There are a few things in life that are certain: death, taxes, and the need to keep your business finances separate from your personal ones. While most business owners are familiar with these, many don’t know about the accumulated earnings tax.

Corporate tax services like Jones CPA Group provides can aid businesses of all sizes in saving money on their taxes; by taking advantage of tax breaks and deductions, companies can reduce their taxable income and lower their tax liability. Corporate tax services can provide several benefits to both small businesses and large corporations, like helping you understand the accumulated earnings tax.

This penalty tax is levied against corporations who succeed but fail to distribute their profits in a way acceptable to the Internal Revenue Service. It is a little-known but important part of owning a business. This article will explain what it is, who owes it, and how to avoid it.

How the Tax Works

The accumulated earnings tax, as opposed to the tax paid when you file your business tax return, is a 20 percent corporate-level penalty tax imposed by the IRS. You must undergo an IRS audit documenting your failure to pay dividends to be subjected to the tax.

If the corporation’s total earnings exceed $250,000, or $150,000 for a personal service corporation, the corporation cannot show that the “excess” earnings accumulation is necessary for meeting financial obligations.

Here’s why you should be upset with this information. Lawmakers set the $250,000 cap in 1981, which became effective on January 1, 1982. It hasn’t been adjusted for inflation since that time, which was forty years ago. That’s absurd, to be honest. If you input that $250,000 into the inflation calculator, the outcome is $774,910.

You are unable to accomplish that, though. Instead, if your accumulated earnings exceed $250,000 or a pitiful $150,000 if you are a personal service corporation, you may be subject to the 20 percent accumulated earnings tax. Although it applies to all corporations, including publicly traded, the 20% penalty tax specifically targets small corporations.

What Can You Do?

Why do you require accumulated earnings of more than $250,000 ($150,000 if you are a personal service corporation)? You won’t have any issues if you can satisfactorily respond to the IRS’s query.

However, do not wait for the audit and question. Take the initiative. Get your justifications and financial details into the company minutes. For example, per IRC Section 303, you require the funds to cover the shareholder’s death taxes, funeral costs, and other associated costs. Because shareholders do pass away.

You require the cash to close down, sell, and attend to other business demands brought on by the owner’s (shareholder’s) passing. Be sure to consider the following reasons why you should maintain the profits within the corporation.

The IRS provides a great list of justifications for accumulating C company earnings in Reg. Section 1.537-2, as follows:

• Plan for a legitimate business expansion or plant replacement
• Buy a company and pay off the corporation’s debt
• If it’s essential to continue the corporation’s operations
• Provide for investing in or loans to suppliers or clients.
• Provide for foreseeable product liability damages.

The IRS considers the following as likely invalid justifications for generating the earnings based on this same regulation:

• Making loans to the shareholders
• Lending to other businesses and corporations backed by the owners
• Making investments in properties unrelated to the corporation’s operations Purchasing securities unrelated to the company’s operations
• Invoking the need for irrational contingencies and risks

How the Triple Tax Works

Will was disinterested. His company made a million-dollar profit. When the IRS inspects, they notice Will’s corporation has $1 million in cumulative earnings and inquire why. Will has no viable options and must pay $150,000 in cumulative profits tax.

He instructs his corporation to give him a dividend of $600,000 to bring the corporate accumulated earnings down to the $250,000 safe harbor after the audit and signing the payment.

First, there would not have been a penalty tax or dividend payment if Tim’s corporation had provided documentation for the $750,000 in accumulated earnings above the $250,000 safe harbor.

Second, even though Will pays a 23.8 percent tax on his dividend due to his high income, this tax may rise considerably. The tax legislation used to tax dividends like ordinary income; this was harsh and is currently being discussed again.

Don’t give the IRS easy access to the accrued earnings tax for you or anyone else who runs a C business. The best response to this tax is to determine the corporation’s financial requirements and include those figures in the company minutes and business strategies.

The corporate tax rate of 21% can persuade you to keep more in your C corporation. If the cumulative earnings of your corporation reach $250,000 ($150,000 if you run a personal service C corporation), you should (no, must) prepare paperwork demonstrating why you require the money internally rather than handing it out as dividends.

