Understanding Why Tax Planning Is A Vital Step For Small Businesses
Though the deadline for filing your taxes may be months away, most small business experts agree: the two best times to get a jump on tax planning are “now” and “all the time.”
We know that isn’t always easy for an overworked, enterprising small business owner, but it’s crucial to your company’s growth and success to make tax planning and strategizing a year-round effort.
Tax planning will help you:
- Reduce the amount of your taxable income,
- Lower your tax rate,
- Utilize all available tax credits and deductions.
If you’ve put off tax planning for the majority of the calendar year, you still have time to research your options and make changes that will lead to the best-case tax scenario for your business. You can also resolve to start the new year with a tax-planning strategy that kicks in on day one.
We get it—you wear a lot of hats while operating your business, and you didn’t plan on “tax planner” being one of them. You have marketing, staff management, product development, customer service, and accounting to worry about. Isn’t that enough?
Not if working in your business takes away from working on your business!
Here’s the deal, though. The solution to failing to plan all year isn’t found in embracing every aggressive year-end tax strategy you’ve heard or read about. Some common mistakes or miscalculations business owners might make include:
- Spending money at the end of the year to reduce tax bills. Remember, spending a buck doesn’t mean a dollar saved come tax time. While many tax deductions are great to take advantage of, wastefully spending money to get or increase them is never a good idea. An exception: when you know you have large purchases coming up at the beginning of the new year and it would benefit you tax-wise by buying them now to take the deduction in your current tax year.
- Accelerating expenses into the current year. If the numbers show next year may be a better one for profits, you’ll want to offset the greater amount of income. Just like in the example above, it literally pays to thoughtfully plan big expenses.
- Choosing the accrual basis when the cash basis makes more sense (or vice versa). Most end-of-year aggressive tax strategies benefit cash-basis taxpayers. Not understanding what your tax reporting designation is can have a huge impact on whether or not you’ll save on taxes by making large purchases now.
Making Smart Year-End Decisions
There’s a good reason financial experts say small business owners need to make tax planning a year-round effort: you’ll be better equipped to make smart decisions that help you minimize tax liabilities and you’ll make wiser business choices. That’s why as one year ends it’s so critical to immediately start the new one by getting your financial records up-to-date, analyzing your profits and losses, and determining ways to put more money in your bank account. Along the way you’ll find that the stress of small business taxes is lessened, which, in turn, helps you make better business judgments.
BONUS TIP: do a strategic tax planning session during your 4th quarter since you’ll have a good idea of where the year is going to end up and then implement a strong plan to roll over to the new year.
Still worried about handling this aspect of your business? A bookkeeper, accountant, and/or CPA can play a starring role in showing you how easy it can be to implement tax-saving strategies that will serve you well come tax time. You’ll learn that a good tax plan requires things like:
- Reviewing and analyzing the books.
- Contributing the maximum allowable amount to retirement accounts.
- Designating deductions as they occur, not right before tax time.
- Tracking carryover tax deductions such as capital and net operating losses.
Year-end tax strategies that could save you money
Here are several ideas that could help reduce your 2020 federal income tax burden. It’s a good idea to consult your Ameriprise financial advisor and tax professional for personalized advice.
Maximize qualified retirement plan contributions
Consider putting as much money as you can into your 401(k), 403(b) or other qualified retirement plan account. Doing so will reduce your taxable income on a dollar-for-dollar basis and will increase your retirement savings. At a minimum, contribute at least the amount your employer will match.
The contribution deadline for 401(k) and 403(b) accounts is Dec. 31, 2020. The contribution limit is $19,000. If you are age 50 or over, you can contribute an additional $6,000.
Deduct medical expenses
If you itemize your tax deductions, you may be able to deduct eligible medical expenses that exceed 10% of your adjusted gross income. There is a wide range of deductible medical expenses — visit the IRS website for details.
Use stock losses to offset capital gains
While no one likes investment losses, you may be able use them to generate a positive result: a lower tax bill for a given calendar year.
The U.S. tax code requires that losses first offset gains of the same type. For example, short-term losses will first offset short-term gains.
Because of the higher tax rate for short-term gains, focusing on short-term losses can have a more substantial effect on your tax savings than long-term losses — especially if you are in a higher federal tax bracket.
If you didn’t have capital gains this year, you can use up to $3,000 in capital losses to reduce ordinary income. You can carry over any remaining net capital loss to future tax years until you use the loss.
Consider charitable giving
As a strategy to increase itemized deductions above the standard deduction and receive a deduction from charitable giving, consider transferring a larger amount into a donor-advised fund to gift over future years. Donations are generally disbursed through the fund per your recommendations, and your contribution to the fund is generally fully deductible the year it’s made.
Another way to implement this tax planning strategy is by bunching smaller annual charitable donations into a larger donation every other year or every few years so you can itemize tax deductions.
To give or not to give? The estate tax is once again becoming a hot button issue even with the lifetime exemption currently set at more than $11.5 million per person. The question is whether any gift given now that uses up the exemption will be grandfathered if there is a future change to the exemption amount. The IRS has issued favorable proposed regulations so no claw-back is expected.
Worst Case Scenario
The worst case scenario is that you do not take advantage of the current lifetime exemption amount and then it is reduced in 2021 to $5 million or to $3.5 million. In that case, you will have forfeited the ability to give away the difference between the current amount and the future amount, which can be more than $6 million or $8 million, depending on the future exemption amount.
Best Case Scenario
The best case scenario is that the current exemption amount is not reduced and you have the ability to use it in future years.
Tax Planning Strategy
If you have not done so already, and are comfortable surrendering control of assets to the next generation, it might be a good idea to take advantage of the $11.58 million per individual lifetime exemption in 2020, or $23.16 million for a married couple. The prevailing view is that the current lifetime exemption amount is as good as it gets and using it up before it’s gone might be your best bet regardless who wins in November.
Here are 5 tax planning ideas to consider before the end of 2020:
- Realize capital losses OR capital gains on stock while substantially preserving your investment position. If you expect significant capital gains, realizing offsetting losses in your portfolio could be beneficial. Alternatively, taxpayers in a low-income year can maximize the 0% capital gains rate by recognizing capital gains and resetting their basis. It’s best to consult with an investment advisor if considering this strategy.
- Defer bonuses. Do you have a large bonus you’re expecting to receive before the end of the year? It may be advantageous to arrange with your employer to defer year-end bonuses until early 2020. Some businesses are still able to claim the bonus expense for 2020, while the recipient can defer the income tax impact.
- Consider bunching itemized deductions. With the higher standard deduction of $12,200, $18,350, or$24,400 based on your filing status, receiving a benefit for your itemized deductions may be complicated. You may be able to save taxes by applying a “bunching” strategy of deferring or accelerating the payment of medical expenses, charitable and other itemized deductions in a certain year.
- Setting up a retirement plan. Retirement plans, including a solo 401(k) or a typical 401(k), need to be established by December 31, 2020 for contributions to count for this tax year. While contributions are often not due until the tax filing deadline in the following year, the plan setup needs to be done within the year you want it to be in place.
- Consider Roth IRA conversions. Depending on your financial circumstances and tax bracket, a Roth IRA may be a more valuable retirement saving vehicle compared to a traditional IRA. A Roth conversion would allow an investor to convert money in a traditional IRA to a Roth IRA. Conversions must be made before year-end to count for that specific tax year. Also, don’t leave this to the last minute as custodians often won’t be able to process these requests within the last couple weeks of the year.