The U.S. economy is growing at an above-trend pace, and the rest of the world seems to be finding its footing. Meanwhile, the Federal Reserve (Fed) continues to normalize monetary policy, and it appears that other central banks are following suit. Interest rates have come down off the highs seen earlier this year, and equity valuations are no longer looking as pricey. With this as the setup, how should investors think about navigating markets during the second half of the year?
With respect to growth, the second half of this year should be better than the first. The weakening in global goods demand that led to disappointing growth metrics in the first quarter seems to have worked its way through the system, with U.S. consumption expected to have grown by nearly 4% from a year prior in the second quarter, and retail sales in Europe showing signs of stabilization. Furthermore, the Purchasing Managers Indices (PMIs) and other soft data all point to a continued improvement in growth outside of the U.S. While the hard data will need to provide confirmation of this trend, the clouds which have been hanging over the international economy for the past few months finally seem to be breaking.
Solid growth in and outside the U.S. would align with policymaker expectations, leading the Fed to continue hiking rates and the European Central Bank (ECB) to hike for the first time around the middle of next year. If these expectations are realized against a backdrop of solid economic growth, it could lead the dollar to soften, providing a boost to emerging markets and supporting a resynchronization of growth as we approach 2019. This resynchronization of global growth could help alleviate trade-related concerns, and provide support for risk assets to move higher. With earnings growth looking solid, equity valuations in-line with or below their long-term averages around the world, and interest rates still historically low, stocks should be able to rally into 2019. However, diversification should remain the central tenet of any investment strategy given the political risk premium which continues to exist in markets around the world.
Many parents are looking for ways to save for their child’s education and a 529 Plan is an excellent way to do so. Even better, is that thanks to the passage of tax reform legislation in 2017, 529 plans are now available to parents wishing to save for their child’s K-12 education as well as college or vocational school.
You may open a Section 529 plan in any state, and there are no income restrictions for the individual opening the account. Contributions, however, must be in cash and the total amount must not be more than is reasonably needed for higher education (as determined initially by the state). There may also be a minimum investment required to open the account, typically, $25 or $50.
Each 529 Plan has a Designated Beneficiary (the future student) and an Account Owner. The account owner may be a parent or another person and typically is the principal contributor to the program. The account owner is also entitled to choose (as well as change) the designated beneficiary.
Neither the account owner or beneficiary may direct investments, but the state may allow the owner to select a type of investment fund (e.g., fixed income securities), change the investment annually as well as when the beneficiary is changed. The account owner decides who gets the funds (can pick and change the beneficiary) and is legally allowed to withdraw funds at any time, subject to tax and penalties (more about this below).
Unlike some of the other tax-favored higher education programs such as the American Opportunity and Lifetime Learning Tax Credits, federal tax law doesn’t limit the benefit only to tuition. Room, board, lab fees, books, and supplies can be purchased with funds from your 529 Savings Account. Individual state programs could have a more narrow definition, however, so be sure to check with your particular state.
Distributions from 529 plans are tax-free as long as they are used to pay qualified higher education expenses for a designated beneficiary. Distributions are tax-free even if the student is claiming the American Opportunity Credit, Lifetime Learning Credit, or tax-free treatment for a Section 530 Coverdell distribution–provided the programs aren’t covering the same specific expenses. Qualified expenses include tuition, required fees, books, supplies, equipment, and special needs services. For someone who is at least a half-time student, room and board also qualify. Also, starting in 2018, “qualified higher education expenses” include up to $10,000 in annual expenses for tuition in connection with enrollment or attendance at an elementary or secondary public, private, or religious school.
Note: Qualified expenses also include computers and related equipment used by a student while enrolled at an eligible educational institution; however, software designed for sports, games, or hobbies does not qualify unless it is predominantly educational in nature.
