Barbara’s Blog

On January 1, 2013, the top tax bracket for individuals rose to 39.6% (the top bracket used to be 35%). The 39.6% bracket applies to singles with taxable income over $400,000 and joint filers over $450,000. However, this new top tax bracket does not only impact individual income taxes. It also affects some business taxes, which will have the overall impact of raising income taxes even more.

Taxation of capital gains and qualified dividends
If you are a sole proprietor or an owner of/or in a partnership, limited liability company, or S corporation, your share of capital gains from the sale of your business’ property is subject to a 20% tax if you are in the 39.6% tax bracket. Last year, the top capital gain rate for this purpose was 15%.

If your business is incorporated and it distributes dividends to you which are treated as “qualified dividends,” those dividends are taxed at 20% if you are in the 39.6% tax bracket. Again, the top rate on qualified dividends was 15% last year.

Section 444 election
Partnerships and S corporations usually must use a calendar year (the same tax period used by its owners). However, they can elect to use a fiscal year if they make a special tax payment intended to thwart the benefit of tax deferral under the fiscal year. This election is called a Section 444 election, and the required payment is the highest individual income tax rate, plus one percentage point. Thus, the payment amount for 2013 is 40.6% (39.6% + 1%). Last year, the required payment was 36%. This required payment applies regardless of whether the owners in these electing entities are high-income taxpayers.

The required payment is due on May 15, 2013, for a company that has already made an election. The due date for a company first making the election in 2013 is May 15, 2014. The required payment is made with Form 8752, Required Payment or Refund Under Section 7519, which must be filed each year the section 444 election is in effect. Find out more about this required payment in IRS Publication 538.

PHC tax
Owners of personal holding companies (PHCs), which is a special type of C corporation that has limited ownership and receives certain types of income, may be subject to a special tax on excess passive income. The PHC tax rate for 2013 is 20%; it was 15% last year. Again, the rate applies without regard to the tax bracket of the PHC’s shareholders.

Accumulated earnings penalty
If a C corporation accumulates more than a set amount of its earnings rather than distributing it to shareholders, it may be subject to a special penalty. The corporation can accumulate any amount for the reasonable needs of the business (e.g., a proposed expansion project or a buyout of a retiring owner). Above these reasonable needs, accumulations are restricted to $250,000 ($150,000 for personal service corporations). Excess accumulations are taxed in 2013 at 20%; the penalty rate had been 15% last year. The penalty applies without regard to the tax bracket of the corporation’s shareholders.

Conclusion
Talk with your tax advisor to learn all of the ramifications that the new top personal tax bracket may have on your overall tax picture.

Will federal sequestration—the automatic budget cuts set to take effect on March 1—impact you? It depends on your business and on who you ask.

What is sequestration?

Sequestration is the name for federal budget cuts (primarily in defense spending) scheduled to begin on March 1 if Congress fails to find way to make required budget cuts to meet a pre-set level. The exact amount of these cuts is difficult to determine; it changes from source to source (I’ve seen mention of $85 billion in initial cuts). Overall, sequestration is supposed to make cuts of $1.5 trillion over 10 years. Also, sequestration means that the federal government is limited in the amount of additional borrowing. Details about the cuts from sequestration can be found in a Congressional Budget Office Report.

Sequestration was suggested by President Obama and agreed to by Congress in the Budget Control Act of 2011 as part of a compromise to raise the federal debt limit.

Which businesses will likely be impacted?

Entrepreneur Magazine said sequestration could result in a “dramatic decrease” in government contracts (how much is unclear). The Chairman of the House Small Business Committee agrees. Many small businesses receive contracts directly or as subcontractors of prime contractors.

A White House blog fact sheet sequestration could result in fewer SBA-guaranteed loans. These are commercial loans that receive government guarantees. The fact sheet pegs the cutback at $902 million.

The New York Times reported that a senior policy analyst with the National Federation of Independent Business thought it impossible to predict the impact of sequestration on small business and whether it would hurt the economy.

