Understanding What a Real Estate Professional Is under The Passive Activity Loss Rules

Because of the potential increased focus on the audit of returns showing rental real estate losses, it is important to understand when Landlords are entitled to deduct losses from rental real estate as ordinary losses rather than having to treat such losses as passive.

To escape passive-loss classification, the Landlord must qualify as a “real estate professional” and must materially participate in the rental activity. Keep in mind this is not the only way to avoid passive loss. There is also the exception for up to $25,000 of losses of an active participant in a rental real estate activity under 469(i). Section 469(c)(7)(B) requires that a Landlord meet two tests in order to be considered a real-estate professional for a taxable year. Those tests are:

  1. The Landlord must show that more than one-half of the personal services performed by him in trades or businesses were performed in real property trades or businesses in which he materially participated; and
  2. The Landlord must show that he worked more than 750 hours in real property trades or businesses in which he materially participated.
For Rent sign in front of new house

The first test becomes an issue only if the Landlord is involved in another occupation in addition to real estate.  The courts in deciding the issue of “real estate professional” have not expressly dealt with this test; rather, they use the fact that the Landlord spent time in an occupation outside of real estate to buttress their conclusions that Landlord has not met the 750-hour test.

I always recommend that Landlords keep contemporaneous time logs, time reports or calendars that they can input manually into a day timer or type into a google calendar.   The log or calendar should provide a detailed account of what the Landlord did with respect to an activity, when he did it, and how much time it took. 

Rental services that qualify for meeting the 750 hour annual requirement includes, but is not limited to:

  1. Advertising to rent or lease the real estate;
  2. Negotiating and executing leases;
  3. Verifying information contained in prospective tenant applications;
  4. Collection of rent;
  5. Daily operation and management;
  6. Maintenance and repair of the property, including the purchase of materials and supplies;
  7. Supervision of employees and independent contractors.

It is a common misconception, however, that qualifying as a real estate professional makes the Landlord’s rental activities nonpassive. This is not the case; rather, a Landlord who qualifies as a real estate professional has merely overcome the presumption that all rental activities are passive regardless of level of participation. For the real estate professional’s rental activities to become nonpassive activities, the Landlord must establish that he or she has met the material-participation standard with regard to the rental activities.  Only those rental activities in which the real estate professional materially participates are nonpassive activities.

Importantly, the statute provides that a qualifying real estate professional must establish material participation in each separate rental activity. An exception is provided, however, by which the Landlord may elect to aggregate all interests in rental real estate for purposes of measuring material participation.  The landlord can elect to treat all rental properties as a single rental activity by filing a statement with his original income tax return for the taxable year.  Merely aggregating rental income and expenses on Schedule E does not suffice.  Without an election, the Landlord must examine each rental property to determine whether he materially participated in the rental of that property.

Material Participation

Material participation is determined under the seven tests set forth in Treasury Regulation § 1.469-5T. To prove “material participation,” the Regulation allows grouping real-property trades or businesses based upon facts and circumstances. The regulation lists 11 types of real property trades or businesses: real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage. However, rental activities cannot be grouped with other real-property trades or businesses.  The seven tests are: 

  1. The individual participates in the activity for more than 500 hours during the tax year.
  2. The individual’s participation in the activity for the tax year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for the year;
  3. The individual participates in the activity for more than 100 hours during the tax year, and the individual’s participation in the activity for the tax year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for the year;
  4. The activity is a significant participation activity for the tax year, and the individual’s aggregate participation in all significant participation activities during the year exceeds 500 hours;
  5. The individual materially participated in the activity for any five tax years whether or not consecutive, during the 10 tax years that immediately precede the tax year;
  6. The activity is a personal service activity, and the individual materially participated in the activity for any three tax years whether or not consecutive preceding the tax year;
  7. Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year.

There are several important considerations when measuring material participation in a Landlord’s real property trade or business.  First, hours spent as an employee are not counted unless the employee is a 5% owner in the employer. Second hours spent as an investor in a real property trade or business such as studying and reviewing financial statements, preparing summaries of the finances or operations, or managing the finances of an activity in a nonmanagerial capacity are not counted toward material participation unless the Landlord is directly involved in the day-to-day management of the business.

