In today’s post we will consider the workings of the self-employment tax, along with methods for its reduction.

                IRC 1401 imposes a tax “on the self-employment income of every individual,” which is known as the Self-Employment Contributions Act (SECA) tax.  This tax is analogous to the Federal Insurance Contributions Act (FICA) tax, which is imposed on those who are employed by others.  There is, however, one significant difference, half of the FICA tax is paid by the employee and the other half is paid by the employer, whereas the self-employed individual must pay both halves.  The SECA tax is made up of two parts: a Social Security tax of 12.4%, which in 2008 is applied against self-employment income up to $102,000; and a Medicare tax of 2.9%, which is applied against all self-employment income. 

                When performing the calculation to determine the SECA tax obligation, it must be remembered that, again, even in the case of self-employed individuals conceptually there is still an employee’s portion and an employer’s portion.  The first step in the calculation is to multiply net earnings from self-employment by 7.65%, which represents the employer’s portion of the SECA tax.  The second step is to subtract the product of this computation from self-employment net earnings.  These first two steps function to ensure that self-employed individuals are not required to count amounts paid regarding the employer’s portion as net earnings from self-employment when determining the amount of SECA tax due.  The third step is to multiply the resulting amount by the applicable rates (15.3% on the first $102,000, 2.9% on everything above that) to determine the SECA tax obligation.  However, one-half of this amount can be taken as an above the line deduction, which ensures that the self-employed individual will not be required to pay income tax on the employer portion of the SECA tax.

                There are several effective methods for reducing the amount of the SECA tax obligation which revolve around the concept of transforming income from self-employment income to income which is excluded from self-employment income.  IRC 1402 lists numerous sources of income that are to be excluded from self-employment income.  Among these the more typically utilized are real estate rent, dividends, capital gains, and distributions related to limited partnership interests.

                There are several techniques which may be of benefit to farmers.  A farm business can be bifurcated into two limited liability companies: one company to own the land, and the other to conduct the farming operations.  The operating company would then pay reasonable rent to the land owning company.  The effect of this is to transform income that would otherwise be a part of “net earnings from self-employment” to income which is excluded.  Of course, either way the farmer would still be responsible for paying income tax on this income, but to the extent that the income is received as rental income the farmer is not responsible for paying SECA tax.

                Another method for increasing the amount of excluded income is to organize the farm as an S Corporation and pay out reasonable salaries and make distributions.  S Corporations are taxed as pass-through entities (similar to partnerships), which means that the shareholder or shareholders are taxed on the income produced by the business but that the corporation itself does not pay any tax (as would a C Corporation).  After the farm has been organized as an S Corporation it can then pay a reasonable salary to the farmer or farmers, to which salary the FICA tax would apply.  Why FICA and not SECA?  Because an individual who is employed by a corporation is not self-employed (for tax purposes), even if that individual owns 100% of the corporation that employs him or her.  Any amounts remaining after the payment of reasonable salaries could then be distributed free of any FICA or SECA tax obligations, although, of course, these amounts would still be subject to income tax.

                Finally, I would be remiss if I failed to mention that there are also various ways of dividing ownership interests in limited liability companies between active and passive that have been used to reduce SECA taxes.  In 1997, the IRS issued proposed regulations in an attempt to clarify SECA tax treatment as applied to limited liability companies.  But due to controversy, the proposed regulations were never adopted, and, as a result, application of the SECA tax to limited liability companies remains ambiguous.  However, it is unlikely that the IRS would challenge a taxpayer proceeding in conformity with the proposed regulations, and, if caution is exercised, this is a strategy that some farmers may find to be of benefit.

                Please join me next time for: Indiana Property Tax Reform or Indiana Property Tax Fiasco.

            Operating under the cash method of accounting can be an effective way of postponing income.  There are two methods of accounting: the accrual method and the cash method.  Under the accrual method income is included in the year that it is earned and expenses are deducted as incurred, whereas under the cash method income is included in the year in which it is received and expenses are deducted as paid.  Most farmers are permitted to utilize the cash method of accounting, and can achieve significant tax savings through structuring transactions in an optimum manner.

            At its most rudimentary, appropriate structuring under the cash method involves delaying the receipt of cash and accelerating the payment of expenses.  This will result in decreasing Taxable Income in the present year at the expense of increasing Taxable Income in the next year, which is normally desirable for the reason that a dollar today is preferable over a dollar tomorrow.  Although, a farmer who anticipates that next year will be significantly more profitable than this year may be well advised to accelerate his or her receipt of cash in the present year and delay his or her expenses until next year, as this would allow him or her to enjoy the benefit of lower marginal rates in the present year.

            Postponing income means that the taxpayer will not pay tax on that income in the current tax year, but that he or she will be required to do so in the future.  There are several ways in which income can be postponed (and, in fact, utilization of the cash method could be thought of as way of postponing income). 

            Section 1031 allows for the exchange of real property, such as farm ground, for “property of a like kind,” and instead of requiring the recognition of capital gain, the taxpayer is permitted to assign the basis of the old property to the new property.  This means that the capital gain will have to be recognized at some point in the future when the new property is sold.  Similarly, amounts contributed on behalf of a taxpayer to a 401(k) account (including SIMPLE 401(k) plans) are not treated as income until distributed.  In 2008, a taxpayer may elect to defer up to $15,500 for this purpose. 

