Year-end Income Tax Planning for Corporations and Businesses

INTRODUCTION
Each year we work with our corporate and business clients to maximize tax savings through year-end planning. Traditionally, year-end tax planning includes taking steps to make sure your business income is taxed at the lowest possible rate, and to postpone the payment of taxes by deferring taxable income or accelerating deductions. As in the past, these time-honored strategies continue to serve as the foundation for year-end tax planning. However, recent tax legislation brings a series of new wrinkles to tax planning for 2006. For example, the Energy Tax Incentives Act of 2005 provides the business community with a host of new targeted tax deductions and credits for qualified energy-related expenditures after 2005. The landmark Pension Protection Act of 2006 (PPA 2006) makes far-reaching changes to the rules for contributions to and distributions from qualified retirement plans and significantly changes the charitable contribution deduction rules. In addition, the Tax Increase Prevention and Reconciliation Act (TIPRA) extends the lower capital gains and dividends tax rates and the increased §179 deduction for two additional years, modifies the foreign income exclusions, offers a new capital gain election for sales of certain musical compositions, changes the wage limitation in calculating the new production deduction, and provides a variety of additional changes.

Planning Alert! At the time we completed this letter, Congress had not extended several popular business tax breaks that expired on December 31, 2005, including: the 15-year amortization of qualified leasehold improvements and restaurant improvements, the work opportunity and welfare-to-work tax credits, and the research and experimentation credit. However, it is possible that Congress will retroactively extend these provisions before the 2006 tax filing season. Please call our firm if you need a status report.

We are sending you this letter to bring you up-to-date on these and other new tax planning opportunities provided by this new legislation, and to remind you of several traditional year-end tax planning strategies. Please keep in mind that many of the provisions contained in the new tax legislation are first effective in 2006, while others won’t be available until 2007, or later. Consequently, pay careful attention to the effective date of each new provision which we highlight prominently in each segment. To help you locate items of interest, we have divided the planning ideas into the following categories:

• Highlights of the Energy Tax Incentives Act of 2005

• Highlights of the Pension Protection Act of 2006

• Highlights of the Tax Increase Prevention And Reconciliation Act

• Highlights of Other Recent Tax Developments Impacting Business

• Traditional Planning for C Corporations

• Traditional Planning for S Corporations

• Traditional General Business Planning

Please Note! We suggest that you call our firm before implementing any tax planning technique discussed in this letter or if you need additional information.

On August 8, 2005, President Bush signed the Energy Tax Incentives Act of 2005 (the Energy Act), which creates several new targeted tax deductions and credits. Businesses that will most likely benefit are those that purchase qualified energy-efficient vehicles or install qualified energy-efficient systems in a commercial building, and contractors constructing qualified energy-efficient homes. Tax Tip. These tax breaks are generally first available in 2006, for qualified energy-efficient property that is "placed-in-service" after December 31, 2005. "Placed-in-service" generally means that the property is on hand and is ready and available for use. If your business is planning to purchase property that may qualify for any of these new benefits, and you want the tax benefit in 2006, make sure that you complete the installation of qualifying property, or the purchase of a qualifying energy-efficient vehicle by December 31, 2006. The following are selected tax credits or deductions that may be available to your business.

New Hybrid Motor Vehicle Credit. For qualifying vehicles placed-in-service after December 31, 2005, the Energy Act created the new hybrid motor vehicle credit. The amount of the hybrid credit for 2006 ranges from a $250 credit (e.g., the GMC Sierra 2WD hybrid pickup truck) to a $3,150 credit (e.g., the Toyota Prius). Planning Alert! Starting in 2006, once a specific auto manufacturer’s sales of hybrid vehicles reaches 60,000, the energy credits for hybrid vehicles purchased from that manufacturer are reduced. Toyota and Lexus exceeded this 60,000 vehicle threshold during the second quarter of 2006. Therefore, for any qualified Toyota or Lexus hybrid vehicle purchased after September 30, 2006, the hybrid credit is reduced. For example, the hybrid credit for the 2006 Toyota Prius is reduced 1) by 50% (from $3,150 to $1,575), if purchased after September 30, 2006, 2) by 75% (from $3,150 to $787.50), if purchased after March 31, 2007, and 3) is eliminated altogether, if purchased after September 30, 2007. All other Hybrids manufactured by Toyota and Lexus (e.g., Highlander Hybrid, Lexus RX400h, Camry Hybrid, Lexus GS 450h) are subject to the same phase-out schedule. Tax Tip. None of the other manufacturers of qualifying hybrids (e.g., Honda, Ford, GM, etc.) sold their hybrids in 2006 at a rate that would cause the credit to be reduced if purchased on or before December 31, 2006. Planning Alert! To the extent your hybrid is used for business, the credit reduces the depreciable basis of the vehicle. Also, this hybrid auto tax credit does not reduce your alternative minimum tax (AMT). If you are considering the purchase of a hybrid automobile, please call our office. We will help you determine whether your exposure to the AMT will reduce or eliminate the credit’s benefit.