In addition, if the individual holds an interest in a real property trade or business through a limited partnership interest, the individual may establish material participation only by satisfying the first, fifth, or sixth tests of the seven tests from the regulations described above.

When measuring material participation, an individual taxpayer is required to count any hours performed by his or her spouse, even if the spouse does not own an interest in the business or if no joint return is filed.  While this rule is advantageous because it makes it more likely the taxpayer materially participates in the real property trade or business, it is a trap for the unwary in the real estate professional context.

The relevant case history has established that it is very difficult for a Landlord who has a full-time job that is not in a real property trade or business to satisfy this first 50% test. The IRS and the courts find it dubious when a Landlord who works 2,000 hours a year at a non-real estate job purports to have spent more time on his or her real estate activities.

If you have any questions about material participation or being a real estate professional call Gregory J. Spadea at 610-521-0604.    

The Setting Every Community Up for Retirement Act of 2019 (SECURE Act)

On December 20, 2019 the President signed into law the Setting Every Community Up for Retirement Act (the SECURE Act) as part of the Further Consolidated Appropriations Act of 2020.   The SECURE Act made various changes to the rules governing retirement benefits.  The key changes are as follows:

Distributions After Death

The most significant changes in the law are that the rules governing required distributions after the death of an employee or IRA owner generally now require that any remaining assets be distributed to the designated beneficiary by the end of the tenth calendar year following the employee or IRA owner’s death. This substantially reduces the benefit of the stretch.

Gold nest egg concept for retirement savings and financial planning

Until now, designated beneficiaries could take distributions over their life expectancy or faster if they wanted. The ability to stretch the distributions over a long period of time provided a substantial income tax benefit.

There are exceptions for spouses, minor children, disabled or chronically ill persons, or persons not more than 10 years younger than the employee or IRA owner.  In addition, withdrawals of up to $5,000 that are used for adoption or childbirth expenses will be exempt for the 10% premature distribution tax for distributions made after 12/31/2019.

These changes are generally effective for persons dying after December 31, 2019.

Traditional IRA Contributions After Age 70 ½

Until now, an individual could not contribute to a traditional IRA if he or she reached age 70 ½ or would reach age 70 ½ by the end of the year for which the contribution is made. Beginning in 2020, this limitation is repealed.

Unlike a traditional IRA, an individual over age 70 ½ is already permitted to contribute to a Roth IRA. However, there are income limits for eligibility to contribute to a Roth IRA. These limits remain in effect.

When Distributions Must Begin

Until now, employees and IRA owners generally had to begin taking distributions at age 70 ½, though they could defer the distribution for the year in which they reach age 70 ½ until April 1 of the following year. However, an employee who is not a 5% owner (with attribution) may defer benefits until retirement; and no distributions are required from a Roth IRA.

The new law increases the age threshold from 70 ½ to 72. This change is effective beginning in 2020 for individuals attaining age 70 ½ after December 31, 2019.

This change benefits some IRA owners who want to do Roth conversions to the extent it will not put them into too high a tax bracket. They will have an additional year or two before they have to take distributions that would be added to their income.

This change also benefits IRA owners who do not need to take distributions from their retirement plans and IRAs. They will be able to accumulate money in their retirement plans and IRAs for a longer period of time.

Planning Considerations

Roth contributions and conversions

It generally makes sense to contribute to a Roth IRA or convert to a Roth IRA to the extent the tax rate on the conversion is less than, equal to, or not too much higher than the tax rate that would otherwise apply to the distributions.

The limitation on the stretch will bunch the distributions after death into a shorter period of time. This generally will result in the distributions being taxable at higher rates.

As a result, Roth contributions and conversions will be much more advantageous than in the past.

Spouses of IRA owners who died within the last nine months

Most married people name their spouse as the primary beneficiary of their retirement benefits. However, under the new law, the surviving spouse’s beneficiaries generally will not be able to stretch the distributions for more than 10 years.

As a result, if an employee or IRA owner died in 2019 within the last nine months, the surviving spouse should consider disclaiming the benefits. In this way, the benefits will pass to the contingent beneficiaries, who may be able to stretch them over their life expectancy under the old law.

