CPA With a View

Frank is here

My new grandson Frank James was born on Feb. 17. Frankie is awesome. A beautiful 8.5 pound baby boy. Another tax accountant in the family. He received his first tax code on Feb. 18.

That makes 8 grandchildren; all under seven years old. What a blast. We were lucky enough to keep Frankie’s two sisters (Cami and Kiera) and his brother (Vinny) at our house while mom was delivering the new guy.

What a fantastic weekend.  Nothing better than family.

The Green Book is Out

The U.S. Treasury Department released the “General Explanation of the Administration’s Fiscal Year 2013 Revenue Proposal” (The Green Book-because it has a green cover). It is 200 pages of the Obama Administration’s proposal for changes in the tax law in 2012 and beyond.

A few of the proposals are highlighted below: 

• A tax credit for increased wages paid to employees.
• 100% bonus depreciation for 2012.
• Payroll tax reduction extension to the end of 2012.
• For years after 2013, repeal LIFO and lower-of-cost-or-market inventory valuation methods. LIFO reserves would be picked up in income over a 10-year period.
• Tax LLC and Partnership “profits interests” issued for services as ordinary income.
• Provides a variety of tax incentives for generating business and jobs in the U.S. and tax disincentives for transferring business and jobs outside the U.S.

Individual Tax Proposals beginning in 2013:

• Increase the highest-two tax brackets of 33% and 35% to 36% and 39.6%, starting when income equals $250,000 for a joint return and $200,000 on a single taxpayer’s return.
• Tax a portion of dividends at ordinary tax rates for high-income taxpayers.
• Increase long-term capital gains from 15% to 20% and add the Buffet Tax explained in my last BLOG post.
• Start itemized deduction and exemption phase-outs for high-income taxpayers.
• Limit the rate in which itemized deductions reduce taxes to 28% of the deduction for certain high-income taxpayers.

Estate and gift tax proposals:

• For taxpayers who die after 2012, the estate and gift tax rules would basically be what was in effect in 2009.  A 45% tax rate with a $3,500,000 Estate Tax and Generation-Skipping Transfer (GST) Tax  exclusion amount per person. Portability among spouses of the exclusion amount would still apply. The lifetime gift tax exclusion would be limited to $1,000,000. Currently, the exclusion amount for Estates, GST and gifts is $5,000,000 and tax rate is 35%.
• GRATs (grantor retained annuity trusts) would be required to have at least a 10-year term and generate some value in the remainder interest.
• New rules would greatly reduce the estate tax benefit of using Grantor Trusts, by coordinating the income tax and estate treatment of such trusts. This is a big deal.

The Green Book is truly a wish list by the Administration. Whether any or all of the items get enacted, will rest with the make-up and direction of Congress, after the election.  

We will see. It will be fun being involved in the process.

Fair Share Tax

The Paying Fair Share Act of 2012 (S-2059) was introduced to the Senate and referred to the Finance Committee by U.S. Senator Sheldon Whitehouse (D-RI) on February 1, 2012.

The goal of the bill is to reduce the deficit by imposing a minimum effective tax rate for high-income taxpayers.

The bill would add Section 59B to the Internal Revenue Code.  If it becomes law, it would be effective beginning in 2013.  It applies to individuals with adjusted gross income in excess of $1,000,000.  This includes all income, for example S-corporation or LLC pass-through income, and capital gains, including gains from the sale of one’s business.

The tax is basically a flat tax of 30% of total adjusted gross income less charitable contributions. The tax would be offset by certain self-employment taxes and payroll taxes incurred by the taxpayer, including the special Medicare taxes that become effective in 2013, pursuant to the 2009 Health Care Bill.

The tax is structured as a second additional minimum tax. The additional tax is the excess of the total tax under Section 59B; less the taxpayer’s regular tax and additional alternative minimum tax (AMT); and less certain credits and payroll taxes mentioned above. The additional amount is phased in for taxpayers with adjusted gross income between one and two million dollars. The full additional amount applies if one’s adjusted gross income is $2,000,000 or more.

