Thursday, March 26, 2009

New Tax Law for Net Operating Loss Carrybacks

By: Richard Bell, CPA

The old rules for companies, defined as proprietorships, partnerships, or corporations, with losses for the year, would be to either carry the loss back to the prior two years, or elect to carry the loss forward for 20 years. For example, if you incurred a net operating loss in 2007, you could carry the loss back to a taxable income year 2005, or 2006, and if the full loss was not utilized you could carry the loss forward to 2008 and beyond for 20 years.

For 2008, if you have a loss , and qualify as a small business type, defined to be a company with prior three average revenues of 15 million or less, you may elect to carry the loss back for three additional years, and may opt to choose the specific year of loss. For example, if you have a net operating loss in 2008 , you may carryback the loss to 2007, 06, 05, 04, or 03. It is not necessary to go to 03 first, you can start with 04 or 05 if you so choose. For losses not absorbed, you may again carry the losses forward for 20 years. Further, you may retain the right to forego the carrybacks and elect to carry the losses forward to 2009 and beyond.

There are always exceptions and special rules to the general rules. For instance you may have filed an election to forego the loss and carry it forward, Generally, this election is irrevocable, but the new tax law allows you to amend this election, to take advantage of the new five year carryback period. Further, if you file a corporate C type return, that is a fiscal year, that began in 2007 and ends in 2008, you can make a special election to treat the return as a 2008 year return instead of a 2007 return, and file the losses in the carryback period.

If you have questions on how to best utilize your business losses, contact Pancho.espejo@bellandcompany.net or Andrew.griffith@bellandcompany.net in our office, they will be glad to assist you.

Wage Compensation for S Corporation Officers

Corporate officers are specifically included within the definition of employee for FICA (Federal Insurance Contributions Act), FUTA (Federal Unemployment Tax Act) and federal income tax withholding under the Internal Revenue Code. When corporate officers perform services for the corporation, and receive or are entitled to receive payments, their compensation is generally considered wages. Subchapter S corporations should treat payments for services to officers as wages and not as distributions of cash and property or loans to shareholders.

S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates.

The Internal Revenue Code establishes that any officer of a corporation, including S corporations, is an employee of the corporation for federal employment tax purposes. S corporations should not attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages.

This fact sheet clarifies information that small business taxpayers should understand regarding the tax law for corporate officers who perform services.

Who’s an employee of the corporation?

Generally, an officer of a corporation is an employee of the corporation. The fact that an officer is also a shareholder does not change the requirement that payments to the corporate officer be treated as wages. Courts have consistently held that S corporation officer/shareholders who provide more than minor services to their corporation and receive or are entitled to receive payment are employees whose compensation is subject to federal employment taxes.

The Treasury Regulations provide an exception for an officer of a corporation who does not perform any services or performs only minor services and who neither receives nor is entitled to receive, directly or indirectly, any remuneration. Such an officer would not be considered an employee.

What's a Reasonable Salary?

The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state "Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation."

The amount of the compensation will never exceed the amount received by the shareholder either directly or indirectly. However, if cash or property or the right to receive cash and property did go the shareholder, a salary amount must be determined and the level of salary must be reasonable and appropriate.
There are no specific guidelines for reasonable compensation in the Code or the Regulations. The various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case.

Some factors considered by the courts in determining reasonable compensation:

• Training and experience
• Duties and responsibilities
• Time and effort devoted to the business
• Dividend history
• Payments to non-shareholder employees
• Timing and manner of paying bonuses to key people
• What comparable businesses pay for similar services
• Compensation agreements
• The use of a formula to determine compensation

Medical Insurance Premiums treated as wages.

The health and accident insurance premiums paid on behalf of the greater than 2 percent S corporation shareholder-employee are deductible by the S corporation as fringe benefits and are reportable as wages for income tax withholding purposes on the shareholder-employee’s Form W-2. They are not subject to Social Security or Medicare (FICA) or Unemployment (FUTA) taxes. Therefore, this additional compensation is included in Box 1 (Wages) of the Form W-2, Wage and Tax Statement, issued to the shareholder, but would not be included in Boxes 3 or 5 of Form W-2.

A 2-percent shareholder-employee is eligible for an AGI deduction for amounts paid during the year for medical care premiums if the medical care coverage is established by the S corporation. Previously, “established by the S corporation” meant that the medical care coverage had to be in the name of the S corporation.

