The administration, Congress and the media have, like a child at Christmas, gone through the whirlwind of unwrapping all the proposals in the President’s budget. Now, a reality check for which of these tax proposals will actually become law.

Proposals That Will Go Forward

Jobs/Hiring Credit

High marks to the President for perseverance. He campaigned on a hiring credit, and Congress first rejected the proposal in the stimulus bill last year. Now Congress is revisiting his idea. However, the likelihood is that you will see Congress significantly change the concept of the President’s proposed hiring credit, to the benefit of the unemployed and business owners. Look for a credit more along the lines of that outlined by Senators Schumer and Hatch that will provide immediate payroll tax relief for hiring new workers (who have been unemployed for more than 60 days). House Democrats in the Ways and Means Committee did not give the President’s proposal for a jobs credit a warm reception the other day, so the administration has some work to do. Congress needs to ensure that the hiring credit is simple and provides immediate relief (cash-in-hand to business owners) if it is going to have a real impact.

Section 179, Bonus Depreciation, COBRA, and Unemployment Benefits

Expect a continuation of these expanded policies. All will be included in a jobs bill. It would be helpful to small business if Congress increased the phase-out point for Section 179. The current $800K is too low for many small businesses. Still to be seen is whether Senator Grassley will successfully push for inclusion of his proposals for small business tax relief included in S. 1381, easily the most comprehensive tax relief for small business that is before the Senate.

Extenders/AMT

Along with continuation of the current “hold-harmless” provision on the individual alternative minimum tax (AMT), there will be a strong effort to include business and individual tax extenders in the jobs bill, with an expanded R&D tax credit as the main engine driving the effort. A key provision of the bill would allow small-medium size businesses to take the general business credits, such as the R&D tax credit, without being limited by the AMT. This assumes that the House/Senate haven’t reached a compromise yet on the separate extenders package. The main fight was on the offsets, with the House now agreeing to drop carried interest – more on that to follow.

Estate/Death Tax

Expect the Senate to add to the jobs bill a $5 million exemption ($10 million/couple) with rates somewhere in the 35%-40% range. Then the fight will be with the House to accept the Senate provision. Treasury Secretary Geithner’s comments about wanting to see the estate tax retroactive to January 1st is a helpful push for an early resolution of estate tax (if the estate tax isn’t resolved by Spring, look for problems in making the estate/death tax retroactive to January 1). There are three possible scenarios:

1.   Likely: Two-year extension of 2009 law
2.   Possible: The Senate position prevails
3.   Hard to imagine, but why not — they’ve screwed it up enough already: Congress does nothing for the year on estate/death tax

Top Rates/Capital Gains/Dividends/PEPS/Pease

Despite a trial balloon from the administration that the slated increase in top rates would be delayed for one/two years, the administration has stated clearly that it wants the rates for the top two levels to be increased from 33/35% to 36/39.6% and capital gains and dividends to go to 20%. While a month ago the chances of the top rates and capital gains/dividends going up was certain, I view that as down slightly thanks to the Massachusetts election and several Democrat members of Congress writing to the President their support for keeping the current rates in place. In addition to the rates going up, the hidden tax increases caused by limitations on personal exemptions (PEPS) and itemized deductions (Pease) will also be brought back. This is a huge tax increase that gets very little notice, hitting higher income families to the tune of more than $200 billion over ten years. Note: the significant tax benefits of the IC-DISC for small and medium business manufacturers who export will stay in place under the administration’s proposal, despite the dividend rate going up.

Expanded 1099 Reporting – for Payments to Corporations for Property or Services

Both the House and Senate included this tax gap proposal in the Health bill. Look for it to show up sometime as a “payfor” this year.

Independent Contractor v. Employee Status

Lost in much of the discussion of the budget is the administration’s sweeping changes to current practice on independent contractor/employee status. The law will allow Treasury/IRS to issue guidance on who is or isn’t an independent contractor, something they have been barred from doing by law since 1978. Space doesn’t allow me to do this justice, but if independent contractor/employer questions are an area of interest for you and your business, this is a world-changing proposal. There haven’t been the votes in the Senate to get through other union-supported policies. This proposal will likely have a rough road as well, but it’s too early to see where the votes are.

Carried Interest

Congress and the administration’s policy as to changing taxation of carried interest seems to be like heaven: everybody wants to go there, just not today. Carried interest was included for the umpteenth time in a House bill (most recently as an extenders “payfor”) and was dropped in discussions with the Senate. When there is a public mark-up, carried interest is included. Then there is a closed door meeting, and the carried interest provision is dropped. Color me skeptical that changes to carried interest happen this year.

