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Thinking Like an Accountant: Tax Tips and Traps for Lawyers Serving Small Businesses

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Thinking Like an Accountant: Tax Tips and Traps for Lawyers Serving Small Businesses

In this one-hour presentation, tax attorneys Ben Wagner and Kathleen Pfutzenreuter discuss some common tax issues and questions that arise for attorneys advising small business owners, including: the home office tax deduction, tax consequences and considerations in employing family members, the Section 199A Deduction from the Tax Cuts and Jobs Act, establishing residency in a lower or no-income tax state, whether certain items, such as cars, boats, and planes, are deductible business expenses, and how to determine whether the client should treat workers as employees or independent contractors.

Presenters

Benjamin Wagner
Tax Attorney
Wagner Tax Law
Kathleen Pfutzenreuter
Tax Attorney
Wagner Tax Law

Transcript

Ben Wagner - Hello everyone. My name is Ben Wagner. I'm here today with my colleague, Kathleen Pfutzenreuter and welcome to Tax tips and Traps for Small Businesses. Today, we're gonna cover a number of tax traps that we see our clients encounter, and also try to give and tips in terms of how to navigate or overcome those traps. We're gonna start with just some very simple and basic ones like, should I have a tax accountant or a tax lawyer? If I work outta my house, how much of that can I deduct? Should I use one checking account or multiple checking accounts for personal and business expenses? What about payments to my kids or my parents or my spouse? Are those deductible and taxable, in what way? And then we're gonna tackle a couple more complex items in terms of the Section 1.99A deduction from the Tax Cuts and Jobs Act. Talk a little bit about what should be included in income. And then also, focus on the concept of residency. This is particularly relevant for people who live in high tax states and talk a little bit about sort of the risks and exposures of trying to leave those states. And then, we're gonna close with a few topics regarding the deductions of things like your vehicle, your boat, or your airplane. Also treatment of workers versus employees and how to avoid the risks inherent with making that determination in regards to independent contractors. And then finally, close out with concepts that might be relevant to taxpayers who are looking to retire and move on from their business. So I'll turn things over to Kathleen to get started with our first topic.

Kathleen Pfutzenreuter - Thanks Ben. First, we will talk about whether or not to work with a tax accountant or a tax lawyer. So the world of tax is large, it touches almost everything. And with that there are a large number of tax practice areas and specialties. So when you're advising a client with regard to their tax matter, it can be helpful to understand what kind of tax professional is best suited for their particular type of issue.

So as noted, there are many types of tax practice areas. We won't be able to cover them all today, but we will cover a few of the major areas and whether an accountant or a tax attorney would be better suited to assist the taxpayer in each particular type of issue. So first, we'll cover compliance then controversy and finally, collections.

So first, compliance. Compliance is basically complying with the state and federal tax laws, rules, and regulations. And there are a number of elements involved in this. Generally, this is going to be best suited for an accountant. So first, understanding filing and reporting deadlines and what types of tax returns need to be filed, when they need to be filed, when taxes need to be paid. So there are a variety of tax forms and filing deadlines, depending on the type of tax period, the type of income. For example, an individual has a different type of tax form to report their income than a business. Both have different filing deadlines. A business itself might have a different type of form depending on the business entity type and the type of tax that its paying. So it might have a different filing and reporting deadline for income tax versus if it's reporting and paying sales tax. So an accountant is going to be helpful with regard to those issues, as well as making sure that the taxes are properly calculated. So ensuring that that taxpayer is only paying as much as they're required to pay under the state and federal tax laws. Also, working with either an accountant or a bookkeeper for tracking income and expenses and maintaining books and records. So, underlying our return, that income and the expenses that are reported on that return, there needs to be books and records to support those numbers. And generally, it's just good practice to maintain those books and records to substantiate that return for the period within which the IRS or the state taxing authority can audit the return. So for example, the IRS's audit statute of limitations is three years. So making sure that you're maintaining those books and records in case when audit.

Next is controversy. So generally, controversy matters are going to be best suited for an attorney. There are some situations in which an accountant can be the type of professional that your client would be working with. So to start, generally, controversy is when there's a problem, there's an issue that's come up with the IRS or with the state taxing authority. Generally, this starts with an audit, that's just an examination of a tax return. There's a number of reasons that a taxpayer's return might get selected for audit. Maybe a third-party has reported that they paid that taxpayer some income and the taxpayer didn't report it on their return. Now the IRS system is caught that discrepancy, and they want more information. It could be that the IRS or the state is running a particular type of audit campaign. So maybe particular type of business has been subject to abuse recently, a particular business type.

So maybe your client is selected, because their business is of a type that they see seen a lot of abuse recently. Maybe it's just a random selection of the returns. There's a lot of reasons that your client might get audited, but in either case, the beginning of an audit is generally the same, no matter the situation, the IRS, the state taxing authority is going to want information and documentation to support the income and expenses that are reported in that tax return. That's called substantiation. And generally, an accountant is going to be best suited to help a taxpayer with those types of substantiation issues, particularly, if the taxpayer worked with an accountant and that accountant can work with the taxpayer on the audit, that is a great combination, because that accountant is going to be familiar with the information documentation that was used to prepare the return. In pretty much any other circumstance, an attorney would likely be more helpful.

