parker buys investment property for $400,000 and collects $1,800 in monthly rent. Thus, his annual income is $21,600. His out-of-pocket expenses (interest, insurance, maintenance) total $12,000, so Brett collects $9,600 in positive cash flow this year, in this hypothetical example.
Suppose that Brett can claim $16,000 of depreciation deductions as well. Now Brett reports $21,600 of income and $28,000 ($12,000 plus $16,000) of expenses from the property, for a net loss of $6,400.
Brett has reported a loss, so no income tax will be due on his rental income. For Brett, this would be $9,600 of tax-free cash flow. If he also can deduct the $6,400 loss from his other income, the tax treatment would be even better.
Loss lessons
In one scenario, Brett has another rental property that generates $7,500 of net income. This passive activity income from Property B can be offset by the $6,400 loss from Property A, so Brett reports a taxable profit of only a net $1,100.
However, many people won’t have passive activity income to offset, or their passive activity loss will be greater than that income. In those cases, deducting the loss from other income is possible, if certain conditions are met.
For one, investors must play an active role in managing the property. That doesn’t mean you’ll have to screen tenants or fix toilets. You can hire a property manager but still play an active role, for this purpose, by making decisions involving the property’s operation or management.
Another condition of deducting losses from a rental property relates to your adjusted gross income (AGI). A deduction as great as $25,000 per year is permitted, but the deduction phases out as your AGI climbs from $100,000 to $150,000. That phaseout range is the same for joint or single filers.
Example 2: Joan, Janice, and Jennifer Smith are sisters; they each own rental property that shows a loss this year, after deducting depreciation. Joan’s AGI is $95,000, so she can deduct her rental property loss this year, up to the $25,000 maximum. Janice’s AGI is $155,000, so she can’t deduct any loss from her rental property. (However, because Janice reports a loss, she also won’t owe tax on the cash flow she receives.)
Suppose that Jennifer’s AGI is $130,000. She is 60% ($30,000/$50,000) through the phaseout range, so she’ll lose 60% of her maximum loss deduction. Jennifer can deduct rental property losses up to $10,000 (40% of the $25,000 maximum) but won’t be able to deduct larger losses.
Keep in mind that rental property losses you can’t deduct currently are not gone forever. Unused losses add up, year after year, to offset future passive activity income. If you have unused losses from prior years, you can use them when your future AGI permits. Moreover, when you sell the property, you can use all of your banked losses then to reduce the tax you’ll owe on the sale.
Nevertheless, a tax deduction you can take immediately is more valuable than a deduction years in the future. If your AGI is between $100,000 and $150,000, actions such as taking capital gains or converting a traditional IRA to a Roth IRA can raise your AGI and reduce current deductions for rental property losses.
Did You Know?
California and Colorado taxpayers had the highest chance of an IRS audit in 2014. Other Western states in the top seven were Nevada, New Mexico, and Arizona. Yet, North Dakota taxpayers were the least likely to be audited.
Source: TaxAudit.com
