Prevent expense account padding with the right policies

Ask employees whether padding expense account reports is wrong and just about everyone will say “yes.” Yet inflated expenses continue to cost businesses thousands of dollars annually. For this reason, every company must establish the right policies to stop it.

How it works

To stop expense padding, you need to know how it works. Expense inflation — where an employee exaggerates the amount of the actual cost of a meal or cab ride and pockets the change — may be the most common expense-padding method.

But cheaters are also capable of inventing expenses and submitting fake documentation to support them or requesting multiple reimbursements by submitting the same receipt more than once. And watch out for mischaracterized expenses. In such schemes, employees provide legitimate documentation for non-business-related expenses, such as treating friends to a night out on the town, and characterize them as “business development” costs.

What to do

To prevent fraud, as well as simply handle expense reporting in a more accurate manner, you’ve got to establish and fine tune effective policies and processes. For example, if you’re still relying on paper reports, switching to an electronic reporting system may make it harder for employees to cheat. Your processes need to scrutinize expense reports and supporting documentation for:

• Inconsistencies,
• Miscalculations, and
• Receipt doctoring.

In addition, set limits such as requiring employees to fly coach class, stay in moderately priced hotels and adhere to a daily meal expense allowance. Also, specify the types of supporting documents you’ll accept — for example, original receipts, but not credit-card statements.

If expense padding becomes widespread, or its perpetrators are particularly devious, you may need to hire a fraud expert to conduct a thorough investigation. This will include examining expense records, interviewing suspect employees and gathering evidence. Be prepared to terminate — and perhaps prosecute — guilty parties.

Stop the bleeding

Don’t let employees bleed your business dry with fraudulent paper cuts. Please contact us for help reviewing your expense reporting system and identifying ways to strengthen it.

© 2016

Should you make a “charitable IRA rollover” in 2016?

Last year a break valued by many charitably inclined retirees was made permanent: the charitable IRA rollover. If you’re age 70½ or older, you can make direct contributions — up to $100,000 annually — from your IRA to qualified charitable organizations without owing any income tax on the distributions.

Satisfy your RMD

A charitable IRA rollover can be used to satisfy required minimum distributions (RMDs). You must begin to take annual RMDs from your traditional IRAs in the year in which you reach age 70½. If you don’t comply, you can owe a penalty equal to 50% of the amount you should have withdrawn but didn’t. (An RMD deferral is allowed for the initial year, but you’ll have to take two RMDs the next year.)

So if you don’t need the RMD for your living expenses, a charitable IRA rollover can be a great way to comply with the RMD requirement without triggering the tax liability that would occur if the RMD were paid out to you.

Additional benefits

You might be able to achieve a similar tax result from taking the RMD payout and then contributing that amount to charity. But it’s more complex because you must report the RMD as income and then take an itemized deduction for the donation. This has two more possible downsides:

• The reported RMD income might increase your income to the point that you’re pushed into a higher tax bracket, certain additional taxes are triggered and/or the benefits of certain tax breaks are reduced or eliminated. It could even cause Social Security payments to become taxable or increase income-based Medicare premiums and prescription drug charges.

 

• If your donation would equal a large portion of your income for the year, your deduction might be reduced due to the percentage-of-income limit. You generally can’t deduct cash donations that exceed 50% of your adjusted gross income for the year. (Lower limits apply to donations of long-term appreciated securities or made to private foundations.) You can carry forward the excess up to five years, but if you make large donations every year, that won’t help you.

A charitable IRA rollover avoids these potential negative tax consequences.

Have questions about charitable IRA rollovers or other giving strategies? Please contact us. We can help you create a giving plan that will meet your charitable goals and maximize your tax savings.

© 2016

Corporate shareholder-employees: Find the right compensation balance

The IRS may object to the compensation of C corporation shareholder-employees. If it’s deemed too high — or not “reasonable” under the circumstances — the IRS could force you to make adjustments that increase taxes.

This can be particularly troublesome for C corporation owners and executives who are also shareholders, because they’ll then be hit with double taxation.