So for example, if there's not perfect books and records available to substantiate that return is filed, the burden on the taxpayer to prove that their numbers are correct. So if they don't have documentation to tie up their expenses, the IRS or the state is going to add those expenses back into their taxable income, that's going to increase their tax liability. In a circumstance like that, it can be helpful to work with an attorney to help the taxpayer figure out another methodology to prove up their expenses, even though they don't have perfect books and records. So maybe using another year for which they do have good records and using that as a sample and projecting back, just coming up with other alternatives so that they don't have a huge tax bill at the end of the audit. And in either case, if they dispute the audit, they can go on to administrative appeals or judicial appeals. And at all of those levels there's going to be the opportunity for negotiations and in trying to settle the case. And so, an attorney can be helpful for that in understanding just the procedural process. So when we're getting to administrative appeals, the case is going to get assigned to an appeals officer.

When you get to the court level, it's going to be assigned to an attorney, be it at the state level, at the AG's office or at the IRS of Chief Counsel. So those are gonna be opportunities to explain to the decision-maker your case, evaluate what's called the hazards of litigation. So the government is going to consider at those various levels, what are the perceived odds of the taxpayer prevailing in the case? And the government might make a settlement based on that percentage. So if it looks like the taxpayer has a good case, like a 75% chance of winning, maybe you can resolve the case for 25% of what's owed. So it's helpful to have an attorney there to evaluate the precedent and the case law, to make sure that you can get the best settlement possible, the best resolution of the case, or if you need to move forward to litigate it, helpful to have an attorney there. The last area that we'll cover is collections. So if it's not a question that the taxpayer owes, it's just a matter that the taxpayer cannot pay right now, what's owed. There are a lot of different ways to try and resolve that kind of issue.

A few common ways to resolve a balance owing is an offer of compromise or an installment agreement. An offer of compromise is basically an offer to pay less than the full amount that's owed to resolve the entire balance. And that is going to be dependent on the taxpayer's financial situation. So their equity and assets, their excess monthly income. And they're going to have to prove all of that up with documentation. And there's just a lot of room for negotiation and for discounts in different ways to try and work and get the lowest number possible with that. And then, an installment agreement is basically a monthly payment and the IRS, the state is going to be looking for the highest monthly payment possible generally. So they're going to wanna do the lowest amount of expenses allowed and looking at the taxpayer's income, try and get the biggest delta that they can and requiring that the taxpayer make that payment. Having an attorney involved can help in the sense that they can understand where some expenses might be allowed that the government might push back on and maybe get that taxpayer a better monthly payment than they could get themselves.

Ben Wagner - So let's talk a little bit about individuals who are working out of their house and how much of that can be deducted on your return. Obviously, this is something that's become very relevant to a lot of people in the last couple of years. The basic rule is that if a taxpayer uses a portion of their home for business purposes, that taxpayer may be able to deduct some of the related expenses for the business use of their home. So that's the good news. And there are a couple of different approaches in terms of how you can quantify that deduction. There's the simplified method, which significantly reduces the burden on recordkeeping, which is kind of nice, particularly for small business owners, where it might not be easy to sort of maintain all the necessary records that need to be kept. And so, if you're gonna use the simplified method to use a prescribed rate of $5 per square foot, and the maximum amount of square footage that can be deducted is 300 feet. So it's very simple in terms of being able to say, well, I've got a home office of X amount of square feet, as long as it's not more than 300. And if it is more than 300, you get a 300-foot deduction or excuse me, 300 feet times $5 in order to get your deduction. The taxpayer who does that is still allowed to deduct the related items like mortgage interest, real estate taxes and things like that, if they qualify as an itemized deductor on schedule A.

So that's the simple method. The regular method is where the taxpayer has to actually maintain and organize the actual expenses of their home office. And this includes things like mortgage interest, insurance, utilities, repairs, and depreciation. So using the regular method, you are able to generally secure a larger deduction, but it means that the taxpayer must maintain all the records necessary in order to support that deduction. The other thing is that you have to make sure that you use the home office exclusively for that purpose. And we're gonna talk a little bit more about that in a second, but basically, once you determine the area that is the home office, you get a allocated percentage of all of those expenses as your home office deduction. And so that, like I said, oftentimes, it can be a more beneficial sort of deduction for the taxpayer, it just comes with a higher threshold of recordkeeping and maintaining those records.

So the requirements in order to claim the home office deduction, there's basically two simple requirements. One is regular and exclusive use, which basically means the taxpayer must use the portion of their home exclusively for conducting business. And this is one that I think a lot of people get tripped up on. We had a client who was a realtor and she basically remodeled her home to make it a custom-built, absolutely beautiful home. And then she used it as a show home, so she would have prospective clients come to her house to see it and see if they like the sort of finishes and the quality and things like that. And if they did, she would then go show them houses that were very similar to hers. And she was very good at using her home in this way, and it helped her get a lot of business. She tried to deduct all of the remodeling expenses that she incurred, because her thought was she had incurred them to sort of build the house that she was using as basically like a spec home. The problem is that she also used the home as her home. And so, when the IRS went to audit her expenses, that she had deducted, they challenged the exclusive use component of that deduction. And frankly, it was a legitimate challenge, because you can't use, or excuse me, you can't deduct space within the home that has other purposes. So if you're using your kitchen as a home office, but it's also your kitchen, that would not be something that you could deduct. You could still take the simplified method of approach and receive a smaller deduction. It's when you're trying to receive that larger deduction that you start getting into trouble.

 The other element that you have to satisfy is that it has to be your principle place of business. So if you're a taxpayer who has an office, but then you're also trying to take the home office deduction, that could be problematic unless you're conducting additional business in your home in the sense that you have maybe a studio or something to that effect, then that might still qualify at that point. But if it's just as simple as an office and an office, remote office, and an office at a different location, that deduction is going to be harder to take. And so, that's the two sort of most important standards when looking at the home office deduction. A couple of other things to consider are that if you have other structures that are on your property, maybe you have a garage or studio or a barn. You can certainly take those as a deduction on your return, but with the same sort of exclusive use characterization or principle that we talked about before, if you're using those spaces for something that is not just your office or your studio, then you're gonna run into trouble when it comes to taking that expense. And finally, we can talk a little bit about the percentage of business use, meaning if there's a portion of the home that is used again, it's an allocated portion, that's how you calculate that expense.

