Phoenix Wealth Building & Insurance Services

Tax-Saving Tips

October 2020

The Latest on Payroll Tax
Deferral

If
you have employees, you must withhold their 6.2 percent share of the Social
Security tax from their wages up to an annual wage ceiling ($137,700 for 2020).
You must pay the money to the IRS along with your matching 6.2 percent employer
share of the tax.

But
under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, as you
likely know, employers are allowed to defer paying their 6.2 percent share of
the Social Security tax on wages paid to employees through the end of 2020.
Fifty percent of these deferred taxes will have to be paid during 2021 and the
remainder in 2022.

Both
the Trump administration and the IRS have issued orders permitting employers to
defer withholding and paying the employee portion of the Social Security tax
for a limited time. But the executive order on employee deferral is much more
limited in scope than the CARES Act employer deferral, and it’s beset with
practical problems for employers.

Which Taxes Can Be Deferred?

The
deferral applies only to the employee portion of the Social Security tax due on
wages paid from

September
1, 2020, through December 31, 2020. No other payroll taxes can be deferred.

Which Employees Qualify for
the Deferral?

Only
employees who earn less than $4,000 biweekly qualify for the deferral.
Employees who are not paid on a biweekly basis qualify if their pay is
equivalent to less than $4,000 biweekly. This would include employees who are
paid less than

·
$2,000 weekly,

·
$4,333 semimonthly, or

·
$8,666.67 monthly.

Each
pay period is tested separately. An employee who earns too much during one pay
period can still qualify for the deferral if he or she earns less than the
ceiling amount in a later pay period.

Is the Deferral Mandatory?

IRS
officials have stated that the deferral is not mandatory. Employers are not
obligated to offer the deferral to their employees. This is so even if an
employee requests it.

What
Happens When the Deferral Period Ends?

The
employee Social Security tax deferral ends on December 31, 2020. IRS guidance
provides that the deferred taxes must then be paid “ratably” from wages paid
from January 1, 2021, through April 30, 2021. Employers must withhold and pay
the deferred taxes from employee wages paid during this period.

Thus,
from January 1, 2021, through April 30, 2021, most employees will have to pay a
12.4 percent Social Security tax instead of the normal 6.2 percent. This
amounts to a 6.2 percent pay cut for affected employees for four months.

What If Employees Quit or
Get Fired?

If
an employee quits or is fired during the four-month repayment period, there may
not be enough wages paid to cover the deferred Social Security taxes. The IRS
says that in this event employers can “make arrangements to otherwise collect”
the deferred taxes. What form such “arrangements” could take is unclear.

Interest,
penalties, and additions to taxes will begin to accrue on any unpaid deferred
Social Security taxes starting May 1, 2021. Thus, if you (the employer) fail to
remit the deferred monies because employees were not employed during the
collection period, you are on the hook.

Due
to the uncertainty involved, many employers have reportedly elected not to
participate in the employee Social Security tax deferral.

Using Whole or Partial Rooms for Your Home Office

With
the COVID-19 pandemic still going on, you may be spending more time working
from your home office.

You
may have taken some extra rooms for your business use. Is that okay?

Section
280A(c) states that you may claim a home office based on the portion of the dwelling
that you use exclusively and regularly for business. Thus, the law dictates no
specific number of rooms or particulars regarding the size of the office.

The
courts make this rule clear, as you can see in the Mills (less than one room) and Hefti (lots of rooms) cases described below.

The Mills Case

Albert
Victor Mills maintained an office in his apartment from which he conducted his
rental property management business. The apartment was small, totaling only 422
square feet. In the office area of the apartment where Mr. Mills had his desk,
he also kept tools, equipment, paint supplies, and a filing cabinet.

The
court agreed with Mr. Mills’s allocations and awarded
the home-office deduction based on his claimed 23 percent business use of the
422-square-foot apartment.

Planning note. Mr. Mills did not
have a single room dedicated to a home office. He had only an area of the
apartment where he grouped his office furnishings, equipment, and supplies. If
you have a similar situation, make sure your business assets are located in a
group.

The Hefti Case

Charles
R. Hefti lived in a big house, totaling 9,142 square
feet. He claimed that more than 90 percent of his home was used regularly and
exclusively for business.

Based
on its review of the rooms, the court concluded that 13 rooms, totaling 19
percent of the home, were used exclusively and regularly for business.

Insights

The
deductible portion of your home for an office includes the area used
exclusively and regularly for business.

