Small Business Taxes & Management^TM--Copyright 2011, A/N Group, Inc.

Introduction

Normally we have two year-end tax planning articles--one for businesses and one for individuals. Because some important tax provisions that can have substantial consequences are expiring, we've created an early article aimed specifically to take advantage of those provisions. While a number of provisions affecting both individuals and businesses are expiring, the business provisions will have the greatest impact and allow for the most planning. Moreover, they require the longest lead time.

The theory behind business tax planning is similar to planning for your personal return. You want to defer the income to a low tax rate year. If you do business as a sole proprietorship (i.e., file a Schedule C), S corporation, partnership, or LLC (limited liability company), income and losses of the business are passed through and reported on your personal tax return. Thus, your approach to year-end planning is similar to that for individual planning. (There are some factors that can complicate the issue; they're discussed below.) And, yes, while it's true you can save taxes by making equipment and other purchases, the lower tax rates means you're out-of-pocket cost is more than 50%. For example, you purchase a $2,000 laptop. If you're in the 35% bracket for federal purposes and 10% for state, you're effective tax rate is probably about 43% (you get a deduction for your state taxes on your federal return). That means the government is picking up $860 of the cost; you're paying for the other $1140. If you're self-employed or doing business as a partnership or LLC, your rate could be slightly higher when you add in the self-employment tax. (Want to get a better idea of the cost? Go to What's a Deduction Worth? on our Frequently Asked Questions page. Best suggestion? Don't buy what you don't need; don't buy more than you need.

Projecting Your Income-Business

Before going any further you've got to have a good handle on the income from the business. Your accounting records are a good starting point, but more than likely you'll have to adjust them to conform to the tax accounting rules. Here are some possible adjustments:

• Depreciation. The depreciation reported on your books may be higher or lower than that used for tax purposes. In some cases, no provision has been made for depreciation for 2011.

• Writeoffs. Bad debt reserves and many book writeoffs are not allowed for tax purposes. That may increase current year taxable income. On the other hand, book writeoffs taken in prior years may be reversing this year and may be deductible for tax purposes.

• Like-kind exchanges.

• Meal and entertainment expenses were fully expensed for book purposes, but generally only 50% of the amounts can be deducted for taxes.

• Installment sales. Tax law doesn't allow the installment method for accounting for sales of goods that are inventory property. For example, if you sell furniture as a business, you can't use the installment sale for those items. On the other hand, you can use the installment method for the sale of store fixtures, office equipment, etc.

• Amortization. You may have capitalized some expenses for book purposes in the past and are currently taking a deduction while you immediately expensed the item for tax purposes. That means your tax income will be higher than book. It's possible for some items to go in the reverse direction. That is, tax income could be lower than book.

• Tax law has some pretty specific rules as to when you can record income and expenses. If you're a manufacturer you'll also have to contend with the uniform capitalization rules. In short, many costs that you may have expensed for book purposes will have to be capitalized for taxes.

Check with your accountant on these issues. Hopefully, the differences will be slight, and, if so, can be ignored. Annualize your income (e.g., take the first 10 months, divide the income by 10 and multiply by 12) to figure your full-year profit or loss. Don't forget to account for any variations during the year. For example, if you're a retailer, the Christmas season is important and annualizing won't work.

Businesses that operate as a sole proprietorship, LLC, partnership, S corporation, etc. have their income (or losses) passed through to the owners and reported on the owners' individual tax returns. That means you'll have to project both the businesses income and your personal income to evaluate your tax bracket. See below.

Projecting Your Income-Personal

If you do business as an S corporation, sole proprietorship, etc. your share of profits or losses are passed through and taxed on your personal return. That means you'll have to do a projection of your personal income before you can do any serious planning. Assemble your records for the first 10 months of the year. If you record income and expenses on a regular basis, this should be a snap. The purpose of this article is to determine if it makes sense to make any last minute capital expenditures to take advantage of bonus depreciation, etc. While we've included a list of items to take into account at the personal level, you can cheat and estimate some of them. For example, your charitable contributions usually run $500 to $1,000. For now your best guess is good enough. Concentrate on the bigger numbers.

