Year-End Tax Planning for Business: Flexibility Can Be a Virtue
For most businesses, year-end tax planning involves a delicate balancing act, and the more flexibility that is built into the plan, the better. That is because the tax code is in a constant state of flux, which makes it challenging to identify the most effective strategies.
For example, a general rule of tax planning says that you should defer income to next year and accelerate deductible expenses into this year to minimize your tax bill. But if you expect to be in a higher tax bracket or Congress increases tax rates effective next year, you may be better off doing the opposite: Accelerating income and deferring expenses to take advantage of this year’s lower tax rate.
Another tax-planning strategy that may make sense to reconsider is maximizing depreciation-related tax breaks.
Bonus depreciation and Section 179 expensing
For many businesses, an effective strategy for generating tax deductions to reduce this year’s tax bill is to invest in needed machinery, equipment or building improvements and place them in service by the end of the year. Often, these assets are eligible for 100% bonus depreciation or the Sec. 179 expensing election, allowing you to fully deduct the cost up front rather than depreciating it over a period of years or decades.
Most new and used machinery and equipment qualifies for 100% bonus depreciation or immediate expensing. In addition, many interior improvements to commercial buildings are eligible for bonus depreciation as qualified improvement property (QIP). (See Sidebar: Can Your Business Deduct the Cost of Interior Improvements?).
A couple of things to keep in mind: First, Sec. 179 deductions in a given year are currently capped at $1.08 million and the deduction is gradually phased out when a taxpayer’s qualifying expenditures exceed $2.7 million (both limits are annually adjusted for inflation). Second, 100% bonus depreciation is scheduled to be phased out after this year. The deduction generally will be reduced to 80% for property placed in service in 2023, 60% in 2024, 40% in 2025 and 20% in 2026. After 2026, bonus depreciation will be eliminated absent Congressional action.
Not right for everyone
Bonus depreciation and Sec. 179 expensing can do wonders for your company’s tax bill and cash flow, but claiming them is not always the best strategy. It is important to look at your overall tax situation to see whether you would be better off using regular depreciation rules to spread the deductions over several years. For example, it may be advantageous to forgo bonus depreciation or Sec. 179 expensing if:
You expect your tax rate to go up in the future. The benefit of a deduction is that it reduces your taxable income and, therefore, your tax liability. The higher your marginal tax rate, the greater the amount of tax avoided.
If you believe your tax rate will increase in the near future — either because you expect to be in a higher tax bracket or you think Congress will raise tax rates — you may be better off deducting less (or investing in less) now. In this instance, you can claim larger depreciation deductions in future years when tax rates may be higher, thus making deductions more valuable.
You are improving the interior of a building that you plan to sell. If you have made a significant investment in QIP in a building you plan to sell, claiming bonus depreciation may set a dangerous tax trap. Why? Because your profits on the sale, to the extent they are attributable to bonus depreciation or any Sec. 179 deductions you have claimed, will be treated as “recaptured” depreciation taxable at ordinary income tax rates as high as 37%.
In contrast, if you deduct the cost of QIP under regular depreciation rules — typically, on a straight-line basis over 15 years — then any long-term gain attributable to such depreciation will be taxable at a top rate of 25% when the building is sold.
You are eligible for the qualified business income (QBI) deduction. The QBI deduction, sometimes referred to as the “pass-through” deduction, currently allows certain sole proprietors and owners of partnerships, limited liability companies and other pass-through entities to deduct up to 20% of their QBI. Among other restrictions, the deduction is capped at 20% of taxable income (excluding net capital gains).
Because bonus depreciation or Sec. 179 expensing reduces your taxable income, it may also reduce your QBI deduction. So, before claiming these deductions, be sure to weigh their potential benefits against the potential tax cost of a reduced QBI deduction.
Look at the big picture
As you can see, there is not one right year-end tax strategy for every business. Your tax advisor can help you look at your overall tax picture and examine how various tax benefits interact with each other to determine the optimal tax-planning strategies for your business.
SIDEBAR: Can your business deduct the cost of interior improvements?
