Small Business Taxes & Management
Year-End Tax Planning--Part I
Small Business Taxes & ManagementTM--Copyright 2020, A/N Group, Inc.
This is going to be one of the most difficult years for many individuals, business owners and tax professionals. There have been some changes in the tax law, but the real issue is your income. As an individual you may have been laid off, as a business your revenue could have plummeted--or, for some businesses, could have gone up. Expenses may be down because you laid off workers, etc. The numbers could be all over, and maybe even out of, the ball park. If your income is way down you might want to generate "artificial" income by selling assets. If you are in the red already, you want to explore possibilities with net operating losses.
For many taxpayers his is not the year to ignore or take year-end planning lightly. You could be throwing away big dollars. And, while taxes may not go up next year, the new administration will be unlikely to decrease them.
Before doing any serious planning you should review your income and expenses for the year. If you have a business operating as an S corporation, partnership, LLC, or sole proprietorship, the income and losses will be passed through to you. So you've got to have a good idea of how the business is doing. Much the same applies if you have a rental property (or properties) and can deduct the losses or if the property throws off income. In the past we've said that rental properties tend to be more stable than an operating business. Even that's not true this year. You may have tenants who are behind in the rent--or moved out.
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're out-of-pocket cost is still more than 50%. For example, you purchase a $1,000 laptop. If you're in the 37% bracket for federal purposes and 10% for state, you're effective tax rate is probably about 45% (you get a deduction for your state taxes on your federal return). That means the government is picking up $450 of the cost; you're paying for the other $550. If you're self-employed or doing business as a partnership or LLC, your rate will be slightly higher when you add in the self-employment tax. Best suggestion? As always, economic considerations come first. Don't buy what you don't need; don't buy more than you need.
For a list of tax rates, facts on alternative minimum tax, standard deduction, credits, etc. go to our Tax Tables page for the details.
Projecting Your Income--Business
Before going any further you've got to have a good handle on the income from your business. Your accounting records are a good starting point, but more than likely you'll have to adjust them to conform to the tax accounting rules. Here are some possible adjustments:
- Depreciation. The depreciation reported on your books may be higher or lower than that used for tax purposes. In some cases, no provision may have been made yet for depreciation for 2020.
- Writeoffs. Bad debt reserves and many book writeoffs are not allowed for tax purposes. That may increase current year taxable income. On the other hand, book writeoffs taken in prior years may be reversing this year and may be deductible for tax purposes.
- Like-kind exchanges. Gain may be deferred for tax purposes but recognized for book. But keep in mind that like-kind exchanges of items other than real estate are no longer allowed for tax purposes. That means you'll have to recognize gain or loss on that truck trade in.
- Meal and entertainment expenses were fully expensed for book purposes, but generally only 50% of meal expenses and none of entertainment expenses can be deducted for taxes.
- Installment sales. Tax law doesn't allow the installment method for accounting for sales of goods that are inventory property. For example, if you sell furniture as a business, you can't use the installment sale for those items. On the other hand, you can use the installment method for the sale of store fixtures, shop equipment, etc.
- Amortization. You may have capitalized some expenses for book purposes in the past and are currently taking a deduction while you immediately expensed the item for tax purposes. That means your tax income will be higher than book. It's possible for items to go in the reverse direction. That is, tax income could be lower than book.
- Nondeductibles. You may have made payments with a business check or credit card that clearly aren't deductible, e.g., that tuition payment for your daughter. You've got to make adjustments for such items. Similarly, you may have contributed money to the business either as a capital contribution or loan. If you're just using your bank deposits as a proxy for your income, be sure to account for these items.
- Payroll Protection Program. If you got a PPP loan the loan forgiveness is not income, but you can't deduct expenses paid with the proceeds of the loan. Got a $50,000 loan and claiming $10,000 was used for rent and $40,000 for payroll? You can't deduct those amounts on your tax return.
