Handle with care: Mutual funds and taxes

Many people overlook taxes when planning their mutual fund investments. But you’ve got to handle these valuable assets with care. Here are some tips to consider.

Avoid year-end investments

Typically, mutual funds distribute accumulated dividends and capital gains toward the end of the year. But don’t fall for the common misconception that investing in a fund just before a distribution date is like getting “free money.”

True, you’ll receive a year’s worth of income right after you invest. But the value of your shares will immediately drop by the same amount, so you won’t be any better off. Plus, you’ll be liable for taxes on the distribution as if you had owned your shares all year.

You can get a general idea of when a particular fund anticipates making a distribution by checking its website periodically. Also make a note of the “record date” — investors who own fund shares on that date will participate in the distribution.

Invest in tax-efficient funds

Actively managed funds tend to be less tax efficient. They buy and sell securities more frequently, generating a greater amount of capital gain, much of it short-term gain taxable at ordinary income rates rather than the lower, long-term capital gains rates.

Consider investing in tax-efficient funds instead. For example, index funds generally have lower turnover rates. And “passively managed” funds (sometimes described as “tax managed” funds) are designed to minimize taxable distributions.

Another option is exchange-traded funds (ETFs). Unlike mutual funds, which generally redeem shares by selling securities, ETFs are often able to redeem securities “in kind” — that is, to swap them for other securities. This limits an ETF’s recognition of capital gains, making it more tax efficient.

This isn’t to say that tax-inefficient funds don’t have a place in your portfolio. In some cases, actively managed funds may offer benefits, such as above-market returns, that outweigh their tax costs.

Watch out for reinvested distributions

Many investors elect to have their distributions automatically reinvested in their funds. Be aware that those distributions are taxable regardless of whether they’re reinvested or paid out in cash.

Reinvested distributions increase your tax basis in a fund, so track your basis carefully. If you fail to account for these distributions, you’ll end up paying tax on them twice — once when they’re paid and again when you sell your shares in the fund.

Fortunately, under current rules, mutual fund companies are required to track your basis for you. But you still may need to track your basis in funds you owned before 2012 when this requirement took effect, or if you purchased units in the fund outside of the current broker holding your units.

Do your due

Tax considerations should never be the primary driver of your investment decisions. Yet it’s important to do your due diligence on the potential tax consequences of funds you’re considering — particularly for your taxable accounts.

 

Sidebar: Directing tax-inefficient funds into nontaxable accounts

If you invest in actively managed or other tax-inefficient funds, ideally you should put these holdings in nontaxable accounts, such as a traditional IRA or 401(k). Because earnings in these accounts are tax-deferred, distributions from funds they hold won’t have any tax consequences until you withdraw them. And if the funds are held in a Roth account, those distributions will escape taxation altogether.

Bad debts aren’t always bad news

The IRS defines a business bad debt as “a loss from the worthlessness of a debt that was either created or acquired in a trade or business or closely related to your trade or business when it became partly to totally worthless.” Although no business owner goes out of his or her way to acquire a bad debt, they’re not always bad news.

The silver lining

Indeed, there’s a potential silver lining to bad debts. In certain situations, you can deduct uncollected debts from your business income, which may reduce your tax liability.

One requirement for a deduction generally is that the amount of the bad debt was previously included in your income. This effectively means that only businesses that use accrual-basis accounting can deduct bad debts.

Cash-basis businesses generally can’t deduct bad debts because they haven’t previously reported the debt as income. So they can’t claim a bad debt deduction simply because someone failed to pay a bill. But they may be able to claim a bad debt deduction if they’ve made a business-related loan that became uncollectible.

What may be deductible

The IRS lists the following examples of potentially deductible bad debts:

  • Credit sales to customers,
  • Loans to clients and suppliers, and
  • Business loan guarantees.

Bankruptcy is a common reason a business might determine that a debt is uncollectible and should be written off. For example, suppose a customer files for bankruptcy and states that the liquidation value of its assets is less than the amount owed to its primary lien holder. Once this customer informs you that your receivable won’t be paid, you can generally write off the amount as a bad debt.