Reviewing existing trusts

Many people left their retirement benefits in trust rather than outright for the same reasons they left their other assets in trust rather than outright. By leaving assets in trust, their beneficiaries’ inheritances will not be included in their estates for estate tax purposes and will be better protected against their creditors and Medicaid.

Some people designed their IRA trusts so that any distributions from the IRA to the trust would be paid out to the beneficiary on a current basis. They may have been willing to have the beneficiary receive modest distributions in the early years but may not want the beneficiary to receive the entire amount at the end of 10 years. These trusts should be reviewed, and if appropriate, changed to discretionary trusts.

Charitable remainder trusts

A charitable remainder trust is a possible workaround to replicate the stretch.  A charitable remainder trust distributes a percentage of the trust assets to one or more individuals for life or for a term of up to 20 years, whereupon the trust ends and the balance of the trust assets goes to charity. The distribution percentage must be at least 5%. The client may select the charities.

The payments can be fixed based on the initial value of the trust or may vary based on the value of the trust each year. The actuarial value of the charity’s remainder interest must be at least 10% of the value of the trust as of inception.

Since a charitable remainder trust is tax-exempt except for New Jersey income tax purposes, it can take the benefits in a lump sum without any adverse tax consequences.

Since the individual beneficiaries receive distributions for life or for a fixed term of up to 20 years, the result is similar to that of a stretch.

There are some tradeoffs to a charitable remainder trust. It is less flexible than a traditional trust since the payments may not vary from year to year except based on changes in the value of the trust assets.

The payments to the individual beneficiaries have to be outright. There is an economic cost since the actuarial value of the charity’s interest has to be at least 10% of the value of the trust as of inception. However, for some people, this may be a small price to pay to be able to replicate the stretch.

Increased Penalties for Failure to File Retirement Plan Returns which Applies to Returns, Notices and Statements required to be filed or provided after 12/31/2019

  1. The fee for failure to file form 5500 increased from $25 per day to $250 per day, with the maximum amount per Form increased from $15,000 to $150,000;
  2.  The failure to file form 8955-SSA penalties increased from $1 per day per participant with a maximum penalty of $5,000, and to $10 per day per participant with a maximum penalty up to $50,000;
  3. Notification of withholding of income tax penalties increased from $10 to $100 dollars for each failure, with the maximum being increased from $5,000 to $50,000;
  4. Fees related to failure to report plan name change, name or address change of plan administrator, plan termination or plan merger increased from $1 per day per failure to $10 per day per failure, with the maximum amount being increased from $1,000 to $10,000.

If you have any questions about tax, trust or estate planning call Gregory J. Spadea at 610- 521- 0604.

Ten Things a Valid Search Warrant Must Have in Pennsylvania

While valid search warrants are permissible under the Pennsylvania Constitution and under the 4th Amendment of the United States Constitution, law enforcement must satisfy very specific requirements to obtain one and even then, the warrant itself must contain certain information. The 10 things every search warrant must have to be valid are as follows:

PA search warrants
  1. A warrant must have an affidavit of probable cause attached to it which tells the person issuing the warrant that there is probable cause for the search and seizure of the item in question. Probable cause is the reasonable expectation that a crime was or is being committed;
  2. A warrant must be based on reliable information by some witness or an informant;
  3. A warrant must have the information used to obtain it corroborated by another source other than that same witness or the informant;
  4. A warrant must be signed and sealed by the issuing judge;
  5. A warrant must have a specific date and time of issuance;
  6. A warrant must identify specifically the property to be seized;
  7. A warrant must name and describe with particularity the person or place to be searched;
  8. A warrant must be executed within a specified period of time not to exceed two days from the date of issuance;
  9. A warrant must be served during the day light hours (typically 8 am -5 pm), unless otherwise authorized on the warrant;
  10. A warrant must state the title of the judicial officer who issued the warrant. This person must also certify that he has found probable cause based upon the facts sworn to or affirmed by police based on the witness or the informant.

If you have any questions about search warrants or are charged with a crime call Gregory J. Spadea at 610-521-0604.

