Although the end of the year is quickly approaching, there's still time to scrutinize your tax situation and zero in on strategies to help trim your 1997 tax liability. Year-end planning is especially critical this year because of the new Taxpayer Relief Act of 1997. The law contains more than 800 changes and nearly 300 new provisions to the IRS code, according to CCH Inc., a provider of legal, tax and business information in Riverwoods, Illinois.
Except for a cut in the capital gains tax from 28 percent to 20 percent, however, most of the new tax law's changes won't affect your 1997 return. But they will impact the tax moves you make in the new year.
As far as your 1997 tax return is concerned, you have until December 31 to put your strategies in place. "Too often, when April rolls around, taxpayers look back and say `I have all this income, and I wish I had written off more expenses last year,' " says Susan Jacksack, a small-business analyst with CCH. "But at that point, it's too late to do much about it."
Play The Gain
To reap the rewards of a lower capital gains tax cut, you must have sold assets, such as stock or a business, on or after May 7, 1997. Under the new law, the maximum capital gains tax rate of 20 percent applies to the sale of assets you hold for more than a year and sold between May 7, 1997, and July 28, 1997. For sales taking place after July 28, the new law requires you to hold the assets for more than 18 months to qualify for the 20 percent capital gains rate. (The law also sets up a "midterm gains" category so if you sold assets after July 28, 1997, and hold them for more than one year--but not more than 18 months--you'll still pay a maximum rate of 28 percent.) For taxpayers in the 15 percent federal income tax bracket, the capital gains rate is even lower: 10 percent.
The rate on short-term capital gains has not changed. Any profits on an asset you've held for 12 months or less are taxed at ordinary income tax rates of up to 39.6 percent. Before the year ends, "match up your capital gains against your losses," says Jacksack. This move will let you save even more on capital gains taxes since your losses will offset any gains you've realized.
Making The Cuts
Your best bet for 1997 is to follow what are considered tried-and-true strategies to trim your tax liability.
For taxpayers using the cash method of accounting, "see where you are at year-end so you can accelerate your expenses for this year and push income into the new year," says Robert Webb, director of the tax department for the Denver accounting firm Gelfond Hochstadt Pangburn & Co. Your aim is to reduce or defer taxes until 1998 or beyond. Under the cash method, income is taxable upon receipt, and expenses are deductible when paid.
One way to move income into the new year is to mail your invoices at the end of December so you don't receive payment for your products or services until next year. To boost your expenses, consider buying any needed equipment before year-end. The yearly limit on the deduction for qualifying equipment placed in service in 1997 is $18,000--$500 more than in 1996. Keep in mind, the deduction can't exceed the taxable income derived from your business. You can also accumulate expenses by stocking up on business supplies, having business repairs done and giving holiday gifts to clients. The deduction limit for client gifts is $25 per recipient.
Taxpayers who use the accrual method of accounting can also reduce their taxes. "While it's more difficult to manage the bottom line for accrual taxpayers, there are still tax-saving steps to follow," asserts Mark Dow, a tax partner in the St. Louis office of Coopers & Lybrand LLP. With the accrual method, sales are taxable and expenses deductible when incurred.
Accrual taxpayers may want to establish an employee bonus plan. This allows a business owner to take a deduction this year for the cost of the plan, but the bonuses don't have to be paid until 1998. Under the law, you have two and a half months after your fiscal year-end to pay the bonuses to employees, as long as they don't own more than 50 percent of the firm. If they do, you must pay the bonuses by year-end to get the deduction.
Both cash- and accrual-method business owners in search of deductions should consider making a charitable donation by December 31. A corporation can deduct up to 10 percent of its net taxable income for charitable contributions. Be sure the charity provides you with written substantiation of the amount contributed if it totals $250 or more.
If you changed your residence this year because of your business, you may be able to deduct certain moving expenses if you satisfy the IRS distance and time requirements. Deductible expenses include the costs of moving household goods and traveling to your new residence. Pre-move house-hunting expenses or temporary living expenses don't qualify.
Also, if you spent time this year looking for a business to purchase but did not purchase one, the expenses you incurred during the search are deductible. If you did purchase one, you cannot deduct search expenses, but you may deduct start-up expenses over the course of at least 60 months.
Another deduction relates to bad debts. If you're unable to collect money from a customer, you can claim a deduction for that amount if you've paid taxes on it. The IRS allows accrual taxpayers to deduct a bad debt in the year that it becomes partially or totally worthless. To prove your deduction, you'll need records showing when your collection efforts ceased and the debt was written off.
