Tag: QuickGuides

Entity Classification Election

Posted on by Peter Harper

Entity Classification Election

Following our previous discussion about entity changes with check-the-box regulations, let’s go into another process that entrepreneurs and executives are likely to consider with the tax season fast approaching: the entity classification election.

What is the Purpose of Entity Classification Election?

The purpose of the entity classification election is to enable business entities to avoid the default tax classification applied by the IRS for federal income tax purposes. Business entities receive a default tax classification, which can result in paying for more federal taxes than necessary. If your entity is eligible to use the entity classification election form, you can change your tax election status and potentially lower your tax liability.

For example, a U.S. corporation can avoid double taxation by using the CTB regulations, and it also benefits foreign eligible entities by avoiding potential double taxation. For example, an entity in India could be classified and taxed differently in the U.S. than in India, such as a tax treaty or an income tax treaty. The CTB rules, therefore, provide the entity in India to elect its entity classification for U.S. tax purposes with that said tax treaty. 

The entity set up in India can also use the tax treaty, along with any treaty benefits included, to qualify for lower dividend withholding taxes if it elects to be taxed as a corporation in the U.S. 

A Parent company in the U.S. can also use the CTB rules to benefit from the tax treaty with India and avoid double taxation. 

What Is A Business Entity Classification?

A business entity is any entity that is recognized for federal tax purposes that is not correctly classified as a trust under Regulations section 301.7701-4 or otherwise subject to special treatment under the Code regarding the entity’s classification. A business entity is classified as either a C-Corporation, partnership, or disregarded entity for federal tax purposes. 

Here is how you can remember:

Association – For purposes of the CTB regulations, an association can be an eligible entity that’s taxable as a corporation by election or under the default rules for foreign eligible entities, as discussed below.

Business entity – A business entity is any entity recognized for federal tax purposes that is not accurately classified as a trust under Regulations section 301.7701-4. Or they are otherwise subject to special treatment under the Code regarding the entity’s classification. 

Corporation – For federal tax purposes, a corporation is any of the following: 

    • A business entity is organized under a federal or state statute or a federally recognized Indian tribe statute if that same statute describes or refers to the entity as incorporated or as a corporation, body corporate, or body politic. 
    • An association.
    • A business entity is organized under a state statute if the statute describes or refers to the entity as a joint-stock company or joint stock association. 
    • An insurance company. 
    • A state-chartered business entity that is conducting banking activities, if any of its deposits are insured under the Federal Deposit Insurance Act or a similar federal statute. 
    • A business entity that is wholly owned by a state or any political subdivision or is wholly owned by any entity described in Regulations section 1.892-2T, such as a foreign government.
    • A business entity that can be taxable as a corporation under a provision of the Code other than section 7701(a)(3). 
    • A foreign business entity as listed on page 7 of Form 8832. 
    • An entity is created or organized under tax laws of more than one jurisdiction (an example can be a business entity that has multiple charters) if the entity will be treated as a corporation with respect to any of the jurisdictions. For examples, see Regulations section 301.7701-2(b)(9).

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What is an Entity Classification Form?

This federal tax form allows certain businesses to select whether they want to be taxed as a corporation, partnership, or disregarded entity for future tax purposes and protected under tax law. 

What is IRS Form 8832?

You can use IRS form 8832 to choose to have:

      • A corporation with more than one owner is treated as a partnership for tax purposes.
      • A corporation with a single owner is treated as a ‘disregarded entity for tax purposes.
      • A partnership is treated as a corporation for tax purposes.
      • A ‘disregarded entity is treated as a corporation for tax purposes.

Which Businesses Can Use Form 8832?

Only businesses that are considered eligible entities can use Form 8832. The following are regarded as eligible entities:

      • Partnerships
      • Single-member LLCs
      • Multi-member LLCs; and
      • Certain types of foreign entities

Not every type of business can use Form 8832 to change their business’s tax classification. The following can be considered businesses eligible for filing Form 8832:

      • Partnerships
      • Single-member LLCs
      • Multi-member LLCs
      • Explicit types of foreign entities (Page 5, Form 8832)

The above entities can use Form 8832 to elect to be taxed as a C corporation, partnership, or sole proprietorship.

If you’re currently a limited liability company (LLC) taxed as a corporation, you can use Form 8832 to revert to a previous tax classification.

Eligible businesses that don’t fill out the form will be taxed based on their default tax status. If you are content with your current or default tax classification, do not fill out Form 8832.

Remember that your business can only change its tax classification once every five years.

Who is Not Eligible to File Form 8832?

Sole proprietors, domestic corporations, and foreign corporations are listed in IRS Regulations 301.7701-2(b)(8). 

