Small Business Taxes & ManagementTM--Copyright 2010, A/N Group, Inc.
Year-end tax planning this year is particularly challenging. The Bush tax cuts are expiring and without action from Congress, tax rates for individuals next year will be much higher. The Republicans and President Obama have reached a compromise. For an outline of the bill go to Highlights of Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010
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.
This is a particularly tricky year for tax planning. While 2010 may have been a bad year for your business, 2011 may not be much better. If there were ever a year to get professional advice, this is it.
The discussion below assumes your business is on a December 31 fiscal yearend.
Things get more complicated, and there's a chance to save more tax dollars, if you do business as a C (regular) corporation. Unlike an S corporation or a partnership, a C corporation is taxed as a separate entity. Moreover, the first $50,000 of income is taxed at only 15%. The next $25,000 is taxed at 25%; the next $25,000 is taxed at 34%. Taxable income from $100,000 to $335,000 is taxed at 39%. (That's to eliminate the graduated rates on income below $100,000.) You may be able to take advantage of the graduated rates to substantially reduce this year's tax bite. The approach is called 'marginal tax rate analysis' and it's very effective.
Example--Fred Flood is an employee and the sole shareholder of Madison Inc., a C corporation. Based on Fred's best estimates, Madison will have taxable income of $125,000 during 2010. So far this year, Fred has taken only $65,000 in salary. Fred and his wife together have taxable income of $70,000. That puts them at the lower end of the 25% bracket. On the other hand, the last $25,000 of income of Madison will be taxed at 39%. If Fred increases his salary by $25,000 Madison's income will decrease by that amount, saving $9,750 in taxes. His personal income will go up by the same amount, resulting in an additional $6,250 in taxes. The difference, $3,500 ($9,750 reduction in corporate taxes less $6,250 increase in personal taxes), is a permanent tax saving.
You can quickly figure the tax saving by finding the difference between your tax bracket and your corporation's. In this case the difference is 14% (39% less 25%). Multiply that by the income shift and you've got your answer.
It may be advantageous to shift income in the other direction.
Example--Fred is an employee and sole shareholder of Madison. Fred normally takes a small salary during the year but a big bonus in December. That totals $200,000. In addition, he has other sources of income. If he does that this year, Madison will have only $20,000 of income, all taxed at 15%. Meanwhile, Fred's individual marginal tax rate will be 33%. Assume Fred can forego $25,000 of salary. The difference in the tax rates is 18%. Multiply that by $25,000 and the dollar saving is $4,500.
You've got to be careful here. Shift too much income and you'll end up with diminishing returns; the lower tax bracket will rise and the higher bracket will fall. At some point, shifting more income will actually increase taxes.
If you've got carryforward losses from prior years and income in 2010, those losses could offset your income. And if you have a loss for 2010 you can carry that loss back 2, 3, 4, or 5 years to offset profits and claim a refund in those years. Any losses that can't be carried back can be carried forward 20 years. That could be good news for your cash flow, but will mean you'll have to examine a number of scenarios before taking action. (The actual election is made when you file your return.)
There are some other points.
Projecting Your Income
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:
Check with your accountant on these issues. Hopefully, the differences will be slight, and, if so, can be ignored. Annualize your income 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.
S Corporations, Partnerships, etc.
If you do business as an S corporation, partnership, sole proprietorship, etc. the net income (or loss) of the business is passed through to the you and reported on your individual tax return. You want to defer income to next year if you anticipate being in a lower tax bracket. Conversely, you want to accelerate income into 2010 if you think you'll be in a higher bracket next year. (Note, LLCs are generally treated the same as partnerships or, if there is only a single member, treated as a sole proprietorship.)
That's the same objective as with your individual return. However, when planning for a business, you can encounter much wider income swings than if your income is from salary, interest, dividends, etc. A bad year for the business can produce a substantial loss. Under general tax rules a net operating loss can be carried back two years or forward 20. That may be small comfort
Example--You're the sole shareholder of Madison Inc., an S corporation. You anticipate a loss of $100,000 in 2010 and are projecting a profit of $120,000 in 2011. You and your wife have very little other income. At first glance you'd want to accelerate income into 2010 or defer deductions to 2011. But in 2008 Madison had an outstanding year, netting $250,000. You might want to increase your 2010 loss and carry it back to 2008 when you were in a high bracket. An added plus is that you'd get back cash from an earlier year.
There are some special considerations applicable to these entities. Keep these points in mind.
