While you may focus on taxes during tax season when you know your income tax return for the prior year is due, you should be thinking about taxes throughout the year. The actions you take during the year can favorably impact your tax results at tax time.
Since you're a Schedule C filer, your business and personal tax pictures are intertwined. Reducing the business income that's subject to tax can save you taxes on your personal (nonbusiness) income. For example, if you bring down your taxable business income by allowable deductions, you can minimize the additional Medicare taxes on earned income and net investment income (if applicable).
In taking actions for tax results, don't do so at the cost of bad business results. Keep in mind that taxes are only one factor in the actions you take. Assess the impact that actions will have on cash flow, productivity, and other business issues. In many cases, as you'll see in this chapter, tax savings align with business and financial advantages.
Actions you take throughout the year can pay off in tax savings on your return. These actions can have effects beyond mere tax savings. They can help protect the financial security of your future, provide current cash flow, or achieve other business objectives. Here are some of the key tax strategies you can use to improve your tax picture. The financial ramifications of some of these strategies are also considered.
This not only gives you tax savings, enabling you to shelter your business profits, it also creates a nest-egg for your retirement years.
Usually, you have to sign the paperwork for a qualified retirement plan such as a solo 401(k) by December 31 in order to have it be effective for the year. Then you have until the extended due date of your return (October 15) to make contributions for the year in which the plan was set up. However, you can set up and fund an SEP plan up to the extended due date of your return.
Also consider adding an IRA or a Roth IRA to your tax strategies. They can be used as your sole retirement plan or as a supplement to a qualified retirement plan, depending on your income (which may limit or prevent IRA/Roth IRA contributions) and how much you can afford to save annually.
From a financial perspective, whether you're just setting up the plan or already have one, the only way to optimize your retirement income from the plan is to stay on top of plan investments. The stock market is volatile but there are investment strategies, such as diversification and asset allocation, that can be used to protect your investments to some extent. You probably want to work with a financial professional or use do-it-yourself education materials that are available from brokerage firms and mutual funds.
Qualified retirement plans and IRAs are discussed in Chapter 8.
If you suffer a disaster loss to business property in an area declared eligible for federal disaster assistance and have not been reimbursed for your loss by insurance or other payment, consider claiming your casualty loss deduction on the tax return for the prior year. This will give you an immediate tax refund so you can use the money to replace the property or otherwise help your business go on.
From a financial perspective, if you'd had good insurance coverage you wouldn't have needed to take any tax deduction for your disaster loss. You would have been reimbursed by your coverage for property damage. If you don't have good coverage or haven't reviewed your policy limits lately, take the time now to speak with a knowledgeable insurance person who can help you protect yourself in case of a future disaster.
Did you know …
Small businesses reported flood damage (38%) and wind damage (36%) as a common cause of losses. Yet only 16% of companies affected by flood damage had coverage, and only 21% of those affected by wind damage had wind insurance. So, check that you carry the appropriate insurance protection.
Deductions for disaster losses, as well as SBA loans for disasters, are discussed in Chapter 7.
Did you know …
It's widely reported that 40% of small businesses never recover from a disaster and nearly two-thirds do not have disaster recovery plans. Don't become a statistic; address this contingency now. Find help with disaster recovery plans from Ready.gov (search “business continuity planning suite”).
The tax rules change all the time as a result of legislation, court decisions, and IRS rulings. Also tax rules expire; some are extended while others are not. If you fail to act on an expiring provision, you may lose an opportunity to save on your taxes.
When tax changes occur during the year, you may have only a limited window of time to act. If you fail to use this window, it may be closed to you by the time you talk with your return preparer at tax time.
Did you know …
At the time this book was prepared, Congress was considering numerous tax law changes that could impact you. Among them were proposals to change retirement plan rules, extend expired or expiring laws, and create new incentives for businesses in certain industries. The fact that there are all of these proposals under consideration in Congress is not unusual, and it's impossible to predict which will become law and when.
Resources to help you stay informed on tax developments impacting your business include:
You may, at some time, outgrow your sole proprietorship status and want to become another type of business entity. The reasons may be tax-motivated; they may be for other business purposes, such as obtaining limited personal liability, or access to equity crowdfunding or other types of investments. Changing your business structure is explained in Chapter 14.
When you hit the month of December, as a cash basis business owner you have considerable latitude on actions that will produce savings on your tax return for the year and even for the year to come. As a general proposition, it is usually beneficial to postpone income and accelerate deductions. This axiom is most helpful when your tax bracket stays about the same from year to year.
However, the strategies of postponing income and accelerating deductions may not work well for you. Your business may not have been profitable year to date, so deferring income would not make sense for you from a tax or cash flow perspective. Similarly, if you expect your income to increase significantly in years to come, deferring income could trigger additional Medicare taxes in deferral years.
Bottom line: You need to take a multiyear view of your income and deductions so you can plan accordingly. If you are uncertain, work with a tax advisor to craft a year-end tax plan for your situation. The following discussion explains how to defer income and accelerate deductions if you choose to use this tax strategy.
Why would you want to postpone the receipt of income? You may be thinking that it's always better to get paid as soon as possible. Certainly this is true in some cases, but deferral can produce tax savings if:
Assuming you want to postpone income so that it becomes taxable next year, you can do this by delaying your billing until late in the year so that payment will be received next year.
