FREQUENTLY ASKED QUESTION: I have money left in my business bank account and December 31st is approaching. I am going to spend all the money so that I can reduce my tax bill. Is this a good strategy?
The short answer: Yes and no. This is actually the most common misconception when it comes to small business tax planning. It is something that many accountants tell their clients to do without really explaining the concept to them and it is something that business owners tell other business owners about, again without explaining the concept.
Why the answer is sometimes yes: If you have legitimate expenses coming up early next year and you can afford to pay these expenses prior to December 31st, you can spend the money and reduce your tax bill, assuming that you are a cash-basis taxpayer.
Why the answer is sometimes no:
- Make sure you’re actually spending the money and not just taking it out. Taking a Shareholder Distribution, a Draw, a Distribution of Profits, or repaying your Officer Loan does not create an expense and has no impact on your profit. Doing this accomplishes nothing other than depleting your business bank account and increasing your personal bank account balance
- Make sure you are actually paying expenses and not just paying off loans and credit cards. Paying off loans and credit cards does not create an expense and has no impact on your profit. Obviously, if you have free cash and no upcoming expenses, paying down debt may be a great financial decision. However, do not do so thinking you will be reducing your tax bill, do so simply to pay down debt.
- Don’t spend money that you wouldn’t ordinarilty spend just to reduce your tax bill. Remember, $1 spent does not equal $1 worth of tax saved. $1 spent creates a $1 deduction, which (depending on your tax bracket, business structure, and state of operation) will only lead to $.00 – $.60 worth of tax saved.
- You may not actually want to accelerate expenses into the current year. If you had a pretty bad year with a lower than average profit and expect your profit to pick back up in the following year, you may want to defer as many expenses into the following year as possible. If you are in the 20% tax bracket this year, but will be in the 30% tax bracket next year and you have $10,000 worth of expenses in question, deducting them this year will save you $2,000, while deducting them next year will save you $3,000.
- Make sure you find out whether you operate on the accrual basis or the cash basis. This strategy only works for cash-basis taxpayers. Accrual-basis taxpayers report all income in the year that it is earned and all expenses in the year that they are incurred. So, just because you are paying for a 2011 expense in 2010 doesn’t mean you get to deduct that payment in 2010 if the expense won’t actually be incurred until 2011.
So, before you make any rash year-end moves for tax planning purposes, make sure you fully understand the concept and make sure you run your ideas past your accountant before making any major moves.
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