Advanced Business Tax Planning
August 31, 2024
August 31, 2024
Business tax planning involves, not only economic planning for that year, but also making wise tax decisions that will benefit the business for years to come. Tax-saving strategies must take into account short-term and long-term goals so that decisions made when starting up a particular venture also represent sound tax decisions in following years.
Choice of Entity
The choice of business form involves selecting among five options: the sole proprietorship, the partnership (general, limited, or limited liability partnership), the S corporation, the C corporation, and the limited liability company (LLC). Generally, the partnership (whether general, limited, or limited liability) and the LLC provide the most favorable tax consequences. However, tax advantages are not the only factors to consider. Additional factors that a business owner should consider include:
• liability protection
• ease of formation
• availability of outside capital or financing
• cost and administration
• transferability of ownership
• separation of ownership and management
• number of shareholders/partners
• eligible investors/owners
• distribution rights
• different classes of ownership interest
• ability to change to a different entity, and
• liquidation of entity
In planning the business structure, business owners must make many decisions. These include the structure of the business. Other considerations that must be taken into account include the amount of debt and equity, the forms of equity, methods for cushioning possible loss, and control devices for the business.
Business owners may consider the possibility of combining the corporate form with individual or partnership ownership or using multiple corporations, taking unto account numerous factors. While the initial capital structure may be changed at a later time, there may be a higher price to pay for subsequent changes. Thus, careful pre-incorporation planning of the capital structure is mandatory.
Example Assume a business is engaged in the manufacture and sale of bottles. It might be set up like this: A corporation is used for the operating part of the business to do the manufacturing and selling, and to carry inventory and accounts receivable. It is stocked with a certain amount of working capital. The real estate and the plant in which it operates, however, are owned by the shareholders individually or in partnership form and are leased to the corporation. The corporation does not own the machinery and equipment it uses to manufacture or package the bottles; they are owned by a limited partnership in which the corporation is the general partner, and the shareholders are limited partners along with one or more trusts for the children of shareholders. The partnership leases the machinery to the corporation. Extensive office equipment, a computer network, a photocopier machine and workstations are also owned by the partnership and leased to the corporation. The leasing arrangements have been set up to pass muster as fair and reasonable on terms that might have been obtained in truly arm's-length transactions.
As a result of this structure:
• The shareholders, as owners of the real estate, may have rental income, and the corporation has a deduction for rent paid.
• The shareholders also have deductions to offset their rental income and other income subject to the passive activity loss rules.
• The rental income going to the limited partnership housing the machinery and equipment could be offset in part by depreciation deductions.
• On an eventual sale or merger of the corporate enterprise, the fact that the corporation does not own the real estate or machinery or equipment may not affect the price to any marked degree, as earnings are more likely to be the controlling factor in determining the value of the corporation.
• Individual ownership of the real estate offers the additional advantage of avoiding a double tax where the owner plans to liquidate at retirement or sell the property of the business in connection with a sale of the business.
Multiple corporations. The strategic use of multiple corporations may provide multiple benefits for the owners and participants in what might otherwise be viewed as a single enterprise, housed in a single corporation. There may be nontax, as well as tax, benefits. Potential nontax benefits could include, among others:
the spreading of risk exposure,
possible benefits of decentralization of operations and management,
the creation of new job opportunities and status for key employees,
facilitating the sale of portions of the business, and
the improvement of the corporate image.
Comment One of the obstacles to obtaining the tax benefits is the controlled group, which prescribes the tests for determining whether two or more corporations are to be considered brother-sister corporations. If they are, they will be denied multiple tax benefits.
Debt v. equity. When financing a corporation, the amount of debt, if any, to be used, the amount of equity, and the form the equity is to take are key determinations.
The use of debt can provide numerous tax advantages when financing corporations. Here are primary considerations:
• Interest paid is deductible. Dividends are not.
• The tax liability of the holder of debt on its retirement is usually minimal. Stock redemption, on the other hand, may result in substantial ordinary income or, at best, capital gain. Note that in a redemption qualifying for capital gain treatment, only the amount distributed in excess of basis is taxed. If the redemption does not qualify for capital gain treatment, the entire amount distributed could be taxed and the corporation has sufficient earnings and profits.
• Debt absorbs earnings and profits and slows accumulation, thus decreasing the risk of an accumulated earnings penalty tax.
• Debt involves a fixed obligation of principal and interest, and, depending on the distribution of debt, default may jeopardize control.
Caution IRC §385 regulations provide rules that recharacterize purported debt of U.S. issuers as equity if the interest is among highly related parties and does not finance new investment in the operations of the issuer. These rules are intended to address transactions that create significant U.S. federal tax benefits while lacking meaningful legal or economic significance.
Control devices. Stock classifications, which are only available to C corporations, are not the sole method for maintaining control over the business. Other methods are listed below:
(1) Shareholder agreements. Voting agreements of a limited duration between shareholders, with built-in renewal provisions.