What Records You need to Deduct Business Meals, Travel and Lodging on Your Federal Tax Return

Many of my clients ask me what documentary evidence is adequate to deduct travel and lodging.  I tell them to get a receipt or credit card statement that shows the amount, date, place, and essential character (business purpose) of the expense. I recommend they use the same credit card or business debit card to pay all the business expenses to keep things simple and organized.  I also recommend clients record their travel in their day timer or google or outlook calendar that can be cross referenced with the travel or lodging receipts.

Adequate evidence for Lodging requires a hotel receipt if it has all the following information:

  • The name and location of the hotel.
  • The dates you stayed there.
  • Separate amounts for charges such as lodging, meals, and telephone calls.

Adequate evidence for Travel will include the airline, train or bus ticket that has all the following information:

  • The name of the passenger.
  • The name of your destination.
  • The date and cost of the ticket.

Adequate evidence for Meals requires a restaurant receipt if it has all of the following information:

  • The name and location of the restaurant.
  • The number of people served.
  • The date and amount of the expense.

There is an exception when you do not needdocumentary evidence if any of the following conditions apply.

  • You have meals or lodging expenses while traveling away from home for which you report to your employer under an accountable plan, and you use a per diem allowance method that includes meals and lodging. 
  • Your expense, other than lodging, is less than $75 such as for cab fare or breakfast.

Keep in mind if your spouse is an employee of your company, you can deduct travel and meals for both you and your spouse as long as you discuss business.  

 If you need help setting up an accountable plan or have any tax questions call Gregory J. Spadea at 610-521-0604.  The Law Offices of Spadea & Associates, LLC is located in Ridley Park, PA and prepares tax returns year-round.  

Understanding What Car & Truck Expenses are Deductible For Business

I have a lot of business owners and self-employed clients who ask what records to keep in order to deduct their car or truck expenses incurred in their business. I first remind them to keep track of the total miles they drive during the year as well as the total miles driven for business. The reason is if the business owner uses their car for both business and personal purposes, the expenses must be split. Therefore, they will need to know the total miles and total business miles to calculate deduction based on the portion of mileage used for business.
There are two methods for figuring car expenses:

Using actual expenses which include:
o Depreciation or Lease payments
o Gas and oil
o Tires
o Repairs and tune-ups
o Insurance
o Registration fees

Federal Tax Law Gregory Spadea Lawyer

Using the standard mileage rate. Under this method business owners will keep track of the business miles driven during the year and multiply that total by the current standard mileage rate in effect. However, the business owner must choose to use this method in the first year the car is available for use in their business. In addition, business owners who want to use the standard mileage rate for a car they lease must use it for the entire lease period. The standard mileage rate for 2019, is 58 cents.

No matter which option you select you must keep adequate records. You should keep a diary, travel log or trip sheets documenting where you went, who you met and the mileage and date. You should also keep documentary evidence such as gas receipts, credit card statements and cancelled checks or repair bills to support your expenses. I always recommend paying all the car and truck expenses with the same credit or debit card.

If you have any questions about deducting car expenses call Gregory J. Spadea at 610-521-0604. The Law Office of Spadea & Associates provides estate and tax planning services to business and individual clients including tax return preparation services year-round.

The Landlord Tenant Eviction Process in Pennsylvania

When a landlord has a tenant who fails to pay rent, a landlord must file an eviction complaint at the local magisterial district court where the property is located.  Once a complaint is filed along with a copy of the lease, a hearing is scheduled in two to three weeks.  It is very important for the landlord to sue for both back rent and possession.  The reason is if the tenant appeals he has to post the lesser of the rent in arrears or three months rent.  

The hearing is very straight forward. The landlord testifies that the tenant has failed to pay rent and a judgment is entered in the landlord’s favor for the amount of rent owed plus court costs and the court will grant the landlord possession.  The landlord can also be awarded attorney fees if they are in the lease.  However, the landlord must have a valid rental license covering the period that he or she is requesting back rent.   

After the magistrate judge enters a judgment and awards a landlord possession, the tenant has the right to file an appeal to the possession portion of the judgment within ten days. After the tenth day, the tenant can still appeal the money portion of the judgment within thirty days of the judgment, but the tenant can no longer appeal the award of possession.  A tenant would file an appeal with the Court of Common Pleas in the county, where the rental property is physically located.  When a tenant files an appeal, they ask the court to enter a Rule to Show Cause, which would require a landlord to file a civil complaint in the court within twenty days. An appeal is conducted de novo, which means a new hearing is required at the Court of Common Pleas and usually takes 9 months for the hearing to be scheduled in Delaware County.

