Also in this Issue:
-Estate Planning Don'ts
-Real Estate No-No's
-How Not to Run Your Business
TAX TRAPS
by Jeff Detwiler detwiler@ddrs.com
Following are eleven rules which I often wish clients had been given and followed long before we meet to discuss particular business or tax needs. In some cases, the consequence for failure to follow these rules is a more complex and costly solution to an otherwise straightforward problem. In other cases, the trap, once entered, cannot be escaped.
Don’t form an "S" Corporation to hold investment real property. While the S Corporation beats the regular corporation as a tax vehicle because only one level of tax applies on sale of the property, the S Corporation is relatively inflexible and has serious disadvantages compared to a partnership or LLC (limited liability company). First, in the event of the death of an owner, property held in a partnership or LLC receives a step-up in basis, allowing the property or the decedent’s interest in the property to be sold with minimal or no capital gain tax; property in an S Corporation receives no step-up - it is the S Corporation stock that is stepped up. Second, once property is in an S Corporation, it cannot come out without paying tax on any appreciation. A partnership or LLC can distribute property tax free - often a necessary first step in preparing for like-kind exchanges or for simply splitting up properties which former co-owners wish to hold separately.
Don’t buy a business without clearance from state sales tax authorities. In many states, California included, the purchaser of a business is liable for all unpaid sales taxes of the seller (including from pre-sale operations and from the sale itself) unless the taxing authority (State Board of Equalization in California) has cleared the sale by giving a certificate. If the certificate requires an amount to be withheld from the purchase price, then by all means follow the requirement or the certificate is no good.
Don’t throw away tax documents after three years. While the standard statute of limitations for federal income tax is three years from the later of the due date or the actual filing date, it is unwise to discard tax records until substantial time has passed, in most cases at least 10 years, and never less than seven. A six year statute of limitations applies to large dollar issues (greater than 25% of tax liability); prior year records are often needed to substantiate carry forwards and may prove useful in substantiating positions taken in later years.
Don’t adopt a regular C Corporation as a business form unless you understand the added tax cost when you sell out. The regular C Corporation is subject to two levels of income or capital gain tax: at the corporate level and at the shareholder level. On sale of the business assets, the overall tax rate can exceed 60% of proceeds. Many business owners assume they can "sell stock" when they retire or exit and avoid the double tax. Unfortunately, the purchaser receives less tax benefits buying stock and usually will pay less for stock. In some cases, a regular corporation makes sense for the size and nature of a business, or cannot be avoided; in others, especially personal service businesses, the likelihood of sale of the business is minimal and a C Corporation imposes no additional burden. Do not assume - analyze and understand the exit possibilities before forming the business.
Don’t transfer insurance policies without reviewing the "transfer for value" rules. Insurance funding of business buyout arrangements and deferred compensation agreements is extremely common practice. Use of insurance in this context is often quite sensible and beneficial. The benefit of having "tax free" insurance proceeds to fund business transitions is often the key to survival for small and midsize businesses. As changes occur in personnel and participants in business insurance arrangements, any transfer of ownership of insurance policies should be reviewed closely to avoid a "transfer for value." While some transfers are possible without adverse effect, a transfer to a person other than those persons permitted by these rules renders insurance proceeds taxable.
Don’t accept signature authority on checking accounts for a business you don’t own and control unless you understand your financial responsibility for business payroll taxes. Too often, troubled businesses "borrow" from the government when times are tough. This practice can end in personal financial disaster, not only for the business owners, but for any "responsible person" with signature authority on business bank accounts. Any person found to have control of funds which should have been paid to the government can be held personally liable for the full amount of the taxes. Know the business track record before you accept check writing authority. Be vigilant, and if payroll taxes go unpaid, make your opposition known in writing, and quit if the situation cannot be remedied promptly.
Don’t treat workers as independent contractors unless they clearly qualify. The penalties for misclassifying employees can be huge. Before you consider treating a worker as an independent contractor, know the "20 questions" list used by the IRS in making the classification. It is generally wiser to treat any close cases as employees and not as independent contractors.
Don’t invest pension funds (even your own) in private deals. Most transactions between a pension trust and its fiduciaries (e.g., the employer) or beneficiaries are prohibited by tax and labor rules as "prohibited transactions" or "self dealing." The consequence for violation of these rules can be disqualification of the pension plan and income taxation of the distributions. If the deal is "too good to pass up" and all your money is "in your pension," pass it up anyway - or seek qualified expertise to analyze the transaction and give clearance.
Don’t rely on tax exemptions without making certain the exemption applies. Tax exemption statutes for all types of taxes are usually strictly interpreted against the taxpayer. They are often referred to by jargon (e.g., like kind exchange, occasional sale exemption, parent-child transfer exemption) which may not even hint at the complex criteria required to qualify for the exemption. For example, the "occasional sale" rule exempting certain single asset sales from sales tax does not apply to any retail business or to a wholesale business that has any retail sales or to any sales of a motor vehicle.
Don’t file tax returns late. Even if you have no tax due (the penalty for late filing with no tax due generally is a nominal amount), the antagonism from overly-skeptical IRS or FTB representatives and their increased scrutiny is too high a price for missing a deadline.
Don’t evaluate tax benefits in a vacuum. It is too often the case that $100 in tax savings ends up costing $110. While complex tax planning is often justified, the benefits should clearly justify the cost, in transaction fees, administrative burden, disruption of normal business, and downstream risks. Look hard at the benefits to be achieved from a particular tax motivated structure. Too many taxpayers seek "tax savings" at any cost. Sometimes paying a little tax now pays large benefits in avoided transaction fees, restrictions and ongoing legal, accounting and administrative costs.
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