The first tax-filing season under the Tax Cuts and Jobs Act (TCJA) offered plenty of uncertainty for businesses as they struggled to understand the law’s sweeping changes. With the next filing season on the horizon, it’s a prime time to incorporate those lessons into your year-end tax planning. In fact, several areas are ripe with opportunities to reduce your 2019 federal tax liability.
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 (decreased 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 that C corporations are subject to at both 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 — their effective tax rate ends up at 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, too, that the reduced corporate tax rate is permanent, while the QBI deduction is scheduled to end after 2025. Ultimately, your business’s individual circumstances will determine the optimal structure.
The QBI deduction
Pass-through entities can take several steps before Dec. 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. Keep in mind that this tactic won’t work for sole proprietorships or partnerships, because they don’t pay their owners’ salaries. Conversely, if the W-2 wages limitation restricts the deduction, sole proprietors and partnerships might be able to take a greater deduction by increasing 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 also qualify for a credit for starting new retirement plans.
The WOTC, generally worth a maximum of $2,400 per employee (although for certain employees, the amount can increase to $9,600), is scheduled to expire Dec. 31, so make those qualified hires before year-end. The NMTC — 39% over seven years — also is set to expire Dec. 31.
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 Sept. 27, 2017, and before Jan. 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.
Congress has thus far failed 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 Section 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, while 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.
Deferring income/accelerating 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 the 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 pay bills that are due in January, as well as certain other expenses, in December. 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. Moreover, this tactic isn’t advisable if you’re likely to face higher tax rates in the future.
You still have time to make a significant dent in your business’s federal tax liability for 2019. We can help you chart the best course forward to minimize your tax bill and put you on solid ground for upcoming tax years, so reach out to a KraftCPAs professional for guidance.