If the tenant does not file an appeal within ten days of the judgment date and the tenant remains in possession of the property, the landlord must then file an Order of Possession with the district court on the eleventh day after the judgement date. The Constable will then call the Landlord in one to weeks after he files for the Order for Possession to arrange to meet him at the property, so  the Constable can remove the tenant from the property and the landlord can change the locks. 

When an appeal is filed by a tenant, the tenant is required to post with the court the judgment in the amount of rent in arrears or three months rent, whichever is less.  If the tenant posts the rent with the court, the tenant will be granted a supersedeas, which means that the Constable cannot move forward with the actual eviction process while the appeal is pending. Furthermore, the tenant must deliver the notice of appeal to the magisterial district court to be granted the supersedeas and serve a copy upon the landlord.

In order to obtain the posted rent after a tenant files an appeal, a landlord must file an application with the Court of Common Pleas so the rent posted by the tenant can be released from escrow.

If a tenant is claiming they are indigent, the tenant can submit an affidavit stating they do not have the financial ability to post with the court the lesser of three months rent or the actual rent in arrears and the court would permit the appeal to proceed.  If the tenant files this affidavit and has not paid rent in the month the appeal is filed, the tenant is merely required to pay one-third  of their monthly rent payment at the time of appeal. The remaining two-thirds must then be posted within twenty days of the appeal.  The tenant must then continue to pay rent every thirty days after filing the appeal with the court.  When a tenant fails to post rent with the court, the landlord can terminate the superseadas by filing to terminate the tenant’s appeal with the Court of Common Pleas.  If you are a landlord and need help evicting a tenant or getting possession, feel free to call Gregory J. Spadea at 610-521-0604.

When To Issue or Not Issue IRS Form 1099

I strongly encourage our business clients, nonprofit organizations and landlords to issue 1099 forms which are required by law. The reason is IRS Form 1099 provides the means of reporting very specific types of income from non-employment related sources that might not be reported elsewhere. If you paid someone for services (other than employees) you must issue them a 1099 by January 31 of the following year. Business income tax returns including IRS Forms 1120S and 1040, Schedule C include a question asking if Forms 1099 were filed as required and by signing your return, you are certifying that your response is true.

I recommend to all my clients to review all disbursements made from January 1, through December 31, summarizing all payments for services to unincorporated individuals and businesses where the accumulated total is $600 or more.  If you pay a Limited Liability Company (LLC) that is taxed like a corporation you still have to issue a 1099 to that LLC.  Make sure you have the correct name, employer identification or social security number and address of everyone you pay before you pay them.

Beyond having to possibly face an IRS or State audit, if you fail to file the correct information by the deadline, fail to include all the required information on a return, or if you include incorrect information, you can be subjected to an array of steep penalties if you cannot show reasonable cause.  If the payee fails to furnish his or her taxpayer identification number (TIN), they are subject to backup withholding at a 28% rate. If you do not collect and pay backup withholding from affected payees as required, you may become liable for any uncollected amount.

Closeup of overlapping Form 1099G Certain Government Payouts and W-2 forms.

Here are a few additional tips of when you do not have to issue 1099’s:

1. Do not send a 1099-MISC to an employee since that is what a W-2 is for.  Remember that someone that performs services for you is either an employee or an independent contractor, but not both.  

2. Do not send a 1099 to someone you’ve paid by credit card, debit card or by services like PayPal. Such payments will be reported on a 1099K that they will receive from their merchant services provider

3. Do not use Form 1099-MISC to report employee business expense reimbursements. Report payments made to employees under a non-accountable plan as wages on Form W-2. 

4. If you pay a non-U.S. citizen who works remotely via the Internet from another country, you do not need to file a 1099 for that person. However, if the foreign worker performs any work inside the United States, you would need to file the 1099. For that purpose, you should have that foreign worker fill out, sign and return to you Form W-8BEN.