Fees on Banks

It remains to be seen what Congress does with this proposal. The administration proposal isn’t detailed and seems primarily a political exercise. It might be something for the jobs bill (doubtful – not ready), but if not that legislation, the number of tax bills that Congress will act on will be very few in number for the rest of the year. Congress, overall, doesn’t appear completely sold on this proposal at the moment.

Proposals That Will Never See the Light of Day
FLPs and GRATs

The administration’s proposals to limit estate planning of family limited partnerships and the use of GRATs has zero interest on the hill.

Cap of 28% on Itemized Deductions – Charities and Mortgage

This didn’t go anywhere as a revenue raiser for health care, so it’s hard to see it going anywhere this year.

The Impact of the Massachusetts Senate Election

The Massachusetts Senate election had a big impact on D.C., especially in the area of tax policy. It’s not only the fact that Brown’s victory greatly strengthens the ability of Senate Republicans to prevent legislation from going forward (but watch out for reconciliation), but the loss of a Senate seat in a state with a strong Democrat voting tradition, coupled with the wide margin of Brown’s victory, has done much to provide focus to many Senators on both sides of the aisle to be more hard-eyed about possible tax increases – and views towards the administration’s tax proposals.

Bottom Line

The outlook for business owners is that no one in Washington is going to be cutting your taxes for you. Businesses will continue to have to work with their trusted financial advisors to take full advantage of federal and state tax incentives if they want to see their taxes cut.
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By Dean Zerbe, alliantgroup, LP

Example. Jane Smith operates a 10-employee business, and she currently covers her employees with health insurance at a cost to her business of $60,000.
Before the new law, Ms. Smith deducted the cost of the insurance and received a tax benefit of $24,000 in her 40 percent tax bracket ($60,000 times 40 percent).

This year, because of the new law, Ms. Smith makes not a single change in her business operations, but because of the new law, she receives a tax credit equal to 35 percent of the $60,000 she paid for health insurance and then she deducts the remainder, for a current-year tax benefit of $36,600. She’s smiling. This new law gives her a tax gift of $12,600.

Ms. Smith receives this gift each year for six taxable years (four years under phase 1 and two years under phase 2). In six years, Ms. Smith will have more than $75,600 in extra cash (note—this calculation includes the incremental increase in the tax credit from 35 to 50 percent in 2014 and 2015).

What will the small-business provisions of the new health care law give you?

The Rules You Want to Know

You qualify for the full 35 percent current-year tax credit on the dollar amount you pay for your employees’ health insurance when you

1. employ 10 or fewer full-time equivalent employees (phaseouts start with 11 equivalent employees),
2. pay each of those full-time equivalent employees an annual full-time equivalent wage of less than $25,000 (phaseouts start at $26,000),2 and
3. pay premiums of no less than 50 percent of the average employee-only small-group coverage premiums, as determined by the U.S. Department of Health and Human Services (these will be posted by the IRS on its Web site by the end of April 2010).

You calculate your full-time equivalent employees by dividing the total hours worked by all employees during the employer’s tax year by 2,080.4 For any one worker, you may not count more than 2,080 hours.

Example. You have 17 employees total, including those who work part-time. This group works 18,000 hours during the year. You have eight full-time equivalent employees (18,000 hours divided by 2,080 equals 8.65, which is then, by law,6 rounded down to the nearest whole number, which makes eight employees your number).

Your payroll is $192,000 for the year. Divide that by eight and you get an annual full-time
equivalent wage of $24,000.

The next test: Did you pay at least 50 percent of the health insurance premium for single
(employee-only) coverage? You can pay more, and you can even pay for family coverage, but you may not pay less than 50 percent of the employee-only coverage.

Phaseout of Credits

The new law contains two provisions that injure or kill your credit:

1. If you have more than 10 full-time equivalent employees, you reduce your credit by 1/15th for each excess employee. (Here, the law kills your credit in total when you have 25 or more full-time equivalent employees.)
2. If the average full-time equivalent wage exceeds $25,000, you reduce your credit by 1/25th for each $1,000 in excess of $25,000. (Here, the law kills your credit in total when you pay an average full-time equivalent wage of $50,000.)

The combination of the two provisions can kill your credit before you reach either the 25-employee limit or the $50,000 wage limit.

