Taxes: don’t pay too much – includes related article on taxpayer rights
Joan C. Szabo
Taxes: Don’t Pay Too Much
As business owners, Antonio and Maria Alho had two concerns in common with many other entrepreneurs. They knew they should be setting up a retirement plan, and they felt they were paying too much in taxes.
When it came time to map out a year-end tax strategy last year, the owners of Alho Masonry in Silver Spring, Md., found a way to deal with both problems in one step. With the help of their accountant, the couple achieved substantial savings by taking advantage of a tax-planning opportunity they had never fully explored before. They established a defined-benefit pension plan for themselves and their employees.
Under the federal tax laws, annual contributions made by an employer to a qualified retirement plan can be paid with pretax dollars and accumulate tax-free until the funds are withdrawn at retirement.
The key to the tax-saving plan is the organization of the Alhos’ company as a Subchapter S corporation, in which they and their two daughters are the only shareholders. In that type of corporation, earnings and losses are passed directly to shareholders, who account for them in their personal income tax returns.
To accomplish the tax savings, the couple invested approximately $50,000 of the company revenues in the retirement plan. That action reduced the amount of taxable income flowing back to them under the Subchapter S arrangement, thereby cutting their federal and state tax bills by $20,000 and establishing a retirement plan from which they will draw future income. They will realize similar savings every year, says their adviser, Sidney J. Burns, a certified public accountant.
Tax professionals say that until the Alhos began seeking tax-saving opportunities, they were fairly typical of the many small-business owners who are so involved in running a business and so bewildered by tax laws that they often fail to recognize the advantages of properly planned tax strategies. As a result, substantial numbers of them pay too much in federal taxes.
While tax planning is a year-round process, the end of the year is a logical time to pause and review the past year’s experiences to determine what changes are advisable. By reviewing their tax situation before the year is over, small-business owners might be able to plan strategies that will reduce the current year’s tax liability as well as help in the new year.
“So many small-business people fail to do year-end planning,” says Thomas P. Brock, president of the Boulder, Colo., accounting firm of Brock, Buchholz & Stow. “They often wait until after the year is over, and then it’s too late to take advantage of some of the techniques that could have saved them money.”
Unfortunately, tax planning, never a simple exercise, keeps getting more complicated. The Tax Reform Act of 1986 includes provisions that have been phased in since its enactment, so its full impact has become apparent only relatively recently. Brock says that all who are “connected with small business, the owners as well as the CPAs who work with them, are having a terrible time keeping up with the tax code. Once small-business people adopt a plan, Congress comes in and changes the rules.”
The sheer size of the 1986 law underscores the complexity. It consists of more than 2,000 pages, and the regulations necessary to implement it make up an additional 7,600 pages. After several years of making significant tax-law overhauls, the nation’s lawmakers are considering additional changes that once again will have an impact for better or worse on many business people.
Further complicating the tax picture for small companies is the extent to which tax reform requires businesses to shift their approach to tax planning. While the 1986 law lowered tax rates, it also eliminated several deductions and preferences. As a result, says William E. King, senior tax manager for Price Waterhouse in Bethesda, Md., “A number of income-deferral and expense-acceleration techniques that once were used by smaller firms are no longer available.”
Small-business people should also be aware that tax planning has become more defensive, says Brock. “Tax accountants are busy making sure their clients are not getting snagged by the many traps in the current system. The number of pitfalls is staggering.” Examples of such pitfalls, Brock says, are the expanded alternative minimum tax (AMT) and the rules that limit the deduction of passive losses and interest expense.
Even though the task is difficult, the tax experts say that business owners are well advised to stay as informed as possible on existing tax provisions and legislative proposals. By acquiring a working knowledge of the tax code, the experts say, small-business owners are better able to work more effectively with their tax advisers.
David L. McDuffie, chairman of Tempaco Inc., an employee-owned wholesaling operation in Orlando, Fla., says he spends at least 20 percent of his time away from his job trying to understand tax matters, including legislative proposals. “A business owner can’t always rely on his accountant to alert him to all the tax nuances that affect a small company,” he says.