So sort of look at the total square footage of the home and figure out what space is being dedicated for the home office space deduction, that's how you sort of calculate that allocation. There is a couple of additional tests for individuals who are employees. You are allowed to take a home office deduction if you're an employee, but to qualify, you have to meet the following elements. The taxpayer's use of that home has to be for the convenience of the employer and not the employee. So again, more recently, that certainly was something that would be easy to fix or easy to meet. The taxpayer cannot rent any portion of their home back to the employer. And so, that's something that you do see occasionally where someone wants to work from home, maybe the business provides them with some sort of rental stipend for using that space. If that happens, you don't get to deduct it, because you're receiving a payment for it. And if the use of the home is merely sort of appropriate and helpful, meaning usually it's for the convenience of the employee, then the taxpayer cannot deduct the home office use at that point, because again, it's for the convenience of the employee and not for the employer.

Kathleen Pfutzenreuter - All right, next we'll talk about using a personal account for business expenses. Is that a good idea? No, short answer. So we see this happen quite a lot. An individual might have their business, they have their personal account, they feel like this is all my income and all my expenses. Anyway, why does it matter? There are a few different reasons. We'll get into a couple here, which I listed on the slide. So in terms of just from a practical standpoint of operating your business, it's easier to track your business income and expenses, it's easier to prepare your financial statements, your tax returns, track profitability, to make changes to improve profitability, if you have a separate business bank account, if you have several businesses separate bank accounts for each of those businesses as well, just because you can kind of have a quick reference then of how the business is doing. In an audit, it's easier to verify the business expenses and it increases the taxpayer's credibility.

So if the taxpayer has types of expenses that are both personal and business, so maybe the taxpayer has to travel for work, and they're taking flights to go to conferences and to do jobs out of state, and then they also take personal trips. If all of that is in a single account, it's really hard to determine which our business and which our personal, particularly if the taxpayer doesn't have good documentation to substantiate what they were doing and when, and the business purpose of their trips. So if they're keeping separate bank accounts and the IRS or the state can see clearly that this taxpayer always runs all of their business income, all of their business expenses through the same account, that's going to give the taxpayer more credibility, if they're not able to otherwise substantiate those business expenses.

Also, it helps to show the taxpayer's profit motive. So this can come up in a circumstance. For example, if the taxpayer has a business on their 1040, so on their individual income tax return on their Schedule C that's been operating at a loss, and then they've been taking that loss against some other income on their tax return. So maybe their spouse has W2 income, or maybe they have W2 income. They've been taking the losses from that Schedule C business against their other income and they're audited. Well, if it looks like they don't have a motive to make a profit with that business, or it looks like that business is a hobby, particularly if there's some element of pleasure in that business. So maybe they're doing videos online for YouTube or TikTok or something like that, and generating income from that, or maybe they're breeding dogs or horses or racing cars, something that seems more fun than something like accounting, they're going to have a higher hurdle to get over to show, look, this isn't my hobby, this is my business.

But even for normal businesses, if it's been operating at a loss for many years, the IRS and state are going to look at why is this happening? Are you actually trying to make a profit? And some of the elements that they're going to consider include whether that business has been operated in a business-like manner. And so, part of that is contemporaneously tracking income and expenses, determining profitability, making changes when necessary to improve profitability. And part of that is keeping your business expenses and income separate from your personal. So it's just helpful to improving that that business is actually a business, not a hobby, not something else, so the taxpayer can get the maximum extent of the expenses allowed on their tax return.

Ben Wagner - All right, let's talk a little bit about hiring your kids and your parents and your spouse, and can that help you in your business? The fact of the matter is it can actually be very, very beneficial for hiring family members, assuming you're good working with those family members, but that's a whole different sort of CLE, that we're not gonna get into today. And the benefit is that there can be some real favorable tax breaks that you can receive for having either your children act as employees or potentially your spouse act as an employee. And then we'll talk a little bit about sort of the parents' problem in terms of what benefits there are there, but let's talk a little bit first about children employees.

So payments for the services of a child under the age of 18, who works for their parents in a trade or business are not subject to social security or Medicare taxes, if that trade or business is a sole proprietorship or partnership in which each parent is a partner of the child. So that's a very nice benefit for small business owners to be able to employ their kids, and then have those wages not be subject to social security and Medicare. It's also true that if the child is under the age of 21 and they work for their parents in the same way, that those wages are also not subject to Federal Unemployment Tax Act taxes or FUTA. And so, that's two very nice sort of benefits to being able to have your child work for you and not have to pay the sort of taxes associated with those wages. For individuals who have a corporation or partnerships where all the of partners are not the child's parents, then all employment taxes must be paid. So this really only applies to sort of really small businesses where the parents are the owners and they're having their children sort of work for the business, but that is a lot of businesses. So there is a really nice benefit there to being able to have your kids work for the small business.

