FEDERAL INCOME TAX LAW ADVICE PART 4

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Legal Brief Writer, Pro Se Assistance Michael A. S. Guth

Dr. MICHAEL A. S. GUTH
Attorney at Law
Ph.D. (Economics), J.D. Univ. of Tenn.
Licensed in Tennessee since 1998
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TAX ADVICE PART 1
TAX ADVICE PART 4
TAX ADVICE PART 7
TAX ADVICE PART 2
TAX ADVICE PART 5
TAX ADVICE PART 8
TAX ADVICE PART 3
TAX ADVICE PART 6
TAX ADVICE PART 9
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QUESTION 17: We have an S-corporation, an Internet software company and have some confusion about prepaying taxes.  We are signed up through EFTPS but do not know whether to prepay through EFTPS as an individual or an S-corp  S-corp taxes are filed as part of the individuals tax return so shouldnt the prepay be done for the individual not the corporation?   Also does the self employment tax and state tax apply to even Internet commerce companies?  We know that Internet companies do no have to pay state tax but when filing as part of the individuals taxes does the state  tax have to be paid?

ANSWER:  Generally, an S corporation is exempt from federal income tax other than tax on Excess Net Passive Investment Income, Capital Gains, or Built-in Capital Gains.  Is your S Corporation paying you a salary?  Will it issue you a W-2 form?  If so, then the corporation needs to being paying FICA taxes to the federal government as it pays you or anyone else a salary.

Without seeing what kind of income and expenses your S Corporation has, I cannot definitively say whether it needs to prepay any taxes.  Most S Corporations end up passing all their income to the shareholders, who in turn declare this income on their individual returns. 

 

If you are an S corporation then you may be liable for...

Use Form...

Income Tax

1120S (S corporation)

Estimated tax

1120-W (corporation only) and 8109

Employment taxes:

  • Social security and Medicare taxes and income tax withholding
  • Federal unemployment (FUTA) tax
  • Depositing employment taxes

941 ( 943 for farm employees)

940
8109

 

Employment Taxes

If the business has one or more employees, various employment taxes may be required. These could include: 1) the federal income tax withheld from your employees' wages; 2) social security (FICA) tax, both the amount withheld from employees' wages and the amount paid as an employer; 3) federal unemployment (FUTA) tax. Social security (FICA) and withheld income taxes are reported together quarterly on IRS Form 941. See Circular E, Employer's Tax Guide, IRS Publication 15 for deposit rules.

Federal Unemployment Tax (FUTA) is reported and paid separate from FICA and withheld income tax. IRS Form 940, an annual return, is used to report FUTA tax. Quarterly deposits are required if unpaid tax exceeds $100. For more information on FICA, FUTA and income tax withholdings, see Circular E, Employer's Tax Guide, IRS Publication 15.

Excise Taxes

The federal government imposes excise taxes on certain business activities. Your software company does not manufacture or sell alcoholic beverages, tobacco, or firearms.  You also would not have to pay excise taxes for operating large vehicles on public highways.

If an S Corporation is required to pay tax at the federal level, it may be required to pay tax at the state level.  Normally, S Corporations are subject to corporate income tax due to Excess Net Passive Investment Income, Capital Gains, or Built-in Capital Gains.

We are signed up through EFTPS but do not know whether to prepay through EFTPS as an individual or an S-corp  S-corp taxes are filed as part of the individuals tax return so shouldnt the prepay be done for the individual not the corporation?

For ordinary income, the prepay should be done on the individuals who will ultimately receive the S Corporation’s income at the end of the year.

Also does the self employment tax and state tax apply to even Internet commerce companies? 

Yes of course.  Someone ultimately receives that income, it does not float around in cyberspace.  The federal and state governments have a right to tax that income when it is received within their territorial jurisdictions.

We know that Internet companies do no have to pay state tax but when filing as part of the individuals taxes does the state  tax have to be paid?

Internet companies do not pay state sales taxes if they have no physical presence in the state.  However, Internet companies have to pay income taxes just like any other company that earns income.   If your S Corporation owes no federal income tax in 2007, then it will probably owe no state income tax.  However, that does not mean your S Corporation can avoid paying FICA taxes on wage income.  If you owe federal income tax on the income you receive in distribution from the S Corporation, then you will likely have to pay state income tax on this same money.  It is only taxed once (at the individual level) and not taxed at both the corporate and individual level when the business entity is an S Corporation.