Although the rules have changed and the techniques that worked well before 1986 do not always work now, various year-end tax-saving opportunities are still available to small-business owners.
“It is simply a matter of understanding them and reformulating your planning,” says Mary Smalligan, national director of taxation of closely held companies for the accounting firm of Deloitte, Haskins & Sells in San Francisco.
Lawrence Angen, tax partner in the Beverly Hills, Calif., office of the accounting firm of BDO Seidman, says, “There are a number of legitimate tax-planning maneuvers available that can produce some rather meaningful benefits and help reduce a small-business owner’s tax liability.”
Which strategies are the most advantageous for small-business owners? Accountants who specialize in small-business tax matters say the following are some of the best planning techniques for small-business people to consider:
Investigate the benefits of an S corporation. Sam Starr, a tax partner with the national tax office of Coopers & Lybrand in Washington, D.C., says that under the Tax Reform Act of 1986, there are compelling reasons for eligible small-business owners to consider organizing their firms as S corporations (named after the section of the tax code that authorizes it).
A business can be organized as a sole proprietorship, a partnership, a corporation, or an S corporation. According to the Internal Revenue Service, about 69 percent of the nation’s businesses are proprietorships, corporations make up 21 percent, and partnerships account for 10 percent.
An S corporation enjoys some of the advantages of an incorporated business, such as limited liability, but at the same time it is not subject to the double taxation of dividends, which is a major complaint of regular corporations and their shareholders. Double taxation occurs when a corporation pays income taxes on its earnings, which are again taxed as income to shareholders when distributed as dividends. If earnings are reinvested in the company, shareholders pay personal income tax on the additional value in the business when it is sold.
With an S corporation, earnings are not taxed at the corporate level. Instead, as noted above, income passes to shareholders in proportion to their ownership of the firm, and it is taxed at personal-income rates. Because the top individual tax rate is less than the top corporate tax rate, the amount of federal tax paid on the earnings of an S corporation will often be less than the tax paid by a regular corporation.
The top regular corporate tax rate is 34 percent. The top individual rate is 33 percent, which applies, for example, to taxable income of $71,900 to $192,930 on a joint return filed by a couple with two dependents. The marginal tax rate is 28 percent in brackets below and above that category, and it is 15 percent in the lowest brackets.
In addition, S corporations are not subject to the new corporate alternative minimum tax, with its burdensome provisions that tax 50 percent of the excess of financially reported income over tax-return income. The AMT requires companies that report higher earnings on their financial statements than on their tax returns to include one-half the difference in AMT income. Companies pay the higher of the AMT or the regular tax. For example, if the corporate financial statement shows book earnings of $200,000, and if the tax return shows profits of only $100,000, the company must include $50,000 in its AMT taxable income.
The S corporation form is especially appropriate for new businesses that may lose money for the first year or two, Starr says. “In this situation, the business is a tax shelter for the owners who materially participate in management, since it provides them with losses that can be used on their tax returns to offset income from other sources.”
The S corporation does have some restrictions. For example, ownership of an S corporation is limited to 35 shareholders, the corporation cannot own 80 percent or more of any subsidiary, and it can have only one class of stock.
Select the proper accounting method. Accounting methods also offer small-business owners tax-saving opportunities. Under tax reform, the cash method of accounting can be used by small businesses with average annual receipts of $5 million or less, S corporations, sole proprietorships, and most partnerships that do not offer products for sale. Personal-service corporations, such as those formed by architects, accountants, and lawyers, also can elect this method. Regular corporations with annual receipts in excess of $5 million generally must use the accrual method.
Under the cash method, taxes are due only on income that has been received, and expenses are deducted when actually paid. The accrual method taxes income when services are rendered, even though the income may not have been collected. Expenses generally are deductible when liabilities become fixed, even if the expenses have not yet been paid.
For many small firms, the cash method offers more flexibility. Says Angen of BDO Seidman: “One of the big advantages is the fact that a small-business owner can better time the recognition of income and expenses with the cash method than with the accrual method, and thus defer taxes.”
