Boost your cash flow, hike your profits, accelerate your growth -- start planning now, and that's what the tax laws can do for you* * *
Complaining about taxes is an American tradition that dates back at least as far as the Boston Tea Party. Chances are, you've often joined in the chorus yourself. If you have adopted a fatalistic attitude about taxes and assume there's little more you can do to alleviate your financial obligations to Uncle Sam, it's time to rethink that position. For, as tax accountants and lawyers know, there's a universe of tax strategies out there to help you better manage your corporate and personal finances.
Some are simple; others are more complicated both to plan for and to take advantage of. Some may not be a good fit for your company. But overall they represent solid, legal, and often overlooked opportunities for company builders who want to boost cash flow, improve bottom-line results, and propel their companies toward more predictable and even accelerated growth.
What follows is not intended to be a comprehensive guide through the world of tax breaks; instead, it's a glimpse at the sorts of opportunities you and your accountant might want to consider.* * *
* Accelerated Deductions. Tax-reform movements may come and go, but some basic tax strategies last forever. That's particularly true in the case of this maxim: Accelerate deductions, delay cash expenditures -- and increase cash flow.
To take advantage of that technique you'll have to time some company activities more carefully. Take your bonus plan, for example. Most companies assume they have to distribute cash bonuses within the taxable year to qualify for a deduction. But the Internal Revenue Service permits you to take a deduction during the year in which you declare bonuses (provided they aren't going to holders of more than 50% of the company's stock), even if payments are delayed up to two and a half months into the next tax year -- which could mean a valuable boost to the current year's cash flow.
* Research and Development. Last year's tax legislation extended through 1991 the research-and-development tax credit for corporate expenses. Reckoning the actual dollar value of the tax credit takes an accountant's sharp pencil, however. While the maximum size of an R&D tax credit is 20%, the amount each company is allowed is based on a complex set of regulations. Still, the message is simple: keep meticulous records of every relevant corporate expenditure.
Meanwhile, it's at least worth considering getting as much research as possible into 1991, while the tax subsidies are a sure thing. Although there is popular support behind extending the R&D credit beyond 1991, recessionary pressures could force legislation to reduce or discontinue the extension.
* Accelerated Construction Costs. In the good old days of accelerated depreciation -- before 1986's Tax Reform Act -- companies could write off the cost of, say, building a production facility over 19 years, no matter what the real life expectancy of the property was. Now such costs must be written off in equal amounts over a 31½-year span.
But you can get around that provision by putting certain construction costs into other categories that qualify for earlier write-offs. Generally, costs for items such as movable wall partitions, computer-ventilation systems, security lighting, landscaping, and the like can be written off much sooner than core structural costs.
And overall benefits add up fast: the present value of the depreciation deduction from $100,000 worth of construction costs, depreciated over 31½ years and assuming an interest rate of 8%, would be about $36,000, according to Robert M. Hersh, a tax partner in the Fort Lauderdale, Fla., office of Grant Thornton. If that same $100,000 were segregated from structural costs and thus depreciated at an accelerated pace over 7 years, the present value of the depreciation deduction would be about $76,000, assuming the same 8% interest rate.
* Car Use. A sweet and simple tax benefit. The IRS recently raised the expense allowance for business use of cars -- and there's no reduction in the rate for mileage past 15,000, as there used to be. On 1990 tax returns the tax write-off was 26¢ a mile. But as of 1991 the rate rose to 27½. As before, the best way to safeguard this deduction is to keep logs to record all business use of cars by date and mileage.* * *
* Perquisites. Thanks to 1989's repeal of Internal Revenue Code Section 89, companies can once more look for ways to motivate managers. That's because certain types of benefit plans, such as medical-and life-insurance packages, no longer have to meet federal nondiscriminatory guidelines. That means they can be designed specifically to reward top-level managers, with their costs offset by corporate tax deductions.