Phaseout Example

Example. For 2010, you have 12 full-time equivalent employees with average annual wages of $30,000. You pay $96,000 in health care premiums that cover at least 50 percent of the employee-only cost, as determined by the average premium for the small-group market in your state.
Your credit is calculated as follows:

Description Calculation Amount

Summary

To find your big smile in this new health care law, consider the following two phaseouts.

Do you have 10 or fewer full-time equivalent employees? (If “yes,” smile.)
Is the annual full-time equivalent wage less than $25,000? (If “yes,” another smile!)

Planning might assist you in this regard. Perhaps you could hire a lower-paid employee or two to help the wage averages.

If you already provide health insurance for your employees, you have to simply thank lawmakers for their generosity, because you are now receiving an extra award for what you already do.

Finally, getting the tax credit for six years is a great bonus for those with plans in place already and certainly an incentive for those small businesses thinking about putting a health insurance plan in place.

You have to like the small-business health care tax credit and the absence of a penalty for small businesses that do not participate.

The IRS has released a draft of Schedule UTP, Uncertain Tax Positions Statement, with accompanying draft instructions, that it proposes to be used by certain taxpayers required to report uncertain tax positions. FIN 48 requires that taxpayers with uncertain tax positions account for and report those positions that affect their income tax liability. The draft Schedule UTP and instructions provide that certain taxpayers will be required to file Schedule UTP beginning with the 2010 tax year.  The requirement only applies to taxpayers required to file Forms 1120, 1120 L, 1120 PC and 1120 F, if they have uncertain tax positions and assets equal to or in excess of $10 million and if they or a related party issued audited financial statements. The draft instructions provide that a taxpayer filing a Schedule UTP will be treated as filing a Form 8275 and Form 8275-R due to the fact that those two forms duplicate information reported on Schedule UTP.

The Internal Revenue Service announced it is developing a schedule requiring certain taxpayers to report uncertain tax positions on their tax returns. The Service is now releasing the draft schedule, Schedule UTP, accompanied by draft instructions that provide a further explanation of the Service’s proposal. The Service invites public comment on the draft schedule and instructions. The schedule and instructions will be finalized after the Service has received and considered all of the comments regarding the overall proposal and the draft schedule and instructions.

The draft schedule and instructions provide that, beginning with the 2010 tax year, the following taxpayers with both uncertain tax positions and assets equal to or exceeding $10 million will be required to file Schedule UTP if they or a related party issued audited financial statements:

• Corporations who are required to file a Form 1120, U.S. Corporation Income Tax Return;
• Insurance companies who are required to file a Form 1120 L, U.S. Life Insurance Company Income Tax Return or Form 1120 PC, U.S. Property and Casualty Insurance Company Income Tax Return; and
• Foreign corporations who are required to file Form 1120 F, U.S. Income Tax Return of a Foreign Corporation.

The draft schedule and instructions also provide that, for 2010 tax years, the Service will not require a Schedule UTP from Form 1120 series filers other than those identified above (such as real estate investment trusts or regulated investment companies), pass-through entities, or tax-exempt organizations. The Service will determine the timing of the requirement to file Schedule UTP for these entities after comments have been received and considered.
The Service is reviewing the extent to which the proposed Schedule UTP duplicates other reporting requirements, such as Form 8275, Disclosure Statement; Form 8275-R, Regulation Disclosure Statement; Form 8886, Reportable Transaction Disclosure Statement; and the Schedule M-3, Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More. The draft instructions provide that a taxpayer will be treated as having filed a Form 8275 or Form 8275-R for tax positions that are properly reported on Schedule UTP. The Service is considering other circumstances under which a tax position reported on Schedule UTP need not be separately reported elsewhere on the tax return or another disclosure statement.

Schedule UTP asks for information about tax positions that affect the United States federal income tax liabilities of certain corporations that issue or are included in an audited financial statement and have assets equal to or exceeding $10 million.

Tax positions to be reported

Schedule UTP requires the reporting of a corporation’s federal income tax positions for which the corporation or a related party has recorded a reserve in an audited financial statement. Schedule UTP also requires the reporting of tax positions taken by the corporation in a tax return for which a reserve has not been recorded by the corporation or a related party based on an expectation to litigate or an IRS administrative practice.
A tax position is required to be reported on a Schedule UTP attached to a particular tax year’s return if:

1. at least 60 days before filing the tax return a reserve has been recorded with respect to that tax position, or at least 60 days before filing the tax return a decision was made not to record a reserve based on an expectation to litigate or an IRS administrative practice, and
2. the tax position has been taken by the corporation in a tax return for the current tax year or a prior tax year. 

