10 Tips to Trim 2003?s Tax Bill: Oil and Gas Drilling Investments Can Offer Enormous One-time Deduction

The hay’s probably already in the barn in terms of 2003 tax planning for most small- to mid-sized businesses. But several area accountants said there’s still enough time before Dec. 31 for some flexibility in how a company’s final tab stacks up.r

The Northwest Arkansas Business Journal asked John Ervin, owner of Ervin & Co. CPAs P.A. in Fayetteville, to give its readers 10 strong strategies for mitigating their tax liabilities this year, which he graciously supplied. His strongest advice, however, is to start planning now for 2004 and beyond. r

“Effective tax planning takes time and is often a result of a specific set of facts and circumstances,” Ervin said. “This means that the Top 10 strategies we’ve given will not be suitable for everyone. When they do fit, however, the results will go into the bank.”r

In addition to Ervin’s checklist (see p. 13), one of the most unique strategies we found is for the lucky lot who saw a huge income surge this year. The Internal Revenue Service approved up to a 90 percent one-time write-off for investing in certain oil and gas drilling programs.r

Randy Philpot, managing partner of Beall Barclay & Co. PLC in Fort Smith and Rogers, said his firm’s wealth management division has explored this option for several of its customers. The program is expected to sunset soon and Philpot said there are serious liability exposure and investment structure considerations.r

But for a non-traditional, latent tax deferral mechanism it’s one that can provide serious savings.r

“You could put $100,000 into a drilling program and generate a $90,000 deduction before Dec. 31,” Philpot said. “For the guys who had a big one-time shot in income this year, it’s an opportunity to diversify out and really see a deduction.”r

The most complex strategy from Ervin involves all the possibilities that arise when taking advantage of the IRS Code Section 179 expensing changes. Bill Magee, a partner with BKD LLP in Little Rock, reminds taxpayers that when it comes to both Section 179 and the 50 percent bonus depreciation rule for new assets it’s time to hustle. Both benefits are scheduled to expire after 2004.r

Ervin and Philpot agreed that if the Democrats regain control of the White House, United States Senate or House of Representatives during next year’s elections, there’s a chance that this year’s discounted capital gains and dividends rate of 15 percent will be repealed. Both, the CPAs said, would likely return to their prior levels at 20 percent and up.r

“The bonus depreciation rules are great … but both that and the Section 179 rules have short lives,” Philpot said. “The best thing you can do is get new assets bought and placed into service by Dec. 31.”r

David Stell, a regional IRS spokesman, said deductions for a home office come with many provisions. In general, the deducttion depends on the percentage of the home that’s used for business. r

Stell said total income tax reported to the IRS for 2000 off 1040 returns was $976.3 billion. Data on subsequent years isn’t available yet, and Stell said there’s no way to accurately predict this year’s tally.r

Ervin’s suggestions, he said, are designed to help taxpayers lawfully keep their own contribution to a minimum in the spirit of the late entertainer Arthur Godfrey who once said, “I’m proud to be paying taxes in the United States. The only thing is, I could be just as proud for half the money.” r

rSIDE BARr

r10 Tax Strategies To Put Money Into Your Pocketr

Note: John Ervin, a CPA and owner of Ervin & Co. CPAs P.A. in Fayetteville, graciously supplied the following strategies. All of them have been condensed, and all are best explained and implemented by a CPA:r

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1. Cost Segregation – A cost segregation study to determine whether real property qualifies as Section 1245 personal property (qualifying for the shorter write-off periods) or section 1250 real property (longer write-off periods) can mean significant savings.r

Example: A nursing home that cost $2.2 million was placed into service in 1995 using a 39-year “life” to depreciate the assets. Annual depreciation would be $56,410. But a cost segregation study showed a significant portion of the original $2.2 million cost can be identified as personal property, which qualifies for a shorter write-off period (27 years).r

The owner of the property is then entitled to a $600,000 catch-up deduction that’s fully deductible in 2003. At an estimated federal and state tax rate of 35 percent, this results in a savings of $210,000.r

