What you paid for your assets and how the Internal Revenue Service values them are not the same considerations, but taxpayers often don’t know the difference.
“This is not the kind of thing you run into every day,” says Thomas H. Ahlbeck, CPA, managing director at SS&G’s Des Plaines, Ill., office. “Some people might only run into this complexity a couple of times in their lifetime.”
However, the wrong basis can add thousands of dollars to your taxes, so it’s important to understand how this can happen, especially as your net worth grows and affairs become more complicated.
Smart Business spoke with Ahlbeck about how to get a handle on this important, but nebulous, accounting concept.
What is basis?
Basis is what the IRS uses as your asset value for determining your gain/loss or taxability of a transaction. For example, if you bought a common stock but don’t know or cannot prove your purchase price, you might have to enter the basis as zero even though you paid significantly more. You’ll pay more taxes on the proceeds you receive — or not be able to write off a loss if the security is worthless.
What is the biggest problem area for figuring basis and how can it be detrimental for your taxes?
Taxpayers are losing a small fortune with nondeductible individual retirement accounts. IRAs can be problematic because you pay thousands of dollars into an IRA and the basis is not easy to track. When people put in after-tax contributions to their IRAs, they might not be keeping track or telling their accountant as it doesn’t have anything to do with their current taxes. Later, unless you can prove those were after-tax contributions, you’ll have to pay taxes on the money again when you take it out.
Once you’re making withdrawals from the IRA, the nondeductible contributions are taken as a percentage of every withdrawal. So, if you put in $100,000 of after-tax dollars originally and the account grows to $150,000, then only two-thirds of that is not taxable and a third of each withdrawal will be taxed.
How is real estate another area where basis is often wrong?
Real estate is another neglected area for basis — particularly primary and secondary residences where accountants aren’t completing a depreciation schedule. Today, many homeowners look at the current market and assume their home will never appreciate. Therefore, they don’t keep records of improvements, which should be added to the basis to narrow any gains when it comes time to sell in 10 or 20 years. This is even more critical for a vacation home because you don’t get the $500,000 exclusion of taxable gain that you might get on your primary home.
Real estate transactions, by their very nature, are held for a sizeable length of time, making it difficult to keep all the records. Your basis can be further complicated because the land and building are held as separate values and the land’s original value is often forgotten when configuring basis for a sale years later. If a property goes through a bankruptcy or debt forgiveness, those also will change the value of the basis.
Another problem is when inheriting or gifting occurs because, again, records can be lost. If someone inherits real estate, the basis value is stepped up to the current market value, which is why an appraisal needs to be done at the time of death. The idea of the increased value, which can happen for no other reason than inflation, is to counteract estate taxes.
However, if a property is gifted, the value of the basis is what the original owner paid for it. Therefore, if a couple jointly own property and one spouse dies, half of the basis will stay at the original purchase price, while the other half will be stepped up to the date-of-death value.
What can you do to prevent some of these difficulties?
The simple rule of thumb is to know the basis of all your assets at all times, meaning what you can use as value against the selling price in the eyes of the IRS. Know what will change the character of an asset, such as when a personal residence becomes rental property. There’s a lot of logic to basis, but with fair market value of property, the contract cost, debt involved, after-tax dollars, inheritance and gifting, the original basis can be confusing and even change without you realizing it.
You also might not recognize the tax consequences of your actions. For example, if you bought a stock for $10,000, you also need to keep track of the reinvestment because it becomes part of the cost to give you a higher basis.
Don’t assume your financial adviser or accountant is tracking basis. If they are, keep an eye on it to ensure they are doing so correctly. Many financial advisers now are tracking basis for stocks and mutual funds, especially with new rules from the IRS, but there can also be basis issues and related loss limitations with a closely held corporation or a partnership.
Know what records you need to have and how long to keep them. When someone gifts you a vacation home, you might not think that you’ll need the paperwork stating what the home originally cost. A lot of people think they only need to save three years of tax records before they throw them out. But as long as the transaction hasn’t been completed, it needs to be tracked.
Thomas H. Ahlbeck, CPA, is a managing director of SS&G’s Des Plaines, Ill., office. Reach him at (800) 869-1834 or TAhlbeck@SSandG.com.
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When a company assumes the role of payroll administrator, there are considerations to protect the assets of the company from risk related to various employment taxes.
