04 . Outsmarting Uncle Sam

As 2006 comes to a close, it’s time to finalize year-end tax planning and start planning for 2007. The typical year-end tax advice for businesses that use the cash method of accounting is to defer income and accelerate deductions. However, there is more to tax planning than that. It also helps to keep on top of new laws.
During 2006 there were two tax laws enacted: the 2005 Tax Increase Prevention & Reconciliation Act, which was signed in May, and the Pension Prevention Act of 2006. The following questions provide some general tax planning ideas and will highlight the portions of tht new legislation that affect businesses. It’s important to consult a tax professional before taking any actions.

Is your business taxed as an S corporation or C corporation?

Although the tax rate on the first $50,000 of C corporation income is 15 percent, you are taxed twice on that income when it is paid out as a dividend. S corporation shareholders pay one level of tax at the individual level. In addition, if a business has a year in which there is a loss, S corporation shareholders, subject to limitations, can deduct those losses against other income they may have on their personal returns.

Which does your business use—Cash or accrual basis?

A cash basis taxpayer has more control of when income is recognized. In the past, if a business carried inventory, the business was limited to using the accrual method. However, certain small businesses are now allowed to use the cash method if their annual average gross receipts are less than $1 million or the inventory is not the focus of your business.

Are you planning on renovating or purchasing a new building?

You should consider a cost segregation study. This will enable you to depreciate different components of the building over shorter lives than it would if you depreciated the building as a whole. For example, a nonresidential building generally is depreciated over a 39-year life. However, a cost segregation study would analyze and reclassify certain portions of the building as equipment or fixtures with much shorter lives, such as five or seven years rather than 39 years. This would allow the taxpayer to accelerate the depreciation write-off and reduce the taxpayer’s taxable income.

Do you have a pension plan in place?

There are now more choices available to suit different business needs, including SEP/IRA, Simple 401(K), profit-sharing plans, and defined-benefit plans. There are also variations of plans, such as new comparability plans. Many of the new comparability plans, if well written, allow substantial contributions to the owner-employers while at the same time allowing for contributions to rank and file employees. Business owners should speak to a tax advisor or pension consultant. A census of the employer should be prepared by the pension consultant to determine which plan best suits the employer.

Are you considering computer/ equipment upgrades?

If your business needs to upgrade computers, furniture, equipment or even off-the-shelf computer software, 2006 and 2007 are the years to do it. Under Code Sec. 179, a taxpayer may elect to deduct in 2006 as an expense up to $108,000 of the cost of new or used equipment or furniture placed in service during the tax year. However, if your asset purchases exceed more than $430,000 in the year, this expensing is reduced dollar-for-dollar if the amount of property exceeds $430,000 for 2006. There are other limitations that may apply, so consult your tax advisor for proper planning.

Are you a manufacturer or a producer?

Code Sec. 199, which became effective in 2005, provides a tax deduction to U.S. taxpayers who manufacture or produce goods in the United States. For 2006, the deduction equals 3 percent of the qualified production activities income or taxable income for the tax year, whichever is less. The deduction increases to 6 percent in 2007, 2008 and 2009, and then to 9 percent after 2009. Under the new act the deduction is limited to 50 percent of the wages, which are deducted in arriving at qualified production activities income. The new law also repealed the special limitation on the amount of W-2 wages that may be taken into account by partners and S corporation shareholders. The changes are effective for tax years beginning after May 17, 2006.
Many businesses may qualify for this deduction even though they might not consider themselves manufacturers. For example businesses such as construction companies, engineering and architectural companies, producers of electricity, natural gas or water, film production, food and beverage companies and computer software companies might also be eligible.

Do you have musical copyrights?

If you have expenses in connection with creating or acquiring certain musical works and copyrights, you may elect to amortize those expenses over five years. This five-year amortization method is an alternative to the income forecast method of accounting for these expenses.
Regarding the Pension Protection Act of 2006, significant changes were made relating to pension plans and their beneficiaries. Changes were made to the funding and disclosure rules for defined benefit plans, conversions of pension plans to cash balance plans, liberalized payout and rollover rules, and more. In addition, changes were made regarding charitable deductions to prevent abuse and encourage more charitable giving. The details related to each of the areas are substantial and require consultation with a tax or pension advisor to determine if they affect you or your business.
There’s a lot to think about as the year comes to an end and you look ahead. As always, you should consult a professional to discuss your specific situation.

Alex Serrano, CPA, is the partner-in-charge of Citrin Cooperman & Company, LLP’s Springfield, N.J. office. He has spent the past 20 years solving the tax planning and strategic problems of both closely-held businesses and individuals, including representing their interests before the IRS. Fluent in Spanish, Serrano serves as an advisor to many Hispanic-owned businesses. Contact Serrano at 973-218-0500, or at aserrano@citrincooperman.com.