Let’s
say you have an office in one room and your files in a second room, and you
never use these rooms for personal purposes. Further, let’s say you use the
office area on a daily basis and the files area in connection with that daily
work.

Both
rooms would meet the exclusive and regular use requirements, just as Mr. Mills’s and Mr. Hefti’s offices
met these rules.

But Not This

“Exclusive
use” means that you must use a specific portion of the home only for business
purposes. You must make no other use of the space.

Exception. One exception to the exclusive use
rule is storage of inventory or product samples if the home is the sole fixed
location of a trade or business selling products at retail or wholesale.

Example 1. Your home is the only fixed location
of your business, which involves selling mechanics’ tools at retail. You
regularly use half of your basement for storage of inventory and product
samples. You sometimes use the area for personal purposes. The expenses for the
storage space are deductible even though you do not use this part of your
basement exclusively for business.

Example 2. In Pearson, Dr. Pearson
practiced orthodontics in a downtown medical building but retained the dental
records of more than 3,000 patients in 36 file drawers (each measuring 26 inches
by 14 inches by 12 inches) and had 1,461 boxes containing orthodontic models
(each box measuring 10 inches by 6 inches by 2 1/2 inches).

He
stored the records in the attic and basement of his home. The areas used for
such storage were not separate rooms, and the remaining portions of the attic
and basement were used by Dr. Pearson and his family for personal purposes.

The
court ruled that Dr. Pearson may not treat the storage areas as home-office
expenses because the records were not inventory or samples and Dr. Pearson did
not operate a wholesale or retail trade or business from his home.

Don’t Let the IRS Set Your S Corporation Salary

You
likely formed an S corporation to save on self-employment taxes.

If
so, is your S corporation salary

·
nonexistent?

·
too low?

·
too high?

·
just right?

Getting
the S corporation salary right is important. First, if it’s too low and you get
caught by the IRS, you will pay not only income taxes and self-employment taxes
on the too-low amount, but also both payroll and income tax penalties that can
cost plenty.

Second,
in most cases, the IRS is going to expand the audit to cover three years and
then add the income and penalties for those three years.

Third,
after being found out, you likely are now stuck with this higher salary,
defeating your original purpose of saving on self-employment taxes.

Getting to the Number

The
IRS did you a big favor when it released its “Reasonable Compensation Job Aid
for IRS Valuation Professionals.”

The
IRS states that the job aid is not an official IRS position and that it does
not represent official authority. That said, the document is a huge help
because it gives you some clearly defined valuation rules of the road to follow
and takes away some of the gray areas.

Market Approach

The
market approach to reasonable compensation compares the S corporation’s
business with others and then looks at the compensation being paid by those
businesses to employees who look like you, the shareholder-employee who is
likely the CEO.

The
question to be answered is, how much compensation would be paid for this same
position, held by a nonowner in an arm’s-length employment relationship, at a
similar company?

In
its job aid, the IRS states that the courts favor the market approach, but because
of challenges in matching employees at comparable companies, the IRS developed
other approaches.

Cost Approach

The
cost approach breaks your employee activities into their components, such as
management, accounting, finance, marketing, advertising, engineering,
purchasing, janitorial, bookkeeping, clerking, etc.

Here’s
an example of how the cost approach works to support a $71,019 salary as
reasonable compensation for this S corporation owner whose corporation had $3.5
million in revenue and 19 employees:

Task

Hours

Wage

Amount

Taxi driver and
chauffeur

104

$12.75

$1,326

General manager

624

$58.32

$36,392

Wholesale buyer

166

$27.59

$4,575

Collections clerk

146

$15.32

$2,237

Sales representative

624

$30.96

$19,149

Order clerk

416

$18.56

$7,340

Totals

2,080

N/A

$71,019

Health Insurance

The
S corporation’s payment or reimbursement of health insurance for the
shareholder-employee and his or her family goes on the shareholder-employee’s
W-2 and counts as compensation, but it’s not subject to payroll taxes, so it
fits nicely into the payroll tax savings strategy for the S corporation owner.

Pension

The
S corporation’s employer contributions on behalf of the owner-employee to a
defined benefit plan, simplified employee pension (SEP) plan, or 401(k) count
as compensation but don’t trigger payroll taxes. Such contributions further
enable the savings on payroll taxes while adding to the dollar amount that’s
considered reasonable compensation.

