As COVID-19 and tax-related relief questions continue, Toni Covey and Jeff Webb of Anderson Advisors answer your tax questions. Do you have a tax question? Submit it to taxtuesday@andersonadvisors.
Highlights/Topics:
- Due to the AB5 Law, my clients can no longer hire me as an independent contractor. Instead, they are hiring out-of-state contractors. Do I need to switch to an S Corp or move my company out of California? It depends and offers various options, such as a worker must be customarily engaged in an independently established trade occupation
- For a preschool that received Coronavirus relief, will the PPP loan forgiveness amount, the grants, and the EIDL advance be taxable as income? PPP loan and grants are not considered taxable income, however, an EIDL of $10,000 will not be forgiven or tax deductible from PPP
- I have solely owned a second home long-term in New York. Do I need to file taxes separately from my wage-earning wife to minimize my capital gains tax considering my present income is limited to Social Security? No, but it primarily depends on how much the wife is earning
- My wife and I own several rental properties and manage/maintain them mostly ourselves with no other employees. Does setting up a corporation to manage the rental properties (each on their own LLC) make sense from a tax standpoint? Consider a corporation to manage the rental properties or manage the LLCs that hold the rental properties
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Resources:
Uniform Transfers to Minors Act (UTMA)
Economic Injury Disaster Loan (EIDL)
Paycheck Protection Program (PPP)
Paycheck Protection Program (PPP) Flexibility Act
Small Business Administration (SBA)
Internal Revenue Service (IRS)
Individual Retirement Arrangements (IRAs)
Unrelated Business Income Tax (UBIT)
Unrelated Debt-Financed Income (UDFI)
California Assembly Bill 5 (AB5)
Capital Gains Exclusion/Section 121
Real Estate Professional Requirements
Passive Activity Losses (PALs)
Healthcare Reform (Affordable Care Act)
Full Episode Transcript:
Toni: Hello, everyone. Welcome to Tax Tuesday. A little bit of a change from the norm. My name is Toni Covey. I’m an EA and Director of Professional Services here with Anderson. Also, your new host, bringing tax knowledge to the masses. We’ve also got Jeff here.
Jeff: Hello. Jeff Webb, CPA. You guys have heard me before, I’m sure.
Toni: CPA to the […].
Jeff: Toni and I are going to wing this today. I know you guys are going to miss Toby. He should be back for the next Tax Tuesday. But Toni and I are going to plow through the questions as we can.
Toni: Yup, absolutely. We got a ton of them for you. As usual, follow us on social media. You can get us on Facebook, YouTube, LinkedIn, Instagram, and Twitter, and give us a call. House rules, Tax Tuesday rules. Ask live and we will answer before the end of the webinar. We actually have people on deck. We have a CPA, bookkeeper, an attorney on standby to answer your questions as they come in. You can send in your questions at taxtuesday@andersonadvisors.com. If you need a detailed response, you will need to become a platinum or a tax client. This is fun, fast, and educational. We want to give back and help educate.
Opening questions. “I am the custodian of my son’s UTMA account. Now that he is of age, what is the best way to convert this account under his name only? Are there any legal or tax consequences to consider?” That’s a good one.
“How do you switch from a regular IRA to a Solo 401(k) to invest in real estate and forgo UBIT or UDFI tax? Do I set up an entity to move funds? Does it matter how much you have in the IRA versus what you make in self-employment income?” We’ll answer that.
“Because of the new AB5 Law Fund, California, my client can no longer hire me as an independent contractor.” That sucks. “Instead they are hiring out-of-state contractors. Do I need to switch to an S Corp or move my company out of California?” We’ll answer that. “We are a pre-school and received Coronavirus relief (COVID-19). Will the PPP Loan forgiveness amount, the grants, and the EIDL events be taxable as income?” We’ll answer that.
“I have solely owned a second home long-term in New York. Do I need to file taxes separately from my wage-earning wife to minimize my capital gains tax, considering my present income is limited to social security?” We will answer that.
“My wife and I own several rental properties and manage them ourselves. Does setting up a corp to manage the rental properties (each on their own LLC),” very good, “make sense from a tax standpoint? No employees and mostly do the maintenance ourselves.” I’ll answer that for you.
