It is not easy trying to break a life-long habit of minimizing income and maximizing deductions in order to produce a low tax bill. Our complex tax rules, plus an Internal Revenue Service consistently on the lookout for missed income and exaggerated deductions, paint a one-sided picture of our tax laws.
Surprisingly, however, the lowest tax bills often result from legitimate tax deductions postponed or ignored. Here’s an example:
A new spring company has the option of deducting up to $5,000 in start-up and organizational expenditures in the year the operation opens its doors. But why would it want to? If the new business had income, it would likely find itself in the lowest tax bracket. If those start-up expenses were ignored in the first year, they – and any start-up expenses that exceed $5,000 – would be available for deduction ratably over the following 180 months. Thus, the $5,000 deduction, deferred until later, more profitable years, would help reduce income that, in all-likelihood, would be taxed at a higher rate than that of the start-up year.
Flexible Tax Laws
Our tax laws offer a degree of flexibility that permits springmakers to legitimately manipulate both income and deductions to achieve a consistently low tax bill. Deferring or postponing the receipt of income in a tax year when profits are up often results in a lower tax bill for both that year as well as later years when income can be offset by a larger-than-usual amount of deductions. As was the case with our start-up expenses, deferring deductions until a tax year when profits (and a higher tax bracket) make them more valuable is a legitimate option.
“Deferring deductions until a tax year when profits (and a higher tax bracket) make them more valuable is a legitimate option.”
Business entities damaged by a hurricane or other disaster often have an incentive not to claim deductions and thus report higher pre-catastrophe income. Higher pre-catastrophe income can lead to higher federal assistance and insurance settlements from damages due to loss of income.
Frequently, a spring business owner or manager will ignore otherwise legitimate deductions and thereby report higher income. Some situations involve third parties – a potential investor, creditor or buyer – who have requested copies of the spring operation’s tax return to assess the income potential of the entity.
If a springmaker is applying for a loan, banks are usually wary of self-employment income because of the ability of individuals to manipulate such income. Likewise, individuals buying a business should be aware that a tax return is not a fair representation of the profitability of the business.
Is fraud committed by not voluntarily disclosing additional expenses that were not reported on the tax returns to a third party? Omitting expenses in financial statements is a violation of generally accepted accounting principles (GAAP); however, small businesses do not always use GAAP-basis financial statements. Tax laws, as mentioned, do not require claiming all deductions for tax purposes.
Recovering Costs
Every business claims a write-off for some capital assets. Whether the building that houses the spring manufacturing business, the furniture or fixtures within that building, or the equipment used by the operation, the cost of these capital assets is usually recovered using a depreciation write-off.
The tax rules allowing for the recovery of amounts spent for equipment do not match tax depreciation with economic depreciation. The write-off period for newly acquired capital assets differs greatly between the period when the building, fixtures or equipment will contribute to the spring operation’s profits and what our lawmakers label an asset’s “useful life.”
In addition to shorter “useful life” write-off periods, the tax rules encourage investment in business assets by allowing accelerated depreciation methods. Investment in business assets is further encouraged by permitting an expensing allowance or first-year write-off of up to $100,000 of the cost of newly acquired equipment under Code Section 179.1 Remember, however, neither accelerated depreciation nor the first-year write-off are mandatory.
Although depreciation deductions do not have to be claimed, they do “accrue” and figure into the computation for gain or loss when property is sold, abandoned or otherwise disposed of.
It is also possible to ignore the standard system of depreciation, choosing instead a slower, more even write-off like the straight-line method. The IRS reportedly looks more closely at any business choosing an alternative depreciation method, such as straight-line depreciation, for newly acquired property rather than using the no-questions-asked modified-asset cost-recovery system (MACRS).
Ignoring the Small Stuff
Although entitled to claim a deduction – any deduction – many spring operation owners or managers ignore the deduction because of a fear that it will increase the likelihood of an audit – or because the paperwork and record keeping isn’t worth the amount of the deduction.
