Moore Colson :: News & Resource Center

Businesses once regularly locked horns with the IRS over whether they could deduct advertising costs as current expenses or had to capitalize and depreciate them. Businesses believed they had to capitalize these costs only when they created a new asset. But the U.S. Supreme Court’s landmark 1992 decision in INDOPCO Inc. v. Commissioner and a subsequent Revenue Ruling shed light on this issue.

It all comes down to the benefits …

In the INDOPCO case, the Court held that creation of a new asset was a sufficient, but not necessary, condition for classifying a cost as a capital expenditure. Costs must also be capitalized, the Court said, if they produce “significant long-term benefits” — for example, benefits that extend well beyond the tax year in which they’re incurred. In this case, the target of a friendly takeover had to capitalize more than $2 million in investment banking fees, legal fees and other costs related to the transaction.

After the INDOPCO decision, many businesses worried that the IRS would extend the court’s holding to advertising costs under the theory that advertising expenses produce benefits beyond the current year. The IRS alleviated those concerns with Revenue Ruling 92-80, which stated that advertising costs “are generally deductible (as ordinary and necessary business expenses) even though the advertising may have some future effect on business activities, as in the case of institutional or goodwill advertising.”

… and certain unusual circumstances

The IRS ruling provided an exception in certain instances. The IRS cited Cleveland Electric Illuminating Co., a U.S. Claims Court case involving an electric company that conducted an advertising campaign to allay public fears about nuclear power. The court required the company to capitalize the expenses because the advertising was directed toward obtaining future benefits significantly beyond those associated with ordinary ads.

You also must capitalize some advertising costs incurred to create a tangible asset expected to last more than one year, such as a billboard or other permanent signage, Web site content, and catalogs.

New vs. old

You can deduct expenses only when they’re related to an existing trade or business. If the company is new, you must capitalize all startup costs, including advertising. These expenses may be amortized and deducted, if elected, once the business is active.

Unfortunately, the distinction between a new and existing business isn’t always clear. In one case, a bank was able to deduct advertising costs related to the development of a new branch because these expenses were used to expand an existing business.
But in another case, when a clothing and cosmetics manufacturer opened a retail store, it had to capitalize the costs associated with the first location, including advertising. Additional retail outlets were then considered expansions of the existing retail business.

Law is far from being clear

Our tax code has never been known for being simple. The question of how to treat advertising expenses is a prime example of just how complex the tax code is. But, until tax simplification occurs — if ever — your tax advisor can help you determine which advertising costs you can and can’t deduct.

Proper documentation is key, so closely track your advertising, marketing and promotional costs.

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Education saving strategies
529 college savings plans now better than ever

When first introduced, 529 college savings plans were hot because they offered a tax-advantaged way to save for college education expenses. In the last couple of years, however, their reputation has suffered due to sales abuses perpetrated by a few investment advisors and the fact that some plans had high fees and inadequate investment options. Federal regulators and state agencies that sponsor the plans took notice.

Sales practices have been cleaned up, and sponsors have come back with lower fees and more investment choices. If you want to contribute to a loved one’s college education and you aren’t already using a 529, it’s time to take another look.

529s — the basics

Officially called “qualified tuition plans,” these plans are also known as “529s” because they were authorized by that Internal Revenue Code section.

The most well known type of 529 plan is the college savings plan, in which you can set aside a sum of money to pay qualified higher education expenses of a beneficiary. The other type is the prepaid tuition plan, with which you can secure future tuition at today’s prices, regardless of how much tuition increases. Most state plans require either you or the beneficiary to be a state resident. Many people choose the 529 college savings plan because of its greater flexibility and because there are no residency requirements.

All 50 states now sponsor 529 college savings plans. Many states’ plans can be purchased either directly or through an investment advisor. The typical plan offers a number of mutual-fund-type investments to choose from.

529s offer numerous advantages

The main benefit of 529 college savings plans is that funds grow tax free. As long as withdrawals are used for qualified college education expenses for the beneficiary, they’ll be tax free. If funds are withdrawn for another purpose, earnings are subject to normal income tax plus a 10% penalty.

