Chapter 16 Tax Planning Strategies – Business Entities

Tax Planning Strategies – Business Entities • What tax planning strategies are available to manufacturers and resellers of inventory? • Issues concerning how to compute ending inventories for purposes of calculating cost of goods sold. • Use of the LIFO method and the impact of the UNICAP rules under Code Sec. 263A. • What tax planning strategies are available to a business entity which purchases real and/or personal property for use in its trade or business activities? • Planning opportunities relating to the acquisition, use and disposition of such properties. • Such, as the use of accelerated depreciation, Sec. 179 expense, and bonus depreciation. • What planning opportunities are available to minimize corporate taxes? • Minimizing the corporation’s Alternative Minimum Tax liability and maximizing its Dividends Received Deduction.

Adopting and Changing an Accounting Method • What is the significance of adopting an accounting method? • Recently Congress has used accounting method rules as a means to broaden the tax base and raise revenues. • Further, the IRS takes the uncontested position that it has unlimited discretion when it comes to accounting methods. • Thus, the taxpayer faces stiff consequences for adopting improper accounting methods • What is an Accounting Method? • Accounting method is not defined anywhere in the Code or regulations, other than to say that the taxpayer’s taxable income should be computed according to the method of accounting (including the accounting treatment of any item) which the taxpayer regularly uses to compute book income. • In general however, an accounting method determines the timing of income recognition or expense deduction for a taxpayer. • How does a taxpayer adopt an Accounting Method? • Generally, by filing an income tax return adopting the method. • However, if a taxpayer wishes to change an accounting method, it must refer to Rev. Rul. 90-38, which states the Service’s position on changing methods. • A taxpayer using a permissible method of accounting is considered to have adopted that method by filing a tax return, and must seek IRS permission to change that method. • A taxpayer using an improper method of accounting is considered as having adopted the method by filing two returns (consistent use) and must seek IRS permission to change that method.

When Does a Change in Accounting Method Occur? • Pursuant to Code Sec. 446(e) a taxpayer who wishes to change his accounting method must first obtain consent of the Commissioner. • An application to obtain consent to change accounting methods is made on Form 3115 within the taxable year for which the change is sought. • Reg. §1.446-1(e)(3)(ii) authorizes the Service to promulgate the administrative procedures which must be followed to obtain the necessary consent, and this is has done through a series of revenue procedures, most recently Rev. Proc. 97-27 • The IRS has issued simplified and uniform procedures which provide automatic consent for certain accounting method changes if all administrative requirements are met. • A change in accounting method includes a change in the treatment of a material item (of income or deduction) within the taxpayer’s overall method of accounting. • Material does not refer to the size of the item, but rather its effect on the timing of income or deduction recognition. The slightest change in timing can be a change in method, requiring Service consent. • What transactions do not constitute a change in accounting method? • Answer: Those which are primarily corrections of a erroneously reported items: • Correction of errors such as math, or posting errors including an incorrect tax liability computation. • Correction of an estimate, such as bad debt estimates and depreciation useful lives. • Correction of an item not involving a timing issue such unreasonable executive compensation re-characterized as a disguised dividend. • Planning Query: A taxpayer changed its practice of shipping Valentine’s Day cards for the next year from October to December. It retained title to the cards until January of the following year as opposed to the time of shipment as had previously been done. Is this a change in accounting method? • Answer: In Hallmark, the court held that the change in reporting card sales was a change in the underlying facts and not a change in method (timing of income recognition).

Procedures for Changing Accounting Methods • The taxpayer must follow the procedures of Rev. Proc. 97-27 to change accounting methods, even if the old method is improper. • This revenue procedure focuses on voluntary compliance, attempting to make it more attractive by providing incentives. • The procedure provides longer spread periods for positive §481 adjustments (from one to four years.) • Provides audit protections. • Waives penalties associated with use of an improper method. • What is a Sec. 481 adjustment? • The §481 adjustment is designed to prevent the permanent escape of items of income and deduction from the tax base that could result from a change in accounting method. • When is the adjustment recognized by the taxpayer? • For voluntary changes, a positive adjustment may be spread over four years; for negative adjustments may be spread forward one year. • For involuntary changes, both positive and negative adjustments must be recognized in the year of change. • Why is it important to determine who initiated the change? • The §481 adjustment is cumulative and the impact of the change on income and deductions is not barred by the statute of limitations. • For involuntary changes, adjustments can be made for years up to and including 1954. • For voluntary changes, adjustment can be made for any year, including pre-1954.

