As year end approaches, businesses have grown accustomed to waiting on Congress to see if certain expiring tax provisions would be extended. Unlike in prior years, however, there does not appear to be as much impetus in Congress to extend some provisions popular in the business community. With corporate tax reform seemingly still miles away, businesses should act now to take advantage of tax benefits available to them under the current rules.

Property Transactions & Cost Recovery

In an attempt to encourage businesses to invest in new property and equipment during the recession, Congress made several temporary law changes that accelerate the cost recovery of those investments. With the economy on the mend and deficits still high, there is not as much support in Congress as in prior years for extending these provisions. Businesses should look to take advantage of these benefits while they last. In addition, complex new tangible property regulations go into effect in January that present some potential tax savings opportunities for businesses that take the requisite action before year end.

Section 179 Expensing Election

Businesses have enjoyed an "enhanced" Section 179 expensing election for the last few years. The Section 179 deduction, enhanced as a means to spur investment by businesses during the recession, enables businesses with taxable income to immediately deduct up to $500,000 of capital expenditures. The $500,000 deduction is reduced dollar-for-dollar to the extent the overall investment exceeds $2 million. Property eligible for the Section 179 deduction generally includes new or used tangible personal property and off-the-shelf computer software. The enhanced deduction also allows businesses to write off up to $250,000 of qualified leasehold improvement, restaurant or retail improvement property.

Originally expired at the end of 2011, the American Taxpayer Relief Act of 2012 ("ATRA") extended the enhanced Section 179 deduction to the 2012 and 2013 tax years. Without Congressional action, the Section 179 deduction limit will plummet from $500,000 in 2013 to $25,000 in 2014. With reports suggesting that the enhanced Section 179 deduction and bonus depreciation (discussed below) have little if any impact on the economy, support on either side of the aisle in Congress to extend this provision is scarce, at least to that extent (a $125,000 deduction limit may garner more support).

Businesses that are considering significant capital investments in 2014 should consider accelerating those purchases into 2013 to take advantage of the enhanced Section 179 deduction while it lasts. As you contemplate that strategy, keep these issues in mind:

• Generally, the assets must be actually placed in service by the end of the 2013 tax year, not merely acquired or contracted for.
• The Section 179 deduction is tied to the business's tax year, not the placed-in-service date. Therefore, while calendar year taxpayers must place the assets in service by December 31, 2013 to qualify for the deduction, fiscal year taxpayers have until the end of their 2013 tax year to place the assets in service.
• The Section 179 deduction is allowed only to the extent of the business's taxable income derived from the active conduct of a trade or business. Any Section 179 deduction that cannot be used as a result of this limitation may be carried forward indefinitely to future tax years. But with the Section 179 deduction scheduled to drop significantly in 2014, it may take a business several years to use up large carryovers generated in 2013.
• Both new and used property are eligible for the Section 179 deduction.

Bonus Depreciation

The bonus depreciation provision allows taxpayers to immediately write off 50 percent of qualifying assets placed in service before January 1, 2014. Qualifying assets generally include tangible personal property and qualified leasehold improvements. The 50 percent bonus depreciation provision expires after December 31, 2013 and, for reasons similar to those enumerated above with respect to the enhanced Section 179 deduction, the prospects for renewal are murky at best.

While bonus depreciation and the Section 179 deduction both accelerate deductions on the acquisition of capital assets, there are some notable distinctions between the two provisions:

• Bonus depreciation may be claimed only on new assets while the Section 179 deduction may be claimed on new or used assets.
• Bonus depreciation is tied to the placed in service date rather than the tax year. Therefore, even for taxpayers with fiscal years, only assets placed in service before January 1, 2014 are eligible for bonus depreciation.
• Bonus depreciation is not subject to any taxable income limitations. Therefore, bonus depreciation deductions can generate, or increase, a net loss.

Automobile Acquisitions and Dispositions

Passenger automobiles are subject to limitations as to the amount of depreciation that can be claimed each year, known as the "luxury auto" limitations (somewhat of a misnomer given that the limitations kick in on automobiles costing less than $16,000). For automobiles placed in service in 2013, the amount of first year depreciation normally would be capped at $3,160, including autos eligible for Section 179 expensing or bonus depreciation. A special provision extended by ATRA through 2013 increases this limitation by $8,000 to $11,160. As its prospects for extension are uncertain, businesses planning to acquire vehicles in the next few months should consider accelerating those purchases into 2013.

Automobiles with a gross vehicle weight in excess of 6,000 pounds, such as large SUVs, are not subject to the luxury auto limitations. The amount of Section 179 deduction that can be claimed on those large vehicles, however, is capped at $25,000.

