Sunday, December 23, 2012

Year-End Tax Plans Focus On 2012 Rule Changes


Year-end tax planning for U.S. taxpayers may be more about what's happening next year.
While there aren't major changes to federal tax law for 2011, there's an "overhang of uncertainty" about what Congress will do next year to reduce the national debt and improve the economy, said Clint Stretch, managing principal of tax policy at Deloitte Tax LLP in Washington.
"There are a lot of unhappy people and a lot of unhappy businesses out there because they want to know what the rules are," said Stretch.
Decisions by lawmakers in 2012 may affect everything from federal levies on income to estate-tax laws. One rule change investors can plan for next year is a new tax-reporting requirement for mutual funds and most ETFs.
Starting next year, financial-services firms will have to report to the Internal Revenue Service and customers information on the cost basis, which is usually the purchase price, of mutual funds and most ETFs bought and sold after Jan. 1, 2012. That means investors will have to decide before selling what reporting method they want to use such as average cost or first shares acquired. Firms already are required to report the cost basis of individual stocks bought after Jan. 1 of this year to the IRS.
"Gone are the days when you can take all your statements in the tax season and go to your accountant and say, 'OK, use all these forms and use them to determine the basis,'" said Maria Bruno, a senior analyst in the investment counseling and research group at Vanguard Group Inc. "Now you really have to think about it at the time of the transaction."
An estimated 44 percent of U.S. households, or about 52 million, owned mutual funds in 2011, and 3.5 million households held ETFs, according to an October research report by the Investment Company Institute, a Washington-based trade group for the mutual-fund industry. Shares of exchange-traded funds, known as ETFs, trade on stock exchanges and don't have a fixed number of shares outstanding.
The IRS has been phasing in the cost-basis reporting rules for financial firms by investment type. The requirements began this year for equities bought and sold after Jan. 1. As a result, taxpayers will use a new Form 8949 for their 2011 returns to record capital gain and loss transactions, said Eric Smith, an IRS spokesman. The form lets investors provide information about securities covered by the law and those acquired prior to the rules, or non-covered shares, according to the IRS.
Next year the legislation extends to mutual funds, most ETFs and dividend reinvestment plans, which generally require investors to reinvest at least 10 percent of dividends paid. In 2013, it includes options (VIX) and fixed-income securities, such as bonds, according to the IRS. The changes don't apply to assets in tax-deferred retirement accounts including 401(k)s and IRAs, the IRS said.
The changes are designed to improve tax compliance and reduce the record-keeping burden for investors by ensuring that they receive the information they need to easily report their gains and losses correctly, said Smith.
Investors may set a preferred method for their firm to use when determining cost basis and investment providers generally will use a default, said Bruno of Vanguard, the world's largest mutual-fund company. While customers can change their decisions at the time of sale for a specific transaction, "there are no do-overs" after securities are sold, she said. Vanguard, based in Valley Forge, Pennsylvania, is encouraging customers to designate a preference before year-end. It can be done online or by mailing a form, Bruno said.
"If you're doing some tax planning and trying to match gains and losses, you may end up using different cost basis methods for different sales," said Lisa Featherngill, managing director of wealth planning for Wells Fargo (WFC) Family Wealth.
For example, taxpayers may have bought shares of stock at $23 this year, so they're covered under the new rules, and additional shares of the same company at $20, said Featherngill, who's based in Winston-Salem, North Carolina, and a certified public accountant. If the security's current value is $18, the investor may tell the brokerage firm to sell the shares with the highest purchase price to generate the biggest loss, she said.
When capital losses exceed gains, the extra can be deducted on individuals' tax returns and used to reduce other income, such as wages, up to an annual limit of $3,000, according to the IRS. If the total loss is more than the cap, the unused portion may be carried over to following years.
Some investors have dwindled away large capital losses that built up and were carried over in 2008 and 2009, which is why they should review whether to take some this year, said Bill Fleming, managing director in the private company services group at accounting and advisory firm PricewaterhouseCoopers LLP.
Many mutual funds distribute taxable capital gains at year- end, which individuals also should consider in their planning, said Clay Stevens, director of strategic planning at Aspiriant, a Los Angeles-based wealth management firm serving clients with at least $5 million in investable assets.
Investors who bought shares of a fund in the middle of the year may have lost money, especially as equity markets have been volatile, while a fund may have had a gain for the year overall, said Stevens. "It may be appropriate to sell a fund to avoid realizing the gain," he said.
Taxpayers who do "harvest" losses should keep in mind that the IRS prevents them from reinvesting in the same or substantially identical investment for 30 days before and after the sale, said Timothy Steffen, director of financial planning for Robert W. Baird & Co. in Milwaukee. And individuals shouldn't upset their long-term investment plan "just to get a tax break," said Rande Spiegelman, vice president of financial planning at Charles Schwab Corp. (SCHW)'s Center for Financial Research.
There also may be tax changes at the state level that individuals should consider, said Elda Di Re, area leader of the personal financial services tax division of Ernst & Young in New York.
New York Governor Andrew Cuomo and legislative leaders reached an agreement on Dec. 6 to create new tax brackets that would cut taxes for married couples earning less than $300,000 and set a maximum levy of 8.82 percent for those joint filers earning more than $2 million. Under a so-called millionaire's tax that is scheduled to expire on Dec. 31, those making more than $500,000 are taxed at 8.97 percent.
Saul Brenner, a tax partner at accounting and advisory firm Berdon LLP, said he had told clients in New York to postpone closing deals until January because of the expected lower rates.
There are other federal tax breaks set to expire at the end of 2011 that individuals may want to use while they still can, said Ted Sarenski, a certified public accountant and president of the fee-based financial planning firm Blue Ocean Strategic Capital in Syracuse, New York. That includes a rule related to charitable donations from IRAs, Sarenski said.
Owners of traditional IRAs, which generally have tax- deferred contributions, must take annual distributions starting at age 70 1/2 or over, according to the IRS. This year, savers are allowed to donate up to $100,000 from their IRA directly to a qualified charity without paying income tax on that money.
"That's often a good way to get rid of the required minimum distribution without it hitting your income," said Stevens of Aspiriant. The tax break doesn't include gifts to so- called donor-advised funds or private foundations, and the payment must be a direct transfer from the IRA trustee to the qualified charity, according to the IRS.
Congress has in the past extended, or retroactively extended, miscellaneous tax breaks that are expiring such as deductions for teachers or the so-called patch on the alternative minimum tax, said Di Re of Ernst & Young. "They always seem to be able to pull that out of the bag at the last minute," she said.
The alternative minimum tax requires taxpayers to compare their tax liability under the regular tax code with what they would owe under the AMT, which doesn't allow taxpayers the full benefits of state and local tax deductions or personal exemptions. Because the AMT wasn't indexed for inflation, over time it captures more Americans and Congress has spared some with a series of annual "patches."
Lawmakers also are debating the extension of a payroll tax cut for workers that expires Dec. 31. Senate Democrats are heading toward a Dec. 9 vote on a plan to pay for it with a 1.9 percent surtax on annual income exceeding $1 million, which Republicans have declared unacceptable.
Advisers including Di Re of Ernst & Young and Fleming of PricewaterhouseCoopers said the biggest changes they're planning for may come at the end of next year.
A provision letting individuals generally gift up to $5 million during their lifetime without paying tax is set to expire at the end of 2012 and revert to $1 million unless Congress acts. Those wanting to move money out of their estate should consider making a plan to use some or all of that gifting opportunity as they prepare this year's return, said Di Re.
In 2013, higher earners also may see a "double whammy" from increased levies on income and investments, said Fleming.
The health-care bill passed by Congress in March 2010 included a 3.8 percent tax starting in 2013 on investment income such as realized capital gains, plus a 0.9 percentage point rise in the Medicare payroll tax on wages for those couples earning more than $250,000 and for individuals making at least $200,000.
President Barack Obama also has proposed letting tax cuts enacted during the presidency of George W. Bush expire at the end of 2012 for those same higher earners, meaning levies on their income increase to as much as 39.6 percent from 35 percent.
"We're telling people, get ready to bunch your income in 2012 and postpone deductions in 2013," Fleming said. "You can't turn income on a dime. You have to plan months and months ahead of time."

Tuesday, December 18, 2012

Year end business tax tips


1. It May be Time to Shop

For companies planning on acquiring property in 2012 or 2013, there may be enhanced savings by making the acquisitions in 2012. Under current law scheduled to expire on Dec. 31, a company can take “bonus” depreciation of 50 percent of the cost for qualified property acquired and generally placed in service by year-end 2012. A company is also allowed, under certain circumstances, to expense up to $139,000 of qualified property in 2012—an amount that drops to $25,000 next year.

2. Put a Veteran to Work


Hiring a military veteran is hugely beneficial to small-business owners this year. As part of the Work Opportunity Tax Credit, any money paid to a qualified veteran (check list for qualifications) can be written off, dollar-for-dollar. The Work Opportunity Credit of up to $9,600 is still available for hiring an unemployed veteran, but in order to be eligible for the credit, you must have the qualified veteran start work before 2013.


