Tax-Trimming Tips For Businesses

Regardless of the form in which you do business - sole proprietorship, partnership, LLC, C corporation, or S corporation - there are many steps you may be able to take in the last few months of the year to make a difference in your tax bill.

Planning for equipment purchases and depreciation

Especially if you are not already in a loss situation, 2002 is a particularly good year to take advantage of expanded deductions for fixed asset purchases.

Internal Revenue Code Section 179 expensing deduction. If you are contemplating the purchase of fixed assets, don't forget that, for 2002, Code Section 179 allows you to expense up to $24,000 of qualifying purchases, rather than depreciate them over several years. If you haven't exceeded the limit already for 2002, you may wish to accelerate purchases that you were already planning to make in early 2003. The deduction is limited to personal property - such as office equipment - that is used in a taxpayer's business. Remember that the expense is limited to the amount of taxable income you generate from businesses. Also, be aware that the expensing deduction begins to be reduced dollar-for-dollar to the extent that total qualifying business property purchases exceed $200,000 for the year.

Bonus depreciation. The new 30% first-year bonus depreciation deduction may be another good reason to make equipment purchases before the end of the year. The new deduction, which applies to qualified asset purchases made between September 11, 2001, and September 11, 2004, is in addition to the Sec. 179 deduction and is also in addition to any "regular" depreciation on the remaining adjusted basis.

Avoid the "midquarter" convention trap. Before making a decision to make year-end purchases, be sure you are aware of the "midquarter" convention rule for depreciation. Under the general rule for depreciation called the "half-year" convention, a business can deduct an entire half year's depreciation for all equipment that is "placed in service" (i.e., use of the equipment has begun) on or before the last day of the year.

However, there is a catch in the rules, known as the midquarter convention, which is applied as follows: If more than 40% of the cost of all personal property placed in service during a tax year is placed in service during the last quarter of the year, the business gets only one months' worth of depreciation for property placed in service during the last quarter. Thus, before making additional equipment purchases, you will want to consider if those purchases will cause more than 40% of the year's asset purchases to fall in the last quarter of the year. Timing is critical for cash-basis taxpayers. Cash-basis taxpayers generally report income when it is received and can take deductions when expenses are paid, unless those expenses must be capitalized. These rules present planning opportunities at year-end. The year-end planning strategy that a business should adopt depends on the financial picture of the business. If you expect the business to do better in 2003 than 2002, you may wish to accelerate income into 2002 to take advantage of offsetting expenses and losses, or a lower tax bracket. On the other hand, if 2002 is expected to be the better year, you may wish to defer income to 2003.

Deferring or accelerating income. Can you delay billings to customers? If you delay billing customers at year end, you may be able to defer the reporting of the income until 2003. Before making this decision, however, consider your expected tax rates for both 2002 and 2003, as well as any credit risk you may be taking as a result of the delay. Also, if you are a sole proprietor, LLC member, partner, or S corporation shareholder, don't forget that individual tax rates will drop in 2003. Finally, you will need to avoid the constructive receipt trap, which may require you to report income before you actually receive it, when certain conditions are met. Please call our office if you would like further information on the constructive receipt rule or to discuss year-end planning for customer billings in general.

Timing of expenses. On the expense side, consider what expenses can be paid in December instead of in January. You may wish to pay bills for which you have received invoices before year end, even if you have to put them on a credit card temporarily. A credit card charge counts as having been paid in the year you sign the charge.

Reminders for accrual basis-taxpayers

Review customer receivables for possible bad debts. Because accrual-basis business can deduct accounts receivable in the year they become uncollectible, now is the time to review your receivables to determine whether they have become bad debts. Before you can claim a bad-debt write off, the IRS requires that you take reasonable steps to collect payment. That can include giving the debtor written warnings or going to a collection agency or small-claims court. For those accounts that you believe to be collectible, you should step up and document your collection efforts.

Deduction for accrued compensation. Accrual-basis corporations can obtain a 2002 deduction for compensation or bonuses approved but not paid by year end to unrelated employees, as long as the compensation is actually paid within two months after the year end.

Contribution deduction for C corporation accrual-basis businesses. Charitable gifts approved before year-end are deductible in 2002 as long as the gift is actually made within two months after year-end. Don't forget the 10%-of-taxable-income limitation, however.

Identify meal and entertainment expenses. As a business owner, if you entertain clients or customers, you can only deduct 50% of your qualifying business meal and entertainment expenses. However, business-related travel expenses and certain expenses for employees are deductible in full. If you have not already done so, be sure that expenses for meals and entertainment are clearly segregated in your records from qualifying business travel and other fully-deductible expenses.

Which expenses are limited? Meals and entertainment expenses qualify for a deduction if they meet at least one of two tests. The entertainment must be "directly related" to the active conduct of your business, which means business is the primary purpose of the meal or entertainment expense, or it must be "associated with" business, which means even if you don't discuss business at the meal, the meal or entertainment expense precedes or follows substantial business discussions. Holiday parties, picnics and other social events you put on for your employees and their families are an exception to the 50% rule; such events are 100% deductible. Country club dues are not deductible at all. However, a deduction is allowed for business meals at a country club even though the club dues aren't deductible, as long as the meals meet the above requirements.

If you are not sure if a particular entertainment, travel, or other expense is deductible, please call our office for guidance.

Other year-end tax tips

Review your basis in pass-through entities. As a partner, limited-liability company member, or Sub-S shareholder, you are allowed to deduct your share of losses only to the extent of your basis in the partnership, LLC, or S corporation. If you business is expecting a loss for 2002, you may be able to ensure - before the end of the year - that you will have enough basis to deduct the loss, by making capital contributions or, possibly, loans to the business before year end. Please check with our office to review the actions you can take before year end in your particular situation to ensure that your loss will be deductible.

Do you qualify for the cash method of accounting? Revenue Procedure 2002-28 liberalized the ability of small businesses to use the cash method of accounting. To qualify, your business must have average gross receipts of less than $10 million and cannot be an entity prohibited from using the cash method of accounting (e.g., a C corporation with average gross receipts in excess of $5 million), and your principal business must not be in the mining, manufacturing, wholesale, retail, or information industries. If you qualify, you can use the cash method of accounting for 2002. If you have been using the accrual basis of accounting and think you may qualify, please contact our office to discuss the possible benefits of switching. Also note that a switch during 2002 may affect the choices you may at year end to accelerate or defer income.

Self-employed health insurance deduction. For 2002, self-employed individuals can deduct 70% of their health insurance premiums as an "above-the-line" deduction on Form 1040. Qualified individuals include sole proprietors, partners and LLC members who perform services for the business, and more-than-2% shareholder-employees of S corporations.

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