If you are considering replacing any vehicles before the end of the year, consider selling the old vehicle outright rather than trading it in. Though mitigated by the extra $8,000 luxury auto depreciation referenced above, vehicles are often worth less than their undepreciated cost basis. When a vehicle is traded in, the realized loss on that vehicle is rolled into the depreciable basis of the new automobile, i.e., the loss is deferred. Selling the vehicle outright will trigger the recognition of that built-in loss. The economic loss may even be less as autos often can be sold outright for more than their trade-in value. Weigh these benefits against the sales tax implications of a sale vs. a trade-in. In some states, sales tax is paid only on the value of the new auto, net of the trade-in value of the replaced auto.

Capitalization Policy

New regulations that go into effect in 2014 allow businesses to write off small asset purchases without the fear that the IRS could come in and disallow the immediate deduction. The amount that can be written off is up to $5,000 per item or invoice if you have an audited financial statement, or $500 per item or invoice if you do not. This de minimis safe harbor also applies to materials and supplies.

To take advantage of this provision, you must have a formal capitalization policy in place as of the first day of the year and you must follow that policy for financial statement purposes (a written policy is required for the $5,000 per item deduction). If you already had a capitalization policy in place as of the first day of your 2013 tax year, you can benefit from this safe harbor this year. Otherwise, you need to take action by the end of the year if you want to apply this provision in 2014.

Loss on Partial Disposition of Building Structures

If you have replaced a portion of your building structure within the last several years (e.g., a roof), you likely are still depreciating that old component that is no longer in service (in addition to the replacement component). Temporary regulations available for 2013 may allow you to write off the remaining cost basis in that replaced component. Alert your CBIZ tax advisor if this situation applies to you and he or she can help you evaluate the opportunity, calculate the deduction and complete the accounting method change request.

Inventory Management

Businesses with inventory that cannot be sold at normal prices because of damages, imperfections, shop wear, changes of style, etc. ("subnormal goods"), may be able to claim a deduction to write down the cost of that inventory. Subnormal finished goods inventory may be valued at bona fide selling prices, less the direct cost of disposition, if such goods are actually offered for sale at the lower prices not later than 30 days after the inventory valuation date. If no market exists, then a taxpayer may be able to write off the entire cost because the goods have become completely obsolete. Subnormal goods do not include merely excess or slow moving inventory.

If the subnormal goods are raw materials or partly finished goods, they can be valued using some reasonable basis. There is no 30-day rule in this case; however, the burden of proof is on the taxpayer to support the value. In no circumstance may the value be less than the scrap value.

Any change in how your inventory is valued from your current practice likely will be considered a change in accounting method. Taxpayers must receive advance permission from the IRS to change a method of accounting. An application for permission to change a method of accounting (Form 3115) must be filed by the end of the tax year for which you are requesting permission to change methods. Depending on the nature of the change, however, certain changes in accounting method are automatically approved by the IRS and Form 3115 does not need to be submitted until the tax return for that tax year is filed.

Timing of Income/Deduction Recognition

While the fate of expiring tax provisions and other uncertainties present unique challenges to year-end planning, traditional income deferral / deduction acceleration strategies may be used to minimize taxable income. Some of the more prominent strategies are below. Note that some of these strategies may necessitate a request to the IRS to change your method of accounting with respect to that item.

Deducting Accrued Compensation and Bonuses

Accrual basis taxpayers may be able to deduct compensation in the year that the services are performed as long as the compensation is paid to the employees within 2 ½ months after the company's year end and other requirements are met. While employers traditionally apply this rule to its regular payroll, payments for bonuses, vacation pay and the related payroll taxes require special consideration.

In order to deduct accrued compensation in the year that the services are performed, not only must the compensation be paid within 2 ½ months of year end, but the employees' rights to the compensation also must be fixed by the end of the year. For example, if an employee's right to receive an accrued bonus is contingent on that employee still being employed on the day the compensation is paid, his right to receive that bonus is not fixed as of year end. Therefore, the compensation is not deductible until paid. See our October 2013 InTouch article, Nuances of Bonus Program Impact Timing of Deduction, for a detailed discussion of this issue and how to structure your program to qualify for the accelerated deduction.

In addition to salary, wages and bonuses, accrued vacation and sick pay may also be deductible in the year it is accrued. The vacation and sick pay must be fully vested by year end and, as with the accrued bonus, must be owed to the employee in the event of termination. Only the portion of the accrued vacation and sick pay that is actually used by the employee within 2 ½ months after year end is deductible in the year accrued. If your company has historically deducted accrued vacation and sick pay in the year paid, you may be able to apply for an automatic accounting method change to accelerate a portion of the deduction.

