2009 may very well go down in history as a watershed year. It has not only brought seismic changes in the politics of the United States, but it also has been accented by an economic recession. During late 2008 and the early months of 2009, financial commentators were quick to spin procrastinations concerning the “financial meltdown” and surviving a “global economic crisis.” The gaming industry was not immune to the effects of the 2008–09 recession—a much different result than prior recessions. As the days and months sped past, the media and business world exhausted labels like “crisis” and “meltdown” for the current economic condition. Now popular catchphrases are focused on a more optimistic message, with news stories focusing on the impending economic recovery. But regardless of when a recovery ultimately comes, or if it already has commenced, many businesses—gaming and non-gaming alike—have simply survived the economic malaise and are now focusing on answering this annual year-end question: What proactive steps can we take to minimize our 2009 tax liability?
While 2009 year-end tax planning is primarily a consideration for gaming businesses that use the calendar year as their tax year, the end of 2009 also requires gaming businesses with tax years other than the calendar year to remain vigilant with respect to expiring favorable tax provisions. The particular facts and operations of a business will ultimately dictate what tax planning steps can be incorporated to minimize federal tax liability. This article is intended to provide a high-level overview of common planning considerations and favorable tax law provisions that are about to expire.
Planning to Minimize Taxes
The fundamental purpose for year-end tax planning is to minimize tax liability. At the end of the day, minimizing tax liability is a question of timing. That is, tax-efficient businesses try to pinpoint the most opportune time to incur expenses or recognize income in order to arrive at the lowest lawful tax liability. There are two standard timing approaches businesses use to minimize taxes: (1) deferring income; and (2) accelerating deductions. While the two approaches are conceptually simplistic, the actual practice is wrought with traps for the unwary and will often be dependent upon the method of tax accounting used by the business taxpayer. Most businesses—and nearly all publicly traded corporations—use the accrual method of tax accounting.
What is Accrual Tax Accounting?
At the outset, the concept of “tax accounting” is a federal tax law-driven concept that may not, in all instances, perfectly match with financial accounting or Generally Accepted Accounting Principals (GAAP). The two most prevalent tax accounting methods are the cash method and the accrual method. Individuals use the cash method of tax accounting. Both case law and U.S. Department of Treasury regulations, for instance, recognize that a taxpayer’s accounting method will generally be accepted if it is used consistently and in accordance with GAAP. As with all methods of tax accounting, the purpose of the accrual method of accounting is to accurately reflect the taxpayer’s income for federal tax purposes.
The accrual method of accounting applies two different tests to determine when a business must accrue income for tax purposes and when a business may accrue deductions. The Internal Revenue Code of 1986, as amended, and corresponding Treasury regulations set forth a two-part test to determine at what time a taxpayer is obligated to accrue income:
1) All events have become fixed with respect to the right to receive the income; and
2) The amount is determinable with reasonable accuracy.
From a federal tax law perspective, the battle often centers on whether the business has a “fixed right” to the income. The analysis will typically turn on whether the right to the income is subject to a condition precedent (i.e., in non-legalese, an event that must occur prior to the time when a party is obligated to perform) or a condition subsequent (i.e., an event occurring after performance that terminates an obligation to perform). As a very basic rule of thumb, a right to income that is subject to a condition precedent is not considered a fixed right to receive the income until the recipient performs its obligations. Conversely, a payment subject to a condition subsequent will usually be treated as a fixed right to receive income.
With respect to the time a business may accrue a deduction, a three-prong test is applied under federal tax law. Under the three-part test, deductions may be accrued when:
1) The facts of the liability have been determined;
2) The amount of the liability can be determined with reasonable accuracy; and
3) “Economic performance” has occurred.
The heart of the three-part test is the third factor, economic performance. The economic performance doctrine, which has been codified in the Internal Revenue Code, generally means that a taxpayer may not deduct an expense until it is actually paid or until the services that the payment or liability arises out of are performed.
As is evident from the two tests for determining when income and expenses may be accrued, the analysis is often complicated and nuanced. For example, simply pre-paying an expense may not be sufficient to satisfy the economic performance test. Rather, it may be necessary for the services that are delivered in exchange for the payment to already have commenced.
Two approaches that are employed to shift income to future years include delaying the completion of work on a project or delaying the delivery of goods or services. For example, a gaming equipment manufacturer may attempt to defer the recognition of income to 2010 by delaying the delivery of equipment purchased by a casino.
There are certain planning mechanisms available to businesses that want to accrue expenses in order to deduct the amounts for federal tax purposes. One statutory-based example that allows for the accrual of expenses is bonus payments to employees. Bonus payments paid to employees may be accrued as a deduction when the employee does not own more than 50 percent of the value of the corporate-taxpayer stock, the bonus is properly accrued on the corporation’s financial books, and the bonus is actually paid within the first two and a half months of the corporation’s tax year.