In Notice 2008-1, the IRS stated that if the medical coverage plan is in the name of the 2percent shareholder and not in the name of the S corporation, a medical care plan can be considered to be established by the S corporation if: the S corporation either paid or reimbursed the 2percent shareholder for the premiums and reported the premium payment or reimbursement as wages on the 2percent shareholder’s Form W-2.

Payments of the health and accident insurance premiums on behalf of the shareholder may be further identified in Box 14 (Other) of the Form W-2.

Schedule K-1 (Form 1120S) and Form 1099 should not be used as an alternative to the Form W-2 to report this additional compensation.

Tuesday, March 17, 2009

Determining Reasonable Compensation - Menard Case

By: Richard Bell

This is a good case to reference in determining reasonable compensation for a shareholder who owns all voting stock and works over the top type hours, in a non-publically traded company that is a C corporation for tax purposes.

Basic facts are that John Menard owns all voting shares of Menard, Inc, the third largest hardware and building supply company in the United States. Menard’s company earned $350 million in 1998 pre tax dollars, the year of the audit, Menard’s compensation consisted of three components, a base salary of $157,500 , a profit sharing bonus of $3,017,000, which was part of an overall compensation plan for all employees of the company, and a 5 % bonus of all pre tax profits, which amounted to about $17.5 million, which was questioned by the IRS. Total Compensation was $20 million for the year.

The US Tax Court decided that the bonus package should be driven by the companies’ rate of return and derived the formula by comparing the executive compensation paid other CEO ‘s in the industry, Lowe’s and Home Depot, and then develop a ratio of CEO compensation to the return on investment earned by each company. This ratio was then applied to the Menard’s earnings to derive the reasonable compensation of its CEO. The amount was $7.1 million, far short of the $20 million paid Menard. The IRS would have taxed the $13 million difference as a dividend. This would have increased the tax to the Menard Corporation by some estimated 40% federal and state or $5.2 million, and the dividend would have increased Menard individual tax bill by the same estimated 40% federal and state or another $5.2 million, thus, on the $13 million non allowed bonus, the tax could have been estimated as high as $10.4 million, not including penalty and interest. Menard would have received a personal refund credit for the excess bonus paid , of an estimated $5.2 million, so net out before penalty and interest would have been $5.2 million. Note, this cases was a 1998 case before the 15% dividend rates went into effect.

The US Court of Appeals reversed the Tax Court opinion, and upheld the incentive driven bonus paid Menard. The court looked at the following factors:

• Full Compensation packages paid the publically traded CEO’s were disregarded, such as stock options, severance packages, and retirement benefits.

• Differences in responsibilities and performance of the three CEO’s were different. Menard was described as micro managing the company, and was the Board of Directors, and held all voting shares of the company, compared to the publically traded companies, who had executive corporate structure.

• The Appeals Court pointed out that if an incentive plan was in place for a non shareholder employee, then a shareholder employee (Menard) should be allowed to participate as well. A shareholder employee is two distinct individuals, an independent investor, and an employee.

My own observation would be to question why Menard is a C corporation for tax purposes? It would appear that the company should consider “S” corp status, but that may be the case now, this was a 1998 matter, in question.


The latest court case can be found at http://caselaw.lp.findlaw.com/data2/circs/7th/082125p.pdf. .

Thursday, March 12, 2009

Tax Changes Included in the Stimulus Act

On February 17th, the American Recovery and Reinvestment Act of 2009 (the Stimulus Act) was signed into law by President Obama. As you know, the new legislation includes some federal income tax changes. However, you may not realize how many. This letter briefly summarizes what we think are the most important changes. That said, we encourage you to contact us for details because there are some new provisions that we simply don’t have space to even mention here. We will start with changes that affect individuals and personal returns.

Tax Changes for Individuals


Refundable Making Work Pay Credit. The Stimulus Act establishes the new Making Work Pay credit for 2009 and 2010. The credit amount equals the lesser of 6.2% of earned income or $400 ($800 for a married joint-filing couple). Since the credit is refundable, it can offset your entire federal income tax liability, including any Alternative Minimum Tax (AMT). Any leftover credit can be collected in cash or applied to your estimated tax payment obligation for the following year.

The credit is phased out (reduced or eliminated) by of 2% of your Modified Adjusted Gross Income (MAGI) in excess of the applicable threshold—$75,000 for an individual taxpayer or $150,000 for a married joint-filing couple. The $400 individual credit is fully phased out when MAGI reaches $95,000 and the $800 married joint-filing credit is fully phased out when joint MAGI reaches $190,000.