Final thoughts

Let’s be realistic about the specter of sequestration vis-à-vis small business. Not every small enterprise is in the market for a loan or is a government contractor. Little else has been discussed on the overall impact that sequestration would have on small business. The actual budget cut resulting from sequestration is only a drop in the federal budget bucket (probably about 2%). Many businesses I know would readily cut their budget by this amount if they didn’t have the funds to pay 100% of what they had previously expected. Why shouldn’t the federal government do the same?

What’s more, even if March 1 comes and goes without further Congressional budgetary action, nothing prevents some activity down the road. Let’s not panic. Let’s wait and see.

On January 24, 1963, President Kennedy gave a special message to Congress, which included his proposals designed to continue to move the U.S. economy out of a recession that had started in early 1961. He proposed slashing the individual and corporate tax rates, which ultimately brought down the top marginal rate from 91% to 70%. He also reduced the top corporate rate from 52% to 48%. Despite political winds indicating that there wasn’t great support for his idea and that maybe it should be done on a temporary basis, he worked for this significant rate reduction on a permanent basis. Some (not all) of his proposals were eventually reflected in the Revenue Act of 1964.

The Heritage Foundation notes that as a result of lowering marginal rates, “tax revenues climbed from $94 billion in 1961 to $153 billion in 1968, an increase of 62% (33% after adjusting for inflation). A quote from Kennedy’s message 50 years ago:

“Our choice today is not between a tax cut and a balanced budget. Our choice is between chronic deficits resulting from chronic slack, on the one hand, and transitional deficits temporarily enlarged by tax revision designed to promote full employment and thus make possible an ultimately balanced budget.”

Another plank in his plan for tax reform was the expansion of the investment tax credit to encourage businesses to invest in certain capital acquisitions. Kennedy reasoned that the cost of the tax credit would be offset by the growth in businesses, which in turn, would lead to more tax collections on increased profits.

The first investment tax credit was enacted in 1962 in response to his call for such an incentive to make U.S. companies more competitive worldwide.  The credit was 7% of the cost of qualified property (essentially equipment and machinery). Once the property was no longer “qualified” (i.e., it was disposed of before the end of its useful life), the credit was recaptured (a portion was taken back into income in the year of disposition, depending on how long the property had been used).

But the credit as first enacted was a far cry from what Kennedy had wanted. The credit was dramatically liberalized in the Revenue Act of 1964 (the same law that cut the tax rates and made some other significant tax changes) by ending the rule that had required the basis of property subject to the credit to be reduced by the amount of the credit. By ending this basis reduction, depreciation could be taken on the full cost of the qualified property.

On a personal note, I recall very well Kennedy’s addresses to the nation and his explanation to the public of the investment tax credit. My dad owned a tool and die company in the Bronx (NYC), and he (a life-long Republican) was very enthusiastic about the proposal. My dad’s company was in a position to utilize the investment tax credit and benefit from it.

Ok, so we’ve had our tax moment for the time being, with enactment of the American Taxpayer Relief Act at the start of this year, making permanent many of the Bush-era tax cuts. However, listening to some members of Congress, I don’t think they get what Kennedy was driving at:  that lower rates and select tax incentives appear to lower revenues but ultimately will drive the economy, leading to greater revenues. With Congress poised to take up major tax reform (something not done since 1986), I hope that the words from 50 years ago are remembered!

If you do payroll in-house, expect to put in more time and money in 2013 to comply with your withholding obligations. Because Congress did not fix the fiscal cliff by the third week in December, it is too late for the IRS to change its withholding tables for January.

The American Payroll Association posted on its Facebook page on December 21: “we believe that employers should continue to use the 2012 withholding tables if they have to process their first payrolls of 2013 before any official guidance is released, as it is the only workable option.”

Down the road
Eventually, the tax situation will be resolved, allowing the IRS to revise withholding tables accordingly.