Inventory Methods • What are permissible inventory methods for tax purposes? • Specific identification - A taxpayer who sells easily identifiable goods may use the specific identification method of valuing ending inventories at actual cost; where items of inventory are identified through accounting or production records, such as serial and invoice numbers. • FIFO (First-in, first-out) uses an order of cost flow that assumes the first unit purchased is the first unit sold. • LIFO (Last-in, first out) uses an order of cost flow that assumes the last unit purchased is the first unit sold. • What is the benefit to using the LIFO method? • This method is beneficial in times of inflation, as it increases the taxpayer’s cost of goods sold, thereby decreasing taxable profits. • What is an administrative difficulty encountered in using this method? • Applying LIFO to each item of inventory for a manufacturer or seller of multiple products would be cumbersome and costly; to rectify this problem the Congress amended the inventory regulations to allow for dollar-value inventory methods.

LIFO – Dollar Value Methods • What is the main advantage of dollar value LIFO inventory methods? • Under dollar value methods, inventory items are grouped into pools of goods reducing the cost of tracking inventories and minimizing the tax effects that may follow a liquidation of older and lower cost items. • Detailed purchase records for each item of inventory need not be maintained. • Decreases in one inventory item (valued at lower, earlier costs) can be offset by increases in other items through pooling and aggregation. • In general, the larger the number of inventory items in a pool the more advantageous. • Under the Dollar Value Method, ending inventory is calculated as follows: • A pool of inventory is first valued at base year prices. • Next, the difference between the beginning and ending balances in the pool is determined, as converted to base year prices; this constitutes the change in inventory. • An increase is added as a layer to ending inventory by multiplying the change by the current price index. • The current price index is computed as the current aggregate price of the ending inventory/ aggregate base year price for the ending inventory. • If a decrease is present remove a layer from inventory, at base period prices, starting with the most recent layer. • Two other simplified methods rely on price indices to determine the value of ending inventories: • Simplified Dollar Value LIFO Procedures - allows taxpayers to group inventories into multiple pools using either the 11 major categories of the Consumer Price Index (retailers) or the 15 major categories of the Producers Price Index (producers). These price indices are then used to value ending inventories. This method is available only to eligible small businesses. • IPIC Simplified Method per the Regulations - This method relies on inflation indices (the change in prices over the year) published by the Bureau of Labor Statistics (BLS): the CPI or the PPI.

UNICAP Planning Issues • The UNICAP rules under §263A re-characterize certain indirect period costs (that would have been expensed and not otherwise included in the cost of inventory) as product costs. • Certain taxpayers are exempt from the provisions of UNICAP: • Resellers of personal property with average annual gross receipts of $10 million or less in the three preceding tax years. • Other special exemptions. • UNICAP and §471 Inventory Costing: • Prior to the application of inventory capitalization rules under §263A, §471 applied to inventory costing and continues to apply to those businesses which are exempt from UNICAP. • What are §263A capitalizable costs? • Under §471 only direct materials, direct labor and indirect costs related to production, that is, factory overhead were required to be capitalized. • Expenses related to sales, office, or management activities were expensed. • Code Sec. 263A captures these expenses, such as mixed services expenses as production costs. • To avoid the retooling that would have been required to capture §263A costs, the UNICAP rules allow taxpayers to continue to use the regular absorption costing rules of §471 (and financial accounting inventory methods) and then add the §263A costs as an additional amount using simplified methods based on estimates. • Three simplified methods allow the taxpayer to retain its financial accounting inventory system with an adjustment to bring the inventory costs into compliance with the UNICAP rules.

Simplified Methods – Mixed Service Costs Adjustment • What are mixed service costs? • Mixed service costs are those labor costs which are allocable, in part, to production or resale activities (capitalizable) and, in part, nonproduction or non-resale activities (expensed). • What simplified methods are available to allocate mixed service costs between production and non-production activities? • Simplified Service Cost Method for Mixed Service Costs. • Producers can elect to use either a labor-based allocation method or a production cost allocation method. • Resellers can use only the labor-based formula. • The allocation methods are expressed through the following formulas. (Note mixed services costs are excluded from the calculation altogether). • Capitalizable service costs (Labor method) = Total §263A labor costs (allocable to production activities) / Total labor costs (total wage costs including production and non-production) * Mixed service costs. • Capitalizable service costs (Production Cost Method) = Total §263A production costs / Total costs (incurred by the company during the year excluding interest) * Mixed service costs