Most 529 college savings plans allow total investments of more than $200,000. To avoid gift taxes without using up any of your $1 million lifetime gift tax exemption, contributions of no more than $12,000 (the annual gift tax exclusion) can be made in a single year. However, the IRS allows you to use up to five years’ worth of the exclusion — $60,000 — in one year so long as you make no additional annual exclusion gifts to the same person over the same five-year period. A husband and wife can use this strategy to fund up to $120,000 to a 529 plan in one year.

The only other college savings vehicles that allow such a large investment are Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) accounts, but they don’t enjoy preferential tax treatment. The Coverdell Education Savings Account (ESA) is tax-advantaged, but it limits deposits to $2,000 each year and is not available if your income exceeds adjusted gross income limits. (See the chart “College saving alternatives.”)

529 college savings plans also offer you control. The funds belong to you until they are disbursed to the college or university. You can change beneficiaries and even decide to take back the funds, though there will be a 10% tax penalty on the earnings. Coverdell ESA account owners can also change beneficiaries, but may encounter some restrictions. With an UGMA or UTMA account, when funds are deposited into the account they become property of the beneficiary, who can spend them however he or she wishes at the age of majority (18 or 21, depending on the state).

Some 529 college savings plans also provide a unique tax incentive. About 30 states allow state residents a tax deduction for contributions to an account in the state’s own program. Some states, however, cap the size of the deduction.

Don’t delay

There is one cloud of uncertainty hovering over 529 plans. The federal legislation that created the plans and their associated tax benefits is scheduled to expire in 2010. And, though Congress is expected to renew it in the next year or two, so far it hasn’t done so. If the law isn’t renewed, future earnings may no longer be tax exempt.

So, if you’re thinking about investing in a 529 plan, don’t delay. Because annual contributions are limited by gift tax considerations, if you don’t contribute now you may never be able to make up for the lost opportunity. And, like retirement plans or other investments, the more time the initial investment has to grow, the more it will likely be worth when it’s needed.

College saving alternatives

	529 College savings Plan	529 Prepaid tuition plan	Coverdell ESA	UGMA or UTMA
Investment amount	Often up to $200,000 or more. You can contribute $12,000 per year (or up to $60,000 within a five-year period) exempt from gift tax.	Can be large enough to cover full cost of tuition. You can often buy fractional units.	Annual contribution limit is $2,000. Full contribution amount may be limited based on the donor’s adjusted gross income.	Unlimited, but gifts that don’t qualify for the annual gift tax exclusion or $1 million lifetime gift tax exemption are subject to gift tax.
Tax implications	Growth is tax free when funds are used for educational purposes — otherwise withdrawals attributable to earnings are taxable plus subject to a 10% penalty. Some states offer a deduction for state residents.	Growth is tax free. Any amount returned to the donor because it wasn’t spent on college expenses may be subject to a tax penalty.	Growth is tax free when funds are used for educational purposes — otherwise withdrawals attributable to earnings are taxable plus subject to a 10% penalty.	No explicit tax benefits, though investment income may be taxed at the beneficiary’s tax rate, rather than the donor’s.
Investment choices	Typically mutual funds and CDs.	Investments determined by sponsor.	Similar to IRA choices.	Unlimited
Uses	Tuition, room and board, books, mandatory fees, computers (if required by school).	Usually just tuition, sometimes room and board. Can be used only at college(s) affiliated with the sponsor.	Tuition, room and board, books, mandatory fees, computers (if required by school). Can also be used for elementary and secondary school expenses.	Not limited to education — can be used for any purpose.
Control of funds	Remains with donor until college expenses are paid. You can change beneficiaries.	Depends on the program, but you can generally get back at least your initial investment if the child doesn’t attend a designated institution.	You have less control than with a 529 college savings plan but more than with an UGMA account.	Once invested, funds become property of beneficiary, who gains complete control at the age of majority.

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Tax Tips
Charging employment taxes: Priceless

Starting this year, most businesses can use a credit card to pay their federal employment taxes through an online service. Not only can this ease the strain on your cash flow, but it can also earn you bonus points and frequent-flyer miles on your credit card. Keep in mind that there is a convenience fee of approximately 2.5% of use tax services. You can’t use a credit card, however, to make employment tax deposits at your local bank. For that, you’ll still need to write a check.