“If you are self-employed, are you able to deduct the purchase of a vehicle on your taxes?” Jeff, that’s going to be a good one for you.
“A relative who is a non-resident alien resides overseas and invests in a US real estate syndication as a limited partner. He receives a K-1. If there is too much withholding on Form 8805 and there is a refund amount shown on form 1040-NR due to over withholding on Form 8805, will the IRS refund the money directly to the 1040-NR filer or through the partnership? The partnership said they received a tax refund and is sending it to my relative but the amount is substantially different from what’s on the 1040-NR.” That is a mouthful. We will answer that for you.
Jeff: I picked that one just so you could read it.
Toni: You’re very good, Jeff. And this is why we love you.
“If the Passive Activity Losses (PALS) from a sold property are not large enough to completely offset the capital gain on the sold property, can the PALS from any other owned properties also be used to offset the capital gain on a sold property?” We’ll answer that.
“California has proposed a wealth tax,” California strikes again, “that would affect current and past residents. As a previous California resident, what can I do to minimize my potential liability for this tax? What is the realistic jurisdiction of the franchise tax board?” We’ll answer that.
“I just started training stocks and am currently trading options. How are these stock options taxed? Is there a process to reduce them?” We’ll answer that. We did pick a lot of questions.
“I hear there are more tax benefits for LLCs. What steps do I need to take to change my business from a sole proprietor to an LLC?” We will answer that.
“What is the preferred method to be taxed in an LLC when starting an assisted living business—C Corp or S Corp?” That’s always the question.
“I bought some dirt and am building a house for resale.”
Jeff: I love that. “I bought some dirt.”
Toni: “I bought some dirt.” Yes. “Do I need to keep it for a year before selling for long-term capital gains? Is my basis the lot and the build cost?” That is a very good question and we will answer that.
“If there are no capital gains on selling a house in one state, but the former owners moved to a new state prior to the sale, are there taxes in the new state?” State tax is fun. We’ll answer that.
All right. Don’t forget, we have a ton of Anderson events to keep you educated. Tax and Asset Protection is our foundation, Structure Implementation, giving you the tools, Tax-Wise, giving you the tax tools, Start & Run a Non-Profit, let’s give back, Infinity Investing, let’s learn how to invest. We have some Anderson-exclusive events. You can find out all about them at andersonadvisors.com/events.
We’re getting started. First question. “I am the custodian of my son’s UTMA account. Now that he is of age, what is the best way to convert this account under his name only? Are there any legal or tax consequences to consider?” What say you, Jeff?
Jeff: The way UTMA accounts work is the account is set up for the son. If it has interest or making any kind of money at all, it is taxable income to your son. Most of these expire once the child becomes an adult. It really depends on the state. Some states say, for UTMA purposes—UTMA is Uniform Transfer to Minors Act—once I become 18 or 21, all the money in that account becomes theirs.
You normally just have to talk to the bank where the account is. These are usually some kind of bank accounts or maybe even a brokerage account, about converting the account over completely to your child. “Are there any legal or tax consequences to consider?” No, because you’ve been recognizing income all along if you have to file a tax return. But otherwise, there’s really no transfer between people or anything, so there are no tax consequences.
Now, the one thing I will say is if you give a large chunk of money in one year into one of these UTMA accounts, it’s just like any other gift and you may have to file a tax return just to report the gift.
Toni: Fantastic. All right, let’s go to the next one. “How do you switch from a regular IRA to a Solo 401(k) to invest in real estate and forgo UBIT or UDFI tax? Do I set up an entity to move funds? Does it matter how much you have in the IRA versus what you make in self-employment income?” Let’s look at this in chunks.
Jeff: Exactly.
Toni: One does not simply forgo UBIT or UDFI. UDFI, sure, because in a Solo 401(k), UDFI is not applied. UBIT still is. We really have to look at what the activity is that you’re doing in the Solo 401(k). Do you want to go into what UBIT is, Jeff?
Jeff: As you said, the UDFI is never going to apply to a 401(k); it does apply to an IRA. As far as UBIT goes—Unrelated Business Income Tax—the keyword here is business. We’re looking at a trade or business. Investing in real estate is typically not considered a trade or business. What they’re looking at for trade or business is maybe you invest in a retail store or something like that. Something that would be that you would consider a normal business. Now, as far as how do you switch from a regular IRA to a Solo 401(k), I think that was the next question was it, Toni?