• Passthroughs from partnerships, S corporations, trusts, etc. If you're a small business owner more than likely this is where the largest source of income. Use the guide above to project your income and add it to your personal income.

• Salary income. This one is easy. You should have cumulative pay stubs that show gross income and taxes withheld. Annualize them as described above. Adjust for bonuses.

• Interest and dividends. You won't have 1099s, but you should have a good idea of your interest and dividend income. Check your last statements from your broker, mutual fund, etc. and annualize the amount (use the year-to-date amount, divide by the number of months the statement covers, then multiply by 12). Caution. Annualizing may not work for dividend income. It's fine for small dividends, but you may have to do some additional work if you have big holdings in some stocks. Alternatively, use last year's amounts and adjust up or down.

• Rental income. If you have rental properties, you'll need to come up with an income estimate. Before annualizing the income or loss for the first 10 months, be sure there are no unusual factors. For example, if you incurred big repairs earlier in the year, you may have to adjust for that. Not sure of how much depreciation to use? You won't be too far off if you use last year's number (unless 2010 was a partial year or you made significant capital improvements in 2010 or 2011).

• Capital gains. For many taxpayers this is an important factor and difficult to predict. And, while going through stock transactions this year could still be painful, it is important since this is where you can do considerable tax planning. Get your brokerage statements for the year to date or all your buy/sell tickets and match them up to find your gain or loss on every transaction. Total short-term gains and losses, then long-term gains and losses (property held more than 12 months).

• Also check for distributions from mutual funds. Some funds may still have carryforward losses, but there's a good possibility some or all of your funds could distribute income before the end of the year. You may be able to call the fund to see what the year-end distribution will be.

• Other income. Did you sell your main or vacation home, win any prizes or awards, settle a lawsuit, receive alimony, etc.? Get a state or local income or real estate tax refund? You could have additional taxable income. Also consider insurance reimbursements you received this year for medical expenses you deducted in an earlier year. Casualties can sometimes produce gains as well as losses. Had any net gambling winnings?

• Principal residence sale. If you sold your principal residence, there's a good chance you'll owe no tax on the sale. If you're single, the first $250,000 of gain should be exempt. If you're married, you can exclude the first $500,000. (Caution. The exclusion doesn't apply or is reduced if you sold a principal residence within the last two years.) However, before you go to the next topic, think again. If you're a long-time home owner, you could have broken this threshold. Remember, you'll have to consider gains deferred on sales made before 1997. The exclusion also contains a number of restrictions. If you used part of the home for business, some of the gain may be taxable. Finally, even if you don't owe any federal taxes, you still could be liable for state income taxes on the sale.

• Distributions from pension plans. You may have taken money out of an IRA, Keogh, 401(k), etc. during the year. Chances are it's all taxable income. (Roth distributions are an exception and a portion of your IRA may be nontaxable if you made nondeductible contributions.) Distributions from some regular pension plans may be part taxable-part nontaxable. In addition, if were under age 59-1/2 and don't qualify for one of the exceptions, you'll owe a 10% penalty. CAUTION. This is an important item. Such distributions can raise your final tax bill significantly.

• Social Security. If this is your first full year on Social Security you'll have to compute the taxable portion. If your AGI is above a threshold 50% may be taxable; above a second threshold 85% is taxable.

• Nontaxable income. Some income escapes taxes. That includes gifts and inheritances (generally, but pensions, annuities, etc. received from an estate are likely to be taxable) interest on most municipal bonds, returns of capital (e.g., principal repayments on a loan), reimbursements from your employer for business expenses, etc. Make sure you don't count any items as income if they're not. But if you're a shareholder in an S corporation or a partner in a partnership or LLC and received distributions in excess of your basis, they may be taxable.

• Check last year's return. Many items repeat year after year. You may find some income you hadn't considered.