Janet Fuersich, a partner in the New York City office of Coopers & Lybrand, recommends that you "structure a flexible perquisite plan, in which your firm decides first how much it can afford to provide per executive, once the relevant tax deductions get factored in." Then give people a choice of benefits. Your menu might include 100% medical coverage, a company car, extra life insurance, college-tuition subsidies, and health-club membership. The payoff for your company is its ability to limit costs while providing benefits tailored to the needs of each executive.
* Supplemental Pensions. Although you may never have heard of a secular trust -- a way to guarantee supplemental pensions and deferred compensation for key executives -- the technique has become increasingly popular since the mid-1980s and offers some appealing tax advantages.
Secular trusts work like this: A company places an amount -- say $10,000 -- in a trust for an executive. Unlike a cash bonus, the money, plus any interest it accumulates after yearly taxes, will be available only at retirement, at which time distributions are at least partially tax-free to the executive. Because corporate funds have actually been set aside for the executive -- and under trust rules cannot be touched by anyone other than the executive even if the company goes under -- the executive has to pay tax on that money the year it goes into the trust. That may seem a little unfair, since the executive can't actually use the funds until retirement. But there's still an overall tax advantage to the strategy because the company takes an immediate tax deduction that, on a $10,000 fund contribution, is probably worth $3,400. The executive's tax liability is probably only $3,100.
That's where arbitrage comes in -- because there's room for maneuvering with the tax spread ($300, in the above example). Your company could simply take the deduction and run, assuming that even if your managers grumble about the early tax bill, they'd still rather have the money in a secular trust than not at all. But, as is more common, you could pay $3,100 directly to your executives to cover their tax liability, and pay the remaining $6,900 into the secular trust. That shields your key executives from having to pay taxes out of their own pockets while guaranteeing the company's $10,000 deduction. Best of all, secular trusts can be combined with vesting schedules or forfeiture provisions to help tie an executive to your company over the long haul.
A variation on the secular trust is an equally obscure pension technique known as the rabbi trust, originated by a Long Island synagogue to provide a retirement fund for its rabbi. The chief difference is that funds contributed to a rabbi trust can be removed by creditors if a company goes bankrupt. That potential risk means the executive has no tax liability until the funds are withdrawn at retirement, when the distribution will be fully taxable. But it also means there's no tax deduction for the corporation until that point.* * *
Last year's tax package deserves credit for extending another tax subsidy, the deduction for education assistance. As the law stands now, your company can deduct education expenses of up to $5,250 per employee as long as you reimburse employees before December 31, 1991.
This deduction can apply to expenses for all course work, even non-job-related studies. To qualify you must make the benefit available to all your employees and you must document that in your employee manual or other materials. One other caveat: the deduction applies only to course costs, not to travel or other expenses.* * *
* Estate Freeze. Perhaps the best news for business owners comes from the 1990 repeal of a provision in the 1987 tax law that had eliminated, as a practical matter, one of the most popular estate-planning techniques, the so-called estate freeze. Under the freeze, owners can give away future growth in their businesses -- either to children or to key employees -- without paying any immediate or future gift or estate taxes on that growth.
For owners ready to tackle the task of estate planning, the savings can be enormous. As Peter Faber, a partner at the New York City law firm of Kaye, Scholer, Fierman, Hays & Handler, explains: "If I owned 100% of the stock in a business worth $10 million and simply gave it or left it to my daughter, I'd owe about $5.5 million in gift taxes. If I waited until it grew to $12 million, I'd owe even more. But if I used the estate-freeze technique instead, I'd avoid immediate gift taxes and manage to pass along all the future growth in the business, tax-free."
In simple terms, here's how an estate freeze works. Owners turn in to the corporation their existing common stock, exchanging it for a set of preferred stock shares created by the company. The common and preferred shares can be designed to have roughly equivalent value, so there's no immediate tax on the swap. The preferred shares pay the owner a regular dividend but will not increase in value. Instead, future growth belongs to the child or employee who, at the time of the freeze, purchases common stock. The purchase price is low because most of the corporation's value is in the preferred stock. The kids or employees can eventually buy the preferred stock, but in the meantime the government is willing to let them have the common stock, which represents all future growth, for a nominal price.