How Do You Fill Out Form 8832?

Form 8832 is a straightforward form to fill out and only requires the entity’s name, address, and tax identification number, followed by making an election by checking the relevant box and the signature of the entity’s eligible owner, member, partner, or officer.

Before you begin filling out your form, you need to gather some information. Take a look at what to have handy for Form 8832:

      • Business name, address, and phone number
      • Employer Identification Number (EIN)
      • Owner’s name and Social Security number (if the business only has one owner)

There are two parts to the form: Election Information (Part I) and Late Election Relief (Part II). Part I asks a series of questions on your tax status election. Depending on your answers, you may be able to skip some lines.

Part II is for businesses seeking late election relief only. To be eligible for late election relief, all of the following must apply:

      • The IRS denied a previous Form 8832 filing because you didn’t file on time.
      • You haven’t filed your taxes because the deadline hasn’t yet passed, or you’ve filed your taxes on time.
      • You have reasonable cause for not filing your form on time.
      • It has been less than three years and 75 days from your requested effective date.

Is Form 8832 Complicated?

No. The required information you need to know is: 

        • The name of your business
        • The phone number and address of your business
        • The employer identification number (EIN)

Who Must File Form 8832?

Keep in mind that it is not a mandatory form at all. It provides eligible entities the option to change their default classification should they wish. 

What Information is Required?

        • The name of your business
        • The phone number and address of your business
        • The employer identification number (EIN)
        • Owner’s name and Social Security number if the business only has a single owner

Where Should It Be Filed?

        • The form can not be filed electronically. 
        • If you are living as either a resident or non-resident in the U.S., you will have to mail it to the appropriate IRS office in your state.
        • If you are a resident or non-resident in a foreign country, you will need to mail the form to the Department of the Treasury, Internal Revenue Services, Ogden, UT 84201-0023.

Where Do You Send the Form?

This will depend on the location your entity is residing in a domestic or foreign location:

        • If you live in the U.S., you’ll mail it to the appropriate IRS office in your state.
        • If you live in a foreign country as a resident or non-resident, you will need to mail the form to the Department of the Treasury, Internal Revenue Services, Ogden, UT 84201-0023.

Once your specific office receives your form, they will notify you immediately whether it has or hasn’t been accepted. A final determination notice of the election change will be sent to you within 60 days of the acceptance decision.

What’s the Form 8832 deadline?

Because Form 8832 is not mandatory, it doesn’t have a deadline per se. It can be filed at any point by an eligible entity. There are, however, specific but basic rules to take note of. When you file the form, you can include the date the change will take effect. 

Broadly, an election specifying an eligible entity’s classification will not take effect more than 75 days before the election is filed, nor can it take effect later than 12 months after the election is filed. However, an eligible entity may be able to apply for an exemption and receive a late election relief in certain circumstances.

How Long Does It Take to Prepare?

The IRS estimates that 17 minutes are required to prepare the form. However, this doesn’t take into account the time it will take to learn and understand the applicable tax law.

What Else Should I Know About Form 8832?

It is essential to know the difference between Form 8832 and Form 2553. Both forms allow certain businesses to request a new tax classification. However, the major difference is the type of tax classification you request.

Form 8832 authorizes businesses to request to be taxed as a corporation, partnership, or sole proprietorship, whereas Form 2553 is the form corporations and LLCs use to elect S-Corp tax status. 

The check-the-box regulations authorize entities to elect to change their U.S. tax classification, though a change in tax classification, no matter how achieved, has tax consequences. This applies to U.S. and International business owners.

Essentially there are three ways to accomplish a classification change:

        • An elective classification change by filing IRS Form 8832.
        • An automatic classification change, wherein an entity’s default classification changes as a result of a change in the number of owners.
        • An actual conversion, wherein an entity merges into, or liquidates and forms, an entity that has the desired classification.

Suppose a corporation elects to be classified as a partnership. In that case, it will be deemed to have distributed all its assets and liabilities to shareholders in liquidation. The shareholders are considered to contribute all the distributed assets and liabilities immediately after that to a newly formed partnership. An entity will be deemed to have liquidated under §331 or §332, and the deemed liquidation will be treated like it were an actual liquidation for tax purposes.  

An entity not regarded as eligible will first need to convert into an eligible entity before making the check-the-box election. 

Lastly, an actual conversion can be implemented.

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Why to Use Form 8832

Businesses receive a default tax classification, which can result in paying more business taxes than necessary. If you’re eligible to utilize the entity classification election form, you can change your tax election status and potentially lower your liability on a tax return, saving you money and building more tax credit.