Connecticut: Effective on or after October 1, 2004 and prior to October 1, 2008, the sale or lease of any hybrid passenger car that has a United States Environmental Protection Agency estimated highway gasoline mileage rating of at least forty miles per gallon is exempt from Connecticut sales and use tax. 

Effective October 1, 2006: The exemption has been amended to redefine the term hybrid passenger car as a passenger car that draws acceleration energy from two onboard sources of stored energy, which are both an internal combustion or heat engine using combustible fuel and a rechargeable energy storage system and, for a passenger car or light truck with a model year of 2004 or later, is certified to meet or exceed the tier II bin 5 low emission vehicle classification.

The exemption applies to the purchase or lease of a new or used qualifying motor vehicle from a motor vehicle dealer and to the purchase of a used qualifying motor vehicle directly from its owner.  

Home Contractor’s Credit For Building Energy-Efficient Residences. Effective for homes substantially completed after 8/08/05 and sold after 2005 and before 2008, contractors who construct or reconstruct qualified energy-efficient homes in the U.S. may be eligible for a new tax credit of $2,000 for each home. To qualify for this credit, the new or reconstructed home must be certified to have met specific IRS approved energy-efficient criteria (generally, the homes must satisfy a 50% reduction in energy consumption standard). Manufacturers of qualifying energy-efficient manufactured homes certified under IRS procedures will also qualify for the $2,000 credit. Certain manufactured homes that meet a lesser energy-efficient standard may qualify for a $1,000 credit. An eligible certifier must use an approved Software Program to calculate the dwelling unit’s energy consumption. Following is a table of IRS approved software programs as of the date of this letter for use in providing certification.

These rules are extremely complex. Please call us if you need additional information.

Up-Front Deduction For Energy-Efficient Buildings. If you build or renovate a commercial building in compliance with specified energy-efficient standards, and you place energy-efficient components of that building in service in 2006 or 2007, you may be able to take an up-front deduction of the lesser of 1) the cost of qualifying "energy efficient commercial building property", or 2) $1.80 per square foot of the building (in certain situations, you may be entitled to only a partial deduction of $0.60 per square foot). Energy efficient commercial building property is generally property: 1) installed in a building located in the U.S. as part of: the interior lighting systems; heating, cooling, ventilation, and hot water systems; or the "building envelope" (e.g., windows, doors, walls, foundation, basement slab, ceiling, roof system, and insulation), and 2) which is certified under procedures developed by the IRS to reduce the "total" annual energy and power costs of the building by at least 50%, as compared to a comparable building meeting specified minimum requirements. To qualify for this deduction, the energy-efficient systems must be inspected and tested by individuals who have been recognized by an IRS-approved organization as having the qualifications to certify the reduction in energy costs.

On August 17, 2006, President Bush signed the landmark Pension Protection Act of 2006 (PPA 2006), a more than 900 page bill that not only makes dramatic changes to qualified retirement plans, but also reforms major provisions of the charitable contribution rules. The following summary highlights selected provisions of the Act impacting businesses.

Removal Of Sunset Rule For §401(k) Roth Provisions. Starting in 2006, employers may adopt provisions in their §401(k) plans offering employees the option to contribute all or a portion of their §401(k) elective deferrals into a §401(k) Roth account. Any employee who chooses this option will be taxed on the amount of the elective deferral, but "qualifying" distributions from the account will be "tax free." A "qualifying" distribution is generally a distribution that is 1) made more than five years after the first Roth elective deferral and 2) is made after age 59½, because of disability, or because of the participant’s death. This §401(k) Roth option was scheduled to terminate after 2010. PPA 2006 removes the sunset date! Planning Alert! An employer must amend an existing §401(k) plan to provide for the §401(k) deferral option. Tax Tip. Participants in a §401(k) plan that has adopted the Roth option will be able to contribute a portion of their wages up to $15,000 ($20,000 if age 50 or older) to the plan. The $15,000/$20,000 §401(k) Roth contribution limits are significantly more than the $4,000/$5,000 limits that apply to Roth IRAs for 2006. Tax Tip. The AGI limits that apply to conventional Roth IRAs do not apply to §401(k) Roth accounts. Therefore, taxpayers of all income levels may participate in §401(k) Roth accounts.

Simplified Annual Reporting. Effective for plan years beginning after 2006, retirement plans with assets of $250,000 or less where the only participants are owners (including partners and their spouses) will not be required to file Form 5500 or Form 5500EZ. In addition, the IRS is to issue guidelines simplifying the annual reporting requirements for plans with less than 25 participants.

New Relief For §401(k) Plans That Provide For Automatic Enrollment. Effective for plan years beginning after 2007, PPA 2006 provides an enhanced exemption from the nondiscrimination and top-heavy rules and less stringent vesting requirements for §401(k) plans that contain qualified automatic enrollment provisions.

