Do you play a major role in a closely held corporation and sometimes spend money on corporate expenses personally? These costs may wind up being nondeductible both by an officer and the corporation unless proper steps are taken. This issue is more likely to arise in connection with a financially troubled corporation.

Deductible vs. nondeductible expenses

In general, you can’t deduct an expense you incur on behalf of your corporation, even if it’s a legitimate “trade or business” expense and even if the corporation is financially troubled. This is because a taxpayer can only deduct expenses that are his own. And since your corporation’s legal existence as a separate entity must be respected, the corporation’s costs aren’t yours and thus can’t be deducted even if you pay them.

What’s more, the corporation won’t generally be able to deduct them either because it didn’t pay them itself. Accordingly, be advised that it shouldn’t be a practice of your corporation’s officers or major shareholders to cover corporate costs.

When expenses may be deductible

On the other hand, if a corporate executive incurs costs that relate to an essential part of his or her duties as an executive, they may be deductible as ordinary and necessary expenses related to his or her “trade or business” of being an executive. If you wish to set up an arrangement providing for payments to you and safeguarding their deductibility, a provision should be included in your employment contract with the corporation stating the types of expenses which are part of your duties and authorizing you to incur them. For example, you may be authorized to attend out-of-town business conferences on the corporation’s behalf at your personal expense.

Alternatively, to avoid the complete loss of any deductions by both yourself and the corporation, an arrangement should be in place under which the corporation reimburses you for the expenses you incur. Turn the receipts over to the corporation and use an expense reimbursement claim form or system. This will at least allow the corporation to deduct the amount of the reimbursement.

Contact us if you’d like assistance or would like to discuss these issues further.

© 2021 Covenant CPA

Can a broken trust be fixed?

An irrevocable trust has long been a key component of many estate plans. But what if it no longer serves your purposes? Is it too late to change it? Depending on applicable state law, you may have several options for fixing a “broken” trust.

How trusts break

There are several reasons a trust can break, including:

Changing family circumstancesA trust that works just fine when it’s established may no longer achieve its original goals if your family circumstances change. Some examples are a divorce, second marriage or the birth of a child.

New tax lawsMany trusts were created when gift, estate and generation-skipping transfer (GST) tax exemption amounts were relatively low. However, for 2021, the exemptions have risen to $11.7 million, so trusts designed to minimize gift, estate and GST taxes may no longer be necessary. And with transfer taxes out of the picture, the higher income taxes often associated with these trusts — previously overshadowed by transfer tax concerns — become a more important factor.

Mistakes. Potential errors include naming the wrong beneficiary, omitting a critical clause from the trust document, including a clause that’s inconsistent with your intent, and failing to allocate your GST tax exemption properly.

These are just a few examples of the many ways you might end up with a trust that fails to achieve your estate planning objectives.

How to fix them

If you have one or more trusts in need of repair, you may have several remedies at your disposal, depending on applicable law in the state where you live and, if different, in the state where the trust is located. Potential remedies include:

ReformationThe Uniform Trust Code (UTC), adopted in more than half the states, provides several remedies for broken trusts. Non-UTC states may provide similar remedies. Reformation allows you to ask a court to rewrite a trust’s terms to conform with the grantor’s intent. This remedy is available if the trust’s original terms were based on a legal or factual mistake.

ModificationThis remedy may be available, also through court proceedings, if unanticipated circumstances require changes in order to achieve the trust’s purposes. Some states permit modification — even if it’s inconsistent with the trust’s purposes — with the consent of the grantor and the beneficiaries.

DecantingMany states have decanting laws, which allow a trustee, according to his or her distribution powers, to “pour” funds from one trust into another with different terms and even in a different location. Depending on your circumstances and applicable state law, decanting may allow a trustee to correct errors, take advantage of new tax laws or another state’s asset protection laws, add or eliminate beneficiaries, and make other changes, often without court approval.

Seek professional guidance

The rules regarding modification of irrevocable trusts are complex and vary dramatically from state to state. And there are risks associated with revising or moving a trust, including uncertainty over how the IRS will view the changes. Before you make any changes, talk to us about the potential benefits and risks.

© 2021 Covenant CPA

If you’re planning your estate, or you’ve recently inherited assets, you may be unsure of the “cost” (or “basis”) for tax purposes.

The current rules

Under the current fair market value basis rules (also known as the “step-up and step-down” rules), an heir receives a basis in inherited property equal to its date-of-death value. So, for example, if your grandmother bought stock in 1935 for $500 and it’s worth $1 million at her death, the basis is stepped up to $1 million in the hands of your grandmother’s heirs — and all of that gain escapes federal income tax.

