Below is an excerpt from Thompson PPPC that exemplifies one of CFS’ basic strategies: encourage business owners to purchase the building they operate out of. Please review for your benefit.
Use of rentals exception can cut self-employment tax
Taxpayers who own closely held businesses can maximize their tax savings by taking advantage of the self-employment tax “rentals exception” under which rentals from real estate and from personal property leased with the real estate (and the corresponding deductions) are excluded in determining net earnings from self-employment. The tax savings can be significant.
Background. The Federal Insurance Contributions Act (FICA) imposes two taxes on employers, employees, and self-employed workers—one for Old Age, Survivors and Disability Insurance (OASDI; commonly known as the Social Security tax), and the other for Hospital Insurance (HI; commonly known as the Medicare tax). For self-employed workers, the FICA tax normally is 15.3%—12.4% for OASDI and 2.9% for the Medicare tax. But for 2012, the self-employment tax rate is 13.3%—10.4% for OASDI, reflecting a two percentage point drop in the OASDI rate for employees, plus 2.9% for the Medicare tax.
There is generally a maximum amount of compensation subject to the OASDI tax, but no maximum for the Medicare tax. The Social Security Administration’s (SSA’s) Office of the Chief Actuary (OCA) has projected that the Social Security wage base for OASDI will increase from $110,100 for 2012 to $113,700 in 2013.
For tax years beginning after 2012, an additional 0.9% Medicare tax is imposed on taxpayers (other than corporations, estates, or trusts) receiving wages with respect to employment in excess of $200,000 ($250,000 for married couples filing jointly and $125,000 for married couples filing separately). (Code Sec. 3101(b)(2)) The tax only applies to the employee portion of Medicare tax. An additional 0.9% tax also applies to net earnings from self-employment. This tax was added by the 2010 Patient Protection and Affordable Care Act (PPACA, P.L. 111-148), which was largely upheld by the Supreme Court. For a Practice Alert on planning for the additional .9% tax, see Weekly Alert ¶ 38 05/03/2012.
In addition, for tax years beginning after Dec. 31, 2012, an unearned income Medicare contribution tax is imposed on individuals, estates, and trusts. For an individual, the tax is 3.8% of the lesser of (1) net investment income or (2) the excess of modified adjusted gross income (MAGI) over the threshold amount. (Code Sec. 1411(a)(1)) MAGI includes wages, salaries, tips, and other compensation; dividend and interest income; business and farm income; realized capital gains; income from a variety of other passive activities; and certain foreign earned income. (Code Sec. 1411(d)) The threshold amount is $250,000 for a joint return or surviving spouse, $125,000 for a married individual filing a separate return, and $200,000 for all others. (Code Sec. 1411(b)) The tax generally doesn’t apply to an active (i.e., nonpassive) trade or businesse conducted by a sole proprietor, partnership, or S corporation. (Committee Report) This tax was added by the Health Care and Education Reconciliation Act of 2010 (HCERA, P.L. 111-52). For a Practice Alert on planning for the additional 3.8% tax, see Weekly Alert ¶ 29 05/13/2010.
Self-employment tax. The self-employment tax is imposed on self-employment income, which is generally defined by Code Sec. 1402(b) as the net earnings from self-employment derived by an individual. In general, Code Sec. 1402(a) defines net earnings from self-employment as the gross income derived by an individual from any trade or business carried on by the individual, less the deductions allowed by the Code which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in Code Sec. 702(a)(8) from any trade or business carried on by a partnership of which he is a member.
