Tax planning is a process of considering various tax options to determine when, whether, and how to conduct business and transactions so that taxes are eliminated or reduced. There are often options of making a taxable transaction in more than one way. The courts strongly support the right to choose the method that will result in the lowest legal tax liability. In other words, tax avoidance is entirely proper.
To plan effective tax even for a small company, the managers need to estimate their personal and business income for the next few years. This is necessary because many tax planning strategies will save tax dollars at one income level, but will create a larger tax bill at other income levels.
A full definition of tax planning strategy is an action that meets certain criteria, and that would be implemented to realize a tax benefit for an operating loss or tax credit carryforward before it expires. Carryforwards are deduction or credits that cannot be utilized on the tax return during a year, and that may be carried forward to reduce taxable income or taxes payable in a future year. Tax planning strategies are considered when assessing the need for and amount of a valuation allowance for deferred tax asset.
Companies can reduce their tax bills by using accelerated depreciation methods for fixed assets. With faster tax write-offs on fixed assets, a company can report lower taxable income and pay lower taxes in the early years of the assets’ lives; a thereby manage tax costs.
Some companies also manage tax costs by locating part of their business in low-tax-rate states while operating retailing outlets or production facilities elsewhere. For example, Delaware has a state tax rate of zero and a company that has a subsidiary or an office in Delaware can transfer money from other outlets in high-tax states. However, the state usually checks carefully whether the transactions were done solely for the purpose of reducing taxes.
It is possible to reduce tax payments in three different ways – a company can reduce income, increase its deductions, and take advantage of tax credits. Many factors depend on gross income, including tax rate and various tax credits.
The Simplified Tax System was established to minimize the compliance burden on small businesses by applying cash accounting rules for income and deductions and simpler rules in recording trading stock and depreciation. Small businesses can also choose how to record income – as cash or non-cash basis – depending on which is the most appropriate to their particular circumstances. A simple end of year tax planning strategy is to delay receipt of the income until after the end of the year. Income can be deferred by issuing an invoice with a date later than the end of the fiscal year. A company can also write off bad debt. To do this a company has to prove that the debt is bad, which means to show that it has made a genuine attempt to recover the debt by year-end.
Although tax planning should be an ongoing and continuous process, end of the year offers especially many tax saving opportunities. A company that has employees can consider a mix of salary and bonuses. A bonus is often preferred over salary since the payment can be deferred until after the company’s year-end. If a small company employs family members, it makes sense to pay them reasonable salary or bonus as well. This will be beneficial where their marginal tax rate is lower than the owners.
Owner-managers of a private corporation often declare bonus at year-end to reduce the corporation’s income to the amount that qualifies for the small business deduction; however, a corporation can also pay dividends to its shareholders. It is also possible to take fund out of a company as a loan. Bus this is a complicated tax area, and such issues should be discussed with professionals to avoid adverse tax consequences.
Tax rate changes nearly always will have a substantial impact on income numbers and the reporting of deferred income taxes on the balance sheet. Deferred tax accounts are reported on the balance sheet as assets and liabilities. They should be classified as a net current amount and a net noncurrent amount.
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