When gearing up for year-end business tax planning, there are many tax provisions for businesses that were included in the Tax Cuts and Jobs Act (TCJA) which can help you reduce your federal tax liability and maximize your tax savings opportunities. Particular items to watch for when you’re thinking about your year-end business tax planning include: entity choice, the qualified business income deduction, popular tax credits, capital asset investments, and income deferral and expense acceleration.
Choosing the Best Entity Type for Your Business
Making sure you’ve chosen the most effective entity type for your business will go a long way towards helping you with your year-end business tax planning. As the TCJA brought into existence the qualified business income (QBI) deduction for pass-through entities, taking a closer look at the current entity type of your business may be a worthwhile exercise. Because the corporate tax rate was reduced to a flat 21% tax rate under the TCJA, recharacterization of your entity type may prove more favorable for taxation purposes.
Characterizing the entity type as a pass-through entity (i.e. a partnership, S corporation, or sole proprietorship) can help you avoid the double taxation pitfall C corporations often fall prey to at the entity and dividend levels, as pass-throughs are taxed just once at the individual tax rate. If the pass-through also qualifies for the full 20% allotted by the QBI deduction (though this is not a given for all pass-throughs), the tax rate for a pass-through could drop from as high as 37% to as little as 30%.
You’ll also want to consider the impact that state and local taxes can have on the entity you choose. Under the TCJA, the amount of the QBI deduction is not limited for corporations but it is limited for owners of individual pass-through entities. However, the QBI deduction is a temporary provision that phases out after 2025 so before you convert your entity type, you’ll want to consider whether your year-end business tax planning should be focusing on this type of recharacterization or whether you’re better off taking advantage of the permanent corporate tax rate reduction.
Maximizing Year-End QBI Deductions
If you do characterize your entity as a pass-through, one especially good way to capitalize on year-end business tax planning opportunities is to take the necessary steps to ensure you’re maximizing the QBI deduction before December 31st arrives.
W-2 wages that have been paid, along with taxable income, and qualified property’s unadjusted basis can work together to effectively limit the QBI deduction. One potential solution is to increase the W-2 wages you pay out by converting independent contractors you’ve hired to permanent employees. Additionally, if you invest in qualified property before the end of the year, you can increase your adjusted basis.
If the W-2 wage limitation doesn’t limit the QBI deduction, owners of S corporation can reduce the amount of wages their business pays them in order to increase their QBI deductions (though partnerships and sole proprietorships can’t take advantage of this approach because their owners aren’t paid wages). However, owners of S corporations may be able to take a larger deduction by increasing their wages if the W-2 wages limitation limits the deduction.
Expanded Bonus Depreciation Benefit
The TCJA expanded the regulations around bonus depreciation and the associated Section 179 expensing election which allows the taxpayer to deduct the entire cost of certain qualifying capital assets which had already been a valuable year-end business tax planning tool for reducing taxable income, prior to the enactment of the TCJA. Qualifying property includes computer hardware, some computer software, and both furniture and fixtures.
Under recently-released final bonus depreciation regulations, 100% of both new and used qualified property purchased after September 27, 2017, and before January 1, 2023, can now be deducted in the year the property is placed into service by the business, though certain conditions must be met for the taxpayer to take advantage of the deduction.
However, starting in 2023 the deduction will drop by 20% each year until it phases out completely in 2027 (though this could change if new legislation alters the expiration date).
Due to a drafting error in the TCJA, qualified improvement property – or any improvement that was made to the interior of a non-residential real property and placed into service after the building was already operational, which were intended to be eligible for a 15-year recovery period reverted to a 39-year recovery period as of January 1, 2018. This essentially means that qualified improvement property is ineligible for bonus depreciation, unless Congress corrects for this through further legislation.
However, qualified improvement property is eligible for Section 179 expensing for improvements such as roofing, alarm, security, and fire protection systems, and HVAC unit installation. Additionally, the maximum deduction for qualified improvement property was increased to a limit of $1.02 million for 2019 with the maximum deduction limited to the amount of income from business activity. Once qualifying property placed into service this year exceeds $2.55 million, the expensing deduction begins phasing out on a dollar-for-dollar basis.
Using Deferred Income and Accelerated Expenses in Year-End Business Tax Planning
If you don’t expect your business to be in a higher tax bracket in the upcoming year, deferring income and accelerating expenses could be a good strategy to employ as part of your year-end business tax planning. You might opt to defer income into 2020 by sending your December invoices toward the end of the month if you utilize the cast-basis accounting method in your business. For businesses with $25 million or less in three-year average annual gross receipts, the TCJA allows the use of cash-basis accounting. If you use accrual basis accounting for your business, delaying the delivery of goods or services until January may be more beneficial.
Regardless of the accounting method you use, you can always choose to accelerate deductible expenses into 2019 charging those expenses on a credit card in late December and making the credit card payments in 2020 (though limitations may apply). Cash-basis businesses can prepay bills that come due in January, as well as certain other expenses.
If you choose to use these techniques to reduce your tax bill, and your entity is a pass-through, you should note that these methods could impact the amount of your QBI deduction. It might be more prudent to maximize the deduction while it’s still available since it’s scheduled to expire after 2025. Additionally, if you think you may face higher tax rates in future years, deferring income and accelerating expenses may not be a good option for your business.
Keep in mind that the TCJA also imposed limitations on the deduction of business losses, which may impact the above planning.
Time still remains for you to create a year-end business tax planning strategy that will help you reduce your 2019 federal tax liability. For help with your year-end planning needs, contact your Untracht Early advisor.