A tax position must be reported regardless of whether the audited financial statement is prepared based on United States generally accepted accounting principles (GAAP), International Financial Reporting Standards (IFRS), or other country-specific accounting standards, including a modified version of any of the above (for example, modified GAAP) that requires a taxpayer to record a reserve for federal income tax positions.

A tax position is based on the unit of account in the audited financial statements in which the reserve is recorded. A tax position taken in a tax return means a tax position that would result in an adjustment to a line item on that tax return if the position is not sustained. A line item on a tax return may be affected by multiple units of account, in which case each unit of account must be reported separately on Schedule UTP.

Unearthing not-so-obvious risks and liabilities is multilayered: Lenders should perform industry risk analyses, interview management, request additional documentation and pay attention to business community word-of-mouth. The following questions are meant to help you uncover some of the potential risks and liabilities that can compromise debt service.

1. Is there an overreliance on certain customers? Companies that rely on any one customer for more than 10% of their annual sales (or one supplier for more than 10% of their materials) risk sudden interruption of operations if the customer (or supplier) cuts its ties. Well-written, long-term contracts are one strategy to combat concentration risks.

2. Is there an overdependency on key people? Lenders should evaluate the age and health of key people and the cost to replace them. Volatile employee or shareholder relations may increase the risk of losing a key person. Signed noncompete agreements and key-person life insurance policies may minimize the stress caused by a key employee’s sudden departure.

3. Are there tax problems? When compounded with interest and penalty charges, tax liabilities can quickly take a toll on a business. Lenders should stay abreast of any customers being audited for income, sales and payroll tax deficiencies.

4. Are there any ongoing lawsuits? Pending litigation is expensive, and it can distract management’s attention from the company’s day-to-day operations. Bitter shareholder disputes may even result in court-mandated liquidations.

5. Is there a high risk of fraud? A strong internal control system is the best defense against fraud risks. While most companies worry about employees stealing assets, lenders should also watch out for managers using fraud schemes to misrepresent the financial health of the company.

6. Are there foreign transactions? In addition to obvious geopolitical risks, foreign activity is susceptible to repatriation and foreign-tax issues, exchange-rate risks, or the possibility that a foreign government might expropriate (or repossess) the company’s foreign property.

7. Are there environmental risks? Environmental regulations may require a business to clean up its own property, even if a previous owner caused the contamination. Routine environmental assessments can help manufacturers and processors keep environmental clean-up costs to a minimum.

Value is in the eye of the beholder. As a lender you often have a stake in private company mergers and acquisitions. So it’s important that you know whether the target’s price is reasonable and that the buyer is emotionally detached. After all, a buyer that overpays is more likely to experience financial problems after the deal closes.

Procuring a professional appraisal upfront can mean the difference between a long-term lending relationship and default. Expert opinions also can assuage any concerns you may have, such as whether income projections are reasonable or comparables are truly similar to your borrower. And knowing business valuation terminology, methodology and potential pitfalls will help you make informed lending decisions.

Standard of value

The term “value” can have many different meanings. Strategic (or investment) value refers to the perceived value to a specific investor. A business seeking to increase market share, for example, might pay a premium to acquire a competitor. Strategic value depends on an investor’s individual situation, requirements and expectations.

An important benchmark in negotiating deals is fair market value. Essentially, this is the price the “universe” of potential buyers and sellers would agree on for a business interest. Fair market value assumes no compulsion to buy or sell and reasonable knowledge of all relevant facts. Beware of deals where strategic value is significantly higher than fair market value. Many buyers overestimate the value of synergies.

Another common standard of value is fair value. In an accounting context, it’s similar to fair market value, except that it’s an exit (rather than an entry) price. Moreover, fair value only considers market participants active in the principal (or most advantageous) market.

Accountants use this term when, for financial reporting purposes, they value assets and liabilities such as intangible assets (customer lists, non-competition agreements, etc), goodwill and contingent payment obligations. Some borrowers may have reported goodwill impairment during the recession, for example. This occurs when the fair value of acquired goodwill is lower than the amount shown on the borrower’s balance sheet. These write-offs may foreshadow financial problems.

Methodology

Appraisers apply three approaches to valuing a business:

Cost (or asset-based) approach. The value of a business is the difference between its assets and liabilities. For example, an appraiser might revalue the amounts shown on a company’s balance sheet. This approach is difficult to use on companies with significant intangible value. It’s typically reserved for holding companies and others that rely exclusively on hard assets.