Miscellaneous Provisions. PPA 2006 contains many other retirement plan provisions including: New diversification requirements for defined contribution plans investing in employer securities; New "working retirement" distributions for participants in certain pension plans; Expanded "hardship" distributions; Removal of various uncertainties for cash balance and other hybrid defined benefit plans; New rules allowing combined defined benefit/§401(k) plans; Major changes in the funding and benefit requirements for financially-troubled defined benefit plans; New criteria for identifying when a multi-employer plan is in financial trouble; Enhanced plan participant notification requirements; New rules for plans sponsored by governments, Indian tribal governments, and churches; Rule changes for the reinvestment of ESOP dividends; Increases in the annual benefit limit for defined-benefit plans; and Modifications to the "top-heavy" rules.

New Law Temporarily Enhances Tax Benefits Of Conservation Easements. Taxpayers may receive a charitable contribution deduction for placing a qualifying conservation easement on real estate in favor of a qualifying organization. For individuals, this deduction is generally limited to 30% of modified adjusted gross income. For regular C corporations, the deduction is limited to 10% of the corporation’s modified taxable income. If the value of the conservation easement exceeds these limitations, the excess may be carried forward for up to five years. Effective for tax years beginning in 2006 and 2007, an individual’s deduction for a qualified conservation contribution of real property is limited to 50% (rather than 30%) of the individual’s modified adjusted gross income less other charitable contributions allowable for the year; a qualified farmer or rancher can deduct up to 100% of the individual’s modified adjusted gross income less other charitable contributions allowable for the year; and, qualified corporate farmers and ranchers can deduct up to 100% of modified taxable income less other charitable contributions allowable for the year. In each case, any excess can be carried forward up to fifteen years. Tax Tip. A conservation easement must satisfy several technical requirements to qualify for these increased limits. Therefore, if you or your business are considering the placement of a conservation easement on your real property in favor of a qualifying organization, please contact us so that we can help you determine if you qualify for these new tax breaks.

On May 17, 2006, President Bush signed the Tax Increase Prevention and Reconciliation Act (TIPRA). This $70 billion tax cut bill not only extends tax breaks that were scheduled to expire, but also creates several new tax relief provisions, including:

Reduced Individual Income Tax Rates For Capital Gains And Dividends Extended Two Years (Through 2010). In 2003, Congress reduced the maximum tax rate on most long-term capital gains and qualified dividends to 15% for individual taxpayers. Although these lower rates were scheduled to expire after 2008, TIPRA extends them through 2010. Tax Tip. If an individual’s capital gain or dividend income would otherwise be taxed in the 10% or 15% tax brackets, the tax rate drops to 5% through 2007, and to zero in 2008 through 2010.

Increase In Kiddie Tax Age Limit Makes Hiring Children More Important. Prior to 2006, children who had not reached age 14 by the end of the tax year were taxed on their unearned income (e.g., interest, capital gains, and dividends) at their parents’ marginal tax rates, if the unearned income exceeded a threshold amount of $1,600 in 2005 ($1,700 for 2006). Effective for tax years beginning after 2005, TIPRA increases the age of children subject to this tax to those under age 18. Tax Tip. Since "earned" income is exempt from the kiddie tax, paying reasonable wages to children under age 18 from a family business becomes an even more valuable tax strategy. If the compensation is reasonable, in addition to avoiding the kiddie tax, various other tax benefits can flow from this arrangement, including: 1) the compensation is earned income so the child can fund a traditional or Roth IRA, 2) sole proprietors or partnerships in which each partner is the child’s parent will not have to pay FICA or Medicare taxes on wages paid to a child who is under age 18, 3) the child’s wages may be taxed at a rate as low as 10% and deducted by you (if paid by your proprietorship or your pass-through entity) at a tax rate as high as 35%, and 4) if you operate as a sole proprietorship or pass-through entity, the deduction of the child’s wages will reduce your adjusted gross income, which could free up all or a portion of other deductions that are phased out as your income increases. Planning Alert! If you employ your children in your family business, be sure to 1) carefully document the reasonableness of the wages, 2) pay the wages as part of the regular payroll, and 3) make sure the payroll checks are timely cashed and placed in the child’s account (e.g. UGMA account).

Higher §179 Deduction Extended. For 2006, your business may deduct, under §179, up to $108,000 of the cost of depreciable tangible, personal business property (e.g., machinery and equipment). This deduction phases out dollar for dollar as the cost of the §179 property for a year exceeds $430,000. The §179 deduction was to be reduced to $25,000 and the phase-out threshold would have declined to $200,000 after 2007. TIPRA extends the higher §179 amounts (indexed for inflation) through 2009.

Miscellaneous Provisions. TIPRA contains other law changes not contained in this letter, including: Modification to wage limitation for domestic production deduction; New penalties for tax exempt organizations participating in tax shelter transactions; New disclosure rules for tax-exempt entities and taxable parties participating in tax-shelter transactions; New reporting requirements for certain tax-exempt income; Income tax exemption for certain CERCLA environmental settlement funds; Extension of the 15% accumulated earnings and personal holding company tax rates through 2010; Various changes to the rules applicable to state and local bonds; and Various changes to the income taxation of nonresident aliens, foreign businesses, and U.S. taxpayers with income from outside the U.S.