“There are several circumstances that may cause a company to run the risk of becoming noncompliant or considered evasive of employment withholding tax obligations, requiring employers by law to withhold taxes from their employees, including federal income taxes and other taxes required by the Federal Insurance Contributions Act such as Social Security and Medicare taxes,” says Walter McGrail, senior manager, Cendrowski Corporate Advisors LLC.
Although not discussed here, these same requirements apply to other employer taxes such as FUTA and taxes required by any states.
Smart Business spoke with McGrail about employment tax risks and what companies can do to mitigate them.
What are employment tax risks, and are they a realistic issue?
Companies are required to withhold taxes and remit them to the Internal Revenue Service via an authorized financial institution, as established by the Federal Tax Deposit Requirements. When the taxes withheld are not remitted, or not remitted in a timely manner, the company may be liable for penalties, interest, or, in the case of proven evasion, prosecution. Noncompliance may result in penalties and interest, whereas evasion may subject the responsible parties to criminal and civil sanctions
According to the IRS, for fiscal years 2009 to 2011, it initiated approximately 500 investigations into employment tax evasion. Of these cases, more than 40 percent were investigated, recommended for prosecution, indicted and ultimately sentenced. Additionally, of those sentenced, 80 percent were incarcerated by means of either federal prison, halfway house, home detention, or some combination, lasting an average of nearly 24 months.
These penalties are most commonly levied against the responsible parties, including, but not limited to, corporate officers, shareholders, members and partners.
What are the most common methods, or schemes, related to employment tax evasion?
There are several common scenarios that could result in evasion or simply result in noncompliance when it comes to employment taxes. The most common, according to the IRS, involve pyramiding, utilizing unreliable intermediaries to remit the tax and misclassifying wages or salaries based on worker status or officers’ compensation treated as distributions. Due to the lengths someone may go to in order to evade employment taxes, there is even a listed transaction related to employment and the use of offshore employee leasing to evade these taxes.
If employment taxes are automatically withheld, how can companies be put at risk?
Companies are at risk when withheld taxes have not been paid in a timely manner, as prescribed by the IRS. Fraud can be an integral part of employment tax evasion.
Pyramiding is one of the more common practices. This involves the employer not remitting the taxes and using the monies to cover other liabilities or operating shortfalls. If the employer continuously uses this practice to continue the operation of the company, the amount can accrue over time (pyramid) to the point where business operations cannot recoup the funds utilized and the company is left with a tax liability and no cash. The frequent result is the business going under.
Unreliable payers can also be an issue. A payer can be either a third party or related (someone employed by the company). Both types of payers can be instrumental in causing the company to be at risk of noncompliance.
Third-party payers generally fall into one of two categories: Payroll Service Providers (PSP) and Professional Employer Organizations (PEO). PSPs typically assume the role of payroll administrator and the responsibility for making employment tax payments and filing the appropriate employment tax returns. PEOs effectively lease employees and assume the role of human resources, managing the administrative, personnel and payroll functions for the company. Tax issues can arise when either type of third-party payer is in control of employment taxes or the company dissolves. This can leave employment taxes unpaid.
If the company utilizes an internal department or employee to pay employment taxes, there are different ways the company can be exposed to risk. One way could be rooted in fraud. If the payer were to pay taxes but not properly credit them to the company’s tax account, the company would still have an employment tax liability and no funds to pay the taxes owed.
Much like other frauds that involve payables, funds can be paid or transferred to a taxing authority while being applied to a different account. The company believes its tax liabilities are being properly paid and may not become aware of an issue for months or years.
How can companies safeguard against employment tax evasion and noncompliance?
There are no guarantees, but one way to reduce possible exposure is to exercise due diligence when engaging a third-party or related payer.
Monitoring is essential to the process. The company can insist on paying all federal taxes electronically, utilizing the Electronic Federal Tax Payment System (EFTPS), which allows users to access tax payment history to ensure payments were made and applied to the appropriate tax account. Additionally, verifying and matching the amounts paid against the information reported on the Employer’s Quarterly Federal Tax Return (Form 941) can aid in reducing noncompliance and the possibility of employment tax evasion.
Additionally, ask your CPA to look at wages and related withholdings as part of the tax return preparation for your company.
Walter McGrail, CPA, is senior manager of Cendrowski Corporate Advisors LLC. Reach him at (866) 717-1607 or email@example.com.
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The number of small businesses is increasing, and as owners focus on growing their companies, many are overlooking available tax incentives.