Market approach. This approach generates pricing multiples from sales of comparable (or guideline) companies. Here, value is a function of the ratio of (multiple) selling price and a financial metric, such as annual revenues or last year’s earnings before interest, taxes, depreciation and amortization (EBITDA).

Pricing data can be obtained from daily stock market quotes and, private, proprietary databases.
Selection criteria for comparables might include transaction date, financial performance, industry and size, for example. Finding a meaningful sample of comparables for some companies — especially niche specialists — can be difficult.

Income approach. Appraisers project cash flows and then discount them back to their net present value. Discount (or capitalization) rates are based on the company’s risk profile. High-risk businesses are assigned a higher discount rate, which equates to a lower value (and vice versa).

The income approach may be difficult for laypeople to understand. Sophisticated buyers and sellers are more likely to use this approach. It’s often the preferred method for startups and companies with significant intangible value.

Pitfalls

Methods and definitions explain some of the “science” underlying business valuations. But accurate appraisals also require finesse and qualitative assessment. Experienced appraisers understand subtle valuation nuances and potential pitfalls.

For example, some sellers try to save money by reusing an appraisal prepared for, say, a previous gift tax return or shareholder buyout. Not only can these valuations be out of date, they may include inapplicable valuation discounts or use an inappropriate standard of value.

Valuations are only valid as of a specific date and for a specific purpose. Therefore, borrowers always should check with their appraisers before recycling an old report in a new context. Do-it-yourself valuations present another minefield of potential problems. The IRS and U.S. Small Business Administration recognize the importance of appraisal training and have established “qualified appraiser” criteria.

Before you finance a deal, ask whether the parties have consulted with valuation professionals. Ask for a copy of the written appraisal report, including the financial exhibits and appraiser’s curriculum vitae. Reliable appraisers have years of valuation experience and have credentials from professional appraisal organizations.

Educated decisions

Filtering through the data and arriving at an accurate value requires mastery of both the art and science of business appraisal. Lenders who understand valuation basics and expect borrowers to obtain outside valuation expertise will have a higher likelihood of making wise lending decisions.

Sidebar: Rule out “rules of thumb”

You’ve likely heard at least one valuation formula, such as one times revenues (for professional practices) or five times earnings (for manufacturers). But borrowers and lenders who bank on these “rules of thumb” may be in for a rude awakening after closing.

Oversimplified formulas overlook unique operating characteristics, such as nonoperating assets, exclusivity contracts or in-process research and development, which differentiate the subject company from its competition. Rules of thumb also may be outdated. For example, a valuation formula popularized during industry consolidation in the mid-1990s may not be relevant in today’s turbulent economy.

Another reason to shun rules of thumb is their ambiguity. To illustrate, does “earnings” refer to net income, pretax earnings, earnings before interest and taxes (EBIT), or some other metric?

Due to their size and scope, these cases were broadly reported and are relatively well known.  The fact is, however, that financial fraud is not limited by size, geography or industry.  Fraud takes many different forms and often goes undetected for long periods of time.  Fraud schemes can be as simple as removing cash from a cash box or submitting false receipts for expense reimbursements to as complicated as a sophisticated Ponzi scheme.

The Association of Certified Fraud Examiners (ACFE) classifies fraud into three broad categories: corruption (including extortion, bribes and conflicts of interest), asset misappropriation (including theft, skimming, payroll fraud and check tampering) and fraudulent financial statements (intended to make a company appear healthier than it is).

Corruption includes situations where an individual uses his or her position in an organization to inappropriately or illegally gain economic self-benefit.  In the Fry’s Electronics case, the vice president of merchandising and operations allegedly charged vendors commissions of as much as 31% in exchange for agreeing to buy merchandise at inflated prices.  He then allegedly funneled the commission money to a “straw” company he created to fund personal gambling debts.

Asset misappropriation represents situations where a person steals or misuses a company’s resources and is, by far, the most common type of financial fraud.  A recent study by the ACFE found that asset misappropriation was involved in approximately 90% of fraud cases.  While some cases may result in very large amounts of damages, often the amounts involved can be relatively small.  Although a “small” fraud can amass to large losses over time if not discovered in time.  In April 2009, a former Lubbock, Texas Independent School District Program Coordinator was sentenced for misappropriating federal “No Child Left Behind” funds, admitting that she stole approximately $13,000 by creating false receipts and invoices. 