(2) Voting trusts. Voting trusts, although infrequently used, may provide a means of retaining control and will normally be valid for a limited period of time, depending on state law. In a voting trust, the trustee holds legal title to the shares, and the participating shareholders are given voting trust certificates. A voting trust shareholder will not bar an S election .
(3) Irrevocable proxies. Depending on state law, irrevocable proxies allow shareholders or owners to grant another party the right to vote on their behalf.
(4) Buy-sell agreements. Such agreements restrict the transfer of an ownership interest in an entity. In order to be enforceable, the restrictions must be "reasonable." Transfers may be limited to specific persons or classes, may require that the entity, generally or upon specified events, be given a first option to buy, or may require the consent of the entity or designated persons as a condition of transfer.
There are many benefits that can be derived by post-organizational planning. Techniques used in this area include corporate reorganization, ESOPs, sale-leasebacks, buy-sell agreements, stock buy-back, and the issuance of debt.
Recapitalization. A recapitalization is the "reshuffling of a capital structure within the framework of an existing corporation." To qualify as a tax-free reorganization, a recapitalization must be undertaken for a valid business purpose.
The reasons for recapitalization are:
(1) Raising capital. When raising capital, one of the concerns of management is to retain control of the company. Raising capital from venture capitalists or other investors usually requires issuance of securities convertible into common stock, such as convertible debentures or convertible preferred stock. Depending on the negotiating power of each party, one possibility is to change the common stock into separate class A voting and class B nonvoting. Management would retain the class A, while the class B is reserved for issuance to the investors on conversion.
(2) Successor management. Bringing in younger management is important to the continuity of any business. Senior management may be concerned about maintaining control and having minority shareholders in the event a junior executive leaves the company. These concerns are usually covered by issuing nonvoting stock which may be converted to voting stock over a period of time and with a buy back agreement in the event of termination. Another alternative, is to issue voting stock to junior management, but tie up the voting rights in senior management for a period of time.
(3) Retirement planning for senior management. A business owner may have a substantial portion of assets invested in his closely held company. When approaching retirement, the owner may be concerned with converting the investment into a retirement fund and having liquidity during retirement. Such planning should include an agreement among the shareholders for computing the price of the stock, how it is to be paid, and security for the payment. In some instances it may be desirable to convert the common into preferred stock or debt with put and call options exercisable at various times.
(4) A falling out among the owners. A falling out may involve only one shareholder or all the owners. A recapitalization provides management with flexibility. Sometimes it is possible to provide for a falling out in a buy-sell agreement. For instance, the agreement might provide a mechanism for triggering a put or call of the shares or conversion into a nonvoting security.
(5) Preserving control. A controlling shareholder can lose control of the corporation through the sale of stock. A recapitalization may allow the controlling shareholder to sell a portion of his stock holdings without loss of corporate control. One way of accomplishing this result would be to recapitalize so as to create two classes of common stock, A and B. The A stock carries ten votes per share; the B stock, one vote per share. These shares are issued to the existing shareholders in exchange for their old common shares. The result does not change the relative voting power or dividend rights of the controlling shareholder with respect to the other shareholders.
Many variations of recapitalization arrangements exist. The exact restructuring of stock will vary with the particular circumstances, taking into account the controlling shareholder(s)' initial voting power to begin with, how much the shareholder(s) can afford to surrender without losing control (not only of day-to-day management but of corporate transactions requiring larger votes than a simple majority), and what amount of dividends the shareholder(s) can afford to give up if necessary in order to assure a sale of stock. The greater the voting power vested in the class B stock, the smaller the dividend differential may be between A and B.
ESOPs. Employee stock ownership plans (ESOPs) have provided may opportunities for post-organizational planning for business interests. Advantages of an ESOP include:
(1) possible purchaser of stock from a major shareholder;
(2) a means of financing, in whole or in part, the purchase of another company or company division;
(3) for larger corporations, it may be a means of fending off hostile takeovers or of going private; and
(4) leveraging the ESOP for financing.
Example The Allegis Corporation sets up an ESOP. The ESOP borrows $1 million from a bank on the guarantee of Allegis and, most likely, its principal shareholders. The ESOP buys $1 million of Allegis stock from Allegis. Over a period of years Allegis will make contributions to the ESOP in accordance with whatever formula exists under the ESOP's plan. Allegis will get deductions for the contributions. The participants will not be taxable, as in any qualified retirement plan. The contributions will be used by the ESOP to pay off the bank loan. The employer, Allegis in this example, has an efficient, tax-favored means of financing and the employees have the benefit of stock ownership.
Sale-leaseback. In a sale-leaseback transaction, a business sells real or personal property, such as real estate or machinery, to a purchaser, often a shareholder or a related partnership and then leases the property back. If the transaction is upheld as a sale-leaseback, the seller-lessee can free his capital in the property for other uses and can take a deduction for rental payments to the buyer-lessor.
