Year-end tax planning can be profitable
The Democrats’ midterm sweep of Congress this month is causing some hand-wringing among small-business owners and others concerned about the possibility of higher taxes.
“People are more anxious about it,” said Steven Hurok, tax director for BDO Seidman in Woodbridge, N.J., noting that many Democrats have not been in favor of extending President Bush’s temporary tax cuts.
Whatever the tax picture may hold, Hurok and other professionals say the possibility of changes makes year-end planning important for small-business owners. The steps that businesses take now can reduce their 2006 federal tax bills and put them in better position to pay less in 2007 and beyond.
Two factors to keep in mind:
* Many strategies must be completed before Dec. 31 to affect 2006 tax levels.
* Tax planning for most small businesses will need to take into consideration the owners’ individual tax situations. That’s because most small businesses are S corporations. An S corporation itself does not pay income tax. Instead, its owners must pay tax on its profit regardless of how much is paid out in dividends.
“An individual owner and the business have to operate with each of their interests as being somewhat integrated,” said Kevin Roach, a partner in the Los Angeles office of PricewaterhouseCoopers’ private company services group.
When it comes to year-end tax planning, companies and individuals generally strive to defer income until the following year and accelerate deductible expenses by paying them this year. They defer income to delay paying taxes on it as long as possible; deductions are accelerated to allow a taxpayer to enjoy the tax benefit sooner.
For example, companies might send December bills to customers a bit later in the month than normal, with the expectation that the invoices will not be paid until January. A business might also pay January expenses, such as a mortgage payment, before the end of the year.
For each $1,000 of income an S corporation defers, an owner in the 35% top federal tax bracket can delay paying $350 in taxes by one year, according to PricewaterhouseCoopers’ “2007 Guide to Tax and Financial Planning,” published this fall by John Wiley & Sons Inc. Each $1,000 of accelerated deductions also will defer the payment of $350 by owners in that bracket.
There are exceptions. This strategy is typically not appropriate for businesses that use an accrual-basis accounting system, which recognizes income and expenses when they are earned or incurred rather than when they are received or paid.
It also is not usually beneficial for business owners subject to the federal alternative minimum tax. This is a separate method of calculating tax that was originally meant to ensure that the wealthiest taxpayers paid their share. The minimum tax, which affects more taxpayers each year, typically provides less favorable treatment for certain items of income and deductions.
Calculating whether an owner will end up subject to the minimum tax in 2006 is a crucial part of year-end tax planning.
In addition to deferring income and accelerating deductions, most small businesses and their owners can benefit from two other year-end tax strategies: setting up qualified retirement plans and updating succession plans.
With some exceptions, a retirement plan must be set up no later than Dec. 31 for the contributions to be tax deductible for 2006. Funding the plan, though, can be delayed until the company’s extended tax-return date or 9 1/2 months after the plan’s year-end, whichever is earlier.
The end of the year also is a good time to set up or update a succession plan, tax experts say.
First, it’s best to determine from a tax perspective whether it makes sense to give other family members ownership stakes in the company or whether plans to sell the business will require changes in the corporate structure or accounting methods.
“Part of a year-end checkup is to think through where the business is going,” Roach said. “Small-business owners get so caught up in the day-to-day operations of their business” they often overlook the need for succession planning, he said.
Other year-end tax strategies include writing off all or part of a business’ bad debts. A company that can prove it has made reasonable efforts to collect a business debt without success can deduct the unpaid amount. This applies particularly to small businesses that are required to use the accrual basis of accounting, such as those with inventory.
Experts also advise documenting before Dec. 31 the donation or destruction of obsolete inventory to be written off in 2006, which can be deducted from taxable income.
Two overlooked items are the domestic production activity deduction and the Section 179 expense election. Tax expert Hurok acknowledges that taxpayers’ eyes often glaze over at the mention of these two, but they are worth taking if possible.
The domestic production activity deduction, designed to encourage the creation of jobs, allows a company to deduct 3% of the income from a qualified production activity. That includes income from tangible personal property manufactured, produced, grown or extracted in the United States, Hurok said.
Companies that qualify include construction contractors, engineers and architectural services, computer software makers and film companies.
For example, a film for which at least 50% of the production-related compensation occurred in the U.S. would qualify. Of course, there would have to be income from the film before a company could use the deduction.
The deduction is scheduled to increase to 6% in 2007 and 9% in 2010. “It’s going to be more useful,” Hurok said.
The Section 179 deduction is a small-business incentive because the amount of money involved rules out participation by large companies. It allows a company to write off the first $112,000 of capital expenditures in 2006 rather than depreciating the expense over several years. A company has to have income to use the deduction, and once capital expenditures exceed $450,000, the deduction is decreased.
No doubt many small-business owners would like to avoid the subject of taxes, especially during the busy last few weeks of the year. But year-end tax planning is a chance to take advantage of tax-cutting strategies that have to be completed before Dec. 31.
It also gives a small-business owner a heads-up on taxes owed and a head start on 2007 planning. The potential savings are worth the time and money involved.
“Give me two hours of your time and I’ll make it worth your while,” Roach said. “It will pay for itself.”