Why Comply?

Even though this form is not mandatory, this will be an advantage for some taxpayers to decide whether their entity will be taxed as a partnership (one with multiple owners), as a corporation, or disregarded for tax purposes (single owner entity) and taxed like a proprietorship.

What is the Best Tax Classification for an LLC?

An ideal tax classification for a limited liability company (LLC) will depend on if you’d like your business profits should be taxed at your personal income tax or corporate tax rates. If you would rather use your personal tax rates instead, you can classify it as a disregarded entity or as a partnership. If not, you can classify it as a corporation instead.

An LLC can be taxed in several ways for the business and its owner to save on taxes. Below are ways how an LLC can be taxed, how your business can benefit from being taxed as an S corporation or as a corporation, and how you can elect this tax option:

An LLC can be considered as a disregarded entity, similar to the way sole proprietorships are treated, or can be taxed as a partnership if it has multiple members. Those are the most usual classification for LLCs, with each case having the profits ultimately taxed as a part of every member’s personal income.

It’s also possible for an LLC to be considered a corporation. If so, the entity will have to pay corporate taxes instead of passing profits through to each member’s personal income tax return.

To be taxed as a corporation, use the entity classification election or IRS Form 8832. The election for being taxed as a new entity will go into effect on the date entered on line 8 of Form 8832. However, the election cannot take effect over 75 days before the date the election is filed, nor will it take effect any later than 12 months after it is filed.

The form includes a consent statement that may be signed by all or one member on behalf of all other members. If one member does sign, there needs to be some record in a company membership meeting that all members have approved this specific election.

For single-member LLCs, you will need to provide the name(s) and owners’ Social Security number. The same will be applied for multi-member LLCs, but with an Employer ID Number instead of Social Security number. 

You can fill out an IRS Form 2553 in order to be taxed as an S corporation, also known as an election by a Small Business Corporation. To start a new tax classification for a year, you will need to file by March 15, which will be effective for the entire year. You must also include all necessary information about each shareholder: name and address, Social Security number, the date the owner’s tax year ends, shares that they owned, and a consent statement.

For any change to a corporation, you must note the following: when your election to corporate status goes into effect, the IRS will determine that any and all liabilities and assets from the previous business (whether it was a partnership or a sole proprietorship) will be added to the corporation in exchange for shares of the corporate stock.

By default, the IRS can tax a multi-member LLC as a partnership since LLCs don’t have a separate IRS tax category.

If you want to convert your LLC’s tax status from a partnership to a corporation while not changing the LLC’s legal form, you will only need to file an IRS Form 8832 (taxed as a C corporation) or an IRS Form 2553 (to be taxed as an S corporation). 

Note that once an LLC has elected to change its classification, it cannot elect again to change its classification for the 60 months after the election’s effective date. 

Any election for changing a partnership classification to a corporation shall be treated like the partnership provided all of its liabilities and assets to the corporation in exchange for stock. The partnership is then immediately liquidated by distributing the stock to its partners.

IRS Form 8832: Q&As

If you have any further questions about Form 8832 and if this is the best decision for your business, please feel free to contact us at Asena Advisor for a private consultation or check out the IRS’ entity classification election page, which will have a digital copy of the form. Click here to check the latter.

Speak with one of our consultants to learn more about how Entity Classification Election can help you.

Shaun Eastman

Peter Harper

Check-The-Box Regulations

Posted on by Peter Harper

Check-The-Box Regulations

Also known as the Regulations, the Check-The-Box regulations (CTB) is a classification process that allows an entity, if they so choose for U.S. tax purposes, to be recognized as a corporation or partnership. Entities that can be considered for CTB are those that have already been incorporated under federal or state law, associations, insurance companies, joint stock companies, state-owned entities, banks, publicly traded partnerships, and certain foreign entities.

When Did Check-The-Box Regulations Come Out?

The IRS declared in Notice 95-14 its intention to simplify the entity classification process. Final entity classification regulations under Internal Revenue Code 7701 and treasury regulations sections 301.7701-1 through 301.7701-3, also known as Check-the-Box or CTB regulations, went into effect on January 1, 1997, for all, whether they are domestic or foreign eligible entity. The regulations allow a qualified (or not automatically classified as a corporation) entity to be classified as a corporate (association) or a flow-through (partnership or an entity disregarded from its owner (DRE)) for U.S. income tax purposes if they wish so.

What Is A “Check-The-Box” Election (IRS Form 8832)?

A CTB election is an entity classification election for federal tax purposes made on Form 8832 – Entity Classification Election. The process can be relatively straightforward; you will need to select the appropriate box and the date that the election will become effective. 