HIGHLIGHTS OF OTHER RECENT DEVELOPMENTS IMPACTING BUSINESSESOver the past two years, there have been other changes to the tax law impacting 2006 tax planning for businesses. The most significant changes resulted from the American Jobs Creation Act of 2004 (Jobs Act). The following highlights selected provisions of the Jobs Act and other developments impacting small and mid-sized businesses:

Non-Qualified Deferred Compensation Arrangements. The Jobs Act created an entirely new set of tax rules for deferred compensation arrangements. Failure to comply with these new rules will result in stiff penalties, including loss of deferral, interest charges, and a 20% penalty tax. These rules are generally effective for compensation deferred in tax years beginning after December 31, 2004. Planning Alert! The IRS has recently released guidance on these rules. If you are an employee participating in a deferred compensation arrangement or your business has such an arrangement with employees or other service providers (e.g., bonus plans, top hat plans, SERPs, Rabbi trusts, stock appreciation rights, phantom stock plans, non-qualified stock options, equity-flavored compensation packages, etc.), it is imperative that the plan be reviewed by legal counsel in light of these new rules, in order to develop a strategy to avoid income taxation, penalties and interest on past and future deferrals. We will gladly assist in this process.

The "Production Deduction." The Jobs Act ushered in a brand new deduction to reward businesses for conducting certain activities within the United States. Among the businesses that may qualify are those involved in the following activities: manufacturing, construction, engineering and architectural services, energy production, farming, mining, film production, software development, production of sound recordings, and the processing or storing of food products. This new deduction is effective for tax years beginning after December 31, 2004, and is based on the following percentages of qualifying income: 2005 and 2006 (3%), 2007-2009 (6%), after 2009 (9%). However, the deduction may not exceed 50% of the wages paid to employees of the business. This production deduction is also allowed for "alternative minimum tax" purposes. Planning Alert! The IRS has recently issued final regulations on the types of business activities that qualify, and how the deduction is to be computed. Also, the Tax Increase Prevention Reconciliation Act of 2005 created further modifications to this deduction for tax years beginning after May 17, 2006. Unfortunately, these rules are too lengthy and complex to discuss in detail in this letter. However, the following is a summary of key points concerning the production deduction:

• Qualifying Business Entities. Regular C corporations, S corporations, partnerships, LLCs, and sole proprietors may generate income qualifying for the deduction. However, the actual deduction for pass-through entities (e.g., partnerships and S corporations) is calculated on the partners’ or shareholders’ returns.

• Calculating The Deduction. Effective for tax years beginning in 2005 and 2006, the deduction is 3% of the lesser of 1) qualified production activities income (QPAI), or 2) taxable income (AGI for individuals); not to exceed 50% of the W-2 wages paid.

• Creating W-2 Wages For Purposes Of The Production Deduction. Remember, the production deduction may not exceed 50% of W-2 wages paid to employees. For example, if the lesser of qualified production income or taxable income (or AGI) is $94,000, the tentative deduction is $2,820. But, if there are no wages paid with respect to qualifying businesses, then the $2,820 production deduction is lost. Many farmers and small businesses reporting qualifying production activities income on Schedule F or Schedule C have paid no W-2 wages during 2006. However, in many of these businesses, a spouse has worked in the business but has not been paid. One strategy to obtain a production deduction is to pay the spouse wages on or before December 31, 2006. However, this strategy will generally be beneficial only where the additional FICA tax paid on the amounts paid to the spouse are offset by an equal reduction in the proprietor’s or farmer’s S/E tax liability. Therefore, the strategy is generally most beneficial when the S/E income of the proprietor or farmer is $94,200 or less (i.e., the SECA wage base for 2006) before the payment of the spouse’s salary. These calculations can be complicated. Please call us and we will help you determine whether or not the payment of wages to your spouse is advisable.

Depreciation Deductions For Business Vehicles. The maximum annual depreciation deduction for business, passenger automobiles is capped at certain dollar amounts (e.g., $2,960 for the first year if acquired in 2006). However, trucks, vans and SUVs are exempt from these "passenger auto" depreciation limitations if the "gross vehicle weight" of the vehicle exceeds 6,000 lbs. (e.g., a full-size pick-up; a full-size van; or a sport utility vehicle). However, SUVs, vans and certain other vehicles are limited to a maximum §179 deduction of $25,000 (instead of $108,000). Tax Tip. Some vehicles weighing over 6,000 lbs. are still entitled to the maximum §179 deduction. For example, a pick-up truck with a cargo area of at least 6 feet of interior length and a van with a seating capacity of more than 9 persons behind the driver are not limited by the $25,000 cap.