“Capital is so important to a growing company to facilitate growth and ensure stability,” says Jeremiah E. Thomas, an associate with Kegler, Brown, Hill & Ritter. “However, small business owners often get focused on running their business and miss out on opportunities to qualify for programs that can ease tax burdens and reduce capital restrictions.”
He says it’s important to know what’s available so that you can maximize your access to money for the benefit of your business.
Smart Business spoke with Thomas about how to uncover government programs that can help ease your company’s tax burden.
Are funds readily available to small businesses?
There are many programs and incentives available, but some can be hard to obtain. While businesses may have the impression that there are easily accessible grants available, many of them are designed for very specific purposes and the average startup likely wouldn’t qualify. However, that doesn’t mean there aren’t other opportunities to lower costs through tax credits and intelligent tax planning on the federal, state and local levels.
What types of tax incentives are available for a new business?
The most easily available tax incentives may be federal tax incentives because, in many instances, they are automatic. Knowing which federal incentives you qualify for and accounting for them on your annual tax return allows you to access ‘easy’ money.
For example, there is relief on capital gains taxes if you own qualified small business stock. There is also the ability to immediately deduct from taxable income certain expenses for starting a business, and small businesses are able to use tax credits for providing health care, energy efficiency improvements, and research and development expenditures.
In contrast, a lot of state and municipal tax programs require some negotiation, for instance, with county representatives to get an abatement for real estate taxes. These credits are valuable, but they take extra steps and costs to receive the benefits.
How are some tax incentives ‘automatic’?
Receiving the benefits of a tax credit can be as simple as knowing the credit exists, factually qualifying for it and checking the appropriate box on your return to get the benefit — there’s no application process.
Also, some of the existing tax software can help automatically identify tax benefits by asking questions to determine if you qualify. However, squeezing every benefit out of a particular tax incentive is more complicated than reading the form. Consulting with attorneys and accountants is a great way to identify the applicable credits, especially with more complex ones.
Are there other incentives that are more valuable or more easily accessed?
Well, there are certainly other programs. There are Small Business Administration loans, with which businesses can take advantage of lower rates to borrow capital to grow, but those programs are pretty complex and take time to apply and qualify for. At the state level, another more complex option is the Technology Investment Tax Credit Program, which provides investors with a tax credit for the money they invest in technology companies. Small companies advertise to investors the ability to get 25 percent of their investment back from the state in the form of a credit. But in order for it to benefit the company, they have to find an investor and understand the credit. Then the investor has to apply and the company has to qualify to receive the benefit, so there are many moving parts.
The state also provides some loan programs and tax credits based on job creation. The state may lay out a number of milestones during negotiation that a company must reach for it to receive a tax credit or qualify for low rate loans.
Are there options for more mature businesses?
On the federal level, large and small companies can both benefit from good structural planning. However, there are certain federal tax incentives that are only available to small businesses, which can be outgrown.
At the state level, broadly speaking, it’s easier for a more mature business to take advantage of the tax programs that exist, as Ohio is more interested in backing companies that can create more jobs, while startup companies might only be looking to hire one or two employees and may need to rely on a narrower band of incentives, such as those focused on technology.
What is the key to finding incentives that work for your business?
The real key is thinking holistically. A business is subject to different taxes. The property you own is subject to real estate tax, but programs such as the Enterprise Zone Abatement Program allow municipalities to establish local development areas where qualified companies can locate and take advantage of real estate tax abatements. There are also a number of ways companies can minimize their sales tax responsibilities, such as Ohio’s research and development sales tax exemption.
It is important to think creatively about the sources of tax and have good advisers on the accounting and legal side to keep you apprised of changes in the law. You can also talk with your local development entities to uncover state and local incentives; these programs are great marketing tools for governments to show how successful small businesses are performing in their area.
Jeremiah E. Thomas is an associate with Kegler, Brown, Hill & Ritter. Reach him at (614) 462-5447 or firstname.lastname@example.org.
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In any economy, smart tax planning can protect income and provide opportunities for businesses to maintain their financial well being. In a tough economy, partnering with a tax professional who can help you devise a strategic plan can help you avoid surprises and can provide a critical advantage.
“We are in terrible financial times. There are lots of losses in the marketplace and income is down for many people,” says Cathy Goldsticker, member, tax services, Brown Smith Wallace LLC, St. Louis, Mo.
