Tax-Saving Tips

Tax-Planning Decisions

Some deductions are under your control because you can decide whether to incur the expenditure. Also, sometimes you are permitted to make tax elections on when to report income or when to claim write-offs. Here are some pointers that can help you minimize your income and maximize your deductions. Or, you can follow the reverse strategy if you already have losses for the year and want to accelerate income to offset those losses (and defer deductions).

• Cash-basis businesses. If you account for your expenses and income on a cash basis, you can influence when you receive income and claim deductions for year-end items. For example, you can delay billing out for services or merchandise so that payment will be received in the following year. In deferring income for services or goods sold, do not delay billing so that collection may be in jeopardy. Also factor in your tax bracket for this year and the bracket you expect to be in next year. If you will be in a higher tax bracket next year because your income will be greater or because of tax law changes, you may not want to defer income. You may prefer to bill and collect as soon as possible to report the income in the lower-tax year.
  On the flip side, you can accelerate deductions by paying outstanding bills and stocking up on supplies. Again, determine whether accelerating deductions makes sense for you.
  However, in accelerating deductions, do not prepay expenses that relate to items extending beyond 1 year. For example, if you pay a 3-year subscription to a trade magazine, you can deduct only the portion of the subscription (one-third) that relates to the current year; the balance is deductible in future years as allocated.
• Accrual method businesses. The board of directors of an accrual-basis C corporation can authorize a charitable contribution and make note of it in the corporate minutes. A current deduction can be claimed even if the contribution is paid after the end of the year (as long as it is paid no later than 2½ months after the close of the year). Charitable contributions are discussed in Chapter 22.
  Similarly, accrual method businesses can accrue bonuses and other payments to employees in the current year that are paid within 2½ months of the close of the year. However, this rule does not extend to payments to S corporation owner-employees—payments are deductible only when received by the owner-employees.
• Owner participation. If you own a business, be sure that your level of participation is sufficient to allow you to deduct all your losses under the passive loss limitation rules. Increase your level of participation and keep records of how and when you participated in the business. Passive loss rules and the various participation tests under these rules are discussed in Chapter 4.
• Increase basis to fully utilize losses. If you are an owner in a pass-through entity, your share of losses generally is deductible only to the extent of your basis in the business. Explore ways in which to increase your basis so that the losses can be fully utilized. For example, if you are an S corporation shareholder, you can increase basis by lending funds to your business. Alternatively, you can work with the corporation’s lenders to restructure debt, making you primarily liable for the amount borrowed (which you then lend to the corporation and increase basis). Basis rules and their impact on deducting losses are discussed in Chapter 4.
• Minimize FICA. Owners who work for their corporations may be able to extract distributions on a FICA-free basis by arranging loans or rentals to the business and taking payments in the form of interest or rents. Of course, these arrangements must be bona fide. However, S corporation shareholders who perform substantial services for their corporation should not erroneously characterize compensation as dividends.
• Review qualified plan selection. If you are self-employed and use an IRA, SEP, SIMPLE, or other qualified plan to save for retirement, review your choice of plan annually to see if it optimizes your benefits while keeping costs down.
  Similarly, corporations should review existing plans to see whether terminations or other courses of action are warranted as cost-cutting measures. If you want to terminate 1 plan and begin another, do not do so without consulting a pension expert. You must be sure that your old plan is in full compliance with the tax laws—including recent changes—before it is terminated.
• Carry medical coverage for yourself and employees. Buy the kind of coverage you can afford. The business picks up the expense for your personal insurance protection. Even if you cannot receive this benefit on a tax-free basis (if, for example, you are a partner or S corporation shareholder who must include business-paid insurance in your income), you can deduct 100% of the coverage on your individual return.
  You can reduce the cost of coverage to the business by buying a high-deductible plan that allows employees to contribute to medical savings accounts on a tax-deductible basis. Alternatively, you can make deductible contributions to Health Savings Accounts (HSAs) on behalf of your employees. You can shift most of the cost of coverage to employees by adopting a premium-only cafeteria plan.
  If you have a C corporation and are a shareholder-employee, you can institute a medical reimbursement plan to cover out-of-pocket medical costs not otherwise covered by insurance (such as dental expenses, eye care, or prescription drugs). Medical coverage strategies are discussed in Chapter 19.
  If you pay more than half the premiums for your employees and qualify as a small employer, you can claim a tax credit for a percentage of your payments.
• Institute other employee benefit plans. If you have a C corporation that is profitable and you are a shareholder-employee, you may be able to turn your nondeductible personal expenses into deductible business expenses. For example, you can have the corporation institute a group term life insurance plan for employees and obtain tax-free coverage up to $50,000. Of course, in weighing the advantages and disadvantages of employee benefit plans, be sure to consider the cost of covering rank-and-file employees, since most benefit plans have strict nondiscrimination rules. Also, take into account the fact that employer-paid educational assistance and adoption plans cannot give more than 5% of benefits to shareholders owning more than 5% of the stock, usually making such plans undesirable for such closely held corporations. Employee benefits are discussed in Chapter 7.
• Reimbursement arrangements. If your company reimburses you for travel and entertainment costs, be sure that the arrangement is treated as an accountable plan. This will ensure that not only does the company save on employment taxes but also that you are not taxed on reimbursements, since your offsetting deductions would be subject to the 2%-of-AGI rule. With an accountable plan, the company deducts the expenses and no income is reported to you. Reimbursement arrangements are discussed in Chapter 8.
• Abandonment versus selling of property. If you have property that simply is of no value to the business, you may want to abandon it rather than sell it for a nominal amount. This will allow the business to take an ordinary loss deduction rather than a capital loss on a sale. A sale of Section 1231 property may result in a capital or ordinary loss, depending on other Section 1231 transactions for the current year and prior Section 1231 losses. Abandonment of property and Section 1231 property are discussed in Chapter 6.
• Disaster losses. If you suffer a disaster loss to business property in an area declared by the president to be eligible for federal disaster assistance, consider claiming the deduction on a return for the year preceding the year of the loss if this will give you needed cash flow or result in a greater benefit from the deduction. Disaster losses are discussed in Chapter 17.
• Review the business structure. Changes in the business climate, in business goals, tax laws, and state laws may warrant a change in the form of business organization. For example, your business may start as a sole proprietorship; later you may want to incorporate in order to take advantage of certain employee benefit plans. Review the options that will afford tax reduction and other benefits. Business organization is discussed in Chapter 1.
• Do year-end planning. Businesses have an opportunity to save on taxes with year-end planning. Well-timed deductions may prove advantageous. Begin year-end planning well before the end of the year in order to have time to implement your decisions.
• Stay abreast of tax law changes. New opportunities are continually being created—through Congressional action, court decisions, and IRS rulings. You need to know what these changes are in order to take advantage of them. Download a free Supplement to this book (available in February 2013) on tax developments affecting small businesses from www.jklasser.com and www.barbaraweltman.com.

