Our colleauges at Berntson Porter & Company have collaborated to provide some end-of-year tax planning tips. Thank you to Jennifer Raybon, David Berthon, and Darcy Kookier for sharing their knowledge!
In order to achieve financial goals, comprehensive tax and financial statement planning is not just a good idea, it is a cornerstone of fiscal success. This activity becomes even more critical as year-end rapidly approaches. Planning should not be limited to estimating tax liabilities. The relationship between taxes and the company’s financial position represented in its financial statements must be planned for and strategized congruently. Basic, but very important factors, to consider when planning are:
• Will I meet my financial covenants with the bank?
• How will my surety view my year-end financial statements?
• Are there additional tax deductions/incentives available?
• How do I meet all potential tax and financial statement goals?
When considering these factors, review the following items to identify how to optimize your position from both a tax and financial statement perspective.
Cash is King
Formulate strategies to maximize the cash balance at the close of the year. Consider requesting early payment from customers on large projects or orders. This will reduce the receivables balance and increase the liquidity of the company. Avoid taking excess stockholder distributions until after the close of the year.
Review Accounts Receivable
Review the accounts receivable aging schedule for uncollectible receivables. Accounts receivable in excess of 90 days are discounted heavily by financial statement users, and in some instances, removed from the collateral/covenant calculations altogether. Consider offering a nominal discount in order to accelerate the receipt of payments. Invoices which are determined to be uncollectible should be written off prior to year-end in order to be deducted for federal income tax purposes.
Planning for Fixed Asset Purchases
Taxpayers may elect to expense up to $250,000 of qualifying fixed asset purchases in the 2009 tax year. This amount begins to phase out if fixed asset purchases exceed $800,000 and can only be expensed to the extent a taxpayer has income from an active trade or business. In addition, taxpayers are eligible to take 50% bonus depreciation on qualifying new assets. This incentive applies to 2009 fixed asset purchases only (except for certain long-lived assets). Since both the increased Section 179 expensing and bonus depreciation are tax adjustments only, these two incentives can generate significant tax deductions without hurting a GAAP basis balance sheet.
Special Considerations for Companies with Inventory
Financial statement users, especially banks, consider proper inventory valuation important. Banks use inventory value in borrowing base calculations in order to determine lines of credit when lending to distributors and manufacturers. Inventory should be valued at the lower of cost or market. Evaluate what your inventory can sell for on the open market, and if the market value is less than what is reported on your books, write it down to net realizable value. When this inventory is written off, it is also a deduction for tax.
Internal Revenue Code (IRC) Section 263A requires certain overhead costs be capitalized as part of inventory for tax purposes. This applies to all manufacturers and to resellers with average gross receipts in excess of $10 million for the previous three years. If 263A has not been required in the past but you are approaching the threshold, estimate what sales are going to be through year-end and determine if there are ways to defer revenue until next year. If you have been subject to Section 263A in the past, evaluate opportunities to lower year-end inventory levels to reduce its impact.
For companies with domestic production activities, IRC Section 199 provides for an additional deduction. Domestic manufacturers are allowed a deduction for 6% of either taxable income or net income from qualified production activities in 2009. In 2010, the deduction increases to 9%. Evaluating what constitutes domestic activities can maximize tax savings as the rate increases.
If your company has excess inventory, consider donating it to a qualified charity. Only C-Corporations that contribute inventory to a qualified 501(c)(3) organization are eligible for the deduction. The deduction can be up to twice the basis of the donated property and companies have two and a half months after year-end to make the contribution.
Finally, if your company has multistate operations, evaluating where the company’s inventory is held could result in tax savings. Most state apportion income based on a 3-factor formula that includes inventory. Take a look at year-end inventory levels by location and determine if it’s possible to move inventory to a state with little or no income tax.
Special Considerations for Contractors
If your company is in the construction business, financial statement users do not like to see a decline in gross profit margin from contracts in progress in prior years that are now completed contracts in the current year. If this becomes a trend, it could indicate poor estimating and job cost report forecasting or that a contractor is not recognizing revenue correctly for financial statement reporting purposes.
Furthermore, the percentage of completion and estimated gross profit percentage should accurately reflect a project’s position at year-end. Costs to complete should be carefully analyzed and forecasted. Job closeouts are important and delays in this process typically reduce profitability. Examine projects greater than 95% complete and focus on closing them out prior to year-end.
Additionally, underbillings are a potential red flag to third-party financial statement users, especially if the project is nearing completion. Underbillings may imply unresolved change orders or inefficiencies in the billing process. From a federal income tax perspective, a contractor will recognize taxable income on these underbillings that could be avoided.
If residential projects are on the contracts in progress schedule, they represent tax deferral opportunities for contractors without affecting the balance sheet. Contractors can defer 100% of the profit on home construction jobs, mainly single family homes and townhouses, and 30% of the profit on residential construction jobs, including apartments, condominiums and even military barracks, until the projects are complete.
Don’t Forget the Covenants
For most, year-end planning is about reducing taxes. Keep your company’s financial statement covenant requirements in perspective, especially during these troubled economic times. It is needless to say that banks have a heightened sensitivity to financial performance which is measured by these covenants. Don’t put yourself in a bad position with your bank in the effort to save a few dollars in taxes. Take the time to review covenants as well as lending agreements to make sure the requirements and needs of your bank or bonding company are understood. Depending on the level of service – audit, review, or compilation – there could be different requirements as well as differences in timing or costs.