QUESTION 18: A British national received a relocation package when he moved from London to New York. Under the terms of his employment contract, he would have to reimburse the company for this relocation assistance if he left within the first year, and reimburse the company 50% if he left within the second year. He plans to move at the start of his second year. The client wanted to know the quickest way he could get his tax refund for the reimbursed relocation package. The relocation package was added to his gross income in 2006, and the company withheld federal income taxes from the gross amount of actual wages + relocation benefit.

ANSWER: It is now June 2007, and the client expects to repay the 50% relocation assistance by mid-December. The reimbursement will be completed in 2007 and should be reflected in his W-2 income statement from his employer. The fastest way to get a refund then is to file his 1040 Form for Tax year 2007 as soon as he receives his W-2 statement from his employer in January 2008. The client's situation is more complicated in that he will also have to file a state and city income tax return and seek a refund of taxes paid to those entities as well as the federal IRS.

In the meantime, I told the client that he should file an amended W-4 form showing that his allowances (measured in $3,400 increments) have increased. With approximately 17 allowances, the client should not have federal income tax withheld from his salary for the remainder of his time working for the employer through September 2007. The amount of taxes already withheld this calendar year will more than cover his tax bill. Upon completing the reimbursement for relocation expenses, he should receive a tax refund in the spring of 2008 covering taxes paid in 2007.


QUESTION 19: I have a client that I prepare tax returns for that is going to be having a taxable event that we need advice on how to minimize both federal & state taxes. They are married filing joint with one dependent. Their income (before the taxable event will be around $100K). They have probably $60K in home interest expense write offs each year. The wife has won a disability claim that she has been working on for the last seven years. She was born in 1958 & the husband was born 1964. She is going to receive a check in the amount of $179,645.32 this month and will be W-2d for these taxable benefits. They are from 2000 to present. She will be receiving $2614.31 per month (adjusted for COLA) going forward until death, the disability is resolved, or her income exceeds 80% of her pre disability income. She will also be receiving a check for $38,350.16 interest on the $179K above.

We need advice on how to minimize their tax burden. Since these payments were from 2000-2007 can we go back and spread the payments out over the years they were actually for, to minimize our marginal tax rate, even though they will be W-2s for this year?

Do you have any ideas that will minimize their tax burden for both federal and state?

ANSWER: Yes, I have many ideas that would help minimize their tax burden, but it may be too late to put them into effect. The time to put tax strategies into effect is long before the tax liability is incurred. Once the income is received a certain way, it is often too late to adopt tax minimizing strategies.

First, if the client has filed some type of worker's compensation claim, then the $179K payment might be interpreted as compensatory damages from a lawsuit. As a general rule, compensatory damages as well as special damages for suffering, if any, are not taxable, because they are viewed as restoring a person to his or her former self. Punitive damages, in contrast, are fully taxable. So the first idea is to have one or both of these payments declared as compensatory damages, thus obviating the filing of a W-2 information return on that payment to the IRS.

Second, assuming that these payments represent wages that should have been earned in the prior six years, then any settlement could require the employer to go back and file corrected W-2 statements to show the additional income in each of those years totaling the $179K. Your client is going to lose out on the Social Security taxes that would have been paid by the employer for those six years, if instead she receives a single lump sum payment in 2007. Why? Because $179K is greater than the threshold income beyond which FICA taxes must be paid. For example, the employer will only have to pay FICA taxes on the first $90,000 of income in 2007, not the full $179K. So my second suggestion is to require corrected W-2 forms from the employer for years 2000 - 20006.

Third, assuming your client does not have outstanding medical bills and needs a lump sum payment immediately, these funds could be partially shielded from taxation by having a portion deposited into a tax free pension account, such as a 401K. Although there are limits on how much income a person can contribute to a 401K plan each year, when restitution for a disability is made, it may be possible to finesse the contribution amount to be higher than what the person could deposit with earned income. Another option would be to have the employer deposit the funds into a defined benefit plan outside the control of your client. The $179K + interest payment could then be used to fund a defined benefit paid to your client each year. There would be no $179K W-2 information tax return under this scenario, so no taxes would be due. However, the income received from the defined benefit pension would be taxable, of course, but at a much lower rate than the lump sum $179K will be.