3.  Accelerate billing and collections.

If you report income on a cash basis method of accounting, immediately sending out bills to increase collections before the end of the year may result in significant tax savings.  Choose your best or most loyal customers out of the bunch and call them to ask for payment right away. Tax brackets will go up at least 5 percent next year, so if you can get your clients to pay you this year, you’ll pay less in taxes.            Provide clients with an incentive to pay early by offering them a small discount, say, 1 to 2 percent.

4.  Pay Your Children

Does your 10-year-old file papers at your office a few times a week? If so, your child could get you a nice tax write-off.  If your child makes $5,250 or less in a calendar year, you get to deduct the entire amount and your child doesn’t need to claim the earnings. What’s better: you can take up to $5,000 of what they earned and put it into an IRA. Most parents will pay their child $250 and put the rest into a retirement fund that the child can access when they are old enough.

5. Startup Expenses

Did you know that you may write off the expenses you incur in the investigatory or startup phase of your business? Eligible expenses include planning, consulting with professionals, training employees and all other ordinary and necessary expenses incurred to get your business off the ground. This deduction works once the business is operational, so if you are still in startup mode on Dec. 31, you must defer the deduction to 2013. The IRS defines an operating business as one that has opened its doors or is accepting transactions.


You can deduct $5,000 of business startup expenses. If your total exceeds that, you may amortize the remainder over 180 months. There are special rules and limitations, so discuss this area with your tax professional.

6. Set up or Fund your Retirement Plan:

Your business needs working capital, but don’t forget about funding your future. Contributions made to retirement plans reduce your taxable income. For 2012, self-employed individuals can contribute $17,000 as a 401(k) deferral, plus 25% of net income. Check with your plan administrator for limits and deadlines for different types of plans.

7. Holiday Party!

Holiday festivities provided for your employees are 100% deductible. Parties for clients and associates are 50% deductible. But there are rules. You must have a business purpose and that consists of more than just promoting goodwill or networking and the expense cannot be lavish or extravagant.

8. Expense Account Reimbursements:

Gather together all those receipts for business expenditures you paid out of personal funds and have your business reimburse you before year end. If your business is operating as a C Corporation, be sure you have an accountable expense plan in place. Post your expenses to a spreadsheet and total by category of expense. Attach all receipts to provide bona fide back up documentation and then cut yourself a check and know that you have just reduced taxable income.

Sunday, December 16, 2012

Fiscal Cliff Complicates Year-end Tax Planning

The “fiscal cliff” has made year-end financial planning especially daunting this year.

Uncertainty, the saying goes, breeds uncertainty. And it’s up in the air as to whether Congress will take action to head off a significant reduction in federal government spending and the expiration of Bush-era tax cuts that are scheduled to take effect January 1. Nor is there any clarity on what alternatives Congress might decide on.

However, income tax planning must go on, even in this uncertain tax environment. As a result, it is essential to know the customary year-end planning techniques that cut income taxes

It all starts with a tax projection of whether the taxpayer will be in a higher or lower tax bracket next year. Once their tax brackets for 2012 and 2013 are known, there are two basic income tax considerations.

• Should income be accelerated or deferred?

• Should deductions and credits be accelerated or deferred.


Capital gains: Take advantage of historically low taxes on long-term capital gains, which apply to stocks and other investments owned for at least a year.

Regardless of what tax bracket you’re in, many expect taxes on capital gains to rise. Currently, individuals with ordinary income above $35,350, or married couples with ordinary income above $70,700, pay 15 percent in capital gains taxes. Those below that level pay no capital gains taxes. Ordinary income includes all income except for income eligible for reduced tax rates, such as dividends and long-term capital gains.

Because of the tax uncertainty, some investment advisers say it makes sense to look at selling stocks that have appreciated significantly before the end of the year to avoid a higher tax bill down the road.

Something else to consider: If you’re selling a stock and taking a gain on it, there are no negative tax implications if you turn around immediately and buy the stock again. That’s different than when you sell a stock for a loss. In that scenario, you can’t claim a loss if you buy the stock again within 30 days

Don’t run out and trigger capital losses to offset capital gains or ordinary income given that this year’s tax rates on both capital gains and ordinary income are likely to look like a bargain compared to the rates that take effect in 2013.

Charitable contributions : Because of the tax uncertainty it might make sense for families to speed up their charitable giving to the end of this year instead of next.

Roth IRA: If you’ve been contemplating converting your traditional IRA to a Roth IRA, the time may be ripe.  With traditional IRAs, you invest pre-tax dollars and pay taxes when you withdraw funds. With a Roth IRA, however, you invest after-tax dollars but pay no taxes when you withdraw funds.  Now could be a good time to convert to a Roth IRA. In future years, your tax rates are likely to be higher.  A conversion is not to be taken lightly, however, because you’ll have to pay taxes on the converted funds.

Income Acceleration:  For taxpayers who think that they will be in a higher tax bracket,  receive bonuses before January 1, 2013. If your employer allows you the choice, this may create some significant income tax savings. Also, be aware that certain high-income earners will pay an extra 0.9 percent in Social Security taxes on earned income above certain thresholds starting in 2013.

AMT - Certain deductions that can be helpful in keeping tax bills low are worthless if you are in the AMT. Among them are deductions you get for paying state income taxes, local property taxes or mortgage interest. In a year when you are going to be in the AMT, it’s best — if possible — to delay paying taxes and mortgages in December and pay them in January.

Get Medical and Dental work done:  Another health care act tax provision will make it more difficult to claim itemized medical deductions. For 2012 taxes, medical deductions must exceed 7.5 percent of adjusted gross income before they can be claimed. In 2013, the expenses must be more than 10 percent of AGI. If there is a chance of exceeding the 7.5 percent floor this year, the individual may want to accelerate into this year discretionary medical expenses, such as prescription glasses and sunglasses, and elective medical or dental procedures not covered by insurance.

Thursday, December 13, 2012

Year end tax planning – It’s different this time

Traditional tax planning has often been summarized and oversimplified into one phrase: “defer income and accelerate deductions.” Well, in light of the changes scheduled to occur Jan. 1, as well as our politicians acting like lemmings ready to go over the “fiscal cliff,” that may not be the best advice.
Starting next year, and without legislative action, the 2001 and 2003 tax cuts will expire, and new
Medicare taxes enacted as part of health care reform will take effect.
The expiration will eliminate several benefits, including:
• Rate cuts across all income brackets
• The full repeal of the personal exemption and itemized deduction phase-out
• The top rate of 15 percent for capital gains and qualified dividends
• Marriage penalty relief and the $1,000 refundable child tax credit
In addition, there are Medicare tax changes and additions. First, the rate of the individual share of Medicare tax will increase from 1.45 percent to 2.35 percent on earned income above $200,000 for single, and $250,000 for joint filers. The 1.45 percent employer share will not change, creating a top rate of 3.8 percent on self-employment income. In addition, investment income such as capital gains, dividends and interest will be subject for the first time to a 3.8 percent Medicare tax to the extent income exceeds $200,000 (single) or $250,000 (joint).
Between rate increases and deduction decreases, the top combined rates on income jump to 24 percent for capital gains, 43 percent for dividends and interest, and more than 42 percent for earned income.
As we can see, it may not make the best sense to defer income into next year in light of these tax rate increases. Alternatively, it may make sense instead to defer deductions and actually accelerate income.
The easiest income to control is capital gains. You can trigger gain and pay tax on stock and other securities without changing position. There is no wash sale rule on capital gains, so stock can be sold and bought back immediately to recognize the gain. But if much of your net worth is tied up in one asset because you’re deferring the tax bill on a large gain, this might be a good time to reallocate that equity.
You may also be able to affect tax by timing how you exercise options. If you do not plan to hold incentive stock options (ISOs) long enough to qualify for capital gains treatment, you can exercise them and sell the stock before tax rates increase.
You can also consider a conversion from a 401(k) or traditional individual retirement account (IRA) to a Roth IRA now, while tax rates are low. Tax will be owed on the amount of the conversion now in exchange for no tax on future distributions if the conversion is made properly and certain other conditions are met.
You might also consider electing out of the deferral of gain available in an installment sale. Deferred income on most installment sales can be accelerated by pledging the installment note for a loan.
First, determine whether tax increases will apply to you. Tax increases are unlikely to affect any income below the income thresholds of $200,000 (single) or $250,000 (joint), and taxes may not increase at all.
Also, if you’re subject to the alternative minimum tax (AMT), you may not benefit from any acceleration in tax. In addition, economic considerations should always come before any tax-motivated sale. We strongly suggest discussing tax strategies within the context of your overall financial plan.
Lastly, let’s hope our political leaders prove our lemmings metaphor wrong and actually deliver some clarity to taxpayers in 2013.

Tuesday, December 4, 2012

2012 Year-End Tax Planning Considerations

Consider your future income, capital gain and payroll taxes:

The current tax environment is very uncertain. One thing is certain, if Congress does not take action before the end of the year, tax rates are scheduled to go up for 2013. The tax increases include the following:

  • The maximum marginal tax rate on long term capital gains will increase from 15% to 20%
  • Qualified dividends increase from 15% to ordinary income rates (high of 39.6%)
  • Marginal tax rates increase for ordinary income and the low 10% bracket will be eliminated
  • Payroll taxes increase from 4.2% to 6.2% on employees resulting in an additional 2% in tax

It is possible that Congress will act and these tax increases will be averted. However, even if Congress does act, it is likely that high net worth individuals will still experience a tax increase next year.

