Monthly Archive: October 2012

Income Tax Planning and Restructure Analysis

“Restructure Analysis” comes into play during routine individual income tax planning throughout the year. It could involve review of a specific tax position or may include review of multiple tax positions involving interrelated returns over a period of many years.  The goal of Restructure Analysis is to rebuild or restructure a tax position to legally reduce tax liability and at the same time bullet proof the strategy from harm in the event of an IRS audit.  To give you an idea of how Restructure Analysis works let’s take for example, a hypothetical common tax position and find through structure analysis a tax strategy to help reduce tax liability.  For example, your tax professional determines you have lots of nondeductible passive losses from real estate rentals.   Your CPA then commences a restructure analysis regarding nondeductible passive losses.  The analysis shows you that investing in some businesses that generates passive income and positive cash flow may be just what you need to offset those losses.

But before you go out and invest your money, your tax attorney discusses with you as to what passive income is not.  Passive income is not dividends, interest, royalties and capital gains.   Passive income is not W2 or 1099 earnings and it is not 1099R retirement earnings.  Passive income is also not partnership guaranteed payments and it is certainly not gambling winnings.  Passive income is only one type of income:  It is income earned by you the taxpayer with no “material participation” in the business that pays you.

Most taxpayers at this point become very interested in this kind of business that generates real cash, offsets rental losses and requires no work at all to earn this money.  Unfortunately, a small number of taxpayers out there over the years have attempted to “create” passive income in order to trigger passive losses” and have not quite followed the rules.   As a result of these bad boys, the IRS looks closely at passive income to determine if the taxpayer truly did not materially participate in the business.  And this brings us to the key question:  What is material participation in a business?   Your tax preparer will present to you a checklist of questions for you to answer to help you decide whether or not you materially participate in the business.  The checklist will include questions like the following:

  1. How many hours during the year did you work in the business?  500 or more.  You are toast.
  2. Did you work more than 100 hours and no one else worked more than you?  You are burnt toast.
  3. Did you do most of the work?  For example if you are sole proprietor with no employees you are not a passive activity even if you only worked 45 minutes the whole year.

There are more questions and more answers so you need to have your CPA go over with you totally bulletproofing your tax return by answering all the checklist questions before you file and sign that return.  To give you an idea how critical bulletproofing is, the IRS routinely Goggles you during an audit to see what the internet says about you regarding material participation.

Are there any safe harbors? As a matter of fact most limited partners or LLC limited members are viewed by the IRS as passive investors.  Ironically, many of the K-1s I have seen from these kinds of partnerships tend to show losses.  If you have some of those investments or plan to acquire in interest in them, then you should structure the investment so that the K-1s shows plenty of passive income, not losses.  With this structure and a fully completed check list prior to filing the tax return,  there would be absolutely no doubt that this income qualifies as the passive income we have been searching for.  As a result of this relatively simply restructure analysis of a common tax position, you have created a legal tax strategy allowing you to receive tax-free income for years to come until your losses are fully offset.  More importantly you can sleep at night knowing that the tax strategy you have chosen has been fully bulletproofed prior to filing your tax return.  By the way, since each taxpayer’s tax positions are unique to their situation and circumstances, please consult your tax professional as to your specific tax position and strategy before attempting restructure analysis on your own.