Not only is the net income or loss of the business passed through to the owner, so are certain 'separately stated items'. For example, if a partnership has $1,000 of interest income from bank accounts, that item is passed through and reported as interest income on your personal return. That interest or dividend income will help you use any investment interest expense you have. Capital gains and losses will also be passed through. They should be taken into account in your personal tax planning. Income or losses on real estate rental properties held by the S corporation or partnership is generally treated in the same way as if you owned the property in your own name.
We're assuming in the discussion below that you materially participate in the business. If you don't, the income, but not the losses, can be passed through to you. We can't define material participation in detail here, but you'd better talk to your accountant if you spend less than 500 hours per year in the business. And simply checking the books at the end of the week doesn't qualify. If you don't materially participate, planning is trickier. Losses can be carried forward, but profits can't. You've got to report them currently.
Whether or not you can deduct a loss from an S corporation, partnership, or LLC on your personal return depends on your basis and amount at risk in the business. If you don't have enough basis in the business and want to take the losses this year, contribute equity capital or loan the business money. (Partnerships may have some other options.) On the other hand, if the losses would be better utilized next year (you anticipate being in a much higher bracket), don't increase your basis. This can be a tricky issue. Check with your tax advisor.
Some activities generate adjustments for the alternative minimum tax (AMT). Again, a complex subject. Large depreciation deductions are the most common item to trigger an AMT problem. Farm activities are another one.
Deferring Income--Accelerating Deductions
By now you should have a good idea of which way you're headed. If 2010 is a big year and '11 won't be as good, you want to push income into 2011. If it's a tossup, you should probably still defer income; it'll improve your cash flow by delaying tax payments. Again, don't overdo it. Here are some strategies.
Depreciation. Last-minute, year-end purchases may qualify for a depreciation deduction, but only if the asset is 'placed in service' in 2010. (See our Glossary for a definition.) The purchase of new (not used) equipment in 2010 qualifies for special 50% bonus depreciation. Your total depreciation is the same, you're just able to write off more in the first year, reducing taxes currently and improving cash flow. Unless Congress extends this provision, it expires at the end of 2010.
Note--The bill presently in Congress would provide for 100% bonus depreciation (e.g., you could write off the entire cost in the first year) on new equipment purchase made after September 9, 2010 and December 31, 2011.
Caution--If you buy too much in the last quarter of the year (more than 40% of your purchases for the full year), you'll have to use the mid-quarter convention to compute depreciation on all assets put in service during the year. There's a slight chance you may come out ahead, but more than likely, you total depreciation for the year will be lower. Moreover, you'll have to endure depreciation computations more complex than usual. One approach is to try to keep your purchases below the 40% threshold. See below for another option.
Caution--Buying an expensive auto may not help you out much. The maximum depreciation for the first year is $11,060 (2010 amount, new autos; $23,060 for used ones), no matter how expensive the car is. Depreciation in later years is also limited, $4,800 in year two, $2,950 in year three and $1,775 in the fourth and subsequent years. Slightly higher limits apply to trucks and vans. Vehicles built on a truck chassis that exceed 6,000 pounds gross vehicle weight aren't subject to this rule.
Expense option. The law (Sec. 179) also allows you to expense up to $500,000 (2010 amount) in asset purchases. (That maximum first-year depreciation for luxury cars also applies here.) There's another plus. Any expensed asset doesn't count toward the total assets placed in service under the mid-quarter convention rule discussed above. Thus, if you buy a $15,000 machine in December and elect to expense it under this provision, it's removed from the base. Moreover, any assets that qualify reduce your income dollar for dollar. The assets must generally be tangible personal property. And there are two limitations--one is an income limitation; the other applies if you put more than $2,000,000 (2010) of such property in service during the year.
For 2010 and 2011, property that can be expensed under Section 179 includes qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property. A lower write-off limitation ($250,000) applies to these types of property.
There's more to tax planning here that just purchasing expensive equipment to write off. Timing your purchase carefully can save tax dollars on your individual return.
Accelerate purchases. Purchase office and operating supplies you might need next year, do repairs and maintenance on equipment, get started on that advertising program, etc. Be careful, however. Special rules apply to companies that must capitalize more costs into inventory. Manufacturers are especially vulnerable. And make sure the repairs are really repairs, not capital improvements.
Inventory purchases don't count. They're generally not deductible until the items are sold. (But see below for obsolete inventory.)
If you're on the cash basis, payments made by December 31 are generally deductible. Thus, make sure you pay any bills before the end of the year. Payments made in cash, by credit card, or a check mailed before the end of the year count.
