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Presented by Robert Schwarzmann and Adam Polakov 1.

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1 Presented by Robert Schwarzmann and Adam Polakov 1

2 Agenda  Tax Landscape  Accounting for Income Taxes  Basics of Accruing Income Tax Expense  Deferred Taxes (ASC 740)  Footnote Disclosures and Valuation Allowance 2

3 Tax Landscape  Expiration of Bush Tax Cuts  Patient Protection and Affordable Care Act  Election Year 3

4 Bush Tax Cuts Sunset – 12/31/2012  Marginal income tax rates return to pre-2001 levels 4

5 Bush Tax Cuts Sunset – 12/31/2012  Capital Gains tax rates will return to pre-2001 levels  Capital gains currently taxed 0 percent for taxpayers in the 10 and 15 percent brackets and at 15 percent for all others.  Will increase to 10 percent for taxpayers in 10 and 15 percent bracket and 20 percent for all others.  Qualified Dividends will be taxed as ordinary income  Qualified Dividends are currently taxed at the same rates as capital gains  Tax rate on Qualified Dividends increases to 43.4% with addition of 3.8% Investment Income Tax  The estate tax will be restored with an exemption level of $1 million and a top tax rate of 55%  Child care credit decreases to $500 from $1,000 5

6 Bush Tax Cuts Sunset – 12/31/2012  Return of the “marriage penalty” on jointly filed taxpayers  Joint filer’s standard deduction returns to 167% of individual standard deduction  End of accelerated “50% bonus” depreciation deductions  Section 179 expensing limitation - $25,000; $200,000 qualified asset additions (currently 125,000; 500,000)  The 2% FICA payroll tax cut is expiring  Alternative Minimum Tax (AMT) patch expires 6

7 Affordable Care Act – New Taxes  Investment Income Tax  3.8% Medicare Tax on Investment Income Impacts individual taxpayers with AGI > $200,000 and joint filers with AGI > $250,000  How does the Act define Investment Income Dividend Income (Tax rate on Qualified Dividends increases to 43.4%) Interest Income Rental Income Royalties Short and Long Term Capital Gains Passive Income from K-1’s where the taxpayer doesn’t materially participate Gain from the sale of a primary residence (exceeding exclusions) Gain from the sale of a 2 nd home 7

8 Affordable Care Act – New Taxes  Certain Income is exempt from the Act Tax-exempt Income on municipal bonds and securities Payouts from Regular or Roth IRAs Payouts from 401(k) or pension Social Security Income Life Insurance Proceeds Pass-through business income on which taxpayer is remitting Self Employment taxes 8

9 Affordable Care Act – New Taxes  Computation  The new Medicare tax is computed as 3.8% on the lesser of 1) Investment Income or 2) the excess of AGI over the income threshold  Example 1  A joint filer has $400,000 of AGI including $240,000 of W-2 wages and $160,000 of investment income  Because the excess of AGI over the income threshold ($400,000 - $250,000) of $150,000 is less than investment income of $160,000, the tax is based on excess AGI.  Additional Medicare tax is $5,700 ($150,000 x 3.8%) 9

10 Affordable Care Act – New Taxes  Example 2  A single filer has W-2 wages of $260,000 and dividend income of $100,000. AGI equals $360,000.  Because the excess of AGI over the income threshold ($360,000 - $200,000) of $160,000 is greater than investment income of $100,000, the tax is based on investment income.  Additional Medicare tax is $3,800 ($100,000 x 3.8%) 10

11 Affordable Care Act – New Taxes  Example 3  A single filer has $285,000 of income from the following sources: IRA payouts of $80,000 Social Security payments of $60,000 Dividend income of $40,000 Long Term Capital Gains of $30,000 Tax Exempt interest income of $75,000  AGI is $210,000 and Investment Income computed under the Act is $70,000  Additional Medicare tax is $380 ($10,000 x 3.8%) 11

12 Affordable Care Act – New Taxes  Example 4  A joint filer purchased a home 30 years ago in New York City for $250,000 and sells it in 2013 for $2 million. The joint filer also has W-2 wages of $100,000. Investment Income is $1,250,000 ($2 million less $250,000 cost basis less $500,000 exclusion) AGI > $250,000 is $1,100,000 ($1,350,000 less $250,000 exclusion)  Additional Medicare tax is $41,800 ($1,100,000 x 3.8%) 12