Tax advisers caution, however, that it may not be easy for a business to change its established accounting method; consent of the IRS is usually required.
Explore ways to shift income and deductions from year to year. For small-business owners who use the cash method of accounting, there are several tax-saving ways to help move income and expenses from one year to the next, says tax accountant Brock. The aim of such a strategy is to pay the IRS no sooner than required. To accomplish this goal, he says, try to defer income and accelerate deductions.
The prospect of higher federal rates, however, complicates the planning picture, he says. “If you believe tax rates are going to increase in 1990, then you will want to move more income into 1989 and take advantage of this year’s lower rates,” Brock says. “To do this, accelerate collections of receivables, perform more services, and do more billing.”
Conversely, expense payments can be deferred to the following year when the potentially higher rates will make deductions more valuable. Employee bonuses could be put over into the higher-tax year, for example. Purchases of supplies, equipment repairs, and other activities that can be delayed will also increase deductions against the higher tax rates.
But deferring deductions does not always work. Lorrie Fry, a tax manager with the accounting firm of Coopers & Lybrand, says small-business owners should take a close look at their receivables, determine which ones are uncollectible, and take the bad-debt deduction in the year the determination was made.
Before tax reform, it was possible to set aside a reserve for bad debts based on past collection history, then deduct a yearly addition to this reserve. A bad debt can be written off now only when it becomes partially or totally worthless.
Under the law, delaying a bad-debt determination may cause problems with the IRS. “If you actually had bad debts on your books last year but overlooked them and deducted them this year, the Service might disallow the deduction,” says Fry.
Consider the simplified LIFO method as a way to defer taxes. Under the last-in, first-out (LIFO) method of accounting, small-business owners can match the current costs of acquiring inventory with current sales. This method is especially beneficial during inflationary periods.
“If a company’s inventory costs are rising, LIFO allows the business owner to reduce the amount of income that is reported as taxable income in any one year,” says Jim Stephenson, a partner in the Northbrook, Ill., accounting firm of Miller, Cooper & Co. He notes that there are simplified LIFO procedures available to small firms, enabling them to avoid some of the paperwork requirements involved in electing LIFO.
Under a LIFO procedure, for example, a company with inventory worth $100,000 at the beginning of the year and $110,000 at the year’s end could deduct the $10,000 difference instead of carrying it on the balance sheet as inventory cost. The $10,000 becomes part of the cost of goods sold and helps reduce income for the year when the cost is subtracted from the sale price. The simplified method allows a small employer to use government-published statistics to calculate the pricing of the inventory. Deloitte’s Smalligan cautions, however, that if a small firm’s inventory costs are dropping, LIFO may not be the best choice because it may actually increase taxable income.
Exporters should investigate the tax benefits of FSC and DISC. Uncle Sam provides tax incentives to companies that export goods and services, notes Jodi Gimbel, tax manager with the firm of Miller, Cooper & Co. One such incentive is the tax-favored foreign-sales corporation (FSC). It is typically a U.S. company’s foreign subsidiary that earns a fee–which is deductible by the U.S. parent–for selling exported products.
The income earned by the FSC is partially exempt from tax. Companies with $5 million or less in export sales can establish a small FSC, which does not have to meet the more costly and complex requirements that a larger firm must meet, says Smalligan.
An alternative to the FSC is an interest-charge DISC (domestic international sales corporation) for up to $10 million in export sales. Unlike an FSC, none of a DISC’s income is exempt from taxes, but it does enable an exporter to defer some federal tax.
Use the estimated-tax rules to your advantage. A company can make its annual estimated tax payments to the IRS according to either of two formulas: Pay 90 percent of the taxes owed for the current year, or pay 100 percent of the previous year’s tax liability.
Accountant Angen says that by paying this year’s tax based on the amount you paid last year, you can take advantage of a unique planning opportunity. “For example, if your company will experience a small loss this year, but next year profits will be especially good, consider creating a minor tax liability of $200 or so for this year,” he says. “By doing this, you can base your estimated tax payments in 1990 on the $200 tax liability you incurred in 1989. You will not have to pay the remaining tax liability for 1990 until the tax-filing deadline in 1991. This maneuver enables you to keep the tax money you owe in 1990 for a whole year and have it earn money in your business.”
