SOLID INVESTMENT AND FINANCIAL STRATEGIES For 2017 and Beyond 1
ENTITY CHOICE CONSIDERATIONS Distribution of Entity Choices Of all the choices you make when starting a business, one of the most important is the type of legal organization you select for your company. This decision can affect how much you pay in taxes, the amount of paperwork your business is required to do, the personal liability you face and your ability to borrow money. Business formation is controlled by the law of the state where your business is organized. This fact sheet provides a quick look at the differences between the most common forms of business entities. The most common forms of businesses are: Sole Proprietorships Partnerships Corporations Limited Liability Companies (LLC) While state law controls the formation of your business, federal tax law controls how your business is taxed. Federal tax law recognizes an additional business form, the Subchapter S Corporation. 2
All businesses must file an annual return. The form you use depends on how your business is organized. Sole proprietorships and corporations file an income tax return. Partnerships and S Corporations file an information return. For an LLC with at least two members, except for some businesses that are automatically classified as a corporation, it can choose to be classified for tax purposes as either a corporation or a partnership. A business with a single member can choose to be classified as either a corporation or disregarded as an entity separate from its owner, that is, a disregarded entity. As a disregarded entity the LLC will not file a separate return instead all the income or loss is reported by the single member/owner on its annual return. The answer to the question What structure makes the most sense? depends on the individual circumstances of each business owner. The type of business entity you choose will depend on: Liability Taxation Recordkeeping Sole Proprietorship A sole proprietorship is the most common form of business organization. It s easy to form and offers complete control to the owner. It is any unincorporated business owned entirely by one individual. In general, the owner is also personally liable for all financial obligations and debts of the business. (State law may also govern this area depending on the state.) Sole proprietors can operate any kind of business. It must be a business, not an investment or hobby. It can be full-time or part-time work. This includes operating a: Shop or retail trade business Large company with employees Home based business One person consulting firm Every sole proprietor is required to keep sufficient records to comply with federal tax requirements regarding business records. Generally, sole proprietors file Schedule C or C-EZ, Profit or Loss from Business, with their Form 1040. Sole proprietor farmers file Schedule F, Profit or Loss from Farming. Your net business income or loss is combined with your other income and deductions and taxed at individual rates on your personal tax return. 3
Sole proprietors must also pay self-employment tax on the net income reported on Schedule C or Schedule F. You may also be able to deduct one-half of SE tax on your 1040. Use Schedule SE, Self-Employment Tax, to compute this tax. Sole proprietors do not have taxes withheld from their business income so you will generally need to make quarterly estimated tax payments if you expect to make a profit. These estimated payments include both income tax and selfemployment taxes for Social Security and Medicare. Subchapter S Corporation The Subchapter S corporation is a variation of the standard corporation. The S corporation allows income or losses to be passed through to individual tax returns, similar to a partnership. The rules for Subchapter S corporations are found in Subchapter S of Chapter 1 of the Internal Revenue Code. An S corporation has the same corporate structure as a standard corporation. It is a legal entity, chartered under state law, and is separate from its shareholders and officers. There is generally limited liability for corporate shareholders. The difference is that the corporation files an election on Form 2553, Election by a Small Business Corporation, to be treated differently for federal tax purposes. Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income. It is treated in the same way as a partnership, in that generally taxes are not paid at the corporate level. An S corporation files Form 1120S, U.S. Corporation Income Tax Return for an S Corporation. The income flows through to be reported on the shareholders individual returns. Schedule K-1, Shareholder s Share of Income, Credits and Deductions, is completed with Form 1120S for each shareholder. The Schedule K-1 tells shareholders their allocable share of corporate income and deductions. Shareholders must pay tax on their share of corporate income, regardless of whether it is actually distributed. Why is the S-corporation the Entity of Choice by so many tax professionals? 4
