After blogging about Gov. Perry’s flat tax proposal, I thought I might spend a little time looking at Herman Cain’s 9-9-9 tax proposal. According to a September 15, 2011 article by Mr. Cain in the Wall Street Journal, he outlined his plan as follows:

“The plan begins with restructuring the tax code to include the broadest possible base at the lowest possible rate. The elements are:

• A 9% corporate flat tax. Businesses would deduct purchases from other businesses and all capital investment. The resulting gross income is taxed at 9%.
• A 9% personal flat tax. Individuals would deduct charitable contributions, then pay 9% on the rest of their income. Capital gains are excluded.
• A 9% national sales tax. This levy would be placed on the consumption of all new goods. Used goods purchased would be excluded.

My plan would also permanently eliminate taxes on repatriated profits, as well as payroll taxes and the estate tax.”

Corporate flat tax. Mr. Cain’s first proposal of a 9% corporate flat tax would certainly be broadening the corporate tax base by the way he is defining taxable income. Mr. Cain’s proposed corporate taxable income definition sounds eerily familiar to the way the state of Texas defines taxable income (see my blog dated October 25, 2011).

Under the Cain proposal, corporate taxable income would be calculated as follows:

Sales – Purchases – Capital investment = Taxable income

I’m assuming all purchases would be deductible, which would include things from raw materials to paper clips and everything in between. Corporate taxpayers would then deduct capital investments (i.e., purchases of machinery and equipment). So it sounds like any machinery or equipment placed in service during the year would be deductible in calculating taxable income. Would this deduction also include the cost of a new building placed in service during the tax year as well? I don’t know the answer to this question. I think it’s important to note that there would be no deduction for wages paid to employees under this plan.

Under the Cain plan for calculating taxable income does a company get to carryforward a loss? It doesn’t sound like it. If a company purchased a building one year and created a tax loss for that year it doesn’t appear that that loss would carryforward to the next year to offset taxable income based on the proposed tax plan. The Cain plan kind of looks like a cash basis method of accounting for expenses – you spend the money, you get a deduction.

Individual flat tax. As with most tax proposals out there, politicians love to talk about the tax rate, but no one ever defines taxable income. As I’ve mentioned before, the tax rate is the easy part of figuring the amount of tax due, the difficult part comes in figuring out what taxable income is. I think politicians assume that everyone gets paid a W-2 wage and so that person’s taxable income is what the W-2 says it is. What about those that are self-employed who don’t work for someone else and don’t get paid on a W-2? What about owners of partnerships, LLC’s, or S corporations who generally don’t get paid via a W-2 (or a full W-2 wage), how do we define their taxable income? In order to take a tax plan seriously I think these questions must be addressed.

Now that I’m down off my soap box, let’s look at Mr. Cain’s plan assuming everyone earns their living the same way and gets paid on a W-2 (it’s nice when we all live in such a simple society). So under his plan I would take my W-2 wage, subtract out charitable contributions, multiply that by 9% and that would be my tax that I would owe. Seems simple enough, especially for those that are use to paying taxes.

However this not good news for all of those that haven’t been paying taxes. The last statistic I saw was that over half of the people who filed income tax returns did not owe any income tax. In fact, many of those same people got refunds of the taxes they did pay and many also got refunds, via the earned income credit, of taxes they did not pay.

The 9% individual income tax would certainly broaden the tax base. The proposal could also provide a tax cut to those who have been paying taxes under the current system of progressive tax rates, but it would also cause those who have not been paying taxes to start paying taxes. So while Mr. Cain is presenting his plan as a tax cut, millions of Americans who have not been paying income taxes will start paying income taxes. For higher income earners, this plan will most likely be a tax cut.

National sales tax. Under the national sales tax plan, the purchase of all goods would be subject to the national sales tax. This would include things we are accustomed to paying sales tax on such as food, TV’s, clothes, cars, etc., but there would also be the national sales tax on homes and probably other goods that we are not used to paying sales tax on.

The 9% national sales tax would tend to affect lower to moderate income families more that higher income families. Lower to moderate income families tend to spend more of their income on purchases (even purchases of necessities) than higher income families do. Those who are able to save some of their earnings will not have these earnings taxed until they decide to spend these savings. However those that have to spend what they earn will have these earnings taxed immediately. The national sales tax seems to be a regressive tax.

In summary, this 9-9-9 tax plan would tend to hit those with the least the hardest. There would be some that are currently paying 0% in taxes that would start paying at least 18% in new taxes (i.e., 9% income tax plus 9% sales tax). Those in brackets above 18% would see a decrease in their taxes. Those who generate their income through investments and capital gains would have an even bigger tax cut because their capital gain income would not be subject to tax under the Cain plan (Mr. Buffet ought to love this, see my blog dated October 3, 2011).