13 Affordable Care Act – New Taxes  Payroll Taxes .9% Medicare Hospital Insurance Tax on Ordinary Income Impacts individual taxpayers with Ordinary Income > $200,000 and joint filers with Ordinary Income > $250,000 Assessed on the employee portion of Medicare  How does the Act define Ordinary Income? W-2 wages Pass-through business income on which taxpayer is remitting self employment taxes (Schedule K-1, Schedule C business income) 13

14 Affordable Care Act – New Taxes  Withholding Employers are required to withhold additional Medicare Tax Employers are not required to consider a spouse’s wages or whether the employee earns wages at a second job Because tax on “employee portion” of Medicare, self employed persons will not be able to deduct one half of this tax from AGI 14

15 Affordable Care Act – New Taxes  Example  A joint filer earns $375,000 in W-2 wages and $150,000 of pass-through income from a business that is subject to self employment taxes  Ordinary Income subject to the.9% Medicare tax is $275,000 ($525,000 ordinary income less $250,000 exclusion)  Additional Medicare tax is $2,475 ($275,000 x.9%) 15

16 Affordable Care Act – New Taxes  Medical Expenses  Itemized Deduction The medical expense “floor” increases from 7.5% to 10% of AGI (minimum amount of medical expenses that must be incurred before getting a tax deduction)  Healthcare Flexible Spending Account contributions limited to $2,500 (pre-tax)  Penalty for nonqualified distributions from Health Savings Accounts increases from 10% to 20% 16

17 Mandatory Health Care Coverage  Effective January 1, 2014, large employers will be assessed excise tax penalties if any of the following are applicable:  Does not offer coverage for all full-time employees  Offers minimum essential coverage that is unaffordable (i.e., the employee contribution is > 9.5% of the employee’s household income)  Offers minimum essential coverage where the plan’s share of the total cost of benefits is less than 60% (Minimum essential coverage is defined as the large employer covering at least 60% of the cost.)  Any full-time employees are certified to have purchased health insurance through a state exchange and qualified for a tax credit 17

18 Mandatory Health Care Coverage  Penalty if Employer does not offer a Health Care plan to all employees  An employer has 75 full time employees (FTE’s) and one employee is not covered by the group policy and the employee receives health coverage assistance  The tax would be based on 45 employees (75 FTEs less a 30 employee predefined minimum threshold)  For each month the employee is not covered, the tax is computed as follows: 1/12 x $2,000 or $167/month per employee 45 employees x $167 = $7,500 tax per month Annual excise tax of $90,000 18

19 Mandatory Health Care Coverage  Penalty if Employer offers Health Care coverage but does not meet certain criteria  Failure to offer all FTE’s the opportunity to enroll in minimum essential coverage under an eligible employer sponsored plan; and  At least 1 FTE has been certified as having enrolled in a state exchange plan and has received a premium tax credit For example, minimum essential coverage is not met if at least one FTE receives a credit or cost sharing reduction in a state exchange plan because the employer’s premium under the health care plan exceeds 9.5% of that employee’s household income or the employer-offered plan pays for less than 60% of covered health care expenses  For each month the employee is not covered, the tax is computed as follows: 1/12 x $3,000 or $250/month per employee Penalty is capped at the penalty the employer would have owed had no health care plan been provided 19

20 Individual Mandate  Effective January 1, 2014, all U.S. residents are required to maintain minimum essential coverage unless they meet one of the following exceptions:  Incarcerated individuals  Undocumented aliens  Individuals who meet certain hardship conditions and are unable to afford coverage  Individuals below the tax filing threshold  Members of Indian tribes 20

21 Individual Mandate  Annual penalty for not having minimum essential coverage will be the greater of  A flat dollar amount or $95 in 2014, $325 in 2015, and $695 in 2016  A percentage of the individual’s taxable income over a certain threshold Phased in at 1% in 2015, 2% in 2015, and 2.5% in

