The weather's getting colder — a sure sign that it's time to prepare your company for the close of the financial year. Ideally, you've been keeping up with at least some of the paperwork this involves all along — but if not, there's still time.
Too many contractors put off thinking about taxes until April, only to find they made an accounting mistake and don't have the funds they need to pay the government. You can avoid this situation by taking certain steps before the year is out.
Haven't kept up with your paperwork? There's still time.
Fix Your Financial Statements
If you're like most contractors, creating and reviewing financial statements is low on your list of priorities. But the IRS requires this information; you'll have to produce it sooner or later. If you prepare it soon enough, you can use it to manage your finances and, quite possibly, legally defer tax payments to a later year.
It all boils down to knowing whether or not you're making a profit, and if you are, how much. So you should begin by updating your financial statements and making sure that everything is correct.
Checking accounts. I had a client who accidentally entered the same $15,000 deposit twice in his check ledger. Since he reconciled his checking account only once or twice a year, it was some time before he caught the error. As a result, his income statement showed $15,000 too much income.
He was in a 35 percent tax bracket, so he ended up paying $5,250 in taxes on income that didn't exist. He eventually got this money back — but until then, the government had it, interest-free.
Accounts receivable. If you keep your books on an accrual basis, it's important to review your accounts receivable and make sure those amounts are actually collectible.
If you are not going to get paid for an invoice, write it off. That way, at least you won't have to pay taxes on money you'll never collect.
Accounts payable. I've seen many A/P lists with lots of old bills on them. Frequently the money is no longer due, because either the amount was accidentally entered twice or the bill was already paid (though not properly accounted for).
If you have old bills in A/P, clear them out so that you can correct your income statement. Just be aware that if you write off an old accounts-payable bill, you will have fewer expenses and more net profit — and therefore more taxes to pay.
Meet With Your CPA or Tax Preparer
Be sure to meet with your accountant or tax preparer no later than the middle of December. Together you should forecast your costs and income for the rest of the year and estimate your net income or taxable profit for the entire year. At that point you can ask your tax preparer what you can do to minimize your tax liability or defer all or part of it to a later year.
The taxes you defer will eventually have to be paid, but for most contractors it's better to have the money now to use in the business than it is to give it to the government any sooner than necessary.
Depreciation. Most contractors don't track depreciation throughout the year, even though the current year's depreciation can affect the amount of taxes they have to pay.
Ask your tax preparer to estimate how much depreciation you can write off this year, because it will be a factor in projecting your net taxable profit.
Time Your Purchases Correctly
You shouldn't buy things just to get deductions, but if there is something you really do need to buy, there may be some tax advantage in timing its purchase.
If your tax preparer knows what your income is likely to be, he or she will be able to tell you whether it makes more financial sense to make purchases before or after the end of the year.
This applies to all kinds of purchases. Perhaps you need to replace your truck or the office computers. Or maybe your trucks and equipment are due for an overhaul or major repairs. You might be running low on office supplies, or custom-printed forms and letterhead. Or, if you have the cash, you might want to prepay licenses, dues, or legal and accounting fees.
Keep in mind that the timing depends on whether you prepare your taxes on a cash or accrual basis.
For example, if you prepare them on a cash basis, you could reduce this year's taxes by paying January's rent in December. If you do them on an accrual basis, you could purchase something this year, pay for it next year, and still be able to deduct or depreciate it on this year's tax return.
Credit cards. Credit cards are a way for a cash-basis taxpayer to buy something and legally deduct it now, but pay for it next year. The IRS treats credit-card purchases as loans that can be deducted in the year they occur. (This applies only to third-party cards like Visa and MasterCard, not to the second-party store cards issued by individual vendors.)
As with any tax deduction, don't take it without first talking to your tax preparer and finding out what kind of documentation you're required to provide.
Cash flow. In some cases, cash flow will be the deciding factor in your year-end planning. One client of mine used to have a hard time pursuing year-end tax-saving strategies because he was always scrambling to come up with enough cash to make a down payment on his liability insurance. Finally, to avoid this problem, he purchased a six-month policy on January 1 and then switched back to a full-year policy on July 1.
Prepare Those 1099s Now
If you paid more than $600 to a subcontractor this year, you are required by law to send him a 1099 form by January 31st of next year.
Too many contractors wait until the last minute and then find that they neglected to get the sub's tax ID number. You are supposed to get this number in advance (before you pay the sub), but that doesn't always happen.
If you can't track down the sub and have to file 1099s without tax ID numbers, you could be subjected to substantial fines.
Consider Taking Money Out of the Business
Bonuses, dividends, profit-sharing plans, and 401(k)s are all ways to take money out of the company in such a way as to reduce or defer taxes. The amounts and methods of distribution depend on the type of company you are: sole proprietorship, partnership, subchapter S-corp, C-corp, or LLC.
However, you should never take money out of your company until you've laid the proper groundwork.
First, your income statement and balance sheet must be accurate and up-to-date; otherwise, you won't even know if you made a profit.
Second, you should be able to accurately project your cash flow, because you don't want to disburse money if it's going to put your company in a bind later on.
And finally, since the tax laws are very specific about how and when you can take money out, you should talk to your tax preparer before cutting yourself or anyone else a check.
I've seen contractors set up and fund profit-sharing plans only to discover that they'd done it all incorrectly. With better planning, the resulting paperwork and penalties could have been avoided.
Make Sure You're Getting Good Advice
If your CPA or tax preparer talks to you only once a year, waits for you to send in your financial statements in February or March, or does your taxes without asking any questions, then you may not be dealing with the right person.
A good CPA or tax preparer should be helping you all year long, should want to see your financial statements in the middle of the year, and should be interested in helping you plan for the end of the year.
Leslie Shiner has worked as a financial and management consultant for more than 25 years. Her office is in Mill Valley, Calif.