To get credit dollars into the economy quickly, the IRS has already released new federal employment tax withholding tables. The new tables will allow employees to collect credits in advance in the form of lower payroll tax withholdings for the rest of 2009. Self-employed individuals can collect credits in advance by reducing their quarterly estimated tax payments.

One-time $250 Economic Recovery Payment for Eligible Federal Program Recipients. The new law provides a one-time $250 Economic Recovery Payment to the following government program recipients.

• Adults eligible for Social Security benefits.

• Individuals of any age who are eligible for Supplemental Social Security
Income (SSI) benefits (other than those who receive them while in a Medicaid
institution).

• Adults eligible for Railroad Retirement benefits.

• Adults eligible for veteran’s compensation or pension benefits.

To receive the $250 payment, you must have been eligible for at least one of these programs for at least one month during the three-month period that includes November and December of 2008 and January of 2009. Congress has ordered these government agencies to get these payments underway as soon as possible, but they must begin no later than the middle of June.

One-time $250 Refundable Credit for Eligible Government Retirees. The Stimulus Act also provides a one-time $250 credit to certain government retirees who won’t qualify for the Economic Recovery Payment benefit. The money is delivered in the form of a refundable tax credit for 2009 of $250 for each eligible individual or $500 for a married joint-filing couple when both spouses are eligible individuals. To be eligible, you must pass all of the following three tests.

1. During the 2009 tax year, you receive any pension or annuity benefits for
service as any employee of the U.S. or any state (or instrumentality
thereof) that is based on wages that were not subject to FICA tax
withholding at the time they were paid.

2. You are ineligible for the aforementioned Economic Recovery Payment benefit.

3. You report a Social Security Number (SSN) on your 2009 Form 1040. (If
married, either you or your spouse must report an SSN on the return.)

Since the credit is refundable, it can offset your entire federal income tax liability, including any AMT. Any leftover credit can be collected in cash or applied to your 2010 estimated tax payment obligation.

Temporary Sales Tax Deduction for Buyers of New Vehicles and Motor Homes. The new law adds a new deduction for state and local sales and excise taxes paid on new (not used) (1) passenger autos and light trucks with gross vehicle weight ratings of 8,500 pounds or less, (2) motorcycles, and (3) motor homes purchased between 2/17/09 and 12/31/09. However, the deduction is limited to taxes allocable to the first $49,500 of the purchase price. The amount will be claimed as an additional itemized deduction if you itemize. If you don’t itemize, it will be added to your standard deduction.

The new standard deduction add-on or additional itemized deduction (whichever applies to you) is subject to phase-out provisions. The phase-out range is between MAGI of $125,000 and $135,000 for unmarried individuals and between MAGI of $250,000 and $260,000 for married individuals who file separately.

Liberalized Higher Education Credit. For 2009 and 2010, the Stimulus Act includes taxpayer-friendly modifications to the Hope Scholarship higher education tax credit. (The Hope credit is also temporarily renamed the American Opportunity credit, but we will stick to calling it the modified Hope credit for the sake of continuity.) Under the revamped rules, the modified Hope credit equals 100% of the first $2,000 of qualified post-secondary education expenses paid during the year plus 25% of the next $2,000. So the maximum annual credit is now $2,500. Under prior law, the maximum Hope credit for 2009 was only $1,800, and it probably would have been about the same for 2010.

The modified Hope credit covers the cost of tuition, fees, and course materials (but not room and board) for the first four years of post-secondary education in a degree or certificate program. It is unavailable for a year if the student has already logged in four years worth of academic hours as of the beginning of that year. Under prior law, the Hope credit was only allowed for the first two years of post-secondary study, and the cost of course materials did not count as a qualified expense.

The modified Hope credit is subject to phase-out rules, but they are considerably more lenient than the prior-law Hope credit rules. The modified Hope credit phase-out range is between MAGI of $80,000 and $90,000 for unmarried individuals and between MAGI of $160,000 and $180,000 for married joint-filers.
The modified Hope credit can offset your entire federal income tax liability, including any AMT. In addition, up to 40% of the modified Hope credit can be a refundable credit, which means you can get some cash back after reducing your federal income tax bill to zero.

Temporary Homebuyer Credit Extended and Liberalized. Legislation passed last year established a temporary refundable tax credit for first-time homebuyers. The Stimulus Act extends the credit for five more months, to cover qualified home purchases between 1/1/09 and 11/30/09. In addition, the maximum credit amounts are slightly increased for 2009 purchases. More importantly, the requirement to repay the credit over 15 years is deleted for 2009 purchases (but not for 2008 purchases).

