Tax Strategies in a Tough Economy - Page 2

Minimizing Self-Employment Taxes

Most taxpayers focus solely on federal and state income tax brackets and are unaware of the potential ramifications of self-employment (SE) taxes. There exists a SE tax of 15.3 percent which is applied to the net earnings from SE income earned by general partners of partnerships, self-employed individuals and members of limited liability companies (LLCs). Many taxpayers are unaware that SE taxes represent a tax liability above and beyond a taxpayer's regular federal and state tax burden.

Many small businesses are minimizing self-employment taxes by converting their business entities from LLCs to S-corporations. Pass-through income and distributions from an S-corporation are not subject to self-employment tax. This is significant since taxable income in excess of "reasonable compensation" to S-corporation shareholders is not subject to SE tax. Of course the S-corporation still pays SE tax on W-2 wages paid to its shareholders; however, the S corporation does receive a deduction for all SE taxes on W-2 wages. For example:

• An S corporation shareholder with W-2 wages of $50,000 and distributable net income of $200,000 would pay $3,825 (7.65 percent of $50,000) in SE taxes in 2009. The S-corporation would also pay $3,825 (7.65 percent of $50,000) in SE taxes; however, the S-corporation would receive a federal and state tax benefit for this deduction.

• Contrast the above example with a general partner of an LLC earning $200,000 in distributable net income. The general partner would pay $19,043 (12.4 percent of $106,800) + (2.9 percent of $200,000)) in SE taxes in 2009.

With the proper tax planning, it is possible to avoid the entanglements of self-employment tax by electing to be taxed as an S corporation.

Take Advantage of the U.S. Construction Activities Deduction

This past year, the IRS issued final regulations making the U.S. Construction Activities tax deduction more advantageous for contractors, builders and developers. The new construction tax deduction is calculated as 6 percent of your Qualified Construction Activities Income for tax years 2007 thru 2009, and will reach a maximum of 9 percent in tax years beginning in 2010 and thereafter.

Qualified Construction Activities Income is loosely defined as the excess of your construction gross receipts over your cost of goods sold directly allocable to such receipts. For example:

If your corporation has $10 million of net income, you would have historically paid about $3.5 million in federal taxes assuming a 35 percent flat rate. However, after a deduction at the fully phased-in rate of 9 percent of qualified construction activities income, federal taxes would only be $3.185 million calculated as 35 percent of $9.1 million. This would result in federal tax savings of $315,000.

Figure 1. Federal Tax Comparison

To qualify for the deduction you must be a contractor, builder or developer engaged in the active trade or business of construction.

Elect to be Taxed as a Real Estate Professional

The last two years have been marked by a major slowdown in the real estate and construction arena leading to large losses for many businesses, especially in the real estate and construction markets.

Generally, rental real estate properties are treated as separate activities and considered passive investments, which means their losses are not currently deductible. The result is a financial predicament in which taxpayers are seeing declining cash reserves while saddled with suspended passive losses.

But by taking advantage of an opportunity to combine separate real estate interests as a single real estate activity, real estate professionals can offset taxable income with rental real estate losses. This election is available only for qualifying real estate professionals who materially participate in real estate activities.

An individual qualifies as an eligible real estate professional if both of the following criteria are met:

• More than 50 percent of the personal services performed by the taxpayer in all trades or businesses during the year are performed in real property trades or businesses in which the taxpayer materially participates. A real property trade or business is broadly defined and includes real property development, construction, acquisition or conversion, rental, management or operation, leasing and brokerage activities.

• The taxpayer performs more than 750 hours of service during the tax year in real property trades or businesses in which the taxpayer materially participates.

The immediate impact of satisfying the material participation qualifications is a transformation of current year passive losses to non-passive. All current non-passive losses are deductible on a taxpayer's tax return as an ordinary deduction. However, passive losses suspended in prior years do not become ordinary losses.

Take advantage of these tax savings strategies to bolster cash flow, stabilize your business and secure a higher bonding limit. Those construction companies that can stabilize their businesses through smarter allocation of resources and tax planning strategies will survive the economic downtown and better position themselves to compete for highly coveted bonded work.

Adam Polakov is a tax manager for Porter Keadle Moore, LLP. He can be reached at 404.420.5974.

Tags: 2009 May Issue , accounting

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