However, a sale-leaseback may be recharacterized:
• as a financing device if the seller retains most of the economic risks of ownership; or
• as a like-kind exchange when the term of the lease extends 30 years or longer or the seller retains reacquisition rights to the property .
Caution Sale-leasebacks between related parties are subject to heightened scrutiny.
Buy-sell agreements. A buy-sell agreement is a contract providing for sale of stock or business interest upon the occurrence of a specified event. Generally, this event is the death of one of the stockholders, but it may also be upon the disability, retirement, or termination of employment of a shareholder. Such agreements ordinarily have these purposes:
• to provide for the orderly transfer of stock interests on the death, retirement or disability of a shareholder;
• to permit the remaining shareholders to retain control, eliminating conflicts with new shareholders who might object to compensation arrangements, employee benefits, dividends, etc., and to allow them to control admission of new shareholders;
• to create a market at a fair price for the interests of shareholders who have become inactive or who have never been active;
• to provide funding for the purchase;
• to fix the price for the sale and purchase;
• to fix the value of the stock for estate tax purposes;
• to reasonably assure the continuance of the business and reduce the risk of dissolution and loss of value;
• to provide a method of realizing gain on investments without having to treat the proceeds as ordinary income; and
• to protect an S election by preventing transfers to disqualified shareholders.
There are three types of agreements:
(1) Cross-purchase agreement. This is a buy-sell agreement solely among shareholders.
(2) Stock redemption agreement. This is an agreement in which the corporation, as well as the shareholders, are parties. In these agreements, the corporation agrees to buy (redeem) the decedent's stock.
(3) Hybrid or combination agreement. In this type of agreement, the corporation and the stockholders agree to buy the decedent's stock. Such an agreement consists of both a cross-purchase and a redemption agreement.
Comment Options to buy property can be considered a form of buy-sell agreement in which the holder of the option is not obligated to buy but may buy on agreed terms and conditions.
Issuing Debt. As discussed above, there are a number of reasons why debt may be favored over equity:
• interest is deductible;
• an accumulation of earnings and profits to redeem debt may be considered reasonable;
• debt can be used instead of a second class of stock in S Corporations; and
• if a shareholder's advance to a corporation is treated as a loan, the shareholder may be entitled to a bad debt deduction if the corporation becomes unable to make repayment.
However, businesses must be cognizant of the debt recharacterization rules . The rules apply if a domestic corporation:
• distributes a debt instrument, or issues a debt instrument as consideration to acquire expanded group stock or
• issues a debt instrument as boot that is received by an expanded group member in an asset reorganization.
The funding rule generally recharacterizes certain debt as equity if a domestic corporation has issued a debt instrument within a 36-month period before or after one of the foregoing transactions:
• a distribution of property other than debt,
• an acquisition of stock for property other than debt, or
• an issuance of boot other than debt in an asset reorganization.
The funding rule also applies if the debt was otherwise issued with a principal purpose of funding one of the foregoing transactions.
Stock buy-backs. A company with a relatively high cash position stemming from a high positive cash flow over its business cycle faces four basic choices:
(1) increase dividend payouts;
(2) invest the cash in the business;
(3) expand through buy-outs and other acquisitions; or
(4) repurchase its own stock.
Further investment in the business does not always make sense, especially for mature companies that no longer require heavy reinvestment. Expanding a business through mergers or acquisitions is not always an easy task, and many promising acquisitions ultimately result in losses and decreased shareholder values.
When the choice of how best to utilize cash boils down to increasing dividends or buying back stock, the stock buy-back sometimes will produce the best results for the business and its shareholders. Stock buy-backs can have a positive effect on shareholder values. The decrease in outstanding shares increases earnings per share and, hopefully, price per share. Stock buy-backs also send a message to investors and shareholders that management believes the company's shares to be undervalued by the market. The result when this message is "digested" by the market is often a further increase in stock price, over and above the mathematical increase in value caused by earnings divided among fewer outstanding shares. From the company's viewpoint, a decrease in the number of outstanding shares means reduced payouts of nondeductible dividends. This in turn can lower the cost of capital to the company and increase net return on its invested capital.
While buy-backs can help to support a company's stock price at lower trading levels, the increased use of the technique has eroded its effectiveness somewhat. The use of excess cash to increase dividend payments may be more effective, with the lower cash position decreasing the potential for a hostile takeover bid financed in part by the company's own cash. Also, increasing dividends carry less risk of liability in suits by shareholders if a buy-back fails to produce the desired results. When a buy-back doesn't work, the company is out the cash and the shareholders have received nothing.
Depreciation
As a general rule, it is better to accelerate than to delay a deduction. Therefore, for planning purposes, when dealing with depreciable assets, businesses should avoid straight-line depreciation and longer recovery periods. Further, if property qualifies for bonus first-year depreciation, it usually will not be advantageous for a taxpayer to "elect-out" of such bonus depreciation treatment.