For a qualified home purchase between 1/1/09 and 11/30/09, the maximum credit equals the lesser of: (1) 10% of the purchase price or (2) $8,000 ($4,000 if you use married filing separate status). Since the credit is refundable, it can offset your entire federal income tax liability, including any AMT. Any leftover credit can be collected in cash or applied to your estimated tax payment obligation for the following year.

Eligibility is restricted to individuals who have not owned a principal residence in the U.S. during the three-year period that ends on the home purchase date. If you are married, both you and your spouse must pass the three-year test.
If you make a qualified 2009 home purchase (between 1/1/09 and 11/30/09), you can choose to treat the purchase as having occurred in 2008. That allows you to claim the credit (which can be as high as $8,000) on your 2008 return and receive the benefit that much sooner.

Computer and Internet Costs—Qualified Expenses for 529 Plan Distributions. The Stimulus Act counts computer costs (including peripheral equipment and software) and charges for Internet access and related services as qualified higher education expenses for purposes of receiving tax-free distributions from 529 plan accounts. This change applies to eligible expenses paid in 2009 and 2010. To be eligible, however, the expenses must be for computer and/or Internet use by the 529 account beneficiary (the student) during any of the years of enrollment in an eligible educational institution. No harm is done if the student’s family also uses the computer and/or Internet access. The cost of software designed for sports, games, and hobbies won’t qualify unless it’s primarily educational in nature.

One-year AMT “Patch”. The Stimulus Act includes another one-year “patch” to prevent millions of individuals from being hit with the dreaded Alternative Minimum Tax (AMT) for the 2009 tax year. The new law increases the AMT exemption amounts for 2009 to $70,950 if you’re a married joint-filer or a surviving spouse (up from $69,950 for 2008), $46,700 if you’re unmarried (up from $46,200), and $35,475 if you use married filing separate status (up from $34,975). Unfortunately, these exemptions are phased-out (reduced or eliminated) for higher-income taxpayers, and the new law doesn’t make any changes in the phase-out rule. The Stimulus Act also includes changes that permit you to use all nonrefundable personal tax credits to reduce your 2009 AMT liability as well as your regular tax liability.

AMT Exemption for Interest on Certain Private Activity Bonds. Interest on public purpose municipal bonds (those issued by state and local governmental entities for public projects) is tax-exempt under both the regular tax and the AMT rules. However, interest on most qualified private activity municipal bonds (state and local government bonds issued for private sector projects like sports venues) has been taxable under the AMT rules (although tax-free under the regular tax rules). The Stimulus Act changes the landscape by making interest on all qualified private activity bonds issued in 2009 and 2010 exempt from the AMT. Therefore, interest on such bonds is exempt from both the regular tax and the AMT.

Tax-free Treatment for First $2,400 of 2009 Unemployment Benefits. In general, unemployment compensation benefits count as income for federal income tax purposes. However, the Stimulus Act grants a one-year exemption for the first $2,400 of unemployment compensation received in 2009. Unemployment benefits above the $2,400 limit will still count as taxable income.

Liberalized Employer-provided Transportation Fringe Benefit Rule. Starting with March of this year and through December of 2010, the Stimulus Act increases the amount you can receive as a tax-free fringe benefit for employer-provided transit passes and van pooling. The maximum tax-free amount is increased to $230. The $230 limit applies to the value of transit passes and van pooling separately or together. Before this change, the 2009 limit for these benefits (separately or together) was only $120.

Hybrid Vehicle Credits Can Offset AMT Liabilities. The new law includes another change that allows you to use your credit from buying a qualifying new hybrid or lean-burn diesel vehicle to offset your AMT liability as well as your regular tax liability. This favorable change is effective for 2009 and beyond.

Residential Energy Credits Liberalized. The Stimulus Act liberalizes the nonrefundable personal credit for up to 30% of expenditures to install: solar water heating equipment, wind energy equipment, geothermal heat pumps, solar electricity generation equipment, or fuel cell equipment in your home. The new law also extends (through 2010) and liberalizes the separate nonrefundable personal credit for expenditures to install energy-efficient insulation, windows, doors, roofs, and heating and cooling equipment in your residence. Most importantly, the previous lifetime limit of $500 was replaced with an aggregate $1,500 cap for 2009 and 2010.

