2003 Year-end Tax Planning for Business

by Ronald J. Kaley, MBA

The time to consider tax saving opportunities for your business is before its tax year-end. Some opportunities may apply regardless of whether your business is conducted as a sole proprietorship, partnership, limited liability company, S corporation or regular corporation. Other strategies may apply only to a particular type of business organization.

Cash Versus Accrual Accounting

Regular corporations and partnerships that have a regular corporation as a partner must use the accrual method of accounting if their average annual gross receipts for the three prior tax years are more than $5 million. If their average annual gross receipts are $5 million or less, regular corporations and partnerships can use the cash method of accounting unless they have inventories, in which case they must use the accrual method. All others, S-corporations, and C-corporations that are personal service corporations, can use the cash method of accounting regardless of their average annual gross receipts. However, if they have inventories, they must use the accrual method, with the exception of certain qualifying small business taxpayers.

In addition, the Treasury has provided a de minimis exception with regard to the use of the accrual method of accounting.

Depreciation Deductions and Asset Expense Election

The timing of asset acquisitions is critical to obtain maximum depreciation deductions. Using other depreciation rules to your advantage will also reduce your taxes. The Jobs and Growth Tax Relief Reconciliation Act of 2003 has given American businesses an opportunity to invest in their futures. The law expanded the current election to expense certain depreciable business assets (Section 179 deduction) and also changed the Modified Accelerated Cost Recovery Systems (MACRS) Bonus Depreciation enacted by the 2002 Tax Act. These modifications allow businesses acquiring qualified, capital assets to deduct a substantial amount of costs in the year of purchase. The following tax changes may offer your business substantial savings.

Generally, if you purchase depreciable tangible personal property (including off-the-shelf computer software), you may elect to treat up to $100,000 as a deduction in the year the property is placed in service for taxable years beginning in 2003, 2004, and 2005. However, the benefits of this election are phased out if more than $400,000 of qualifying property is placed in service in taxable years beginning in 2003, 2004, and 2005. These dollar limitations are indexed annually for inflation for taxable years beginning in 2004 and 2005. This asset expense election is further increased for qualifying property placed in service by a qualifying “enterprise zone business.”

Additional First-Year Depreciation for Qualifying Property

The MACRS Bonus Depreciation created by the 2002 Tax Act allowed an additional first year bonus depreciation deduction equal to 30% of the qualifying property cost. The 2003 Tax Act enhances this tax benefit which is effective May 5, 2003, and the deduction is not limited by taxable income. The Bonus Depreciation is deductible in the year of purchase without regard to when the capital asset was purchased during the year. Qualifying property is generally defined as property whose original use commenced with the taxpayer after the effective date and must have a recovery period of less than 20 years as defined under the tax code. In addition, a business may deduct the regular depreciation on the difference of the original cost less the Bonus Depreciation.

The 2003 Tax Act extended the Bonus Depreciation expiration date until December 31, 2004 and increased the Bonus Depreciation from 30% to 50% effective for purchases of qualifying property after May 5, 2003.

Inventory Shrinkage

Businesses that do not take a physical inventory count at the end of their taxable year may accrue a deduction for estimated inventory “shrinkage” at year-end. Inventory shrinkage is a catchall amount attributable to items such as undetected theft, breakage and bookkeeping errors, which cause a taxpayer’s actual inventory to be less than the amount recorded on its books. In estimating shrinkage at year-end, businesses may take into account their experience in prior years, sometimes adjusted for special circumstances and other factors that management considers appropriate. The adoption of a method of estimating inventory shrinkage is a change of accounting method, which requires conformity with IRS procedures.

Conclusion

Business tax planning is very complex. Careful planning involves more than just focusing on lowering taxes for the current and future years. How each potential tax saving strategy affects the entire business must also be considered. In addition, planning for closely held entities requires a delicate balance between planning for the business and planning for its owners.

Ronald J. Kaley, MBA is a tax manager with Echelbarger, Himebaugh, Tamm & Co., P.C. (EHTC). He specializes in the areas of tax, business planning and cost segregation studies. He may be reached at 616.575.3482 or e-mail ronk@ehtc.com.