Estimated-tax rules cannot be used by large companies that have over $1 million in tax income for any of the three prior years.
Determine if your firm qualifies for a tax credit for research costs. Accountant King says that if your firm is starting to develop a new product, be sure to determine what types of expenditures qualify for the research credit. “If a small-business owner wants to make a significant investment in a new product, the cost of that investment could be reduced if the expense qualifies for a research credit,” he says.
Accountant Smalligan explains how the credit works: “The credit is equal to 20 percent of the increase in qualified research expense over the average amount incurred during a three-year base period or, if less, 20 percent of half of the current year’s expenditures. Your deduction for research expenses must be reduced by one-half of the credit for 1989.”
Consider placing real estate in your own name. Many business owners may still be able to save thousands of dollars on corporate taxes if they personally purchase and place their firm’s real-estate assets in their own name, says Jacob R. Brandzel, national tax partner with the accounting firm of Laventhol and Horwath.
Brandzel says that putting a firm’s stores, warehouses, land, or office buildings in the name of the business owner is an excellent way to extract income from the business without paying corporate taxes on it.
This strategy can help reduce the amount of accumulated income and the tax penalties that may be levied on it. Once a corporation’s liquid assets exceed the business’s reasonable needs, the IRS may try to assess an accumulated-earnings penalty, says Brandzel. But extracting corporate income as rental payments to the owner can effectively distribute earnings, thus avoiding the penalty.
Another benefit of this strategy, Brandzel says, is that it helps avoid the risk of “unreasonable compensation.” This is an issue that arises when the IRS claims an owner’s salary exceeds his or her value to the business. For example, an owner may draw a salary of $200,000 but the government can claim the owner’s services are worth only $100,000. Unless the owner has a valid defense, corporate taxes will be due on the difference. Brandzel says that an owner can sidestep the limits on earnings by drawing the IRS-accepted $100,000 salary and a reasonable amount of rental income.
Look into the benefits of establishing a retirement plan. A number of small-business owners fail to explore the tax benefits of establishing a retirement plan, says Jack N. Brown, tax director for Ernst & Young’s Entrepreneurial Services Group in Berwyn, Pa.
“This is one area where a small-business owner can make some hay with a relatively simple transaction. But 9 times out of 10 the business owner has failed to explore this particular option to the fullest,” he says.
The reason for this, says Brown, is that smaller companies often don’t have a lot of funds to invest in retirement plans. But the tax benefits of such planning should not be overlooked, he says.
As the Alhos discovered, one of the biggest advantages of establishing a retirement plan is the tax deductibility of contributions to the plan. Says Smalligan: “The type of plan a company selects will depend on a number of factors such as annual profits, the owner’s age, the number and age of the firm’s employees, their salaries, and the length of time employees generally stay with the company.”
Self-employed individuals, salaried workers with sideline businesses, and full-time or part-time home-based business owners should consider establishing a tax-free Keogh retirement plan. With a Keogh, it is possible to put aside tax-deductible annual contributions. As with other retirement programs, the earnings accumulate tax-free until they are withdrawn at retirement. The amount that can be contributed each year depends on the type of plan that is selected.
A Keogh must be established by Dec. 31 of the year for which it is claimed. But Keogh contributions can be made as late as the due date (including extensions) of the tax return. If the self-employed individual hires employees, they must be offered participation in the plan.
Watch out for the alternative minimum tax. The AMT is a parallel tax system set up to ensure that both individuals and businesses actually incur some tax liability each year. Corporations are required to figure their taxes using the regular system at a top rate of 34 percent, and again under the minimum tax method at a 20 percent rate. A firm pays the higher of the two figures.
AMT income is determined by adjusting taxable income for certain tax benefits, including accelerated depreciation, income-tax accounting methods such as long-term contract or installment sales, and net operating losses.
