Tax season may be months away, but now is the time to start planning so you can strategically manage your tax burden.
Time slips away, the year is almost over, and the holidays will soon be upon us. In just a couple of months, we will be celebrating at midnight, while the crystal ball drops in Time Square, and Anderson Cooper and Kathy Griffin spar in drunken revelry.
It's tax planning time.
No one wants to think about taxes before they must, but maybe a little planning can help reduce the sting, or just give you a head's up on what will be due.
Tax planning is simple. The goal of year-end tax planning is to defer tax from the current year into next year. A dollar paid today is more valuable than a dollar paid later, therefore, if you can postpone paying tax, you will be paying less. And next year, you repeat the process, and again in the following year, which postpones paying tax on the deferral indefinitely.
There are two ways to reduce current year taxable income, which in turn, reduces current income tax:
Defer revenue into the subsequent year; or Accelerate expenses into the current year.
Deferring revenue can be tricky and will vary depending upon the specific business. Some businesses, such as retail, do not have control over the timing of sales. Other businesses have flexibility for year-end revenue recognition. If a business can hold off the completion of a project, or the receipt of cash, revenue recognition may be postponed until the next year.
There are two overall accounting methods: cash and accrual. A cash basis taxpayer records income when cash is received and an accrual basis taxpayer records income when cash is earned. It is much easier for a cash basis taxpayer to postpone income because revenue recognition is tied to the receipt of cash. Invoices can be held until after year-end and the associated tax on the income will be postponed until the following year. Of course, a business must be sure the corresponding reduction in cash flow will not create liquidity issues.
An accrual basis taxpayer has a harder time deferring income. Generally, an accrual basis taxpayer recognizes revenue when it is earned. Income is taxable when a transaction is complete, irrespective of when payment is received. To defer income into another period, a business will need to hold up the completion of transactions until after year-end. Construction contractors using the completed contract method can postpone finishing a large job the last week of December and wait until the first week of January, a manufacturer can hold a large shipment until after the first of the year, but these options have drawbacks. If income deferral is detrimental to business relationships, the tax deferral will be accomplished at a high cost. Each transaction should be evaluated before a blanket policy of deferral is established.
Accelerating expenses is generally the easier method to reduce current year income. What you have to remember is the tax rate is not 100%. If you incur expenses to
reduce your income down to nothing, you pay no tax because your business was not profitable. The goal of all businesses is to maximize income, and paying unnecessary expenses just to reduce taxes is silly. You want to accelerate necessary expenses into the current year. If you need a new piece of equipment, but were holding off on the decision to purchase, you might consider making the purchase by year-end.
A cash basis taxpayer will deduct expenses when paid and an accrual basis taxpayer will deduct expenses when incurred. A cash basis taxpayer can reduce income by paying bills before year-end whereas an accrual based taxpayer will need to incur the expense.
Businesses can take advantage of Section 179 expensing for fixed-asset purchases to generate large deductions. If a business does not have more than $2 million of asset additions during the year, up to $500,000 of fixed-asset additions can be expensed. An expensive piece of equipment can be purchased in December and the business can take a dollar for dollar income deduction for the full purchase price of the asset. There are limitations for automobiles.
Sometimes it may not be wise to defer current income into the following year. If 2016 was a bad year and income is low, it may be better to accelerate income and pay tax at a lower rate, especially if projections for the upcoming year are optimistic.
Similarly, if tax laws change, it may be more beneficial to either accelerate or postpone income, depending upon how those changes affect income tax rates. But that knowledge would require a different kind of crystal ball.
Pamela Schuneman, C.P.A., is a practicing tax accountant in Sarasota. She has 33 years of experience helping her clients navigate the vast federal tax system and has worked with businesses as varied as Fortune 500 companies to small sole-proprietors. Contact her at [email protected]