Here is an example of how an S-corporation could save you in SE taxes if you were a one person S-corporation. Example: The taxable income generated by your S-corporation business is estimated to be $100,000 for 2016 or 2017 before you pay yourself. You take a $50,000 salary. Only that amount is hit with the 15.3 percent federal Social Security and Medicare tax, which amounts to $7,650. You can withdraw the remaining corporate cash flow in the form of distributions to yourself that will not be subject to SE taxes (this will be added to your personal income on which you will pay tax at your current tax bracket). If you operate the same business as an LLC or sole proprietorship (assuming one owner) where each member is subject to SE taxes, you owe SE tax on your entire $100,000 profit, for a total of $14,130 ($100,000.9235 = $92,350 15.3%). Operating as an S-corporation could save you thousands ($14,130 $7,650 = $6,480). Remember: You must be able to show that a $50,000 salary is reasonable. If the IRS thinks it s too low, it may try to reclassify all or part of your purported cash distributions as disguised wages. Future tax bills look to possibly remove this tax break. Limited Liability Company A Limited Liability Company (LLC) is a relatively new business structure allowed by state statute. LLCs are popular because, similar to a corporation, owners generally have limited personal liability for the debts and actions of the LLC. Other features of LLCs are more like a partnership, providing management flexibility and the benefit of passthrough taxation. Owners of an LLC are called members. Since most states do not restrict ownership, members may include individuals, corporations, other LLCs and foreign entities. Most states also permit single member LLCs, those having only one owner. 5
A few types of businesses generally cannot be LLCs, such as banks and insurance companies. Check your state s requirements and the federal tax regulations for further information. There are special rules for foreign LLCs. For additional information on the kinds of tax returns to file, how to handle employment taxes and possible pitfalls, refer to Publication 3402, Tax Issues for Limited Liability Companies. Which structure best suits your business? One form is not necessarily better than any other. Each business owner must assess his or her own needs. It may be important to seek advice from business experts and professionals when considering the advantages and disadvantages of a business entity. 6
Retirement Plan Considerations INCREASE IN RETIREMENT PLAN CONTRIBUTION LIMITS The limits on contributions to retirement plans are increased as shown on the following table. Retirement Plan Contribution Limits Year IRA Simple 401(k) Def Cont SEP % of Profit 2017 5500 12500 18000 54000 20/25 Catch-up Contributions for individuals 50 years or older for certain Plans: IRA or ROTH IRA $1,000 SIMPLE PLANS $3,000 401(k) $6,000 Note: The SEP IRA does not allow catch-up contributions 7
The 401(k) series A good way to increase retirement plan contributions on lower levels of profit. (or S Corporation Salaries) Must be started by end of first year, you can t wait until the following year to set up like a SEP IRA Only problem is that if a self employed person is not maximizing contributions to their current retirement plan, they won t do it to the 401(k) either The 401(k) series Solo (k) or Safe Harbor 401(k) Profit $50,000 $80,000 $220,000 Cont: $18,000 $18,000 $18,000 +25% 12,500 20,000 36,000 =401(k) $30,500 $38,000 $54,000 If 50+ $36,500 $44,000 $60,500 vs SEP $10-12K $16-20K $54,000 8
Roth 401(k) NOT SUBJECT TO INCOME LIMITS OF ROTH IRA Not Tax Deductible, but distributions are generally tax free 401K Loans available Maximum deferral per employee will be $18,000OR $24,000/year for age 50+ Maximum contribution from employer is 25% of employees compensation. Combined contribution between employer and employee not to exceed $54,000/year (2017) 9
Investment Considerations Consider Purchasing Investment Real Estate in this market The IDEAL Formula I D E A L Income from Cash Flows Depreciation Deductions Equity Buildup Appreciation Leverage 10
Investing in Real Estate for the Benefit of the Client and the Realtor Return on Investment and Cash Flow 11
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Tax Advantages-The Real Estate Professional Rule SPECIAL RULE FOR RENTAL REAL ESTATE Under this special rule if you actively participate in your rental real estate you may offset or deduct up to $25,000 (12,500 if married and filing separately) of passive losses against non-passive income. To qualify, However, you must meet all of the following tests: 1. you own at least 10% interest in the rental activity 2. you cannot hold your interest as a limited partner 3. the rental activity cannot be subject to a net lease 4. you or your spouse must actively participate in the rental activity Making management decisions is the key to qualifying as being active. It is not necessary for you to manage the property yourself if you retain the management decision responsibilities. You need to be active in the decision making process. A deduction of up to $25,000 in net real estate rental passive losses from nonpassive income by a taxpayer is limited also to taxpayers with an adjusted Gross Income (AGI) of no more than $100,000. If the taxpayer's AGI exceeds $150,000, no part of the $25,000 allowance is available. For AGI between $100,000 and $150,000, the $25,000 allowance will be reduced by 50% of that amount over $100,000 up to $150,000. 16
