Tax Saving Tips March 2020

At the end of this letter is a reprint of the Committee on Finance Report, Stimulus Package Outline, Chairman Chuck Grassley

Use Your Business to Maximize Charitable Donations
Giving to your church, school, or other 501(c)(3) charity is a noble act no matter how you choose to give.

But for the purposes of tax savings, some forms of giving are much more beneficial to you than are others. As a business owner, you can use some business strategies to get the money to these institutions as business expenses.

While this does not change anything from the institution’s perspective, it hugely increases your tax savings. The Tax Cuts and Jobs Act (TCJA) makes it harder to benefit from your personal donations.

Let’s say you donate $10,000 to a church, school, or other 501(c)(3) charity:

Will you get a tax deduction—in other words, will you itemize?
Will you benefit from the entire $10,000 as an itemized deduction? In other words, did the $10,000 simply put you over the hump that beat the standard deduction?
Say you can deduct all $10,000 as an itemized deduction. Would making it a business deduction increase the tax benefit value to you?

The TCJA made two big changes that make it less likely that you will itemize. First, the TCJA set a $10,000 limit on your state and local income and property tax deductions. Second, it increased the 2020 standard deductions (adjusted for inflation) to

$12,400 for individuals, and
$24,800 for married couples filing jointly.

Even if you make a big donation, think about the problem this creates—suppose you are married and donate $17,000 to charity. If this is your only itemized deduction, your donation does you no good because it’s less than $24,800. Fortunately, there’s a much more tax-savvy way to give.

As a business owner, you can make a few modifications and convert your church, school, and other 501(c)(3) donations to a different type of deduction—an ordinary business expense—which increases the tax savings that land in your pocket year after year.

To turn a charitable donation into a business expense, the donation has to be involved in some way in promoting your business. In one way or another, you need to prove that your strategy has as its purpose attracting customers and revenue for your business.

The tax law rule is that your donation must

have a direct relationship to your business, and
create a reasonable expectation for a commensurate economic return.

Here are four examples of successful business practices that benefit charities and create business deductions:

In the Marcell case, the owner of a trucking company contributed cash to a hospital because he wanted to impress the chairman of the charity drive, who was a potential customer. The court found that Philip Marcell had a reasonable expectation for a commensurate return on his donation and treated the contribution as a business expense.
ABC Company attaches rebate slips to some of its products that it sells to customers. The customers can then present the rebate slips to the charity, at which point ABC Company pays the charity the amount listed on the slip.
In Revenue Ruling 72-314, the IRS ruled that the stockbroker corporation that paid 6 percent of its brokerage commissions to the neighborhood charity could deduct the payments as business expenses because there was a reasonable expectation that the arrangement with the charity would direct new business to the brokerage and help retain existing business.
Sarah Marquis, a sole-proprietor travel agent, made payments to charities on the basis of business they did with her. She had 30 charities as clients, and those 30 charities accounted for 57 percent of her business.

Eight Things to Know About the SECURE Act
The Setting Every Community Up for Retirement Enhancement (SECURE) Act changed the landscape for retirement and savings planning.

Here are eight important reminders about this new law:

You can’t use contributions made in 2020 but applied to 2019 for any SECURE Act provisions that apply to contributions made after December 31, 2019.
If you inherit an IRA, you now have to empty it within 10 years. But there are many exceptions to this rule, including one for the surviving spouse.
You determine whether your inherited IRA qualifies for the old stretch IRA rules on the date of death of the original owner.
The “qualified birth and adoption” distribution exception to the 10 percent penalty is $5,000 per child per parent, based on our reading of the law.
Your inherited IRA distributions don’t count toward your RMDs for your other retirement accounts.
Minors who inherit an IRA get the old stretch rules, but once they reach the age of majority, they have 10 years from that date to deplete the account.
The new $10,000 Section 529 allowable distribution for payments of principal and interest on student loans is a lifetime limit on the beneficiary, but you (the account holder) can apply excess distributions to the beneficiary’s sibling, and those distributions count toward the sibling’s $10,000 lifetime limit.
The ability to retroactively create a stock bonus, pension, profit-sharing, or annuity plan does not allow plan participants to make retroactive elective deferrals. The retroactively created plan allows business contributions only. Remember, the retroactive ability applies in 2021. You hurt your plan participants by waiting. Don’t wait. Put your 2020 plan in place now.