If you're on the accrual basis, the rules become more complex. You may have to show that, by the end of the year, the liability was fixed, and the goods or services were provided. (There's more to this issue, but it's beyond the scope of this article.) You may be able to accelerate the deduction by cutting a check before the end of the year. Additionally, if there's any uncertainty as to the liability (for example, you contract to have a project done, but the price is contingent on a number of factors), firm it up before the end of the year.
Pay bonuses to employees. If it's been a good year, pay bonuses to employees. Be sure to warn them that it may be a one-time event. There are no special tax implications here. The bonuses are just like additional salary.
Expense accounts. Make sure all employees turn in their expense reports on time. If you're on the cash basis, consider an earlier cut off, say December 20, so that the reports can be processed and the checks cut before the end of the year.
Writeoffs. You can write off any undepreciated value of equipment abandoned before the end of the year. In order to claim a loss you have to take some affirmative action. You can sell it for scrap (get a receipt), donate it, or sell it to another business. Leaving it in the corner of the shop won't do.
You can deduct business bad debts that are partially or wholly worthless, but, once again, proof is important. Make a concerted effort to collect the debt before the end of the year. Consider turning collection over to an attorney who specializes in this area. You may have to pay him 25% to 50% of what he recovers, but that's a small price to pay if he collects some cash for you and you get a tax deduction for the remainder.
Inventory writeoffs are trickier, but may produce much more in savings. You've got to be able to show the decrease in value. Not too much trouble if you use the 'lower of cost or market' method and can prove the market prices. But more likely than not, that option is not available. You can show the price is below carrying cost by actual (bona fide) sales within 30 days of the inventory date. Value the inventory at the selling price less costs of disposal. Inventory that may qualify for the writedown includes shopworn, obsolete, out of style, etc. goods. You can also write down the value of unsalable goods. For example, those damaged in processing, returns, etc. Figure the cost of reworking them. Check with your tax advisor on the details here.
Farmers and ranchers. Farmers and ranchers using the cash method can deduct prepaid feed costs in the year of payment if the expenditure is a payment and not a deposit; there's a business purpose for the payment; and deducting the amount doesn't materially distort income. Farmers should keep in mind that they can income average their farm income.
State income taxes. Compute and make any estimated state income taxes before the end of the year.
Charitable contributions. A C corporation can deduct charitable contributions accrued before the end of the year if paid within 2-1/2 months of yearend. The contribution must be authorized by the board of directors and a copy of the minutes must be attached to the tax return. This doesn't apply to other entities.
Related taxpayers. When related taxpayers use different accounting methods, the accrual basis payer is placed on a cash basis with respect to payments that generate income or deductions.
Example--Fred is a 60% shareholder in Madison Inc. Madison is a calendar-year taxpayer and uses the accrual method of accounting. At December 31, 2010 Madison owes Fred $1,200 for interest on a loan he made to the business and $4,000 for 2 months rent on a building Fred owns and rents to the business. Madison doesn't pay the $5,200 until 2011. Madison can't accrue the expenses in 2010; they're only deductible when paid in 2011.
This rule applies to any item that would be income to the recipient. Typical ones include interest, rent, bonuses, nonemployee compensation, etc.
What constitutes a related taxpayer? There's a long list, but the two most important ones are a more than 50% shareholder in a regular corporation or a shareholder (or partner) who owns any interest in an S corporation (or partnership). The constructive stock ownership rules apply. That is, your son, daughter, etc. is deemed to own whatever stock you own.
Personal service corporations. The related taxpayer rule is extended for personal service corporations. They can't deduct payments made to any shareholder/employees before the amounts are includible in the income of the recipient.
Example--Dr. Flood is a 5% shareholder in Madison Healthcare Inc., a regular corporation. At the end of 2010 Madison accrues $12,000 in salary to the doctor. If Madison doesn't pay the doctor before December 31 it can't deduct the amount until it's paid in 2011.
Disabled access. The law contains two special provisions that can help your year-end planning. The first is the disabled access credit. You can take a credit of up to 50% of the amount of any eligible expenditure that enables a small business to comply with the requirements of the Americans with Disabilities Act. For example, removing architectural barriers such as putting in a ramp, widening booths in a restaurant, modifying equipment or devices for disabled workers or customers, etc. The eligible expenditures can't exceed $10,250 for the year.
Second, you can immediately expense, rather than capitalize, costs to remove architectural and transportation barriers to elderly and disabled individuals. Careful. While there's some overlap with the disabled access credit, only expenditures to remove architectural barriers apply here. You can get the maximum benefit by taking the credit on some items and saving the expense election for others. There's an annual limit of $15,000 on these expenses.
