Are you doing all you can to save tax?
No business wants to pay more tax than it has to, yet many do just that. Some don’t take advantage of all the breaks available to them; others fail to plan, paying tax that could be deferred or falling into tax traps. If you own the business, it’s likely your biggest investment, so thinking about long-term considerations, such as your exit strategy, is critical as well. And if you’re an executive, you likely have to think about not only the company’s taxes, but also tax considerations related to compensation you receive beyond salary and bonuses, such as stock options.
Projecting income
Projecting your business’s income for this year and next will allow you to time income and deductions to your advantage. It’s generally better to defer tax. So if you expect to be in the same or a lower tax bracket next year, consider:
Deferring income to next year. If your business uses the cash method of accounting, you can defer billing for your products or services. Or, if you use the accrual method, you can delay shipping products or delivering services.
Accelerating deductions into the current year. If you’re a cash-basis taxpayer, you may want to make an estimated state tax payment before Dec. 31, so you can deduct it this year rather than next. But consider the alternative minimum tax (AMT) consequences first. Both cash- and accrual-basis taxpayers can charge expenses on a credit card and deduct them in the year charged, regardless of when paid.
Warning: Think twice about these strategies if you’re experiencing a low-income year. Their negative impact on your cash flow may not be worth the potential tax benefit. And, if it’s likely you’ll be in a higher tax bracket next year, the opposite strategies (accelerating income and deferring deductions) may save you more tax. Keep in mind that individual income tax rates are scheduled to go up in 2013. So if your business structure is a flow-through entity, you may face higher rates even if you remain in the same tax bracket. Check back here for the latest information.
Depreciation
For assets with a useful life of more than one year, you generally must depreciate the cost over a period of years. In most cases the Modified Accelerated Cost Recovery System (MACRS) will be preferable to the straightline method because you’ll get a larger deduction in the early years of an asset’s life.
But if you make more than 40% of the year’s asset purchases in the last quarter, you could be subject to the typically less favorable midquarter convention. Careful planning during the year can help you maximize depreciation deductions in the year of purchase.
Other depreciation-related breaks and strategies also are available:
Bonus depreciation. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 encourages businesses to invest by significantly enhancing bonus depreciation. (See “What’s new! Make the most of bonus depreciation while it’s available.”)
Section 179 expensing election. Business owners can use this election to deduct (rather than depreciate over a number of years) the cost of purchasing such assets as equipment, furniture and off-the-shelf computer software. For 2011, the expensing limit is $500,000.
The break begins to phase out dollar for dollar when total asset acquisitions for the tax year exceed $2 million. You can claim the election only to offset net income, not to reduce it below zero.
For 2012, the expensing limit and phaseout threshold have dropped significantly, to $139,000 and $560,000, respectively. For 2013, these amounts are scheduled to drop again, to $25,000 and $200,000.
Sec. 179 may be less important while 100% bonus depreciation is available. Depending on the type of asset, 100% bonus depreciation may provide the same tax savings — without any net income requirement or limit on asset purchases. But only Sec. 179 expensing can be applied to used assets, and you’ll also want to consider state tax consequences.
Cost segregation study. If you’ve recently purchased or built a building or are remodeling existing space, consider a cost segregation study. It identifies property components and related costs that can be depreciated much faster and dramatically increase your current deductions. Typical assets that qualify include decorative fixtures, 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 located in a state that doesn’t follow federal depreciation rules. (For information on some breaks for owners of leasehold, restaurant or retail properties, see “What’s new! Depreciation-related breaks extended and expanded.”)
Manufacturers’ deduction
The manufacturers’ deduction, also called the Section 199 or domestic production activities deduction, has been fully phased in and is now 9% of the lesser of qualified production activities income or taxable income. The deduction is also limited by W-2 wages paid by the taxpayer that are allocable to domestic production gross receipts.
The deduction is available to traditional manufacturers and to businesses engaged in activities such as construction, engineering, architecture, computer software production and agricultural processing. The deduction isn’t allowed in determining net earnings from self-employment and generally can’t reduce net income below zero. But it can be used against the AMT.
Vehicle-related tax breaks
Business-related vehicle expenses can be deducted using the mileage-rate method (51 cents per business mile driven Jan. 1 through June 30, 2011, and 55.5 cents per mile driven July 1, 2011, through Dec. 31, 2012) or the actual-cost method (total out-of-pocket expenses for fuel, insurance and repairs, plus depreciation).
Purchases of new or used vehicles may be eligible for Sec. 179 expensing, and purchases of new vehicles may be eligible for bonus depreciation. (See “What’s new! Make the most of bonus depreciation while it’s available.”) However, many rules and limits apply. For example, under Sec. 179 expensing, you can deduct up to $25,000 of the purchase price of an SUV that weighs more than 6,000 pounds but no more than 14,000 pounds. The normal Sec. 179 expensing limits generally apply to vehicles weighing more than 14,000 pounds.