Committing fraud through the creation of fraudulent financial statements is often a complex scheme and one in which the ability to cover one’s tracks becomes more and more difficult over time.  In the Satyam case, the CEO stated in his resignation letter that the “gap between actual operating profit and the one reflected in the books of accounts continued to grow over the years”.  While in his letter he suggests that the fraud was not undertaken for personal enrichment, often other reasons to commit such fraud are present, including the need to demonstrate meeting outside expectations for sales and profits.

In the current economic environment many companies have cut pay, laid off personnel and devoted fewer resources across the organization, including to those areas related to internal controls.  While the risk of fraud is always present, those changes can create an environment that is more susceptible to fraud.  With that in mind, what steps can an organization take to lessen the risk of fraud?  Here are some suggestions:

• Hotline.  The ACFE study found that tips were the most common detection method of fraud.  Of the tips provided, more than half of those came from employees of the organization in which the fraud occurred.  While public companies are mandated by the Sarbanes-Oxley Act of 2002 to establish anonymous reporting methods, no such requirement exists for private companies.  Providing an avenue for the anonymous reporting of fraud through a third-party, with no fear of retaliation, is an effective control in the detection of fraud.  In addition, hotlines available to those outside the company can lead to discovery of corruption.

• Segregation of duties/mandatory vacation.  In small organizations, resources dedicated to internal control are often limited.  For example, a single employee might be responsible for issuing purchase orders, processing accounts payable, issuing checks and preparing bank reconciliations.  It would be relatively easy for a person in this position to commit fraud without knowledge of top management.  Taking steps such as implementing a management review process, requiring mandatory time off or splitting up duties with other personnel will help address this fraud potential.

• Surprise audits/reviews.  Don’t fall into a routine.  Individuals understanding that an audit or a review can occur at any time, with no advance warning, is an effective deterrent.  Review supplier lists.  Audit cash disbursements.  Audit headcount and payroll.  Periodically perform a few simple reviews and audits and the risk of fraud decreases.

• Management review of internal controls.  Take the time to perform a review of internal controls.  Identify areas of weakness and take steps to address these gaps.

• Employee training.  Take efforts to train employees about workplace fraud, the damage that it can have on the health of the organization and the impact it could have on their own jobs.  Make sure they understand what it is and what to do if they discover or suspect fraud has occurred.

• Background checks.  As part of the employment process, consider using credit checks in addition to reference and background checks.  While the vast majority of employees are honest and hardworking, those with serious personal financial issues might be more susceptible to committing fraud.

• Tone from the top.  It all starts at the top.  Employees will respond to the behavior and guidance of top management.  If management ignores controls, it’s more likely that employees won’t take controls seriously.  Lead by example and the control environment will be much more effective.

No single magic bullet exists for preventing fraud.  One can put in every fraud prevention technique imaginable and there is no guarantee that fraud won’t occur.  However, with a commitment by top management to fraud prevention and ethical behavior, a robust and well designed internal control environment, and a commitment by employees to fraud prevention, the risk of fraud in such an organization is greatly reduced.

Please call us if you wish to further discuss your fraud prevention program.

Starting in January 2010 the income ceiling for Roth conversions is eliminated.  This presents an interesting dilemma for individuals who can afford the conversion: convert now and accelerate taxable income, which breaks a general cardinal rule of paying tax before it is due.  On the other hand, a Roth IRA, unlike a traditional IRA, would enable both tax-free withdrawals and the avoidance of the required minimum distribution (RMD) rules– allowing more wealth to accumulate tax-free for a longer period of time.  The Roth conversion analysis is a decision that involves paying taxes now vs. the opportunity to grow wealth tax-free for a longer period of time.

Although conversion to a Roth IRA does trigger immediate taxable income, Congress provided a special incentive in 2010 to jump-start Roth conversions. In 2010 (and 2010 only), individuals will have the choice of recognizing their conversion income in 2010 or averaging it over 2011 and 2012. The latter option, which must be elected, allows you to pay taxes on the converted amount ratably over two years, instead of recognizing it all as income in one year. You will be taxed at the rates in effect for 2011 and 2012.

For some taxpayers, their tax rate may rise after 2010 even if their income does not. President Obama has proposed, and Congress is expected to enact, legislation to restore the top two pre-2001 marginal income tax rates after 2010. This means that the top two brackets could be 39.6 percent and 36 percent after 2010. There is the option to pay the full tax on the Roth conversion on your 2010 income tax return, at 2010 income tax rates.

