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Profits aren't enough
Keep your bottom line healthy with regular tax planning
If you own or operate a business, you know how tough it can be to stay ahead of the competition while
strengthening the balance sheet. But making a nice profit doesn't necessarily guarantee a healthy bottom line.
You also need to be aware of how your company — and those profits — will be taxed. Of course, you also
should consider the business risks before executing any tax-saving strategies. Your tax advisor can help you
home in on the best ways to keep your tax bill under control and your bottom line healthy.
Defer income.
In potentially high-income years, consider deferring some income to later years. For example, if your business uses the cash method of accounting, you may be able to defer billing for your products or services as you approach year end. Or, if you use the accrual method, you can delay shipping products or delivering services until the new tax year. If you expect to be in a higher income tax bracket next year, you may be better off accelerating income into the current year.
Accelerate deductions.
This can also save taxes in a high-income year. If you're a cash-basis taxpayer, a simple example is your state tax deduction. If you make an estimated state tax payment before Dec. 31, you can deduct it this year rather than next year. Be sure to consider the alternative minimum tax (AMT) effects of your planning. If you want to accelerate deductions and don't have ready cash, consider charging expenses on your bank credit card. In low-income years, deferring deductions may make sense. For accrual taxpayers, accelerating and deferring deductions is possible, but much more complicated.
CHART 4:
2007 CORPORATE TAX RATE SCHEDULE |
|
| Taxable income |
Base tax |
Marginal tax rate
(tax on next dollar)¹ |
|
| $0 |
$0 |
15% |
| $50,000 |
$7,500 |
25% |
| $75,000 |
$13,750 |
34% |
| $100,000 |
$22,250 |
39% |
| $335,000 |
$113,900 |
34% |
| $10,000,000 |
$3,400,000 |
35% |
| $15,000,000 |
$5,150,000 |
38% |
| $18,333,333 |
$6,416,667 |
35% |
|
| ¹ Personal service corporations taxed at flat 35% rate. |
|
| Source: U.S. Internal Revenue Code |
Take advantage of the manufacturers' deduction.
The manufacturers' deduction, or the Section 199 deduction, presents many businesses with a wide range of planning and computational challenges and opportunities. In 2010, when it's fully phased in, the deduction will be equal to 9% of the lesser qualified production activities income or taxable income (adjusted gross income for individuals). The deduction is 6% for 2007 through 2009 (up from 3% in 2006).
The deduction is further limited to 50% of W-2 wages paid by the taxpayer during the calendar year ( or, for fiscal year taxpayers, during the calendar year that ends in the fiscal tax year). Effective for taxable years beginning after May 17, 2006, only W-2 wages attributable to domestic production may be included. Because the deduction is limited by wages, businesses that use few employees or rely heavily on independent contractors probably won't benefit much from it.
A qualified production activity is much broader than the traditional meaning of manufacturing. For example, the deduction is available to businesses engaged in activities such as construction, engineering, computer software production and agricultural processing. It applies to several categories of qualifying activities, including any lease, rental, license or sale of qualifying production property that's manufactured, produced, grown or extracted in a while or insignificant part in the United States.
The deduction isn't allowed in determining net earnings from self-employment and, generally, can't create or increase a net operating loss (NOL). But it can be used against the AMT. (See the Tax Action Strategy on page 9 for more NOLs).
Determine whether your business qualifies, if there are ways to increase your deduction, and how to capture the necessary information in your accounting system.
Tax Action Strategy:
CLAIM ALL BUSINESS LOSSES
Generally, a net operating loss (NOL) may be carried back two years to generate a current tax refund, which can provide a cash infusion in times of loss. Any loss not absorbed in the prior two-year period is then carried forward for up to 20 years. If you prefer, you may choose to waive the carryback and carry the entire loss forward, which may be beneficial if your marginal tax rate in the carryback years is unusually low, or if the alternative minimum tax (AMT) in prior years makes the carryback less beneficial. The portion of an NOL that qualifies as a Gulf Opportunity (GO) Zone loss can be carried back five years. Keep in mind as you do your business tax planning that the GO Zone NOL expires after Dec. 31, 2007. Other losses that may generate a deduction include casualty and theft losses (to the extent they aren't covered by insurance) and losses from the sale or abandonment of business assets.
Consider business structure.
