CHAPTER 11

Strategizing Year-Round for Tax Savings

While you may focus on taxes during tax season when you know your income tax return for the prior year is due, you should be thinking about taxes throughout the year. The actions you take during the year can favorably impact your tax results at tax time.

Since you're a Schedule C filer, your business and personal tax picture is intertwined. Reducing the business income that's subject to tax can save you taxes on your personal (nonbusiness) income. For example, if you bring down your taxable business income by allowable deductions, you can minimize or avoid high-income limitations on your personal exemptions and itemized deductions as well as the additional Medicare taxes on earned income and net investment income.

In taking actions for tax results, don't do so at the cost of bad business results. Keep in mind that taxes are only one factor in the actions you take. Assess the impact that actions will have on cash flow, productivity, and other business issues. In many cases, as you'll see in this chapter, tax savings align with business and financial advantages.

Tax-Savvy Business Decisions

Actions you take throughout the year can pay off in tax savings on your return. These actions can have effects beyond mere tax savings. They can help protect the financial security of your future, provide current cash flow, or achieve other business objectives. Here are some of the key tax strategies you can use to improve your tax picture. The financial ramifications of some of these strategies are also considered.

Set Up a Qualified Retirement Plan

This not only gives you tax savings, enabling you to shelter your business profits, it also creates a nest-egg for your retirement years.

Usually, you have to sign the paperwork for a qualified retirement plan by December 31 in order to have it be effective for the year. Then you have until the extended due date of your return (October 15) to make contributions for the year in which the plan was set up. However, you can set up and fund an SEP plan up to the extended due date of your return.

Also consider adding IRAs to your tax strategies. They can be used as your sole retirement plan or as a supplement to a qualified retirement plan, depending on your income and how much you can afford to save annually.

From a financial perspective, whether you're just setting up the plan or already have one, the only way to optimize your retirement income from the plan is to stay on top of plan investments. The stock market is volatile but there are investment strategies, such as diversification and asset allocation, that can be used to protect your investments to some extent. You probably want to work with a financial professional or use do-it-yourself education materials that are available from brokerage firms and mutual funds.

Qualified retirement plans and IRAs are discussed in Chapter 8.

Take a Disaster Loss on the Prior Year's Return

If you suffer a disaster loss to business property in an area declared eligible for federal disaster assistance and have not been reimbursed for your loss by insurance or other payment, consider claiming your casualty deduction on the tax return for the prior year. This will give you an immediate tax refund so you can use the money to replace the property or otherwise help your business go on.

From a financial perspective, if you'd had good insurance coverage you wouldn't have needed to take any tax deduction for your disaster loss. You would have been reimbursed by your coverage. Having had such a loss, take the time now to speak with a knowledgeable insurance person who can help you protect yourself in case of a future disaster.

Casualty deductions for disaster losses, as well as SBA loans for disasters, are discussed in Chapter 7.

Stay Up on Tax Developments

The tax rules change all the time as a result of legislation, court decisions, and IRS rulings. Also tax rules expire; some are extended while others are not. If you fail to act on an expiring provision, you may lose an opportunity to save on your taxes.

When tax changes occur during the year, you may have only a limited window of time to act. If you fail to use this window, it may be closed to you by the time you talk with your return preparer at tax time.

Resources to help you stay informed on tax developments impacting your business include:

• BarbaraWeltman.com
• IRS.gov
• JKlasser.com
• Your tax professional

Change Your Business Structure

You may, at some time, outgrow your sole proprietorship status and want to become another type of business entity. The reasons may be tax-motivated; they may be for other business purposes, such as obtaining limited personal liability, or access to equity crowdfunding or other types of investments. Changing your business structure is explained in Chapter 12.

Year-End Planning

When you hit the month of December, as a cash-basis business owner you have considerable latitude on actions that will produce savings on your tax return for the year and even for the year to come. As a general proposition, it is usually beneficial to postpone income and accelerate deductions. This axiom is most helpful when your tax bracket stays about the same from year to year.

However, the strategies of postponing income and accelerating deductions may not work well for you. Your business may not have been profitable year to date, so deferring income would not make sense for you from a tax or cash-flow perspective. Similarly, if you expect your income to increase significantly in years to come, deferring income could trigger additional Medicare taxes in deferral years.

