BUSINESS TAX LOOPHOLES (that may also be applied to the church.)
By: Richard J. Shapiro
(Note: Most of the following suggestions are for “profit” oriented corporations. However, since most churches are incorporated, many can be applied. But check with your accountant before making any tax liability decisions.)
BEST TAX SHELTER IN AMERICA IS A BUSINESS OF YOUR OWN
*Living quarters may be provided on a tax-deductible basis for the corporation and tax-free to the shareholder-employee if the corporation requires him to live on the premises for a good business reason.
This might apply for a shareholder serving as a hotel, motel, farm or ranch manager. It might also apply to the manager of a nursing home, hospital or funeral home and other occupations requiring close and more or less continuous availability in connection with the business.
*Use of deductible company car: The use of a company car can be a valuable fringe benefit. The expenses of the car, including depreciation, are deductible by the corporation and not taxable to the shareholder-employee if it is used exclusively, on company business.
If a shareholder-executive is given the use of two cars, and it is clear that one of them is being used by his wife for non-business purposes, he will be taxed on the value of the use of the car. But his tax liability will be less than the cost of renting a car, and most likely less than it would cost him to buy, finance and maintain the car on his own.
If the extra car is treated as extra compensation, the attending expenses deductible by the corporation as compensation, subject to the overall limitation of reasonableness. If treated as dividend income to the shareholder, it would not be deductible by the corporation.
*Deductible chauffeur: The cost of a chauffeur may be deductible by the corporation and not taxable to the shareholder-employee if deemed an “ordinary and necessary expense,” sometimes translated as “appropriate and helpful.”
*Company dining rooms, employee cafeterias, and other “eating facilities” operated by an employer for employees are not subject to the 80% limit on business meal deductions if the facility…
1. Is located on the business premises of the employer, and
2. Brings in revenue that normally equals or exceeds its direct operating costs, and
3. Does not discriminate in favor of highly compensated employees.
(New IRC Section 274 (n)(2): Amended IRC Section 132(e)(2).)
*Bail-out loophole for family members: Income and estate tax considerations generally make it desirable for family members to hold stock in a close corporation. The family head may wish to give them money to buy stock from the corporation, or they may already have their own money to buy in.
There are two good reasons why it may be desirable for family members to acquire their stock directly from the corporation as soon as the corporation is set up:
1. The stock will be cheaper at that time than later, assuming that the corporation succeeds; and
2. The rules governing corporate redemptions are less restrictive when the stock is acquired directly from the corporation rather than by a transfer from a family head or other family member.
*Leasing assets to your own corporation: The fact that the corporate form is selected as the basic means of conducting a business enterprise does not mean that all of the physical components of the enterprise need be owned by the corporation. Indeed, there may be legal, tax and personal financial planning reasons for not having the corporation own all the assets to be used in the business.
Whether the corporation is to be the continuation of a sole proprietorship or partnership or a wholly new enterprise, decisions can be made about which assets owned by the predecessor or acquired for use in the corporation are to be owned by the corporation and which assets are to be made available to the corporation through a leasing or other contractual arrangement.
For the assets that go to the corporation, decisions must be made about how they are to be held and on what terms they are to be made available to the corporation.
There are several possible choices. The assets may be owned by:
(1) An individual shareholder or some member of his family;
(2) A partnership, limited or general, in which family members participate; or
(3) A trust for the benefit of family members.
A separate corporation is still another possibility, but the risk of being considered a personal holding company and incurring penalties due to passive income (including rent and royalties) may make this impractical.
Normally, a leasing arrangement is used for the assets to be made available for corporate use. Assuming that the rental is fair, it would be deductible by the corporation and taxable to the lessor. Against the rental income, the lessor would have possible deductions for interest paid on loans financing the acquisition of the asset, depreciation, maintenance and repairs, insurance and administrative costs.
These deductions might produce a tax-free cash flow for the lessor. When depreciation and interest deductions begin to run out, a high-tax-bracket lessor might find that he is being taxed at too high a rate on the rental income. At this point, he may transfer the leased property to a lower-tax-racket family member.
He might also consider a sale of the property to his corporation, possibly on installment terms to reduce the impact of tax liability. This sale would serve to extract earnings and profits from the corporation at favorable tax rates. At the same time, it would give the corporation a higher tax-basis for the asset than it had in the hands of the lessor, thus increasing the corporation’s depreciation deductions. This, of course, would reduce the corporation’s tax liabilities and benefit the shareholders the lessor included, if he is a shareholder.
*Profits reported by low-bracket children. Losses deducted by high-bracket parents: A business can be organized as a corporation, a proprietorship or a partnership, or even a trust. Use combined forms of ownership to cut taxes.
1. Use a corporation to operate the business.
2. Have an individual, as sole proprietor, or a partnership own the machinery and equipment and rent it to the corporation.
3. Have an individual or partnership hold title to the real estate and rent it to the corporation.
4. Use a trust (for the benefit of the children of the owners) as a partner in the partnership (in either the equipment partnership or the real estate partnership, or in both).
This arrangement accomplishes these tax benefits:
1. Tax losses are passed through to the owners. When partnerships begin producing income, transfer title to the children for income-splitting purposes.
2. Income from the rental goes to the owners without dilution for corporate taxes.
3. Income to children aged 14 or over benefits from income splitting.
The possibilities for combining the above are endless. Consider such additional entities as S corporations, multiple corporations and multiple trusts.
Family corporation operates a business.Stock is 100% owned by D, Dad and M, Mom
Lease – Real estate partnership
Rent – 100% owned by father and mother of Dad, D
Rent – 50% owned by adult son, a college student, of D
Lease – 50% owned by a trust for the benefit of D’s minor daughter
This is a three-generation family business combination:
First generation – Father and mother
Second generation – Dad, D, and Mom, M
Third generation – Adult son and minor daughter
*Deduct medical expenses without subtracting percentage of income: One of the healthiest tax benefits you can provide for yourself or your key employees is a corporate medical reimbursement plan under Section 105(b).
You get full reimbursement of medical expenses without reduction for the 7.5% of adjusted gross income limitation on medical expenses. For example, if you are currently earning $40,000, the first 7.5% or $3,000 you spend on medical expenses is lost forever as a deduction.
Medical expenses that are reimbursed to you or are paid directly for your benefit are fully deductible by the corporation as compensation.
The amounts reimbursed to you or paid for your benefit are not included in your gross income.
Simply put, all medical expenses for you and all your dependents can be paid by your corporation and are fully deductible by the corporation without your having to pay one penny of income tax on the benefits.
Uninsured (self-insured) medical expense reimbursement (pay) plans have to meet the breadth-of-coverage requirements applicable to qualified pension plans. In order for medical expense reimbursements to be excluded from the employee’s income, the plan must not discriminate in favor of key employees (highly compensated individuals and certain stockholders).