There's still time this year to take advantage of both benefits, but you must act quickly.
Incentive stock options. If you've issued incentive stock options to employees and some of them have exercised, but not sold the stock, encourage them to make a disqualifying disposition. By selling the stock early, and before the end of the year, they avoid any alternative minimum tax treatment and the company gets a tax deduction.
Defer income. Cash-basis taxpayers can delay billing customers until it's too late to get the check before next year.
If you're on the accrual basis, deferring income is more difficult. Income is taxable when all events that determine the right to receive the income have occurred and the amount is determined with reasonable certainty. A complete discussion is beyond the scope of this article. However, you can't defer reporting the income by not billing. Delaying shipment of the goods till next year may not work either. Selling goods on consignment (if that's possible) can defer income.
You should also be careful with respect to customer deposits. If you have unrestricted use of the funds and you do not have to repay the amount, a deposit becomes taxable income when received. Similarly, amounts received before services have been provided or goods have been delivered are reportable.
This can quickly become a tricky issue. It gets even more complicated if you want to report an amount for financial statement purposes, but defer it for tax reporting. The ultimate outcome will depend heavily on the facts and circumstances. Best to discuss the details with your tax advisor.
Installment sale. You may be able to defer taxes with an installment sale. That won't work for stock in trade (i.e., inventory items), but can be helpful if you're selling equipment, real estate, etc. Careful. You can't defer recognition of any depreciation recapture. That's all income in the year of sale.
Like-kind exchange. If you need new equipment, trucks, etc. a like-kind exchange will defer any gain on the sale. That includes any depreciation recapture. CAUTION. The equipment must be of the same class. For example, a truck for a truck. You can't trade 5 computers for a truck.
Accelerating Income--Deferring Deductions
If you think you'll be in a higher bracket next year you should weigh accelerating income into 2010. Be careful not to overdo it. Fortunately, this is often easier than deferring income.
Accelerating income. Cash-basis taxpayers can bill customers earlier. Many may want to pay before the end of the year. You might want to offer a discount for early payment.
Accrual-basis taxpayers can make sure income will be included in 2010 by finishing projects, delivering goods or services, or making sure that both the right to receive the income is fixed and the amount is determinable with reasonable accuracy. It should be pretty easy to word a contract or agreement in such a way as to guarantee the amount will be includible. Check with your accountant on the details.
Collapse installment sale. You can make all the unrecognized gain on an installment contract taxable in 2010 by pledging the installment note for a loan or by selling the note. This approach can have substantial costs (e.g., you may have to discount the note), so be sure to weigh all the pros and cons.
Equipment sales. If you got some equipment that's not being used, consider selling it. The sale will generate cash, only some of which will be offset by the tax. In most cases any gain will be ordinary income from depreciation recapture. You could also have a loss. Any loss is generally fully deductible, without the capital loss limitations. (See below for some capital gain/loss strategies for regular corporations.)
Another option is a sale and leaseback. This is usually used just to generate cash, but there's nothing wrong with using it to create taxable income. If the asset is fully depreciated or almost so, you may be able to generate deductions in future years. This option shouldn't be taken lightly. Work through the numbers with your accountant.
Defer depreciation. While you need take no action now, you can reduce your depreciation expense for 2010 by not electing the Sec. 179 expense allowance. The 50% bonus depreciation for 2010 is automatic; you can, however, make an election not to take it. Both elections are made when you file your return.
You can defer any depreciation on new equipment to next year by delaying the purchase of the asset or at least making sure that it doesn't qualify as being placed in service (see the glossary) in 2010.
Delay writeoffs. You may not have to write off obsolete equipment or inventory this year. However, things are trickier for bad debts. You must generally write them off in the year they become worthless.
Defer expenses. You can defer expenses by not making repairs, delaying bonuses, waiting until 2009 to buy office supplies, stretching out some contractual payments, etc.
Casualties. If you suffered a casualty loss in 2010 that was fully reimbursed by insurance, and don't buy qualified replacement property during the applicable replacement period, you'll have to report a gain (or loss) as a result of the casualty.
Example--Your equipment was destroyed by a fire. At the time of the fire the property was worth $250,000, but your adjusted basis in the equipment was only $50,000. You got a check from the insurance company for $250,000. If you buy suitable replacement property you can avoid recognizing the $200,000 gain. However, because of the fire you'll have a $300,000 operating loss for the year. Because of losses in prior years you can't carry the loss back and it could take years to use it up as a carryforward. The best approach here would be to not replace the property. Report the gain. Because of the losses you'll still pay no taxes and can start fresh, using those depreciation deductions in future years when they'll do the most good.
