An Expense is an Expense,
But it Takes Planning to Make a Deduction
One of the greatest fears we accountants have is to fail in our duty to advise clients on how best to minimize their income tax bill. Just the shear volume of changes in the tax codes of our nation and its states creates a problem, but when you add the fact that our professional liability insurers are always on our backs to keep us from being sued, well it’s just about enough to drive even the stoutest of hearts to triple checking everything that goes out of the door to a client.
Since even CPAs like a little sleep every now and then, this article is our shot at reminding you to plan your cash flow to maximize your deductions this year. There are a great many things we can go into in this article, but it would be impossible to list them here. We will, however, spend a little time on planning your year-end taxable income, within the law, and talk about the new domestic manufacturing deduction.
Now, what do we mean by expense as opposed to deduction? Can a deduction be an expense? Why isn’t an expense for the business automatically a deduction? The answer is that a deduction is an expense of some kind that can also be used as a reduction to taxable income while an expense may or may not be a deduction. For example, buying your customer lunch is a valid expense of carrying on your business, but the deductible amount is only 50% of the total expense.
Some common deductions for a business would be the cost of any products sold, maintenance and operating expenses, supplies, utilities and numerous other possibilities. If there are meals or entertainment included in the expenses then only 50% of those expenses would be deductible. One big advantage for a company versus individual deductions is the deductibility of personal interest. Interest paid on auto loans, credit card debt and other items of personal interest would be fully deductible for companies, but for individuals, personal interest is non-deductible. The interest you pay on credit cards and car loans is non-deductible. You can, however, purchase the car and pay the credit cards with loans secured by your primary or secondary residence and deduct that on Schedule A of Form 1040.
An expense is also not a deduction if it falls outside of your tax year. For example, if you are on a cash basis, the only deductions you can take are those that you paid for during the year. That’s why December is a good collection time for accountants and many other companies that sell to cash basis payers. On the other hand, deductions for accrual basis taxpayers are basically deductible when the supplies or products are delivered into your care. Some key things you need to remember are that there are certain catches to some deductions. Regardless of whether you are a cash basis taxpayer or accrual basis taxpayer, that machine you just bought must be placed in service by year-end. The deductibility of equipment and depreciation are as dependent on the date they were placed in service as the day they were paid for under whatever accounting method you use. These tricky little "gotchas" point out the absolute need to contact your tax advisor on important decisions.
You may or may not have been involved with Foreign Sales Corporations (FSC), but several years ago, the European Union brought allegations that by allowing a U.S. company to avoid some tax on its foreign sales, the United States was giving an illegal subsidy to those exporters. The World Trade Organization ruled in favor of the European Union and a race began to find a replacement to the FSC that would pass muster with the World Trade Organization. After an attempt that was shot down by the WTO, Congress passed and the President signed legislation that created a deduction from business income of up to 9% of the taxable income a company generates from the sale of domestically produced items. The actual deduction is limited to total wages paid in any year and is phased in over a period of six years, starting at 3% for 2005 and 2006 and reaching 9% for 2010. You can bet there will be rules galore on how to calculate the deduction, so stay tuned for future updates.
If you are a manufacturer, and the definition of a manufacturer is broad, this deduction will provide huge rewards to you, but be careful. By making what you believe to be a strategic move to minimize payroll costs, you may lose the deduction. Since the deduction is limited to W-2 wages, if you outsource all your labor to temporary agencies or providers of employees that simply charge you an hourly rate for their employee’s services, you may kill the availability of the deduction.
Once again, Uncle Sam has managed to get rid of one complication in the tax code for another. Thankfully, the basics of controlling your expenses under the two main accounting methods have not changed. Whether you are in business or an individual taxpayer, timing and characterization of expenses are the keys to minimizing your taxable income. Let us know if you have any questions. We will be glad to help you.
Happy Labor Day!