When planning for treatment of tax expenses, consider these accounting methods and choices of accounting periods for controlling the amount of tax liabilities that may be incurred.
Deferred Installment Sales
A company may be able to defer income if it makes sales of personal property on an installment sales basis. An installment sale is defined for tax purposes as requiring two or more payments. Therefore, a company that sells personal property on a credit basis requiring only one payment in a certain period would not qualify for use of this deferral method. This deferral is permitted even if the overall method of accounting used is an accrual method. The company realizes a cash flow improvement by not having to prepay the tax on profits until they have been realized in cash payments. If you sell on installment sales contracts, do not fail to utilize this deferral method.
Another consideration is the company’s credit policy. In establishing a credit policy, the firm should consider the tax advantages of certain installment sales. This deferral gets particularly beneficial if the company is experiencing an increase in accounts receivable. Typically, big-ticket-item retail stores, such as furniture and appliance dealers, can take significant advantage of installment sales deferment. By looking to the installment sales method of tax deferments, the company may not only have the benefit of deferring income taxes, but it may also provide an opportunity to charge slow-paying customers interest in consideration for extended payment terms.
Bad Debt Method
One company may choose to recognize its bad debts for tax purposes at the point where these debts actually become known to be worthless. Another company may set up a reserve and obtain a tax deduction based on an estimate of the debts that will be bad. The reserve method simply accelerates the tax deduction for bad debt, because the deduction is allowed in the year the reserve is established, based on the probability of some accounts going bad, rather than when the specific debt is determined to be bad.
Sometimes, by changing accounting methods, a company can eliminate short-term profits associated with inflation and the cost of inventory. In other words, if the company has significant inventory levels that were produced at lower costs and it is currently producing inventory at much higher expenses, by selling off the most recently made or purchased inventory items, the company will realize a profit only between the current selling price and the current higher costs. In doing so, the company retains, as a matter of bookkeeping, only old inventory at lower costs. This is a change from a first-in, first-out (FIFO) accounting system to a last-in, first out (LIFO) system.
Consideration of the Taxable Entity
In planning the creation of a business, the principals should consider discussing tax liabilities associated with the various forms of business entities available. Consideration of whether to incorporate or enter partnerships, subchapter S corporations, or domestic/ international sales corporations should be reviewed. Each of these has particular tax liabilities. Some of them are associated with particular types of businesses and may not be applicable to the business in which you engage. Partnerships and subchapter S corporations can be useful to avoid double taxation, which arises because the corporation is taxed on its profits and again when the profits are distributed in the form of dividends. Again, there is an income tax liability associated with a receipt of the dividends by the owners.
Partnerships and subchapter S entities, however, shift income from the entity to the shareholders’ or partners’ tax return. Tax losses, as well, flow directly through to the owners or partners. One of the criteria that should be considered when setting up the business entity is the relative tax rate for the individuals as compared to the corporate rate. The corporate rate may be higher than the rate at which the principals are taxed. The qualifications for subchapter S status change periodically.
Financing Considerations for Fixed Assets
Rapid Depreciation Methods. When a fixed asset is purchased, accelerated cost recovery systems can be used, which at the same time increase cash flow. The law in this area changes frequently, and consultation with a good tax advisor will help you to understand how the depreciation deductions work and what is currently available.
Investment Tax Credits. The laws regarding investment tax credits (ITCs) also change frequently. Congress permits and withdraws such credits as a means of altering tax revenue and/or stimulating the economy. A description of the normal situation when an ITC is available follows. An ITC affords the taxpayer an opportunity to reduce income tax liability by buying or constructing equipment or other qualifying properties. Property that qualifies for ITC normally includes tangible depreciable property, which typically must have a useful life of at least three years. Due regard must be given to the fact that usually no ITC is permitted for buildings or permanent structural components. In the case of leased property, a lessor for a qualifying piece of property may be able to pass the credit on to the lessee. The ITC or any portion may be carried back for 3 years or carried forward for 15 years. Unused credit for the current year generally is carried back for the earliest carry back year, and any other remaining unused credit is applied to each succeeding year in chronological order.
Again, serious consideration should be given to consulting with a tax advisor in this area. The tax laws change on a regular basis, and before you make any capital decision, you should consider an ITC.
Tax Benefit To Leasing
There are certain tax benefits to leasing, although the controversy surrounding these benefits still exists. Leasing may have these advantages:
- The cash needed to purchase the property is available for other uses.
- The lessor may pass through the ITC, if any, to the lessee for his or her use. This benefit probably will not be passed on without a corresponding payment to the lessor.
- The lessor bears the risk of obsolescence or loss.
- Lease payments may exceed depreciation and interest. In this respect, it may give the lessee a higher deduction in the form of immediate expense dollars.
Cash Management through Tax Planning
Compensation Plans. There are three types of compensation plans: basic, deferred, and pension- and profit-sharing funds. Funded and unfunded deferred compensation plans offer numerous advantages. For example, in the funded pension plan, the employer’s contribution to the fund is currently deductible as an expense. Any earnings generated internally by the trust fund are tax exempt. Finally, the employees are not taxed on an individual basis until after retirement. After retirement, the employee’s income should be less than he or she is receiving as an active employee. The employee gets the benefit of a lower tax rate at a later date. This is an income-deferred plan available to employees through the cooperation of their employer. There are firms and businesses that plan compensation packages, which can be very helpful in demonstrating different ways in which a company may save cash flow through the design of compensation plans.
Employees’ Stock Ownership. Like compensation plans, many firms offer their employees participatory ownership plans. These plans offer two advantages:
- By giving the employees some participatory ownership in the firm, there is greater loyalty and greater concern for the firm’s well-being. Each employee has a vested interest in the success of the firm. As the firm grows and succeeds, so does the personal worth of the individual.
- An employee stock ownership plan offers an employer a deduction without the payment of cash. However, when a stock purchase plan causes significant dilution of the ownership, the company may become subject to a suit called a derivative lawsuit by those owners who have had their percentage ownership decreased by sale of additional stock.
This is generally associated with the issuance of new stock. An employee stock ownership plan may use a profit-sharing or stock bonus format. There is a major advantage to a profit-sharing format: It allows distribution of benefits to employees in the form of cash or securities as well as employer stock. This may be an important consideration if the employer’s stock is not publicly traded or does not otherwise have a ready market. In a profit-sharing format, there are two basic limitations:
- The employees’ contributions to the stock ownership plan trust may come only from current or accumulated profits.
- The plan may not borrow funds on the basis of corporate majority stockholder guarantees to purchase employee stock.