Business Year-End Planning
By James Philbin, Partner -Tax & Business Services
The end of the year is an important time for business owners to evaluate the current and future status of operations and the associated tax implications. Businesses must understand the tax law changes that impact their industries and ultimately, their profitability. A number of tax reform proposals were passed in 2014 and 2015. However, progress on further legislation will not likely be finalized until early 2016.
Here are some of the tax saving provisions, expired as of December 31, 2014, that may be extended again for 2015:
BONUS DEPRECIATION AND CODE SECTION 179 EXPENSE DEDUCTIONS
The Tax Increase Prevention Act (TIPA) extended the additional 50 percent bonus depreciation allowance for one year to apply to qualifying property acquired and placed in service before January 1, 2015. Qualified property includes tangible property with a 20-year life or less, purchased computer software, water utility property, or qualified leasehold improvement property. Bonus depreciation has been available every year since 2008. As enacted, there is no limit on the total amount of bonus depreciation that may be claimed. The fifty-percent bonus depreciation deduction is taken before regular depreciation is computed for the year property is placed in service.
TIPA also extended through 2014 the Code Sec. 179 dollar limit of $500,000 and the investment limit of $2 million. The $500,000 deduction and $2 million investment limit have been in place since 2010. For purposes of Code Sec. 179, qualifying property is depreciable tangible property that is purchased for use in an active trade or business.
A taxpayer may also elect to treat qualified real property as Code Sec. 179 property. However, only $250,000 of the cost of qualified real property may be expensed. Qualified real property generally consists of qualified leasehold improvements, qualified retail improvement property, and qualified restaurant improvement property.
The expense deduction allowed by Code Section 179 is independent of the bonus depreciation allowance. The Code Section 179 deduction is computed first, and the taxpayer’s basis in the qualifying property is reduced by the amount of that deduction. Any bonus depreciation deduction is computed on the remaining basis in the property. Used and new property qualifies for the Code Section 179 expense allowance without regard to the recovery period. Only new property with an MACRS recovery period of 20 years or less qualifies for first year bonus depreciation. Therefore, a taxpayer should generally first expense property that does not qualify for bonus depreciation.
Unless there is further legislative action, the 179 deduction limit is reduced to $25,000, and the investment limitation is reduced to $200,000 for 2015.
Research Credit. TIPA extended the research credit to apply to any amounts paid or incurred for qualified research and experimentation before January 1, 2015. The research credit was provided to encourage taxpayers to increase their research expenditures and applied to many industries and types of businesses.
Work Opportunity Credit. The Work Opportunity Tax Credit for all targeted groups was extended through December 31, 2014 and applies with respect to wages paid to persons who began work for their employer before January 1, 2015. Employers hiring certain individuals are eligible for a credit generally equal to 40 percent of first-year wages which could be in excess of $9,000. Targeted groups include qualified individuals in families receiving certain government benefits, veterans, summer youth employees, and ex-felons.
Other expired provisions that could be extended include:
- 100% exclusion of gain on small business stock.
- New Markets Tax Credit.
- Deduction for energy-efficient commercial buildings and various other energy credits.
- Enhanced deduction for charitable contributions of food inventory.
- Low-income tax credits for non-federally subsidized new buildings.
- Adjusted-basis reduction of stock after S corporation charitable donation of property.
- Shorter recognition period for S corporation builtin gains.
While we wait for another Extender Bill, there are many other ways that businesses can plan to reduce tax liability and enhance long-term profitability. Here are additional year-end tax planning opportunities to consider:
DOMESTIC PRODUCTION ACTIVITIES DEDUCTION
An important, but often overlooked, tax benefit for US businesses is the Domestic Production Activities Deduction (DPAD). The deduction is equal to nine percent of the lesser of the taxable income or qualified production activities income (QPAI) and effectively gives an eligible company a double deduction. The DPAD is available if a business has income from the sale of tangible personal property (products), buildings or computer software. The products must be manufactured, produced, grown or extracted primarily in the United States. The deduction is also available for income from certain services, such as engineering and architecture.
To accelerate deductions and avoid having to depreciate asset costs over a period of years, companies may treat certain costs of maintaining assets as repairs or maintenance, generally deductible in full in the year paid. In late 2013, the IRS issued repair regulations that explain when taxpayers must capitalize costs and when they can deduct expenses for acquiring, maintaining, repairing and replacing tangible property. The regulations have many provisions that enable taxpayers to deduct their costs more easily. These provisions include the de-minimis expensing rules, the write-off of expenses for materials and supplies, the deduction of recurring maintenance costs, and the replacement of building systems.
For businesses that export their products internationally, creating an Interest Charge-Domestic International Sales Corporation (IC-DISC) can help a company defer tax on income and utilize a lower tax rate when the income ultimately becomes subject to tax. An IC-DISC is a U.S. corporation that must pass both the qualified export receipts and qualified export assets tests.
An IC-DISC is not subject to regular U.S. corporate income tax. As a result, the IC-DISC does not pay tax on a commission received from the parent or affiliate exporter. The IC-DISC was designed as a means by which a U.S. exporter could borrow funds from the U.S. Treasury at a low interest rate. More specifically, the U.S. shareholder must pay an interest charge on its IC-DISC-related deferred tax liability.
