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Partners may have to report more income on tax returns than they receive in cash

Are you a partner in a business? You may have come across a situation that’s puzzling. In a given year, you may be taxed on more partnership income than was distributed to you from the partnership in which you’re a partner.

Why does this happen? It’s due to the way partnerships and partners are taxed. Unlike C corporations, partnerships aren’t subject to income tax. Instead, each partner is taxed on the partnership’s earnings — whether or not they’re distributed. Similarly, if a partnership has a loss, the loss is passed through to the partners. (However, various rules may prevent a partner from currently using his or her share of a partnership’s loss to offset other income.)

Pass through your share

While a partnership isn’t subject to income tax, it’s treated as a separate entity for purposes of determining its income, gains, losses, deductions and credits. This makes it possible to pass through to partners their share of these items.

An information return must be filed by a partnership. On Schedule K of Form 1065, the partnership separately identifies income, deductions, credits and other items. This is so that each partner can properly treat items that are subject to limits or other rules that could affect their correct treatment at the partner’s level. Examples of such items include capital gains and losses, interest expense on investment debts and charitable contributions. Each partner gets a Schedule K-1 showing his or her share of partnership items.

Basis and distribution rules ensure that partners aren’t taxed twice. A partner’s initial basis in his or her partnership interest (the determination of which varies depending on how the interest was acquired) is increased by his or her share of partnership taxable income. When that income is paid out to partners in cash, they aren’t taxed on the cash if they have sufficient basis. Instead, partners just reduce their basis by the amount of the distribution. If a cash distribution exceeds a partner’s basis, then the excess is taxed to the partner as a gain, which often is a capital gain.

Illustrative example

Two people each contribute $10,000 to form a partnership. The partnership has $80,000 of taxable income in the first year, during which it makes no cash distributions to the two partners. Each of them reports $40,000 of taxable income from the partnership as shown on their K-1s. Each has a starting basis of $10,000, which is increased by $40,000 to $50,000. In the second year, the partnership breaks even (has zero taxable income) and distributes $40,000 to each of the two partners. The cash distributed to them is received tax-free. Each of them, however, must reduce the basis in his or her partnership interest from $50,000 to $10,000.

More rules and limits

The example and details above are an overview and, therefore, don’t cover all the rules. For example, many other events require basis adjustments and there are a host of special rules covering noncash distributions, distributions of securities, liquidating distributions and other matters. Contact us if you’d like to discuss how a partner is taxed.

Warning for retailers and other businesses using the LIFO method

Recent supply shortages may cause unexpected problems for some businesses that use the last-in, first-out (LIFO) method for their inventory. Here’s an overview of what’s happening so you won’t be blindsided by the effects of so-called “LIFO liquidation.”

Inventory reporting methods

Retailers generally record inventory when it’s received and title transfers to the company. Then, it moves to cost of goods sold when the product ships and title transfers to the customer. You have choices when it comes to reporting inventory costs. Three popular methods are:

1. Specific identification. When a company’s inventory is one of a kind, such as artwork or custom jewelry, it may be appropriate to use the specific-identification method. Here, each item is reported at historic cost and that amount is generally carried on the books until the specific item is sold.

2. First-in, first-out (FIFO). Under this method, the first units entered into inventory are the first ones presumed sold. This method assumes that merchandise is sold in the order it was acquired or produced. Thus, the cost of goods sold is based on older — and often lower — prices.

3. LIFO. Under this method, the last units entered are the first presumed sold. Using LIFO usually causes the low-cost items to remain in inventory. Higher cost of sales generates lower pretax earnings as long as inventory keeps growing.

Downside of LIFO method

LIFO works as a tax deferral strategy, as long as costs and inventory levels are rising. But there’s a potential downside to using LIFO: The tax benefits may unexpectedly reverse if a company that’s using LIFO reduces its ending inventory to a level below the beginning inventory balance. As higher inventory costs are used up, the company will need to start dipping into lower-cost layers of inventory, triggering taxes on “phantom income” that the LIFO method previously has allowed the company to defer. This is commonly known as LIFO liquidation.

