By James P. Kenney, CPA

Has your accountant ever said to you, "My best clients pay taxes"? This is quickly followed by "And they are happy to do so because it means they're making money!"

While it is true that success breeds success, unfortunately, the more you earn, the more you have to pay in taxes. The good news is that while Congress has eliminated many opportunities for tax savings in recent years, there still exist many planning opportunities to help minimize your tax bill. Here are some opportunities to consider.

Assess your organizational status
You should periodically assess whether your current form of business ownership is the most advantageous from a tax perspective. With unincorporated businesses, partnerships, limited liability companies (LLCs) and S corporations, the income is generally passed through and reported on the individual owner's income tax return. C corporations, meanwhile, pay taxes at corporate tax rates. You need to consider that the federal rate on personal income taxes reaches as high as 39.6%, while the highest C corporate tax rate is 35% and is often much lower, depending on income levels.

Additionally, certain items that may be deducted in a C corporation are not deductible as direct expenses in the pass-through entities and therefore must be recharacterized as compensation. An example of this would be company-paid health insurance premiums for the business owner and his or her family members.

However, you must be careful because, while the lower tax rates of a C corporation may be attractive today, income from a C corporation is often subject to what is called a "double" tax. For example, dividends paid out of C corporations are taxable to the shareholder and not deductible by the company. Additionally, a second level of tax could result from the sale of business assets and the subsequent liquidation of the net proceeds to its owners.

While only some C corporations formed after 1993 are "qualified small businesses" and eligible for some tax relief on the sale of stock, most S corporations and LLCs are generally not subject to the corporate-level tax at all. Therefore, it is quite conceivable that you will end up paying less tax over the long run if you are formed as one of the pass-through entities. Careful analysis, including forecasts, income assumptions, liability issues and business succession plans, is critical when selecting the proper form of business ownership.

There are also other advantages of S corporations and LLCs. For example, you may be able to deduct business losses, especially those incurred during the start-up phase, on your personal return. Also, earnings passed through and taxed on personal tax returns increase the tax basis of your business interest. So if the business is sold, the resulting taxable gain is less than it would be as a C corporation. Finally, S corporation distributions to shareholders, while they reduce your basis, are not subject to income and Social Security taxes.

Take advantage of business-related asset purchases
One method to reduce taxes is to elect to "expense" certain fixed-asset acquisitions rather than depreciating them over their estimated lives. Tax rules provide for a write-off of up to $24,000 (in 2001) of the cost of tangible personal property used in the trade or business. The fixed assets must be placed in service before the end of the year, and the opportunity to take advantage of this expense election begins to phase out when annual asset purchases exceed $200,000.

Maximize contributions to qualified retirement plans
Accrued contributions to a qualified retirement plan, like a profit-sharing plan, are immediately deductible by your company even if the business does not pay the cash until the due date of the corporate tax return. This allows for up to an 8-1/2 month deferral of payment after year-end if your company receives the automatic filing extension.

Additionally, many defined contribution plans allocate the contribution to participants based on their relative compensation to the total compensation paid by the company. Therefore, if you (as the business owner) and your family members are among the most highly compensated employees, a significant portion of the contribution is credited to your accounts. The company can deduct the contribution against its taxable income and the money accumulates in a tax-free environment until it is withdrawn years later. Corporate write-offs and tax-free accumulations — now that's a "win-win" combination!

Consider options under various accounting methods
If your company uses the cash method of accounting, you may consider delaying billing notices to customers to avoid the constructive receipt of income at year-end. Another tactic is to purchase non-inventoried supplies eligible for expense deduction prior to the close of your tax year. With some restrictions, certain personal service corporations, partnerships and small C corporations may be eligible for the cash method of accounting.

Accrual-basis taxpayers can write off uncollectible accounts receivable that have no chance of being collected. You can also either delay shipping products or providing services until the next tax year, or make shipments FOB destination rather than shipping point so title does not pass until the goods are received by the customers.

Consider workers' employment status
You may be able to save employment taxes, like social security taxes, in addition to fringe benefit costs by classifying workers as independent contractors, rather than employees. You will need to be aware of the special rules that qualify workers as independent contractors, as opposed to employees, because there are stiff penalties for misclassifying an employee as an independent contractor. On the other hand, you may want to consider if a worker's wages qualify for the "Work Opportunity Tax Credit," which allows for a tax credit of up to $2,100 on first-year wages paid to certain targeted groups like qualified veterans, ex-felons and summer youth workers.

Year-end planning is essential
Taxes on small businesses can be complicated, and if not adequately addressed, can place a significant tax burden on your business. This makes careful tax planning, especially before year-end, absolutely essential to minimizing your tax bill.

Remember: While paying taxes is a better problem than not paying them, there's no reason you should pay more than your fair share.

James P. Kenney, CPA, is one of the owners of Wolf & Company, P.C., a regional accounting firm headquartered in Boston, Massachusetts, providing accounting, audit, tax and business consulting services to individual and business clientele in a wide variety of industries. Visit Wolf & Company's web page at www.wolfandco.com.

Back To Top | Previous | Next