Keeping track of small items purchased for the spring manufacturing business is often too time consuming to be worth the trouble. Keep in mind, however, for many expenses such as travel, entertainment and the like, physical receipts are not required for amounts less than $75. Of course, a contemporaneous record is necessary to support a claimed deduction, including the standard mileage deduction.
Home Office No-No
A valid reason many owners and managers ignore the home office deduction is the impact a home office can have on the profits when the home is eventually sold. Generally, up to $250,000 ($500,000 for those filing jointly) of gain on the sale of a principal residence used as such for at least two of the five years preceding the sale may be ignored for tax purposes.
This exclusion applies even if part of the dwelling was used as a deductible home office. The exclusion doesn’t apply, however, to depreciation deductions claimed for that home office. Instead, depreciation is recaptured (generally, subject to a 25% maximum tax rate) to the extent that gain is realized on the sale. Remember, depreciation must be recaptured or paid back, whether or not it is claimed on the return. Gain can’t be avoided by foregoing depreciation deductions on the home office.
One option involves employing a two-off, three-on strategy. After three years of business use, the space is utilized for personal use for two years. Starting with two personal-use years and continuing this pattern keeps the space eligible for the home sale exclusion, since it will meet the two-out-of-five years residential use test.
Repair or Accumulate Deductions
Under our tax rules, a repair is not always an immediately deductible expense; it is often classed as a “capital expenditure.” Expenses that keep property in an ordinarily efficient operating condition and do not add to its value or appreciably prolong its useful life are generally deductible as expenses.
If, however, those repairs such as painting, mending leaks, plastering and conditioning gutters on a building are part of an overall plan to fix up, remodel or rehabilitate the building housing the spring manufacturing operation, then both the IRS and an owner attempting to utilize those expenditures in a later tax year, can legitimately classify them as “capital improvements.” In fact, the IRS will often label them “capital improvements” whenever they feel they are part of a capital-
improvement plan.
The Other Side of the Coin
Ignoring or postponing tax deductions is only one strategy and may not always be the correct one for a particular spring manufacturer. Frequently, the spring operation needs more, not fewer, currently deductible expenses – thus the popularity of “prepaid” expenses. Yes, even cash-basis spring manufacturers may deduct certain prepaid expenses in the year paid. If the payment creates an asset having a useful life extending substantially beyond the end of the tax year in which paid, the expenditure may not be deductible, or may be deductible only in part, in that year.
If, for example, a calendar-year spring manufacturer signs a three-year business property lease on December 1 of the tax year and agrees to pay an “additional rental” of $18,000 plus monthly rental of $1,000 for 36 months, he can deduct only $1,500 for the tax year ($1,000 rent plus 1/36 of $18,000). The $18,000 is paid for securing the lease and must be amortized over the lease term.
Ignoring perfectly legitimate tax deductions is not an easy habit to break. However, matching the available tax deductions with the spring operation’s income can, if handled properly, increase the value of the deductions while ensuring a tax bill consistently in the lowest possible tax bracket.
A fluctuating economy, combined with a tax system that takes progressively larger bites as taxable income increases, often means deductions may be worth more next year than today. On the other side of the coin, an exceptionally profitable year might warrant claiming every tax deduction available to the spring business, or postponing income wherever possible to reduce the current tax bill now. The strategy is “tax planning.” Tax planning is a year ’round activity that reaps big rewards – and consistently low tax bills – year after year.
Mark E. Battersby is a freelance writer, author and lecturer specializing in the fields of taxes and finance. For more than 25 years, his columns, features and reports have appeared in leading trade journals and magazines, including Springs. Battersby is also the author of four books. Readers may contact him by e-mail at mebatt12@earthlink.net.
Note
1. Professional assistance complying with our complex tax laws is strongly recommended. Those professionals can also provide the current allowances permitted by the IRS. For example, while the $5,000 ceiling for an immediate write-off of startup expenses is a matter of law, the first-year expensing allowance under Code Section 179 is adjusted for inflation. The Section 179 write-off for 2006, adjusted for inflation is $108,000 with a ceiling of $430,000. Capital expenditures above $430,000 during the 2006 tax year will result in a dollar-for-dollar reduction in the Section 179 expensing write-off.
Ignoring Deductions
