To pay or not to pay, that is the question

For taxpayers that make estimated tax payments throughout the year, the payment for the fourth quarter is due on January 15 of the next year. Even though this payment is made in the following year, it is still credited as a payment for the tax year in which it applies. But, if the taxpayer lives in an "income tax state" (a state with its own income tax, like Arkansas or Louisiana, but not Texas) and makes estimated tax payments to the state, there is a catch to when these payments are deductible on a Federal return.

Allowable itemized deductions for individuals on a Federal 1040 include state and local taxes paid. These taxes include income, real estate, and personal property taxes as well as some other taxes paid to a state or local government. The deductible portion of these taxes is the amount actually paid during the year, not amounts assessed or paid in other years. Here are a few examples:

Bob, who does not live in an income tax state, pays his personal property taxes for 2012 in October of 2013 for $500. At the same time, he receives his assessment for 2013 of $600 which will be due in October 2014. Bob's deduction for personal property taxes in 2013 is $500, because that is what he actually paid even though it was related to the previous year.  The $600 will be deductible to him in 2014 when it is paid.

Peggy lives in an income tax state and makes state estimated tax payments quarterly. In January 2013, she made her 4th quarter payment for 2012 for $500. Then, in April, June, and September of 2013 and in January 2014 she made quarterly payments of $600 each for her 2013 state taxes. Peggy's state tax deduction on her Federal return for 2013 is $2,300 ($500 + 3 $600 payments) which is the total of the payments made during 2013, even though one of them was related to a previous year.

This example leads us to the point of this article. If Peggy makes her state fourth quarter payment for 2013 in December 2013 instead of January 2014, her state tax deduction on her Federal return will be $2,900 instead of $2,300. As a result, her Federal tax liability would be decreased slightly because of the added deduction. It is for this reason that taxpayers living in income tax states should always consider paying their final estimated tax payment before the end of the year.

But, as is usually the case, there are caveats with this plan - the Alternative Minimum Tax and the time value of money.

Taxpayers subject to the Alternative Minimum Tax (AMT) will not realize the benefit of paying their state estimated tax payment early because those payments will be added back as a preference item on Form 6251.  Therefore if taxpayers are close to or already subject to the AMT, they should make their payments as scheduled (not early).

Taxpayers must also consider the time value of money when paying estimated tax payments early.  For example, if the funds needed to make the estimated tax payment will be accessed by selling investments at a gain, then the net effect of the transaction might be zero because the additional benefit from the payment could be offset by the additional income recognized from selling the investments in the same year.  Furthermore, the funds used to pay taxes earlier by 15-30 days may lose investment earnings which could be large if the estimated tax payment is large.

In closing, taxpayers should consider making their 4th quarter state estimated tax payment in December (now!) as long as they are not subject to the AMT and they have liquid funds to make the payment without creating additional income.

Straight cash

Cash basis taxpayers can make decisions during these last few days of December to improve their tax situation.

Cash basis taxpayers report income and expenses in the year that they actually occurred.  This allows cash basis taxpayers to defer income or accelerate expenses as the situation requires.

Income

Income must be recognized by a cash basis taxpayer when it has been constructively received and is available to the taxpayer.  If a taxpayer receives a check in January for work performed in December, that income is taxable in the next year.  However, if a taxpayer receives a check in December for work performed in December but puts it in a drawer and doesn't deposit the check until January, this is still income to the taxpayer because it had been constructively received and was available in December.  With this being the case, tax basis taxpayers can manage their cash inflows at year-end by sending out bills later to defer collection to next year, or requiring customers to prepay if more cash/income is needed.

Expenses

Expenses can be recognized by a cash basis taxpayer in the year paid or charged.  Yes, you read that correctly, charged.  The IRS will allow charges on a credit card as cash basis expenditures, even if the bill is not paid until the next month.  This provides some wiggle room for businesses that have cash flow concerns at year-end, because they can use a credit card to make purchases instead of cash.

Cash basis taxpayers can also use the end of the year to stock up on capital assets, especially right now due to the expiring Section 179 and Bonus depreciation provisions.

A word of caution: just because an entity is a cash basis taxpayer does not mean that every cash expense is deductible.  All expenses must still be properly substantiated and properly deductible.

Cash basis taxpayers should also consider their business operations when making year-end decisions on spending.  Yes, buying $5,000 of office supplies on New Years Eve will reduce the tax burden on the entity, but will that cash outlay penalize the business operations in January?

 

2013 year end planning

Over the next few weeks, this publication will address several topics related to year end tax planning. With Thanksgiving coming next week, it is time for business and individual taxpayers to get their financial houses in order for the end of the year. Topics to be addressed include the following:

  • New tax rates for 2013, including new capital gains rates and the Medicare surtax
  • Alternative minimum tax
  • Incentive stock options
  • Capital gains harvesting
  • Retirement contributions and other year end expenditures
  • Depreciation allowances for businesses
  • Considerations for cash vs. accrual basis taxpayers

If you have other topics you would like see addressed, please comment on this post or contact me below.

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