Post-Year Tax Elections to Cut Your Tax Bill

Even though the tax year is over, there are still certain decisions that you can make after the year has ended to favorably impact your tax liability. Here are some elections and actions that can be helpful when you file your tax return for the current year:

Take optimum write-offs for business equipment purchase.

When the business can benefit from a larger deduction, instead of depreciating the cost of equipment over the life of the property, consider electing first-year expensing. Alternatively, when the business cannot benefit from a current depreciation deduction because it does not have sufficient income to offset the deduction, consider electing alternative depreciation to spread deductions over future years. Time business equipment purchases carefully in view of the mid-quarter convention. Depreciation and expensing are discussed in Chapter 14.

Elect to forgo a net operating loss carryback.

If the business has an NOL in 2012, it can generally carry the loss back 2 years (3 years for small business disaster losses; 5 years for farmers and ranchers; 10 years for product liability) and forward for 20 years. Alternatively, it can elect to forgo the carryback and simply carry the loss forward. Where a corporation was in a low tax bracket in prior years but is in a higher tax bracket now (and expects to remain in a high bracket in the future), it may be advisable to elect to forgo the carryback. If the business simply does not have any prior income to offset by an NOL, do not make an election; simply carry the loss forward. By not making the election, you preserve the right to carry back the NOL if the IRS subsequently audits an earlier return and income results. Net operating losses are discussed in Chapter 4.

Installment sale.