YOUR BUSINESS GROWS BUT YOUR TAX RATE SHRINKS
A recent Supreme Court decision enables growing companies to cut their tax bills. Instead of expanding the business through the formation of a new operating division, form a new corporation. The old owners retain all the stock of the original corporation but transfer more than 20% of the stock of the new company to a third party (such as a key executive or outside investor).
Benefit: The two companies are taxed as independent enterprises. Each is taxed initially at the lowest (15%) tax bracket. (Under the old law, their incomes were added together. The totaled amount, therefore, could reach into higher brackets.)
Example: One corporation with $150,000 in taxable income must pay $41,750 in taxes at rates in effect after July 1,1987. But two companies with $75,000 in income must pay only $13,750 each. The $27,500 total represents a net tax saving of $14,250, or 34% of the original tax bill.
Source: Vogel Fertilizer, 455 US 16.
PAYROLL TAX ALERT
A firm that fails to pay the government payroll taxes withheld from employees’ wages runs a real risk that the IRS will close down its business.
Strategy: Resume paying current payroll tax liabilities as soon as possible, before paying any overdue liabilities.
Reason: The IRS usually won’t close a business if its current liabilities are being paid. And they will agree to work out a payment schedule for the old liabilities.
Extra reason: A penalty is imposed for every payment missed. The firm will pay more in penalties if it bypasses current payments to pay off old ones.
Source: Edward Mendlowitz, Mendlowitz Weitsen.
BIGGER WRITE-OFFS FOR BUSINESS START-UP COSTS
The tax law provides a very favorable opportunity for those who invest in starting up a small business. If both investors and new companies follow a few simple rules, they can be certain that if the business fails, investors can be protected through an ability to deduct their loss against ordinary income rather than taking it as a capital loss. The provision is not new, but it has been streamlined and liberalized in recent years.
The tax saving resulting from a capital loss is considerably less than the saving resulting from an ordinary income loss.
Capital losses of any size can be used to offset capital gains (either long or short). But if the net result of all capital transactions is a loss, it can be deducted from ordinary income only at the rate of $3,000 per year. The remainder can be carried forward and used in later years. But, even so, it would take over eight years to write off a $25,000 loss if the investor didn’t have any realized gains in that period.
Any unused capital losses expire at the taxpayer’s death. Thus, if an older investor realizes a large loss, he may find it impossible to take advantage of all of it. Accordingly, a provision for turning all kinds of capital losses into ordinary income losses is very valuable. And that’s what is offered by Section 1244 of the Internal Revenue Code.
How the Investor Deducts the Losses
The basic feature of Section 1244 is that the annual $3,000 limit on capital losses that may be used to offset ordinary income does not apply. Section 1244 capital losses can be deducted from ordinary income up to $50,000 a year ($100,000 for a married couple filing jointly). Losses in excess of these amounts are then treated the same as other capital losses.
There is no lifetime limit on Section 1244 losses. Accordingly, if a corporation is failing, a better strategy than immediate liquidation might be to keep it (barely) alive for several years and sell part of the stock every year in order to take deductions far in excess of the one-year limit.
It is important to realize that the investor cannot deduct the corporation’s operating losses against his taxable income, as he would with an S corporation. He can deduct his capital loss on the sale of the stock, but not until he sells it or until he can show that it is worthless.
How a Corporation Can Qualify Under Section 1244
To safeguard its investors, a company must meet the following requirements:
1. The total capital contributed (that is, the amounts paid to the company by stockholders when they buy newly issued stock) may not at any time exceed $1,000,000. (Retained earnings are not counted toward this limit.) The stock may be sold in a single transaction or in several transactions spread over a period of time. And it may be sold in a private sale or a public offering.
2. The corporation must operate a business. It cannot be a passive investment vehicle owning real estate or securities or a tax shelter.
3. It is no longer required that the corporation have a written plan covering the offering.
4. Stock issued in exchange for personal services does not qualify under Section 1244. To meet the test, the stock must be issued for money or property.
Section 1244 is one of the very few provisions of the tax law that has no disadvantages and doesn’t cost anything to use. Obviously, if the business prospers, Section 1244 will never be used, but that is hardly something to complain about.
Source: Edward Mendlowitz, a partner in Mendlowitz Weitsen, CPAs, New York.
ADD NEW CAPITAL TO YOUR BUSINESS AND DEDUCT IT AS AN OPERATING EXPENSE
If a corporation is earning more than $100,000 per year before taxes, it will pay income taxes at the rate of 34% or more on that part of its income over $100,000. This means that the government is paying at least 34% of any additional deductible expense item. When expenses increase by $1.00, net income is reduced by no more than 66 cents.
Thus, if a way can be found to invest a dollar of additional capital in the corporation and deduct it as an operating expense, then Uncle Sam will pay at least 34 cents of that dollar.
And there is a way to do it. It’s called an Employee Stock Ownership Plan. With an ESOP, the corporation can deduct as an operating expense amounts contributed to the plan if the plan is qualified under ERISA. In addition, money contributed to the plan can be invested in stock or securities of the corporation. The ESOP is somewhat similar to a qualified pension or profit-sharing plan, but with the difference that it buys or owns stock of the corporation. This stock may be new issues purchased directly from the company, or stock in the possession of a corporate stockholder.
Methods of Contributing to the Plan
The corporation can contribute to the ESOP in either of two ways. It can contribute stock. For every dollar of stock the corporation contributes, it increases its cash on hand by 34 cents (the amount of the tax saving). Alternatively, it can contribute cash that is then used by the ESOP to buy stock from the corporation or from stockholders. The result is exactly the same:
Net cash outlay for ESOP contribution -$1.00
Cash received by the corporation from the ESOP for purchase of stock + 1.00
Tax saving + .34
Net change in cash position + .34
Furthermore, the ESOP may (if its charter permits) borrow money and use it to buy stock from the corporation or from stockholders. This is called a leveraged ESOP.
The program of contributing stock, or investing plan assets in stock, is entirely within the control of the company’s management and can be discontinued at any time. Even in the unlikely event that the plan trustees want to buy more stock than management wanted them to have, they could not force the company to sell it to them.
Rules of Employee Stock Ownership Plans
Every employee who qualifies must participate in the ESOP. Vesting cannot be delayed; all contributions to the plan for every employee must vest immediately, and the vested shares must be distributed to the employee upon retirement or termination (but not sooner than seven years after shares have been allocated to the participant). Further, no more than one third of the ESOP contributions for a year may be allocated to officers, stockholders or highly paid employees.
Moreover, the employer must offer to repurchase the shares at a price determined by a fair valuation formula that is established in advance. However, if the corporation’s charter or bylaws restrict ownership of stock to the ESOP or to employees only, then the employee can only be offered a cash and not a stock distribution.