There’s no standard test or formula for determining whether a debt is a bad debt; it depends on the specific facts and circumstances. To qualify for the deduction, you simply must show that you’ve taken reasonable steps to collect the debt and there’s little likelihood it will be paid. If you have outstanding debts that you don’t think will be paid and could be deductible on your 2017 tax return, be sure, if you haven’t already, to take steps to try to collect the debt.

Wholly vs. partially worthless debt

The IRC doesn’t define “worthlessness.” Courts, however, have defined wholly worthless debts as those lacking both current and potential value. The U.S. Tax Court says that partial worthlessness is evidenced by “some event or some change in the financial condition of the debtor . . . which adversely affects the debtor’s ability to make repayment.”

In general, you may recover a portion of a partially worthless debt in the future. You never recover any part of a wholly worthless debt.

Important topic

The right tax strategy for your company’s bad debts is an important topic to consider every year end. Our firm can help you ensure you’re taking all the bad debt deductions you’re entitled to.

Pondering the purchase of a life insurance policy

What, if any, role life insurance should play in your financial plan depends on a variety of factors. These include whether you’re single or married, if you have minor children or other dependents, and your net worth and estate planning goals. There’s also the tax impact to consider. Let’s look a little more closely at some of the issues behind whether you should buy a policy.

Looking at your situation

Life insurance is appealing because relatively small payments now can produce a proportionately much larger payout at death. But the fact that the return on the investment generally isn’t realized until death can also be a downside, depending on your financial situation and goals.

If you have others depending on you financially, your No. 1 priority is likely ensuring that they will continue to be provided for after you’re gone. Life insurance can be a useful tool for achieving this goal.

If you’re single and have no dependents, life insurance may be less important or even unnecessary. Perhaps you’ll want just enough coverage so that your mortgage can be paid off and your home can pass unencumbered to the designated heir(s) — or just enough to pay your funeral expenses.

Assessing your finances

Some people of high net worth may not need life insurance for any of the aforementioned purposes. Nonetheless, it might serve other purposes in their estate plans. For example, a policy can provide liquidity to pay estate taxes without having to sell assets that you want to keep in the family. Or it can be used to equalize inheritances for children who aren’t involved in a family business so that family business interests can go only to those active in the business.

While proceeds are generally income-tax-free to the beneficiary, they’ll be included in your taxable estate as long as you’re the owner. If your estate might exceed your estate tax applicable exemption amount ($5.49 million for 2017), some or all of the life insurance proceeds could be subject to estate taxes. To avoid this result, consider having someone else own the policy. This can create other tax complications, however, so it’s important to consult your tax advisor.

Figuring out your needs

For many people, life insurance is critical to creating financial security for their family or achieving other financial goals. Please contact our firm for specific insight into this important matter.

Are frequent flyer miles ever taxable?

If you recently redeemed frequent flyer miles to treat the family to a fun summer vacation or to take your spouse on a romantic getaway, you might assume that there are no tax implications involved. And you’re probably right — but there is a chance your miles could be taxable.

Generally, miles awarded by airlines for flying with them are considered nontaxable rebates, as are miles awarded for using a credit or debit card. The IRS even addressed the issue in Announcement 2002-18, where it said:

Consistent with prior practice, the IRS will not assert that any taxpayer has understated his federal tax liability by reason of the receipt or personal use of frequent flyer miles or other in-kind promotional benefits attributable to the taxpayer’s business or official travel.

There are, however, some types of miles awards the IRS might view as taxable. Examples include miles awarded as a prize in a sweepstakes and miles awarded as a promotion.

For instance, in the 2014 case of Shankar v. Commissioner, the U.S. Tax Court sided with the IRS in finding that airline miles awarded in conjunction with opening a bank account were indeed taxable. Part of the evidence of taxability was the fact that the bank had issued Forms 1099 MISC to customers who’d redeemed rewards points to buy airline tickets.

The value of the miles for tax purposes generally is their estimated retail value. If you’re concerned you’ve received miles awards that could be taxable, please contact us.

How to steer clear of tax issues related to shareholder loans

Owners occasionally need to borrow funds from their businesses. If your business is structured as a corporation and it has extra cash on hand, a shareholder loan can be a convenient and low-cost option — but it’s important to treat the transaction as a bona fide loan. If you don’t, the IRS may claim you received a taxable dividend or compensation payment rather than a loan.

