Tax Planning Basics for Businesses

David Perkins

Tax planning is the process of looking at various tax options in order to determine when, whether, and how to conduct business and personal transactions to reduce taxes. Every business owner will have options as to when and how to complete a taxable transaction. You have the right to choose the timing and method that results in the lowest tax liability. There is nothing wrong or illegal about tax planning or tax avoidance, as long you don’t use illegal means. Illegal means includes deceit, subterfuge or concealment in one or more of the following categories:

 • failure to report income;

• claiming fictitious or improper deductions; or

• improper allocation of income to a related taxpayer who is in a lower tax bracket.

 Steering clear of these leaves quite a bit of room to maneuver.

Every tax-planning strategy is based upon structuring a transaction to accomplish one or more of the following often-overlapping goals:

A. Lower Taxable Income.

By lowering taxable income, one lowers the amount of taxes due. Many strategies to reduce taxable income will simply delay or defer the recognition of income. This alone is valuable, of course, given the time value of money. Other tactics include increasing tax-deductible expenses, moving income to entities that enjoy lower tax rates, or finding losses to offset investment gains.

B. Claim All Available Tax Credits.

Tax credits are dollar-for-dollar reductions to your tax bill. Deductions are dollar-for-dollar reductions of your taxable income. There is a big difference. Tax credits are much more valuable than deductions because a $100 credit reduces your tax bill by $100, regardless of your tax bracket. In contrast, a deduction simply reduces your taxable income by the product of the deduction amount times the applicable tax rate. For example, if you are in the 33% tax bracket, a $100 deduction will reduce your taxes by $33.

C. Lower the Applicable Tax Rate.

Such strategies include the rationalization of taxable income between tax years in light of marginal tax rates; moving income to persons or entities that are taxed at lower rates; moving income into accounts that are non-taxable or tax deferred; or conducting transactions in a manner that qualifies for lower rates (such as long-term vs. short-term capital gain rates).

D. Control the Effects of the Alternative-Minimum Tax (AMT).

The AMT was established in 1986 to ensure that higher-income individuals and corporations pay at least a basic level of tax, regardless of the number of tax credits and deductions that they garner. It requires that federal income taxes be calculated by two separate and distinct methods — regular tax laws and AMT laws. You pay the higher of the two. C-corporations with annual revenues less than $5 million (and in some cases up to $7.5 million) are exempt. Individual taxpayers that have incomes more than $75,000 face heightened risk of triggering AMT taxes. AMT tax rates are lower, such as 26 percent and 28 percent for individuals, but far fewer credits and deductions are allowed.

Here is a list of suggestions for applying each of the above to your business.

WAYS TO LOWER THE CURRENT TAXABLE INCOME OF YOUR BUSINESS

Maximize the Expenses Recognized In The Current Year.  Do this by paying (cash basis of accounting) or booking (accrual basis) expenses in the current year that might otherwise be recognized in future years. This is accomplished by incurring the expenditure before year-end by issuing a purchase order or paying expenses such as rent, insurance or taxes. Talk to your accountant about your particular situation.

Contribute to a Qualified Retirement Plan. Employer contributions to qualified retirement plans are tax deductible. Qualified plans generally mean employer sponsored pension, profit sharing or stock bonus plans that meet requirements of

Internal Revenue Code section 401(a), or an annuity that meets requirements of Internal Revenue Code section 404(a)(2). There are three types of qualified plans: defined contribution, defined benefit and hybrid. If you do not have a qualified plan in place, talk to an attorney, accountant or financial advisor. In some cases, a plan must be in place before year end to be fully utilized the following year.

Increase or Accelerate Charitable Contributions. Donating to a worthy cause not only does good but can reduce your taxable income. Advancing next year’s payment might be considered as well, as many nonprofit organizations now accept credit cards. The charity will appreciate the earlier receipt of the money and you get a deduction. Empty your closets of old clothes, furniture and the like and donate them to a charity. Remember to get a receipt and figure out the fair market value of the goods you donate. If you’re audited, no receipt means no deduction.