For example, assume a taxpayer sold his/her business in 2013 and recognized a $3,000,000 capital gain and also had $400,000 of other ordinary income. In addition, assume itemized deductions for taxes, home interest and charitable deductions ($200,000) equaled $400,000.  In this example, the person’s regular and AMT tax would be approximately $475,000. Under the the Paying Fair Share Act there would be additional taxes of $365,000, calculated as follows:

$3,000,000 less $200,000 (charitable contribution) times 30% equals $840,000. Reducing the $840,000 by the regular and AMT tax of $475,000 results in the Section 59B fair share tax of $365,000.

What a hit for a small business owner who took major risks and created jobs over the years. You judge the fairness. You know my thoughts.

The good news is the S-Corporation Association is aware of the bill.  The Association understands how it impacts small business, especially flow-through entities like LLCs and S-Corporations, and will be working to educate Congress on the impact of this provision.

Also, based on my conversations with contacts in Washington, D.C., it doesn't seem likely this type of legislation could pass with the current make-up of Congress and the fact that it is an election year.  It truly seems to be a political play.  That's too bad.

More to come.

Caribbean

My wife and friends are back from the sailing trip in the Caribbean. Sounds like I should have joined them, relaxing and sailing for a week.  At least I got to walk my dog in the freezing cold in Minnesota four times a day.  There is always next year.

Passive Activity Rules – Part II

As I mentioned in my post last week, Internal Revenue Code (IRC) Section 469 states that losses from passive activities can only be deducted against income from passive activities or when the activity is disposed. Generally, passive activity is any trade or business owned by the taxpayer that the taxpayer does not materially participate in and/or any rental activity owned by the taxpayer.

Last week, I highlighted rules used to determine what is or is not 1) material participation or 2) a rental activity.  This week you’ll find special passive loss rules relating to the definition of rental operations, certain activities that are passive and non-passive, and grouping of activities.

Below are a few of the special rules:

1)      Special rules under Treasury Regulation 1.469-1T(e)(3) define what constitutes a rental activity and what is not a rental activity. Generally, the level of service provided with the property determines whether it is rental activity or not.

2)      The re-characterization rules in Treasury Regulation 1-469-2T(f) provide that certain activities are passive if they generate a loss, and not passive if they generate income (i.e. the worst of both worlds). The most common is a rental activity whereby the property is rented to an activity in which the taxpayer materially participates.

3)      The self charged interest (and guaranteed payments for capital) rules of Treasury Regulation 1.469-7 provide that interest income received by a taxpayer from a loan to a passive activity owned, all or part, by the taxpayer is passive income to the extent the offsetting interest expense of the activity is allocated to such taxpayer. The rules also indicate that interest income from a loan from a pass-through entity allocated to the lender is treated as passive income if the lender invested the funds in a passive activity.

4)      The grouping rules of Treasury Regulation 1.469-4(3), 1.469-4(f) and 1.469-11 must be reviewed to determine whether one can or must group certain business operations and rental operations under the passive loss rules. It may or may not be beneficial to group. One must look at their specific facts and circumstances in determining the proper course of action. I highly recommend looking at the rules before your tax return is complete to determine what makes sense and how you can reduce your disallowed passive losses.

5)      With regards to grouping business operations and rental activities, Revenue Procedure 2010-13 requires one to disclose new activities, new groupings and regroupings beginning with 2011 tax returns. Generally, once an activity is grouped (which includes not being grouped), it cannot be regrouped unless the original grouping was clearly inappropriate or a material change in the situation has occurred that makes regrouping appropriate.

The key is to review all business and rental activities to determine which, if any, of the rules apply and/or if you should be changing your grouping to minimize any negative impact of the passive loss rules.

Tax Season is Here-No Caribbean

Tax season is here. I love this time of year. Meeting with clients and bringing value. It gets really crazy busy, but it truly is a blast.  My wife and I had a tripped planned on a sail boat with friends in the Caribbean this week. Due to the time of year and the fun at the office, I pulled out of the trip last week and her friend is taking my place.

Now you truly know the real me. I would rather enjoy being with my team during tax season, than on a boat in the Caribbean. After tax season it is a different story, back on the water.

Passive Activity Rules - Review Your Status

Internal Revenue Code (IRC) Section 469 states that losses from passive activities can only be deducted against income from passive activities or when the activity is disposed. Generally, passive activity is any trade or business owned by the taxpayer that the taxpayer does not materially participate in and/or any rental activity owned by the taxpayer.

