Small Business Taxes & ManagementTM--Copyright 2019, A/N Group, Inc.
The theory behind business tax planning is similar to planning for your personal return. You want to defer the income to a low tax rate year. If you do business as a sole proprietorship (i.e., file a Schedule C), S corporation, partnership, or LLC (limited liability company), income and losses of the business are passed through and reported on your personal tax return. Thus, your approach to year-end planning is similar to that for individual planning. (There are some factors that can complicate the issue; they're discussed below.) And, yes, while it's true you can save taxes by making equipment and other purchases, you'll still likely to be out of pocket more than 50% of the cost. If you're self-employed or doing business as a partnership or LLC, your rate could be slightly higher when you add in the self-employment tax. Best suggestion? Don't buy what you don't need; don't buy more than you need.
The discussion below assumes your business is on a December 31 fiscal yearend.
Projecting Your Income
We discussed the basics of income projection in our introductory article Year-End Planning--Part I. You can't do any serious planning if you don't have an idea of where you're at now--and some idea of next year.
Things get more complicated, and there's a chance to save more tax dollars, if you do business as a C (regular) corporation. Unlike an S corporation or a partnership, a C corporation is taxed as a separate entity. The good news is that under the new law C corporations are taxed at a flat 21%. But if the business distributes its income as a dividend, the dividend is taxable to the shareholder. Smaller businesses often distribute much of their income and those dividends are effectively tax twice--once at the corporate level and once at the shareholder level.
If you've got carryforward losses from prior years and income in 2019, those losses could offset your corporate income. Any current losses that can be carried forward. But the deduction is limited to 80% of taxable income. Since a dollar today is worth more than a dollar tomorrow, the benefit of an NOL is less than in prior years. If possible, leveling income from year to year can prove beneficial. Talk to your tax adviser.
The current corporate rate of 21% is just slightly below the 22% bracket for married individuals which starts at taxable income above $78,950. That means you're better off taking a small salary and leaving the rest in the corporation. But that's in a world where a married couple can live on income of less than $100,000 (add the standard deduction to the $78,960 to arrive at gross income, assuming no other adjustments or income). Whether you can live comfortable on that amount depends on your spending pattern and where you live. So taking a bigger salary may be necessary, but keeping it as small as possible makes sense.
Paying a dividend may not be that onerous. If your taxable income is below $78,950 (married, filing joint) the dividends will escape taxes. Above that and up to $488,850, the dividends are taxed at 15% (a 3.8% additional amount appies if your AGI is greater than $250,000 (married, filing joint). Caution. Many small business owners let the corporation pay some personal expenses. The IRS will recharacterize them as disguised dividends, not deductible by the business, but dividend income to a shareholder. There are some other points. Keep in mind you can't arbitrarily increase or decrease your salary. Too high a salary could allow an unreasonable compensation challenge by the IRS. Too low a salary can also be challenged. Check with your tax advisor and consider longer-term effects as well. And you can't just compare your individual rate to your corporate one. You've also got to look at your projected personal rate for 2020.
S Corporations, Partnerships, etc.
If you do business as an S corporation, partnership, sole proprietorship, etc. the net income (or loss) of the business is passed through to you and reported on your individual tax return. You want to defer income to next year if you anticipate being in a lower tax bracket. Conversely, you want to accelerate income into 2019 if you think you'll be in a higher bracket next year. (Note, LLCs are generally treated the same as partnerships or, if there is only a single member, treated as a sole proprietorship.)
That's the same objective as with your individual return. However, when planning for a business, you can encounter much wider income swings than if your income is from salary, interest, dividends, etc. A bad year for the business can produce a substantial loss. Under general tax rules a net operating loss can be carried forward. However, that may be small comfort. C corporations report the carryback on their own returns. Net losses by a sole proprietorship, partnership, or S corporation account for net operating losses on the owner's personal tax return (Form 1040).
There are some special considerations applicable to these entities. Keep these points in mind.
Not only is the net income or loss of the business passed through to the owner, so are certain 'separately stated items'. For example, if a partnership has $1,000 of interest income from bank accounts, your share of that item is passed through and reported as interest income on your personal return. That interest or dividend income will help you use any investment interest expense you have. Capital gains and losses will also be passed through. While you may not have sold any stocks through your business, you could have a capital gain (or ordinary income) on the sale of business assets such as a building, equipment, etc. They should be taken into account in your personal tax planning. Income or losses on real estate rental properties held by the S corporation or partnership is generally treated in the same way as if you owned the property in your own name.