The fair market value basis rules apply to inherited property that’s includible in the deceased’s gross estate, and those rules also apply to property inherited from foreign persons who aren’t subject to U.S. estate tax. It doesn’t matter if a federal estate tax return is filed. The rules apply to the inherited portion of property owned by the inheriting taxpayer jointly with the deceased, but not the portion of jointly held property that the inheriting taxpayer owned before his or her inheritance. The fair market value basis rules also don’t apply to reinvestments of estate assets by fiduciaries.

Gifting before death

It’s crucial to understand the current fair market value basis rules so that you don’t pay more tax than you’re legally required to.

For example, in the above example, if your grandmother decides to make a gift of the stock during her lifetime (rather than passing it on when she dies), the “step-up” in basis (from $500 to $1 million) would be lost. Property that has gone up in value acquired by gift is subject to the “carryover” basis rules. That means the person receiving the gift takes the same basis the donor had in it ($500 in this example), plus a portion of any gift tax the donor pays on the gift.

A “step-down” occurs if someone dies owning property that has declined in value. In that case, the basis is lowered to the date-of-death value. Proper planning calls for seeking to avoid this loss of basis. Giving the property away before death won’t preserve the basis. That’s because when property that has gone down in value is the subject of a gift, the person receiving the gift must take the date of gift value as his basis (for purposes of determining his or her loss on a later sale). Therefore, a good strategy for property that has declined in value is for the owner to sell it before death so he or she can enjoy the tax benefits of the loss.

Change on the horizon?

Be aware that President Biden has proposed ending the ability to step-up the basis for gains in excess of $1 million. There would be exemptions for family-owned businesses and farms. Of course, any proposal must be approved by Congress in order to be enacted.

These are the basic rules. Other rules and limits may apply. For example, in some cases, a deceased person’s executor may be able to make an alternate valuation election. Contact us for tax assistance when estate planning or after receiving an inheritance. We’ll keep you up to date on any tax law changes.

© 2021 Covenant CPA

Despite the COVID-19 pandemic, government officials are seeing a large increase in the number of new businesses being launched. From June 2020 through June 2021, the U.S. Census Bureau reports that business applications are up 18.6%. The Bureau measures this by the number of businesses applying for an Employer Identification Number.

Entrepreneurs often don’t know that many of the expenses incurred by start-ups can’t be currently deducted. You should be aware that the way you handle some of your initial expenses can make a large difference in your federal tax bill.

How to treat expenses for tax purposes

If you’re starting or planning to launch a new business, keep these three rules in mind:

  1. Start-up costs include those incurred or paid while creating an active trade or business — or investigating the creation or acquisition of one. 
  2. Under the tax code, taxpayers can elect to deduct up to $5,000 of business start-up and $5,000 of organizational costs in the year the business begins. As you know, $5,000 doesn’t go very far these days! And the $5,000 deduction is reduced dollar-for-dollar by the amount by which your total start-up or organizational costs exceed $50,000. Any remaining costs must be amortized over 180 months on a straight-line basis.
  3. No deductions or amortization deductions are allowed until the year when “active conduct” of your new business begins. Generally, that means the year when the business has all the pieces in place to start earning revenue. To determine if a taxpayer meets this test, the IRS and courts generally ask questions such as: Did the taxpayer undertake the activity intending to earn a profit? Was the taxpayer regularly and actively involved? Did the activity actually begin?

Eligible expenses

In general, start-up expenses are those you make to:

  • Investigate the creation or acquisition of a business,
  • Create a business, or
  • Engage in a for-profit activity in anticipation of that activity becoming an active business.

To qualify for the election, an expense also must be one that would be deductible if it were incurred after a business began. One example is money you spend analyzing potential markets for a new product or service.

To be eligible as an “organization expense,” an expense must be related to establishing a corporation or partnership. Some examples of organization expenses are legal and accounting fees for services related to organizing a new business and filing fees paid to the state of incorporation.

Plan now

If you have start-up expenses that you’d like to deduct this year, you need to decide whether to take the election described above. Recordkeeping is critical. Contact us about your start-up plans. We can help with the tax and other aspects of your new business.

© 2021 Covenant CPA

Fraud is costly for all victimized companies, but it’s even worse in the construction sector. According to the Association of Certified Fraud Examiners’ Report to the Nations: 2020 Global Study on Occupational Fraud and Abuse, construction companies affected by fraud lose a median $200,000 per fraud incident, compared with $125,000 per incident for all organizations.

