Management. Tax Concepts. Are you aware of your SALT liabilities? Understanding the NIIT The 3.8% tax can take a bite out of some home sale profits

Transcription

1 Management SUMMER 2015 Tax Concepts Are you aware of your SALT liabilities? Understanding the NIIT The 3.8% tax can take a bite out of some home sale profits How to meet the challenges of managing a family business Umbrella insurance policies guard against the unexpected Mount Arlington Office Newton Office

2 Are you aware of your SALT liabilities? Does your company operate in multiple states? If so, there s a good chance that you owe some state and local taxes (SALT) outside your home state. But many small businesses are unaware of their SALT liabilities. While it s sometimes difficult to determine whether sufficient business activity has taken place in another state to trigger SALT liability, this usually isn t a valid excuse for nonpayment. The penalties for nonpayment can be steep, which makes complying with SALT obligations critical for small businesses. The concept of nexus To know when SALT liabilities may be triggered, you need to understand the concept of nexus. This describes the degree of business activity that must be present in a state before your business is considered to have a presence there and becomes subject to that state s taxing jurisdiction. Taxes that could fall under SALT liability include income, payroll, franchise, and sales and use taxes. But what establishes nexus for one type of tax might not establish nexus for another. Let s take a closer look at nexus for income tax. If your company has income tax nexus in another state, you must file an income tax return and pay income tax in that state. Your company doesn t have to maintain a physical presence in a state for nexus to kick in. A number of situations can trigger nexus from an income tax standpoint, including: m Employing workers who reside in the state, m Performing installations, repair or warranty work in the state, m Leasing or owning property (including inventory), m Leasing to customers in the state, and m Holding meetings or conducting training in the state. Even attending trade shows could trigger nexus. Nexus requirements differ from state to state, so check with each state for its specific requirements. In general, if your company generates income from any source located inside a state, nexus will apply to income tax. One exception is salespeople who live in and make sales in a state, but with the orders being fulfilled in another state. Get a break via voluntary disclosure If you discover after the fact that you owed state and local tax (SALT) for prior years, you may be able to take advantage of a voluntary disclosure program. Most states now offer such programs, which eliminate or lower penalties and interest on unpaid SALT and limit the look-back period. The Multistate Tax Commission offers a voluntary disclosure program that allows you to negotiate a favorable settlement agreement with multiple states through a single point of contact. This could be beneficial if you owe back SALT in more than one state. This program is available for the payment of any type of tax assessed by a state s department of revenue. You must approach the state first to be eligible if the state discovers your back taxes and approaches you, it ll likely assess full penalties and interest. 2

3 There are a few specific scenarios in which nexus won t apply to state income taxes. These include: m The solicitation of sales and taking of orders in another state by employees or independent contractors of a business, m The acceptance of such orders by customers in another state, and m The filling of orders from inventory located in another state. But keep in mind that such scenarios might establish nexus for other taxes, such as sales and use taxes. Defining nexus consistently To provide some degree of consistency in defining nexus for income tax liability, the Multistate Tax Commission has created an optional model statute that defines nexus based on a certain amount of economic activity. Among the states using the model statute are California, Colorado, Connecticut, Kansas, Michigan, Ohio and Washington. According to the commission s Factor Presence Nexus Standard for Business Activity Taxes, nexus applies for income tax purposes if, during the tax period, a company 1) possesses at least $50,000 of in-state property, 2) processes at least $50,000 of in-state payroll, or 3) makes a minimum level of sales into a state. The sales minimums vary from one participating state to the next, ranging from $250,000 to $500,000. This model also applies nexus for income tax purposes if at least 25% of a company s total property, payroll or sales occurs in a state during the tax period. Making SALT collections a priority As states and municipalities seek to boost revenue in the wake of the recession, many have prioritized the collection of taxes from out-of-state companies. Some states have created new departments devoted exclusively to finding out-of-state companies that should be paying SALT but aren t. In addition, more states are taking advantage of cross-border agreements with other states departments of revenue. They also are sharing audit findings with each other and collaborating with federal customs agents. In this environment, it s critical that businesses understand their SALT obligations and pay all taxes due in a timely manner. Be sure to consult with your tax advisor for more detailed guidance with regard to your potential SALT liabilities. u 3

4 Understanding the NIIT The 3.8% tax can take a bite out of some home sale profits Summer generally is an optimal time to sell your home. If you re putting up a For sale sign on your lawn this year, make sure you understand the 3.8% net investment income tax (NIIT) that applies to profits on some home sales. NIIT doesn t apply to everyone For NIIT purposes, net investment income includes interest, dividends, annuities, rents and royalties, net capital gains, and other investment income, reduced by certain expenses that can be allocated to that income. Several types of income are excluded, including (with certain exceptions) income from an active trade or business. Not everyone is subject to the tax, though. It s limited to taxpayers whose modified adjusted gross income (MAGI) exceeds the following thresholds: m Single or head of household $200,000 m Married filing jointly $250,000 m Married filing separately $125,000 Generally, MAGI is equal to adjusted gross income (AGI). But if you live and work abroad, you ll need to add back the foreign earned income exclusion to determine your MAGI. The tax applies to your net investment income or the excess of your MAGI over the threshold, whichever is less. So, for example, if a married couple has MAGI of $350,000, including $75,000 of net investment income, the tax is 3.8% of $75,000. Triggering events Sales can trigger the NIIT in two ways: First, a net capital gain is investment income that s potentially subject to the tax. Second, if you re not otherwise subject to the tax, a large gain can push your MAGI above the threshold. An IRS webpage, Questions and Answers on the Net Investment Income Tax, clarifies that the NIIT also doesn t apply to gains that qualify for the Section 121 exclusion for regular tax purposes. The tax does apply, however, to the extent gain exceeds the exclusion, as well as to gains on sales that don t qualify for the exclusion. For a home to qualify for the exclusion, you must own and use it as your principal residence for at least two years during the five-year period preceding the sale. And you can t use the exclusion more than once every two years. If the home is a nonprincipal residence (a vacation home, for instance) you won t qualify for the exemption. Further, if you don t meet the two-year requirement, the entire net gain is taxable unless you meet the one narrow exception. If you re forced to sell your principal residence in less than two years because of job loss, health issues or certain other unforeseen circumstances, you may be entitled to a prorated exclusion. Ask your tax advisor about the details if you believe that this exception might apply to you. Strategies to reduce or eliminate the tax If a home sale will trigger the NIIT either because the gain will exceed the exclusion amount or because the home isn t your principal residence there may be strategies you can use to reduce or even eliminate the tax. They include: Harvesting losses. If you own stocks or other investments that have declined in value, consider selling them to generate capital losses you can use to offset the gain. 4