5. Do not issue 1099’s to corporations.

If you need help issuing 1099’s or have any questions, please contact Gregory J. Spadea at 610- 521-0604.  The Law Offices of Spadea & Associates, LLC prepares tax returns year round.   

When Can I Deduct Alimony on my Federal Tax Return Ordered Prior to December 31, 2018

When divorce occurs, one ex-spouse is often obligated to make continuing payments to the other spouse. However, for the payments to be deducted by the payer, they must meet the tax-law definition of alimony. For any particular payment to qualify as deductible alimony for federal income tax purposes and meet the tax law definition of alimony, all the following requirements must be met:

  1. The payment must be made pursuant to a written divorce decree or separation agreement such as a temporary support order. Note that payments made in advance of signing a written divorce or separation agreement or before the effective date of a court order or decree cannot be deductible alimony. Such payments are considered voluntary and are therefore nondeductible. The same is true for payment of amounts in excess of what is required under a written divorce decree or separation agreement.
  2. The payment must be to or on behalf of a spouse or ex-spouse. Therefore, payments to third parties, such as attorneys and mortgage companies, are okay if made on behalf of a spouse or ex-spouse and pursuant to a divorce decree or separation agreement.
  3. The divorce decree or separation agreement must state the payments are alimony.
  4. After divorce or legal separation (meaning the couple is considered divorced for federal income tax purposes), the ex-spouses cannot live in the same household or file a joint return for the year they separated or thereafter.
  5. The payment must be made in cash or cash equivalent such as check or money order.
  6. The payment cannot be fixed or deemed child support in the divorce decree.
    Fixed child support simply refers to amounts designated as such in the divorce or separation agreement, so it’s easy to identify. Payments are considered to be deemed child support if they are terminated or reduced by any of the following so-called contingencies relating to a child: a. Attaining the age 18, or the local age of majority.
    b. Death.
    c. Marriage.
    d. Completion of schooling.
    e. Leaving the ex-spouse’s household.
    f. Attaining a specified income level.
  7. The payer’s return is required to include the recipient’s social security number.
  8. The obligation to make payments (other than payment of delinquent amounts) must cease if the recipient party dies. If the divorce decree is unclear about whether or not payments must continue, state law controls. If under state law, the payer must continue to make payments after the recipient’s death, the payments cannot be alimony. Therefore, to avoid problems, the divorce decree should always explicitly stipulate whether a payment obligation continues to exist after the death of the recipient party. Failing this test is probably the most common cause for lost alimony deductions.
  9. There is also an IRS rule that states if alimony payments decrease by more than
    $15,000 per year between years 1 and 2, or years 2 and 3, then part of the payments will not qualify for a tax deduction to the payor (and hence will not be taxable to the payee.) In other words, if alimony payments total more than $15,000 per year then they must last more than one year and cannot be reduced too quickly. The reason for this is because the IRS sees this as a property settlement, not alimony. Because of this rule replacing all monthly payments with a lump sum “alimony” payment that is paid all in one year will often cause a trigger of this recapture rule, since alimony will go down to $0 in year

Keep in mind the Tax Cuts Jobs Act repealed the deduction for alimony paid and the corresponding inclusion of alimony in income by the recipient. The provision is effective for any divorce or separation agreement executed after December 31, 2018, or for any divorce or separation agreement executed on or before December 31, 2018, and modified after that date, if the modification expressly provides that the amendments made by this provision apply to such modification. Thus, alimony paid under a separation agreement entered into prior to the effective date is generally grandfathered.

It is very important to consult a tax attorney like Gregory J. Spadea before signing the marital settlement agreement. You can reach him at the Law Offices of Spadea & Associates, LLC in Ridley Park at 610-521-0604.

Understanding Philadelphia’s Contractor Property Tax Exemption and the Three 10 Year Property Tax Abatement Programs

CONTRACTOR’S 30 MONTH PROPERTY TAX EXEMPTION PROGRAM

Under the contractor’s tax exemption program, the property owner may obtain a real estate tax exemption for up to 30 months from the date the building permit is issued for the increase in the assessed value of the property due to the improvements being made to the property.

