With so much confusion surrounding what’s going to happen with tax rates, business owners are facing more than the usual difficulty when trying to do tax planning for the 2010 year end. And, as a result of the recent election, the tax landscape has become even more uncertain, says Mark Klimek, a member at McDonald Hopkins LLC.
“While the recent elections provide some hope that scheduled tax rate increases will be revised or postponed, most people believe that tax rates are going up, especially for those at higher income levels,” says Klimek. “It is hard to predict exactly where tax rates are going to come out, but there is a good chance that 2010 will be the end of the 15 percent rate on dividends and capital gains, and lower individual income tax rates for high-income taxpayers. In light of this, there are different planning opportunities that business owners should consider given the uncertainty.”
Smart Business spoke with Klimek about strategies business owners should consider for 2010 to prepare for the changes in 2011.
Why should businesses be concerned?
More than anything else, taxes affect the bottom line of the business. In today’s environment, most businesses have cut costs as much as they can. If these businesses can save on taxes, the bottom line of the business can be improved without adversely affecting the business itself, the level of service provided to the customers or the quality of products. The complexity of tax laws often results in business owners overlooking opportunities to save on taxes and improve their bottom line.
What can businesses do now to take advantage of current rates?
The likely increases in tax rates will generally impact individual taxpayers, so businesses structured as S corporations or limited liability companies are more at risk, since the income from these types of businesses is taxed to their owners. One way to prepare for an increase is to consider accelerating income into 2010. While this is the opposite of traditional tax planning, which is to defer income, in an environment of rising tax rates, deferral means that income will be taxed at higher rates in subsequent years.
Instead of accelerating income, a company could consider deferring deductions. Some provisions in recent tax legislation allow for faster depreciation of capital assets that were purchased for the business. A business may want to consider not taking that accelerated depreciation, instead deferring it to a later year. There may be other deductions you could put off until 2011, when you may get a bigger tax break.
C corporations do not, at least for now, appear to be subject to the risk of substantially increased rates in 2011. These types of businesses may want to accelerate compensation payments, such as year-end bonuses to certain employees, to allow the employees to take advantage of lower rates in 2010.
How else can a company lessen its potential tax burden?
If the business is a corporation and there is cash available to pay dividends, consider paying them in 2010 at a 15 percent tax rate instead of at a rate that could go as high as 39.6 percent in 2011.
If the company does not have cash on hand and one or more shareholders still want to take money out of the corporation at 2010 tax rates, consider paying dividends or completing a redemption of stock with a promissory note. The taxpayer/shareholder can pay tax on the receipt of the note at 2010 tax rates, and the company can pay off the note the following year, or whenever it is able to.
Work with a financial adviser or accountant to carefully consider your options. You do not want the company to distribute a promissory note, for instance, if the company will be unable to pay it off for a number of years. If this is the case, the income tax on the income has been paid at lower 2010 rates, but if the shareholder is not going to get that cash for years, the benefit of lower taxes is lost.
Is there other legislation that is expiring at the end of 2010?
There are a few provisions that are set to expire at the end of 2010. These have a fairly narrow focus, but if they apply to your business, the impact of the expiration of these provisions ought to be considered.
The first has to do with businesses that are having financial difficulty and engage in certain types of debt restructuring. Usually, debt restructuring results in cancellation of debt income to the debtor. A provision in the 2009 tax act allowed businesses to defer this income until 2014, then pay the tax on this income over five years. This provision expires at the end of this year. If a business is considering or working on a debt restructuring transaction, it should consider triggering the taxable event by the end of the year. This is especially true if the business is structured as a partnership or an LLC, since these types of businesses cannot take advantage of certain other exemptions from cancellation of debt income.
The other provision that expires this year was just passed on September 27, and allows a shareholder to exclude 100 percent of the gain on the sale of certain stock if it is purchased by the end of this year and is held for five years or more. The exception is fairly narrow in that it is only available for newly issued shares in C corporations with assets of less than $50 million; you can not buy someone else’s stock and hold it for five years and get the exclusion. So if you were to put your money today in a qualifying C corporation and get issued new shares and hold the stock for five years, you would not pay any taxes when you sell it. One area where we are seeing businesses take advantage of this provision is where the business has been considering a stock incentive plan for key employees. Stock issued to employees would qualify for this exclusion, and provide a built-in incentive for the employees to stay with the business for at least five years. There are other requirements, so talk to your accountant or tax advisor if you are considering trying to take advantage of this exclusion.
Mark Klimek is a member at McDonald Hopkins LLC. Reach him at (216) 348-5453 or firstname.lastname@example.org.