Vehicles weighing 6,000 pounds or less don’t satisfy the SUV definition and thus are subject to the passenger automobile limits. For autos placed in service in 2011, the depreciation limit is $3,060; the 2012 limit hasn't yet been released. The limit is increased by $8,000 for autos eligible for bonus depreciation. The amount that may be deducted under the combination of MACRS depreciation, Sec. 179 and bonus depreciation rules for the first year is limited under the luxury auto rules.
In addition, if a vehicle is used for business and personal purposes, the associated expenses, including depreciation, must be allocated between deductible business use and nondeductible personal use. The depreciation limit is reduced if the business use is less than 100%. If business use is 50% or less, you can't use Sec. 179 expensing, bonus depreciation or the accelerated regular MACRS; you must use the straightline method.
Employee benefits
Including a variety of benefits in your compensation package can help you not only attract and retain the best employees, but also manage your tax liability:
Qualified deferred compensation plans. These include pension, profit-sharing, SEP and 401(k) plans, as well as SIMPLEs. You can enjoy a tax deduction for your contributions to employees’ accounts, and the plans offer tax-deferred savings benefits for employees. Small employers (generally those with 100 or fewer employees) that create a retirement plan may be eligible for a $500 credit per year for three years. The credit is limited to 50% of qualified startup costs. (For more on the benefits to employees, see “401(k)s and other employer plans.”)
HSAs and FSAs. If you provide employees with qualified high-deductible health insurance, you can also offer them Health Savings Accounts. Regardless of the type of health insurance you provide, you also can offer Flexible Spending Accounts.
Fringe benefits. Some fringe benefits, such as group term-life insurance (up to $50,000), health insurance, parking (up to $230 per month for 2011, $240 for 2012), mass transit / van pooling (up to $230 per month for 2011, only $125 for 2012) and employee discounts, aren’t included in employee income. Yet the employer still receives a deduction and typically avoids payroll tax as well.
Certain small businesses providing health care coverage to their employees may be eligible for a new tax credit that became available in 2010. Remember, tax credits are more powerful than deductions because they provide dollar-for-dollar savings. (See Health care coverage credit for small businesses.)
NQDC. Nonqualified deferred compensation plans generally aren’t subject to nondiscrimination rules, so they can be used to provide substantial benefits to executives and other key employees. But the employer generally doesn’t get a deduction for NQDC plan contributions until the employee recognizes the income.
NOLs
A net operating loss occurs when operating expenses and other deductions for the year exceed revenues. Generally, an NOL may be carried back two years to generate a refund. Any loss not absorbed is carried forward up to 20 years.
Carrying back an NOL may provide a needed influx of cash. But carrying the entire loss forward can be more beneficial in some situations.
Tax credits
Tax credits reduce your business’s tax liability dollar-for-dollar, making them particularly valuable. Numerous types of credits are available to businesses. Here are a few that have been extended or created by recent legislation:
Research credit. The 2010 Tax Relief act extended the research credit (also commonly referred to as the “research and development” or “research and experimentation” credit) through 2011 only, but there’s been much discussion about making it permanent. The credit generally is equal to a portion of qualified research expenses. It’s complicated to calculate, but savings can be substantial, so consult your tax advisor.
Work Opportunity credit. The 2010 Tax Relief act also extended the Work Opportunity credit only through Dec. 31, 2011. It benefits businesses hiring employees from certain disadvantaged groups, such as ex-felons, food stamp recipients and disabled veterans. (Note that the act did not extend the provision expanding the eligible groups to include unemployed veterans and disconnected youth.) The credit equals 40% of the first $6,000 of wages paid to qualifying employees ($12,000 for wages paid to qualified veterans). (For information on the subsequent extension and expansion of the Work Opportunity credit for hiring qualified veterans, see the “VOW to Hire Heroes Act of 2011” Tax Act Summary.)
Health care coverage credit for small businesses. For tax years 2010 to 2013, the maximum credit is 35% of group health coverage premiums paid by the employer. To get the credit, you must contribute at least 50% of the total premium or of a benchmark premium. The full credit is available for employers with 10 or fewer full-time equivalent employees (FTEs) and average annual wages of less than $25,000 per employee. Partial credits are available on a sliding scale to businesses with fewer than 25 FTEs and average annual wages of less than $50,000.
Retention credit. If you hired workers in 2010, you may be eligible for a retention credit for 2011. It generally applies to workers who qualified for payroll tax forgiveness under the Hiring Incentives to Restore Employment (HIRE) Act of 2010 and are retained for 52 consecutive weeks. The tax savings per qualified retained worker are equal to the lesser of 6.2% of wages paid to the worker during the 52-week retention period or $1,000.
