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It's that time of year again--time for some last-minute strategies to reduce your tax liability and keep cash flow humming in your business. But to reap the benefits of these moves, it's important to act by December 31. Waiting until April of next year means a missed opportunity--and, in all likelihood, a higher bill from the IRS.
Despite all the election year talk about tax cuts, rates for 1996 are unchanged. The top corporate rate, which many companies are required to pay, is 35 percent. For small-business owners who file tax returns as individuals, such as sole proprietors and partners, the top individual tax rate is 39.6 percent.
"Review the Past 11 months of your company's revenue and expenses, and project your tax liability for the year," advises Allan Zachariah, tax director of the Atlanta office for accounting and consulting firm BDO Seidman LLP. Doing such a projection, Zachariah explains, will help determine how to minimize your taxable income.
Small firms typically have a lot of ups and downs from one year to the next. "If you make a lot of money one year and have to pay taxes on all that profit, your business won't have the reserves needed to tide you over in some other year when business may not be as good," says Susan Jacksack, small-business analyst with CCH Inc., a provider of legal, tax and business information in Riverwoods, Illinois.
This year, small-business owners have some new planning considerations and the chance to save more on taxes, thanks to some changes recently enacted by Congress. For example, if you intend to buy equipment for your business, keep in mind that Congress increased the yearly limit on this business deduction to $18,000 effective next year for qualifying equipment placed in service during 1997. The limit will continue to increase incrementally each year until it reaches $25,000 by 2003. (Under the law, this deduction cannot exceed the taxable income derived from your business.)
If you want to purchase equipment before year-end but cash is tight, consider charging it. As long as you place the equipment in service by December 31, you can still take the deduction for 1996 even though you won't start paying for it until next year.
Another key change that affects planning for small firms is a provision in the new Health Insurance Portability and Accountability Act, which allows a limited number of self-employed individuals and employees who work for small businesses to establish medical savings accounts (MSAs) under a four-year pilot program starting next month. Contributions made to these accounts are tax-deductible, earnings on the MSA are tax-deferred, and distributions are tax-free if they are used for qualified expenses.
MSAs are available to companies with 50 or fewer employees as well as self-employed and uninsured individuals. Since only 750,000 individuals (not including the uninsured) nationwide will be allowed to establish MSAs during the four-year experiment, Jacksack recommends entrepreneurs interested in setting up an MSA next year take steps now and contact health insurance companies marketing these plans to get information.
Beyond these recent changes, your aim this year is to recognize income (if your tax bracket is low) or pile on the deductions (if your bracket is higher), advises Jacksack. Another tried-and-true rule, whatever your tax situation, is to defer taxes whenever possible. Says Jacksack, "Taking steps to reduce or defer taxes is a good way to cut business costs without hurting the quality of your product or service."
If your business uses the cash method of accounting, and if you need to defer taxable income into next year, wait until the end of December to mail invoices, suggests Thomas P. Ochsenschlager, a tax partner in the Washington, DC, office of accounting firm Grant Thornton LLP. This way, payments won't be received until early 1997. Under the cash method, income is taxable upon receipt, and expenses are deductible when paid.
To accumulate deductions, think about doing business repairs you've been putting off and stocking up on office supplies. In addition, if you know you're going to be traveling on business in the new year, buy the tickets before the end of 1996. Catch the holiday spirit, and do some shopping for your clients. The IRS lets you take a deduction for business gifts of up to $25 per recipient.
For businesses using the accrual method of accounting, one tax planning step that can work to your advantage is to establish a bonus plan for your employees. Under the accrual method, sales are taxable and expenses are deductible when incurred. By setting up a bonus plan, you can take a deduction this year for the cost of the plan. But you don't have to actually pay the bonuses until next year: By law, you have two and a half months after your year-end to pay the monies to employees, as long as they don't own more than 50 percent of the firm, Ochsenschlager explains.
Both cash and accrual method businesses should take deductions for bad debts. If someone owes your company money you haven't been able to collect, you are entitled to a deduction for the debt amount. Accrual accounting taxpayers may deduct a bad debt in the year in which it becomes partly or totally worthless. To substantiate your deduction, keep records showing when the debt became uncollectible.
Another way to reduce taxable income is to make a charitable donation before the end of the year and take a deduction for it. A corporation can donate up to 10 percent of its net profits, says Jacksack. If you give away $250 or more, a canceled check is no longer considered adequate documentation, so make sure the charity provides you with written substantiation of the contribution amount or a description of the property given.
If you are a self-employed individual paying taxes quarterly, be sure to review your estimated tax payments to make sure you have paid a sufficient amount and aren't flirting with a penalty for underpayment. The law requires estimated tax payments to add up to at least 100 percent of last year's tax or 90 percent of the tax you will owe in 1996 (whichever will help you to avoid a penalty). If your prior year's adjusted gross income is more than $150,000, you are required to pay 110 percent of last year's tax bill.
A major tax planning step that is effective for both cash and accrual method companies is to defer as much income over the long haul as possible. The best way to accomplish this is through qualified retirement plans such as Keogh plans, 401(k) plans and Individual Retirement Accounts.
Keogh plans are the primary retirement savings vehicle for self-employed individuals. Remember, though, that contributions to a Keogh plan are tax-deductible only as long as they are paid by the due date for filing the return for the year. But the Keogh plan must be set up by December 31 if you want contributions to be deductible for the 1996 tax year. The maximum amount you can contribute to a Keogh in 1996 is $22,500.
With a 401(k) plan, you don't pay taxes on the portion of your salary you set aside in the plan. This year, the IRS allows you to contribute up to $9,500 to a 401(k) plan.
Whichever type of retirement plan you choose, you'll gain a number of important tax benefits. Not only do they help reduce taxes owed, but contributions to retirement plans grow tax-free until they are withdrawn.
Income shifting is another way to help lower your taxable income, says Bruce Graber, a tax manager with the New York City office of accounting firm Coopers & Lybrand LLP. Income shifting involves "transferring income-producing assets to someone in a lower tax bracket," says Graber. The key is to make sure the person to whom you are transferring the assets is age 14 or older. Income shifted to a child under 14 is taxed at the parent's top marginal rate after the first $1,200 of income, so you won't reduce your tax bill much if you transfer funds to your young children.
Under current law, an individual can give up to $10,000 annually per person (or $20,000, if your spouse joins in the gift) to any number of individuals and pay no gift tax on those transfers.
There are plenty of tax breaks available, so don't put off implementing them until it's too late, Jacksack advises. Trimming and postponing taxes as much as possible should be your objective every year. Don't let 1996 be any different.
BDO Seidman LLP, 285 Peachtree Ctr. Ave., #800, Atlanta, GA 30303, (404) 688-6841, ext. 3247;
CCH Inc., (847) 267-2484, firstname.lastname@example.org;
Coopers & Lybrand LLP, 1301 Ave. of the Americas, New York, NY 10019, (212) 259-1000;
Grant Thornton LLP, http://www.gt.com.