2011 Q1 | Lower Taxes May Mean More Jobs

In some ways, the title of the Small Business Jobs Act of 2010 says it all. This new federal law aims to create jobs within the United States, with small companies acting as engines of growth. Among the multiple provisions of this act, several provide tax benefits for small businesses. The authors of the new law hope that lower taxes will make many small and thus more to add employees.

Equipment deductions

One provision of the new law expands Section 179 of the tax code, which allows small companies to buy business equipment and take a first-year tax deduction. Ordinarily, companies must depreciate the equipment they buy, thus spreading deductions over several years.

From 2008 through 2010, Congress passed a series of laws setting the maximum first-year “expensing” election at $250,000. Once annual equipment purchases topped $800,000, companies would lose the tax benefits of expensing, dollar for dollar. In the Small Business Jobs Act of 2010, the $250,000 expensing cap for 2010 was increased from $250,000 to $500,000, and the higher limit was set for 2011 as well (Up to $250,000 of the $500,000 cap can be deducted for lease hold improvements, such as renovating a store or a restaurant.) For each of those two years, the phase out is now $2 million.

Example 1: ABC Corp. spends $450,000 on business equipment in 2011. It can immediately deduct $450,000, which is under the $500,000 cap.

Example 2: DEF Corp. spends $1.1 million on business equipment in 2011. It can immediately deduct $500,000, the amount of the cap. The other $600,000 of equipment purchases will be depreciated under standard IRS rules.

Example 3: GHI Corp. spends $2.2 million on business equipment in 2011. The company’s expenditures are $200,000 over the $2 million phaseout threshold so its expensing election is reduced by $200,000, from $500,000 to $300,000. The company can depreciate the other $1.9 million of equipment purchases under standard IRS rules.

With the new law in place, if a company spends $2.5 million or more on equipment this year, no expensing will be permitted. As you can see, the increased deduction and phaseout levels greatly expand the number of companies that might save tax by deducting equipment expenses right away.

The Section 179 tax deduction is limited to the buyer’s taxable business income that year. If a company spends $100,000 on equipment in 2011, for example, it must have at least $100,000 of taxable income this year to take a full deduction.

Startup deductions

The new law also increases startup deductions allowed under Section 195 of the tax code. For 2010 and 2011, the ceiling is raised from $5,000 to $10,000, and the phaseout threshold rises from $50,000 to $60,000. With this arrangement, new companies can deduct the lesser of (1) the amount of the startup expenses or (2) $10,000, reduced by the amount by which the startup expenditures exceed $60,000.

Example 4: JKL Corp. has startup expenses of$10,000 in 2011. The company can deduct all $10,000 of its outlays.

Example 5: MNO Corp. has startup expenses of $63,000 in 2011. The company is $3,000 over the $60,000 threshold so it can deduct $7,000 of its outlays: $10,000 minus the excess $3,000.

You incur startup costs when you’re investigating or creating a new business but have not actually begun operations. (Money spent to buy capital equipment doesnt qualify.) Those costs might include market surveys, advertisements, travel to line up suppliers, consulting fees, and wages paid prior to opening the doors of a new business. Such outlays may be deductible in the year that you begin operations, under Section 195. Costs you cant deduct right away can be amortized over 180 months, beginning in the month operations begin.

Example 6: MNO Corp. takes a $7,000 deduction for startup costs, out of $63,000, as previously explained. The remaining $56,000 may be amortized over 180 months, providing MNO with a deduction of $311 a month for those 180 months.

Built-in gains

Standard C corporations face many tax hurdles. They could owe corporate income taxes on profits, for example. The IRS might determine that a business owner’s compensation is unreasonable and deny a deduction to a C corporation.

To avoid such tax traps, small companies may elect to be S corporations rather than C corporations. To qualify for this election, S corporations must meet certain criteria: they can have no more than 100 shareholders and only one class of stock, for example. After an S corporation election, business owners report company profits on their personal tax returns and the company owes no corporate tax.

Some C corporations elect S corporation status while holding appreciated assets. In the past, a 10–year rule had been in effect-if holdover assets with built–in gain were sold within 10 years of a switch to S corporation status, the company would owe tax on the built–in gain at the highest corporate tax rate, which is now 35%. The American Recovery and Reinvestment Act of 2009 shortened that 10–year holding period to seven years for 2009 and 2010. The new Small Business Jobs Act further reduces the holding period to five years for dispositions of assets with built–in gain in 2011.

With this new provision, companies that have made the C…to…S switch won’t owe corporate income tax in 2011 on the built…in gain of appreciated assets sold after five years from the conversion. The reduced tax bite may help small businesses sell off unneeded assets and raise capital.

