This is the time of year when the small-business owner has to start thinking of year-end strategies for his/her company. Because tax strategies have a large, yet controllable, influence on your business, they should be your main focus as a business owner.
The business owner’s tax decisions depend on, among other things, whether or not income is recognized based upon the cash basis or the accrual basis of accounting. Let’s look at these two choices.
If your business is on the cash basis, it means that income is recognized only when received and expenses only when paid. To a great extent, therefore, the cash-basis taxpayer has control over the company’s financial and tax results.
For example, if your business is having a great year and “needs” expenses in order to reduce its tax liability, then as many expenses as possible should be paid before the company’s year end.
Even if the business is somewhat short of cash at year end, there are still other options whereby you can “time” the recognition of income and expense. Owner(s) can contribute capital to the business or can borrow money on a short-term basis in order to pay as many expenses as possible before year-end. (Please note that the calendar year is not necessarily the only choice for your business’s year end. Consult your tax adviser as to your options.)
If the company is having a bad year and is losing money, now is a great time to “shelter” income by making sure that your cash receipts are as high as possible before the year is closed out.
This might require you to contact your customers who have large outstanding account balances and ask them to pay off as much of their balances as they can before year end. One option that will make this more attractive to them is to offer a discount if they pay their debts earlier than when previously intended.
You therefore should contact your customers who owe large balances and see if some kind of accommodation can be reached whereby they pay you sooner rather than later.
This method of accounting recognizes income when earned and expenses when incurred.
When a sale is made and the customer has a legal obligation to pay you the amount billed, income is said to have been earned.
Conversely, when you have incurred an expense that imposes a legal obligation on your company to pay the creditor, an expense is said to have been incurred.
At first blush, it might seem to you that there are not many options for you to use wise tax planning under the accrual basis. Actually, there are.
Let’s talk about income first. Assuming your customer agrees and you want to reduce your tax liability, you can delay the shipping of your product until after the first of the year. In that fashion, income will not be recognized until the calendar year 2005.
On the other hand, if your company is not having a particularly good year and you want to recognize more income in 2004, you can ship some of your product early or accelerate your income by other means appropriate to your business in order to increase your revenue for the year.
Somewhat similar procedures can be used in the timing of expenses to coincide with your tax situation. For example, if you are having a great year, you might want to incur certain expenses earlier than otherwise in order to increase expenses for the current year.
On the other hand, you could postpone certain purchases until the following year so that you would get more of a tax benefit from them.
It’s a matter of keeping your eye on the present as well as the immediate future so that you can “time” income and expenses more beneficially.
Another Consideration — Forms of Business Organization
It is beyond the scope of this article to delve too deeply into all of the tax considerations that affect your business. I would be remiss, however, if I didn’t mention something about the Subchapter S (Sub S) Corporation.
Simply put, the Sub S Corporation gives you all of the benefits of a corporation while allowing the income or loss of the company to flow directly to your personal income tax return. This has some very distinct benefits.
For example, if your corporation did not choose the Sub S Election, it would be taxed separately on its net income after all expenses, including your salary. This means that if you wanted to take dividends from your company, over and above your salary, you would have to pay a tax on the dividends, yet the corporation would receive no tax deductions for them. This amounts to double taxation.
The way to legally get around this is to have your accountant or attorney make a Sub S Election whereby the entire net income or loss flows directly to your return and you don’t have to concern yourself with the double-taxation dilemma.
A Sub S Election can be a great tax tool for your company. Use the timing decisions that I mention above under the headings of Cash Basis and Accrual Basis in order to further benefit from Sub S.
These timing decisions apply to the Sub S Corporation with one big exception: you and the company are one from a tax standpoint. Therefore, when you are thinking about allocating income or expense to a particular year based upon the financial results of your company, you must put your personal tax situation into this mix, since, from a tax point of view, you and the company are indistinguishable.
Here’s a tip if you have made the Sub S Election and are having a bad year. In order for you to personally take full advantage of any losses, you must have invested or loaned enough dollars to the corporation to cover your current losses.
I don’t want to go too deeply into this because it is somewhat technical. But, if your Sub S Corporation is having a bad year, you want to make sure that you have invested or loaned enough dollars so that you can fully absorb the losses.
Your investment and the loans that you have made to your company are collectively referred to as your “basis.” You must have a high enough basis in the company to fully absorb your losses. Check with your tax adviser on this very important issue.
Another Issue — Financial Planning
I mention this element because you might have a loan agreement that states that you will be in default unless you keep certain ratios at pre-determined levels. Ask your accountant or attorney to review any loan agreements that you might have in order to be sure there are no specific financial-statement hurdles and requirements in them.
If you have some strictures in your loan agreement, it might not be too late to address them and make appropriate changes to your financial statements before you have an unexpected New Year’s surprise — that you have defaulted on your loan provisions. Ouch!
Keeping a close watch on year-end planning is ultimately your responsibility. You must, however, consult with your accountants and attorneys on a timely basis to assure yourself that you are planning wisely. The benefits of so doing can be tremendous. Good Luck!
Theodore F. di Stefano is a managing partner at Capital Source Partners and can be contacted at [email protected].