Year-End Tax Moves
Tax consultant offers tips for business owners
BY Milton Zall, special to airport business
You can reduce your 1999 tax bill by taking certain steps before the year ends. Here's a rundown of some of the more important tax moves you can make before 1999 draws to a close.
Marginal rate analysis
There's a chance to save some tax dollars, if you do business as a C (regular) corporation. Unlike an S corporation or a partnership, a C corporation is taxed as a separate entity. The first $50,000 of income is taxed at 15%. The next $25,000 is taxed at 25%; the next $25,000 is taxed at 34%. Taxable income from $100,000 to $335,000 is taxed at 39%. (This is done to eliminate the graduated rates on income below $100,000.) You may be able to take advantage of the graduated rates to substantially reduce this year's tax bite through "Marginal tax rate analysis". Example — Jim is an employee and the sole shareholder of XYZ Corp., a C corporation. Based on Jim's best estimates, XYZ will have a taxable income of $125,000 during 1999. Thus far in 1999, Jim has taken only $65,000 in salary. Jim and his wife Mary together have a taxable income of $60,000. That puts them well within the 28% bracket. On the other hand, the last $25,000 of income of XYZ will be taxed at 39%. If Jim increases his salary by $25,000, XYZ's income will decrease by that amount, saving $9,750 in taxes. His personal income will go up by the same amount, resulting in an additional $7,000 in taxes. The $9,750 reduction in corporate taxes less a $7,000 increase in personal taxes, yields a permanent tax saving of $2,750. You can calculate your potential tax saving by finding the difference between your tax bracket and your corporation's. In this example, the difference is 11% (39% less 28%). Multiply that by the amount of the income shift ($25,000 in this case) and you have your answer.
Contributions to IRA and Keogh Plans
In order to ensure the tax deductibility of your contributions to IRA and Keogh plans, make sure you make them in time. For IRAs, you can deduct contributions made before April 15, 2000, and have until that date to establish the IRA if you do not already have one. For Keoghs however, your Keogh plan must be established by December 31, 1999, although you have until April 15, 2000 to make your 1999 contribution.
Sale of Real Estate
If your business owns real estate that has appreciated in value and is considering selling it in 1999, one way to avoid incurring taxes on your capital gain is to make a "like-kind exchange" for another similar property that will also be held as an investment. If you make such an exchange, no income tax is due now. Income tax will be payable only when you dispose of the second property.
If you do business as an S corporation, partnership, sole proprietorship, etc. the net income (or loss) of the business is passed through to you and reported on your individual tax return. You want to defer income to next year if you anticipate being in a lower tax bracket. Conversely, you want to accelerate income into 1999 if you think you will be in a higher bracket next year. By now, you should have a good idea of which way your income is headed. If 1999 is a big year and 2000 will not be as good, you want to push income into 2000. If it's a toss-up, you should probably still defer income; it will improve your cash flow by delaying tax payments.
Timing the Acquisition of Depreciable Property
The tax reform legislation enacted thirteen years ago bars business owners from placing business equipment into service at the end of the year and still getting a full year's worth of depreciation. Under present rules, when you place depreciable assets into service, this has a direct bearing on the depreciation allowance you are entitled to. If you place more than 40% of your annual equipment purchases into service during the last quarter of the year, all of the business equipment placed in service during the year is subject to the "mid-quarter" rule. Under this rule, the quarter during which an asset is placed in service governs your depreciation allowance — the middle of that quarter is used to calculate the amount of depreciation that you are entitled to. When we speak of placing equipment into service, we mean that it is ready to be used, it need not actually be placed in use.
If you place 60% or more of your equipment into use during the first three quarters of the year, you are subject to the half-year rule, which treats all equipment placed into service during the year as having been placed into service halfway through that year.
If you are contemplating purchasing business equipment before the end of the year, it is prudent to ascertain where you stand with respect to the half-year versus the mid-quarter rules.
In order to determine whether you will benefit more from the mid-quarter or the half-year rule, you must perform alternate calculations and vary the timing of asset acquisitions to see which acquisition schedule is most advantageous. If you are planning to acquire business equipment before the end of 1999, ask your accountant to go through these calculations with you. You may be in for a pleasant surprise.
You still have some time to set up a pension plan for this year. An SEP or a regular profit-sharing plan may make sense. Ask your tax advisor what form of pension plan is best for your business. In addition, do not forget to pay bonuses to employees before year-end if it has been a good year. Warn them though that it may be a one-time event. Paying these bonuses in 1999 will reduce your business' taxable income.
You may take a full deduction and write it off as an expense up to $18,500 of the cost of equipment placed in service during the year instead of depreciating it. If you have not availed yourself of this option yet, keep in mind that equipment placed in service during 1999 that is going to be expensed can be written off regardless of when it was acquired — even the last day of the year. If you decide to expense an equipment purchase, it does not matter when it is acquired during the year. The only thing to watch out for is if later on, you convert the equipment to non-business use, you have to pay the government back for the deduction you previously took, so make sure you expense something that will remain in your business.
The $18,500 expensing allowance is only available to you if you have not already acquired other business equipment in 1999 that is valued at more than $200,000. If you have, this option is phased out on a dollar-for-dollar basis when you go over the $200,000 threshold, and disappears entirely if you acquire more than $210,000 of business equipment in 1999.
The $18,500 expensing allowance can only be used to offset taxable income from your business. If your taxable income falls below $18,500, you do not get the full benefit of taking the $18,500 expensing allowance. However, if you have another business that has taxable income, the unapplied balance can be applied against taxable income from the other business.
Accumulated Corporate Earnings
Small, family-owned corporations often retain earnings within the corporation rather than declaring a dividend to avoid the double taxation of these earnings — i.e., initially as corporate earnings subject to the corporate income tax and then as personal income received by the officers of the corporation (your family members) through corporate dividends that are subject to individual income tax.
There is a $250,000 limit set on the amount of accumulated earnings that a closely held family corporation can have. Any accumulated earnings in excess of the $250,000 limit are subject to a 39.6% penalty tax.
To avoid incurring this tax, make sure by year's end that you declare sufficient dividends to stay clear of the $250,000 limit. The only exception IRS allows to the $250,000 limit is if you can show that the earnings are being retained in order to meet the reasonable needs of your business. Some examples of "reasonable needs" are retaining the earnings in your business to provide you with the money you need for working capital or future expansion. Another example is retaining the earnings in order to purchase a facility that you are currently renting.
If IRS challenges the retention of corporate earnings in excess of $250,000 however, you will have to be able to document the business purposes for which these excess retained earnings are being held. If your contention is that you are retaining the excess earnings in order to acquire property, you will need to have documentation, such as cost estimates from builders, architect's plans, insurance estimates, etc., to show that you were retaining excess earnings for such a purpose. Without such documentation the IRS will disallow your claim and impose the penalty tax.