Wednesday, February 27, 2008

Year-End Tax Planning for Small Businesses

What are some best practices for small business owners as the end of the year approaches?

By far, the most effective form of tax planning involves meeting with their CPA at the end of August or beginning of September. At this time, two-thirds of the year is over and the accountant will have sufficient data to run an accurate tax plan. Barring any unforeseen circumstances that transpire during the fourth quarter, there is no reason why an accountant cannot determine what the client’s tax return will look like in March or April. Having this “mock tax return” prepared in August or September will allow the small business owner four months to implement tax savings strategies, implement tax deferral strategies, or pay in any tax due before the end of the year. Additionally, if it appears that the taxpayer is on pace to receive a large tax refund, the tax planning can work in the reverse by allowing the taxpayer to reduce their estimated taxes and/or payroll withholdings in order to increase their current cash flow (no reason to float the government an interest-free loan).

What is the one thing every small business owner must do?

Take a complete, accurate inventory count. For accrual-basis taxpayers, this is required. For cash-basis taxpayers, not only does it make good business sense to keep tabs on your inventory, but your inventory count could indicate that a switch to the accrual-basis of accounting will put your business in a better position in terms of taxes and audit risk.

What is the one thing they must not do?

Lose sight of whether they are a cash-basis or accrual-basis taxpayer. An accrual-basis taxpayer who tries to prepay all their upcoming expenses or hold off on depositing current year income in an effort to reduce current year income will be unpleasantly surprised to find out that they depleted their cash balance for no reason. When reporting on the accrual basis, income is reported when earned, not when deposited and expenses are reported when incurred, not when paid. On the flip-side, a cash basis taxpayer should not assume that they can deduct their December phone bill whether or not they pay it before the year is over. Cash-basis taxpayers report expenses when paid, not when incurred and they report income when received, not when earned.

What is the most common mistake made this time of year?

Many small business owners tie their profit into the amount of money they have in the bank. If they have $100k in the bank, they think their profit is $100k…if they have $0 in the bank, they think their profit is $0 (it’s a mistake that is more common than the average person would think). This leads to irrational end-of-year moves such as taking a large draw or S-Corporation distribution in an effort to reduce the ending bank balance, and in turn reduce their “profit.” Since items like draws and S-Corporation distributions are not tax deductible, they do nothing to decrease the business profitability. In cases where the owner distributes more than is available for distribution, they run the risk of reducing their basis in the business, which could lead to a situation where any losses they incurred cannot be deducted in the current year.

Along the same lines, many small business owners rush to make large equipment purchases at the end of the year in order to reduce their profits. However, certain businesses that do not qualify to expense these equipment purchases under Section 179 bonus depreciation rules, put themselves into a trap. If during any tax year more than 40% of new assets are placed into service during the last three months of the tax year, the Midquarter Convention applies. When using the Midquarter Convention, you generally receive a lower than normal amount of depreciation for the year. If this is the scenario that the small business owner is in, they are better off using those monies to pay expenses rather than purchase equipment.


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