Self-employment health insurance

For several years, self-employed individuals have been able to deduct 100% of the cost of health insurance for themselves and family members. However, that deduction does not reduce the amount of self-employment income subject to self-employment (Medicare and Social Security) tax. Under the new law, self-employed individuals can deduct health insurance premiums when calculating earned income subject to self-employment tax for tax years beginning in calendar year 2010.

Example 7: Joan Barnes is a self-employed Web designer. In 2009, she reported earned income of $90,000. Joan paid $8,000 in health insurance premiums in 2009, which she deducted from her gross income; nevertheless, she paid Social Security and Medicare tax on $90,000 of earnings.

Assume that Joan had the same earned income and health insurance premiums in 2010. Again, she will deduct that $8,000 deduction from her gross income on her tax return. For 2010, though, she will owe Medicare and Social Security tax only on $82,000 of earned income: $90,000 of earnings minus $8,000 in health insurance costs.

Cell phones

The tax code considers certain types of assets to be “listed property.” The list includes items such as cars, motorcycles, cameras, and computers—in essence, assets that a business might provide to employees but that also can provide a non-business personal benefit. Employees with listed property must keep records to show business use versus personal use. There may be limits on depreciation deductions and employees might have to report some taxable income from personal use of listed property. Your depreciation and related deductions are limited if listed property is not used more than 50% for business.

When cell phones were introduced, they were relatively expensive; employer-provided cell phones were often a perk to selected employees. Therefore, cell phones were classed as listed property. Now, of course, cell phones are priced for a mass market and may be a workplace necessity. Therefore, the new law removes cell phones and similar devices from the category of listed property, effective in 2010. If an employer-provided cell phone is used primarily for business, employees won’t have to report any taxable income for personal use.

Fed funding

Under the new law, the Small Business Administration (SBA) will create an online lending platform that lists all lenders offering SBA-guaranteed loans. This platform will display the interest rates each lender charges for SBA loans so that small business borrowers can compare rates.

Among other features of the Small Business Jobs Act are increased funding and lower fees for some SBA loans. The SBA also will conduct a three-year pilot program that offers grants to states with plans to increase small business exports. Beyond the SBA, federal contracting requirements are being amended to encourage bids from small companies and federal agencies have been told to solicit bids from small businesses.

2011 Q1 | More Flexibility in Retirement Planning

Some provisions of the Small Business Jobs Act of 2010 are not restricted to small companies or to job creation. Instead, they provide more choices for retirees and preretirees.

An annuity alternative

The new law gives individuals the option of annuitizing a portion of an annuity, an endowment, or a life insurance policy. That is, you can partially convert one of these financial instruments to a stream of income while the remainder is left alone. The annuity period must last for 10 years or more, or for the lives of one or more individuals.

Example 1: Carol Thomas, age 70, has invested $100,000 in a deferred annuity. This is a type of investment contract that permits investment income to grow tax free until money is withdrawn. Carol’s deferred annuity is now worth $200,000.

Starting in 2011, Carol can annuitize part of her deferred annuity. She decides to use $100,000 for an annuity that will pay her a fixed amount as long as she lives. The other $100,000 remains in her deferred annuity, where Carol hopes for more growth. At the time Carol makes this decision, her deferred annuity contract consisted of one…half taxable earnings ($100,000) and one…half aftertax dollars she invested. Therefore, half of her cash flow would be tax free until Carol receives a full return of half of her investment: $50,000.

Roth rollovers

The Small Business Jobs Act also allows rollovers from elective deferral plans to Roth~ designated accounts.

  • Elective deferral plans are employer sponsored retirement plans that allow employees to defer some compensation and the tax on that compensation. They include 401(k), 403(b), and 457(b) plans.
  • Designated Roth accounts (DRACs) are employer sponsored plans with many of the same features as Roth IRAs. They are funded with aftertax contributions. After age 59 1/2, and after five years, all DRAC withdrawals are tax free.

To execute a rollover, your company plan must offer DRACs to employees who participate in the retirement plan. Also, you must be entitled to take distributions from your employer’s plan, which typically means that you are at least age 59 1/2 or have left the company, although some plans permit younger employees to take “in service” distributions.

If you qualify, you can execute a rollover immediately. Of course, you’ll owe income tax when you convert pretax money to an aftertax DRAC.

