Estimated Tax Payments – What You Need To Know

estimated-tax-payments

By: Cassandra Bartole

What are estimated tax payments?

Estimated tax payments are those made to pay tax on income that is not subject to withholding, including earnings from interest, dividends, rents, and self-employment income, among others. Additionally, taxpayers who choose to not have taxes withheld from other taxable income (such as wages and salaries reported on a W-2, unemployment compensation, or the taxable portion of Social Security benefits) should also make estimated tax payments. Estimated tax payments are made to the Internal Revenue Service, and typically paid each quarter (April 15th, June 15th, September 15th, and January 15th of the following year), but payments can be made throughout the year at any time.

Do I have to make estimated tax payments?

Many people who receive regular salary or wage compensation and do not have other significant sources of income are not required to make estimated payments, provided their tax withholdings paid throughout the year are adequate. The exact amount of necessary tax withholding will vary with each individual’s tax situation. Your accountant may advise you to make estimated payments if your expected income increases significantly in the following year. Your accountant may also advise you to make estimated payments if you are in business with yourself because estimated tax is used to pay both income tax and other taxes like self-employment tax and alternative minimum tax. When individuals do not pay enough through withholdings and estimated tax payments, they may be subject to a penalty.

   Individuals who are sole proprietors, partners and S-Corporation shareholders must make estimated tax payments if they expect to owe tax of $1,000 or more. Corporations must make estimated tax payments if they expect to owe tax of $500 or more. 

How do I make estimated tax payments?

To make an estimated tax payment, you can use the Electronic Federal Tax Payment System or pay by phone. Your accountant may also give you vouchers with your tax return which you can use to write a check and mail to the address given to make the payment.

What happens if you don’t make a payment?

If you do not make a payment on time or you don’t pay enough a penalty may apply. Taxpayers will not be subject to a penalty if they meet any of the following requirements:

  • They owe less than $1,000 in tax on their tax return
  • Throughout the year the taxpayer paid the smaller of these two amounts:
    • At least 90% of the tax due for the current year
    • 100% of the tax shown on their tax return for the prior year, or 110% if your prior year’s adjusted gross income was more than $150,000 (or $75,000 for married filing separate)

Additionally, you do not have to pay estimated tax for the current year if you meet the following three requirements:

  • You had no tax liability for the previous year (meaning you didn’t have to file an income tax return, or your total tax was $0)
  • You were a U.S. citizen or resident for the whole year
  • Your previous tax year covered a 12-month period

The penalty can also be waived if the individual underpaid due to unforeseen circumstances such as:

  • Casualty, disaster, or another unusual situation
  • The individual retired after reaching age 62 during a tax year when estimated tax payments applied
  • The individual became disabled during a tax year when estimated payments applied

How does a W-2 and other withholding affect estimates?

For many individuals, if they earn a regular salary or wages, estimated tax payments can be avoided simply by asking their employer to withhold more tax from their earnings. To find out how much you should withhold based on your income you can use the Tax Withholding Estimator.

This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied upon for tax, legal, or accounting advice. If you have any questions about your tax situation or our tax services, please do not hesitate to contact us at Lear & Pannepacker.

What is Depreciation Recapture?

what-is-depreciation-recapture

By: John Ruggieri

What is depreciation recapture? 

When discussing the tax implications of selling real estate, one needs to also be aware of various issues to make an informed decision.  One such aspect is depreciation recapture.  Depreciation recapture is the portion of gain that is attributable to the depreciation deduction previously taken by the taxpayer.  Depreciation recapture happens when a depreciable asset is sold, and the sale price exceeds the tax or adjusted cost basis. Some of the most common examples are rental properties and equipment that are sold for gains after they have been depreciated. 

Ordinary income is taxed at a different rate than capital gains tax rate. For most taxpayers ordinary income is their wages, rents, and any short-term capital gains. These are taxed at a variable rate depending on your income such as 10%, 12%, 22%, 24%, 32%, 35% and 37%. Depreciation recapture is a taxed at a fixed 25% on the portion of the gain that is attributable to prior depreciation. Meanwhile, the highest capital gain tax rate is 20% for taxpayers in the highest bracket. Some taxpayers can even have a 0% tax rate, if they make under $40,400 and are single or, $80,800 if married filing jointly. 

Let’s see an example of depreciation recapture:

  • Purchase price of the property is $1,000,000
  • Depreciation deductions claimed in the last five years: $100,000
  • Sale price in year six: $1,200,000
  • Depreciation recapture tax rate: 25%
  • Capital gains tax rate: 15% 

The adjusted cost basis here would be: $900,000 ($1,000,000 – $100,000)

The gain from the sale will be the sales price less the adjusted cost basis: $300,000 ($1,200,000 – $900,000)

The first $100,000 of the gain will be subject to depreciation recapture of 25%. 

The $200,000 leftover will then be subject to capital gains tax rate of 15%. 

How do you avoid depreciation recapture on a rental property?

There are not many ways the taxpayer can avoid paying depreciation recapture. Taxpayers however can elect into a 1031 exchange. A 1031 exchange is when an investor elects to have their proceeds from a real estate transaction used in their cost basis for a new property. This allows the investor to avoid capital gains and depreciation recapture in the short term. There are however many rules that investors must understand. These rules include, “a swap of properties thar are for business or investment purposes” i.e., rental properties. The property also must be considered like in kind, meaning that the new property for the investor must be similar to the old property. Additionally, the new asset must be purchased within 180 days. When electing a 1031 exchange be sure to have accurate record keeping as the IRS has very strict rules and regulations. 