Toni: No. The next question is, “Do I set up an entity to move funds?” I think maybe they’re referring to the sponsoring.
Jeff: Because the 401(k) is going to have to have a sponsor, right?
Toni: Right.
Jeff: Easiest is a C Corporation or an S Corporation. A sole proprietorship is not going to qualify. A partnership could qualify, but it’s complicated to say the least. What you would do is, say you have a corporation sponsoring this 401(k). The way you’re going to start after you set up the 401(k) is if you have a regular IRA, you can roll that IRA into your 401(k). If you have a couple of hundred thousand dollars in that IRA, you have your starter money for investing in that real estate without having to have the company throw money into it or even possibly have a salary in deferring money.
The easiest way is to roll over a large IRA into a Solo 401(k). If not that, then there could be employee contributions through salary or employer contributions based on salary.
Toni: Right. We unpacked that for you, so let’s pack it back up. What you’re going to do is you need to first set up your sponsoring entity. To Jeff’s point, we recommend a C or S Corporation typically. Then, you’ll be able to set up the Solo 401(k) sponsored by the corporation, then you’re going to be able to roll your IRA over to the Solo 401(k), and you’re good.
“Does it matter how much you have in the IRA versus what you make in self-employment income?” I don’t know that we address that. But I think what they’re asking is how to make contributions to the Solo 401(k) and you’re going down the right road there. You are looking at earned income from the corporation to yourself to be able to make a contribution to the Solo 401(k). Or did I just repeat something you already said, Jeff?
Jeff: No. When you’re talking about self-employment income, that’s more along the lines of a partnership or a sole proprietor where you account the self-employment income to make your contributions. Otherwise in an S Corporation or corporation where you typically see the 401(k), you have to have salary compensations to yourself in the form of some kind of payroll to make those contributions, so Solo 401(k). The IRA Rollover, you can do regardless of whether you have a salary or not, once you have that Solo 401(k) set up.
Toni: Right. We have two different things happening. You’ve got your IRA Rollover which you can do right away as Jeff said, and then you’ve got your self-employed income. Typically we’re wanting you to look at a C or S Corporation for that, so we’re talking salary. Anything else to add to that one, Jeff?
Jeff: Nope. Toby sometimes has to translate for me, too.
Toni: I’m a good translator. All right. “Because of the AB5 Law, my client can no longer hire me as an independent contractor. Instead, they are hiring out-of-state contractors. Do I need to switch to an S Corporation or move my company out of California?” I can’t wait to hear what you have to say about that, Jeff.
Jeff: For those who don’t know about AB5, I don’t know how you can not know even if you don’t live in California. There’s so much news about it.
Toni: Exactly.
Jeff: There’s a three-prong test to determine whether you are truly an independent contractor or not. The first two tests are the typical you control your own schedule and so forth. It’s the third test that really makes it difficult. The worker is customarily engaged in an independently-established trade occupation. What it gets down to is you got to be doing something that the company doesn’t normally do. Which is why Uber and Lyft are really ticked off.
Back to your question, yes, they are hiring out-of-state contractors. I’m not sure how that works for out-of-state contractors because if I live in Utah and I’m working in California as a Lyft driver, that income is still going to be subject to California law. Now, if it’s more consulting type work that you can do from out-of-state, then, yeah, that makes perfect sense that they could hire those people.
Toni: Here’s what I have trouble with, with this one. Let’s just say you set up an S Corporation in Texas. You’re still performing the service or if you’re still performing the service in California, there’s where I have an issue. We’re trying to use this strategy.
Jeff: The only difference is what he asked first, “Do I switch to an S Corporation?” If your clients were paying your S Corporation, I’m not sure that AB5 would apply in this case because the S Corporation cannot be an independent contractor. They’re their own entity. Have you run into that at all, Toni?
Toni: I have not, but this has come up before. I just can’t commit. I have a form over substance issue with setting it up for that purpose, but can it work? Possibly.