We're assuming in the discussion below that you materially participate in the business. If you don't, the income, but not the losses, can be passed through to you. We can't define material participation in detail here (see our FAQ Material Participation), but you'd better talk to your accountant if you spend less than 500 hours per year in the business. And simply checking the books at the end of the week doesn't qualify. If you don't materially participate, planning is trickier. Losses that can't be used currently can be carried forward, but profits can't. You've got to report them currently.
Whether or not you can deduct a loss from an S corporation, partnership, or LLC on your personal return also depends on your basis and amount at risk in the business; you must be actively involved in the management of the company. If you don't have enough basis in the business and want to take the losses this year, contribute equity capital or loan the business money. (Partnerships may have some other options.) On the other hand, if the losses would be better utilized next year (you anticipate being in a much higher bracket), don't increase your basis. This can be a tricky issue. Check with your tax advisor.
Some activities generate adjustments for the alternative minimum tax (AMT). While no longer nearly as important a factor as in the past, some individuals can still be susceptible. Again, a complex subject. Best to run the numbers in tax software or talk to your tax advisor.
Deferring Income--Accelerating Deductions
By now you should have a good idea of which way you're headed. If 2019 is a big year and '20 won't be as good, you want to push income into 2020. If it's a tossup, and your projected income with any additional amount won't be high enough to put you in above the threshold where rates could be increased, you should probably still defer income; it'll improve your cash flow by delaying tax payments. Again, don't overdo it. Here are some strategies.
Depreciation. Last-minute, year-end purchases may qualify for a depreciation deduction, but only if the asset is 'placed in service' in 2019. (See our Glossary for a definition.) For 2019 you can generally still write off the full amount of the cost of the equipment using 100% bonus depreciation or Sec. 179 expense option. Your total depreciation over the life of the asset is the same, you're just able to write off more in the first year, reducing taxes currently and improving cash flow. You can opt out of the bonus depreciation for any class of property, potentially improving tax options when you go to file your return.
Caution--Buying an expensive auto for business use may not help you out much. There are caps on the first-year depreciation. Depreciation in later years is also limited. Vehicles built on a truck chassis that exceed 6,000 pounds gross vehicle weight aren't subject to this rule.
Expense option. The law (Sec. 179) also allows you to expense up to $1,020,000 (2019 amount) in asset purchases such as shop equipment, furniture and fixtures, etc., but not real property (see an exception below). (That maximum first-year depreciation for luxury cars also applies here.) Thus, if you buy a $15,000 machine in December and elect to expense it under this provision, it's removed from the base. Any assets that qualify reduce your income dollar for dollar. The assets must generally be tangible personal property. And there are two limitations--one is a business income limitation (it can't reduce your income below zero); the other applies if you put more than $2,550,000 (2019) of such property in service during the year. If you can't use the writeoff because of the income limitation the unused amount can be carried forward.
Property that can be expensed under Section 179 also includes qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property.
Accelerate purchases. Purchase office and operating supplies you might need next year, do repairs and maintenance on equipment, get started on that advertising program, etc. Be careful, however. Special rules apply to companies that must capitalize more costs into inventory. Manufacturers are especially vulnerable. And make sure the repairs are really repairs, not capital improvements.
Small equipment. Most businesses can expense up to $2,500 per invoice in equipment. (The limit is $5,000 for taxpayers with an applicable financial statement; generally for a small business that means an audited statement.) That means a $1,600 computer, desk, etc. can be expensed without resorting to using the Section 179 expense option on it. This is a big advantage from several standpoints. First, you don't have to track the equipment for depreciation purposes. Second, the purchase doesn't fall under some of the Section 179 rules which can be restrictive. The flip side is that you have to have a policy (unwritten is acceptable; written is preferred) of expensing up to $2,500 (or some lower number). And you'll have to use the same approach for book and tax purposes.