There may be exceptions to this general rule, however, such as when the business cannot fully utilize the depreciation deductions until later years, possibly in a start-up situation. Also, a business that will be sold or acquired within a relatively short period may be better off with straight-line depreciation or longer recovery periods to preserve a high basis for assets or to avoid creating a net operating loss that cannot be used by an acquirer.
Business Equipment
Lease vs. purchase equipment. The lease or rental payments for plant or equipment used in a trade or business are fully deductible as ordinary and necessary business expenses. At first glance, this would seem to give renting a tax advantage over buying. However, the same factors that apply to the purchase of plant and equipment by a business also affect the purchase of equipment by a lessor. The purchaser of business property may recover the cost of the property through depreciation or section 179 expensing, see below.
Election to Expense Business Equipment
Subject to certain restrictions, a business can make a yearly election under IRC §179 to expense the cost of equipment placed in service. Generally taxpayers should expense assets with the longest recovery (depreciation) period in order to accelerate the recovery of their costs. For example, given the choice of expensing the cost of 20-year property or three-year property, the section 179 expense allowance normally should be allocated to the 20-year property since the full cost of the three-year property will be recovered in only three years without resort to electing expensing for this property.
Fully expensing qualifying property, instead of depreciating the property, could provide additional benefits to the taxpayer. By lowering adjusted gross income (AGI) through section 179 expensing, the taxpayer may qualify for itemized deductions that are limited by the taxpayer's AGI. Additionally, the section 179 deduction is allowed in full for property placed in service even on the last day of the tax year. Taxpayers have the option of waiting until the end of the year before deciding if purchasing qualified property for their business will provide them with desired tax benefits.
In addition, when a taxpayer is planning to make regular equipment purchases over several years, the acquisition of equipment should be structured, if possible, so that the purchases do not surpass the section 179 phased-out threshold in any given year.
Before deciding to elect the section 179 deduction, consideration should be given to some long-term issues. For example, if the taxpayer is in a relatively low income tax bracket, it may be better for the taxpayer not to take the deduction if he or she expects to be in a higher income tax bracket in later years. Depreciation may provide a more valuable tax benefit to reduce taxable income in the following years.
Improvements and Repairs
Repairs vs. improvements. Incidental repairs that neither materially add to the value of the property nor appreciably prolong its life are usually considered to be currently deductible. On the other hand, expenditures that materially add to the value of the property or appreciably prolong its life are treated as capital expenditures and as such are not currently deductible but must be depreciated or amortized. Because currently deductible expenses are more beneficial than capital expenditures, businesses should insure that all repairs are correctly characterized.
Leasehold improvements. A lessee must amortize the cost of improvements over the applicable recovery period of the property, regardless of the remaining lease term. This rule makes lessee improvements more costly if the lease term is less than the recovery period. Deductions for the improvements, to a significant extent, may be delayed until the lessee surrenders the lease. A lessee desiring to make improvements to leased property should negotiate with the lessor to have the lessor make the improvements and adjust the rental accordingly. The increased rent charged by the lessor would be deductible as paid, so that the full "cost" of the improvements to the lessee would be deducted by the end of the lease term.
Business Vehicles
Business deductions. Taxpayers may deduct the business use of a vehicle using one of two methods, the standard mileage deduction or the actual use method. The standard mileage deduction may not be used if the taxpayer uses the car for hire (taxi service), operates more than one car at the same time (fleet operations), takes a depreciation or section 179 deduction for the car, or is a rural mail carrier.
Business use. An employer's depreciation deductions for a car are subject to reduction when the car is used for personal as well as business purposes. If qualified business use is 50 percent or less in the year the car is placed in service, it does not qualify for the section 179 expense deduction. If qualified business use fails to meet the 50-percent requirement during any tax year, the car must be depreciated under the alternative MACRS straight-line method for that tax year and all succeeding tax years. Further, failure to continuously meet the business use requirement triggers the recapture of any amount by which previously allowed depreciation exceeded the amount allowable under the alternative MACRS method.
However, an employee's personal use of the car is generally treated as a qualified business use, provided that the value of the use is included in the employee's gross income and that income tax is withheld on such compensation. Personal use by an employee who is also at least a five-percent owner of the employer's business or who is related to the employer does not qualify for this treatment.
An employee that is not reimbursed for business use of his or her vehicle is entitled to deduct the expenses using the standard mileage deduction or the actual use method. However, the employee should keep in mind the following two special restrictions which apply to such expenses: (1) depreciation deductions are not allowed for the car unless it is used for the convenience of the employer and is required as a condition of employment, and (2) unreimbursed employee expenses (and expenses reimbursed under a nonaccountable plan) are deductible only to the extent that they, together with other miscellaneous itemized deductions, exceed two percent of the employee's adjusted gross income.
Caution For tax years 2018 through 2025, miscellaneous itemized deductions subject to the 2% AGI limitation are not allowed.
Meal and Travel Expenses
Business meals. Deductions for business meals are generally limited to 50 percent of the portion of the cost that is not lavish or extravagant. The deduction limit applies to tips and taxes as well, but not to the cost of travelling to the restaurant or place of entertainment.
