Consider key person insurance as a succession plan safeguard

In business, and in life, among the most important ways to manage risk is through insurance. For certain types of companies — particularly start-ups and small businesses — one major threat is the sudden loss of an owner or hard-to-replace employee. To safeguard against this risk, insurers offer key person insurance.

Under a key person policy, a business buys life insurance covering the owner or employee, pays the premiums and names itself beneficiary. Should the key person die while the policy is in effect, the business receives the payout. As you formulate and adjust your succession plan, one of these policies can serve as a critical safeguard.

Costs and coverage

Key person insurance can take a variety of forms. Term policies last for a specified number of years, typically five to 20. Whole life (or permanent) policies, which are generally more expensive, provide coverage as long as premiums are paid, and they gradually build up cash surrender value. This value appears on a business’s balance sheet and may be drawn on, if the business needs working capital.

The cost of key person insurance also depends on the covered individual’s health, age and medical history, as well as the desired death benefit. When budgeting for premiums, bear in mind that premiums generally aren’t tax deductible. On the flip side, death benefits typically aren’t included in the business’s taxable income when received.

In terms of coverage limits, insurers may quote a rule of thumb of eight to 10 times the key person’s annual salary. But every business will have different cash flow needs when a key person unexpectedly dies. A more accurate estimate typically comes from evaluating lost income (or value), as well as the costs of finding and training a suitable replacement.

An important decision

If you’ve already chosen a successor, you can buy a policy that covers both of you. And if you haven’t, it may be even more critical to buy coverage on your life to protect the solvency of your business. Please contact our firm for help deciding whether key person insurance is for you.

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Victims of a disaster, fire or theft may be able to claim a casualty loss deduction

If you suffered damage to your home or personal property last year, you may be able to deduct these “casualty” losses on your 2016 federal income tax return. A casualty is a sudden, unexpected or unusual event, such as a natural disaster (hurricane, tornado, flood, earthquake, etc.), fire, accident, theft or vandalism. A casualty loss doesn’t include losses from normal wear and tear or progressive deterioration from age or termite damage.

Here are some things you should know about deducting casualty losses:

When to deduct. Generally, you must deduct a casualty loss on your return for the year it occurred. However, if you have a loss from a federally declared disaster area, you may have the option to deduct the loss on an amended return for the immediately preceding tax year.

Amount of loss. Your loss is generally the lesser of 1) your adjusted basis in the property before the casualty (typically, the amount you paid for it), or 2) the decrease in fair market value of the property as a result of the casualty. This amount must be reduced by any insurance or other reimbursement you received or expect to receive. (If the property was insured, you must have filed a timely claim for reimbursement of your loss.)

$100 rule. After you’ve figured your casualty loss on personal-use property, you must reduce that loss by $100. This reduction applies to each casualty loss event during the year. It doesn’t matter how many pieces of property are involved in an event.

10% rule. You must reduce the total of all your casualty or theft losses on personal-use property for the year by 10% of your adjusted gross income (AGI). In other words, you can deduct these losses only to the extent they exceed 10% of your AGI.

Have questions about deducting casualty losses? Contact us!

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2017 Q2 tax calendar: Key deadlines for businesses and other employers

Here are some of the key tax-related deadlines affecting businesses and other employers during the second quarter of 2017. Keep in mind that this list isn’t all-inclusive, so there may be additional deadlines that apply to you. Contact us to ensure you’re meeting all applicable deadlines and to learn more about the filing requirements.

April 18

• If a calendar-year C corporation, file a 2016 income tax return (Form 1120) or file for an automatic six-month extension (Form 7004), and pay any tax due. If the return isn’t extended, this is also the last day to make 2016 contributions to pension and profit-sharing plans.
• If a calendar-year C corporation, pay the first installment of 2017 estimated income taxes.

May 1

• Report income tax withholding and FICA taxes for first quarter 2017 (Form 941), and pay any tax due. (See exception below.)

May 10

• Report income tax withholding and FICA taxes for first quarter 2017 (Form 941), if you deposited on time and in full all of the associated taxes due.

June 15

• If a calendar-year C corporation, pay the second installment of 2017 estimated income taxes.

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Offer plan loans? Be sure to set a reasonable interest rate

Like many businesses, yours may allow retirement plan participants to take out loans from their accounts. Such loans are governed by many IRS and Department of Labor (DOL) rules and regulations. So if your company offers plan loans, your plan document must comply with current laws — including setting a “reasonable” interest rate.