Federal Tax Rules
Income Tax. Contributions made by the account owner or other contributor are not deductible for federal income tax purposes, but many states offer deductions or credits. Earnings on contributions grow tax-free while in the program. Distribution for a purpose other than qualified education is taxed to the one receiving the distribution. In addition, a 10 percent penalty must be imposed on the taxable portion of the distribution, comparable to the 10 percent penalty in Section 530 Coverdell plans. Also, the account owner may change the beneficiary designation from one to another in the same family. Funds in the account roll over tax-free for the benefit of the new beneficiary.
Gift Tax. For gift tax purposes, contributions are treated as completed gifts even though the account owner has the right to withdraw them – thus they qualify for the up-to-$15,000 annual gift tax exclusion. One contributing more than $15,000 may elect to treat the gift as made in equal installments over that year and the following four years, so that up to $75,000 can be given tax-free in the first year.
Estate Tax. Funds in the account at the designated beneficiary’s death are included in the beneficiary’s estate – another odd result, since those funds may not be available to pay the tax. Funds in the account at the account owner’s death are not included in the owner’s estate, except for a portion thereof where the gift tax exclusion installment election is made for gifts over $15,000. For example, if the account owner made the election for a gift of $75,000 in 2018, a part of that gift is included in the estate if he or she dies within five years.
Tip: A Section 529 program can be an especially attractive estate-planning move for grandparents. There are no income limits, and the account owner giving up to $75,000 avoids gift tax and estate tax by living five years after the gift, yet has the power to change the beneficiary.
State Tax. State tax rules are all over the map. Some reflect the federal rules, some quite different rules. For specifics of each state’s program, see http://www.collegesavings.org.
Considering the differences among state plans, the complexity of federal and state tax laws, and the dollar amounts at stake, please call the office and speak to a tax and accounting professional before opening a 529 plan.
Crowdfunding websites such as Kickstarter, GoFundMe, Indiegogo, and Lending Club have become increasingly popular for both individual fundraising and small business owners looking for start-up capital or funding for creative ventures. The upside is that it’s often possible to raise the cash you need but the downside is that the IRS considers that money taxable income. Here’s what you need to know.
What is Crowdfunding?
Crowdfunding is the practice of funding a project by gathering online contributions from a large group of backers. Crowdfunding was initially used by musicians, filmmakers, and other creative types to raise small sums of money for projects that were unlikely to turn a profit. Now it is used to fund a variety of projects, events, and products and in some cases, has become an alternative to venture capital.
There are three types of crowdfunding: donation-based, reward-based, and equity-based. Donation-based crowdfunding is when people donate to a cause, project, or event. GoFundMe is the most well-known example of donation-based crowdfunding with pages typically set up by a friend or family member (“the agent”) such as to help someone (“the beneficiary”) pay for medical expenses, tuition, or natural disaster recovery.
Reward-based crowdfunding involves an exchange of goods and services for a monetary donation, whereas, in equity-based crowdfunding, donors receive equity for their contribution.
Are Crowdfunding Donations Taxable?
This is where it can get tricky. As the agent, or person who set up the crowdfunding account, the money goes directly to you; however, you may or may not be the beneficiary of the funds. If you are both the agent and the beneficiary you would be responsible for reporting this income. If you are acting as “the agent”, and establish that you are indeed, acting as an agent for a beneficiary who is not yourself, the funds will be taxable to the beneficiary when paid–not to you, the agent. An easy way to circumvent this issue is to make sure when you are setting up a crowdfunding account such as GoFundMe you clearly designate whether you are setting up the campaign for yourself or someone else.
Again, as noted above, as the beneficiary, all income you receive, regardless of the source, is considered taxable income in the eyes of the IRS–including crowdfunding dollars. However, money donated or pledged without receiving something in return may be considered a “gift.” As such the recipient does not pay any tax. Up to $15,000 per year per recipient may be given by the “gift giver.”
Let’s look at an example of reward-based crowdfunding. Say you develop a prototype for a product that looks promising. You run a Kickstarter campaign to raise additional funding, setting a goal of $15,000 and offer a small gift in the form of a t-shirt, cup with a logo or a bumper sticker to your donors. Your campaign is more successful than you anticipated it would be and you raise $35,000–more than twice your goal.