Consider your exposure to the 3.8% Medicare surcharge tax:

On January 1, 2013, certain provisions of The Health Care and Education Reconciliation Act of 2010 (the “Act”), including imposition of a new 3.8% Medicare surcharge tax, go into effect. The Medicare surcharge tax applies as follows:

  • The net investment income for high income taxpayers includes a 3.8% Medicare surtax on the lesser of two amounts: (1) their net investment income, or (2) the excess of the taxpayer’s modified adjusted gross income over a threshold amount
  • The threshold amount is $200,000 for single filers or $250,000 for joint filers and $11,650 for irrevocable trusts and estates with discretionary distribution provisions
  • Investment income is defined to include taxable interest and dividends, long and short term capital gains, annuity income, passive rental income, royalties, and passive activity income

Accelerating investment income in 2012 may be advantageous for you. The 3.8% Medicare surcharge tax is imposed on passive activities but not on income derived from an active business. Together with your accountant and financial planners, you may want to assess whether to sell assets and recognize gain, accelerating income this year to avoid the imposition of the 3.8% Medicare surcharge tax next year. Individuals may want to assess whether they are active or passive and explore opportunities of becoming active in their trade or business.

Consider the future of estate and gift taxation:

For the remainder of 2012, the combined gift and estate tax exemption is at $5,120,000 per person. The exemption significantly expands one’s ability to make lifetime gifts without incurring a gift tax. Time is running short to take advantage of the certainty of current law:

  • A married couple can gift a total of $10,240,000 free of any gift tax
  • Many states impose an estate tax, but far fewer impose a gift tax
  • Even at this late date, if you want to make lifetime gifts of amounts above $1,000,000 there is time to effectively and completely make gifts of your assets, removing them from your estate for estate tax purposes
  • Each person can make annual tax-free gifts of $13,000 per person, per recipient, as well as unlimited direct gifts for educational and medical expenses

Currently, this historically large exemption is scheduled to expire on December 31, 2012, with a return to a $1,000,000 exemption and a 55% federal tax rate on gifts over that amount. There is much speculation whether Congress will adopt an exemption over $1,000,000, but the fact is that no one knows and everyone is guessing. Where your legacy is concerned, don’t be caught short relying on speculation.

Monday, November 12, 2012

Five tax planning opportunities in Obama’s re-election


While the presidential election may be complete, there is still significant uncertainty surrounding the future of tax policy. Although we know President Obama will serve a second term, we don’t know whether a divided Congress will reach an agreement on the fate of the soon-to-expire Bush tax cuts. And if congressional gridlock does in fact rule the next two months, the country faces its most dramatic tax law changes in decades when these cuts expire on Jan. 1, 2013.
In the absence of partisan agreement, tax rates will rise for every American in 2013. As a result, during the remaining days of 2012, tax planning takes on a heightened level of importance.
To that end, here are five planning ideas that may help you save significant tax dollars: 
1. Accelerate year-end bonuses into 2012. There is one axiom on which almost all tax planning opportunities are based: defer income, accelerate deductions. But in the waning months of 2012, high-income taxpayers will want to give strong consideration to taking a contrarian approach and accelerating income into the current year.
The maximum personal tax rate is currently 35 percent. With the expiration of the Bush tax cuts, this rate will rise to 39.6 percent in 2013. In addition, beginning next year taxpayers earning wage income in excess of $200,000 ($250,000 for married filing jointly) will pay an additional 0.9 percent Medicare tax on wages in excess of those thresholds.
Crunching the numbers, assuming you already reside in the highest tax bracket, accelerating a year-end bonus from January 2013 into December 2012 could save you up to 5.5 percent, (40.5 percent to 35 percent) in federal tax.
2. Accelerate corporate dividends into 2012. Currently, qualified dividends are taxed at a preferential 15 percent tax rate. Absent any further legislation, however, dividends will again be taxed at ordinary income rates as high as 39.6 percent in 2013. Tack on the additional 3.8 percent surtax imposed upon net investment income (primarily interest, dividends and capital gains) for taxpayers earning in excess of $200,000 ($250,000 for married filing jointly) that is slated to begin in 2013, and wealthy taxpayers will experience a near-tripling in their dividend rate, from 15 percent to 43.4 percent.
As a result, owners of corporations should consider accelerating any planned 2013 dividends into 2012 to take advantage of the lower rates.
3. Sell your business. The sale of corporate stock, an interest in a partnership, or the assets of a sole proprietorship generally results in capital gains. As does the sale of real estate, except to the extent the gain is attributable to previous depreciation deductions.
At the moment, the tax rate applied to these gains — provided the assets have been held longer than one year — is 15 percent. If the Bush tax cuts expire, this rate will rise to 20 percent, and beginning in 2013, the additional 3.8 percent surtax on net investment income discussed above may apply as well, raising the maximum rate on long-term capital gains for some taxpayers to a high of 23.8 percent.
Quite obviously, this increased tax could become prohibitive. To illustrate, imagine you own real estate valued at $1.2 million that you purchased years ago for a minimal investment. For simplicity’s sake, assume a sale of the property generates $1 million of long-term capital gain. In 2012, this gain would generate a federal income tax bill of $150,000, leaving you with $1,050,000 of after-tax cash.
Wait until January, however, and the tax rate on this same $1 million gain may well be 23.8 percent, leaving you with a $238,000 federal tax bill and only $962,000 of after-tax cash, a decrease of a rather substantial $88,000.
4. Elect out of the installment method. Should you sell your business or real estate in 2012 for a string of payments, at least one of which is to be received in a future year, you may be tempted to report the gain on the installment method. Under this method, you would be permitted to defer portions of the underlying gain until the related payments are subsequently received. But as previously highlighted, 2012 might not be the time to seek deferral.
The downside of the installment method is that you do not “lock in” to the tax rates in place during the year of sale for use against all future gain recognition. Instead, you are at the mercy of Congress, and if the tax rates rise during subsequent years, any gain recognized during those years is subject to the increased rates.
Consequently, if you sell an asset during 2012, you should consider electing out of the installment method and recognizing the full amount of gain on your 2012 tax return. This will allow you to pay tax at the current 15 percent rate, rather than at a potential 23.8 percent rate in 2013. 
Fortunately, you don’t have to make that decision in the next two months, as the election to opt out of the installment method is made upon the filing of a tax return. This means taxpayers have until October 2013 — assuming a timely extension is filed — to take in the fate of the Bush tax cuts before making any decisions. 
5. Die. I’m joking, of course, but if you haven’t been consulting with a competent estate tax attorney, it’s not the worst idea in the world. If you have a sizable estate, that estate is currently subject to a $5,120,000 lifetime exemption and a 35 percent tax rate. Should Congress fail to act by year-end, those amounts are set to return to $1,000,000 and 55 percent, respectively. So if you really want to provide for future generations, you may have to take one for the team before New Year’s Day. The family will miss you, but extra cash can heal a lot of pain.

Wednesday, October 10, 2012

Three Reasons Oct. 15 is the Second Most Important Day for Taxes

April 15 has a pretty good chance of remaining the No. 1 day for taxes, but Oct. 15 is likely a close second. Three reasons Oct. 15 is important for taxpayers: (1) extension filers must submit their returns to avoid a monthly 5-percent, late-filing penalty on balance due, (2) Fresh Start participants must pay taxes due to avoid further penalties and interest because their six-month grace period ends and (3) the 2013 filing season starts in 100 days so now is a good time to assess the impact of life changes on 2012 taxes.
October really is the new April for taxes. Taxpayers used to believe the only day they had to worry about was the April filing deadline, but more people are realizing how paying attention to their tax situation year-round can put more money in their wallet.

1. Extension to file deadline is Oct. 15 - returning clients eligible for special discount

On average, more than 10 million taxpayers applied for a tax filing extension each of the past few years - even though approximately 66 percent of them were due a refund.
One reason taxpayers put off filing is to make sure they have all the paperwork needed to file an accurate return. Rushing to file at the last minute can also result in missing out on claiming tax credits and deductions to which they may be entitled, which can lead to overpayment of taxes. Not claiming all the deductions and credits to which they are entitled, picking the wrong filing status, not filing at all and assorted other missteps cause taxpayers to forfeit $1 billion in refunds annually.

2. Fresh Start participants face payment deadline Oct. 15

This year, the IRS introduced Fresh Start Penalty Relief allowing a six-month payment grace period for those unemployed for 30 consecutive days and self-employed taxpayers who lost at least 25 percent of business income in 2011 due to the economy - in addition to meeting other qualifications.
Those who met the qualifications will not face failure-to-pay penalties if their 2011 taxes, interest and any other penalties due are paid by Oct. 15. Those who can't pay in full by the extended deadline will have to pay penalties on the amount not paid by Oct. 15. The failure-to-pay penalty is 0.5 percent of the unpaid taxes for each month after the due date (cannot exceed 25 percent of unpaid taxes). The "meter" on interest for the taxes due started April 15.