Taking a closer look

A corporation can make de minimis loans of $10,000 or less to shareholders without paying interest. But, if all of the loans from the corporation to a shareholder add up to more than $10,000, the advances may be subject to a complicated set of below-market interest rules unless you charge what the IRS considers an “adequate” rate of interest. Each month the IRS publishes its applicable federal rates (AFRs), which vary depending on the term of the loan.

Right now, although interest rates are starting to rise, they’re still near historic lows, making it a good time to borrow money. For example, in July 2017, the adjusted AFR for short-term loans (of not more than three years) was only 1.22% (up from 0.71% in July 2016). The rate was 1.89% (up from 1.43% in July 2016) for midterm loans (with terms ranging from more than three years to not more than nine years).

The AFRs are typically below what a bank would charge. As long as the corporation charged interest at the AFR (or higher), the loan would be exempt from the complicated below-market interest rules the IRS imposes.

The interest rate for a demand loan — which is payable whenever the corporation wants to collect it — isn’t fixed when the loan is set up. Instead it varies depending on market conditions. So, calculating the correct AFR for a demand loan is more complicated than it is for a term loan. In general, it’s easier to administer a shareholder loan with a prescribed term than a demand note.

Staying under market

If a corporation lends money to a shareholder at an interest rate that’s below the AFR, the IRS requires it to impute interest using the below-market interest rules. These calculations can be complicated. The amount of incremental imputed interest (beyond what the corporation already charges the shareholder) depends on when the loan was set up and whether it’s a demand or term loan. There are also tax consequences for this imputed interest to both the corporation and the shareholder.

Additionally, the IRS may argue that the loan should be reclassified as either a dividend or additional compensation. The corporation may deduct the latter, but it will also be subject to payroll taxes. Both dividends and additional compensation would be taxable income to the shareholder personally, however.

Making it bona fide

When deciding whether payments made to shareholders qualify as bona fide loans, the IRS considers a variety of factors. It assesses the size of the loan, as well as the corporation’s history of earnings, dividend payments and loan repayments. It also looks at the shareholder’s ability to repay the loan and power to make corporate decisions.

In addition, the IRS will factor in whether you’ve executed a formal, written note that specifies repayment terms — including the interest rate, maturity date and collateral.

Getting started

Under the right circumstances, a shareholder loan could be a smart tax planning move to make this year. Contact our firm to help you set up and monitor your shareholder loans to ensure compliance with the IRS rules.

© 2017

Wills and living trusts: Estate planning imperatives

Well-crafted, up-to-date estate planning documents are an imperative for everyone. They also can help ease the burdens on your family during a difficult time. Two important examples: wills and living trusts.

The will

A will is a legal document that arranges for the distribution of your property after you die and allows you to designate a guardian for minor children or other dependents. It should name the executor or personal representative who’ll be responsible for overseeing your estate as it goes through probate. (Probate is the court-supervised process of paying any debts and taxes and distributing your property after you die.) To be valid, a will must meet the legal requirements in your state.

If you die without a will (that is, “intestate”), the state will appoint an administrator to determine how to distribute your property based on state law. The administrator also will decide who will assume guardianship of any minor children or other dependents. Bottom line? Your assets may be distributed — and your dependents provided for — in ways that differ from what you would have wanted.

The living trust

Because probate can be time-consuming, expensive and public, you may prefer to avoid it. A living trust can help. It’s a legal entity to which you, as the grantor, transfer title to your property. During your life, you can act as the trustee, maintaining control over the property in the trust. On your death, the person (such as a family member or advisor) or institution (such as a bank or trust company) you’ve named as the successor trustee distributes the trust assets to the beneficiaries you’ve named.

Assets held in a living trust avoid probate — with very limited exceptions. Another benefit is that the successor trustee can take over management of the trust assets should you become incapacitated.

Having a living trust doesn’t eliminate the need for a will. For example, you can’t name a guardian for minor children or other dependents in a trust. However, a “pour over” will can direct that assets you own outside the living trust be transferred to it on your death.