Business and Other Tax Changes

Generous Section 179 Deduction Rules Extended. The Stimulus Act extends the $250,000 Section 179 first-year depreciation deduction allowance by one year, through tax years beginning in 2009. Without this change, the maximum Section 179 deduction would have been only $133,000. The new law also extends the $800,000 phase-out threshold for reduced Section 179 deductions. Without this change, the threshold would have been only $530,000.

First-year Bonus Depreciation Extended. The Stimulus Act extends the 50% first-year bonus depreciation break to cover qualifying new (not used) assets that are placed in service by no later than 12/31/09. However, the deadline is extended through 12/31/10 for certain longer-lived assets, transportation equipment, and aircraft.

For a new passenger auto or light truck that’s used for business and is subject to the luxury auto depreciation limitations, the extended bonus depreciation break increases the maximum first-year depreciation deduction by $8,000 for vehicles placed in service by 12/31/09. The estimated maximum first-year depreciation deduction for 2009 is now $10,960 for new cars and $11,060 for new light trucks.

Corporate Election to Claim Credits Instead of First-year Bonus Depreciation Extended. Prior law allowed corporations that are otherwise eligible to claim 50% first-year bonus depreciation to elect to forego bonus depreciation and instead “free up” otherwise unusable R&D and minimum tax credit carryovers. Credits freed up by this election are refundable. However, the election was only available with respect to bonus depreciation on qualified assets that were: (1) purchased after 3/31/08 and (2) placed in service by 12/31/08 or by 12/31/09 for certain longer-lived assets, transportation equipment, and aircraft. The Stimulus Act extends the two placed-in-service deadlines by one year to 12/31/09 and 12/31/10, respectively.

Note: Making the election doesn’t result in any lost depreciation deductions. It just postpones depreciation deductions for affected assets.

Longer Carryback Period for 2008 Losses (Small and Medium-sized Businesses Only). The new law allows eligible businesses to elect to carry back 2008 Net Operating Losses (NOLs) for three, four, or five years to obtain refunds of taxes paid for those years. This is a favorable (but temporary) exception to the general two-year NOL carryback rule. The election is only available for losses generated by businesses with average annual receipts of $15 million or less.

For calendar-year taxpayers, the election is available for NOLs generated in calendar-year 2008. For fiscal-year taxpayers, the election is available for NOLs generated in tax years that either begin in 2008 or end in 2008. (A fiscal-year taxpayer can make the election for one year or the other—but not both.)

No Corporate ACE Adjustment for Interest on Tax-exempt Bonds Issued in 2008 and 2009. C corporations affected by the corporate AMT rules generally must include tax-exempt interest as income in calculating the Adjusted Current Earnings (ACE) adjustment for AMT purposes. The Stimulus Act deletes the ACE adjustment for tax-exempt interest on bonds issued in 2009 and 2010.

Government Contractor Withholding Rule Delayed until 2012. The Stimulus Act delays by one year a controversial provision that will eventually require 3% federal income tax withholding from certain payments to government contractors. The withholding rule is now scheduled to apply to payments made in 2012 and beyond. Before this change, it was to apply to payments made in 2011 and beyond.

Debt Discharge Income from Reacquiring Debt in 2009 and 2010 Can Be Deferred. The new law allows a business that reacquires its own debt at a discount to elect to defer the resulting taxable debt discharge income and then spread it out over five years. This election is available with respect to debt discharge income that results from debt reacquisition transactions that occur in 2009 and 2010. The intent is to allow struggling businesses to restructure their debts in a tax-favored fashion.

Pursuant to the election, debt discharge income from a debt reacquisition that occurs in 2009 is deferred until the fifth tax year after the tax year in which the reacquisition occurs (2014 for a calendar-year taxpayer). The income is then spread evenly over five tax years beginning with that fifth year (2014–2018 for a calendar-year taxpayer). Debt discharge income from a reacquisition in 2010 is deferred until the fourth tax year after the tax year in which the reacquisition occurs (2014 for a calendar-year taxpayer), and the income is then spread evenly over five tax years beginning with that fourth year (2014–2018 for a calendar-year taxpayer).

Break for S Corporation Built-in Gains in 2009 and 2010. When a regular C corporation converts to tax-favored S corporation status, the corporate-level built-in gains tax generally applies when built-in gain assets (including receivables and inventories) are turned into cash or sold within the recognition period. The recognition period is the 10-year period that begins on the conversion date.

The Stimulus Act establishes an exception for built-in gains recognized in S corporation tax years beginning in 2009 and 2010 if the seventh year of the recognition period has gone by before the beginning of the tax year beginning in 2009 or 2010. Gains that fall under this exception won’t be hit with the built-in gains tax.