If you're self-employed, monitor your estimated taxes, says Dow. "If you are falling short in terms of required estimated tax payments, then increase your withholding by year-end," he says. 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 1997 (whichever will help you avoid a penalty). Note that a special rule applies to individuals with adjusted gross income (AGI) for the previous year in excess of $150,000. To qualify for the prior year's safe harbor, these high-income individuals must pay 110 percent of the prior year's tax instead of 100 percent.
In looking for tax savings, don't neglect your retirement program. Putting money into a Keogh, 401(k) or an Individual Retirement Account (IRA) is one of the best ways business owners can lower their taxable income. Money contributed to a retirement plan is generally tax-deductible and grows tax-free until withdrawn.
Keogh plans, designed for self-employed individuals, must be established by December 31 for contributions to be deductible in 1997. The maximum amount you can contribute varies depending on the type of Keogh you set up. With a 401(k) plan, you can set aside a tax-free portion of your salary each year. The maximum limit this year is $9,500.
The new tax law has created several new types of IRAs, making these investments more attractive than they were in the past. One of the most significant new retirement accounts is the Roth IRA, named after its principal sponsor, Sen. William V. Roth Jr. (R-DE). Roth IRAs will not be available until next year, however. While contributions made to these IRAs will not be tax-deductible, the funds can grow tax-free. You'll also be able to withdraw money from this IRA without paying taxes if certain qualifications are met.
Contributions of up to $2,000 per year ($4,000 if filing jointly) will be allowed for all IRAs. However, the ability to make the full contribution "phases out" if your AGI is between $95,000 and $110,000 for single filers and between $150,000 and $160,000 for joint returns. The lower your AGI within these ranges, the greater your maximum allowable contribution. If you earn more than $110,000 (single) or $160,000 (joint), you cannot contribute at all.
A number of other changes resulting from the new tax law will also impact small-business owners. While the provisions won't affect your 1997 return, keep them in mind as you look ahead to the new year and beyond.
The new law improves the health insurance deduction for self-employed individuals, for example. Under prior law, the deductible percentage was scheduled to move up from 40 percent in 1997 to 80 percent by 2006. Under the new law, the deduction is raised to 100 percent over several years. While the deduction remains at 40 percent of health insurance expenses in 1997, it will increase to 45 percent in 1998 and 1999. In 2000 and 2001, it will rise to 50 percent. It will reach 60 percent by 2002 and then jump to 80 percent from 2003 through 2005. In 2006, it will be 90 percent and will finally reach 100 percent in 2007.
The 20 percent alternative minimum tax for small companies is repealed for tax years starting January 1, 1998. A small company is defined as one that had average annual gross receipts of less than $5 million for a three-year period beginning January 1, 1995.
Under the new law, the tax treatment of home offices is liberalized starting in 1999. According to the change, business owners who keep records, schedule appointments and perform other such activities from a home office qualify for a deduction as long as they don't have any other fixed place of business where they do a large amount of administrative work. The change effectively overturns a Supreme Court decision that determined no deduction could be taken if the home office was used merely for administrative or management functions.
The new law also gradually increases the amount that is exempt from gift and estate taxes to $1 million by 2006. Currently, each taxpayer is entitled to make a combination of lifetime gifts and estate transfers of as much as $600,000 without paying gift or estate taxes. Next year, the amount begins to increase, rising to $625,000. In light of these recent changes, it's a good idea to carefully review your will or trust to determine if any changes need to be made, says Jacksack.
Starting in 1998, the new law limits to two years a business owner's ability to carry back net operating losses and extends the carry-forward period to 20 years. Under the old law, a business owner could carry losses back three years and forward 15. If you find yourself in this situation, you will have to utilize these losses within a shorter carry-back period, says Dow.
Limited partners can breathe a sigh of relief, thanks to the new tax law. An IRS regulation that would have charged self-employment taxes on the business profits of thousands of limited partners was given a temporary moratorium under the Taxpayer Relief Act. Though at this point the change is not permanent, supporters of the moratorium hope it will raise awareness among small-business owners of the dangers of the "stealth" tax and act as a call to action to make the moratorium permanent. (For more information, see "Tax Talk," September.)
While tax-planning should be a year-long endeavor, many taxpayers wait until December's final days to come up with strategies to save on their tax bills. If you find yourself in that situation, don't despair, says Webb. You still have time to make some tax-saving moves for 1997 and get ready for next year, when, thanks to the Taxpayer Relief Act, there will be new ways to trim your federal tax bill.
CCH Inc., http://www.toolkit.cch.com
Coopers & Lybrand LLP, 1 Metropolitan Sq., #2200, St. Louis, MO 63102, firstname.lastname@example.org
Gelfond Hochstadt Pangburn & Co., (303) 831-5038, email@example.com
Wilson, Sonsini, Goodrich & Rosati, 650 Page Mill Rd., Palo Alto, CA 94301-1050, (415) 493-9300