There are a variety of rules used to determine what is or is not 1) material participation or 2) a rental activity. Taxpayers and return preparers should review the rules each year to determine the correct classification (passive or non-passive) of the activity. Depending on the circumstances, one may want an activity to be classified as passive. For example, if the activity generates income, the income can be offset by other passive losses.

The basic rule is that one must participate more than 500 hours in a year to achieve material participation status. There are a few exceptions, see Treasury Regulation 1.469-5 and 1.469-5-T  for the rules.

Below are a few of the unusual rules relating to participation that may impact the classification of a business activity:

1)      When determining material participation in an activity, only participation when the activity is owned by the taxpayer counts. Therefore, if the activity is acquired or started late in the year, it may be difficult to meet the various hours-worked rules for material participation.

2)      If one is a limited partner in a limited partnership, the more than 500 hours of participation rule must be used to determine whether the partner passes the material participation event. LLC members may or may not be treated as limited partners under this rule, based upon the particular facts and circumstances.

3)      Participation by the taxpayer’s spouse counts as participation, even though the spouse has no ownership in the activity.

4)     If one materially participated in an activity 5 out of the last 10 years, they are considered to materially participate in the current year. The rule is 3 out of 5 years for Personal Service Activities.

5)     Time “on call” to perform service does not count as participation.

6)     All work and services provided count as participation except:

a) Work not customarily done by an owner won’t count if one of the principal purposes for doing the work is to obtain material participation status.

b)  Work performed as an investor not working day-to-day in the business is ignored. For example, reviewing financial statements or strategic plans in a non-managerial capacity.

7)      The executor or fiduciary of an estate or trust must materially participate in the activity for the activity to be considered non-passive to the estate or trust.

Next week, I will post some of the unusual rules relating to the definition of rental operations, certain activities that are passive and non-passive, and grouping activities into one.

The key is to review all business and rental activities each year and determine the proper status (passive or non-passive).  Then, work with your CPA to determine what can be done to classify them in the best way for tax purposes.

Grandma Turns 90

Sunday we celebrated Grandma’s 90^th birthday. Awesome Italian cook. I love her food. She gave me my awesome Italian wife. We celebrated at the boat house with 8 grandchildren and 18 great grandchildren. Pretty special day.

Stones Tour Rumor  

The rumors are picking up on a 2012 Stones tour. It would be a celebration of their 50^th year as a band. WOW would that be fun. Tax blogging from a Stones show. Can’t beat it.

Year-End Planning: Plan to Maximize Your Domestic Production Deduction

Businesses can claim a domestic production activities deduction (DPD) under Internal Revenue Code (IRC) Section 199 to offset income from domestic manufacturing and other domestic production activities.

The DPD equals 9% of the smaller of:

(1) the taxpayer's "qualified production activities income" (QPAI) or

(2) the taxpayer's taxable income (modified adjusted gross income, for individual taxpayers), excluding the DPD.

Qualified production activities eligible for the DPD include items such as:  the manufacture, production, growth or extraction of qualifying production property by a taxpayer in the U.S.; construction or substantial renovation of real property in the U.S.; and engineering and architectural services performed in the U.S. relating to the construction of real property.

The DPD can't exceed 50% of the applicable W-2 wages of the employer for the tax year.  The wages must be allocable to the taxpayer's domestic production activities, and they include tips and other compensation as well as elective deferrals to 401(k) and other plans. 

The DPD for oil-related activity is subject to a special reduction to QPAI.

It is important for businesses to calculate the tentative DPD and the W-2 deduction cap before year-end.  If the wage deduction cap will limit the otherwise available deduction, the business may want to pay or accrue additional compensation to maximize the DPD (for example, in the case of a closely held business whose owners do not draw substantial salaries).

Properly allocating expenses in determining QPAI is important. If activities don’t impact QPAI, the expenses related to the activity should not be allocated to QPAI. It’s worth spending time analyzing your activities and following the expense allocation rules which can be complex; it could increase the 9% DPD.

Also, if certain amounts are being paid to owners of pass-through entities (S-Corporations, Partnerships and LLCs), such as interest, rents, compensation; reducing these amounts generally has no impact on taxable income, but may increase QPAI thereby increasing the DPD.