What Is The Effect Of A Check The Box Election?

Regulations under a Check-The-Box election allow an eligible (i.e., not automatically classified as a corporation) entity to be classified as a corporation (association) or as a flow-through (a partnership or entity that is disregarded from its owner (DRE)) for U.S. federal tax purposes.

The CTB regulations permit U.S. investors to create limited liability partnerships (LLP) or companies to incorporate business entities in foreign countries, particularly civil law countries. That way, all members would enjoy limited liability, which would be treated as a corporation under foreign limited liability and could be treated as a partnership or disregarded entity under U.S. tax law. 

However, the entity cannot change its classification again for five years, with this limitation applying only to changes made by an election. Accordingly, a new eligible entity that elects from its default classification may change its classification by election at any time. 

The Benefits Of The US Check-The-Box Regulations

Now that we have defined what the CTB is, let’s go into more detail about the benefits that come with it:

Benefits Of Check-The-Box Regulations For Entities With Two Or More Members

In a domestic entity with two or more members, the default classification (if no CTB election is made) is that of a partnership. 

Some of the benefits of making a CTB election are:

    • A corporation, such as C Corporations, is considered a separate legal entity and continues in perpetuity. 
    • As a U.S. corporation, it can benefit from various Double Tax Treaties the U.S. has in force. 
Benefits Of Check-The-Box Regulations For Entities With One Member

The Default classification of a domestic entity with a single member is that it will be treated as a disregarded entity and, therefore, as a sole proprietorship. The same benefits will apply if an election is made to be taxed as a corporation.

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Considerations On Whether To Check-The-Box For Foreign Subsidiaries

Following the benefits of CTB, the following are factors to take into mind before making a final decision:

Deferral And Timing Of Income

Due to U.S. taxpayers being taxed on a worldwide basis, U.S. owners of a transparent foreign entity are not able to defer or time the amount of U.S. tax on their foreign income. U.S. tax is payable when the income is earned, regardless of whether they repatriate the cash. 

Making a CTB election for your foreign subsidiary to be classified as a corporation gives the U.S. shareholder more flexibility on whether and when they want to receive a dividend from the foreign subsidiary. U.S. tax is only payable once the cash is distributed to the U.S. owner. 

Rate Differential

Suppose you decide to treat a foreign eligible entity as transparent. In that case, the U.S. owner is considered to be earning the entity’s income directly and, therefore, taxable at the U.S. owner’s marginal rate, which could be as high as 37%.

If you make an election to treat the foreign subsidiary as a corporation and separate entity, the tax rate would be 21% in the U.S. 

There are various tax planning opportunities available.

Use Of Foreign Losses

A US taxpayer may prefer a transparent entity initially to realize the current tax savings that foreign losses can provide.

Foreign Tax Credit Regime

This regime prevents U.S. taxpayers from paying U.S. tax on income that a foreign jurisdiction already has taxed. 

U.S. citizens and domestic corporations may credit income taxes paid to foreign countries (subject to limitations). Generally, a U.S. person may only claim a credit for the foreign income tax if they paid. 

However, Section. 902 allows domestic corporations to claim a credit for taxes paid by underlying foreign corporations as if the U.S. taxpayer paid these taxes directly. U.S. shareholders will then claim this deemed-paid credit in the same year the undistributed income is taxed. 

Can An LLC Check-The-Box?

Yes, an LLC can apply CTB regulations. Limited Liability Companies have the advantage of the flexibility and limited liability for their owners. However, from a tax and accounting perspective, it will take on the complexity of the box it checks. An LLC can therefore make a CTB election.

New Check-The-Box Rules Simplify Entity Classification

The new regulations simplify entity classification. These new rules divide business entities into three groups:

  • Those automatically classified as corporations – such as insurance companies, banking organizations, state-owned companies, and specific listed organizations formed outside of the U.S.
  • Those that may elect to be classified as partnerships or corporations – include all other business entities with at least two members.
  • Those that may elect to be classified as corporations or be disregarded for tax purposes – entities that may elect to be classified as corporations or be disregarded, include all business entities not in the group automatically classified as corporations with only a single owner.

Classifying Business Entities Under The Check-The-Box Regulations

If you already have a business, whether an LLC or Corporation, here are some ways to determine if it falls under CTB regulations.

Determining If a Separate Entity Exists

U.S. Federal tax laws are applied to determine whether a separate entity (S.E.). Local law will not be the determining factor. 