This repurchase requirement could be very troublesome in some circumstances. Suppose, for example, the company encounters financial difficulties and starts running in the red. Large numbers of employees might demand to have their shares distributed and immediately repurchased, since it is very likely that the value would decrease as a result of the losses. Thus, just at a time when cash is critically short, a large cash outlay to repurchase shares would be required.
Less problematic, but potentially difficult, is the fact that under an ESOP voting rights must he passed through to the employees. That means that each employee has the right to vote the shares in which his ownership is vested, even though the plan is nominally the owner of the shares. But this rule does not apply to a profit-sharing plan for 1980 and later acquisitions of stock. The employee continues to have voting rights if the shares that are distributed are retained – and this could mean trouble for the active owners of the corporation.
There is one plus in this situation. The employer corporation may be reimbursed by the plan for certain expenses incurred in establishing and administering the plan.
Source: Edward Mendlowitz, a partner in Mendlowitz Weitsen CPAs, New York.
AVOIDING DEPRECIATION RECAPTURE
Tax-free incorporation is a highly desirable technique when a proprietor or partners want to sell business assets that would be subject to depreciation recapture.
It may happen that the partners have taken sizable deductions for accelerated depreciation, but now they feel the property should be sold. If they retain the partnership, they will have to report a great part, if not all, of the profit on the sale as ordinary income on their personal income tax returns. But if they incorporate the business before the property is sold, and if the corporation sells the property, the corporation is the one to report the ordinary income. This is true even though the accelerated derreciation was originally, deducted by the partners before the corporation existed. Thus, the tax-free incorporation provides a way for partners to shift their tax liability from themselves to the corporation or any depreciation recapture. Investment credit can be handled the same
way; the corporation, rather than the individual owners, reports the recapture. However, for these rules to be applicable, all of the assets of the unincorporated business must be transferred to the corporation.
Source: Edward Mendlowitz, a partner in Mendlowitz Weitsen, CPAs, New York.
DEDUCTING S CORPORATION LOSSES AGAINST OTHER INCOME
One good use of an S corporation is when a new business is started and expects to lose money at first. The S form can be elected at the beginning and can be continued as long as the business loses money. Those losses will be available immediately to those stockholders who are active participants in the business, and will shelter income from other sources. Then, when the business gets rolling and begins to show a profit, the stockholders may decide to abandon S status so that the profits can accumulate in the business and their taxable incomes are not increased by the addition of the profits from the business.
New S corporations must adopt a calendar year. An exception is made only where there is a strong business purpose for the use of a fiscal year. Furthermore, if there is a more than 50% change in ownership, then a calendar year must be adopted or the S status ceases.
If the stockholders are confident that the period of losses will be brief, they should time the start-up so that the first taxable year will be very short. For example, start the business in September and the first fiscal year will only be three or four months. The stockholders get the benefits of the losses during the brief start-up period. Then they can terminate the S status for the second fiscal year beginning January 1.
This can be most applicable to a service business, such as a window-washing operation or telephone-answering service that started as an unincorporated organization, keeping its books on the accrual basis. In that case, the accounts payable are negligible as most of the expenses are labor.
In a service business on the accrual basis, taxes are paid on profits represented by accounts receivable. As an example, let’s say that such profits in the first year’s accounts receivable amounted to $50,000; the profit equals that amount, and taxes are paid on it.
At this point, the business is restructured as an S corporation on the cash basis. But the old organization keeps collecting the cash on its existing accounts receivable, while the new S company pays all expenses. Assume that three months’ expenses come to approximately $50,000, and that billed but uncollected accounts receivable also come to $50,000. Cash to pay the bills of the S company can be generated by transferring the $50,000 in accounts receivable collections from the old organization as an investment in the new business. Meanwhile, however-at least for the roughly 90-day period during which no cash collections are coming into the S company from its own new accounts receivable-the new company reports a loss.
Source: Edward Mendlowitz, a partner in Mendlowitz Weitsen, CPAs, New York.
BUYING OUT A SHAREHOLDER AND DEDUCTING THE COST
One of the worst things that can happen to a closely held company is trouble among the shareholders. Buying out the dissenting shareholders can be very costly.
Some companies have tried to minimize the cost of a buyout by deducting it as a business expense. Problem: Company stock is a capital asset. And the cost of a capital asset is generally not deductible. Opportunity: Show that there is a compelling business reason for the buyout. The elimination of friction between shareholders is not enough. The company must show that without the buyout its business will be in jeopardy.
How the rule works:
*Winner. A company produced a patented product under license. But the conduct of one of the shareholders upset the patent owner, who threatened to cancel the license agreement if the shareholder was not removed from the company. So the company bought the shareholder out and deducted the cost.
Courts of Appeals Decision: Without the license, the company would have been out of business. So there was an overriding business motive for the deal, and the deduction was ruled okay.
*Loser. A company wanted to close an unprofitable subsidiary. But it was contractually committed to buy out the interest of the subsidiary’s manager first.
IRS objection: The company business was healthy on the whole. The fact that the company had made a bad investment in the subsidiary did not entitle it to specially favored tax treatment.
The Court’s Decision: The fact that there was some business motive for the deal did not outweigh the fact that it was a purchase of capital stock. The deduction was disallowed.
Source: Winner; First Star Mfg., USCA-5, 355 F. 2d 724. Loser: Harder
Services 67 TC 585.
JUSTIFYING A BIG SALARY IN A POOR BUSINESS YEAR
The owner and top executive of a closely held business probably won’t find it difficult to justify, even a large salary as being reasonable during a good business year. After all, somebody has to be responsible for the company’s fine showing. And the company can prove the executive’s value by equating his leadership with the company’s success.
But this argument can turn against the company when business goes bad. If the executive continues to draw a high salary, the IRS may contend that he is making more than he reasonable deserves. Result: Part of the salary will be construed as a taxable-dividend that is not deductible by the company.
To avoid this problem, a business owner may decide to take less compensation during a prior business year, perhaps by not taking a year-end bonus. But this has a double drawback. Not only is the owner’s income reduced, but the reasonableness of his compensation in other years may be questioned. Reason: Executive compensation must be tied to personal performance, not company performance. If compensation goes up in a good year and down in a bad year, while the executive owner’s job remains the same, the IRS may say that part of the good year’s compensation was really a disguised dividend, which the company cannot deduct.
Demonstrate that adverse business conditions have made the top executive’s job both more important and more difficult to perform. So that he is now working harder than ever to earn his pay.
Arguments to use:
*Poor earnings have led several executives to quit or be discharged. So that the remaining officers have been forced to assume extra duties.
*The top executive has had to spend long hours reviewing every phase of the company’s business. Cite specific problem areas, such as product line, costs, personnel, credit policies and so forth.