• If Congress retains 2012 tax rules. If Congress extends the 2 percentage point reduction in the employee share of Social Security taxes (part of FICA) as well as the tax rates for all individuals, then current tables, with some adjustments reflecting cost-of-living increases, will apply. Employees will see little or no changes in their paychecks.
• If Congress does not extend the Social Security tax break and/or retain current income tax rates. The IRS will issue new tables to reflect tax law changes. The tables will incorporate tax rates as of January 1. If, for example, the Social Security tax break is not extended for 2013, someone earning $50,000 would owe $1,000 more in this tax than he or she paid in 2012. This amounts to lower take-home pay of about $42 per paycheck (assuming paychecks are issued twice a month). If income tax rates are raised on high earners, their income tax withholding will reflect their added tax liability.

What is already new for 2013

• Regardless of movement on the fiscal cliff, some payroll tax changes are certain to apply starting in January. Higher Social Security tax wage base. Earnings up to $113,700 will be subject to the Social Security portion of FICA in 2013 (up from $110,100 in 2012).

• Additional Medicare tax on high earners. Employers must begin withholding for the 0.9% additional Medicare tax once an employee’s taxable pay exceeds $200,000. This withholding obligation applies even if the employee will not owe the tax (e.g., because he/she is married with a threshold for the tax of the couple’s earnings over $250,000).

You can find more information about withholding and the additional Medicare tax, which likely won’t apply to any employees until later in the year, here.

What to tell employees
Employees listening to the news about the fiscal cliff may be confused about what the news means for them. Here are some items to share with your staff:

• You are complying with tax law requirements on payroll withholding.
• If Congress fails to extend the Social Security tax cut for them, their paychecks will be smaller; you cannot do anything about this.
• Inform high earners about the new additional Medicare tax. High earners cannot request that you increase FICA withholding, but they can ask for additional income taxes to be withheld; these taxes can then be applied toward their FICA obligation when they file their Form 1040 for 2013.
• Regardless of any payroll changes, employees who have experienced or expect to experience life changes in 2013 (e.g., the birth of a child, the purchase of a home, or a spouse returning to or retiring from the workforce) may want to complete Form W-4, Employee’s Withholding Allowance Certificate, to make changes in their income tax withholding. More withholding allowances equals less withholding and more take-home pay; fewer allowances means less take-home pay.

Final thought
Confused? Who wouldn’t be at this point? It’s tough enough for employers to figure withholding on wages. With Congressional inaction making it impossible for the IRS to craft new tables for the start of 2013, it means that the rest of the year will be slightly off. When withholding tables are eventually released, they will have to take into account what was not done at the start of the year. Instead of doing payroll in-house, this year may be the time to use an outside payroll service. Whatever you decide, good luck.

According to the annual Employee Benefit Research Institute (EBRI) Survey, “employer-sponsored retirement savings plans are an important savings vehicle for American workers.” In addition to helping employees save for retirement, employees increasingly turn to their companies to inform them about retirement issues.

You can help to meet employee needs by sharing certain information.

1.    Active participation status

If your company has a qualified retirement plan covering employees, you are required to report this on W-2 forms. More specifically, active participation status of employees is denoted in Box 13 of Form W-2.

Why is this information important for employees? It tells them whether they are subject to an IRS income limitation for making deductible IRA contributions. If they are active participants, they cannot deduct such contributions unless their modified adjusted gross income is below set limits.

Even if they are active participants, they can still save for retirement using a Roth IRA. Again, income limits apply here, but being covered by a retirement plan is not. Direct employees to IRS Publication 590 for details on IRA contributions.

2.    Opt out elections

If you have an automatic enrollment feature in your company’s 401(k) plan, you must give employees the right to opt out or to reduce the default salary reduction contribution. Usually this is done at least 30 days but no more than 90 days before the start of the plan year (most small businesses run their plans on a calendar year). Find more about the opt-out feature from the IRS; this includes the notice form you give to employees.