Rentals exception. Certain items are specifically excluded in determining net earnings from self-employment. One of these exclusions is rentals from real estate and from personal property leased with the real estate (together with the deductions attributable to them). This “rentals exception” doesn’t apply to:
- Rentals received in the course of a trade or business as a real estate dealer;
- Rentals from real estate paid in crop shares if certain conditions are met; and
- Payments made for rooms or other space where services (e.g., maid service) are also rendered to and primarily for the occupant’s convenience. (Code Sec. 1402(a)(1), Reg. § 1.1402(a)-4(c)(2))
The “rentals exception” doesn’t apply to rentals received by an individual in the course of a trade or business as a real estate dealer. In general, an individual who is in the business of selling real estate to customers with a view to the gains and profits that may be derived from those sales is a real estate dealer, and the rents from the property are includible in net earnings from self-employment. Thus, a real estate dealer who receives rentals from real estate and from personal property leased with the real estate must include those rentals in self-employment income. (Code Sec. 1402(a)(1), Reg. § 1.1402(a)-4(a))
IRS has ruled that an individual who merely holds real estate for investment or speculation and receives rentals from the property isn’t considered a real estate dealer. Thus, an office building owner who provided normal building services and who was an investor, not a dealer, wasn’t subject to self-employment tax on the rentals. (Rev Rul 55-559, 1955-2 CB 315) Similarly, the Tax Court has held that a taxpayer who acquired 10 parcels of real estate for the purpose of producing rental income wasn’t a real estate dealer. He didn’t offer or advertise any of the parcels for sale and, although he lost the properties to foreclosure, the lenders who foreclosed weren’t his customers. (Blythe, (1999) TC Memo 1999-11)
Tax planning strategy. Taxpayers can withdraw money from their closely held business while dramatically cutting their self-employment income by simply leasing property they own to their closely held business. Under Code Sec. 1402(a)(1) and the regs, rentals from real estate and personal property leased with it, and the corresponding deductions, are excluded in computing net earnings from self-employment, unless received by a real estate dealer in the course of his trade or business.
Whether payments for the use of land or occupancy of rooms is rental income depends upon the nature and amount of services rendered the occupant by the landlord or owner. Reg. § 1.1402(a)-4(c)(2) provides that payments aren’t rental income if services are rendered primarily for the convenience of the occupant and are other than those usually rendered in connection with the rental of rooms or other space for occupancy only. For example, the furnishing of heat and light, the cleaning of public entrances, exits, stairways and lobbies, and the collection of trash aren’t services that turn rental income into self-employment income.
But, Reg. § 1.1402(a)-4(c)(2) provides that rents from living quarters aren’t exempt if the landlord provides services primarily for the occupant’s convenience, for example, maid service. Similarly, payments for the use or occupancy of rooms or other space aren’t rentals from real estate where services are also rendered to the occupant. For example, payment for the use or occupancy of rooms in hotels, boarding houses, or apartment houses furnishing hotel services, or in tourist camps or tourist homes, or space in parking lots, warehouses, or storage garages aren’t rent excluded from self-employment income. Such payments are included in determining net earnings from self-employment.
In Chief Counsel Advice 200816030, IRS concluded that a qualified joint venture election under Code Sec. 761(f) wouldn’t cause self-employment tax to be imposed on income from a rental real estate business that would otherwise be excluded. Each spouse had a share of the qualified joint venture income, and each spouse could exclude his or her respective share of the qualified joint venture income from net earnings from self-employment under the Code Sec. 1402(a)(1) exclusion.
References: For the self-employment rentals exception, see FTC 2d/FIN ¶ A-6105 ; United States Tax Reporter ¶ 14,024.04 ; TaxDesk ¶ 576,018 ; TG ¶ 1785
Tax Rates for the 2012 Tax Year
Federal income tax brackets for 2012
2012 Tax Rates
The year 2012 could be the last year for America’s current tax rate structure. Six tax rates, ranging from 10% to 35%, have been in place since 2003. The Tax Relief Act of 2010 temporarily extended the current tax rate structure through the end of 2012. Tax rates will revert automatically to their pre-2003 levels unless new legislation is passed.
For 2012, there will be six tax rates of:
* 33%, and
The tax rates for 2013 are scheduled to change as follows: the 10% rate will be collapsed into the 15% rate; the 25% rate will become 28%; the 28% rate will become 31%; the 33% rate will become 36%; and the 35% rate will become 39.6%. These tax rate changes will take effect beginning in 2013 absent further legislation.
Capital gain income might be taxed at different rates. There are special capital gains tax rates that apply for dividends, long-term investments, collectibles, and certain types of real estate.
Note: These tax rate schedules are provided for tax planning purposes. To compute your actual income tax, please see the 2012 instructions for Form 1040 and the 2012 Tax Tables.
Each tax rate applies to a range of income, which is called a tax bracket. Each tax rate applies to a specific range of taxable income, which is income after various deductions have been subtracted.
Single Filing Status
[Tax Rate Schedule X, Internal Revenue Code section 1(c)]
* 10% on taxable income from $0 to $8,700, plus
* 15% on taxable income over $8,700 to $35,350, plus
* 25% on taxable income over $35,350 to $85,650, plus
* 28% on taxable income over $85,650 to $178,650, plus
* 33% on taxable income over $178,650 to $388,350, plus
* 35% on taxable income over $388,350.