If your business is planning interior renovations, there may be a tax advantage to completing them by the end of this year. Interior improvements properly classified as qualified improvement property (QIP) are eligible for bonus depreciation, which currently allows you to deduct 100% of the cost up front. After 2022, however, bonus depreciation deductions are scheduled to be gradually reduced and then eliminated after 2026.
QIP includes most improvements to the interior of an existing nonresidential building, such as drywall, ceilings, interior lighting, fixtures, interior doors, interior HVAC components, fire protection, mechanical, electrical and plumbing. It does not include improvements to elevators, escalators or the building’s internal structural framework, nor does it include enlargement of the building.
QIP became eligible for bonus depreciation in 2018, so if you made qualifying improvements since that time, you may have an opportunity to recover deductions you missed and claim a tax refund.
Year-end tax planning tips for investors
Savvy investors know that taxes can have a big impact on their returns. And while tax considerations should generally take a back seat to sound investment strategies, as you review your investment options think about moves that can slash your tax bill. Here are a few ideas to consider as we approach the end of 2022.
Harvest losses (or gains)
Before year’s end, take inventory of the capital gains and losses you have recognized so far. If you expect to end the year with a net capital gain, consider “harvesting” losses by selling some investments that have declined in value and using those losses to offset the gain and reduce your taxable income.
What if you expect to end the year with a net capital loss? In that case, you might consider harvesting some gains from which the loss can be deducted. This strategy enables you to sell one or more investments that have appreciated in value without triggering capital gains tax.
You should, however, avoid offsetting your entire net capital loss. Why? Because you can use up to $3,000 in net capital loss to offset ordinary income, such as salary or interest ($1,500 if married filing separately). Any excess is carried forward and deducted from capital gains or ordinary income (up to the applicable limit) in future years. So, if you harvest gains to offset a net capital loss, try to preserve $3,000 of that loss to offset ordinary income, which is generally taxed at higher rates than capital gains.
Beware the wash sale rule
If you harvest losses or gains, you may be tempted to immediately buy back the investment to keep your portfolio’s asset allocation intact. That way, you enjoy the tax benefits of recognizing the loss or gain without actually giving up the investment. This can be an effective strategy, but be sure to plan carefully to avoid violating the “wash sale” rule.
Under the rule, if you sell a stock or other security at a loss and purchase a substantially identical security within 30 days before or after the sale, the loss deduction is disallowed. To avoid this result, wait at least 31 days before you buy back the investment (though an unexpected price increase can wipe out the tax benefits). Or buy an investment that is similar, but not substantially identical. Keep in mind that the wash sale rule applies only to investments sold at a loss, not to those sold at a gain.
Donate appreciated assets to charity
If you are charitably inclined, consider donating long-term appreciated assets — such as stocks, bonds or real estate you have held for more than one year — to charity. You will avoid tax on the gains you would have realized had you sold the assets, while enjoying a charitable deduction equal to the assets’ fair market value (subject to certain limitations and assuming you itemize deductions).
Avoid year-end mutual fund investments
Mutual funds typically distribute accumulated dividends and capital gains near the end of the year. There is a common misconception that investing in a fund just before a distribution gives you access to free money.
On the contrary, because the value of your shares is immediately reduced by the amount of the distribution, you will essentially pay income tax on the distribution without receiving any benefit. If you instead invest after the distribution, you will be in the same financial position, but without the added tax liability.
Maximize contributions to traditional IRAs and retirement plans
If you have not maxed out your deductible or pretax contributions to traditional IRAs, 401(k) plans or other tax-advantaged retirement accounts, do not miss this opportunity to reduce this year’s taxable income while building your nest egg. Far too many taxpayers fail to take advantage of their annual retirement contribution limits and miss out on reducing their taxable income.
Contributions to 401(k)s or similar employer plans generally must be made by December 31. But you can take a 2022 deduction for traditional IRA contributions made as late as April 18, 2023.
Strike a balance
Effective financial planning requires a balanced approach that considers both tax efficiency and sound investment principles. Your tax and investment advisors can help you strike a balance between the two.