*Special duties have been forced on top executives, who have had to negotiate with unions about layoffs and job reassignments, bargain with landlords and suppliers, and try to collect debts from cash-short customers.
*Without the top executive’s fine performance, the company would be even worse off. Generate statistics which compare the company favorably to competitors in the same industry.
Important: You will need to prove these arguments in the face of a challenge by the IRS. So keep records now that show the executive’s special performance. Use corporate minutes, office correspondence, memorandums and other contemporary records to document the executive’s activities.
Source: Robert Holzman, PhD., professor emeritus of taxation at New York University and author of the Encyclopedia of Estate Planning, Boardroom Books, Springfield, NJ 07081.
INTEREST DEDUCTIBLE; PRINCIPAL TOO
Employee stock ownership plans are a tax-saving means of corporate financing. The essence: A firm sets up a plan, which borrows money from a bank on a note guaranteed by the corporation. The plan uses this to buy stock from the corporation. The corporation makes contributions annually in cash or stock to the plan, for which it gets tax deductions. The contributions are used to pay off the bank loan. In effect, the corporation raises capital with tax-deductible dollars.
The ESOP can be used as a personal financial planning tool for the shareholder-owners of a close corporation who are otherwise locked into the corporation.
If the corporation redeems part of their shares in an ordinary way, they’re almost certain to be taxed at ordinary income rates. And that transaction will be treated as a dividend distribution (which the corporation pays taxes on) rather than a sale or exchange.
The corporation itself faces a major problem on redemptions. It must accumulate the necessary funds. They can be accumulated only out of after-tax dollars.
By interposing an ESOP, the picture changes dramatically. The shareholders have a market for their shares-the ESOP. The plan buys their shares with deductible contributions made with pretax dollars.
If there isn’t enough money in the ESOP at the time to effect the purchase, then the plan borrows money from a bank in the procedure outlined above. The same approach may be used by the shareholder’s estate as a means of realizing cash on stock held by the estate without getting dividend treatment.
Insurance angle: The ESOP, as an alternative to borrowing to raise cash to purchase stock from the estate, may, according to current thinking among practitioners, carry life insurance on a key shareholder. If the corporation itself were to carry such insurance to facilitate redemption, the premiums paid wouldn’t be tax deductible. By interposing an ESOP, the premiums effectively become tax deductible, since they’re paid by the Plan out of tax-deductible dollars contributed to it by the company.
The shareholder-executive will be able to participate in the plan himself and enjoy its benefits.
*His company will make tax-deductible contributions to the plan.
*He won’t be taxed until the benefits are made available to him.
*The payout is required to be made in company stock and he won’t be taxed on the unrealized appreciation in the stock over the cost to the plan until he sells the stock.
*On a transfer of his plan benefits to his beneficiaries, other than his estate, upon his death, they won’t be includable in his estate and will escape estate taxes.
Valuation of shares on a sale to the ESOP. Another is the necessary distribution of corporate information to the employee-shareholders. If corporate progress isn’t to the liking of employees, expect worker dissatisfaction.
The concepts are new. But the idea is one well worth exploring.
TAX-WISE WAYS TO IMPROVE CASH FLOW IN BAD YEAR
The company that makes money this year but expects to lose money next year should file Form 113R. This extends the time for paying taxes until the date return is due. And the loss shown on the return can be carried back to wipe out this year’s tax bill.
A company with losses can get a quick refund of the prior year’s taxes through its loss carryback by filing Form 1139. The IRS must generally respond to this refund request within about 90 days. Requirement: The company must file its regular tax return before the Form 1139 is filed.
Estimated taxes. Many firms routinely base one year’s estimated tax payments on the previous year’s tax liability. But the resulting tax payments will be too high if income goes down. So be sure the company’s accountants base estimated payments on actual earnings as the year progresses. During a stretch when the company is losing money, it need pay no estimated taxes at all.
Trap. Business may improve later in the year as the economy picks up. Then the company may wind up with a large tax liability after all. And the IRS may ask why the company did not make any estimated-tax payments during the course of a profitable year. What to do then: File Form 2220. This shows that the company was actually losing money for most of the year and did not owe the taxes. Make sure the company’s bookkeepers examine Form 2220 at the beginning of the year. It will show them what records must be kept to protect the company from tax penalties.
Retirement plans. If the company is locked into making large pension-plan contributions and is afraid that it may not be able to afford them, plan now to ask the IRS for a waiver of the contribution requirements.
The company must be able to show that it is suffering from genuine economic hardship to qualify for a waiver. And it must show that the waiver is in the best interest of the pension plan’s participants.
How: Show that the waiver will help the company regain economic strength and continue in business.
Related companies. Many businesses are operated through several different corporations. And the swift-changing economic conditions may affect the separate companies differently. Some profit while others lose. What to do: Look at the effects of filing a consolidated tax return. The profits of one company may then be offset by the losses of another. And the net tax bill may be reduced.
Point: A consolidated return does not have to be decided upon until the normal time for filing the tax return. At that point, with all the good and bad news in, the results of consolidated and separate filings can be compared to see which one produces the best outcome for the company as a whole.
Source: Harris A. Garris, CPA, tax manager, Richard Eisner & Co., New York.
CORPORATE CHARITY LOOPHOLE
Many companies use charitable gifts to establish goodwill with influential business and community leaders. Catch: A corporation’s deduction for charitable contributions is limited to 10% of its taxable income. This limit can be a problem even for very profitable companies that use smart tax planning to keep their taxable income as low as possible.
Tactic: A company can get around the 10% limit by deducting the payment to charity as a business expense. It simply needs to show that it expects to receive a significant business benefit in return.
Business expense deductions have been allowed for contributions to:
*A charity that agreed to actively cooperate in the company’s advertising program.
*An organization that was the favorite charity of a potential major client of the company.
*Several charities that regularly made bookings through the company’s travel agency services.
*A hospital that agreed to make medical facilities available to the company.
To ensure a deduction, have corporate records document two things: First, a business reason for the donation. And second, the fact that the company expects to receive a financial return on the expenditure.
TAX-FREE SEVERANCE PAY
In troubled economic times, even top executives sometimes lose their positions. In these circumstances, it is more important than ever that any severance or termination payments receive the most favorable tax treatment possible.
Key: Severance pay is taxable as ordinary salary. But payments made to compensate the ex-employee for damages are tax free.
The dismissed employee can bring suit against his former company in court, or before a federal agency (such as the Equal Employment Opportunity Commission), alleging that he suffered damages as a result of his wrongful dismissal. (The dismissal may have harmed his business or personal reputation, caused embarrassment or resulted in physical or emotional harm.)