Even though this plan is touted as a tax cut plan, it does seem to be a very regressive tax plan by placing more of a burden on lower to moderate income families and giving higher income earners a tax break. I’m not opining on if this is good or fair tax policy, but I did want to point out that this plan is only a tax cut plan if you are already paying taxes in excess of 18%. If you’re not paying more than 18% in taxes then this is a tax increase plan – even if this plan touted as a “flat tax”. Based on the latest data I saw from the IRS I would have to assume that for more than half of the US taxpayers the Cain plan would be a tax increase plan and most likely a tax cut for the other half.

Based on my understanding of Cain’s tax plan, I’m not sure if the above consequences are his real intent or not with his 9-9-9 tax plan. However before anyone jumps on the “flat tax” bandwagon I think one needs to understand more than just the tax rate portion of any tax plan.

First, Texas basically has a flat tax system in place now. The Texas tax rate is 1% for all taxpayers, except wholesalers and retailers with a rate of 0.5%. So figuring the tax rate in the state is pretty easy: decide if you are a wholesaler or retailer and use 0.5%, if not use 1%. No progressive tax rates here.

Don’t mess with taxes in Texas. Next, years ago states adopted a three factor method for apportioning income to states based on a company’s payroll, property, and sales in a state. If a company operated in multiple states across the US, and if all states followed this three factor apportionment method, a company should end up apportioning 100% of its income to all of the states it operates in – no more, no less. States began tweaking this apportionment method by double or triple weighting the sales factor in an attempt to apportion more of a company’s income to that state where it is making sales, but may have little to no property or payroll in that state. By tweaking these apportionment factors, a company could end up apportioning more than 100% of its taxable income to the states it operates in. Texas has taken the tweaking of the apportionment factors to a new level. Texas only apportions income to its state based on the sales factor and completely disregards payroll and property. By disregarding two of the three factors, a company could apportion more income to a state who only utilizes one factor instead of all three.

Who taxes on gross margin instead of net income? Finally, and what I think is the most egregious part of the Texas tax laws, is that Texas taxes a company on its gross margin. Therefore, under the gross margin tax scheme, a company doesn’t take into account any expenses that are not classified as costs of goods sold when calculating its taxable income. That means in Texas a company could be losing money when the company takes into account all of its income and expenses, but could end up paying a significant amount of Texas state income taxes under this gross margin method.

No political agenda here. I’m not stumping for one candidate or another, but when I see the governor of Texas proposing a flat tax, knowing how his state calculates taxable income with its flat tax rate, it really makes me wonder what his plan would look like. Just because a tax plan is called a flat tax doesn’t mean the tax code would be simplified and taxpayers would pay less in taxes.

Tax rate isn’t the issue. What I think we need to remember is that applying a tax rate to taxable income is a very simple process, where the complication occurs is figuring out what taxable income is. The determination of taxable income is generally the complicated part of paying taxes, not applying a tax rate.

So this begs the question, what is Warren Buffet doing, and what tax loopholes is he taking advantage of, that the rest of us are missing or not taking advantage of?

If we take a closer look at what we know and can assume about his tax situation (since he hasn’t made his personal return available to the public to see how he actually got to an effective rate of 17%, we’ll have to guess) ,we know that his annual salary (i.e., W-2 wage) is only $100,000. I say only because the man is a billionaire and you would normally expect his annual salary to be much larger. At an annual salary of $100,000 that would put him in a tax bracket of 28%, far less than the 35% bracket that those who earn $1 million a year would pay.

So if his salary puts him in the 28% bracket how does he then lower his rate to 17 percent? The answer to that question is most likely the fact that he probably generates significant capital gain income which would only be taxed at 15 percent rate. If he took a “millionaire’s” salary of, say, $1 million a year his bracket would be higher than the current 28% and it would be more difficult to lower his effective rate through capital gain income closer to the 15% capital gain rate he now reports.

That seems like a simple explanation. But how does he get into the 17% bracket? What is Warren Buffet doing that the rest of us aren’t doing in order to reduce his tax rate? The answer to this question seems to be that he generates his cash flow from capital gain income which is taxed at a 15% rate while the rest of us generate our cash flow from W-2 wages or other sources of income that are taxed at ordinary income rates that range up to 35%.

The moral to the story may be that if we can generate sufficient income at ordinary tax rates and then convert that to capital gain producing income in the future then we can lower our effective tax rate from 35% to 17%.