If you sold property on an installment basis where at least 1 payment is due after the year of sale, you report the gain over the period in which payments are made. However, you can opt to report all of the gain in the year of sale, regardless of when payments are received. This is done simply by reporting the full amount of gain on the 2012 return. Reporting the full gain may be advisable if you have losses in the year of sale to offset the gains. It may also make sense if you expect to be in a higher tax bracket (the capital gains rate may increase after 2013) when additional installment payments will be received.

Real estate professionals.

If you own multiple rental properties that produce a net loss, you can escape the passive activity loss limitation imposed on investors by aggregating the properties to qualify as a real estate professional. To do this, you must attach an election to your return. Without the election, a reported net loss may be disallowed.

SEP contribution.

If 2012 is a profitable year but you don’t have a qualified retirement plan for your business, it’s not too late to create and fund one. You have until the extended due date of the return to set up a SEP and add the deductible contribution for 2012.

Track Carryovers

You may have tax write-offs that you are unable to use because of a dollar, a percentage, or some other limit. Be sure to keep track of the carryovers so you can use them in future years to the extent allowed. Here are some common carryovers to keep records on:

Capital losses.

Unused capital losses for individuals have an unlimited carryforward. Unused capital losses of C corporations have a 5-year carryover limit.

Charitable contribution carryover

If charitable contributions are limited because of adjusted gross income (AGI) or taxable income, excess amounts can be carried forward for up to 5 years (15 years for contributions of conservation easements).

General business credit carryover.

If you have any unused general business credit, it can be carried forward for up to 20 years.

Home office deduction carryover.

If your home office deduction in 2012 is limited because of your gross income from the home office activity, the excess deduction can be used on the 2013 return to the extent there is sufficient gross income from the home office activity. You do not have to be in the same home office in the carryover year in order to use the carryover. There is no time limit on the use of a home office deduction carryover.

Investment interest

Unused investment interest by individuals has an unlimited carryover period. Investment interest may arise, for example, on borrowing to purchase stock in your incorporated business.

Net operating loss carryover.

If you have a net operating loss (NOL) carryover that has not been used up, carry it forward for up to 20 years. The NOL is reported as a negative figure on the “other income” line on Form 1040.

Audit-Proofing Your Return

It is impossible to completely audit-proof your return. However, you can take steps to minimize your exposure.

Perhaps the number 1 audit trigger for small business is improper classification of workers. Small business owners may treat workers as independent contractors when they should be treated as employees. If the IRS successfully reclassifies workers as employees, you could owe back employment taxes, interest, and penalties as well as risk loss of qualified status for your retirement plan. In other words, the monetary risks of misclassification are substantial.

You can rely on a safe harbor to avoid misclassification. You need to show that it is an industry practice to treat such workers as independent contractors. All company practices should be consistent.

• Contract terminology in any agreements with these workers should reflect independent contractor status.
• Form 1099-MISC should be issued each year to all your independent contractors.
• Treat all workers on a consistent basis every year (independent contractors should remain independent contractors).
• Treat all workers with similar responsibilities on a consistent basis (all workers who handle a particular job should be treated either as employees or independent contractors, depending on the circumstances).

Many audit problems arise in connection with deductions. Your goal should be to claim all the deductions to which you are entitled in order to minimize your business income. At the same time, you want to audit-proof your return to avoid confrontations with the IRS. The following are some tips you can use to ensure that your write-offs will be allowed.