EXAMPLE: A taxpayer has adjusted gross income (AGI) of $137,500. The maximum deduction available in this tax year will be $6,250. ($137,500 - $100,000) = 37,500 X 50% = $18,750 $25,000 - $18,750 = $6,250 SUSPENSION RULES Amounts that are disallowed as deductions under the passive loss limitation are carried forward, or "suspended," and can be used to offset net passive income in future years from any source. If not used up before the property generating the passive loss is sold, the suspended losses are deductible in the year of sale from any type of income. REAL ESTATE PROFESSIONAL RULE Probably one of the most significant positive changes of the 1993 Omnibus Reconciliation Act affecting real estate professionals is the modification to the passive loss rules. Commencing in 1994 real estate professionals may offset losses from real estate against non-passive income. A person is considered a real estate professional if more than half of the personal services he/she performs are in real property trades or businesses in which he/she materially participates. Real property businesses are development, construction, acquisition, rental, management, brokerage, etc. Of particular benefit may be this rule as it applies to spouses filing a joint return. One spouse may qualify and have losses which may be offset against the other spouses income. To treat losses from rental real estate as non-passive you met three conditions: 1. You must materially participate in the real estate activity creating the loss. That means regular, continuous and substantial participation. 17
2. More than half of your business - connected personal efforts must be concentrated in a real estate business or businesses. 3. You must materially participate in your real estate business, or businesses. Warning!!!!!!!!!!!! For my buy-hold-rent investors, beware of fairly recent IRS wins in courts against individuals who own rental properties and who have deducted tax losses from the operation of their rentals. Since 1994, accountants and their clients have been operating under a mistaken impression of the Real Estate Professional Rules of the 1993 tax law change. Under that tax change, it appeared that Realtors who met the rules could take unlimited write-offs from their properties. However, in the past several years, the courts have been finding that indeed, we cannot write-off all of our deductions unless we meet very, very, very, specific requirements. The crux of the problem is identified in the IRS s own instructions to its agents who will be auditing rental property deductions and losses of Realtors. IRS MSSP Guidelines Beginning with the 1994 year, a taxpayer who meets ALL of the following can deduct current rental real estate losses in full regardless of how high his/her AGI might be: 1. More than half of the taxpayer's personal services in all businesses must be in real property businesses. A real property business is real property development, construction, acquisition, conversion, rental, management, leasing, or brokerage. 2. The taxpayer must spend more than 750 hours a year in real property trades or businesses. NOTE: For time to be counted in either of the above two tests, the taxpayer must materially participate in the activity. 3. The taxpayer must materially participate in each rental real estate activity unless he or she has filed an election to group all rental real estate activities as one (for purposes of materially participating). My observation: Fulltime Realtors should have no problem meeting rules number #1 and #2, however, rule #3 looks to be very troubling. What Realtors have to be able to show is that they are materially participating in the management of each property, unless they make a special election to aggregate their rental properties, wherein they only need to show that they are materially participating in the management of ALL their rental properties. The IRS uses a time line of 500 hours per year as one of it s tests of material participation, and 100 hours per year as another test. In either case, however, the election to aggregate is of PRIME importance on your 2017 return (2016, if not yet filed), so that the investor only has to be able to prove the 500 or 100 hour test on ALL of their rental properties, instead of having to meet those tests on EACH of their rental properties. Please, please talk to your accountant 18
about this election, because most of us in the business have simply misunderstood this point. I have included a draft of the proper election language for your use. Election Wording Election to Treat All Real Estate Interests as One Activity (IRC Section 469(c)(7)(A)) and Regulation 1.469-9(g)(3) Tax Year 2014 Helen J. Smith 4572 South Providence Street Urbana, IL 61802 SSN:234-56-7890 Pursuant to IRC Section 469(c)(7)(a), Helen J. Smith, SSN 234-56-7890 elects to treat all rental real estate interests as one activity to qualify as a materially participating real estate professional this tax year. Estate and Succession Planning Current Federal Estate tax Exemption is $5,540,000 and the current Annual Gift Tax Exemption is $14,000. Let me explain what this means. 19
What are your Plans???????? 1. Build Net Worth? 2. Grow Mail Box Income? 3. Leave Net Worth to Heirs? 4. Leave Income Stream to Heirs? 5. Do Your Heirs want the Properties???????? 6. Do your heirs want to work as hard as you do?????? Suffice it to say that leaving real estate to your heirs, or others for that matter, at your death can be a spectacular way to keep the tax man at bay, depending on: 1. Your total net worth 2. How you have used trusts 3. Use of CRATS 4. And other strategies beyond the scope of this brief seminar Acquisition Strategies 20