Example
You complete a job for a customer on Christmas Eve. You send the invoice by mail on New Year's Eve. Because the invoice will be received by the customer next year, payment will be deferred.
Should you employ this strategy? It depends on your situation. Don’t defer income if:
The flipside to deferring income is accelerating deductions. This means taking action so that you can claim write-offs this year rather than waiting until next year. Because you are on the cash method of accounting, strategies include the following:
Example
Your monthly IT bill for maintenance is $50 and it is due on the fifth of the month. You can pay the January bill before December 31 so that it's deductible this year, rather than next year.
As a cash basis business, you can nail down write-offs this year by charging expenses to a major credit card by December 31. You'll receive the bill and pay it next year, but the deductions for these expenses are allowed for the year of making the charges. But this rule doesn't apply to store-issued credit cards, only to American Express, Discover, MasterCard, and Visa.
Even though the year has ended, your opportunities for actions to reduce taxes in that year and, in some cases, years to come, are still in play. These actions take the form of elections you make when you file your tax return. The beauty of these elections is that you can look over the results of your business activities—how profitable you were or how much of a loss you had—before deciding on what do to.
As a general rule, if you are in a low tax bracket this year but expect to be in a higher one for years to come, you might want to forgo current tax write-offs where possible so that you can use them in future years. This doesn't mean foregoing deductions you're entitled to; it means using tax rules, such as tax elections discussed next, to your advantage. Because of your higher tax bracket in the future, the write-offs will produce greater tax savings for you then.
However, keep in mind the concept of the time value of money. Having tax savings now, even though it may be smaller than what you could have had in the future, may be just about as valuable to you because of what money is worth to you now versus its worth in the future.
The following discussion covers some of the tax elections to consider.
If you bought a computer, furniture, equipment, or machinery for your business, you have a number of choices on how to deduct the cost. You can deduct costs up front in many cases, but this may not be the best action from a tax perspective if the write-offs are more valuable to you in future years. Instead you may prefer to spread deductions over future years when the write-offs are more valuable to you by saving you more in taxes at that time. Here's how to take the best advantage of deductions for buying business equipment:
Write-off options for your office equipment is discussed further in Chapter 6.
Usually, you have only until the end of the year to set up a qualified retirement plan. However, if you missed this deadline, you can still set aside money for retirement on a tax-advantaged basis using:
There are opportunities to lease what you need for your business instead of buying it. Financially, you'll tie up less capital by leasing and probably be in a better position to budget your costs.
From a tax perspective, leasing may result in larger or at least less complicated deductions. Some items you may consider leasing (or paying by the month) are:
You may even consider renting items you need on a short-term basis rather than buying them or agreeing to a long-term lease. For example, if you are a carpenter, you can rent tools from Home Depot, Lowes, or other outlets. You might even consider using an app such as Toolsity.com, which is a marketplace for peer-to-peer renting of power tools.
Carryovers are write-offs from actions you took in prior years but were not allowed to use at that time because of limitations in the tax law. If you fail to keep track of them, you may forget them and fail to take write-offs you've earned. Fortunately, if you use the same tax preparation software or the same tax return preparer year after year, the carryovers are tracked for you. However, if you make a change, it's up to you to check for carryovers. Here are some key carryovers to look for:
This is something that's virtually impossible to do. You can be as careful and accurate as possible but still be audited by the IRS. However, you can take steps to minimize your audit exposure and to protect yourself in case you are selected for examination despite your best efforts. Remember that the IRS is looking more carefully at sole proprietors than at other taxpayers (see Chapter 1). So tread lightly and:
Some actions may cause IRS computers to single you out for further scrutiny. This may not lead to a full-blown audit but could trigger a letter (which is technically an audit, too, called a correspondence audit) where the IRS seeks further information or explanation and certainly will cause you some grief or apprehension by its mere receipt, which could have been avoided. These are actions to avoid so you won't call attention to your return:
It had been commonly thought that taking a home office deduction was an automatic audit red flag. While the IRS never confirmed this, the belief persisted. Today, however, there are now so many legitimate home-based businesses that it defies logic to think the IRS is auditing every home-based business. What's more, the IRS has created a simplified home office deduction because it recognizes that there are so many home offices and that deducting actual expenses is very time consuming. More details of the home office deduction are in Chapter 6.
When you have any questions about write-offs or other tax actions, work with a knowledgeable tax advisor. Make sure your tax person hasn't been the subject of previous IRS sanctions or other actions that may ultimately call your return into question.
Did you know …
The information you share with a tax preparer for tax return preparation is not confidential. Unlike attorney–client privilege, there is only limited protection for certain disclosures to a paid preparer for federal income tax purposes. This limited protection doesn't cover federal tax return preparation, any state taxes (unless the state gives protection), or federal non-tax matters, such as securities matters.
You may want to review the IRS audit guide for your industry if there is one. The IRS has more than three-dozen Audit Technique Guides (ATGs) covering such businesses as architects and landscape architects, art galleries, business consultants, day-care providers, construction industry, ministers, veterinary medicine, and a number of cash businesses.
Now that you have planning strategies under your belt, you may want to focus on ways to grow your business. For instance, you may want to get a mentor to learn how to move ahead. Another strategy for growth to consider is getting certified so you can access government contracts and corporate procurement programs. And you certainly can use technology in various ways to be more productive and even expand. These topics are covered in the next chapter.
Chapter Takeaways