22 Other Provisions in the Act  Small Business Health Care Credit ( )  Credit is available up to 35% of health insurance premiums  Maximum eligibility for the credit is for employers with 10 or fewer workers with average wages of $25,000 or less 22

23 Election Year Proposals  President Obama’s Tax Proposals  Set long term capital gains rate to 20% (Increases to 23.8% with the Medicare tax on investment income under the Affordable Care Act)  Reinstate the top two pre-2001 individual income tax rates (36% and 39.6%), but maintain Bush era tax rates for lower income taxpayers  Tax dividends at ordinary income tax rates 23

24 Election Year Proposals  Establish limitations on the benefits of itemized deductions for higher income earners  Supports Federal Estate Tax of 45% with an exemption of $3.5 million  Repeal the Alternative Minimum Tax; Replace the AMT with the “Buffett Rule” which would institute a minimum 30% tax on taxpayers with an AGI > $1 million  Reduce the corporate tax rate from 35% to 28% while removing deductions/loopholes embedded in the tax code 24

25 Election Year Proposals  Governor Romney’s Tax Proposals  Repeal the 3.8% Medicare tax on Investment income embedded in the Affordable Care Act  Reduce the tax rate on long term capital gains, dividend income and interest income rate to zero for all taxpayers with AGI below $200,000  Maintain a 15% rate on capital gains and qualified dividends for taxpayers with AGI > $200,000  Permanent, across-the-board 20% tax cut on all individual income tax rates 25

26 Election Year Proposals  Governor Romney’s Tax Proposals cont’d  Repeal the Alternative Minimum Tax  Eliminate the Federal Estate Tax  Reduce the corporate tax rate from 35% to 28% while removing deductions/loopholes embedded in the tax code  Supports transitioning our Corporate Tax to a Territorial tax system 26

27 Accounting for Income Taxes  Definitions  Basics of Income Tax Expense Accrual  Deferred Tax Components  Balance Sheet Approach vs. Expense  Footnote Disclosure  Valuation Allowance 27

28 Accounting for Income Taxes  Definitions  Income Tax Expense – tax expense recorded on Income Statement Current Tax Expense/(Benefit) – amounts owed to (or due from) federal and state tax authorities that must be paid currently Deferred Tax Expense/(Benefit) – amounts owed to (or due from) federal and state authorities but not yet paid or received  Income Tax (Payable)/Receivable – current income tax liability or receivable recorded on balance sheet  Deferred Tax Asset/(Liability) – an asset/liability on a company’s balance sheet that may be used to reduce (or increase) a subsequent period’s income tax payable 28

29 Accounting for Income Taxes  Basics of Accruing Tax Expense  Pre-tax book income (GAAP) Adjust for Permanent Items  Examples of permanent tax adjustments (M-3’s) Tax exempt interest income Fines & Penalties Social Club Dues Meals & Entertainment Federal income tax expense  APB 11 (Income Statement) Approach Pre-tax income + Perm M-3s x blended rate = tax expense 29

30 Accounting for Income Taxes Federal Rate.34 State Rate.06 Benefit of Federal deduction of state tax (6% x 34% = 2%) (.02) Net State Tax.0396 Blended Rate Using a Blended Tax Rate: 34% + 6% x (1-.34) = 37.96% for GA corporations

31 Accounting for Income Taxes  In a multi-state environment the blended rate can get much more complicated  When state apportionment formulas are computed each year, the rate can fluctuate based on the individual state activity  Calculating state tax expense under APB 11:  NC: 70% apportionment x 6.9% tax rate =.0483  GA: 30% apportionment x 6.0% tax rate =.018  = 6.63% blended APB 11 state tax rate  Blended rate = % x (1-.34) =

32 Accounting for Income Taxes  Effective Tax Rate (ETR)  Expected ETR = tax expense / pre-tax book income  What is the impact of an increase in tax-exempt income?  What is the impact of an increase in social club dues?  ETR may fluctuate even if Permanent M-3s are consistent  Timing differences do NOT impact the ETR  Differs from Statutory tax rate (34%) 32