The lesson is, don’t wait until tax preparation time to review your QPAI, review it before year end and determine how you can maximize QPAI and avoid the taxable income and wage limitation.

Holiday Kick-off Weekend

What an awesome Thanksgiving day and weekend. The  Christmas season is here. What a great time of year. My family loves it. This year our soldier son will join us. That is special. Time to get in the mood. Go get your tree. I can’t wait to hang up my Internal Revenue Code ornament.

Rumors on Gift Tax Law Changes

Unofficial comments are being made all over the Internet and the press that the Congressional Super Committee, in charge of the debt ceiling and deficit reduction project, may recommend reducing the 2011 and 2012 $5,000,000 lifetime gift tax exclusion back to the 2009 level of $1,000,000 effective November 23, 2011.  This is the date they are required to report their recommendation.

Hard to believe this may happen, but who knows. Anyone contemplating large gifts in 2011 and 2012 should talk to their advisors ASAP and monitor the committee’s action and press releases.

This is Congress back at making planning impossible. I will post any updates as they are released.

Year-End Planning: Research and Development Credit

If your business develops, designs, manufactures, fabricates, assembles or constructs products, you may qualify for the Internal Revenue Code (IRC) Section 41 credit for increasing research activities. 

The credit equals 20% of wages and supplies spent on qualifying research activities in excess of a base amount. The base amount is calculated using various historical research and development activity of the taxpayer. The 20% amount is reduced for certain alternative calculations and elections.  The credit generally will not be less than 7% of qualifying expenditures. In addition, several states have similar state level credits for research and development activity. 

The key to securing the credit is identifying activity that qualifies for the credit, documenting the project and substantiating the expenses incurred. 

Below is a list of activities that qualify for the credit:

• Developing a new or improved product or formula
• Developing prototypes
• Designing tool, molds and dies
• Testing new technologies and concepts
• Testing new materials
• Developing new and improved manufacturing, constructing and assembly processes
• Developing or upgrading software - special rules apply to internal use software

To determine whether activities may qualify for the credit, you need to answer “yes” to the following questions regarding a project:

1)    Did the activity relate to any of the following results?

• A new or improved function or product
• Improved performance
• Improved reliability
• Improved quality of a product
• Established the capability for developing or improving a product or process
• Established the method for developing or improving a product or process
• Determined the design of a new product or process

2)    Did the activity rely on any of the following sciences?

• Physical
• Biological
• Engineering
• Computer

3)    Were any of the following uncertain at the beginning of the activity?

• Capability of achieving the desired result
• Method of achieving the desired result
• Design or appearance of the desired result

I highly recommend implementing a system to identify and substantiate qualifying activities. You will maximize your credit and withstand IRS scrutiny.

It is not too late to figure out what you did in 2011 that qualifies. Do it now, don’t wait until your tax return is being prepared. You want to know the credit amount to assist in 2011 tax planning and projected tax calculations.

Also, many taxpayers amend tax returns to claim additional credits, once I explain what qualifies. This is limited to years where the statute of limitations has not expired (generally 3 years) and the taxpayer’s ability to document the project and substantiate the cost.

Finally, it is important to remember that S-Corporation shareholders, LLC members, and partners in partnerships 1) have limitations on the amount of the credit and 2) for those who do not materially participate in the business have an alternative minimum tax preference for research and development expenditures. Proper planning is a must in these situations.

Florida Boating

I spent a long weekend in Fort Myers Beach boating, relaxing on the beach and having fun at the Tiki bars.  First experience with my deck boat. I named her Miss You after the Rolling Stones song from the Some Girls album released in 1978. 

Now that I have been back home for a while, the name makes perfect sense. I miss being on the beautiful Gulf of Mexico listening to tax podcasts.  I will be back a few times before tax season starts and after tax season in May with all eight of my grandkids. Can't wait.

 

Year-End Planning for Inventories

Before year end, spend some time analyzing your inventory and costing methods to ensure the calculations and methods take advantage of tax saving opportunities in the Internal Revenue Code for inventory costing.

