How Do I Time Income and Expenses at the End of the Tax Year?
If you are reading this in the fall, or even December it's a good time to think about how you can save money on your business taxes by timing income and expenses.
Lower Your Tax Bill by Timing
Many businesses have found that they can minimize business taxes year-to-year by considering carefully when to make payments to increase expenses and tax deductions and push receipts to create income at the end of the tax year. In general, you want to move income into a year of lower taxes and expenses into a year of higher taxes, but this is a big over-simplification.
Cash Accounting and Year-End Timing
The first thing to check before you think about before you move payments and income between two years is what accounting method you are using. The accounting method you use for your business (cash or accrual) makes a difference in the timing of payments and income and in the determination of constructive receipt. Since most small businesses use cash accounting, the timing examples will focus on this method.
In an interview between The Balance SMB and CPA Gail Rosen, Rosen explained that if your business is on a cash basis, you can consider delaying the sending of late-in-the-year invoices, so payment is not received until 2020. Your business can also purchase items you want in 2019, instead of waiting till 2020.
income. In cash accounting, you count business income when you actually or constructively receive it (explained below) during the tax year.
For example, let's say you do $1000 of web design, and you send the customer a bill in December. You receive the payment in January. Under cash accounting, you count it as income in January when you receive the payment.
Expenses. It's the same for expenses: If you receive a bill for $800 in December and you pay it in January, it counts as an expense in January.
The principle of constructive receipt applies to payments and income that cross over the end of the year. Constructive receipt only applies to businesses using the cash accounting method.
According to the IRS, constructive receipt means that income is constructively received when an amount is credited to your account or made available to you without "substantial restriction or limitation," even if you don't have possession of it.
For example, if your bank credits your business bank account with interest in December, you must count that as income in December, because it's available to you. It's considered income even if you didn't withdraw it or enter it into your books until January.
This discussion of cash vs. accrual accounting is a general overview. Your business situation is specific and there are many exceptions. Talk to your tax professional before you attempt to time income and expenses,
Timing Payments at Year-end
Before you start to think about timing income and expenses, you first have to determine when (this year or next year) you want to lower your business income for tax purposes. The usual strategy of small businesses is to lower your current year's taxes by prepaying expenses and deferring income.
But Gail Rosen explains that the tax strategy of deferring income or prepaying expenses is not for everyone. If you are going to be a higher tax bracket for 2020, then you may consider doing the opposite in your tax planning. This is especially true for growing businesses.
Some ways to lower your tax bill this year:
Make deductible gifts and donations. As explained by Gail Rosen, a charitable gift is deductible in the year paid. If the check is mailed unconditionally and clears in due course, the contribution is considered paid when mailed. A contribution charged on a credit card is deductible in the year the charge is made, not in any later year when the credit card company is paid . Read more about business tax deductions for charitable gifts, to be sure the gift or donation is deductible to your business.
PrePay Expenses. if you are pre-paying your business insurance or loan, send the payment by credit card or make sure you mail the check in time to the recipient or charge your credit card by year-end. the recipient does not have to receive the payment by year-end.
Buy assets. When you buy an asset, you can take depreciation expense on that asset. This expense lowers your tax bill.
The IRS considers an asset to be owned by a business when it is "placed in service," that is when it is ready and available for a specific use.
You may be able to take a large part of the depreciation expense the first year you own an asset. Talk to your tax professional about buying assets.
Delay income. That doesn't mean not cashing a check you received as payment, because you have received it even if you didn't cash it (remember constructive receipt). You can delay sending out bills until after the first of the year to make sure you receive the money next year.
Timing Employee Pay and W-2 Income
Employee wages at year-end are sometimes tricky, because of constructive receipt. Employee wages must be recorded in the correct year, and the date of the paycheck is controlling. If a paycheck is dated in December, that is the year the employee is considered to have received the pay, even if the paycheck hasn't been picked up yet.
Sometimes, paychecks reflect income from two years; the last week in December and the first week in January, for example. If the paycheck is dated in January, all of the income is considered to have been received in the second year, because the employee did not have receipt of the money in the first year.
But, if the employee had access to the wages in the first year "without substantial limitation or restriction" (remember constructive receipt), all of the money is considered to have been received in the same year. This might be the case if the money is deposited using direct deposit in December, for a pay period ending in January.
Some years have more pay periods, which might also affect the amount of an employee's paycheck between two years.
This issue affects amounts on employee W-2 forms. Check with your tax professional if you aren't sure how to allocate employee pay across two years.
Using a Credit Card for End-of-year Payments
It's certainly appropriate to use a credit card to make those end-of-year payments. You don't have to pay off the balance now, but the expense can be recorded this year. For example, if you buy a laptop for your business before the end of the year, using your business credit card, you can get the tax deduction this year and pay off the credit card next year.
1099 Reporting for Independent Contractors at Year-end
An independent contractor that performed work for your company may have received payment in early January, but you might have mailed (and recorded) the payment in December and recorded the payment as part of the contractor's Form1099-MISC for this year.
The independent contractor should include the payment as it is reported on this year's Form 1099-MISC, but subtract the payment and attach an explanation with the return. The independent contractor must then include the payment on next year's return, even though no 1099 may be issued for next year.
Accrual Accounting and Year-end Timing
In accrual accounting, you generally report income in the year it is earned and deduct or capitalize expenses (by recording them as an asset and taking depreciation on them) in the year incurred. The purpose of an accrual method of accounting is to match income and expenses in the correct year.
Expenses are recorded when (a) the liability amount is set and recorded, and (b) the property or services are provided or the property is used. Some recurring items used during the year can be treated as incurred during the tax year, even if some events haven't occurred. This might be the case if you buy a supply of copy paper and use it during the year.
Income is recorded in the year when your right to receive the income has occurred and you can determine the amount. If you are using the accrual method, you include an amount in gross income at the earliest date:
- When you receive payment
- When the income amount is due to you
- When you earn the income
- When title passes.
You can record advance payments by customers. If you use the accrual method, you can postpone including the advance payment in your business income until the next year, but not beyond that tax year.
For example, Let's say you did $1000 of web design, and you sent the customer a bill in December. If you are using the accrual method:
- The $1000 bill for your services must be included in your business income in December because that's when you "incurred" the income.
- The $180 expense for office supplies is included in your December expenses because the amount is fixed and you are using the office supplies.
The timing of income and expenses to lower your tax bill is a complicated decision. This information is a general overview, not intended to be tax or legal advice. Discuss possible end-of-year timing with your tax professional.
IRS. "Publication 538 Accounting Periods and Methods," Cash Method, Page 8. Accessed Nov. 9, 2019.
IRS. "Publication 946 How to Depreciate Property." What is the Placed in Service Date? Page 30. Accessed Nov. 9, 2019.
IRS. "Publication 538 Accounting Periods and Methods," Accrual Method, Pages 10-13. Accessed Nov. 9, 2019.