WAYS TO FIND, QUALIFY FOR AND CLAIM BUSINESS TAX CREDITS

A taxpayer can take a dollar off its tax bill for every tax credit dollar for which it qualifies! Obviously, it's an extremely powerful tool for tax reduction. Most federal tax credits currently available to small businesses, however, are very narrowly targeted to encourage you to take certain actions that lawmakers have deemed desirable. There are also a few credits designed to prevent double taxation and a few designed to encourage certain types of investments that are considered socially beneficial. The credits can be divided into four categories:

Credits for Certain Taxes. Credits are permitted to offset the sting of certain taxes, including FICA taxes on tips for food and beverage establishment employees, foreign taxes, a portion of prior alternative minimum tax (AMT) liability, and gasoline taxes paid by farmers or off-highway-vehicle users.

Activities that Benefit the Poor and Disadvantaged. There are a number of credits designed to encourage employment or investment that benefits certain groups: the welfare-to-work credit, the disabled access credit, the empowerment zone employment credit, the Indian employment credit, the low income housing credit, the credit for contributions to Community Development Corporations, and the work opportunity tax credit.

Credits for Activities that Benefit the Environment. Currently, the largest group of credits are those for investment in equipment or processes that save energy or protect the environment in some way: alternative fuels, qualified electric vehicles, reforestation, energy, alcohol fuel, enhanced oil recovery and renewable resource electricity production.

Credits for Certain other Investments. The smallest (and shrinking) group of credits relates to certain investments that are deemed socially beneficial: rehabilitation of old or historic buildings, orphan drug programs and research and development.

WAYS TO LOWER THE APPLICABLE TAX RATE

Strategies for lowering the rate at which income is taxed include the rationalization of taxable income between tax years in light of marginal tax rates, moving income to persons or entities that are taxed at lower levels, moving income into accounts that are non-taxable or tax deferred, and conducting transactions in a manner that qualifies for lower rates (such as long-term

vs. short term capital gain rates).

Allocate Income Among Years to Avoid Higher Tax Brackets. This technique, known as Marginal Tax Rate Analysis, is simply the process of managing income levels between years in an effort to eliminate or reduce the amount of income that is taxed at higher rates.

Hold Appreciated Investments Long Enough to Qualify for Long-Term Gains Treatment. Investments held for less than one year are taxed at ordinary income tax rates, which are higher than capital gains rates. Investments held for more than a year are taxed at long-term capital gain

rates, which are lower at all income levels. A rate that is even lower may be available

for transactions occurring after December 31, 2000, if the asset is held more than five years.

Make Charitable Contributions with Appreciated Assets Instead of Cash.

Doing so will save you from owing tax on the capital gain and you will still be able to deduct the full, appreciated value of the stock (if you have held the investment more than a year).

Gift Money, Assets or Investments to Entities that Enjoy Lower Tax Rates.

Any person can give $11,000 in cash or property per year to any person or persons, with no income tax or gift consequence to either party. This tax code provision is most often used to move assets to children and grandchildren because the amount transferred will not be subject to estate and/or generation skipping tax. It is an effective tool for moving income generating assets to persons that enjoy lower tax rates. As long as the gift is $11,000 or under, there is no reporting requirement. Additionally, one spouse may give $22,000 and as long as the amount is reported and both spouses consent on the return, the amount will not be taxable.

Shift Income to Entities Domiciled in Cities, States or Countries with Lower Overall Tax Rates. City, County, State and Country taxes vary significantly. Businesses that have multiple locations of operation and/or a non-local client base, and even individuals, should consider how taxes could be reduced if income could be attributed to another locale.

WAYS TO CONTROL THE EFFECTS OF THE CORPORATE ALTERNATIVE MINIMUM TAX (AMT)

The corporate alternative minimum tax (AMT) applies to C-corporations only. It was established in 1986 and has been weakened by laws enacted in 1993 and 1997. Small corporations generally are exempted from the AMT if they had average gross receipts of less than $5 million for the first three taxable-year periods beginning after December 31, 1993. If this is true, then a corporation will continue to qualify for the exemption as long as it’s average three year gross receipts do not exceed $7.5 million. Studies have shown that many small corporations are unaware of their exemption to AMT and erroneously pay tax under the AMT.  The first step to minimizing the effects of the AMT is to find out if you are exempt. If not, consult your tax advisor. The corporate

AMT calculations are complex.