Assuming that the liability is fixed and that the amount can be determined with reasonable accuracy by year end, accrual basis taxpayers generally can deduct accrued payroll taxes in the year accrued. Accrued payroll taxes are not subject to the 2 ½ month or related party limitations applicable to accrued compensation, and the ability to deduct accrued payroll taxes is not contingent on whether the related accrued compensation is deductible in the year accrued. The accrued payroll taxes generally must be paid by the earlier of 8 ½ months after year end or when the company files its income tax return for that year. Changing the treatment of payroll taxes qualifies for an accounting method change under the automatic change provisions.

Deducting Accrued Payments to Related Parties

Accrual basis taxpayers can only deduct amounts owed to cash basis related parties in the year that the expenses are paid. This limitation ensures that the owner recognizes the income in the same tax year that the business claims the deduction. This limitation commonly applies to accrued expenses such as compensation, rent and interest expense. Businesses should take measures to ensure that those payments are made prior to year end.

For purposes of this limitation, related parties generally include greater-than-50 percent shareholders of C corporations, all Personal Service Corporation shareholders, all S corporation shareholders and all partners or LLC members. Accrued guaranteed payments to a partner in a partnership are deductible but are taxable to the partner in the year accrued, not in the year received.

The related party limitation on the deductibility of accrued expenses applies not only to the related parties themselves, but also to their relatives. For example, not only is the accrued compensation to an S corporation shareholder not deductible until paid, but neither is any accrued compensation owed to his spouse, parent, child or sibling.

Deferring Recognition of Advance Payments / Gift Cards

Accrual basis businesses generally recognize income when all events have occurred that fix the right to receive such income and the amount can be determined with reasonable accuracy. Therefore, an advance payment generally is recognized as income when it is received, even if the taxpayer has yet to provide the goods or services that generate the income.

Taxpayers that receive advance payments have the ability to adopt an accounting method that allows them to defer income recognition on advance payments. Income from advance payments for the provision of services generally can be deferred for one year. Income from advance payments for the sale of inventory may be deferred multiple years, depending on when the income is recognized for financial accounting purposes. Changing when income is recognized from advance payments is a change in accounting method and can be applied for under the automatic or advance consent procedures, depending on which deferral method is chosen.

As gift cards have exploded in popularity and complexity (separate gift card companies, retailers selling gift cards for unrelated merchants, etc.), the IRS has struggled to keep up with equitable rules for gift card sale income recognition. Historically, the IRS only allowed deferral of gift card sale income if the gift card was sold and redeemed by the same entity. Now gift cards that are redeemable by other entities can qualify for income deferral of up to one year. Companies that wish to change their gift card income treatment to take advantage of the one-year deferral can apply for an accounting method change under the automatic change procedures. 

S Corporation Issues

Despite recent increases in individual tax rates and the ongoing promise of corporate tax reform, S corporations continue to be a popular entity for doing business because of its single layer of taxation, general avoidance of self-employment tax, and owners' familiarity with the corporate form. S corporations often have unique issues that must be navigated to avoid negative tax consequences.

Managing Built In Gains Tax

The built-in gains (BIG) tax imposes a corporate level tax on the amount of gains inherent in assets that were held by a C corporation at the time it converted to an S corporation. If any BIG assets are sold within the recognition window (discussed below), the C corporation pays tax on the net recognized BIG at the highest corporate tax rate and the total gain recognized (net of the tax on the recognized BIG) is taxed at the shareholder level.

Traditionally, assets disposed within 10 years of when the corporation converted to an S corporation (the "recognition window") were subject to the BIG tax. Recent tax law changes have reduced this window to 7 years and most recently to 5 years through 2013. The recognition window is scheduled to revert to 10 years beginning in 2014. S corporations that are beyond the five-year window, but still within the 10-year window, should consider disposing of any built-in gain property (unless they are confident that the assets will be held beyond the 10-year window).

The amount of realized BIG that must be recognized in a tax year is limited to the S corporation's total taxable income. Therefore, the BIG tax can be mitigated by taking steps to reduce taxable income, such as paying additional bonuses (assuming total compensation is reasonable). Any realized BIG that is not recognized due to the taxable income limitation carries over and is recognized the following year (subject again to the taxable income limitation). If taxable income can be managed until the expiration of the recognition window, the S corporation can avoid recognition of the BIG completely.

