Taxes in 2011: Wearing Down Your Green

The tax man cometh, and in 2011 he arrives with a vengeance. The Bush tax rate cuts will be allowed to expire for the wealthiest among us (increasing the maximum tax bracket from 35% to 39.6%), but that may be the least of the worries for the business class, which includes a lot of individuals earning $200,000 a year, and couples earning $250,000 who will be lumped in with the mega rich. The federal capital gains tax rate will rise from 15% to 20%, which accountants point out is actually a 33%, not 5% increase in the tax on investment income, and that’s in addition to the increases in state capital gains tax rates (Wisconsin’s has risen from about 2% to 5 %).

The feds alone could claim approximately 50% of every business dollar earned, claiming private-sector income that could be used for job creation, higher wages, and decent benefits.

Throw in measures to cap the tax value for itemized deductions such as mortgage interest and charitable donations to 28%; ensnare 28 million families (up from four million) in the Alternative Minimum Tax, which hits high-tax states like Wisconsin especially hard; usher in the return of the marriage penalty for the first $1 of income and some level of the death tax (most likely 55% on estates over $1 million); cut the child tax credit in half from $1,000 to $500 per child; and impose higher business taxes as a result of Obama Care — and you may want to run for cover.

Gordon Meicher, a partner in the accounting firm Meicher & Associates, said the problem extends beyond lumping small business owners in with the super rich. The tax increases illustrate a degree of economic illiteracy among the political class. “When you buy a business, especially when you buy common stock, you’ve got to repay your debt, and you don’t get a deduction for paying down the debt you’ve incurred to buy the business,” he explained. “So if you have $250,000 and you make another $50,000, you need that to pay debt. Well, if you’re giving the government half of it, you don’t have the money to pay the debt and expand the business.

“That’s why we don’t get job creation. It’s not only the lumping; it’s that they don’t understand what they are doing.”

Fortunately, there are things you can do to protect some of your wealth, especially if you’re willing to report income in 2010 in order to be taxed at the existing lower rates.

Normally, accountants tell clients to defer income and accelerate deductions; with the tax increases that already are baked into the 2011 federal budget, CPAs now are advising them to accelerate income and defer deductions until next year when rates are higher and the deductions are worth more.

These are definitely cash flow plays, but who better to have your cash — your company or Uncle Sam?

Tipping Their Tips

IB talked to Meicher and partner Jason Kadow, and Mike Scholz, tax director of Wegner CPAs, and Kim Anderson, tax partner at Clifton Gunderson, to identify 10 ways to protect your assets.

1. Convert to a Roth IRA.

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   As a business owner, you always want to maximize contributions to a retirement plan because once you get money into a retirement plan, those earnings are deferred. So if you’re going to convert to the Roth IRA, our tax professionals say 2010 is the year to take your Individual Retirement Account, no matter what your income level, roll those funds over to a Roth IRA, and pay less tax than if you make the conversion in a future year.

   “Let’s say you convert a $100,000 account,” Meicher stated. “They want you to pay tax on $50,000 each year forward for two years. We are paying all of the tax this year to make certain we have the lower 28% bracket. In the future, your income could be higher, and you could end up paying over 40% instead of 28% federal tax, and this income is added on top of your total other income. So what we’re doing with many clients that convert to a Roth is we are having them pay the tax this year even though they don’t have to.”

   Converting in 2010 locks in the tax savings for life because when you convert from a traditional IRA to a Roth, all of your earnings on that Roth IRA are non-taxable for the rest of your life, not deferred.

   Say you have a traditional IRA with $20,000 in it, convert it to a Roth in 2010 and pay tax on it this year, everything it earns in the future is yours, not the government’s.

   “The advantages of a Roth compared to a traditional IRA are one, no more taxes, and two, you don’t have to start taking it out when you are 70-1/2,” Meicher said. “Three, you can let your heirs inherit the Roth and they must take it out over their life expectancy. Essentially, you are getting up to a full lifetime of tax-free income, up to 60 to 80 years of investment earnings with no federal or state tax.”

   Not only can you get that money working tax free, you might in effect pay no taxes on the rollover, which are due in 2011 or 2012, if your business has reported losses. “If you’re a contractor with huge losses, it’s a perfect year to do Roth rollover if you still have some funds in your retirement account,” Scholz indicated. “If you do the rollover, that generally is taxable income but you can use other business losses to offset that, so in effect, you pay zero taxes on that rollover just because of where your business is, and other flow-through losses may offset that.

   “Sometimes, when given lemons, make lemonade out of it.”

