TLB has issued a year-end tax letter for individuals covering recent changes in tax rules and regulations and covering simple strategies for minimizing your 2007 tax obligation.

When choosing the type entity to operate your business there are several legal and financial aspects to consider. These considerations vary, and carry different weight, depending upon each set of facts and circumstances. However, if you operate your business entity as a corporation – TLB recommends you recheck your reasons for not making the so-called “S” election. Some of the reasons why the S-election is advantageous are as follows:

1. Your selling your business – Upon the sale or distribution of corporate assets or business, tax is paid at both the corporate and shareholder level. If you are thinking of retiring or selling your small business in the future, you should seriously consider the advantages of making an S-election.

2. Unreasonably high compensation issues – C-Corporations have to worry about paying unreasonably high compensation. In order to get money out of a C-Corporation most taxpayers take out cash in the form of compensation bonuses. On an IRS examination, agents consider these unreasonable high compensation issues to determine if taxpayers are trying to avoid paying a corporate level tax and tax at the individual level for the receipt of dividends. If raised during examination the service will hit you for the tax and for substantial penalties. This issue doesn’t exist for the S-Corp, as all the corporate income flows through to the shareholder and is taxed only at that level.

3. Accumulated Earnings – O.K. if you avoid the unreasonable compensation issue noted in number 2 above, perhaps you will run into too high a level of accumulated earnings. In this scenario, the IRS may try to assert that the C-Corporation is not paying this cash out because of a desire on the part of the taxpayer to avoid paying taxes on the dividends. Again, this issue just doesn’t apply to the S-Corp, because all income flows through each year.

4. Personal expenses – lets face it many taxpayers try to funnel personal expenses through the business, or perhaps something that every body thought was legitimately a business expense is disallowed upon IRS examination. In a C-Corporation environment this could be disaster. Most likely the IRS will consider the payment of the personal expenses a dividend – so the taxpayer has to pickup the tax on that. In addition, now that the corporation loses the expense, its taxable income is increased and the corporation has to pickup the tax on its level. Add on penalties and something as innocuos as disallowed auto expenses totaling, lets say $10,000, will now cost the taxpayer an additional $7,000 – $9,000 in tax and penalties. Lets hope tax preparers out there are encouraging their clients to play it straight when it comes to personal expenses – especially with their C-Corp clients.

5. Utilization of losses – As a C-corporation any losses generated by the business, stay with the corporation, but may be carried forward. This is nice, but isn’t particularly useful if you are generating income otherwise (other businesses, earned compensation, etc.) The S-Corp allows losses to flow through to the shareholders, which can then utilize these losses to offset other income.

6. Save on payroll taxes – As noted in number 2 above, many taxpayers pay themselves a salary higher than they normally would in order to get the cash out of their C-Corporation and to avoid having to pay the corporate level tax. In this scenario, the taxpayer is paying 12.4% (6.2 employee, 6.2 employer) for social security on approximately the first $95,000 of wages plus 2.9% medicare on the total wages paid. If you were an S-Corp you might pay yourself a more reasonable wage, say comparable what you might pay an outsider and save yourself up to 15.3% in employment taxes by taking the resulting corporate profits as flow through income.

7. Keep the cash basis of accounting – C-Corporations that exceed $5million when applying the average annual gross receipts test (Is your accountant monitoring this every year for you?) are required to convert to the accrual basis of accounting. This could result in a huge change in taxable income, expecially in the first year. In this scenario, an S-election could save you and the use of the cash basis of accounting, particularly in light of IRS Revenue Procedure 2002-28, which provides for safe harbor provisions.

8. Is your C-Corporation a QPSC or a PSC? If so an S-Corp may be for you.

In many small businesses TLB has found that the S-Corporation is the preferred corporate entity and just seems to make the most sense. Of course there may be reasons one would want to operate as a C-Corporation – sounds like a future post. As always, please consult with TLB on any and all of these issues, before taking action, to determine the ramifications of an “S” election (i.e. the built in gains tax) and to plan accordingly.

