Lower your liabilities

guest commentary by David Potts

2010 ends Friday. For most people the only real significance of this Friday is their annual new year’s resolution to lose 20 pounds, but if you are interested in lowering your 2010 income tax liability it should be a call to action.

For those who view this Friday, Dec. 31, as a call to action, to make good decisions about potential year-end tax moves you need to know your marginal tax rate, your basis of accounting, and your accountant’s telephone number.

Your marginal tax rate is the incremental tax rate you pay at your specific level of taxable income. To determine your marginal tax rate, you need to know your filing status, your expected taxable income, and your business structure. The income from proprietorships, partnerships, S corporations, and most limited liability companies pass through the owner’s individual tax returns and therefore individual income tax rates apply.

If your business operates as a C corporation, the tax rates are different than those for individuals. Once you know your marginal tax rate, you can make a better decision as to how much money, if any, you should spend before this Friday’s midnight. Think of your marginal tax rate  as how much Uncle Sam will subsidize your business spending. If you are in a combined 32% Federal and state tax bracket, then spending $10,000 on deductible expenses to lower your taxable income will actually only cost you $6,800 – after income tax savings are considered.

In considering year-end tax moves, you also need to consider your method of accounting. Are you a cash basis taxpayer or an accrual basis taxpayer? A cash basis taxpayer recognizes income when received and deductions when paid. An accrual basis taxpayer recognizes income when earned and deductions when incurred, irrelevant of when paid.

Continuing with the example above, a cash basis taxpayer must actually write a check or make a payment to generate a deduction; an accrual basis taxpayer must only have made a valid purchase on credit, payment can be made later. (If you are a cash basis taxpayer and sign a valid note with the seller or even charge it to a credit card, the IRS considers the date paid as the date the note was signed or the credit card was charged.) Knowing whether you are a cash basis or accrual basis taxpayer will allow you take advantage of appropriate tax saving strategies.

So what are some of the last minute possibilities to reduce your 2010 income tax liability?

• Defer income and accelerate expenses.
This is traditional tax advice that is still applicable this year since Congress extended the Bush era tax cuts through 2012. Deferring income and accelerating expenses lower your taxable income and therefore reduce you income tax liability. For cash basis taxpayer’s this is as simple as paying your expenses before year-end and collecting your income after year-end.

Let me diverge for a minute. Some business owners are “confused” by what is meant by deferring income. Receiving payment in December and waiting until Jan. 2 to deposit this money in the bank isn’t deferring income. If you receive the money at any time in December it should be reported as income on your tax return. You can properly defer income by delaying sending your bills so that payment in the normal course of business won’t be received until after Dec. 31.

If you are one of the die-hard who insist on not depositing the income you receive in the last two weeks of December until Jan. 2 and this is reflected in your bank statements, if you are audited by the IRS, expect to owe additional taxes after the audit is complete. A business that shows zero deposits in the last two weeks of December is rather obvious.

• Purchase equipment that qualifies for expensing.
Without making an election under Internal Revenue Code section 179 to expense qualifying assets, the purchase of furniture, fixtures, machinery and equipment, and other tangible personal property used in a trade or business must be deducted over several years through depreciation.

For 2010 (and 2011), a business that buys qualifying property can expense (deduct in one year) up to $500,000 of assets purchased as long as total assets purchased don’t exceed $2,000,000. But beware, there are several limitations you have to consider. The amount of assets you elect to expense cannot exceed your taxable income. The ability to expense automobiles and trucks less than 6,000 lbs. gross vehicle weight is limited is $11,060 for cars and $11,160 for light vans and trucks. A $25,000 expense limit applies to SUV’s over 6,000 lbs.

The expense limit for qualified leasehold improvements is $250,000. My best advice? Call your CPA to help you avoid a surprise due to the various limitations imposed by the Internal Revenue Code related to the expensing election.

• Purchase equipment that qualifies for the first-year bonus depreciation deduction.
For qualifying assets purchased after September 8, 2010 and before Jan. 1, 2012, you can elect to deduct the 100% of the cost of the asset in the year purchased. This sounds like a repeat of the previous paragraph.

So what’s the difference between Section 179 and the bonus depreciation? Here are a couple of significant differences to be aware. Section 179 applies to both new and used property. The first-year bonus deprecation applies only to new property. Section 179 has income requirements and limitations. The first-year bonus depreciation doesn’t. For example, you can have a loss and still qualify to deduct the cost of new equipment. This is a great benefit for taxpayers that have other taxable income for the business’ loss to offset.

• Prepay expenses.
The IRS allows some expenses to be prepaid and deducted under certain conditions. Examples of prepaid expenses allowed as a current deduction include prepaid intangible drilling costs, prepaid feed for farmers, and incidental materials and supplies not carried in inventory. But some expenses, for example rent expense, are generally not allowed to be prepaid and deducted in the current year. Again, ask your CPA for advice on what expenses qualify for prepayment.

• Stockholders’ in S corporations that expect to have an operating loss should check their stock’s basis.
Most small businesses that are incorporated elect to be taxed as an S corporation. If an S corporation has a net loss for 2010 and the loss exceeds the owner’s “basis” in his stock (plus any note payable by the corporation to that stockholder) on Dec. 31, the loss in excess of the owner’s basis will not be allowed this year.

If your S corporation has sustained losses this year and you have other income that can be offset by the loss, make sure there is adequate basis in your stock in order to deduct the loss. If you stock’s basis in lacking, you can increase it before the year ends by loaning money to the corporation or making additional capital contributions.

• Make note payments early.
If you are a cash basis taxpayer that normally pays your loan payments near the first of each month, pay them by Dec. 31. The portion of the payment that is principle is not deductible but the portion that is interest is deductible.

• Write off bad debts.
If you are an accrual basis taxpayer, review your trade accounts receivable for accounts that you don’t expect to collect. These accounts can be deducted as bad debts. Cash basis taxpayers never recognize these trade accounts receivable as income, therefore trade accounts receivable are not allowed as a bad debt deduction. However, a cash basis taxpayer that has loaned money to a borrower and doesn’t expect to collect on the debt can deduct this loan as a bad debt.

• Call a CPA.
The best strategy to reduce your income taxes for 2010 is to call a CPA. The suggestions discussed above are just a few of the possibilities to reduce your 2010 income tax liability. In addition, the Internal Revenue Code is laced with pot holes to hit and manure to step in. A CPA can help you avoid these hazards. But remember, you only have five days from today to act. Get a move on it!

About Potts
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. Although every effort is made to provide you accurate and timely tax information, it is general in nature and not specific to your facts and circumstances. Consult a qualified tax professional to discuss your particular case.

Also, feel free to e-mail topic suggestions or questions to [email protected]