Taxable sale. Because you offered something (a gift or reward) in return for a payment pledge it is considered a sale. As such, it may be subject to sales and use tax.
Taxable income. Since you raised $35,000, that amount is considered taxable income. But even if you only raised $15,000 and offered no gift, the $15,000 is still considered taxable income and should be reported as such on your tax return–even though you did not receive a Form 1099-K from a third party payment processor (more about this below).
Generally, crowdfunding revenues are included in income as long as they are not:
– Loans that must be repaid;
– Capital contributed to an entity in exchange for an equity interest in the entity; or
– Gifts made out of detached generosity and without any “quid pro quo.” However, a voluntary transfer without a “quid pro quo” isn’t necessarily a gift for federal income tax purposes.
Income offset by business expenses. You may not owe taxes however, if your crowdfunding campaign is deemed a trade or active business (and not a hobby) your business expenses may offset your tax liability.
Factors affecting which expenses could be deductible against crowdfunding income include whether the business is a start-up and which accounting method (cash vs. accrual) you use for your funds. For example, if your business is a startup you may qualify for additional tax benefits such as deducting startup costs or applying part or all of the research and development credit against payroll tax liability instead of income tax liability.
Timing of the crowdfunding campaign, receipt of funds, and when expenses are incurred also affect whether business expenses will offset taxable income in a given tax year. For instance, if your crowdfunding campaign ends in October but the project is delayed until January of the following year it is likely that there will be few business expenses to offset the income received from the crowdfunding campaign since most expenses are incurred during or after project completion.
How do I Report Funds on my Tax Return?
Typically, companies that issue third-party payment transactions such as Amazon if you use Kickstarter, PayPal if you use Indiegogo, or WePay if you use GoFundMe) are required to report payments that exceed a threshold amount of $20,000 and 200 transactions to the IRS using Form 1099-K, Payment Card and Third Party Network Transactions. The minimum reporting thresholds of greater than $20,000 and more than 200 transactions apply only to payments settled through a third-party network; there is no threshold for payment card transactions.
Form 1099-K includes the gross amount of all reportable payment transactions and is sent to the taxpayer by January 31 if payments were received in the prior calendar year. Include the amount found on your Form 1099-K when figuring your income on your tax return, generally, Schedule C, Profit or Loss from Business for most small business owners.
Again, tax law is not clear on this when it comes to crowdfunding donations. Some third-party payment processors may deem these donations as gifts and do not issue a 1099-K. This is why it is important to keep good records of transactions relating to your crowdfunding campaign including a screenshot of the crowdfunding campaign (it could be several years before the IRS â€œcatches upâ€) and documentation of any money transfers.
Don’t Get Caught Short
If you’re thinking of crowdfunding to raise money for your small business or startup or for a personal cause, consult a tax and accounting professional first. Don’t make the mistake of using all of your crowdfunding dollars on your project and then discovering you owe tax and have no money with which to pay it.
Tax reform likely has you considering your business’s tax structure. We’ll show how you can use a spousal partnership to reduce your tax hit compared with a sole proprietorship. And here’s the real surprise: you can possibly save more money with this type of partnership compared with the S corporation.
It works like this:
1) You own an existing sole proprietorship or want to start a new business.
2) You and your spouse form a general partnership or limited liability company to manage the business.
3) You and your spouse provide cash or property for your interests in the new business.
4) Your spouse does not participate in any way in the business. He or she is merely an investor.
Here are the tax benefits to you:
– Your spouse’s income is free from self-employment tax.
– You and your spouse both still qualify for the new pass-through income deduction under Section 199A.
– The IRS audits partnerships at a much lower rate than proprietorships (Schedule Cs).
– You don’t have to worry about the costs or hassle of running payroll or determining your reasonable
compensation as you would if you operated the business as an S corporation.
Here are the potential issues:
– The passive activity rules limit your spouse’s use of any losses against regular income.
– Your cost of preparing a partnership return (but you’d have this cost with an S corporation, too).