Agency perspectives

Neither the IRS nor DOL provides a set percentage for plan sponsors to use. Yet both require the rate to be “reasonable.” The IRS asks if the interest rate is similar to local interest rates and to what local banks charge individuals for similar loans with similar credit and collateral. Meanwhile, DOL regulations say that an interest rate is reasonable if it’s equal to commercial lending interest rates under similar circumstances.

The DOL provides several examples of how to determine the interest rate. For example, suppose the plan loan interest rate is set at 8%, but local banks offer between 10% and 12% for similar circumstances. In this example, the loan will fail to meet the reasonable standard.

Keep in mind that the plan participant pays the interest to his or her own retirement plan account. That’s one reason why charging an interest rate that’s lower than what local banks are charging isn’t considered reasonable. The purpose of charging interest on retirement plan loans is to help prevent long-term harm to the participant’s retirement nest egg.

Ill consequences

If your plan fails to assess a reasonable interest rate, participant loans may result in a prohibited transaction. What does this mean? Prohibited transactions are certain transactions between a retirement plan and a disqualified person. Disqualified persons taking part in a prohibited transaction must pay a tax.

A prohibited transaction includes the lending of money or other extension of credit between a plan and a disqualified person. However, the laws specifically exempt plan loans from the prohibited transaction list as long as they comply with applicable rules. If your interest rate isn’t reasonable, the plan loan may lose its exempt status and become subject to the prohibited transaction tax.

Ongoing task

Ensuring you’re offering a reasonable plan loan interest rate is an ongoing task. Review your plan document and loan policy statement to determine whether the plan sets an interest rate. You may need to update the document to comply with the more recent regulations and interest rates. We can help you with this review, as well as in calculating a reasonable rate.

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Who can — and who should — take the American Opportunity credit?

If you have a child in college, you may be eligible to claim the American Opportunity credit on your 2016 income tax return. If, however, your income is too high, you won’t qualify for the credit — but your child might. There’s one potential downside: If your dependent child claims the credit, you must forgo your dependency exemption for him or her. And the child can’t take the exemption.

The limits

The maximum American Opportunity credit, per student, is $2,500 per year for the first four years of postsecondary education. It equals 100% of the first $2,000 of qualified expenses, plus 25% of the next $2,000 of such expenses.

The ability to claim the American Opportunity credit begins to phase out when modified adjusted gross income (MAGI) enters the applicable phaseout range ($160,000–$180,000 for joint filers, $80,000–$90,000 for other filers). It’s completely eliminated when MAGI exceeds the top of the range.

Running the numbers

If your American Opportunity credit is partially or fully phased out, it’s a good idea to assess whether there’d be a tax benefit for the family overall if your child claimed the credit. As noted, this would come at the price of your having to forgo your dependency exemption for the child. So it’s important to run the numbers.

Dependency exemptions are also subject to a phaseout, so you might lose the benefit of your exemption regardless of whether your child claims the credit. The 2016 adjusted gross income (AGI) thresholds for the exemption phaseout are $259,400 (singles), $285,350 (heads of households), $311,300 (married filing jointly) and $155,650 (married filing separately).

If your exemption is fully phased out, there likely is no downside to your child taking the credit. If your exemption isn’t fully phased out, compare the tax savings your child would receive from the credit with the savings you’d receive from the exemption to determine which break will provide the greater overall savings for your family.

We can help you run the numbers and can provide more information about qualifying for the American Opportunity credit.

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Make sure the IRS won’t consider your business to be a “hobby”

If you run a business “on the side” and derive most of your income from another source (whether from another business you own, employment or investments), you may face a peculiar risk: Under certain circumstances, this on-the-side business might not be a business at all in the eyes of the IRS. It may be a hobby.

The hobby loss rules

Generally, a taxpayer can deduct losses from profit-motivated activities, either from other income in the same tax year or by carrying the loss back to a previous tax year or forward to a future tax year. But, to ensure these pursuits are really businesses — and not mere hobbies intended primarily to offset other income — the IRS enforces what are commonly referred to as the “hobby loss” rules.

If you haven’t earned a profit from your business in three out of five consecutive years, including the current year, you’ll bear the burden of proof to show that the enterprise isn’t merely a hobby. But if this profit test can be met, the burden falls on the IRS. In either case, the agency looks at factors such as the following to determine whether the activity is a business or a hobby:

• Do you carry on the activity in a business-like manner?
• Does the time and effort put into the activity indicate an intention to make a profit?
• Do you depend on income from the activity?
• If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
• Have you changed methods of operation to improve profitability?
• Do you (or your advisors) have the knowledge needed to carry on the activity as a successful business?
• Have you made a profit in similar activities in the past?
• Does the activity make a profit in some years?
• Do you expect to make a profit in the future from the appreciation of assets used in the activity?