Energy-related credits. The 2010 Tax Relief act extends certain energy-related incentives. While most typically apply to either home builders or manufacturers of energy-efficient appliances, there are some that are more generally applicable. For example, if you buy or lease hybrid or lean-burn-technology vehicles, you may be able to claim tax credits, but these credits phase out once a certain number of a particular vehicle has been sold. However, because of either 2011 expiration dates or restrictions based on units sold, these credits generally won't be available for 2012 unless extended again.
Other credits. The 2010 Tax Relief act also extended — through 2011 only — the empowerment zone tax credit and certain disaster relief credits for the Gulf Opportunity Zone.
Business structure
Income taxation and owner liability are the main factors that differentiate one business structure from another. Many businesses choose entities that combine flow-through taxation with limited liability, namely limited liability companies (LLCs) and S corporations. (See the Chart “Tax differences based on business structure” to compare the tax treatment for pass-through entities vs. C corporations. Also see the Charts “2011 individual income tax rate schedules” and “2012 individual income tax rate schedules” and the Chart “2011 and 2012 corporate income tax rate schedule.”) Sometimes it makes sense to change business structures, but there may be unwelcome tax consequences, so be sure to consult your tax advisor.
Some tax differences between structures may provide planning opportunities, such as those related to salary vs. distributions. (See “Employment taxes for owner-employees.”)
Exit planning
An exit strategy is a plan for passing on responsibility for running the company, transferring ownership and extracting your money from the business. This requires planning well in advance of the transition. Here are the most common exit options:
Buy-sell agreements. When a business has more than one owner, a buy-sell agreement can be a powerful tool. The agreement controls what happens to the business when a specified event occurs, such as an owner’s retirement, disability or death. Among other benefits, a well-drafted agreement:
- Provides a ready market for the departing owner’s shares,
- Sets a price for the shares, and
- Allows business continuity by preventing disagreements caused by new, unwanted owners.
A key issue with any buy-sell agreement is providing the buyer(s) with a means of funding the purchase. Life or disability insurance often helps fulfill this need and can give rise to several tax and nontax issues and opportunities.
One of the biggest advantages of life insurance as a funding method is that proceeds generally are excluded from the beneficiary’s taxable income. There are exceptions, however, so be sure to consult your tax advisor.
Succession within the family. You can pass your business on to family members or close relatives by giving interests, selling interests or doing some of each. Be sure to consider your income needs, how family members will feel about your choice, and the gift and estate tax consequences.
Now may be a particularly good time to transfer ownership interests. If your business has lost value, you can transfer a greater number of shares without giving away more value for gift tax purposes, and valuation discounts may further reduce the taxable value. On top of that, for 2012, the lifetime gift tax exemption is $5.12 million, but it's scheduled to drop to $1 million for 2013. You also can leverage your $13,000 annual gift tax exclusions. (See “Gift interests in your business” for more information.)
Nonfamily succession. If family members aren’t interested in or capable of taking over your business, one option is a management buyout. This may provide for a smooth transition because there may be little learning curve for the new owners. Plus you avoid the time and expense of finding an outside buyer.
If you want rank and file employees to become owners as well, an employee stock ownership plan (ESOP) may be the ticket. (See the Case Study “ESOPs benefit both owners and employees.”)
Selling to an outsider. This can also be an excellent option. If you can find the right buyer, you may even be able to sell the business at a premium.
Sale or acquisition
Whether you’re selling your business as part of your exit strategy or acquiring another company to help grow it, the tax consequences can have a major impact on the transaction’s success or failure. Here are a few key tax considerations:
Asset vs. stock sale. With a corporation, sellers typically prefer a stock sale for the capital gains treatment and to avoid double taxation. Buyers generally want an asset sale to maximize future depreciation write-offs.
Taxable sale vs. tax-deferred transfer. A transfer of ownership of a corporation can be tax-deferred if made solely in exchange for stock or securities of the recipient corporation in a qualifying reorganization. But the transaction must comply with strict rules. Although it’s generally better to postpone tax, there are some advantages to a taxable sale:
- The seller doesn’t have to worry about the quality of buyer stock or other business risks that might come with a tax-deferred transfer.
- The buyer benefits by receiving a stepped-up basis in its acquisition’s assets and not having to deal with the seller as a continuing equity owner, as it would in a tax-deferred transfer.
- The parties don’t have to meet the technical requirements of a tax-deferred transfer.
Installment sale. 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. But an installment sale can backfire. For example:
- Depreciation recapture must be reported as gain in the year of sale, no matter how much cash the seller receives.