3. Oct. 15 signals 100-day countdown to e-file, means still time to impact 2012

Even with e-file starting in 100 days on Jan. 22, there is still time for taxpayers to review their 2012 tax situation and make changes that might improve it. Also, because the start of the filing season has been delayed this year, people who typically get their tax returns in January may have to prepare themselves for a later arrival in February.
"Sitting down with a tax professional in October to look at last year's return and estimate next year's return can help taxpayers develop a financial strategy to be more prepared during these uncertain times," Rice said.

Saturday, October 6, 2012

Commonly Missed Federal Income Tax Deductions

Following are some of the most commonly missed deductions on federal income tax returns.

Charitable Contributions of Physical Items

Contributions given to a charitable organization are a common deduction on federal income tax returns. Many people know they can deduct the amount of any cash contributions made to such organizations. But they overlook deducting the value of other types of contributions to charitable organizations.

If you have donated clothing, furniture, baby toys, or any other item that is in good working condition, you can deduct the fair market value of that item on your federal income tax return.

Are you unsure how much an item you want to donate is worth? If so, some organizations publish guidelines to help you determine the fair market value.

Certain Costs Related to Refinancing

With many homeowners seeing the lowest mortgage interest rates they have seen in their lifetime, there has been an abundance of refinancing of homes. Some homeowners have been able to take advantage of the low interest rates to refinance their homes multiple times.

If you paid points related to your refinancing, you can deduct a portion of those points on your federal income tax return. You can calculate the amount of your deduction by dividing the number of months of your loan in the current year by the total number of months of your loan term, and then multiple that fraction by the amount you paid in points.

In addition, if you refinance and have points from a previous mortgage that you have not finished deducting, you can deduct the full amount of the remaining point cost.

Expenses as a Teacher

If you are a teacher of grades kindergarten through 12, or an office aide or principal in an elementary, middle, or high school, you can deduct up to $250 in expenses on suppliers you use for teaching that are not paid for by the school.

Energy Efficiency Upgrades to Your Home

The federal government has generally been supportive of providing an incentive for homeowners to improve the energy efficiency of their homes. Therefore, they offer federal income tax deductions on various energy efficiency improvements. These deductions can include a portion of expenses for insulation, high-seer air conditioning and heating equipment, solar panels, and energy efficient windows.

Casualty Losses

If your home was damaged due to any act of nature, including but not limited to tornadoes, hurricanes, floods, and forest fires, where the area was declared a federal disaster area, then your losses from the disasters can be deducted on your federal income tax.

Saturday, September 22, 2012


40 years ago, little did Maureen Rice know when she married Art Dorrington that her three sons would be competing in golf in the Ri-Dor Cup against her three nephews.  Throw in two son-in-laws and the first annual Ri-Dor Cup will be played today at Brighton Dale Links in Kenosha, Wisconsin between the Rice’s and the Dorrington’s – hence the Ri-Dor Cup.

Although the actual Ryder Cup will start on September 27, 60 miles south in Medinah, Illinois between Team USA and Team Europe, the Ri-Dor Cup will be just as competitive.  Golf has been part of the families for years.  They learned the game from their fathers who learned from their fathers. 

The Dorringtons, Dan, Brian, and Michael,  played competitively at Greendale, Wisconsin High School and currently reside in Wauwatosa, Wisconsin.   The fourth member of their team, brother-in-law Chris Muench,  is currently the golf coach at Greendale High School and is married to Colleen Dorrington.   The Rices, Kevin, Michael, and Bobby,  played competitively at Marquette University High School in Milwaukee.  The fourth member of their team, Rhett Holland of Wauwatosa, is married to Sara Dorrington and played competitively in college.

27 holes will be played on Saturday in true Ryder Cup format.  They will play Foursomes, Fourballs and Singles matches.  Team uniforms will be worn and trash talking will not be allowed on the course.  They will play for the Cup and the right to brag for the next year or two. 

Future plans are in the works.  Two of the Rices reside in the Chicago area, so it may become a Wisconsin versus Illinois competition in the future. 

Maureen Rice Dorrington lives in Greendale and has 10 grandchildren so the Ri-Dor Cup may go on for many years.

Thursday, September 6, 2012

Who Should Take Education Tax Breaks: Parents or Students?

When it comes to education tax breaks, it’s important to carefully consider your options, and plan out who is going to take what tax break. This is an important distinction because it’s an either/or situation in terms of who gets the tax break. If the parent claims the education tax deduction or credit, then the child (in this case, the dependent) can’t claim it. If the child claims it for himself or herself, then the parent can’t claim it. Parents have to communicate with their kids since the education tax breaks are only allowed to be claimed on either one of your tax returns and not both.

Is the Student a Dependent?

First of all, you need to determine if the student is a dependent. If a parent claims his or her student as a dependent, then that’s who gets to take the tax credit or education deduction. Whether it’s the American Opportunity Tax Credit, Lifetime Learning Credit, or the Tuition and Fees Deduction, only one person gets the tax advantage and it often comes down to whether the student is a dependent in the eyes of the IRS. If a student is a dependent on someone else’s tax return, the student doesn’t qualify for these tax breaks.
If a student isn’t claimed as a dependent, though, it’s possible for him or her to claim an education tax credit, or take the deduction.  One thing to keep in mind, each student cannot claim more than one tax break. So it’s one of the education credits or education deduction (not all of them).

Should the Student Take the Tax Credit or Deduction?

In some cases, it makes sense for the student to take the tax break. If the student is married, and no longer dependent on a parent for support, obviously that’s who should take the education tax break. Additionally, if the student makes enough money to owe taxes, it makes sense to reduce that tax bill as much as possible.
Most of the time, though, students don’t earn enough money to owe taxes. As a result, in many cases, it makes more sense for parents to claim their children as dependents and reap the benefits of the tax breaks. After all, parents have spent quite a lot to raise their children, and probably help pay for college. It’s only reasonable that they receive some sort of financial benefit in return – and a lower tax bill is one way to recoup a few of those costs.

Friday, August 31, 2012

5 tips on how you pay taxes on gambling wins.

It fun to roll the dice, bet on the ponies or win in cards -- especially when you are on holiday.
Winning only makes your days off that much sweeter.
But there's a price: Your gambling winnings are fully taxable and must be reported on your income tax return, according to Mike Dobzinski, the Plantation-based spokesman for the Internal Revenue ServicesGambling income
includes winnings from lotteries, raffles, horse races, and casinos -- whether it is cash or the fair market value of prizes such as cars and trips.
He gives four tips for gamblers to be aware of:

Gambling operators are required to  give you Form W-2G, Certain Gambling Winnings, if you win $1,200 or more in gambling winnings from bingo or slot machines and more than $5,000 in winnings (reduced by the wager or buy-in) from a poker tournament.
Report all gambling winnings on the “Other income” line of Form 1040, U.S. Federal Income Tax Return.
Claim your gambling losses up to the amount of your winnings on Schedule A, Itemized Deductions, under "Other Miscellaneous Deductions."  You must report the full amount of your winnings as income and claim your allowable losses separately. You cannot reduce your gambling winnings by your gambling losses and report the difference. Your records should also show your winnings separately from your losses.
Keep accurate records.
"If you are going to deduct gambling losses, you must have receipts, tickets, statements and documentation such as a diary or similar record of your losses and winnings," Dobzinski said.
Go to IRS Publication 529, Miscellaneous Deductions, for more information. Or call 1-800-829-3676.

Thursday, August 30, 2012

Got IRS Penalties? Relying on Adviser Better Than TurboTax.

No one wants trouble with the IRS, especially not penalties. But they are a part of audits and can be downright Draconian. Getting out of penalties can be a big accomplishment.
One area of frequent flubs is IRS Form 3520. People know about FBARs these days and even the FATCA Form 8938. But filing Form 3520? Not so much.
An owner of a foreign trust must file it or face a penalty of $10,000 or 35% of the gross reportable amount, whichever is greater. IRC 6677(a). Then, the penalties can snowball. If you fail to file for 90 days after the IRS notifies you, there’s an additional $10,000 for each 30-days up to a maximum of the gross reportable amount.
Fortunately, there’s no penalty if you have reasonable cause. What’s reasonable? There are no regulations defining “reasonable cause” for failing to file Form Form 3520, but there is other “reasonable cause” learning.
In James v. USA, Dr. Brian Chivas James created a foreign trust in Nevis, West Indies to shield his assets from malpractice claims. From 2001 through 2003, he contributed $1,604,146, and filed Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner.
However, he failed to file the required Form 3520. He claimed that his accountant, George Famiglio, messed up. Dr. James relied on Famiglio for his personal and business taxes.  He gave Famiglio all appropriate trust documents and Famiglio was supposed to handle all filings.
Dr. James wasn’t trying to hide the trust, he just wasn’t up on the requirements. He argued he acted prudently in hiring Famiglio so had reasonable cause. The IRS didn’t agree and wouldn’t let the doctor off the hook.
The IRS assessed $578,950 in penalties for failure to file Form 3520 for 2001 – 2003. Dr. James paid and sued for a refund arguing he had reasonable cause. When the IRS asked for summary judgment, the court ruled against the IRS noting that:
  • Dr. James timely provided all  required data to Famiglio and relied on him to advise him on trust filings;
  • There was evidence Famiglio did advise him on some trust matters; and
  • Based on his conversations with Famiglio, Dr. James believed he had filed all required forms.
The court said there was a genuine issue of material fact whether Famiglio provided Dr. James with advice on which he reasonably relied. This was a nice taxpayer victory. Yet keep in mind that Dr. James had to incur significant legal expenses.

