Small Business Taxes & Management
Year-End Planning--Part 1--2016 Basics
Small Business Taxes & ManagementTM--Copyright 2016, A/N Group, Inc.
As opposed to prior years, we won't have to worry about "extenders" legislation at the end of 2016. The Protecting Americans from Tax Hikes Act (PATH Act) passed at the very end of 2015 dealt with virtually all of the expiring provisions, making some permanent, and extending some only for a limited time. For example, the deduction for mortgage insurance premiums expires at the end of 2016, but the deduction for state and local sales tax is now permanent. While it is possible Congress might change its mind and extend some provisions that expire at the end of 2016, that seems unlikely.
What about legislation in 2017? What will a new president do? Much of tax planning is about taking a deduction in the right year. If tax rates decline next year, you want to postpone income to next year and accelerate deductions to 2016. Speculating on the outcome of the election is foolish at this point. What's more, major tax legislation could take more than a year to get through Congress unless one party is in control of both houses and the presidency, and even then it might be tight. That, coupled with effective dates most likely means 2017 won't look much different than 2016, at least on the tax front.
Here's the abbreviated list of provisions that were extended (either permanently or temporarily) at the end of 2015:
- Credit for certain nonbusiness energy property
- Tax credit for research and experimentation
- Work opportunity tax credit
- Deduction for state and local sales tax
- 15-year straight-line cost recovery for qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail improvements
- Additional first-year depreciation to 50 percent of basis of qualified property
- Increase in expensing option (Section 179) for business property
- Deduction for qualified tuition and related expenses
- Tax-free distributions from individual retirement plans for charitable purposes after age 70-1/2
- Discharge of indebtedness on principal residence excluded from gross income of individuals
- Employer wage credit for employees on active duty who get differential pay
For more information, go to our article Congress Renews Tax Extenders.
The theory behind business tax planning is similar to planning for your personal return. You want to defer the income to a low tax rate year. If you do business as a sole proprietorship (i.e., file a Schedule C), S corporation, partnership, or LLC (limited liability company), income and losses of the business are passed through and reported on your personal tax return. Thus, your approach to year-end planning is similar to that for individual planning. (There are some factors that can complicate the issue; they're discussed below.) And, yes, while it's true you can save taxes by making equipment and other purchases, you're out-of-pocket cost is still more than 50%. For example, you purchase a $1,000 laptop. If you're in the 39.6% bracket for federal purposes and 10% for state, you're effective tax rate is probably about 46% (you get a deduction for your state taxes on your federal return). That means the government is picking up $460 of the cost; you're paying for the other $540. If you're self-employed or doing business as a partnership or LLC, your rate will be slightly higher when you add in the self-employment tax. (Want to get a better idea of the cost? Go to What's a Deduction Worth? on our Frequently Asked Questions page.) Best suggestion? As always, economic considerations come first. Don't buy what you don't need; don't buy more than you need.
We mentioned above that 2017 is likely to be very much like 2016 from a tax standpoint. While there are some provisions that will expire (e.g. the deduction for mortgage insurance premiums), their effect is likely to be minor. Based upon the way Congress has been dealing with issues, major tax legislation is unlikely, at least until closer to yearend 2017 and changes almost assuredly won't be retroactive. If Congress does pass major reforms, it's likely to take the form of lower rates accompanied by a cutback in "expenditures". That's tax-speak for deductions. If you're a small business owner, you'll most likely be pleased with any new legislation. From an individual standpoint, you may be less happy, particularly if your annual income is large. You're probably most at risk in having your deductions or credits cut back if you're taking advantage of "loopholes" or tax benefits that only apply to a limited number of taxpayers.
What's the take away? Rates could be lower in the future, but you could lose deductions. Unless you expect to have substantially more income next year, you should probably defer income to next year and take deductions this year.
For a list of tax rates, facts on alternative minimum tax, standard deduction, credits, etc. go to our Tax Tables page for the details.