Dangers of reclassification

If your enterprise is reclassified as a hobby, you can’t use a loss from the activity to offset other income. You may still write off certain expenses related to the hobby, but only to the extent of income the hobby generates. If you’re concerned about the hobby loss rules, we can help you evaluate your situation.

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Getting your money’s worth out of a company retreat

Company retreats can cost enormous amounts of time and money. Are they worth it? Sometimes. Large-scale get-togethers can involve considerable out-of-pocket costs. And if the retreat is poorly planned or executed, participants’ wasted time is the biggest expense.

But a properly budgeted, planned and executed retreat can be hugely profitable, producing fresh ideas, renewed enthusiasm and heightened employee morale. Here are a few ways to get your money’s worth out of a company retreat.

Create specific objectives

First, nail down your goals and objectives. Several months ahead of time, determine and prioritize a list of the important issues you want to address. But include only the top two or three on the final agenda. Otherwise, you risk rushing through some items without adequate time for discussion and formalized action plans.

If one of the objectives is to include time for socializing, recreation or relaxation, great. Mixing fun with work keeps people energized. But if staff see the retreat as merely time away from the office to party and golf, don’t expect to complete many work-related agenda items. One successful way to mix work and pleasure is to schedule work sessions for the morning and more fun, team-building exercises later in the day.

Set limits, allow flexibility

Next, work on the budget. Determining available resources early in the planning process will help you set limits for such variable costs as location, accommodations, food, transportation, speakers and entertainment.

Instead of insisting on certain days for the retreat, select a range of possible dates. This openness helps with site selection and makes it easier to negotiate favorable hotel and travel rates. Keep your budget as flexible as possible, building in a 5% to 10% safety cushion. Always expect unforeseen, last-minute expenses.

Have fun

Company retreats are serious business in the sense that you’re sacrificing time and productivity to identify strategic goals and improve teamwork. But these events should still be fun experiences for you and your staff. We can help you establish a reasonable budget to help ensure an enjoyable, productive and cost-effective retreat.

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2016 IRA contributions — it’s not too late!

Yes, there’s still time to make 2016 contributions to your IRA. The deadline for such contributions is April 18, 2017. If the contribution is deductible, it will lower your 2016 tax bill. But even if it isn’t, making a 2016 contribution is likely a good idea.

Benefits beyond a deduction

Tax-advantaged retirement plans like IRAs allow your money to grow tax-deferred — or, in the case of Roth accounts, tax-free. But annual contributions are limited by tax law, and any unused limit can’t be carried forward to make larger contributions in future years.

This means that, once the contribution deadline has passed, the tax-advantaged savings opportunity is lost forever. So it’s a good idea to use up as much of your annual limit as possible.

Contribution options

The 2016 limit for total contributions to all IRAs generally is $5,500 ($6,500 if you were age 50 or older on December 31, 2016). If you haven’t already maxed out your 2016 limit, consider making one of these types of contributions by April 18:

1. Deductible traditional. If you and your spouse don’t participate in an employer-sponsored plan such as a 401(k) — or you do but your income doesn’t exceed certain limits — the contribution is fully deductible on your 2016 tax return. Account growth is tax-deferred; distributions are subject to income tax.

2. Roth. The contribution isn’t deductible, but qualified distributions — including growth — are tax-free. Income-based limits, however, may reduce or eliminate your ability to contribute.

3. Nondeductible traditional. If your income is too high for you to fully benefit from a deductible traditional or a Roth contribution, you may benefit from a nondeductible contribution to a traditional IRA. The account can still grow tax-deferred, and when you take qualified distributions you’ll be taxed only on the growth. Alternatively, shortly after contributing, you may be able to convert the account to a Roth IRA with minimal tax liability.

Want to know which option best fits your situation? Contact us.

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The Section 1031 exchange: Why it’s such a great tax planning tool

Like many business owners, you might also own highly appreciated business or investment real estate. Fortunately, there’s an effective tax planning strategy at your disposal: the Section 1031 “like kind” exchange. It can help you defer capital gains tax on appreciated property indefinitely.

