December 3, 2020

End of Year Tax Planning: Profit Shifting

With less than 30 days until the end of the year, what can a small business owner do to reduce income taxes?

One popular strategy is to shift profit into the next tax year to defer income taxes.

…What does that mean, exactly, and is it legal?

In this article we will discuss:

  1. How to increase tax deductions

  2. How to defer income to next year

First, you should know that it’s not always best to shift profit to next year!
…like a game of chess, you should be thinking many steps ahead for optimal tax savings.
 
This is where detailed tax strategy comes into play.
 
While deferring tax payments to a later date always seems like a good idea, you could be in a higher tax bracket next year, and end up paying much more than if that income was taxed this year.
 
It’s a game of numbers…thinking about next year, and running scenarios.
 
Now, on to the basic strategies…
Can you prepay expenses and get a tax deduction this year?
The treatement depends on if you are a Cash-Basis or Accrual-Basis taxpayer.
 
Cash-Basis
If you are a “Cash-Basis” taxpayer, you can prepay and deduct expenses that are related to the next 12 months (or less).
 
Example 1:  You pay $3,000 a month in rent and would like a $36,000 deduction this year. So on Thursday, December 31, 2020, you mail a rent check for $36,000 to cover all of your 2021 rent.  You get to legally deduct the $36,000 in 2020 as rent expense.
 
Example 2:  In December 2020, you pay $10,000 for an insurance policy which begins on February 1, 2021 and ends on January 31, 2022.  You may not deduct the $10,000 in 2020, because the benefits of your payment (insurance coverage), extend beyond the next 12-months, and into the tax year following the upcoming tax year.
 
Accrual-Basis
The laws are not as straight forward for “Accrual-Basis” taxpayers.  The general idea of the accrual-basis is that you deduct expenses as the economic benefits have been received.
 
In Example 1 above, an accrual-basis taxpayer would not be able to deduct rent prepaid in December 2020 which is related to use of the property in 2021.
 
However, an accrual-basis taxpayer would be able to deduct a $20,000 insurance premium paid in December 2020 for a policy period covering December 1, 2020 to November 30, 2020.  This is because the IRS states that economic performance of an insurance premium occurs when the policy premium is paid.
 
Also, with accrual-basis, you can deduct expenses that you haven’t paid yet…as long as the expense has been incurred.
 
…for example, if you get a bill from your attorney on December 15, 2020 for services performed in 2020, you can deduct the bill amount in 2020 even if you don’t pay it until 2021.
 
Paying Expenses with Credit Cards
Any expenses, which are otherwise deductible this year, can be charged to a credit card and be deducted this year…even if the credit card bill is not paid before the end of the year.
 
Important note:  Unless you report your business profit on a Schedule C, the credit card must be in the name of the business.  If the owner of a corporation uses a personal credit card, the corporation should reimburse the owner before December 31, for it to be a valid deduction.
 
Can you delay invoicing customers, or not deposit checks, to reduce revenue this year?
Again, there are different treatements based on whether you are on the cash-basis or accrual-basis.
 
One tactic some cash-basis business owners try to deploy is not depositing customer checks received.  By not depositing the checks, it doesn’t show up on the bank statement and therefore is, ‘hidden’.  This is not legal, per the IRS.  A check received should be counted as revenue in the period it was received.
 
What is completely legal for cash-basis taxpayers, is to delay sending invoices to customers.  Even if you send invoices on December 20, 2020, as long as you don’t receive payment in 2020, it will not be taxable income for 2020.
 
For accrual-basis taxpayers, the IRS requires that you report income in the period on the earliest of the following dates:
  • When you receive payment
  • When the income amount is due to you (you have invoiced the customer)
  • When you earn the income
  • When title passes (in the case of inventory)
“When you earn the income” is a bit nuanced.  As a practical matter, most small business owners on the accrual-basis will only report income when it has been invoiced.
 
Back the to the chess game…
Taxpayers that generally pay $50,000 or more in taxes per year should consider the effort worth while to analyze impacts of when to shift income, or not.
 
If you have questions about profit shifting or would like assistance to strategize the timing of income, please reach out.
 
Chris Naquin
Wayfinder CPA

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