Lower of Cost or Market

Many taxpayers do not calculate the Lower of Cost or Market method correctly and miss appropriate inventory cost write downs. Most rely on the numbers from the audited financial statements, based on Generally Accepted Accounting Principals (GAAP), which do not necessarily apply the tax rules correctly. The rules for writing down inventory under the Lower of Cost or Market method or the subnormal goods method (which is a similar concept) are detailed in the Treasury Regulations under Internal Revenue Code (IRC) Section 471. Note that the Lower of Cost or Market method is not allowed if one is using the Last In First Out (LIFO) method.

LIFO

It is my opinion that many taxpayers shy away from LIFO because of the complexity. It is true that it adds additional work and complexity, but that may be outweighed by additional tax savings. Start with a simple calculation: Inventory cost times annual percentage increase (inflation) in inventory costs times your combined federal and state tax rate. For example, if you have $5,000,000 with costs increasing by 5% per year and a combined federal and state tax rate of 40%, LIFO will save you approximately $100,000 per year in taxes.

If you adopt it, the challenge is determining what inflation index to use or whether to calculate your own.  The IRS provides index based on industries and inventory items.

The tax law also requires one to use LIFO for financial reporting purposes if they want to use it for tax purposes. This may impact various items relating to the financial statement, like buy-sell agreements, bank covenants, earn-out calculations or bonding capacity. Most taxpayers add supplemental statements to their annual report that don't reflect LIFO. This is allowed under the tax rules. Many times the supplemental statements are used for the items previously mentioned.

Taxpayers are allowed to automatically change to the LIFO method any time before the extended due date of the return for the year they desire to change. The election to use LIFO is made on Form 970.

Don't wait until after year end to look at your inventory costing. There are several methods to choose from, two of which are mentioned above. Do it now before the end of the year as part of year-end tax planning. Determine what method makes the most sense for your business and tax goals.

Minnesota Boating Season

Spent the weekend on the house boat on the beautiful St. Croix River.  Boating season is coming to an end in Minnesota. Can't wait for my first trip to Florida in October to cruise around Fort Myers Beach. Back to reading tax articles and code on the beach and posting BLOGs from Florida.

Year-end Planning: Depreciation Asset Classification

A few weeks back I posted rules and reminders relating to bonus depreciation and 179 write off as part of the year-end planning process. I also recommend all businesses review their depreciation schedules each year to make sure the assets are classified correctly and not included in long-period depreciation classes. It is amazing to me how many times we look at new clients’ depreciation schedules and discover assets included in the 39-year class that can be depreciated over 5, 7 or 15 years. The IRS issued Revenue Procedure 2008-52, which allows taxpayers to correct asset classifications and catch up on depreciation in one year.

Below is a list of certain assets that qualify for short depreciation periods which are commonly misclassified for depreciation purposes.