Bottom line: You need to take a multiyear view of your income and deductions so you can plan accordingly. If you are uncertain, work with a tax advisor to craft a year-end tax plan for your situation. The following discussion explains how to defer income and accelerate deductions if you choose to use this tax strategy.

Postponing Income

Why would you want to postpone the receipt of income? You may be thinking that it's always better to get paid as soon as possible. Certainly this is true in some cases, but deferral can produce tax savings if:

• You expect to be in a lower tax bracket in the coming year. Maybe your spouse is retiring and your overall income will drop. Maybe you're giving up wages from a full- or part-time job to concentrate on your business.
• You will be in a lower tax bracket because of cost-of-living adjustments (COLAs). Each year, the IRS adjusts more than two-dozen tax items to account for inflation. Even without any action on your part, you may pay less taxes from these COLAs. For example, if your income remains about the same, COLAs can put you in a lower tax bracket and/or save you money because of increased personal exemption amounts and other increased tax write-offs to which you are entitled.

Assuming you want to postpone income so that it becomes taxable next year, you can do this by delaying your billing until late in the year so that payment will be received next year.

Should you employ this strategy? It depends on your situation. Don't defer income if:

• You need cash flow. If you're short or running short of funds to pay your bills, then getting paid quickly should be your goal.
• There is any concern about collection. If you suspect that your client or customer may have his or her own financial problems, take the money now if you can (remember the adage about a bird in the hand).
• You expect to be in a much higher tax bracket next year. Postponing income may trigger the 0.9% additional Medicare tax on earnings that could have been avoided had you received the income this year.

Accelerating Deductions

The flipside to deferring income is accelerating deductions. This means taking action so that you can claim write-offs this year rather than waiting until next year. Because you are on the cash method of accounting, strategies include the following:

• Pay all of your outstanding payables. You may owe money to your vendors and suppliers. Even though payment isn't due until next year, you can do so before the end of the year.

• Stock up on supplies. Before the end of the year purchase all of the paper, toner, and other supplies you expect to use in the coming year.
• Prepay certain expenses, such as subscriptions, insurance, and rent. However, remember that you cannot deduct all of the prepayment if it relates to items extending beyond one year (see Chapter 7 for details).
• Start a health savings account. If you have a high-deductible health plan (HDHP) in place by December 1, you can make a full year's contribution to a health savings account (HSA) even though you only have the plan for one month (see Chapter 8).
• Buy equipment. If you need a laptop, tablet, or other equipment, you may have been putting off buying because you've been distracted, haven't made a decision on which item to buy, or for other reasons. Don't delay any longer if you expect to be highly profitable this year. Make the purchase early enough to place the item in service (make it available for business use) by December 31. It's not enough to order the item by the end of the year; you must have it ready for use in your business by then.

As a cash-basis business, you can nail down write-offs this year by charging expenses to a major credit card by December 31. You'll receive the bill and pay it next year, but the deductions for these expenses are allowed for the year of making the charges. But this rule doesn't apply to store-issued credit cards, only to American Express, Discover, MasterCard, and Visa.

Post-Year Tax Elections

Even though the year has ended, your opportunities for actions to reduce taxes in that year and, in some cases, years to come, are still in play. These actions take the form of elections you make when you file your tax return. The beauty of these elections is that you can look over the results of your business activities—how profitable you were or how much of a loss you had—before deciding on what do to.

As a general rule, if you are in a low tax bracket this year but expect to be in a higher one for years to come, you might want to forgo current tax write-offs where possible so that you can use them in future years. Because of your higher tax bracket in the future, the write-offs will produce greater tax savings for you then.

However, keep in mind the concept of the time value of money. Having tax savings now, even though it may be smaller than what you could have had in the future, may be just about as valuable to you because of what money is worth to you now versus its worth in the future.

The following discussion covers some of the tax elections to consider.