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The Internal Revenue Code Section 1031 Exchange-A property improvement issue DEFERRING TAX ON RENTAL REAL ESTATE BY EXCHANGING A. What is an Exchange 1. Disposing (selling) of one property and the acquisition (buying) of another property 2. Usually involves three (or more) parties 24
Logistics of an exchange. Chart 1. The regular exchange Chad is the Seller (Exchanger) Direct Deeding: Contract date is February 1, 2017 Closing March 5 Sales Proceeds Ann Ann is the Buyer of Chad s Qualified Intermediary 45-day Identification Period deadline is April 19, 2017 180 day deadline is Sept 1, 2017. Purchase Proceeds Direct Deeding Jane Identification date is 4/1/17, Contract date is 4/1/17 Closing date is June 1 2017 Jane is the Seller of replacement property to 25
Logistics of an Exchange The fact that a contract has been negotiated for the purchase of the replacement property prior to the sale of the relinquished property will not preclude a tax-deferred exchange result. A seller who has entered into a contract to sell the relinquished property may still enter into an exchange of the property, if an exchange agreement is entered into prior to closing. On the other side of the exchange, the seller of the relinquished property may enter into a contract to purchase the replacement property prior to closing on the sale of the relinquished property. The Language of Exchanging 1. Like-kind property 2. Unlike-kind property a. Cash b. Boot c. Net loan relief 3. Gain a. Realized b. Recognize c. Unrecognized Delayed Exchanges 1. Purpose is to allow a person to dispose of their property without knowing exactly what the new property will be 2. You have days from the day of sale to the replacement property 3. You have days from a day out sale to the replacement property 4. You must place sale proceeds in a qualified and properly set up escrow account 26
A COMBINATION OF BOTH RETIREMENT PLANS AND INVESTING IN REAL ESTATE CONSIDER THE REAL ESTATE IRA A. Introduction This opportunity is legal although few professionals really understand the details. This opportunity is very complex, although after you have done it once, the process does not seem that difficult. This opportunity is like a ladder, at the first rung, everyone can quickly grasp the details, but as you climb the ladder, the higher rungs become much more difficult to both understand and to implement. I have used the phrase, Many are called but few are chosen to emphasize that while many, many, many real estate agents get very excited about the possibilities of this investment, if 10% of them actually follow up and make the investment I would be surprised. B. Terminology 1. The ability to purchase real estate in a retirement plan includes ALL retirement plans. This means that the following retirement plans can own real estate properties. a. IRA b. ROTH IRA c. SEP (Simplified Employee Pension) d. 401(k) e. Profit sharing plan f. Money purchase plan g. Defined benefit plan Custodian or Trustee-A custodian or trustee is required for all individual account arrangements. These two terms are synonymous. A custodian or trustee must be a bank, federally insured credit union, savings and loan institution, or other entity approved by the IRS to act as trustee or custodian. An individual cannot qualify as trustee or 27
C. Advantages custodian. The trustee or custodian is the entity which is responsible for receiving and holding contributions and plan assets; maintaining accurate records of contributions, earnings, distributions, and other relevant records; making distributions to beneficiaries, and providing annual statements to account holders. The most commonly used name for these custodians or trustees is SPECIAL ASSET TRUSTEE, and the 5 better known SAT s are: a. Equity Trust, Elyria, OH b. Entrust, Oakland, CA c. Fiserve, Denver, CO d. Pensco e. Sterling Trust, Waco, TX Among the most obvious advantages of investing retirement plan assets in real estate properties are: 1. Income tax (Federal and State) deferral. Keeping the money that would otherwise be paid in taxes in the investment 2. Investing in what you know as opposed to conventional investment vehicles such as stocks, bonds, and mutual funds that you may not understand as well 3. Investing in what you can control 4. If a ROTH IRA is used to own the real estate properties, the opportunity for tax-free profits, as opposed to tax deferred profits is available D. Disadvantages Not all is a bed of roses with this investment alternative. The following list provides reasons why you should not consider the Real Estate IRA. 1. The federal income tax rates, both marginal and capital gains rates, have never been lower. So paying your taxes now, (owning the property outside of your retirement plan) may be a wise decision. 2. Any tax write-offs attributable to the rental property owned by the retirement plan are not deductible 3. Complexity, complexity, complexity!!!!! 4. Finding professional advisors that know what they are doing 5. Avoid Prohibited Transactions!!!! These are: a. Personally borrowing money from your retirement plan b. Selling property to your retirement plan c. Receiving unreasonable compensation for managing the property 28
d. Using the retirement plan as a security for a loan e. Purchasing property for personal use with your retirement plan funds 29