If a business entity, for example, has more than a single member, and if participants were to carry on a trade, financial operation, business, or venture, followed by dividing the resulting profits, an S.E. is considered to exist (even if one is or isn’t considered to exist under an applicable state law). A mere expense-sharing collaboration or mere co-ownership of an asset, however, does not create an S.E.

Automatic Classification as Corporation

Below are the following entities that are automatically classified as corporations:

    • A business entity is arranged under federal or state statute (or under the statute of a federally recognized Indian tribe) if that said statute should describe or refer to the entity as incorporated or a corporation, body corporate, or body politic. 
    • An association as determined under Regs. Sec. 301.7701-3, where an unincorporated entity that elects to be taxed as a corporation.
    • A business entity is arranged under a state statute if that same statute describes or refers to the entity as a joint-stock association or company.
    • A business entity is taxable as an insurance company.
    • A state-chartered business entity that is conducting banking activities, if any of its deposits are insured under the Federal Deposit Insurance Act. It is also amended or a similar federal statute.
    • A business entity that is completely owned by a state or political subdivision. Also, a business entity is completely owned by a foreign government.
    • Any business entity that can be taxable as a corporation under a provision of the Code other than Sec. 7701(a)(3). For example, include a publicly traded partnership, real estate investment trust, tax-exempt entity, or regulated investment company.
    • A foreign entity designated explicitly as a corporation (see Regs. Sec. 301.7701-2(b)(8) for a list).
    • A business entity with multiple charters and is treated as a corporation in any one of the jurisdictions.
Classifying unincorporated domestic single-owner entities

A newly formed domestic single-owner entity that cannot be automatically classified as a corporation — including a single-member limited liability company or an LLP is, by default, classified as a disregarded.

Classifying unincorporated domestic multi-owner entities

A newly formed domestic entity that has two or more owners, which is an eligible entity, is classified by default rules as a partnership.

The IRS ruled in Rev. Rul. 2004-77 that if an eligible entity has two members under local law. Still, suppose one of the members is a disregarded entity owned by the other member. In that case, the eligible entity cannot be classified as a partnership and be taxed as a disregarded entity or also elect to be taxed as a corporation.

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Beware Of Tax Consequences Of Classification Changes

Taxpayers need to understand the tax treatment when an entity’s classification changes. If that entity changes its classification from a corporation to a partnership or a disregarded entity, the resulting tax consequence of that transaction will often be treated as a taxable liquidation.

Although it may be straightforward to file Form 8832 to change the classification of an entity, the tax exposure can be significant and immense.  

What Does It Mean When an LLC Checks The Box?

The IRS provides the following summary regarding the default rule:

  • A Limited Liability Company is an entity created by state statute.
  • Depending on elections made by Limited liability companies and the quantity of members, an LLC will be treated by the IRS as either a corporation, partnership, or a piece of the owner’s tax return (as a “disregarded entity”).
  • A domestic LLC that has, at minimum, two members is classified as a partnership for federal income tax purposes. That would apply unless the members decide to file Form 8832 and elects to be treated as a corporation.
  • For income tax purposes, limited liability companies that have a singular member will be treated as an entity that isn’t separate from its owner unless it files Form 8832 and affirmatively elects to be treated as a corporation. However, an LLC that only has a singular member is still considered a separate entity for employment tax and certain excise taxes.
For any more information on Check-The-Box regulations, contact Asena Advisors.

 

Shaun Eastman

Peter Harper

How to Avoid the Net Investment Income Tax

Posted on by Peter Harper

How to Avoid the Net Investment Income Tax

Ever since the net investment income tax, or NIIT, was introduced by the IRS, taxpayers have tried to understand this tax and at the same time try to avoid it. What follows is an introduction of what this tax entails, how it is triggered, the types of income that are and are not included, how to calculate it and, strategies for how to avoid or minimize it. 

What Is The Net Investment Income Tax?

This is a tax that is not widely understood by many people, but is a very important concept to learn about, especially if a large part of one’s income is derived from investments. 

Simply put, the NIIT is a 3.8 percent tax that is applied on certain investment income. For the purposes of calculating net investment income (NII), the IRS looks at income derived from investments (before any applicable taxes are applied) such as bonds, stocks, mutual funds, annuities, and loans (minus properly allocable expenses). 

The other way to think about this tax is that it is a surtax imposed on certain unearned income. The tax equals 3.8 percent of the lesser of the taxpayer’s NIIT, or the excess of the taxpayer’s modified gross income (MAGI) over a certain threshold (discussed later in this article). 

The tax applies to estates, trusts, families and individuals. However, certain income thresholds need to be met before the tax takes effect. 

When Did The Net Investment Income Tax Take Effect?