The objective: A settlement can be reached with the company that allocates part of the termination payment as compensation for harm. What would have been taxable severance pay is converted into tax-free damages. Extra benefits: The company can profit from this sort of agreement as well. Since it is paying its former employee in tax-free dollars, it may be able to negotiate a smaller settlement that gives the employee more in the end.
R & D TAX BREAK: GOVERNMENT PAYS HALF
The special break in the tax law for any company developing a new product or improving an old one is a research-and-development tax credit that was extended by the 1986 Tax Reform. The company can use it to reduce its tax bill by up to 20% of the increase in its R & D budget. The new credit is available in addition to other, normal R & D deductions. Together, they may cut the cost of the company’s research by more than half.
Important to do now: Have the company reexamine its new-product expenditures. Many companies now simply expense these items. But R & D costs should be defined and segregated in the company books, so that creditable items are not overlooked.
Claim the credit for the cost of experimentation and investigation involving the development of a new product or the functional improvement of an old one. It is also available for the cost of applying experimental results to a new plan or design.
*The cost of stylistic changes.
*Quality-control testing and inspections that are a normal part of the production process.
When the company uses its own staff on the R & D, it can claim the credit for:
*Wages. These include not only salaries paid to researchers, but also those paid to their support staffs. Examples: A secretary who types R & D reports. An assistant who puts information into a computer. A maintenance worker who cleans R & D equipment. When a regular employee spends only some time on R & D projects, allocate a portion of the employee’s wages for the credit.
*Supplies. Claim the credit for the cost of any supplies used in R & D. But the credit does not apply to the cost of the land or depreciable equipment purchased for the R & D. (Claim the regular investment credit for such equipment.)
*Payments for the use of research equipment. These include lease and rental payments for computers, special laboratory equipment costs and license payments.
The R & D credit is available in addition to normal R & D deductions. So the company must consider both when computing the real cost of its research work. Combined, they may cut the real cost of research work by more than 50%.
Do not forget to claim a credit for them on the company’s tax return for the year that just ended. Point: The credit can be carried back three years or forward 15 years. Even if the company ran at a loss last year, the credit can be used to obtain a refund of taxes paid for prior years. Or it can be used to shelter future profits from tax.
Because the credit applies only to increases in the company’s R & D expenditures, the timing of a company’s research efforts will greatly affect their tax impact. Be sure to consult with the company’s tax advisers about this and other technical aspects of the law.
Source: Robert Feinschreiber, partner, Robert Feinschreiber & Associates,
law firm, New York.
WHEN KICKBACKS ARE TAX DEDUCTIBLE
Kickbacks – some legal, some illegal – present some difficult dilemmas for business. Let’s examine them:
Kickbacks to government employees aren’t deductible by the payor. Payments to businesspersons are – if the payor hasn’t violated any state law that would subject him to a criminal penalty. In many states, such as New York, there are commercial bribery laws, which forbid the payment of money to an employee of another corporation unless the recipient’s employer knows about it.
The tax relevance: The payor will lose the tax deduction if the employer of the purchasing agent, executive, loan officer, etc., doesn’t know about the kickback. That should discourage the making of such kickbacks, which of course, is what the law is trying to do.
But these are unusual times. The payee’s employer may be hard put to pay a valuable person what he demands.
The employer doesn’t have to increase the salary if the employee is permitted to sweeten his own income satisfactorily in another way. Many employers consider themselves sufficiently familiar with the product (or service) that their employees are buying to know when shoddy merchandise or inflated prices are involved, and they feel that the employee’s acceptance of a commercial bribe won’t hurt what the company is getting. For his part, the employee is hardly likely to let the kickback distort his judgment if it would result in the loss of his job.
So we have the bizarre situation of both employee and employer benefiting from a kickback, which the payor is permitted to deduct for tax purposes.
HOW TO CUT TAXES ON COMPANY REAL ESTATE
Federal tax law is much harder on real estate owners than it was before Tax Reform – but there are two often-overlooked ways companies owning real estate can cut their tax bills…
*Classify as many assets as possible in a building as personal property. Generally, an asset qualifies as personal property if it is movable – even if it probably never will be moved. Examples range from office partitions to emergency generators and similar heavy equipment.
Benefit: Personal property can be depreciated in only seven years, compared with 31 1/2 years for real property, producing annual tax savings of about 15 cents on the dollar during the depreciation period.
Better: Some types of businesses are now allowed to depreciate personal property in only five years.*
* Classify as many assets as possible as site improvements. These are improvements to property that are not part of a building.
Examples: Parking lots, landscaping, paved roads, fencing. Such items are depreciable over a period of 15 years, compared to the 31 1/2 year period for real property, producing tax savings of about 7 1/2 cents on the dollar.
Trap: If the company’s accountants lump these items in with the cost of a building, tax benefits will be lost.
This type of classification – called cost segregation analysis in tax jargon – generally isn’t difficult, but few companies take the time to go through the process.
Trap: On new construction, contractors provide cost breakdowns, but not according to asset depreciation periods.
Example: A contractor will routinely lump all plumbing costs together, and a building’s plumbing is classified as real property depreciated over 31 1/2 years. But if, for instance, a third of the plumbing is used in connection with new landscaping, it may easily qualify as a site improvement eligible for 15-year depreciation, producing large tax benefits.
Companies that buy already – existing properties are likely to be at even more of a loss than those that build, because they don’t even get a contractor’s cost breakdown. In this case, they must hire tax experts to survey the property and assign each asset to the most advantageous tax category.
Special care should be taken in the company’s effort to identify its personal property. The first thing to remember is that companies often have a choice in determining whether their necessary assets will qualify as personal property or real property.
Example: A guard station that is built into a building’s lobby will qualify as real property depreciable over 31 1/2 years. But a guard station that is set up in the lobby (and can be removed) will be personal property that is depreciated much more quickly. The same distinction applies to permanent walls versus movable walls and partitions, central air conditioning versus
portable air conditioning units, installed lighting versus movable lighting, and so forth.
In addition, many items which might normally be thought of as part of a building may surprisingly qualify for faster depreciation as personal property.
Examples: Store counters, pumps, heavy installed equipment (such as printing presses or refrigeration units), power lines, and outdoor advertising displays attached to a building. Depreciation deductions even have been allowed for air space that was used up as a company filled a dump site.
Caution: There are many gray areas among asset definitions, and several dozen exceptions to the standard write-off periods of seven and 31 1/2 years for personal and real property. So it’s important to retain experienced experts in the field of asset accounting to help the company get the most from unexpected deductions.
*Hotels, motels, restaurants, department stores and several other types of retail companies.
Source: F. Robert Effinger, vice president, Marshall & Stevens, real estate appraisers and valuation consultants, 600 S. Commonwealth Ave., Los Angeles 90005, and Thomas C. Moore, regional vice president, Marshall & Stevens, 111 Parker St., Tampa, Florida 33606.