3.    Employer contributions

Depending on the type of qualified retirement plan used by your company, you may or may not be required to make any contributions on behalf of employees. Certainly, this is information that employees want to know.

If you make contributions and plan to change them in any way (e.g., reducing the percentage used to figure your contributions; changing the timing of contributions to an annual lump sum for employees still on the payroll at that time), you must notify employees in writing. You’ll find notice requirements buried in the IRS Checklist (it may be too late for changes for 2013, but check with your tax advisor).

4.    Loan options

Your qualified plan may permit participants to borrow money from their accounts. The tax law limits how much can be borrowed and requires repayment in level amounts over a period of no more than five years (with the exception of borrowing to buy a home). The plan sets the interest rate on the borrowing.

Tell employees, through a form letter or in the employee manual:

•  Who to contact (the plan administrator) if they want to take a loan.

•  What the loan means for plan participation. Usually, they are barred from contributing while the loan is outstanding.

•  Whether interest is deductible. This usually depends on whether the participant is an owner or other key employee.

5.    Special distributions

Usually, qualified retirement plans must bar distributions until employees retire or leave the job. However, distributions can be taken earlier (without disqualifying the plan) under certain circumstances:

•  Hardship distributions can be made if a participant has a serious financial need, such as paying funeral expenses for a spouse or dependent. The distribution is taxable to the participant (and subject to penalty unless a penalty exception applies).

•  In-service distributions to a participant age 62 or older who is still working for the company. Again, the distribution is taxable to the employee, but not subject to a penalty because he or she is over age 59½ (a penalty exception).

•  Distributions pursuant to QDROs (qualified domestic relations orders) for a participant who is getting a divorce or legal separation. The court can direct that benefits be paid to an “alternate payee,” such as the spouse. Such amount is not taxable to the participant but rather to the alternate payee.

Conclusion

If employees ask questions about your company’s retirement plan or their retirement planning that you can’t answer, consult with a tax or financial advisor.

The election is behind us and Congress will hopefully focus on fixing the tax mess we’re in. According to the Heritage Foundation, the U.S. is facing taxmageddon, which is a one-year $494 billion tax increase slated to strike the economy on January 1, 2012. What will the tax fix mean for small businesses?

Our tax survey
In mid-October, we conducted an entirely unscientific survey of subscribers to our Big Ideas for Small Business newsletter. We wanted to know whether taxes really matters to you, and in which way. We learned the following.

More than four-fifths (80.6%) of responders said taxes influence their business decisions; only 13.1% said taxes had no impact on their business decisions while the balance was not sure.

For those who said that taxes influenced their decisions, here is how:

• Hiring and firing/outsourcing: 56.1%
• Purchasing/leasing equipment: 66.1%
• Buying/leasing vehicles: 44.6%
• Fringe benefits (including retirement plans, health insurance coverage, etc.): 64.6%
• Legal business structure: 54.6%

When asked “what is the most important tax issue on your mind right now,” the answers were evenly divided among uncertainty, high rates, and complexity. One person noted that complexity with compliance has a huge impact on his decisions to hire and grow. Another person said that he is not hiring now due to unknown pending tax changes. Others said that spending, particularly at year-end, is dependent on tax laws.

Of course, not everyone plans their activities on tax results. Some said taxes are only an influence, not a deciding factor. One person indicated that dreams, goals, and self-realization are his driving factors, not taxes. Another person indicated that she focuses on generating income, not worrying about taxes.

If only Congress could know what my readers think!

Have you gone to a website of the federal government lately? You may be surprised to learn that they appear to be slanted almost entirely to workers.  Employers have to work very hard to find information about topics of concern to them on these sites.

Examples:

• The Department of Labor (DOL) information about unemployment insurance is subtitled “workforce security.” It tells workers how to file claims. Admittedly, the DOL is designed primarily for worker information. However, just a few years ago, the site had very helpful links and resources for employers (especially small employers) dealing with their workforce; this information is gone (or at least so buried that it’s difficult to find).