Wednesday, August 29, 2012

Roth IRA conversions: Still tax-smart.


In 2010, I wrote that the conditions were ideal for converting traditional IRAs into Roth accounts. Previous restrictions on conversions had been removed, and income triggered by conversions was taxed at relatively low rates. Today, we are once again looking at excellent conditions for Roth conversions.

Here’s how to take advantage:
Conversion basics A Roth conversion is treated as a taxable distribution from your traditional IRA, since you’re deemed to receive a taxable payout from your traditional account with the money then going into your new Roth account. So a conversion before year-end will trigger a bigger federal income tax bill for this year—and maybe a bigger state income tax bill too. However, two positive factors may outweigh the extra 2012 tax hit.
Today’s federal income tax rates might be the lowest you’ll see in your lifetime, especially if the so-called Bush tax cuts expire this year as scheduled. So if you convert this year, you’ll pay today’s relatively low rates on the extra income triggered by the conversion and completely avoid the potential for higher future rates on all the post-conversion income that will be earned in your new Roth account. That’s because qualified Roth withdrawals taken after age 59 1/2 are totally federal-income-tax-free.
If you convert this year, you don’t have to worry about the extra income from converting causing you to be hit with the new 3.8% Medicare surtax on investment income, which will kick in next year. While the extra income from a 2013 conversion would not itself count as investment income for purposes of the 3.8% surtax, it would raise next year’s modified adjusted gross income (MAGI). Higher 2013 MAGI could, in turn, cause some or all of next year’s investment income to be hit with the surtax, especially if you convert a traditional IRA with a big account balance. While not everyone who converts in 2013 will be exposed to the surtax, nobody who converts this year will be exposed, and that’s a good thing.
The combined tax-hiking impact of the Bush tax cuts going bye-bye and the looming 3.8% Medicare surtax has been dubbed Taxmageddon. The point to be made here is that a Roth conversion done this year can allow you to keep more of your post-2012 income out of Taxmageddon territory.

Don’t forget the impact of 2010 conversions If you chose to spread the income from a 2010 Roth conversion 50/50 over 2011 and 2012 (as you were allowed to do), you already have some conversion income on the books for this year. So if you do another conversion this year, your 2012 income will be that much higher. Take that into account when estimating the extra tax bill from a 2012 conversion.

Another nice thing about the Roth conversion strategy is that you can always change your mind well after the fact. Believe it or not, you have until Oct. 15, 2013, to “recharacterize” (unwind) a 2012 conversion. For example, say you convert a traditional IRA into a Roth account between now and year-end. Then the value of the converted account takes a nosedive. In this unhappy scenario, you would still have to pay extra 2012 income tax on value that later disappeared. Thankfully, that risk is mitigated by the fact that you have until Oct. 15,2013, to recharacterize the converted account back to traditional IRA status. After the recharacterization, it’s like the ill-advised 2012 conversion never happened. So you don’t owe any extra 2012 tax from the now-unwound conversion deal.
Relatively low current tax cost for converting, plus a chance to avoid higher tax rates scheduled for 2013 and beyond (think Taxmageddon) on income that will accumulate in your Roth account equals another perfect storm for the Roth conversion strategy. But you have to get it done this year to reap the tax-saving benefits. That said, please don’t get carried away. Consult a good tax pro before converting a traditional IRA with a significant balance. You want to be sure you understand exactly what you’re getting into.

Sunday, August 26, 2012

Tweak withholding to avoid big tax bill.


The Internal Revenue Service recently reminded taxpayers it's not too late to adjust your 2012 tax withholding to avoid large refunds or big tax bills at tax time. "Taxpayers should act soon to adjust tax withholding to bring withholding closer to what they owe, putting more money in their pockets during the year," said IRS spokesman David Stell.
"Most people have taxes withheld from each paycheck (or pay taxes on a quarterly basis through 'estimated tax' payments), and each year millions of workers have far more taxes withheld from their pay than is required," said Stell. "Many people anxiously await their tax refunds to make major purchases or pay financial obligations. But we urge them not to tie major financial needs to the arrival of refunds, especially when they need this money by a certain date."
Don't let Uncle Sam be your investment fund manager OR your travel agent. You want that money in your pocket so you can invest it. In other words, "Tweak that W-4" ( When your refund is larger than $200, or you owe more than that, it's time to tweak your W-4. People often over-withhold as the source of a vacation fund. Uncle Sam doesn't pay you interest on it. If you want to save for a vacation, have your credit union transfer $200 per month into a savings account.
Employees: When you start a job, your employer has you fill out IRS "Form W-4, Employee's Withholding Allowance Certificate." This tells your employer how much to withhold from your wages to pay your federal income taxes monthly. Paula Ross, spokeswoman for the Oklahoma Tax Commission, said state withholding is based on the federal W-4, and if you find yourself owing more than $50 in Oklahoma income tax yearly, divide the amount by your paydays and add the additional amount to Line 6 of Form W-4.
You might want to change your W-4 when certain life events happen during the year, including changes in your marital status, birth of a child, getting or losing a job and buying a home. Update your W-4 every January by changing the number of "withholding allowances," but if you need to decrease withholding allowances for changes in your marital status (married to single), you must give your employer a new Form W-4 within 10 days of those events.
Self-employed: Form 1040-ES is for the self-employed. If you owe $1,000 or more in taxes annually, you must make "estimated tax payments" to pay your income tax, Social Security and Medicare taxes quarterly. Use the worksheet in "Form 1040-ES, Estimated Tax for Individuals" ( to see if you must pay estimated taxes quarterly. Make estimated payments to avoid owing taxes at tax time. Also see "Publication 505, Tax Withholding and Estimated Tax".

Saturday, August 25, 2012

Now Is the Time: Converting a C Corporation to an S Corporation or LLC


For closely held corporations that still have C status,1 the current uncertain economic environment, depressed asset values (especially in certain real estate markets), and historically low income tax rates on distributions to individuals (qualified dividends) from C corporations (which are scheduled to expire at the end of 2012)2 may present an opportunity to exit C status and its attendant double taxation at an acceptable current tax cost. Tax advisers should be talking to their C corporation clients about the opportunities that now exist to avoid substantial future taxes.