WAYS TO TAKE MONEY OUT OF THE COMPANY
The new tax law creates new ways for business owners and top executives to be paid by the company in tax-advantageous ways.
*Interest-free loans can be made from the company to owners and top executives. Loans that have been properly drawn up have repeatedly withstood IRS challenges. Key: You must be able to show that the loan is legitimate. So agree to a reasonable repayment schedule, and observe all the legal formalities.
*Pension pay-outs. The new tax law provides that pensions need not be taken right after retirement. The first pension payments can safely be delayed until at least age 70. Point: Many executives remain active for some years after they retire. They may continue to do special tasks for the company, or act as paid consultants for other businesses. These executives may not need their pension benefits right away. Advantage of waiting: The pension plan account continues to accrue earnings tax-free. So you receive greater benefits when you choose to take them. Review the company’s pension plan to be sure it allows a delay in drawing benefits.
*Deferred compensation. The company may not be able to afford a pension plan that covers all employees. But it may still want to provide retirement benefits for top executives. To do it: Set up a deferred compensation plan. This takes the form of a contractual commitment to pay top executives a certain amount after retirement. The payments are deductible by the company when made.
*Stock appreciation rights. Rights may be suitable for some closely held companies. How they work: The executive is treated as if he owned company stock. If the value of the stock goes up by a certain date, the executive receives a payment determined under a prearranged formula. The payment may be deducted by the company. Advantages: Managers get an incentive interest
in the company that is similar to ownership. But the company avoids increasing the number of its shareholders. Drawback: Incentive amounts that accrue under the plan must be charged against corporate earnings even before they are paid out. So reported earnings are reduced.
If the company is sensitive about its reported earnings, this type of plan may be disadvantageous.
Source: Richard Reichler, principal, Ernst & Young, international accounting firm, New York City.
S CORPORATION TRAPS
Some small corporations can qualify for special tax treatment under Subchapter S of the tax law. Election of S corporation status is voluntary and termination is also voluntary-usually. But there are a number of pitfalls that can result in involuntary loss of S corporation status, whether the shareholders like it or not.
*Having more than 35 shareholders.
*Transferring S corporation stock to a partnership, a corporation, certain trusts or a nonresident alien.
*Creating a second class of stock.
*Acquiring another corporation or a subsidiary that is ineligible for S corporation status.
*Becoming an ineligible corporation, such as a member of an affiliated group.
Avoiding the Traps
Shareholders should enter into an agreement that:
*Forbids any of the above actions by any shareholder without the consent of the others.
*Provides for indemnification against additional tax liability by anyone who, intentionally or unintentionally, causes the loss of S corporation status.
*Requires any stockholder who plans to sell or transfer shares to give the other shareholders a right of first refusal on the purchase.
DEDUCTING VACATION COSTS AS BUSINESS EXPENSE
Tax Reform has cracked down on many travel-related deductions. But there are still deductions you can take for travel, and you should not miss those that still apply.
Traveling for Business
*Travel expenses. You can fully deduct the cost of getting to and from your destination on a trip made primarily for business reasons. This expense remains fully deductible even if you extend the trip for pleasure or take a side trip for pleasure. In addition, during the business part of your stay, you can deduct the cost of hotel, lodging, local transportation, and 80% of meals and business-related entertainment.
Example: You travel to New York City strictly for business reasons, and decide to take a side trip for the weekend, vacationing at a sumptuous Long Island beach resort. The trip between New York City and home remains fully deductible, as long as you can prove you traveled there for business; but the cost of traveling between New York City and the resort is not deductible because that part of the trip is entirely for personal pleasure. Also, the related expenses of meals, lodging, and local transportation while at the beach resort are not a deductible business expense.
*Mixing business with pleasure. The cost of traveling to and from your destination on a trip made primarily for vacation or pleasure isn’t deductible, even if you conduct some business while on the trip, However, some of the other business-related expenses may be deductible.
Example: You go on a vacation to Florida, but, while there, you take a customer who lives in Florida out to lunch. Under tax reform, 80% of the meal expense is deductible if business was actually discussed during the meal. Be sure to include tax, tips, and parking lot fees at the restaurant when calculating the 80%. The cost of traveling to the restaurant, if you take a taxi, for example, is 100% deductible.
* Taking your spouse along. Expenses for your spouse while you are on a business trip are deductible if you can prove that there is a real business purpose for her presence. Unacceptable to the IRS: That you needed your spouse along to answer the phones, type, or run the slide presentation. However, there are some circumstances that may warrant deducting traveling expenses of a spouse who accompanies you on a business trip. Such as:
1. A husband-and-wife jointly owned business.
2. Business travel to a foreign country where your spouse is fluent in that foreign language and you are not.
Even if you are not allowed to deduct your spouse’s travel, you can still deduct the amount that it would have cost you to travel alone.
Example: You rent a car for business purposes during your stay in New York City, at the cost of $100 per day. The entire $100 is tax deductible, even though your wife sometimes accompanies you while you are traveling in the car.
Ship travel can be an asset on a combined business-vacation trip.
Reason: Days spent in transit count as business days in the allocations formula.
Example: A two-day business meeting in Paris is followed by a two-week European vacation. If you fly (one day each way), only 22% is deductible (two business days plus two days of travel out of a total of 18 days away). But if you sail (five days each way), 46% is deductible (two business days plus 10 days of travel out of a total of 26 days away).
Source: Edward Mendlowitz, partner, Mendlowitz Weitsen, CPAs, New York.
NEW BUSINESS/HOME OPPORTUNITIES
Corporation owners face the problem of taking money out of the business at the least possible tax cost. Dividends and salaries are fully taxable. You can borrow from the company tax-free, but Tax Reform has limited the tax deduction for the interest you pay.
Big exception: Within broad limits, mortgage interest on your residence (or second residence) is deductible in full. If you’re planning to buy or build a home, borrow the money from your corporation, not from a bank. Let the corporation hold the mortgage. The interest you pay goes back to your company, but it will be fully deductible on your personal tax return.
Interest is fully deductible on mortgage amounts totaling up to $1 million when the mortgage financing is used to buy, build or improve your home (or second home).
If you already have a home, you can still borrow an additional $100,000 from your company on a second mortgage or home-equity loan and use the money for a purpose other than home improvement. The interest will be fully deductible.
Be sure the corporation charges market-rate interest on the loan, and document it with a promissory note and a properly recorded mortgage. Make all payments on schedule. Carry the loan, the mortgage and the repayments correctly on company books, so you’ll have no difficulty proving the transaction is bona fide.
Source: Irving L. Blackman, partner, Blackman Kallick & Co., 180 N.
LaSalle St., Chicago 60601.
