Controlling When Income Gets Taxed

Although your former grade school teachers may not want to hear it, putting something off can sometimes be a good idea.

Putting it another way, "justice delayed" may be "justice denied," but taxes delayed can be taxes minimized!

The idea that we're trying to convey is that it's usually worthwhile to delay when you have to report income, if you can do so legally. This is true even if you figure that you'll be in the same tax bracket in all relevant years. What you gain is the use of your money for a longer period of time. The advantage may be as little as passbook earnings on the money, or as much as the growth resulting from a needed investment of money or equipment into your business.

Now, you generally don't have the option of actually delaying payment of the income tax you owe. While most taxpayers can get an automatic six-month extension of the time to file their return (e.g., until October 15), you still have to pay the taxes you owe by the filing deadline, usually April 15, or face penalties and interest payments. It's possible to obtain an extension to pay tax if you can demonstrate to the IRS's satisfaction that you could not pay on time without undue hardship. However, this is not something that you'll want to do unless absolutely necessary, since even if you can get the extension you will owe interest on the unpaid taxes, beginning on the original due date.

What we're really talking about is the fact that it's often possible to delay your taxes indirectly, by taking actions that delay the time when particular income items must be reported on your return. Your primary strategy will usually be to postpone receipt of income until the next year, and accelerate payment of expenses into your current tax year. (This will be much easier to do if you use the cash method of accounting.) In this way you can delay your tax liability to the next quarter, or even the next tax year.

As a general rule of thumb, you should always try to minimize your taxes in the present year, even if doing so means you may have to pay slightly more tax in the future.

After all, no one knows what the future holds. The tax laws are constantly changing, and there's a good chance that whatever you think you may owe in the future will be different by the time you get there. Furthermore, economic conditions or personal plans can change, and your business may look entirely different even one year down the road. In the worst-case scenario, you could die unexpectedly, and in some cases you can avoid tax altogether if you die before paying it.

In broad terms, you can minimize taxes in the current year by postponing the receipt of income so that more of it will be taxed next year, and by accelerating deductions into the current year.

Postponing income, accelerating deductions. A few specific how-to ideas are listed below. Use of the cash method of accounting is preferable if you intend to implement strategies relating to the year in which income or expense is reported.

• Delay collections — delay year-end billings until late enough in the year that payments won't come in until the following year.
• Delay dividends — if you operate your business as a C corporation, arrange for any dividends to be paid after the end of the year.
• Delay capital gains — if you are planning to sell an asset that has appreciated in value, delay the sale until next year.
• Accelerate payments — where possible, prepay deductible business expenses, including rent, interest, taxes, insurance, etc.
• Accelerate large purchases — close the purchase of depreciable personal property or real estate within the current year.
• Accelerate operating expenses — if possible, accelerate the purchase of equipment, supplies, or the making of repairs.
• Accelerate depreciation — elect to expense the cost of new equipment or deduct "bonus" depreciation if you are eligible to do so, rather than to use normal depreciation methods.
• Make the maximum retirement plan contributions — Put money in a tax-deferred plan to save taxes and build a nest-egg.

But what if you use the accrual method of accounting for a small business you own? Although strategies aimed at changing the year in which income and deductions will be accounted for are usually more difficult to accomplish using the accrual method, this does not mean that they cannot be done. If you use the accrual method, which is required by the IRS for larger businesses or those with inventory, you'll need to learn how to navigate through the accrual method accounting rules in order to reach the tax result that you want:

• If you want to delay taxation on a certain amount of income, make sure that all events fixing the liability for payment of that income are not met by year's end. For instance, if you're selling goods, delay shipment until next year.
• If you want to accelerate a deductible expense into the current year, make sure that all events fixing the liability and amount of payment as well as the economic performance have been completed by year's end. If you are purchasing goods, services, or the use of a property, make sure that you have a valid contract covering all necessary terms, and that the goods, services, or properties are delivered, performed, or used by year's end. If you do this, you are "one up" on a business that uses the cash method of accounting, because you've received the benefit and deduction for the expense item before you've actually had to pay for it. Of course, this assumes that the terms of the transaction don't require payment until the following year.

Accelerating income, postponing deductions. What if, after looking into your tax situation, you have decided that you should take steps to maximize the amount of income that will be taxed in your present tax year, because you'll probably be in a higher bracket next year? You can accomplish your goal by accelerating income, and postponing expenses into the following year. How do you go about doing this? In most cases, you can simply do the opposite of the suggestions listed above. For example, instead of delaying your billings, send out all of your bills early, and do everything that you can to collect them before year's end.

Again, any strategies aimed at changing the year in which items of income and deduction will be accounted for will be much easier to accomplish if you use the cash method of accounting.

Using tax-advantaged retirement plans. Another way to defer the day of reckoning is to plow as much money as you can into qualified, tax-free retirement plans. In most cases, you or your business will get a tax deduction for the amount contributed, and you won't have to pay income tax on the amounts until you start taking money out of the plan when you retire.

Meanwhile, any income earned on the investments made by the plan will build up, tax-free. If you are a business owner, you have a great deal of control over the way the plan is set up, and there's sure to be a plan that fits into your business goals and retirement objectives. If you are an employee, you can work within the plan (if any) your employer provides, or set up your own plan through an IRA account.