Let's talk a little bit about spousal employees. So payments for the services of a spouse who works for their partner's trade or business are not subject to FUTA tax if that trade or business is a sole proprietorship. So we've got that sort of special caveat there. Payment for the diversed services of a spouse in a private home are not subject to social security, Medicare, or FUTA taxes. So that's for someone who's providing some home care for someone. And then, for corporations or partnerships where the spouse is a partner, all employment taxes must be paid. So basically, if you have a corporation, Ascorp is the most common that you probably run into, you're not gonna be able to take advantage of these tax benefits. Again, it's really sort of targeted for small partnerships or sole proprietorships, that's who's going to see the benefit on this. For parental employees, payments for the services in the son or daughter's trade or business are subject to tax. One thing that I'll mention too, just about the kids before I forget, the benefit is very real in order to be able to pay your children and not have to pay their taxes.

But one thing that you really have to be aware of, and this is something that I've seen from other sort of tax planners sort of advocating these payments. Well, there is a nice benefit there, the children do have to do some work. I had a friend who was a dentist, who he was advised by his tax planner to sort of make sure that he was paying his son wages out of his dental practice for contributing to helping with the business. Well, the issue with that is at the time he was told to do that his son was five. And so, that's just not an okay thing to do. The children have to be providing some services to the business in order to be able to take advantage of this potential break. So, it's a little bit obvious, but it's also something that unfortunately, it's an area we do see abuse in. So just try to keep that in mind.

To kind of close out the concept of parent payments. So, like I said, payments when it's coming from a corporation or from a partnership, those payments to a parent are not going to be deductible. However, if you're making payments for the services of a parent that are not in the son or daughter's trade or business, those payments might be exempt if the following conditions are present. So the son or daughter has a child or stepchild living in the home, the son or daughter is a widow or widower divorced and not remarried, or living with a spouse, because of mental and physical disabilities, cannot care for the child or stepchild for at least four continuous weeks in a calendar quarter in which the service is provided, the child or stepchild is under the age of 18 and requires personal care of an adult for at least four continuous weeks, during the calendar quarter in which a service is performed due to the mental or physical disabilities.

So basically, if you're gonna be paying your parents sort of help with home service care, that is a payment that might be exempt from FUTA or from social security. But again, you've gotta make sure that you meet all of those qualifications. And so, it's not as quite as simple as just here's the check, we don't have to worry about the taxes, but in many situations, the reason that the parent is being paid for that home service is because those situations or those conditions are in fact present in the case.

Kathleen Pfutzenreuter - All right, next we'll cover the 199A deduction. So this deduction arose in 2017 as part of the Tax Cuts and Jobs Act. And it's set to phase out at end of 2025. And basically, this is a deduction that allows some individuals to deduct up to 20% of certain types of income, so qualified business income. And we'll talk a little bit about what that is in the next slide. So the individuals who can deduct the 199A deduction include shareholders and S corporations, sole providers, partners in a partnership, and some trusts and estates. So the maximum possible deduction is limited once the taxpayer reaches certain thresholds of taxable income. We'll talk about that on a later slide. And business income from certain fields or trades can also affect the taxpayer's available deduction. So when we're talking about qualified business income, this is all a pretty complicated calculation.

So this is just a very high level overview. Like we were talking about before, some circumstances an accountant is best suited for certainly if you've got a taxpayer who might qualify for this, it would likely be a good idea for them to talk to an accountant about making the calculation, but in either case from a high level, qualified business income is basically the type of income that the business was designed to generate. So if the business is, is in the business of making widgets, the income related to making widgets. For other types of income, those likely won't be included in the QBI calculation. So here we've got a list of some of the types of income or other items that wouldn't be included in QBI. A few examples include capital gains or losses, most investment dividends. And earlier I referenced some thresholds. So again, the calculation can be complicated, but just high level. So there are basically, two levels of thresholds.

The first level is listed here in the first bullet. So $340,100 for married filing jointly and up to $170,050 for other filers. So up to those amounts, the taxpayer may claim the full 20% deduction. Once you get above those thresholds, but below the second level of thresholds, which are listed here in the slide of $448,100 for joint filers, $220,050 for other filers. In that area, there's a partial allowance for the deduction, depending on whether or not the income comes from a specified service, trade or business. So if the trade or business is one that depends for its principle asset on the reputation or skill of one or more of its employees or owners, then it might not qualify, or it might only qualify for a partial deduction if it's in between the two thresholds. And some examples as relevant here for all of us would be law firms. Also, other examples are listed on the slide, including consulting, athletics, financial services, health, trading. So any of these types of businesses, now you might either not get the deduction or only get a partial deduction depending on the income of the individual. And then, once you get above that top-tier threshold, now there are other qualifications that come in that can limit the deduction, including the amount of W2 wages paid by the business.

Ben Wagner - Awesome, so let's talk a little bit about income. Go from the very complex QBI to what is income even mean? The basic rule as defined in IRC Sections 61, is that income means, "From whatever source derived, including, but not limited to the following..." And that statute was written that way on purpose. Meaning, when they drafted it, they wanted it to be as all-encompassing as possible and that's exactly what's happened. And so, some of the simple ones like compensation for services, for commissions, or fringe benefits, things like that, those are obvious, gross income derived from your business, again, fairly obvious. Gains derived from dealing in property, that's starting to get a little bit more complex. Interest is a pretty simple one.

Royalties and dividends and annuities, those are simple to track, and most people do understand that those are probably gonna be subject to income tax. Income from life insurance and endowment contracts, that gets a little bit trickier, because it's not always going to be subject to tax. The thing to sort of take away from that one is that if you get your life insurance paid for by your business, then the proceeds may be subject to tax. If you pay for it yourself, then the proceeds are likely not going to be subject to tax. Things like a pension, that's another thing that's relatively simple and straightforward, income from discharge of indebtedness is one that we see a lot, that people just cannot understand, and I get it to a degree, because that usually pops up when you have a loan or a debt that you owed and the individual or the entity that you owed the money to decided to forgive the debt, so you no longer have to pay the money.