Special Strategies for S Corporations
Although most tax advisors generally disfavor S corporations—largely because a single layer of tax (or pass-through treatment) can be achieved through use of a limited liability company, which is taxed under the much more favorable and flexible partnership tax regime of the Internal Revenue Code—there are still a number of S corporations in existence, which supports highlighting a common S corporation planning technique.
An S corporation shareholder may only claim loss deductions of the S corporation to the extent to which:
1) The shareholder has “basis” in his or her shares; and
2) The basis of a shareholder loan to an S corporation.
A shareholder without sufficient basis has trapped losses, and while these losses can be carried over to subsequent tax years, they cannot be currently used against other income of the shareholder. One common method to increase share basis is the use of a “one-day” loan to increase share basis. Adopting this planning approach, however, may carry some risks and involves careful structuring.
Expiring Favorable Tax Law Provisions
There are several tax law provisions that are set to expire at the end of 2009 that may be of beneficial use to businesses operating in the gaming industry. The following is a selected summary of expiring tax law provisions that may be of particular interest to gaming industry businesses.
Bonus Depreciation
Under current law, certain so-called “qualified property” is eligible for an additional 50 percent bonus depreciation during the first year of depreciation allowances. The bonus depreciation allows a business to claim depreciation deductions equal to 50 percent of the business’ cost paid for depreciable property. To be eligible for the 50 percent bonus depreciation:
1) The property must either be subject to the Internal Revenue Code’s Modified Accelerated Cost Recovery System for property with a recovery period of 20 years or fewer, certain computer software, qualified leasehold improvement property, or certain water utility property;
2) The property is placed in service prior to Jan. 1, 2010; and
3) The original use of the property commences with the business.
The bonus depreciation applies unless a business affirmatively elects out of the bonus depreciation. As an illustration, suppose that a casino purchases $1 million of gaming equipment that is “qualified property” for Internal Revenue Code purposes. The casino may be eligible for $500,000 in bonus depreciation deductions for 2009.
Generous Expensing Under Code § 179
Code § 179 allows certain types of taxpayers to elect to expense up to a prescribed amount of the cost of depreciable property rather than claim depreciation deductions. The effect of Code § 179 expensing is that a taxpayer may be allowed to accelerate the cost recovery for purchases of tangible personal property. The Code § 179 expensing limit for 2009 is $250,000. Absent congressional action, the limit will fall to slightly more than $125,000, after adjustment for inflation, in 2010. Code § 179 also imposes an investment ceiling, which reduces the Code § 179 expensing limit dollar-for-dollar. During 2009, the ceiling is $800,000, which is expected to fall to slightly above $500,000, after inflation adjustments, for 2010.
Research Tax Credits
Businesses are eligible to claim a credit for qualified research expenses that are incurred prior to 2010. The credit amount is determined through a formula, which involves additional computations. At a basic level, the research credit is equal to 20 percent of the excess of the qualified research expenses over a base amount. Over the years, the research credit has been a particular focus of IRS scrutiny because, among other reasons, of the debate with respect to the types of expenses that are eligible to be included within the definition of qualified research expenses. Research credits can be particularly beneficial for gaming equipment suppliers involved in the development of new products and equipment.
Accelerated Cost Recovery
A favorable change to the tax law for 2009 accelerates the period over which a business may recover the costs for expenses associated with improvements to qualified leasehold, qualified restaurant and qualified retail improvements. The accelerated recovery period allows a business to write off the qualifying expenses over a 15-year period, rather than the 39-year period that ordinarily applies. The accelerated cost recovery for qualifying improvements may be particularly beneficial to casino properties.
Final Thoughts
Year-end tax planning for any business necessarily involves an examination of particular facts and circumstances of the business, including the earnings and business plan. A business that has substantial expiring net operating losses (NOLs) may desire to accelerate the recognition of income in order to fully utilize the expiring NOLs. Similarly, a business that already has significant earning losses during 2009 may have little need to adopt planning techniques that result in the acceleration of deductions. Additionally, there are several expiring favorable provisions of the federal tax law that may be advantageous to gaming businesses. Thus, now is the time for gaming businesses to start examining their current tax positions and assessing whether any planning steps should be undertaken to minimize 2009 tax liability.
Peter J. Kulick is a tax and gaming attorney with Dickinson Wright PLLC, which has an international gaming law practice with offices in Michigan, Nashville, Washington, D.C., Toronto and Phoenix. He received his LL.M in tax law from New York University. Kulick may be reached at pkulick[at]dickinsonwright.com.
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