“Ultimately, you may be doing so well on reducing your regular tax bill that you throw yourself into AMT exposure,” says accountant Starr. He notes that when the AMT is activated, your tax strategies may be just the opposite of what they would be under the regular system.
Place life insurance for buy-sell agreements or “key man” coverage outside the corporation. Partners in a closely held business often purchase insurance on each other so that they can use the proceeds of the policy to make up for losses incurred when one partner dies. In other cases, they establish buy-sell agreements funded with insurance to provide the company with cash to purchase stock from the deceased’s heirs. In either plan, the insurance proceeds flow into the company.
Tax accountant Angen says now is a good time to review these arrangements to be sure the insurance that funds the buy-sell agreement or “key man” coverage is outside the company. “The imposition of the AMT on life-insurance proceeds under the Tax Reform Act of 1986 may require a restructuring of many of these arrangements,” he says.
Angen notes that before tax reform, the receipts of the insurance proceeds were never subject to tax. They still are not subject to regular tax, but they are subject to the AMT. The effect could be to reduce the amount of the proceeds, thus leaving less cash for the intended purpose.
The accounting firm of Laventhol and Horwath provides the following example of how the AMT could affect these proceeds: Company ABC expects to report an equal amount of income on its books and its tax return in 1989. If one of the owners of the company dies during the year and the firm receives $250,000 in insurance proceeds on his life, this extra income will show up on the company’s books. As a result, the firm is subject to the AMT on half the difference between book and tax earnings, or $125,000. Based on a 20-percent corporate tax rate, the company will be hit with an unexpected tax bill of $25,000.
To avoid this problem, the insurance for these arrangements should be purchased from the individual owner’s personal funds and kept outside the corporation. In this way, insurance proceeds cannot be considered salary or dividends–both of which are taxable.
Review the benefits of offering employees a flexible spending account. These accounts allow employees to contribute pretax dollars through a salary-reduction program to fund expenses such as those related to child care or elder care. Employees’ salaries are reduced by the amount of their contributions to the plan.
Flexible spending accounts cannot discriminate in favor of highly compensated employees. These plans offer substantial benefits to both the employer and the employee, say tax professionals. The employer saves Social Security tax and unemployment insurance on salary-reduction amounts elected by employees. The employees save on federal and in most cases state income taxes, as well as on Social Security tax.
Hire your children. Sole proprietors should consider employing their children under 18, says Christopher J. Lauzen, owner of a Comprehensive Accounting franchise in Geneva, Ill. This year a child can earn slightly over $3,000 tax-free, which helps reduce the sole proprietor’s total tax liability. Also, the income paid to children under 18 is not subject to Social Security tax.
This listing makes it evident that in view of all the tax-saving strategies available, year-end planning has assumed a more vital role than ever before for business people.
Small-business owner McDuffie, in Orlando, says the significance of such planning for business people cannot be emphasized enough. “Taxes are nearly as much a part of my business as making payroll,” McDuffie says.
Stephenson of Miller, Cooper & Co. offers this assessment on planning: “Without year-end planning, a small-business owner often forgoes forever the opportunity to save on taxes for the year.”
PHOTO : Tax planning produced big savings for masonry-firm owners Antonio and Maria Alho, shown at
PHOTO : a job site with accountant Sidney J. Burns.
PHOTO : Tax filing should be simpler, said Reps. J.J. Pickle, D-Texas, and Richard Schulze, R-Pa.,
PHOTO : at a hearing where 392 IRS forms were displayed.
PHOTO : Small-business owners too often fail to investigate the tax benefits of establishing a
PHOTO : retirement plan, says Ernst & Young tax accountant Jack N. Brown.
PHOTO : Though some tax rules have changed, certain year-end tax-saving strategies are still
PHOTO : possible for owners of small firms. “It is simply a matter of understanding them and
PHOTO : reformulating your planning,” says Mary Smalligan, with the accounting firm of Deloitte,
PHOTO : Haskins & Sells in San Francisco.
COPYRIGHT 1989 U.S. Chamber of Commerce
COPYRIGHT 2004 Gale Group