33 Accounting for Income Taxes  How to reflect on books  Tax is similar to other accrued expenses Debit expense, credit tax reserve account Payments exceeding accrual create prepaid  Monitor the balance in the reserve account by tracking current tax position (accruals vs. estimated payments) as well as deferred tax balances (supported by components of deferred tax) 33

34 Accounting for Income Taxes  Making Tax Payments  Estimated Payments Due 4 times each year  Final Extension payment for prior year Due March 15  Payment with return If necessary  Refunds and Overpayments Represent receivable on balance sheet 34

35 Accounting for Income Taxes  Payment v. Accrual  Why are they different? Examples of Temporary Items of Tax Adjustment (M-3’s) Bad Debt Reserve Fixed Asset Depreciation Accruals for Deferred Compensation Accruals for Contingencies  Why are they Temporary?  Each item of income or expense is the same for book & tax over time 35

36 ASC 740 Deferred Taxes  ASC 740 Balance Sheet Approach to Taxes  Timing differences between book basis and tax basis  Does not impact total tax expense or ETR  Recognizing deferred tax assets and liabilities  Taxable Temporary Differences  Deferred Tax Liability (DTL) Book Basis > Tax Basis; Future Taxable income  Deductible Temporary Differences  Deferred Tax Asset (DTA) Book Basis < Tax Basis; Future Taxable Expense 36

37 Deferred Tax Liability Example  Fixed asset depreciation  Furniture costs $20,000  Book depreciates over 10 yrs straight line - $2,000  Tax depreciates over 7 yrs w/50% bonus – $11,429  Favorable Tax adjustment = $9,429 Reduces taxable income in current period  Book basis = $18,000 Tax basis = $8,571  Deferred component = ($9,429)  Book Basis > Tax Basis = Deferred Tax Liability  Future taxable income upon reversal 37

38 Deferred Tax Asset Example  Bad Debt Reserve  Initial reserve for books is $2,000,000  Allowed reserve for tax is $150,000  Unfavorable Tax adjustment = $1,850,000 disallowed deduction (or additional income)  Deferred component = $1,850,000  Book Reserve > Tax Reserve = Deferred Tax Asset 38

39 Deferred Tax Inventory  Fixed Assets (9,429)  Bad Debt Reserve 1,850,000  Total Timing Differences 1,840,571  Tax rate 37.96%  Deferred Tax Asset(rounded) 700,000  Reported on the footnote of the company’s audited financial statements 39

40 Example – Accruing Tax Expense APB 11 Tax AccrualTiming DifferencesTax Return Pre tax book income: $1,000,000 $1,840,571$2,840,571 Tax Exempt Interest: ($75,000) Tax Exempt Interest: ($75,000) Permanent Taxable Income: $925,000 Taxable Income on Tax Return: $2,765, % $351,000 (Rounded) Current Tax Payable: $1,051,000 (Rounded) Payment > Accrual$700,000 40

41 Accruing Tax Expense Under APB 11 Debit(Credit) AJE # 1Income Tax Expense 351,000 Income Tax Payable (351,000) AJE # 2Income Tax Payable 351,000 Deferred Tax Asset700,000 Cash (1,051,000) 41 Income Tax ExpenseIncome Tax PayableDeferred Tax Asset Dr / (Cr)351,000(351,000)700, , ,000

42 Accruing Tax Expense under ASC 740 Debit(Credit) AJE # 1Income Tax Expense 1,051,000 Income Tax Payable (1,051,000) AJE # 2Income Tax Payable 1,051,000 Cash (1,051,000) AJE #3Deferred Tax Asset 700,000 Income Tax Expense (700,000) 42 Income Tax ExpenseIncome Tax PayableDeferred Tax Asset Dr / (Cr)1,051,000(1,051,000)700,000 (700,000)1,051, , ,000

43 Footnote Disclosures  Components of ASC 740 current year tax expense  Current & Deferred (current / non-current)  Federal & State  Rate Reconciliation (a recon between the statutory rate and the effective tax rate)  Remember: Perm Differences only!  Deferred tax inventory  Tax effected {37.96%} 43

44 Disclosure: ASC 740 Components of expense Components of total ASC 740 income tax expense: Current tax expense (tax return)1,051,000 Deferred tax benefit(current year)(700,000) TOTAL TAX EXPENSE351,000 44