Structures range from sole proprietorship to C corporation. (Note that, beginning in 2007, an unincorporated business owned by a married couple can be treated as a sole proprietorship instead of a partnership). Income taxation and owner liability are the main factors that differentiate one from another. Many businesses choose entities that combine flow-through taxation with limited liability, namely limited liability companies (LLCs) and S corporations. Some tax differences may provide planning opportunities. For example, to reduce the 2.9% Medicare tax, S corporation shareholder-employees may want to keep their salaries reasonable low and increase their distribution of company income (which generally isn't taxed at the corporate level). But C corporation owners may prefer to take more income ( which is taxed at the corporate level) as salary, to the extent reasonable, because the Medicare tax is lower than the (generally 15%) tax they'd pay on dividends.
Maximize depreciation with a cost segregation study.
If you have recently purchased or built a building or are remodeling existing space, make sure you maximize your depreciation deductions. Although real property generally must be depreciated over 27½ or 39 years using the straight-line method, certain parts of the "building" can qualify for a shorter depreciable life.
A cost segregation study identifies property components, and their related costs, that can be depreciated over five or seven years using 200% of the straight-line rate, or over 15 years using 150% of the straight-line rate. This allows you to depreciate the property much faster and may dramatically increase your current deductions. Typical assets that qualify for this faster depreciation include decorative fixtures, cabinets, security equipment, parking lots, landscaping and architectural fees allocated to qualifying property. The benefit of a cost segregation study may be limited in certain circumstances - for example, if the business is subject to the AMT or is located in a state that doesn't follow federal depreciation rules.
Act now to take advantage of accelerated depreciation.
Through 2007 a shortened recovery period of 15 years (rather than 39 years) is allowed for qualified leasehold and qualified restaurant improvements. Those made to the interior of a qualifying nonresidential building more than three years after the building was placed in service generally qualify. And the improvements can be made by either the lessor or the lessee.
Take into account other depreciation rules.
Careful planning during the year can help you maximize depreciation deductions in the year of purchase. You generally will want to use the Modified Accelerated Cost Recovery System (MACRS), instead of the straight-line method, to get a larger deduction in the early years of an asset's life. The IRS generally treats all newly acquired tangible assets other than real estate as being placed in service at the midpoint of the year. This gives you six months of depreciation in the first year. But if you made more than 40% of the year's asset purchases during the last three months of the year. you must use the generally less favorable midquarter convention.
Tax Action Strategy:
EXPENSE WHEN YOU CAN
Generally, equipment with a useful life well beyond the taxable year must be capitalized. An exception is the Section 179 expensing election. It allows a current deduction for assets that otherwise would be subject to normal depreciation rules. The maximum Sec. 179 deduction for 2007 is $125,000, and it will be indexed for inflation through 2010. But for tax years beginning after 2010 this amount is scheduled to drop back to $25,000 per year.
Given that, it may be appropriate to schedule major capital asset purchases in the next few years when greatest tax benefits may be available. And if you have more than the maximum $125,000 limit in 2007, choose those assets for expensing that would have had the longest life under the regular depreciation rules. If total asset acquisitions in 2007 exceed $500,000, the expensing election begins to phase out.
An expanded Sec. 179 expensing election and a special depreciation allowance are available for qualified Gulf Opportunity (GO) Zone property. Some of those provisions are scheduled to expire for property place in service after Dec. 31, 2007. But the Small Business and Work Opportunity Tax Act of 2007 extended the Sec. 179 GO Zone provisions through 2008, and the deadline for the special depreciation allowance for certain residential and nonresidential property is Dec. 31, 2010, if the building is located in specified portions of the Go Zone. Certain property used in such buildings also may qualify for the extended special depreciation allowance.
Manage your inventory.
You must calculate the dollar amount of inventory you have on hand at year end. If your ending inventory value is low and the cost of merchandise sold is higher, your taxable income will be lower — so the inventory method you choose can significantly affect your taxable income.
Maximize tax credits.
Tax credits reduce your business's tax liability dollar-for-dollar. Several tax credits that had expired at the end of 2005 have been extended through 2007, including the Empowerment Zone and the research and development credits. The Work Opportunity and Welfare-to-Work credits also were revived for 2006, combined into a single credit for 2007, extended through Sept. 30, 2011, and expanded to include additional qualified groups, such as disabled veterans.
Write off bad debts.
Business bad debts are treated as ordinary losses and can be deducted when they become either partially or wholly worthless. For individuals and certain other entities, the IRS may consider loans made to closely held corporations as not business related and, if not repaid, reclassify them as nonbusiness bad debts, which must be wholly worthless to be deductible and are treated as short-term capital losses.
Look into qualified deferred compensation plans.