When double taxation comes into play

When a corporation distributes profits as salaries, the firm gets a deduction for the amount. The owner or executive pays personal income tax on the money, of course, but it’s only taxed once. But if the corporation pays the owner or executive dividends, the money is taxed twice — once at the corporate level and again at the personal level. Plus, the business can’t deduct dividend payments.

But compensation must be reasonable. If the IRS considers it too high, it can label part of the payments as “disguised dividends,” which are taxed twice. There could also be back taxes and penalties.

What’s considered reasonable?

There’s no simple formula for determining a reasonable salary. The IRS will look at the amounts that similar corporations pay their executives for comparable services. Some of the other factors it considers are the employee’s duties, experience, expertise and hours worked.

Not surprisingly, the issue of reasonable compensation frequently winds up in court. To protect yourself, spell out the reasons for compensation amounts in your corporate minutes. The minutes should be reviewed by a tax professional before being finalized. Cite any executive compensation or industry studies, as well as other reasons why the compensation is reasonable.

If your business is profitable, you should generally pay at least some dividends. By doing so, you avoid the impression that the corporation is trying to pay out all profits as compensation. We can help determine whether dividends should be paid and, if so, how much they should be.

© 2016

Estate tax deferral offers relief to some business owners

If a substantial portion of your wealth is tied up in a family or closely held business, you may be concerned that your estate will lack sufficient liquid assets to pay estate taxes. In such cases, heirs may be forced to borrow funds or, in a worst-case scenario, sell the business in order to pay the tax.

For some business owners, Internal Revenue Code Section 6166 provides welcome relief. It permits qualifying estates to make an election to defer a portion of their estate tax liability for up to 14 years. Generally, during the first four years of the deferment period, the estate pays interest only, followed by 10 annual installments of principal and interest.

Consider your eligibility

An estate tax deferral is available if the value of an “interest in a closely-held business” exceeds 35% of your adjusted gross estate. A business is closely held if it conducts an active trade or business and it’s a:

• Sole proprietorship,
• Partnership or LLC (if your gross estate includes 20% or more of its capital interests or the entity has 45 or fewer partners or members), or
• Corporation (if your gross estate includes 20% of its voting stock or the corporation has 45 or fewer shareholders).

To determine whether you meet the 35% test, you may only include assets actually used in actively conducting a trade or business. Passively managing investment assets doesn’t count. Unfortunately, it’s not always easy to distinguish between the two — particularly when real estate is involved. The IRS considers several factors and has issued guidance on the matter.

Get professional guidance

An estate tax deferral might lend a helping hand to your family and business. But the rules are complex. We can provide professional guidance on whether this is the right strategy for you.

© 2016

The “kiddie tax”: A trap for the unwary

It’s common for parents, grandparents and others to make gifts to minors and college students. Perhaps you want to help fund education expenses or simply remove assets from your taxable estate. Or maybe you’re hoping to shift income into a lower tax bracket. Whatever the reason, beware of the “kiddie tax.”

What is the kiddie tax?

For children subject to the kiddie tax, any unearned income beyond $2,100 (for 2016) is taxed at their parents’ marginal rate (assuming it’s higher), rather than their own likely low rate.

For example, let’s say you transferred to your 16-year-old some stock you’d held for several years that had appreciated $10,000. You were thinking she’d be eligible for the 0% long-term gains rate so could sell the stock with no tax liability for your family. But you’d be in for an unhappy surprise: Assuming your daughter had no other unearned income, $7,900 of the gain would be taxed at your rate (15% or 20%, depending on your bracket).

Or let’s say you transferred the appreciated stock to your 18-year-old grandson with the plan that he could sell the stock tax-free to pay for his college tuition. If his parents are in a higher tax bracket, he won’t end up with the entire $10,000 gain available for tuition because of the kiddie tax liability.

Who’s a “kiddie”?

Years ago, the kiddie tax applied only to those under age 14 — providing families with the opportunity to enjoy significant tax savings from income shifting. Today, the kiddie tax applies to children under age 19 and to full-time students under age 24 (unless the students provide more than half of their own support from earned income).