Optimize Write-offs for Equipment Purchases

If you bought a computer, furniture, equipment, or machinery for your business, you have a number of choices on how to deduct the cost. You can deduct costs up front in many cases, but this may not be the best action from a tax perspective if the write-offs are more valuable to you in future years. Instead you may prefer to spread deductions over future years when the write-offs are more valuable to you by saving you more in taxes at that time. Here's how to take the best advantage of deductions for buying business equipment:

• Don't elect first-year expensing (Section 179 deduction). You don't get this write-off (up to $500,000 in 2013, for example) unless you elect it on Form 4562. By not making the election you allow the cost of the equipment and machinery to be depreciated, in part in the first year as well as over a number of coming years.
• Waive bonus depreciation. This write-off of cost (50% in 2013, for example) is automatic for qualified property, but you don't have to use it. You can opt out and, instead, use regular depreciation.

Waive NOL Carrybacks

If the current year was poor and you have a net operating loss (NOL) in your business, you usually apply that NOL to the two prior years and then carry forward any unused portion of this NOL (NOLs are discussed in Chapter 4). However, you are permitted to waive the carryback (it must be waived for both carryback years). This allows you to apply the NOL to future years (up to 20).

It may be wise to waive the carrybacks if you were in low tax brackets in prior years and expect your future to be so much brighter. Simply carrying forward the NOL will make the write-offs much more valuable.

Use SEPs and IRAs

Usually, you have only until the end of the year to set up a qualified retirement plan. However, if you missed this deadline, you can still set aside money for retirement on a tax-advantaged basis using:

• IRA. This can be set up and funded by April 15. This deadline applies even if you have a filing extension. If you're looking for current tax deductions, then you'll want to use a traditional IRA. If you can afford not to take deductions now for the potential of future tax-free retirement income, then use a Roth IRA. Both of these options are discussed in Chapter 8.
• SEP. As explained earlier in this chapter, you can sign the paperwork and make your contribution by October 15 for the prior year. The contribution limits and other rules for SEPs are discussed in Chapter 8.

Lease Instead of Buy?

There are opportunities to lease what you need for your business instead of buying it. Financially, you'll tie up less capital by leasing and probably be in a better position to budget your costs.

From a tax perspective, leasing may result in larger or at least less complicated deductions. Some items you may consider leasing (or paying by the month) are:

• Software applications. You can buy software and usually deduct the cost of this purchase. Or you can use cloud-based applications that charge a fixed monthly amount. Tax-wise you may come out about even. However, cloud applications enable you to budget for your software needs; buying has an upfront cost but you may not be able to accurately predict when you'll need to buy new versions when old ones become obsolete or are no longer serviced by the software company.
• Vehicles. Lease payments are fully deductible, although leasing an expensive vehicle may trigger imputed income, called an inclusion amount. The inclusion amount each year you lease the vehicle is very modest. In contrast, buying a vehicle, other than a heavy SUV or a non-personal-use vehicle (see Chapter 5), is subject to annual dollar limits on depreciation.
• Business equipment. Medical offices, contractors, and certain other businesses use expensive equipment. Whether it is better to buy or lease depends on your situation.

Don't Overlook Carryovers

Carryovers are write-offs from actions you took in prior years but were not allowed to use at that time because of limitations in the tax law. If you fail to keep track of them, you may forget them and fail to take write-offs you've earned. Fortunately, if you use the same tax preparation software or the same tax return preparer year after year, the carryovers are tracked for you. However, if you make a change, it's up to you to check for carryovers. Here are some key carryovers to look for:

• General business credit carryover. If you have any unused general business credit, it can be carried forward for up to 20 years. The general business credit is discussed in Chapter 9.
• Home office deduction carryover. If your home office deduction from last year or a prior year was limited because of your gross income from the home office activity, the excess deduction can be used now to the extent you have sufficient gross income from the home office activity. You do not have to be in the same home office (you could have moved to a new home) to use the carryover. There is no time limit on the use of the home office deduction carryover.
• Net operating loss carryover. If you had a net operating loss from a prior year that you didn't use up by carrying it back to the two prior years, you can use the unused portion of the NOL this year. If it's not used up this year, you can use if for up to 19 more years (there is a 20-year carryforward).