Ensuring Loans Will Be Respected

Loans between S corporations and their shareholders are common. Shareholders will often lend money to the S corporation as a way to generate basis against which to deduct losses passing through from the S corporation. Alternatively, S corporations may lend money to a shareholder as a way to transfer funds to him without reducing the shareholder's basis or triggering gain recognition on excess distributions. The IRS will closely scrutinize these transactions to ensure that their treatment for income tax purposes is consistent with the economic realities of the transactions.

The loan transaction between the S corporation and the shareholder must represent bona fide indebtedness if the transaction is to be respected. The proper form of the transaction should be followed, especially when back-to-back loans are involved (i.e., money loaned from a bank or related party to the shareholder which is in turn loaned to the S corporation). The loans should be properly documented and the payments should follow the proper trail (e.g., the S corporation should make loan payments directly to the shareholder, not to the bank from which he borrowed the money). Consider the following questions when evaluating whether a bona fide indebtedness exists between the S corporation and the shareholder. If the answer to any of these questions is "no", the validity of the loan could be questioned:

• Is the loan memorialized in a written document?
• Does the loan provide for a reasonable rate of interest?
• Are all of the other terms of the loan agreement commercially reasonable?
• Are both parties abiding by the terms of loan (e.g., making regular payments if required)?
• Is the corporation accounting for the loan in its books and records consistently with the terms of the agreement?
• In the case of a back-to-back loan, is the corporation making loan payments to the shareholder rather than to the originating lender?

If your S corporation has made loans to, or received loans from, any shareholders, review those loans before year end and make sure that the terms are properly documented and that the loans are managed in accordance with those terms.

Expiring Tax Provisions

Several prominent business tax provisions are scheduled to expire at the end of 2013. Unlike in prior years when the general consensus was that most of these provisions would be extended, those prospects are considerably less certain this time. An improving economy, concerns over budget deficits and an increasingly toxic relationship between Democrats and Republicans in Congress threaten the future of many of these provisions, even those with widespread bipartisan support.

We've already discussed several expiring provisions above (enhanced Section 179 deduction, bonus depreciation, five-year BIG tax recognition window, etc.). Here is a list of some other tax provisions set to expire on December 31. Businesses that would otherwise qualify for these benefits should ensure all necessary actions are taken before January 1 to receive the benefits.

Research and experimentation tax credit – This popular credit rewards businesses that make investments to research new and improved products and processes. While the research credit frequently lapses, only to be later reinstated and extended, businesses should look for opportunities to accelerate qualifying expenditures to ensure that the tax benefit is derived.

Work Opportunity Tax Credit (WOTC) – Employers that hire members of certain targeted groups (such as veterans and individuals receiving certain government benefits) are eligible for a tax credit generally equal to 40 percent of the worker's first year wages up to $6,000 (qualified wage cap varies by group). Like the research tax credit, this provision has bipartisan support and likely will be extended, though perhaps not until after the first of the year.

100 percent small business stock gain exclusion – A noncorporate taxpayer that acquires qualifying small business stock before January 1, 2014 and holds the stock for at least five years can exclude 100 percent of the gain on the eventual disposition of that stock. The stock must be originally issued stock of a C corporation with gross assets that do not exceed $50 million (80 percent of which must be used in an active business). Businesses will need to act quickly to form the corporation or issue additional shares before year end. The exclusion is scheduled to drop to 50 percent beginning January 1.

15-year recovery period for qualified real property – Certain property generally depreciated over 39 years may be recovered over 15 years if placed in service before January 1, 2014. Eligible property includes qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property. As the improvements must be placed in service by year end, businesses should take steps to ensure that improvements currently in process are completed and placed in service by December 31.

Section 179D energy efficient commercial building deduction – Businesses that are "going green" and making energy efficient renovations and upgrades to their buildings can qualify for an accelerated deduction of the expenditures. Expenditures for lighting and HVAC systems that meet certain energy efficiency standards often qualify for the benefit. Property must be placed in service before January 1, 2014 to qualify for the benefit so while it may be too late to initiate new improvements before year end, qualifying taxpayers should make sure that current improvements are placed in service before January.

Various energy incentives – Along with the 179D deduction, several other energy incentives are set to expire at year end, such as the nonbusiness energy property credit, renewable resources credit and energy efficient new home construction credit. The future prospects of all of these energy incentives after December are uncertain.

We have only discussed some of the most common planning strategies here. Consult your CBIZ MHM tax advisor for more information about these strategies and other actions your business should take before year end. For tax strategies that you as an individual should consider, refer to our companion Tax Alert, Year-End Tax Planning for Individuals.

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