Rather than putting tax planning at the bottom of the agenda, start thinking about ways to cut your losses and gain tax advantages through deductions and other smart investment moves.
“There are important tax planning decisions that can be made now, and over the next year, that can give individuals and businesses more leverage as they weather the financial storm,” says Martin Doerr, member in charge, tax services, Brown Smith Wallace.
Smart Business spoke with Doerr and Goldsticker about smart tax planning strategies to consider implementing before the end of 2011, and what to be aware of for 2012.
When should a traditional IRA be converted to a Roth IRA, and what are the pros and cons?
If your traditional IRA has lost substantial value, consider converting it to a Roth IRA this year because the tax on the conversion is based on fair market value. Because that has dropped in 2011, the tax cost of the conversion will be lower.
The benefit of converting an IRA to a Roth IRA is the ability to grow the investment with tax-free earnings and later withdraw the money without paying tax. The flip side is recharacterizing a Roth IRA back to a traditional IRA if the Roth has lost significant value since making the conversion to a Roth. If the IRA was converted to a Roth IRA in 2011, it can be recharacterized in the same tax year. You have until the extended due date of your 2011 tax return to do this (Oct. 15, 2012).
On the other hand, if you are 59-and-a-half or older and the value of your traditional IRA has plummeted, consider liquidating the investment if the value is less than your tax basis (your nondeductible contributions), as doing so would earn you a miscellaneous itemized tax deduction.
There are many issues to consider, including the impact on AMT, so talk to your accountant about whether this strategy makes sense for you.
How can an investor make the most of stocks that have lost value?
Many people have stock market losses that will carry forward, and there may be no tax advantage in generating more losses in 2011. You might sell gain stocks to use up those losses, then repurchase them immediately. There is no ‘wash sale’ rule for gains.
The success of this plan depends on the investment portfolio, strategy and market view. Whether you think there is more appreciation left in gain stocks now, or you want to move out of those stocks and into different ones, if you have losses to use, there is effectively no tax when gain stocks are sold. And you will have higher basis in your stocks, which may be helpful if capital gain rates increase in the future.
How can someone take advantage of the $5 million gift exemption?
The current lifetime gift limit is $5 million per taxpayer, so a husband-wife household can take advantage of a combined $10 million tax-free gift. These limits apply to tax years 2011 and 2012, and, given the fluctuation of rules, this is a great opportunity for high-net-worth taxpayers to pass on their wealth to their children.
What tax benefits are available for 2011 capital purchases?
Now is the time to invest in qualifying business equipment and still realize the 100 percent bonus depreciation. New equipment such as technology, furniture and, in certain cases, leasehold improvements, can be written off. That makes 2011 a great year to put new equipment in service or make construction improvements. Bonus depreciation is scheduled to reduce to 50 percent for 2012, and, after that, it is not yet known if it will be renewed.
How do income tax rates for 2011 compare to potential rates in 2012?
Income tax rates are scheduled to remain the same, with slight adjustments based on the Consumer Price Index. However, if you have qualifying deductions, it’s best to use those in 2011 to realize tax savings sooner.
On the other hand, if you have income that can be deferred, it would be wise to defer that until next year and pay that tax later.
What planning can be done to minimize the Alternative Minimum Tax?
This burdensome tax can be an unpleasant surprise for many people. The AMT exemption, approximately $74,000 for couples in 2011, is up slightly from 2010 but is scheduled to drop considerably next year. Even with the larger exemption, care should be taken to capture and protect all of your tax deductions. For example, if you have substantial deductions and you are in AMT, consider deferring, if you can without penalty, state taxes, real estate taxes and investment expenses until 2012, since none of these is deductible against AMT.
However, if your 2011 regular tax is larger than your AMT, accelerate, if possible, payment in 2011 for state income tax, real estate tax and investment expenses.
Is charitable giving still a beneficial tax planning activity?
Whether or not you are subject to AMT, continue charitable giving if your heart is there for the organization. Assuming you still want to support the nonprofit, there are options. For example, if you are 70-and-a-half or older, you can make a donation directly from your IRA, which allows you to offset taxable income.
Martin Doerr is member in charge, tax services at Brown Smith Wallace LLC, St. Louis, Mo. Reach him at email@example.com or (314) 983-1350. Cathy Goldsticker is member, tax services at Brown Smith Wallace. Reach her at firstname.lastname@example.org or (314) 983-1274.