- Tax law has some pretty specific rules as to when you can record income and expenses. If you're a manufacturer you'll also have to contend with the uniform capitalization rules. Construction contracts may be reported on the completed contract or percentage of completion method. In short, many costs that you may have expensed for book purposes could have to be capitalized for taxes.
CAUTION--If you got a PPP loan and the loan was, or you expect it to be, forgiven, it's not income to the business. On the other hand, at this time, the law states that you can't deduct expenses you paid with the loan proceeds. For example, you got a $200,000 loan and $180,000 was forgiven. You claimed you paid $140,000 in salary and $40,000 in rent from the loan proceeds. Your salary deduction for 2020 must be reduced by $140,000 and your rent deduction by $40,000. There is a small chance the rules could be changed, but for planning purposes, you should go with the current law.
Check with your accountant on these issues. Hopefully, the differences will be slight, and, if so, can be ignored.
In the past we've suggested annualize your income (e.g., take the first 10 (or 11 if you have them) months, divide the income by 10 (or 11) and multiply by 12) to figure your full-year profit or loss and then account for any variations during the year. Far fewer businesses are likely to be able to do that this year. You might try and forecast revenue and expenses through the end of the year. Alternatively, use the latest couple of months, say August, September, and October, divide by three and multiply by two to estimate November and December. Whatever you do, don't just wing it. Use a rational approach. You might even use more than one scenario. Again, this will be an important year for tax planning.
Businesses that operate as a sole proprietorship, LLC, partnership, S corporation, etc. have their income (or losses) passed through to the owners and reported on the owners' individual tax returns. That means you'll have to project both the businesses income and your personal income to evaluate your tax bracket. See below.
Projecting Your Income-Personal
If you do business as an S corporation, sole proprietorship, etc. your share of profits or losses are passed through and taxed on your personal return. (If you, or you and your spouse are the only shareholders in an S corporation, taking a smaller or larger salary won't change the outcome materially. A larger salary will just mean the pass-through income from the S corporation will be reduced and vice versa. But the total income will be virtually unchanged. That means you'll have to do a projection of your personal as well as business income before you can do any serious business planning. Fortunately, projecting your personal income is likely to be easier. Assemble your records for the first 10 months of the year. If you record income and expenses on a regular basis, this should be a snap. The purpose of this article is to determine if it makes sense to make any last minute busness capital expenditures to take advantage of bonus depreciation, etc. While we've included a list of items to take into account at the personal level, you can cheat and estimate some of them. For example, your charitable contributions usually run $500 to $1,000. For now your best guess is good enough. Concentrate on the bigger numbers.
- Passthroughs from partnerships, S corporations, trusts, etc. If you're a small business owner more than likely this is where the largest source of income. Use the guide above to project your income and add it to your personal income. If you're a minor investor you may not be privy to current financial information. Get the best information you can. Estates can produce income that's taxed to the beneficiaries. Ask the executor for his projection.
- Passive activity losses. Rental properties, S corporations, partnerships and LLCs in which you don't materially participate can generate passive losses. In the past any income may have been offset by losses. If you've run out of carryforward losses, you could now have taxable income. If the activity is fully disposed of in 2020 usused losses may be deductible. A similar situation can occur with respect to amounts at risk. Prior losses could have been limited by your investment at risk.
- Salary income. This one is easy. You should have cumulative pay stubs that show gross income and taxes withheld. If nothing has changed during the year, annualize them as described above. Adjust for bonuses. Be sure to take into account any unemployment payments, severance pay, etc.
- Interest and dividends. You won't have 1099s, but you should have a good idea of your interest and dividend income. Check your last statements from your broker, mutual fund, etc. and annualize the amount (use the year-to-date amount, divide by the number of months the statement covers, then multiply by 12). Caution. Annualizing may not work for dividend income. It's fine for small dividends, but you may have to do some additional work if you have big holdings in some stocks or have significant holdings in mutual funds. That could be especially important this year. Alternatively, use last year's amounts and adjust up or down.