5 Converting a second home into a principal residence. If you re selling a nonprincipal residence, it may be possible to convert it into a principal residence, which in many cases provides only a partial exclusion. Keeping track of improvements. The NIIT applies to profit, not gross proceeds. To the extent that you ve made improvements to the property, it may help to reduce your profit, which may in turn help you to reduce or perhaps avoid the NIIT. In fact, all of these strategies are designed to reduce your net investment income, as well as your MAGI, potentially eliminating NIIT. A reality check There ve been a number of misconceptions about the NIIT and home sales since the tax went into effect two years ago. Knowing the facts about the potential tax impact on the sale of your home can put your mind at ease or prompt you to look into appropriate tax strategies. u How to meet the challenges of managing a family business Owners of family businesses face unique challenges that nonfamily-business owners don t have to worry about. These often arise from the dynamics of family relationships and the need to transfer these into the business environment. Family relations can sometimes get messy. When family members go to work together, it can be hard to flip a switch and pretend that problems at home don t exist. Family businesses that don t recognize these situations and confront them head-on can end up with major problems both at work and at home. Setting boundaries The first rule of managing a family business sounds simple, but it can be hard to implement: Leave family stuff at home when you walk into the office. And similarly: While at work, decisions always must 5

6 these too should be based more on their capabilities than their name or bloodlines. The corollary to the first rule is that, for the most part, business matters should be left at the office. This isn t to say that you and your family employees should never talk about business at home, but it s important to set boundaries. For example, designate certain times and places at home for business discussions, or designate times and places when shop talk is off limits like the dinner table. A family business constitution be made with the best interest of the business in mind. If you own a family business, tough choices may arise. For example, suppose you have to make a promotion decision between a family employee and a nonfamily one. The nonfamily employee is better qualified, but you know that promoting him over the family member is going to cause friction at home. For the sake of the business, though, you should promote the nonfamily employee. It s critical to guard against even a hint of nepotism in family businesses. If nonfamily employees believe that family employees are receiving preferential treatment, this can severely damage workplace morale and possibly lead to an avalanche of employee turnover. Preferential treatment can include salary and compensation. As a family business owner, you walk a fine line here: Family members shouldn t receive higher compensation just because of their name if their performance or responsibilities don t warrant it. On the flip side, owners sometimes go too far the other way and undercompensate family employees to avoid bad appearances. The best solution is to pay family employees market salaries based on their performance and job responsibilities. Family members may have opportunities to participate in company ownership, but One of the best ways to find the right balance between family and business is to draft a family business constitution. This is a formal document created with input from all family employees that specifies how the business will be managed from a family perspective. A family business constitution typically addresses such areas as: Business and family balance. How will family employees determine the right balance between business and family? This balance doesn t have to be the same for every family employee; instead, they should all be encouraged to find the right balance for themselves based on their business and family responsibilities. Business ownership. What criteria will dictate which family employees can own shares in the business? How can these shares be transferred or sold, and what are the policies governing dividend payments? Hiring, compensation and termination. What kind of experience and education must family members possess to be hired in the family business? How will their compensation be determined? And under what circumstances can family employees be terminated? Be proactive There are certainly unique challenges involved in running a family business. The best way to meet them is to be proactive and head them off before problems arise. u 6

7 Umbrella insurance policies guard against the unexpected Responsible financial planning should include asking some what if questions. For example, what would happen if you or someone in your family were involved in an accident for which you were held legally liable? A $1 million or higher legal judgment could lead to financial ruin for many families and affluent families with a large net worth are at particular risk. In today s litigious society, it s smart to guard against this kind of financial catastrophe by purchasing a personal liability umbrella policy. What does it cover? This policy type provides liability coverage above the limits of other policies, like homeowners and car insurance. For example, it would kick in if you or a family member were sued after causing a car accident, or if you were found liable for injuries suffered by a visitor while on your property. It also may provide coverage if you or a family member is sued for libel or slander. If you believe your homeowners or automobile policy includes sufficient liability coverage, think again. Few of these policies provide $1 million or more of coverage, and legal judgments today can easily reach this level or higher. Umbrella insurance policies are relatively inexpensive. You should generally expect to pay around $500 per year for each $1 million worth of coverage you buy. How much coverage do you need? One rule of thumb is that your coverage amount should roughly equal your family s net worth. How is it sold? Umbrella insurance is usually sold along with other policies, like homeowners and automobile insurance. In fact, most insurance companies don t sell it on its own. The umbrella policy will kick in if you face a judgment that exceeds the liability limits on those other policies. So, talk first to your homeowners or automobile insurance agent. He or she can help you determine the right level of coverage and suggest the best umbrella policy to meet your needs. This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use MTCsu15 7

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