YOUR TAXES : PART FOUR: SPECIAL SITUATIONS : Personal corporations face big tax bite : New rule means that many will have to pay hefty one-time surcharge

<i> Nina Easton is a staff writer in Los Angeles for the American Banker, a daily financial newspaper. </i>

David Grant, a 39-year-old Los Angeles attorney, must file two separate federal tax returns on his 1987 income. When he does, his tax bill will be based on 14 months of income--two more than the average taxpayer.

Grant, a tax lawyer specializing in financial institutions, calls this “the dreaded phenomenon of bunching your income,” and for many professionals like him, it will mean a painful one-time surcharge on their tax bills.

That’s because the new tax law generally requires partnerships, “S corporations” and personal service corporations to convert from fiscal years to calendar years that end Dec. 31.

Grant is a partner in the law firm McKenna, Conner & Cuneo, where in the past he paid taxes on his share of the firm’s income using a fiscal year ending Oct. 31. Now, McKenna, Conner must change its fiscal year to a calendar year ending Dec. 31. As a result, Grant will owe taxes on his November and December, 1986, income--as well as all his 1987 income--when he files his tax return one year from now.


The calendar year requirement is the most important of several changes that will require partnerships, sole proprietorships and incorporated professionals to rethink their tax strategies. Here are a few other signposts to the new law:

If you are incorporated, consider changing your firm’s status to a sole proprietorship or an S corporation so you can take advantage of individual tax rates, which now are lower than corporate rates. An S corporation, with a maximum of 35 shareholders, provides the limited liability protection of a corporation, but its income flows through to the individual owners for taxation at a lower rate.

Beware of the alternative minimum tax. Because of changes to the tax law, more and more high-income taxpayers--particularly those accustomed to large tax breaks--will find themselves subject to this once obscure tax.

Review your pension plan. Highly paid professionals covered under defined benefit plans will find their tax-deductible contributions sharply curtailed and their benefits reduced. Self-employed workers who lost the ability to deduct contributions to their IRAs should consider setting up a Keogh plan to recoup those deductions.


“Just about every pension plan will need to be amended under the new law,” said Jack Oldham, a partner with the accounting firm Kenneth Leventhal & Co. in Newport Beach.

Keep detailed expense records. The new tax law narrows the definition of legitimate business deductions. If you use your car for business, the Internal Revenue Service expects you to keep daily records. Business meals and entertainment also will be subject to tighter scrutiny. Beginning this year, only 80% of the costs of wining and dining business clients is deductible.

The calendar year requirement hits hardest at incorporated professionals--particularly many doctors and lawyers--who had used a separate fiscal year to defer personal income taxes.

Typically under the old tax law, these professionals set a fiscal year end of Jan. 31 for their corporation. Between Jan. 31 and Dec. 31 they paid themselves a low salary, receiving the bulk of their income in the form of a large bonus in early January. They could then defer paying personal taxes on that January income until the following year.

The new tax law eliminates this deferral game. And individuals with corporations using a Jan. 31 fiscal year end will wind up paying taxes on a whopping 23 months of income when they file their returns on their 1987 income. “It’s a major one-time hit,” said Harvey A. Bookstein, managing director of the accounting firm Roth Bookstein & Zaslow in Los Angeles.

The new law, however, does provide some relief. Most professionals can spread that extra income over four years. And tax advisers are urging their clients to do just that, particularly because the individual rate cuts that Congress adopted won’t be fully in place until 1988. “In most cases it will make a lot of sense to spread that income over four years,” Oldham said.

However, incorporated professionals--particularly many doctors and lawyers who are not part of a larger partnership--were excluded from that four-year spread, according to Oldham.

Congress’ decision to force self-employed professionals onto a calendar year is causing an uproar not only among those who face higher tax bills but also among accounting firms. Accountants argue that they can no longer stagger their workload and will be swamped each tax season. As a result, Washington policy makers are under pressure to amend or eliminate the requirement.


Treasury Department officials have indicated that they are studying the possibility of supporting congressional efforts to grant exemptions to a broader range of firms under the new provision. However, the officials warned tax experts not to assume that Congress would ease the requirement. The calendar year rule will raise an extra $1.7 billion over the next five years, and if the provision were liberalized, Congress would need to find other ways to make up that revenue.

Congressional changes to the nation’s tax code in recent years have reduced the benefits of being an incorporated professional--and the 1986 law is no exception.

Among the tax benefits bestowed on incorporated professionals in the past were more generous pension deductions, the ability to defer taxes through different year ends and a lower corporate rate. That’s all changed.

For the first time in recent history, individual rates will be lower than corporate rates. When the tax cut is fully in place, the top corporate rate will be 34%, down from last year’s 46%; and the top individual rate will be 28% (or 33% for certain high-income taxpayers), down from 50%.

Both partnership and S corporations--organizations that are only recognized for federal tax purposes and are taxed much like partnerships--will benefit from those lower individual rates. In both forms of business, income flows through to individuals who pay taxes on it.

Gregg W. Ritchie, senior tax manager with Peat, Marwick, Mitchell & Co. in Los Angeles, suggests that incorporated professionals “wind down” their firms--that is, stop putting additional income into it--rather than go through the process of liquidation.

Of course, many personal service corporations also can benefit from the lower tax rates simply by paying out all of their income as salary to the individual owners.

One thing the new law won’t change is your accountant’s bill. Once touted for its simplicity, the new law in fact is complex and requires tax planning that is tailored to the specific business of an individual.


“This bill is the furthest thing from simplicity that I’ve seen in my career,” Oldham said.