Grossbach Zaino & Associates, CPA's, PC

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Tax Exempt? Not Always

Public charities and other nonprofits count on being exempt from federal income taxes. However, even after the IRS has formally recognized a nonprofit’s tax exemption, the organization could have a tax liability if it has “unrelated business income.” The purpose of the tax on unrelated business income is to prevent tax-exempt nonprofits from gaining an unfair competitive advantage over commercial businesses that are conducting similar enterprises.

When the Tax Can Apply

The tax is triggered when a nonprofit generates income from a trade or business activity that it regularly carries on, and the activity is not substantially related to the purpose that forms the basis for the organization’s tax exemption. The tax can apply even if the organization uses the profits from the activity to further its mission.

Income-producing activities that should be carefully scrutinized for unrelated business income potential include:

n Sales of souvenirs, prepackaged foods, tee shirts, or other merchandise (but see When the Tax Doesn’t Apply for exceptions)

n Joint ventures with for-profit partners

n Sales of commercial advertising

n Travel tours

Where the potential for unrelated business income exists, it may be possible to sidestep a tax problem by structuring an arrangement differently, altering a product lineup, or making other changes to bring the activity within the scope of the organization’s mission.

When the Tax Doesn’t Apply

As in most areas, the tax law contains exceptions that allow certain activities to escape the reach of the unrelated business income tax. Among them:

n Volunteer efforts in which substantially all of the work is conducted by volunteers

n Selling donated merchandise

n Hospital gift shops operated for the convenience of employees, patients, and visitors

n Agricultural fair and exposition entertainment and recreational activities

n Certain trade shows

Nonprofits are constantly looking for new ways to keep their missions alive by expanding their revenues. Understanding the unrelated business income rules and how the tax can be avoided will help ensure that the IRS does not share in those revenues.

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Summer Jobs, Teen Taxes

Will your child have to pay taxes on the income earned at a summer job? It’s important to know the guidelines and keep good records.

  • Tips from waitressing, etc., are considered taxable income.
  • Net earnings of $400 or more from self-employment (e.g., babysitting, lawn mowing) are subject to self-employment tax, in addition to income tax.
  • Your child may be taxed on unearned income (dividends and interest) from bank and investment accounts set up under your child’s Social Security number.
  • Your child can claim an exemption from federal income-tax withholding if he or she had no income-tax liability last year and doesn’t expect to owe income taxes this year (e.g., because anticipated earnings are less than the standard deduction for single taxpayers, $6,300 for 2015).

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A Little Pain, No Taxable Gain

The paint. The dust. The torn-up room. Home improvement projects may not be high on your list of enjoyable events. But, when you’re ready to sell your house, any money you’ve spent on fixing it up may save you from paying tax on the sale.

The Home-sale Exclusion

You probably know that a married couple is entitled to $500,000 of tax-free gain ($250,000 for singles) on a home sale if they’ve used the house as a principal residence for two out of the five years prior to the sale. Taxable gain is the difference between your basis in the home (essentially, your cost) and the selling price. So, for most people, the exclusion eliminates or severely reduces any tax on a home sale. But not for all.

And that’s where home improvements could come into play. If you’ve kept good records, you can increase your home’s basis by adding in remodeling costs. Generally, any work that adds to your home’s value or extends its life counts toward your basis.

What Counts?

Examples of eligible expenditures include:

  • Putting in a patio, deck, or swimming pool
  • Finishing a basement or attic
  • Landscaping
  • Adding a room or fireplace
  • Vinyl or aluminum siding or similar exterior improvements like masonry work
  • Storm windows and doors
  • New plumbing or heating system
  • Air conditioning

Simple repairs, such as painting or fixing broken gutters and windows, don’t get added to your basis. But, if repairs are scheduled as part of a home improvement project, the entire cost of the renovation can be added to your basis.

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Business Start-up Costs — What’s Deductible?

