TAX INSIDER

Top 10 business income tax planning ideas for the pandemic

From accelerating bad debt deductions to repatriating foreign income, here are ways businesses can improve their cash flow in these difficult times
By Lewis Taub, CPA, Timothy Larson, CPA, and Joshua James, CPA

During this time when all businesses want to maximize cash for operations, some of the most basic tax planning ideas warrant the attention of all business owners. These "oldies but goodies" in the tax planning bucket can make a significant difference in reducing income tax, thereby increasing cash flow and even creating tax refund opportunities. Many of these ideas can be used on 2019 tax filings not yet completed.

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 worthlessness of a debt is determined by the particular facts surrounding each debt. The regulations do not contain a specific definition of the term "worthless." The judicial standard for this determination is more pragmatic than it is legal. Court cases often rely on what could be considered sound business judgment in determining worthlessness. (See, e.g., Estate of Mann, 731 F.2d 267 (5th Cir. 1984)).

Legal action is not required to determine if a receivable can be written off. Instead, if all the facts and circumstances indicate that legal action may not be effective, there is enough basis to write off the debt.

The bad debt deduction is only allowed for any 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)). It is permissible to take a partial worthless bad debt deduction as a receivable becomes worthless. On the other hand, a business can also 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 also be charged off on the entity's books and records. Furthermore, the business can defer taking any deduction until the year that the debt is totally worthless. However, the deduction cannot be postponed beyond the year the debt is completely worthless (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. However, 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.

For goods purchased to be resold, the term "market" means the current bid price (replacement cost) at the date of the inventory for the product purchased in the usual volume. In today's turbulent economic times, obtaining this value presents a problem if the business's normal source of supply is inaccessible. The Tax Court has held that the current bid price is the prevailing price in the market available to the taxpayer (D. Loveman & Son Export Corp., 34 T.C. 776 (1960), acq., 1961-2 C.B. 5, aff'd, 296 F.2d 732 (6th Cir. 1961), cert. denied, 369 U.S. 860 (1962)). Therefore, if normal circumstances do not exist because of the COVID-19 pandemic, the business must use the prevailing market in the LCM calculation. It is important to emphasize that market value is determined at the date of the inventory (Regs. Sec. 1.471-4(a)(1)).

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, including those required under Sec. 263A, the uniform capitalization rules for inventory (Regs. Sec.1.474-4(a)(1)).

Corporations can apply for a refund of excess 2019 estimated taxes before the 2019 tax return is filed

During this economic downturn when cash can be tight, it is important to realize that a corporation can have an overpayment of 2019 corporate estimated taxes refunded before the actual filing of the corporate tax return.

Form 4466, Corporation Application for Quick Refund of Overpayment of Estimated Tax, can be filed before the 2019 tax return is filed, and the IRS will refund the claimed overpayment within 45 days (Regs. Sec. 1.6425-1(b)(1)). This can be a very valuable tool to use during this period when there may be delays in gathering all the information to prepare the 2019 tax return completely.

The form can be used for several types of corporate filings, including a Form 1120, U.S. Corporation Income Tax Return, and Form 1120-F, U.S Income Tax Return of a Foreign Corporation. In past years, a calendar-year corporation that files Form 1120 would have had to file Form 4466 to apply for a quick refund of 2019 estimated taxes by April 15, 2020. However, the IRS extended this due date to July 15, and therefore the opportunity for a calendar-year corporation to receive a quick refund of an overpayment of 2019 estimated taxes before the filing of the tax return is still available (see Notice 2020-23 and the IRS's FAQs on deadline extensions). Fiscal year corporations may also have any opportunity to utilize Form 4466 if the original due date for the 2019 tax return has not yet passed.

The form simply asks for the expected tax on the eventual return and the estimated taxes paid, including any overpayment carried over into 2019 from a prior year. Details must be given for the dates of payments and the amounts paid, which the IRS will verify. To apply for this quick refund, the estimated tax overpayment must be both at least 10% of the expected tax liability and at least $500.

One caveat: Care should be taken in determining the expected tax on the return to be filed. If the amount requested is "excessive" compared to the ultimate tax on the return, a penalty will be assessed under Sec. 6655(h).

Depreciate idle equipment

It is entirely possible that as a result of reduced demand in the current economy that manufacturers find themselves with property that becomes idle.

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. As a result of the rule, even though 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. (Samson Inv. Co., T.C. Memo. 1998-271.)

An ordinary 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)).

There are certain requirements to obtain that beneficial tax deduction. 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. For example, an election to change the classification of an entity from a corporation to a disregarded entity could give the shareholder an ordinary deduction if the fair market value of the subsidiary's assets is less than the entity's liabilities. The shareholder receives no payment on its stock reflecting the entity's worthlessness. Another identifiable event may be the liquidation of a subsidiary that does not qualify under Sec. 332. More specifically, the liquidation would not qualify under Sec. 332 if no money is paid to the parent for the stock of the subsidiary.

Ensure adequate stock and debt basis in S corporations and partnerships

Much has been written about the provisions in the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, that 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. However, if these relief provisions are generated through a partnership or S corporation, the partner/shareholder 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.

The rules for debt basis in S corporations are much different and more limiting than those for partnerships. Specifically, 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)).

An interesting opportunity exists for computing S corporation basis for an S corporation that receives a loan under the Paycheck Protection Program instituted under the CARES Act (PPP loan). These 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. That said, this benefit should be monitored for any IRS ruling to the contrary.   