This may be a quick way to reduce income and get your money's worth out of a tax deduction. Small purchases can be done quickly. Many small items can be ordered from a vendor's stock. Larger equipment could entail a custom order which might not be "placed in service" by December 31. But be careful. Buying an item that may not be used for over a year that comes with a 1-year warranty may be a poor business decision. So is buying equipment you may never need or buying equipment with features you'll never use just to get a bigger deduction.
Inventory purchases don't count. They're generally not deductible until the items are sold. (But see below for obsolete inventory.)
If you're on the cash basis, payments made by December 31 are generally deductible. Thus, make sure you pay any bills before the end of the year. Payments made in cash, by credit card, or a check mailed before the end of the year count.
If you're on the accrual basis, the rules become more complex. You may have to show that, by the end of the year, the liability was fixed, and the goods or services were provided. (There's more to this issue, but it's beyond the scope of this article.) You may be able to accelerate the deduction by cutting a check before the end of the year. Additionally, if there's any uncertainty as to the liability (for example, you contract to have a project done, but the price is contingent on a number of factors), firm it up before the end of the year. The rules here can be complex. Best to discuss with your tax advisor.
Pay bonuses to employees. If it's been a good year, pay bonuses to employees. Be sure to warn them that it may be a one-time event. There are no special tax implications here. The bonuses are just like additional salary. (But check the withholding rules.)
Expense accounts. Make sure all employees turn in their expense reports on time. If you're on the cash basis, consider an earlier cut off, say December 20, so that the reports can be processed and the checks cut before the end of the year.
Writeoffs. You can write off any undepreciated value of equipment abandoned before the end of the year. In order to claim a loss you have to take some affirmative action. You can sell it for scrap (get a receipt), donate it, or sell it to another business. Leaving it in the corner of the shop won't do.
You can deduct business bad debts that are partially or wholly worthless, but, once again, proof is important. Make a concerted effort to collect the debt before the end of the year. Consider turning collection over to an attorney who specializes in this area. You may have to pay him 25% to 50% of what he recovers, but that's a small price to pay if he collects some cash for you and you get a tax deduction for the remainder.
Inventory writeoffs are trickier, but may produce much more in savings. You've got to be able to show the decrease in value. Not too much trouble if you use the 'lower of cost or market' method and can prove the market prices. But more likely than not, that option is not available. You can show the price is below carrying cost by actual (bona fide) sales within 30 days of the inventory date. Value the inventory at the selling price less costs of disposal. Inventory that may qualify for the writedown includes shopworn, obsolete, out of style, etc. goods. You can also write down the value of unsalable goods. For example, those damaged in processing, returns, etc. Figure the cost of reworking them. Check with your tax advisor on the details here.
Farmers and ranchers. Farmers and ranchers using the cash method can deduct prepaid feed costs in the year of payment if the expenditure is a payment and not a deposit; there's a business purpose for the payment; and deducting the amount doesn't materially distort income. Farmers should keep in mind that they can income average their farm income.
State income taxes. Compute and make any estimated state income taxes before the end of the year. Special rules may apply. Talk to your tax advisor.
Charitable contributions. A C corporation can deduct charitable contributions accrued before the end of the year if paid within 2-1/2 months of yearend. The contribution must be authorized by the board of directors and special rules may apply when filing your tax return. This doesn't apply to other entities. S corporations, partnerships, etc. must make the contribution before the end of the year and the deduction is passed through to the shareholders or partners and reported on their personal return. Because of the changes in itemized deductions, those passed through contributions may or may not save tax dollars on your personal return.
Related taxpayers. When related taxpayers use different accounting methods, the accrual basis payer is placed on a cash basis with respect to payments that generate income or deductions.
Example--Fred is a 60% shareholder in Madison Inc. Madison is a calendar-year taxpayer and uses the accrual method of accounting. At December 31, 2019 Madison owes Fred $1,200 for interest on a loan he made to the business and $4,000 for 2 months rent on a building Fred owns and rents to the business. Madison doesn't pay the $5,200 until 2020. Madison can't accrue the expenses in 2019; they're only deductible when paid in 2020.
This rule applies to any item that would be income to the recipient. Typical ones include interest, rent, bonuses, nonemployee compensation, etc.