- If tax rates increase in the future, the overall tax could wind up being more on an installment sale than on a cash sale. (Remember, the favorable 15% rate on long-term capital gains is scheduled to end after Dec. 31, 2012.)
Of course, tax consequences are only one of many important considerations when planning a merger or acquisition.
Incentive stock options
If you’re an executive with a larger company, you may receive incentive stock options (ISOs). ISOs receive tax-favored treatment but must comply with many rules. ISOs allow you to buy company stock in the future (but before a set expiration date) at a fixed price equal to or greater than the stock’s fair market value at the date of the grant.
Therefore, ISOs don’t provide a benefit until the stock appreciates in value. If it does, you can buy shares at a price below what they’re then trading for, as long as you’ve satisfied the applicable ISO holding periods. Here are the key tax consequences:
- You owe no tax when the ISOs are granted.
- You owe no regular tax when you exercise the ISOs.
- If you sell the stock after holding the shares at least one year from the date of exercise and two years from the date the ISOs were granted, you pay tax on the sale at your long-term capital gains rate.
- If you sell the stock before long-term capital gains treatment applies, a “disqualifying disposition” occurs and any gain is taxed as compensation at ordinary-income rates.
If you’ve received ISOs, plan carefully when to exercise them and whether to immediately sell shares received from an exercise or hold them. Waiting until just before the expiration date to exercise ISOs (when the stock value may be the highest, assuming the stock is appreciating) and holding on to the stock long enough to garner long-term capital gains treatment often is beneficial. But there’s also market risk to consider.
In several situations, acting earlier can be advantageous:
- Exercise early to start your holding period so you can sell and receive long-term capital gains treatment sooner.
- Exercise when the bargain element is small or when the market price is close to bottoming out to reduce or eliminate AMT liability.
- Exercise annually so you can buy only the number of shares that will achieve a breakeven point between the AMT and regular tax and thereby incur no additional tax.
- Sell early in a disqualifying disposition and pay the higher ordinary-income rate to avoid the AMT on potentially disappearing appreciation.
On the negative side, exercising early accelerates the need for funds to buy the stock, exposes you to a loss if the shares’ value drops below your exercise cost, and may create a tax cost if the preference item from the exercise generates an AMT liability. With the help of your tax advisor, evaluate the risks and crunch the numbers using various assumptions to determine the best strategy for your situation.
Nonqualified stock options
The tax treatment of nonqualified stock options (NQSOs) is different from that of ISOs: NQSOs create compensation income (taxed at ordinary-income rates) on the bargain element when exercised (regardless of whether the stock is held or sold immediately), but they don’t create an AMT preference item. (See the Chart “ISOs vs. nonqualified stock options” for a direct comparison.)
You may need to make estimated tax payments or increase withholding to fully cover the tax on the exercise. Also consider state tax estimated payments.
Restricted stock
Restricted stock is stock that’s granted subject to a substantial risk of forfeiture. Income recognition is normally deferred until the stock is no longer subject to that risk or you sell it. You then pay taxes based on the stock’s fair market value when the restriction lapses and at your ordinary-income rate.
But, under Section 83(b), you can elect to instead recognize ordinary income when you receive the stock. This election, which you must make within 30 days after receiving the stock, can be beneficial if the income at the grant date is negligible or the stock is likely to appreciate significantly before income would otherwise be recognized. Why? Because the election allows you to convert future appreciation from ordinary income to long-term capital gains income and defer it until the stock is sold. (See the Case Study “How the Sec. 83(b) election can save taxes on restricted stock.”)
There are some disadvantages of a Sec. 83(b) election: First, you must prepay tax in the current year. But if a company is in the earlier stages of development, this may be a small liability. Second, any taxes you pay because of the election can’t be refunded if you eventually forfeit the stock or its value decreases. But you’ll have a capital loss when you sell or forfeit the stock.
Work with your tax advisor to map out whether the Sec. 83(b) election is appropriate for you in each particular situation.
NQDC plans
Nonqualified deferred compensation plans pay executives in the future for services to be currently performed. They differ from qualified plans, such as 401(k)s, in several ways. For example, NQDC plans can favor highly compensated employees, but any NQDC plan funding isn’t protected from your employer’s creditors.
One important NQDC tax issue is that employment taxes are generally due once services have been performed and there’s no longer a substantial risk of forfeiture — even though compensation may not actually be paid or recognized for income tax purposes until much later. So your employer may withhold your portion of the payroll taxes from your salary or ask you to write a check for the liability. Or it may pay your portion, in which case you’ll have additional taxable income.
Keep in mind that the rules for NQDC plans are tighter than they once were, and the penalties for noncompliance can be severe: You could be taxed on plan benefits at the time of vesting, and a 20% penalty and potential interest charges also could apply. So check with your employer to make sure it’s addressing any compliance issues. •
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