Tax Simplification

As a mom, my view of Mother’s day is thinking about the future, and what it holds for my son.  He’s a strong student, so I’m optimistic he’ll be in a position to appreciate the benefits of tax planning when he’s older.  Of course, what kind of planning one will be doing 20 or so years from now is a big question.    

Some interesting thoughts about tax overhaul include the risk to “S” corporations from corporate tax reform.  Ernst & Young  sponsored a study looking at some scenarios around this issue. According to the E&Y article, it’s important to consider “S” corps because they represent more than half of all business activity.  If the plan is to reduce corporate tax rates and then make up the difference through individual taxation, the E & Y scenario gurus believe the tax bill of your average “S” officer / shareholder would increase on average, by 8 percent or $27 billion annually from 2010 through 2014.  Not sure how they got this nugget, but in their alternate tax reality the biggest changes in tax payments (as in paying more) would be to agriculture and mining, followed by construction and retail trade, and then manufacturing, finance and insurance.

While the piece I read was sketchy on the details, it’s worth thinking about.  As we’ve seen from the current recession, what’s best for the big companies isn’t necessarily best for the economy as a whole.  Small business remains the icon for what can bring back prosperity.  That will certainly mean S corps matter.

An Investment newsletter for financial planners  highlighted by the AICPA had similarly dire ideas around some proposed simplification tax reforms.  They predict nothing bad until 2013, but in particular anticipate capital gains related tax breaks are the most at risk.  Another area where the planners see issues is sheltering retirement income, if you’ve got plenty of it.  That doesn’t sound so off base, as with the aging of the baby boom, most of the savings in this country will be related to retirement. 

While simplifying the tax code is offered as an easier fix than cutting the budget, it’s discussions about the implications that make me think that’s going to be the hardest fix of all.

Audit I Forget..?

While many tax payers are done for the year, the question lingers.  What are the odds the IRS will put you on the “A” list –  as in to be audited?   Last week, the IRS released its tally sheet of who was audited in their 2010 fiscal year.  In general  the rates were up.  Also generally, the recipients of additional IRS attention were the usual suspects:  individuals with income between $200,000 and $1 million, businesses with gross receipts of more than $25,000 and individuals claiming the earned income credit.  Higher income puts you at the top of the class.  Corporations with assets of $100 million or more had a 14.5% chance of an audit, vs. those with $250,000 to $1 million at a 1.3% chance of getting a notice.  Give the IRS some credit; they go where the money is.

So if those are the odds you’ll be investigated, what are the chances it’ll cost you?  According to the  data book, the IRS assessed financial penalties against 27.1 million individuals last year.  More than half of those were for failure to pay tax.  Only a little more than 1.1 million businesses suffered the same fate, with 42% of the assessments related to failure to pay.  If the IRS decides to look at criminal investigations, the numbers get more serious.  Of the roughly 3,000 cases referred for prosecution, more than 2,000 resulted in conviction.  Almost 82% of those convicted were incarcerated (home confinement with an electronic bracelet is included in those numbers.)  Don’t say I didn’t warn you.

Speaking of warnings, the IRS does have a special program started in 2010 to audit businesses for payroll taxes.  (For more detailed discussions about the program specifics, you can go to my post “Going Where the Money Is”).  Word is the issue they’re most focused on for these audits is whether employees are properly classified as “employees” or "independent contractors”.    While at a high level the idea of someone who has more discretion on how the work gets done is usually contractor material, there are lots of grey areas.  For sure you don’t want the IRS discussing the topic with you.  It’s worth asking a trusted advisor who knows about this type of thing if you are operating in shades of grey.  If so – move into black and white territory as fast as you can.   It’ll beat wearing an orange jumpsuit. 

Structural Damage Control

Financing and market opportunity get all the attention in a business start up.  However, an equally important question that needs to be addressed early on is the legal structure of the business.  As early stage companies make life and death decisions pretty regularly, legal structure feels like one of those things to think about “when you have time”. This leads to the “common wisdom” of  trying to start with the simplest structure possible, and then let it evolve with the company’s needs. A new study by the SBA indicates this evolutionary approach to business structure is a myth.  Over the first four years of a business’ life less than 10% of companies make a change in their legal structure.  By that time, many issues that should have been addressed earlier have turned from minor problems to major issues.

