The end of the tax year for calendar-year law firms is just around the corner. Now is the time to take those last-minute steps that can reap significant tax savings on your 2022 return. Here is some tax-cutting advice to consider.
- Time Income and Expenses Wisely
Deferring revenue into the next tax year and accelerating expenses (including state and local income tax estimated payments due in January) into the current tax year is a tried-and-true strategy for businesses that use cash-basis accounting. For example, your firm could delay billing clients until late December and expedite the payment of bonuses. There is a big caveat, though. If your firm expects to earn greater revenue in 2023, you may well be better off reversing the strategy — accelerating revenue and deferring expenses. You will reduce your 2023 taxable income and boost the value of the expense deductions.
Pass-Through Entity Tax Elections
If your firm is a pass-through entity (S-Corporation or Partnership/LLC), consider taking advantage of state pass through entity tax (PTET) elections if you have not done so already. The Tax Cuts and Jobs Act of 2017 (TCJA) capped the state and local tax deduction that individuals may take on their 1040 returns (starting in 2018 and effective through 2025) to $10,000. This cap is often referred to as the “SALT cap.” As a result, several states enacted SALT cap workarounds to enable pass-through entities to pay state tax at the entity (partnership or S-Corp) level that would have otherwise been due at the individual level. Paying the state tax at the entity level allows for a full federal tax deduction of the state tax liability, essentially circumventing the $10,000 SALT cap in effect at the individual level. Hence, a PTET election can save significant tax dollars.
Related Read: Illinois 2022 Budget To Raise New Tax Revenue
For example, assume your firm nets $2,000,000 of income this year and assume a five percent state tax rate. The state tax due on the net income will be $100,000. By making a PTET election, the entity, rather than the individual owner(s), will pay the state tax and be permitted to deduct the full $100,000 state tax expense, lowering federal taxable income that flows to individual owner(s) by $100,000. Assuming a federal tax rate of 37%, this will result in $37,000 (100,000 X 37%) of tax savings. Without the PTET election, the individual owner(s) would pay the $100,000 state tax on their individual state tax return(s),but would only be able to deduct up to $10,000 (SALT cap) if they itemize deductions. And usually, this $10,000 SALT cap is already reached when individuals have other taxes to deduct, such as real estate taxes, state taxes paid on non-law firm income, foreign taxes, etc., resulting in no additional benefit to the individual taxpayer.
Note that if a PTET election is made, the individual owners will usually receive either a credit on their state return for their portion PTET paid or an exclusion of the income that was taxed at the entity level (depending on each state’s law).
State rules vary regarding when PTET elections can be made and availability of tax credits or income exclusions to individual taxpayers. A review of the PTET laws in the states in which your firm conducts business in or has residents in will help determine if any state PTET elections should be made and if any tax should be paid before year-end. PTET election laws passed by various states in recent years are expected to remain an option for taxpayers as long as the federal SALT cap limitation remains in place. ORBA can help you work through tax planning related to PTET to ensure tax optimization.
- Take Advantage of 100% Bonus Depreciation
TCJA increased the bonus depreciation to 100% for property placed in service after September 27, 2017 and before January 1, 2023. Business property placed in service during this time period would be eligible for a full tax deduction in the same year that the property is placed in service as opposed to capitalizing the costs and deducting them over a number of years. The increase is temporary, though, because 2022 is the last year that the 100% deduction is available. Absent future legislation, the bonus depreciation will decrease to 80% in 2023, 60% in 2024, 40% in 2025, 20% in 2026 and 0% in 2027 and later years. Note that without 100% bonus depreciation, the full cost of the property will eventually be written off, just at a slower pace.
To make the most of bonus depreciation, your firm can purchase computer systems, software, equipment and office furniture, among other depreciable items before year’s end. The deduction also applies to qualified improvement property (generally, interior improvements to nonresidential real estate). Order now to ensure that you can place the items in service before year-end. If you later determine that the deduction will be worth more in the future due to higher revenue, you can simply refrain from placing the property in service for now, or if the property needs to be used in 2022, an election to opt out of bonus depreciation may be made, which would provide a portion of depreciation expense deduction in 2022, and push the remaining depreciation deductions to future years.
Your firm might also benefit from the Section 179 expensing provision, which allows businesses to immediately deduct 100% of the purchase price of new and used qualifying property. The maximum Sec. 179 deduction for 2022 is $1.08 million. The deduction begins phasing out on a dollar-for-dollar basis on qualifying property purchases above $2.7 million. Unlike bonus depreciation, Section 179 expense is limited to your firm’s taxable income and cannot produce a loss for the firm. Any unused 179 expense is carried forward to future tax years.