Estimating your expenses and deductions. You've also got to come up with an estimate of your deductions. The items below are common deductible expenses.

• Alimony. If your divorce was structured properly it should be deductible. However, payments that are really part of a property settlement or child support aren't deductible. Conversely, alimony is taxable to the recipient; property settlements and child support aren't.

• Contributions to SEP, IRA, Keogh, etc. Some will depend on your income (e.g., SEP contributions may depend on your Schedule C income).

• If you're self-employed or a shareholder/employee in an S corporation, you may be entitled to deduct 100% of health insurance premiums you paid.

• Medical expenses. Add up all your expenses. Include medical insurance premiums not deducted elsewhere, doctors, dentists, hospitals, travel to and from the doctor, etc. Also include medical appliances such as glasses, hearing aids, etc. You may be able to deduct additions to your home if required or prescribed by a doctor. For example, a wheelchair ramp, special sink, etc. This can get tricky. Check with your tax adviser. Of course, reduce the amount by any reimbursement from insurance. Your deduction is limited to the amount that exceeds 7.5% of your adjusted gross income (AGI).

• Taxes. Include real estate taxes, state income taxes paid in 2011, and personal property taxes. When adding your taxes be sure to include any payments made when you filed your 2010 state return. Last year you could deduct either your state income taxes or your state sales taxes paid, but not both. At this time, that provision has not been extended.

• Interest. You're generally limited to interest on a home mortgage, including a mortgage on a second home. To that you can add a home equity loan with a principal amount of no more than $100,000. Interest to purchase an interest in an S corporation or partnership is also fully deductible (but not on Schedule A). Interest on other investments may or may not be deductible. Compute the total amount; we'll discuss planning later.

• Charitable contributions. Go through your receipts and checkbook. You may receive a notice from your church at the end of the year. For now you can use an estimate. Remember the rules on charitable contributions. You'll need a canceled check or receipt for all contributions; a receipt for those over $250.

• Education expenses. Amounts paid for your children or yourself may qualify for a credit or deduction. More than likely the amount spent will far exceed the amount qualifying for a tax benefit.

• Casualty or theft loss. It's got to be a big one. Only losses that exceed 10% of your AGI, plus $100 per casualty are deductible.

• Miscellaneous deductions. Include professional or union dues not reimbursed by your employer, tax preparation fees and books or software to help you prepare your return, investment expenses, safe deposit box rental, job-related education, and unreimbursed employee business expenses. If you work out of your home that can include a second telephone line, etc. Remember, only the amount over 2% of your AGI is deductible. If you had gambling winnings, gather all your losing tickets, etc. They can be deducted, but only to the extent of winnings.

Finding your tax bracket. If you've got a good handle on your income and expenses you can net the two to arrive at your taxable income. Be sure to also subtract out personal exemptions (use $3,650 each for yourself and spouse and dependent children). If your AGI exceeds certain thresholds your personal exemption and itemized deductions may be limited.

If you're pretty confident of your computations, you can find your tax bracket by using the Tax Tables in our Reference File. Keep in mind that long-term capital gains and qualifying dividends are taxed at a lower rate. Go to our Tax Tables for the details.

Caution. There's a good possibility you'll be subject to the alternative minimum tax (AMT). That can make the computations much more complex. If you don't want to talk to your tax adviser, get a computer program. Final or planning versions of popular programs should be available soon. In a pinch you can use last year's program. The final tax amounts will be off, but not significantly, and may be good enough for planning purposes.

Expiring Provisons--Business

Tax planning this year, particularly for businesses, is complicated by a number of expiring tax provisions. While most are timing issues (an immediate deduction versus depreciation over a number of years) some are significant. Some of these expiring provisions may be extended, but based upon what's going on in Congress that's not very likely at this time. Here are some of the more frequently encountered and important changes.

• Current law allows for 15-year straight-line cost recovery for qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail improvements placed in service before January 1, 2012. The same improvements done after the end of 2011 will generally have to be depreciated over 39 years.