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2. Bonus Depreciation – In 2003, Congress expanded the first-year bonus depreciation of qualified property from 30 percent to 50 percent of the basis. To qualify, the original use of the property must commence with the taxpayer after May 5, 2003. The provisions of the 2003 Tax Act expire Dec. 31, 2004.r

If a company qualified for the additional depreciation on a $50,000 truck, it could claim $30,000 instead of the regular $10,000 deduction. The depreciation amounts produce even greater tax reductions when coupled with Tip No. 3.r

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3. Code Section 179 – Small businesses can under this section of the code expense the cost of depreciable assets in the year they’re acquired. The 2003 Tax Act substantially increased the allowable amount from $25,000 to $100,000. Qualifying property must generally be tangible personal property whether new or used.r

Section 179 is a complicated and lengthy subject, but suffice it to say, it’s a remarkable tool for maximizing deductions in the current year.r

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4. Intangible Assets — Almost every business possesses intangible assets that benefit it in a substantial and tangible way. Those assets could be a copyright, a patent, a recognizable trade name, or a franchise. Frequently, the intangible assets are spun off into a separate company and royalties are paid for their use. r

Another intangible asset would be the personal guarantee of the owner. Since this can reduce the owner’s borrowing power, he or she might be due a fee for the guarantee. Identifying the intangibles and protecting them is essential. And their values should be recognized.r

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5. Entertainment Facilities – Internal Revenue Code denies trade or business expense deductions for items or facilities used in connection with entertainment — except for firms in the business of entertainment. Goods and services, including the use of the facility, can receive deductions if they are sold by the taxpayer in a bona fide transaction for fair market value.r

For instance, the IRS recently permitted a full deduction for business owners who incurred entertainment-facility expenses through a separate “S” corporation they also owned. The sole purpose of the “S” corp. was to develop and operate the entertainment facility. There are some limitations, but there are benefits when the dual ownership is properly structured.r

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6. Employing the Spouse – Wages paid to a spouse as an employee incur Social Security taxes and therefore may reduce the owner’s self employment tax. The reduction is offset by a higher FICA burden, but those payments may qualify the spouse for benefits they might not have otherwise been entitled to such as retirement and disability benefits through Social Security.r

There’s also salary deferrals and potential deductions for medical costs that can be powerful tools.r

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7. Shifting Income to a Child – Employing a child under age 14 offers minimal benefits because of the “kiddy tax,” but after the family member reaches 14 there are some savings available. The owners shift income from taxation at their higher rate by getting a deduction for the family member’s salary and thereby taxing it at the child’s lower rate.r

The parent also can provide the employee with fringe benefits such as group-term life insurance.r

With a standard deduction of $4,450 and a $3,000 IRA deduction, the child could earn as much as $7,750 and not pay any income taxes. If the parent’s income tax rate is 30 percent, shifting $7,750 to the child would produce an income tax savings of $2,325.r

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8. Signing Bonus – The IRS has ruled that payments that don’t require the performance of future services by an employee don’t represent remuneration for services performed and therefore are not wages for income-tax withholding. In short, this technique can reduce payroll costs and attract top-notch talent. r

The amounts are taxable, but the employer is relieved of withholding requirements. The catch is any bonus predicated on continued employment is subject to the withholding.r

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9. Capital Gains and Dividends – Prior to the 2003 Tax Act, dividends were taxed as ordinary income while capital gains generally were taxed at a maximum rate of 20 percent. But the rate on dividends was reduced to 15 percent retroactive to Jan. 1, 2003, and effective May 6, 2003, for capital gains. There are some qualified entity and holding period restrictions.r

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10. Deducting the Cost of Fishing Trips – The Eight Circuit Court of Appeals recently reversed a lower court by ruling that the cost of an employer-sponsored fishing trip can be a deductible travel and entertainment expense. But this doesn’t provide a blank check for businesses to deduct hunting and fishing trips.r

The key element is the employer has to show the trips were directly related to business. It has to demonstrate that it had “more than just a general expectation of a derived business benefit from the trip, its employees actively participated in business activities, and the principal aspect of the activity was the active conduct of business.” r