Projecting Your Income-Business
Before going any further you've got to have a good handle on the income from your business. Your accounting records are a good starting point, but more than likely you'll have to adjust them to conform to the tax accounting rules. Here are some possible adjustments:
- Depreciation. The depreciation reported on your books may be higher or lower than that used for tax purposes. In some cases, no provision may have been made yet for depreciation for 2016.
- Writeoffs. Bad debt reserves and many book writeoffs are not allowed for tax purposes. That may increase current year taxable income. On the other hand, book writeoffs taken in prior years may be reversing this year and may be deductible for tax purposes.
- Like-kind exchanges. Gain may be deferred for tax purposes but recognized for book.
- Meal and entertainment expenses were fully expensed for book purposes, but generally only 50% of the amounts can be deducted for taxes.
- Installment sales. Tax law doesn't allow the installment method for accounting for sales of goods that are inventory property. For example, if you sell furniture as a business, you can't use the installment sale for those items. On the other hand, you can use the installment method for the sale of store fixtures, shop equipment, etc.
- Amortization. You may have capitalized some expenses for book purposes in the past and are currently taking a deduction while you immediately expensed the item for tax purposes. That means your tax income will be higher than book. It's possible for some items to go in the reverse direction. That is, tax income could be lower than book.
- Nondeductibles. You may have made payments with a business check or credit card that clearly aren't deductible, e.g., that tuition payment for your daughter. You've got to make adjustments for such items. Similarly, you may have contributed money to the business either as a capital contribution or loan. If you're just using your bank deposits as a proxy for your income, be sure to account for these items.
- Tax law has some pretty specific rules as to when you can record income and expenses. If you're a manufacturer you'll also have to contend with the uniform capitalization rules. In short, many costs that you may have expensed for book purposes will have to be capitalized for taxes.
Check with your accountant on these issues. Hopefully, the differences will be slight, and, if so, can be ignored. Annualize your income (e.g., take the first 10 months, divide the income by 10 and multiply by 12) to figure your full-year profit or loss. Don't forget to account for any variations during the year. For example, if you're a retailer, the Christmas season is important and simply annualizing won't work. Same if you run a concession stand at the beach.
Businesses that operate as a sole proprietorship, LLC, partnership, S corporation, etc. have their income (or losses) passed through to the owners and reported on the owners' individual tax returns. That means you'll have to project both the businesses income and your personal income to evaluate your tax bracket. See below.
Projecting Your Income-Personal
If you do business as an S corporation, sole proprietorship, etc. your share of profits or losses are passed through and taxed on your personal return. (If you, or you and your spouse are the only shareholders in an S corporation, taking a smaller or larger salary won't change the outcome materially. A larger salary will just mean the pass-through income from the S corporation will be reduced and vice versa.) That means you'll have to do a projection of your personal as well as business income before you can do any serious planning. Assemble your records for the first 10 months of the year. If you record income and expenses on a regular basis, this should be a snap. The purpose of this article is to determine if it makes sense to make any last minute capital expenditures to take advantage of bonus depreciation, etc. While we've included a list of items to take into account at the personal level, you can cheat and estimate some of them. For example, your charitable contributions usually run $500 to $1,000. For now your best guess is good enough. Concentrate on the bigger numbers.
- Passthroughs from partnerships, S corporations, trusts, etc. If you're a small business owner more than likely this is where the largest source of income. Use the guide above to project your income and add it to your personal income.
- Salary income. This one is easy. You should have cumulative pay stubs that show gross income and taxes withheld. Annualize them as described above. Adjust for bonuses.
- Interest and dividends. You won't have 1099s, but you should have a good idea of your interest and dividend income. Check your last statements from your broker, mutual fund, etc. and annualize the amount (use the year-to-date amount, divide by the number of months the statement covers, then multiply by 12). Caution. Annualizing may not work for dividend income. It's fine for small dividends, but you may have to do some additional work if you have big holdings in some stocks or have significant holdings in mutual funds. That could be especially important this year. Alternatively, use last year's amounts and adjust up or down.
