Five steps for keeping your business's tax liabilities under control
IN THE NEW YEAR, managing tax liabilities will require extra planning, to prepare for the unexpected. U.S. tax laws have been subject to frequent incremental changes, with an uncertain future. Increases in tax rates effective
The higher individual tax rates also apply to income from flow-through entities, such as "S" corporations and Limited Liability Companies (LLC's) that elect to be taxed as partnerships. These rates reflect the U.S. Affordable Care Act's new 3.8% tax on unearned investment income of joint filers making over
The year 2013 brought more than just higher rates and new taxes yet to be fully clarified. It also saw the expiration of many significant tax provisions, such as bonus depreciation and certain tax credits, some of which have a history of being renewed retroactively. Meanwhile, there has been talk of taxing the wealthy even more, but also of decreasing regular corporate rates to retain businesses in the U.S. rather than cause an exodus to foreign countries. The outcomes will impact the choice of business entity.
Following are five potential areas for savings, summarized in the accompanying box (facing page). It is critical that companies work with their tax advisors to assure adequate consideration of the unique facts of their situations.
#1 Reduce tax rates
There are many strategies for reducing effective tax rates. One is converting income to the lower rates on long-term capital gains and qualifying dividends.
For example, U.S. companies that export can obtain such tax advantages through Interest-Charge Domestic International Sales Corporations ("ICDISC's"). These provide a means of deferring income from foreign sales through a shell entity, which is subject to tax only upon its distribution at favorable tax rates. The operating company pays the IC-DISC a commission based upon its net exporting income. The commission is an income tax deduction, saving up to 43.4% in U.S. tax, but not taxed to the IC-DISC. The tax is incurred only when the IC-DISC distributes the cash to owning individuals, and then at the lower 23.8% rate on dividends.
Similarly, multi-entity businesses may establish a captive insurance company to fund their risks. The potential benefits are an ordinary tax deduction for up to
On another note, stockholders can exclude a portion of the gain upon sale of qualifying small business regular corporation stock, as long as the stock meets certain requirements and is held for more than five years. While the 100% exclusion for 2013 has expired, a 50% exclusion relative to a 28% rate from the original 1993 law still applies to stock issued in 2014. This effectively reduces the long-term capital gains rate to 14%, although somewhat higher for taxpayers subject to unearned investment income and alternative minimum taxes.
For owners of closely held businesses who have families, it may also be a good thing to involve other entities and taxpayers. Employment of family members can have tax benefits. Family Limited Partnerships, useful in estate planning, likewise impact rates.
#2 Claim deductions
Certain frequently overlooked deductions are worth considering in planning. U.S. manufacturers and other types of businesses may qualify for the Domestic Production Activities Deduction. The deduction is computed as 9% of net income from qualified production activities, but is limited to 50% of U.S. W-2 wages, to exclude companies that outsource their operations.
Additionally, as long as employers maintain accountable plans, businessrelated expenses incurred personally by owners and key people on the company's behalf are deducted by the company and reimbursed to the employee tax-free. This helps employees tax-wise, because without it, unreimbursed business expenses on the employee's personal tax return can be subject to exceeding a 2% threshold of adjusted gross income before obtaining an itemized deduction.
If expenses extend to purchasing a vehicle, a major tax consideration is the severe limitation on depreciation deductions for the more expensive ones. An exception to depreciation caps is made for heavier vehicles, including SUV's, that weigh 6,000 pounds or more. Moreover, when it comes time to sell a vehicle whose remaining tax value exceeds market, only an outright sale rather than trade-in allows for an immediate deduction of the loss.
Other opportunities may exist with assets. The last-in, first-out ("LIFO") method of inventory accounting is beneficial to elect when prices are rising, as it allows expensing the most recent purchase prices against sales revenue first, while retaining older prices in inventory. Utilizing government indexes minimizes documentation risks.
Prepaid expenses, such as insurance or maintenance, are traditionally set up by accountants as assets that are expensed as they are consumed in the future. This practice effectively defers the tax deduction. A special election may be made so that these items may be written off currently.
Further savings are possible by writing off old assets. For accounts receivable, write-offs are allowed when the taxpayer can document that reasonable collection efforts have been exhausted. Depending on company policy, this might occur, for example, when an account is turned over ELECTRICAL APPARATUS /
#3 Defer income
It may be possible to shift income into a future year. When selling stock or assets, the installment method is applied when cash is received over time. The seller incurs tax on gain ratably only upon receipt of cash. This may enable a higher share of the gain to be taxed at lower tax rate brackets in different tax years. However, a limitation is that ordinary gains are taxed before capital gains.
