If you own a small business, you are probably too busy to even think about taxes most of the year. But some of the things you can do to cut your tax bill are easier than you think -- like buying a Suburban instead of that Lexus sedan you have your eye on.
Defer Your Income, Hurry Your Expenses
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.
If you expect next year's marginal rate to be the same or lower than this year's, consider pushing taxable income from this year into next or accelerating into this year deductions that would otherwise be claimed the following year.
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 Dec. 31. That would violate the tax doctrine of "constructive receipt." On the other hand, postdated 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 Dec. 31 is the magic date here, too. For check and credit card purchases, cash payment is deemed to occur as of the date the check is written or mailed 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 deductions for the previous year.
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 for three years on Dec. 31, you can only deduct one-third of the price in your yearly return. However, if you set a price break by prepaying for more than a year, a court decision says you can generally deduct the whole amount in the year you pay.
Establish a 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 by Dec. 31 to claim a deduction for that year. 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, "Tax-Free Retirement Accounts for the Self-Employed."
Buy New Equipment
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 $105,000 of tax-year 2005 equipment additions ($102,000 for tax years beginning in 2004). Even last-minute 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 next year if you fail to take full advantage of this year's $105,000 (or $102,000) allowance. (In fact, the allowance is now so big, you probably won't use the whole thing!) 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 OK. 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.
Buy a Heavy SUV and Save Taxes
The American Jobs Creation Act of 2004 imposed a reduced $25,000 limit on Section 179 deductions for heavy SUVs. This restriction applies only to SUVs put to business use after October 22, 2004. Not to worry! The idea of buying a heavy SUV still works quite well. Why? Because the tax law allows you to claim the $25,000 Section 179 writeoff plus the "regular" first-year depreciation writeoff. For example, say you spend $60,000 in 2005 to buy a new Cadillac Escalade that is used 100% in your business. You can generally claim the following first-year deductions on your business's 2005 federal return: the $25,000 Section 179 writeoff plus $7,000 worth of regular depreciation (20% x ($60,000 - $25,000)). So your first-year depreciation deductions add up to $32,000, or about 53% of the new Escalade's cost. This is a far better deal than if you spent the same $60,000 on a new BMW used 100% for business (in that case, your first-year depreciation writeoff would be limited to about $3,000 under the so-called luxury auto rules).
Buy a Heavy Non-SUV for Even Greater Tax Savings
The full Section 179 deduction ($102,000 for tax years beginning in 2004; $105,000 for 2005) is still available for heavy business vehicles that are not considered to be SUVs under the tax law. Both new and used vehicles can qualify for this important exception. Non-SUVs include:
Bottom Line: Heavy vehicles that fall under these three exceptions remain eligible for the full Section 179 writeoff ($102,000 for tax years beginning in 2004; $105,000 for 2005). That means you can probably deduct the full business portion of your heavy non-SUV's cost in Year One. Sweet!
Hire the Kids
If you operate a sole proprietorship or husband-wife partnership, think about hiring your children under the age of 18. 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 $5,000 of wage income (in 2005) with his or her own standard deduction ($4,850 for 2004). 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 35%. You can legitimately stiff Uncle Sam out of $560 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, Medicare, 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.