No Self-Employment Tax?
Limited partners in a partnership don’t pay self-employment taxes on their share of partnership net income. To make your limited-partner situation crystal clear to the IRS, make sure your spouse meets the limited-partner requirements by:
– providing no services to the partnership
– complying with the limited partnership statute of your state
– and signing a document delegating management authority of the LLC to you.
Proposed regulations originally issued in 1996 would clarify who is a limited partner for self-employment tax purposes, but the Treasury Department never finalized them. Under the proposed regulations, a limited partner can’t have personal liability for the debts of the partnership by reason of being a partner, have authority to contract on behalf of the partnership, or participate in the partnership’s business for more than 500 hours during the partnership’s taxable year. (Note. Above, we recommended no participation for the spouse.)
Planning note. Although the IRS has not finalized the proposed regulations, you should follow them because they represent substantial authority and protect you from the substantial underpayment penalty.
Tax reform gave you a new 20 percent pass-through deduction starting in 2018. Partnership pass-through income qualifies for Section 199A, but partnership guaranteed payments do not. Guaranteed payments compensate partners for services to the partnership and are self-employment income to the partner, and deductible as a business expense by the partnership. Unlike S corporations, which require reasonable compensation by salary for owner/employees, the tax law has no requirement that a partnership make guaranteed payments to its partners. Therefore, in your spousal partnership, you and your spouse can take cash distributions of the partnership profits and no guaranteed payments in order to maximize your pass-through deduction. Another bonus: unlike an S corporation, where shareholder distributions must be pro rata based on ownership interest, partnerships have no such requirement.
Example. Louis and Lisa, a married couple, have a partnership. Louis is a 60 percent partner and Lisa is a 40 percent partner. The partnership has net income of $100,000, and none of the Section 199A limitations apply to them. With no guaranteed payments, they get a $20,000 Section 199A deduction. If the partnership pays Louis a $50,000 guaranteed payment, then only the $50,000 partnership net income qualifies for the Section 199A deduction, reducing that deduction to $10,000 (20 percent of the net income).
Passive Loss Issues
Under the passive loss rules, a passive loss can only offset passive income. A limited partner’s interest in a partnership is automatically passive regardless of participation level. If it’s unlikely your business will suffer a loss, then this isn’t a major concern. If your business does have a loss, you’ll have to
carry forward the loss until there is passive income that can absorb it. If you have activities that create passive losses (a rental activity, for example), then the passive income created by this strategy could allow you to use your losses in the current tax year.
Example. John is a limited partner in his spouse’s business. The partnership passes through $10,000 of passive net income to John. John also owns a rental property that generates a $5,000 passive loss. John can net the partnership income and the rental loss and only pay taxes on the $5,000 of net passive income. This income offset works with privately held partnerships, but not with publicly traded partnerships, where the tax law requires separate application of the passive loss rules.
By the Numbers
Jean wants to start a graphic design business. She has three options:
1) Form a single-member LLC with herself as sole owner
2) Form a multimember LLC with her husband, Tom, who would have no involvement in the business
3) Form a single-member LLC or corporation and elect S corporation status
Let’s assume that the business nets $50,000 in the first year of operation, Jean’s S corporation reasonable compensation is $35,000, and they are in the 22 percent tax bracket. Here’s a comparison of four options.
Jean pays the least amount of taxes on the structure where her husband is a 40 percent limited partner. Note that the S corporation results in more tax than the single-member LLC taxed as a sole proprietorship because the increased pass-through deduction from the sole proprietorship negates the payroll tax savings from the move to the S corporation.
Tax planning after tax reform has mostly focused on C and S corporation tax strategies. But as you have just seen, in the right circumstances a spousal partnership can:
– provide optimal tax reduction over the sole proprietorship and S corporation,
– eliminate the need for payroll and reasonable compensation determinations, and
– reduce your overall risk of an IRS audit.
By running your partnership as a limited liability company, you also leave the door open to electing a different tax treatment in a later year if business changes make the S corporation a better tax strategy for you.