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How a Tax Benefit becomes a Shelter

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Joe owns a short line railroad. Joe needs to repair a bridge over the Little Stinky River. But Joe doesn’t have any money and his profitability is so low, he can’t get a bank loan. No problem. Joe is having a few stiff ones at the local bar and is sadly telling the bartender that without repairing the bridge, he’ll have to shut down his railroad. Ted Tax Lawyer is sitting at a nearby bar stool and says, “there might be a way to do this. How many miles is your railroad?” “100”, Joe answered. You need to set up an LLC and assign your track to it for a $1 for 3 years, and the bridge for 20 years. The LLC will charge the railroad a toll to cross it.” Ted asks Joe how many trips across the bridge per day and Joe says, “two, One up and one back”. “So that’s 730 trips a year? How much will it cost to fix the bridge to like new?” Joe thinks for a minute and says, “$1 Million”. “And the bridge will last for how long? Ted asks. “20 years”. “Okay so that’s 14,600 trips over the bridge for its lifetime is that correct?” Ted inquires. I guess, so, Joe answers.” Ted, pulls out his calculator, “that adds up to $69 a trip. So, you now sell shares in the LLC to investors, ” Tax Lawyer Ted replies. “But who would buy it?” Joe asks, pleadingly. “Guys who want a tax credit, now”. They can buy a share in the LLC and when the LLC spends the money on the bridge, they get up to a 50% credit which is paid back in dribs and drabs over 20 years as income. So, each share would be $7,000 since there is a cap of $3,500 per mile per year. You’ll need to take three years to repair that bridge. So, for every dollar invested they get a 50% credit on their taxes in the for each year” Tax Lawyer Ted explains. That means if a guy invests $100,000, he is creditted with having already paid $50,000 to IRS on his taxes”.

So that’s how a tax shelter works. A benefit such as this, has to be (1) Assignable; (2) spend; and (3) large enough to get someone’s attention as a credit.

Some Christmas Candy

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In the new Tax Act there are a number of business incentives and what some would euphemistically call loopholes. However, these loopholes can be advantageous for some.
They continue some of these things which would have expired at the end of 2009. These include the Research Credit, Indian Employment Credit, Railroad Track maintenance credit, rapid depreciation for car race tracks, rapid depreciation for business property on an Indian Reservation, enhanced charitable deduction for donation of school book inventory, DC and Puerto Rico Investments, and extension of the 100% gain on certain small business corporation stock. Today’s loophole is tomorrow’s tax shelter. Where you see the words “accelerated” or “rapid” depreciation, that means you can invest in something and get an early write-off. The word “credit” means you get to reduce your tax by a dollar for every dollar of credit. Again, this is a great thing.

New Tax Act Changes, the GST

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There is one area that folks might want to review if they have sizable estates. This is the year to make gifts to grandchildren because there is no GST tax. Thus, if there are sufficient other assets available to grandma, she might want to consider making an outright gift of $1,000,000 in Trust to the grandchildren. Such a trust could be tied up until they reach a ripe age like 40 or 50 and have had their first divorce, etc. And the Trust could grow. Assume that it is invested for growth and an annual growth rate of 5%. In 20 years that Trust would have doubled in value. In 30 years the Trust would be worth almost $4 Million (not a bad nest egg for middle age). At 10% the numbers are even more compelling. And if Grandma is worth like $100 Million, it might be the year to consider paying some 35% gift tax money to fund a generation skipping Trust. After all in two years the rates could be 55%. The trade-off is that there is no step-up in basis. On the other hand if you use cash or high basis stocks for the gift, its not too bad a deal. Additionally, if there is a trust with a life estate which has a deferred GST due to a taxable termination or distribution, 2010 is the year to end that life estate either through disclaimer or other means. We have two weeks.

Alternative Minimum Taxes

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Back in the 1980’s high income individuals and corporations were perceived to be skewing their income through converting capital gains to ordinary income, buying assets and taking advantage of depreciation and tax credits and seemed to owe little or no taxes. To require them to pay “something” Congress came up with the alternative minimum tax. It is a separate tax calculation. Very basically, all deductions, exemptions are disallowed the the taxpayer gets a single exemption of $70,950 for married couples filing jointly The AMT rate is 26-28% depending on income. 26% on the first $175,000 of income and 28% on anything about that (again married filling jointly). The capital gain rate is 25%. Depreciation is calculated at slower rates, tax exempt private activity bonds interest (like Airport and sports arena bonds) are added back into the calculation. Depreciation deductions are limited. Incentive stock option income is added in. Certain farm tax shelter losses are added back in. In a corporate context, long term contracts are re-calculated, key man life insurance proceeds are added back in. Because of the way it works, planning to avoid the AMT is well nearly impossible. For example, a person pays his state estimated income taxes and his real estate taxes in a year when due. Such expenditures may trigger AMT. Or employee business expenses may likewise trigger the AMT. The funny thing is that once you are subject to the AMT, the numbers always turn out the same, no matter what the deductions are. The reason that AMT expiring tax provision is a huge deal is that the trigger number for the AMT will go down from $70,950 to $45,000 in 2011 (for married couples). This means that more taxpayers will be subject to AMT.

Let’s explore some of these suggestions

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Suppose you start a new business in the last two months of the year and it is a C corporation. The good news is that if you sell the stock in that business down the road you will not owe capital gains taxes. In the meantime, however, profits of the business will pay corporate level taxes and when you pay yourself dividends, they will be taxed at very high rates. If you “zero out” the income of the business by paying yourself a huge bonus, the IRS can come in and call that bonus a disguised dividend and hit you and the corporation with taxes and penalties (if that bonus is deemed to be excessive compensation (which we’ll examine down the road). So, while you are being offered a potentially huge benefit by excluding capital gains, you will be paying for it in the meantime. Had you instead chose an S Corporation or an LLC you would avoid the corporate level tax and would avoid the excessive compensation issues since those are flow through entities.
So, you have to run the numbers and see whether its worthwhile to do this. Also, if you have an LLC which might be sold in five years, this might be a time to convert it to a C Corporation, but you’d need to review the issues involving excessive compensation before you make that choice. We’ll next discuss the concept of alternative minimum taxes.