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It’s hard to believe the Tax Cuts and Jobs Act (TCJA) was passed almost two years ago. Then came the first filing season under the TCJA, and it was a time of uncertainty for many businesses as they wondered how these changes would impact their bottom lines. With the next filing season quickly approaching, you can incorporate the lessons learned into your year-end tax planning. Here are some areas of note for businesses and their 2019 federal tax returns.
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%, make it worthwhile to re-evaluate whether your current entity type is the most tax-favorable.
Pass-through entities, including sole proprietorships, partnerships and S Corporations, traditionally have been seen as a way to avoid the double taxation C Corporations are subject to at the entity and dividend levels. Pass-through entities are taxed only once, at an individual tax rate, but that rate can be as high as 37%. If they qualify for the full 20% QBI deduction — not always a sure thing (see below) — their effective tax rate is about 30%.
The deduction for state and local taxes also plays a role in the entity choice. The TCJA limits the amount of the deduction for individual pass-through entity owners, but not for corporations.
Bear in mind the reduced corporate tax rate is permanent (or as permanent as any tax cut can be), while the QBI deduction is slated to end after 2025. Ultimately, your business’ individual circumstances will determine the optimal structure.
The QBI deduction
Pass-through entities can take several steps before December 31 to maximize their QBI deduction. The deduction is subject to phased-in limitations based on W-2 wages paid (including many employee benefits), the unadjusted basis of qualified property and taxable income. You could boost your deduction, therefore, by increasing wages (for example, by hiring new employees, giving raises or making independent contractors employees). To increase your adjusted basis, you can invest in qualified property by year-end.
If the W-2 wages limitation doesn’t limit the QBI deduction, S Corporation owners can increase their QBI deductions by reducing the amount of wages the business pays them. (This tactic won’t work for sole proprietorships or partnerships because they don’t pay their owners’ salaries.) On the other hand, if the W-2 wages limitation limits the deduction, they might be able to take a greater deduction by increasing their wages.
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.
Capital asset investments
Purchasing equipment and other qualified capital assets has been a valuable tool for reducing taxable income for years, but the TCJA further greased the wheels by expanding bonus depreciation and Section 179 expensing (that is, deducting the entire cost in the current tax year).
For qualified property purchased after September 27, 2017, and before January 1, 2023, you can deduct the entire cost of new and used (subject to certain conditions) 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 deduction will drop 20% each year going forward, disappearing altogether in 2027, absent congressional action.
Congress has thus far failed to take 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.
Qualified improvement property is, however, eligible for Sec. 179 expensing. The TCJA makes this expensing available to several improvements to nonresidential real property, including roofs, HVAC, fire protection systems, alarm systems and security systems. It also increases the maximum deduction for qualifying property: For 2019, the limit is $1.02 million. (The maximum deduction is limited to the amount of income from business activity.) The expensing deduction begins phasing out on a dollar-for-dollar basis when qualifying property placed in service this year exceeds $2.55 million.
Defer income / Accelerate expenses
This technique has long been employed by businesses that don’t 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. (Note that the TCJA now allows businesses with three-year average annual gross receipts of $25 million or less to use cash-basis accounting.) If your accounting is done on an accrual basis, you could delay delivery of goods and services until January.
Any business can accelerate deductible expenses into 2019 by putting them on a credit card in late December and paying it off in 2020 (subject to limitations), and cash-basis businesses can prepay bills due in January, as well as certain other expenses. Some caveats now apply to this approach. First, it could affect the amount of the QBI deduction for pass-through entities. It might make more sense to maximize the deduction while it’s still around — the deduction currently is scheduled to sunset after 2025 and could be eliminated before then. Moreover, this tactic isn’t advisable if you are likely to face higher tax rates in the future.
If you have questions about year-end tax planning strategies for businesses, contact a member of your DGC client service team or Joel Rothenberg, CPA, JD, LLM at 781-937-5135 / firstname.lastname@example.org or Catherine Doe, CPA at 781-937-5331 / email@example.com.
Joel and Catherine will host a year-end tax planning webinar for businesses on November 12th. Click here to register or view the recording.