            The other method by which a taxpayer’s obligation may be reduced is by taking full advantage of all applicable exclusions, deductions, exemptions, and credits.  One popular method for increasing deductions is depositing funds into an Individual Retirement Account (IRA).  The maximum contribution amount eligible for deduction in 2008 is $5,000.  Additionally, there are, of course, an abundance of other available exclusions, deductions, exemptions, and credits, but the trick here is to work with an accountant who can ferret all of these out.

            Please join me next time for: The Self-Employment Tax or All These Taxes Are Taxing My Patience.

             Visit a personal injury attorney website or read a publication from almost any other state and you will find a section usually lacking from materials from most Indiana lawyers who handle accident claims; a CASE RESULTS or SETTLEMENTS/VERDICT section in which the lawyers list fact situations from real-life claims they have handled, including the results.  Not so in Indiana, according to the Indiana Supreme Court Disciplinary Commission.
            On September 4, 2008 the Indiana Supreme Court imposed a public reprimand on Indianapolis personal injury attorneys Scott Benkie and Douglas Crawford for engaging in attorney misconduct in the advertisement of their legal services.  In a firm brochure entitled "We Work for You," Benkie and Crawford described several prior successful representations by listing the area of law, client names, amounts recovered, and other facts.  

READ MORE
http://www.state.in.us/judiciary/opinions/pdf/09040801per.pdf

Expect more disciplinary actions in the future.  Despite the fact that Indiana lawyers who assist accident victims are prohibited from making self-laudatory statements, using any statement that is likely to create an unjustified expectation, and from making any statement that contains statistical data or any other information based on past performance or prediction of  future success, some lawyers even in Indiana, continue to ignore advertising rules by listing jury verdicts and settlement amounts they have recovered for injured clients.

                According to Will Rogers the income tax system is excruciatingly simple: “If you make any money, the government shoves you in the creek once a year with it in your pockets, and all that don’t get wet you can keep.”  However, there are steps that can be taken to minimize the amount of money that gets “wet.”  I will elaborate on these steps in subsequent posts, but before I do that, I think a short description of how the income tax system works would be appropriate.
                First, Gross Income must be determined by computing “all income from whatever source derived,” less certain postponed and excluded items, such as gifts received, amounts contributed to 401(k) accounts, and proceeds from life insurance.  Second, above the line deductions must be taken to determine the Adjusted Gross Income.  Above the line deductions include (among other items): trade and business expenses of self-employed individuals, contributions to Individual Retirement Accounts, and contributions made by self-employed individuals to pension, profit-sharing, and annuity plans.  And third, below the line deductions, which will be either itemized deductions or the standard deduction, must be taken along with personal and dependent exemptions to finally arrive at Taxable Income.
                Also, it is important to bear in mind the difference between items excluded from gross income and above the line deductions on the one hand and below the line deductions on the other.  This distinction is critical for the reason that all items in the former will reduce Taxable Income, but the same cannot always be said of the latter.  This is because below the line deductions require the taxpayer to make a choice between two mutually exclusive alternatives: either receive the standard deduction or take itemized deductions.  In other words, a taxpayer will always be able to reduce his or her Taxable Income by amounts contributed to 401(k) accounts and Individual Retirement Accounts, but if he or she receives the standard deduction then itemized deductions must be foregone, or, alternatively, if he or she takes itemized deductions then the standard deduction will be unavailable.
                After Taxable Income has been calculated, then the taxpayer’s obligation is determined based upon calculations performed in accordance with the marginal rates.  However, even after this initial calculation of the tax amount, a taxpayer may still be able to lower his or her ultimate tax liability by subtracting credits.  Credits reduce tax on a dollar-for-dollar basis because they are applied directly against the tax due, as opposed to deductions and exemptions which are applied against the taxpayer’s income.  There are two main types of credits: non-refundable and refundable.  Non-refundable credits can reduce a taxpayer’s obligation to zero, but cannot reduce it below zero.  Refundable credits, on the other hand, can reduce a taxpayer’s obligation below zero, and, as a result, can cause a taxpayer to receive a refund.  Several of the more commonly used credits include the non-refundable credit for the elderly and the permanently and totally disabled, the partially refundable child tax credit, and the refundable credit for tax withheld on wages.
                And, in addition to the Federal income tax, Indiana imposes a State income tax of 3.4%, which is determined by reference to the taxpayer’s Federal adjusted gross income along with a few quirks.  Also, there is a county income tax due, the percentage of which varies depending upon the county of residence from .01% to 2.08%.

                Please join me next time for: How to Minimize Income Tax or I Wear a Barrel Because Uncle Sam Took My Slacks.

You Wouldn’t Use Sandbags to Stop a Tornado and You Wouldn’t Hide in the Basement to Escape Flooding, So Why Are You Using a Sole-Proprietorship or a General Partnership to Run Your Farm Instead of a Limited Liability Company? 

