Rather than your true love sending you a partridge in a pear tree, wouldn’t you appreciate some money-saving tax tips? For my year-ending 12 Tax Days of Christmas series, I’ll dig back into the archives of previous topical columns to reiterate understandable, realistic and legitimate tax strategies that you need to implement now in order to have a much smaller tax bill come April 15.
For this eighth tax day of Christmas, consider pre-paying expenses this year and pushing income into next year -- one of the tried-and-true year-end tax strategies that can save business owners thousands of dollars. It may sound simple and straightforward, but it’s important to discuss key points before making a financial move. That's why I’ve created the 10 Commandments of moving money at year-end that should be helpful in your analysis.
1. It’s the time value of money.
Realize you’re not really saving tax, you are just delaying when you pay it. This is a "time value of money" issue. For example, you may prepare your rent for the business location by $5,000 in late December and your landlord is willing to accept it. You have now accelerated a write-off into the current year and reduced your taxable income by $5,000. If you are in an effective tax bracket (fed and state) of 20 percent, you just saved $1,000 in tax -- this year. But that's not all. Holding all other income and expenses constant, you will have $5,000 less in write-offs next year (because you expensed your rent this year and accelerated it). Thus, you will end up paying the $1,000 in taxes next year. Did you really save $1,000? No. However, you were able to delay the process and get to use that money in your money your business all year. If you were able to make 10 percent on that money, you would have "saved" $100 by delaying the payment. That is the time value of money.
Related: The 12 Tax Days of Christmas: Day 8
2. Don’t let the tax tail wag the dog.
Don’t go out and spend money just for the sake of saving taxes. Be smart and wise. Make a good economical decision. If you really don’t need a new iPhone, truck or piece of equipment, don’t go buy it. If you are in an effective tax bracket of 20 percent (as in the example above) and buy something stupid for $10,000, you may have saved $2,000 in taxes, but you’re stuck with a $10,000 piece of junk. I would rather have $8,000 to spend on something more useful in my business early next year that makes sense.
3. Use a credit card.
If you are a cash-basis taxpayer, you can put expenses for your business that you plan to pay for in early January, but don’t have the cash in December. The beauty is, you get the write-off this year and accelerate the expense. However, make sure you have the self-control to actually pay off the credit card in January when you do make the money. If not, it could be a dangerous move.
4. Hold off on collecting A/R.
Maybe your customers will think you are a great vendor by not calling and trying to collect what they owe you during the holidays, but deep down, you’ll know that you’re going to push hard to collect the money in early January and not have to pay the taxes on the revenue this year. It’s always a bummer trying to collect in December anyway, so don’t stress. And if you can stretch your nickels and dimes into January, the deferral on taxes (see tip number one above) could be a great benefit come tax time.
5. Know the 12-month rule.
The IRS doesn’t allow business owners to pre-pay any expense they want, or for an exorbitant amount. An expense you pay for in advance generally can only be deducted in the year for which it applies; as cash-basis taxpayers, this makes sense. However, it’s important to take note of the 12-month rule when deciding which expenses to pay and how much. Under this rule, a taxpayer can deduct a prepaid "future" expense, if the expense is for a right or benefit that extends no longer than the earlier of 12 months, or until the end of the tax year after the tax year in which you made the payment. This is a good rule to follow for rents and leases, accounting and legal fees and advertising retainers.
6. Communicate what you’re doing.
If you’re pre-paying an expense, it’s important to let the recipient know what you are paying for and why. You want to make sure the payment is applied properly to the expense you had in mind.
7. Document the payment properly.
It’s important to make sure any pre-payment can be documented with a banking transfer, postmarked envelope, cancelled check or any receipt that is date stamped electronically or by a third party to prove to the IRS you made the payment in the current year.
Related: The 12 Tax Days of Christmas: Day 6
8. Confirm what you are doing with your tax professional.
If you are using a CPA, enrolled agent or paid preparer, they are going to want to know what you are doing and approve of it. They will ultimately be the one signing your tax return, and if they don’t feel comfortable with the strategy, they could eliminate it from your final return.
9. Consumable versus asset.
Be careful to consider if an expense results in the creation of an asset that has a useful life that extends beyond a year. Such an expense, especially if it’s pre-paid, may not be deductible. Think about a tenant improvement in your business, such as replacing the carpet and paying for it in December. Because it’s an asset with a useful life greater than a year, it would need to be put on the books as an improvement or an asset. Now, maybe you can deduct it under another rule, such as a 179 expense, but be careful trying to simply write it off as an expense.
10. Interest expense has a different rule.
It's important to note, that under IRC Section 416 , if a cash-basis taxpayer prepays loan interest, the interest is only deductible in the year to which the interest relates. You might want to argue the 12-month rule would apply and allow the deduction (see number five above). However, the IRS specifically indicates that this type of expense is an exception and still not a write-off when it’s pre-paid.
Hopefully, these 10 commandments will give you some guidance and ideas when you think of ways to save taxes near the end of the year, and remember to keep good records when implementing any strategy up against a deadline.