Example 2: Lynn Parker, age 60, works for ABC Corp., where she has $80,000 in her 401(k), all from pretax contributions. Her plan permits Lynn to take distributions from her 401(k). In 2011, Lynn rolls over $80,000 to a DRAC offered by ABC Corp. She will have to report $80,000 of taxable income from the rollover. Beginning January 1, 2016, Lynn can take as little or as much from her DRAC, tax free•

2011 Q1 | Choices for Holding Investment Property

Now that prices are off sharply from their peak levels of a few years ago, you may want to invest in real estate. If so, you are looking for a promising property at the right price. Assuming you find such an opportunity, you’ll have to make still another crucial decision: how to hold your property.

Outright ownership

The simplest option is to hold the property in your own name. You’ll have absolute control and flexibility. You can make the decisions on capital improvements, tenant selection, and so on; you can sell the property or refinance it. You’ll face some disadvantages with this form of ownership, however. Depending on the amount of capital you’re willing to invest, you might be limited in what you can buy. You’ll also have to be sure that you’re adequately insured against any liability resulting from someone being injured on your property.

Joint ownership

Married couples especially might want to hold investment property as joint tenants with the right of survivorship. That way, when one owner dies, the surviving owner inherits automatically. The real estate won’t go through probate, which can be expensive and time consuming.

The downside? When property is held as joint tenants with right of survivorship, no other heirs can inherit it. If you have remarried and hold property in this manner with your spouse, for example, you can’t leave all or part of this investment to children from a previous marriage.

General partnerships As another approach to real estate investing, you might pool your capital with others to form a general partnership.

Example 1: Tom Adams, Richard Baker, and Harriet Carter form a partnership to buy investment property. When they find something for sale that they all like, each will contribute one-third of the capital.

With this method, the partners will have access to more expensive real estate (compared to what they could have bought as individuals), and they will have extra hands to help oversee their investment. Any investment losses can be passed through to each partner.

Suppose that the partnership of Tom, Richard, and Harriet buys an office building. In 2011, the property posts a $30,000 loss for tax purposes. As per their partnership agreement, each of the co owners will report a $10,000 loss on his or her tax return for the year. That loss may be deducted now or in the future, depending on the taxpayer’s adjusted gross income and the partner’s adjusted basis in the venture.

As with anything, general partnerships are not without drawbacks. Conflicts may arise if the individual owners disagree among themselves on issues relating to the real estate. Also, each partner is personally liable for debts the partnership incurs. Even with insurance, the investors’ personal assets might be at risk.

Limited partnerships

Some limitations to the general partnership might be more appealing. A limited partnership is a specialized form of partnership, with two types of partners.

Limited partners are usually investors with no say in the management of partnership assets. They are liable only for the capital they contribute and any notes they sign. Often, any real estate losses are allocated largely to the limited partners for tax purposes.

One or more general partners runs the business. In a real estate limited partnership, the general partner is responsible for managing the property or delegating that responsibility. The general partner bears liability for all of the partnership’s obligations.

Limited liability companies

A limited liability company (LLC) might offer the best features of all the other structures. As an LLC investor (or member), you’ll benefit from partnership taxation. That is, any losses from the real estate are passed through to each member’s tax return. In addition, LLC members enjoy the same type of limited liability that corporate shareholders have, so their other personal assets are not at risk.

In these litigious times, you should not downplay the threat of personal liability from real estate investments. By recognizing the danger, you may be able to limit your exposure.

Example 2: Jane Clark invests in several rental properties. She as no co-owners. To minimize her paperwork, Jane could create a single-member (one owner) LLC to hold all those properties. Instead, Jane creates a separate single-member LLC for each property. Therefore, if a tenant is severely injured at one of Janes properties and sues for damages, the risk can be confined to that one property rather than affect all of the investment real estate Jane owns.

2011 Q1 | You and Your Company Can Avoid the Disguised Dividend Tax Trap

If you are the owner or part owner of a C corporation, you might think that your compensation plan is relatively straightforward. You pay yourself a salary to cover your living expenses during the year. At year end, if your company has made money, you pay yourself a bonus. Your company deducts the salary and bonus so it winds up with little or no net income and pays little or no corporate income tax.

In such a scenario, you might be in for a shock. The IRS could say that your compensation is unreasonable. Part of your compensation may be recast as a dividend, subject to both corporate and personal income taxes.

Example: Grace Moran owns 100% of ABC, a C corporation. She pays herself a salary of $10,000 a month, or $120,000 a year. In 2011,Grace pays herself a $300,000 bonus. ABC reports no taxable income for 2011, and Grace pays personal income tax on her total income of $420,000.

The IRS examines ABC’s corporate return and decides that Grace’s $120,000 salary is reasonable compensation for her efforts. The other $300,000 is classified as a dividend, bringing ABC’s corporate income up to $300,000 for the year. Counting state and federal taxes, ABC owes about $100,000 in corporate income tax. Grace, meanwhile, also has to pay personal income tax on both the $300,000 dividend and her $120,000 salary.