When that forgiveness happens, they then issue a 1099 for the amount that was forgiven, and that amount may have to be included as income to the taxpayer that received the loan forgiveness. Now, there are some exceptions to that that include insolvency. So if you can show that prior to the discharge, you were insolvent, then you may be able to exclude some or all of that income from tax, but it's definitely one that taxpayers who are in that situation are usually just trying to figure out their finances and they get discharge from debt, and they think they're in a good spot, and then they get that 1099 six months later, and they realize they may have a tax debt that they're also gonna have to tackle. So that's a common one that we see that's tricky and it can kind of sneak up on some people in terms of how it sort of plays out.

 Distributed shares from partnership gross income, again, a relatively straightforward one. Income in respect of a decedent, some money that might come from an estate or from a trust. Let's talk a little bit about the timing of income. So most individuals are cash basis taxpayers and are generally taxed on income, including in the situations that we just went through when that is constructively received. So there was a very famous case involving a football player for the Green Bay Packers, who back in the seventies, received a vehicle for winning the MVP of the Super Bowl. But instead of receiving the keys and going to pick up the car right away, he was just told that he won the vehicle in December, but he didn't go and pick it up until the following year. And so, he tried to take the income on the following year when he actually had control and use of the vehicle. The IRS audited him and the IRS won, because the tax court said that when he received the award, he had constructive receipt of the vehicle. And therefore, the amount that was received for income should have been included in the previous year. And so, that timing is important.

Some people think, "Well, if I just get a check and I don't cash it until later, then I don't have to recognize the income until later." And that's not the case. It's the receipt, the constructive receipt of that item that triggers the sort of taxability of it. For prepaid income, cash payers, this is taxpayers that receive compensation for future services, like a flat fee retainer for legal representation. You only include that income if there's no requirement that the work must be performed. So if it's a flat fee and you're just being paid and you're gonna work moving forward, then that has to be included. But if you have to send out billing statements to justify the costs that are being incurred on that retainer, then in that situation, it only is charged as income, once those sort of costs are occurred, or incurred, excuse me. And cash versus check. This is another one that's sort of typical, particularly for small business owners. There is no difference for this when it comes to income.

Both are valid types, and more importantly, both should be counted. I still remember one of the very first meetings I ever had with a client. And I sat down with him and I was talking to him about his collections case and I asked him, how much money did you make last year? And with a straight face, he looked right back at me and said, "Well, how much should I have make?" And this is just something that we're not supposed to be doing, cash or check, it all gets counted. Small business owners do have a tendency to forget to count the cash, but I will tell you that the IRS's algorithms are getting very good and their algorithms know that if you have a certain business type, that you should also have a certain amount of cash that should be included in your income. And if they can't see that, then that's a potential audit risk, because the algorithm will say, hey, we see this bar, restaurant here, all it reported was the wages that were received or excuse me, all it reported was the income was received via its square account, and there were no cash to deposits that were reported.

That's a giant red flag for the IRS to consider on an examination. In terms of how do I determine my income, we're gonna touch a couple of, sort of more common topics that we see. Bartering has become a little bit more popular here in the last couple of years. And the thing to remember there is that the income is attributed for whatever you're agreeing to trade in. So if it's a service for a good, you have to just put value on those things when you're making those trades. And that's how you determine whether or not there should be income in regards to that transaction. So, a good thing to do there is just sort of paper up your file in terms of what it is you're doing, or what you're receiving, and make sure that you have kind of a fair market value associated with the items that were exchanged. And that'll be the best way for you to be able to figure out what portion of that should be subject to income tax, when you go to prepare your returns.

Life insurance proceeds. As I mentioned, if they're paid to a taxpayer beneficiary and they're paid by the taxpayer who died, or the beneficiary, with after tax money, then those proceeds are not going to be subject to tax. Proceeds resulting from a settlement, this is another area where we see a lot of mistakes that get made. In order to have the proceeds from a settlement be non-taxable, the taxpayer has to be able to demonstrate that those proceeds were received as the result of physical injury. And if you can't show that there was physical injury, then at that point, the proceeds that were received are going to be subject to tax. Now where we see mistakes get made in this area, is that the attorney handling the claim, doesn't clearly sort of stipulate in the settlement, what the proceeds are for. And then as you might imagine, when the IRS goes to audit that settlement, they just say, "Well, look, we don't see in here any sort of clear allocation of these settlement proceeds," to maybe say wages or medical expenses or whatever it might be and without that breakdown, the IRS will err on the side of everything in here is subject to tax. So it's really critical that if you're an attorney who works in that field and you're working to resolve a case and you have a settlement agreement that had a physical injury, that was a part of that settlement, it's really important to make sure that that's clearly spelled out in the agreement so that the IRS can't come back later and say, "Hey, this whole settlement should be subject to tax," when in fact the opposite should have been true.

Kathleen Pfutzenreuter - Next, we'll talk about residency. So here, we've got it within the context of Minnesota, although many states follow very similar rules. So you'll wanna check your own state just to verify what their specific rule is. But in general, these are just some ideas to keep in mind as they are general principles that are often considered by states who have income tax for individuals. So some states have individual income tax, some states do not, and the states set their own rates. So some states have higher rates, some states have lower rates. Minnesota happens to be on the higher end with our highest individual income tax rate at 9.85%, depending on the individual's income. And this state individual income tax is in addition to federal income tax.

