June 29, 2020
Examine all business receivables to determine if a write-off can be taken.
An accrual basis business can take an ordinary deduction for the write-off of a business bad debt (Sec. 166(a)). Care must be taken to ensure that the amount due cannot be recovered. Otherwise, the actual collection of the receivable will create taxable income in a later year.
The bad debt deduction is only allowed for debt that becomes worthless within the tax year for which the deduction is taken. Therefore, two determinations need to be made to support the write-off of a business receivable: both the actual worthlessness of the debt and the fact that the debt became worthless in the year that the deduction is taken.
A deduction can be taken if the receivable is partially worthless (Sec. 166(a)(2)). A business can defer the deduction to a later year when partial worthlessness is greater and take the accumulated amount in one year. The amount written off in any year must be charged off on the entity's books and records. The business can defer taking any deduction until the year that the debt is totally worthless but it cannot be postponed beyond that year (Regs. Sec. 1.166-3)).
Use the lower-of-cost-or-market method for valuing inventory.
The lower-of-cost-or-market (LCM) method of inventory valuation can result in current write-downs of inventory cost before the sale of the inventory (Regs. Sec. 1.471-4). The method can be used by a distributor or a manufacturer of products. The LCM method is not available if the last-in, first-out (LIFO) method of inventory is used (Regs. Sec. 1.472-2(b)).
Each item of inventory must be considered separately to determine the proper inventory value for tax purposes. This requirement prevents a business from using a percentage write-down approach that is permitted for accounting and book purposes.
With regard to manufactured products, the market value to the manufacturer is measured by the costs to replace the inventory in the same manner as it was produced. This includes direct labor, direct material, and indirect costs (Sec. 263A). The uniform capitalization rules for inventory (Regs. Sec.1.474-4(a)(1)) apply.
Apply for a refund of excess 2019 estimated taxes before your 2019 return is filed.
To apply for this quick refund, the estimated tax overpayment must be at least 10% of the expected tax liability and at least $500. Carefully determine the amount of estimated taxes that you should have paid in 2019. If the amount requested to be refunded is "excessive" compared to the ultimate tax on the return, a penalty will be assessed (Sec. 6655(h)).
Depreciate idle equipment.
Depreciation is allowed on assets that are temporarily idle, provided the taxpayer can demonstrate an intention to devote them to active use as soon as conditions permit. This is referred to as the "idle asset" rule. Under this rule the right to depreciation continues until the property is abandoned or otherwise disposed of. Certain depreciable property may be idle as a result of decreased demand, the property can still be depreciated because it is still considered to be "placed in service." The property simply must be in a condition ready for use once the market picks up again.
Deduction for worthless stock of a subsidiary
An opportunity exists for a corporation to take an ordinary, not capital, loss when the stock of an "affiliated entity" becomes worthless (Sec. 165(g)(3)).
Certain requirements apply. First, for the worthless entity to be "affiliated," the stockholder must own stock representing at least 80% of the voting power and at least 80% of the value of the entity's stock. Second, 90% of the subsidiary's aggregate gross receipts for all tax years during which the subsidiary has been in existence must be from sources other than royalties, rents, dividends, interest, annuities, or gains from sales or exchanges of stock and securities.
The ordinary loss opportunity applies to a domestic or foreign subsidiary. The business does not need to be disposed of to obtain the loss. However, there must be an identifiable event that occurs to take the loss.
Ensure adequate stock and debt basis in S corporations and partnerships.
Provisions of the CARES Act can result in increased deductions and potential refunds of taxes paid. These include the technical correction to the depreciation provisions for qualified improvement property, the increased interest deduction under Sec. 163(j), and the net operating loss (NOL) carryback provisions. A partner/shareholder of a partnership or S corporation must have adequate tax basis to take any deduction or loss that flows through from the entity to benefit in the current year from these favorable provisions.
A basis calculation for shareholders and partners consists of a running computation from the point in time when the owner obtained an ownership interest in the entity and must be updated each year to reflect all of the relevant activity that affects basis. It is important to have the calculation completed to the extent possible before year end to determine if additional basis needs to be created by making additional capital contributions or loans before the end of the year.
For an S corporation shareholder to receive basis for debt of the entity, the shareholder must have made the loan directly to the entity (Sec. 1366(d)(1)). Loans to an S corporation from third parties, even from another entity that the shareholder owns, do not create tax basis in the resulting S corporation debt. In addition, a shareholder's guarantee of an S corporation debt does not create tax basis. In contrast, partners do get basis from third-party loans to the partnership (Sec. 752(a)).
Paycheck Protection Program (PPP) loans can be fully forgiven if 60% of the loan proceeds was used for payroll costs and 40% was used for overhead expenses, like mortgages and rent payments, as well as utility costs. For an insolvent company, forgiveness of debt is not considered tax-free income of the type that increases the stock basis in an S corporation (Sec.108(d)(7)(A)). However, it does appear that an S corporation that is not insolvent when its PPP loan is forgiven can receive an increase in basis for the forgiveness. Be aware that the IRS could issue a ruling to the contrary.
When taking losses for debt, the shareholder or partner must be "at risk" (Sec. 465) for the debt. Limited partners of partnerships are not at economic risk of loss for recourse liabilities and thus are not allocated a share of those liabilities for tax basis purposes. Conversely, a shareholder's at-risk amount for an interest in an S corporation includes the amount of money and the adjusted basis of other property contributed to the activity, as well as certain loans the shareholder made to the S corporation. Determining whether the shareholder is at risk depends on numerous factors, including the source of the funds loaned and the security given for the loans.
