Tax Lawyer's Blog

At year end tax professionals generally advise their cash basis clients to accelerate expenses and defer income. However, this strategy only makes sense where a taxpayer’s marginal tax rate will decrease or remain relatively constant.

Experts are predicting that Congress and President Obama will raise tax rates either by the end of this year or sometime next year; therefore, tax professionals should be careful before giving their clients (especially those who earn more than $235,000 per year) the standard advice.

Here are two examples that illustrate the problem. The first example assumes that the taxpayer’s tax rate is the same in 2009 and 2010. The second example assumes that the taxpayer’s tax rate increases from 35% in 2009 to 39.6% in 2010.

Example 1 – Constant rate 35% in 2009 and 35% in 2010

Taxpayer, Shug Dulman, made $400,000 in 2009 from his solely owned consulting business, Dulman Services, Inc. He expects to make the same in 2010.

In November the company received invoices showing payments due to vendors, suppliers and creditors in the amount of $40,000. Additional invoices of $20,000 are expected to be received sometime in December.

Dulman expects to bill clients in November and December for services rendered in the amount of $120,000.

Dulman’s 2009 tax liability without standard tax planning:

$400,000

 120,000  (accounts receivable paid in 2009)

 (40,000) (November invoices paid)

$480,000 (adjusted taxable income)

       35%

$168,000 (tax liability)

Dulman’s 2009 tax liability with standard tax planning:

$400,000

          0  (Defer billing of A/R to January 2010)

 (60,000) (November invoices paid and December invoices pre-paid)

$340,000 (adjusted taxable income)

       35%

$119,000 (tax liability)

Dulman has deferred $120,000 of income to 2010 and accelerated $20,000 of expenses to 2009 thereby shifting $140,000 ($480,000 – $340,000) of its taxable income to 2010.

Through the use of simple deferral of income and acceleration of expense techniques Dulman has obtained a one year, interest-free deferral of $49,000 ($140,000 x .35%) of taxes.

Remember, the result obtained here is merely a deferral of taxes. It is valuable to Dulman because it provides interest-free additional working capital that can be used to generate additional income.

Assuming Dulman’s cost of capital to be 6%, the implementation of the normal year-end tax planning strategy saves it $2,940 of interest it would have incurred if it were forced to borrow the $49,000. 

Example 2 – Tax rate 35% in 2009 and 39.6% in 2010

Here’s what happens if the Obama tax increases are in effect in 2010 assuming the same facts as above and that Dulman is given the standard advice to defer income and accelerate expenses.

Dulman’s tax liability in 2009 is still $119,000.00 and it has still effectively deferred $49,000 of taxes to 2010 thereby saving the $2,940 it would have had to pay in interest if it had borrowed the funds.

However, Dulman’s 2010 tax rate will be 4.6% higher than its 2009 tax rate and by following the standard year-end tax planning advice it will have cost itself $6,440.00 in increased 2010 taxes:

$120,000 (income deferral)

   20,000 (expense acceleration)

$140,000

     4.6%  (2010 rate increase)

$   6,440  (tax liability increase)

Dulman’s 2010 increase in taxes exceeds by $3,500 ($6,400 – $2,940) the interest savings it will have obtained through the 2009 deferral. Dulman will never recover this difference because it is not a deferral, but rather a real tax loss.

Words to the Wise:

1. Taxpayers and their advisors should consider the potential effects of new or pending tax legislation in determining whether or not to accelerate the payment of expenses and defer income in 2009. Blindly following the standard year end strategy could yield some very bad results.
2. The above analysis should be made even in cases where a legislative increase in marginal tax rates is unexpected. For instance, if a taxpayer expects to be in a higher tax bracket in 2010 (absent new legislation), he should carefully consider whether the cost of accelerating expenses and deferring income to the current tax year will actually save him money in the long run.

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