So some taxpayers as part of kind of their planning for retirement or things like that want to move to a state with lower income tax or no income tax, or maybe they're moving for another reason they want warm weather, and the lower or no income tax is just an additional item for that. But in either case, it needs to be established that they have residence in the new state for tax purposes, otherwise, they'll generally considered to still be a resident of the state from which they came. So breaking residency is something that needs to be kind of consciously done. An example that came up in one of our cases, the taxpayers had just retired. They had lived in Minnesota their entire lives, worked in Minnesota and they left and went to Costa Rica, and they were in Costa Rica for two years and returned to Minnesota and then went to Arizona and different places for vacations and looking for a retirement home. In either case, they thought that they weren't residents of Minnesota for the two years they were in Costa Rica since they didn't spend any time in Minnesota, but that's actually not the case. That's not how domicile works. And we'll talk about now, two of the basic rules that are generally considered in establishing where a taxpayer's domicile is for income tax purposes. The first rule is the 183-day rule. And the second rule is the domicile test.

So 183-day rule. Basically, an individual is considered to be a Minnesota resident for tax purposes if two elements are satisfied. And those are listed here in the slide. The first is that the individual spends half the year or more in the state. For Minnesota, for purposes of the day count any part of a day counts as the full day. So even if they're in Minnesota for just an hour or a few hours, that counts as a day in Minnesota. The second requirement it is that the individual or their spouse has an abode in Minnesota, whether they rent, own, whatever the case may be. And an abode means a residence that's suitable for year-round use. And it has to be equipped with its own cooking and bathing facilities. If these two elements are satisfied, then the individual is going to be considered a Minnesota resident for income tax purposes.

The second test is the domicile test. And so, this test is trying to determine the taxpayer's subjective intent. So where does this taxpayer intend to make their home permanently or for an indefinite period of time? So it can be kind of hard to establish taxpayer's intent and so, like many situations in the law where you're trying to make an intent determination, it's a facts and circumstances analysis. So the state of Minnesota, and I know a lot of other states have very similar analysis for this in terms of the factors considered. Generally, these factors are not going to be considered exclusive, but there's kind of a list that the states look at and we've included some of the major factors here. So first is physical presence. So where does the taxpayer spend the majority of their time? They might spend 163 days in Minnesota, a 100 days in Mexico, 100 days in Arizona. So they're not spending more than half the year in Minnesota, but they are spending the majority of their time there. And so, in that respect, that could weigh in favor of their domicile remaining in Minnesota. Their family and community connections. So where are the things and the people that are important to them, where is their spouse? Where are their children? Where are their parents, their sisters, their brothers, their aunts, their uncles, their keepsakes. So where do they have all their photos and things that would be special and important to them, their pets, their memberships, their church, and schools for their kids? Where are all those located? That's going to help establish where is their domicile.

Also, professional association. So for example, for an attorney, where do they have their license, which state, if they're a member of the bar, which state are they a member of the bar? If they're a member of a country club, what state? Looking at their housing. What is their housing like in their original state and then their new state? So if their house in Minnesota a mansion, they've got a shack in Florida, if so, it's gonna look more likely that they're a resident in Minnesota and not Florida, and then statements and declarations of legal residence. So basically, anything that would have their address on it. So their driver's license, their voter registration and history, where are they voting at? Where are their bank accounts? What address do they use on their legal documents and for their insurance, and also, things like hunting and fishing licenses. If kind of the overall consensus in looking at these factors makes it seem as though it would be fair for the state to tax this individual, because they're availing themselves of the benefits and privileges of a resident of that state, then more than likely the state is going to make a determination that that individual is a resident for individual income tax purposes.

Ben Wagner - Great, let's talk a little bit of about whether or not you can deduct your vehicle, boat or airplane. And this is something that's changed a lot over the last few years. So it's certainly an important thing to dive into, but the general rule of thumb is that a taxpayer cannot deduct personal living or family expenses. However, if you have an expense that is for something, but that is also partly used for business and partly used for personal purposes, you can divide the total cost between the business and the personal parts and deduct the component that's related to the business use. But as you might imagine, if you're going to try to take advantage of that deduction you have to be able to track how you are using those items for business purposes. And so, to determine the percentage of business use versus personal use, it's absolutely critical that the taxpayer tracks all of the assets so that it can be properly apportioned.

So with things like vehicles, it's fairly straightforward. You keep a mileage log, you do it contemporaneously, and you make sure that when you're using your vehicle for business purposes, you're going to and from a client's site or you're going to and from some sort of warehouse or somewhere that you have to go pick up inventory or whatever it might be, you make sure that you keep a contemporaneous sort of record of what that trip was for and how long it took. And the nice thing is that a lot of the apps today and tax software items have a built-in mileage tracker that can basically turn your phone into a mileage log. So you just hit a button when you leave, you arrive, you hit the button again, and then it just creates in basically an Excel spreadsheet that just shows all of the trips. Then you just have to add the detail in terms of why it was that you were making the trip. So that's kind of the good news when it comes to tracking mileage. For something like a boat, it's a little trickier, because prior to 2017, there were certainly professional services firms that would have boats that they would like to use to entertain clients, particularly those that live on sort of nice water locations. Here in Minnesota, it's land of 10,000 lakes. And so, people would have a boat that they would use for entertaining and bringing people out to schmooze 'em a little bit and try to get business from them.

