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Moore Colson Newsletter -
April 2006
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Article 2 | Article 3 |
Article 4 | Article 5
Your business’s accounting method
Don’t overlook this tax planning tool
Did you know that your accounting method can have a huge impact
on your tax liability? That’s right: It may generate an unexpected,
adverse tax consequence, or it can be an effective planning tool.
One term, varied applications
The term “accounting method” includes not only your overall
method of accounting — such as cash, accrual or percentage of
completion — but also the accounting treatment of any item. Examples
of accounting for a specific item, or category of item, can include
the treatment of capitalized costs, inventory or prepaid expense
items.
Some accounting methods are specified by law. For example,
contractors with a certain level of gross receipts may be required
to use a particular method for job costs, and there are specific
rules for accounting for vacation pay. However, most accounting
methods are chosen — although often unwittingly.
IRS, blanket consent for changes
You’re generally considered to have established an accounting
method if you have used it for two years. And, once you’ve
established an accounting method, you must then get IRS permission
to change to a different method.
IRS consent must be requested before the end of the taxable year for
which you wish to make the change. But some method changes — known
as automatic changes — are given a blanket consent and simplified
procedures. These changes can be made when you file your tax return
and don’t require advance consent.
One change, dual components
When you make an accounting method change, two things are
happening: 1) You’re making the switch in your accounting treatment
for the current year, and 2) you’re creating a “catch-up” adjustment
to reflect the change needed to reverse the accrued or deferred
build-up resulting from the old accounting treatment.
If it sounds complicated, you’re right. But the benefits can be
tremendous, as reflected in the following examples:
Example 1: Cash method. If your company uses the accrual
method of accounting, it may have to recognize (and pay tax on) most
of its income before cash is received. If it can change to the cash
method of accounting, the income may be deferred until cash is
received; plus, you gain more control over the timing of items and
minimize recordkeeping. Switching to this method often results in a
refund because the business is adjusting the accumulated change
amount of accrued income.
Example 2: Depreciation. If you’ve been depreciating assets over
the incorrect useful life — for example, over 39 years when it’s
really 15-year property — and then correct the depreciation, it’s
considered an accounting method change. Such a change can be
beneficial: By depreciating property over a shorter period, you can
get larger deductions in the early years of ownership.
To uncover depreciation mistakes associated with real estate you
own, consider a cost segregation study. It might show that a
significant portion of a building you’re depreciating over 39 years
is, in fact, only 7- or 15-year property. This automatic accounting
method change could result in a big refund in the year of change due
to the catch-up on the accelerated depreciation.
Simpler rules, larger tax breaks
In recent years, the IRS has become serious about simplifying
tax accounting rules and giving business taxpayers a break. They
have simplified or broadened the use of some accounting methods,
made more accounting method changes automatic and cut down change
procedures.
And it gets better. For most companies, once their year end closes,
it’s too late for tax planning. However, the magic of automatic
accounting method changes is that
certain businesses may be able to reap the benefits of tax planning
as late as when they file their tax return.
Review now, see benefits later
For returns that haven’t yet been filed, or those on extension,
you still have time to review your accounting method choices and
their potential tax effect and see whether any automatic changes can
reduce your 2005 tax bill.
And if you’re starting a business — or, just encountering a new
item, class of items or transaction in your existing business —
think about the impact of accounting methods before you just make an
entry in the books.
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Jump for joy!
Could the new manufacturer’s deduction apply to
you?
The American Jobs Creation Act of 2004 brought a new
deduction for domestic production activities. Although
commonly referred to as the “manufacturer’s deduction,” it’s
available to more businesses than just traditional
manufacturers. It applies to sales of tangible property
produced primarily in the United States, and the scope of
qualifying activities is broad.
The deduction is based on a business’s qualified production
activities income (QPAI). In 2010 when fully phased in, it
will equal 9% of the lesser of QPAI or taxable income
(adjusted gross income for individuals). But the deduction
is limited to 50% of wages paid during the calendar year and
is 3% in 2006 and 6% in 2007 through 2009. Available to
corporations, pass-through entities and individuals, the
deduction can be used against both regular and alternative
minimum tax.
If your business manufactures, grows, develops, creates,
constructs or assembles a product, it will be well worth the
effort to determine if this deduction might apply to you.
First see if your business has qualifying activities. You
may be able to restructure certain processes or procedures
to maximize your benefit. You may also be able to increase
your deduction by choosing, for example, certain methods for
allocating costs — and by ensuring your accounting system
tracks eligible expenses.
Which rules must you use?
