Summer is great time to think about college and to make financial plans for your kids. Better yet, let them make money over the summer and put it in a tax-favorable college savings account. As you consider their plan options, consider the two most common tax favored savings tools available.
There are two types of accounts that you can establish to save for higher education expenses in a tax favorable manner. These two types of accounts are Coverdell Education Savings Accounts and 529 Plan accounts.
The first type of account is known as a Coverdell Education Savings Account. A Coverdell account is typically set up for the higher education expenses of a child. The contributed funds grow in the account tax deferred and the money comes out for education expenses tax free. There is no tax deduction for amounts contributed to a Coverdell but you do have significant investment options including self-directed investment options (similar to IRA rules). A Coverdell has the following rules and benefits.
- $2,000 annual contribution limit per beneficiary (e.g. child or grandchild).
- Parents (or grandparents) can contribute without limitations to a Coverdell until a beneficiary reaches age 18 if the contributor has income of less than $190k (married joint) or $110,000 (single). For high-income earners, keep in mind that the child can always contribute to their own account with gifted funds (no need to have earned income) so you can always get around the income limitation by having the child contribute themselves.
- Funds can be used for tuition, fees, books, and equipment for college as well as certain K-12 expenses too.
- There are zero federal or state income tax deductions on Coverdell accounts.
- Accounts can be invested into stocks, mutual funds, and can even be self-directed. They operate similar to an IRA.
- Contributions grow tax-free and can be withdrawn for education expenses until the account beneficiary reaches age 30. Unused amounts can be transferred to another family member beneficiary.
The second type of account is a 529 Plan account. Contributions to 529 Plan accounts can be eligible for a state income tax deduction (depending on the state). Money contributed to a 529 Plan account is invested into a state managed fund. A 529 has the following rules and benefits.
- Amounts are invested into a state run program.
- Amounts can be withdrawn for tuition, fees, books, supplies, equipment, special needs, room and board.
- Up to a few hundred thousand dollars can be invested per beneficiary by any person.
- There are no federal tax deductions or credits for contributions.
- Many states offer tax deductions for contributions to 529 Plan accounts. For example, Arizona offers a $4,000 tax deduction for married tax filers and a $2,000 deduction for single filers. Thirty-five states offer some type of state income tax deduction for 529 Plan contributions. However, there are some states, like California, who offer no tax deduction for contributions to 529 Plan accounts. Click here to see a comprehensive list that outlines the different state funds and tax deductions (or credits for some states).
- Downside, invested amounts must be invested solely into state run programs. There are no other investment options.
In summary, Coverdell accounts have the benefit of allowing account owner’s to decide how the money will be invested with zero tax deductions available on contributions while 529 Plan accounts give you zero investment options (all funds go to state run fund) but offer state income tax deductions in most states.
If you live in a state that offers a tax deduction on contributions, such as Arizona, then the 529 Plan account is a great option if you can stomach having the money go into a state run fund. On the other hand, if you live in a state with zero income tax (e.g. Texas or Florida) or if you live in state with zero 529 Plan deductions (e.g. California) then you might as well use a Coverdell account because you’re not trading any tax deductions for investment options. For those who can’t make up their mind and who have the funds, consider doing both but do the Coverdell first. There is no restriction against doing a Coverdell account (no tax deductions, but investment options) and a 529 Plan account (possible state tax deductions but no investment options).
Are you growing your business? Adding new products or services? New locations? Adding partners or owners? If so, these are all instances when you should consider setting up a subsidiary or other new entity for your existing company. While you can run multiple streams of business through one entity, there are tax, asset protection, and partnership reasons why you may want to open up a new subsidiary entity for your new activity.
Let’s run through a few common situations when it makes sense to open up a subsidiary entity. And by subsidiary, I mean “a new entity which is owned wholly or partly by your primary business entity or by a common holding company.” Your new subsidiary could result in a parent and child relationship where your primary entity (parent) owns the new subsidiary entity (child), or it could be a brother and sister type structure where the primary business is a separate entity (brother) to the new entity (sister) and the two are only connected by you or your holding company that owns each separately and distinctly. (See the diagrams below to view the differences.)
I. Adding a New Product or Service
You may want a new entity to separate and differentiate services or products for liability purposes. For example, let’s say you are a real estate broker providing services of buying and selling properties and you decide to start providing property management services. Because the property management service entails more liability risk, a new entity owned wholly by your existing business could be utilized. The benefit of the new subsidiary is that if anything occurs in the new property management business, then that liability is contained in the new subsidiary and does not go down and affect your existing purchase and sale business. On the other hand, if you ran the property management services directly from the existing company without a new subsidiary and a liability arose, then your purchase and sale business that is running through the same entity would be effected and subject to the liability.