Sidestepping the snare

With careful planning, your C corporation can avoid this tax trap. Possible strategies include:

  • creating a formal compensation plan. Your corporate minutes can explain the plan and report its adoption. Such a plan might call for owner-executives to receive a salary plus a bonus that’s determined by financial goals, such as revenues, profits, and market share. If you worked for years with little compensation, helping your company to grow, your minutes might state that some of your compensation is a makeup for prior sacrifice.
  • using external comparisons. Your compensation plan might refer to an industry study indicating that executives at other companies in your field are paid amounts comparable to those you are likely to receive. You might get such data from an industry association.
  • paying some corporate income tax. In the previous example, Grace could pay herself a $200,000 or $250,000 bonus, rather than a $300,000 bonus. That would leave some money in the company subject to corporate income tax. On the first $75,000 of corporate income, your company will pay only 15% or 25% in federal corporate income tax.
  • paying some dividends. Taking some profits as double-taxed dividends can indicate you are not “zeroing out” corporate income to avoid tax.
  • making an S corporation election. Your company must meet several criteria (for example, it can have only one class of stock). But, if your company meets these criteria and makes the election, it will be an S corporation and, therefore, will not be subject to corporate income tax.

2010 Q4 | Planning During Uncertain Times

Some of the tax laws that were passed in the early years of this century will expire after 2010. Next year, prior law could take effect. Alternatively, Congress may pass new tax laws effective in 2011-or even some laws that are retroactive to the beginning of2010. Therefore, tax planning for year-end 2010 is unusually challenging.

The articles in this issue of the CPA Client Tax Letter are based on current law, as of this writing. However, Congress may act by year-end, changing current law substantially. Therefore, our office will keep you posted to let you know what changes, if any, have been signed into law and how they might affect your personal tax planning.

Income tax

In 2010, six federal income tax rates exist, ranging from 10% to 35%. Current law calls for five tax rates to be in effect for 2011, from 15% to 39.6%. As you can see, such a change would increase tax obligations for many people. In that case, year-end tax planning might suggest accelerating income into 2010, to pay tax at lower rates, while deferring deductions until 2011 when higher tax rates might make deductions more valuable.

The Obama Administration has proposed keeping 2010 tax rates for most taxpayers; only those with income over $200,000 ($250,000 for married couples filing joint returns) would face higher rates. As some lawmakers have pointed out, though, such a limited increase might do little to reduce the federal budget deficit. Therefore, Congress could decide to increase tax rates for people earning $150,000; $100,000; or even less. On the other hand, some federal legislators have suggested keeping the tax rates of 2010 in effect for another year to help stimulate the economy.

In addition, many specific income tax breaks expired after 2009. For example, you could deduct sales tax in 2009 but not in 2010. Congress may pass a so-called “extenders” bill that would reinstate those tax breaks for 2010. Such a bill, if passed, could lead you to change your year-end strategies.

Estate tax

The federal estate tax has not been in effect for deaths occurring in 2010. Some lawmakers have announced their intention of reinstating the estate tax for 2010, but such an effort, if successful, would be controversial, to say the least. The deeper in the year we go before any change in estate tax law happens, the less likely it becomes that the federal estate tax will be retroactively instituted for 2010.

Regardless of how deaths in. 2010 are treated, it’s highly probable that the federal estate tax will be back in effect for deaths in future years. Under current law, the estate tax exemption in 2011 would be only $1 million. If that happens, many estates would owe federal tax, based on the value of the decedent’s home, investments, life insurance, and so on.

Some Senators and Representatives have suggested increasing the exemption amount to $35 million, the same as it was in 2009. Others would like to see an even larger exemption, perhaps $5 million. Lawmakers also are debating the issue of “portability”: the idea of allowing a surviving spouse to use any remaining federal estate tax exemption that was not fully used by the first spouse when he or she died.

Estate tax rates also are on the table. In 2009, the last year this tax was in effect, the top rate was 45%. Under current law the to rate will be 55%, plus a 5% surtax for very large estates. Some people in Congress favor bringing the rate down to 45% and others would go even lower. Any revisions in the federal estate tax rules also would affect the gift tax and the generation-skipping transfer tax.

With far-reaching changes in tax law likely to pass in late 2010, feel free to contact our office periodically to keep up with legislative developments. Once the situation has clarified, we can help you accomplish two key goals: determining whether your estate plan needs to be updated and getting timely ideas for year-end income tax savings.