Although this new deduction has the potential to benefit
numerous taxpayers, its implementation will be somewhat
burdensome due to its complex — and changing — rules. Even
though the deduction took effect in 2005, the IRS is still
releasing guidance on interpreting and applying the law.
Expect clarification and further guidance throughout 2006.
Until final regulations are issued, you may rely on either
the proposed regulations or an earlier notice. This provides
additional planning opportunities.
What should you do now?
Remember that the deduction is already available — even if
all the rules aren’t finalized. So take steps now to
maximize your benefit. And don’t forget its recurring nature
— it’s not just a one time write-off, and the deduction
percentage will be increasing.
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What you don’t know can hurt you
The alternative minimum tax
Although Congress has diligently discussed the issue of the
alternative minimum tax (AMT) for the last several years, it
hasn’t come up with a workable long-term solution to this
insidious tax system. It’s easy to fall into the AMT trap
because there are only two AMT rates (26% and 28%), the
brackets are compressed, and fewer write-offs are allowed.
So, while it was originally aimed at the very wealthy who
were sheltering excessive amounts of income, many average
taxpayers are now feeling the AMT’s sting.
Complex and hard to predict
The AMT is a separate tax system with its own set of rules.
You must calculate your tax under both methods and then pay
the higher amount. Certain deductions, credits, exclusions
or other benefits, which are allowed to reduce your regular
income tax, aren’t allowed for the AMT. The AMT calculation
starts with regular taxable income and then adds back those
disallowed items.
The most common AMT triggers include state and local income
taxes, exercise of incentive stock options, accelerated
depreciation, large amounts of certain itemized deductions,
and numerous dependents.
AMT exemption amount may help
An AMT exemption amount, which varies according to your
filing status, reduces the amount of alternative minimum
taxable income that’s subject to AMT. Congress has been
tinkering with the numbers to help taxpayers avoid the AMT
trap. Many taxpayers receive a reduced AMT exemption amount
due to a phaseout based on income. For joint returns, the
phaseout starts at $150,000 of AMT income and is fully
eliminated at $382,000. For singles, the exemption is phased
out between $112,000 and $273,000 of AMT income.
For 2006, however, the exemptions (and the corresponding
phaseouts) are scheduled to revert to lower amounts if
Congress doesn’t act to increase them. Several Congressional
leaders have indicated that addressing AMT is a top priority
for 2006.
Credit provides moderate relief
In limited situations you may get some relief in the form of
the AMT credit. Paying the AMT in one year on deferral
items, such as depreciation adjustments, may entitle you to
an offsetting AMT credit in the next year.
To take advantage of the credit, plan for the AMT when
anticipating significant transactions, such as selling off
assets or exercising incentive stock options, as well as in
your year end tax planning.
Plan ahead to avoid getting bit
Knowing where you stand AMT-wise may allow you to adjust
your income and deductions to minimize the tax. This can
work both ways:
- If you suspect you may be subject to the AMT this
year, postpone until next year payment of deductions
that aren’t allowed for AMT purposes, such as state
income tax.
- If you already know you’ll be subject to the AMT,
recognize income this year to take advantage of its
lower maximum rates — 28% rather than the maximum
regular tax rate of 35%.
While it’s difficult to gauge the effect of the AMT, you
should be aware of its potential impact and be cautious
before making large payments or entering into transactions
that may subject you to the AMT.
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Putting the brakes on fringe benefit misclassification
For many businesses, fringe benefits are an important tool
for rewarding executives and other valued workers. And many
benefits receive tax-favored treatment, which helps both
employers and employees.
But the IRS is concerned that many companies are
misclassifying fringe benefits that should be treated as
compensation and be subject to income and employment taxes.
To curb abuses in this area, the IRS has issued the
Executive Compensation — Fringe Benefits Audit Techniques
Guide. Although the guide is intended for IRS examiners, it
provides businesses with a handy roadmap they can use to
determine whether their fringe benefits satisfy IRS
requirements.
Benefits presumed to be taxable
Fringe benefits can raise a number of issues for any
business because the expense may — or may not — be deducted
by the employer or excluded from the employee’s gross
income.
That’s why it’s helpful to know what the IRS requires. In
the guide, it instructs examiners to analyze fringe benefits
using this three-step approach:
1. Identify the fringe benefit and start with the assumption
that its value will be taxable as compensation to the
worker.
2. Check to see if there are any statutory provisions that
exclude the benefit from the employee’s income.
3. Value any nonexcludible portion of the benefit for
inclusion in the worker’s gross income.
Fringe benefits are generally valued at the amount the
employee would have to pay for the benefit in an
arm’s-length transaction.