What constitutes a related taxpayer? There's a long list, but the two most important ones are a more than 50% shareholder in a regular corporation or a shareholder (or partner) who owns any interest in an S corporation (or partnership). The constructive stock ownership rules apply. That is, your son, daughter, etc. is deemed to own whatever stock you own. If there's a hint a party is related, check with your tax advisor.
Incentive stock options. If you've issued incentive stock options to employees and some of them have exercised, but not sold the stock, encourage them to make a disqualifying disposition. By selling the stock early, and before the end of the year, they avoid any alternative minimum tax treatment and the company gets a tax deduction.
Defer income. Cash-basis taxpayers can delay billing customers until it's too late to get the check before next year.
If you're on the accrual basis, deferring income is more difficult. Income is taxable when all events that determine the right to receive the income have occurred and the amount is determined with reasonable certainty. A complete discussion is beyond the scope of this article. However, you can't defer reporting the income by not billing. Selling goods on consignment (if that's possible) can defer income. Check with your tax advisor on your specific situation.
You should also be careful with respect to customer deposits. If you have unrestricted use of the funds and you do not have to repay the amount, a deposit becomes taxable income when received. Similarly, amounts received before services have been provided or goods have been delivered are generally reportable.
This can quickly become a tricky issue. It gets even more complicated if you want to report an amount for financial statement purposes, but defer it for tax reporting. The ultimate outcome will depend heavily on the facts and circumstances. Best to discuss the details with your tax advisor.
Installment sale. You may be able to defer taxes with an installment sale. That won't work for stock in trade (i.e., inventory items), but can be helpful if you're selling equipment, real estate, etc. Careful. You can't defer recognition of any depreciation recapture. That's all income in the year of sale.
Like-kind exchange. In the past a like-kind exchange (i.e., a trade-in) would defer gain on trucks, equipment, etc. but no longer. This technique only works for real estate.
Simplified Employee Pension. Probably the simplest of all plans. The business makes a contribution to the employee's SEP-IRA. Payment doesn't have to be made till the extended due date of the business return. The business gets a deduction, but it's not taxable to the employee for income or FICA. You decide every year how much to contribute. Use Form 5305-SEP to set up the plan.
Accelerating Income--Deferring Deductions
If you think you'll be in a higher bracket next year you should weigh accelerating income into 2019. Be careful not to overdo it. Fortunately, this is often easier than deferring income.
Accelerating income. Cash-basis taxpayers can bill customers earlier. Many may want to pay before the end of the year. You might want to offer a discount for early payment.
Accrual-basis taxpayers can make sure income will be included in 2019 by finishing projects, delivering goods or services, or making sure that both the right to receive the income is fixed and the amount is determinable with reasonable accuracy. It should be pretty easy to word a contract or agreement in such a way as to guarantee the amount will be includible. Check with your accountant on the details.
Collapse installment sale. You can make all the unrecognized gain on an installment contract taxable in 2019 by pledging the installment note for a loan or by selling the note. This approach can have substantial costs (e.g., you may have to discount the note), so be sure to weigh all the pros and cons.
Equipment sales. If you got some equipment that's not being used, consider selling it. The sale will generate cash, only some of which will be offset by the tax. In most cases any gain will be ordinary income from depreciation recapture. You could also have a loss. Any loss is may be fully deductible, without the capital loss limitations. (See below for some capital gain/loss strategies for regular corporations.)
Another option is a sale and leaseback. This is usually used just to generate cash, but there's nothing wrong with using it to create taxable income. If the asset is fully depreciated or almost so, you may be able to generate deductions in future years. This option shouldn't be taken lightly. Work through the numbers with your accountant.
Defer depreciation. While you need take no action now, you can reduce your depreciation expense for 2019 by not electing our of bonus depreciation and not electing the Sec. 179 expense allowance. The 100% bonus depreciation is automatic; you can, however, make an election not to take it. There may be more than one way to reduce your depreciation deduction. The elections are made when you file your return but you've got to factor them into your planning now.
You can defer any depreciation on new equipment to next year by delaying the purchase of the asset or at least making sure that it doesn't qualify as being placed in service (see the glossary) in 2019.
Delay writeoffs. You may not have to write off obsolete equipment or inventory this year. However, things are trickier for bad debts. You must generally write them off in the year they become worthless.
Defer expenses. You can defer expenses by not making repairs, delaying bonuses, waiting until 2020 to buy office supplies, stretching out some contractual payments, etc.