The contractor’s tax exemption program applies to developers who are building or rehabbing a residential property that will be leased or sold. Application to the contractor’s tax exemption program must be made by December 31 of the year that the building permit is issued.  Properties that are eligible under the contractor’s tax exemption program include a dwelling unit in a single house, duplex, triplex, townhouse, row house, or multi-family building.

WIlliam Penn on top of Philadelphi City Hall overlooking Philadelphia

The tax exemption under this governmental program begins on the first day of the month after the building permit is issued by the city of Philadelphia’s Department of Licenses and Inspections and concludes 30 months later or until the property is leased or sold, whichever comes first.  You would use the same application as the 10 year tax abatement program and it should be filed at the same time as tax abatement application along with copies of the permits.  

10 YEAR PROPERTY TAX ABATEMENT PROGRAMS

The tax abatement program provides for a real estate tax abatement for a period of 10 years for the increase in the property’s assessed value based upon the improvements made to the property.  The 10 Year tax abatement program is actually divided into three separate application processes depending upon how the property is being used—Section 19-1303(2) (Ordinance 961), 19-303(3) (Ordinance 1130) and 19-1303(4) (Ordinance 1456-A) of the Philadelphia Code.

What part of the tax abatement program a property owner should apply for depends upon whether the property is owner-occupied or an investment property, and, if the property is an investment property, whether the property is being rented or sold after the property improvements are completed, and, finally, whether the improvements to the property are being made to a vacant lot (i.e., new construction) or to an existing building structure.

Ordinance 961 offers a 10 year tax abatement in improvements made to existing residential building structures that will either be sold at the completion of the improvements or occupied by the property owner.

Ordinance 1456-A provides for a tax abatement for new construction of residential properties that will be sold upon completion. A dwelling unit in a single house, duplex, townhouse, row house and multi-family building qualify for a tax abatement under Ordinance 1456-A.

Under Ordinance 1130, property owners may obtain a tax abatement for improvements due to rehabilitation of a preexisting building structure or new construction of commercial, industrial and any other business properties, including rental residential properties. In other words, property owners who newly-build or improve existing commercial and industrial properties should apply for this governmental program.

Both Ordinance 1130 and Ordinance 1456-A require the submission of the tax abatement application within 60 days from the date the building permit is issued, while, on the other hand, the property owner is “asked” to submit the application under Ordinance 961 by Dec. 31 of the year that the building permit is issued.

To illustrate the benefit of the tax abatement programs, if the property owner increases the property’s assessed value from $100,000 to $250,000 through improvements made to the property and, assuming the property owner is eligible for both the contractor’s tax exemption and tax abatement programs, that increase in the property’s assessed value will be exempt or abated from real estate taxation for up to 12-and-a-half years. Under the city’s current real estate tax program, the real estate savings will be well over $20,000.

Under all three 10 year tax abatement programs, the 10-year tax abatement does not begin until the year following the completion of the property improvements.  What happens in many circumstances is that the city reassesses the property soon after the improvements are completed. If the reassessment occurs in the middle of the year in which the improvements are completed, the increase in real estate taxes will not be abated for that year and, thus, the property owner will have to pay this real estate tax increase for the remainder of that year until the tax abatement goes into effect the following year.

That is where the contractor’s tax exemption program comes in. Since the city is prohibited from collecting any increases in real estate taxes for the first 30 months after the building permit is issued, assuming the property improvements are completed well in advance of the expiration of this 30-month period of time, the property owner, if eligible for the contractor’s tax exemption program, will not have to pay for any increases in the assessed value of the property.  This is why it really makes sense to apply for both the Contractor exemption and the 10 year property tax abatement at the same time and attach the building permits to each application.

If you have any questions or need help applying for any of the property abatement programs please call Gregory J. Spadea at 610-521-0604.

Understanding the Accumulated Earnings Tax Before Switching To a C Corporation in 2019

The June 2018 Penn Wharton Budget Model survey indicated that over 235,000 business owners are projected to convert their pass-through businesses to C corporations.  Their primary motivation is to take advantage of the new 21% corporate tax rate under the 2018 Tax Cuts and Jobs Act.  This is particularly important for business owners who can’t fully benefit from the new Qualified Business Income deduction. In fact, the biggest switchers are owners of specified service businesses whose taxable income exceeds $415,000 for married filing jointly filers.

