We get an influx of new clients every year. Most of them come with bad habits their past accountants taught them. Things I would never advise that don’t make much sense.
Every year it seems I have to untrain at least one new client from deferring their income the wrong way. Usually more than one.
Let me be clear – income shifting by deferring income or prepaying expenses can be a great tactic. I use them in a pinch to avoid a surprise when someone had a great year.
What if your income was much larger than anticipated and it’s pushing you into a higher tax bracket. If we didn’t have time to plan for that, then income shifting tactics would be a possibility.
Most people do it the wrong way
I’ll hear something in a year-end meeting like this.
“I’ve already started holding my checks and won’t deposit them until January. That should help keep our taxes down.”
Yes, but it will also get you in a lot of trouble.
This isn’t just a bad strategy, it’s illegal.
There is a right way to defer income and a wrong way. Holding checks you receive from your customers until next year is the wrong way. If the only reason you’re not counting the income is that you made the choice not to put it in the bank, too bad. It’s still income for the year you receive the check.
There’s a very clear tax law on this. This isn’t my interpretation of a complex law. Or an issue of not being aggressive. There’s not much to interpret here.
The IRS is keen on this game
Let’s say you get picked for an audit. What do you think an auditor would do if they see your average monthly deposits drop in December? I would look at January deposits. What? Those increased? How can that be? Let’s check the deposit images from the bank. Oh, these checks dated mid or late December were all deposited in January. Why?
You’d better have a good, legal reason for that or else you’re getting hit with some nasty penalties.
So what is the right way to defer income? Assuming you’re a cash basis taxpayer, you have to stop collecting income to defer it. You’d have to stop invoicing your customers, or invoice them so late in the year they don’t pay it until the next year.
Great for taxes, but it could cripple your cash flow. Not to mention it causes confusion with your customers and gets them out of the rhythm of paying on time. And it can be an administrative headache.
So I don’t recommend it often. Most people will move to prepay expenses instead if they need a timing strategy like this. It’s easier to manage. Tax law says you can prepay a lot of expenses up to 12 months in advance without issue.
A word of caution – don’t become over-dependent on this strategy. Recall I said I use this in a pinch. It is never the cornerstone of a successful long-term tax plan. People tend to look at it and think it is easy, so they keep relying on it year after year.
Timing techniques can work against you
Let’s say you prepaid $30,000 of expenses this year. And you expect your business to continue growing, so your income will be higher next year. Now you’re missing $30,000 of deductions next year.
Fast forward to the end of next year.
You have to prepay that $30,000 again to get back to even. But wait, that didn’t reduce your taxes because your income grew. Let’s prepay another $30,000. Total cash need = $60,000.
It doesn’t take long for you to need hundreds of thousands of dollars at the end of every year to keep this going. It’s like a self-inflicted Ponzi scheme – you keep taking from later years to benefit you now. At some point, it grows out of control.
What happens when your income goes down for a year? Or you need that cash for something else? The scheme comes crashing down and you’re left with a huge tax bill.
I saw this happen to someone not long ago. They had to include over $400,000 of income in one year because they didn’t have the cash to keep prepaying expenses. That shot them up to a higher tax bracket. They ended up paying more in one year than they had saved all the prior years combined.
What’s the better option?
Use these income deferral techniques only when you need to save a nasty tax bill in the fourth quarter. Don’t rely on them too much.
And have a comprehensive tax strategy in place at the beginning of the year. One that allows you to legally reduce your tax bill in other, more sound ways.
If you liked this post, check out our Independent Optometrist’s Guide To Financial Freedom
Eric Levenhagen, CPA CTS is the only financial consultant who helps private practice optometrists improve the financial health of their practice with a simple, proven process called Financial Harmony which will reduce their taxes and increase their after-tax profits by at least $10,000 in the first year, guaranteed.