It is also important to remember that with regard to taking losses for debt, the shareholder or partner must be "at risk" under 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. (See Taub, "Sec. 465 Traps for the Unsuspecting S Corporation Shareholder," The Tax Adviser (July 2010).)

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. Note that while these changes may possibly 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 and possibly an NOL to be carried back or forward.

Rev. Proc. 2018-31 includes a list of automatic changes in accounting methods and should be reviewed to determine which changes can apply on a case-by-case basis. Some very common ones that are relevant to a wide range of businesses include:

  • Changing the treatment of prepaid expenses — Deduct prepaid expenses when paid using the "12-month rule" (Regs. Sec. 1.263(a)-4(f));
  • Changing the treatment of accrued compensation — Deduct the amounts that are fixed and determinable at year end and are paid within 2½ months after year end (Regs. Sec. 1.461-4);
  • Changing the treatment of advanced payments received — Defer the receipt of those payments to the subsequent year (Rev. Proc. 2004-34, Sec. 451(c), Rev. Proc. 2019-37, Prop. Regs. Sec. 1.451-3);
  • Reviewing the 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; and
  • Reviewing the application of the uniform capitalization rules on inventory — Is there overcapitalization? Are percentages used in the "simplified method" overstated based on changed circumstances?

Consider repatriating excess cash from foreign operations

U.S. multinational businesses that may now 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.

In many cases, the cash to be distributed may have already been subject to U.S. tax (for 10%-or-greater U.S. shareholders) as a result of, for example, the one-time transition tax implemented under the 2017 law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, and imposed by Sec. 965. That is, the transition tax generally applied to the U.S. shareholder's portion of the post-1986 earnings and profits (E&P) of a controlled foreign corporation (or of another foreign corporation having a U.S. corporate shareholder with at least 10% ownership), and applied irrespective of whether the foreign E&P was actually distributed to the United States. As a result, the foreign E&P became foreign previously taxed earnings and profits (PTEP).

Thus, business owners should determine whether their foreign operations have any PTEP that could be repatriated tax free because that PTEP would be accessed first upon an actual cash distribution. (See 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 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.

It is also important to note that 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. It should be noted, however, the 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 also be analyzed.

Reevaluate transfer-pricing arrangements

It has become clear that the economic impact of the COVID-19 pandemic will run deep as businesses face reduced sales and profit margins, reduced cash flow — whether for the U.S. parent business or the foreign subsidiary — and/or revised customs declarations or adjustments. 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.

Traditionally, transfer pricing has provided a mechanism to realign income streams or expense categories to tax-favorable jurisdictions. The COVID-19 pandemic has not necessarily provided U.S. multinationals an opportunity to shift tax burdens between jurisdictions, but instead, arguably, provided an opportunity to minimize economic damages resulting from this global pandemic. By no means are we suggesting that current intercompany policies and benchmarking analyses, etc., are worthless, but instead that proactively reevaluating the functional analysis, the changes in business industry, extraordinary items resulting from severance and/or shutdowns, and new functions and risks inherent in the business can be used to rationalize and support modifying such intercompany pricing to maximize cash flows where they are most needed.

One area that could warrant a "fresh look" (only for C corporations) is property sold and/or services provided by the U.S. business to its offshore affiliates and the resulting 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 as a result of the TCJA, the Sec. 250(a) FDII deduction results in a potential 13.125% effective tax rate on FDII. Given the global economic disruption, it may be more palatable, depending on retooled functions and risks, 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 and to evaluate whether it is prudent 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.

Using 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 an ideal candidate for a Sec. 991 IC-DISC (interest charge domestic international sales corporation). The setup and use of an IC-DISC is extremely easy and low-maintenance. It should be noted that albeit a true "oldie but goodie," an IC-DISC can only provide prospective tax benefits (i.e., 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.

For example, an S corporation that forms an IC-DISC will pay it a fully deductible commission for its export services. The IC-DISC (1) is not taxed on the commission income; and (2) pays a dividend to the S corporation equal to the commission received in the same year (or early the year thereafter). Provided the IC-DISC is properly formed and complies with certain statutory requirements, the tax advantages are simply a function of the current tax rate disparity between ordinary income and qualified dividends — that is, ordinary tax rate operating income of the S corporation is converted (in an amount equal to the commission) to the lower tax rate qualified dividend income coupled with an ordinary tax rate deduction for the S corporation on commissions paid.

The following 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.

The takeaway

In these challenging economic times, it is extremely worthwhile to review many of the classic tax-saving opportunities that have provided a significant reduction of taxes during a wide range of economic conditions. While the recently enacted CARES Act contains several significant tax-saving opportunities, a great deal of needed cash can be generated by applying the tried-and-true tax provisions that have been used by tax planners for many years. The possibilities are not limited to just the ones noted in this article. Therefore, it is essential to review all the circumstances of each business to determine "oldies but goodies" that are relevant in each set of circumstances. 

Lewis Taub, CPA, and Timothy Larson, CPA, are tax directors and Joshua James, CPA , is a tax senior, all in the New York City office of Berkowitz Pollack Brant, Advisors + CPAs. To comment on this article or to suggest an idea for another article, contact Sally Schreiber, senior editor, at Sally.Schreiber@aicpa-cima.com.

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