The 1990 tax law left one real risk. "If the IRS decides that the preferred stock an owner receives in place of his common stock is worth much less than the original common stock's value -- usually because it doesn't pay an adequate dividend -- the owner will have to pay a gift tax on the transfer," warns Arthur H. Rosenbloom, chairman of MMG Patricof & Co., an international investment banking firm in New York City. To avoid that, peg the preferred stock's dividend and other characteristics at levels that match those of publicly traded preferred stock with similar characteristics.
* GRITs. The opportunities for using grantor retained income trusts (GRITs), another once-popular tax-and estate-planning technique, have narrowed, but there are still some tax advantages. In the past, business owners could have used GRITs to reduce the gift taxes that come due when transferring their businesses to their children. Owners who used them would hold on to the investment income from their businesses over a specified number of years, even though they had passed ownership of the companies over to an irrevocable trust.
GRITs can still be used to pass on ownership of a residence, whether it's a yearlong or vacation home. "So if a man owns a $1-million residence and knows he plans to retire to Florida in 15 years, he can transfer ownership of the home to a 15-year GRIT whose beneficiary is his son or daughter," suggests Richard Rothberg, a trusts-and-estates partner at the New York City law firm of Kronish, Lieb, Weiner & Hellman. The IRS would then assign a present value to the gift, based on actuarial tables pegged to the owner's age, life expectancy, and the length of the GRIT; if those tables assigned, say, a 25% present value, the owner would have to pay gift taxes on only a $250,000 transfer, though the house was worth four times as much.
GRITs may also still be used with gifts of artwork and other tangible personal property.
* Selling the Business. Don't listen to people who say there's no way to avoid taxes on the sale of a business. You can make use of a device called a charitable remainder trust, which is a trust that at some point passes on to a charity everything that remains in it.
"It comes into play when someone has a low cost basis [valuation at the time you start up or purchase a company] in his business and the potential to sell it at a very nice profit," explains Douglas Brown, president of Sherwood Trust Consultants, in Springfield, Mass. "He sets up a charitable remainder trust and gives it a life term, after which the trust will go to the charity. He donates his stock to the trust and then receives an immediate charitable income-tax deduction." The trust then sells the stock to an outside buyer (ideally, the buyer has already been identified and oral negotiations have taken place); the purchase price passes into the trust, where it earns investment income (possibly tax-free) and continues to pay the founder an agreed-upon rate of return over the rest of the trust's lifetime.
Assume your company has a cost basis of $100,000 and a sale price of $2 million. If you sold it outright, you would wind up paying about 35% in taxes on a capital gain of $1.9 million. That would leave an after-tax profit of $1,235,000 -- which might yield an annual income of $93,000 (assuming a 7% after-tax rate on $1,235,000, plus the untaxed $100,000). If at age 55 you had instead set up a charitable remainder trust, the full $2-million sale price could have been invested; assuming the same 7% after-tax rate, you would receive annual payouts of $140,000. You'd also receive an immediate tax deduction of about $400,000 for your contribution, which is the government's calculation of the value of the discounted $2-million contribution. At the end of the trust's life, the remaining funds would pass on to the charity.* * *
* Insurance. For business owners and their executives, using an insurance trust to avoid estate taxes on the payouts from life-insurance policies is a simple personal tax-saving technique.
Here's how to do it: set up a trust whose purpose is to own all existing and future insurance policies on your life. As long as the trust owns the policies, the proceeds to your beneficiaries will be free -- that's right, absolutely free -- of estate taxes that now can run as high as 55%.
One potential problem: if the insured person dies within three years of transferring ownership of existing policies to the trust, the law says that policy proceeds must be taxed as part of the overall estate. Of course, your beneficiaries are no worse off than if the transfer hadn't taken place. One strategy to avoid possible transfer problems is to make an outright gift of funds to the trust, which then purchases its own insurance policies.