Similarly, businesses that are below certain revenue thresholds may elect to be taxed using the cash method of accounting, under which there are income planning opportunities as to the timing of receipts and disbursements.
On another note, exchanging assets can be beneficial for deferring taxable gains. Section 1031 allows proceeds from sales of certain business assets, including real estate, to be placed into escrow and reinvested without immediate tax. The proceeds are reinvested by purchasing another property. The income taxes on gains are deferred until the replacement property is sold.
Likewise, putting money aside into a qualified retirement plan offers current deductions for income that is not taxed until the future. Beyond that, a significant deferral is possible by using a retirement plan in connection with an owner's exit from the business. When 30% or more of regular corporation stock is contributed to an Employee Stock Ownership Plan ("ESOP"), the related gain may be deferred by reinvesting the proceeds in qualified replacement securities, in a manner similar to exchanges. Moreover, if the company subsequently elects "S" status, the ESOP's share of its flow-through earnings are exempt from taxation. ESOP-owned stock may collateralize bank financing, which the company pays off through fully deductible contributions to the plan. As employees retire or leave, the ESOP pays them out in cash.
#4 Expense capital items
New regulations have expanded opportunities for writing off capital expenditures. Capitalization limits, used by most companies to expense smaller items, now may be protected from
In a similar vein, for businesses that add to their facilities, a cost segregation analysis could be extremely beneficial. The analysis separates personal property, qualifying for a quicker write-off, from real property, which is permanently affixed to real estate. For example, if a company installs wiring especially for new equipment, that wiring can qualify for a fiveor seven-year write off, rather than over the thirtynine-year building life.
In addition, small business expensing rules, known as section 179, continue in 2014, albeit at a lower benefit than in 2013. Up to
#5 Choose the right entity
The choice of entity depends heavily on the direction of future tax legislation. In light of the growth in individual rates and the continued lower regular corporate rates, it may seem like a good idea to convert businesses away from flowthrough entities. However, in most cases, a larger disparity in rates will be needed before regular corporations become more tax efficient.
This is because regular corporations are double-taxed, incurring their own tax first, without any long-term capital gains break. Then, as money is distributed to owners, it is taxed again at the individual level, without a deduction to the corporation. The law enforces the double tax by limiting owner salaries to "reasonable" levels, and by preventing corporations from accumulating excess earnings.
Unlike in regular corporations, the incomes of flow-throughs are taxed directly to their individual owners, largely independent of distributions. However, the Affordable Care Act burdens inactive investors in these entities with the new 3.8% tax on unearned investment income. The tax effectively equalizes their rates with self-employment taxes incurred by active owners of LLC's, partnerships, and sole proprietorships on income in excess of the social security tax base.
Only active stockholders of "S" corporations are exempt from this new tax, just as they had been from prior self-employment taxes, for tax savings over other flow-throughs. On the other hand, LLC's have many other advantages over "S" corporations, including absence of corporate formalities, unrestricted owner types, flexibility of income allocation and distributions, and more immediate tax benefits of losses if incurred. The best entity choice depends on particular circumstances.
Unfortunately, switching entities is costly. Existing corporations converting to LLC's must dissolve and incur the double tax. Electing "S" status, on the other hand, is less onerous, but still causes the loss of any credits or carryovers from previous years, and subjects the corporation to "built-in gains" tax at the time of the election, which includes adjustments of property to market value. If sold within a period of years after the election, "S" corporations are open to double taxation. *
Tax savings ideas for 2014
Here's a summary of the ways in which a business can reduce its tax liability in 2014:
#1 Reduce tax rates
* Insurance captive
* Sale of qualifying regular corporation stock
* Other entities and taxpayers
#2 Claim deductions
* Manufacturers' deduction
* Owner and key people expenses
* Purchase and sale of vehicles
* Last-in, first-out inventory cost
* Prepaid expense deduction
* Bad debt write-offs
* Inventory markdowns and disposals
#3 Defer income
* Installment method
* Cash basis
* Asset exchange
* Qualified retirement plan
* Exit involving ESOP
#4 Expense capital items
* Capitalization limits
* Routine maintenance
* Cost segregation
* Section 179 expensing
#5 Choose the right entity
* Regular corporation
* "S" corporation
Those considering employing any of these strategies should first consult a tax professional.-WW
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