2007 Year-End Tax Planning For Small Businesses: Opportunities Abound

As 2007 draws to a close, now is an ideal time to evaluate a business's financial and tax situation. Proper and timely planning can ensure that your business maximizes its 2007 tax and minimizes its federal income tax liability not only this year, but into 2008 and beyond. Tax planning for year-end 2007 presents new opportunities and new challenges for small businesses to reduce or defer federal income tax liability.

While traditional planning techniques remain fundamentally important considerations this year for small business, new opportunities born from recent legislation and changes in the tax laws can help defer or minimize federal income tax liability not only for 2007, but 2008 as well. While the Small Business and Work Opportunity Tax Act of 2007 (2007 Small Business Tax Act) targeted nearly $5 billion in tax incentives principally to small businesses.

Business Planning Basics
Tax planning strategies do not come in a one-business-fits-all package. Tax planning is as unique and varied as today's businesses and, while certain traditional planning approaches can help businesses across the board minimize or defer taxes, every plan must account for the particular needs and circumstances of the company. However, three factors will affect year end planning for every business, including: business structure, accounting method and anticipated profits and losses for 2007 and 2008 of the company.

Business structure
The structure of your business determines how business income will be taxed. While C corporations are subject to two levels of tax, the income, losses, deductions, and credits of passthrough entities like S-corps, partnerships and limited liability companies (LLCs) are passed through to the owners and reported on their individual income tax returns. Therefore, not only is the structure of the business itself important with respect to taxation, but with passthrough entities, an owner's individual tax situation is a particularly significant factor in year end tax planning.

Accounting method
The accounting method used by your business is a factor that impacts year end tax planning strategies. Your accounting method is important to tax planning because it affects your ability to time and shift income between 2007 and 2008. Whether your business operates on a cash or accrual basis will determine when income must be recognized for tax purposes and when expenses are deductible.

Many small businesses and sole proprietors operate on a cash basis. Cash basis taxpayers recognize and report income when it actually or constructively receives cash or its equivalent (i.e. checks, notes, letters of credit, forgiveness of debt), and take deductions when expenses are actually paid or transferred, regardless of when the cost was incurred.

Cash-basis business that anticipate being in the same or higher tax bracket in 2007 than 2008 can smooth out their taxable income by deferring income to 2008 and accelerating deductions this year. To push income into 2008, defer cash-basis businesses can delay billing clients or customers (for example, wait until mid-January) for services and products so that payment is not received until 2008. Alternatively, if you anticipate your business's taxable income to be higher in 2008, you may want to accelerate income in 2007 and defer deductions until next year.

For accrual basis taxpayers, generally the right to receive income, rather than actual receipt, determines the year of inclusion in income. Expenses are deductible in the year in which all events have occurred to establish the liability and the amount of the item can be ascertained with reasonable certainty. Thus, you may be able to deduct an expense before actual payment. Accrual method businesses that anticipate higher income in 2007 than in 2008 should consider deferring income to 2008 by delaying the shipment of products or provision of services until the beginning of your 2008 tax year. Moreover, payments received in advance from the sale of goods or services may generally be deferred until 2008, assuming certain requirements are met.

Deductions
Deduction planning is an integral aspect of year end business tax planning. There are many important deductions beyond the Code Sec. 162 deduction for ordinary and necessary business expenses that may benefit many small businesses by lowering their tax liability.

Equipment expensing
Most small businesses are eligible for the Code Section 179 deduction, a generous and lucrative tax break that enables businesses (especially capital intensive companies) to immediately deduct up to $125,000 in 2007 for equipment purchases that otherwise would have to be depreciated over a number of years. (The 2007 Small Business Tax Act increased the base limit from $112,000 to $125,000 for tax years 2007 through 2010.)

To qualify for the deduction, equipment must be used more than 50 percent for business purposes and must be in use by December 31, 2007. The deduction applies to new and used equipment, as well as computer and software purchases. Property also eligible for Code Sec. 179 expensing includes tangible recovery property that is Code Sec. 1245 property (i.e. most depreciable property other than buildings and land improvements). If feasible, consider maximizing the deduction by using the expensing deduction for property with the longest recovery period. However, the Code Sec. 179 deduction is essentially a "use it or lose" tax break: any unused Code Sec. 179 allowance can not be rolled over into the next year.

If your business is considering additional equipment purchases but is close to reaching the $125,000 expensing limit this year, consider postponing additional purchases until 2008, if possible. In 2008, you can deduct another $125,000 (or more, as adjusted for inflation) for equipment purchases.

The expensing deduction does begin to phase-out by the amount by which qualifying property placed in service during the tax year exceeds the investment limitation, which was formerly $450,000. The 2007 Small Business Tax Act retroactively raised the investment limitation to $500,000 for tax years beginning in 2007 through 2010. This means that, for 2007, the maximum amount that you can expense under Code Sec. 179 is reduced dollar-for-dollar for eligible property placed in service during the tax year in excess of $500,000.