Taxpayers may consider:
(1) whether the 50-percent limitation on the amount of expenses that can be claimed as a deduction can be avoided and
(2) how best to meet the substantiation requirements.
Travel expenses. Expenses incurred in traveling away from home on business are fully deductible only when the primary purpose of the trip is business. When determining if the trip is primarily for business or personal reasons, he amount of time spent on business as compared to personal activities is important. In addition, when the primary purpose of the trip is business, but the trip is extended for vacation or a nonbusiness side trip occurs, the business-related travel expenses.
Example Jane Arthur works in Atlanta and takes a business trip to New Orleans. Arthur stops in Mobile, Alabama to see her parents. She spends $630 on the nine-day trip for meals, travel, lodging and other travel expenses. If she had not stopped in Mobile, the trip would have taken six days and the travel expenses would have been $580. Jane can deduct $580, which includes round-trip transportation to and from New Orleans
If the primary purpose of the trip is not business-related, such as visiting with relatives or sightseeing, only those expenses that are incurred for business-related activities are deductible.
Planning Tip Since many individuals combine personal vacations with business travel, careful planning of such combined trips can result in substantial tax savings.
Research
Deductible and amortizable expenses. Research and experimental expenditures generally must be amortized ratably over five years (15 years for expenditures attributable to foreign research). However, prior to 2022 a taxpayer could elect to deduct certain reasonable research and experimental expenses by claiming the deduction on the income tax return for the first tax year in which the costs are paid or incurred in connection with its business. Only costs of research in the laboratory or for experimental purposes, whether carried on by the taxpayer or on behalf of the taxpayer by a third party qualify. Market research and normal product testing costs are not research expenditures.
Research credit. To encourage businesses to increase their spending on research and development of new technologies, products, and services, a research credit is available. The research tax credit applies to qualified research expenses, including, expenses incurred with respect to in-house research, contract research, and basic research conducted by certain entities.
There are basically four categories of qualified expenses to which the credit applies, the first of which refer to in-house research activities:
(1) wages for employees involved in the research activity,
(2) costs of supplies used in research,
(3) payments to others for the use of computer time in qualified research (except if the taxpayer receives or accrues any amount from another person for computer use), and
(4) sixty-five percent of costs of contracting with another party to conduct research on the taxpayer's behalf (75 percent of costs paid to a qualified research consortium and 100 percent of costs paid for energy research to eligible small business, universities, and federal libraries).
Inventory
A taxpayer generally must use inventories to reflect income if the production, purchase, or sale of merchandise is an income-producing factor. To calculate taxable income, the taxpayer must value inventory at the beginning and end of each tax year. Inventory practices must be consistent from year to year, and most businesses with inventory must use the accrual method of accounting. However, a business is not required to use inventories or account for them using the accrual method if it meets the gross receipts test for a small business.
LIFO valuation method. LIFO (last-in, first-out) is an acceptable way of reducing taxes in periods of rising prices. In an inflationary environment, switching to LIFO and using LIFO as the inventory valuation method reduces taxes by reducing reportable taxable income. In a stable or deflationary economic environment, however, the opposite is true.
LIFO enables taxpayers to deduct the most current cost of inventory against sales income. If used for tax purposes, LIFO must be used in financial statements but not in financial forecasts .
Investments
Interest. The deduction of interest paid or accrued on a debt incurred in a trade or business other is generally limited regardless how the taxpayer’s business is organized (i.e., corporation, partnership, sole proprietorship, etc.). The business interest deduction may not exceed the sum of:
(1) business interest income of the taxpayer for the tax year;
(2) 30 percent of the taxpayer’s adjusted taxable income for the year, including any increases in adjusted taxable income as a result of a distributive share in a partnership or S corporation, but not below zero; and
(3) floor plan financing interest of the taxpayer for the tax year.
Dividends. For C Corporations, after-tax return can be increased by a shift from interest or rent-paying investments to investments in stocks paying dividends. Dividends are, in effect, 50 percent tax free ( 65 percent tax free, if 20 percent or more of the stock of a corporation is owned, excluding nonvoting nonconvertible preferred shares).
Tax-exempt municipal bonds may, under favorable market conditions, also merit consideration, provided that the corporation is in a high enough tax bracket to make the return worthwhile when compared to the returns available on taxable obligations.
Corporate earnings invested in stocks and bonds, instead of in the business, are accumulated earnings and care must be taken to avoid the accumulated earnings penalty tax.
Also, earnings on such investments are personal holding company income and the personal holding company penalty tax is to be considered if at least 60 percent of the corporation's adjusted gross income is personal holding company income and a limited number of individuals own the corporation.
Business Insurance
Generally, the goal of business-related insurance is to reduce costs or to shift certain risks from the business to the insurer.