Alternative strategies

Fortunately, there may be ways to achieve your goals without triggering the kiddie tax. For example, if you’d like to shift income and you have adult children who’re no longer subject to the kiddie tax but in a lower tax bracket, consider transferring income-producing or highly appreciated assets to them. Or, if you want to help your grandchild fund college, consider paying tuition directly to his or her school. An added bonus: a direct tuition payment isn’t subject to gift tax.

For more on the kiddie tax and ways to achieve your goals without triggering it, contact us.

© 2016

To deduct business losses, you may have to prove “material participation”

You can only deduct losses from an S corporation, partnership or LLC if you “materially participate” in the business. If you don’t, your losses are generally “passive” and can only be used to offset income from other passive activities. Any excess passive loss is suspended and must be carried forward to future years.

Material participation is determined based on the time you spend in a business activity. For most business owners, the issue rarely arises — you probably spend more than 40 hours working on your enterprise. However, there are situations when the IRS questions participation.

Several tests

To materially participate, you must spend time on an activity on a regular, continuous and substantial basis.

You must also generally meet one of the tests for material participation. For example, a taxpayer must:

1. Work 500 hours or more during the year in the activity,
2. Participate in the activity for more than 100 hours during the year, with no one else working more than the taxpayer, or
3. Materially participate in the activity for any five taxable years during the 10 tax years immediately preceding the taxable year. This can apply to a business owner in the early years of retirement.

There are other situations in which you can qualify for material participation. For example, you can qualify if the business is a personal service activity (such as medicine or law). There are also situations, such as rental businesses, where it is more difficult to claim material participation. In those trades or businesses, you must work more hours and meet additional tests.

Proving your involvement

In some cases, a taxpayer does materially participate, but can’t prove it to the IRS. That’s where good recordkeeping comes in. A good, contemporaneous diary or log can forestall an IRS challenge. Log visits to customers or vendors and trips to sites and banks, as well as time spent doing Internet research. Indicate the time spent. If you’re audited, it will generally occur several years from now. Without good records, you’ll have trouble remembering everything you did.

Passive activity losses are a complicated area of the tax code. Consult with your tax adviser for more information on your situation.

© 2016

HSA + HDHP = Your ideal benefits strategy?

 

Health Savings Accounts (HSAs) were created as a tax-favored framework to provide health care benefits mainly for small to midsize businesses and the self-employed. So, assuming your company falls into one of these categories, have you considered the strategy of using these accounts with a high-deductible health plan (HDHP)?

Tax benefits

The tax benefits of HSAs are quite favorable and substantial. Eligible individuals can make tax-deductible (as an adjustment to AGI) contributions into HSA accounts. The funds in the account may be invested (somewhat like an IRA), so there’s an opportunity for growth. The earnings inside the HSA are free from federal income tax, and funds withdrawn to pay eligible health care costs are tax-free.

An HSA is a tax-exempt trust or custodial account established exclusively for paying qualified medical expenses of the participant who, for the months for which contributions are made to an HSA, is covered under an HDHP. Consequently, an HSA isn’t insurance; it’s an account, which must be opened with a bank, brokerage firm, or other provider (typically an insurance company). It’s therefore different from a Flexible Spending Account in that it involves an outside provider serving as a custodian or trustee.

Dollar limits

The 2016 maximum contribution and deduction for individual self-only coverage under a high-deductible plan is $3,350, while the comparable amount for family coverage is $6,750. Individuals age 55 or older by the end of 2016 are allowed additional contributions and deductions of $1,000. However, when an individual enrolls in Medicare, contributions cannot be made to an HSA.

For 2016, an HDHP is defined as a health plan with an annual deductible that is not less than $1,300 for self-only coverage and $2,600 for family coverage, and the annual out-of-pocket expenses (including deductibles and co-payments, but not premiums) must not exceed $6,550 for self-only coverage or $13,100 for family coverage.

Worthy of consideration

An HSA with an HDHP is, of course, but one benefits strategy of many. But it’s worth considering. Please call us for help determining whether it would be the right move for your company this year or perhaps in 2017.