Well, after 2017, the Tax Cut and Jobs Act, the IRS and the government eliminated the ability to get that benefit. So if you're trying to take a deduction for something like a boat, you have to be using the boat for something that's not entertainment. You have to be using it for something like delivery or using it for something like whatever, I guess, whatever it might be, you have to be using it in that way that's not entertainment. If it's entertainment, then it wouldn't be allowed as a business expense. You can still do it. And there are certainly firms that are still taking advantage of that option. They're just not able to take the deduction relating to caring for and operating the boat. Airplanes are another interesting one, because as you might imagine, there's an area for abuse there, and it's kind of a tricky one too, in the sense that when it comes to your airplane, you don't have to keep a mileage log, because the FFA requires airplanes to have their logs. So that stuff is already there, all the information in terms of who's on the plane, where the trip was in terms of to and from.

Oftentimes, if you're maintaining a private plane, you've got sort of maintenance records that are kept by either the hanger you're using or the company that you're using to sort of do that. And so, a lot of the recordkeeping is actually done for you, but it's also kind of a trap in the sense that, because the FFA requires you to maintain all of the sort of flight logs in terms of who's on that plane, if you're using the plane for personal use, it's going to be fairly apparent, because if the flight log show you and 10 clients, going to somewhere, maybe you're going to a cabin to talk business or something like that, that would certainly be an allowed expense, but if the flight log show you and your family taking a trip to Vail, that is not an allowable expense, and that's where taxpayers get tripped up, because they put the plane in the business's name and many of them even use the planes more for business than they do for personal use, but because they have it and they get comfortable using it, they then end up using it for personal use. And when that happens, you need to make sure that that use gets backed off of the sort of expense side and moved over to the income side, because that is exactly what it is, once you're using the plane in that way. So like a lot of the things we've talked about today, it really boils down to just making sure that you're doing a good job of tracking the sort of use and making sure that you're maintaining good records to sort of support that use.

Kathleen Pfutzenreuter - All right, next, we'll talk about independent contractors versus employees. So a lot of businesses wonder which is a better fit for their business? And having employees. One of the main benefits in that regard is that the business then has control over the employees. So they get to say where the employee does the work, when, how, what tools they use, they have control over that employee. Whereas independent contractors are considered to be effectively running their own business. Some kind of perceived benefits for businesses and having independent contractors include the items listed here, so first being payroll taxes. So generally, employers are going to be required to withhold and remit the employee share of social security and Medicare taxes, as well as the employee's income tax, and also pay over the employer's share of social security and Medicare taxes.

Whereas an independent contractor takes care of all of that themselves. And so, the business doesn't have that responsibility related to an independent contractor. Also, independent contractors, generally don't receive benefits, and they're generally not protected by workers' compensation or most labor laws. So the first thing that you wanna consider, if your client is being audited, just as background, this type of audit is called a worker classification audit. So the IRS or the state is trying to make a determination as to whether or not a certain worker or class of workers or all of the workers, whether or not they're employees are independent contractors for tax purposes. So the first part of the analysis on the federal level, and this can apply at the state as well, it just depends on your state, it does apply here in Minnesota. Although the Minnesota Department of Revenue generally does not raise it on its own. The taxpayer needs to be educated or aware that this Safe Harbor Relief exists. So this is very good to know about. It is supposed to be considered first on the federal level, even if the taxpayer doesn't request it, that doesn't mean it always happens. So it's good for you as an attorney to know about this.

So basically, Section 530, Safe Harbor Relief if it applies, effectively stops the work classification audit. So that's great. So you wanna know if your client qualifies. And to qualify, they have to meet these three requirements, the first being reporting consistency. So they have to always have treated the worker and similarly situated workers as independent contractors for tax purposes. So that means filing a 1099 for these types of workers, rather than a W2, for example. Substantive consistency. They have to always have treated this worker or type of worker as an independent contractor. They can't have at some point treated them as employees and then switched over, they don't qualify then for section 530. Reasonable basis. So the statute itself includes some examples of what reasonable basis might be, but there's also a catchall that says that any reasonable basis should be considered for why the business thought that it was proper to treat these workers as independent contractors for tax purposes. So the two examples listed in the statute include prior audit. So if there was a worker classification audit before on the state or federal level, and the outcome of the audit was consideration of similarly situated workers and a determination that those workers were independent contractors, if that's the case, then it's reasonable for the business to rely on that and continuing to treat those types of workers as independent contractors. Another example, is the industry standard.

So do the competitors in the industry, the majority of the competitors in this field treat this type of worker as an independent contractor? If so, then that can be reasonable basis. The traditional analysis. So if your client doesn't qualify for 530 Safe Harbor Relief, then the audit rolls on and goes into consideration of the traditional factors. So there are about 20 factors that are considered, they fall into these three broad categories listed here. So the first is behavioral control. So this is what we talked about before. Does the business control how the employee or the worker performs the services, where, and when, and what they're doing? If so, that's going to look like they're an employee, not an independent contractor. Financial control. So does the worker have to make a significant investment? Are they paying for their own tools? Those types of things. Is there money on the table from the worker, or is the business paying for everything? If the worker is making a substantial investment, that looks more like an independent contractor. Is that worker making their services available to the public in general, or are they only working for this business? If they're advertising their services and working for others that looks more like an independent contractor. Then the relationship of the parties.

So how does the worker perceive the relationship? Is there a contract in place that indicates that the worker is an independent contractor? A lot of businesses get hung up on this. They think this is kind of a silver bullet if they've got an independent contractor agreement and that isn't how it works. So that is one factor that's considered. It's good to have it, but it's not determinative. The IRS or the state is still going to look at the other factors to determine whether or not that relationship looks more like an employer-employee, or an independent contractor relationship. And then also, the permanency of the relationship. So is the worker only working for this business on an ongoing basis, or is it just a specific job or a specific few jobs? That's gonna look more like an independent contractor.

