Client Alerts The New Landscape for Business Year-End Tax Planning

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11.01.19 | By: Thomas Vance

For many businesses, the first filing season after the 2017 tax law changes was a time of uncertainty.  Many businesses struggled to ascertain the impact on their bottom line from the law’s sweeping changes. With the next filing season on the horizon, there are lessons learned that you can incorporate into your year-end tax planning.

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Entity choice

The creation of the qualified business income (QBI) deduction for pass-through entities, paired with the reduction of the corporate tax rate to a flat 21% rate from a top rate of 35%, made it worthwhile to re-evaluate whether your current entity type is the most tax-favorable.

The best answer depends on your unique circumstances. Even if this evaluation was done for 2018, changes in your projected income or other circumstances may make it worthwhile to revisit this question more often. 

Pass-through entities (PTE), including sole proprietorships, partnerships and S corporations, avoid the double taxation C corporation income, which is subject to federal and state tax at both the entity and dividend levels. The income from PTE is taxed only once, usually at an individual tax rate, but that rate can be as high as 37%. If the business qualifies for the full 20% QBI deduction — not always a sure thing (see below) — the maximum income tax rate is about 30%.

The deduction for state and local taxes also plays a role in the entity choice. The new law limits deductions of state and local taxes for individual owners, but not for corporations. In addition, the application of Social Security and Medicare taxes, as well as the net investment income tax, add layers of complexity.

Finally, bear in mind that the reduced corporate tax rate is permanent (or as permanent as any law can be), while the QBI deduction is slated to end after 2025. 

The QBI deduction

PTEs can take several steps before December 31 to maximize their QBI deduction. If the individual or trust has net taxable income above certain thresholds, the deduction is subject to phased-in limitations based on W-2 wages paid (including many employee benefits), the cost of qualified property and taxable income.

Related Read: “IRS Provides Final QBI Real Estate Safe Harbor Rules

Owners subject to these limitations can boost their deduction by increasing these factors. For example, wages paid can be increased by hiring new employees, giving raises or making independent contractors employees. You can also invest in qualified property by year end.

As another example, if the wage/property limitations do not apply, then S corporation owners can increase their QBI deductions by reducing the amount of wages the business pays them (assuming this is still within the range of “reasonable compensation”). On the other hand, if the deduction is limited by wages/property, an S corporation owner might be able to take a greater deduction by increasing their wages (again, within the range of “reasonable compensation”).

Related businesses should also examine how they share costs for property and wages.  The owners may also need to evaluate whether grouping these businesses for QBI deduction purposes makes sense.   

Related Read: “IRS Provides QBI Deduction Changes Just In Time for Filing”

Tax credits

Some of the most popular tax credits for businesses survived the tax overhaul, including the Work Opportunity Tax Credit (WOTC), the Small Business Health Care tax credit, the New Markets Tax Credit (NMTC) and the research credit (also referred to as the “research and development,” “R&D” or “research and experimentation” credit). Smaller businesses may qualify for a credit for starting new retirement plans.

The WOTC, generally worth a maximum of $2,400 per employee (although for certain employees, that can increase to $9,600), is currently scheduled to expire on December 31. So make those qualified hires before year end. The NMTC — 39% over seven years — also is set to expire at year end.

Many businesses overlook the R&D credit.  This is often of significant value if the time and costs associated with improving a product or business process can be adequately documented. Certain start-up businesses that owe no net income tax can use the credits against payroll taxes.

Capital asset investments

Purchasing equipment and other qualified capital assets has been a valuable tool for reducing taxable income for years, but the new law increased the benefit by expanding bonus depreciation and Section 179 expensing (that is, deducting the entire cost in the current tax year).

If purchased before January 1, 2023, you can deduct the entire cost of new and certain used qualified property in the year the property is placed in service. Special rules apply to property with a longer production period.

Eligible property includes computer systems, computer software, vehicles, machinery, equipment and office furniture. Starting in 2023, the amount of the bonus deduction will drop 20% each year going forward, disappearing altogether in 2027 (assuming no further legislation).

Unfortunately, Congress has thus far failed to take action to correct a drafting error in the new law that leaves qualified improvement property (generally interior improvements to non-residential real property) ineligible for bonus deprecation. In addition, certain real property businesses may have elected to use the alternative depreciation system (ADS) to avoid the new limits on interest expenses.

Qualified improvement property is eligible for Section 179 expensing. Section 179 applies to several improvements to non-residential real property, including roofs, HVAC, fire protection systems, alarm systems and security systems. The maximum deduction for qualifying property has also increased. For 2019, the limit is $1.02 million. One drawback to Section 179 as compared to bonus depreciation is that the deduction is further limited to the amount of income from the business activity. The Section 179 deduction begins phasing out on a dollar-for-dollar basis when qualifying property placed in service this year exceeds $2.55 million.

The benefit does not come without some grey area.  If bonus depreciation or Section 179 deductions will result in a net loss for the year, it is important to consider the impact of the new rules limiting the use of net operating losses to 80% of income in future years. In some cases, it may be more beneficial to forego the additional deductions.

Deferring income / accelerating expenses

This technique has long been employed by businesses that do not expect to be in a higher tax bracket the following year. If you use cash-basis accounting, for example, you might defer income into 2020 by sending your December invoices toward the end of the month so that payments arrive the following year. Note that many more businesses are allowed to use the cash method for tax purposes because the threshold to use the cash method is now $25 million or less of gross receipts (using a three-year average).

Any business can accelerate deductible expenses into 2019 by paying them in 2020 – this includes charging expenses to a credit card that will not be paid off until 2020 (subject to limitations). Cash-basis businesses can prepay bills due in January, as well as certain other expenses.

As with all things after the new law, the traditional strategy of deferring income and accelerating deductions now comes with some caveats. First, deductions may limit the amount of income eligible for the QBI deduction. In some cases, it might make more sense to maximize the deduction before it sunsets at the end of 2025. The results of the 2020 elections may also change expected future tax rates. This strategy is usually only sound when future tax rates are expected to be equal to or lower than current rates.

Act now

You still have time to make a significant dent in your business’s federal tax liability for 2019. We can help you chart the best course forward to minimize your tax bill and put you on solid ground for upcoming tax years.

For more information, contact Thomas Vance at tvance@orba.com or 312.670.7444. Visit orba.com to learn more.

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