Business Start-Up and Organizational Expenses. Expenses incurred to start a new trade or business (start-up expenditures) or to set up a new corporation or partnership (organizational expenditures), are not immediately deductible. However, prior to the Jobs Act, if a business filed the proper election, it could amortize the start-up expenditures and/or organizational expenditures generally over a 60-month period (beginning with the month the business began operations). For "start-up expenditures" and "organizational expenditures" incurred after October 22, 2004, the Jobs Act extends the amortization period from 60 months to 180 months. However, as under prior law, the amortization deduction is only allowed if the taxpayer timely elects to amortize the expenses. In addition, a business may elect to deduct up to $5,000 of start-up expenses and separately elect to deduct an additional $5,000 of organizational expenditures (if applicable) in the taxable year in which the business begins. However, each of these $5,000 amounts is reduced by each dollar the total start-up expenditures or organizational expenditures exceed $50,000, respectively. Therefore, there is no up-front deduction for start-up expenses if the total start-up expenses equal or exceed $55,000 and there is no up-front deduction for organizational expenditures if those expenses equal or exceed $55,000. Planning Alert! The election to expense and/or amortize start-up expenses or organizational expenditures must be made by the due date of the return for the year in which the business begins. Missing this due date, in some situations, could cost your business the entire deduction. Tax Tip. If you, as a shareholder of your corporation or a partner in your partnership, pay these expenditures out of your personal funds, make sure you properly document the expenses to the corporation or partnership and the corporation or partnership reimburses you. Otherwise, these deductions may be lost.

IRS Announces Telephone Excise Tax Refund. After a string of defeats in the courts, the IRS recently announced that anyone who paid the 3% Federal telephone excise tax on long-distance telephone service after February 28, 2003 and before August 1, 2006 is entitled to a refund of the tax. Taxpayers other than individuals (e.g., C Corporations, S Corporations, partnerships, limited liability companies, non-profits) generally have to compute the actual amount of telephone excise tax they paid during the refund period. Planning Alert! If you paid the telephone excise tax on both local and long-distance service and the local service is not separately stated, the total excise tax is refundable. However, if the amount paid for long distance calls is separately stated from the charge for local service, the excise tax paid on the local service amount is not refundable. The excise tax refund is claimed as a refundable credit on your 2006 income tax return. The IRS says that it is considering an "estimation method" that businesses and nonprofits may use to compute the amount of their telephone excise tax refund if they do not want to document the amount of tax paid. However, such guidance had not been issued at the time we completed this letter.

Year-End Planning With Corporate Tax Rates. Your C corporation (a corporation that is not an S corporation) may be able to shift income between 2006 and 2007 and save taxes by taking advantage of the progressive corporate tax rates. For example, corporate income between $100,000 and $335,000 is taxed at 39%, while income between $50,000 and $75,000 is taxed at only 25%. If, for instance, your corporation expects $50,000 of income in 2006 and $125,000 in 2007, your company could save taxes of $3,500 by accelerating $25,000 of 2007 income into 2006 (i.e., $25,000 X 14%). On the other hand, if your corporation is expecting lower tax rates in 2007 than in 2006, deferring income into 2007 will not only save taxes but would defer them until next year as well. Planning Alert! Please call us before accelerating income from 2007 into 2006 so that we can help you evaluate other considerations such as the time value of money.

Year-End Planning For Personal Service Corporations. If you own a C corporation that is a personal service corporation (PSC), all income retained in that corporation is taxed at a flat rate of 35%. Your corporation is a PSC if its business is primarily in the areas of health, law, accounting, engineering, actuarial sciences, performing arts, or consulting. Furthermore, in order to be classified as a PSC, substantially all of your corporation’s stock must be held by employees who are performing those services. Tax Tip. Generally, it is preferable from a tax standpoint to leave as little taxable income in a PSC as possible. This may be accomplished by paying reasonable salaries and compensation to the stockholders/employees by year-end.

Newly-Formed Corporations. If you have started a new business this year and have filed articles of incorporation with the Secretary of State, you generally must treat the corporation as a regular C corporation. This can create a tax trap if your new business generates a tax loss in its first year. In that event, the loss will be trapped inside the corporation and you will not be able to use the loss to offset income on your personal income tax return. Tax Tip. You may, however, be able to take this loss on your personal return if you file a timely S election for the first year of the new corporation. Generally, this election must be made no later than the 15^th day of the third month following the date your corporation starts business. However, in certain situations, the IRS may allow a late S election if you intended to make a timely election, but failed to do so. Please call our office before you set up a new corporation, and we will help you decide whether an S election is advisable. Planning Alert! It is always best to call us before you set up any new business so we can help select the "best" business entity from a tax planning standpoint, and so we can help file any necessary elections, etc.

Pay Sufficient Estimated Tax. If your C corporation had less than $1 million of taxable income for each of the past three tax years, it will be classified as a "small corporation" and may base its quarterly estimated tax payment on 100% of its "prior" year tax liability. If the corporation is not a "small corporation," it must generally base its quarterly estimated tax payment (after the first installment) on 100% of its "current" year tax liability, or 100% of its annualized tax liability. Planning Alert! If your "small corporation" had no income tax liability in the prior tax year (e.g., it incurred a tax loss for the prior year or was not in existence last year), it must pay 100% of the "current" year tax or 100% of the annualized tax to avoid an estimated tax underpayment penalty. Tax Tip. If your "small corporation" anticipates showing a small tax loss in 2006, you may want to accelerate income (or defer expenses) in order to generate a small income tax liability in 2006. This will preserve the corporation’s ability to use the "100% of last year’s tax" safe harbor for 2007 estimates. If the corporation expects taxable income of more than $1 million for the first time in 2006, you should consider deferring income into 2007 or accelerating deductions into 2006 to ensure that your corporation’s 2006 taxable income does not exceed $1 million, so that it maintains its "small corporation" status for 2007.