• Canopies and awnings. Readily removable equipment or apparatus used for providing shade or cover. Includes canopies that are largely decorative, but not canopies that are an integral part of a building's structural shell.
• Decorative millwork. This is decorative finished carpentry, examples of which include detailed crown moldings, lattice work placed over finished walls or ceilings, and cabinets. Decorative millwork serves to enhance the overall décor of the business and is not related to the operation of the building. (Cabinets and counters in a restroom are excluded from this category.)
• Doors. Special lightweight, double action doors installed to prevent accidents in a heavy traffic area. For example, flexible doors, clear curtains, or strip curtains used between stock areas and selling areas.
• Electrical outlets. Only those outlets specifically associated with particular items of machinery and equipment (as opposed to operation of the building as a whole).
• Electrical connections. Special electrical connections which are necessary and used directly with a specific item of machinery or equipment or connections between specific items of individual machinery or equipment, such as dedicated electrical outlets, wiring, conduit, and circuit breakers by which machinery and equipment is connected to the electrical distribution system.
• Facades in interior of building. Facades, such as false storefronts, made primarily of synthetic materials (foam, fiberglass, cast stone, or glass reinforced concrete) that are not permanently attached and not intended to be permanent. This category would include false balconies, as well as finishes on interior columns that are not permanently attached and not intended to be permanent.
• Fire protection equipment. This includes special fire detection or suppression systems directly associated with a piece of equipment. For example, a fire extinguisher designed and used for protection against a particular hazard created by the business activity.
• Floor coverings. Only if not permanently attached and not intended to be permanent, such as vinyl composition tile installed with strippable adhesive, sheet vinyl, and carpeting.
• Foundations or footings, concrete. Foundations or footings for signs, light poles, canopies and other land improvements have a 15-year life.
• Heating, ventilation, and air conditioning (HVAC). The HVAC unit must meet the sole justification test. The sole justification for the installation is that it is required to meet temperature or humidity requirements essential for the operation of other machinery or the processing of materials or foodstuffs.  An HVAC unit may meet this test even though it incidentally provides for the comfort of employees, or serves, to an insubstantial degree, areas where such temperature or humidity requirements are not essential.
• Kiosks. These are small, often prefabricated, retail outlets that aren't permanent.
• Landscaping and shrubbery. This is landscaping (including irrigation systems) that will be replaced contemporaneously with a related depreciable asset or that will be destroyed when the related depreciable asset is replaced. Examples: depreciable landscaping, shrubbery, trees, plant foliage, or sod placed around a parking lot. Such assets have a 15-year life.
• Light fixtures, interior. These are light fixtures that are decorative in nature and not necessary for the operation of the building. In other words, if all the decorative lighting were turned off, the other sources of lighting would provide sufficient light for the building. These fixtures are 5- or 7-year property depending on the type of industry.
• Lighting, exterior. Lighting that highlights only the landscaping or building exterior (but not parking areas or walkways), as well as plant grow lights, that does not relate to the operation or maintenance of the building.
• Lighting, exterior, pole mounted. Outdoor lighting systems that are pole mounted or freestanding and serve to illuminate sidewalks, parking or recreation areas have a 15-year life.
• Music and public address (PA) system. Equipment and apparatus used to provide amplified music or sound; also includes wiring. Does not include a PA system that is an integral part of a fire protection system.
• Parking lots. Grade level surface parking areas built of asphalt, brick, concrete, stone or similar material have a 15-year life. This category includes bumper blocks, curb cuts, curb work, striping, landscape islands, perimeter fences, and sidewalks. However, in a Coordinated Issue Paper, the IRS has said that open-air parking structures providing multi-level parking accessed by a ramp system are structures and therefore are depreciable over 39 years. IRS's stance on stand-alone open-air parking structures is to be contrasted with its more favorable view of parking towers consisting of an auto carousel mechanism and supporting tower structure. IRS Private letter ruling 9751010 says that such towers are tangible personal property for purposes of the depreciation rules.
• Poles and pylons. Light poles for parking areas and poles used in concrete footings or bolt-mounted for signage have a 15-year life.
• Plumbing and similar hookups. Water, gas, or refrigerant hook-ups, if directly connected to appliances or equipment needed for a particular type of business.
• Security equipment. Includes electronic article surveillance systems including surveillance cameras, recorders, monitors and related equipment, in which the primary purpose is minimization of theft in retail areas.
• Signs. Interior and exterior signs used for display or theme identity, and any signage not pertinent to the operation of the building. Does not include exit signs.
• Site grading. The following assets have a 15-year life:

... Clearing, grading, excavating and removal costs directly associated with the construction of sidewalks, parking areas, roadways and other depreciable land improvements.

... Site work, including site drainage, sewers, roads, sidewalks, paving, curbing, general site improvements, site fencing and enclosures, and other site improvements not directly related to the building.

... Patio stonework embedded in the ground and applied to exterior half walls that are not an integral part of the building's structural shell.

• Walls, if movable. These are interior (partition) walls built so they can be (1) readily removed and remain in substantially the same condition after removal as before, or (2) moved and reused, stored or sold in their entirety.
• Wall coverings. Includes strippable wall paper and vinyl that causes no damage to the underlying wall or wall surface.
• Window accessories. Window accessories such as drapes, curtains, louvers, post-construction tinting that is readily removable, and interior decorative theme decor.

I recommend you review your depreciation schedule with your accountant and calculate how much additional depreciation, if any, you can take this year.

Boat House Swimming

Spent the morning swimming at the boat house condo indoor pool with Patrick (6), Max (4), Jimmy (3) and Jack (1). My four grandsons given to me by my daughter. They are awesome. I am exhausted from throwing them up, splashing around and swimming with them hanging on me. Now relaxing by the pool reading the weekly tax alert. What a way to start my day. I am so lucky.