Avoid the Gift Tax—Use the Tuition and Medical Strategy
If you or a well-off relative are facing the gift and estate tax, here’s a planning opportunity often overlooked: pay tuition and medical expenses for loved ones. Such payments, structured correctly, do not represent gifts.

The monies spent by you on the qualified medical and tuition payments reduce your net worth and taxable estate, but they do no harm to your income, gift, or estate taxes. Further, the loved one who benefits from your help does not incur any tax issues.

As unusual as this sounds, with the tuition and medical payments, you operate in a tax-free zone.

Gift and Estate Tax Exclusion

If you die in 2020, your heirs won’t pay any estate or gift taxes if your estate and taxable gifts total less than $11.58 million.

If you are married and have done some planning, you and your spouse can avoid estate and gift taxes on up to $23.16 million.

Lawmakers set the current rates with the TCJA and also set them to drop by 50 percent in 2026. Gifts made now continue as excludable should they exceed the upcoming 50 percent drop.

Beating the Gift Tax with Tuition

The tuition exception to the normal gift tax rules involves direct payment of tuition (money for enrollment) made to an educational organization on behalf of another individual.

You may not two-step this. For example, you can’t write a check to granddaughter Amy for $50,000 that she in turn uses for her tuition. Here, you made a $50,000 gift.

But if you write the $50,000 check directly to the educational organization to pay for Amy’s tuition, you are in the tax-free zone. The $50,000 does not bite into your gift and estate tax exemptions, because it’s for tuition.

The unlimited benefit here applies only to tuition for full-time and part-time students. You can’t use it for items such as dorm fees and books. You can’t pay the money to a trust and then require the trust to pay a grandchild’s future tuition costs (this fails the test for direct payment to the institution).

Qualifying Educational Organization

Tax code Section 170(b)(1)(A)(ii) defines “educational organization” as “an educational organization which normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on.”

The regs elaborate by explaining that the term “educational institution” includes primary, secondary, preparatory, or high schools, and colleges and universities.

Example. You have four children, ages 7, 8, 9, and 10, at a private school where the tuition is $17,000 per year per student. Grandma Grace pays directly to the school the tuition for each of the children. Grandma Grace has no gift tax or other tax issues. Her payments are in the tax-free zone.

You can also pay the tuition to a foreign university. That tuition payment is in the tax-free zone just as if you had paid it to the University of Chicago.

Irrevocable prepaid tuition meets the rules and offers planning opportunities. Grampa Zeke has four grandchildren, all in the first and second grades of private schools. He sets up and funds an irrevocable plan with each of the private schools to pay the tuition at their respective schools. The plans qualify for tax-free zone treatment.

Planning note. Prepaid tuition can be a great death-bed strategy.

Beating the Gift Tax with Medical

The tax-free zone treatment of medical expenses requires that you pay the money directly to the medical care provider or insurance company (when paying for health insurance).

Under this plan, you avoid gift taxes when you pay directly to the provider any medical expense that would qualify as an itemized deduction on your Form 1040. Here are the basics:

Qualifying medical expenses are limited to those expenses defined in Section 213(d) and include expenses incurred for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body or for transportation primarily for and essential to medical care. (See IRS Pub. 502, Medical and Dental Expenses for an easy-to-understand list of itemized medical deductions—note this link produces a PDF of the publication.)
In addition, the unlimited exclusion from the gift tax includes amounts paid directly to the insurance company for medical insurance on behalf of any individual.
The unlimited exclusion from the gift tax does not apply to amounts paid for medical care that are reimbursed by the donee’s insurance. Thus, if payment for a medical expense is reimbursed by the donee’s insurance company, the donor’s payment for that expense, to the extent of the reimbursed amount, is not eligible for the unlimited exclusion from the gift tax, and the gift is treated as having been made on the date the reimbursement is received by the donee.

Example. Sam, your buddy, takes a big fall while climbing Mount Everest. You pay $67,000 of his medical bills directly to the medical providers. You are in the tax-free zone and face no gift tax.

Say that the insurance company reimburses Sam for $31,000 of the medical bills that you paid, and Sam keeps the money. Now, you have the following tax situation:

You have $36,000 of medical bills that you paid directly to the provider that are in the tax-free zone and not subject to gift taxes ($67,000 – $31,000).
You can avoid $15,000 of gift taxes because of the 2020 annual exclusion. Thus, of the $31,000 reimbursed to Sam by the insurance company, you pay gift taxes on $16,000 and avoid taxes on the remaining $15,000 because of the annual exclusion.