   It still has to make sense to transform those lemons, however. “If someone is real close to retirement, it doesn’t make sense to pay all that tax right now,” Anderson said, “but if you have a ways to go …”

   Anderson also advised paying that tax from funds other than the Roth, otherwise you’re taking money out of your retirement stash to pay taxes. “You have to have enough money to pay that tax out of other funds in order for it to make sense,” she noted.

   Meicher believes that forcing this conversion in 2010 helps make the federal government temporarily look good. More taxes paid this year means a lower budget deficit.

2. Gain on capital gains.

   Capital gains are another example of taking your medicine (paying the tax) now while rates are lower, and saving your capital losses by engaging in the type of economic activity that trigger the capital gains tax. Otherwise, you’re simply harvesting tax losses.

   “This is something I’m doing personally,” Meicher said. “I’m taking my gains and paying all my tax this year. I’m actually forcing myself the last two years to pay more tax than I would because I’m going to be paying at a lower capital gains rate.”

   This means electing out of the “installment sale” when you sell part of your company. Rather than paying the taxes over several future years, when the rates will be higher, pay them now.
    

3. Conducting a cost-segregation study.

   According to Scholz, a great tax-planning strategy, especially for businesses that have purchased or built a building, is conducting a cost-segregation study. He noted that for the purpose of depreciation, buildings have a 39-year life.

   “This is when you buy real estate, you look at components of real estate, and if they have shorter tax life than the building, you can deduct the depreciation faster,” Scholz explained.

   Things inside the manufacturing facility building that might have a shorter life than the building might include specialized electrical components for power equipment needs, or specialized flooring that is part of a manufacturing process, or outside docks used in the loading and unloading of trucks.

   In those cases, accelerating depreciation makes sense. “You would need to get an engineer involved, typically, but break that 39-year-life into a shorter life,” Scholz advised. “It could be seven years or 15 years, but there could be tremendous savings.

   “You can, through a cost segregation study, trigger a lot of depreciation that could offset a lot of your operating income and save taxes this year.”

   Such studies also are flexible enough to give you options. “Say the idea is that I’m okay paying tax this year, but I know those deductions are going to be worth more to me next year,” Scholz explained. “You can make the cost segregation study effective for next year, and pick up all the depreciation in 2011. There is a lot of flexibility as to when you want it to be effective.”

4. Check out fixed-asset purchases.

   According to Anderson, fixed-asset purchases are still being given preferential treatment for 2010 in that the government is allowing up to $250,000 in immediate expensing for personal property purchases (note: this does not apply to real estate). The U.S. Senate, which reconvenes in September, might still try to raise that to $500,000 for 2010, but either way, fixed-asset purchases are still a great benefit, Anderson stated. “If you purchased $50,000 worth of equipment, you can expense it all in the current year, as opposed to depreciating it over five to seven years,” she said. “It’s an acceleration of the benefit.”

   In addition, the IRS actually has made it easier to go back and do a change-in-accounting method regarding fixed assets. According to Anderson, if a business has been capitalizing things that really should have been repairs and maintenance, you can go back and use a change in accounting method and deduct all that for the current year. The change-in-accounting method was not always automatic, but now that it is, more clients are taking advantage of it.

   “We’re going back and reviewing their fixed-asset schedules to see if they have been capitalizing their repairs and maintenance,” Anderson said. “Once they do a change-in-accounting method, they can expense all those things going forward, instead of capitalizing them.”
    

5. Make plans to adjust for the alternative minimum tax.

   At this point, it looks as though Congress will not extend a tax-saving AMT provision. It’s estimated that last year there were about four million households, out of 151 million households, that pay the AMT, CitiGroup and other large institutions report that approximately 28.5 million people, one in five families, will be affected. These families will have to calculate their tax burdens twice, and pay taxes at the higher level.

   Obviously, it’s time to plan accordingly. One suggestion from Meicher, who has clients with $60,000 in income that already pay the alternative minimum tax, pertains to the timing of property-tax payments. “You don’t get to deduct your real estate taxes if you pay them in December, necessarily, and doubling up on your real estate taxes used to be a good idea for many taxpayers. The point is, you have to plan very carefully, and you don’t want to double up on real estate taxes, as a rule, whereas previously you did.”

   Scholz said Congress could still increase the AMT exemption, but probably not until December, when members normally try to extend popular things.