Tax Inefficiency of C Corporations

C corporations are taxed on their taxable income at federal rates up to 35%.3 Distributions of qualified dividends to individual shareholders are taxed again at a federal rate of 15%, and those dividends are not deductible by the corporation. Thus, the total federal tax rate on distributed earnings from a C corporation is 44.75% [(1 × 0.35) + (.15 × (1 – 0.35)]. If a corporation has elected to be an S corporation or a business is not operated in corporate form (e.g., partnership, limited partnership, or limited liability company (LLC)), there is only one level of taxation at the owner level, and a savings of 9.75% of taxable income, assuming the owners are individuals taxed at the highest individual rate.4 This difference is even greater when taking into account state taxation.
Managing Tax Inefficiency: Lowering Taxable Income
A usual approach to managing the inefficient taxation of C corporation operating income has been to pay as much of the income as possible to shareholder-employees in the form of compensation, which, unlike dividends, is deductible. Such an approach may reduce the taxable income of the C corporation to an acceptable level and result in the earnings being taxed only once at the shareholder-employee level. But this approach has its limitations.
Compensation must be reasonable: Sec. 162 allows a deduction for compensation that is (among other things) “reasonable.” Where a large percentage of corporate earnings is paid as compensation, particularly where the compensation is proportionate to shareholdings, the reasonableness of it may be difficult to defend.5 Moreover, while in some businesses high amounts of compensation as a percentage of corporate income may be reasonable (e.g., where personal services are the principal contributor to income, such as in a dental practice),6 in other businesses where capital is a principal contributor to income (e.g., rental real estate or manufacturing and sales with large capital investment), compensation that is a high percentage of pre-tax corporate income may be more difficult to justify.7
Shareholders may object to some compensation arrangements: Managing the level of corporate taxable income by paying compensation to shareholder-employees may be a difficult strategy to implement where there is more than one shareholder and the individual shareholder-employees do not believe that compensation payments that are proportionate to stockholdings accurately reflect their respective contributions to the success of the enterprise. Certain shareholders may be unwilling to agree to a compensation arrangement that they believe does not adequately reward their efforts or which they believe excessively rewards the efforts of others.
Compensation can be costly: Compensation is subject to payroll taxes, including Social Security and Medicare tax. The combined rate of Social Security and Medicare taxes payable by employers for 2012 is 7.65% on the first $110,100 of wages, and the combined rate for employees is 5.65%.8 For wages in excess of $110,100, the employer and employee are both subject to a Medicare tax of 1.45%.9
Even if double taxation of C corporation earnings can be acceptably and justifiably managed through payment of compensation to shareholder-employees, there remains the problem of managing double taxation of C corporation earnings when disposing of the C corporation itself or of its underlying business.
Managing Tax Inefficiency When Disposing of the Business
The management of the tax inefficiency of C corporations on the disposition of the business held in the corporation in an asset sale is a function of the double taxation of C corporation income and the concepts of “inside” and “outside” gain. Gain on the sale of the business assets (including corporate goodwill) is “inside gain” taxed at the corporate level. Outside gain is gain the shareholders have on the distribution of the after-tax sales proceeds from the sale of corporate assets. Inside and outside gain will also occur where appreciated assets are distributed to shareholders in exchange for their shares.
Double Taxation on C Corporation Liquidating Distributions
If a corporation sells all its assets and distributes the proceeds to its shareholders in a liquidating distribution, the corporation is subject to tax on the asset sale and the shareholders are subject to tax on the distribution. The distribution of assets in liquidation is treated at the corporate level in the same way as if the assets were sold for cash and the proceeds distributed to shareholders in exchange for their shares.10 The shareholders would also have a tax on their gain measured by the difference between the liquidation proceeds (or the net fair market value (FMV) of the assets if they are distributed in kind) and the basis of the shares in their hands.11 Thus, whether the C corporation sells all of its assets and distributes the proceeds in liquidation or distributes all of its assets in liquidation, the tax consequences to the corporation and its shareholders are substantially the same. In both cases, there is double taxation. In general, the federal double-tax rate of 44.75% (plus applicable state tax net of any federal benefit from deducting state tax) should apply if the shares of the corporation are a long-term capital asset in the hands of the shareholders. In considering these alternatives, both corporate and shareholder tax attributes such as net operating or capital loss carryovers should be considered.
Described above is how inside gain (gain at the entity level) and outside gain (gain at the owner (shareholder) level)cause double taxation of C corporation earnings on the sale of corporate assets. But what would be the result if the sale of the business took the form of a sale of the shares of the C corporation by the shareholders? Would double taxation be avoided?
Business Limitations and “Practical” Double Taxation on Share Sales
Before even getting to the tax implications of the sale of shares of the C corporation, the general reluctance of a buyer of a corporate business to buy the shares cannot be denied. A buyer who buys the shares could inherit undisclosed and perhaps even unknown liabilities. While seller warranties may assuage a buyer’s reluctance, they are only as comforting as the seller’s ability to make good on them. There are cases, however, where the buyer may have no choice but to buy shares rather than the underlying assets. This can occur, for example, where the corporation holds a valuable asset such as a lease that is not transferrable, or where the corporate charter itself has value, as in the case of a bank or insurance company.
If the disposition of the C corporation business takes the form of a sale of its shares rather than a sale of the business assets, it might at first appear that there is only one level of taxation. The shareholders would pay tax on gain equal to the difference between the sales price and their basis in their shares.12 Assuming that the shares are long-term capital gain property, the shareholders would face only a 15% federal tax. This is a good result as far as it goes, but it does not go far enough. There is still “practical” or “economic” double taxation because the share sale shifts the problem of “inside” or corporate-level gain to the buyer.
The buyer of the C corporation shares would have a basis in those shares equal to the amount paid (assuming FMV was paid),13 but the assets of the C corporation (inside basis) would remain their historic basis.14 Thus, the difference between that historic basis and the FMV of those historic assets remains subject to tax upon disposition or carries a tax cost in the form of reduced future depreciation or amortization. Financial accounting recognizes this by requiring a deferred tax liability to be set up in the accounts of the post-acquisition entity.15
In essence, the buyer who buys shares will inherit a deferred tax liability (in the form of future tax on the sale of the low-basis assets or reduced tax-deductible cost recovery) and will expect to be compensated for that increased cost by way of a reduced price for the shares. The buyer might demand that the price be reduced by what would otherwise be the present value of the entire deferred tax liability. Such a reduction in purchase price would put the buyer and seller in approximately the same position as they would have been in had the C corporation sold assets and the selling shareholders absorbed the corporate-level tax. Alternatively, the buyer and seller may agree on a purchase price that results in each of them bearing a portion of the deferred tax liability.
Obviously, the greater the difference between the FMV of C corporation assets and their basis in the hands of the C corporation (inside appreciation), the greater the potential problem of double taxation of that inside appreciation. If such appreciation is likely to get larger in the future because current values are depressed, this may be the time to exit C status.

Exiting C Status, Generally

There are two strategies for exiting C status.16 Each of these strategies involves the conversion of the C corporation to a passthrough entity. In general, the income, deduction, gain, loss, and credit of the passthrough entity pass through to its owners, and the entity itself is not subject to tax.17 The first, and least expensive exit strategy, is to convert to S corporation status.18 But, as more fully discussed below, S corporation status may not be a suitable alternative for every C corporation and its shareholders. When S status is not achievable or its requirements are not compatible with other needs of the business and its shareholders, a second strategy is available. The C corporation can convert to an LLC and continue its operations in that form.19
Exiting C Status by Making an S Election
The easiest and least costly method to exit C status is to convert to S corporation status, but that has its limitations and may not be possible or desirable in all situations.
Electing S corporation status: The shareholders of a C corporation may elect S status and, in general, the corporation will avoid a corporate-level federal tax on its operating income or on gain resulting from the sale of its business. Items of income, deduction, gain, loss, and credit are generally taken into account only by the shareholders and not by the corporation in computing taxable income and tax. A favorable aspect of an S election is that in many cases it takes a corporation out of C status and its attendant double taxation without a tax consequence.
Eligible C corporations: Not every C corporation is eligible to be an S corporation. There are shareholder requirements, a capitalization requirement, requirements for corporations with accumulated earnings and profits where the corporation has certain levels of passive income, and requirements relating to the corporation itself.
Corporate requirements: Only domestic corporations that are not (1) financial institutions using the Sec. 585 reserve method of accounting for bad debts, (2) insurance companies taxable under subchapter L, (3) possessions corporations, or (4) DISCs or former DISCs can qualify for S status.20
Shareholder requirements: An S corporation cannot have more than 100 shareholders.21 Only individuals who are U.S. citizens or residents,22 certain estates,23 certain trusts,24 and certain tax-exempt organizations25 can be shareholders of an S corporation.
Capitalization requirement: S status is available only to corporations with one class of stock outstanding26 (differences in voting rights among the shares of common stock do not violate the one class of stock requirement).27 The one class of stock requirement can become problematic and a serious limitation where there is a need or desire for special allocations of corporate earnings to certain shareholders (e.g., certain shareholders would like a preferred return on their shares). In general, a corporation has only one class of stock for these purposes if all outstanding shares confer identical rights to distributions and liquidation proceeds. However, otherwise ordinary commercial transactions between the corporation and a shareholder, such as compensation arrangements and leases, with a principal purpose to circumvent this requirement, can violate the one class of stock requirement.28
Unless certain safe-harbor requirements are met, the one class of stock rule can also be a problem where financing arrangements include consideration in the form of equity-based payments including “equity kickers” or options to buy shares.29 Careful analysis is required where shareholders are not treated identically or where lending arrangements include some form of equity interest.
Requirements Relating to Corporations With Earnings and Profits and Passive Income
An S corporation can be subject to tax at the corporate level30 and its S status terminated31 if it has certain amounts of passive income and also has earnings and profits accumulated during years when it was a C corporation. For this purpose, passive income includes rents, royalties, interest, annuities, and dividends.32 This problem may be avoided if the earnings and profits can be purged by distribution to the shareholders as dividends. With the 15% federal tax rate on dividends in effect for this year, an earnings and profits purge in 2012 may be a tax-efficient way to remove those earnings from corporate solution at a favorable tax rate.
Limitations on S Election Tax Efficiencies
Corporate-level tax on built-in gain: The excess of the FMV of assets over their adjusted basis at the time of the S election is built-in gain. Any of this built-in gain recognized during the 10-year period beginning with the first day of the first tax year for which the corporation was an S corporation remains subject to corporate-level tax.33 Only the excess of the FMV of those assets over their respective tax basis is subject to this corporate-level tax. Post-election appreciation is subject to only one level of taxation.34 Thus, it is essential that an appraisal of all assets be performed at the time of the S election to document the assets on hand and to keep track of their future sale.
Appraisal of all assets means all assets, even assets that are not reflected on the corporation’s balance sheet, including self-created intangibles, such as goodwill and going-concern value, and patents and trademarks, the costs of which have been expensed. The appraisal process should be similar to that undertaken when allocating an FMV purchase for an entire business among its various assets. The importance of accurate appraisals cannot be overemphasized. There are severe civil penalties for misstating the value of property.35
Tax efficiency—income from operations: In general, S corporation earnings are subject to tax only at the shareholder level except for the tax on built-in gain. However, the tax on built-in gain does not necessarily present a problem for all corporations. For example, it might not be an issue for a service corporation where income is not earned through the regular sale of property or a corporation in the real estate rental business (where the income was from an active trade or business) and the intent was to hold assets for the long term.36
Salaries and wages paid to S corporation shareholder-employees are subject to payroll tax, which has caused some S corporations to pay little or no salary to shareholder-employees, hoping to avoid payroll tax. The IRS is well aware of this strategy, and works aggressively to prevent its use. Unreasonably low salaries paid to S corporation shareholder-employees who hope to withdraw income from the corporation as distributions rather than compensation to avoid the payroll tax will likely be challenged by the IRS, resulting in the recharacterization of some portion of dividend distributions to the shareholder-employees as compensation.37
Tax efficiency—income from disposition of the business: Subject to the tax on built-in gain, the sale of the S corporation’s business is generally not subject to a corporate-level federal income tax. It is important to note that post-election appreciation in value is not subject to the corporate-level built-in gain tax, and after the election has been in effect for 10 years, the built-in gain tax no longer applies. In addition to there being only one level of taxation on the actual sale of the assets, where desirable, it is possible to sell the shares of the S corporation and for the buyer and seller to jointly elect to treat the transaction as an asset sale.38 This elective treatment accommodates situations where certain assets of the corporation are not transferrable or where the S corporation’s charter has value in and of itself.
S election mechanics and miscellaneous concerns: The S election requires the shareholders’ unanimous consent39 and is effective for any year if made in the prior year or on or before the fifteenth day of the third month of the year.40 Documentation of the filing of those elections should be made a permanent part of corporate records.41
In general S corporations must use the calendar year, but a fiscal year is possible in certain circumstances.42 It is important that there be shareholder agreements that bar unilateral action by a shareholder that would cause the S election to be revoked. This could occur, for example, if a shareholder transferred his shares to an ineligible person such as a nonqualifying trust. In addition, shareholder agreements should deal with distributions of cash to pay tax on S corporation earnings. The shareholders are liable for income tax on their distributable shares of S earnings whether they are distributed or not. Therefore, agreements should be in force to require distributions of at least enough cash to cover those tax liabilities.
Since, in general, the shareholders of an S corporation are taxable on the income of the S corporation, the tax-compliance burden may be increased. Each shareholder may be required to file individual tax returns and pay individual tax and estimated tax in each state in which the S corporation does business.
It is also important to determine the manner in which each state where the S corporation is liable for tax treats S corporations generally. Some states do not recognize S corporations as passthrough entities (all income is taxed at the corporate level),43 and some states have a hybrid approach.44 Some states require withholding on income of nonresident shareholders of S corporations.45 It is also important to determine whether a shareholder may claim a credit on his resident state income tax return for his nonresident state income tax on his share of the S corporation’s income. An analysis of state tax responsibilities is essential.
For corporations with foreign subsidiaries, there must be additional planning to best use U.S. foreign tax credits.
The S Election Exit From C Status: Summary
The S election can be an efficient and inexpensive way to exit C status and its double taxation on operating income and upon the sale of the business. However, it is not the ideal solution in every situation.
Limitations on the number of shareholders, the characteristics of the persons who can be shareholders, and restrictions on the capital structure impose limitations on the availability of S status. If S corporation status is not feasible, a company may be able to achieve the desired results by converting to an LLC.

