Navigating the IRS’s complex tax regime can be daunting: There are traps and pitfalls around every corner, and to avoid them, most privately-held businesses need a skilled tax advisor. However, where there is a tax risk, there is usually a corresponding opportunity. While there are too many tax-related risks to address here, this article will the focus on the top 10 most common risks and opportunities we see today.
Not keeping up with tax compliance can be devastating. With an arsenal of weapons to enforce compliance, the IRS is becoming increasingly impatient with businesses that aren’t keeping up with the myriad of tax rules and regulations, whether noncompliance is intentional or not. Today, nearly every business is engaged in cross-border transactions, and the IRS has very strict rules regarding the reporting and disclosure of international activities, such as maintaining foreign bank accounts and engaging in transactions with related entities. Failure to report or disclose transactions can lead to extremely punitive penalties and the disallowance of otherwise legitimate deductions.
2. Adequate Documentation
The IRS is increasingly focused on the economic substance of a transaction and frowns on transactions that are motivated by taxes. Many incentives, such as research and development credits, have strict documentation requirements. If the documentation is not there to support the economics of an activity or the credits or deductions claimed, the IRS will simply deny the claim or recast the transaction in such a way as to benefit the Treasury. If a taxpayer is diligent in documentation and record keeping, often the “burden of proof” to disprove the economics remains with the IRS. If the taxpayer is less diligent, the burden of proof can shift back to the taxpayer.
3. Choice of Entity
Choosing the right entity structure for a business is critical, and it’s required when first establishing a business, during the time resources are most limited. All entities – C corporations, S corporations, partnerships, limited liability companies, and sole-proprietorships – are used for various purposes in tax and legal planning, including, limiting liability exposure, protecting and moving assets, limiting double taxation (taxing the same dollar twice), and ensuring flexibility in ownership. It’s important to use the right entity in the right situation, and it can be costly to later unwind an inefficient structure.
4. Proper Elections
Along with choosing the proper entity, businesses must consider a myriad of elections to try to minimize tax risks and maximize opportunities. Elections to be considered include depreciation and other asset deduction methods, accounting methods around revenue recognition, consolidated tax return elections, year-end elections, and tax sharing elections. Some of these elections need to be made in the first year of business, and failure to make them can create significant tax exposures later on. Or, at best, correcting a failure to make an election or an improper election can be time consuming and expensive.
5. Ownership Changes
Ownership of businesses and assets frequently change, but these changes can create unintended tax exposures. Some of the more common tax exposures resulting from changes in ownership might include limiting net operating losses and other favorable tax attributes being carried forward, accelerating or triggering taxable income, terminating a partnership and favorable accounting methods, and exposure to transfer taxes, sales taxes, and property tax reassessments. With careful planning, many of these pitfalls can be limited or avoided altogether.
6. Sales Tax Exposure
In searching for ways to increase revenues – especially as the economy continues to move from one based on manufacturing to one based on e-commerce and services – state jurisdictions are expanding the reach of sales taxes. Many states now tax services, data processing, software as a service, and similar activities that traditionally fell outside of the sales tax base. Even for newer or smaller companies operating in losses, sales tax exposure can become significant quickly. In acquisition transactions, often the most significant tax exposure that comes up in due diligence relates to sales tax, and it’s increasingly common for sales tax exposures to scuttle a deal.
7. Asset or Activity Location
One of the first things tax advisors do to optimize a business’s tax profile is where the business’s economic drivers should reside, whether they’re intellectual property, personal goodwill, workforce, customer relationships, or other intangible assets. Often business owners don’t proactively locate such assets; instead they inadvertently put them in efficient structures. It would be very easy to unwittingly move assets into unintended entities or expatriate an asset. Businesses need to consider double taxation issues, related-party transactions and remuneration, the movement and protection of assets, planning for growth and cash flows, transferability of assets, and minimizing jurisdictional (domestic and foreign) taxes. All of a business’s significant economic drivers should be identified and supported by legal documentation.
8. Unnecessary Exposure in Multiple Jurisdictions
In today’s business environment, almost all businesses have transactions and activities that cross multiple domestic and foreign jurisdictions. Along with planning asset and activity locations (discussed above), the specific activities of the business and its personnel need to be closely monitored; otherwise a business inadvertently can create unnecessary exposure and sometimes even double taxation in multiple jurisdictions. Most state and foreign jurisdictions have tax laws that favor their jurisdiction, and they usually aren’t consistent with the other jurisdictions in which the business conducts activities. However, where there is disparity in
jurisdictions designed to favor a particular
jurisdiction, the same disparity can create an arbitrage tax rate benefit with proper planning.
9. Maximizing Incentives
There are many tax incentives available to privately-held businesses. Some are more common or readily known than others. Identification of all available incentives requires a skilled tax advisor, and it may require an advisor who has industry specialization. For example, many jurisdictions offer (or are open to negotiate) sales tax or property tax exemptions or rebates, enterprise zone incentives to encourage activities in a particular location, energy credits, grants, and subsidies. Not putting sufficient focus on exploring and identifying credits and incentives will result in lost cash.
10. Unprepared Due Diligence
Finally, it’s wise for a private business to anticipate scrutiny either from a taxing jurisdiction, such as the IRS, or a prospective buyer. Not being prepared to have books and records looked at can be devastating, and the effects can range from severe penalties and fines imposed by the IRS to failing the due diligence standards of a prospective buyer. Although not entirely necessary, many privately-held businesses maintain their books and policies in a manner consistent with those of publicly-held companies – that is, their records are transparent and can withstand the scrutiny of a trained eye.