Some types of fraud are more prevalent in the construction industry, particularly payroll and billing fraud. These can lead to legal liability and fines. For example, paying under-the-table cash wages to avoid paying payroll taxes could result in criminal charges and significant penalties. To prevent your managers and workers from acting illegally or unethically, tighten your internal controls. 

Essential controls

Certain internal controls are essential — including segregation of duties. This means that multiple employees should handle multiple financial or accounting tasks. For example, the person who processes cash transactions shouldn’t also prepare your company’s bank deposits. If you don’t have enough accounting employees to segregate duties, consider outsourcing some or all accounting functions. Also, have monthly bank statements sent directly to you or a manager independent of your accounting department.

You can reduce purchasing fraud threats by naming someone other than your purchasing agent — you or an estimator, for instance — to review vendor invoices, purchase orders and other documents. Also use prenumbered purchase orders and regularly check materials and supplies to ensure they correspond to what was ordered.

Kickbacks and bid-rigging can be kept to a minimum with scrutiny. If your company is suddenly winning bids that you haven’t in the past and that seem like a stretch, verify that your bid processes have been followed. Sometimes employees disguise illegal activities as change orders, so be sure to scrutinize each change order.

To minimize the risk of payroll fraud in your company, ask someone independent of your accounting department to verify the names and pay rates on your payroll. And if you don’t already, pay employees using direct deposit, rather than with checks or cash. You may also want to make surprise jobsite visits to compare employee headcounts to time reports and wage payments. 

Get help 

Don’t forget to enlist the help of fraud experts. We can review your accounting records and inventory and visit jobsites to help assess risk and suggest additional internal controls.

© 2021 Covenant CPA

A fresh look at CRTs, CRATs and CRUTs

A charitable remainder trust (CRT) allows you to support a favorite charity while potentially boosting your cash flow, shrinking the size of your taxable estate, and reducing or deferring income taxes. In a nutshell, you contribute stock or other assets to an irrevocable trust that provides you — and, if you desire, your spouse (or others you designate) — with an income stream for life or for a term of up to 20 years. At the end of the trust term, the remaining trust assets are distributed to one or more charities you’ve selected.

When you fund the trust, you’re entitled to claim a charitable income tax deduction equal to the present value of the remainder interest (subject to applicable limits on charitable deductions). Your annual payouts from the trust can be based on a fixed percentage of the trust’s initial value — this is known as a charitable remainder annuity trust (CRAT). Or they can be based on a fixed percentage of the trust’s value recalculated annually — in what’s known as a charitable remainder unitrust (CRUT).

CRUT advantages

Generally, CRUTs are preferable for two reasons. First, the annual revaluation of the trust assets allows payouts to increase if the trust assets grow, which can allow your income stream to keep up with inflation. Second, donors can make additional contributions to CRUTs, but not to CRATs.

The fixed percentage — called the unitrust amount — can range from 5% to 50%. A higher rate increases the income stream, but it reduces the value of the remainder interest and, therefore, the charitable deduction. Also, to pass muster with the IRS, the present value of the remainder interest must be at least 10% of the initial value of the trust assets.

The determination of whether the remainder interest meets the 10% requirement is made at the time the assets are transferred. If the ultimate distribution to charity is less than 10% of the amount transferred, there’s no adverse tax impact related to the contribution.

NIMCRUTs can provide an income boost

By designing a CRUT with a “net income with makeup” feature — known as a NIMCRUT — you can reduce or even eliminate payouts early in the trust term and enjoy larger payouts in later years when you’re retired or otherwise need an income boost.

Each year, a NIMCRUT distributes the lesser of the unitrust amount (say, 5%) or the trust’s net income. The trustee can invest the trust assets in growth investments that produce little or no income, allowing the trust to grow tax-free and deferring distributions to later years. The deferred payouts accumulate in a “makeup account.”

When you’re ready to begin receiving an income, the trustee shifts the assets into income-producing investments. You can use the funds in the makeup account to increase your distributions beyond the unitrust amount (up to the amount of net income).

Handle with care

CRTs, CRATs and CRUTs require careful planning and solid investment guidance to ensure that they meet your needs. Contact us to discuss your options before taking action.

© 2021 Covenant CPA

No matter the size or shape of a business, one really can’t overstate the importance of sound accounts receivable policies and procedures. Without a strong and steady inflow of cash, even the most wildly successful company will likely stumble and could even collapse.