Launching a new business takes hard work — and money. Costs for market surveys, travel to line up potential distributors and suppliers, advertising, hiring employees, training, and other expenses incurred before a business is officially launched can add up to a substantial amount.

The tax law places certain limitations on tax deductions for start-up expenses.

  • No deduction is available until the business becomes active.
  • Up to $5,000 of accumulated start-up expenses may be deducted in the tax year in which the active business begins. This $5,000 limit is reduced (but not below zero) by the excess of total start-up costs over $50,000.
  • Any remaining start-up expenses may be deducted ratably over the 180-month period beginning with the month in which the active business begins.

Example. Gina spent $20,000 on start-up costs before her new business began on July 1, 2015. In 2015, she may deduct $5,000 and the portion of the remaining $15,000 allocable to July through December of 2015 ($15,000/180 × 6 = $500), a total of $5,500. The remaining $14,500 may be deducted ratably over the remaining 174 months.

Instead of deducting start-up costs, a business may elect to capitalize them (treat them as an asset on the balance sheet). Deductions for “organization expenses” — such as legal and accounting fees for services related to forming a corporation or partnership — are subject to similar rules.

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A Different Way To Give — Donor-advised Funds

Are you looking for a different way to give to your favorite charities? If you are, you may want to consider a donor-advised fund.

Donor-advised funds are a popular option because they offer several attractive benefits: relatively modest contribution guidelines, little to no set-up costs, few ongoing responsibilities, name recognition if desired, and the ability to consolidate contributions and thereby make a greater impact. In 2013, assets in donor-advised funds totaled over $50 billion.*

Fund Basics

With a donor-advised fund, you make a contribution (or series of contributions) to the fund and recommend how you would like your gifts to be disbursed. Generally, the donor’s recommendations will be followed, but the sponsoring organization has the final say as to how the money is actually distributed.

Tax Benefits

As the donor, you can potentially take advantage of these tax breaks:

  • An immediate deduction that reduces your federal taxable income (subject to certain tax law limitations)
  • Avoidance of capital gains taxes on appreciated assets you donate directly to the fund
  • A reduction in the value of your estate, potentially saving future estate taxes

Do Your Research

If you are interested in setting up a donor-advised fund, do your homework. Ask the sponsoring organization what types of assets it will accept. Funds also may have minimum contribution requirements to establish a named fund. Make sure you understand what restrictions apply to grants, what fees are involved, and what services are offered to help donors. And find out whether the fund will continue in perpetuity or end when you die.

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S Corporation Officers: Are You Taking a Paycheck

If your company is organized as an S corporation, you may wonder whether it is better to take income from the company as salary or as cash distributions. Of the two options, distributions carry the least tax cost because they are not subject to employment taxes. But that doesn’t mean you shouldn’t take a paycheck from your firm.

IRS Warning

Over the years, the IRS has made a point of warning S corporations not to attempt to avoid federal employment taxes by having corporate officer/shareholders treat their compensation as cash distributions, payments of personal expenses, or loans instead of as wages. According to the IRS, distributions must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.

What Is a “Reasonable” Salary?

To avoid problems with the IRS, you should be sure to take a reasonable amount of salary if you receive any direct or indirect payments from your company. However, the tax law has no hard-and-fast guidelines regarding what is considered “reasonable.” When the issue has come up in court, the determination has been based on the facts and circumstances of the particular case. Various factors have come into play, including:

  • Duties and responsibilities
  • Time and effort devoted to the business
  • Training and experience
  • What comparable businesses pay for similar services
  • Timing and manner of paying bonuses to key people
  • Payments to employees who are not shareholders
  • The corporation’s dividend-paying history
  • Compensation agreements
  • The use of a formula to determine compensation

An Exception

What about an S corporation officer who doesn’t perform any services for the corporation — or whose services are very minor? In this relatively unusual situation, assuming the officer receives no direct or indirect pay, he or she would not be considered an employee.