Final Thoughts

The primary rule to remember when using the tuition and medical gift tax-free strategy is that you must make the payments directly to the institutions and providers. Imbed this rule in your brain as rule one for this strategy. Don’t violate it.

If you have a loved one who needs tuition or medical help from you, use the tax-free zone method. For example, you have an estate tax problem and Uncle Jimmy needs help with his medical bills. Don’t make a monetary gift to Jimmy to help him. Instead, make your checks payable to the medical providers who are billing Uncle Jimmy.

Even if you don’t have a gift tax problem today, use the tax-free method because, who knows, you could win the lottery tomorrow.

And don’t forget this strategy. Sure, you have an $11.58 million estate and gift tax exemption this year. In 2026, that’s scheduled to drop by 50 percent (adjusted for inflation). But the current deficit issues could trigger a drop to, say, the 2008 exemption amount of $2 million, or lower.

Beat the Unfair $10,000 SALT Cap with a C Corporation
C corporations cause double taxation for business owners, so you probably think you want to avoid them at all costs.

And for many of you, this is true, as the S corporation often provides the lower overall tax outcome.

But for some of you, the C corporation could provide the best tax outcome because it bypasses the $10,000 state and local tax (SALT) deduction cap, which was introduced by the Tax Cuts and Jobs Act (TCJA).

Prior to the TCJA, you could deduct as itemized deductions on your Form 1040, Schedule A—without limit—the following foreign, state, and local taxes:

Income taxes
Real property taxes
Personal property taxes
Foreign income and real property taxes

Tax reform took two direct actions against your Form 1040 itemized deductions for foreign, state, and local taxes. Beginning in tax year 2018,

you can’t deduct foreign real property taxes, and
your combined state and local income, real property, and personal property tax deductions may not exceed $10,000 ($5,000 on a married filing separate return).

If you operate your business as an S corporation, the S corporation passes its net income to your individual tax return. This causes you, the individual, to pay state income taxes on the S corporation income. Those state income taxes are subject to the $10,000 cap.

C Corporation Loophole

But there is an exception: This $10,000 limit applies only to individuals—meaning, taxes deducted on your Form 1040, Schedule A. The limit does not apply to C corporations.

If you operate your business as a C corporation, then your C corporation pays state income taxes on its net income and deducts those taxes on its corporate income tax return.

Husband-Wife Partnerships: The Tax Angles
When both members of a married couple participate in an unincorporated business venture, must it be treated as a husband-wife partnership for federal tax purposes? Answer: maybe, or maybe not. Figuring out the answer is important because it can have a huge impact on the couple’s self-employment tax situation.

Husband-wife partnerships must also file annual federal returns on Form 1065 along with the related Schedules K-1. As you know, partnership returns can be a pain. For these reasons, you generally want to avoid husband-wife partnership status when possible.

Example: Self-employment Tax Hit on Profitable Husband-Wife Partnership

Your husband-wife partnership will produce $250,000 of net self-employment income in 2020 (after applying the 0.9235 factor that reduces net income to taxable self-employment income on Schedule SE).

Assume the $250,000 is properly split 50/50 between you and your spouse ($125,000 for each). You owe $19,125 of self-employment tax (15.3 percent x $125,000), and so does your spouse, for a combined total of $38,250.

The problem with husband-wife partnership status in your situation is that the maximum 15.3 percent self-employment tax rate hits $125,000 of net self-employment income not once but twice (first on your Schedule SE and again on your spouse’s separate Schedule SE).

In contrast, if you could say that your business is a sole proprietorship run only by you, only you would be on the hook for the self-employment tax.

You would pay the maximum 15.3 percent self-employment tax rate on the first $137,700 of your 2020 net self-employment income, but the self-employment tax hit would be “only” $24,325 [(15.3 percent x $137,700) + (2.9 percent x $112,300) = $24,325]. That’s a lot better than the $38,250 self-employment tax hit if your business is classified as a 50/50 husband-wife partnership.

When Does the Husband-Wife Partnership Actually Exist for Tax Purposes?

Good question. As you can see from the preceding example, the self-employment tax can make the husband-wife partnership an expensive proposition. Of course, the IRS would love it if you had to treat it that way.