IRS feeling charitable

Last year, the IRS stunned the tax community by announcing that a common estate planning tool, the charitable remainder trust (CRT), would be disqualified unless the grantor’s spouse waived certain inheritance rights. In many states, your spouse has a “right of election” to receive a portion of your estate — which may include assets earmarked for charity — regardless of your estate plan’s terms.

Earlier this year, after a barrage of complaints, the IRS suspended the new rule. Pending further guidance, a CRT will not be disqualified unless a right of election is actually exercised.

Retirees want to know

A great way to reduce your tax bite in your golden years is to retire to a state with no or low income tax. Up until 10 years ago, this strategy didn’t work, because retirement benefits generally were taxed by the state where you earned your living. But in 1996, federal lawmakers barred states from taxing qualified plan and IRA benefits paid to nonresidents.

Currently, these states have no income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming.

New Hampshire and Tennessee limit their income taxes to dividends and interest income. Many of the states with personal income taxes provide exemptions for all or a portion of retirement plan assets or Social Security benefits.
When comparing the tax burdens in various states, don’t limit your examination to income tax. You should also look at other state and local taxes, such as sales, property and inheritance taxes.

Take stock of your inventory method

If your inventory costs are rising, consider switching to the last-in, first-out (LIFO) inventory method. LIFO allocates your most recent and, presumably, higher expenses to the cost of sales, reducing your taxable income.

If you already use the dollar-value LIFO method, you may be able to enjoy additional savings by electing to use the inventory price index computation (IPIC) method. IPIC enables you to reduce administrative costs — and, in many cases, generate greater tax benefits — by relying on government indexes to calculate LIFO values rather than developing an internal index.

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How long should you keep business records?

If your filing cabinets are bursting at the seams, it may be time to dispose of papers you no longer need. To help you get started, we offer the following record retention guide. Keep in mind that our list is not exhaustive and the recommended retention periods are intended as general guidelines. Depending on your circumstances, you may need to hang on to certain documents longer. So before you get out the shredder, check with your tax and legal advisors.

Business records	1 year	3 years	7 years	Permanent
Accident reports and claims (keep current documents until settled, then archive for seven years)			X
Accounts payable/receivable ledgers and schedules			X
Audit reports (external)				X
Audit reports (internal)		X
Bank statements and reconciliations			X
Canceled checks for important payments				X
Canceled checks (other)			X
Capital stock and bond records				X
Cash books and charts of accounts				X
Contracts and leases (current)				X
Contracts and leases (expired)			X
Corporate articles, bylaws, minute books, etc.				X
Correspondence (legal and other important matters)				X
Correspondence (routine)		X
Deeds, mortgages, bills of sale				X
Depreciation schedules				X
Employee applications		X
Employee personnel records (after termination)			X
Financial statements (year end)				X
General ledgers, journals and year end trial balances				X
Insurance policies and records (keep current documents until expired, then archive for three years)		X
Inventory records			X
Invoices from vendors			X
Payroll records			X
Property records (including appraisals)				X
Purchase orders (purchasing department copies)			X
Purchase orders (other copies)	X
Receiving sheets	X
Retirement and pension records				X
Sales commission reports			X
Sales records			X
Subsidiary ledgers			X
Tax returns, worksheets and other documents used to determine tax liability				X

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Cutting-edge tax strategies for the under-depreciated

To survive and thrive in today’s highly competitive business environment, you must constantly be on the lookout for strategies that can give your business an edge. One opportunity you shouldn’t overlook is depreciation. The rate at which you recover fixed asset costs can have an enormous impact on your finances. And recent IRS guidance makes it easier to correct past depreciation mistakes — which can give your cash flow a much-needed boost.

Building a case

If you’re planning to acquire, construct or renovate a building or have done so in the last several years, you should have a cost segregation study done. These studies apply engineering, tax and accounting principles to identify building components that are eligible for accelerated depreciation. Based on this information, you can reallocate a portion of your cost to property with shorter recovery periods, dramatically reducing your tax bill.