A company was charged with engaging in illegal business practices. It settled by making a cash payment to the government, but it did not admit to any wrongdoing. IRS: Fines and penalties aren’t deductible. But since the company was never formally found guilty of any wrongdoing, its payment wasn’t a fine or penalty and was deductible as a business expense.
Source: IRS Letter Ruling 8704003.
PAYING YOUR CHILD A TAX-DEDUCTIBLE ALLOWANCE
A favorite tax-planning tactic is to have a minor child work for the family-owned business. Income earned by the child is taxed at the child’s tax rate, which is likely to be much lower than the parents’ rate. In addition, the company gets a deduction for the child’s salary. A dramatic taxpayer victory* shows just how effective this tactic can be.
The facts: The taxpayers owned a mobile-home park and hired their three children, aged 7, 11 and 12 to work there. The children cleaned the grounds, did landscaping work, maintained the swimming pool, answered phones and did minor repair work, The taxpayers deducted over $17,000 that they paid to the children during a three-year period. But the IRS objected,
and the case went to trial. Court’s decision: Over $15,000 of deductions were approved. Most of the deductions that were disallowed were attributable to the 7-year-old. But even $1,200 of his earnings were approved by the court.
Key: The children actually performed the work for which they were paid. And the work was necessary for the business. The taxpayers demonstrated that if their children had not done the work, they would have had to hire someone else to do it.
*Walter E. Eller, 77 TC 934.
Source: Irving Blackman, a partner, Blackman Kallick Bartleslein, CPAs, 300
S. Riverside Plaza, Chicago 60606.
DEDUCTING SPOUSE’S EXPENSES ON YOUR BUSINESS TRIP
If you take your spouse along on a business trip, can you deduct his or her expenses?
Usually-no. They’re regarded as personal expenses, even if the spouse performs incidental business services, such as answering the phone. However, if the spouse’s presence is essential to the business purpose of the trip, the expenses may be deductible. Examples:
*A wife accompanies her husband on a business trip abroad; she knows the language and customs of the country, and he does not.
*A wife serves as secretary on a business trip. She formerly worked for the company and is familiar with technical details.
*An important customer has told an executive to bring “your charming wife” to any business meetings.
Deduction has been allowed where the taxpayer was a diabetic and his wife went along to take care of possible medical emergencies, for which she has been trained to deal. It would help if the taxpayer would prove he would have had to hire a nurse if his wife had not accompanied him.
One taxpayer-husband won by proving his wife “was not enthusiastic about accompanying her husband on his trips.” Another winner showed that his wife had not gone shopping or swimming on a trip to Hawaii.
Two Are Cheaper Than One
Suppose the spouse’s expenses are held to be nondeductible. The taxpayer can still deduct whatever it would have cost him to travel alone.
Example: Taxpayer and spouse take a double room at a hotel. The taxpayer can deduct the cost of a single room.
Source: Dr. Robert S. Holzman, professor emeritus of taxation at New York University and the author of Encyclopedia of Estate Planning, Boardroom Books, Springfield, NJ 07081.
DRIVE THE COMPANY CAR TAX FREE – ALMOST…
Business owners, who are sole proprietors, can drive the company car until it has fully depreciated and then switch to keep it for personal use without tax liability. The car will not become taxable until it is sold. At that time, there will be a taxable gain to the extent that the sale price exceeds the depreciated basis in the car-that is, the original cost of the car reduced by the depreciation deductions that were claimed.
ALL ABOUT HOME OFFICES
The ratio of time spent working and the precise kind of work performed in a given locale are crucial to all tax determinations on home office status by the IRS. Three landmark cases:
*Homework: A home office is normally deductible only if it is your primary place of business. The IRS uses this rule to deny deductions to many persons who are required to bring work home, but who also have business offices. Case: The Court of Appeals has ruled that orchestra musicians could claim home-office deductions for their practice studios, in spite of the IRS claim that their primary place of business was the concert hall. Key: The musicians spent more time at home practicing than they did performing. Impact: Salespersons, professors, writers and others who in
fact spend most of their time working at home can use this case to try to justify deductions for themselves.
Source: Ernest Drucker, 715 F2d 67.
*Proportion: Sally Meiers owned and managed a laundromat. Each day she spent an hour at the laundry and two hours in her home office, where she did necessary administrative work. The Tax Court denied Sally’s home-office deduction, because the laundromat, not her home, was her principal place of business. Sally appealed. Court of Appeals: Sally spent more time working at home than anywhere else. Thus, the home office was her principal place of business and the deduction was allowed.
Source: John and Sally Meirs, CA-7, No. 85-1209.
*Kind of work: A college professor spent 80% of the work week doing research and writing in an office at home. The IRS ruled the home office was not his “principal place of business” (he had an office at the college), nor was it used “for the convenience of the employer.” Court of Appeals: The home office was the professor’s principal place of business, as his college office wasn’t private enough for the scholarly work required by his job. Moreover, the use of the professor’s home was for the employer’s convenience, as it relieved the college of the necessity of providing a suitable office. Home-office deductions allowed.
Source: David J. Weissman, CA-2, 751 F2d 512.
An executive could deduct maintenance costs and depreciation on a separate office he built near his vacation home and used exclusively to review the company’s long-range plans. The IRS said the office was a nondeductible personal expense. But the court allowed the deduction. The alternate office was appropriate and helpful to the executive in performing his duties.
Source: Ben W. Heineman, 82 TC 638.
BUSINESS TRAVEL AND ENTERTAINMENT TAX TRAPS
Executives with large business-entertainment expenses shouldn’t miss out on deducting costs because of IRS traps. The traps can be avoided, and the tax law can be made to work to your advantage.
Five typical traps and how to avoid them.
*Failing to plan trips to your advantage. Travel expenses from trips within the US are deductible when your business or job requires you to go away from home. Bonus: Your trip doesn’t have to be solely for business for you to deduct the expense. It’s perfectly legitimate to deduct traveling expenses when non-business purposes are included as part of the trip.
Key: As long as the primary purpose of the trip is business, you can deduct travel expenses to and from the business destination no matter what else you do on the trip. The trip is deductible even if you extend it for vacation or include a non-business side trip to another destination. Caution: Money spent traveling for personal purposes, of course, isn’t deductible.
*Letting your foreign travel exceed seven days. Trips made outside the US are deducted the same way as trips made within the US when the length of the trip is seven days or less. Example: You can go to London for the primary purpose of spending one day on company business, and then spend six days touring England. The air fare from the US to London is deductible.
Trickier: Fully deducting foreign trips that last longer than seven days. Nail down this deduction: Vacation for less than 25% of the total time you spend outside the US.
Saver: You don’t lose your whole travel deduction if you spend too much time on pleasure. Instead, you can prorate the deduction according to the number of days spent doing business and the number spent otherwise.