As is the case with all taxes, the main purpose for including NIIT as part of the Health Care and Education Reconciliation Act, was to raise revenue. In this case, this surtax was used to help pay for the Affordable Care Act. The official name of this tax is actually “Unearned Income Medicare Contribution Tax,” which would logically imply that it is used to fund Medicare. However, this is not the case. The surtax is effective for tax years beginning after December 31, 2012.

What Triggers Net Investment Income Tax?

In the case of individual taxpayers, section 1411(a)(1) of the tax code imposes a tax (in addition to any other tax imposed by subtitle A) for each taxable year equal to a tax rate of 3.8 percent of the lesser of the individual’s NII for that tax year, or the excess (if any) of the individual’s MAGI for that tax year, over the threshold amount. We will discuss the calculations behind this tax, later in this article.

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What Counts As Net Investment Income?

Net Investment Income Includes:

For the purposes of calculating this tax, net investment income includes short and long-term capital gains (as well as gains from the sale of investment real estate, and gains from the sale of interests in partnerships and S corporations to the extent the partner or shareholder was a passive owner), taxable interest income, rental and royalty income, qualified and non-qualified dividends, passive income from investments, business income from trading financial instruments or commodities, and taxable portion of non-qualified annuity payments (for example, Roth IRAs). 

It Doesn’t Include:

In general, NII does not include wages, unemployment income, operating business income from a non-passive activity, Social Security Benefits, alimony, tax-exempt interest, self-employment income, municipal bonds, Alaska Permanent Fund Dividends and distributions from certain qualified plans (those described in sections 401(a), 403(a), 403(b), 408, 408A or 457(b) of the tax code), such as qualified annuities.

What Is Exempt From NIIT?

The NIIT does not apply to any portion of a gain that is excluded from regular income tax. Therefore, gains from sale of a principal residence are excluded from the NIIT unless the gain exceeds the principal residence exclusion amount of $250,000 (for a single filer) or $500,000 (if filing jointly with your spouse).

In addition, non-resident aliens (NRAs), who are individuals that are neither U.S. citizens nor U.S. residents, are not subject to this tax. The U.S. Treasury regulations state that in the case of a U.S. citizen or resident who is married to a non-resident alien individual, the spouses will be treated as married filing separately for purposes of section 1411. The U.S. citizen or resident spouse will be subject to the threshold amount for a married taxpayer filing a separate return, and the non-resident alien spouse will not be subject to the NIIT.

Who’s Subject To The Net Investment Income Tax?

All individuals who file tax returns, except NRAs, are subject to NIIT if they have NII and MAGI over the aforementioned taxable income thresholds. 

Trusts and estates that have undistributed NII and an AGI greater than the highest tax bracket applicable will be subject to this tax. 

Is Your MAGI Greater Than The Threshold?

For the purposes of meeting the threshold to be subject to this tax, the MAGI amounts are:

  • Married filing jointly — $250,000
  • Married filing separately — $125,000
  • Single or head of household — $200,000 or
  • Qualifying widow(er) with a child — $250,000

How To Calculate The NIIT?

The tax itself is computed on Form 8960 of one’s U.S. tax return. Individual filers report and pay the tax on Form 1040, while trusts and estates report and pay this tax on Form 1041. 

For purposes of calculating NII, modified adjusted gross income is a household’s AGI, with certain deductions and tax-exempt interest payments, such as contributions from individual retirement accounts (IRAs), included again. The relevant deductions for purposes of AGI are listed on Schedules 1, 2, and 3 of Form 1040. If your MAGI is higher than the thresholds for your filing status, you will need to pay NIIT.

The next step is to calculate your NII based on the included income stated above. Before you can calculate your NII, however, you first need to ascertain what your gross investment income is. This is the amount prior to considering any eligible deductions (which are discussed later in this article). 

Once you arrive at the gross investment income, it will be reduced by deductions allowed against the income tax which are properly allocable to those items of gross income or net gain to arrive at the NII. 

Finally, the amount that will be subject to NIIT at a rate of 3.8 percent will therefore vary as follows: 

  • If your NII is higher than the amount by which MAGI surpasses the threshold, the tax applies to your MAGI
  • If your NII is lower than the amount by which MAGI surpasses the threshold, the tax applies to your NII

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Will I Have To Pay Both The 3.8% Net Investment Income Tax And The Additional .9% Medicare Tax?

You may be subject to both taxes, but not on the same type of income, as these two taxes apply to different types of income. The 0.9 percent additional Medicare tax applies to individuals’ wages, compensation, and self-employment income over certain thresholds, but it does not apply to income items included in NII.

Can Tax Credits Reduce My NIIT Liability?