Retailers, such as auto dealers, that have less inventory on hand in 2022 may be facing this situation. Higher tax obligations could exacerbate any financial distress they’re currently experiencing.

Fortunately, the House is currently considering legislation — the Supply Chain Disruptions Relief Act — that would provide relief to auto dealers affected by LIFO liquidation. Specifically, the bill would let them wait until the end of 2025 to replace their new vehicle inventory for purposes of determining income for sales in 2020 and 2021. Stay tuned for any progress on this proposed law.

For more information

Accounting for inventory is one of the more complicated parts of U.S. Generally Accepted Accounting Principles. Fortunately, we can help evaluate the optimal reporting method for your business and discuss any concerns you may have regarding LIFO liquidation in today’s volatile marketplace.

The tax mechanics involved in the sale of trade or business property

There are many rules that can potentially apply to the sale of business property. Thus, to simplify discussion, let’s assume that the property you want to sell is land or depreciable property used in your business, and has been held by you for more than a year. (There are different rules for property held primarily for sale to customers in the ordinary course of business; intellectual property; low-income housing; property that involves farming or livestock; and other types of property.)

General rules

Under the Internal Revenue Code, your gains and losses from sales of business property are netted against each other. The net gain or loss qualifies for tax treatment as follows:

1) If the netting of gains and losses results in a net gain, then long-term capital gain treatment results, subject to “recapture” rules discussed below. Long-term capital gain treatment is generally more favorable than ordinary income treatment.

2) If the netting of gains and losses results in a net loss, that loss is fully deductible against ordinary income (in other words, none of the rules that limit the deductibility of capital losses apply).

Recapture rules

The availability of long-term capital gain treatment for business property net gain is limited by “recapture” rules — that is, rules under which amounts are treated as ordinary income rather than capital gain because of previous ordinary loss or deduction treatment for these amounts.

There’s a special recapture rule that applies only to business property. Under this rule, to the extent you’ve had a business property net loss within the previous five years, any business property net gain is treated as ordinary income instead of as long-term capital gain.

Section 1245 Property

“Section 1245 Property” consists of all depreciable personal property, whether tangible or intangible, and certain depreciable real property (usually, real property that performs specific functions). If you sell Section 1245 Property, you must recapture your gain as ordinary income to the extent of your earlier depreciation deductions on the asset.

Section 1250 Property

“Section 1250 Property” consists, generally, of buildings and their structural components. If you sell Section 1250 Property that was placed in service after 1986, none of the long-term capital gain attributable to depreciation deductions will be subject to depreciation recapture. However, for most noncorporate taxpayers, the gain attributable to depreciation deductions, to the extent it doesn’t exceed business property net gain, will (as reduced by the business property recapture rule above) be taxed at a rate of no more than 28.8% (25% as adjusted for the 3.8% net investment income tax) rather than the maximum 23.8% rate (20% as adjusted for the 3.8% net investment income tax) that generally applies to long-term capital gains of noncorporate taxpayers.

Other rules may apply to Section 1250 Property, depending on when it was placed in service.

As you can see, even with the simplifying assumptions in this article, the tax treatment of the sale of business assets can be complex. Contact us if you’d like to determine the tax consequences of specific transactions or if you have any additional questions.

ESG Investing Trends from 2020

Approximately one-third of all U.S. assets — $17.1 trillion — under professional management are placed in sustainable investments.

Sources: https://www.ussif.org//Files/Trends/2020%20Trends%20Report%20Info%20Graphic%20-%20Overview.pdf https://www.ussif.org/files/US%20SIF%20Trends%20Report%202020%20Executive%20Summary.pdf

Sales Tax Basics for Small Businesses

Sales tax can be intimidating for entrepreneurs. Rules differ in each state, county and city, but some basics are universal.

WHAT’S TAXABLE

Generally, if you sell a tangible product, you’ll be required to collect sales tax from buyers. But some states also impose sales tax on services.

PERMIT REQUIRED

If you’re required to collect sales tax in your state, you’ll need a sales tax permit. Once you receive the permit, the state will assign to you a filing due date and frequency, which is generally determined by your annual revenue and can be monthly, quarterly, or annually. Keep in mind if your company operates in more than one state, you may need to apply for multiple state sales tax permits.