You pay a needless and threefold tax if you are subject to the 20% accumulated earnings penalty tax: corporate income tax, tax on extra earnings that have accumulated, and dividend income tax.

Who Can Help with the Process?

Outsourced corporate bookkeepers can help business owners track their earnings and expenses to avoid being taxed on their accumulated profits. They can also help business owners keep track of their costs so that they can deduct them from their income taxes. This can help business owners save money and time.

Many small business owners and entrepreneurs are unaware of the many benefits they can receive from working with a Certified Public Accountant (CPA). A CPA can help save small business owners money on their taxes and offer invaluable financial planning and cash flow management advice.

For example, a CPA can help small business owners determine which deductions they are eligible for and offer guidance on how to best structure their business to maximize profits.

In addition, a CPA can also provide peace of mind to small business owners by ensuring that financial records are up-to-date. As a result, hiring a CPA is often one of the best decisions a small business owner can make.

Best Houston accountants, like Jones CPA Group, LLC, have a wealth of experience working with small businesses and can offer the customized service essential for success. When searching for the best CPA for small businesses, look for one with expertise in your industry and specific needs.

Remember, the accumulated earnings tax is a 20 percent corporate-level penalty tax imposed by the IRS. This hidden tax was set in 1981 and has not been adjusted for inflation. If you input that $250,000 into the inflation calculator, it would be equivalent to over $1 million today. Beware of this hidden tax when filing your business t

Houston area investment property owners have every reason to be concerned about the Net Investment Income Tax (NIIT). It’s an extra 3.8 percent of tax in addition to whatever amounts you are already paying for federal income and self-employment tax.

With rental properties as a primary focus for the NIIT, it can quickly make a good potential investment look downright frightful.

The good news is there are some ways to reduce your rental income tax exposure to it. In fact, you may even qualify to be exempt from it altogether. Let’s dig into it and see how you are affected.

What is the Net Investment Income Tax?

The Net Investment Income Tax has been around since 2013 and is found in the Internal Revenue Code section 1411.

According to the IRS, “the NIIT applies at a rate of 3.8% to certain net investment income of individuals, estates, and trusts that have income above the statutory threshold amounts. ”

As intimidating as that sounds, there are several ways to avoid this tax even if you are above the income “threshold amounts”.

What is Net Investment Income?

Net investment income includes:

• Rental income
• Capital gains from:
  • Sale of investment real estate (including the sale of a secondary residence)
  • Sale of stocks, mutual funds, and bonds
  • Capital gain distributions from mutual funds
  • Sale of interests in S corporations and partnerships
• Royalties
• Dividends and Interest
• Income from passive activities businesses and those trading commodities or financial instruments

Net investment income is not:

• Wages, unemployment compensation, Social Security benefits, or alimony
• Self-employment income
• Operating income from a non-passive business (see the Real Estate Professional exemption discussed below)
• Tax-exempt interest payments or distributions from Qualified Plans

How is the modified adjusted gross income for the Net Investment Income Tax calculated?

Simply put, for the purposes of calculating the Net Investment Income Tax, your modified gross income is usually the same as your adjusted gross income from line 37 on Form 1040 minus any above-the-line deductions.

It’s important to note that any income that is excluded from gross income for regular income tax calculation is not subject to the Net Investment Income Tax.

Taxpayers living abroad or those who have income from passive foreign investment companies or controlled foreign corporations may have more adjustments to calculate their modified adjusted gross income. IRS code 1.1411-10(e) can help with those unique situations.

What are the income thresholds?

The income thresholds that trigger the Net Investment Income Tax vary based on your filing status and your modified adjusted gross income as shown here:

● Single $200,000
● Married filing jointly $250,000
● Married filing separately $125,000
● Head of household $200,000
● Qualified widow(er) with a dependent child $250,000

How is the Net Investment Income Tax calculated?

The Net Investment Income Tax is 3.8 percent is of the lesser of

• the amount of modified adjusted gross income exceeds your income threshold, as shown above, or
• your Net Investment Income.