Deductibility. In most instances, businesses may deduct ordinary and necessary premiums paid on insurance other than life insurance. Businesses may deduct the premiums if the insurance protects the business against risks arising in taxpayer's trade or business or in course of taxpayer's income-producing activities. Deductible insurance premiums include policies for:
• casualty insurance;
• liability insurance;
• officer's and director's liability insurance;
• professional and malpractice insurance;
• medical malpractice insurance;
• medical, accident, sickness, hospitalization and disability premiums paid by an employer;
• worker's compensation; and
• overhead disability expense insurance.
Insurance proceeds. Insurance proceeds received by a business may be wholly taxable, wholly tax-free, or may trigger gain or loss, depending on a number of factors. Special rules may apply in determining the character of gain or loss as capital or ordinary.
Proceeds received for damaged or destroyed business property may trigger a gain or loss, depending on whether the property's basis is less than or greater than the amount of proceeds received. The character of the gain or loss generally would be determined by IRC §1231 under which, simply stated and as a general rule, a net gain would be taxed as a capital gain and a net loss as an ordinary loss. Business interruption insurance proceeds paid because of lost income, earnings and profits are taxed as ordinary income. Proceeds received on an insurance policy on the life of an employee are tax-free.
Overhead and key person insurance. A business owner's temporary or permanent disability or death can have a serious impact on the business, especially if the business is highly dependent on the owner's skills and services. Thus, consideration should be given to obtaining overhead disability insurance and key person insurance.
Overhead disability insurance should be maintained when necessary to cover rent or mortgage obligations, the salary of employees, utilities and insurance premiums in case of disability. The cost of overhead insurance is deductible, but the business generally recognizes any insurance proceeds as gross income.
Expenses. The premiums paid by the employer on key person insurance payable to the employer are not deductible, but the proceeds payable on the death of the insured are generally not taxable to the beneficiary of the policy.
Capital vs. Ordinary Income for Investors
Characterizing income as capital gain rather than as ordinary income and using passive losses to offset other types of income (e.g., wages, interest or dividends) have been very important goals in tax planning. Note that the tax benefits of passive losses are still severely restricted under the passive loss limitation rules. See below and Passive Activity Losses.
Unlike individuals, who enjoy preferential tax treatment for long-term capital gains, C corporations do not get preferential tax treatment for long-term capital gains. Capital gains are added to the corporation's ordinary income along with other income items and taxed at the corporate tax rates. Under prior law, corporations enjoyed lower tax rates for long-term capital gains, and were therefore required to classify capital gains as short-term or long-term. Although the preferential treatment was eliminated, corporations must continue to classify capital gains and losses as short-term and long-term.
For corporations, capital losses remain deductible only against capital gains. Moreover, unlike individuals, who may carry over unused capital losses until fully absorbed, corporations may carry over such losses for only five years; however, corporations are entitled to carry back such losses for three years.
Qualified Business Income
Individuals, trusts and estates may deduct up to 20 percent of certain domestic qualified business income from partnerships, S corporations and sole proprietorships for tax years beginning after December 31, 2017, and before January 1, 2026.
The qualified business income (QBI) deduction is generally the lesser of:
• combined qualified business income, or
• 20 percent of the excess (if any) of taxable income over net capital gain
QBI is the net amount of qualified items of income, gain, deduction, and loss from a qualified trade or business. These items are qualified to the extent they are:
(1) effectively connected with the conduct of a trade or business within the United States; and
(2) included or allowed in determining taxable income.
Qualified business income does not include:
(1) reasonable compensation that the business pays to the taxpayer for services rendered;
(2) guaranteed payments to a partner for services rendered; or
(3) to the extent provided in regulations, payments described in IRC §707(a) to a partner for services rendered.
If the net amount of qualified income, gain, deduction, and loss is less than zero, the loss is carried over to the next tax year. Thus, any QBI deduction allowed in the next tax year is reduced (but not below zero) by 20 percent of the carried-over loss.
Qualified trade or business. A qualified trade or business is any trade or business carried on by the taxpayer in the United States, other than: (1) the trade or business of performing services as an employee; or (2) a specified service trade or business.
A specified service business is a trade or business that involves the performance of:
• services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business whose principal asset is the reputation or skill of one or more of its employees or owners; or
• services consisting of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.
Planning Pointer Prior to the issuance of the "anti-abuse" rules, practitioner's considered a strategy to spin-off parts of a service business into independent qualified businesses (referred to by some as the "crack and pack" strategy). For example, in the case of a service business, such as a law firm or doctor’s office that owns the real estate the business operates from, the owner may wish to create a new entity to hold the real estate and then lease it back. This would have the effect of reducing the profits of the original business, which presumably were not eligible for the QBI deduction, and shifting profits to the new entity, where they could potentially be eligible for the QBI deduction.
A different strategy might involve employees instead of real estate or other depreciable property. For example, consider the treatment of nonlegal personnel in a law firm. What about the possibility of creating a separate entity to employ those persons and effectively leasing those employees back to the firm?
