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Blake Christian
Blake Christian
Optimizing Tax Strategies in a Challenging Economy

While recent government statistics are indicating that the economy may be getting “less bad,” most economists believe we will experience more financial challenges this year before seeing any real signs of recovery.

May 28, 2009
by Blake Christian, CPA/MBT

The bright side of a challenging economy is that there are numerous tax-planning opportunities that are made even more beneficial in today’s economic environment. There are myriad ways to reduce taxable income or increase a book loss in order to maximize tax refunds. In addition, the combination of low capital gain rates, low interest rates and relatively low asset and business valuations offers a window of opportunity to transfer stock or assets to management, employees or family members in a tax-advantaged manner.

Following are three areas in which companies and entrepreneurs can maximize their income, estate and gift-tax planning during the current economic downturn:

  1. Asset and Business Valuations
  2. Since a large percentage of land, buildings, business assets and stock/LLC and partnership interests have decreased in value during the last two years, many businesses and equity owners will find this to be an excellent time to transfer assets or equity interests to executives, employees and consultants.

    1. Asset Transfers
    2. If a closely-held business owner wants to transfer partial ownership in an asset or business entity — for example, a C Corp may want to transfer a warehouse, corporate office building, to its shareholders. The current economic environment will generally result in a lower spread between fair market value and the tax basis in the assets. Therefore, the gain on a sale or distribution will be less than in prior years.

      IRC Section 311(b)(1) can trigger both a corporate level gain (equal to the difference between fair market value and tax basis in the asset) as well as a shareholder level gain equal to the fair market value (net of liabilities transferred) of the asset sold or distributed, so the lower the fair market value, the lower the corporate and shareholder level tax from both C and S Corps.

    3. Business Ownership Transfers  
    4. Values of corporate stock, as well LLCs and partnerships interests have also generally decreased in value. Therefore, this provides significant opportunities to:

      • Issue options, restricted stock or partnership/LLC units to key employees to preserve corporate cash and motivate employees.
      • Utilize IRC Section 83 (Transfer of Property in Exchange for Services) in order to allow the recipient flexibility in controlling the timing and type of income which is eventually reported upon vesting — or earlier if the recipient elects to accelerate income reporting with an IRC Section 83(b) election. Section 83 also allows the employer to claim a deduction equal to the amount of income reportable by the employee/recipient.
      • Allow employees to purchase stock while the value is more affordable — a qualified “Employee Stock Purchase Plan” [ESPP – see IRC Section 423(b)(1) and (2)] can provide for up to a 15 percent discount from fair market value of the company stock to further encourage employee ownership — thereby generating enhanced team building and company loyalty. There is no income inclusion required for the employee in connection with the discount offered under an ESPP.

In addition to minimizing the company’s cash outflow, these strategies position the recipient of the stock or LLC/partnership interests to secure capital gain income (current maximum 15% rate) versus higher-taxed wages (current maximum 35% rate).

Another strategy which has been made more attractive as a result of the lower economic values is a conversion of a C Corporation to S Corp status in order to minimize the long-term overall tax burden. The current low asset and stock values will generally minimize the IRC Section 1374 “Built-In-Gain” (BIG) tax exposure which can be triggered for periods following an S conversion. These BIG items are measured by the difference between fair market value and the tax basis in assets held on the conversion date and sold within the 10 subsequent years. The 2009 Stimulus Bill reduced the BIG tax measurement period from 10 years to seven years, but only for S conversions that originally occurred in 2001, 2002 or 2003. For S elections and appreciated property transfers from C Corps in carryover transactions occurring post 2003, the 10-year BIG measurement period will continue to apply.

Besides generally making the distribution of corporate profits more tax-efficient, a future sale of corporate assets is dramatically improved from a tax perspective since the basis in the S Corp stock is adjusted each year for profits, losses, distributions and shareholder loans and contributions. The overall tax burden resulting from the sale of C Corp assets, followed by a liquidation of the C Corp can result in as high as a 70 percent combined state and federal tax burden, while an S Corp asset sale and liquidation will generally limit the combined tax to 40 percent or less.

One caution is that both personal-level ordinary and capital gain tax rates will likely increase in 2009 or later years and Congress is continuing to evaluate the elimination of the current cap on FICA/Social Security based on W-2 (vs. combined W-2 and dividend distributions) on S Corp profits. Therefore the overall annual tax burden on S Corp profits may be closer to the C Corp tax burden in future years. However, the tax benefits upon sale of assets should continue to be much more beneficial for S Corps.

  1.  Minimizing Taxable Income/Maximizing Refunds
  2. While corporate management and corporate boards continue to strive to maximize their book profits and cash-flow, the current economic environment and tax planning opportunities afford taxpayers significant opportunities to accelerate deductions, defer income and claim various tax credits — ultimately minimizing taxable income and reducing their overall tax burden.

    • Any C Corp that has a tax loss in a given year can obtain refunds for the two prior years of federal taxes paid by carrying back their fiscal 2008 loss. For tax losses in 2008, businesses with less than $15 million of gross receipts can carry their fiscal 2008 (and only 2008) loss back for up to five years. S Corp losses can also create significant current and prior year tax benefits to the shareholders via reduction of current estimated payments and carryback of personal losses from S Corp K-1 loss flow-through for two to five years, depending on revenue level.

    Businesses can generate larger tax losses for unfiled or amended 2008 tax returns, by making certain elections such as IRC Section 179 expensing, bonus depreciation, cost segregation analysis, inventory write-downs and claiming partially or wholly worthless bad debt write-offs, proper expense accruals, etc. These combined tax deductions can have a very dramatic impact on a company’s reported tax losses and result in maximum federal refunds. Depending on the states you file in, state refunds may also be available.

    To expedite C Corp refunds from loss carrybacks, there are several methods which have different rules and refund acceleration provisions. In order of preference:

    • Form 4466 must be filed by the 15th day of the 3rd month following fiscal year end. If this deadline is not met;

    • Form 1139 should be used within the first 12 months of year end. If neither of these forms is filed to accelerate your refund;

    • Form 1120X can be filed. Refunds associated with Amended S Corps will be claimed on Form 1040X to report the revised S Corp K-1 taxable income or loss.

  3.  Estate Planning Opportunities
  4. The decreased value in asset and stock values, along with relatively low interest rates also makes this a perfect time for high net worth taxpayers to review their estate plans in order to position their estate and gift tax plans for tax minimization.

    By transferring ownership of real estate, stock or other assets to key executives, line employees or family members via sale, gift, trust, etc. or a combination of these options, transferors can minimize gift and estate tax obligations over the long term.

    Since it is likely that estate tax rates will be increasing post 2010, taking advantage of the current low asset values can ensure that a larger percentage of a decedent’s estate can be transferred in a tax free or tax minimized manner.

Conclusion

While the economic landscape is somewhat bleak, business owners should take this opportunity to refine their income, estate and gift tax planning for optimal long term advantage … but time is of the essence.

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Blake Christian, CPA/MBT, is a Tax Partner in the Long Beach, California office of HCVT, LLP. Christian is also Co-Founder of National Tax Credit Group, LLC.