In a tepid economy where every penny counts, it can be painful to leave money on the table for Uncle Sam. The good news is you don’t have to. You can lower your tax bill — or at least defer the payment of taxes to the next year — without too much pain and completely within the guidelines of the IRS code.
The flexibility to take advantage of such tax deferral hinges on your method of accounting. The two most common accounting approaches go by the labels, “cash basis” and “accrual basis.” The ability to defer taxes outlined here applies to those companies using the cash basis method.
The IRS has very stringent guidelines on what types of companies can qualify for a cash basis method — guidelines that, in most cases, limit such a method to companies with gross revenues under $5 million. But, as with most things related to taxes and the IRS, there are circumstances that can enable larger companies to comply with the guidelines, and there are other circumstances that prevent smaller companies from utilizing the method.
Using cash basis accounting, a company books the revenue when the check arrives, not when charges are invoiced (as with the accrual method). Likewise, with a cash basis, expenses are booked when checks are written, not when the bill is received. By paying down its receivables before the end of the year, a company can reduce (or, technically, defer) the amount of taxes it might owe in the year that is ending. Likewise, even on work completed and billed, under the cash basis, if payment doesn’t arrive until after Dec. 31, taxes won’t be due until the following calendar year.
But the IRS does not want companies trying to manage its payables and receivables strictly to game the timing on its taxes, so be forewarned: If you file your returns using the cash basis, simply telling your customer to pay in the New Year won’t fly with the IRS due to a concept called “constructive receipt.”
“This means if a small business has control over when it collects, it must recognize the income during the current period whether they have the cash in hand or not,” according to Jason Dillon, accounting director of Small Business Accounting, LLC in Birmingham, Ala. “For many basic small businesses, the best way to shift some of the tax liability is to simply plan to complete the service or transaction in the new tax year. If it’s consistent that the business won’t be paid or even invoice their customer until it completes the transaction or service, they’ll be able to recognize the income in the following tax year.”
Managing year-end inventories is important to those who use the accrual method of accounting, as well. The company books the expense of the inventory in the year the inventory is sold. According to Mark Gleason, a CPA in Edina, Minn., “Business owners should dispose of worthless or obsolete inventory on or before Dec. 31 if they want to expense the cost of the worthless inventory.” (The reason you see such bargains in the week between Christmas and New Year’s Eve.)
The most important move with inventory is to take it on the last business day of the year. “First, business owners will need to account for any differences between the actual inventory and inventory on the books; this will be reported on their tax returns,” Gleason said. “And second, small businesses need to assess if they have inventory they can’t sell or that has lost value.”
As the inventory leaves the business, you’ll then be able to take the expense in the current year. “Along with this, I think business owners should sit down during December and plan for the opportunities in the coming year, properly plan for their tax liabilities, and set measurable and attainable goals without compromising what makes them great businesses in their communities,” he said.