Jeff: Yeah. I think it might work. C Corp would work even better, but there are different issues with that because a C Corp is a completely independent entity. It’s its own taxpayer. Moving my company out of California for talking about Schedule C or even a partnership, you couldn’t work from San Diego and say your company is in Nevada and defeat AB5. I think that would be a fail. But you could possibly be an S Corporation or C Corporation in California under AB5.
The other downside of this is the $800 a year franchise fee for having a corporation or an S Corporation in California.
Toni: But they’re going to put it outside of California.
Jeff: True. I’m thinking they might be able to put it inside California and be exempt from AB5.
Toni: That’s a possibility. My concern here is if the S Corporation is performing a function of the hiring entity. Does that make sense?
Jeff: Yeah. I see what you’re saying. I think AB5 was designed to attack companies that have a large number of independent contractors. That doesn’t justify what I’m pushing at. I don’t even know if that was considered when they wrote this law.
Toni: What I’m looking at is putting into context, we’re going to put an Uber driver in an S Corporation in Texas. S Corporation filed in Texas, but we’re Ubering in California.
Jeff: Right. That’s not going to work. If you’re actually performing work in California, that’s always going to be a problem.
Toni: That was my issue. It’s not going to stake out in an audit.
Jeff: Yeah, but I’m thinking if you’re doing strictly consulting under an S Corporation, I don’t think they can make your corporation an employee, but they may try to make the employees within the S Corporation employees of the contractors.
Toni: That’s what I thought.
Jeff: We never know what’s going to happen with California.
Toni: It’s too new. All right. Let’s keep rolling here. “We are a pre-school and received Coronavirus relief. Will the PPP Loan forgiveness amount, the grants, and the EIDL events be taxable as income?” The answer is no. Those are loans and a grant, not income. The one thing that is worth noting—I don’t know if you’ve already gotten your loan forgiven—is that if you did receive an EIDL grant, let’s say it was $10,000, that amount is not going to be forgiven in a PPP loan. If you got a grant for $10,000, $10,000 of the PPP loan will not be forgiven. That’s just something to keep in mind as it relates to that. Anything to add on that one, Jeff?
Jeff: So, on the PPP loan forgiveness amount, that is not taxable income. However, with the IRS and the Treasury Department preaching pretty much against the will of Congress, anything you pay for with that PPP loan is not tax-deductible. They’re using a backdoor method to get around what Congress proposed when they came up with this loan forgiveness. We’re hoping before the end of the year to see some legislation to overturn that.
Toni: Yeah. Obviously, we don’t agree with that at all, so hopefully, that will be rectified.
Jeff: Correct.
Toni: “I have solely owned a second home long-term in New York. Do I need to file taxes separately from my wage-earning wife to minimize my capital gains tax, considering my present income is limited to social security number?” No. Jeff?
Jeff: I actually tested this one, Toni, and we talk about ‘it depends.’ It primarily depends on how much your wife is earning. I found that if she’s earning around $100,000, you could save a couple of thousand dollars if you file separately. On the other hand, if she is only making about $50,000, if you file separately it’s going to cost you twice as much in taxes. Then again, when you get up to $200,000 level, filing jointly works out better. This is one of those cases where you really need to look at it. Those tax preparers—I know we do—will actually test this as part of the tax preparation, which works out better for you.
Toni: All right, perfect. “My wife and I own several rental properties and manage them ourselves. Does setting up a corp to manage the rental properties (each on their own LLC) make sense from a tax standpoint? No employees and mostly do the maintenance ourselves.” We typically do recommend looking at a corporation to either manage the rental properties or manage the LLCs that hold the rental properties. Good on you, putting those properties into their own separate LLCs. That’s exactly what we would recommend for asset protection purposes, but for tax purposes, the corporation can be a very good tax planning tool. Would you like to share why, Jeff?
Jeff: The corporation allows us to deduct some items that normally are not deductible. One of the big ones is the medical reimbursement plan, Section 105 Plan, that’s called. That allows the corporation to reimburse for medical expenses. There are other expenses that can be reimbursed, certain educational expenses where we talk about management fees coming in with the income to it, the corporate meetings will become sometimes called the 288 deduction.