* Charitable Donations. Finally, a one-shot tax break that's too sweet to ignore came out of 1990's tax legislation. During tax year 1991 those who make charitable donations of artwork and other "appreciated tangible personal property" won't be socked with hefty penalties under the Alternative Minimum Tax (AMT) law. If you are a collector, the enticement speaks for itself. Since the AMT "preference" charge can be quite hefty for an art collection that rose in value during the go-go '80s, it's worth accelerating planned donations.
Some advice from managers who are experienced in weighing tax matters against the other financial needs of growing companies:
* Start tax planning early. "Since this is my second start-up, I'm trying to avoid some of the mistakes I made the first time around," says Mark Klein, chief executive of Channel Computing Inc., a software developer in Newmarket, N.H. "I learned along the way that tax savings can help pay for corporate growth, so with Channel I went out and hired my tax accountant and started tax planning before I even hired any full-time employees." Recently, Klein decided to purchase -- rather than lease -- new, expanded office space because he calculated that tax subsidies helped tip the balance to make it more profitable to buy.
* Keep detailed tax records. M. C. "Mac" McConnell, whose Fort Lauderdale, Fla., company, The Artful Framer Gallery, has grown from $175,000 in sales to $625,000 over the last four years, keeps meticulous records of all expenditures. "My computer software forces me to categorize every check I write and every deposit I receive, so there's absolutely no guessing -- or missed opportunity -- when it comes to figuring out my taxes."
Ann Blakeley, president and CEO of Earth Resources Corp., a hazardous-waste-management firm, agrees. "Since we do a lot of research and development, the R&D tax credit really adds up for us. So I tell my people that they've got to keep the same kind of accurate, detailed records -- complete with full documentation and very precise time and cost breakdowns -- that they would keep for any project where we were billing a customer."
* Document top-level tax decisions. John C. Heenan, the chief financial officer of Physical Acoustics Corp., in Lawrenceville, N.J., must juggle the needs of four foreign subsidiaries with the tax considerations of a U.S. parent. "I've found it helpful in dealing with the IRS to keep detailed minutes of meetings in which board members or key executives authorize decisions about tax-related matters like charges to foreign subsidiaries or how we'll make use of our net operating losses. It's better to prepare the records in advance than to have to scramble around for documentation if the company gets audited."
* Don't let taxes run the company. Although tax savings can definitely add up, it's essential for managers to remember that those savings are only one factor in a business decision. "It feels as if I've spent $5 trillion on accountants, only to come down to one basic conclusion," emphasizes Richard Novak, owner of N.H.S. Inc., in Soquel, Calif., which sold $23 million worth of skateboards and snowboards last year. "If you earn $100 in profit on the sale of skateboards, you'll eventually have to pay $40 or so in taxes. Rather than coming up with some kind of crazy, time-consuming tax scheme that just puts off the inevitable, I'd rather pay my taxes and put that $60 to work in ways that will generate more sales for the company."
IS YOUR ACCOUNTANT SAVVY?
Sophisticated tax strategies require expert advice
It's not uncommon for young companies to outgrow their accountants. But how can you tell if that's the case? Here are the types of questions you might ask -- and some red flags to watch out for.
Question: Anything new on the tax front?
Answer: No, things are about the same.
Any company, particularly any growth company, that relies on the same tried-and-true tax plans and strategies year after year is missing out, since the Internal Revenue Code itself is a fluid body of regulations that changes to offer new opportunities each year. If you can't remember the last time your accountant suggested a change in tax strategy, it may be time to look around for a new one.
Question: I read something in The Wall Street Journal about a private-letter ruling. Is that something we should be looking into?
Answer: I don't know; what did it say?
Private-letter rulings are among the best indicators available about IRS thinking on innovative tax strategies. Companies contemplating state-of-the-art tax maneuvers can petition the IRS for a ruling, by mail, on the tax consequences and risks, if any. Good accountants stay up-to-date on monthly publications of those rulings and look for ways to relate them to their clients' needs.
