Understanding what income you must report and the various business deductions you may claim is only half the job. You must also know when to report income and when to postpone it, when to claim certain deductions and when not to claim them. You should also be aware of the common traps that business owners often fall into with their “income and deductions“. In this post we will discuss about: tax-saving tips, and common errors for some areas where you should pay special attention and how to avoid them.
It is important to recognize that you should not always go at it alone. You may need to get the assistance of tax professionals or additional information from the official tax office. You need to know how to obtain referrals to tax professionals. You also need to know some important tax office telephone numbers to call for assistance. Such information is included throughout this post.
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).
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. This income deferral strategy is more important than ever in view of declining personal income tax rates. On the flip side, you can accelerate deductions by paying outstanding bills and stocking up on supplies.
However, in accelerating deductions, do not prepay expenses that relate to items extending beyond one year. For example, if you pay a three-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 two-and-a-half months after the close of the year). Similarly, accrual method businesses can accrue bonuses and other payments to employees in the current year that are paid within two-and-a-half 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.
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.
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.
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 one 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).
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 percent of benefits to shareholders owning more than 5 percent of the stock, making such plans undesirable for such closely held corporations.
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 two-percent-of-adjusted gross-income floor. With an accountable plan, the company deducts the expenses and no income is reported to you.
Take Optimum Write-offs for Business Equipment Purchases
When the business can benefit from a larger deduction, instead of depreciating the cost of equipment over the life of the property, consider electing ftax officet-year expensing (e.g., a deduction of up to $250,000 in 2008). 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.
Abandonment Vs. 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 “transactions for the current year and prior 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.
Elect to Forgo a “Net Operating Loss (NOL)” Carry-back
If the business has an NOL in 2008, it can generally carry the loss back two years (three years for small business disaster losses; five years for farmers and ranchers and Gulf Opportunity Zone losses; 10 years for product liability) and forward for 20 years. Alternatively, it can elect to forgo the carry back 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 carry back. 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 TAX OFFICE subsequently audits an earlier return and income results.
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.
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 TAX OFFICE rulings. You need to know what these changes are in order to take advantage of them.
Taxation Common Mistakes and How to Avoid Them
Salary of Corporate Officers
Some corporations have been claiming deductions for management or consulting fees paid to the corporation’s owners. At the same time, these corporations have not claimed deductions for salary. This leads the TAX OFFICE to conclude that the corporations are misclassifying payments to corporate officers as fees rather than compensation in order to avoid payroll taxes.
Corporations may be liable for penalties for failing to withhold and deposit payroll taxes and for failing to file required payroll tax returns. Of course, sometimes payments to shareholders may very well be management or consulting fees for occasional outside assistance. But if these individuals conduct the actual business of the corporation—perform the services for which the corporation was organized or provide management services on a full-time or consistent basis—the payments look more like compensation. S corporations especially may also fail to deduct compensation paid to owner employees and instead call distributions to them dividends.
The rationale for this strategy is to reduce the corporation’s liability for payroll taxes. Again, the TAX OFFICE has identified this strategy as a common error and has imposed penalties on S corporations that have followed it. If an owner-employee performs substantial services for the S corporation, some reasonable amount of payment for services must be treated as deductible compensation subject to payroll taxes.
Loans from shareholders to their corporations that bear an interest rate lower than the applicable federal rate (a rate set monthly by the TAX OFFICE, which varies with the term of the loan) result in phantom or imputed interest. Shareholders must report this interest; corporations can deduct the imputed interest. If the corporation fails to take an interest deduction, the TAX OFFICE may conclude that the shareholder has not really made a loan but rather a contribution to the capital of the corporation, and no deduction for the corporation will be allowed.
Loans to shareholders from their corporations may also present tax deduction problems. Shareholders are entitled to deduct imputed interest in this case (as business or investment interest), with the corporation picking up the imputed interest as interest income. Unfortunately, some corporations are failing to report the income, but they are still showing the loan on their balance sheets. This is an unnecessary error for corporations to make. If the shareholders are also employees of the corporation, then the corporation can claim a deduction for compensation to the shareholder-employees to offset the imputed interest income. If, however, the shareholders are not employees of the corporation, the payments to them must be treated as dividends, which are not deductible by the corporation.
Travel and Entertainment Deductions
Some businesses claim a full deduction for business meals and entertainment. They do not correctly apply the 50-percent limit on these deductions. This problem commonly occurs for meals and entertainment away from home. Bad Debt Deductions Some individuals are claiming bad debt deductions as ordinary losses rather than short-term capital losses. In other words, they are classifying the bad debt as a business bad debt when, in fact, it may be a non-business bad debt. For example, if a shareholder has a bad debt for a loan to the corporation, the loan should be treated as a non-business bad debt because it is not incurred in a trade or business; rather, it is made to protect one’s investment as a shareholder.
Some businesses fail to reduce deductions for casualty losses by any insurance reimbursements received. This results in an overstatement of casualty losses.
Claiming Losses in General
Some taxpayers claim losses in excess of amounts that are otherwise allowed. They fail to observe the passive loss limitation rules that limit loss deductions for activities in which there is no material participation. Just because someone owns stock in an S corporation, for example, does not mean that he or she is a material participant in the business. The shareholder must meet special material participation tests to deduct losses in excess of passive income.
Other taxpayers may be deducting hobby losses in excess of income from this type of activity. While income from a hobby-type activity is fully taxable, losses are deductible only to the extent of income from the activity. Also, some shareholders in S corporations claim losses in excess of their basis in the corporation. Losses are deductible only to the extent of a shareholder’s basis in stock and loans to the corporation. Basis is adjusted annually for various transactions—shareholder’s distributive share of S corporation income that is taxable to the shareholder, distributions by the corporation, and losses claimed.
Losses in excess of basis are not lost. They can be carried forward and used in a subsequent year when there is sufficient basis to offset them. Important: States may have different rules on the treatment of losses.
Business Owners focus should be on running your business and making it profitable. This may leave you little or no time to attend to tax matters. It may be cost effective to use the services of a tax professional to maintain your books and records, file your returns, and provide needed tax advice.
There are many different types of tax professionals to choose from. The particular type of counsel you seek depends in part on your needs and what you can afford to pay for the services provided.
The types of tax professionals you can consult include:
- Enrolled agents
- Certified public accountants (CPAs)
- Tax attorneys
Storefront tax return preparation services may provide assistance with filing your returns. They generally are not staffed to provide tax guidance. Keep in mind that any information you disclose to an attorney is completely confidential under the attorney-client privilege. This privilege has been extended to other federally authorized tax practitioners (such as accountants) in civil tax matters. However, it does not apply to the following situations:
- Tax return preparation
- Criminal tax matters
- State tax matters (unless there is a special state-created accountant-client privilege)
- Matters involving other agencies (such as the Securities and Exchange Commission)
If there is anything you absolutely want to remain confidential, then you must use an attorney. The attorney may hire an accountant to perform accounting tasks and, as the attorney’s agent, tax information disclosed to the accountant in this situation remains completely confidential. If you do not know the name of a specific individual to help you, ask business acquaintances for referrals. Another source of references is the Yellow Pages of your phone book. Then, if you wish to check whether a particular CPA is licensed as claimed, you can call your state Society of CPAs. Similarly, if you want to check on a particular attorney, call your state Bar Association. Do not hesitate to ask the professional what he or she charges for the services to be provided.