Fourth, if any of the $179K is going to be used to pay third parties such as physical therapy offices, hospitals, doctors, etc., then you could structure the settlement for the company to pay the third parties directly. That would reduce the total lump sum payment given to your client and thus reduce her taxes. If the company pays the medical providers directly, then she effectively pays them with pre-tax dollars. If the money is paid to her and then she pays taxes on it, then she is paying her medical debts with after-tax dollars.
QUESTION 20: The client is a tax accountant preparing personal and business federal income tax returns for a man who is sole or principal shareholder of an S corporation. In 2005 or early 2006, the S corporation acquired $30,000 in assets to improve a car wash station in Florida. The S corporation was leasing the property as a car wash and did not own it. At the end of 2006, the S corporation sold the $30,000 in capital assets for $120,000 and also transferred lease of the car wash facility to the buyer. The client now wants to know what IRS forms he must file for his underlying client to report the $90,000 capital gain. As a tax accountant, our client is relatively sophisticated and wants to know specifically what forms are appropriate with Form 1120S, and what numbers should appear on what lines of Schedule K to report this gain.

ANSWER: A few preliminary observations are in order. First, the client is asking in July 2007 about income taxes that were due on April 15, 2007, or sooner, if the provisions of estimated tax payments were triggered by this windfall gain. Second, it is astounding that this client achieved a 400% return in less than one year on his investment in car washing equipment and canopies and related peripherals. The accountant said this enormous gain is due in part to the car wash's location, which is somewhat doubtful as there must be competing car washes in a 2-mile radius, and also represents goodwill for the established client base. The latter explanation is more plausible, but it still defies reason to pay four times the acquisition cost of equipment and peripherals one year later. Finally, this client apparently intends to declare a basis in the capital goods of $30,000. If he had engaged in appropriate tax planning prior to this transaction, he would have found the means to increase his basis in the equipment so that his tax burden would not be so high.

We begin the tax analysis with IRS Form 4797 Sales of Business Property. This form is used to report gains from the sale of business property generally held over one year. With the fact pattern expressed above, it appears the car wash equipment was held less than one year. The first part of this form applies to property held for over a year. It turns out that the IRS treats "capital gains" income on the sale of most, but not all kinds of, assets held by a business less than a year as ordinary income. Accordingly, you will need to report the car wash equipment should be listed on Line 10 of Form 4797 together with the date of acquisition, date of sale, gross proceeds, cost basis, and any depreciation. Under the facts above, column G of Line 10 should show a $90,000 capital gain. That same amount of $90,000 should be listed on Line 17. As you move down the form, you will list 0 on line 18a, and then $90,000 on Line 18b. This same amount is then reported on Line 14 of the shareholder's 1040 income tax return.

Line 14 reports business asset sales income apart from the capital gains disclosed on Schedule D. Schedule D gains are reported directly above Line 14 on Line 13 of the 1040 form. Therefore, it will not be necessary for your client to list the $90,000 on Schedule D, because he is already reporting this "capital gain" as ordinary income on Line 14 of the 1040 form.

Because the $120,000 payment by the buyer includes approximately $90,000 in goodwill, it will be necessary for both the buyer and the seller to fill out IRS form 8594. The purpose of Form 8594 is to show the basis in the car wash equipment has jumped from $30,000 to $120,000, and to allow the buyer to claim $120,000 as her basis on some future transaction when she eventually sells the car wash equipment or fully depreciates her cost basis.

Finally, the S Corporation needs to report the $120,000 pass through payment by the corporation to its shareholder. The S Corporation will use Schedule K-1 of IRS Form 1120S. Box 1 of that form is for Ordinary Income. Following the instructions for Part II of Form 4797, it would be consistent for the S Corporation to report the $120,000 proceeds as ordinary income and allow the shareholder to subtract his basis using Form 4797.

We note Congress amended the tax code to impose a maximum taxable rate of 15% on (long term) capital gains through 2010. In an alternative scenario, the S Corporation would report the $120,000 proceeds under Box 7 (Short Term Capital Gains) of Schedule K-1 of Form 1120S. The shareholder will then declare the $120,000 as gross proceeds under the short term capital gains part on line 5, column F, Schedule D to his 1040 Form. Short term capital gains are taxed at the same marginal rate as ordinary income, so the shareholder is unlikely to receive any preferential tax treatment from realizing a short-term capital gain of $90,000. This scenario eliminates the need for filing Form 4797 to show the after-basis proceeds of the sale of business assets, as the basis is declared and subtracted on Schedule D instead of Form 4797.