How Last Minute Tax Savings Can Hurt Your Optometry Practice
By Eric Levenhagen December 23, 2020
Most practice owners know the importance of the December 31 tax planning deadline. There are very few things you can do to affect your 2020 tax liability after the end of the year.
The end of the year is also when I tend to see even the smartest people make some illogical choices. They see their year-end tax projection and a high estimated tax bill. Something inside their brain kicks into gear to try and avoid those taxes. Many times at an even higher cost.
Here are the top 3 tax-saving strategies I see considered (and over-used) at the end of each year. Along with opportunities and pitfalls to consider with each.
1. Prepay Expenses (applies most to cash basis taxpayers)
This is one of the most common timing strategies out there. Especially when you find yourself in a pinch at year end.
It can be a viable strategy.
You can normally deduct up to 12 months of expenses in advance without much problem from the IRS. Common items include:
Rent & lease payments on property, vehicles & equipment,
insurance premiums, and
stocking up on supplies.
The trouble comes in when you rely too much on this as a cornerstone of your planning from year to year.
The major catch here is you are taking deductions from next year to create more deductions this year. Robbing Peter to pay Paul, as they say.
I have seen several cases with many years of prepaid expenses under a previous advisor’s guidance. It makes sense that you will need to keep increasing the amount of expenses you prepay each year to get back to even. Especially if your practice is growing every year.
A quick example: Let’s say you prepaid $20,000 in expenses at the end of 2019. That’s $20,000 in deductions you don’t have for 2020, so you’ll need to prepay that again this year. But now you’re only even for the year. If your revenue grew you have even more net income and a higher tax bill than last year. So you prepay another $30,000 to reduce taxes for 2020. In 2020, it cost you $50k to defer $30k, which may have saved you $15k (or less).
Rinse and repeat for a couple more years and you’ll need well over $100,000 at the end of Year 3 or 4 to keep making this work. What happens if your practice growth stalls for a year or you have another need for that cash? This strategy implodes on you. I saw a business owner’s taxable income inflated over $400,000 in 2019 alone due to misusing this technique. And it wiped out all their past savings since it was taxed in a higher tax bracket.
Prepaying expenses can work as a timing strategy when used strategically in a given year. But then you better go back to the drawing board early in 2021. Consider alternative techniques to protect your income from higher taxes.
2. Defer Income (again, for cash-basis taxpayers)
This is another very common technique I see a lot of advisors overuse. And most people do it the wrong way.
I often have to “untrain” someone from holding back checks they receive in November and December. Their plan is to deposit them in January and not claim the income until next year.
Not only is it a bad move, it’s illegal. If the only thing preventing you from reporting the income is your choice to not make the deposit, too bad. It’s still income for this year. If you ever get audited, the IRS is keen on this game. You’ll be in an indefensible position. And the penalties can be severe, depending on the amount of money we’re talking about.
The only way to make this work is to stop billing your patients and insurance companies. I don’t recommend this in very many cases, but that’s the way to do it. People won’t usually pay your bill unless you send it. Insurance companies won’t pay claims that weren’t submitted.
There are multiple problems with this. It can cripple your cash flow at year-end. So you have to have enough in reserve to weather this self-inflicted storm. Plus it can cause confusion with your patients. Not to mention an administrative headache with your staff or claims processor.
It can be hard enough to get paid on time anyway, so why throw a monkey wrench into this process?
It is usually better to use other viable strategies to defer taxes if you’re in a pinch.
3. Buy Equipment, Vehicles, etc.
The classic technique - spend more money to pay less tax. Spend a dollar to save 40 cents.
This is a viable strategy. The first-year depreciation rules are still favorable to business owners. Most equipment, computers, and furniture will qualify for a 100% deduction in the year purchased. This is true whether they are new or used.
Vehicles are a different story. It depends on whether it’s a heavy vehicle (GVWR over 6,000 lbs.) or a lighter passenger vehicle (most cars). There are also differences for SUV’s, vans and pickup trucks.
The problem is when people go looking to buy new (or new to them) stuff for the tax breaks. I’ve seen people go into debt on equipment they didn’t need or weren’t planning on purchasing. Once they saw their estimated tax bill, the plan changed.
The best practice is to analyze new asset purchases in November and December the same way as the rest of the year. If you are planning on buying a new asset in January or February and you do need the deduction this year, see if you can speed up the purchase. But don’t make up needs for new stuff just for the tax deductions.
Keep in mind that your new equipment has to be “placed in service” by December 31. That means you actually have to have it installed and use it. If it’s still being shipped or if it’s sitting in storage at the end of the year, it’s not a deduction until next year anyway.
How To Avoid These Pitfalls
The best time to implement a comprehensive tax strategy is before the year begins.
If you need to use some combination of these or other last-minute techniques for this year, proceed cautiously. Be sure you're also getting your plan for next year in place now.
The best tax strategies available take a full year to maximize your benefits.
Last-minute tax planning is very reactive. Only a proactive approach can help you legally avoid the most taxes possible while increasing your after-tax cash flow.
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.