- Rental income. If you have rental properties, you'll need to come up with an income estimate. Before annualizing the income or loss for the first 10 months, be sure there are no unusual factors. For example, if you incurred big repairs earlier in the year, you may have to adjust for that. Same for utilities and certain other items. Or the space was vacant for a time. Not sure of how much depreciation to use? You won't be too far off if you use last year's number (unless 2015 was a partial year or you made significant capital improvements in 2015 or 2016).
- Capital gains. For many taxpayers this is an important factor and difficult to predict. Some taxpayers may still have unrecognized losses from prior years, but chances are you've got realized gains. For many taxpayers this is important since it's where you can do considerable tax planning. Get your brokerage statements for the year to date to find your gain or loss on every significant transaction. Total short-term gains and losses, then long-term gains and losses (property held more than 12 months).
- Also check for distributions from mutual funds made to date. There's a very good possibility some or all of your funds could distribute income before the end of the year. In some cases the payouts could be substantial. You may be able to get information from the fund to see what the year-end distribution will be. Keep in mind that you could receive a large distribution from the fund even though it performed poorly.
- Other income. Did you sell your main or vacation home, win any prizes or awards, settle a lawsuit, receive alimony, etc.? Get a state or local income or real estate tax refund? You could have additional taxable income. Also consider insurance reimbursements you received this year for medical expenses you deducted in an earlier year. Casualties can sometimes produce gains as well as losses. Had any net gambling winnings? Collecting on a prior-year installment sale?
- Principal residence sale. If you sold your principal residence, there's a good chance you'll owe no tax on the sale. If you're single, the first $250,000 of gain should be exempt. If you're married, you can exclude the first $500,000. (Caution. The exclusion doesn't apply or is reduced if you haven't used the house or condo as your principal residence for two of the last five years or you claimed the exclusion on another residence within the last two years.) However, before you go to the next topic, think again. If you're a long-time home owner, you could have broken this threshold. Remember, you'll have to consider gains deferred on sales made before 1997 if this is your first sale since the law change. The exclusion also contains a number of restrictions. If you used part of the home for business, some of the gain may be taxable. Finally, even if you don't owe any federal taxes, you still could be liable for state income taxes on the sale.
- Distributions from pension plans. You may have taken money out of an IRA, Keogh, 401(k), etc. during the year. Chances are it's all taxable income. (Roth distributions are an exception and a portion of your IRA may be nontaxable if you made nondeductible contributions.) Distributions from some regular pension plans may be part taxable-part nontaxable. In addition, if were under age 59-1/2 and don't qualify for one of the exceptions, you'll owe a 10% penalty. CAUTION. This is an important item. Such distributions can raise your final tax bill significantly.
- Social Security. If this is your first full year on Social Security you'll have to compute the taxable portion. If your AGI is above a threshold 50% may be taxable; above a second threshold 85% is taxable.
- Nontaxable income. Some income escapes taxes. That includes gifts and inheritances (generally, but pensions, annuities, etc. received from an estate are likely to be taxable) interest on most municipal bonds, returns of capital (e.g., principal repayments on a loan), reimbursements from your employer for business expenses, etc. Make sure you don't count any items as income if they're not. But if you're a shareholder in an S corporation or a partner in a partnership or LLC and received distributions in excess of your basis, they may be taxable.
- Check last year's return. Many items repeat year after year. You may find some income you hadn't considered.
Caution!--If you turned 70-1/2 this year you'll have to start taking distributions (required minimum distributions or RMD) from your IRA and certain other plans if you're a business owner or retired. Check the rules with your accountant or the plan trustee. You don't want to incur a penalty--its 50% of the amount that should have been distributed.
Estimating your expenses and deductions. You've also got to come up with an estimate of your deductions. The items below are common deductible expenses.
- Alimony. If your divorce was structured properly it should be deductible. However, payments that are really part of a property settlement or child support aren't deductible. Conversely, alimony is taxable to the recipient; property settlements and child support aren't. This can be a big number, so make sure the payments qualify.