Not surprisingly, several IRS publications attempt to create the impression that involvement by both spouses in an unincorporated business activity usually creates a partnership for federal tax purposes.

IRS Publication 334 (Tax Guide for Small Business) says the following:

If you and your spouse jointly own and operate an unincorporated business and share in the profits and losses, you are partners in a partnership, whether or not you have a formal partnership agreement.

In other words, you don’t have to believe that you have a husband-wife partnership to have a husband-wife partnership for tax purposes.

Similarly, IRS Publication 541 (Partnerships) says:

If spouses carry on a business together and share in the profits and losses, they may be partners whether or not they have a formal partnership agreement. If so, they should report income or loss from the business on Form 1065.

But in many (if not most) cases, the IRS will have a tough time prevailing on the husband-wife partnership issue. Consider the following direct quote from IRS Private Letter Ruling 8742007:

Whether parties have formed a joint venture is a question of fact to be determined by reference to the same principles that govern the question of whether persons have formed a partnership which is to be accorded recognition for tax purposes. Therefore, while all circumstances are to be considered, the essential question is whether the parties intended to, and did in fact, join together for the present conduct of an undertaking or enterprise.

The following factors, none of which is conclusive, are evidence of this intent:

the agreement of the parties and their conduct in executing its terms;
the contributions, if any, that each party makes to the venture;
control over the income and capital of the venture and the right to make withdrawals;
whether the parties are co-proprietors who share in net profits and who have an obligation to share losses; and
whether the business was conducted in the joint names of the parties and was represented to be a partnership.

In many (if not most) real-life situations where both spouses have some involvement in an activity that has been treated as a sole proprietorship, or in an activity that has been operated using a disregarded single-member LLC that has been treated as a sole proprietorship for tax purposes, only some of the five factors listed in Private Letter Ruling 8742007 will be present. Therefore, in many such cases, the IRS may not succeed in making the husband-wife partnership argument.

Regardless of the presence or absence of the other factors listed above, the husband-wife partnership (LLC) argument is especially weak when (1) the spouses have no discernible partnership agreement and (2) the business has not been represented as a partnership to third parties (for example, to banks and customers).

If You Don’t Want 100 Percent Depreciation, Elect Out or Else
As you likely know, the TCJA increased bonus depreciation to 100 percent. Unlike most tax provisions that involve a tax election, this one requires you to elect out if you don’t want it.

For example, you (or your corporation) buy two $50,000 trucks, each with a gross vehicle weight rating of 6,500 pounds and a bed length of 6.5 feet. You use the trucks 100 percent for business. Because of the weight and bed size, the trucks are exempt from the luxury passenger vehicle depreciation limits.

You have five choices on how to deduct the vehicles on your 2019 tax return (the one you are filing or about to file—we are in tax season):

Do nothing. This forces you to use bonus depreciation and deduct the entire $100,000 cost in year one. In addition, you deduct your operating expenses such as gas, oil, and insurance.
Elect out, choose Section 179 expensing of any amount of your $100,000 cost of the trucks, and depreciate the balance. For example, you could elect to deduct $30,000 of Section 179 expensing on each truck and then depreciate the remainder using MACRS. In addition, you deduct your operating expenses such as gas, oil, and insurance. (Note. The trucks are not subject to the $25,000 SUV ceiling because of their weight and bed length.)
Elect out, don’t use Section 179, and depreciate the trucks using the five-year MACRS depreciation schedule (which takes six years).
Elect out, don’t use Section 179, and depreciate the trucks using the five-year straight-line depreciation schedule (which also takes six years).
Use the 57.5 cents IRS standard mileage rate for each business mile driven. The 57.5 cents per mile rate includes operating expenses and 27 cents a mile for depreciation.

Okay, you get the big picture. Two trucks, each with a cost of $50,000 and both exempt from the luxury vehicle limits. Five choices as to the deduction.

Luxury Vehicles

Because of their gross vehicle weight, the vehicles mentioned above were exempt from the luxury vehicle depreciation limits that apply to

cars with curb weight of 6,000 pounds or less, and
SUVs, pickups, and crossover vehicles with a gross vehicle weight rating of 6,000 pounds or less.

Had the vehicles failed the weight test, their bonus depreciation for 2019 would have been limited to $18,100.