- Rental income. If you have rental properties, you'll need to come up with an income estimate. Before annualizing the income or loss for the first 10 months, be sure there are no unusual factors. For example, if you incurred big repairs earlier in the year, you may have to adjust for that. Same for utilities and certain other items. Or the space was vacant for a time. Not sure of how much depreciation to use? You won't be too far off if you use last year's number (unless 2019 was a partial year or you made significant capital improvements in 2019 or 2020). You may have given tenants an abatement in rent for one or more months. That will reduce your rental income.
- Capital gains. For many taxpayers this is an important factor and difficult to predict. You may have unrecognized losses from prior years, but chances are you've got realized gains. You may have losses (for some taxpayers significant ones) if you sold stocks as they went down early in the year. For many taxpayers this is important since it's where you can do considerable tax planning. Get your brokerage statements for the year to date to find your gain or loss on every significant transaction. Total short-term gains and losses, then long-term gains and losses (property held more than 12 months) Your broker can help, but call as soon as possible.
- Also check for distributions from mutual funds made to date. There's a very good possibility some or all of your funds could distribute income before the end of the year. In some cases the payouts could be substantial. This could be a very tricky area this year depending on how the fund handled the market downturn early in the year. You may be able to get information from the fund to see what the year-end distribution will be. Keep in mind that you could receive a large distribution from the fund even though it performed poorly, or conversely, a small distribution even if it had significant gains.
- Other income. Did you sell your main or vacation home, win any prizes or awards, settle a lawsuit, receive alimony, etc.? Get a state or local income or real estate tax refund? You could have additional taxable income. Also consider insurance reimbursements you received this year for medical expenses you deducted in an earlier year. Casualties can sometimes produce gains as well as losses. Had any net gambling winnings? Collecting on a prior-year installment sale?
- Principal residence sale. If you sold your principal residence, there's a good chance you'll owe no tax on the sale. If you're single, the first $250,000 of gain should be exempt. If you're married, you can exclude the first $500,000. (Caution. The exclusion doesn't apply or is reduced if you haven't used the house or condo as your principal residence for two of the last five years or you claimed the exclusion on another residence within the last two years.) However, before you go to the next topic, think again. If you're a long-time home owner, you could have broken this threshold. Remember, you'll have to consider gains deferred on sales made before 1997 if this is your first sale since that law change. The exclusion also contains a number of restrictions. If you used part of the home for business, some of the gain may be taxable. Finally, even if you don't owe any federal taxes, you still could be liable for state income taxes on the sale.
- Distributions from pension plans. You may have taken money out of an IRA, Keogh, 401(k), etc. during the year. Chances are it's all taxable income. (Roth distributions are an exception and a portion of your IRA may be nontaxable if you made nondeductible contributions.) Distributions from some regular pension plans may be part taxable-part nontaxable. In addition, if were under age 59-1/2 and don't qualify for one of the exceptions, you'll owe a 10% penalty. CAUTION. This is an important item. Such distributions can raise your final tax bill significantly. But this year is unique.
- Social Security. If this is your first full year on Social Security you'll have to compute the taxable portion. If your AGI is above a threshold 50% may be taxable; above a second threshold 85% is taxable.
- Nontaxable income. Some income escapes taxes. That includes gifts and inheritances (generally, but pensions, annuities, etc. received from an estate are likely to be taxable) interest on most municipal bonds, returns of capital (e.g., principal repayments on a loan), reimbursements from your employer for business expenses, etc. Make sure you don't count any items as income if they're not. But if you're a shareholder in an S corporation or a partner in a partnership or LLC and received distributions in excess of your basis, they may be taxable, and that could be in addition to any income the entity passed through.
- Check last year's return. Many items repeat year after year. You may find some income you hadn't considered.
Caution!--If you turned 70-1/2 this year you'd normally have to start taking distributions (required minimum distributions or RMD) from your IRA and certain other plans if you're a business owner or retired. Everyone is entitled to defer required distributions from IRAs and defined contribution plans this year. You won't have to double-up next year. If you already started taking distributions you can also defer distributions with no penalty.