An IRA to Roth IRA conversion should be considered by individuals who:

• Can afford the tax on the converted amounts;
• Anticipate being in the same or higher tax bracket in the future than they are currently in;
• Have a significant amount of time before reaching retirement to allow assets to grow tax-free and recoup dollars that may have been lost due to the conversion tax;
• Anticipate a taxable estate; and
• Wish to grow assets tax-free and leave assets to children who could take tax-free distributions over their life expectancy.

Convert Nondeductible IRAs?
Individuals who have nondeductible IRAs (or a mix of nondeductible and deductible) can convert and pay little or no tax.  Nondeductible IRAs are not taxable when converted to Roth IRAs if the account holder has no appreciation in the IRAs and doesn’t own deductible IRAs.  For example, a married couple, ineligible to contribute directly to a Roth IRA and with no existing IRAs can contribute $5,000 each to a nondeductible IRA for 2009 and 2010.  Then, the next day they can convert the nondeductible IRA to a Roth IRA.  The result is a transfer of $20,000 in taxable assets to a Roth IRA which will never again be subject to income tax if certain holding requirements are met.  Individuals with a mix of deductible and nondeductible IRAs must prorate the conversion, so regardless of which specific account or amount they convert, part will be treated as taxable and part as nontaxable.  For example, an individual has $100,000 in a deductible IRA and $50,000 in a nondeductible IRA.  If that individual were to convert $30,000 to a Roth IRA, he would recognize $20,000 of taxable income on the conversion (100,000/150,000 * 30,000).

Roth Redo: A Money-Back Guarantee?
If you’re not satisfied with your conversion, you may want to take a mulligan.  With Roth conversions, you can.  For example, say Jack, a 60 year old individual with a combined 45% effective tax rate converts $1 million from a traditional IRA to a Roth IRA on January 15th, 2010, resulting in a $450,000 tax liability.  He proceeds to watch the value of his Roth IRA decline by 25% to $750,000 over the next 21 months, as a result of poor investment performance.  At that point (up to October 15 of the following year) he can “recharacterize” the IRA as a traditional IRA and, if he wishes, try the conversion again the following year, at presumably a lower tax cost.

The year 2008 aside, it’s unusual to experience a 25% decline in a well-diversified, balanced portfolio.  However, any one asset class could have an off year or two, which leads into the next Roth conversion strategy.  Consider breaking out your new Roth IRA into 3-5 separate accounts consisting of uncorrelated asset classes.  You can then cherry pick the losing account to achieve a lower tax cost via recharacterization, while leaving the winners to keep growing and eventually pay out tax-free profits.  For example, assume Jack placed one-third of his Roth assets in taxable bonds, one-third in international stocks, and one-third in U.S. growth stocks.  In the 21 month period ending October 2011, his taxable bond Roth account returned 5%, international stocks declined 30%, and U.S. growth stock returned 10%.  Jack could recharacterize the Roth IRA invested in international stocks which lost $100,000 in value, thereby reducing his Roth IRA conversion tax liability.

There are a significant number of tax and financial considerations that come into play when determining whether to convert your traditional IRA to a Roth IRA.  Please consult with your tax and financial professional about this new 2010 planning opportunity.

1. The maximum contribution that can be made to a defined contribution plan in 2010 under Section 415 is the lesser of $49,000 or 100 percent of compensation—the same limit as in 2009.
2. The limit on employee elective deferrals to Section 401K and Section 403b plans has remained at $16,500 in 2010.  The limit for Section 457 plan salary reductions has likewise kept steady at $16,500.
3. The maximum elective deferral for a SIMPLE or 401 K SIMPLE plan is $11,500 in 2010.
4. The limit on IRA contributions remains at $5,000 for 2010.  Those 50 and older can still contribute an extra $1,000 under the special catch-up provision.

Here are a few of the income tax changes:

1. The standard deduction for joint filers and surviving spouses who do not itemize in 2010 is $11,400, the same as 2009.  For heads of household, the deduction is $8,400, and for unmarried individuals it’s $5,700.  The aged and the blind get an additional $1,100 or $1,400 added to their standard deductions, depending on their filing status.
2. The personal exemption has remained steady at $3,650 for 2010.  The exemption started to be phased out at $250,200 of adjusted gross income for married filers, $208,500 for heads of household, $166,800 for unmarried individuals and $125,100 for married individuals filing separate returns in 2009.  The phase-out has been eliminated in 2010
3. The phase-out of itemized deductions began at $83,400 of adjusted gross for married individuals filing separate returns, and $166,800 for all other taxpayers.  The phase-out has been eliminated in 2010.