How it works

Section 1031 of the Internal Revenue Code allows you to defer gains on real or personal property used in a business or held for investment if, instead of selling it, you exchange it solely for property of a “like kind.” In fact, these arrangements are often referred to as “like-kind exchanges.” Thus, the tax benefit of an exchange is that you defer tax and, thereby, have use of the tax savings until you sell the replacement property.

Personal property must be of the same asset or product class. But virtually any type of real estate will qualify as long as it’s business or investment property. For example, you can exchange a warehouse for an office building, or an apartment complex for a strip mall.

Executing the deal

Although an exchange may sound quick and easy, it’s relatively rare for two owners to simply swap properties. You’ll likely have to execute a “deferred” exchange, in which you engage a qualified intermediary (QI) for assistance.

When you sell your property (the relinquished property), the net proceeds go directly to the QI, who then uses them to buy replacement property. To qualify for tax-deferred exchange treatment, you generally must identify replacement property within 45 days after you transfer the relinquished property and complete the purchase within 180 days after the initial transfer.

An alternate approach is a “reverse” exchange. Here, an exchange accommodation titleholder (EAT) acquires title to the replacement property before you sell the relinquished property. You can defer capital gains by identifying one or more properties to exchange within 45 days after the EAT receives the replacement property and, typically, completing the transaction within 180 days.

The rules for like-kind exchanges are complex, so these arrangements present some risks. If, say, you exchange the wrong kind of property or acquire cash or other non-like-kind property in a deal, you may still end up incurring a sizable tax hit. Be sure to contact us when exploring a Sec. 1031 exchange.

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Listen and trust: The power of collaborative management

Many business owners are accustomed to running the whole show. But as your company grows, you’ll likely be better off sharing responsibility for major decisions. Whether you’ve recruited experienced managers or developed “home grown” talent, you can empower these employees by taking a more collaborative approach to management.

Not employees — team members

Successful collaboration starts with a new mindset. Stop thinking of your managers as employees and instead regard them as team members working toward the same common goals. To promote collaboration and make the best use of your human resources, clearly communicate your strategic objectives. For example, if you’ve prioritized expanding into new territories, make sure your managers aren’t still focusing on extracting new business from current sales areas.

You also must be willing to listen to your managers’ ideas — and to act on the viable ones. Relinquishing control can be hard for business owners, but keep the advantages in mind. A collaborative approach distributes the decision-making burden, so it doesn’t fall on just your shoulders. This may relieve stress and allow you to focus on areas of the company you may have neglected.

Confidence and development

Even as you move to a more collaborative management model and include employees in strategic decisions, don’t forget to recognize their individual skills and talents. You and other managers may have uncertainties about a new marketing plan, for instance, but you should trust your marketing director to carry it out with minimal oversight.

To ensure that managers know they have your confidence, conduct regular performance reviews where you note their contributions and accomplishments and explore opportunities for growth. Moreover, help them grow professionally by providing constructive, ongoing training to develop their leadership and teamwork skills.

An open mind

As you learn to trust your management team with greater responsibility, keep in mind that the process can be bumpy. In a crisis, your instinct may be to take charge and brush off your managers’ advice. But it’s critical to keep your mind open and be receptive to input from people who may one day run your company. Let our firm assist you in assessing the profitability impact of your management team.

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When an elderly parent might qualify as your dependent

It’s not uncommon for adult children to help support their aging parents. If you’re in this position, you might qualify for the adult-dependent exemption. It allows eligible taxpayers to deduct up to $4,050 for each adult dependent claimed on their 2016 tax return.

Basic qualifications

For you to qualify for the adult-dependent exemption, in most cases your parent must have less gross income for the tax year than the exemption amount. (Exceptions may apply if your parent is permanently and totally disabled.) Generally Social Security is excluded, but payments from dividends, interest and retirement plans are included.

In addition, you must have contributed more than 50% of your parent’s financial support. If you shared caregiving duties with a sibling and your combined support exceeded 50%, the exemption can be claimed even though no one individually provided more than 50%. However, only one of you can claim the exemption.

Factors to consider

Even though Social Security payments can usually be excluded from the adult dependent’s income, they can still affect your ability to qualify. Why? If your parent is using Social Security money to pay for medicine or other expenses, you may find that you aren’t meeting the 50% test.

Don’t forget about your home. If your parent lives with you, the amount of support you claim under the 50% test can include the fair market rental value of part of your residence. If the parent lives elsewhere — in his or her own residence or in an assisted-living facility or nursing home — any amount of financial support you contribute to that housing expense counts toward the 50% test.