Election to amortize. There are a number of expenses that may be deductible or can be capitalized and amortized over a number of years. In addition, sometimes it's possible to choose an amortization period that's longer than normal. Stretching out a deduction can often be beneficial for a start-up company.
C Corporations have some special problems and planning possibilities. Here's a review of some of the more frequently encountered ones.
Level income. Small corporations may be able to stay in the 15% or 25% bracket year after year by leveling income. If that's possible, try to do so.
Capital gains and losses. Capital gains of a C corporation are generally taxed at ordinary income rates, but no more than 35%. Capital losses can be carried back 3 years and forward 5. After that they're lost. If you have capital losses that may be expiring, try to generate offsetting capital gains.
Net operating losses. Net operating losses (NOLs) can be carried back or forward. See the discussion at the beginning of this article. If you have, or could have, an NOL this year, you may want to increase the loss if the year to which it will be carried was a high tax one. For example, you're usually in the 15% bracket, but in 2008 you were in the 35% bracket.
Paying dividends. You might want to consider paying a dividend out of the corporation. Such a move might reduce the risk of an accumulated earnings or unreasonable compensation issue in the future, or can reduce your accumulated earnings and profits if you're thinking of switching to a S corporation. With the tax rate on dividends for individuals now 15% (0% for those in the 10% or 15% bracket), the tax bite isn't as onerous as it once was. Since the corporation still won't get a deduction, paying a salary or other deductible expense to get cash into the shareholder's pockets generally still makes the most sense. Check with your tax advisor.
Alternative minimum tax. Preference items generated by an S corporation or partnership are passed through to the partners and reported on their individual income tax returns for alternative minimum tax (AMT) purposes. A C corporation files its own AMT, and it can be considerably more complicated. Again, check with your tax advisor.
There are also some special considerations for S corporations. Some of the points below are very technical in nature, but you can achieve considerable tax savings if you're careful. Check with your tax advisor before acting.
Basis problems. You can only deduct losses up to your basis in the S corporation. Unused losses can be carried forward and used later. If you're in a high bracket this year, you might want to consider adding equity capital or making a loan to the corporation to use the losses in 2010. If losses have used up all your equity and debt basis in an S corporation, repayment of debts the corporation owes you will generate taxable income. If you take a distribution from the corporation that exceeds your basis, you can generate a capital gain.
Built-in gains. If your S corporation was previously a C corporation, you may have built-in gains on certain assets (assets acquired while a C corporation). Selling such assets can result in a separate tax. For 2010, the recognition period for such built-in gains is reduced from 7 years. If you'll trip the tax this year, consider holding off till 2011 when the recognition period will be only 5 years (but only for 2011!).
Deferred compensation. New rules apply to accrued vacation and similar deferred compensation transactions. You can accrue such payments at the end of 2010, but they'll only be deductible in 2010 if actually paid within 2-1/2 months of yearend. A note, letter of credit, etc. won't work. And this will only work for unrelated employees.
Basis problems. The rules generally follow S corporations (see above) but you can also include amounts for which you, as a partner, are personally at risk. That means loans of the partnership for which you are liable. But that cuts both ways. An increase in such loans increases your amount at risk; a reduction in such loans decreases your amount at risk. Check your status before the end of the year.
December 31 deadline. It's important not only for deductions but also for capital expenditures. If the property is not "placed in service" by December 31, you can't take depreciation, Section 179, etc. until next year. If you've got a project that's nearing completion, try to accelerate the process if you want it to count for this year. Don't miss your chance because you couldn't get a certificate of occupancy, etc.
Deferral of discharge of indebtedness. If you buy back a loan for less than the face amount, your business will have income from discharge of indebtedness (DOI; also know as cancellation of debt income). A special rule applies for debt discharged before January 1, 2011 where you can include the amount in income over a 5-year period. Reconsider Entity Choice
While you're doing your year-end planning you should also take the time to reevaluate your choice of entity. If you do business as a sole proprietor you might want to incorporate or form an LLC. If you operate as a C corporation, you might want to consider electing S status. Yearend is a particularly convenient time to make the switch. Take the time to go through all of your options. IMPORTANT. This is not a decision to be made lightly. Consult your tax advisor.
Copyright 2009-2010 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536
--Last Update 12/13/10