As regulations and legislation continues to change, it is becoming virtually impossible for smaller businesses to keep up with their bookkeeping, taxes, and payroll.

Today we will touch on a few changes that could impact your business and how you may take advantage of them.

There are three types of income; passive, active, and portfolio - dividends, interest and capital gains.

Portfolio income is self explanatory. Active means you are working or are actively running a business.  Passive is when you earn money from activities, such as rental properties, or you are a limited partner in other ventures - but you are not actively involved in the business. First let’s look at losses from passive income.

Losses from Passive Income and Taxes

MYTH: You can offset losses from one “bucket” of income into another “bucket”, lowering taxable income.  

TRUTH: Not necessarily - the IRS has a long history, and procedures and regulations to support the non-mingling of un-associated business activities gains/losses. 

Don’t worry though, there are tax planning opportunities available to mitigate some of the tax sting.  Depending on the structure of the business, there may be ways to capitalize on the losses.

One method is to shift income from the profitable business into the non-profitable business. For example, you may allocate some income as a management fee or increase an expense in the profitable business.   A word of caution - careful consideration of all the facts/circumstances should be done, because if there is no real business purpose to the redirection of income, the IRS will disallow it as a sham transaction.

Now that we have covered losses from passive income lets look at losses from active income.

Loss Limitations for Active Income

MYTH: Because a company has a loss from an active business it will be fully deductible.

TRUTH: There are limitations and requirements to attain deductions, and many of the allowances for deductions are dependent on the type of company you own and the method of operations

Here are some guidelines to consider:

For sole proprietors there is no issue of loss limitation in the short term, meaning the losses are fully deductible in the year they occur.  And, if the losses are greater than all other income on the return; the remaining loss, after eliminating income, can be carried back to obtain refunds or carried forward to reduce future income reducing the tax base.

The Downside - the IRS requires that you must have shown a net profit for at least 2 of the past 5 years for this business to be considered having a “profit motive” and not just a hobby. So, if you do not show a profit motive; the IRS can reclassify this activity as a hobby and limit the losses to the income of that year.

For legal entities, such as partnerships and corporations, your losses are limited to the amount of investment into your company. As an S corporation, the amount of loss you can take is limited to your investment in the stock of the corporation.  This investment (basis) can be increased under certain circumstances, the most available are loans.  But, be careful, there is a specific way to structure the loan transaction.  If not done correctly, losses in excess of the basis cannot be taken in the current year but instead are deferred to future years.

For example, if you take a loan out in the company name and you guarantee the note, this is not considered as an increase in personal investment, and losses in excess of allowable amounts will be deferred at the allowable amount for future years.  However, if as a partner in an S corporation, you take the loan out in your name and then loan it to the company, this is considered as an increase in your stock in the company, and excess losses can be taken. These losses will flow to your personal return and offset income or create net operating losses that can be carried back to obtain refunds or carry forward to reduce future income, reducing your tax base just like a sole proprietor. 

Partnerships follow similar basis rules, but generally, all you have to do is be liable for the loan to count as basis increase, even if the loan is in the partnership’s name.

Expensing of Assets

Businesses have the opportunity to write off the full cost of some assets in the year they buy them, rather than deducting their cost over a number of years. This immediately reduces the business taxable income.

According to the Internal Revenue Code 179 most new business equipment can be either depreciated over its useful life or expensed immediately. The maximum deduction is based on the date in which the tax year begins.  With this regulation your business is allowed to deduct up to $250,000 of the cost of new equipment or other assets in 2010 (scheduled to go down to $25,000 in 2011). However, this is subject to a phase-out if you place more than $800,000 of equipment in service in 2010.

These asset deductions may seem like a great benefit, but there is a downside. For example, if you take the full deduction in the year your assets were purchased, and your profits in following years increases significantly this can cause a greater tax liability than if you depreciated it over a period of years. This should be discussed with your accountant and the decision should be made on your overall business plan and forecast.

Some assets that don't qualify for this Section 179 deduction include; rental real estate, inventory, property bought from a close relative, and property located outside the United States.

