Spooky tax laws

guest commentary by David Potts

It’s spooky how fast time passes. It’s also spooky how fast tax laws change. There are differences between the income tax laws in 2009 and in 2010 and you should be aware of these differences. If these changes affect you then plan ahead and place yourself in the best possible position to minimize your income tax liability.

Income tax planning is not an easy task. One strategy doesn’t fit everybody.  While some people will be better off accelerating their income into 2009 to reduce their income tax in 2010, most will be better off accelerating their deductions to reduce their taxable income this year. It just depends on your situation. Let me illustrate.

Larry is married with a son in college. Larry is paying tuition for his son in excess of $4,000 this year. The Internal Revenue Code allows Larry to deduct up to $4,000 of qualified tuition expense as long as his adjusted gross income doesn’t exceed $130,000. If Larry’s income exceeded $130,000 by $1 then the allowable deduction would be reduced to $2,000. With planning and a little forecasting Larry might discover that he could make a deductible IRA contribution that would reduce his adjusted gross income and preserve the full $4,000 tuition deduction.

You won’t know what you should do if you don’t look forward. The Internal Revenue Code is full of income limitations and phase out provisions. Tax planning may help you avoid tax “gotchas”. (Just for your information, this particular tuition tax deduction expires in 2009 unless a tax bill is passed to extend the current expiration date.)

Each year as magazines and televisions start delivering tax tips, they always include “defer your income and accelerate your deductions.” Why? Because that is how you reduce your taxable income. It is kind of like saying you make money in the stock market by buying low and selling high. Both sayings are always true. We will still be saying the same thing 20 years from now.

Every individual taxpayer and many businesses determine their taxable income by accounting for their income and expenses on a cash basis. This simply means you recognize income when you receive the cash as opposed to when you earn the income. And you recognize an expense as a deduction when you pay the bill, not when you actually buy the product or service.

If you own a business that accounts for its income and expense on a cash basis, you are generally familiar with the concept of deferring income. You may know some other business owner that receives payment for his goods or services in the middle of December and won’t deposit these receipts until January for the purpose of reducing their taxable income and their tax liability. This works if they don’t get caught. It’s just not legal. It’s not the deposit date that determines when you have income, it’s the date when you received payment. It’s the date you have control of the funds that determines when it’s income. If you receive the payment in 2009 it should be recorded as income in 2009.

How can you properly defer income? Arrange your business transactions so you won’t get paid until 2010. Delay sending an invoice until December 31 so that your customer won’t receive it until January. If it is customary in your business to take an advance payment before you start a job, live on the edge and don’t require your customer to make the payment until January. Or you could simply ask your customer to wait to pay you. In this current economy you might be doing him a great favor.

Other possibilities to defer income would include asking your boss to defer any bonuses you have earned until 2010; delay the sale of investments that have gains; or sell property on an installment sale.

You have more control over the decision to accelerate your deductions and when. Whereas income for a cash basis taxpayer is realized when received, deductions are realized when paid. If you accelerate payment of an expense, make sure it is a tax deductible expense and currently deductible. A large expenditure to repair a duplex you own and rent may be a deductible expense but based on your circumstances it may not be currently deductible due to passive loss limitations. The purchase of an expensive Christmas gift for a client will be limited to $25. There is no advantage to paying principal on a loan. The point is to make sure the expenditure is tax deductible.

What if you want to accelerate payment of your tax deductible expenses but your cash flow is lacking. You can borrow money from a bank then pay your bills. You can also pay with a credit card. A payment by a credit card is considered payment with borrowed funds. The date the payment is deductible is the date the charge hits the credit card, not the date you pay the credit card bill.

Effective income tax planning is based on your facts and circumstances. For most people, income tax payments are one of their largest expenses throughout life. It is worth the time and effort to look for ways to minimize your income taxes.

Over the next couple of months I will be focusing on ways for you to reduce you tax bill. But think about discussing your situation with a certified public accountant. Experience counts.

David Potts is a certified public accountant also accredited in business valuation. Owner of Potts & Company, Certified Public Accountants for more than 25 years, his practice focuses on small and medium size businesses and their owners in the areas of taxation, accounting and bookkeeping, business valuation and business advisory services. He is a Fort Smith native and a graduate of the University of Arkansas. You can follow more of his thoughts at ThePottsReport.com.

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