- Alimony. If your divorce was finalized before January 1, 2019 it should be deductible by you (and income to the recipient). However, payments that are really part of a property settlement or child support aren't deductible. Conversely, alimony is taxable to the recipient; property settlements and child support aren't. This can be a big number, so make sure the payments qualify. If you're unsure of your situation, talk to your accountant.
- Contributions to SEP, IRA, Keogh, etc. Some will depend on your income (e.g., SEP contributions may depend on your Schedule C income). You can make contributions as late as return filing (no later than April 15th for some plans), but if you're going to use that for planning, make sure you have the funds.
- If you're self-employed or a shareholder/employee in an S corporation, you may be entitled to deduct 100% of health insurance premiums you paid.
- Medical expenses. Add up all your expenses. Include medical insurance premiums not deducted elsewhere, doctors, dentists, hospitals, travel to and from the doctor, etc. Also include medical appliances such as glasses, hearing aids, etc. You may be able to deduct additions to your home if required or prescribed by a doctor. For example, a wheelchair ramp, special sink, etc. This can get tricky. Check with your tax adviser. Of course, reduce the amount by any reimbursement from insurance. Your deduction is limited to the amount that exceeds 7.5% of your adjusted gross income (AGI).
- Taxes. Include real estate taxes, state income taxes paid in 2020, and personal property taxes. When adding your taxes be sure to include any payments made when you filed your 2019 state return this year. Remember, you're limited to $10,000 here and that includes all taxes.
- Interest. You're generally limited to interest on a home mortgage, including a mortgage on a second home. Only interest on the first $750,000 of debt counts. Home equity interest isn't deductible unless the proceeds of the loan are used to improve your home (then it's technically no longer home equity interest). Interest to invest in an S corporation or partnership. is also fully deductible (but not on Schedule A). Interest on other investments may or may not be deductible.
- Charitable contributions. If they're significant go through your receipts and checkbook. You may receive a notice from your church or charity after the end of the year. For now you can use an estimate. Remember the substantiation rules on charitable contributions. Keep in mind that you're entitled to a standard deduction of $24,800 if you're married filing joint or $12,400 if you're single (more if you're over 65 or blind). If your taxes, medical, interest and charitable contribution don't break those amounts, the contribution contribution won't do you much good. For 2020 you can deduct up to $300 (restrictions apply) toward AGI.
- Education expenses. Amounts paid for your children or yourself may qualify for a credit. More than likely the amount spent will far exceed the amount qualifying for a tax benefit.
- Casualty or theft loss. Business casualty losses are still deductible, but personal ones are only deductible if they occur in a presidentially declared disaster area.
- Miscellaneous deductions. They're generally no longer deductible, but there are some exceptions.
- Life changes. The biggest factors on your tax return may be life changes. Have a baby? Get married? Get divorced? Child out of college? Spouse passed away? These can make big differences in your taxes, even if your income and deductions stay the same. Just retired? Your income may drop substantially. Or, if you're still working and collecting social security your income may be much higher. There's often little or nothing held from these types of income.
Finding your tax bracket. If you've got a good handle on your income and expenses you can net the two to arrive at your taxable income.
If you're pretty confident of your computations, you can find your tax bracket by using the Tax Tables in our Reference File. Keep in mind that long-term capital gains and qualifying dividends are taxed at a lower rate. Go to our Tax Tables for the details. However, we strongly suggest you use tax software to do the calculations. Many 2019 versions have a 2020 planning module. Alternatively, you can use the 2019 version. For planning purposes you won't be far off.
Caution. Your chance of getting hit with the alternative minimum tax (AMT) is substantially less than before the 2017 tax law change. But it's still possible. If you were subject to it in 2019 there's a chance you may face it again.
We'll discuss specifics of tax planning for businesses in the next article and planning for individuals in the final article.
Copyright 2020 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. 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 11/10/20