In this week’s tax planning article I’m going to cover prepaid expenses and the ability to bring forward tax deductions to reduce your current year tax bill.

Before I do it’s important to note that this particular strategy only works for businesses that are classified as Small Business Entities (SBE’s). In the 2018 financial year that is businesses with a gross turnover (total sales) of less than $10,000,000.

Should you Prepay expenses?

At first glance this may seem like a matter of robbing Peter to pay Paul. We are prepaying costs we would have otherwise paid next year in order to bring the deduction forward. Clearly, the result of that is higher expenses this year and lower expenses next year, right?

One point to note is that we operate our businesses in an environment that makes it impossible to fully predict future tax law changes. As a result, any strategy that can bring a deduction forward into a year we are certain about (lock in the benefit), rather than leaving it to the uncertainty of next year is potentially worth considering.

Another benefit of prepayments is that it often allows you to lock in this year’s prices before your supplies have set their yearly price increases. Note – while it is not tax deductible this is especially useful for Health Insurance!

How does this strategy work?

So, you have some cash available and you’re looking for a way to reduce this years tax bill without wasting money on things you don’t really need? Great position to be in!

Lets look at how prepaying an expense helps you achieve this!

Sample Information

Your business has made a profit of $150,000 for the current financial year before tax and owner’s pay. Well done! To make the example easy I’m going to assume that all of the profit is taxable in your hands, as an individual.

Option 1 – No prepayments

The whole business profit of $150,000 is paid to you as the business owners and you pay tax on the money at your normal marginal rates.
Based on current marginal tax rates you will pay $46,132.00 in tax (including Medicare levy).

Option 2 – Prepay $10,000 of expenses

In this example you take $10,000 in cash and use it prepay some tax deductible expenses that you otherwise would have paid next year. The remaining $140,000 of profit is paid to you as the business owners and you pay tax at your normal marginal rates.

Based on current marginal tax rates you will pay $42,232.00 in tax (including Medicare levy).

The net result is a $3,900 saving in total tax paid on your business profits for the year…but keep in mind you do have $10,000 less in your bank account.

Other Points to Notes

  • Assuming you have two almost identical years in business and the tax laws stay the same you could argue that this is not a tax saving. You have ‘deferred’ the tax until next year by bring the deductions forward into this year. Keep that in mind when you see accounting firms claiming that they have saved their clients $millions in tax for a particular year. I guarantee you most of it is just deferring tax to a later year.
  • If you inadvertently prepay expenses that are not tax deductible then the system doesn’t work!

What sort of items can you prepay?

The answer to that question depends very much on your business and the suppliers you have. Generally speaking you can look at items like:

• Office supplies and stationery;
• Insurance policies;
• Rent on your business premises;
• Lease payments on equipment and other assets;
• Interest on business/investment loans (make sure your loan agreement allows for interest prepayments); and
• Maintenance and service contracts – for example your accountant might allow you to prepay next year’s fees! ?

Profit First Australia

Clearly, for the sample strategy to play out as described you would need to have $10,000 of cash available to make the prepayments. If all your cash is gone then any tax planning advice I give you for the current year is almost useless.

This is where Profit First comes in. If you want to create a situation in which you can realistically take advantage of these sorts of opportunities you need to plan. My usual recommendation is to set aside some of your Operating Expenses money each week/fortnight/month in preparation for year end, bulk prepayments.

If you don’t currently use Profit First in your business you can learn more about the system here.

Next Steps

What should you do next?

• Look out for more tax planning tips in the coming weeks!
• Ensure you and your accountant are working towards a year end tax planning strategy, and
• If your accountant isn’t doing tax planning then contact us!