These attempts would be limited the adopted rules. If a trade or business provides property or services to a service business and there is 50 percent or more common ownership of the trades or businesses, the portion of the trade or business of providing property or services to the related service business is treated as a separate service business with respect to the related parties. QBI Deduction and Excluded Specified Service Business Income.
Net Operating Losses
When a taxpayer's deductible business expenses (including employee business expenses), flow-through losses from a partnership or S corporation, and casualty and theft losses (whether personal, business, or investment-related) exceed gross income from all sources, a net operating loss (NOL) has been sustained.
In tax years beginning after 2020, the NOL deduction for a tax year is limited to the sum of:
(1) the aggregate amount of unused net operating losses from tax years that began before 2018 that are carried forward to the tax year, plus
(2) the lesser of :
(a) the aggregate net operating losses arising in tax years beginning after 2017, carried forward to the tax year, or
(b) 80 percent of the excess (if any) of (i) taxable income computed without regard to the deductions under IRC §199A and IRC §250, over (ii) the aggregate amount of net operating losses arising in tax years beginning before 2018, carried forward to the tax year.
Comment Since NOLs are used in the order in which they arise, the 80 percent limitation will not come into play until all pre-2021 NOLs have been used up.
Any unused NOL is carried forward indefinitely.
Comment For tax years beginning after 2020, the carryback period is generally unavailable, with two exceptions. A two-year carryback will apply to the NOL or portion of an NOL attributable to a farming loss and to NOLs of non-life insurance companies.
Excess business losses treated as NOL carryforward. Effective for tax years beginning after 2020 and before 2029, excess business losses of a noncorporate taxpayer are treated as an NOL carryover to the following tax year. Therefore, such losses are not included in the computation of NOL for the current tax year.
The practical effect of this provision in many cases is simply to delay deduction of the disallowed loss one year. However, if the taxpayer does not have taxable income in the carryforward year (after offset by any other unused NOL carryforwards arising in earlier years), then the NOL carryforward deduction for the disallowed loss will be delayed until a tax year in which there is taxable income to offset.
Passive Activity Losses
In general, any deduction or credit attributable to a passive activity can only be used to offset income from a passive activity. Unused losses may be carried over to a subsequent tax year. Essentially, a passive activity is an activity in which the taxpayer does not materially participate. However, rental activity is treated as a passive activity regardless of whether or not the taxpayer materially participates, unless the taxpayer qualifies as a real estate professional.
In determining income from a passive activity, portfolio income (e.g., interest, dividends, annuities) is excluded. Likewise, expenses attributable to such income are excluded from the computation of loss from a passive activity.
Planning strategies. Although the passive activity loss rules can have a devastating impact on the ability to claim loss deductions, their effect can be mitigated by using the following strategies:
(1) Buy into an investment that generates passive income. Since passive losses can be deducted against passive income, this will allow a taxpayer to absorb the passive losses that would otherwise not be currently deductible.
(2) Buy working interests in oil and gas properties. A working interest in an oil or gas property held through an entity that does not limit a taxpayer's liability is not treated as a passive activity even if the taxpayer does not materially participate in the activity. Losses may, therefore, be deducted against other income. A working interest is one that is burdened with the cost of development and operation of the property.
(3) Acquire rental real estate. Taxpayers that actively participates in a real estate rental activities may qualify deduct up to $25,000 of its passive losses against nonpassive income.
(4) Become a material participant in the activity. Generally, an investment is not considered a passive activity if a taxpayer materially participates in the business. Material participation can be shown in a number of ways. If a taxpayer has substantial losses from a passive activity, it could be worthwhile to increase the level of the taxpayer's involvement to that of a material participant.
(5) Dispose of the taxpayer's entire interest in the passive activity. Passive losses may be claimed in the year the entire interest in the investment is disposed of by the taxpayer.
C Corporations. Normally, the passive loss limitations do not apply to C corporations. However, closely held corporations (e.g., those in which five or fewer individuals own more than 50 percent of the stock of the corporation) and personal service corporations are subject to these passive loss limitations. When shareholders who own more than 50 percent of the stock of a corporation materially participate in the activity, the corporation is treated as materially participating in the activity.
Employee Benefits
Businesses may directly or indirectly deduct certain employee benefits and other employee related expenses. These can include, among others:
• certain non cash fringe benefits, training costs, and employment taxes;
• employee welfare benefit plans;
• retirement benefits; and
• health insurance
Retirement Planning
A retirement plan established by an employer for employees may take many forms, such as a pension plan, profit-sharing plan, stock bonus plan, or annuity plan. Regardless of the type of plan, the primary tax advantages of a retirement plan are two fold:
(1) the employee escapes current tax on amounts contributed to the plan and on income earned on such amounts and
(2) the employer currently deducts its contributions to the plan.
Each type of plan is subject to a variety of restrictions. Some of the restrictions, such as the requirements governing plan coverage, are aimed at protecting employees from being discriminated against by the employer. Other restrictions, such as the limitations on amounts that may be contributed, set ceilings on the tax benefits that the employer and the employee may reap from the plan. Still others, such as the survivor annuity requirements, offer protection to an employee's spouse.