Having a career vs. working a job.

Third observation: My third observation somewhat relates to this post on recruiting as it relates to the 40 hour work week. In my view of the world I can see my work as either a “career” or as a “job”. If I view my work as a “career” I’m going to spend time doing the extras to learn, grow, and advance. That may require:

• working more than eight hours a day,
• working on Saturdays,
• coming in early or staying late,
• checking e-mails or voicemails from home,
• reading about work related stuff on my personal time,
• or attending networking events.

If I view my work as just a “job” then I’m probably just punching a time clock from 8 to 5 everyday and only doing things that need to be done to get by. It’s not bad to view your work as one or the other, but you can’t view your work as a job and expect to advance or grow the same as someone who views their work as a career. Additionally, we don’t all want the same outcome from work. We don’t all have the same goals for our professional career. So when starting a new job as a student you need to decide which group you fall in and plan your career path accordingly.

Importance, or lack thereof, of internships for landing your first job.

Second observation: I also get questions from students of the importance of an internship in the accounting field or to have a part-time job as an accountant in order to get their first job in the accounting world. In my view I don’t believe that it is that important to have had an internship or a job as an accountant. What I think is most important is that they have had a job while in college. Why? Because I like students who have demonstrated they know how to work while they’ve been in school. These students have demonstrated they can do more than one thing at a time. We can teach students or new hires what they need to know when they start working for us, but what I find hard to teach is how to work. I believe knowing how to work comes from within. Personal drive can always take you a long way. It reminds me of a company slogan I once heard that goes something like this, “We don’t teach our people to be nice, we hire nice people.” Therefore we don’t teach our people how to work, we hire people that know how to work.

With recruiting season right around the corner, and now having gone through the recruiting for over 20 years now, I thought I would share some general observations I’ve had over the years.

First observation: One of the more interesting questions I always seemed to get asked is, “How many hours a week will I work?” I find this question not only interesting, but somewhat perplexing. The people asking this question are students who are generally taking a full class load at school, probably working a part-time job, and trying to balance other interests and activities all at the same time. These are generally people accustomed to juggling many balls at the same time. I often wonder if these students have a limit to the time they spend in class and on school work and when they hit that limit, do they stop because they’ve hit their “40 hours” for that week? Or are these students staying up late getting assignments done, cramming for tests, working part-time jobs, balancing other interests like family and recreation? I’m curious to find out, when the time comes that these students have completed school and juggling all of these responsibilities, do they expect to switch to a leisurely 40 hour work week? Didn’t they do the extras in school to be successful, get good grades, have outside interests, and work part-time? So why would they expect that to change once they enter the work force? Aren’t they going to continue these same habits they developed in college in their professional careers too?

 Key Differences between Utah and Federal R&D Credit. The Utah R&D credit does have several key differences from the federal R&D credit.  First of all, to qualify for the credit the research must be done in the state of Utah.  Second, the Utah credit also has two different calculations of the credit that are added together in determining the amount of the current year credit.  Finally, the Utah credit does not require either a reduction in the amount of the credit or disallowance of the R&D expenses as the federal credit does. 

Double the Benefit. As mentioned above, the Utah credit has two parts to the calculation of the credit.  The first calculation closely follows the federal credit calculation and uses a rate of 5.0% of qualified expenses for increasing research activities above the base amount.  The second calculation, which is more generous that the first calculation, uses a rate of 9.2% of qualified research expenditures for a taxable year (prior to 2010 the rate was 6.3%). 

Credit Carryforward and Non-carryforward. The credit calculated in the first calculation at a rate of 5.0% can be carried forward 14 years if not utilized in the year it was created.  However, the 9.2% credit cannot be carried forward.  Therefore, the 9.2% credit is a use-it-or-lose it credit in the year it is created.  There seems to be no ordering rules regarding which credit should be used first.  Therefore, you would think that you would want to utilize the 9.2% before you utilize the 5% credit.  That way if there was any credit carryforward available, up to the amount of the 5.0% credit, you would carry the 5.0% credit forward to the next year.

Enacted vs. effective rate. GAAP generally requires that a small life insurance company compute its deferred taxes no different than any other company.  GAAP generally requires that a company should measure its deferred tax assets and liabilities at the enacted tax rate (generally 34% or 35%).  However, small life companies can have an effective rate as low as 13.6% due to the small life insurance company deduction.  Therefore, should a small life insurance company record its deferreds at the enacted rate or its effective rate?

