| Review Time Say goodbye to 2006 with a clean financial slate.
Source: CUSTOM HOME Magazine
Publication date: 2006-11-30
By Steve Maltzman, CPA The end of 2006 is just around the corner and with it comes the end of the accounting year for many builders. Is your custom building company ready? Are there any last-minute tax-saving steps that you can take to cut your company's and your personal 2006 tax bill? Are there any transactions you need to make to beef up your year-end financial statements? Following are some ideas to discuss with your tax professional prior to your company's year-end:
Tax Deferrals. The deferral of income and the associated tax can be the equivalent of an interest-free loan from the government. Additionally, if the proceeds of that loan are invested wisely enough, money can be earned to pay the original tax on the income. A basic principle of taxation is to accelerate deductions. The acceleration of deductions by a taxpayer postpones the payment of taxes and thus gives the taxpayer the use of the money in the intervening period. This is true whether the taxpayer's bracket is expected to go up or down. With rare exception, it is always better to defer income taxes. Following are some ways to do it:
If your company files its tax return on a completed-contract basis you should consider deferring closings on house sales. When scheduling closings around year-end, you may want to consider pushing as many as possible into 2006 in order to accelerate income or postponing them until 2007 in order to defer income.
Accelerate payment of overhead expenses. This technique works best for cash-basis taxpayers. To accelerate deductions for 2006 you may want to pay as many overhead payables in the current year as possible. If you have cash available you may want to consider prepaying some of your January 2007 expenses. If you will owe state tax for 2006 you may want to prepay it before year-end to get the deduction for your federal tax return (but be aware of possibly getting hit by the alternative minimum tax if you are in a state with a higher state tax rate).
Domestic Production Activities Deduction. Section 199 of the IRS code provides builders with a tax deduction in 2006 of up to 3% of qualified production activity income with the deduction increasing to 6% in 2007 and 9% by 2010. Qualified production activity is equal to adjusted gross profit, which is defined as sales less direct construction costs less an allocation of indirect construction costs as outlined in section 263a of the IRS code. For custom builders building on their own land the market value of the land (defined as cost plus 5% if the land was held for less than five years, cost plus 10% for land held for up to 10 years, and cost plus 15% for land held up to 15 years) needs to be deducted from sales while the land cost is deducted from direct construction cost. This deduction is limited to 50% of W-2 wages paid in the calendar year.
The following is an example of how this deduction works. ABC Custom Homes, a builder electing to report earnings on a completed-contract basis, closed 10 homes with total revenue of $10 million. Construction costs included direct construction costs of $6 million and land held for less than five years with a cost basis of $2 million.
As long as the W-2 wages for the year exceed $54,000 and do not put the company into a loss for tax purposes, ABC Custom Homes can claim a deduction of $54,000. If ABC is a flow-through tax entity (S Corp, LLC, sole proprietorship, partnership), the deduction flows through to the stockholders, members, or owner.
Owner's Compensation. Custom builders who are S Corporations should talk to their tax professionals about possibly reducing their W-2 wages, resulting in a reduction in payroll taxes. According to the IRS, shareholder-employee wages of S Corporations need to pay themselves “reasonable” wages. How low can you go? This is a matter of judgment, and documentation supporting your position is strongly recommended. Clearly, the stated salary need not be any more than what would be necessary to hire an outsider to perform the same job. One note of warning: When deciding to replace wages with distributions, be careful not to reduce your basis in the company (tax basis equity) below zero. Distributions in excess of an S Corporation's stockholder's basis may be subject to additional capital gain taxes.
For C Corporations it is important to pay any bonuses to over 50% of stockholders and officers prior to the end of the year in order to get the tax deduction in 2006. Employee bonuses can be accrued and paid in 2007, but officer and stockholder bonuses must be paid in order to take the deduction.
Home Energy Credit. If you are building energy-efficient homes, you may be entitled to a tax credit of up to $2,000 per home. This credit is available on homes built with heating and cooling consumption less than 50% of a comparable home constructed in accordance with certain federal standards. The home must also have building envelope component improvements providing a level of heating and cooling energy consumption that is at least 10% below that of a comparable home.