- Reconsider Your Retirement Plan
Law firms that do not already offer a retirement plan may qualify for a tax credit of up to $5,000, for three years, for the costs of starting a SEP, SIMPLE IRA or qualified plan (such as a 401(k) plan). Eligible costs include set-up costs, administration costs, as well as costs relating to educating employees about the plan. The credit is generally available to small businesses with 100 or fewer employees that earned at least $5,000 in the preceding year and the plan must cover at least one non-highly compensated (NHCE) employee. A NHCE is an employee that receives less than $135,000 in 2022 ($150,000 in 2023).
The amount of the credit is 50% of eligible start-up costs, up to the greater of:
• $500; or
• The lesser of: $250 multiplied by the number of NHCEs; or $5,000.
Your firm may start claiming the credit in the tax year before the tax year that the plan becomes effective. Including an automatic enrollment feature can add a tax credit of $500 per year for a three-year taxable period, beginning with the first taxable year of the feature. Firms that already have a plan can fund certain plans until the tax filing date (including extensions) and claim the employer contribution deduction in 2022. Now is the time to re-evaluate your current plan to ensure that you are offering the most tax-advantageous type.
- Enjoy Some Fully Deductible Meals While You Can
The 2021 Consolidated Appropriations Act increased the allowable deduction for business meals from 50% to 100% in 2021 and 2022 — as long as the expense is for food or beverages provided by a restaurant. Food and beverage expenses must not be lavish or extravagant and the taxpayer or an employee must be present.
In addition, certain meal-related expenses are always 100% deductible. That includes expenses related to recreational, social or similar activities for employees, such as holiday parties (provided they do not favor highly-compensated employees). Note that free food and beverages in break rooms or provided for the convenience of the employer, such as meals made available for employees who must stay on call for emergencies, are subject to the applicable business meal limits.
Costs of business entertainment remains fully nondeductible. Your firm should account for business entertainment expenses separately from meals expenses to ensure all meals expenses are identified and deducted in accordance with applicable laws. If an entertainment event includes both meals and entertainment (such as at a sporting event), taxpayers should obtain separate receipts for the meals and beverages portion of the event to substantiate the meals/beverages deduction. Otherwise, the entire expense will be deemed nondeductible entertainment expense.
Some of the tax breaks outlined above will be less valuable after 2022. For others, law firms need to forecast future revenues to determine the best move. ORBA can help your firm plot the best course now.
Sidebar: Ways for attorneys to reduce personal tax liability
Individual taxpayers have some avenues to reduce their taxes, too. For example, the stock market’s volatile year may mean taxpayers should consider loss harvesting and Roth IRA conversions.
Taxpayers that have realized capital gains during the year may want to sell poorly performing investments, reducing the capital gains on a dollar-for-dollar basis. Any excess capital losses over capital gains may offset up to $3,000 of ordinary income, with any remaining loss balance carried forward for future tax years. Further, by donating the sale proceeds to charity, individuals may claim a charitable contribution deduction if they itemize as well. If there are no losses to harvest, individuals may donate appreciated stock directly to charity and claim a charitable contribution deduction for the amount of the fair market value of the stock at the time of the donation and will not have to pay capital gains tax on the appreciation as would be the case if the stock is sold with no losses to offset the gain.
A few items to consider when contemplating stock sales:
• 2022 may catch taxpayers by surprise as fund managers need to sell off appreciated securities to pay for 2022 stock redemptions. This will result in capital gains to taxpayers that otherwise suffered a 20% loss in their portfolio this year. Taxpayers are advised to regularly assess their capital gains as the year-end approaches to determine how much losing stock should be sold. Capital gain distributions from mutual funds are usually paid out in December.
• Taxpayers need to consider the wash sale rules. If any securities are sold at a loss and re-purchased within 30 days before or after the sale, the loss will the disallowed. If taxpayers wish to remain invested in the market within the 30 days of selling securities, they may consider purchasing similar, but not identical investments. Otherwise waiting until 31 days to repurchase the same securities may be the best course of action.
• Anticipated future capital gains should be taken into consideration as well. Because excess capital losses may be carried forward indefinitely to future tax years, taxpayers that are anticipating large capital gains from any source (i.e., sale of investment property, sale of business stock, etc.) in 2023 and the near future should carefully review their loss positions this year and sell as needed to help offset not only 2022 capital gains, but potential near future capital gains.
Converting a Traditional IRA to a Roth IRA
This also is an opportune time to convert part or all of a pre-tax traditional IRA to an after-tax Roth IRA. Future distributions from Roth IRAs are nontaxable as long as the Roth IRA is held for at least five years before taking any distributions (note that the 10% early withdrawal penalty will still apply if distributions are taken out before age 59½). Further, unlike traditional IRAs, Roth IRAs have no required minimum distributions, which allows longer tax-free growth. To convert from a traditional IRA to a Roth IRA, taxpayers will have to pay income tax on the fair market value of converted assets of the traditional IRA — but individuals who convert stocks that have fallen in value or are in a lower tax bracket this year will not take as much of a tax hit.
For more information, contact Manal Shalabi at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Law Firm Group.