And here are some other items that may be important to you.

1. The social security tax rate for individuals stays at 7.65% in 2010.  The rate for self-employed individuals also remains constant at 15.3%.  The taxable wage base for the OASDI portion is $106,800 in 2010—and that gets hit with the full 7.65% tax for individuals.  Any additional compensation over that limit is subject to only the Medicare portion of 1.45%.
2. In 2010, the federal annual gift tax exclusion amount has remained at $13,000.  The lifetime gift tax exemption has stayed at $1 million.
3. The federal estate tax exemption was $3.5 million in 2009, and as of right now is scheduled to be unlimited in 2010.  Watch for probable action on federal estate taxes by the Congress and President.  Most experts expect the federal estate tax exemption for 2010 to be reinstated at $3.5 million.

These changes may affect your own retirement or tax plans.

As always, please feel free to call to discuss these or other financial security issues of concern.

Pension plans create income tax deductions for the business, and allow employees to exclude contributions from their taxable income.  However, the employer must include all eligible employees in the plan, and retirement benefits are generally taxable to the participants.

Certain nonqualified benefit arrangements can generally be more selective in terms of participation, but the income tax results are generally not as favorable—especially for the business owners.

Disability income insurance coverage provided by the business can also be selective, and the premium can be deductible.  However, the owner-employee with disability income coverage must generally choose between excluding the premium from income or getting a tax-free benefit in the event of a claim.

Could the best employee benefit be a long-term care insurance (LTCi) plan?

C corporation employers have the greatest number of potential advantages for implementing LTCi plans for their employees.

1. The premium is deductible by the corporation.
2. There is no practical limit to the amount of premium that can be paid by the employer for an employee’s policy.
3. The company can pick the employees to be covered by the plan.
4. The premium paid by the corporation is not included in the employee’s taxable income.
5. The benefits paid to the insured are tax free.
6. Spouse and dependent family members of participating employees may also be included under the plan.

Most of the advantages described are also available to the owners and employees of S corporations, LLCs, partnerships or proprietorships.

For entrepreneurs who have employees nearing retirement, or whose key employees have aging parents, long-term care insurance may be perceived to have high value.  LTCi helps pay for costs associated with chronic illness that, in most cases, Medicare or Medicaid won’t.

The federal government has strongly encouraged business owners to provide LTCi plans to employees, even in some cases if those covered are only the group of owner-employees.  LTCi plans are worth considering by closely-held business owners.

As always, please feel free to call to discuss these or other financial security issues of concern.

Others with IRA balances may be interested in making a tax-free transfer to a new IRA custodian, or in splitting the current IRA account for various reasons.

Tax-free transfers may be made by trustee-to-trustee transfer, direct rollover or 60-day rollover.

We have found that in thinking about transfers, clients want to know:

• Does the account they’re starting with qualify for a tax-free transfer to another qualified account?
• Is the vehicle into which they intend to transfer a qualified plan balance one that can accept a tax-free transfer?
• What administrative procedures need to be followed to accomplish the transfer?
• What special considerations need to be evaluated to help determine whether the proposed transfer makes economic and tax sense?

Rollover distributions from the following plans are eligible for tax-free transfers:

• IRAs
• Qualified pension plans
• Tax-sheltered annuities (403(b) plans)
• Governmental 457(b) plans
• A 403(a) annuity

Rollover distributions can generally be transferred to a traditional IRA or pension plan on a tax-free basis if the pension plan will accept them.

Distributions that might otherwise qualify for a tax-free rollover might be defeated by one or more of the following complications:

• The 20% mandatory withholding on distributions from pension plans may make it difficult for the participant to accomplish a complete rollover of a taxable distribution.
• The prerequisite within a pension plan of a triggering event prior to the distribution of a pension balance may mean that a distribution is not allowed at all.
• The fact that the source of funds intended for rollover is from a beneficiary account rather than the participant’s own IRA may mean rollover is not allowed.
• Multiple IRA rollovers in the same 12-month period may be disallowed by IRS rules.

When done properly, rollovers offer the opportunity to continue tax-deferred growth on  retirement assets.  If done improperly, an attempted rollover may result in a large unexpected income tax result, and cause you to be liable for an extra 10% penalty tax, plus any state penalties.

As always, please feel free to call to discuss these or other financial security issues of concern.