New tax breakthrough for LLCs
An important new Tax Court case could provide valuable tax savings for owners of limited liability corporations (LLCs) and partners in limited liability partnerships (LLPs). The decision permits a couple to use a loss from an LLC or LLP to offset highly taxed income. Previously, it was presumed that such losses could only be used to offset income from other “passive” activities.
Background: New forms of business ownership featuring limited liability are growing in popularity. In particular, the LLC setup is advantageous for its owners (called “members”). As with other pass-through entities, like S corporations and partnerships, items of income and loss of an LLC are passed through to the members. There’s only one level of tax as opposed to double taxation for C corporations.
However, the IRS has long presumed that the passive activity loss (PAL) rules automatically apply to LLCs. If a business activity is characterized as a passive activity, the loss may only be used to offset income from other passive activities. Therefore, you can’t use a PAL to offset income from wages or other highly taxed income. Any excess loss is suspended and is carried forward to future years.
A passive activity is defined as a trade or business in which you do not “materially participate.” The IRS has established several tests for determining material participation. But certain activities, such as rental real estate and limited partnership interests, are treated as passive activities right from the start.
In the new case, a couple’s losses from several LLCs and LLPS were disallowed by the IRS. But the Tax Court disagreed with the IRS’ presumption. Unlike a limited partner in a limited partnership, LLC and LLP owners do not compromise their limited liability under state law by participating in management. Therefore, the taxpayers should not automatically be treated as passive investors. If they qualify as material participants, they can deduct the losses against other income.
Based on the new Tax Court case, some LLC members may be entitled to refunds for prior years. This new decision may have particular significance for many LLC members. If you have any questions about the potential tax benefits, call our office and we would be glad to assist you.
Advice to Clients in Uncertain Markets
In the “flash crash” on May 6, 2010, the Dow Jones Industrial Average dropped nearly 1,000 points only to recover more than 600 points by the market close. On the heels of the financial crisis of 2008, this incident only exacerbated investors’ concerns. Some strategies to manage volatility risk that CPAs can recommend to clients are:
Diversify. Overall risk can be reduced by investing in a variety of assets and asset classes, not just stocks.
Refrain from market timing. Individual investors who maintained a long-term, diversified investment strategy and did not sell at market lows in 2009 have recovered a large portion of their paper losses. Those who sold at market lows only to buy back into the market as the market rose committed a classic investment mistake.
Only use limit orders. A limit order is an order to trade at a specified or better price. In contrast, a market order is an offer to trade at whatever the market price happens to be when the trade is executed. During the flash crash, trades ranged from $0.01 to $100,000 (although certain trades were later canceled).
Never use stop-loss orders. A stop-loss order becomes a market order when a security trades at or below the order price. Use of stop-loss orders means a position could be liquidated at potentially very low prices during periods of extreme volatility.
Avoid excessive use of exchange-traded funds (ETFs). By design, ETFs are diverse investment vehicles that trade throughout the day like common stock. While ETFs can be an effective tool for certain investors, their short-term price risks are typically not recognized by many individual investors. During the flash crash, many less liquid ETFs experienced large price aberrations. ETFs represented a staggering 70% of all trades canceled on May 6, 2010.
Avoid margin. The use of margin (money borrowed from a broker with investments as collateral) can be very risky in volatile markets. The use of excessive margin can force sales when markets suffer an intraday minicrash such as the flash crash.
Refrain from writing puts or uncovered calls. In exchange for upfront premiums, the seller of a put option must purchase a stock at a specified price, and the seller of a call option is obligated to sell a stock at a specified price. Writing puts and calls can be extremely risky. Use of uncovered calls is a fundamental mistake (an uncovered call obligates the seller to sell stock not owned at a set price, in essence creating unlimited liability). Although writing covered calls and buying puts can be a risk-reduction strategy, it is costly in terms of forgoing upside appreciation potential above a call’s strike price.
Unless investors are satisfied with the returns of strictly short-term (and low-yield) U.S. Treasury securities, some degree of market exposure and risk is necessary to earn a return. Investors who simply held on to their positions during the flash crash had recovered all or most of their paper losses within about a week. While future market directions are unknown, individual investors who did not panic or were not forced to sell during this latest market instability were in positions to re-evaluate their investment strategies at little or no cost.
By Luis Betancourt, CPA, Ph.D., William M. VanDenburgh, Ph.D. and Philip J. Harmelink, CPA, Ph.D.
Article Source: Journal of Accountancy
Produce big manufacturing deductions
The so-called “manufacturing deduction” isn’t just limited to companies that manufacture products in the traditional sense of the word. It’s available to a wider range of business operations than you might think.
What’s more, the maximum deduction is increasing to 9% of qualified production activity income (QPAI) in 2010. If your company is in the top 34% tax bracket, this effectively amounts to a 3.15% tax cut.
Here’s some background information. Under Section 199 of the tax code, a qualified domestic producer can currently deduct 6% of the lesser of its QPAI or its taxable income. The maximum deduction was initially doubled from 3% after 2006.
Production activities must be performed in whole, or in significant part, on U.S. soil. The annual deduction is limited to 50% of the W-2 wages.