Exiting C Status by Converting to an LLC

If a C corporation is not a candidate for an S election because of the requirements for S status discussed above, the current economic environment and depressed values for assets as well as historically low individual income tax rates on qualified dividends and long-term capital gains may make conversion to an LLC an acceptable exit strategy. The major difference between the exit from C status by conversion to S status and the exit from C status by converting to an LLC is that the latter has immediate tax consequences, which the corporation and its owners must evaluate in light of the future potential tax savings.
Income Tax Consequences of Converting a C Corporation to an LLC
In general, an LLC with one owner is disregarded for federal tax purposes and is treated as a sole proprietorship, branch, or division of the owner,46 and an LLC with more than one owner is classified as a partnership for federal tax purposes.47 Therefore, a conversion from C to LLC is not merely a change in the tax status of a corporation; it involves liquidating the C corporation and transferring the C corporation’s assets to an entity treated as a partnership (if the C corporation had more than one shareholder) or a disregarded entity (if the C corporation had only one shareholder).
The mechanics of a conversion from a C corporation to an LLC can take one of four forms:
Assets up: In the assets up form of conversion, the C corporation is liquidated and its assets are transferred to its shareholders who then transfer them to the LLC. (See Exhibit 1.)
Interests over: In the interests over form, there is an actual transfer of the shares of the C corporation to an LLC (which is then the sole shareholder of the C corporation) followed by an actual liquidation of the C corporation with its assets being distributed to the LLC. (See Exhibit 2.)
Assets over: In the assets over form, the C corporation transfers its assets to an LLC in exchange for all the interests in the LLC, followed by an actual liquidation of the C corporation in which the C corporation distributes the LLC interests to its shareholder. (See Exhibit 3.)
Merger or statutory conversion under state law: The merger of a C corporation into an LLC or its statutory conversion into an LLC under applicable state law are forms of conversion available in only some states. Where allowed, a C corporation can merge into an LLC or can be converted to an LLC by election. 48 (See Exhibits 4 and 5.)
Analysis of Income Tax Consequences and Other Considerations
Assets up: The assets up form is a liquidation of the C corporation, which is a taxable event at the corporate level measured by the difference between the FMV of the corporation’s several assets and their respective bases.49 The shareholders will recognize gain to the extent of the excess of the FMV of the assets distributed in liquidation over the basis in their shares.50 The basis of the assets in the hands of the shareholders will be their FMV upon distribution from the corporation.51 The contribution of that property to the LLC is generally not a taxable event,52 and the property’s basis in the hands of the LLC is the same as it was in the hands of the LLC member (former C corporation shareholder).53
Interests over: In the interests over form, the shareholders’ transfer of their C corporation shares to an LLC is generally not a taxable event,54 and the basis of the C corporation shares in the hands of the LLC is the same as the shareholders’ bases in those shares.55 The members’ bases (former shareholders) in their LLC interests is the same as their bases in C corporation shares.56 Upon the liquidation of the C corporation, the tax consequences are the same as the liquidation of the C corporation in the assets up approach. The C corporation will recognize gain. The LLC will also recognize gain, but that gain will be taxable at the member level,57 and the members’ bases in their membership interests will increase by their share of that taxable income.58 Thus, the basis of the assets of the C corporation in the hands of the LLC will be FMV, and the basis of the LLC interests in the hands of the member(s) will reflect the FMV of the assets. If there is only one shareholder of the corporation so that the LLC is disregarded, the result should be the same and the assets up analysis should apply.
As more fully discussed below, the IRS seems to take the position that the assets up approach requires an actual transfer of assets (rather than a transfer of an interest in an LLC). In the case of the interests over approach, the assets of the C corporation are actually transferred to the LLC whether or not the LLC is a disregarded entity. The only difference is whether the member(s) of the LLC (former shareholder(s) of the corporation) will be taxed on the distributions from the liquidation corporation directly because the LLC is disregarded or as partners in a partnership because the LLC is classified as a partnership.
Assets over and statutory merger or state law elective conversion: In Letter Ruling 200214016,59 the IRS concluded that a statutory merger of a C corporation into an LLC under applicable state law should be analyzed as an assets over transaction. The C corporation was considered to have transferred all of its assets to a newly formed LLC in exchange for LLC interests (at that point the C corporation was the only member) and the LLC’s assuming the C corporation’s liabilities. The LLC interests were considered to be distributed to the shareholders in liquidation of the C corporation. The C corporation had more than one shareholder, and the resulting entity was held to be a partnership.
The ruling is silent on whether an election under Sec. 754 was made or could be made.60 The IRS appears to be applying the assets over default provisions of Regs. Sec. 1.708-1(c)(3), which require an actual transfer of partnership assets for the assets up form to be followed.61 Where the facts are similar to those of Letter Ruling 200214016 and there is a distribution of an interest in a disregarded entity that becomes a partnership upon the receipt of interests by more than one shareholder in exchange for his shares, the availability of a Sec. 754 election is appropriate since the shareholders have acquired a partnership interest even if a partnership interest was not distributed by the corporation.62 In the case of a single-shareholder corporation, the distribution of the LLC should be viewed as the distribution of the assets of the corporation to the shareholder in liquidation, and the assets up analysis should apply.63
In an elective statutory conversion of a C corporation to an LLC, the same analysis should apply. Regs. Sec. 301.7701-3(g)(1)(iii) treats the elective conversion of an association taxable as a corporation to a disregarded entity as a distribution of all of its assets and liabilities to its single owner in liquidation of the corporation (assets up). While such an elective conversion of a domestic corporation is not permissible,64 the practical consequences of an elective state law conversion of a corporation to an LLC are the same as an elective conversion for tax purposes under Regs. Sec. 301.7701-3(g)(1)(iii). It is not clear whether the IRS would treat the state law elective conversion of a multishareholder corporation to an LLC the same way it treated the merger of the corporation into the LLC in Letter Ruling 200214016. Prudence would suggest that, in the case of a multishareholder corporation, careful consideration should be given to a Sec. 754 election.
Self-employment tax consequences: Where the business of the C corporation continues as an LLC, it is possible that all of the income of the enterprise can be subject to self-employment tax. This may not be a substantial problem where the shareholder(s) of the C corporation has been paid compensation at or above the wage base.