COLLECTION

Be sure to collect tax on all sales, regardless of the source. You’ll need to collect tax on sales in brick-and-mortar stores, online, or through Amazon’s marketplace. And in most states, even if you had no sales for a period, you’ll still need to file a sales tax report for the period or risk paying a fine or having your sales tax permit revoked.

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Goodwill in a bad economy

In today’s volatile economy, many businesses and nonprofits have been required to write down the value of acquired goodwill on their balance sheets. Others are expected to follow suit — or report additional write-offs — in 2022. To the extent that goodwill is written off, it can’t be recovered in the future, even if the organization recovers. So, impairment testing is a serious endeavor that usually requires input from your CPA to ensure accuracy, transparency and timeliness.

Reporting goodwill

Under U.S. Generally Accepted Accounting Principles (GAAP), when an organization merges with or acquires another entity, the acquirer must allocate the purchase price among the assets acquired and liabilities assumed, based on their fair values. If the purchase price is higher than the combined fair value of the acquired entity’s identifiable net assets, the excess value is labeled as goodwill.

Before lumping excess value into goodwill, acquirers must identify and value other identifiable intangible assets, such as trademarks, customer lists, copyrights, leases, patents or franchise agreements. An intangible asset is recognized apart from goodwill if it arises from contractual or legal rights — or if it can be sold, transferred, licensed, rented or exchanged.

Goodwill is allocated among the reporting units (or operating segments) that it benefits. Many small private entities consist of a single reporting unit. But large conglomerates may be composed of numerous reporting units.

Testing for impairment

Organizations must generally test goodwill and other indefinite-lived intangibles for impairment each year. More frequent impairment tests might be necessary if other triggering events happen during the year — such as the loss of a key person, unanticipated competition, reorganization or adverse regulatory actions.

In lieu of annual impairment testing, private entities have the option to amortize acquired goodwill over a useful life of up to 10 years. In addition, the Financial Accounting Standards Board recently issued updated guidance that allows private companies and not-for-profits to delay the assessment of the goodwill impairment triggering event until the first reporting date after that triggering event. The change aims to reduce costs and simplify impairment testing related to triggering events.

Writing down goodwill

When impairment occurs, the organization must decrease the carrying value of goodwill on the balance sheet and reduce its earnings by the same amount. Impairment charges are a separate line item on the income statement that may have real-world consequences.

For example, some organizations reporting impairment losses may be in technical default on their loans. This situation might require management to renegotiate loan terms or find a new lender. Impairment charges also raise a red flag to investors and other stakeholders.

Who can help?

Few organizations employ internal accounting staff with the requisite training to measure impairment. Contact us for help navigating this issue and its effects on your financial statements.

© 2022

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February Short Bits

New per diem business travel rates became effective on October 1

Are employees at your business traveling again after months of virtual meetings? In Notice 2021-52, the IRS announced the fiscal 2022 “per diem” rates that became effective October 1, 2021. Taxpayers can use these rates to substantiate the amount of expenses for lodging, meals and incidental expenses when traveling away from home. (Taxpayers in the transportation industry can use a special transportation industry rate.)

Background information

A simplified alternative to tracking actual business travel expenses is to use the high-low per diem method. This method provides fixed travel per diems. The amounts are based on rates set by the IRS that vary from locality to locality.

Under the high-low method, the IRS establishes an annual flat rate for certain areas with higher costs of living. All locations within the continental United States that aren’t listed as “high-cost” are automatically considered “low-cost.” The high-low method may be used in lieu of the specific per diem rates for business destinations. Examples of high-cost areas include Boston, San Francisco and Seattle.

Under some circumstances — for example, if an employer provides lodging or pays the hotel directly — employees may receive a per diem reimbursement only for their meals and incidental expenses. There’s also a $5 incidental-expenses-only rate for employees who don’t pay or incur meal expenses for a calendar day (or partial day) of travel.