Although the new 21% rate is tempting, C corporations are subject to double taxation. Corporate income is taxed once at the entity level and again when it is distributed to shareholders as dividends. This can be avoided if the corporation retains all of it’s profits to finance growth.  However, this opens the door to the Accumulated Earnings Tax (AET) if profits accumulate beyond the reasonable needs of the business.

The AET is a penalty tax imposed on corporations for unreasonably accumulating earnings. The tax rate on accumulated earnings is 20%, the maximum rate at which they would be taxed if distributed.  The tax is in addition to the regular corporate income tax and is assessed by the IRS, typically during an IRS audit. There is no IRS form for reporting the AET. If imposed, the earnings are subject to triple taxation when eventually distributed to the shareholders. Once at the entity level, then when the AET is imposed and finally when the accumulated earnings are distributed to shareholders.

The AET applies when there is intent to avoid income tax at the shareholder level by accumulating earnings in the corporation. The AET applies even when tax avoidance is not the main reason for the accumulation of income but is only one of several reasons.  Keep in mind the IRS allows for an accumulated earnings credit of $250.000 or $150,000 if you are taxed as a Personal Service Corporation. Therefore, once your retained earnings exceed those limits you need to be concerned about the AET and document why your corporation needs accumulated earnings exceeding that amount.

The fact that a corporation is a holding or investment company is automatically considered evidence of the existence of a tax avoidance purpose unless the corporation can establish it wasn’t formed to avoid tax. A holding company is a corporation in which there is practically no activity other than the holding of investment property. An investment company is one that buys and sells stock, securities, real estate, and other investment property, in addition to holding investment property. If the corporation is not a holding or investment company, a tax avoidance motive is considered present if the corporation has accumulated earnings and profits in excess of the reasonable needs of the business unless it can prove otherwise by a preponderance of the evidence. The IRS regulations identify the following situations that may indicate accumulations beyond the reasonable needs of the business exist:

  1. Loans to shareholders or related parties.
  2. Payments by the corporation that personally benefit the shareholders.
  3. Investments in assets having no reasonable relationship to the corporation’s business.
  4. A weak dividend history.
  5. Retention of earnings to provide against unrealistic hazards.
  6. Working capital levels that appear high in relation to the needs of the business.

7. Salaries paid to shareholder/employees that are either extremely high (avoiding corporate  

     income tax) or extremely low (avoiding shareholder income and employment tax).

The AET is not assessed if accumulated earnings are reasonable in light of business needs. This subjective test can be satisfied by a variety of business reasons including retaining earnings to satisfy the reasonably anticipated future needs of the business.  The IRS regulations provide some broad criteria that can be used to justify that earnings are being accumulated for reasonable business needs. These include:

  1. Providing for a business expansion or plant replacement.
  2. Acquiring a business enterprise through purchasing stock or assets.
  3. Facilitating the retirement of company debt created in connection with its trade or business.
  4. Providing necessary working capital for the business.
  5. Providing for investments in suppliers, or loans to customers or suppliers to maintain the business of the corporation.

6. Providing for contingencies such as the payment of reasonably anticipated losses such as an

    actual or potential lawsuit, loss of a major customer, or self-insurance.

The accumulated amount does not have to be used immediately or within a short period after the close of the tax year, so long as it will be used within a reasonable time depending on all the facts and circumstances relating to the future needs of the business.   

To avoid the AET which is 20% of “accumulated taxable income”, a corporation must be able to demonstrate to the IRS that its accumulations are necessary to meet its business needs. The corporation must have sufficient facts and documentation to substantiate that the plans for present and future business needs require additional funds. A determination of whether the accumulation of earnings and profits is a reasonable business need is based on the facts and circumstances of each case. 

The dramatic reduction in the corporate tax rate from 35% to 21% has sparked renewed interest in the AET. Although it remains to be seen whether flow-through entities will rush to covert to C corporations, those that do will need to pay attention to this tax.  Conversion may be the way to go if owners have no need for distributions and the corporation avoids the AET by proving its accumulations are for the reasonable needs of the business.

If you have any questions, please call Gregory J. Spadea at 610-521-0604.

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