Taxes and Planning in 2010

There has been a flurry of tax-related legislation since President Obama took the oath of office. On February 17, 2009, the President signed the American Recovery and Reinvestment Act of 2009 (ARRA), a $790 billion stimulus package intended to spur the American economy. The House of Representatives approved an unemployment insurance extension bill on November 5, 2009 which included a provision allowing businesses with net operating losses (NOLs) in 2008 or 2009 to carry back those losses for up to five years. This bill, known as The Worker, Homeownership, and Business Assistance Act (the Act), was signed into law by President Obama on November 6, 2009.

This article addresses projected changes in tax rates as well as major components from the ARRA and the Act having the greatest impact on construction business owners.

Tax Rates

It is expected that President Obama and the Democratic majorities in Congress will raise the capital gains and ordinary income tax rates beginning in 2011 on higher-income taxpayers. President Obama has indicated that effective January 1, 2011 the following changes will impact taxpayers earning more than $200,000 and joint filers earning more than $250,000:

• Increase the qualified dividend income and long term capital gains rate from 15% to 20%.
• Reinstate the top individual income tax rates (currently 33% and 35%) to 36% and 39.6%.
• The President has proposed establishing limitations on the benefits of itemized deductions (home mortgage interest, charitable contributions, etc.) for taxpayers in the 36% and 39.6% tax brackets.
• The President is planning to raise the cap on payroll taxes to bolster our bankrupt social security trust fund. Currently, all taxpayers remit payroll taxes on earnings up to $106,800. Pursuant to the President’s proposal, payroll taxes will be re-instituted on taxpayers in higher income tax brackets, i.e., joint filers in excess of $250,000 and on earnings of individual filers in excess of $200,000. For example, if you are married filing jointly and earn $300,000 in wages, then your social security tax base would be $156,800 ($106,800 + $50,000 (earnings in excess of $250,000)). Based upon the 6.2% payroll tax rate currently in effect, the joint filer in this example would owe an additional $3,100 ($50,000 * 6.2%) in social security taxes.

Construction business owners need to plan carefully during 2010 to take into consideration the impact of these projected increases in taxes. It is difficult to project with certainty exactly how legislation effective January 1, 2011 will be written, but one thing is for certain: taxes are going to increase in the future.

As part of a Health Care Reform package, the House of Representatives recently passed a 5.4% tax surcharge, amongst a myriad of other taxes, on higher-income taxpayers. As this Article was being written, the ultimate fate of health care reform is unknown.

Five-year NOL Carry back

The Act expands the NOL carry back provision from the American Recovery and Reinvestment Act (ARRA) passed in February 2009. Businesses may now offset 50 percent of taxable income in the fifth preceding year and 100 percent of taxable income in the remaining four carry back years. In summary, there would be no limit on carry backs for the first four years of the carry back period, but for year five, the carry back would be limited to 50 percent of a taxpayer’s taxable income in that year.

The NOL carry back provisions from the Act do NOT include any gross receipts test limitations and are available to all taxpayers with losses in either 2008 or 2009. The Act provides an election for taxpayers to either carry back 2008 losses five years or 2009 losses five years to recapture taxes that have been paid in years when the taxpayer was profitable. The Act does not allow, however, taxpayers to carry back losses five years for both the 2008 and 2009 tax years. Therefore, taxpayers must carefully determine which scenario is most beneficial depending upon their tax position.

Deferred Taxes on Cancellation of Indebtedness Income

Taxpayers that incur cancellation of indebtedness (COD) income during 2009 or 2010 have the option to defer any COD income arising from the reacquisition of a debt instrument for five years and then are allowed to recognize the deferred COD income pro-rata over the following five years. This means that the deferred COD income will be recognized ratably from 2014 through 2018.

Treasury Regulations and the ARRA broadly define the reacquisition of a debt instrument to include the following:

• An acquisition of a debt instrument for cash
• The exchange of a debt instrument for another debt instrument
• The exchange of corporate stock or a partnership interest for a debt instrument
• The contribution of a debt instrument to the capital of the issuer
• The complete forgiveness of a debt instrument by the holder of such instrument.

The following example illustrates how taxes could be deferred on the realization of COD income:

ABC Corp has a $10 million loan with the bank. In 2009, ABC Corp restructures the loan to $6 million. ABC Corp realizes $4 million of debt discharge income on the re-negotiated debt instrument, but doesn’t recognize that income in 2009. Instead, it recognizes $800,000 of debt discharge income ($4 million / 5 yrs) in each of the five years from 2014 to 2018.

Homebuyer Credit

The homebuyer credit has been extended for first-time homebuyers and has also been expanded to include current long-term homeowners and taxpayers in higher-income tax brackets. The credit has been extended to include all contracts initiated on or before April 30, 2010 and which close no later than June 30, 2010.

The tax credit program includes a tax credit of up to $6,500 for existing homeowners who have owned and occupied a primary residence for a period of five consecutive years during the last eight year period. The purchase price must be less than $800,000 for both current and first-time homebuyers. Congress has also increased the adjusted gross income limitations for qualifying taxpayers. Single tax filers who earn up to $125,000 are eligible for the full credit amount. Single tax filers earning between $125,000 and $145,000 will receive a partial credit and a complete phase-out of the credit occurs with an adjusted gross income in excess of $145,000. Joint tax filers with an adjusted gross income of $225,000 or less are eligible for the total credit amount. Joint tax filers will face a partial phase-out of the credit as earned income climbs towards $245,000 with a full phase-out of the credit occurring if adjusted gross income exceeds $245,000.

Estate and Gift Taxation

There has been much speculation regarding future exemption levels on estate tax. The President has proposed freezing the estate tax exemption at its current 2009 levels of $3.5 million per individual with the excess taxed at a top tax rate of 45%. The estate tax is scheduled to expire next year, but it is highly unlikely that Congress will allow a one-year gap in estate taxation to occur in 2010. Many pundits believe that the President’s proposed exemption level of $3.5 million per individual will pass Congress in the upcoming year and will likely be implemented through 2020.

Failure to File Penalties Increasing

The penalty for failure to timely file partnership and S corporation returns is increasing for returns required to be filed after December 31, 2009 from $89 per each partner/shareholder for each month that the return is not filed to $195 per partner/shareholder per month. This large increase in penalties (almost a 120% increase) has been implemented to promote higher filing compliance from S corporations, partnerships, and LLCs.

Construction business owners need to be pro-active in discussing these tax law changes with their CPAs, lenders, and bonding agents. Those construction companies who can more effectively stabilize their business through smarter allocation of resources and tax planning strategies will be better positioned once we emerge from the economic downturn.

Porter Keadle Moore, LLP is a founding member of ProfitCrew, an association of accountants and business advisors dedicated to helping construction companies build profitable businesses. For information, contact Adam Polakov at apolakov@pkm.com or visit www.pkm.com.