Simplified Production and Simplified Resale Method • Simplified Production Method - allows the taxpayer to compute inventory balances using the §471 rules and to add allocable §263A costs (other than interest) to ending inventory. • The portion of additional §263A costs which must be inventoried for the year is computed as follows: • Inventoriable additional §263A costs = Additional §263A costs incurred / Total §471 costs incurred * Code §471 costs in ending inventory (basically ending inventory valued under §471) • Simplified Resale Method - applies to resellers subject to UNICAP and calculates an additional §263A amount to be added to ending inventory based on either actual or historic absorption rates. • This method uses a combined absorption ratio which is the sum of the storage and handling costs ratio and the purchasing costs absorption ratio. • The storage and handling costs ratio = current year’s storage and handling costs / ∑ beginning inventory plus current purchases. • The purchasing costs ratio = the current year purchasing costs/ current year purchases. • Note: Service costs allocable to these functions must be included in the cost calculations; the taxpayer may use the simplified service cost method to determine this allocation. • What planning opportunities are available with §263A? • Reg. §1.263A-3(c)(ii) provides a safe harbor allocation rule for service costs associated with purchasing activities – the one-third/two-thirds rule. • Reg. §1.263A-3(c)(4)(vi) excludes distribution costs, such as loading dock costs, from capitalizable costs, and pick and pack activities • Taxpayers may choose to actually allocate all expenses required under the UNICAP rules, which may produce larger costs of good sold than the simplified methods.

Planning for the Acquisition of Personal property • What is personal property? • Personal property is defined as tangible property other than realty (land, buildings, and permanent structural components of buildings.) • What tax incentives are available on the acquisition of personal property? • One permanent credit exists for the acquisition of personalty - the business energy credit. • The taxpayer is permitted a credit for 30 or 10% of energy conservation expenditures involving solar or geothermal energy property. • Sec. 179 allows small businesses to elect to immediately expense up to $250,000 of the cost of personal property acquired during the year. • There is a dollar for dollar reduction in the amount of the allowable deduction if total personalty placed in service during the year exceeds a maximum ($800,000 in 2010). • There is also a taxable income limitation, which limits the taxpayer’s §179 expense deduction to the taxpayer’s trade or business income for the year before any §179 expense deduction. • A temporary 50% bonus depreciation deduction is permitted for original use property placed in service during 2010 with a MACRS recovery period of 20 years or less.

The Use and Disposition of Personalty • Cost recovery methods • The taxpayer has any number of choices in the method used for cost recovery. • However, most use MACRS. • Note there is an AMT adjustment for property depreciated using the • MACRS 200 declining balance method. • There is no AMT adjustment for amounts taken as §179 expense. • A unique planning opportunity is presented by the interplay of the mid-quarter convention and the Sec. 179 expense deduction. • For property placed in service in the fourth quarter the cost or the part of the cost of which is expensed under §179, this expensed amount is not included in the 40% calculation (numerator or denominator) for purposes of determining whether all property must be depreciated using the mid-quarter convention. • Dispositions of Personalty • The disposition of personal property used in a trade or business is subject to deprecation recapture under Code §1245.

The Acquisition of Realty • What tax incentives does the acquisition of real property offer? • Two tax credits – the rehabilitation credit and the low-income housing credit. • The rehabilitation credit offers taxpayers a 10 (for historic structures) or 20 (for buildings placed in service prior to 1936) percent credit on qualified rehabilitation expenditures incurred in rehabbing old buildings. • Qualifying expenditures must be incurred within a 24 month period and exceed the greater of (1) $5,000 or (2) the cost of the building. • At least 75% of the external walls must be retained as either internal or external walls and 50% of external walls must be retained as externals. • Rehabilitation expenses are included in the basis of the property less 100% of the credit. • A portion of the credit may be recaptured if the building is sold within 5 years; the credit is earned ratably 20% per year. • Low-income housing credit offers developers of low-income housing a credit on that portion of the building (not land) rented to qualified low-income tenants. • This credit may be taken repeatedly over 10 years as long as the units remain rented to low-income tenants. • The credit is subject to recapture for a 15 year period. • Owners must sign a commitment letter to keep the housing low-income housing for 30 years. • There is no basis reduction for the credit. • Occupancy and rental gross income tests must be met. • The credit rates are adjusted monthly to reflect current interest rates to yield either a 70% or 30% present value return on investment. • The current credit rates are approximately 9% for new, non-federally funded, housing or substantially rehabilitated housing or 4% for new housing financed through government or tax-exempt subsidies).