If your collections aren’t as efficient as you’d like, consider these five ways to improve them:

1. Redesign your invoices. It may seem superficial, but the design of invoices really does matter. Customers prefer bills that are aesthetically pleasing and easy to understand. Sloppy or confusing invoices will likely slow down the payment process as customers contact you for clarification rather than simply remit payment. Of course, accuracy is also critical to reducing questions and speeding up payment.

2. Appoint a collections champion. At some companies, there may be several people handling accounts receivable but no one primarily focusing on collections. Giving one employee the ultimate responsibility for resolving past due invoices ensures the “collection buck” stops with someone. If budget allows, you could even hire an accounts receivable specialist to fill this role.

3. Expand your payment options. The more ways customers can pay, the easier it is for them to pay promptly. Although some customers still like traditional payment options such as mailing a check or submitting a credit card number, more and more people now prefer the convenience of mobile payments via a dedicated app or using third-party services such as PayPal, Venmo or Square.

4. Get acquainted (or reacquainted) with your customers. If your business largely engages in B2B transactions, many of your customers may have specific procedures that you must follow to properly format and submit invoices. Review these procedures and be sure your staff is following them carefully to avoid payment delays. Also, consider contacting customers a couple of days before payment is due — especially for large payments — to verify that everything is on track.

5. Generate accounts receivable aging reports. Often, the culprit behind slow collections is a lack of timely, accurate data. Accounts receivable aging reports provide an at-a-glance view of each customer’s current payment status, including their respective outstanding balances. Aging reports typically track the payment status of customers by time periods, such as 0–30 days, 31–60 days, 61–90 days and 91+ days past due.

With easy access to this data, you’ll have a better idea of where to focus your efforts. For example, you can concentrate on collecting the largest receivables that are the furthest past due. Or you can zero in on collecting receivables that are between 31 and 60 days outstanding before they get any further behind.

Need help setting up aging reports or improving the ones you’re currently running? Please let us know — we’d be happy to help with this or any aspect of improving your accounts receivable processes.

© 2021 Covenant CPA

Do you have significant investment-related expenses, including the cost of subscriptions to financial services, home office expenses and clerical costs? Under current tax law, these expenses aren’t deductible through 2025 if they’re considered investment expenses for the production of income. But they’re deductible if they’re considered trade or business expenses.

For years before 2018, production-of-income expenses were deductible, but they were included in miscellaneous itemized deductions, which were subject to a 2%-of-adjusted-gross-income floor. (These rules are scheduled to return after 2025.) If you do a significant amount of trading, you should know which category your investment expenses fall into, because qualifying for trade or business expense treatment is more advantageous now.

In order to deduct your investment-related expenses as business expenses, you must be engaged in a trade or business. The U.S. Supreme Court held many years ago that an individual taxpayer isn’t engaged in a trade or business merely because the individual manages his or her own securities investments — regardless of the amount or the extent of the work required.

A trader vs. an investor

However, if you can show that your investment activities rise to the level of carrying on a trade or business, you may be considered a trader, who is engaged in a trade or business, rather than an investor, who isn’t. As a trader, you’re entitled to deduct your investment-related expenses as business expenses. A trader is also entitled to deduct home office expenses if the home office is used exclusively on a regular basis as the trader’s principal place of business. An investor, on the other hand, isn’t entitled to home office deductions since the investment activities aren’t a trade or business.

Since the Supreme Court decision, there has been extensive litigation on the issue of whether a taxpayer is a trader or investor. The U.S. Tax Court has developed a two-part test that must be satisfied in order for a taxpayer to be a trader. Under this test, a taxpayer’s investment activities are considered a trade or business only where both of the following are true:

  1. The taxpayer’s trading is substantial (in other words, sporadic trading isn’t considered a trade or business), and
  2. The taxpayer seeks to profit from short-term market swings, rather than from long-term holding of investments.

Profit in the short term

So, the fact that a taxpayer’s investment activities are regular, extensive and continuous isn’t in itself sufficient for determining that a taxpayer is a trader. In order to be considered a trader, you must show that you buy and sell securities with reasonable frequency in an effort to profit on a short-term basis. In one case, a taxpayer who made more than 1,000 trades a year with trading activities averaging about $16 million annually was held to be an investor rather than a trader because the holding periods for stocks sold averaged about one year.

Contact us if you have questions or would like to figure out whether you’re an investor or a trader for tax purposes.

© 2021 Covenant CPA

There’s a harsh tax penalty that you could be at risk for paying personally if you own or manage a business with employees. It’s called the “Trust Fund Recovery Penalty” and it applies to the Social Security and income taxes required to be withheld by a business from its employees’ wages.

