When It Comes to Getting Business Tax Advantages, It’s All in the Timing

As the old year winds down and you plot business strategy for the new one, make a note to ask your accountant about two tax-planning ideas that can do good things for your bottom line in 2001.

The ideas are as old as the graduated income tax but not nearly as complicated:

* Make money when you are least likely to lose it to taxation.

* Spend it when you are most likely to lose it to taxation.

In accountant-speak, this means if you want to limit what the government takes in income taxes, you must recognize business income and incur business expenses with the tax consequences in mind.

“Tax planning addresses the timing and the methods by which you report income and claim deductions,” said David L. Nadel, whose Encino accounting firm, D.L. Nadel, specializes in tax planning for individuals and small and mid-size businesses.

“The strategies boil down to two things: shifting income into low tax-bracket periods and expenses and credits into high tax-bracket periods.”

Nadel added an important coda to his advice: Whatever strategy you follow, don’t let the tax code rule what you do.

“Sometimes people do things they don’t need to do just for the tax benefit,” he said. “Sound economic decision-making should always take priority over tax planning.”

How do you balance the financial health of your business against the strictures of the tax code? The answer depends on the size and legal structure of your business, Nadel said, and on the accounting method by which you keep track of income and expenses.

Most sole proprietors keep their books on a cash basis, meaning they record income when received and expenses when paid. As this implies, sole proprietors may time income and expenses to suit their tax needs with relative ease--for example, by putting off mailing invoices to their customers or by speeding payment to their suppliers.

The same discretion is available to any cash-basis business--meaning one that maintains no inventory and posts average sales of less than $5 million over three years, he said.

Businesses not meeting those criteria must keep their books on the accrual method, meaning they record income and expenses when incurred, no matter when they actually receive or make payments.

As this distinction makes clear, an accrual-basis business has little leeway in timing income, Nadel said. If such a business contracts to provide, say, $1 million in goods or services, with half due in the last quarter of one year and half in the first quarter of the next, it must recognize half the income in each quarter.

Indeed, the Internal Revenue Service routinely checks into the timing of contracts when auditing the books of such businesses, and it may impose stiff penalties on a business that attempts to get around the letter of the law.

“Sophisticated tax planning avoids illegal strategies,” Nadel said, “and there are so many good legal strategies that it’s not necessary at all to skirt the law.”

But if accrual-basis businesses can’t time their income, they may time their expenses with the tax benefits in mind--for example, by paying bonuses and buying supplies and equipment before the end of the year.

The practice shifts deductible expenses into the current year and reduces taxable income, and it makes sense if you expect your tax bill to be higher this year than next. It can, however, pay off no matter what your expectations if a deduction this year would be more valuable to you than one next year, Nadel said. What’s more, you gain a deduction for the purchase of supplies and equipment even if you use a credit card and pay the bill in the next year.

Most employers see yet another idea with big implications for their tax bills--pensions. Besides thinking of them first and foremost as employee benefit plans, Nadel said they can be an important part of year-end tax planning.

Indeed, pension plans allow employers and employees to shift income from one pocket open to taxation to another shielded from it, with two big advantages:

* The employer gets a deduction against business income equal to the contribution.

* The employee shelters the contribution--along with any earnings it generates while invested--from taxes until retirement.

There are, however, many wrinkles in pension law, and it takes careful planning to make the most of them, Nadel said.

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Next: How a family-run business in Lake Arrowhead does exactly that.

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Recent Financing and Insurance columns are available at https://www.latimes.com/finin. Juan Hovey can be reached at (805) 492-7909 or at jhovey@gte.net.