Ordinarily, the costs associated with a commercial building are depreciable over 39 years. For residential real estate, the recovery period is 27½ years. Often, building owners allocate most or all of their investment to the real estate, even though much of the cost can be allocated to other types of property and recovered more quickly.

For example, land improvements, such as fences, sidewalks, parking lots and light poles, are depreciable over 15 years. And many building components can be classified as personal property and depreciated over three, five or seven years.

Classifying property

There are no hard-and-fast rules for distinguishing between personal property, which is eligible for accelerated depreciation, and structural components, which must be depreciated as part of the building. The answer depends on a number of factors, including how the property is affixed to the building or the land, whether it’s designed to remain in place permanently, and how difficult it would be to move or remove. Personal property may include:

• Machinery,
• Moveable partitions,
• Easily removed wall and floor coverings,
• Awnings, and
• Light fixtures.

In some cases, an item’s classification depends on its function. Building components normally thought of as structural may qualify as personal property if they relate more closely to business processes than to the building’s operation. Examples might include reinforced concrete flooring used to support heavy manufacturing equipment, and electrical systems used to operate machinery, medical equipment or internal communication networks.

Adjusting depreciation for previous years

You can apply cost segregation not only to newly acquired or constructed buildings, but also to buildings you acquired, built or renovated years earlier.
Armed with an engineering report that supports your cost allocation, you can adjust your depreciation for previous years and, under current IRS rules, claim a one-time “catch-up” deduction for all the depreciation deductions you missed. You’ll need to file IRS Form 3115, “Application for Change in Accounting Method.” Consent is granted automatically in most cases.

As the following example demonstrates, the cash flow benefits can be staggering. Lookback Inc. acquired a commercial building in 2003 for $6 million and placed it in service on Jan. 1, 2004. It allocated $1 million to land and is depreciating the cost of the $5 million building over 39 years. Lookback commissioned a cost segregation study, which revealed that $500,000 of the $5 million is properly allocable to land improvements and $1 million is allocable to five-year personal property.

The chart “How Lookback saved with a cost segregation study” compares the company’s depreciation deductions with and without cost segregation. By reclassifying the property, Lookback is able to increase its 2006 depreciation deductions by more than $700,000, including “catch-up” deductions for depreciation it could have claimed in 2004 and 2005. Assuming a marginal tax rate of 35%, this translates into tax savings of almost $250,000 this year. And cost segregation will continue to reduce Lookback’s tax bill over the next several years.

Freeing yourself from a tax trap

Depreciation can also create a dangerous tax trap. Fortunately, in a 2004 ruling, the IRS offered taxpayers some relief. When you sell real estate or other property, you must adjust its cost basis to reflect prior depreciation. The catch is that prior depreciation is the greater of: 1) depreciation you actually claimed on the property, or 2) depreciation you could have claimed on the property.
This so-called “allowed or allowable” rule resulted in some unpleasant surprises for taxpayers who disposed of property and then found themselves with taxable gains based on depreciation deductions they never actually took.

In the past, taxpayers who found themselves in this predicament were out of luck. But under Revenue Procedure 2004-11, you can correct past depreciation mistakes, even after you’ve disposed of the property, by filing an amended return for the tax year in which the property was sold. The usual limitation period for amending a return is three years.

Looking outside the box

Cost segregation studies can uncover a gold mine of hidden cash. And amending a tax return after the sale of real estate in light of depreciation mistakes can protect you from a tax trap, but if you limit your search to buildings you may be overlooking a rich source of tax-saving opportunities. A detailed review of all your fixed-asset schedules, covering vehicles, furniture, computers, tools, equipment and other personal property can reveal missed depreciation deductions you can recapture this year.

Depreciation can be missed for a number of reasons: Property might be misclassified or inadvertently omitted from depreciation schedules, or its cost might have been entered incorrectly.

Getting the depreciation you deserve

Accelerating depreciation deductions to reduce your tax bill is like getting an interest-free loan from the government. Looking at it another way, failing to recover fixed-asset costs as quickly as possible is like paying your taxes years before they’re due. Cost segregation studies and fixed-asset reviews can help you avoid that decidedly unappealing result while tapping new sources of cash.

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