            Indiana farmers in the central and southern parts of the state are struggling this season against flooding, and, as a result, farm profits are literally being “swept away.”  Although, what many Hoosier farmers do not realize is that while natural disasters may be costly, the government is second to none at sweeping away profits, and, much like acts of God, taxation cannot be avoided entirely, but its effects can certainly be mitigated through careful planning.

            Farms face numerous calamities: wild fires, swarming insect populations, floods, tornadoes, and the list goes on.  Similarly, farmers are subject to a number of different taxes: income and self-employment tax, property tax, gift and estate tax, and unfortunately this list goes on as well.  But fortunately there are tools for confronting almost every adversity faced by farmers, including taxes.  In this post I will summarize the various tools available for minimizing tax, and in future posts I will provide a more thorough explanation as to the way in which each technique is to be implemented.

            The amount of income tax due can be lowered by utilizing the most advantageous accounting method, postponing income, and taking all applicable exclusions, deductions, exemptions, and credits.  And as to the related topic of self-employment tax, the principal method for lowering this burden is to minimize the amount of net earnings from self-employment, which can be accomplished through intelligent business structuring.

            Property tax has been a source of enmity in the Hoosier state for the last several years, and the debate has lost none of its initial virulence.  While a challenge to the assessed value of property is a possibility, the first line of attack should be diligence in assuring that all applicable credits and deductions are received.

            Gift and estate taxes can be a significant hurdle for family farmers who wish to provide for the continuing involvement of their children.  But there are methods for successfully transferring management and ownership of the family farm from the present generation on to the next.  These include: special use valuation, installment payments, creation of conservation easements, implementation of various types of trusts, life-time gifting, organization of limited liability companies, and execution of buy-sell agreements.

            Please join me next time for: A Short Explanation of the Income Tax System or A Day Trip Through Dante’s Inferno.

            Indiana State Senator Dennis Kruse, R-Auburn, found out the hard way that speaking on a cell phone can be a distraction while driving when he lost control of his own vehicle while talking on his phone and ended up in a ditch.  That experience caused him to author Senate Bill No. 119, which proposes to make it a Class D infraction for a person less than 18 years of age to drive while using a hand-held mobile phone.  He hopes that once the bill gets a hearing that it can be expanded to include older drivers. 

            Even more disturbing, there is evidence that a huge percentage of drivers, especially young ones, are blending the tasks of driving and text messaging.  A recent Zogby poll revealed that 66 percent of drivers in the 18 to 24 age range confessed that they use their phones to text while driving.  Currently, only two states (Washington and New Jersey) have passed statutes prohibiting driving while texting.  Hopefully, Indiana will take the lead in eliminating this class of distracted drivers from our highways so that potential auto-related tragedies might be avoided.

            Cost conscious Americans in waves are downsizing to smaller vehicles.  The good news is that they are saving money on fuel costs and are reducing emissions.  The bad news is that they  may be switching to a vehicle that is less safe to drive, and as a result their auto insurance premiums are going up (“Downsizing: Switching to a Small Car Can Increase Your Insurance Bill.” 

www.insure.com/articles/carinsurance/small-car.html.  16July2008.) 

            Small cars are simply not as safe as larger cars and trucks.  They tend to get in more accidents than larger vehicles, which creates higher repair costs and more litigation costs resulting from personal injuries.  The size of the vehicle is not the only factor that causes more and larger insurance claims.  Because smaller cars tend to be less expensive they are driven by younger, higher-risk drivers.

            Automobile insurance companies and lawyers who represent insured people in Indiana have long battled over what amount might be presented at trial as the medical expenses caused by a motor vehicle collision.    Plaintiff’s counsel (those who represent the injured person) has always advocated the position that the full amount of medical bills incurred was the relevant measure of the damages caused by the negligent driver.  Defense counsel (those who represent the drivers who caused the collision) has always maintained that the only amount presented at trial should be the amount paid not the amount billed.  They wanted the at-fault motorist to receive the benefit of any write-offs received by the injured person  that were negotiated by his own insurance company.  Obviously, this tactic could produce significantly lower recoveries by injured motorists by reducing the amount of the medical bills attributed to the injuries sustained in the accident. 

            Until recently Indiana law was unsettled in this area.  The Indiana Court of Appeals, Stanley vs. Walker, 888 N.E. 2d 222 (Ind.App. June 3, 2008),  recently made a finding that injured parties are allowed to present the full amount of medical expenses incurred as a measure of damages to a jury for verdict consideration.   

http://www.in.gov/judiciary/opinions/pdf/06030803cld.pdf

 Visit www.sunherald.com/business/story/675669.html to see the top 5 offenders on the list (including State Farm at #4).

Allstate and State Farm sell a huge share of auto insurance policies in Northern Indiana, including many drivers in Kosciusko County.   Given the massive profits reported by these two insurance giants you would think that they could afford to be cooperative in resolving personal injury claims and protecting their own insureds.  Not so.   Judges, mediators, medical providers, and accident attorneys throughout our area have experienced extreme frustration in dealing with claims for injuries involving these two insurance companies.  Unfortunately, when injured people are hurting and need help the most, they are finding that they are in a war with their own auto insurance company.