Planning note. Your S corporation compensation
determines the amount that your S corporation can contribute to your SEP or
401(k) retirement plan. The defined benefit plan likely allows the corporation
to make a larger contribution on your behalf.

Section 199A Deduction

The
S corporation’s net income that is passed through to you, the shareholder, can
qualify for the 20 percent Section 199A tax deduction on your Form 1040.

Getting Around the New Law That Impairs the Stretch
IRA Strategy

Last
December, the Setting Every Community Up for Retirement Enhancement (SECURE)
Act became law.

The
SECURE Act was intended mainly to expand opportunities for individuals to
increase their retirement savings and to simplify the administration of
retirement plans. That’s the good part.

But
the act also included a big unfavorable change that kneecapped the so-called
stretch IRA estate planning strategy that was employed by well-off IRA owners.

The Stretch IRA Strategy

The
stretch IRA strategy involves keeping as much money as possible in your
traditional IRA or Roth IRA while you’re still alive and then leaving the
account to your spouse or a younger beneficiary, who keeps the inherited
account rolling for as long as possible and keeps collecting the tax benefits.
Thus, the term “stretch IRA.”

The
SECURE Act Imposes a New 10-Year Account Liquidation Rule That Seriously
Injures the Stretch IRA Strategy

Unfortunately
for the estate plans of well-off IRA owners and the tax situations of some of
their IRA beneficiaries, the SECURE Act requires most non-spouse beneficiaries
to drain inherited IRAs within 10 years after the account owner’s death.

As
we just explained, the pre–SECURE Act required minimum distribution (RMD) rules
allowed a non-spouse IRA beneficiary to gradually drain the substantial
traditional or Roth IRA inherited from good-ole Grandpa Frank over the
beneficiary’s IRS-defined life expectancy. That deal is off the table if
Grandpa Frank dies in 2020 or later.

Who
Is Affected by the SECURE Act Change?

The
SECURE Act’s anti-taxpayer 10-year account liquidation rule doesn’t affect RMDs
taken by original traditional IRA owners. They still operate under the same RMD
rules as before.

As
under pre–SECURE Act law, original owners of Roth IRAs need not take any RMDs
for as long as they live. Roth IRA owners are unaffected.

Beneficiaries
who want to quickly drain their inherited IRAs also are unaffected.

Bottom line. The 10-year account
liquidation rule affects only certain non-spouse beneficiaries who would
otherwise keep inherited accounts open for as long as possible to reap the tax
advantages.

Exception
for Eligible Designated Beneficiaries

The
SECURE Act’s 10-year account liquidation rule does not immediately affect
accounts inherited by a so-called eligible designated beneficiary.

An
eligible designated beneficiary is

·
the surviving spouse of the deceased account owner,

·
a minor child of the deceased account owner,

·
a beneficiary who is no more than 10 years younger than the
deceased account owner, or

·
a disabled or chronically ill individual.

Under
the exception for eligible designated beneficiaries, RMDs generally can be
taken from the inherited account over the life expectancy of the eligible
designated beneficiary, beginning with the year following the year of the
account owner’s death.

Other
non-spouse beneficiaries, whom we will call affected beneficiaries, will
be slammed by the 10-year account liquidation rule.

Following
the death of an eligible designated beneficiary, the account balance must be
distributed within 10 years.

The
account balance also must be distributed within 10 years after a child of the
account owner reaches the age of majority under local law.

10-Year
Account Liquidation Rule Specifics

When
applicable, the 10-year account liquidation rule generally applies regardless
of whether you, as the original account owner, die before or after your RMD
beginning date. Thanks to another SECURE Act change, the RMD rules do not kick
in until age 72 if you attain age 70 1/2 after 2019. If you are in that age
category, your required beginning date is April 1 of the year following the
year during which you attain age 72.

And
then, again thanks to the other SECURE Act change, an affected beneficiary must
drain the account inherited from you by the end of the 10th calendar year
following the year of your demise. Until that deadline is reached, your
beneficiary can leave the account untouched.

Failure
to comply with the 10-year account liquidation rule will expose the affected
beneficiary to a penalty equal to 50 percent of the account balance that
remains after the 10-year deadline has passed.

Reminder. As stated earlier, the
SECURE Act’s 10-year account liquidation rule applies only to affected
beneficiaries who inherit IRAs from original account owners who die after 2019.
An IRA inherited by a non-spousal beneficiary from an original account owner
who died in 2019 or earlier is unaffected, so the inherited account can still
work as a stretch IRA, the same as before the SECURE Act.