Other documents

There are other documents that can complement a will and living trust. A “letter of instruction,” for example, provides information that your family will need after your death. In it, you can express your desires for the memorial service, as well as the contact information for your employer, accountant and any other important advisors. (Note: It’s not a legal document.)

Also consider powers of attorney. A durable power of attorney for property allows you to appoint someone to act on your behalf on financial matters should you become incapacitated. A power of attorney for health carecovers medical decisions and also takes effect if you become incapacitated. The person to whom you’ve transferred this power — your health care agent — can make medical decisions on your behalf.

Foundational elements

These are just a few of the foundational elements of a strong estate plan. We can work with you and your attorney to address the tax issues involved.

© 2017

Should you change your business — or transform it?

As its market and technological needs evolve, every company needs to change. There’s even a formal term for the undertaking: “change management.” From an operational standpoint, change involves opening up the hood and switching out old engine parts for new ones. Even if it affects the business as a whole, change means focusing on specific areas and making alterations over relatively short periods.

At some point in the existence of many companies, the organization needs to go beyond change to transformation. This is much different. Business transformations aren’t so much about switching out parts as overhauling the entire engine, possibly modifying the frame and even applying a new coat of paint. Let’s look a little more closely at the distinction.

Reinvent yourself

Say a large commercial construction company was having trouble meeting its sales goals because of environmental regulations. So, it decided to augment its sales teams with environmental engineers who could better assess the compliance impact. The company applied change management principles — such as building a case for the idea and adjusting its business culture — and was successful. This was no doubt an important change, but the business itself wasn’t transformed.

The objective of a true transformation is to essentially reinvent the company and implement a new business model. And that model needs to be a carefully, formally devised chain of interlocking strategic initiatives that apply to the entire organization.

Perhaps the most obvious and universal example of a business transformation is Apple. The technology giant, once a head-to-head competitor with IBM on the personal computer market, found itself struggling in the 1990s. So, under the tutelage of the late Steve Jobs, it transformed itself into a mobile technology company. It still makes computers, of course, but the company’s transformative success can really be attributed to its mobile devices and operating systems.

Think and act wisely

Every business transformation differs based on the history, nature and size of the company in question. But there are best practices to keep in mind. For example, start with your customers, visualizing what they need (even if they don’t know it yet). Also, build a chain of initiatives, so you’re not trying to do everything all at once. And use metrics, so you can track specific dollar amounts and productivity goals throughout the transformation.

Above all, be ready for anything. Even the best-planned transformations can produce unpredictable results. So keep expectations in line and take a measured, patient approach to every initiative involved.

Bring along help

Successful business transformations can be spectacular and profitable. But, make no mistake, the risk level is high. So if you decide to embark on this journey, bring along your trusted financial, legal and strategic advisors.

© 2017

3 strategies for handling estimated tax payments

In today’s economy, many individuals are self-employed. Others generate income from interest, rent or dividends. If these circumstances sound familiar, you might be at risk of penalties if you don’t pay enough tax during the year through estimated tax payments and withholding. Here are three strategies to help avoid underpayment penalties:

  1. Know the minimum payment rules. For you to avoid penalties, your estimated payments and withholding must equal at least:
  • 90% of your tax liability for the year,
  • 110% of your tax for the previous year, or
  • 100% of your tax for the previous yearif your adjusted gross income for the previous year was $150,000 or less ($75,000 or less if married filing separately).
  1. Use the annualized income installment method. This method often benefits taxpayers who have large variability in income by month due to bonuses, investment gains and losses, or seasonal income — especially if it’s skewed toward year end. Annualizing calculates the tax due based on income, gains, losses and deductions through each “quarterly” estimated tax period.
  2. Estimate your tax liability and increase withholding. If, as year end approaches, you determine you’ve underpaid, consider having the tax shortfall withheld from your salary or year-end bonus by December 31. Because withholding is considered to have been paid ratably throughout the year, this is often a better strategy than making up the difference with an increased quarterly tax payment, which may trigger penalties for earlier quarters.

Finally, beware that you also could incur interest and penalties if you’re subject to the additional 0.9% Medicare tax and it isn’t withheld from your pay and you don’t make sufficient estimated tax payments. Please contact us for help with this tricky tax task.

