Tax Guide: Business Tax Planning
Universal Advisor, 2007 Issue No. 3

Although treasure maps have been a literary theme in many books and stories, no actual pirate treasure maps have ever been documented. Treasure Island made the notion of a treasure map popular and used it as part of its plot to start its adventurers on a quest and to motivate characters through difficult times. For business tax planning, a checklist of great ideas can serve as that treasure map — but with far fewer headaches!

Cost Segregation

Cost segregation is an important technique to accelerate depreciation deductions. By segregating and properly classifying construction costs, businesses will be able to identify costs that should be treated as components of machinery and equipment rather than as part of a building. The proper classification of fixed assets can result in increased depreciation deductions (and increased tax savings), because costs capitalized as part of a commercial building are depreciated over a 39-year period while costs capitalized as machinery and equipment are typically depreciated over a five- or seven-year period.

Research and Experimentation Credits

Taxpayers that undertake research to develop technical advances or resolve technical problems may be eligible to claim the research credit. The research credit applies to activities such as the development of new or improved products, development of new or improved manufacturing processes, engineering efforts that reduce manufacturing costs, and in some cases, the production of custom parts, development of prototypes, and development of internal use software. The credit can be as large as 6.5 percent of qualified research expenditures.

Transaction Cost Analysis

Merger and acquisition activity appears to be even more prevalent today than in the past, leading in many cases to large, success-based fees for investment bankers. Recent IRS regulations require that these fees be reviewed and analyzed contemporaneously to determine the amounts that should be deducted, amortized, or capitalized.

Domestic Production Activities Deduction

The Domestic Production Activities Deduction (DPAD) is available for businesses that conduct manufacturing, farming, extraction, software development, architectural, engineering, or construction activities. In 2007, the deduction is 6 percent (doubled from 3 percent in 2006) of income from qualified activities. The deduction is limited to 50 percent of qualified wages and may not exceed 6 percent of the company’s taxable income.

Recent changes that may affect taxpayers include:

• Cost allocation requirements for companies with less than $100 million in sales were simplified.
• Qualifying wages are limited to amounts connected with qualifying activities.
• The limitation on wages passing through from a flow-through entity was eliminated.

Charitable Contributions by Businesses

C Corporations that donate appreciated property to charities are allowed to claim deductions that are limited to the cost basis of the property in many situations. Deductions for donations of inventory to charities that will use the donated property for the care of the ill, the needy, or infants can generally be claimed for an amount equal to the cost of plus 50 percent of the appreciation in value the property. The deduction is limited to two times the cost basis of the property, however.

Shareholders of S Corporations may be able to claim charitable deductions for the full fair market value of certain qualified gifts of appreciated long-term capital gain property that is donated by the corporation. For donations of such property made after December 31, 2007, the shareholders must reduce their basis in the corporation’s stock by the deductible amount of the gift rather than by the donated property’s cost basis. For 2007, the basis adjustment is limited to the donated property’s basis. S Corporations that are contemplating contributions of eligible property should complete the donation before the end of 2007 to take advantage of this rule.

Cash Versus Accrual Method of Accounting

The cash method of accounting allows taxpayers to report income and expense when cash is received or paid rather than when it’s earned or when liabilities are incurred. Consequently, it permits certain taxpayers a significant opportunity to simplify their tax reporting and record keeping and to substantially defer income when a company has significant uncollected receivables at the end of the year.

Taxpayers whose revenues are less than $10 million (average of the past three years) may be eligible to “automatically” switch to the cash method without paying a user fee if they’re in the following industries:

• Professional and personal service
• Construction
• Transportation
• Leasing
• Certain types of “custom” manufacturing

Taxpayers with revenues greater than $10 million may be eligible to change to the cash method if their business is predominately service-based and they have no inventory. To make this change, a business must apply to the IRS before the end of its tax year.

Elect S Corporation Status

In general, more and more businesses are being organized as flow-through entities, such as partnerships or limited liability companies. A flow-through entity is any entity in which the company’s income is taxed directly — or “flowed through” — to the owner. Distributions made by flow-through entities are not taxed when made from previously taxed income. A C Corporation, in contrast, is subject to a double tax, as the corporation pays tax on its income and shareholders pay tax on distributions made by the corporation as dividends.

Taxpayers that are affected (or likely to be affected) adversely by double taxation should consider making an S election. In general, a C Corporation that elects S status is taxed as a flow-through entity on income earned after the election. Previously accrued or “built-in” gains and income that has been previously earned at the time of the election are not eligible for this benefit. Consequently, when assets with built-in appreciation are sold and when distributions are made from income that was previously earned, two levels of tax will still be incurred. However, the double tax on the sale of appreciated assets ends after 10 years. As a result, the S election is particularly beneficial for taxpayers that don’t expect to sell their businesses (or any significantly appreciated assets) within the 10-year “recognition” period. If the value of your business is currently depressed, this can be a good time to make an S election, since any appreciation after the S election is made will not be subject to corporate level tax.

Issuing Stock or Ownership Interests in LLCs to Employees

Companies have a number of reasons to provide employees with an ownership interest in the company for which they work. These include reducing the current cash outlay for compensation, providing incentives for performance, and “handcuffing” valuable employees to the company while options or ownership interests vest. The payment of employee compensation in the form of an ownership interest can be complex, since legal, business, and tax objectives must all be considered.

Two common types of ownership interests that employers grant to employees are stock options and profits interests in a partnership or LLC.

• Stock options granted under qualified Incentive Stock Option or “ISO” plans generally do not result in taxable income to the employee until the shares acquired under the plan are sold. However, the employer does not obtain a tax deduction for the benefit provided, and the exercise of ISOs can result in alternative minimum taxable income to the employee. Options granted under nonqualified plans are not required to satisfy the requirements applicable to ISO plans and may be a more useful tool in many situations. Although the employee will generally be taxed immediately if the value of the stock received exceeds the option price, the employer may claim a deduction that is equal to the employee’s taxable benefit.
• Grants of profits interests in partnerships or LLCs provide an employee with a share of the future earnings of a business but no interest in the existing value of the assets of the business. The grant of a profits interest is generally tax-free to the employee if structured properly.