Many businesses struggled with uncertainty this past tax-filing season as the newly-passed Tax Cuts and Jobs Act (TCJA) had significant changes for their bottom lines. With the upcoming tax filing season right around the corner, incorporating lessons learned from last year can help with the year-end tax planning for your business. There are a number of specific areas filled with valuable opportunities to lessen your federal tax liability for 2019.
Choosing the Right Entity
When you consider to the overall reduction of the corporate tax rate from 35% down to a flat 21%, coupled with the formation of the qualified business income (QBI) deduction for pass-through entities, re-evaluating whether or not your current entity type is the most tax-favorable starts to become more and more worthwhile.
C corporations are subject to double taxation at both the entity and dividend levels, which in turn makes pass-through entities, including sole proprietorships, partnerships, and S corporations, appear as a way to avoid this taxation. While pass-through entities are only taxed once at an individual tax rate, this particular rate has the potential to be as high as 37%. However, If they can qualify for the full 20% QBI deduction (see explanation below for why this isn’t always true), their effective tax rate would be as low as 30%.
Also playing a significant role in the choice of entity type is the deduction for state and local taxes. While the TCJA does limit the amount of the deduction for owners of individual pass-through entities, it does not affect the limit for corporations.
It’s important to remember that while the reduced corporate tax rate is permanent, the QBI deduction will end after 2025. Therefore, the optimal structure for your business will be based on individual circumstances.
How is the QBI Deduction Affected?
In order to maximize their QBI deduction, pass-through entities have several different steps they can take before December 31. For businesses, this deduction is subject to phased-in limitations based on the unadjusted basis of qualified property, W-2 wages paid (including many employee benefits), and taxable income. By increasing wages—like hiring new staff, turning contractors into full-time employees, and offering raises—you have the opportunity to increase your deduction. You can also invest in qualified property by year-end to increase your adjusted basis.
Should the W-2 wages limitation continue to not limit the QBI deduction, S corporation owners will be able to boost their deductions by decreasing the total amount of wages that the business pays them. Unfortunately, this strategy tactic would be unsuccessful for either partnerships or sole proprietorships because they are not the ones paying their owners’ salaries. However, if the W-2 wages limitation begins to limit the deduction, increasing wages could allow them to take a more significant deduction.
Qualifying Tax Credits
Even with this tax overhaul, some of the most popular tax credits for businesses remain, including the New Markets Tax Credit (NMTC), the Work Opportunity Tax Credit (WOTC), the Small Business Health Care tax credit, and the research credit—also referred to as the “research and development,” “R&D,” or “research and experimentation” credit. With starting new retirement plans, smaller businesses may qualify for a tax credit.
The WOTC, generally worth a maximum of $2,400 per employee (although it can increase to $9,600 for certain employees), is currently scheduled to expire on December 31. That means before year-end, you should make those qualified hires. The NMTC — 39% over the course of seven years — will also expire at year-end.
What Does This Mean for Capital Asset Investments?
For years, purchasing equipment and other qualified capital assets has been an effective tool for reducing taxable income. However, the TCJA made this process even smoother by expanding Section 179 expensing (deducting the entire cost in the current tax year) and bonus depreciation.
For qualifying property purchased after September 27, 2017, and before January 1, 2023, you are able to deduct the entire cost of new and used (subject to certain conditions) qualified property in the year the property is placed in service. Properties that have a longer production period will be subject to special rules.
Items considered under eligible property includes computer software, computer systems, vehicles, machinery, office furniture, and equipment. Beginning in 2023, the amount of the deduction will drop 20% each year moving ahead—meaning it will disappear altogether in 2027, should there be no action from Congress.
As of now, Congress has not taken any action to correct a drafting error in the TCJA that leaves qualified improvement property (generally interior improvements to nonresidential real property) ineligible for bonus deprecation.
However, it is important to note that qualified improvement property is eligible for Sec. 179 expensing. Thanks to the TCJA, expensing is now available for several improvements to nonresidential real property, including HVAC, alarm systems, roofs, fire protection systems, and security systems. The maximum deduction for qualifying property for 2019 has increased to a $1.02 million limit. The maximum deduction is limited to the amount of income accumulated from business activity. Once qualifying property placed in service this year begins to exceed $2.55 million, the expensing deduction will start phasing out on a dollar-for-dollar basis.
Accelerating Expenses and Deferring Income
Businesses that have no expectation of being in a higher tax bracket the following year have long been using this particular technique. For cash-basis accounting, deferring income into 2020 by sending your December invoices toward the end of the month may be a feasible option. It is important to note that the TCJA now allows businesses to use cash-basis accounting if they have a three-year average annual gross receipt of $25 million or less. You also have the option to delay the delivery of goods and services until January if your accounting is done on an accrual basis.
If you would like to accelerate deductible expenses into 2019, you have the option to pay them on a credit card in late December and pay it off in 2020 (subject to limitations). In this case, cash-basis businesses can prepay bills that may due in January, as well as certain other expenses.
Although, there are now some caveats that apply to this type of approach. First, it could affect the amount of the QBI deduction for pass-through entities. It is recommended to maximize the deduction while it still exists. The deduction is currently is scheduled to sunset after 2025 and could potentially be eliminated before that date. Although, if you believe you will face higher tax rates in the future, this tactic isn’t advisable.
There is still plenty of time to fix the dent in your business’s 2019 federal tax liability. CRI is ready to help you figure out how to move forward to minimize your tax bill and prepare you properly for upcoming tax years. Contact a CRI tax advisor for more information.