45 Current Income Tax Expense Book Income$1,000,000 Income tax expense($925,000 x 37.96%)(351,000) Net Income after tax649,000 Income Tax Expense351,000 Tax Exempt Interest(75,000) Temporary adjustments1,840,571 Taxable income2,765,571 Tax due with returnAt 37.96%$1,051,000 Equals current component of income tax expense 45

46 Disclosure: Rate Reconciliation Pre-tax income at statutory rate$1,000,000 x 34%340,000 Tax exempt interest income75,000 x 34%(25,500) State income tax, net of federal benefit $925,000 x 6% x (1-.34)36,500 TOTAL INCOME TAX EXPENSE351,000 Effective Tax Rate:351,000 / 1,000, % Blended Tax Rate:37.96% 46

47 Disclosure: Deferred Tax Inventory In tax $$ Bad Debt Reserve703,580 Premises & Equipment(3,580) Net Deferred Income Tax Asset700,000 47

48 Cushion or Excess Reserves  A cumulative over or (under) accrual of income tax expense  Unallocated tax liability on the balance sheet  Additional tax expense to cover exposure or risky tax positions  ASC 740 does NOT provide for any excess tax reserve that cannot be supported by a book/tax basis difference  Materiality (audit standards) 48

49 Valuation Allowance – GAAP  Should a valuation allowance against the corporation’s deferred tax asset be booked for GAAP?  Is it “More likely than Not” (greater than 50%), after evaluating all available evidence, that the deferred tax asset will not be realized?  Requires significant judgment in evaluating negative and positive evidence 49

50 Valuation Allowance – GAAP  Negative Evidence - objective and verifiable  Cumulative losses over past 3 yrs – very difficult to conclude a valuation allowance is not needed  Large net operating loss carry forward amounts Tax is 20 yrs; GAAP looks at a much shorter timeframe  No carry-back capacity  Expiring credits  Capital losses with no capital gains  Future income in jeopardy  Going Concern opinion in the audited financial statements. 50

51 Valuation Allowance – GAAP  Positive Evidence that an allowance is not warranted  Strong earnings history, exclusive of the unusual or extraordinary item generating losses  Strong income projections – prove that the Corporation will quickly return to profitability! Immediate future, not 20 yrs!  Taxable Income Planning strategies 51

52 Valuation Allowance – Financial Reporting  Tax planning strategies are actions that are “prudent and feasible” that an enterprise might not ordinarily take, but would take to prevent an operating loss or credit carry forward from expiring  Future taxable income is the weakest form of evidence!  Less objective, less verifiable  Compare projections to actual over last 3 yrs  Debit to Expense; negatively impacts equity and capital  Effective tax rate of 0% going forward 52

53 Valuation Allowance – Testing Deferred Tax Asset  Determine what financial statement income is projected  Utilize consistent income projections  Adjust for permanent and temporary tax differences  Consider reversal of taxable temporary differences  Tax planning strategies  Consider use of NOL C/fwd and credits to offset taxable income and tax  Quickly returning to profitability! 53

54 Valuation Allowance  If credits are likely to expire before they can be used, an allowance is necessary  Georgia Retraining credits – 3 yr carry-forward period  Georgia Low Income Housing Credits – 3 yr carry-forward period  If capital loss carry forwards will expire before capital gains are generated, an allowance is necessary  If taxable income cannot be reliably projected in the near future, an allowance may be necessary 54

55 Reversing the Valuation Allowance  When actual circumstances improve and some of the deferred tax attributes are able to be used, the valuation allowance is reversed in the period of the change  Continued, sustained earnings over multiple quarters  Significant judgment  Credit to income tax expense  For example, if a capital gain is generated in 2011, the deferred tax asset related to the capital loss carry forward can offset the tax on the gain 55

56 Tax Rate environment  What if income tax rates go down?  The impact of any tax rate changes should be reflected as of the date of the change  For a corporation with a significant amount of deferred tax asset, an income tax rate change will generate a charge to current earnings Debit income tax expense Credit deferred tax asset 56

57 Questions? 57

58 Robert Schwarzmann Contact Information 58 Adam Polakov


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