Every $1,000 worth of deductible expenses trims $270 off your income tax bill if you’re in the 27% bracket and can knock off an extra $153.00 if you’re subject to the self-employment tax. Bills for qualifying expenses you pay before year-end are deductible on the current year’s return; those you hold off on until the new year are deductible the following year.
Buying business property at year-end can prove either an advantage or disadvantage. First, the plus side. The law generally allows you to claim six months’ worth of the depreciation in the year you put the property into service, regardless of how late in the year you make the purchase. Even if you buy on the last day of the year, you can earn a substantial depreciation write-off.
This midyear convention works against you, of course, if you buy your business property early in the year. Even if you buy in January, for example, you still get only half a year’s worth of depreciation for the first year of ownership.
Now, the potential problem. You can trip yourself up if you buy too much business property at year-end. If the cost of assets put into service during the final three months of the year exceeds 40% of the total cost of business property put into service during the year, the half-year convention is replaced by a midquarter convention. That means depreciation is calculated as though each asset was put into service in the middle of the calendar quarter during which it was first used.
A year-end purchase would earn just six weeks’ worth of depreciation, then, instead of six months. However, triggering the midquarter convention rule would also boost write-offs for property put in service early in the year: Assets placed in service during the first quarter would earn 10 1/2 months’ worth of depreciation rather than six months’.
This is the provision of the tax law that lets you write off immediately up to $500,000 of otherwise depreciable property put into service in 2013. If you choose expensing, you don’t have to bother with the midyear or the midquarter convention. Regardless of how late in the year you put the property into service, you can deduct the full cost of up to $500,000 of qualifying items ($25,000 in 2014 unless congress acts on a higher limit).
Consider how that can boost your deduction. Say you buy $10,000 of business property with a five-year tax life. Under the midyear convention, your first-year depreciation deduction would be a healthy $2,000. Choose expensing, though, and you can write off the entire purchase price on the current year’s return. Expensing generally won’t let you deduct $20,000 of the business cost of a car all at once, however, regardless of how much the car costs. Even under the liberalized “luxury car” rules okayed in the aftermath of the September 11 terrorist attacks, in the biggest first-year auto write-off for a business vehicle purchased in 2002 and 2003 is $7,660. (An exception to the luxury car rules allows you to use expensing if your new business vehicle weighs more than 6,000 pounds. For a car, that’s 6,000 pounds empty–so you can forget it; but for a sports utility vehicle, it’s 6,000 pounds including the maximum for passengers and cargo, so many SUVs can qualify.)
Successful efforts to trim your taxable business income can produce double savings. In addition to cutting your income tax bill for the year, you may also save on Social Security taxes. Self-employment income is subject to a 15.3% Social Security tax. The full tax applies to the first $117,000 of earnings from salary, wages and net self-employment income in 2014. Every $1,000 of extra business deductions can save $153 in Social Security taxes, as well as saving on income taxes.
If your endeavor shows a profit in at least three years out of every five, the law assumes you’re trying to make money. Fail the three-of-five-year test, however, and it is assumed the activity is a hobby. Unless you can prove otherwise, your deductions are limited to the amount of income you report. You can’t claim a loss.
Your year-end planning needs to consider both where you stand on the profit-or-loss front and how you’re doing on the three-out-of-five-year test. If you need to show a profit this year to avoid having your activity branded a hobby, your strategy may be the opposite of that outlined above. You may want to press for collection of any income you’re due and put off paying expenses or buying new equipment until the new year.
The theory here is simple: Income you don’t receive until after midnight on New Year’s Eve isn’t taxed until the following year. Even if you’ll be in the same tax bracket, you win by putting off the tax bill by an entire year.
It’s tough for employees to postpone wage and salary income. You can’t ask your employer to hang on to your December paycheck until January; nor do you push income into the next year by not cashing your check until then. Income is taxable in the year it is “constructively received.” Basically, that means the year you could have had the money if you wanted it.
Assume, for example, that in December your boss offers you a choice of receiving a Christmas bonus in December or the following January. Regardless of which you choose, the IRS will expect you to report and pay tax on the income with your return for the year the offer was made. If standard practice in your company is to pay year-end bonuses the following year, however, the income would be taxed in the year you get the check.
If you are self-employed or do free-lance or consulting work in addition to a job, you have more leeway, assuming you use the cash basis of accounting. Delaying billings until late December, for example, can assure you that you won’t receive payment until the next year. If you are pressing for payment on an overdue account, it might make sense to give your tardy client a breather. Business considerations certainly come first. But if it’s unlikely you have anything to lose by holding off on collections, doing so can push some taxable income into the following year.
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