Married taxpayers can choose between filing a joint tax return or a separate tax return. The Married Filing Jointly filing status provides more tax benefits than filing separate returns, but taxpayers will need to weigh the pros and cons and decide for themselves which is the best filing status.
If you are married, then you and your spouse can filing a joint tax return. You are considered married if you are legally married on the last day of the year. In order to file jointly, both you and your spouse must agree to file a joint tax return, and both must sign the return. Married Filing Jointly (MFJ) provides more tax benefits than filing a separate return.
The IRS advises that, “If you and your spouse decide to file a joint return, your tax may be lower than your combined tax for the other filing statuses. Also, your standard deduction (if you do not itemize deductions) may be higher, and you may qualify for tax benefits that do not apply to other filing statuses” (from Publication 501, “Married Filing Jointly”).
What’s a Joint Tax Return?
By filing a joint tax return, both spouses report all their income, deductions, and credits. Both spouses must sign the return, and both spouses accept full responsibility for the accuracy and completeness of the information reported on the tax return.
The IRS cautions, “Both of you may be held responsible, jointly and individually, for the tax and any interest or penalty due on your joint return. One spouse may be held responsible for all the tax due even if all the income was earned by the other spouse” (from Publication 501). The IRS may grant relief from joint liability for taxes through innocent spouse relief, separation of liability, or equitable relief. Refer to Publication 971 (Innocent Spouse Relief) for additional information about these tax relief programs.
If your spouse died during the year, you can still file a joint return for that year. In the following years, you can file as a surviving spouse, as head of household, or as a single taxpayer. The IRS explains, “If your spouse died during the year, you are considered married for the whole year and can choose married filing jointly as your filing status” (from Publication 501).
Filing Joint versus Separate Returns
Filing a separate return provides relief from joint liability for taxes. However, married taxpayers who file separately are not eligible for many tax deductions and credits, and have higher tax rates. In general, it is more advantageous to file a joint return.
Domestic Partners Cannot File Joint Returns
The IRS does not follow state law for recognizing same-sex marriages. The Federal Defense of Marriage Act of 1996 defined marriage as “a legal union between one man and one woman as husband and wife, and the word ‘spouse’ refers only to a person of the opposite sex who is a husband or a wife.”
Some states, such as California, are requiring domestic partners to file tax returns as if they were married. Domestic partners should consult with an experienced tax professional for advice on filing their federal and state tax returns.
Election for Husband and Wife Unincorporated Businesses
An unincorporated business jointly owned by a married couple is generally classified as a partnership for Federal tax purposes. For tax years beginning after December 31, 2006, the Small Business and Work Opportunity Tax Act of 2007 (Public Law 110-28) provides that a “qualified joint venture,” whose only members are a husband and a wife filing a joint return, can elect not to be treated as a partnership for Federal tax purposes.
Reasons why a Husband and Wife might want to make the election not to be treated as a partnership
Because a business jointly owned and operated by a married couple is generally treated as a partnership for Federal tax purposes, the spouses must comply with filing and record keeping requirements imposed on partnerships and their partners. Married co-owners failing to file properly as a partnership may have been reporting on a Schedule C in the name of one spouse, so that only one spouse received credit for social security and Medicare coverage purposes. The election permits certain married co-owners to avoid filing partnership returns, provided that each spouse separately reports a share of all of the businesses’ items of income, gain, loss, deduction, and credit. Under the election, both spouses will receive credit for social security and Medicare coverage purposes.
Definition of a qualified joint venture
A qualified joint venture is a joint venture that conducts a trade or business where (1) the only members of the joint venture are a husband and wife who file a joint return, (2) both spouses materially participate in the trade or business, and (3) both spouses elect not to be treated as a partnership. A qualified joint venture, for purposes of this provision, includes only businesses that are owned and operated by spouses as co-owners, and not in the name of a state law entity (including a limited partnership or limited liability company) (See below). Note also that mere joint ownership of property that is not a trade or business does not qualify for the election. The spouses must share the items of income, gain, loss, deduction, and credit in accordance with each spouse’s interest in the business. The meaning of “material participation” is the same as under the passive activity loss rules in section 469(h) and the corresponding regulations (see Publication 925, Passive Activity and At-Risk Rules). Note that, except as provided in section 469(c)(7), rental real estate income or loss generally is passive under section 469, even if the material participation rules are satisfied, and filing as a qualified joint venture will not alter the character of passive income or loss.