• Report business income. While there is an underground economy operating strictly for cash, do not join these ranks. The failure to report income can result in criminal charges punishable by fines and jail time. The IRS is becoming increasingly sophisticated about discerning unreported income. It has developed audit guides for various industries to enable its auditors to detect unreported income. For example, by examining the amount of flour ordered by a pizzeria, the IRS can determine how many pizzas should have been sold—the failure to fall within reasonable parameters can lead to charges of failing to report income.
• Keep good records. You need proof to back up your deductions, such as when the expense was paid or incurred, the amount of the expense, and why you think it is deductible. If you develop good recordkeeping practices, you will automatically be assured of the necessary evidence to support your deductions. For example, if you want to claim deductions for travel and entertainment expenses, you must have certain proof of expenditures. Using a computer to keep your books and records can simplify both recordkeeping requirements and tax return preparation. Recordkeeping is explained in detail in Chapter 3.
• Formalize agreements between corporations and shareholders. If loans are made to or from shareholders, be sure that the interest rate, terms of repayment, and other particulars of the loans are written down. Have the note signed by all of the parties. Formal agreements should also be made if property is leased by a shareholder to the corporation. In addition to promissory notes, contracts, or other agreements between the parties, it is a good idea to put any agreements into the minutes of the corporation.
• Be careful when claiming deductions and credits. Make sure you meet eligibility requirements before taking write-offs. Be aware that the IRS may flag returns that claim excessive deductions. Some tax professionals advise that you keep deductible expenses under 52% of gross income on Schedule C (50% on Schedule F) and suggest that deductions over 67% of income on Schedule C (or 71% on Schedule F) are likely to attract IRS attention. These numbers are only guidelines; claim all deductions to which you are entitled. Even if the IRS examines your return, you can prove entitlement to your write-offs.
• Supply all necessary information. In completing business returns, be sure to fill out all forms and schedules required. Also include all required information for claiming certain deductions. For example, if you have a bad debt, you cannot simply deduct the loss. You must attach a statement to the return detailing the nature and extent of the bad debt.
• Review the IRS audit guide for your industry (if such a guide has been released). This guide is used by IRS personnel to review returns of businesses within an industry and thus provides key information about what the IRS is on the lookout for. Currently there are more than 3 dozen “Audit Technique Guides” available free from the IRS at www.irs.gov.
• Review special information for your industry. The IRS has created industry-based guidance for farming, automotive, entertainment, fishing, gas retail, manufacturing, online auctions, real estate, restaurants, and some links for other industries and professions at www.irs.gov/ (search: “industries professions”).
• Ask for the IRS’s opinion. If you are planning a novel transaction or want to take a deduction about which you are unsure, you may be able to get the IRS’s view on the situation. You may want to request a private letter ruling. If the ruling is favorable, you can be confident of your position. If it is unfavorable, you may be able to modify the situation as the ruling suggests. The IRS charges a user fee for issuing letter rulings (the amounts vary). Before asking for a ruling, though, it may be better to discuss the situation with a tax professional who can research existing precedent and help you prepare a ruling request.
• File on time. If you delay filing, you face not only penalties and interest but also the loss of deductions. For example, you must claim a deduction for contributions to a qualified retirement plan no later than the due date of your return. If you cannot meet the filing deadline, be sure to ask for a filing extension in a timely manner. File the correct form for claiming a filing extension appropriate to your business return. (See Table 24.1.) Also, check state income tax rules for filing extensions that may require a separate form.
• Get good advice. If you are unsure of whether you need to report certain income or whether you are entitled to claim a particular deduction, ask a tax professional. You may have special questions concerning the new tax law.
  Be sure to understand the protection you receive from attorney-client privilege. This privilege also applies to accountants and other federally authorized tax practitioners with respect to federal civil tax matters. But the accountant-client privilege does not apply to mere tax return preparation, state tax matters (unless your state extends similar protection), or other federal nontax matters (such as securities matters).
  Make sure your tax advisor is not taking erroneous deductions or making other false reporting on your behalf. The IRS is cracking down on unscrupulous tax return preparers, and their clients can get caught in an audit web.

TABLE 24.1 Forms for Filing Extensions

• Use the right tax return preparer. The IRS has stepped up its review of tax return preparers, looking for those who take questionable positions on clients’ returns. If you use a preparer who falls in the IRS’s net, your return may be examined.

Planning Ahead

The ever-changing tax laws make it challenging to devise long-term tax strategies for your business. This is especially true at this time when historic budget deficits may result in new tax hikes and the elimination of some tax breaks; some changes could even be made retroactive. Still, it is important to be able to plan ahead so you can decide in which year it may be more favorable to purchase capital equipment, hire new workers, or take other actions that can affect your after-tax profits.

Many of the tax changes that take place each year are the result of cost-of-living adjustments (COLA). Others are the product of phased-in law changes, while still others are IRS devised. In Table 24.2 you will find a listing of some common scheduled adjustments and law changes affecting small businesses over the next several years.

TABLE 24.2 Tax Items and Their Changes