When the IC-DISC pays a dividend to its owners, individual shareholders will generally pay a tax at the qualified dividend rate of 15-20%. In effect, the shareholders are converting a 39.6% tax on ordinary income to a 15-20% tax on qualified dividends.
For profitable businesses with an older owner-employee group, a defined benefit plan can help quickly build a substantial retirement for shareholders and provide a substantial tax deduction. A defined benefit plan has higher contribution limits than the traditional 401(k) profit sharing plan. The defined benefit contribution is usually based on salary levels and years of service in the business and is based on actuarial factors including age and the assumed rate at which contributions will grow.
A participant’s annual retirement benefit is determined by the plan’s benefit formula. The maximum annual benefit at retirement is generally the lesser of $210,000 for 2015 and 2014, or 100 percent of a participant’s average compensation for the highest three years.
Defined benefit plans are more complicated to set up than most other types of qualified retirement plans, and they’re more expensive to administer. But for an older high-income businessperson, the tax and financial benefits can be substantial.
As with other kinds of qualified retirement plans, rank and file employees of the business generally have to be included in a defined benefit pension plan. However, the plan can have minimum age and service requirements, so that new and younger employees do not have to participate. Contributions for younger employees who are in the plan will be significantly lower than the owner-employee contributions. Benefits under the plan do not have to vest immediately, so employees who stay with the company for only a short time can’t take their benefits with them when they leave. The plan also can be integrated with social security, so that a greater percentage of plan benefits go to employees above the wage base.
A company can also enhance its defined contribution plan for key employees by offering a Supplemental Executive Retirement Plan (SERP). Due to compensation limitations for qualified retirement plans, company executives including business owners often can’t obtain the true full amount of retirement benefits that they should receive based on their compensation level. Additional retirement benefits can be offered to a select group without affecting the tax-qualified status of the retirement plan by implementing a SERP. This type of plan is designed to provide executives the additional benefits that a qualified retirement plan would have allowed them, if not for compensation limitations imposed under the Internal Revenue Code.
Other advantages of a SERP are less stringent rules and disclosure requirements than for a qualified plan, which make it proportionately easier and cheaper to administer. How these plans are structured also impacts whether the executive participating in the plan must take benefits set aside on his or her behalf immediately into income, or whether the executive can defer tax until a later time, such as when he or she receives a distribution of benefits under the plan.
DEFERRING GAIN ON SALE OF REAL ESTATE
Gain or loss on the disposition of real estate is taxed as a capital asset except as to depreciation recapture, unless the property is held primarily for sale to customers. However, if a taxpayer exchanges its real estate for like-kind property, no gain is recognized on the sale, but rather is deferred. Real property for exchange can vary in type and still be considered like-kind. For instance, an owner-occupied industrial building can be exchanged for a multi-family apartment complex.
MAKE THE BEST OF A LOSS SITUATION
Corporate stock is generally considered a capital asset in the hands of individual shareholders. As such, gains and losses from sales of stock are treated as capital gains and losses. Although capital gains are potentially taxed at preferential rates, capital losses are usually unattractive to individual investors because they only offset capital gains plus $3,000 of ordinary income. Thus, if a client has a large capital loss and no capital gains, the tax benefit of the loss ends up being spread over many years.
Fortunately, there’s an exception to this general rule. IRC Sec. 1244 allows certain shareholders to treat losses from the sale of qualified corporate stock as ordinary losses rather than capital losses (subject to annual dollar limits). Because an ordinary loss offsets ordinary income without limitation, the tax benefit is bigger. Qualifying a new corporation’s stock under IRC Sec.1244 is beneficial because losses can be characterized as ordinary when the stock is sold (or becomes worthless). Gains from the sale of such stock still qualify as capital gain.
To qualify as Section 1244 stock, specific requirements must be met when the stock is issued as well as in the year of loss. Shareholders are limited in the amount of ordinary loss they can claim on Section 1244 stock in a particular tax year. Any loss in excess of this limit is a capital loss. The annual limitation for ordinary loss treatment is $50,000 except for married taxpayers filing joint returns, who have a $100,000 limit, regardless of which spouse owns the stock.
SMALL BUSINESS HEALTH CARE TAX CREDIT
A business with fewer than 25 full-time equivalent employees that pays an average wage of less than $50,000 a year and pays at least half of employee health insurance premiums is entitled to a tax credit. For 2015, the credit is equal to 50 percent of premiums paid for small business employers and 35 percent of premiums paid for small tax-exempt employers. To be eligible for the credit, a small employer must pay premiums on behalf of employees enrolled in a qualified health plan offered through a Small Business Health Options Program (SHOP) Marketplace. The credit is available to eligible employers for two consecutive tax years.
Tax planning should complement a company’s overall business plan, and tax saving strategies must take into account short and long-term goals. Planning opportunities should also be considered along with the personal tax and financial planning goals of the business owners. It’s important to meet with your Marcum tax advisory team, which will have answers to your questions regarding 2015 tax planning.