Personal service corporations, partnerships and S corporations are generally limited to a calendar year. Generally, they may elect a different tax year only if such tax year results in a deferral not longer than three months. In the case of electing partnership or S corporation, the partnership or S corporation must make certain required tax payments. An electing personal-service corporation is required to meet minimum distribution requirements in the deferral period. Usually, sole proprietors use the calendar year.
One of the most important items to consider in choosing a year-end, however, is your business season (or natural business year). You may want to end the year during your slow season to make the year-end closing period easier.
This section discusses some of the more important options minimizing current and future income tax liabilities.
CASH CONSERVATION THROUGH TAX PLANNING
Deferring income taxes to be paid in the future can have a significant impact on the capital needs of a growing business. Deferring taxes is essentially an "interest-free" loan from the government, freeing up cash that would otherwise have to be borrowed to finance inventories or capital expansion.
A profitable business is not the only entity that can benefit from tax planning. In startup ventures conducted in a "flow-through" entity form (proprietorship, S corporation or partnership), good tax planning can minimize the losses currently deductible by entrepreneurs/partners/shareholders, enabling them to increase the amount of their capital available to the business. Furthermore, as seen in the following discussions, much of the groundwork for good future tax planning is established in a venture's first year.
Cash Method. The most common overall methods used to compute income are the cash receipts-and-disbursement method and the accrual method. In most cases, a company will elect a method of accounting in its tax return that provides immediate tax benefits. The cash method, which recognizes income and expense based on when cash is received and disbursed, provides the most flexible means of differing taxable income into future tax years.
Use of the cash method is restricted, however. Corporations with average annual gross receipts, during the specified base period, of more than $5 million must use the accrual or another IRS-approved method of tax accounting. Partnerships (if they have no regular corporations as partners) and S corporations that are not tax shelters may continue to use the cash method regardless of their gross receipts. The cash method generally cannot be used if inventories are a significant portion of a company's business.
Accrual Method. The accrual method, which recognizes income and expenses based on when income is earned or an obligation to pay a debt is incurred, generally provides better matching of revenue and expenditures. This method is typically required for financial reporting purposes. For tax purposes, the taxpayer must compute taxable income under the method of accounting regularly used to compute income in keeping books (regardless of the method used for financial reporting) unless the method used does not clearly reflect income.
Once a method of accounting is adopted it can be changed only with IRS permission. Permission is usually granted in the case of switching from the cash method to the accrual method; it is routinely denied in switching from the accrual to the cash method.
Cash and accrual methods are overall accounting methods of the business. In addition to on overall method, more specialized accounting methods are necessary for most businesses. A brief overview of these methods follows. Your tax advisor or accountant should be consulted for further details.
In the first year in which the business has inventory, it must choose an appropriate method to account for that inventory. Methods commonly used are average cost; first-in, first-out (FIFO); and last-in, first-out (LIFO) methods.
Average Cost. This method prices inventory on the basis of the average cost of all similar goods available during the period. It is mainly used because it is simple and relatively easy to use.
FIFO. This method assumes that inventory is used in the order that it is purchased or produced. Under this method, ending inventory is stated at approximate current costs, with the oldest cost charged against current sales. In periods of inflation, this can cause "paper profits" to be recognized and taxed. It also results in the highest reported earnings. The FIFO method is probably the most commonly used inventory control.
LIFO. This method became popular in prior years due to significant inflation. The LIFO method assumed that the most recently purchased or produced goods are used first - the opposite assumption from FIFO. Although generally this is a more difficult method to use, a simplified LIFO method of accounting of inventories is available to small business. A taxpayer can use the simplified LIFO method if average annual gross receipts for the three proceeding tax years do not exceed $5 million. In periods of inflation, LIFO results in lower inventory valuations, higher cost of sales and lower taxable income. This method is most commonly used by companies facing rising production and material costs. The LIFO inventory method is adopted by filing Form 970 with the income tax return for the tax year in which the method is first used.
Overhead Costs. A mechanism must be established to capture overhead costs and relate them to an inventory's direct material and labor costs. Manufacturers typically allocate the "poll" of indirect costs to inventory on the basis of a standard unit, such as labor dollars or hours. Once a method has been established, it cannot be changed without IRS permission. As a result, many of the planning techniques for inventory overhead costs need to be addressed when the business is starting.
RESEARCH AND DEVELOPMENT EXPENDITURES
Current Expense v. Amortization - Research and Development (R&D) expenses are those expenses incurred in developing new products, processes, etc., and expenses incurred in significantly improving existing products. There are two tax methods available for deducting R&D expenses -deduct currently or amortize over 60 months. In most cases, currently deducting provides the best answer. Once an election has been made to defer R&D expenses, that method must be continued unless IRS permission to change is received.
LONG-TERM CONTRACT METHODS
Taxpayers involved in the construction of property that spans a tax year-end, or in the manufacture of "unique" items not normally carried in inventory, have several specialized accounting methods available to them. The adoption of these methods allows for tax deferral potential.
Percentage-of-Completion Method (PCM). A common method of accounting for long-term contracts is the percentage-of-completion method, which is typically used for financial reporting purposes. PCM recognizes income on the basis of percentage of the job that is complete based on cost incurred. This method "smoothed out" revenue earned over a number of periods and results in little, if any, deferral of income for tax purposes.
Percentage-of-Completion/Capitalized-Cost Method.As instituted by the Tax Reform Act of 1986, and subsequently modified by the Revenue Act of 1987, this method replaces the completed-contract method of accounting. The new method requires the taxpayers to use PCM for 70% of the contract. The balance of the contract is reported according to the taxpayer's regular method of accounting (e.g., completed contract).
TAX DEDUCTIONS OF PROPERTY
A limited number of taxpayers are permitted to expense currently up to $10,000 of asset additions in a given year. The deduction is phased out, dollar for dollar, for any taxpayer with more than $20,000 of additions a year.
A corporation may elect to amortize organizational expenditures over a period of not less than 60 months, beginning with the month in which the company begins business. Organizational expenditures are defined as those incidental to the creation of the corporation, e.g., incorporation fees, legal fees, and franchise fees. The election to amortize these expenditures must be made in the company's first tax year by inclusion of statement; otherwise, the amount is deductible only in the year of dissolution. A similar election is available for partnerships, but no such election is available for sole proprietorships.
Start-up costs are defined as costs incurred after the decision to acquire or establish a particular business but before its actual operation. These expenses are generally those that would be deducted currently if they have been incurred after the commencement of the company's operation. Start-up expenses do not include interest, taxes and research, and experimental expenses. In general, taxpayers are allowed to treat start-up costs as deferred expenses amortized over 60 months. An election to amortize must be attached to the initial return.
MODIFIED ACCELERATED COST RECOVERY SYSTEM
Under the Modified Accelerated Cost Recovery System (MACRS) of tax depreciation, specified "cost recovery" allowances are provided for different property classes. The Tax Reform Act of 1986 created eight primary classes of property ranging from 3 to 3 1/2 year lives. For each class of property, published tables specify the percentage of the purchase price deductible as depreciation in any year.
Even though tables exist to mechanically compute annual depreciation deductions, there is still a great deal of flexibility in planning the timing and amount of depreciation deductions. For example, the straight line method (rather than the accelerated method built into the tables) can be used, if desired, over other specified extended lives. This may also be important when the business is operating in a state where net operating loss carry-overs are not allowed. It is not necessary to conform the method of depreciation used for financial reporting purposes to the MACRS system.