How to make the election to be treated as a qualified joint venture
Spouses make the election on a jointly filed Form 1040 (PDF) by dividing all items of income, gain, loss, deduction, and credit between them in accordance with each spouse’s respective interest in the joint venture, and each spouse filing with the Form 1040 a separate Schedule C (Form 1040), Profit or Loss From Business (Sole Proprietorship) (PDF) or Schedule F (Form 1040), Profit of Loss From Farming (PDF), Form 4835, Farm Rental Income and Expenses(PDF) and, if otherwise required, a separate Schedule SE (Form 1040), Self-Employment Tax (PDF). For example, to make the election for 2009, jointly file your 2009 Form 1040, with the required schedules (see below). The partnership terminates at the end of the taxable year immediately preceding the year the election takes effect. For information on how to report the business for the taxable year before the election is made, see Publication 541 on Partnerships and terminations.
A business owned and operated by the spouses through a limited liability company does not qualify for the election
Only businesses that are owned and operated by spouses as co-owners (and not in the name of a state law entity) qualify for the election. See Rev. Proc. 2002-69, 2002-2 C.B. 831, for special rules applicable to husband and wife state law entities in community property states.
How to report Federal income tax as a qualified joint venture (including self-employment tax)
Spouses electing qualified joint venture status are treated as sole proprietors for Federal tax purposes. The spouses must share the businesses’ items of income, gain, loss, deduction, and credit. Therefore, the spouses must take into account the items in accordance with each spouse’s interest in the business. The same allocation will apply for calculating self-employment tax if applicable, and may affect each spouse’s social security benefits. Each spouse must file a separate Schedule C (or Schedule F) to report profits and losses and, if otherwise required, a separate Schedule SE to report self-employment tax for each spouse. Spouses with a rental real estate business not otherwise subject to self-employment tax must check the box on Line 1 of Schedule C and should not file Schedules SE.
However, if there are other net earnings from self-employment of $400 or more, the spouse(s) with the other net earnings from self-employment should file Schedule SE without including the amount of the net profit from the rental real estate business from Schedule C on line 2. If the election is made for a farm rental business that is not included in self-employment, file two Forms 4835 instead of Schedule F.
In general, spouses do NOT need an Employer Identification Number (EIN) for the qualified joint venture
Spouses electing qualified joint venture status are treated as sole proprietors for Federal tax purposes. Using the rules for sole proprietors, an EIN is not required for a sole proprietorship unless the sole proprietorship is required to file excise, employment, alcohol, tobacco, or firearms returns. If an EIN is required, the filing spouse should complete a Form SS-4 and request an EIN as a sole proprietor.
What to do if the spouses already have an EIN for the partnership
One spouse cannot continue to use that EIN for the qualified joint venture. The EIN must remain with the partnership (and be used by the partnership for any year in which the requirements of a qualified joint venture are not met). If you need EINs for the sole proprietorships, see above on EINs for sole proprietors.
How to handle requests from the IRS for a partnership return from the spouses for tax years for which the election is in effect
Once the election is made, if the spouses receive a notice from the IRS asking for a Form 1065 (PDF) for a year in which the spouses meet the requirements of a qualified joint venture, the spouses should contact the toll-free number that is shown on the notice and advise the telephone assistor that they reported the income on their jointly-filed individual income tax return as a qualified joint venture. Alternatively, the spouses can write to the address shown on the notice and provide the same information.
If the spouses elect to be treated as a qualified joint venture, how do they report and pay Federal employment taxes?
If the business has employees, either of the sole proprietor spouses may report and pay the employment taxes due on wages paid to the employees, using the EIN of that spouse’s sole proprietorship. If the business already filed Forms 941 or deposited or paid taxes for part of the year under the partnership’s EIN, the spouse may be considered the “successor employer” of the employee for purposes of determining whether the wages have reached the social security and Federal unemployment wage base limits. See Publication 15 for more information on the successor employer rules. See above regarding the allocation of the deductions for income tax purposes.
Duration that the election remains in effect
Once the election is made, it can be revoked only with the permission of the IRS. However, the election technically remains in effect only for as long as the spouses filing as a qualified joint venture continue to meet the requirements for filing the election. If the spouses fail to meet the qualified joint venture requirements for a year, a new election will be necessary for any future year in which the spouses meet the requirements to be treated as a qualified joint venture.