Common fringe benefits
The guide discusses common fringe benefits such as:
Club memberships. Most club dues aren’t deductible,
including those for business, social, athletic, sporting,
airline and hotel clubs. But an employer may deduct the cost
if it treats club dues as compensation includible in an
employee’s gross income and wages.
If the employer doesn’t treat club dues as compensation,
employees may exclude the dues from their income as a
working-condition fringe benefit, provided the dues
otherwise qualify as a deductible business expense.
The guide alerts examiners that some corporations attempt to
deduct club dues by disguising them as compensation paid to
departing employees as part of their severance packages. The
value of such club memberships should be included in taxable
wages, so the guide advises examiners to scrutinize
employment contracts and severance agreements.
Athletic skyboxes and entertainment suites. For
luxury skyboxes leased for more than one event, a business
may deduct up to the face value of a nonluxury box seat for
each luxury seat in the skybox. The remaining cost of
attendance is deductible to the extent it satisfies the
requirements for deducting entertainment expenses. If the
skybox is used personally by top executives, the value of
the benefit may be taxable income. Luxury boxes rented by
related parties are treated as a single lease in determining
whether the boxes are leased for more than one event.
The audit guide also discusses a variety of other fringe
benefits such as corporate credit cards, executive dining,
no- or low-cost loans, outplacement assistance, qualified
employee discounts, spousal and dependent life insurance,
transportation, employer-paid parking, relocation expenses,
noncommercial air travel, employer-paid vacations, and
wealth management services.
The road ahead
If your company offers any of these benefits, now is a good
time to review your program in light of the IRS guidance.
Otherwise, the road ahead could be a bumpy one filled with a
tax audit and penalties.
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Identity crisis
Threats abound, but you can minimize your identity theft
risk
Identity theft is one of the fastest-growing crimes in this
country. According to the 2005 Identity Fraud Survey Report,
published by consultancy Javelin Strategy & Research, more
than 9 million Americans were victimized by identity theft
in 2004, costing consumers about $5 billion and businesses
more than $50 billion.
Most identity theft victims pay little or no out-of-pocket
costs — credit card companies and other businesses bear most
of the losses. Still, the crime exacts a heavy financial and
emotional toll on victims and their families. Not only can
it take weeks or months to put your finances back in order,
but you may also have difficulty obtaining credit or
qualifying for a loan until the matter is resolved. And
identity theft may cause problems with the IRS.
Identities are easy to steal
Thieves need remarkably little information to take over your
identity. Armed with your name, date of birth and Social
Security number (SSN), they can open new credit card and
bank accounts, establish telephone or wireless services, buy
a car, and more — all in your name. Crooks can run up
charges on your existing credit cards or use counterfeit
checks to drain your bank account.
The impact of identity theft goes beyond finances. A thief
may obtain a driver’s license or other identification with
his or her picture and your name, giving your name to the
police during an arrest. When the offender fails to show up
for a court date, your name will be on the arrest warrant.
Besides nabbing your wallet or purse, thieves can capture
your identity by:
• Stealing records while on the job,
• Hacking into an institution’s computer systems,
• Bribing or conning an employee into revealing information,
• Rummaging through your trash,
• Stealing your mail,
• Filing a fraudulent change-of-address form to divert your
mail to another location, or
• Using computer spyware or other electronic means.
An identity thief may even pose as a representative of a
legitimate company or government agency, either by e-mail (“phishing”)
or phone (“pretexting”).
Taxing problems
In one phishing scam, identity thieves attempt to trick
taxpayers into revealing personal information by sending an
e-mail claiming that the taxpayer is under investigation for
tax fraud. The e-mail directs the taxpayer to a
legitimate-looking IRS Web site.
But that’s not the only way identity theft and tax records
can collide. In another scenario, an offender uses your name
and SSN to file a fraudulent tax return and steal a refund.
Typically, he or she files the return electronically as
early in the filing season as possible. Later, when you file
your return, the IRS computers will flag it as a duplicate
and freeze any refund you may claim.
Still another scheme involves a person who, wishing to
conceal his or her identity, uses your SSN to get a job. The
employer reports that person’s W-2 wages to the IRS under
your name, which leaves you with underreported income on
your return.
The IRS’s response
Until recently the IRS had no agency wide policies and
procedures for dealing with identity theft, making it
difficult for taxpayers to resolve these issues. Since 2005,
the IRS has adopted several recommendations from the
Treasury Inspector General for Tax Administration, which
independently oversees the IRS. They include developing an
Enterprise Identity Theft Strategy, which includes updated
communication for the taxpayers, and modernizing its
processes to dramatically reduce the time needed to resolve
identity theft issues and to ensure taxpayers are treated
fairly and consistently.
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