Ignore a tax deduction? Sometimes it makes sense

Why would any veterinarian ignore perfectly good, legitimate deductions at tax-filing time?

Our complex tax rules and an Internal Revenue Service ever on the lookout for missed income and exaggerated deductions paint a one-sided picture of the nation's tax structure.

It is not easy trying to break a life-long habit of minimizing income and maximizing deductions in order to produce a lower tax bill. Surprisingly, however, the lowest tax bills often result from legitimate tax deductions postponed or ignored.

A start-up business has the option of deducting up to $5,000 in start-up and organizational expenditures the year it opens.

But why would it want to?

If the new business has income, it will likely find itself in the lowest tax bracket. If those start-up expenses are ignored the first year, they - and any start-up expenses that exceed $5,000 - will be available for deduction gradually over the following 180 months. Thus, the $5,000 deduction deferred until more profitable years will help reduce income that at that time will in all likelihood be taxed at a higher rate.

Flexible tax laws

Tax laws offer a degree of flexibility that permits veterinarians and their practices to manipulate both income and deductions legitimately to achieve a consistently lower tax bill. Deferring or postponing receipt of income in a tax year when profits are up often results in a lower tax bill for both that year and later years when income can be offset by a larger-than-usual amount of deductions.

As was the case with our start-up expenses, deferring deductions until a tax year when profits - and a higher tax bracket - make them more valuable is a legitimate option.

Veterinary practices and other businesses damaged by a hurricane or other disaster often have an incentive not to claim deductions and thus report higher pre-catastrophe income, which can lead to higher federal assistance and insurance settlements covering loss of income.

Another situation that might prompt a veterinarian to ignore deductions to show a higher income might involve a potential investor, creditor or buyer, who may have requested copies of the practice's tax return to assess its income potential.

If a veterinarian or a practice principal is applying for a loan, banks usually are wary of self-employment income because of the ability of individuals to manipulate earnings on paper. Likewise, individuals buying a practice or business should be aware that a tax return is not always a fair gauge of profitability.

Is fraud committed by failure to disclose to a third party expenses that were not reported on a tax return? Omitting expenses in financial statements violates generally accepted accounting principles (GAAP), but small businesses do not always use GAAP-based financial statements. Tax laws, as mentioned, do not require claiming all deductions for tax purposes.

Recovering costs

Every practice claims a write-off for capital assets - the building, furniture, fixtures and equipment - usually on a depreciation schedule.

Tax rules allowing for recovery of money spent for equipment don't match tax depreciation with economic depreciation. The write-off period for newly acquired capital assets differs greatly between the period when the assets contribute to business profits and what is called an asset's "useful" life.

In addition to a shorter useful-life write-off period, rules encourage investment in assets by allowing accelerated depreciation methods, and by allowing an expensing allowance or first-year write-off of up to $100,000 of the cost of newly acquired equipment under Code Section 179. However, neither accelerated depreciation nor the first-year write-off are mandatory.

Although, depreciation deductions do not have to be claimed, they do "accrue" and figure into the computation for gain or loss when property is sold, abandoned or otherwise disposed of.

It is possible to ignore the standard system of depreciation, choosing instead a slower, more even write-off such as the straight-line method. But the IRS reportedly looks more closely at those who choose alternative depreciation methods instead of the no-questions-asked, modified-asset cost-recovery system (MACRS).

Ignoring the small stuff

Some practitioners may ignore a deduction, fearing that it will increase the likelihood of an audit, or because it isn't large enough to justify the paper work and record-keeping.

While keeping track of small items may seem too time-consuming to be worth the trouble, remember that for many expenses, such as travel and entertainment, physical receipts are not required for amounts under $75. Of course, a contemporaneous record is necessary to support a claimed deduction, including the standard mileage deduction.

Home office no-no

A valid reason many veterinarians ignore the home-office deduction is the impact that office can have on profits when the home is eventually sold. Generally, up to $250,000 ($500,000 for those filing jointly) of gain on the sale of a principal residence used as such for at least two of the five years preceding the sale may be ignored for tax purposes.

This exclusion applies even if part of the dwelling was used as a deductible home office. The exclusion does not apply, however, to depreciation claimed for that home office. Instead, depreciation is recaptured (generally, subject to a 25 percent maximum tax) to the extent that gain is realized on the sale. Remember that depreciation must be recaptured or paid back, whether it was claimed on the return or not. Gain cannot be avoided by foregoing depreciation deductions on the home office.

One option involves employing a two-off, three-on strategy. After three years of business use, the space is for personal use for two years. Continuing that pattern keeps the space eligible for the home-sale exclusion, because it will meet the two-out-of-five years residential use test.

Deducting for repairs

Under tax rules, a repair is not always an immediately deductible expense; often it is classified as a capital expenditure. Expenses that keep property in an ordinarily efficient operating condition and do not add to its value or appreciably prolong its useful life usually are deductible.

If, however, repairs such as painting, fixing leaks, plastering and conditioning gutters are part of an overall plan to fix up, remodel or rehabilitate a practice building, both the IRS and an owner attempting to use those expenditures in a later tax year can legitimately class them as capital improvements. In fact, the IRS often will label them capital improvements whenever it believes they are part of a capital improvement plan.

The other side of the coin

Ignoring or postponing deductions is only one strategy and may not be right for everyone. Frequently, the business needs more, not fewer, deductible expenses. It's driving the popularity of so-called "prepaid" expenses. Even cash-basis veterinary practices may deduct certain prepaid expenses in the year paid. If the payment creates an asset having a useful life extending substantially beyond the end of that tax year, it may not be deductible, or may be deductible only in part, in that year.

If, for example, a veterinarian's calendar-year practice signs a three-year property lease on Dec. 1 of the tax year and agrees to pay an "additional rental" of $18,000 plus monthly rental of $1,000 for 36 months, he or she can deduct only $1,500 for the tax year ($1,000 rent plus 1/36 of $18,000). The $18,000 is an amount paid for securing the lease and must be amortized over the lease term.

Ignoring perfectly legitimate tax deductions is not an easy habit to break. However, matching the available tax deductions with the veterinary practice's income can, if handled properly, increase the value of the deductions while ensuring a tax bill consistently in the lowest possible tax bracket.

A fluctuating economy combined with a tax system that takes progressively larger bites sometimes means deductions will be worth more next year than today. On the other side of the coin, an exceptionally profitable year might warrant claiming every tax deduction or postponing income wherever possible to reduce the current tax bill.

This strategy is called tax planning, a year-round activity that can reap big rewards - by consistently lowering tax bills - year after year.

Battersby is a financial consultant in Ardmore, Pa.