Liberalized Small Business Stock Sale Rules for New Issues. Sellers of qualified small business corporation (QSBC) shares can potentially exclude up 50% of the resulting gains from federal income taxation (subject to several limitations). To encourage new investments in QSBC stock, the Stimulus Act increases the gain exclusion percentage from 50% to 75% for qualifying sales of QSBC shares that are issued between 2/18/09 and 12/31/10.

Work Opportunity Credit Rules Liberalized. The Work Opportunity Tax Credit (WOTC) is intended to give employers a tax incentive to hire members of certain targeted groups. The new law adds unemployed veterans and disconnected youths as new targeted groups. This change applies to unemployed veterans and disconnected youths who begin work for electing employers in 2009 and 2010.

COBRA Premium Subsidy. Group health plans maintained by employers that have at least 20 employees are required to offer certain employees and their dependents the opportunity to continue to participate in the group health plan for up to 18 months. This is referred to as COBRA continuation coverage. The Stimulus Act provides for a 65% government-provided subsidy for COBRA continuation payments for up to nine months to Assistance Eligible Individuals (AEIs) for periods of coverage beginning on or after 2/17/09. Although this subsidy is provided by the government, AEIs will pay 35% of their COBRA premiums with the remaining 65% being paid by the former employer, who is effectively reimbursed for these payments by a reduction in payroll taxes.

An AEI is an employee (and COBRA eligible family members) whose employment has been involuntarily terminated between 9/1/08 and 12/31/09 and who elects COBRA coverage. AEIs who were involuntarily terminated after 8/31/08 and before 2/17/09 and did not enroll for COBRA benefits at the time of their termination, have a special extended 60-day period in which to elect COBRA benefits. They can make the COBRA election during the period beginning on 2/17/09 and ending 60 days after the date on which their former employer provides them the notice regarding the extended election period.

Conclusion


Even though this letter is too long, we have only scratched the surface. We ask you to contact us if you want additional information or if you have questions. We will be pleased to help. For more information you may call Deanna at 501.753.9700.

Friday, March 06, 2009

Cash or Accrual?

By: Brady Pipkin, CPA

Businesses with gross receipts under $1 million are eligible to elect to file tax returns on the cash basis of accounting. Most businesses with gross receipts between $1 and $10 million are eligible to file returns on a cash basis. Taxpayers who derive the largest part of their gross receipts from the following activities are not eligible to file cash basis tax returns.

• Mining activities

• Manufacturing

• Wholesale trades

• Retail trade

• Information industries such as newspapers, periodical books, database
publishers and sound recording industries

Why does this matter? By filing returns on the accrual basis of accounting (the other way to do it), taxpayers are taxed on receivables. Taxpayers are not able to deduct your prepaid expenses until they are actually expensed. The accrual method also allows taxpayers to deduct unpaid expenses (accounts payable and accrued liabilities) in the year the expenses are incurred. By switching to the cash basis of accounting for tax purposes, taxpayers can postpone the tax on receivables until collected and can deduct prepaid expenses when paid. The cash method also disallows deductions for unpaid expenses until those expenses are paid (i.e. you cannot deduct your expenses in accounts payable until you pay them).

Ultimately, the amount difference between the accrual and cash method comes down to the timing of when you will be taxed on income and allowed deductions for expenses. For many trucking companies, receivables are large, especially in today’s economy when customers are paying slower. By switching to the cash method for tax reporting, the tax on these receivables can be deferred until they are collected. In the year that taxpayers elect cash basis, it is typical to have a large adjustment that has a large decreasing effect on taxable income.

For a trucking company that has $350,000 in receivables and $100,000 in payables (and yes, we can still elect cash basis for 2008), the adjustment would result in a $250,000 decrease to taxable income in the first year. This adjustment usually results in substantial tax savings for the stockholders. If you assume a 25% tax rate (which is not unrealistic with both federal and state taxes) and that the company would still have income after the adjustment with no carryover losses from prior years, the tax savings would be $62,500.

As with any major tax election or change, you should consult with us or your tax advisor. If your tax advisor has not informed you that this election is available, you should consider switching (or at a minimum, get a second look at your tax returns). Failing to take advantage of the cash method can cost businesses a lot of money in taxes that are paid too early. In today’s economy, trucking companies need to defer the tax and use the savings to pay other bills.

If you would like to discuss the benefits of converting your company to the cash basis for income tax reporting, please contact Brady Pipkin, CPA at 501.753.9700.