Those can all be substantial deductions. And why we care about that is when we have a corporation manage the rental properties, the rental property income is probably going directly to you or through some pass through. Whereas, if we pay a management fee to the corporation, that decreases the amount of revenue coming directly to you, transfers it to the corporation, and then the corporation has these other deductions that may reduce or eliminate any tax on the corporation. That’s one of the reasons why we’re interested in this.
Toni: We’ve got a live question that asked, “Would a land trust be better as far as asset protection?” The answer to that is no. The land trust does not provide asset protection. A land trust can help in a number of ways in your structure depending on your said effects circumstances. It can also help with anonymity. But the land trust does not provide liability protection as the LLC or a C Corporation would. Anything else to add to that one, Jeff?
Jeff: Nope.
Toni: All righty, let’s keep moving. “If you are self-employed, are you able to deduct the purchase of a vehicle on your taxes? If so, how?”
Jeff: Let’s start off with the best scenario. You have purchased a vehicle that is used 100% in your business. You do construction and you bought a heavy-duty pick-up, the whole equipment, metal railings, and so forth. That vehicle could be put in your self-employment business if it meets certain qualifications, it could be completely deducted in the first year under the bonus depreciation or Section 179. But again, it needs to be 100% business use.
Once you start dropping down below 100% business use, then you’re only going to be able to deduct a portion of that same amount. We sometimes see people get in trouble saying, yeah, this vehicle is used 100% in my business, but it turns out they’re commuting, they’re using it for personal mileage, they’re not tracking […] mileage. If you’re audited and the IRS sees 100% use vehicles, they’re going to want to check and audit. And you’re going to have to validate that as far as how the vehicle was used and so forth, the mileage.
Toby often talks about that. He prefers that you put the vehicles in your own name and be reimbursed for the expenses. One of the things he says is commercial insurance on a vehicle is expensive. If they know you’re using it for work, it’s a problem. Toby likes to push the reimbursement for personal vehicles. A lot of people like that giant deduction in the first year if they can get it. Most cars are not going to be subject to that deduction. Only trucks and SUVs are going to qualify for that bonus depreciation. Do you have anything else?
Toni: No, I’m with Toby on that. I prefer the reimbursement mileage or actual expense method. It may be a little bit more conservative, but I agree with Toby on that one. If there’s going to be any personal use of the vehicle, you really rather not have that in the business name versus in your personal name. It does come attached with a sometimes higher cost for insurance, for registration, and things with this nature.
This is a fun one. Okay, just give me five minutes to read through this. “A relative who is a non-resident alien resides overseas and invests in a US real estate syndication as a limited partner. He receives a K-1. If there is too much withholding on Form 8805 and there is a refund amount shown on form 1040-NR due to over withholding on Form 8805, will the IRS refund the money directly to the 1040-NR filer or through the partnership? The partnership said they received a tax refund and is sending it to my relative but the amount is substantially different from what’s on the 1040-NR.” All right, what say you, Jeff?
Jeff: I’m going to jump right into the middle of this question where they’re saying the partnership received a tax refund. That doesn’t sound quite right to me. Does it sound right to you, Toni?
Toni: No, not at all.
Jeff: Okay. Typically, what happens is when you have a non-resident alien who’s receiving in what is called effectively connected taxable income, money earned in the US, exactly as this question said, they received a K-1 and they withhold generally 30% of any money received and send it to the IRS. It’s required by law. The penalties for not doing it are substantial and that’s why they will always do it. Depends on what country they’re from and what the tax treaty is, but you generally suppose this could be 30%.
Oftentimes, withholding is way more than this […] do. You need to complete that 1040-NR and there’s a line to report how much was withheld on Form 8805. Just like a regular 1040, you figure the tax, how much was withheld, and if there’s an overpayment, it will be refunded to the taxpayer—the person who files the 1040-NR. I’ve never seen it repaid to the partnership.
They’ve already withheld on you, and the reason they withhold so much is a lot of people don’t file that 1040-NR. They don’t file the tax return. The IRS doesn’t care; they already got 30% of your money. They’re fine with that. It’s generally a good idea to complete this tax return if you’ve got any kind of withholding whether it’s 8805 or your W-2 or so forth.
Toni: You picked this question, so I’m saying it’s all you.
Jeff: That’s all I got.