An employer must decide whether the advantages of establishing a qualified retirement plan, including such non-tax advantages as the ability to attract and retain employees, outweigh the statutory and regulatory burdens imposed on such plans.
There are two basic kinds of qualified retirement plans: defined contribution plans and defined benefit plans.
Defined contribution plans. Defined contribution plans provide for a separate account for each person covered by the plan. A defined contribution plan does not guarantee an employee a fixed level of benefits when the employee retires. Instead, the employer contributes a fixed amount to the individual participant accounts and the accounts rise or fall based on the trust fund's investment performance.
There are three major types of defined contribution plans: profit-sharing plans, stock bonus plans, and money purchase pension plans. A profit-sharing plan is a plan maintained by the employer to provide for employee participation in the profits. A stock bonus plan is designed to provide benefits similar to those of a profit-sharing plan, except accumulated benefits are distributable in the employer company stock. A money purchase plan is a pension plan designed to provide employees with benefits that will be paid upon retirement or for a period of years after retirement.
401(k) plans. An employer may set up a 401(k) plan that permits an employee to elect between receiving current compensation or having a portion of the compensation contributed to a qualified profit-sharing or stock bonus plan. A 401(k) plan offers an interesting tax-planning opportunity by providing increased flexibility in the form that compensation incentives may take. However, a 401(k) plan must be part of an otherwise qualified profit-sharing or stock bonus plan and, therefore, is generally subject to the same requirements, in addition to other restrictions.
Defined benefit plans. Defined benefit plans are plans, such as pension and annuity plans, that are not defined contribution plans. In general, contributions to such plans are based on actuarial assumptions that provide for a set benefit for each participant.
SEP and SIMPLE plans. There are also several types of plans that have fewer restrictions than defined contribution and defined benefit plans. These include simplified employee pensions (SEPs) and Savings Incentive Match Plan for Employees (SIMPLE) retirement plans.
A SEP is an arrangement under which an employer makes contributions to the IRAs or individual retirement annuities of its employees. Self-employed individuals may participate in SEPs.
An employer with no more than 100 employees earning at least $5,000 annually may establish a SIMPLE retirement plan. A SIMPLE plan may be part of a qualified 401(k) plan or it may take the form of contributions to IRAs established for the participating employees.
SIMPLE plan vs. qualified plans. The following is a comparison of the most important features of a SIMPLE account arrangement with the most important features of qualified plans.
Complexity. SIMPLE plans have less complexity and administrative costs.
Mandatory employer contributions. SIMPLE plans generally require employer matching vested contributions up to a certain amount. Defined contribution plans do not require employer contributions.
Number of plans. An employer may ordinarily maintain two or more qualified plans. However, an employer who chooses to establish SIMPLE plans may generally not maintain any other qualified plan
After-tax contributions. Many qualified plans permit employees to make after-tax contributions. SIMPLE plans may not receive such contributions. Both qualified plans and SIMPLE plans may place restrictions on when an employee may withdraw vested benefits from the program. Except as a substitute for matching contributions, an employer may not make nonelective contributions to SIMPLE accounts.
Top heavy rules. Top heavy rules apply to qualified plans, but not to SIMPLE accounts.
Rollovers. Eligible rollover distributions from a qualified plan may be rolled over to any such plans or arrangements. A distribution from a SIMPLE account may be rolled over to another SIMPLE account at any time or, after two years, a qualified plan. However, a distribution from a qualified plan may not be rolled over to a SIMPLE plan.
Taxation of distributions. Non-rollover distributions from a SIMPLE account are taxed under the same rules that apply to distributions from conventional IRAs and SEPs. The tax on excess distributions likewise applies to distributions from SIMPLE accounts.
Minimum distributions. A SIMPLE IRA is generally treated in the same manner as any other IRA and is subject to the minimum distribution requirements that apply to IRAs.
Employer's deduction for contributions. The 25 percent of compensation limitation and the carryover rules that apply in the case of the employer's contributions to a qualified plan or SEP also apply in the case of employer contributions to a SIMPLE account arrangement.
Timing on contributions. A qualified plan must be in existence on the last day of the tax year in order for contributions made during the grace period to be deductible for that year. An employer may establish SIMPLE plan after the end of the tax year and the grace period will still apply.
Health Insurance
Employer premiums for medical, sickness, accident, hospitalization and disability insurance are generally deductible. A self-employed individual may deduct medical insurance premiums as a business expense or personal itemized deduction.
Cafeteria Plans
Under a cafeteria plan, participants may choose among two or more benefits (specified by the plan) consisting of cash (a taxable benefit) and at least one qualified nontaxable benefit. Typical nontaxable benefits available under a cafeteria plan include dependent and health care spending accounts, health plan coverage, and group-term life insurance. Contributions to a cafeteria plan are neither taxed when paid nor when received in the form of a nontaxable benefit.
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