Each state also has different rules regarding 1031 exchanges. For example, New Jersey recognizes 1031 exchanges and will allow the taxpayer to make this election. If you are a Pennsylvania resident on the other hand, you will not be allowed to have a 1031 exchange due to Pennsylvania not recognizing them. 

How long do you have to do a 1031 Exchange?

How long you have to do a 1031 exchange depends on what 1031 exchange the taxpayer chooses. There are four types of exchanges: simultaneous exchange, delayed 1031 exchange, reverse exchange, and a construction or improvement exchange. In a simultaneous exchange you must purchase or receive the new property at the same time as the one being sold by the taxpayer. In a delayed 1031 exchange the taxpayer has 45 days to identify a new rental/investment property and 180 days to finish the sale of their old property. This is also the most commonly used 1031 exchange. In a reverse exchange the taxpayer must pay in all cash. Additionally, in a reverse exchange the taxpayer has 45 days to sell their old investment/rental property and then has 180 days, including the first 45 days to sell their old property, to complete the sale of a new rental/investment property. Lastly, in a construction and improvement 1031 exchange the entire sale proceeds must be used to make improvements or as a down payment for the new rental/investment property. Furthermore, the new property must be equal or higher in value. 

As with any tax planning or transaction, we highly recommend you consult with your CPA or accountant.  Please feel free to contact us to understand the implications of depreciation recapture and its overall impact on deciding whether or not to sell real estate or equipment. 

Distributions vs Guaranteed Payments

distributions-vs-guaranteed-payments

What are distributions?

To begin with, distributions from both partnerships and S-corporations are the same. Distributions can consist of the following:

  • Withdrawals by partners in anticipation of current year earnings
  • Distribution of the current or prior year earnings not needed for working capital
  • Complete or partial liquidation of a partner’s interest
  • Final distribution to all partners when the company is liquidated

In the case of any of these distributions, the distribution must be reported on your tax return in the tax year it was received. However, there are certain instances where distributions may instead be treated as a sale or exchange, such as in the following situations:

  • Unrealized receivables or substantially appreciated inventory items distributed in exchange for any part of the partner’s interest in other partnership property including cash
  • Other property (cash included) distributed in exchange for a partner’s interest in unrealized receivables or substantially appreciated inventory items
  • A distribution of property to the partner who contributed the property to the partnership
  • Payments made to a retiring partner or successor in the interest of a deceased partner that are the partner’s distributive share of partnership income or guaranteed payments

How are distributions different from guaranteed payments?

Guaranteed payments differ from distributions in that they are considered salary and “other” payments. Guaranteed payments are compensation to members of a partnership in return for their time invested, services provided, or capital made available. These payments are also taxable income and are treated as ordinary income and self-employment income for tax purposes. This means that guaranteed payments do not have to pay income and FICA taxes but will be subject to self-employment taxes and estimated income taxes as necessary. Guaranteed payments are also beneficial to the company they are paid out from, as they can be deducted as a business expense. Distributions are classified as profit-sharing payments as opposed to ordinary income but must also be reported on the receiving partner’s individual tax return. When a distribution of cash or property is realized, the partner’s adjusted basis is decreased, but it cannot decrease beyond zero. In any case, the partnership does not realize the gain or loss because of a distribution to the partners.

What is partnership basis?

The basis of a partnership is the money the partnership has plus the adjusted basis of any property contributed by the partners, including cash and noncash assets. Partnership basis is divided into two concepts, inside basis and outside basis. Inside basis is the adjusted basis of each partnership asset, according to the partnership tax account. Outside basis represents each partner’s basis in the partnership interest.  

For example, if Partner A contributes an asset with a tax basis of $20,000 and a fair market value (FMV) of $50,000, while partner B contributes $50,000 cash, the total increase in inside basis of the partnership would be the combined $100,000. However, the outside basis for Partner A would be $20,000, while Partner B’s would still be $50,000. If Partner A sold their partnership interest for $50,000, they would recognize a gain of $30,000, while Partner B would recognize no gain if sold at the same price.

Do partnership distributions and guaranteed payments lower basis?

When a partnership or S-corporation distributes cash or noncash assets the partners’ basis will be decreased accordingly, as the basis is determined by cash or noncash assets contributed to the business. This also means if cash or noncash assets are contributed to the business, basis will increase. In the case of guaranteed payments to partners, basis will not be affected, as they are treated as taxable compensation to the partners. 

How are distributions and guaranteed payments taxed?

A common issue that arises with distributions is the possibility of double taxation, as partners are taxed on the income of the partnership regardless of distributions. It is important to make sure that the partner is not reporting the distribution a second time. Both guaranteed payments and distributions are reported on Schedule K and K-1 on the business tax return, while partners would report the guaranteed payments on Schedule E as ordinary income on their personal tax return. Partners are taxed on the net income a partnership earns based on their partnership percentage, regardless of any distribution, unless they exceed the partner’s basis. In the case of a partnership distributing more than the partner’s basis, the difference between the partner’s basis and the distribution will be taxable income. Like a guaranteed payment the difference will be subject to self-employment tax and will require estimated income tax payments as necessary.

This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied upon for tax, legal, or accounting advice. You should consult with your own tax, legal, or accounting advisor before engaging in any transaction.