Adjust Your Tax Position to Generate Cash Flow Now
By Steve Pierson
Article Date: 10-01-2009
Copyright(C) 2009 Associated Equipment Distributors. All Rights Reserved.
Let careful planning and understanding of your options be your guide.
In these hard economic times it is important that dealers are fully aware of the effects of the tax law on their business. It is incumbent on the business owner to take full advantage of any opportunities the tax system may leverage for their business. Let’s take a look at some opportunities that have been recently enacted into legislation and some pitfalls for the unwary if proper planning is not undertaken.
Special Depreciation Option
For property placed in service after Dec. 31, 2007, and extended to property placed in service after Dec. 31, 2008, in tax years ending after that date, an additional depreciation deduction is available, equal to 50 percent of the adjusted basis of “qualified property.” The property generally must be acquired before Jan. 1, 2010, and must be placed in service before Jan. 1, 2010. “Qualified property” includes most types of new property other than buildings. There is no alternative minimum tax (“AMT”) depreciation adjustment for qualified property that provides for the additional 50 percent first-year depreciation allowance. This means there is no AMT adjustment for the entire recovery period of qualified property.
If Code Section 179 expensing is claimed on qualified property (detailed below), the amount expensed “comes off the top” before the additional 50 percent first-year depreciation allowance is computed. The full 50 percent additional depreciation allowance is available for qualified property, whether or not the half-year or midquarter depreciation convention applies in the placed-service year, and may be claimed even if the property is placed in service on the last day of the taxpayer’s tax year.
The 50 percent additional first-year depreciation allowance applies to qualified property unless the taxpayer “elects out.” The election out may be made for any class of property for any tax year and if made, applies to all property in that class that has been placed in service during that tax year. There must be a definitive election out of bonus depreciation or the bonus applies.
According to the Internal Revenue Service, simply not taking the bonus on the return is not an election out of the bonus. If an election out of bonus depreciation is made, then AMT depreciation applies to that property.
The key to planning in this area is that a bonus may not always be beneficial. This may be the case when state income tax law does not allow the bonus deduction. Other elements to consider are whether the taxpayer has basis in the business (LLC or S Corporation) in which to take the loss. This will determine whether a loss carryback would be allowed or if the losses would simply be carried over.
In short, a detailed analysis would need to be made computing the effect of the bonus or election out, AMT, basis and possible passive loss issues that may arise when planning for the current year and the future.
Many dealers may want to look at Code Section 179 expensing of equipment additions in 2009. A taxpayer can elect to deduct as an expense, rather than to depreciate, up to a specific amount of the cost of new or used tangible personal property placed in service during the tax year in the taxpayer’s trade or business (“Section 179 property”).
For tax years beginning in 2008 and now under new legislation in 2009, the tax law increases the expensing limit to $250,000 and the investment ceiling limit to $800,000. Additions in excess of $800,000 reduce the $250,000 limit, dollar-for-dollar, up to $1,050,000.
The point here is that dealers in 2009 may not be adding a large amount of equipment to their fleets, hence the expensing of Section 179 property may be viable and even preferred since most states also allow Section 179 expensing and the expensing also applies to used property.
The bonus depreciation and Section 179 expense should certainly create cash flow for the business with few or no income taxes in the current and prior year and the potential for tax refunds on carryback claims. I believe in the current year it is important to run projections to plan for income taxes currently and in the future. The analysis should also include state income taxes to avoid any surprises due to varying state laws in this area.
Restructuring of Business Debt
A discharge of debt will create income to the debtor under any condition. This can occur when debt is forgiven, restructured or replaced. This income can be excluded, however, in the case of debtors in Title 11 bankruptcy, insolvency, and real property business debt.
But what if these exceptions don’t apply? In addition, if these exceptions do apply, a taxpayer must reduce tax attributes like net operating loss and business credit carryovers and the depreciable basis of business assets up to the amount of the debt cancellation income.
Under these circumstances, though debt is excluded, tax benefits of loss carryovers and depreciation may be partially or fully eliminated. Is there an alternative?
Under new legislation for debt discharges in tax years ending after Dec. 31, 2008, a taxpayer can elect to have debt discharge income from the reacquisition, restructuring or forgiveness of an applicable debt instrument after Dec. 31, 2008, and before Jan. 1, 2011, included in gross income ratably over five years beginning with the fifth tax year (fourth tax year in the case of 2010 income) discharge following the tax year in which the repurchase occurs. This election replaces the use of the exclusion as stated above in bankruptcy and insolvency situations.
Let me illustrate:
In 2009, XYZ Equipment Corp. repurchases notes for $6 million that it issued with an adjusted issue price of $10 million. The company realizes $4 million of debt discharge income, but doesn’t recognize that income in 2009. Instead, it recognizes $800,000 of debt discharge income ($4 million ÷ 5) in each of the five years from 2014 to 2018, inclusive.
For purposes of these rules the term “debt instrument” is defined to include a bond, debenture, note, certificate, or any other instrument or contractual arrangement constituting indebtedness. Two or more applicable debt instruments that are part of the same issue and reacquired during the same tax year may be treated as one applicable debt instrument. However, a pass-through entity may not treat two or more applicable debt instruments as one applicable debt instrument if the owners and their ownership interests in the entity immediately prior to the reacquisition of each applicable debt instrument aren’t identical.
In addition, the election to defer debt discharge income from a reacquisition of an applicable debt instrument can be made for any portion of the debt discharge realized from the reacquisition. So for instance, if a taxpayer realizes $250,000 of debt discharge income from the reacquisition of an applicable debt instrument, the taxpayer may elect to defer only $100,000 of the income. The remainder of the debt discharge income might qualify for exclusion under the rules stated above for bankruptcy or insolvency.
Although all of the deferred debt discharge income will eventually be recognized, the taxpayer benefits from the deferral of tax to later years. None of the taxpayer’s tax attributes have to be reduced as described above. This election will leave a very viable alternative to debt-troubled businesses and may be an alternative to business restructuring or other alternatives. Again, planning is imperative in determining the best strategy for providing for current and future cash flow needs.
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