Consider an automatic change in accounting method to reduce taxable income.
Automatic changes in accounting methods can be made by the due date of the tax return, including extensions. Therefore, it is not too late to consider those changes to reduce 2019 taxable income. While these changes may only have a benefit in the year of change, those changes made on the 2019 tax return could result in significant tax savings on the 2019 tax return as well as a NOL to be carried back or forward. Depending in the circumstance, you may need permission for the IRS.
Change the treatment of prepaid expenses.
Deduct prepaid expenses when paid using the "12-month rule" (Regs. Sec. 1.263(a)-4(f)). You can change the treatment of accrued compensation by deducting the amounts that are fixed and determinable at year end and are paid within 2½ months after year end (Regs. Sec. 1.461-4).
The receipt of advance payments can be deferred to the subsequent year (Rev. Proc. 2004-34, Sec. 451(c), Rev. Proc. 2019-37, Prop. Regs. Sec. 1.451-3).
Review class lives used for depreciation. Often the class lives are simply incorrect and result in too long a depreciation period, which can be significantly shortened on review.
Review the application of the uniform capitalization rules on inventory to determine if there is overcapitalization. Check if the percentages used in the "simplified method" are overstated based on changed circumstances.
Consider repatriating excess cash from foreign operations
U.S. multinational businesses that may be facing liquidity or cash-flow challenges should consider repatriating excess cash from their foreign entities provided the foreign entities have the requisite distributable reserves or retained earnings to do so under local law. The cash to be distributed may have already been subject to U.S. tax.
Business owners should determine whether their foreign operations have any previously taxed earnings and profits (PTEP) that could be repatriated tax free because that PTEP would be accessed first upon an actual cash distribution (Notice 2019-1 and Regs. Sec. 1.960-3(c). Corporate shareholders also have the option of accessing foreign cash in excess of this PTEP because foreign earnings accumulated since 2017 can be repatriated to their U.S. corporate shareholders and generally receive a full dividends-received-deduction (i.e., exempt from U.S. taxable income) as a result of the Tax Cuts and Jobs Act (TCJA). This tax reform provision was not extended to individual and passthrough entities, so the prospect of repatriating PTEP to individual and/or passthrough entities has much greater appeal.
Shareholders of S corporations that made a timely Sec. 965(i) election in 2018 (for the 2017 tax year) to defer the one-time transition tax until such time the S corporation suffers a "triggering event" (as defined in Sec. 965(i)(2)) may have an opportunity to repatriate certain foreign earnings to the S corporation without triggering a federal income tax liability. Even though the foreign earnings accumulated through 2017 were not taxed in the United States yet, the Sec. 965(i) election has the effect of shifting them over to PTEP and thus the distribution of such PTEP would not be taxed in the United States. Even so, a cash distribution of PTEP would be subject to the 3.8% net investment income tax and the impact of any foreign currency gain or loss must be analyzed.
Reevaluate transfer-pricing arrangements.
From a transfer-pricing perspective, internal cross-border pricing policies for goods (manufacturing, distribution, and/or sales), services, royalties, and/or interest on financing may no longer be relevant (or "in range") due to the significant business disruption resulting from the pandemic.
C corporations should determine if property sold and/or services provided by the U.S. business to its offshore affiliates results in foreign-derived intangible income (FDII) to the U.S. corporation. FDII is the amount of a corporation's deemed intangible income that is attributable to sales of property to foreign persons (including foreign affiliates) for use outside the United States. It can also apply to the performance of services for foreign persons or with respect to property outside the United States.
Coupled with the 21% tax rate for domestic corporations under TCJA, the Sec. 250(a) FDII deduction results in a potential 13.125% effective tax rate on FDII. Depending on the circumstance, it may be possible to increase the price the U.S. parent corporation charged to its foreign affiliates for certain goods or services. This allows the U.S. parent to increase its cash flow (from the foreign affiliates) while subjecting the incremental taxable income to a (lower) 13.125% tax rate.
Another area to consider is intercompany loans to capitalize some or all of the intercompany loans and/or reset the interest rate in the notes to ease the pressure on the foreign affiliate to make timely principal and/or interest payments to the U.S. parent company.
Use an IC-DISC to minimize the tax on exports
If a passthrough entity is engaged in: exporting directly goods that it manufactures; providing architectural or engineering services that are conducted in the United States for a project built outside of the United States; and/or manufacturing goods that are included in a product that is exported by someone else, the business could be a candidate for a Sec. 991 IC-DISC (interest charge domestic international sales corporation). An IC-DISC can provide prospective tax benefits (no opportunity for tax refunds from prior years) starting as soon as the entity is formed. There is zero impact on the supply chain and invoicing functions.
There are two administrative pricing methodologies generally used to determine the amount of the IC-DISC commission: (1) 4% of qualified export receipts; or (2) 50% of IC-DISC net income. The business has the flexibility to choose the method that produces the maximum tax benefit each year.
Feel free to contact any member of our team at (610) 828-1900 (PA) or (732) 341-3893 (NJ) with questions. You can contact me at
[email protected]
and Marty at
[email protected]
. As always, we are happy to help.
Stay safe,
David Gibbs, CPA, CCIFP, MBA
Partner
McCarthy & Company
Disclaimer: This alert is for informational purposes only and does not constitute professional advice. Information contained in this communication is not intended or written to be used as tax advice, and cannot be used by the recipient to avoid penalties that may be imposed under the Internal Revenue Code. We strongly advise you to seek professional assistance with respect to your specific issue(s).