2010 Q4 | Year-End Tax Planning for Investors

For the past two years, investors have experienced extraordinarily tumultuous times. From late 2008 through early 2009, stock markets in the United States and around the world have fallen sharply. The S&P 500 Index, a leading benchmark for the U.S. stock market, lost about half of its value, for example.

As the winter of 2009 came to a close, stocks rebounded. For the remainder of last year and into early 2010, stocks enjoyed one of the strongest recoveries since the 1930s. Investors who held on recouped some of their losses, and those who rimed the market successfully had sharp gains.

During the second quarter of 10, however, stocks dived again. Debt woes in Europe and sluggish employment growth in the United States discouraged investors. As of this writing, the outlook for the balance of2010 is uncertain.

The bottom line? Depending on your investment history, you may have a mix of gains and losses in your portfolio, short term or long term. To make savvy trades by year-end, a careful review of your holdings in taxable accounts should be done to see exactly where you stand.

Capital gain concerns

In 2010, most taxpayers owe tax at 15% on long-term capital gains. Certain low-income taxpayers have a 0% tax rate. Under current law, the 0% rate would be eliminated, and the 15% rate would move up to 20%.

The Obama Administration has proposed that the 0% and 15% tax rates be retained; only high-income taxpayers (those with income over $200,000, or $250,000 on a joint return) would owe 20% tax on long-term gains. At present, no one knows how capital gains will be taxed in 2011.

How can you proceed? The following are suggested strategies for minimizing taxes.

Take losses

If you own securities in your taxable account that are trading at levels below your purchase price, you can sell them before year-end. Such trades will provide capital losses. At year-end, those losses can offset the capital gains tax on any profits you have taken. If you have excess losses for the year, up to $3,000 can be deducted from your ordinary income. Excess losses can be carried over to future years with no time limit.

Example 1: Jim Bell takes $11,000 worth of capital gains during 2010 and $19,000 worth of capital losses. Therefore, he has a net capital loss of $8,000 for the year. Jim takes a $3,000 deduction on his 2010 tax return and carries over $5,000 of losses for use in the future.

After you sell securities at a loss, wait at least 31 days before repurchasing them. The capital loss won’t count if you buy them back too soon. If you are concerned about being out of the market for that time period, you are allowed to buy a similar but not identical security right away.

Take Gains

After taking losses in taxable accounts, go over your holdings for which you have a paper profit. Do you intend to sell them soon, either for investment reasons or to raise cash:’ If so, you can sell them in 2010, tax free, up to the amount of your net capital losses for the year.

Example 2: Meg Clark tallies her gains and losses for 2010 in early December. She discovers that she has net capital losses of $6,000 so far. Meg intends to sell $30,000 of ABC Mutual Fund shares in early 2011 to raise money for her daughter’s college bills. At current prices, Meg would have a $5,000 gain on the sale. Meg can sell those shares in 2010, tax free, because her gains would be more than offset by her net capital losses. She’ll have a $1,000 net loss for the year, after taking $5,000 of tax-free gains, and she can deduct that $1,000 net capital loss on her 2010 tax return against her ordinary income.

What if Meg also has a $10,000 paper profit on XYZ Mutual Fund, and she expects to sell those shares in 2011?  Should she sell those shares in 2010, too? If she does, the first $1,000 of gains will be offset by her net capital loss and the other $9,000 will be taxed; however, Meg will lock in the gain and owe tax at only 15%.

If Meg expects her taxable income in 2011 to be well over $200,000, taking those gains in 2010 might make sense. Even if her income will be lower, she may want to take gains this year if she fears that tax rates will increase and she’ll owe 20% or more on a sale in 2011.

Yet another tactic: Meg could give some of her XYZ shares to her widowed mother, Karen, whom Meg is helping to support. Then Karen could sell those shares in 2010. As long as Karen’s taxable income remains under $34,000 for the year, she will owe 0% tax on long-term capital gains. At year-end, our office can help you make those types of sell, hold, or giveaway decisions.

Looking backward

As mentioned previously, you can deduct up to $3,000 worth of net capital losses on your tax return and carry forward excess losses to future years. Therefore, you should check your 2009 tax return to see if you’re carrying forward any unused capital losses. You’ll find that information on Schedule 0 of Form 1040. If you have such losses from the 2008 bear market or prior years, you can take gains to soak them up without paying any taxes out of pocket.

Example 3: Louis Ward has $20,000 worth of loss carry forwards from previous years. He hasn’t taken any capital gains or losses this year. If Louis generates $17,000 in net capital gains by the end of 2010, his loss carry-forwards will offset the tax on those gains. He can deduct the remaining $3,000 of net loss against his 2010 ordinary income, reducing his existing taxable income for the year and his resulting tax obligation.