For tax purposes, in this instance, the income from the new subsidiary entity (child) will flow down to the parent entity without a federal tax return, and as a result, there is no benefit or disadvantage from a tax planning standpoint.
II. Opening a New Location
What if you’re establishing a new retail or office location for your business? Let’s say you are a restaurant opening up your second location. For asset protection purposes, you should consider setting up a second entity for the new location. This can limit your risk on the lease (don’t sign a personal guarantee) for the new location or for any liability that may occur at the new location. In this instance, if one location fails or has liability, it won’t affect the other location as they are held in separate entities. The saying goes, “don’t put all your eggs in one basket.” In this case, the basket is the same entity and the locations are your eggs. In the multiple location scenario, you should consider the brother-sister subsidiary structure such that each location is owned in a brother-sister relationship (e.g. neither owns the other) and their common connection is simply the underlying company (or person) who owns each entity for each location. Because both locations have risk it is useful for each to have their own entity and not to own each other (as can occur in the parent-child subsidiary). When structured in a brother-sister relationship, the liability for each location is contained in each subsidiary entity and cannot run over into the other subsidiary entity (the sibling entity) or down to the owner (which may be you personally or your operational holding company).
For tax purposes, the brother and sister subsidiary income (usually single member LLCs) flows down to the parent or primary entity where a tax return is filed (usually an S-Corp). (See the diagram below for an illustration.)
III. Adding a New Partner
Maybe you’re starting a new business or operation where you have a new partner involved. If this partner isn’t involved in your other business activities or your existing company, it is critical that a new entity be established to operate the new partnership business. If you have an existing entity where you run business operational income (e.g., an S-Corporation), then this entity may own your share of the new partnership entity (e.g., an LLC) with your new partner. Your share of the new partnership income flows through the partnership to your existing business entity where you will recognize the income and pay yourself. In this instance, your existing entity is the parent and the new partnership is a partial-child subsidiary. The new partnership entity will typically file a partnership tax return.
IV. California Caveat
Because of gross receipts taxes in California, you may use a Q-Sub entity model where the subsidiary entity is actually another S-Corporation and is called a Q-Sub. This is available only when the parent entity is an S-Corporation and can avoid double gross receipts tax at the subsidiary and parent entity level.
Make sure you speak to your tax attorney for specific planning considerations as there are asset protection and tax considerations unique to each business and subsidiary structure.
Do you have a Solo 401(k)? Have you been filing form 5500-EZ each year for the Solo 401(k)? Are you aware that there is a penalty up to $15,000 per year for failure to file? While some Solo 401(k)s are exempt from the 5500-EZ filing requirement, we have ran across many Solo 401(k) owners who should have filed, but have failed to do so.
The return a Solo 401(k) files is called a 5500-EZ, and it is due annually on July 31st for the prior year. If you have a Solo 401(k) and you have no idea what I’m talking about, stay calm, but read on.
Benefits of Solo 401(k)s
One of the benefits of a Solo 401(k) is the ease of administration and control, because you can be the 401(k) trustee and administrator. However, as the 401(k) administrator and trustee, it is your own responsibility to make the appropriate tax filings. This would include filing any required tax returns for the 401(k). Solo 401(k)s with less than $250,000 in assets are exempt and do not need to file a 5500-EZ. All plans with assets valued at $250,000 or greater must file a form 5500-EZ annually. A tax return is also required for a Solo 401(k) when the plan is terminated, even if the plan assets are below $250,000. Recently, more and more Solo 401(k) owners have contacted us because they set up their Solo 401(k) online or with some other company, and were never made aware that they are supposed to file a 5500-EZ when their plan assets exceed $250,000. Some of these individuals have multiple years in which they should have filed the 5500-EZ, but failed to do so. The penalties for failing to file a 5500-EZ when it is required can be quite severe, with fees and penalties as high as $15,000 for each late return plus interest.
Failure to File Relief
Fortunately, the IRS has a temporary pilot program that provides automatic relief from IRS Late filing penalties on past due 5500-EZ filings. The penalty relief began as a temporary program in 2014 and was made permanent via Rev Proc 2015-32.
In order to qualify for this program, your Solo 401(k) plan must not have received a CP 283 Notice for any past due 5500-EZ filings, and the only participants of your Solo 401(k) plan can be you and your spouse, and your business partner(s) and their spouse. There is a $500 fee due for each delinquent return up to a total of $1,500 or three years. This program is available to all Solo 401(k) plans, regardless of whether it is a self-directed plan.
The IRS has provided details via Rev Proc 15-32. In order to qualify and receive a waiver of penalties under the program, you must follow the program exactly. In short, you must do all of the following:
- File all delinquent returns using the IRS form in the year the filing was due. This must be via paper form.
- Mark on the top margin of the first page, “Delinquent Return Submitted under Rev. Proc. 2015-32.”
- Complete and include IRS Form 14704.
