Deduction Junction

Plan ahead to minimize next year’s tax bite and maximize your savings.

There’s a five-letter word that sends shivers down the spine of every business owner—TAXES. Since another tax deadline is right around the corner, now is the perfect time to plan ahead and strategize for your 2009 returns.


If you want to put yourself in the best position vis-à-vis your company’s tax obligations, you need to make some decisions. These decisions will be made based on your financial situation and will have to take into account what kind of business you are running. Is it a sole proprietorship, where the money coming into the business is taxed as your personal income? Or a partnership, LLC, S-corp or C-corp with shares, and where everyone, including yourself, takes a fixed salary?


The rules and expectations are different. Under one form, you are personally liable for the business’s taxes. In another, you may not be. Because of this complexity, there is one cautionary measure you should remember from the outset: As with any other business decision that could have serious legal consequences attached to it, you will want to consult with your accountant or attorney before you put your plan in action. The key here is to remain faithful to, at least, the letter of the law.


The Breakdown


The question of which side of the law your taxes are on goes to the heart of what tax planning is. Tax planning is minimizing your tax burden as you find necessary, within the confines of the law. This is as opposed to tax evasion, which is doing the same thing, illegally, and will land you in jail. In other words, the lawful manipulation of credits and debits, depreciation, payments and so on to lower your tax liability or delay tax payments (or push them up if that fits your fiscal needs better) is fine. It is accomplished by changing how and when you do business. Anything else—and here we are talking deception, subterfuge and concealment—is pretty much tax evasion. So, because you don’t want to face a federal indictment, much less time in one of our fine federal prisons, make sure you get clear legal and financial advice.


Lowering Your Burden


There are two ways to lower your tax burden. The first is to use each and every deduction and credit you are entitled to in order to both reduce the portion of your income that is subject to taxation and reduce the tax bill itself. The second method is to lower your tax rate.


Deductions and Credits


Thanks to the complexity of the U.S. Tax Code, there are many deductions that you can take to lower your tax burden. Doing this, however, requires some knowledge of what is deductible and what isn’t. You also need to follow any special rules that may apply to the deduction you’re trying to use. There are, for example, special rules that apply to deductions for meals and entertainment, automobile expenses and business travel. As a business owner, you may find that you can deduct certain benefits that would otherwise be considered nondeductible personal expenses. You can also take advantage of deductions for purchasing health insurance for your employees, making retirement investments or providing certain perks through your business.


Of course, it’s not all good news. There are some kinds of deductions, like the depreciation on the sale of business property, that can have a real impact on your taxes later on, when the IRS seeks to recapture these funds. In these cases, you are merely putting off a tax payment, not eliminating one.


As deductions are taken off your taxable income, credits are subtracted directly from your tax bill, offering a more direct reduction in your tax burden. The usual way of looking at the difference is that a tax credit worth $1 equals $1 off your tax bill. On the other hand, a deduction worth that same dollar is worth the number of cents equal to your tax bracket. Therefore, if you are in the 33 percent tax bracket, your deductions are worth 33 cents on the dollar. It is no surprise, then, that credits are a better way to go than deductions.


Unfortunately, Congress and the IRS have figured this out as well and have limited the use of tax credits to a few situations. These credits are often only for specific industries and usually come with intricate rules that must be followed correctly in order to claim them. While some credits are straightforward, such as those designed to prevent double taxation, Congress also determined that by offering tax credits, they can manipulate the behavior of businesses eager to lower their taxes, encouraging them to do things that the lawmakers want such as making investments that Congress finds socially beneficial.


Reducing Rates


While there is no real way to reduce your tax rate, there are ways around your tax rate that, with some planning ahead of time, will be to your advantage. It’s all about structure and the way you move your money.


It begins with the legal structure of your business. Is it a corporation, a partnership, or a sole proprietorship? You have to choose the right organization for your business and each of these different forms comes with its own set of tax rules, advantages and disadvantages.


The next thing to consider is the way your transactions are structured. If possible, structuring your payments so they can be classified as capital gains can be very beneficial, especially for non-corporate businesses where the owner pays the business taxes through his personal returns. In this case, he can take advantage of lower tax rates for long-term capital gains.


The final way you can shift things to a lower tax rate is to funnel income from a high tax bracket payer to a lower tax bracket payer. You might do this by hiring your children or by giving one or more of you children part ownership of the business. This means that the net profits are shared among a larger group. If, however, you plan to shift unearned income to a child under 18 years of age, check with your tax professional: The IRS has placed severe limits on this practice.


Manipulating Payments


Sometimes, timing is everything, and while you can’t really delay paying your income tax, there are elements of your tax liability that you can legally delay. It’s usually a good idea to do so. You get to use your money longer and that’s always useful, especially if you need to make improvements or have other big-ticket items to purchase.


This is accomplished by postponing the receipt of income until next year while paying more of your expenses this year. This also works by delaying dividend payments and capital gains, as well as accelerating large purchases, operating expenses and depreciation. By doing this, you may be able to push your taxes to the next quarter or even to the next tax year.


These methods are easiest if you use cash accounting; however, you can do these things under the accrual method as well. It will simply be a little more difficult, since you will have to abide by the rules of accrual accounting. That said, the key things you will have to be sure of is that all of the events fixing the liability for payment of that income are not met by year’s end if you wish to delay income. In other words, if you sell something, you can delay shipping it until the New Year. The reverse is true for accelerating expenses. You need to make sure that all of the events have been completed by year’s end.


There may be a situation in which you want to maximize your income for the current tax year. This means you will wish to accelerate income and postpone your expenses. The most straightforward way of doing this is to delay expense payments while sending out early bills and doing whatever you can to collect them by year’s end.


Know The Red Flags


A tax audit can be one of the most terrifying experiences for a small business owner, much like a long, slow, painful root canal, but without the whimsy. Here are some of the triggers that will guarantee a fraud investigation by the IRS:



  • Claiming fictitious or improper deductions on your return. Examples include excessive travel expenses for a salesman or claiming a large deduction for charity when there is no paperwork to support the claim.

  • Improperly allocating income to a relative who is in a lower tax bracket. One example would be a corporation distributing money to the children of the majority shareholder.

  • Poor accounting. This includes not keeping proper records or differences between the company’s tax returns and its financial statements.

  • Failure to report income. Examples of this include a shop owner failing to report a portion of his sales receipts or a shareholder’s failure to report dividends.


Unfortunately, there is no guaranteed way to prevent a tax audit, but there are many things you can do to reduce the odds of being selected. Do yourself and your business a favor and keep your accounting absolutely aboveboard and make sure, once again, that everything you do is legal. Remember, the old cliché is true: If a potential tax shelter, deduction, credit, etc., sounds too good to be true—it probably is. For more information on your small business taxes, visit irs.gov and toolkit.com. —Charles M. Cooper


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