• The IRS website has been revamped recently. If you look at the homepage, you wouldn’t think there were any taxes on businesses; all of the photos and links are for individuals. Again, the site does contain information for businesses, but you really have to look hard.

• The PBGC, which is the government agency insuring private pensions, provides information to workers about how to make claims and more. It is challenging for employers who want information about their obligations to find suitable links. Information about premium amounts and paying them is there, but again you really have to look. Previously, there had been easy-to-find links for employers.

These are just some examples that I encountered when seeking information relevant to business owners. It is now challenging to find guidance and resources for businesses on many federal websites. Is this an accident, an error, or a political statement?

During the political conventions, both parties promised a new tomorrow for small businesses. Unfortunately, there is an unhappy small business community today. According to results from the recent SurePayroll survey, most indicators are down:

• Optimism of small business owners in August was at 60%, which represents a 2% decline from July.
• Hiring in August (compared with July) was down by 0.1% (and paychecks for employees was down by 0.2%)
• Only 18% of small businesses sought loans in 2012, and 32% of these had trouble obtaining them.

How does this play against the political backdrop?

Democratic Party platform
The Democratic Party platform related to small business states:

“Small businesses employ half of all working Americans, and, over the last two decades, have created two out of three net new jobs. Democrats believe that small businesses are the engine of job growth in America. President Obama signed 18 small-business tax cuts to encourage businesses to hire more workers and make job-creating investments in machinery and equipment and proposed significant additional small business tax relief. He encouraged investment and supported start-ups by allowing businesses to write off the full cost of new equipment and machinery they bought in 2011. Altogether, the President’s Small Business Jobs Act accelerated $55 billion in tax relief through 2011. Democrats made it easier for small businesses to access the loans they needed to grow and hire. The President signed into law changes to help entrepreneurs raise capital while maintaining key investor protections. Small businesses are now once again creating jobs. Democrats have helped small businesses provide health insurance to their workers with a tax credit to help pay for the cost of coverage. In 2014, the tax credit will grow and small businesses will be able to pool their purchasing power together to get affordable coverage.

We recognize the importance of small business to women, people of color, tribes, and rural America and will work to help nurture entrepreneurship.

President Obama and the Democratic Party are committed to continue cutting red tape for small businesses, helping them sell their goods around the world and access the capital they need to grow. This includes tax cuts for small businesses that make new investments, hire more workers, or increase wages.”

GOP platform
The GOP platform related to small business and entrepreneurship states:

“America’s small businesses are the backbone of the U.S. economy, employing tens of millions of workers. Small businesses create the vast majority of jobs, patents, and U.S. exporters. Under the current Administration, we have the lowest rate of business startups in thirty years. Small businesses are the leaders in the world’s advances in technology and innovation, and we pledge to strengthen that role and foster small business entrepreneurship.

While small businesses have significantly contributed to the nation’s economic growth, our government has failed to meet its small business goals year after year and failed to overcome burdensome regulatory, contracting, and capital barriers. This impedes their growth.

We will reform the tax code to allow businesses to generate enough capital to grow and create jobs for our families, friends and neighbors all across America. We will encourage investments in small businesses. We will create an environment where adequate financing and credit are available to spur manufacturing and expansion. We will serve as aggressive advocates for small businesses.”

Bottom line
It is great to see both parties acknowledging the importance of small business to the U.S. economy. This rhetoric is great, but actions following the election are the only meaningful thing for small business and our country.

It’s vital for small business owners to assess whether the last four years of a Democratic Administration have been helpful to their companies and the economy, and to decide which party going forward can better serve small business interests. Vote accordingly.

About 70% of Boomer-owned businesses are expected to change hands within the next 10 or so years, according to a 2006 article by Robert Avery of Cornell University.

Many of these owners have adult children or other relatives who work for them, and the owners may be thinking of ways to transition to retirement without a huge tax bill.