Audit-Proof Your Return

This is something that's virtually impossible to do. You can be as careful and accurate as possible but still be audited by the IRS. However, you can take steps to minimize your audit exposure and to protect yourself in case you are selected for examination despite your best efforts. Remember that the IRS is looking more carefully at sole proprietors than at other taxpayers (see Chapter 1). So tread lightly and:

• Classify workers correctly. The hottest audit issue is improper classification of workers and the IRS takes every opportunity to look at business returns to see that workers aren't being misclassified as a way to avoid paying employment taxes that would otherwise be owed for employees. Theoretically, if you misclassify workers, the IRS has unlimited time to go back and seek penalties, a result that would be financially disastrous. As a practical matter, it may limit penalties to three years, but even this can cause serious financial harm. Fortunately, you can rely on some safe harbors and IRS programs for relief. These are covered in Chapter 7.
• Report business income. The IRS is well aware of the underground economy operating strictly in cash where income isn't reported. The failure to report income can result not only in penalties and interest for back taxes; it can also produce criminal charges punishable by fines and jail time. Make sure you report all of the income you receive. Keep in mind that the IRS is getting more sophisticated in detecting unreported income. There's another reason for reporting income: Your tax return is the basis for obtaining a mortgage and other financing. Underreporting can prevent you from qualifying for a loan that you are really able to repay.
• Keep good records. This is the only way to disprove an IRS claim that you aren't entitled to the write-offs you've claimed. Pay special attention to recordkeeping requirements for travel and entertainment costs (Chapter 5) and charitable contributions (Chapter 7).
• Observe limitations. While most business expenses can be written off, there are many limitations that curtail current deductions and credits for these expenditures. Don't take more than you're allowed to write off. One of the most common mistakes is deducting all of the cost of meals and entertainment when only 50% is allowable in most cases.
• Supply all required information. IRS computers can detect when information is missing. Be careful to answer all questions on the return and to complete all required forms and schedules.
• File on time. If you can't meet the filing deadline of April 15, just ask for an extension. You'll automatically be able to file a timely return until October 15. Use IRS Form 4868 to request the filing extension (see Chapter 3). There are no statistics to show you are any more likely to be audited if you receive a filing extension, but if you file late (or not at all), your audit chances skyrocket.

Some actions may cause IRS computers to single you out for further scrutiny. This may not lead to a full-blown audit but could trigger a letter (which is technically an audit, too, called a correspondence audit) where the IRS seeks further information or explanation and certainly will cause you some grief or apprehension by its mere receipt, which could have been avoided. These are actions to avoid so you won't call attention to your return:

• Misreporting income that has been reported to you. Make sure that the information on your 1099s is properly included on your tax return. What happens if the information on a 1099 is wrong or reports income that you didn't receive until the following year? See Chapter 4.
• Claiming a lot of deductions relative to your income. While you're entitled to take all of the deductions for which you qualify, recognize that if the percentage of these deductions is high compared with your income, the IRS may want answers. There is no hard-and-fast rule on what the “safe” percentage is. A number of years ago, one government report indicated that keeping deductible expenses on Schedule C to less than 52% of income was safe and that claiming deductions over 67% was likely to draw IRS attention. This isn't meant as a guideline, but as a heads-up to you. Certainly claim all the deductions you're entitled to (and have proof to support), with the understanding that it could lead to further inquiry.

It had been commonly thought that taking a home office deduction was an automatic audit red flag. While the IRS never confirmed this, the belief persisted. Today, however, there are now so many legitimate home-based businesses that it defies logic to think the IRS is auditing every home-based business. What's more, the IRS has created a simplified home office deduction because it recognizes that there are so many home offices and that deducting actual expenses is very time consuming. More details of the home office deduction are in Chapter 6.

When you have any questions about write-offs or other tax actions, work with a knowledgeable tax advisor. Make sure your tax person hasn't been the subject of previous IRS sanctions or other actions that may ultimately call your return into question.

You may want to review the IRS audit guide for your industry if there is one. The IRS has more than three-dozen Audit Technique Guides (ATGs) covering such businesses as architects and landscape architects, art galleries, business consultants, day-care providers, construction industry, ministers, veterinary medicine, and a number of cash businesses.

What's Ahead

Now that you have planning strategies under your belt, it may be time for your business to grow up and move on. This could mean, for example, moving from a home office to commercial space, changing your business structure from a sole proprietorship to a corporation or limited liability company, or selling your business. These topics are covered in the final chapter, which follows.