Need for a valuation allowance. Deferred tax assets or liabilities should be measured using the enacted tax rate.  A small life insurance company who is eligible for the small life insurance company deduction should consider the effect that the deduction will have on the amount of future taxable income that is expected to be available when assessing the realizablility of its deferred tax assets.  Based on this analysis the company may need to then determine the need for a valuation allowance. 

Realizable amount. A small life insurance company should record its deferred tax assets and liabilities at the enacted rate.  If the company has a net deferred tax asset balance after it has netted it deferred tax assets and liabilities, the company should then determine if it needs to record a valuation allowance to net the deferred tax asset balance to a realizable amount that may be different from the enacted rate. 

Small life insurance company defined. A small life insurance company is a life insurance company that has less than $500 million in assets and has taxable income of less than $15 million.  Both the asset and income of the company must be determined at a controlled group level.  For the asset test, the controlled group includes all companies of the group (both insurance and non-insurance companies).  For the income test, the taxable income only includes life insurance companies of the controlled group. 

Small life insurance company deduction. The small life insurance company deduction is equal to 60% of the first $3 million of taxable income.  The rate is phased out on taxable income between $3 million and $15 million.  The maximum small life insurance company deduction is $1.8 million. 

If you have any questions or comments please call me at (801) 984-1856, e-mail me at gdenning@larsco.com, or post a comment here.

Fears realized? Several years ago many companies worried about this possibility of having to disclose its uncertain tax positions (“UTP”) to the IRS when GAAP adopted FIN 48 (Accounting for Uncertainty in Income Taxes).  Under FIN 48, issued by the FASB in 2006, a company had to evaluate all of its tax positions through a recognition and measurement process.  The tax positions that were determined to be uncertain then had to be recorded and disclosed in the company’s financial statements.  Many companies worried at that time that the next step in the process would be that the IRS would want copies of its FIN 48 workpapers that would basically provide a roadmap for the IRS when it came into audit.  Now, instead of using the FIN 48 workpapers as the roadmap, the IRS has its own schedule to help in its audits in accessing a company’s UTPs.

A UTP list for the tax return. The IRS expects the preparation of Schedule UTP will flow naturally from the preparation of the company’s financial statements.  On Schedule UTP companies will list out U.S. income tax positions for which a FIN 48 reserve was established in the audited financial statements.

Will companies change the way it evaluates tax positions? It will be interesting to watch the process of disclosing UTPs unfold in the coming years.  Prior to FIN 48 companies were generally willing to take aggressive positions on their tax returns because these positions didn’t have to be disclosed.  With the adoption of FIN 48 companies tended to reevaluate their tax positions knowing that the tax positions now have to be disclosed on the company’s financial statements.  However this disclosure was made in general terms and nothing specific was disclosed with respect to any particular tax position.  Now that these positions will have to be disclosed on the tax return as well, will companies still be willing to take some of the aggressive tax positions that may have been taken in the past? 

Uncertain or unclear tax law impact. It may not be just aggressive tax positions that we’re talking about either, it may be tax positions where the tax law is unclear or uncertain.  In these cases taxpayers generally tend to interpret unclear and/or uncertain law in their favor.  Will this change and will companies start taking into account more of an IRS view knowing that this position may need to be disclosed on Schedule UTP. 

Easier audits for IRS? It will also be interesting to see how the IRS now uses this new information being reported on Schedule UTP to conduct its audits.  Only time will tell. 

If you have any questions or comments please call me at (801) 984-1856, e-mail me at gdenning@larsco.com, or post a comment here.

• issue audited financial statements;
• file Form 1120, Form 1120-L (life insurance companies), or Form 1120-PC (property and casualty insurance companies);
• have total assets of $100 million or more; and
• have a UTP that must be reported of Schedule UTP.

Phase-in based on size of company. The UTP filing requirements will be phased in over a five year period based on the size of the company.  The total asset base is phased in as follows:

• 2010 – $100 million or more of total assets
• 2012 – $50 million or more of total assets
• 2014 – $10 million or more of total assets

Audited financial statements. Audited financial statements generally include financial statements upon which an independent auditor has expressed an opinion and are prepared under GAAP or IFRS.  Audited financial statements do not include compiled or reviewed financial statements.

What tax positions must be disclosed on Schedule UTP? Generally there are two types of UTPs that must be disclosed:

1. Any tax position for which there is a FIN 48 reserve recorded in the audited financial statements, or
2. A tax position for which no reserve was recorded because the taxpayer expects to litigate the position if the position is challenged by the IRS.

It is important to note that a company will not be required to report a UTP for a tax position taken in a year before 2010.  Until a tax position is taken and a reserve is recorded for that position no disclosure on Schedule UTP will be required.