• For 2011, up to $250,000 of the $500,000 allowed for Section 179 expense option can be used for qualified real property. That generally means qualified leasehold improvement property, qualified retail improvement property, and qualified restaurant property.

• The additional first-year depreciation for 100 percent of basis of qualified property is expiring. Until the end of the year you can depreciate the full cost of any new equipment purchases (e.g., any tangible personal property and some special purpose property, but not real property such as buildings) in the year placed in service. For example, Madison LLC buys a new lathe for $25,000. It can depreciate the entire cost in 2011. The 50 percent bonus depreciation will be available for property placed in service before January 1, 2013. Thus, the same lathe placed in service in 2012, assuming a 7-year life, would be entitled to depreciation of $14,286 in 2012, $3,061 in 2013, etc.

• The higher expense election under Section 179 decreases from $500,000 to $139,000 in 2012 and the phaseouts based on total qualifying purchases drops from $2,000,000 to $560,000.

• Because of the elimination of the additional first-year depreciation, the maximum first-year writeoff for cars and light trucks will drop from about $11,000 to about $3,000.

Some of these benefits overlap, but depending on your tax situation. In any event, to secure the benefits in 2011, the assets must generally be placed in service before January 1, 2012. That means equipment, leasehold improvements, etc. must be available for use. You can't just order the tractor. It must be ready to go to work. If it still has to be assembled, installed, etc. it's generally not placed in service. (That doesn't mean you have to use the equipment.) Thus, there's not much time left for certain equipment or any remodeling. In the case of construction, you might want to split the project so that, say two rooms can be done by the end of 2011; the other four rooms will have to wait till 2012. Working on the whole project simultaneously may mean nothing is placed in service until 2012. In any event, you don't have much time left to order equipment, etc.

Two points. First, as we said above, even the best deduction doesn't make the purchase free. You're still picking up most of the cost. Second, whether or not you can use the accelerated deduction will depend on your situation. The 15-year recovery of leasehold, restaurant, and retail improvements will benefit all businesses who can qualify. But a 100% first-year recovery of equipment or the use of the Section 179 expense option won't provide much in tax benefits if you expect to incur losses for the next few years or expect to be in a low tax bracket for some time. And you don't want to drop into a much lower than normal bracket this year only to be in a higher than normal one later because of the accelerated deduction. In the latter cases there's no need to rush to make a year-end purchase.

The bonus depreciation rule can be particularly worthwhile for autos and light trucks. If you were planning to make a purchase soon, consider accelerating it into 2011.

Keep in mind that bonus depreciation is only applicable to new property. Section 179 expensing applies to both new and used.

Unless you're always in the top or near the top bracket, work through the numbers to determine which approach is best. And keep in mind that you might be able to generate a net operating loss that can be carried back to recover taxes paid in an earlier year.

Other expiring provisions include:

• Tax credit for research and experimentation expenses (this one is likely to be renewed),
  
• New markets tax credit,
  
• Credit for construction of new energy efficient homes,
  
• Work opportunity tax credit, and
  
• Empowerment zone tax incentives.

Expiring Provisions-Individuals

There are a number of expiring provisions that affect individuals. Generally, the dollar amounts involved are much smaller and the benefits more focused (e.g., the $250 above-the-line deduction for teachers) and there's not a lot of planning you can do. (One exception is the deduction for state and local general sales tax.) Here's a list of ones that could be of interest:

• Credit for certain nonbusiness energy property,
  
• Expansion of adoption credit and adoption assistance programs,
  
• Increased AMT exemption amount,
  
• Deduction for certain expenses of elementary and secondary school teachers,
  
• Deduction for premiums for mortgage insurance,
  
• Deduction for state and local general sales tax,
  
• Special rules for contribution of capital gain real property for conservation purposes,
  
• Above-the-line deduction for qualified tuition and related expenses, and
  
• Special rules for qualified small business stock (Sec. 1202).

--Last Update 12/08/11