- Contributions to SEP, IRA, Keogh, etc. Some will depend on your income (e.g., SEP contributions may depend on your Schedule C income). You can make contributions as late as return filing (no later than April 15th for some plans), but if you're going to use that for planning, make sure you have the funds.
- If you're self-employed or a shareholder/employee in an S corporation, you may be entitled to deduct 100% of health insurance premiums you paid.
- Medical expenses. Add up all your expenses. Include medical insurance premiums not deducted elsewhere, doctors, dentists, hospitals, travel to and from the doctor, etc. Also include medical appliances such as glasses, hearing aids, etc. You may be able to deduct additions to your home if required or prescribed by a doctor. For example, a wheelchair ramp, special sink, etc. This can get tricky. Check with your tax adviser. Of course, reduce the amount by any reimbursement from insurance. Your deduction is limited to the amount that exceeds 10% (7.5% if you or your spouse was born before January 2, 1952) of your adjusted gross income (AGI).
- Taxes. Include real estate taxes, state income taxes paid in 2016, and personal property taxes. When adding your taxes be sure to include any payments made when you filed your 2015 state return this year. Chances are unless you're in a no-income-tax state or your adjusted gross income is low, you'd be deducting state income taxes. But that may not be true if a significant portion of your income isn't taxed for state purposes. For example, in New York State, the first $20,000 of pension income per person escapes tax. We wouldn't suggest purchasing a car, boat, etc. to boost your sales tax expense, but if you do you can add that to the table amount.
- Interest. You're generally limited to interest on a home mortgage, including a mortgage on a second home. To that you can add a home equity loan with a principal amount of no more than $100,000. Interest to purchase an interest in an S corporation or partnership is also fully deductible (but not on Schedule A). Interest on other investments may or may not be deductible. Compute the total amount; we'll discuss planning later.
- Charitable contributions. If they're significant go through your receipts and checkbook. You may receive a notice from your church at the end of the year. For now you can use an estimate. Remember the rules on charitable contributions. You'll need a canceled check or receipt for all contributions; a receipt for those over $250.
- Education expenses. Amounts paid for your children or yourself may qualify for a credit or deduction. More than likely the amount spent will far exceed the amount qualifying for a tax benefit.
- Casualty or theft loss. It's got to be a big one. Only losses that exceed 10% of your AGI, plus $100 per casualty are deductible. Remember, any insurance reimbursement reduces the loss.
- Miscellaneous deductions. Include professional or union dues not reimbursed by your employer, tax preparation fees and books or software to help you prepare your return, investment expenses, safe deposit box rental, job-related education, and unreimbursed employee business expenses. If you work out of your home that can include a second telephone line, etc. Remember, only the amount over 2% of your AGI is deductible. If you had gambling winnings, gather all your losing tickets, etc. They can be deducted, but only to the extent of winnings.
- Life changes. The biggest factors on your tax return may be life changes. Have a baby? Get married? Get divorced? Child out of college? Spouse passed away? These can make big differences in your taxes, even if your income and deductions stay the same. Just retired? Your income may drop substantially. Or, if you're still working and collecting social security your income may be much higher.
Finding your tax bracket. If you've got a good handle on your income and expenses you can net the two to arrive at your taxable income. Be sure to also subtract out personal exemptions (use $4,000 each for yourself and spouse and dependent children). If your AGI exceeds certain thresholds your personal exemption and itemized deductions may be limited.
If you're pretty confident of your computations, you can find your tax bracket by using the Tax Tables in our Reference File. Keep in mind that long-term capital gains and qualifying dividends are taxed at a lower rate. Go to our Tax Tables for the details.
Caution. There's a good possibility you'll be subject to the alternative minimum tax (AMT) and the net investment income tax. That can make the computations much more complex. If you don't want to talk to your tax adviser, get a computer program. Initial or planning versions of popular programs are available or should be shortly.
More to Come
We'll discuss specifics of tax planning for businesses in the next article and planning for individuals in the final article.
Copyright 2016 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536
--Last Update 10/31/16