© 2017

Tax calendar

October 16 — Personal returns that received an automatic six-month extension must be filed today and any tax, interest and penalties due must be paid.

  • The Financial Crimes Enforcement Network (FinCEN) Form 114, “Report of Foreign Bank and Financial Accounts (FBAR),” must be filed by today, if it hasn’t been filed already, for offshore bank account reporting. (This report received an automatic extension to today if not filed by the original due date of April 18.)
  • If a six-month extension was obtained, calendar-year C corporations should file their 2016 Form 1120 by this date.
  • If the monthly deposit rule applies, employers must deposit the tax for payments in September for Social Security, Medicare, withheld income tax and nonpayroll withholding.

October 31 — The third quarter Form 941 (“Employer’s Quarterly Federal Tax Return”) is due today and any undeposited tax must be deposited. (If your tax liability is less than $2,500, you can pay it in full with a timely filed return.) If you deposited the tax for the quarter in full and on time, you have until November 10 to file the return.

  • If you have employees, a federal unemployment tax (FUTA) deposit is due if the FUTA liability through September exceeds $500.

November 15 — If the monthly deposit rule applies, employers must deposit the tax for payments in October for Social Security, Medicare, withheld income tax, and nonpayroll withholding.

December 15 — Calendar-year corporations must deposit the fourth installment of estimated income tax for 2017.

  • If the monthly deposit rule applies, employers must deposit the tax for payments in November for Social Security, Medicare, withheld income tax and nonpayroll withholding.

© 2017

Do you need the protection of a D&O insurance policy?

Your efforts toward ensuring your financial security might be focused on building up your assets through wise investing or growing your business. But protecting the assets you already have is just as important. And if you serve as a director or officer of a company, or even sit on the board of a nonprofit, your assets may be vulnerable. One way to gain some protection is to obtain coverage under a directors and officers (D&O) insurance policy.

Assessing your risks

D&O insurance helps protect an organization’s directors, officers and board members from liability resulting from management decisions. Just a few examples of how such individuals can put themselves at risk include:

  • Committing a crime,
  • Failing to disclose a conflict of interest, or
  • Breaching their fiduciary responsibilities.

But even if directors or officers do nothing wrong, they still can be held financially responsible for others’ missteps if they’re sued and the organization lacks sufficient assets to protect them. Indeed, directors and officers are vulnerable to many types of lawsuits.

Employment-related litigation — covering such claims as harassment, discrimination and wrongful termination — is particularly common, while legal action also may be brought by unhappy shareholders, lenders, customers, suppliers, competitors or government regulators.

You may feel less vulnerable if you sit on the board of directors of a nonprofit. Although nonprofits do lack shareholders, they still have stakeholders — financial contributors or other individuals with a personal interest in the organization’s mission. Thus, nonprofit directors, officers and board members can find themselves at risk if these stakeholders decide to sue its leaders for mismanagement.

Contemplating coverage

When contemplating a D&O policy, determine exactly what it covers. For example, some insurers won’t cover fraud-related claims, while others specifically exclude employment-related litigation.

Next, weigh what’s covered against the specific risks you’re most likely to face. For example, if you’re thinking about joining the board of an organization with a history of rocky employee relations, determine whether you’ll be protected from employee-related lawsuits. If you uncover potential gaps in the D&O policy, or if it includes provisions that could lead to your coverage being rescinded in certain situations, you may need to obtain additional protection through supplemental liability insurance.

Building a safeguard

Make no mistake, a D&O policy can be costly because of the high financial stakes involved. So an organization in cost-cutting mode may not wish to offer you this coverage. Nonetheless, if you’re a director, officer or board member, a policy may serve as a critical safeguard for your family’s assets. Contact our firm for an assessment of your situation.

Sidebar: D&O vs. E&O

Many people mistakenly view errors and omissions (E&O) insurance as an alternative to a directors and officers (D&O) policy. Don’t be among them; the two types of policies cover different sets of risks.

E&O insurance covers the business itself against problems stemming from potential failures in the products and services a business offers its customers; D&O insurance protects individual officers and directors from financial risk stemming from management decisions — either yours or someone else’s.

© 2017