Indeed, any tax credit that is allowed to offset a tax liability imposed by subtitle A of the tax code may be used to offset the NII. However, if the tax credit is only allowed to be offset against tax imposed by Chapter 1 of the tax code, such as regular income tax, that credit may not reduce the NIIT. For instance, foreign tax credits may not be used to reduce NIIT exposure in the U.S., as they are only allowed to offset a tax liability on regular income tax. Further, foreign tax credits are only allowed against taxes imposed by IRC Chapter 1. 

Strategies To Avoid Or Reduce The Tax

There are various strategies and planning opportunities to either reduce your NII or reduce your MAGI, which will result in reduced taxable income. No blanket strategy or planning tool exists, and due to the complex nature of the NIIT, it is advisable to consult professionals such as your tax advisor or CPA on possible mitigation. The IRS will not be lenient if these regulations are willfully avoided. This is why it is so important to get advice from a tax advisor who has experience dealing with these sorts of matters.

Tips For Managing Your Investments

As stated previously, no blanket strategy or planning tool exists, due to the complex nature of this tax. However, if you do have investment income and if you think you will be subject to this tax, there may be deductions available for you to take advantage of.

Some examples of deductions which may be properly allocable to gross investment income include brokerage fees, investment advisory fees, tax preparation fees, fiduciary expenses (which only apply to estates and trusts), interest expense, investment advisory fees, expenses incurred in relation to royalty and rental income, and state and local income taxes. 

If the deductions are not properly allocable to gross investment income, then they will not be allowed. For instance, brokerage fees that are not properly allocable will not be allowed as a deduction. The instructions to Form 8960 provide examples of deductions that are not deductible for NII purposes; for example, deductions for contributions to IRAs or other qualified plans. 

Additionally, special rules apply for traders of financial instruments and commodities regarding the deduction of expenses in relation to self-employment income.

 

If you have further questions or want to begin the process, reach out to one of our Asena consultants.

Arin Vahanian

Peter Harper

Sole Proprietorship vs LLC

Posted on by Peter Harper

Sole Proprietorship Vs. LLC: What’s The Difference?

It is most likely for individuals and small business owners to structure their businesses as either sole proprietorships or LLCs. Suitability of structuring your business as one or the other arises because of slight differences in formations and protections of each entity.

Sole Proprietorship
  • The easiest business structure is the sole proprietorship, as it has minimal startup costs for entrepreneurs. The set-up of a formal structure is not required.
  • They are run by a single individual who owns all the business assets and is responsible for all the liabilities.
  • The IRS automatically considers a business structure operating in a natural person’s name as a sole proprietorship. 
  • A sole proprietorship’s owner is personally liable for any financial losses and debts that may arise during trading.
Limited Liability Company (‘LLC’)
  • An LLC is a business entity that can have one or more owners. A formal structure is required as owners must file articles of organization with the secretary of state to form the LLC.
  • An LLC provides its owners (referred to as members) with limited liability, meaning members are not personally liable for business debts and claims.
  • An LLC is a pass-through entity; by default, the IRS classifies single-member LLCs as sole proprietorships and multimember LLCs as partnerships for tax purposes. The members may also elect to have the LLCs taxed as S-Corporations or C-Corporations by filing the necessary forms with the IRS.
  • An LLC can be member-managed, or an election can be made to have third parties manage the entity.

Why Change A Sole Proprietorship To An LLC

Changing your business from a sole proprietorship to an LLC may be worthwhile if you’d like to grow your business and to engage in more risk than before. LLCs provide members with limited liability protection, which does not apply to sole proprietorships. 

Multiple owners can also own LLCs, while individuals may be more willing to invest in an LLC than a sole proprietorship as they will be entitled to some share of the business profits.

The Pros And Cons Of Each Business Structure

Sole Proprietorship
Pros of Sole Proprietorships
      • Forming a sole proprietorship is less expensive and requires less paperwork. (Licenses and permits could still be mandatory depending on the nature of the business)
      • The net business income of the sole proprietorship is included in the owner’s personal income tax returns. The tax rate applied to the business profits depends on the owner’s individual tax rate.
      • The owner of a sole proprietorship is solely responsible for all management decisions and responsibilities. Therefore, board/member resolutions are not required when any decisions regarding the business need to be made.
Cons of Sole Proprietorships 
      • Owners have personal liability for all debts and claims of the company, and their personal assets may be at risk to settle unpaid debts and other legal liabilities of the business.
      • Owners of sole proprietorships will be required to use their own resources (capital or credit facilities) to fund their startups, as they cannot provide external investors with any securities in the form of stocks.
Limited Liability Company (LLC)
Pros of an LLC 
      • An LLC is considered as a separate entity from its members. Subsequently, members are not personally liable for the business’s debts and other legal liabilities (i.e., they have limited liability protection). 
      • Members of LLCs include the business profits in their individual tax returns because the LLC is classified as a pass-through entity. Furthermore, members may be able to apply the 20% pass-through deduction to business profits.
      • LLCs may have fewer state-imposed filing requirements than corporations.
Cons of an LLC 
      • Forming an LLC is more expensive than setting up a sole proprietorship, and depending on the state requirements, ongoing fees may be imposed annually.
      • Members of LLCs receive units in proportion to their contribution/LLC agreement. These units are not as easy to transfer as stocks in a corporation. This difficulty in transferring ownership is one of the reasons that external investors/venture capitalists prefer investing in corporations over LLCs.