Let’s look at two examples.

Example 1: Mary, a taxpayer filing with as “single” status, has a modified adjusted gross income (MAGI) of $250,000 which includes $100,000 that is Net Investment Income (NII).

Mary’s Net Investment Income Tax (NIIT) will be the lesser of

• her $100,000 NII, or
• the amount her MAGI of $250,000 exceeds the single taxpayer threshold of $200,000, which would be $50,000.

$50,000 is the lesser amount, so, Mary will owe 3.8 percent of $50,000 making her NIIT for the year, $1,900 ($50,000 x 3.8% = $1,900).

Example 2: Tom and Becky, filing status “married filing jointly”, have a MAGI of $450,000 which includes $100,000 of NII.

Tom and Becky’s NIIT will be the lessor of

• their $100,000 NII
• or the amount their MAGI of $450,000 exceeds the married filing jointly threshold of $250,000, which would be $200,000

In this instance, the NII of $100,000 is the lesser amount, so, Tom and Becky will owe 3.8 percent of $100,000 making their NIIT for the year $3,800 ($100,000 x 3.8% = $3,800).

You will use Form 8960 to calculate your Net Investment Income Tax and then report the results on Form 1040.

Exemptions from the Net Investment Income Tax

There are some individuals who are automatically exempt from the Net Investement Income Tax including those with the following status as defined by the IRS:

• Nonresident Aliens (NRAs)
• Dual resident claiming foreign residency for tax purposes
• Dual resident claiming partial year tax residency (exemption only for the partial year Net Investment Income earned while claiming US residency)

Some estates and trusts also may be exempt:

• Charitable trusts and retirement plan trusts (section 501)
• Charitable remainder trusts (section 664)
• Estate or trust with unexpired interests (section 170)
• Grantor trusts (sections 671-679)
• Real estate investment trusts and Common Trust Funds
• Perpetual Care Trusts
• Electing Alaska Native Settlement Trusts

Unfortunately, most real estate investors do not fall under the above exemptions, however, do not give up hope. There are still some income exemption strategies you can use.

Real Estate Professionals NIIT Exemption

The IRS gives a real estate professional the ability

• to deduct their rental losses from non-rental income, and
• to possibly have their income exempt from the Net Investment Income Tax.

This sounds great you say, so sign me up. Well, it’s not quite that easy.

The IRS has a strict definition of who can be viewed as a real estate professional for tax purposes. This exemption strategy also requires material participation in the rental activity as opposed to passive participation.

First, let’s examine the IRS definition of a Real Estate Professional.

To qualify, you must spend (a) more than 750 hours working in real estate business activity and (b) this must be more than fifty percent of your over all working time.

This means if you worked 20 hours a week with your rental properties and other real estate work, any other work would be limited to less than 20 hours a week.

Second, you must show you are materially participating in the rental business and not just passively involved. The most common ways are (1) doing all the work yourself, or (2) spending over 100 hours of work on the property yourself given that’s more than anyone else.

The IRS does allow you to group rentals together to combine work time in order to pass the material participation criteria.

The last part of this exemption strategy is to show the rental activity as a business and not an investment. To do this, the real estate professional. The safe harbor rule provided is to show at least 500 hours a year devoted to the rental activity.

As a safe harbor rule, this is guidance and not a requirement, so be prepared to establish your material participation with clear record-keeping as this will protect your rental activity qualifying as a business.

Short-Term Rental NIIT Exemption

Short-term rentals are generally viewed as a business and not an investment provided you materially participate in the rental activity. This applies whether you use a Schedule C or Schedule E to report the business.

Again, good record keeping including your time spent coupled with a solid understanding of the IRS rules regarding rental property businesses will ensure you can use this NIIT exemption.

Real Estate Tax Services

The Net Investment Income Tax is just one factor you need to consider when planning your real estate tax strategy. To be honest, when it comes to rental income tax advice, there’s no shortage. But that does not mean it’s the right advice for your real estate goals.