Manufacturing deduction
The Code Sec. 199 deduction for qualifying domestic production activities benefits a broad array of businesses, including construction, engineering, architecture, and farming. For 2007, the deduction generally equals six percent of the lesser of (1) qualified production activities income for the tax year, or (2) taxable income that does not take the deduction into account for the tax year. However, the deduction cannot exceed 50 percent of W-2 wages allocable to domestic gross receipts. The deduction applies for both regular and alternative minimum tax (AMT) liability. Code Sec. 199 rules are extremely complex and calculating the deduction is complicated as taxpayers must make numerous allocations. Our office can help you determine the amount of the deduction under Code Sec. 199 you may be entitled to.

Compensation and bonuses
If your company operates a qualified retirement plan, consider maximizing 2007 contributions to qualified retirement plans since the contributions are tax deductible in the year that they are made to plan participants.

Moreover, paying year-end bonuses in December or January can create a significant compensation-based business deduction. For example, businesses can deduct in 2007 a bonus paid in 2008, as long as the obligation is paid within two and one-half months of the close of 2007. Accrual businesses can take a deduction in 2007 for bonuses not actually paid to employees until 2008 as long as (1) the employee does not own more than 50 percent in value of the business's stock, (2) the bonus is properly accrued on the company's books before the end of 2007, an the bonus is paid within two and one-half months of 2008.

Loss deductions
Business losses sustained during the tax year, while not particularly welcomed, can be deducted if your business has not been compensated by insurance or otherwise. For passthrough entities such as S corps, LLCs and partnerships, losses will be passed through and deducted on the owners' personal income tax returns. Loss deductions can be taken for:
• Bad debts;
• Casualty and theft losses;
• Capital losses;
• Losses on the sale of business assets; and
• Net operating losses.

Start-up costs
If you just launched your business in 2007 and you incurred expenses before the business actually began operating, you may be able to deduct some of these start-up costs. While start-up or pre-opening expenses are generally not deductible, and must be capitalized, you can elect to deduct up to $5,000 of start-up costs as long as the business is up and running by the end of 2007. The remainder of any start-up expenses must be ratably amortized over a 180-month period.

Extended incentives
Businesses should examine whether they can benefit from certain popular tax incentives that were set to expire in 2007, but have been extended and enhanced under the 2007 Small Business Tax Act, including the:
• Work Opportunity Tax Credit;
• FICA Tip Credit;
• Qualified Zone Academy Bond Credit; and
• Certain energy credits and deductions.

Expiring Tax Breaks
Unless Congress extends them, this year will be the last chance for businesses to take advantage of certain tax breaks set to expire in 2007, such as:

• Qualified leasehold and restaurant improvements. For property placed in service before 2008, qualified leasehold improvements and qualified restaurant can be deducted over a 15 year period (in lieu of 39 years) using the straight-line depreciation method.

• Qualified environmental remediation costs. Taxpayers can elect to treat qualified environmental remediation expenses paid or incurred before 2008, and that would otherwise be chargeable to a capital account, as deductible in the year paid or incurred.

• Contributions of food, books or computer technology. Businesses may take an enhanced deduction for contribution of food and books through 2007. C corporations may also take an enhanced deduction for contributions of computer technology or equipment donated to schools or libraries before 2008.

• Research credit. The incremental research credit may be claimed for increases in business-related, qualified research expenditures and for increases in payments to universities and other qualified organizations for basic research. Research funded by person other than taxpayer is not eligible for credit. The credit may not be claimed for expenses paid or incurred after December 31, 2007, but credits from previous years may be carried forward.

AMT Planning
The alternative minimum tax (AMT) is not a challenge reserved solely for individual taxpayers; it may affect your small business as well. While it is anticipated that Congress will enact another round of temporary AMT relief before year's end, whether such relief will come in the form of another "patch" or more comprehensive reform is uncertain.

The 2007 AMT exemption amount for corporations is $40,000, subject to an income-based phase-out. The AMT income tax rate for businesses is a flat 20 percent rate. The AMT method requires calculation of alternative minimum taxable income (AMTI), which is determined by adjusting the corporation's regular taxable income by certain adjustments, preference items, and an exemption amount. The alternative taxable income is multiplied by 20 percent to determine the tentative minimum tax. The AMT equals the excess, if any, of the tentative minimum tax over the regular tax for the tax year. The AMT is reduced by AMT foreign tax credits.

Small corporations that meet an annual average gross receipts test (GRT) under Code Sec. 55(e) are exempt from the AMT. To qualify under the GRT, a corporation's average annual gross receipts for all three tax year periods beginning after 1993 and ending before the current year can not exceed $7.5 million. Computing the AMT is complicated and time-consuming.

For help determining your business's potential AMT liability, or for advice on how to implement any of the tax-saving opportunities reviewed in this letter, please contact Mike Scialo (mscialo@cdhcpa.com) or Dan Duncan (dduncan@hcpa.com) for more information.

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