Bank income taxes: Things to consider before year-end
The “Fiscal Cliff” is approaching. It remains to be seen how the government will respond, if at all. Between now and year end, there are some things to consider.
Save up to 28.40% of the tax on Accumulated Earnings & Profits
The opportunity to make a deemed dividend election to reduce or eliminate accumulated earnings and profits (Retained earnings from your C-Corporation days) and incur tax at only 15% on that dividend will end absent an extension of the preferential tax rate on corporate dividends. This becomes even more urgent if your Accumulated Adjustments Account (triple A) is low or zero. The additional 3.8% surtax on the lesser of net investment income or the excess of net investment income over $200,000 for single and $250,000 for married taxpayers means that the effective rate on future dividends may be as high as 43.4%.Assume your accumulated earnings and profits is$4,000,000. The 2012 tax on a deemed distribution would be no more than 15% or $600,000. In 2013forward, absent action by congress, the tax may be as much as $1,736,000.The election can be done with little or no impact on capital. You may choose to distribute cash to cover the tax, but it is not required. Absent a cash distribution for the tax, the effect of the election is a dividend paid and an immediate capital contribution. You’ll need the approval of all of the shareholders, so taking action soon is urgent.
Some of your shareholders may want to begin to track their time devoted to their duties in working onthe business. The issue is whether the shareholder is an active or passive shareholder. If passive, their distributive net income (DNI) will be included in the calculation of net investment income and may be subject to the additional 3.8% surtax mentioned elsewhere in this article. For shareholders that are employees who work more than 500 hours each year, they are active and will not need to include allof their DNI in investment income. Certain separately stated items on K-1’s will need to be included regardless of the active or passive nature of the shareholder (e.g. – dividends). This is most likely important to shareholders that serve on the board but are not employees. They would need to document 500 or more hours per year devoted to board meetings, reading board packets and other time such as that spent in board training (e.g. – for compliance with BSA), etc. There are other ways for shareholders to qualify as active but the 500 hours of activity is likely to be the most common.
A reminder of the bad debt conformity election under regulation§1.166-2(d)(3). In order to make this election, you must obtain an “Express Determination Letter” from your primary regulator for each subsequent examination cycle. You must conform your bad debt deduction to loans classified as loss for regulatory purposes. The benefit is a safe harbor for deducting worthless loans. The risk is that an IRS exam may result in a timing adjustment that flows through to shareholders and triggers the need for them to amend their personal tax return. In an examination, the agent is likely to examine recoveries in the years after a charge-off; the closer the date of the recovery to the date of the charge off, the higher the likelihood of a timing adjustment.
Other Real Estate Issues
Other real estate (ORE) must be taken in to possession with a tax basis equal to fair market value (FMV). Once in your possession, subsequent write-downs to FMV are not deductible until the property is sold. In an IRS exam, there is often a difference of opinion on FMV at the date of foreclosure. Ideally, appraisals will be dated on or very close to the date of foreclosure. IRS has taken the position in examinations that carrying costs for ORE should be capitalized as opposed to currently deducted. Capitalized costs would then effectively become deductible in the year of disposal of the property. Under examination, misclassification of these costs may result in timing adjustments triggering the need for shareholders to amend their personal tax returns. Holding the ORE property out for rent should justify the treatment of carrying costs as currently deductible as a §162 cost of a trade or business. This is easy to support when the property actually produces rental income. For those that do not, it will be important to document that the property has been held out for lease. (e.g. evidence of advertising the property in the paper, on Craig’s List, etc.) Do your accounting records allow you to attribute carrying costs to the specific properties? If not, you’ll need to address this.
Accrued bonuses need to comply with the regulations to allow for their deductibility in the current tax year. To be deductible, the bonuses accrued must be fixed and determinable as of December 31 and paid within 2 ½ months after yearend. Accrued bonuses would not be deductible if the bonus plan requires the employee to remain employed through the payment date and if they do not remain employed, the bonus reverts back to the company.
Avoid Involuntary Termination of Your S-Corp Election
The possibility that corporate tax rates will be lowered may mean that this is no longer the case. Pending Basel III capital rules may also contribute to S-Status being unattractive. If you find yourself impacted by the capital conservation buffer, there may be restrictions on your ability to distribute funds to shareholders for taxes. The continuing benefit of operating as an S Corporation will need to be evaluated on a case-by-case basis.
Let us know if these points prompt questions or if you are aware of other issues you want to consider before year end.
by Frank Conroy
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