 

Where should I form my LLC?

An LLC typically forms in the state in which the business activities of the entity will be conducted. It is possible to create the LLC in a different state; however, the LLC will then be classified as a Foreign LLC, which may lead to additional filing requirements with the secretary of state and higher administrative costs in most states. The IRS has special rules for foreign LLCs and must be considered if this option is elected.

Responsibilities As An LLC Owner

The members’ responsibilities will be decided in the LLC operating agreement. This will detail whether the owners have elected to have the LLC be member-managed or manager-managed. If the LLC is member-managed, the members will be responsible for the day-to-day management of the LLC. If the LLC is manager-managed, the members are responsible for electing suitable individuals to make management decisions and oversee the entity’s operations. 

Members also need to ensure that the business complies with the formalities and filing requirements of the relevant state to ensure that the LLC does not lose its limited liability protections.

How To Transition A Sole Proprietorship To An LLC

Dissolving or canceling any registered Fictitious Business Names or Doing Business As (DBAs)

If the sole proprietorship was trading under a different name, the necessary documentation must be filed with the state to dissolve or withdraw the current DBA. After that, you can use the same name to register your LLC if the name is not already registered to another LLC.

Choosing a business name

The new LLC name needs to be distinguishable from all other registered entities. You can start searching on the state’s business search tool.

Selecting a registered agent

A registered agent is an individual or company who will be responsible for receiving legal correspondence and documentation on behalf of the company. It may be one of the members or an attorney/accountant.

Filing Articles of Organization

While it may differ from state to state, this document needs to detail the name and address of the LLC, the contact details and names of the owners, the application date, and a description of the new business.

Drafting an operating agreement

The operating agreement is an internal document that needs to be drafted by members and will set out the rules for ownership and the management of the newly formed LLC. It will detail what will happen if additional members are introduced to the LLC, if the LLC will be liquidated, or if members leave the LLC.

Applying for an Employer Identification Number (EIN)

As LLCs are pass-through entities, an application for a new EIN number needs to be obtained if the LLC will be multimember or if the election is made by its members to be taxed as a corporation.

Opening a bank account

A bank account for any new business needs to be opened in the name of your LLC to ensure a clear separation between the LLC funds and the members’ personal funds. This also eases the management of assets and allows for more accurate recordkeeping.

Contacting licensing agencies

Suppose the nature of the business requires the LLC to obtain business licenses or permits to operate. In that case, the relevant agencies need to be contacted to ensure that the licenses or permits are transferred from the sole proprietor to the newly formed LLC.

Updating business information

Inform clients and other stakeholders of the new business to ensure they issue invoices and payments to the newly formed LLC and no longer to the sole proprietor. Insurance companies must be advised of the change from a sole proprietorship to an LLC to advise if a new business insurance policy may be required.

Reviewing your current contracts

Please review the current contracts between the sole proprietorship and its clients to ensure they can be transferred to the newly formed LLC. These contracts need to be updated between clients and your LLC and are no longer the personal name of the owner of the sole proprietorship.

Necessary Documents

Documents required for the transition from a sole proprietorship to an LLC include (but may not be limited to in some states):

  • Articles of Organization 
  • Operating Agreement
  • Form 8832 if the members elect to change the default classification of the IRS.

Stop using your Sole Proprietorship

Ensure that all the payments and checks have cleared and close the bank account of the sole proprietorship. Update all existing contracts and insurance policies to include the newly formed LLC, not the sole proprietorship.

Maintaining Your Limited Liability Protections

Members of the LLC need to ensure that they do not pierce the corporate veil by providing that business assets do not get mixed with their personal assets. Should this be the case, your LLC risks losing its limited liability protection.

 

If you would like a consultation on which is best for you, contact Asena Family Office.

Jean-dré Tombisa

Peter Harper