Properly Document Loans to Shareholders. If you borrow from your closely-held corporation, you should make sure there is a written agreement to repay your loan, a fair interest rate is charged, and the loan is authorized by a corporate resolution. Without adequate interest and proper documentation, the IRS may treat your loans as constructive distributions which could result in dividend treatment and double taxation. Planning Alert! A corporation should charge interest at least equal to the applicable Federal rate on loans to shareholders. Otherwise, subject to certain exceptions, the IRS will impute interest and the imputed interest will result in dividend treatment if the corporation has earnings and profits. The IRS publishes a "blended annual rate" to facilitate the computation of foregone interest for a below-market demand loan of a fixed principal amount that remains outstanding for the entire calendar year. For 2006, this interest rate is 4.71%.

TRADITIONAL PLANNING FOR S CORPORATIONS

Check Your Stock And Debt Basis Before Year End. If your S corporation is anticipating a taxable loss this year, you should contact us as soon as possible. These losses will not be deductible on your personal return unless you have adequate "basis" in your S corporation. You will have basis to the extent of the amounts paid for your stock (adjusted for net pass-through items and distributions) plus any amounts you have personally loaned to your S corporation. If you merely guarantee a third-party loan made to your S corporation, this will not give you basis for loss pass-through purposes. Tax Tip. It may be possible to restructure an outside loan to your corporation in a way that will give you adequate basis. However, this restructuring must occur before the end of the tax year. Planning Alert! The rules for restructuring loans to an S corporation are complicated. Please do not attempt to restructure your loans without contacting us first. Also, if you finance losses of an S corporation with loans from other corporations controlled by you, or if you borrow from another shareholder, the IRS may take the position that a restructuring of these loans does not give you basis. It is best not to finance S operations with funds borrowed directly from related corporations or from other shareholders.

Salaries for S Corporation Stockholders/Employees. The combined employer and employee FICA tax rate is 15.3% of your wages up to $94,200 for 2006 ($97,500 for 2007). For 2006, the combined rate drops to 2.9% for wages in excess of $94,200. Tax Tip. If you are a stockholder/employee of an S corporation, you may wish to take no more than a "reasonable salary" from your corporation to minimize your FICA tax. Other income that passes through to you or is distributed to you as a distribution on your stock is not subject to FICA tax. Planning Alert! Determining "reasonable salaries" for S corporation stockholders/employees is a hot audit issue and the IRS has taken many taxpayers to court and won! The IRS has been successful where S corporation owners pay themselves no salary even though they provided significant services to the corporation. In these cases, the courts generally held that all amounts paid out to the S corporation owners were actually wages subject to FICA and Medicare taxation. Caution! Minimizing your FICA tax could also reduce your Social Security benefits when you retire. Furthermore, if your S corporation has a qualified retirement plan, reducing your salary may reduce the amount of contributions that can be made to the plan on your behalf since contributions to the plan are based upon your "wages." Additionally, the cost of health insurance benefits paid by the corporation for employees who own more than 2% of the S corporation stock must be included in the wages of the employee (but not subject to social security or Medicare).

Procedures for Making Late S Elections for Non-Corporate Entities. If you are an owner of a general partnership, limited partnership, limited liability company, or limited liability partnership, the business income that passes through to you is generally subject to Social Security and Medicare taxes. Tax Tip. You might save taxes if you elect to treat your general partnership, limited partnership, limited liability company, or limited liability partnership as an S corporation, and then pay yourself a "reasonable salary" for your services. Historically, you accomplished this by electing to tax the pass-through entity as an "association" (by timely filing Form 8832), followed by an S election (by timely filing Form 2553). The IRS regulations now provide that a non-corporate pass-through entity may elect "S corporation" treatment by timely filing a single Form 2553. This only works if your non-corporate pass-through entity meets all of the other qualification requirements of an S corporation (e.g., proper number of owners, all income is allocated pro-rata to the owners based upon their ownership interests, etc.). Planning Alert! Notwithstanding the potential for FICA tax savings, an S election could have adverse tax consequences. For example, gain may be triggered when the S election is made if the liabilities of the business exceed the tax basis of its assets. Please call us before making an S election and we will help you decide if it is feasible.

Connecticut Pass-Through Entities.  The requirement that a pass-through entity (partnerships and entities taxed as partnerships and S corporations) make estimated Connecticut income tax payments on behalf of its nonresident members is repealed. The law is effective for taxable years beginning on or after January 1, 2006. On or after June 6, 2006, pass-through entities need not make further estimated payments for their nonresident members.