The ESOP/S Corporation Structure May be Perfect

I attended the Employee-Owned S Corporations of America (ESCA) Annual Event in Washington, D.C. this week.  ESCA's purpose is to protect, improve and encourage the ESOP/S Corporation structure. Check out their website at http://www.esca.us/.

I love attending the event.  It reminds me how great the structure is and what good it does for a company's stakeholders, especially employees.  I should not have to be reminded, the accounting firm I am part of is an ESOP/S Corporation.

Background:  An ESOP (Employee Stock Ownership Plan) is a qualified retirement plan required to invest primarily in the stock of the company establishing and sponsoring the ESOP. Many times such stock is the only investment held by the plan.  The plan is subject to the rules applicable to most retirement plans in the Internal Revenue Code (IRC) and the Employee Retirement Income Security Act of 1974 (ERISA).  In addition, both the IRC and ERISA have special rules only applicable to ESOPs.  In most situations the plan does not pay tax on income earned from its investments.  It is tax exempt under IRC Section 501.  An S Corporation is a U.S. corporation that elects to be taxed under Subchapter S of the IRC. Subchapter S provides that the income earned by the corporation is not taxed to the corporation, but is allocated (not necessarily distributed) as income taxable to the shareholders. The allocation is based on each shareholder’s percentage ownership. To the extent the shares are owned by an ESOP, its allocation of the income is not taxed, because, as mentioned above, ESOPs don't pay tax on the income earned by its investments.

What an awesome situation if all the stock is owned by the ESOP.  No tax on the corporation’s income. A great incentive for employee ownership.

Sounds like a loophole. It’s definitely not. The participant will pay income tax on all distributions they receive from the ESOP, which includes the value created by the corporation's retained income.  No corporate tax and taxation when the ESOP accounts are distributed is consistent with the single tax structure for all S Corporations.

The real beauty of the structure is that it is one of the few things that Congress passed 1) with bi-partisan support, and 2) that works. The laws creating the structure were passed in 1997 and 1998.  President Clinton was in office and Congress was controlled by Republicans.  I was there and participated in the process.  It had significant bi-partisan support.

The structure allows businesses to retain more profits to create jobs and value for the employee owners. The ESOP is created and funded by the company, not from the employees’ paychecks. It provides retirement security for employees for generations and reduces their reliance on social security.  Studies show that ESOP companies are more productive and the owner employees have larger retirement plans than non-ESOP companies. Check out the website of NCEO at http://www.nceo.org/ for more information on these studies.

ESCA has been instrumental in helping craft and get legislation introduced to further promote the ESOP/S Corporation. The most recent of which is The Promotion and Expansion of Private Employee Ownership Act (H.R. 1244 and S. 1512) which was introduced to the U.S. House of Representatives earlier this year and was introduced to the U.S. Senate this week.  The bill includes four provisions that expand the benefit of the ESOP/S Corporation structure.

These provisions will:

• Encourage S Corporations to sell their stock to an ESOP, by allowing IRC Section 1042 tax deferred sales to apply to sales to ESOP/S Corporations
• Expand financing opportunities for the ESOP/S Corporation structure
• Provide added technical assistance from the Department of the Treasury relating to the ESOP/S Corporation structure
• Allow certain ESOP/S Corporations to maintain Small Business Status with the SBA

You can see a copy of the bill on our website or Google it "H.R. 1244 2011"

I believe every business, especially those going through the business succession process, should seriously look at the ESOP/S Corporation structure.  It may meet the needs and goals of both the current owners and employees.  It can't hurt to go through the exercise of looking at the feasibility of the structure for a company.

Tax accountant inside, not outside

My day was made in Washington, D.C.  I was having a drink in the Corner Bar, near the Treasury Department and White House, and met a lobbyist, Judy.  We talked about my reason for being in Washington, D.C. which was promoting ESOP/S Corporation tax legislation. We talked about her favorite tax code change, the Tax Reform Act of 1986 (a game changer for tax shelters). After chatting a while about taxes, lobbying and my favorite band the Rolling Stones, she stated that I sure didn't come across as a tax accountant.  That made my day.  Although one of my favorite things to do on this earth is to read tax code, regs, articles, rulings and cases etc. (i.e. be a tax guru nerd), I would hate to get picked out of a "guess his profession" line up as the tax geek.  Based on my ½ hour talk with Judy, I think I am okay for now.