Casualties. If you suffered a casualty loss that was reimbursed by insurance and you're nearing the end of the replacement period, and don't buy qualified replacement property during the applicable replacement period, you'll have to report a gain (or loss) as a result of the casualty.
Example--Your equipment was destroyed by a fire. At the time of the fire the property was worth $250,000, but your adjusted basis in the equipment was only $50,000. You got a check from the insurance company for $250,000. If you buy suitable replacement property you can avoid recognizing the $200,000 gain. However, because of the fire you'll have a $300,000 operating loss for the year. Because of losses in prior years you can't carry the loss back and it could take years to use it up as a carryforward. The best approach here could be to not replace the property. Report the gain. Because of the losses you'll still pay no taxes and can start fresh, using those higher depreciation deductions in future years when they'll do the most good.
Election to amortize. There are a number of expenses that may be deductible or can be capitalized and amortized over a number of years. In addition, sometimes it's possible to choose an amortization period that's longer than normal. Stretching out a deduction can often be beneficial for a start-up company.
There are also some special considerations for S corporations. Some of the points below are very technical in nature, but you can achieve considerable tax savings if you're careful. Check with your tax advisor before acting.
Basis problems. You can only deduct losses up to your basis in the S corporation. Unused losses can be carried forward and used later. If you're in a high bracket this year, you might want to consider adding equity capital or making a loan to the corporation to use the losses in 2019. If losses have used up all your equity and debt basis in an S corporation, repayment of debts the corporation owes you will generate taxable income. If you take a distribution from the corporation that exceeds your basis, you may generate a capital gain.
C corporation history. If your S corporation was once a C corporation, there's a good chance that there's some accumulated earnings and profits from the C corporation. These 'tainted' amounts can cause problems. If your personal income is low this year, consider a dividend of some or all of these amounts. It'll provide benefits for the S corporation in the future. CAUTION. A special election must be made. Consult your tax advisor.
Deferred compensation. Special rules apply to accrued vacation and similar deferred compensation transactions. You can accrue such payments at the end of 2019, but they'll only be deductible in 2019 if actually paid within 2-1/2 months of yearend. A note, letter of credit, etc. won't work. And this will only work for unrelated employees.
Net investment income tax. This tax is on investment gains, dividends, interest, rental income, etc. It also applies to passive income from S corporations, partnerships, LLCs, etc. Most small business owners materially participate in their business. In such cases the tax isn't a factor. But you could have an equity interest in a friend or relative's business where your participation is minimal. Income from that business will be subject to the 3.8% NII if your AGI exceeds $200,000 ($250,000 for married, joint). It's pretty late in the year to do much about it unless you're near the threshold for material participation.
Salaries. The IRS is definitely serious about officers' salaries in an S corporation. If you (or another party) is an officer or provides services to the corporation you must be compensated. The big question is how much. For more information go to S Corporation Salary--Two Recent Cases and S Corporation Officers' Salaries. Taking no salary is very likely to cause a red flag. Taking only a nominal amount may be only slightly better. The IRS can compare your salary with distributions. Large distributions with a low salary has been used by the IRS to indicate insufficient salary.
Basis problems. The rules generally follow S corporations (see above) but you can also include amounts for which you, as a partner, are personally at risk. That means loans of the partnership for which you are liable. But that cuts both ways. An increase in such loans increases your amount at risk; a reduction in such loans decreases your amount at risk. Check your status before the end of the year.
NII. Like S corporations, your share of income from partnerships and LLCs where you don't materially participate is subject to the net investment income tax. See the discussion above.
Reconsider Entity Choice
While you're doing your year-end planning you should also take the time to reevaluate your choice of entity. If you do business as a sole proprietor you might want to incorporate or form an LLC. Under the new law operating as a C corporations could be better taxwise than doing business as an S corporation or sole proprietorship. The analysis is more complicated if you do business as a partnership. But there are still good reasons to continue operating as an S corporation. Yearend is a particularly convenient time to make the switch. Take the time to go through all of your options. You may want to wait to take any action to see what changes any tax reform legislation brings. IMPORTANT. This is not a decision to be made lightly. Consult your tax advisor.
Copyright 2019 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 12/10/19