In today’s economy, news of mergers, spin-offs or reorganizations can energize businesses and financial markets. Small businesses can also take advantage of these techniques to merge with a complementary company, spin-off a high-flying division or reorganize their capital structure.
Smart Business spoke with David L. Musser, a partner with Nichols Cauley & Associates LLC, about how S corporations can grow their business through mergers, acquisitions or reorganizations and assess the best tax strategy to achieve this.
How does this tax treatment work for businesses?
The reorganization provisions of the Internal Revenue Code, which are primarily located in the IRC Sections 354, 355 and 368, allow a variety of tax-free transactions in the form of combinations, divisions and recapitalizations. The tax-free treatment of these types of transactions is based on the theory that the corporation has essentially continued its old business within the corporate structure, without distributing boot or assets to the shareholders, despite the various implementing sales and exchanges.
Stated another way, the tax-free reorganization provisions of the Code are intended to recognize that in some cases there simply has not been a sufficient change in the economic circumstances of the corporation and its shareholders to justify the imposition of an income tax.
How can corporations realize tax-free transactions under the Internal Revenue Code?
The Code’s definitions are concerned with the form of the transaction rather than its substance. Accordingly, form plays an important role in achieving the desired tax result. This does not mean the economic consequences of a transaction can or should be ignored. Tests such as ‘business purpose,’ ‘continuity of shareholder interest,’ ‘continuity of business enterprise,’ and the ‘step-transaction’ doctrine can be applied to disqualify what otherwise seemingly qualifies, under the technical requirements of the Code, as a tax-free reorganization.
If the transaction meets the requirements for a tax-free reorganization, the property, stock and securities passing between corporations involved in the transaction and the stock and securities passing to shareholders of the corporations can be received without recognition of gain or loss. The price to be paid for tax-free (tax-deferred) treatment of reorganization exchanges is in the basis carryover and adjustment rules.
What other factors should a corporation consider when pursuing a tax-free reorganization/recapitalization?
A tax-free reorganization is only one way to acquire the assets or stock of another corporation. A major difference between a tax-free and taxable transaction is that stock of the acquiring corporation is the principal if not sole consideration that can be conveyed in a tax-free reorganization.
Some factors should be considered when deciding whether an S corporation should purchase the stock or assets of a target corporation, or combine with the target via a tax-free reorganization.
- The effect on the S election of the acquiring corporation
- Restrictions on what can be purchased
- Consideration conveyed to the target
- The effect of the target’s existence
- Recognition of gain or loss
- Basis and holding period
Corporations should also consider the following when determining whether to pursue a stock purchase, asset purchase or reorganization:
- Target shareholders often prefer stock sales due to capital gain and installment sales treatment. It may be difficult or impossible if regulatory approval is required. A stock sale avoids the reporting requirements that apply to asset sales (IRS Form 8594).
- S corporations may prefer an asset purchase because it allows new basis for depreciation and eliminates exposure to pre-purchase claims against the target. Paperwork needed to document the transfer of the assets can be burdensome. As with stock sales, regulatory approval may be required.
- In reorganization, the S corporation generally succeeds to the target’s earnings and profits, which can lead to liability for the tax on excess new passive income and termination of the S election after three years. S corporations may also be exposed to built-in gains tax for appreciation assets obtained from the target that are sold within 10 years.
- A method even exists to buy stock but, under IRC 338(h)(10), elect to treat it as an asset purchase.
Are there other options for corporations to limit their tax burden?
Corporations should also consider the introduction of qualified Subchapter S subsidiaries (QSubs). A QSub is a corporation 100 percent owned by an S corporation that has made a valid QSub election for that subsidiary. In addition to being 100 percent owned by an S corporation, a QSub must be a domestic corporation that otherwise meets the basic requirements to be an S corporation.
A QSub is technically neither a C corporation nor an S corporation. Instead, a QSub is not treated as a separate corporation for federal tax purposes (although it is still treated as a separate corporation for other purposes). A QSub’s assets, liabilities, and items of income, deduction and credit are treated as owned by the parent S corporation.
Whether acquiring a company or reorganizing, these tax techniques are highly complex, so it is imperative that you seek a tax professional before proceeding.
David L. Musser, CPA, CIA, CFP, is a partner with Nichols Cauley & Associates LLC. Reach him at email@example.com or (404) 214-1301.