Tax articles tend to be fairly predictable. First, they get a little boring. Second, they generally focus on Federal income tax and say very little about state taxes. Finally, they generally use a bunch of terms that mean one thing to most normal people and something completely different to tax preparers. This article will be the exception. Well...at least we will talk about state income taxes this month and not the Federal variety.
Depending on where you earn your income, you could pay a hefty amount of state income tax on your business income or absolutely nothing. States have become so creative that what used to mean one thing (e.g. franchise tax) now has a component that its meaning in that state is "income tax." Texas is one example of such a state. Including Texas as a state with an "income" tax, all but 3 of the 50 United States have some form of income tax. With some state rates exceeding 10% of taxable income, some state taxes are onerous and anything you can do to reduce that drag on net income pays hefty dividends.
The good news is...
...that much of what you would do to minimize taxes at the state level are those actions you are already taking for federal tax purposes. Just as a reminder, here are a few of the tax planning techniques we have discussed in the past:
- Accelerating or deferring income based on anticipated income tax rates.
- Accelerating or deferring expenses based on anticipated income tax rates.
- Accelerating or deferring fixed asset acquisitions where your business gains an overall benefit by taking a specific action.
- Establishing retirement or other employee benefit plans in the current year to benefit mainly the business owners. This can be tricky because of anti-discrimination rules in pension laws.
- Declaring bonuses in 2005 for payment in 2006. Note - generally, greater than 50% owners must be paid in cash before year-end and all accruals must be paid within 2 ½ months of year end for corporations on the accrual basis.
Some businesses automatically take the purchase of an ad in a yearbook or the purchase of advertising at the local Little League field as donations. This may not be wise, since some people will pay self-employment taxes on net business income. The tax code does not recognize contributions as business expenses for owners of businesses that are taxed only at the Form 1040 level. Hence, you should be very careful to classify payments as they are. If you are purchasing sign space at the Little League field because you are an orthopedic surgeon and you want the moms and dads to think of you when a need arises, call it advertising. Even at the corporate level, you are limited to donations that equal up to 10% of taxable income. Anything that is legitimately a promotional expense will free you up to deduct a higher amount of other contributions.
Take care not to...
...spend money or incur expenses just for the sake of reducing taxable income. Remember, you may get a $25,000 deduction for that new widget maker, but the combined federal and state tax savings won't be enough to cover all the cash you paid out. For example, assume you are in a 45% tax bracket for all Federal and state taxes. When it's all said and done, a $25,000 deduction saves you $11,250 in taxes, but you are still out the net amount of $13,750. Spending just to get a tax deduction is generally not a good idea. If, however, you need the equipment, make sure it is in and running before the end of your tax year. Otherwise, you may not be able to take a deduction until the following year.
Some more good news is...
...most states provide economic incentives to lure businesses or to encourage expansion of businesses in their states. These can be direct loans, guaranteed loans, property tax credits or elimination, jobs credits, etc. Take a trip down to your local business development authority (Development Authority, Chamber of Commerce, etc.) or call your state economic development office. Somewhere in the building will be a person who is familiar with most, if not all, incentives offered by local and state governments. Particularly if you are anticipating an expansion, make sure you know the rules on timing of applications. Some states provide sales tax and other credits for qualified businesses. Unfortunately, some companies neglected to have their plans approved prior to starting construction or purchasing equipment. The key word here is incentive. Why would a state offer a $100,000 credit package for a new plant that's just about to open? The answer is it might not because you obviously didn't need the state's help. Any time you are thinking of expanding your business, find out what incentives the state offers to induce you to expand and then apply for those incentives immediately.
Some bad news on incentives is...
...the days of big state tax incentives may be numbered. Earlier this year, a federal appeals court ruled that tax incentives given to Daimler-Chrysler by the State of Ohio were unconstitutional. Without getting into specifics, the bottom line is that the future of these big incentives is questionable. The matter has or will be taken up by the United States Supreme Court, so now we can only wait. Legislation has also been introduced in Congress to protect the statesÂ’ rights to offer such incentives. For now, use every incentive you can find.
Okay, we admit that...
...some of the items in this article are anything but new. Still, everybody needs a reminder of the obvious every now and then. Taxes can take a huge bite out of your available fund, so make sure you use every legitimate deduction your state allows. If you are uncertain as to what you can deduct or what economic incentives are available to you, give us a call. Helping you make the most of your income is what we are all about.
Have a fantastic October!