Obviously, the deduction is fair game for traditional manufacturers of goods, but it also applies to farmers, fishermen, miners and a variety of businesses in the construction field. In fact, IRS regulations single out construction activities for special treatment. For instance, a qualified company doesn’t actually have to construct buildings. The deduction may be extended to certain taxpayers in the business of painting, drywalling and landscaping.
Similarly, the deduction is generally available to engineers and architects. As long as the services are related to construction, the costs qualify for the deduction, even if no actual construction takes place. The deduction may also be claimed by businesses conducting feasibility and environmental impact studies.
Depending on your situation, you may want to modify your business operation to qualify for the increased deduction in 2010. Don’t make any snap judgments if your business operation appears to fall outside the scope of a traditional manufacturing activity. We can make a definitive assessment of your situation. Please do not hesitate to call us and schedule a meeting for this purpose.
Dealing With Clients in Financial Distress
Managing receivables is difficult in the best of times, and these challenges have been made even more difficult by the current economic environment. But there are several steps your CPA firm can take.
Get a handle on billing issues at the outset. First, send out invoices in a timely manner. Invoices are more likely to be paid when the value of your services is still fresh in mind. The earlier an invoice goes out, the earlier it will get paid. Second, if your client has certain requirements or guidelines for processing payment, find out what they are upfront (this can be particularly important for companies requiring the electronic submission of invoices, which is becoming more prevalent). Third, provide clear explanations of the work performed and, if the invoice is likely to draw complaints for being out of line with estimated costs, a phone call to the client with an explanation before the invoice goes out can help eliminate surprises.
Many companies have a 30- or 45-day payment policy. Consider having the client agree to a shorter time frame. This is especially important when the client is experiencing financial difficulties.
Whether or not your client is facing financial difficulties, when your work is expected to take several months, you should have your client agree to progress billing. The shorter the period covered by the billing, the better. But be prepared to stop work if bills are not paid on time. When your client is weak financially, consider an advance retainer agreement.
FOLLOW UP REGULARLY
Once the invoice is out and becomes overdue, follow up regularly. Don’t just send a balance overdue notice. Speak directly with your client and try to get an explanation for any significant outstanding balance, which may provide some guidance as to how concerned you need to be. Also, it is more difficult to avoid a personal phone call than a standard form letter.
Consider setting reserves for any anticipated uncollectible amounts. This is an art, not a science, and the amount reserved may depend on the client’s financial condition, payment history, whether any amounts are disputed and myriad other factors. Also consider setting an across-the-board reserve for all receivables based on collections history. For example, if in any given year the firm is unable to collect 3% of total billings, consider reserving 3% of total receivables.
WATCH FOR RED FLAGS
Throughout the engagement, keep a lookout for red flags that payment problems may be ahead. Is the client hinting at financial difficulty, complaining about work product or more aggressively demanding that your firm adhere to a budget? Did the firm’s large corporate client recently submit a Form 8-K with the SEC stating that it is unable to make a large loan payment coming due? If a client is in jeopardy of declaring bankruptcy, consider timing issues. For example, payments made 90 days before the bankruptcy filing are typically considered preferential payments (or preferences) and, subject to certain exceptions, the bankruptcy trustee may sue your firm for repayment. If your firm holds a retainer, consider when it’s best to apply it to any outstanding balance.
Also determine whether any significant engagement milestones are approaching, such as a deadline for an audit report. And then consider whether your firm should stop work or at least inform the client that you will need to do so if an outstanding balance is not brought current.
CONSIDER DISPUTE RESOLUTION OPTIONS
When disputes elevate to the level of client dissatisfaction or where there is even the possibility of such elevation, consider having a colleague sit in on meetings or calls with the client to discuss overdue fees. Some firms have a designated workout partner who fills such a role, or it may be done on an ad hoc basis. Either way, that colleague can help diffuse difficult situations, represent the “firm’s” position and oftentimes mediate a beneficial resolution. If litigation ever develops, it may be helpful to have a second person as a witness to conversations with the client.
As part of the collections process, clients may request discounts. If the discount is based on dissatisfaction with service, consider obtaining a release of liability in connection with any reduction in fees. Restructuring payment terms is a frequent request by clients in economic dire straits. If the firm and client agree to new payment terms or the scope of the engagement is revised due to budget issues, it is advisable to document these new details in an amended engagement letter or agreement.
If legal action becomes necessary, weigh the pros and cons. A common response to many collection lawsuits is a counterclaim accusing the CPA of malpractice. This brings additional costs and expenses. Careful consideration must be given before suing a client, who is soon to be (if not already) a former client.
If legal action is required, be sure to review the engagement agreement. This is, in essence, the contract on which the firm would be suing. For example, does the engagement letter provide for the recovery of attorneys’ fees, are fee disputes subject to arbitration, and is the firm entitled to interest on unpaid amounts? These answers may dictate whether legal action makes sense. Also consider with your legal counsel whether to include such clauses in engagement letters. Keep in mind that, if you perform services requiring independence, unpaid bills, for example, from a prior year’s audit would make your firm not independent to perform the next year’s audit.
Communication is one of the keys to collection. Keep clients informed and address any potential collection problems upfront. This may be the easiest way to prevent them from becoming actual collection problems.
by Jason M. Rosenthal, Esq.
Article Source: Journal of Accountancy