As a Houston accountant with years of experience helping real estate professionals and investors, I can help you craft the right tax strategy that will find every rental income tax deduction possible and preserve as much of your profit as possible.

Schedule a no-obligation consultation with us today and let us prove our worth as the leading accounting services for small businesses in Houston.

In the corporate world, it’s not uncommon for employees to have business-related expenses. With even more workers moving their offices into their homes, these expenses have become even more important. Most companies have formal policies and procedures in place to help account for these costs and plans to help those employees obtain reimbursement. These plans are often referred to as an accountable plan. 

What is an Accountable Plan?

Corporate expenses made from employees need certain legal protections for both the company and the employee as well as regulations in regard to tax deductions. An accountable plan is the arrangement between the corporation and the employee for reimbursement of business-related purchases made by the employee. This reimbursement arrangement necessitates employees to substantiate expenses and return unsubstantiated advances.

What types of expenses are covered?

In a corporate office, an employee may have certain needs that arise that are related to their scope of duties. This could include:

• Mileage reimbursement
• Paper
• Desks, Chairs, and other office equipment
• Internet
• Training costs
• Licenses
• Subscriptions
• Business Cards
• Computers
• Food expenses related to business meetings

Each expense accounted for must relate directly to the business and be within the employee’s scope of their required duties for 100% reimbursement. For example, if you were to take a personal trip to the store, the company’s accountable plan would not be able to reimburse you fully and it would expect to be repaid or it would be treated as income for the employee which is also subject to being taxed as such. For mixed expenses, the same expectations would apply. This could include a cell phone, for example, that is used for personal and for business calls.

What are the benefits of an Accountable Plan?

In 2018, the Tax Cuts and Job Act, specifically eliminated itemized deductions and redefined how business expenses and deductions were handled. Out-of-pocket expenses could no longer be used on the employee’s personal tax returns. With the accountable plan, businesses can reimburse employees for these business expenses as long as they are properly claimed, documented, and are then no longer taxable to the recipient.

An Accountable Plan is a wonderful way to pull money out of the corporation and diminishes the overall amount of taxes being paid. By diminishing your total net ordinary business income you are also cutting down one of the criteria for the reasonable salary testing, and this could possibly decrease your salary. This prevents a possible cash drain that could affect the employer as well as the employee.

How can S Corps specifically benefit from an Accountable Plan?

For S corporations, having the accountable plan allows the owner-employees to continue to deduct these business-related expenses by extending it to the business itself. The business will then have the capability to deduct those reimbursed amounts as if they had obtained the expense directly from the corporation itself. This mitigates the tax liability from the employee.

Another benefit for S corporations is the use of their home for business purposes can be reimbursed through an accountable plan. This could include property tax, insurance, home maintenance, mortgage, and even repairs. These expenses, however, are allocated based on the percentage of square footage that is used solely for business-related purposes.

How can C Corps specifically benefit from an Accountable Plan?

For C corporations, some of the same rules and benefits can apply. However, specifically relating to C Corps, there is an exception. In regards to an accountable plan, C corps have a medical reimbursement plan available. This piece of the accountable plan can allow employees to get reimbursed for their medical expenses as long as the company has a medical reimbursement plan already in place in writing. This could include copays and even your medical prescriptions.

Can Partnerships benefit from an Accountable Plan?

With partnerships, the ability to deduct these expenses from an accountable plan can vary when compared to S corps or C Corps. When you are a partner, you generally cannot deduct expenses of the partnership on your personal tax return. This means that the partnership should account for and deduct its own business costs. When using the accountable plan you have in place for your partnership, the reimbursement becomes tax-deductible and reduces the share of the taxable net income. This is especially helpful for partnerships who have at-home office expenses and could use a tax-free reimbursement from their accountable plan.

Summary

An accountable plan is an excellent way for businesses to get more money out of their corporation while helping their employees have a smooth reimbursement process. For S corps and C corps alike, it has been shown to be overtly advantageous in multiple regards. If you are looking to form your own accountable plan, consult with a local CPA near you, who can guide you through the process and the specific IRS regulations in place.