To attract and retain the best employees and manage your tax liability, qualified deferred compensation plans can be useful. They include pension, profit-sharing and 401(k) plans, as well as SIMPLEs and SEPs. You can enjoy a tax deduction for your contributions to employees' accounts, and the plans offer tax-deferred savings benefits for employees. (For more on the benefits to employees, see page 13.) The Pension Protection Act of 2006 (PPA) includes many provisions affecting traditional pension plans, so it's critical to ensure you're in compliance with the new rules if you provide such a plan.
Provide fringe benefits.
Fringe benefits are a crucial part of any compensation package. Some fringes, referred to as "statutorily excluded" benefits, aren't included in employee income. With these fringes, both the employer and the employee come out ahead: The employer receives a deduction, but the value of the benefit is tax free to the employee. Plus, the business usually avoids payroll taxes on these amounts.
This favored tax treatment gives both parties incentive to "shift" some compensation from salary to fringe benefits. Examples of benefits treated in this manner include group-term life insurance (up to $50,000), health insurance, parking and employee discounts.
Follow the rules for nonqualified deferred compensation.
Nonqualified deferred compensation arrangements are a promise to pay executives and key employees sometime in the future for services to be currently performed. The plans are often geared to the individual and based on his or her performance or on the company's performance. Under PPA, employers with defined benefit retirement plans that are underfunded at a certain level or are terminated single-employer pension plans can't fund nonqualified deferred compensation plans.
Some 2004 tax law changes — many of which are still in the process of being implemented — are tightening the rules for nonqualified deferred compensation. The changes generally affect the timing of initial deferral elections, changes to elections, timing of distributions and how benefits are funded. Distributions are allowed only for specific — such as separation from service or disability — and payment of benefits generally can't be accelerated. If a plan fails to meet the requirements, it will result in loss of tax deferral. In addition, all amounts previously deferred will be taxed, plus charged interest and a penalty of 20%.
These rules apply to a wide range of plans and arrangements, but they specifically exclude 401(k)s and other qualified employer plans, qualified governmental plans, and any bona fide plan covering vacation leave, sick leave, compensatory time, disability pay or death benefits. Nonqualified deferred compensation can still be effective way to compensate employees. If you haven't already done so, you need to amend your plan documents by Dec. 31, 2007.
Develop a comprehensive succession plan.
All business owners should create an exit strategy to sell their companies or pass them on to their children, other family members or key employees. Your plan should include choosing the best and appropriate amount of insurance; utilizing valuation discounts; developing a buy-sell agreement; and determining whether an employee stock ownership plan (ESOP) could work for you. You will want to have a comfortable retirement while the business continues under the leadership and direction of your children or key employees — or in the hands of a new owner. A business succession plan will require consulting with family members, developing an effective management structure, and working with legal and financial advisors to set up and implement the plan.
Make the most of selling your business.
The first tax consideration may be whether to sell assets or your equity interest, such as stock. With a corporation, sellers typically prefer a stock sale for the capital gains treatment and to avoid double taxation. Buyers, on the other hand, generally want an asset sale to maximize future depreciation write-offs.
The transaction of transferring your business can be either taxable or tax-deferred, depending on whether the seller is receiving immediate cash or stock. Although it's generally best to avoid - or postpone - tax, there are some advantages to a taxable sale. For example, the seller doesn't have to worry about the quality of buyer stock or other business risks that might come with a tax-deferred acquisition. Also, the buyer receives a stepped-up basis in the assets and doesn't have to deal with the seller as a continuing equity owner, as would happen in a merger transaction. The parties also don't have to meet the technical requirements of a tax-deferred transaction.
If a taxable sale is chosen, the transaction may be structured as an installment sale, due to the buyer's lack of sufficient cash or the seller's desire to spread the gain over a number of years. Installment sales are also useful when the buyer pays a contingent amount based on the business's performance. Watch out, though: An installment sale can backfire because depreciation recapture must be reported as gain in the year of sale. Also, if tax rates increase in the future, the overall tax could wind up being more on an installment sale than on a cash sale. As a result, the extension of the 15% rate on long-term capital gains through 2010 is good news for anyone considering an installment sale. Be sure to calculate the potential tax effect before you finish negotiations.
Benefit from tax breaks for the self-employed.
If you're self-employed, you can deduct 100% of health insurance costs for yourself, your spouse and your dependents. This above-the-line deduction is limited to the net income you've earned from your trade or business. You can also deduct above the line half of the self-employment tax you pay on your self-employment income. And you may be able to deduct home office expenses against your self-employment income.
Download printable Tax Guides PDF >
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7 Penn Plaza, Suite 804, New York, New York 10001 | T: 212-697-8540 | F: 212-573-6805 | E: info@tarlow.net
Copyright 2007 Tarlow & Co., C.P.A.'s
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