Self-Employed Business Income. If you are self-employed and use the cash method of accounting, consider delaying year-end billings to defer income until 2007. Planning Alert! If you have already received the check in 2006, deferring the deposit does not defer the income. Also, you may not want to defer billing if you believe this will increase your risk of not getting paid.

Accruals To Related Parties. Don’t forget, year-end accruals to certain cash-basis recipients must satisfy the following rules in order for an accrual-basis business to deduct the accruals. These rules apply to fiscal year as well as calendar year-end businesses:

• Regular C Corporations. If your regular C corporation accrues an expense (e.g., compensation, interest, etc.) to a cash basis stockholder owning more than 50% (directly or indirectly) of the company’s stock, the accrual is not deductible by the corporation until the "day" it is includable in the stockholder’s income. Tax Tip. If the corporation’s tax rate for 2006 is significantly greater than the stockholder’s individual rate for 2006 and 2007, the accrued amount should be paid by the end of 2006.

• S Corporations And Personal Service Corporations. If your S corporation or personal service C corporation accrues an expense to any shareholder (regardless of the amount of stock owned), the accrual is not deductible until the day it is includable in the shareholder’s income.

• Partnerships, LLCs, LLPs. If your business is taxed as a partnership, its accrual of an expense to any owner will not be deductible until the day it is includable in the owner’s income.

• Other Related Entities. Generally, an expense accrued by one related partnership or corporation to another cash-basis related partnership or corporation is not deductible until the day it is includable in the cash-basis entity’s income.

Other Year-End Accruals. Generally, if an accrual-basis business accrues year-end compensation to its employees, the accrual must be paid no later than the 15th day of the third month after year-end to be deductible for the year of the accrual. Otherwise, the accrual is not deductible until paid. Planning Alert! These rules also apply to accrued vacation pay, and to accruals for services provided by independent contractors (e.g., accountants, attorneys, etc.).

Establishing a New Retirement Plan for 2006. Calendar-year taxpayers wishing to establish a qualified retirement plan for 2006 (e.g. profit-sharing, 401(k), or defined benefit plan) must adopt the plan no later than December 31, 2006. An exception to this general rule applies to SEP plans. A SEP may be established by the due date of the tax return (including extensions). A SIMPLE plan must be established no later than October 1, 2006.

FICA Withholding On Deferred Compensation. If your business sponsors a nonqualified deferred compensation plan, you may have certain FICA tax withholding and reporting responsibilities. IRS regulations provide that FICA taxes are due on most deferred compensation in the year the compensation is earned, rather than the year it is paid. The IRS says that your business can pay its portion of the FICA tax (and can withhold the executive’s portion) with the final payroll of the year. The specifics of these regulations are too lengthy to address in detail in this letter. Please call us if you have questions.

Personal Use Of Company Cars. If your company provides employees with company-owned cars, the company is required to include the value of the personal use of the car in the employees’ W-2 income. However, this is not required if the employee reimburses the company for the personal use. Tax Tip. If the employee chooses to reimburse the company for personal use of the car, the obligation for reimbursement should be established on or before December 31st so the employee will not have income in one year and a deduction in the next. This can be accomplished by establishing a published policy for reimbursement of personal use. Furthermore, your company should obtain signed statements from its employees documenting their business and personal mileage for the company car.

Certain Business Modifications To Your Trucks And Vans Make Them 100% Business. Generally, if you use a passenger vehicle in your business, you are required to keep a log or other documentation to support your business mileage. However, if you make certain modifications to your business pick-up or van, the IRS says that, for tax purposes, the vehicle will be deemed to be used 100% for business, even though you have some nonbusiness use. For example, a pick-up truck that has either permanently affixed decals or special painting advertising your business, and is equipped with either a hydraulic lift gate, permanently installed tanks or drums, or permanently installed side boards, is deemed to be used 100% for business. The same is true of a van that has the company name permanently affixed to the vehicle, has only seats for the driver and one passenger, and the back of the van is generally filled with shelving or merchandise during on-duty and off-duty hours. Tax Tip. These specially-equipped business vehicles are not limited by the passenger automobile depreciation caps even if they do not have a gross vehicle weight of more than 6,000 lbs. Furthermore, if you inadvertently applied the depreciation limits to these vehicles in prior years, the IRS says that you may use the automatic accounting method change procedures to correct the prior year’s returns. If you think you may have this situation, please call us and we will help you recoup your deductions.

IRS Authorizes Cafeteria Plans To Extend Use-It-Or-Lose-It Deadline By 2½ Months. Employees participating in a cafeteria plan or a flexible savings account plan can generally elect to make a pre-tax salary reduction contribution to the plan. They can then access that account to reimburse themselves for qualified expenditures tax free (e.g., medical expenses, dependent care assistance, adoption assistance). Historically, to get this tax-favored treatment, employees were required to forfeit any amounts that remained in the plan at the plan’s year end. Good News! IRS now says amounts deferred into cafeteria plans may be used to pay qualified expenses during the plan year and up to 2½ months after the plan’s year end. Therefore, for a calendar year plan, if the plan is properly drafted, employees may use any unused amounts in the account as of December 31, 2006 to reimburse expenses incurred after December 31, 2006 so long as the payment occurs no later than March 15, 2007. Planning Alert! Employers have until the end of the cafeteria plan year to amend a plan to include this new 2½ month rule. If you have a calendar year cafeteria plan that was not amended in 2005, your plan must be amended by December 31, 2006, if you want your employees to have the benefit of this new rule for 2006.