The reasons business structure is so important fall into two buckets – legal liability and taxes.  I know very little about the legal liability bucket – it was too gross when I looked inside.  My summary from the quick, unpleasant glance is that you get more protection from either a tightly crafted partnership agreement or a corporation, but you trade some flexibility for the protection.  Think of it like wearing a bullet proof vest.  If you need it, it’s worth the trouble, but it’s no fun to wear while you’re running a race. (This is another way of saying make sure to ask someone knowledgeable or you’ll really be in trouble.)

In terms of taxes, it’s essentially the opposite.  A more complex company structure typically provides more tax flexibility.  One unusual consideration related to tax payments and business structures is there’s a choice to be made about whether the business entity or the business owners pay the income taxes.  The Cliffs Notes version of this very high level view is that typically capital intensive businesses are better off paying taxes.  Generally, all others should let the participants pay the taxes, albeit ensuring these tax payers have taken steps to minimize those payments.

Notice how even at the most basic level this is already dense, headache inducing material.  Unfortunately it really is worth taking some aspirin and getting clarity about areas of risk for your particular business that can be offset through structural decisions.   Think of it as making sure the foundation on your house is done correctly.  You wouldn’t wait until after it’s built to check…

Last Minute Tax Tips

The government remains open for business, and your taxes are due soon.  This year it is delayed a little bit, to April 18^th.  (One more weekend of going to the office for me!) So there is a little time to do some last minute “planning” -- or should we say remediation -- presumably last-minute and planning can’t really be combined. 

First off – while it’s too late for the Roth conversion deal (two years to pay the tax liability if you converted a traditional IRA to a Roth before 12/31/10) you can still take a 2010 deduction by contributing to a traditional IRA by the 18^th.  The same holds true for contributing funds to a qualified Health Savings Account ($6,150 for family, $3,050 for individuals). 

Another good reminder is to make sure you’ve got all your charitable donations noted.  If you give via payroll deduction, you don’t get a letter, but you can count the donation as an offset to your taxable income.

Not to encourage marital strife, but it’s worth checking to make sure filing jointly is the best plan.  One example where this might work is if one spouse has fairly big medical bills, but the couple’s combined income makes the threshold for getting the medical deduction out of reach.  This is not a one-variable decision, so you need to see the final difference on the return before you make a change.  Still – it’s worth checking.

Finally, this little nugget from the GAO in their report to Congress on how the IRS is doing this year.  While avoiding a shut down, apparently the IRS is hampered by restrictions on checking for mathematical errors on returns, unless they do a full audit.  According to the report, if the IRS doesn’t have the permission in the existing 13 Math Error Authority designations, they can’t check for a mistake (or fraud) unless the return gets audited.  An example cited in the report is for the Residential Energy Credit, which this year had a lifetime cap put on of $1,500.  I checked a number of returns this season to make sure the limit wasn’t exceeded.  Apparently the IRS won’t be doing the same.   It’s awkward to advocate for tax compliance when the government doesn’t even pretend that enforcement is consistent.    (Oops, more late tax season crankiness!  Good thing we’re almost done.) 

IRS Closed in April?!

Would the IRS get an extension, if there’s a government shut down this week?  Would penalties and interest be reduced by the days of the shutdown?  Would you get interest on your refund for days when the “CLOSED” sign was up?  Do filing deadlines move?  What about notice deadlines?

In Congressional testimony this week, IRS Commissioner Doug Shulman acknowledged that the agency is in discussions with the White House about what to do if they aren’t allowed to stay open during filing season.  The last set of contingency plans was done for an October shutdown.  The existing program calls for checks still going out, but no processing of tax returns.  No processing of tax returns in April?! Shulman was mum on the specifics, beyond suggesting that the complexity of shutdown contingencies increases at you get closer to April 18^th.  One has to wonder why Congress needs a hearing to find this particular insight. 

Shulman also talked about how cutting the IRS budget as proposed for this year would save $600 million and cost $4 billion in lost revenue.  Presumably Congressional representatives schooled in the years before “No Child Left Behind” are struggling to figure out the mathematics of this equation.   (Apologies for the late in tax season snarkiness.  I’ll stop now.)

On a more helpful note, the Wall Street Journal’s last minute tax advice column has a tiny reminder at the end that’s really important if it applies to you.  People who have a non-US bank account, or a bunch of small bank accounts off-shore that at any point in the year totaled $10,000 or more, need to note this on their tax return.  In addition you have to file a special form with Treasury by June 30.  They tell you on IRS.gov that there are no extensions for compliance on this one.  Assuming the IRS is open for business on June 30^th, this is one deadline not to miss.  The success of going after tax cheats outside the US is increasing the scope of the search.  Mess up anywhere on this topic and your chances of doing more than your fair share of deficit reduction increase greatly.