Toni: All right. Nice. Let’s keep going. “If the Passive Activity Losses (PALS) from a sold property are not large enough to completely offset the capital gain on the sold property, can the PALS from any other owned properties also be used to offset the capital gain on a sold property?”
Jeff: I’m going to do some back to basics teaching on this one. I apologize. Passive activity losses—PALs as we call them—can only be offset by passive activity income. Here’s the rub. I sell a property. I have all these passive activity losses in this property. Those losses are released automatically when you dispose of a property.
Let’s say I have $50,000 of PALs in there, […] they’re gone. When you sell the property, it is true that it’s subject to capital gain. But if something special is called passive capital gain, that is if you have any capital gain on the sale of a rental property, that gain is considered passive. That can offset other passive losses.
If I have two properties and they each have $50,000 of passive losses and $100,000 gain on the sale, $50,000 is going to be released from the disposing of the property. The other $50,000 in the property I’m still holding on to is going to get released because I have all these passive capital gains to offset those losses.
Toni: That would be if you had not made the election to aggregate, correct?
Jeff: Correct. By aggregating, 99 times out of 100, it applies to real estate professionals. The only way to do real estate professional successfully with multiple properties is you have to aggregate all your properties. That says that they’re all one activity even though you still report them separately.
What happens when you’re aggregating, if you sell one of (say) three properties, it’s not considered completely disposed of, so it does not release that gain or loss by itself. You have to actually dispose of everything that’s aggregated.
Toni: Substantially all.
Jeff: Substantially all. If you buy 10 properties this year and you immediately become a real estate professional, it’s not going to be an issue because you’ll never have any passive losses. Where we see these affecting people is I’ve had these rental properties for 10 years and I have all these passive losses. Now, I want to be a real estate professional. I can start deducting some of my losses. Those passive losses that are already there get locked into that aggregation until you dispose of everything that’s aggregated. Or, as Toni said, substantially all.
Toni: Substantially all. Yup. We do run into that. We have run into that. You need to look at it. If you want to qualify as a real estate professional and you’ve already got a ton of suspended PALS, we’ll need to look at that and look at, are you planning on selling any properties in the near future? Those are things we need to take into consideration.
Jeff: You can’t see me but I’m emphatically nodding my head.
Toni: Very good. Next time we need to have your beautiful mug on the webcam. We’ve got to have people seeing you agree with me for once.
Anyway, let’s keep going. “California has proposed a wealth tax that would affect current and past residents. As a previous California resident, what can I do to minimize my potential liability for this tax? What is the realistic jurisdiction of the Franchise Tax Board?” It depends on who you’re asking. Are you asking the Franchise Tax Board? They’re going to say they have all the jurisdiction everywhere. Go ahead, Jeff.
Jeff: This wealth tax, it’s been proposed but it hasn’t been approved, is a 0.4% tax on your net wealth if your net wealth is greater than $30 million. It’s going to affect, I think they said, the top 0.1%. It might have been slightly higher than that.
As far as current and past residence, if you’re already out of California, I don’t think it’s going to affect you. The issue that’s always been with California is they never let you leave. We have people who have moved out of the state, typically at the higher end of the income level. They say because of your social connections here, you have these friends, and you have a second property here, you’re still a California resident. That’s always been an issue. I don’t think you have to worry about it. I don’t think, like I said, that this law has been passed. Yes, there’s the concern that rich people are going to be moving out of California left and right.
There’s this second reason for that. California already had the highest state tax of 13.3%. They’re adding on the bracket that raises that tax rate to 16.8%. Between the wealth tax and this higher bracket, wealthy people are going to get hit pretty hard. There’s been some analysis that they could lose more money than the wealth tax is actually making for the state if they have a plethora of people moving outside the state.
Toni: All right. “I just started trading stocks and am currently trading options. How are the stock options taxed? Is there a process to reduce them?”
Jeff: Stock options, by their very nature, are typically going to be taxed as short-term capital gains or losses. As a capital loss, they’re going to be subject to a limitation of $3000 of loss that you can recognize each year. You have to carry over the rest. As short-term capital gains, they’re going to be subject to your ordinary income tax rates. If you’re in the 22% bracket then you’re going to be paying 22% on any net gains.
