Every $1,000 worth of deductible expenses trims $280 off your income tax bill if you're in the 28% bracket and can knock off an extra $153.00 if you're subject to the full 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 now lets you write off immediately up to $108,000 of otherwise depreciable property put into service in 2006. 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 $108,000 of qualifying items.
Expensing generally won't let you deduct the full cost of a new business car all at once, though. The first-year auto write-off for a business vehicle purchased in 2006 is $2,960. You can use expensing to write off up to $25,000 in the year of purchase if your new business vehicle weighs between 6,000 and 14,000 pounds. For a car, that's the empty weight; but for a sports utility vehicle, it's 6,000 to 14,000 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 about $94,200 of earnings from salary, wages and net self-employment income in 2006. (We estimate that the figure will increase to about $98,400 in 2007.) 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.