Easing the financial burden

Sometimes caregivers fall just short of qualifying for the exemption. Should this happen, you may still be able to claim an itemized deduction for the medical expenses that you pay for the parent. To receive a tax benefit, the combined medical expenses paid for you, your dependents and your parent must exceed 10% of your adjusted gross income.

The adult-dependent exemption is just one tax break that you may be able to employ to ease the financial burden of caring for an elderly parent. Contact us for more information on qualifying for this break or others.

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Filing deadline rapidly approaching for flow-through entities

The federal income tax filing deadline for calendar-year partnerships, S corporations and limited liability companies (LLCs) treated as partnerships or S corporations for tax purposes is March 15. While this deadline is nothing new for S corporation returns, it’s earlier than previous years for partnership returns.

In addition to providing continued funding for federal transportation projects, the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 changed the due dates for several types of tax and information returns, including partnership income tax returns. The revised due dates are generally effective for tax years beginning after December 31, 2015. In other words, they apply to the tax returns for 2016 that are due in 2017.

The new deadlines

The new due date for partnerships with tax years ending on December 31 to file federal income tax returns is March 15. For partnerships with fiscal year ends, tax returns are due the 15th day of the third month after the close of the tax year.

Under prior law, returns for calendar-year partnerships were due April 15. And returns for fiscal-year partnerships were due the 15th day of the fourth month after the close of the fiscal tax year.

One of the primary reasons for moving up the partnership filing deadline was to make it easier for owners to file their personal returns by the April 15 deadline (April 18 in 2017 because of a weekend and a Washington, D.C., holiday). After all, partnership (and S corporation) income flows through to the owners. The new date should allow owners to use the information contained in the partnership forms to file their personal returns.

Extension deadlines

If you haven’t filed your partnership or S corporation return yet, you may be thinking about an extension. Under the new law, the maximum extension for calendar-year partnerships is six months (until September 15). This is up from five months under prior law. So the extension deadline doesn’t change — only the length of the extension. The extension deadline for calendar-year S corporations also remains at September 15. But you must file for the extension by March 15.

Keep in mind that, to avoid potential interest and penalties, you still must (with a few exceptions) pay any tax due by the unextended deadline. There may not be any tax liability from the partnership or S corporation return. But if filing for an extension for the entity return causes you to also have to file an extension for your personal return, you need to keep this in mind related to the individual tax return April 18 deadline.

Filing for an extension can be tax-smart if you’re missing critical documents or you face unexpected life events that prevent you from devoting sufficient time to your return right now. Please contact us if you need help or have questions about the filing deadlines that apply to you or avoiding interest and penalties.

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Don’t make hunches — crunch the numbers

Some business owners make major decisions by relying on gut instinct. But investments made on a “hunch” often fall short of management’s expectations.

In the broadest sense, you’re really trying to answer a simple question: If my company buys a given asset, will the asset’s benefits be greater than its cost? The good news is that there are ways — using financial metrics — to obtain an answer.

Accounting payback

Perhaps the most common and basic way to evaluate investment decisions is with a calculation called “accounting payback.” For example, a piece of equipment that costs $100,000 and generates an additional gross margin of $25,000 per year has an accounting payback period of four years ($100,000 divided by $25,000).

But this oversimplified metric ignores a key ingredient in the decision-making process: the time value of money. And accounting payback can be harder to calculate when cash flows vary over time.

Better metrics

Discounted cash flow metrics solve these shortcomings. These are often applied by business appraisers. But they can help you evaluate investment decisions as well. Examples include:

Net present value (NPV). This measures how much value a capital investment adds to the business. To estimate NPV, a financial expert forecasts how much cash inflow and outflow an asset will generate over time. Then he or she discounts each period’s expected net cash flows to its current market value, using the company’s cost of capital or a rate commensurate with the asset’s risk. In general, assets that generate an NPV greater than zero are worth pursuing.

Internal rate of return (IRR). Here an expert estimates a single rate of return that summarizes the investment opportunity. Most companies have a predetermined “hurdle rate” that an investment must exceed to justify pursuing it. Often the hurdle rate equals the company’s overall cost of capital — but not always.

A mathematical approach

Like most companies, yours probably has limited funds and can’t pursue every investment opportunity that comes along. Using metrics improves the chances that you’ll not only make the right decisions, but that other stakeholders will buy into the move. Please contact our firm for help crunching the numbers and managing the decision-making process.

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