The Economic Recovery Tax Act of 1981 (ERTA) has created some welcome new accelerated depreciation opportunities. But beware: When commercial real estate is involved, ERTA baits a giant tax trap that can be sprung when you sell the property.
The new law dictates that real estate be depreciated over only 15 years. That's good, because it creates substantial tax deductions. The law also gives you a choice of two methods: the accelerated method, which yields larger cost-recovery deductions in the early years, and the straight-line method, which spreads the deductions evenly over the 15 years. If the accelerated method is selected, however, all or part of the taxable profit when the building is sold will count as ordinary income -- not as a capital gain.
Let's look at the sad case of Sam Smart, who is solidly in the 50% tax bracket. He pays $400,000 for a new commercial warehouse; $100,000 is allocated to the land, $300,000 to the building. Sam elects the accelerated method in order to cut his tax bill as much as possible.
It is now 15 years later. Sam sells the warehouse for $400,000. After 15 years all the cost has been recovered via deductions so the building's tax basis is zero, although the land's tax basis is still $100,000. Therefore, Sam's profit for tax purposes is $300,000 ($400,000 sales less $100,000 tax basis). The tax bill on this profit is a whopping $150,000 ($300,000 X Sam's 50% tax bracket).
ERTA requires that when a commercial building is sold the government must "recapture" any cost recovery deductions taken under the accelerated method. The Internal Revenue Service achieves this recapture by taxing the amount that had been deducted, but which was later realized as profit, as ordinary income. That's the trap.
Suppose, instead, that Sam had elected the straight-line method. He would have paid more taxes in the first few years he owned the building, but the tax bite when he sold would have been easy to bear. The $300,000 profit would have been taxed as a capital gain. The top capital gains rate of 20% would result in only a $60,000 (20% of $300,000) tax bill -- just 40% of the bill Sam actually paid.
ERTA's recapture provisions hit residential real estate less hard than they do commercial real estate. If the accelerated method is used, only the excess of the total cost recovery deduction over the amount available if the straight-line method had been used is recaptured and taxed as ordinary income.
But the moral of the story of Sam Smart is: Do not make any real estate depreciation decisions without getting a complete explanation of the down-the-road tax consequences from a qualified professional.
DELAYED BONUS CAN SPELL DISASTER
Suppose you run a closely held corporation that decided to deduct a bonus for your majority stockholder late last year, but not pay it until sometime this year. Your purpose is to prevent both the corporation and the stockholder from having to pay tax on the money until next year. Sounds like a good idea, but one false move could spell disaster.
Here is a typical scenario: Big Deal Inc. ends its fiscal year on December 31. Boss is the sole shareholder. In December 1981, Big Deal declares a $10,000 bonus payable to Boss. But Big Deal neglects to pay the bonus until April 1, 1982.
The sad results are that Boss must pay tax on the $10,000 in 1982 and Big Deal cannot deduct the $10,000 -- not in 1981, not in 1982, not ever. Impossible? Sorry, but the Internal Revenue Code spells out the rule: If Boss owns more than 50% of the corporation's stock, Big Deal must pay the bonus within 2 1/2 months after year-end. Otherwise, it loses corporate deduction for Boss's bonus.
Here's another twist: Same facts as in the scenario above, but Big Deal pays Boss on March 1, 1982 (within 2 1/2 months), though Big Deal had plenty of cash to pay all bonuses due on December 31, 1981. Big Deal now gets its tax deduction in 1981 for Boss's bonus, but the bonus (even though paid in 1982) is taxable to Boss in 1981. Why? Because Boss could have written a check in full for the bonus in 1981, so he is assumed to have "constructive receipt" of the money in 1981. And that is the law.
Can you beat the IRS at this game? Yes, but it may be more trouble than the bonus is worth. The best way is to run your corporate cash balance down to nearly zero on the last day of the corporation's year.
A 1981 case opens a possible new way for Boss. Since 1953, a corporation had been authorizing bonuses at the end of December but paying them six weeks later. The corporate bylaws and company policy required two signatures on all checks. This time the court overruled the IRS. The boss, by company policy, could not write a good check for himself without a second signature. So he didn't have "constructive receipt" of the money. (See Mortimer I. Kahn, W.D.N.C. 1981.)
Let's summarize the tax lessons so no reader of this column will get burned by the 2 1/2-month rule:
1. Keep the corporation year-end cash balance low to avoid "constructive receipt."
2. Require a second signature on all checks.
3. Pay the boss's bonus within 2 1/2 months after the corporation's year-end.