The case of Hospital Corp. of America v. Commissioner of Revenue established the right of taxpayers to utilize cost segregation studies for computing depreciation and provides guidance in identifying tangible personal property in a building, which is eligible for accelerated methods of depreciation over fewer years as compared to the traditional 27.5 year recovery period for residential rental property and the 39.5 year recovery period for commercial real estate.The result of cost segregation analysis is significant savings to the taxpayer, and an incentive for investment, particularly when the taxpayer has the ability to elect the provisions of code section 179, which allows expensing (to a limit) of certain depreciable items all in one year.

The determination of whether an item is personal property or real property (ie: a structural component), as usual, depends upon the facts and circumstances, however, the IRS position is that the following items, if used in the operation and maintenance of a building are examples of structural components (ie: real property): bathtubs, boilers, ceilings, central air conditioning and heating systems, chimneys, doors, electrical and wiring, fire escapes, floors, hot water heaters, HVAC units, lighting fixtures, paneling, partitions – if not readily removable, plumbing, roofs, sinks, sprinkler systems, stairs, tiling, walls, and windows (Reg. Section 1.48-1(e)(2))

Sorry lottery fans – except for the fact that you just hit the big one – you just can’t win, at least not with the IRS. As you probably know if you ever do hit the big one and win $100 million – you don’t always actually receive $100 million. Instead, you receive an annual annuity from the lottery commission, which I might add isn’t chump change, but after paying for taxes, lawyers, investment management, not to mention the new house, new spouse and an Escalade (I would get a Bentley – it holds its value better), a couple million a year just doesn’t go as far as it used to.One option available to lottery winners from outside third parties is to exchange your newly won stream of payments for a lump-sum payment that you could totally blow – I mean invest – now. As you might suspect, the IRS has treated these lump-sum payments as ordinary income, and therefore subject to the individual income tax rates (probably at the current top rate of 35%) and not at capital gain rates (15%). So not only did you cash out your winnings at less than 100 cents on the dollar, 35% of whatever is left is gone to the federal government (we haven’t even mentioned the state).The Second Circuit recently upheld the IRS position in this regard, which was previously upheld by the Third, Ninth and Tenth Circuits and by the Tax Court in Prebola v. Comissioner, (No. 05-6953-ag – 3/27/2007). In upholding the IRS position the courts have been applying the “substitute for income doctrine,” which holds that lump-sum payments received in exchange for what would otherwise be received as ordinary income are treated as ordinary income.Sorry Ms. Prebola.

The IRS announced in a June 6, 2007 news release that it is undertaking a National Research Project with a goal of designing, and implementing a successful strategy to collect data that will be used to measure payment, filing and tax law compliance. In undertaking this project, the IRS is attempting to take advantage of the auditing capacity created by undertaking a National Research Project on approximately 5,000 S-Corporations, which will be concluding. The project will begin in October, 2007 and will initially audit approximately 13,000 individuals for tax year 2006. The focus will be on those parts of an individual return that cannot be verified through third-party information reporting, according to an IRS spokesman. The IRS is hoping to extend the program several years so that it may refine the data collected in order to assist in determining the so-called “tax gap” which was previously estimated by the IRS at $345 billion for tax year 2001.