Less recordkeeping

If your company uses per diem rates, employees don’t have to meet the usual recordkeeping rules required by the IRS. Receipts of expenses generally aren’t required under the per diem method. But employees still must substantiate the time, place and business purpose of the travel. Per diem reimbursements generally aren’t subject to income or payroll tax withholding or reported on an employee’s Form W-2.

The FY2022 rates

For travel after September 30, 2021, the per diem rate for all high-cost areas within the continental United States is $296. This consists of $222 for lodging and $74 for meals and incidental expenses. For all other areas within the continental United States, the per diem rate is $202 for travel after September 30, 2021 ($138 for lodging and $64 for meals and incidental expenses). Compared to the FY2021 per diems, both the high and low-cost area per diems increased $4.

Important: This method is subject to various rules and restrictions. For example, companies that use the high-low method for an employee must continue using it for all reimbursement of business travel expenses within the continental United States during the calendar year. However, the company may use any permissible method to reimburse that employee for any travel outside the continental United States.

For travel during the last three months of a calendar year, employers must continue to use the same method (per diem or high-low method) for an employee as they used during the first nine months of the calendar year. Also, note that per diem rates can’t be paid to individuals who own 10% or more of the business.

If your employees are traveling, it may be a good time to review the rates and consider switching to the high-low method. It can reduce the time and frustration associated with traditional travel reimbursement. Contact us for more information.

© 2021

10 financial statement areas to watch for COVID-related effects

The COVID-19 pandemic is still adversely affecting many businesses and not-for-profit organizations, but the effects vary, depending on the nature of operations and geographic location. Has your organization factored the effects of the pandemic into its financial statements? You might not have considered this question since last year if your organization prepares statements that comply with U.S. Generally Accepted Accounting Principles only at year end.

As we head into audit season for 2021, it’s time to evaluate whether your financial situation has gotten better — or worse — this year. Here are 10 financial statement areas to home in on:

1. Revenue recognition. Assess how changes in customer preferences, contract modifications, discounts, refund concessions, and changes in credit policies or payment terms impact the top line of the income statement. Also consider related collectability of accounts receivable.

2. Government grants. You may account for these grants as revenue or donor-restricted contributions. Government funding programs may have eligibility, documentation, expense tracking and other requirements (such as government audits) that you may need to address.

3. Estimates and fair values. These items are typically based on budgeting and forecasting of revenue, costs and cash flows. Uncertainty may increase the discount rates used in making estimates and decrease the fair values of certain balance sheet items.

4. Investments. Market changes caused by the pandemic may negatively affect the fair values of investments and financial instruments that qualify for hedge accounting.

5. Inventory. It’s possible that certain market conditions — including inflation, reductions in production and supply chain disruptions — may affect the value of raw materials, work-in-progress and finished goods inventory. Consider the need for write-offs due to obsolescence.

In addition, travel and work restrictions may delay, restrict or prevent year-end physical inventory counts. Your external auditors may have to observe counts remotely, which, in turn, may require additional testing procedures during audit fieldwork.

6. Property, plant and equipment. Evaluate changes in useful lives and related deprecation due to changes in business plans. There may also be potential impairment of long-lived assets and leased assets.

7. Goodwill and other intangible assets. Because of COVID-19 triggering events, these items may require impairment testing and write-offs may be needed.

8. Deferred tax assets. Consider the realizability of these assets in light of current year losses and uncertainty about future events, including the impact of possible federal tax law changes.

9. Accrued liabilities. You may need to book additional liabilities this year for employee terminations, changes in benefits and payroll tax payment deferrals. Also consider whether existing contingency accruals are still adequate.

10. Long-term debt. You may have debt classification issues for existing loans if your organization fails to meet its debt covenants. Financial difficulties may result in debt modification or extinguishment. Also evaluate the compliance requirements of the Paycheck Protection Program (PPP) loans and the probability of forgiveness.

This list is a useful starting point for discussions about how the pandemic has affected financial results in 2021. If you have questions about how to report the effects, contact us for guidance. Your preparedness will help facilitate audit fieldwork and minimize adjustments to your in-house financial reports.

© 2021

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