Tax Court Says The Deductibility Of Expenses Paid By Partners And Shareholders May Be Limited. It is not uncommon for a partner in a partnership to individually incur and pay business expenses of the partnership. Historically, the IRS has ruled that a partner may deduct business expenses paid on behalf of the partnership only if there is an agreement (preferably in writing) between the partner and the partnership providing that those expenses are to be paid by the partner, and that the expenses will not be reimbursed by the partnership. The Tax Court recently denied a deduction for a partnership expense paid by a partner where the Court was unable to find any agreement between the partner and the partnership that the partner pay the expense. The Court concluded that a verbal agreement was not enough, where the Court found no routine partnership practice that rose to the level of an agreement. Tax Tip. If you are a partner paying expenses on behalf of your partnership, to be safe, you should have a written agreement with the partnership providing that those expenses are to be paid by you, and that they will not be reimbursed by the partnership. Planning Alert! The courts continue to hold that corporate shareholders may not deduct expenses they pay on behalf of their corporation unless they are required to incur the expenses as a part of their duties as an employee. Even if the expenses are deductible, the shareholders/employees must classify them as miscellaneous itemized deductions which are subject to the 2% reduction rule, and are not deductible at all for alternative minimum tax purposes. This applies to S corporations as well as C corporations. Tax Tip. If the expenses paid by a shareholder for an S corporation or C corporation are reimbursed to the shareholder based on a qualified accounting, the corporation can take a full deduction and the shareholder will exclude the reimbursement from taxable income.

Worker Classification Continues To Be A Hot Tax Issue. If you hire independent contractors to work in your business, you run some risk of the IRS later arguing that these workers should have been treated as your "employees." If successful, the IRS could impose an array of tax penalties on your business. Tax Tip. Even if these independent contractors should have been treated as employees, the IRS says that you can avoid reclassification (and related penalties) if you have a "reasonable basis" for treating the workers as independent contractors. Here is one way you can satisfy this "reasonable basis" test: 1) file all necessary 1099 forms for the workers on a timely basis; 2) consistently treat all employees performing similar duties as independent contractors; and 3) before you hire the workers, obtain an opinion from a knowledgeable tax person that it is appropriate to treat the workers as independent contractors for tax purposes. Planning Alert! The rules for determining whether a worker is an independent contractor or an employee are very complex. Please call our office if you need assistance with this determination.

Your Daily Transportation Might Constitute "Business Travel." Generally, daily travel from your home to your "regular place of business" is considered a nondeductible, personal commuting expense. However, the IRS says that if you have a "regular place of business away from your home," you can deduct daily travel from your home to any "temporary work location" even if the work location is within the metropolitan area in which you live. If you have no regular place of business away from your home, the temporary work location must be outside your "metropolitan area" for your daily travel to qualify as business mileage. Tax Tip. The IRS says you are considered traveling to a "temporary work location" if you realistically expect your work assignment there to last for one year or less. Furthermore, the Tax Court recently agreed that a taxpayer could treat as business mileage any daily travel to a temporary work site located beyond a 35 mile radius from his home, because it was considered outside the metropolitan area. The IRS also says that if you have a qualifying home office, travel from your home to any business location is generally business travel regardless of the distance or frequency.

Club Dues. Club dues are generally not deductible at all, unless the dues are business related and are paid to professional organizations (e.g., ABA, AICPA, AMA), civic or public service organizations (e.g., Kiwanis, Lions, Rotary, Civitan), business leagues, trade associations, chambers of commerce, boards of trade, or real estate boards. Tax Tip. Although you may not generally deduct dues paid to country clubs, golf and athletic clubs, and airline clubs, there is a special rule for employers who reimburse these club dues. If you document to your employer the percentage of the time you use these clubs for bona fide business purposes, your employer can reimburse you for this business portion of the club dues and elect to exclude that reimbursement from your Form W-2. However, if your employer makes this election, the employer may not deduct the reimbursement.

FINAL COMMENTS
Please call us if you are interested in a tax topic that we did not address in this letter. Tax law constantly changes due to new legislation, cases, regulations, and IRS rulings. Our firm closely monitors these changes and we will be glad to discuss any current tax developments and planning ideas with you. We urge you to call us before implementing any planning ideas addressed in this letter, or if you need more information.

Note: The information contained in this material represents a general overview of tax developments and should not be relied upon without an independent, professional analysis of how any of these provisions may apply to a specific situation.

Circular 230 Disclaimer: Any tax advice contained in the body of this material was not intended or written to be used, and cannot be used, by the recipient for the purpose of 1) avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions, or 2) promoting, marketing, or recommending to another party any transaction or matter addressed herein.