   “One thing that is kind of an elephant in room is that we have huge deficits,” he noted, “so how are we going to pay for it? There is a thought that wealthy people are paying the AMT, but that is not true. You can have people that make $70,000 to $100,000, and if they are paying enough in property taxes or state income taxes, or if they have a number of dependents that they are claiming on their tax return, they are trapped in AMT. In some cases, there isn’t a lot you can do about it.”

   The fall session might also see some action to benefit self-employed individuals, which bears watching. “Self-employed individuals have for years been able to deduct their health insurance against their taxable income, but not against their self-employment income, so you still had to pay self-employment tax on that,” Anderson explained. “What they are talking about doing is allowing health insurance as a deduction against self-employment tax.”
    

6. Think shorter maturity when it comes to municipal bonds.

   This is an old protectionary stalwart, but with rates so low, it’s hard to get long-term municipal bonds without taking significant risk, Meicher noted, so consider thinking short term.

   When interest rates go up, as they eventually will, the price of bonds goes down, so anyone who extends 30 years on a municipal bond probably will lose money because rates will go up sometime, significantly, during this period. “What I’m recommending to clients is to try and get two-to-five-year maturities on municipal bonds,” he said. “That way, you don’t have significant principle risk.

   “For those worried about interest rates in the future, long-term bond funds of any variety would not be a good investment.”
    

7. When managing inventory, don’t be the LIFO of the party.

   Companies using the LIFO accounting method (Last In, First Out, meaning the most recently purchased items are sold first) usually have a tax-deferred advantage. But the prospect of higher tax rates might change the calculation.

   If you’re looking at future higher rates, why don’t you take a hit this year and terminate the LIFO election for that inventory,” Scholz said, “and trigger some added income this year when the tax rates are lower.”

   The question of whether to write down inventory often is a gray area but with higher taxes coming, it makes sense for some.

   Said Meicher, “If you keep your inventory high, you’re going to have those deductions next year at a much higher rate than this year if you are over that [higher tax] income level, so that would work.”
    

8. Avoid the depreciation deduction.

   In some cases, it’s wiser to not take a deduction for depreciation in 2010 because it will be worth more in future years. “An example would be if I buy a piece of equipment at the end of the year, and you can deduct it all if it’s placed in service. It does not matter if you pay for it,” Meicher said. “Well, what you want to do is maybe not place it in service because you’re going to want that deduction in the future more, even when you consider the time value of money.”
    

9. Be a good host.

   If you have a corporate event at your house, you can be reimbursed for costs and not pay taxes on rental income. In addition, a business owner can rent out his or her house for up to 14 days, and if it’s for a legitimate business purpose, take the fair rental value of what he had to pay. One short-term example is an annual company party at the owner’s home, for which the owner can be reimbursed.

   A longer-term example of this was in Atlanta during the 1996 Olympic Games, when people rented their houses out for two weeks for $20,000 and didn’t pay any tax on it due to the exemption. A more recent example was the 2010 PGA Championship at Whistling Straights, where people in the Kohler and Sheboygan areas rented their houses out to golfers and others and won’t pay tax on it.

   The exemption also applies to vacation homes, Meicher noted, but it has to be for a legitimate business purpose. That does not include a board of directors meeting, he noted, but renting to perfect strangers is considered enough of a distant transaction.

   “They have no problem because they are renting to people they don’t know,” Meicher explained. “Any money they get is going to be legitimate because they are renting to strangers. It’s an arms-length transaction.

   “Say you and your wife have a board meeting and spend $10,000 for a day-long event. You can’t do stuff like that. This deduction works as long as it’s ordinary and reasonable, then you’re not going to have a problem.”
    

10. Make sure your business entity is the most advantageous legal entity.

    This tip is so obvious, IB almost didn’t include it in the list, but it was raised by Anderson. So just in case this has never occurred to you, and you’d be surprised at how often it’s overlooked, especially in light of new taxes, review your business entity selection. “If you’re a C-Corp, you’re double taxed,” Anderson noted. “With S-Corps and Limited Liability Companies, that doesn’t happen. If you have an operating entity in an LLC, those operating profits are subject to the self-employment tax, whereas if you use S-Corp, you limit those payroll taxes to the amount you are paying yourself in wages. So make sure you are in the most advantageous entity.”

The Time is Now

If you are going to maximize your income, December 2010 will be too late to set all the logistical wheels in motion. “This is the perfect time to take a look at your tax position,” Scholz advised. “You have four months to control how many taxes you can pay. If it gets to December, it’s almost too late because there are fewer things you can do.”

Anderson agreed, noting that some of the protectionary measures take some time to materialize: “You’ve got to start thinking about it a couple of months ahead of time,” she counseled.

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