Because taxes are considered property of the government, the employer holds them in “trust” on the government’s behalf until they’re paid over. The penalty is also sometimes called the “100% penalty” because the person liable and responsible for the taxes will be penalized 100% of the taxes due. Accordingly, the amounts IRS seeks when the penalty is applied are usually substantial, and IRS is aggressive in enforcing the penalty.

Wide-ranging penalty

The Trust Fund Recovery Penalty is among the more dangerous tax penalties because it applies to a broad range of actions and to a wide range of people involved in a business.

Here are some answers to questions about the penalty so you can safely avoid it.

What actions are penalized? The Trust Fund Recovery Penalty applies to any willful failure to collect, or truthfully account for, and pay over Social Security and income taxes required to be withheld from employees’ wages.

Who is at risk? The penalty can be imposed on anyone “responsible” for collection and payment of the tax. This has been broadly defined to include a corporation’s officers, directors and shareholders under a duty to collect and pay the tax as well as a partnership’s partners, or any employee of the business with such a duty. Even voluntary board members of tax-exempt organizations, who are generally exempt from responsibility, can be subject to this penalty under some circumstances. In some cases, responsibility has even been extended to family members close to the business, and to attorneys and accountants.

According to the IRS, responsibility is a matter of status, duty and authority. Anyone with the power to see that the taxes are (or aren’t) paid may be responsible. There’s often more than one responsible person in a business, but each is at risk for the entire penalty. You may not be directly involved with the payroll tax withholding process in your business. But if you learn of a failure to pay over withheld taxes and have the power to pay them but instead make payments to creditors and others, you become a responsible person.

Although a taxpayer held liable can sue other responsible people for contribution, this action must be taken entirely on his or her own after the penalty is paid. It isn’t part of the IRS collection process.

What’s considered “willful?” For actions to be willful, they don’t have to include an overt intent to evade taxes. Simply bending to business pressures and paying bills or obtaining supplies instead of paying over withheld taxes that are due the government is willful behavior. And just because you delegate responsibilities to someone else doesn’t necessarily mean you’re off the hook. Your failure to take care of the job yourself can be treated as the willful element.

Never borrow from taxes

Under no circumstances should you fail to withhold taxes or “borrow” from withheld amounts. All funds withheld should be paid over to the government on time. Contact us with any questions about making tax payments. 

© 2021 Covenant CPA

Without trust between you and your employees, your business probably wouldn’t be very successful. Delegating responsibility, sharing ideas, working as a team — all require a certain level of trust. However, too much trust can lead to occupational fraud and conflicts of interest. To maintain the proper balance, establish a policy that outlines your disclosure expectations and require employees to follow it.

Purchasing power

What constitutes conflict of interest? Let’s look at a fictional example: Veronica is the manager of a manufacturing company’s purchasing department. She’s also part owner of a business that sells supplies to the manufacturer — a fact she hasn’t disclosed to her employer. And, in fact, Veronica has personally profited from her business’s lucrative long-term contract with her employer.

What makes this scenario a conflict of interest isn’t so much that Veronica has profited from her position, but that her employer is ignorant of the relationship. When employers are informed about their employees’ outside business interests, they can act to exclude employees, vendors or customers from participation in transactions where there might be a conflict of interest. Or they can allow parties to continue participating in a transaction — even if it runs contrary to ethical best practices. But it’s the employer’s, not the employee’s, decision to make.

Prevention is the best policy 

Sometimes employees simply neglect to inform their employers about possible conflicts of interest. In other cases, they go to great lengths to hide conflicts. Perhaps they’re afraid a conflict will jeopardize their jobs or get them into legal trouble.

Prevention is the best policy here. Develop conflict-of-interest policies and communicate them to all employees. Provide specific examples of conflicts and spell out exactly why you consider the activities depicted to be deceptive, unethical and possibly illegal. Don’t forget to state the consequences of nondisclosure of conflicts, such as immediate termination.

Providing personal information

You might also require employees to complete an annual disclosure statement on which they list the names and addresses of their family members, their family’s employers and business interests, and whether the employees have an interest in those entities (or any others). To help ensure accurate statements, provide employees with a hotline to call if they have questions about your policy, aren’t sure how it relates to their circumstances or want to report someone else with an apparent conflict.

Also protect your business from conflicted vendors and customers. Before entering into a new agreement, compare the names and addresses on your employee disclosure statements with ownership information provided by prospective business partners.

Not necessarily fraud

Conflicts of interest aren’t necessarily fraud. But if you don’t know how an employee is personally profiting off your company, it could suffer serious consequences, including financial losses. Contact us for help reducing this risk. 

© 2021 Covenant CPA