Question: A friend was telling me about increasing his managers' 401(k) savings without running afoul of IRS guidelines. What do you think?
Answer: Sounds shady to me.
Accountants who haven't bothered to keep abreast of subtle changes in the tax laws or new approaches to maximizing tax loopholes often try to deflect attention away from their own inadequacies by exacerbating corporate fears of the tax man. In fact, if a colleague or reputable published source recommends a strategy, odds are pretty strong that it stays within the letter of the tax law -- as long as an accountant who knows his or her business has designed it effectively.
Question: I just got a notice that I'm going to be audited. What should we do?
Answer: What do you mean "we?" I don't do audits.
Competent accountants display confidence in their ability to defend every line on their clients' tax returns. If yours doesn't, start running.
The corporate world is littered with tax guides. Here are some worth pursuing.
Allyear Tax Guide: Starting Your Business, by Holmes F. Crouch, is a somewhat preachy but always practical guide to the nitty-gritty tax issues that matter for start-ups and companies whose sales are less than $1 million. Included are specific instructions about what records to keep, which practices can get new businesses in trouble, and which tax forms to use and when. The book can be ordered for $12.95 from Robert Erdmann Publishing, 810 West Los Vallecitos Blvd., Suite 210, San Marcos, CA 92069; (800) 833-0720, Dept. 15 .
The Ultimate Tax Planning Guide for Growing Companies, by Robert W. Wood, may be off-putting at first because of its length -- 462 pages -- and textbook-like appearance, but the inclusion of highlighted advice sections that focus on how corporations can minimize taxes, protect against audits, and avoid IRS penalties makes the book well worth its $27.95 price tag. Also included are sections that detail tax laws and strategies relating specifically to sole proprietorships, partnerships, C corporations, and S corporations. To order, contact Business One Irwin, Homewood, IL 60430; (800) 634-3966.
The Coopers & Lybrand Guide to Business Tax Strategies and Planning is the guide for owners and executives who want their tax information in a style that is quick, breezy, and easy to follow. In 208 pages -- with plenty of bullets to facilitate skimming -- this book provides tax tips on buying and running a business, designing employee-benefits and -compensation strategies, and coordinating personal-finance matters for owners. The price, $9.95, is also painless. To order, contact Simon & Schuster, 1230 Ave. of the Americas, New York, NY 10020; (800) 223-2348.
ALSO KEEP IN MIND
Inc. has previously covered some highly profitable tax strategies. Here are some worth considering:
* Simplified employee pension plans are a cross between individual retirement accounts and corporate profit-sharing plans, and are appealing because of sizable tax savings through payroll-tax reductions and a business-expense deduction for all corporate contributions ("The Big Easy," January 1991, [Article link]).
* Flexible spending accounts allow your employees to pay medical, child-care, and other qualified expenses with pretax dollars, while your plan administration costs are more than offset by payroll-tax savings ("Flexible Spending," October 1990, [Article link]).
* Annual stock gifts, valued at up to $10,000 per parent per child, can be made by business owners as part of a long-term estate-planning process -- free of estate and gift taxes ("Bringing Up Baby," August 1990, [Article link]).
* 401(k) wraparounds allow you to enhance the income- and tax-deferral opportunities of your key executives by designing 401(k) plans that permit deferral of bonuses and other special compensation ("Beyond the 401(k)", July 1990, Doc. No.07901031).
* Charitable contributions by business owners can be coordinated on the corporate and personal front so you can maximize a range of valuable tax incentives ("Smart Gifts," April 1990, [Article link]).
* FIFO to LIFO is a switch in inventory-accounting methods that may allow you to cut taxes and improve your cash flow ("Taking Stock," November 1989, [Article link],).
* S-corporation status still offers a powerful inducement if you want to avoid double taxation of your corporate dividends ("The Do-It-Yourself Tax Cut," September 1989, [Article link]).