- Mail all documents to the IRS, Ogden, UT office.
In sum, if you have a Solo 401(k) plan that should have filed a 5500-EZ for prior years, then you should take advantage of this program, which will save you thousands of dollars in penalties and fees. If you have any questions about this program or would like assistance with submitting your late 5500-EZ filings under this program, please contact our law firm as we are assisting clients with current and past due 5500-EZ filings for their Solo 401(k)s.
Self-Directed IRA investors should be aware of the following IRA tax reporting responsibilities. Some of these items are completed by your custodian and others are the IRA owner’s sole responsibility. Here’s a quick summary of what should be reported to the IRS each year for your self-directed IRA.
IRA Custodian Files
Your IRA Custodian will file the following forms to the IRS annually:
|IRS FORM||PURPOSE||WHAT DOES IT REPORT|
|Form 5498||Filed to the IRS by your custodian. No taxes are due or paid as a result of Form 5498.|| |
IRA contributions, Roth conversions, the account’s fair market value as of 12/31/17, and required minimum distributions taken.
|Form 1099-R||Filed to the IRS by your custodian to report any distributions or Roth conversions. The amounts distributed or converted are generally subject to tax and are claimed on your personal tax return.||IRA distributions for the year, Roth IRA conversions, and also rollovers that are not direct IRA trustee-to-IRA trustee.|
IRA Owner’s Responsibility
Depending on your self-directed IRA investments, you may be required to file the following tax return(s) with the IRS for your IRA’s investments/income:
|IRS FORM||DOES MY IRA NEED TO FILE THIS?||DUE DATE|
|1065 Partnership Tax Return||If your IRA is an owner in an LLC, LP, or other partnership, then the Partnership should file a 1065 Tax Return for the company to the IRS and should issue a K-1 to your IRA for its share of income or loss. Make sure the accountant preparing the company return knows to use your custodian’s tax ID for your IRA’s K-1’s and not your personal SSN (or your IRAs Tax ID if it has one for UBIT 990-T tax return purposes). If your IRA owns an LLC 100%, then it is disregarded for tax purposes (single-member LLC) and the LLC does not need to file a tax return to the IRS.||March 15th, 6-month extension available|
|990-T IRA Tax Return (UBIT)||If your IRA incurs Unrelated Business Income Tax (UBIT), then it is required to file a tax return. The IRA files a tax return and any taxes due are paid from the IRA. Most self-directed IRAs don’t need to file a 990-T for their IRA, but you may be required to file for your IRA if your IRA obtained a non-recourse loan to buy a property (UDFI tax), or if your IRA participates in non-passive real estate investments such as: Construction, development, or on-going short-term flips. You may also have UBIT if your IRA has received income from an active trade or business such as a being a partner in an LLC that sells goods and services (C-Corp dividends exempt). Rental real estate income (no debt leverage), interest income, capital gain income, and dividend income are exempt from UBIT tax.||April 15th, 6 -month extension available|
Most Frequently Asked Questions
Below are my most frequently asked questions related to your IRA’s tax reporting responsibilities:
Q: My IRA is a member in an LLC with other investors. What should I tell the accountant preparing the tax return about reporting profit/loss for my IRA?
A: Let your accountant know that the IRA should receive the K-1 (e.g. ABC Trust Company FBO John Doe IRA) and that they should use the Tax-ID/EIN of your custodian and not your personal SSN. Contact your custodian to obtain their Tax-ID/EIN. Most custodians are familiar with this process, so it should be readily available. If your IRA has a Tax-ID/EIN because you file a 990-T for Unrelated Business Income Tax then you can provide that Tax-ID/EIN.
Q: Why do I need to provide an annual valuation to my custodian for the LLC (or other company) my IRA owns?
A: Your IRA custodian must report your IRA’s fair market value as of the end of the year (as of 12/31/17) to the IRS on Form 5498 and in order to do this they must have an accurate record of the value of your IRA’s investments. If your IRA owns an LLC, they need to know the value of that LLC. For example, let’s say you have an IRA that owns an LLC 100% and that this LLC owns a rental property, and that it also has a bank account with some cash. If the value of the rental property at the end of the year was $150,000, and if the cash in the LLC bank account is $15,000, then the value of the LLC at the end of the year is $165,000.
Q: I have a property owned by my IRA and I obtained a non-recourse loan to purchase the property. Does my IRA need to file a 990-T tax return?
A: Probably. A 990-T tax return is required if your IRA has income subject to UBIT tax. There is a tax called UDFI tax (Unrelated Debt Financed Income) that is triggered when your IRA uses debt to acquire an asset. Essentially, what the IRS does in this situation is they make you apportion the percent of your investment that is the IRA’s cash (tax favorable treatment) and the portion that is debt (subject to UDFI/UBIT tax) and your IRA ends up paying taxes on the profits that are generated from the debt as this is non-retirement plan money. If you have rental income for the year, then you can use expenses to offset this income. However, if you have $1,000 or more of gross income subject to UBIT, then you should file a 990-T tax return. In addition, if you have losses for the year, you may want to file 990-T to claim those losses as they can carry-forward to be used to offset future gains (e.g. sale of the property).
