Here's a novel thought. Let Uncle Sam pay for your holiday gifts and entertaining.
No, I’m not talking about anything illegal. You cannot buy personal gifts and bill them to your business. That's called fraud. But if your business uses the cash method of accounting (as most sole proprietors do) you may be able to legally cut your tax bill by hundreds or thousands of dollars by making a few strategic decisions for your business between now and the end of the year. If you are a sole proprietor, those tax savings may more than cover your holiday spending.
Here's how to make it happen.
Estimate your profit or loss for this year and next
Your net earnings and your adjusted gross income (AGI) will determine eligibility for many deductions. So, the first move you need to make is to estimate your net business income and personal AGI for this year and next.
Why both years? Well, it's not unusual for business owners to have considerable year-to-year differences in income, sometimes due only to when a couple of big customers get around to paying bills at the end of the year.
A typical example: you are a consultant and author. You found a publisher for your book in October of 1999 and agreed on terms, but by the time the contract was actually signed and all the paperwork made it through accounts payable at the publishing company you didn't get the first half of your advance until the first week in January. You finished the book in 4 months, and the second half of the advance arrived promptly. So, instead of an extra $5,000 income you had expected to have in 1999 and $5,000 in 2000, you wound up with all $10,000 in 2000.
To make the tax situation worse, you did a series of Internet training seminars for a government agency in 1999 and there was a typo in the contract number you included in your invoice. It took months to determine why you weren't paid and then to fix the mistake, so the $6,000 you were expecting in 1999 didn't arrive until February of 2000. And now you've just signed a deal with a large corporation for a $24,000 project, and under your normal working arrangements, one-third of that amount is required to start their project. Oops.. if they get that out on time, add another $8,000 to this year's income.
Bottom line: you have $22,000 more in income than you had last year, and about $16,000 more than you expect to make next year. By the time Uncle Sam and his state and local cousins get done nibbling away at the $22,000 "windfall" you had this year, you may only have half of it left. Ouch! That's quite a bite.
Time Your Equipment Purchases
To Maximize Tax Deductions
Under section 179 of the tax law you can choose to expense (deduct) a certain amount of equipment, furnishings and other capital expenditures in one year, instead of depreciating them over time. For the year 2000, the amount of such purchases you can deduct is the lesser of $20,000 or your earned income. That maximum 179 deduction goes up to $24,000 for 2001. (See the important notes below)
You can save considerably on your taxes by timing equipment purchases to take maximum advantage of the section 179 expense election. Here are two examples to show you how.
You are a new business owner. It took a while to get going, but you finally started landing customers this fall. Still, it looks like you'll show a quite a loss for this year, and you had no other earned income. With the work coming in from the clients you did land, you have enough money to buy that top-of-the-line notebook computer. Total cost (with the 25 gig hard drive, extra battery, swappable DVD drive and 15-inch monitor: about $4,000. If you make the purchase this year, you will have to depreciate the expense over the next five years. Assuming you make a healthy profit next year, by waiting until January 2 to purchase the computer you'll be able to deduct the entire cost in one year.
It’s been a good year. A very good year. Profits are high and you want to reinvest them in new equipment to grow your business even more. You've already spent $8,000 on items that qualify for the section 179 expense election and you want to purchase two powerful new Internet servers because your web site is growing rapidly. The total cost will be $22,000. If you buy both servers this year, you're total equipment purchases for the year will come to $30,000 – that's $10,000 more than you can deduct in 1 year even if you have the income to support the deduction. So, you would only be able to expense one of the servers (plus the other $8,000 in equipment previously purchases) this year. The cost of the other $11,000 server would have to be depreciated over 5 years. So, next year and each year after, you'd only be able to deduct a little more than $2,000 of the cost of that second server.
However, if you buy one of the servers this year and one on January 2, you would be able to expense the full cost of the one server in 2000, and the full cost of the second server in 2001, assuming you had sufficient profit to make you eligible and that your total 179 deductions were under $24,000 next year. Deducting the total cost in one year could save you over $4,000 in taxes for 2001.
- The small print: If you've purchased more than $200,000 in equipment during the year the amount you can deduct is reduced by each dollar more than $200,000 of equipment you've purchased.
- If your spouse has a business and also buys equipment and you file a joint return, you are treated like one business for the purposes of section 179. In other words, the combined amount that can be expensed for 2000 is $20,000, not $40,000.
- A bit of relief: You can't use the deduction to create a loss; however, if you are a sole proprietor, any income, even income from a job you have as an employee in someone else's business is considered earned income.
- When all else fails: If your equipment purchase doesn't qualify for the section 179 expense election, it can be depreciated over it's useful life. So you don't lose everything – just the ability to deduct everything in a single year.
Other tools and business "toys"
If you had a windfall year, computers aren't the only things you can use to reduce the tax bite. Any piece of equipment or gadget which you will legitimately use in your business can be deducted (up to the limit describe previously). So if you are projecting a sizeable profit you may want to consider buying any of a wide variety of products for your business before the end of the year.. Among them: a digital camera; a lightweight portable projector that hooks to your notebook (for showing PowerPoint presentations, for instance); a business card scanner, a digital recorder, new ergonomic furniture; new file cabinets, etc.
Buying equipment isn't the only way to reduce your taxes before the end of the year. There are many other ways to accomplish the same goal while benefiting your business. Here are several other ideas to consider:
Throw a holiday party for your employees
Unlike other entertainment expenses, holiday parties or company picnics are fully deductible. That’s because they work like an incentive to boost morale and a company team spirit. About the only hitch is that you have to invite all employees, and the parties do have to be special events, not a routine occurrence.
Put your kids to work on weekends and the holiday vacation
Make them earn the money they spend on gifts instead of just giving it to them. You benefit by converting a personal expense into deductible business expense (your child’s salary) and by helping teach your kids the value of a dollar. If your child is under the age of 18, the salary you pay them is not subject to social security and Medicare taxes if your business is a sole proprietorship. The kids gain by making money and learning real work skills that can help them get jobs elsewhere later on. They can earn up to $4,400 tax free (for the year 2,000) and another $2,000 on top of that if they put the extra $2,000 into a deductible IRA. They also gain a sense of pride in having worked to make the money they spend buying gifts for the family. Caveat: the salary and job has to be reasonable. You would have a hard time justifying paying your 7-year old $30 an hour to handle customer service calls.
Give your retired parents or in-laws a job during the holidays
This presumes your retired parents want to work, are in a low income bracket and the amount they earn from you won’t be more than the minimum they can earn before their social security benefits become taxable. They benefit from the extra income they earn, which is taxed at a lower rate than yours and from the satisfaction they derive from contributing their skills and knowledge to your success. You get to deduct money you might otherwise just give to your parents if they are in financial need.
Fund your retirement
If you haven't already done so, be sure to set up a qualified retirement plan if you're self-employed. If you want to use a KEOGH plan, you'll need to get it set up before the end of the year. You can set up a SEP or SIMPLE plan up until the time you file your tax return for 2000. However, the sooner you put money in the plan the faster it starts earning tax-deferred interest.
Janet Attard is the author of The Home Office and Small Business Answer Book (Published by Henry Holt & Company) and of Business Know-How: An Operational Guide for Home-Based and Micro-Sized Businesses With Limited Budgets (published by Adams Media, Inc.) Look for the books at your favorite bookseller, or click here to order.
For additional information contact Janet by email at [email protected].