The Use and Disposition of Realty • What cost recovery methods are available for real property? • Cost recovery for realty is computed on a straight-line basis with a 27.5 year recovery period for residential realty and 39 year recovery period for non residential realty. • Taxpayers should consider cost segregation studies to isolate elements of a building’s cost and to reclassify them as depreciable personalty or improvements with cost recovery periods of much less than 27.5 years, usually 15 or 20 years. • The IRS has acquiesced to this procedure through a number of pronouncements, most notably, Rev. Proc. 2002-9. • Rev. Proc. 2002-9 permits a taxpayer to treat a change in an asset’s cost recovery period as an automatic change in accounting method. • Dispositions of Real Property: • Gain on the sale of real property is subject to depreciation recapture under §1250 to the extent that accelerated cost recovery deductions exceed straight-line recovery. • As all realty is currently depreciated using straight-line §1250 does not yield recapture. • However, corporate taxpayers are required under §291 to treat 20% of their accumulated straight-line depreciation as ordinary income on sale.

Planning for the Corporate Alternative Minimum Tax • Many corporations are not subject to AMT, why? • In 1997, Code Sec. 55(e) was enacted to exempt corporations with average annual gross receipts of $7.5 ($5 million for start-up companies) million or less from the AMT. • In many respects planning to minimize the corporate AMT is similar to that of planning for individual AMT. • What differences exist? • The corporate AMT rate is a flat 20%. • The AMT exemption is $40,000 less AMTI in excess of $150,000. • The AMT credit is not limited to timing differences; thus the AMT credit carryover is the AMT for the year. • The AMT credit may be used against regular tax liabilities in future years limited to the tentative minimum tax liability for the carryover year. • Some corporate AMT adjustments include the following: • Slower cost recovery periods for assets. • Differences in the gain or loss on the sale of those assets due to different regular and AMT asset bases. • Private activity bond income is a tax preference item. • Investment interest expense is adjusted for the inclusion of private activity bond interest in AMTI. • The largest AMT adjustment for corporations is the ACE adjustment. • ACE (adjusted current earnings) approximates financial accounting income with some tax breaks retained. • The adjustment is equal to 75% of the excess of ACE over AMTI. • Negative ACE adjustments are allowed only to the extent of post-1989 positive adjustments; however, positive adjustments may not be offset by prior year negative adjustments. • ACE does not permit installment sales of non-dealer property which exceed the taxpayer’s applicable percentage of such sales per Code §56(g)(4)(D)(iv). • The applicable percentage is defined in Code §453A as that portion of total installment sales (including only those that exceed $150,000) that exceeds $5 million.

Planning for the Dividends Received Deduction (DRD) • What is the DRD and what purpose does it fulfill? • Code §243 permits a corporate taxpayer to deduct a percentage of dividends received from other corporations to prevent several tiers of tax on the same earnings. • For corporations whose stock ownership is less than 20% of the outstanding stock, the deduction is limited to 70% of dividends received. • For corporations whose stock ownership is between 20% and 80% of the outstanding stock of the corporation, the deduction is 80% of dividends received. • For corporation’s whose investment is greater than 80%, a 100% deduction is allowed for dividends received. • The deduction may be further limited by the taxpayer’s taxable income. • For taxpayers who receive only a single tier of dividends, that is 80% or 70%: • The actual DRD is the lesser of (1) 80% (or 70%) of the dividend received or (2) either 80% (or 70%) of the taxable income of the corporation without regard to deductions for NOLs or capital loss carrybacks or the DRD. • In general, the full DRD is available if the corporation has positive operating income. • However, if the corporation has an operating loss, the DRD is limited by taxable income before the deduction for the DRD, NOL or CL carryback. • The exception: The taxable income limit does not apply, if the deduction (in full) is sufficient to trigger or add to an NOL, the full DRD is allowed. • Thus, corporations should consider increasing expenses or realize additional income if operating income is close to the DRD to avoid the taxable income limit. • Two tier dividend analysis - If the taxpayer receives both 80% dividends and 70% dividends the Code provides that the limits apply sequentially. • First the taxable income limit is applied to 80% deduction. • For purposes of this calculation 70% dividends are included in taxable income. • Second, the limitation is applied to dividends received from non-20% corporate investments. • For purposes of computing the 70% limitation, dividends received from 20% corporate investments are excluded as is the related DRD.

Chapter 16 Tax Planning Strategies – Business Entities