*Not deducting the right expenses. Included: Air, train and taxi fares; automobile maintenance and operation expenses; meal and hotel bills; charges for telephone calls; laundry and dry cleaning costs; expenses for your spouse if there’s a real business purpose for your spouse to be with you on the trip.
Caution: The IRS will scrutinize the reasons for this last deduction. However, if your spouse comes along with you just for personal reasons, you can deduct the amount that it would have cost you to travel alone.
*Entertaining for the wrong reasons. Entertainment, amusement or recreational expenses that you incur because of your trade or business are deductible. Included: Amounts spent for entertaining guests at night clubs; social, athletic and sporting clubs; theaters; sporting events; on yachts; or on hunting, fishing and other trips.
The reason you’re entertaining is all-important to the IRS. The expense must be directly related to the active conduct of a trade or business, You must be able to show that:
You actually did business during the period of entertainment.
The main purpose of the entertainment was the business transaction.
Your business expectations were more than just general ones for the future.
Also deductible: Entertainment that’s associated with your trade or business and takes place directly before or after the business discussion.
*Failing to keep entertainment records. Don’t fall into the trap of thinking you’ll somehow be able to reconstruct your entertainment expenses at an audit. The IRS won’t allow deductions if you try to prove them this way.
Better idea: Write accurate records soon after the entertainment. Although you aren’t expected to record the expenses at the exact moment you incur them, it’s crucial that you can prove them through these accurate written records.
Key: Save all receipts connected with the expense. The IRS will demand proof showing the amount spent and the date, name and address of the place at which the entertaining was done. If this information isn’t contained on your credit-card receipt, write it down in your own records. Also: The IRS will demand to know your business relationship to the people you entertained, and it will question you as to what business was actually discussed.
Source: Lawrence W. Goldstein, tax manager, and Howard A. Rabinowitz, tax partner, Ernst & Young, New York.
THE PASSIVE LOSS RULE
The Tax Reform Act of 1986 requires you to separate your income and investment losses into two categories-one for “passive activities” and one for “nonpassive activities.” It then prohibits you from offsetting income from nonpassive activities, such as salary, with losses from passive activities, such as tax-shelter investments. Passive activity losses may offset only passive activity income.
*Limited partnership interests of all kinds (i.e., tax shelters).
*All rental activities.
*Business activities in which the taxpayer does not materially participate, including sole proprietorships, S corporations, and general partnerships.
“Materially” means being involved year-round on a regular, continuous, and substantial basis.
*Work that pays wages, salary, or commissions.
*Investing that yields “portfolio income” such as dividends, capital gains, interest, or royalties.
*Business activities in which there is laterial participation by the taxpayer.
Who’s affected: The passive loss rule applies to individuals, trusts and estates, personal-service corporations (self-incorporated doctors, dentists, lawyers, etc.) and S corporations. It does not apply to regular C corporations. Closely held C corporations are subject to the rule in a modified form. At greatest risk: High-income taxpayers who have invested heavily in tax shelters.
There is a phase-in period. Passive losses from investments acquired before October 22, 1986 (the date on which the President signed the Tax Reform Act), will be partially deductible against non-passive income through 1990.
Problem: If you acquired your interest in a passive activity after October 22, l986, none of your losses from that activity will be deductible against non-passive income. The phase-in rule does not apply to these losses.
Individuals who are locked into investments that throw off large passive losses must use certain strategies to deal with their losses.
Find investments that produce passive income, which will absorb the passive losses. Trap: Income from a mutual fund is not considered passive. Only, investments that fit the new law’s definition of a passive activity will generate passive income. Example: Rental properties such as occupied apartments, office buildings, parking lots, and shopping centers. You don’t have to be a limited partner in these deals to get passive income, because all rental activity is considered passive, whether it’s in the form of a limited partnership or not.
Convert nonpassive income into passive income. You might do this by converting a corporation that is not subject to the passive loss rules into a corporation that is subject to the rules.
Example: Convert a regular corporation that is throwing off a great deal of taxable nonpassive income into an S corporation, and then hire a manager to run the S corporation. Income from an S corporation in which the owner does not materially participate (that is, in which he is not involved year-round on a regular, continuous, and substantial basis) is passive income.
Restructure leasing arrangements with your business. Suppose you are currently leasing a building that you own to a manufacturing company that you own. You’ve been renting the building to the company at a rate of only $100,000 a year. Your depreciation deductions on the building give you a tax loss, which you needed and could use under the old law. But under the new law, you can’t use the loss. What you need now is passive income.
What to do: Increase the rent to the amount that is the building’s fair market rent today. This will give you net income (above the depreciation deductions), and it will be passive income, because it comes from rental activity.
Source: Jerry Williford, partner, Grant Thornton, CPAs, 2800 Citicorp
Center, Houston, TX 77002.
HOW TO “CASH IN” A BUSINESS WITH MINIMUM TAX BITE
Practical way to transfer a business to the principal’s children (or other family members) with a minimum of tax liability: (1) Arrange to transfer some stock to family. (2) Later, have the corporation buy the rest of principal’s share. (3) Instead of paying him a lump sum of cash, have the money paid as a lifetime annuity. In that way, the money is distributed in
fixed, annual installments. The advantages:
The business is removed from the owner’s estate immediately, without the imposition of gift or inheritance taxes.
The owner gets a lifetime income, which can meet retirement needs just as well as a lump-sum payment.
The estate isn’t swollen with cash or notes that would be received in a lump-sum redemption. The annuity lasts only during the principal’s lifetime.
Business isn’t saddled with a traumatic outflow of working capital. The annuity is paid out of profits and is spaced evenly over the lifetime of the former owner of the business.
How to do it: Calculate the fair market value of the shares. Then use IRS actuarial tables to translate the value of those holdings into a monthly, lifetime annuity plus interest.
Taxes are paid only on the income that’s received each year, not on the cash value of the annuity in the year received. For tax purposes, the annuity payments are divided into three layers: (1) Return of capital (not taxed). (2) Profit on the sale of stock (capital gain). (3) Interest on the unpaid balance (taxed as ordinary income).
Unique home deductions were allowed when:
*A person who managed a family business was required to be on the premises around the clock to handle operations. He incorporated the business and then signed an employment contract under which the company provided him with a house and paid his utility bills. Since the Tax Code says that lodging given to an employee for the benefit of an employer is tax-exempt, he was able to take the house and utility payments tax free. And the company got to deduct the expense payments and depreciate the home.
Source: Jim Grant Farms, TC Memo 1985-174.
Air space was depreciable when a company bought property for use as a dump site. As the air space was filled up, the company could deduct its cost.
Source: H. Kendrick Sanders, 75 TC 157.
(The above material was published by Boardroom Reports, 1991.)
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