Depreciation. Pay attention to your equipment purchases. The proper timing of equipment acquisitions can increase or decrease the overall depreciation deductions for the year. A general depreciation rule—called the half-year convention—is that a business can deduct an entire half-year's depreciation for all equipment placed in service anytime during the year. However, if more than 40% of the cost of all equipment purchases took place during the last quarter of the year, the “mid-quarter convention” rule kicks in. Under this rule, depreciation on assets placed in service during the last quarter of the year is limited to only one and one-half months instead of six months of depreciation. If this rule comes into play, depreciation is also limited on purchases made during the first three quarters of the year.
If you are looking to purchase a new vehicle to be used in the business beware of depreciation limits on the purchase of passenger vehicles used in the business. A passenger vehicle with an enclosed body that is built on a truck chassis is not considered a passenger vehicle if it has a gross vehicle weight rating above 6,000 pounds.
For asset acquisitions don't forget Section 179, which allows a deduction of up to $108,000 of fixed asset purchases in 2006. Passenger vehicles used in the business are not allowable for the section 179 deduction, and it is limited to $25,000 for purchases of heavy SUVs (defined as having a gross vehicle weight between 6,001 and 14,000 pounds).
Employee Benefits. There is a wide range of retirement plans that allow you to save some of your wages not subject to income tax. Some plans even provide for a tax deduction for the company. Following is a brief introduction to some of the programs. Be careful of discriminatory retirement and deferred compensation plans as well as limitations that may be placed on owners and highly compensated employees.
A SIMPLE plan provides for up to $10,000 of earnings to be set aside in a retirement plan not being subject to taxes until they are distributed. The company can also contribute to this plan and get a tax deduction.
For 2006, up to $15,000 can be contributed to a company 401(k) plan with an additional $5,000 for employees over 50. Ask your tax advisor about safe harbor rules, which can remove the contribution limit of owners and highly compensated employees, as well as about employing your spouse to obtain additional family tax deferrals.
Profit-sharing plans can be established that provide for company contributions (and deductions) that may be tiered, providing a larger contribution for key employees.
There are a number of medical benefit plans, including a flexible spending account (FSA), cafeteria plan, health savings account (HSA), and health reimbursement arrangements (HRA), that enable you to pay medical, dependent care, and other expenses with pretax dollars. The spent dollars reduce taxable earnings and escape federal, state, local, and Social Security taxes. Be careful of exclusions for stockholders and highly compensated employees of an S Corp, LLC, or other flow-through entity.
Improve Your Financial Statements. For builders who are required to present financial statements to their bank or outside investor there are a number of things you may want to do prior to year-end to improve the look of the statements. When making some year-end transactions you need to look at both the tax and financial statement effects. Sometimes transactions that would improve your financial statement may actually increase your current-year tax liability.
Consider selling off noncurrent assets and turning them into current assets. This move would improve your working capital ratio, which your bank looks at as a measure of liquidity.
Another method of improving liquidity is to refinance your debt, moving it from current (due by the end of 2007) to long term. As an owner of a C Corporation you may want to issue a long-term note to the company and use the proceeds to pay off current debt.
Minimize prepaid expenses. Often bankers throw out prepaid expenses in their calculation of working capital.
The year end is also a good time to make sure that all of your corporate activities are up to date. The main advantage of having a corporation is to protect your personal liability. However, lawyers have been able to “pierce the corporate veil” when the entity was not properly treated as a corporation. Be sure to:
update your corporate minutes so they document all activities mentioned in your bylaws that need to be acted upon by the corporation's officers.
make sure that all related party transactions are properly documented. Officer loans to and from the corporation need to be formalized. Check with your tax advisor on interest requirements.
One last thing: It's also time to start looking forward to 2007. If you haven't already started, now is a good time to work on your business plan and operating budgets for next fiscal year. And so the cycle of planning, budgeting, and reviewing begins again.—<i>Steve Maltzman, CPA, is president of SMA Consulting in Colton, Calif. He can be reached at smaltzman@smaconsulting.net.</i>
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