The Chief Counsel’s Office of the IRS advised what costs are subject to capitalization under §263A in connection with growing grapes for wine production. (See CCA 200713023) The taxpayer which operates vineyards that produce wine grapes and a winery, uses an overall accrual method of accounting, treating the grape-growing and wine-making activities as a single trade or business. Most or all of the harvested grapes are sent to the taxpayers winery to be crushed to produce juice that will be processed into wine.The IRS explained that the actual preproductive period (APP) of a grape crop grown in wine production ends when the crop is crushed. The crush, the IRS noted, marks the point in time when: (1) the crop loses its physical character as grapes and is converted into the raw materials and by-product of wine production; (2) T stops growing grapes and starts producing wine; (3) T ceases to incur costs to produce grapes and begins to incur costs to produce wine; and (4) the “farming business” of grape growing ends under §63A(e)(4) and the nonfarming trade or business of producing wine begins. Extending the APP beyond the crush point would result in the capitalization of inappropriate costs into a “crop” that no longer exists, the IRS summarized.The IRS further stated that preproductive period costs incurred between the end of the APP of a grape crop and the blossoming of the subsequent crop are generally deductible as a cost of maintaining the vine. Preproductive period costs incurred between the harvest of the crop and the end of the actual preproductive period of the crop are capitalized to the crop unless they are “field costs,” as defined in Regs. §1.263A-4(b)(2)(i)(C)(2)(i), i.e., irrigating, fertilizing, spraying, and pruning, that provide no benefit to the crop which has already been severed from the vines, the IRS stated. The field cost exception applies during the period between harvest and the “sale or disposition” of the crop, or the onset of the crush, the IRS noted.

Here is a common scenario: A shareholder of a corporation rents property to his corporation, in which he materially participates (maybe a builder, landscaper, consultant, etc.), and earns a profit on the rental activity. In addition, the shareholder also owns other rental property that is reporting a loss for tax purposes. In several cases we have seen the taxpayer utilize the losses of one property to offset the gain from the other property.The problem with that strategy is the so-called self rental rule discussed under regulation 1.469-2(f)(6) of the IRS. Under this rule, if a shareholder rents property to his corporation in which he materially participates, at a profit, the profit is not considered passive income and therefore cannot be offset by losses from other activities (including other rentals) that are passive. These regulations were recently upheld by the Ninth Circuit as constitutional in the case of Beecher v. Commissioner, No. 05-71894 (9th Cir. – 3/23/2007)

When operating a business entity it is not uncommon for a taxpayer to incorporate for a number of reasons, two of which are individual protection from liability and several potential tax advantages. In selecting to organize as a corporation (and not electing to be treated as an S-Corporation) commonly referred to as a C-Corporation, small business owners need to also consider whether or not their corporation is going to be considered a “personal service corporation” or a “qualified personal service corporation.” Each of these classifications significantly change tax implications when compared to a C-Corporation that is not classified as a PSC/QPSC.

One pitfall of a PSC/QPSC is that it is denied the graduated tax rates for corporations which start at 15% and incrementally reach 34% up to a maximum of $100,000 of taxable income, and is instead taxed at a flat 35% rate on taxable income. However, over $100,000 careful planning is required for the PSC/QPSC corporation, as the graduated rates fluctuate at various income levels between 34% and 39%, which, in some cases might make the flat rate of 35% desirable.

Section 269A(b)(1) of the Internal Revenue Code states that the term personal service corporation means a corporation the principal activity of which is the performance of personal services and such services are substantially performed by employee-owners.

Section 448(d)(2) provides that the term qualified personal service corporation means any corporation which (A) substantially all of the activities of which involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting, and (B) substantially all of the stock of which is held directly or indirectly…

Another pitfall of the PSC is that internal revenue code section 280H restricts the amount that can be deducted by a personal service corporation for amounts paid to owners if the corporation has elected a non-calendar tax year. This could have very costly consequences in the year of disallowance and at the least minimizes a taxpayers planning opportunities.

There are several options to avoiding tax traps with PSC/QPSC corporations, including making a subchapter “S” election; minimizing time spent in the business in order to avoid the so-called function test; and transferring at least 6% of the corporations stock to someone who is not an employee (maybe a spouse) and who is permitted to own the stock in order to avoid the stock ownership test.

The traps and consequences that befall unwary PSC/QPSC corporations was recently illustrated (ironically) in the Tax Court case Rainbow Tax Service, Inc. v. Commissioner (128 T.C. No. 5 – 3/8/2007). In this case, a tax preparation and bookkeeping firm attempted to make the case that it was not providing accounting services, which is specifically referenced in code section 448(d)(2) as an element of a QPSC. The court held that these services were considered to be in the “field of accounting,” and therefore Rainbow Tax Service, Inc. was subject to the flat 35% corporate tax.