Summary and Analysis of Tax Cost

It is clear that the form of the conversion from C to LLC can be very important to the tax outcome for the shareholders. Since the conversion is a taxable event at the corporate and shareholder levels, it is important that the form allows a step-up to FMV of the assets formerly held by the corporation.
In the context of a multishareholder corporation, the IRS has taken the position that the merger of a corporation into an LLC should be analyzed as an assets over transaction. It may take the same position for an elective statutory conversion. In those situations, careful consideration must be given to an election under Sec. 754. In the context of a single-shareholder corporation that converts to a single-member LLC by way of a state law merger or state law election, the assets up analysis appears most appropriate.
Analysis of Tax Cost
Since the conversion of a C corporation to an LLC is a taxable event, it is necessary to analyze whether the current tax cost of the conversion is less than the present value of the future tax cost of double taxation of C corporation earnings and the present value of the future tax cost of disposing of the C corporation’s business. In making this analysis, it is necessary to consider whether and to what extent the assets of the C corporation will appreciate in value and how much operating income the C corporation will generate over a period of years, as well as the possibility of managing double taxation by paying tax-deductible compensation to shareholder-employees. In addition, some assumptions will have to be made about future tax rates, and appraisals will have to be obtained to establish and document the FMV of the business.
If the value of the assets in excess of their basis is sufficiently small and those assets are expected to appreciate in value, the cost upon conversion and the opportunity cost of the current payment of tax may not be too expensive in light of the tax savings on future appreciation. In addition, the existence of favorable tax attributes at the corporate level might reduce the current tax cost. Since the tax consequences of conversion are based on FMVs and the transactions are not between unrelated parties dealing at arm’s length, it is imperative to obtain bona fide appraisals to support the FMV that is used to determine gain. There are severe penalties for misstating the value of assets.


Double taxation of C corporation income from operations and from the sale of its business make C status tax inefficient. Changes in federal tax law scheduled to take effect in 2013 would worsen this tax inefficiency. The owners of a C corporation can avoid the tax inefficiency of the C corporation form by converting the corporation to S corporation status or converting it to an LLC.
While converting to an S corporation may be able to be accomplished without a current tax cost, converting a C corporation to an LLC can result in current tax at the corporate and shareholder level. Nevertheless, that current tax cost may be far less than the future tax cost of operating the business in a C corporation and incurring double taxation at what may be higher tax rates, or of incurring the higher tax cost (or reduced value) on a disposition of the business and the attendant double taxation of any appreciation in the value of the business. Since individual tax rates on qualifying dividends from C corporations and on capital gains are at historically low rates, this is may be the time to exit C status.

1 Referring to corporations that are subject to tax under Secs. 301 through 385.
2 The current federal income tax rate on qualifying dividends is 15% (or less in certain circumstances) (Sec. 1(h)(1)(B)). This tax rate is set to expire or “sunset” after 2012 (Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16, § 901). Absent a legislative change, the individual income tax rate on dividends will be the same rate imposed on ordinary income. In a similar fashion, the current 15% individual income tax rate on long-term capital gains will rise to its pre-2002 rate of 20%. In addition, beginning in 2013 the Health Care and Education Reconciliation Act of 2010, P.L. 111-152, imposes a 3.8% tax on the net investment income of certain individuals.
3 Sec. 11(b).
4 The highest current ordinary income tax rate imposed on individuals is 35% (Sec. 1). This is scheduled to increase to 39.6% in 2013. See note 2 above.
5 Regs. Sec. 1.162-7(b)(1); O.S.C. & Assocs., Inc., 187 F.3d 1116 (9th Cir. 1999).
6 La Mastro, 72 T.C. 377 (1979).
7 Labelgraphics, Inc., 221 F.3d 1091 (9th Cir. 2000).
8 IR-2012-27. The Middle Class Tax Relief and Job Creation Act of 2012, P.L. 112-96, enacted Feb. 22, 2012, extended a two-percentage point reduction in the employee share of payroll tax through the end of 2012.
9 Sec. 3101(b).
10 Sec. 336(a).
11 Secs. 331(a) and 1001.
12 Sec. 1001.
13 Sec. 1011.
14 Sec. 338. Absent an affirmative election to treat the share sale as an asset sale with attendant tax consequences, there is no change in “inside” basis as a result of a share sale.
15 FASB Statement No. 109, Accounting for Income Taxes, ¶30.
16 This article addresses only the federal income tax consequences of exiting C status. The tax law of each jurisdiction in which the corporation is subject to tax must be consulted and considered. Where the C corporation (or its subsidiaries) is subject to tax in jurisdictions outside the United States, both foreign tax law and U.S. tax law as it applies to the foreign activities of U.S. taxpayers must also be taken into account.
17 Sec. 701 (relating to partnerships); Sec. 1366 (relating to S corporations).
18 Secs. 1361–1379.
19 While the business formerly operated in a corporation could operate as a sole proprietorship, general partnership, or limited partnership, we believe that the limited liability company is the entity of choice for operating a business outside of corporate solution.
20 Secs. 1361(b)(1) and (b)(2).
21 Sec. 1361(b)(1)(A). The 100-shareholder limitation is relaxed by rules that permit members of a family (as defined) to be treated as one shareholder (Sec. 1361(c)(1)).
22 Sec. 1361(b)(1)(C).
23 Secs. 1361(b)(1)(B) and (c)(3).
24 Secs. 1361(c)(2), (d), and (e).
25 Sec. 1361(c)(6).
26 Sec. 1361(b)(1)(D).
27 Sec. 1361(c)(4).
28 Regs. Sec. 1.1361-1(l)(2)(i).
29 Regs. Sec. 1.1361-1(l)(4)(ii).
30 Sec. 1375.
31 Sec. 1362(d)(3).
32 Sec. 1362(d)(3)(C)(i); Regs. Sec. 1.1362-2(c)(5)(ii). Such passive income may not be problematic if earned in an active trade or business.
33 Sec. 1374(d)(7). For tax years beginning in 2011, the 10-year period was shortened to five years (Small Business Jobs Act of 2010, P.L. 111-240, §2014(a)).
34 Sec. 1374(d)(2).
35 Sec. 6662(e).
36 The 10- or 5-year period, as the case may be. See note 33 above.
37 Rev. Rul. 74-44, 1974-1 C.B. 287; Spicer Accounting, 918 F.2d 90 (9th Cir. 1990).
38 Sec. 338(h)(10); Regs. Sec. 1.338(h)(10)-1(b)(4).
39 Sec. 1362(a)(2).
40 Sec. 1362(b).
41 The election is made by filing Form 2553, Election by a Small Business Corporation.
42 Sec. 1378.
43 See, e.g., N.H. Rev. Stat. §77-A:1(IIIb).
44 For example, Massachusetts, which imposes a corporate-level tax when receipts exceed a certain amount. See Mass. Gen. Laws ch. 63, §32D.
45 See, e.g., R.I. Gen. Laws §44-11-2.2(3)(b).
46 It is beyond the scope of this article to discuss state income tax consequences of the conversion of a C corporation to an LLC; nevertheless, the state tax consequences must be considered and evaluated when planning such conversions.
47 Regs. Sec. 301.7701-2. Regs. Sec. 301.7701-3(a) allows an election to treat an LLC as a corporation.
48 See, e.g., New York Bus. Corp. Law §901 (merger) and R.I. Gen. Laws
§7-16-5.1 (election).
49 Sec. 336.
50 Secs. 331 and 1001.
51 Sec. 334(a).
52 Sec. 721(a). Under Sec. 721(b), gain may be recognized if the LLC would qualify as an investment corporation within the meaning of Sec. 351 if the partnership was incorporated.
53 Sec. 723. The partnership’s basis is increased by any gain recognized under Sec. 721(b) by the contributing partner.
54 Sec. 721. Although a transfer to a partnership that is an investment company within the meaning of Sec. 351 would not be tax free under Sec. 721(b), the gain recognized to the shareholders of the C corporation would be reflected in their LLC interests under Sec. 722, and the basis of the C corporation shares in the hands of the LLC would be their fair market value. Upon liquidation of the C corporation, there would be gain recognized at the corporate level but not at the shareholder level since the gain was recognized on the transfer to the LLC.
55 Sec. 723. If the LLC is an investment company within the meaning of Sec. 351, the LLC’s basis is increased by any gain recognized under Sec. 721(b) by the contributing partner.
56 Sec. 722. If the LLC is an investment company within the meaning of Sec. 351, the member’s basis is increased by any gain recognized under Sec. 721(b) by the contributing partner.
57 Sec. 701.
58 Sec. 705.
59 IRS Letter Ruling 200214016 (4/5/02).
60 Where a partnership interest is acquired in a taxable transaction, an election under Sec. 754 permits the inside basis of partnership assets to be adjusted to reflect the outside basis of the partnership interest. The election is irrevocable and in subsequent acquisitions of partnership interests can cause a downward adjustment of the basis of partnership assets.
61 Regs. Sec. 1.708-1(c)(3)(i).
62 Regs. Sec. 301.7701-3(f)(2).
63 Rev. Rul. 99-5, 1999-1 C.B. 434; Assoc. Chief Counsel Legal Advice AM 2012-001.
64 Regs. Secs. 301.7701-3 and 301.7701-2.