“Is there a process to reduce them?” Not really that I can think of. I will say that the typical investor who invests in options doesn’t do as well as they would help. They typically have more losses than they do gains. Turning stocks is a different issue. Stocks that you hold long-term are going to be subject to long-term capital gains which brackets are 0%, 15%, and 20%, I believe. Is there still a 10% rate?
Toni: No.
Jeff: I thought they eliminated that one. The reason I said the options are going to be subject to short-term capital gains and losses is they typically expire within a few months unless you invest in what’s called LEAPS which are long-term options that are a year or more, unless people who are investing in options are getting in and getting out of it quickly.
What did you think about the part of, is there a process to reduce them? Anything come out to you?
Toni: Is there a process to reduce the capital gains?
Jeff: Yeah.
Toni: The structure that we use is one of them—that we use here in Anderson—gives you the opportunity for potential income splitting. You can put the brokerage account and your LLC. Have that LLC taxed as a partnership. Have your managing member of the LLC as your C Corporation. Do a small percentage. Somewhere in the neighborhood 10%, 20%, more or less.
Immediately, you have a percentage of the gain going up to the corporation, take advantage of those lovely deductions that Jeff was talking about a little bit earlier. If you wanted to do more, you could. You can do what we call a guarantee payment from your LLC to your corporation to create a deduction that flows through your personal tax return. There are things you can do to mitigate the tax consequence. You definitely want to get in for tax planning.
Jeff: Good answer.
Toni: Got my Toby on today. All right. Let’s see what we got next. “I hear there are more tax benefits for LLCs. What steps do I need to take to change my business from a sole proprietor to an LLC?”
Jeff: I don’t know who did this question but I’m guessing you probably haven’t heard Toby talk about LLCs before. There are absolutely no tax benefits for an LLC. The LLC is primarily for liability protection.
Toni: That is going to depend on how you have the LLC taxed.
Jeff: Correct. You have to choose how that LLC is taxed. Is it still a sole proprietor? LLCs can be sole proprietors. They can be a partnership. They can be S Corps. They can be corporations.
Toni: This does imply that you’re going to be treating your LLC as a sole proprietor or as disregarded. I get where you’re going with that Jeff. If you’re looking at tax benefits, we can still look at an LLC. We just need to look at how that LLC is taxed. Usually, it’s always best to have a separate taxpayer. That’s going to be a C Corporation. We can move things off of your personal tax return, put them on the corporate tax return, and take advantage, once again, all of those benefits Jeff was educating us about a little earlier.
Jeff: Right. The determination of what type of taxing entity you want the LLC to be is going to depend primarily on what the business is. Part of the decision process is to see what type of business you have, what your goals are, and so forth. Then, make a determination of which entity, which fits you best. Sometimes, it’s not going to be an LLC. Sometimes, it’s going to be an inc, corporation, or possibly a limited partnership. In general, I think LLCs do everything we need the LPs to do. Correct?
Toni: Yup. We used to use LPs quite frequently. Thanks to the Tax Cuts and Jobs Act, the LLC became a lot more attractive than the LP was. The Tax Cuts and Jobs Act took away that Schedule A 2% investment expense deduction that you were able to take previously. We had to pivot, move to the LLC, and change our strategy there a little bit.
All right, let’s keep rolling. “What is the preferred method to be taxed in an LLC when starting an assisted living business? C or S Corporation?” The famous answer to that question is going to be, it depends. Do you want to tell them why?
Jeff: Well, rather than tell them why, I’ll give you my opinion. Maybe a couple of different entities, if I have an assisted living business and I have a building that they’re working on, I don’t want that in the same business. I want to keep that legally separated from each other because both the building itself and the assisted living operations have their own share of liability that could fall on them.
What do you think of the operation side of it, Toni?
Toni: The operation side is going to go into the corporation. We need to decide to the point of their question. Then, we need to decide if their operation is going to be a C or an S Corporation.
Jeff: Correct. Part of my analysis is depending on the number of employees you have on the business, it may lean more towards an S Corporation. I don’t know how you feel about that.
Toni: For me, it depends. If you spent a lot of money upfront on training, education, mentoring, and the like and this is not a line of business you were in before, we’re going to look at a C Corporation. If you have a lot of medical expenses and things in this nature, we’re going to look at a C Corporation. Especially if you have both of those two things combined. We’re going to look at a C Corporation. But that doesn’t mean we always have to be a C Corporation, either.
