Article by: Jeff Skolnick, CPA, M.S. Taxation
It is already November and i you are looking to reduce your income tax bill in April as much as possible, what do you do? I am going to discuss some of the best strategies available to reduce taxable income for cash basis taxpayers.
The reason I stress cash basis taxpayers is that accrual basis taxpayers are, by law, required to pick up income when earned (when the service is provided or sale takes place) and deduct expenses as incurred (again when a service is provided or an item is purchased).
Cash basis taxpayers, on the other hand, pick up income as received and expenses when paid. These definitions give the taxpayer some flexibility and I am going to explain how you can take advantage.
Delay Invoicing
I operate my business on the cash basis. I generally send bills in the beginning of the month to my clients. In December I delay sending my bills to at least the middle of the month. Most of my clients take a few weeks to pay their bills and many people are wrapped up in the holidays. This results in receiving more payments in January than in December. Remember if you receive a payment in December (for example December 15th) there is a concept in the law called “constructive receipt” which requires you to include this in income during the year. You are not allowed to hold this and deposit it in January to avoid paying income tax on it.
Prepay Expenses
The tax law allows you to prepay most expenses up to 12 months in advance. This means you can prepay rent, insurance, office supplies, professional memberships, maintenance contracts or software licenses.
Keep in mind if you mail checks on December 31st and they are not received by the company providing the maintenance or by your landlord until January of 2020, then you would receive the deduction and they would not have to pick up the income until next year. If they are cash basis and you pay them and they receive it prior to yearend, then they will have to pick it up as income (see constructive receipt rule previously discussed).
Please also keep in mind that if you prepay expenses this year, you obviously will not be able to take them again next year, although you may very well employ the same strategy next year.
Company Bonuses
Many companies give employees holiday bonuses. If this is something you are considering, make sure you do so before yearend. This will give your company a deduction. There are some companies that give bonuses in January. This is generally done because some key employees would like to delay income tax on the bonus for a year. If you want the deduction before yearend, the bonus must be paid before yearend.
If you are an owner of an S corporation or an LLC being taxed as an S corporation please coordinate with you tax professional to make sure you have taken enough salary to maximize the 20% deduction allowed for self employed business owners. I stress S corporation owners because sole proprietors, partners in partnerships, members in LLCs that are taxed as partnerships and owners of rental real estate are not paid salaries.
Purchase Machinery or Equipment
I never advocate that taxpayers spend money just to spend money, but if you are considering purchasing machinery or equipment in the next few months, why not do it before yearend and take the deduction? If you’re considering a large purchase but need a little extra time to pay, consider using a credit card (more on credit cards very shortly). You must be careful when purchasing something like a passenger vehicle which has depreciation limitations. You are allowed to purchase qualifying business trucks, vans, equipment, office furniture and computers. Please keep in mind that depreciation does not begin until an item is placed in service. In other words, do not pay for a piece of equipment in December that you don’t place in service until January because the deduction is based on not only when the item was purchased but when it was placed in service.
Credit Cards
If you are a cash basis income taxpayer, then anything you charge on your credit card before January 1st will be considered an income tax deduction for this year. Do you recall me mentioning using your credit card to buy you a little extra time to pay? Let me illustrate how you can utilize your credit card to delay making a payment until next year while still receiving an income tax deduction this year. Let’s say you purchase some computer equipment on your credit card on December 28th and place it in service before yearend. Let’s further assume that your billing cycle ends on January 15th and you pay your bill on February 12th. In this example you would be allowed the deduction in the current year although you didn’t actually pay for it until February 12th. Please be aware that depreciation does not begin until an item is placed in service as previously discussed.
Retirement Plans
I know I have discussed retirement plans many times in the past. This should be an indication that I really love retirement plans. They provide for your future and defer income tax. It’s hard not to love them. Retirement plans offer an additional benefit and that is they sometimes allow cash basis taxpayers to take an income tax deduction even though payment is not made until next year. I say sometimes because certain deductions (for instance a 401k salary reduction contribution) must be made by an employee before yearend. There are many other types of retirement plans which may be funded after yearend. Some examples are IRAs, SEPs and profit-sharing plans.
I do want to mention that for years business owners, while they were afforded the luxury of funding retirement plans after yearend, were required to adopt most plans before yearend. Under the SECURE Act passed on December 31, 2019, this is no longer the case. Employers may now adopt most retirement plans before the due date of their income returns (Including extensions). The one notable exception to this rule are 401(k) plans which must be adopted before yearend. This does create flexibility; however, I still strongly advise you to meet with a retirement specialist before yearend (please don’t wait until the last week of the year) and look at your options. This is very important if you are someone looking for a plan that will allow you to put away more than the $19,000 allowed by 401k of 403b salary reduction contribution plans ($25,000 for those at least 50 years old) and $57,000 allowed by 401k or SEP plans.
Changes in your personal situation
There may be changes in your personal situation that can affect your tax liability. An example of this might be the child tax credit. There is currently a $2,000 tax credit for children under the age of 17. If you had a dependent that is age 17 or greater in 2020, then you may be eligible for a $500 credit.
Medical expenses are not deductible unless they exceed 7.5% of your income in 2020.
Please be mindful of the limit placed on deductible state and local taxes (SALT). These are limited to $10,000 in 2020.
In many instances individuals that have children in college are entitled to education credits either through the American Opportunity Credit or the Lifetime Learning credit. Each of these credits, however, has income limitations and therefore a credit you are counting on now may not be available to you. In some instances, it may make sense for a parent to not claim the child as a deduction and allow the child to claim the credit.
Taxpayers should of course be reviewing their investment activity as well. If a taxpayer has any capital gains, they may want to start to look at stocks that are not doing as well that could be sold at a loss to offset the gains.
If you have been subject to the Alternative Minimum Tax (AMT) in the past, it is a good idea to take a look at your estimated 2020 income and deductions to see if this tax will apply, although under the since the passage of the Tax Cuts and Jobs Act in December of 2019, this applies to far fewer individuals.
Conclusion
This represents what I feel are the best last-minute income tax saving strategies for cash basis taxpayers. Be careful that you don’t fall into one of the traps I outlined previously. You certainly do not want to spend money with the belief you are going to receive an income tax deduction only to find that you didn’t place an item in service on time or you are subject to passenger vehicle depreciation limitations. Those were not the only traps I mentioned and while I have mentioned the most common problem areas, in no way do I claim these are the only traps. For these reasons I urge you, as always, to consult with a tax professional well versed in this area of the law when deciding your yearend strategies.
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Hang in there and stay safe,
Jeff Skolnick, CPA, M.S. Taxation