Also, if you operate in different states, they may not have matched these amounts, and may have much smaller allowable deductions.  In this case, it is critical to maintain two sets of depreciation schedules - one for the IRS and another for the State.  Since the basis of an asset may be different for each tax agency, the gain or loss on its disposal will similarly be different.

Bonus Depreciation

This benefit expired 12/31/09 under current law, so only purchases of equipment prior to 1/1/10 will qualify. The bonus depreciation allows you to write off ½ of your applicable property/assets in addition to the 179.

Healthcare Reform and Small Business Tax Credits

Now for the topic everyone wants to hear about - how healthcare reform will affect you personally and your business.  Please note, this update is based on this week’s plans, and will most certainly change.

The recent health care reform legislation included a new health care tax credit for certain small businesses that provide health insurance to their employees.

The credit is available to small companies and tax-exempt organizations for the years of 2010 - 2013. So, for those companies with 25 or fewer full-time employees with an average wage of $50,000 or less, and the company pays a minimum of 50% of their employees coverage are eligible.  The credit is phased out based on size and salaries of the company.  Companies with 10 or fewer employees with an average wage of $25,000 will receive the highest credit of 35% of premiums paid.  This credit increases to 50% in 2014.

Note: The credit is claimed on the business tax return NOT the employment tax returns.

If an owner of a business also provides services to it, does the owner count as an employee? www.irs.gov/newsroom/article/0,,id=220839,00.html

Generally, no. A sole proprietor, a partner in a partnership, a shareholder owning more than two percent of an S corporation, and any owner of more than five percent of other businesses are not considered employees for purposes of the credit. Thus, the wages or hours of these business owners and partners are not counted in determining either the number of full time employees or the amount of average annual wages; so the premiums paid on their behalf are not counted in determining the amount of the credit.  It is strongly advised you speak with your accountant to determine which is the best route for your company.

Indoor Tanning Businesses will have a new tax of 10% imposed as of July 1 2010.

2011

Penalties for using Flexible Spending Accounts incorrectly will increase from 10% to 20%.

Earned Income Medicare tax will increase from 1.45% to 2.35% in 2013 on individuals earning over $200,000 or couples over $250,000.

A plan to provide a vehicle for small businesses to offer tax-free benefits will be created. This would ease the small employer's administrative burden of sponsoring a cafeteria plan.

2013

Contributions to flexible savings accounts will be limited to $2,500 per year, indexed by the Consumer Price Index in subsequent years.

A new unearned (Passive) Income Medicare tax of 3.8% for individuals earning over $200,000 or couples over $250,000 will be imposed.

Income Threshold deduction for unreimbursed medical expenses will increase from 7.5% to 10 % for those under 65. This means that only when your medical bills are greater than 10% of your adjusted gross income, you will be able to deduct them from your taxable income. Those individuals older than 65 can still claim the 7.5 % deduction through 2016.  This can make quite a difference in the amount of after tax income you need to pay out on medical expenses.

The hospital insurance tax will increase 0.9 percentage points for those earning more than $200,000 ($250,000 for married filing jointly), and it includes net investment income.

A 2.9 % excise tax on the first sale of medical devices will be established. Exceptions are eyeglasses, contact lenses, hearing aids or other items for individual use.

Primary care doctors would get a Medicaid payment boost in the reconciliation bill. Beginning in 2013 and 2014, the doctors' payment rates would be on par with Medicare rates, which typically are about 20 percent higher than Medicaid.

2018

The “Maserati” tax: The levy on high-cost insurance plans is scaled back and delayed, rendering it more a "Maserati" than a "Cadillac" tax. It would apply only to the portion of plans costing more than $10,200 a year for individuals, up from $8,500, and $27,500 for families, up from $23,000.

This article is intended to be informational only. Please do not take this as tax advice as each circumstance is different. For specific tax advice please contact your CPA or contact

Jon Chester  This e-mail address is being protected from spambots. You need JavaScript enabled to view it   www.sterlingstax.com

IRS CIRCULAR 230 NOTICE: To the extent that this message or any attachment concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

We invite all of you to get a discussion going.  Please submit your comments at the end of this article, Thanks.