IN THE SPIRIT
of the season -- tax season that is -- we've created a list of year-end maneuvers that can save the self-employed money off their taxes. Don't feel guilty for manipulating things to your advantage. It's always better to receive from Uncle Sam than to give.
Joy, Joy, Joy from Cash Method Manipulations
Many small businesses can use the cash method of accounting for tax purposes. This privilege becomes a real treat at year's end, because you have some flexibility to time income and deductions with the goal of reducing, or at least deferring, taxes.
See our article on Year-End Personal Tax Planning
On the income side, cash basis taxpayers are required to include only payments received by year's end. For checks, the key date is when they hit your mailbox, not when they are cashed or deposited. So the surest path to deferral is via waiting until next year to send out bills. Just make sure this doesn't increase the risk of not getting paid at all. You can't put Uncle Sam on hold by asking customers to keep your checks out of the mail until after December 31. That would violate the tax doctrine of "constructive receipt." Post-dated checks aren't income until the day you actually cash or deposit them, and bounced checks are ignored completely until they are replaced with good paper.
On the expense side, you get a deduction in the year you pay the cash. So December 31 is the magic date here too. For check and credit card purchases, cash payment is deemed to occur as of the date on the check and the transaction date, respectively. However if you use a store charge card (like Sears) or arrange for installment payments with a vendor, you get no deduction until you make payment in cash. So it's better to use third-party cards like Visa or American Express to lock in 1997 deductions.
What kind of expenses can you pay and deduct before year's end? Let your imagination run wild. Common items include office supplies; postage; security monitoring; Internet access and online services; stationery; business cards; advertising; business and professional licenses; dues for professional organizations; Chamber of Commerce and civic club dues (Lions, Elks, Women's Club, etc.); legal fees; accounting; fees for tax preparation and advice; education and training; 50% of business meals and entertainment; and business travel expenses.
In a nutshell, the litmus test for deductibility is whether you would have incurred the expense if you weren't in business. The general rule for prepayments is no current deduction for any expenditures that deliver value more than 12 months past year's end. For example, if you renew your Wall Street Journal> subscription through 2000 on December 31, you can only deduct one-third of the price in your 1997 return.
Beware of one critical point: If you have a line of business with inventory, you must use the accrual method of accounting in doing your taxes. Unfortunately, the accrual system makes it difficult to postpone recognizing income, and there are limitations on the expense side as well. Check with your tax adviser.
Celebrate New Year's Eve with Your New Retirement Plan
If you're a successful small business owner without a qualified retirement plan for yourself, get one. And before you argue cash shortage, remember the tax savings can actually finance part of your annual contributions.
For a Keogh, the paperwork must be done before year's end to claim any 1997 deduction. You can put off the contribution itself until as late as the extended due date for this year's return. SEPs can be set up as late as the extended due date. However, in either case it makes sense to contribute as early as you can in order to take advantage of tax-deferred compounding. For more on SEPs and Keoghs, see our story, "Retirement for the Self-Employed."
Toast Your Year-End Equipment Additions
Most business equipment must be depreciated over either five or seven years. This generally translates into a first-year deduction of only 20% of the cost of five-year property and 14.29% of seven-year property. However, there's a special break available to most sole proprietors (and most other small businesses as well). It's called the "section 179 deduction," and it permits an immediate write-off for up to $18,000 of equipment additions. Even last-minute 1997 additions qualify, as long as you start using the stuff before that giant disco ball at Times Square comes all the way down.
Understand this is a "use it or lose it" concept. There's no carry-over into 1998 if you fail to take full advantage of this year's $18,000 allowance. The deduction is also limited to your taxable income from business activities. But, since any salary earned by you -- or your spouse if you file jointly -- counts as business income for this purpose, the rule seldom causes problems, even for start-ups.
The equipment in question must be purchased. Both new and used are O.K., but no trade-ins please. Finally, it must also be used over 50% for business. When there's mixed business and personal use, only the business percentage can be deducted. For example, if you buy a new $3,500 computer next week and use it 60% for business, you can claim a $2,100 section 179 deduction on your 1997 return.
Buy a Suburban
As you probably know, cars used for business are subject to a special reduced section 179 limit ($3,160 for autos purchased this year). The already-puny allowance is further reduced by any personal use. To wit: The deduction for a new $40,000 Lexus used 75% for business is an almost laughable $2,370, or less than 6% of the car's cost.
But if you find a "heavy" sport utility vehicle (SUV) that rings your chimes and buy before year's end, it's a whole different -- and much better -- story.
According to IRS regulations, a passenger vehicle built on a truck chassis is considered a "truck" for tax purposes when it has a gross vehicle weight (the manufacturer's maximum weight rating when loaded) over 6,000 pounds. Truck status means very favorable depreciation rules when the vehicle is used over 50% for business. Some popular SUVs pass the truck test; the Chevrolet Suburban is the beefiest example. There are several others, so ask dealers about models that fit the bill. If you buy one, our advice is retain documentation of the weight rating for your tax records.
Now, let's get specific about the tax advantages. Say you buy a new $35,000 Suburban to be used 100% in your sole proprietorship business. As long as you put that big hunk of metal to work before year's end, you can bag a whopping $18,000 section 179 deduction (assuming no other 1997 equipment additions). You then depreciate the balance of the cost ($17,000) over the normal schedule for five-year property. That sure beats the wimpy $3,160 first-year write-off for a "regular" car costing the same amount. Another plus: Heavy SUVs also escape the 8% luxury tax on passenger vehicles priced over $36,000.
Hire the Kids for the Holidays
If you operate a sole proprietorship or husband-wife partnership, think about hiring your under-age-18 children over the holidays. It can cut the tax bite on family income. Why? Because you get a business deduction for money you may have just given the kids anyway. That deduction reduces both your income and self-employment tax. On the kid side of the deal, there are no Social Security or federal unemployment taxes, and each child can shelter up to $4,150 of 1997 wage income with his or her own standard deduction. So you get a tax break, and there's zero tax cost to your children with this perfectly legal scheme.
To illustrate, let's say your marginal rate is 36%. You can legitimately stiff Uncle Sam out of $576 by paying your two teenage kids $800 each (say 100 hours at $8 an hour) for helping out during the holiday rush. This doesn't even count the additional self-employment tax savings (2.9% or 15.3% of the wages depending on your income level). Kids actually saving you money? What a concept! For their part, the children owe no federal taxes unless they have substantial income from other sources. (Putting the kids to work can have other benefits, too, like keeping them out of the mall.)
If your business is run as a corporation, you can still hire the kids and deduct the wages on the company tax return. However, in this case, the payments are subject to Social Security and federal unemployment taxes just like wages paid to regular workers. That still beats paying outsiders for work your kids could do.
If this idea seems worthwhile, don't abuse it. Wages paid to your children must be reasonable in relation to the job. Paying $20 an hour to a seven-year-old to sweep the floors just won't fly with IRS auditors.