For Small Businesses -- Three Cutting-Edge Tax-Cutting Strategies

John J. Connors, JD, CPA
Tax Educators' Network, Inc.

Special from Tax Hotline
June 1, 2006

S mall business is considered by many to be the backbone of our economy, creating more than half of the gross national product, employing half of all private sector employees, generating 60% to 80% of new jobs over the past 10 years, and producing 13 to 14 times more patents per employee than large firms.

But now, small firms must be brutally competitive. Every edge -- including strategic use of tax breaks -- is important for success. Here are some select strategies to help your business gain the edge. Be sure to talk them over with your tax adviser.

EQUIPMENT PURCHASES

Instead of depreciating over a number of years the cost of equipment, such as computers, office furniture, and machinery, small businesses can claim an immediate deduction for the cost through expensing (first-year write-offs).

The dollar limit on expensing in 2006 is $108,000. But, this limit can be claimed only if the business buys no more than $430,000 of equipment this year. The limit phases out dollar for dollar for purchases over this threshold, so that no deduction can be claimed when purchases top $538,000 -- a number that large companies typically exceed. This is how large firms are prevented from using expensing.

Extra opportunity: The dollar limit on expensing is increased by up to $35,000 for businesses in empowerment zones, renewal communities, the District of Columbia, and the New York City Liberty Zone (the area affected by the 9/11 attack). The dollar limit is increased by $100,000 for the Gulf region (affected by Hurricanes Katrina, Rita, and Wilma). The dollar limit is restricted to $25,000 for the purchase of an SUV weighing more than 6,000 pounds.

Special expensing opportunities exist for other business costs. Examples...

Start-up costs, partnership organizational expenses, and corporate organizational expenses up to $5,000 (additional amounts are deducted ratably over 180 months).

Expenditures to remove architectural barriers to the elderly and handicapped up to $15,000 per year.

Film or TV production costs up to $15 million ($20 million in certain cases) by small production companies.

The aim of expensing is to provide an immediate tax break for buying business equipment, whether new or used, and to reduce the record-keeping burden on small businesses. But the opportunity to claim such large write-offs is scheduled to expire at the end of 2007. (The limit is set to revert to $25,000 annually unless Congress keeps the higher limit.)

Expensing can be used only if the taxpayer has active trade or business income at least equal to the deduction. For this purpose, active trade or business income includes trade or business income reported on Schedule K-1 of Form 1065 (for partnerships and LLCs) or Form 1120S (for S corporations) only if the owner is active in the business. (Passive investors cannot benefit from this write-off unless they have other independent sources of such income.) It also includes wages of an employee, including compensation of an owner’s spouse, from any employer when filing a joint return, as well as other sources of self-employment income.

Strategies: Businesses that aren’t profitable won’t benefit from expensing (unless they expect to get profitable within the near future). They can forgo expensing the cost of equipment purchases and instead depreciate them. Alternatively, they may be better off tax-wise to lease equipment, since lease payments are fully deductible.

REMEDIATION COSTS

Buildings that become contaminated must be cleaned up for continued use. (For example, buildings in the Gulf region contaminated with petroleum.) This can cost thousands of dollars, and small-business owners aren’t exempt from these responsibilities. Usually the tax law requires that these expenditures be capitalized (added to the property’s cost basis). However, a business may be able to claim an immediate deduction for remediation costs under the right circumstances...

You can show that the remediation merely returns the property to its precontamination condition and does not add to the value of the property or extend its useful life.

Example: The owner of a nursing home was allowed to deduct the cost of remediation for mold. Replacing the contaminated Sheetrock was immediately and fully deductible. Similarly, a deduction has been allowed for asbestos removal.

You clean up property in the Gulf region. Under the Gulf Opportunity Zone Act of 2005, 50% of costs for site cleanup and demolition related to damage caused by Hurricane Katrina, Rita, or Wilma are deductible. This break extends only for costs paid or incurred before 2008.

SELF-EMPLOYMENT TAX

Limited liability company (LLC) owners are self-employed individuals with personal liability protection. For purposes of the self-employment tax, LLC members can be classified as general partners (taxable on the full extent of business income passed through to them) or as limited partners (exempt from self-employment tax on their share of business income).

While self-employment tax treatment has not been settled, there is some guidance. A proposed regulation -- Section 1.1402(a)-2(h)(3) -- treats an LLC member as a general partner (subject to self-employment tax on his/her entire distributive share of business income) if the member either materially participates in the business activities for more than 500 hours during the year or has the authority to bind the LLC to a third-party contract. And, as always, he pays self-employment tax on any guaranteed payments (as opposed to his share of the profits).

If an LLC member does not meet either test, he might still be subject to self-employment tax if he has guaranteed any of the firm’s debt. However, the proposed regulation offers a possible solution by allowing LLC members to own “varying interests” in the underlying entity. So, even though a managing member–type interest might indeed be subject to self-employment tax, that same member might simultaneously own an investor-type interest, which would escape this tax.

Example: An LLC has three owners, A, B, and C. A doesn’t perform any services for the business and is merely an investor. B receives a guaranteed payment for working 600 hours during the year for the business. C receives a guaranteed payment for working 1,000 hours a year. C, as manager for the LLC, has authority under state law to bind it to third-party contracts.

Even though A, B, and C each receive one-third of the income from the LLC, only B and C pay self-employment tax on this amount (as well as on their guaranteed payments). Under the proposed regulations, A is treated as a limited partner because he does not work more than 500 hours for the business and does not have contracting authority.

Strategies: Review the LLC operating agreements and modify them to take advantage of the “varying interest” rule. Classify owners as managing members or investor interests. Make sure that annual work for the business is documented if it does not exceed the 500-hour threshold.

Payments to retiring owners: Retiring LLC owners can minimize self-employment tax by creating a retirement program and ceasing all work.

Example: Say a law firm organized as a limited liability partnership (LLP) creates an unfunded retirement benefit program (as opposed to a qualified retirement plan) to pay retiring partners a benefit starting at age 60 (or age 55 if they have at least 25 years at the firm). The IRS agrees that payments under this program are not subject to self-employment tax as long as no service is rendered after retirement. Working “of counsel” or participating in any other way in the firm requires payments under the program to be subject to self-employment tax.

Bottom Line Publications interviewed John J. Connors, JD, CPA, a former instructor at the University of Notre Dame. He is owner of the Tax Educators’ Network, Inc., a company providing continuing education products and consulting services, 10406 N. Council Hills Dr., Mequon, Wisconsin 53097.