Q: How do I file a 990-T tax return for my IRA?
A: This is filed by your IRA and is not part of your personal tax return. If tax is due, you will need to send the completed tax form to your IRA Custodian along with an instruction to pay the tax due and your custodian will pay the taxes owed from the IRA to the IRS. Your IRA must obtain its own Tax ID to file Form 990-T. Your IRA custodian does not file this form or report UBIT tax to the IRS for your IRA. This is the IRA owner’s responsibility. Our law firm prepares and files 990-T tax returns for our self-directed IRA and 401(k) clients. Contact us at the law firm if you need assistance.
Sadly, not many professionals are familiar with the rules and tax procedures for self-directed IRAs, so it is important to seek out those attorneys, accountants, and CPAs who can help you understand your self-directed IRA tax reporting obligations. Our law firm routinely advises clients and their accountants on the rules and procedures that I have summarized in this article and we can also prepare and file your 990-T tax return.
For most American workers and business owners, the first vehicle to save and invest in is your 401(k). The tax benefits and the typical company matching that offers free company money make a 401(k) a great place to save and invest for the long-haul. But what if you’ve maxed out your 401(k) contributions? What else can you do?
Here are the three options you should consider that provide significant tax and financial benefits:
1. Back-Door Roth IRA
This is a really cool option that many clients utilize every year. (I do too.) First, you may be thinking that you can’t do a Roth IRA because your income is too high or because you already maxed out your 401(k). WRONG: It is still possible to do a Roth IRA, but you just have to know the back-door route. The reason it’s called a back-door Roth IRA is because you make a non-deductible traditional IRA contribution (up to $5,500 annual limit, $6,500 if 50 or older). Then, after the non-deductible traditional IRA contribution is made, you then convert the funds to Roth. There is no income limit on Roth conversions, and since you didn’t take a deduction on the non-deductible traditional IRA contribution, there is no tax due on the conversion to Roth. And now, voila, you have $5,500 in your Roth IRA. That’s the back-door route.
There is a road block though for some who already have funds already in traditional IRAs. The Roth conversion ordering rules state that you must first convert your pre-tax traditional IRA funds, which you got a deduction for and now pay tax when you convert, before you are able to convert the non-deductible traditional IRA funds. So, if you have pre-tax traditional IRA funds and you want to do the back-door Roth IRA, you have two options:
- First, convert those pre-tax traditional IRA dollars to Roth and pay the taxes on the conversion.
- Second, if your 401(k) allows, you can roll those pre-tax traditional IRA dollars into your 401(k). If you don’t have a traditional IRA, you’re on easy street and only need to do the two-step process of making the non-deductible traditional IRA contribution and then convert it to Roth.
You have until April 15th of each year to do this for the prior tax year. Additionally, while the GOP tax-reform restricted Roth re-characterizations, Roth conversions and the back-door Roth IRA route were unaffected. For more detail on the back-door Roth IRA, check out my prior article here.
2. Health Savings Account (HSA)
If you have a high-deductible health insurance plan, you can make contributions to your HSA up until April 15th of each year for the prior tax year. Why make an HSA contribution? Because you get a tax deduction for doing it, and because that money comes out of your HSA tax-free for your medical, dental, or drug costs. You can contribute and get a deduction, above the line, of up to $3,400 if you’re single or for up to $6,750 for family. We all have these out-of-pockets costs, and this is the most efficient way to spend those dollars (from an account you got a tax deduction for putting money into). If you didn’t have a high deductible HSA-qualifying plan by December 1st of the prior year, then the HSA won’t work.
Any amounts you don’t spend on medical can be invested in the account and grow tax-free for your future medical or long-term care. Health savings accounts can also be invested and self-directed into real estate, LLCs, private companies, crypto-currency or other alternative assets. We’ve helped many clients invest these tax-favored funds using a self-directed HSA.
For more details on health savings accounts, check out my partner Mark’s article here.
3. Cash Balance Plan or Defined Benefit Plan
If you’re self-employed you may consider establishing a cash balance plan or a defined benefit plan (aka “pension”), where you can possibly contribute hundreds of thousands of dollars each year. The amount of your contribution depends on your income, age, and the age and number of employees you may have. A cash balance plan or defined benefit plan/pension will cost you ten thousand dollars or more in fees to establish, and is far more expensive to maintain and administer. But, if you have the income, it’s a valuable option to consider. For more details on cash balance plans, check out Randy Luebke’s article here.