Jeff: I was just going to move at the property itself. That I would probably put on a partnership. You could have been managed by another entity. It could be managed by a C Corp. What you don’t want it to do is be managed by the same C Corporation that’s running this assisted living business. Otherwise, you’ve just messed your liability protection together and you’re not protected at all.
Toni: Very good point. All right, let’s keep rolling. “I bought some dirt and am building a house for resale. Do I need to keep it for a year before selling for long-term capital gains? Is my basis the lot and building costs?”
Jeff: What do we call this, Toni? Go ahead.
Toni: It doesn’t matter how long you hold the property. It’s about your intent. If your intent going in is to build a house and sell it, it’s going to be an ordinary income. If you build a house and hold it long-term, hold it out for rent, then that’ll be different. Then, you’ve turned it into a capital asset instead of inventory. You would then be able to sell it at the long-term capital gains rate. Jeff?
Jeff: That’s a great point and that’s exactly what I was thinking. If I build it and sell it, I was going to go there but I decided that I’m a dad, I can’t do that.
Toni: I did it.
Jeff: If you built it, they come, and they buy it, that is a flip. It’s going to be taxed as ordinary income. It’s not going to be subject to long-term capital gains or any kind of capital gains no matter how long you hold it.
As Toni said, if you build it and set up the rent, then it’s going to be subject to capital gains if you do later sell it. Ideally, if you can place, service it, and rent it out for a year, then sell it at the end of the year, you’re going to get those long-term capital gains rates.
The clocks start ticking from the time the building is available for rent, not when it’s actually rented out. If you advertise it for two or three months then you’d have to wait another nine or 10 months of renting it out to get these long-term rates.
Toni: “Is my base the lot and building cost?” Yes. If you do, in fact, turn this into a long-term hold and we’re talking about basis, it’s going to be how much you pay for the lot and how much you pay for the build. It’s the basis that you’re going to use for depreciation. In this case, it’s inventory. It’s just going to be your cost of goods sold.
All right, let’s go. What do we get next? “If there are no capital gains,” this is heavy on capital gains today, “on selling a house in one state but the former owners move to a new state prior to the sale, are there taxes in the new state?”
Jeff: How this works is if you have sold a property and a state that has a tax, that state is always going to tax that sale. Whether you live in New York and you sell a property in California, California is going to tax that sale.
Where you live at that time of the sale is also going to tax that. Back to California-New York. You’re a New York resident. California is going to tax it first. They’re going to get their piece. New York is also going to include that sale in your income. However, anytime you have the same income being taxed by two states, normally your residence state, sometimes the other state gives you a credit for taxes paid to the other states. You’re not going to be paying double taxes. You will be filing returns on both states and report that income.
Toni: All right. Very good. Let’s keep going unless you have something else. Oh, was that it?
Jeff: Hey, it’s 3:58.
Toni: Oh, wow. Okay. Thanks for providing us with all of your questions. Replays are available in your platinum portal of Tax Tuesday. You could also get them in the Anderson Business Advisors Podcast absolutely free.
Jeff: The Apple Play and the Google Play.
Toni: We talked about the Anderson events. Don’t forget to go ahead and check that out as well. We want to educate, educate, educate. That is what we are all about. Follow us on Facebook. I don’t know how you follow. You subscribe. You do all the different things with Anderson on Facebook, YouTube, LinkedIn, Instagram, and Twitter. As always, you can give us a call if you like to schedule a consult and speak with our wonderful staff.
Questions, send them to taxtuesday@andersonadvisors.com or visit andersonadvisors.com. We will answer it. By we, I meant Toby, will answer those questions for you as we did today. We still have our team members in the chat answering questions for you that you’re submitting as they come through.
Thanks again so much for joining us. I hope that I was an acceptable fill-in for Toby.
Jeff: I was just going to say, Toni, thanks for filling in. That worked out really well. These poor listeners will get to be able to eat supper one time on this Tuesday.
Toni: I know. If you’re a platinum client, you can find me on platinum office hours now.
Jeff: Until next time. Thanks again, Toni.
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