Ben Wagner - Great, let's talk about some of the tax traps facing business owners who are looking to retire. One of the sort of trickier ones that we see is qualified business, or excuse me, qualified benefits plan. So a lot of small of business owners, particularly those who in their earlier years were not setting aside as much money as they wanted to for retirement, occasionally tried to accelerate that savings, as they get closer and closer sort of closing their business or moving on. The problem with that is that for many qualified benefits plans, there are restrictions in terms of how that acceleration can occur or if it can occur. And so, in order to make sure that you maintain and qualify with your benefits plan and under IRC Section 401a, it's really important to make sure that you're saving money pursuant to the plan terms. And so, what we tell people is oftentimes your plan is being administered by a trustee or a fiduciary of some kind. If you're going to make the decision to try to increase your savings, just make sure you speak with them first before just trying to stock away as much money as you can in the plan thinking it's all gonna be okay, because if you do that and you do in fact infringe upon the plan's terms, it can cause all kinds of problems both for you and for the business. So certainly not something that you wanna do and definitely work with your, like I said, retirement professional, fiduciary, financial advisor, whoever it is you're working with to make sure that you're saving money in that plan pursuant to the plan's terms.

Another trap that we see for some of our small business owner clients is when they go to sell a partnership interest. Generally, the sale of a partnership interest is considered to be a capital asset, which means that you would pay, capital gains tax, or you would incur a capital loss. But one notable exception to that treatment occurs when the partnership holds something called hot assets, which is described pursuant to IRC Section 751. In these instances, a portion of the partnership interest could be converted from a longterm capital gain to ordinary income. And the sale may be required, or excuse me, the taxpayer may be required to report that as ordinary income, even if the partnership itself actually incurred a loss when the sale occurred. And that's the nastiest sort of version of this trap is taxpayer might have a business that was failing is deciding to get out of that business, because they can't continue to operate it, so they sell their partnership interest either to another business owner or back to the partnership or whatever it might be. But when they make that sale, if they're incurring a capital loss on that sale, a lot of them think, "Well, it doesn't matter. I'm losing money, I'll have this deduction or this," excuse me, "This capital loss carried forward, that I'm gonna be able to take it against future capital gains, so it's fine, let's just do it." But if that partnership had some of those hot assets and perhaps the most common one is inventory, that taxpayer may also have to incur an income tax hit for ordinary income, because of the sale of those hot assets.

So it's just really something to make sure that if you're thinking about selling your business to really work with usually your accountant, to make sure you're identifying whether or not the partnership holds any of those hot assets and what the tax ramifications are to their sale. Because again, particularly in the situation where a taxpayer is selling the business at a loss, many people think, "That's fine, I'll just move forward, I'm finally getting out from underneath this," and then they get the surprise of having to treat some of those assets as being subject to ordinary income, when it comes time to prepare their return. And finally, let's talk a little bit about depreciation recapture on installment sale, because that's one that comes up a lot and unfortunately, taxpayers can be very, very surprised by it. It's a useful strategy, certainly for the retiring business owner, because you may be able to sort of spread out the gain that you would sort of receive over the course of your sale.

So you find someone who wants to buy your business and you do it using an installment sale. And so, you're receiving money over time, which means you're paying tax as you receive those payments, which is potentially a very nice thing, depending on which sort of tax bracket you might find yourself in. But the trap there, is that depreciation recapture and ordinary gain from inventory sale must be recognized in the year that the installment sale is signed. So if you have significant depreciation recapture as part of your sale, well, the other portion of the sale might be sort of spread out over five years or 10 years. You're going to recognize the gain from that recapture in the year that you sign the agreement. And so that means, again, you may be thinking, "Well, I'm deferring much of this gain, year over year for the next five years or 10 years," and that's true to a degree, but a portion of it might be sort of carved out again, as depreciation recapture, that amount is gonna have to be recognized as income in the year that the agreement is finalized. So certainly something to keep in mind and again, work with your accountant to sort of do the calculations on the front end, so you know exactly what it is you're walking into.

And our final topic for traps for retiring business owners is the battle between covenant not to compete in goodwill. So it's usually one of the final items that gets negotiated in the sale of a business and it's the allocation of the purchase price to both a non-compete or a goodwill asset class. And how this allocation gets made has very significant tax ramifications for both the buyer and the seller. The allocation of the purchase price relating to the non-compete is taxable as ordinary income to the seller in the receipt year. Whereas the amount allocated to goodwill is taxable is capital gain.

So as you might imagine, most sellers want to try to allocate more of the purchase price towards goodwill and less of it towards a non-compete. However, that same allocation has the reverse impact for the buyer, because if the purchaser of the business purchases too much goodwill or not even too much, it's just their purchase of the goodwill gets classified as an IRC section 197 intangible asset, and is amortized over 15 years, starting in the month that the agreement was executed. So there's always this tug of war between buyer and seller in terms of how to allocate the remaining sort of portion of the proceeds from the sale to both the non-compete and to goodwill, because either side has benefits in terms of how that allocation occurs. And our only sort of advice on this is make sure you're working with a good attorney as you're going through the sale to make sure that a, the allocation is clearly spelled out and b, that it reflects the kinda reality on the ground. Some people think, "Well, I can just use goodwill and I'll just pump that up as much as possible." Well, if you can't demonstrate the sort of support or basis for that goodwill, that certainly could be problematic for you if the IRS were to audit how that allocation occurred. So there has to be sort of a good audit file in terms of how you're calculating the goodwill and how you're calculating the non-compete.

So with that, we've reached the end of today's session. Obviously, you've got the contact information here, if you do have any questions for us, but thank you all for joining us and have a great day.

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