If you want your successors to own your business while you enjoy capital gains treatment for disposing of your ownership interest, follow tax rules scrupulously. Your successors can end up with 100% ownership of your corporation, you get the payout you want, and it won’t cost your successors a penny.

Here’s how the transaction should be set up:

• Assume you own 100% of your corporation (it doesn’t matter whether it’s a C or S corporation) and you have two adult children who work for you. You want them to own the business so you can retire to a nice community in a better climate and enjoy the fruits of your labor. You give some stock to each child; the amount is up to you. There’s no income tax when you give shares to your children. For federal gift tax purposes, you can give up to $13,000 worth of stock in 2012 with no tax (or $26,000 if you are married and your spouse consents to the gift).
• Now the corporation redeems all of your stock. If the corporation has sufficient cash, it can pay you the full redemption price. If not, the corporation can give you an installment note and pay you off over a fixed period (say five or 10 years).

Legal results: Following the redemption, your children own 100% of the corporation. You are no longer involved in the company (other than as a creditor if you are paid in installments).

Tax results: The redemption is treated as if you’d sold your stock to the corporation; this “sale” is taxed at the favorable capital gain rate (15% in 2012). If the corporation pays you out over time, then you report your gain over the period of the installments (unless your tax picture favors opting out of installment reporting so that you pick up all of the gain in the year of the redemption). Your children are not treated as having received a dividend from the corporation, even though they now own the entire business without any personal cash outlay.

Traps: This favorable redemption rule does not apply if you retain any interest in the business other than as a creditor (i.e., one who is owed money from the corporation). Caution is advised if you want to remain as a consultant or a board member; in some situations these positions can be considered a retained interest that prevents favorable redemption treatment. Doing the arrangement incorrectly can mean:

• You’re taxed on the proceeds as dividend income (which may not be taxed favorably after 2012 if you’re considered a high income taxpayer).

• Your children may be burdened with dividend income as well.

Because of the need to follow tax rules exactly, it is wise to work with a knowledgeable tax advisor who can help you structure the arrangement. You can also review this arrangement in a private letter ruling.

As an employer, you have to pay federal unemployment tax (FUTA) in addition to your state unemployment tax. The federal tax is figured on the first $7,000 of wages for each employee. The FUTA tax rate is 6%. This rate is reduced by a tax credit for state unemployment insurance.

The credit rate for state unemployment insurance normally is 5.4%. However, if states borrowed money from the federal government to pay their unemployment claims and have failed to repay the money, then employers in those states (called “credit reduction states”) have a reduced credit.

Technically states have until November 10 to repay their loans, but as it stands now, employers in 26 states are looking at additional FUTA taxes.

Employers in Indiana and South Carolina could have a credit of only 4.5% (a credit reduction of 0.9%), resulting in $63 additional FUTA tax for each employee

Employers in Alabama, Arkansas, California, Connecticut, Florida, Georgia, Illinois, Kentucky, Minnesota, Missouri, Nevada, New Jersey, New York, North Carolina, Ohio, Pennsylvania, Rhode Island, Virginia, and Wisconsin could have a credit of only 4.8% (a credit reduction of 0.6%), resulting in $42 additional FUTA tax for each employee

Employers in Arizona, Colorado, Delaware, Kansas, and Vermont could have a credit of only 5.1% (a credit reduction of 0.3%), resulting in $21 additional FUTA tax for each employee

On a per-employee basis, the additional tax isn’t much. But the principle of the higher tax is significant. You — the employer — are penalized because your state has not been able to manage its finances well enough to avoid borrowing or repaying loans on time. It is likely you are based in a state with a high unemployment rate. And there’s nothing you can do about it (other than relocating).

The Department of Labor determines which states are credit reduction states; the IRS posts these states and the amount of the credit reduction late in the year. For 2011, for example, there were 21 credit reduction states, with credit reductions ranging from 0.3% to 0.9%.

I’ll be on the lookout for the final tally of credit reduction states for 2012.