03 Oct Business
For an enviable financial statement, implement a robust tax plan
This is the third post in Joel’s series 2016 / 2017 Tax Planning Guide: Year-Round Strategies to Make the Tax Laws Work For You.
Running a profitable business these days isn’t easy. You have to operate efficiently, market aggressively and respond swiftly to competitive and financial challenges. But even when you do all of that, taxes may drag down your bottom line more than they should. Don’t let that happen. Take steps like these — and work with your tax advisor — to make your tax bill as small as possible.
Projecting your business’s income for this year and next can allow you to time income and deductions to your advantage. It’s generally — but not always — better to defer tax, so consider:
Deferring income to next year. If your business uses the cash method of accounting, you can defer billing for products or services at year end. If you use the accrual method, you can delay shipping products or delivering services.
Accelerating deductible expenses into the current year. If you’re a cash-basis taxpayer, you may pay business expenses by Dec. 31, so you can deduct them this year rather than next. Both cash- and accrual-basis taxpayers can charge expenses on a credit card and deduct them in the year charged, regardless of when the credit card bill is paid.
Warning: Don’t let tax considerations get in the way of sound business decisions. For example, the negative impact of these strategies on your cash flow might not be worth the potential tax benefit.
Taking the opposite approach. If it’s likely you’ll be in a higher tax bracket next year, accelerating income and deferring deductible expenses may save you more tax over the two-year period.
For assets with a useful life of more than one year, you generally must depreciate the cost over a period of years. In most cases, the Modified Accelerated Cost Recovery System (MACRS) will be preferable to other methods because you’ll get larger deductions in the early years of an asset’s life.
But if you make more than 40% of the year’s asset purchases in the last quarter, you could be subject to the typically less favorable midquarter convention. Careful planning can help you maximize depreciation deductions in the year of purchase.
Other depreciation-related breaks and strategies may be available:
Section 179 expensing election. This allows you to deduct (rather than depreciate over a number of years) the cost of purchasing eligible new or used assets, such as equipment and furniture. The expensing limit for 2015 had been $25,000 — and the break was to begin to phase out dollar-for-dollar when total asset acquisitions for the tax year exceeded $200,000 — but Congress revived the 2014 levels of $500,000 and $2 million, respectively, for 2015. Now these amounts are annually adjusted for inflation, and they’re $2.01 million and, still, $500,000 for 2016. Additionally, the new law permanently includes off-the-shelf computer software on the list of qualified property. And, beginning in 2016, it adds air conditioning and heating units to the list. You can claim the election only to offset net income from a “trade or business,” not to reduce it below zero to create a loss.
The break allowing Section 179 expensing for qualified leasehold- improvement, restaurant and retail-improvement property has also been made permanent. For 2015, a $250,000 limit applied, but, beginning in 2016, the full Sec. 179 expensing limit applies.
50% bonus depreciation. This additional first-year depreciation for qualified assets expired Dec. 31, 2014, but it has now been extended through 2019. However, it will drop to 40% for 2018 and 30% for 2019.
Qualified assets include new tangible property with a recovery period of 20 years or less (such as office furniture and equipment), off-the-shelf computer software, water utility property and qualified improvement property. Beginning in 2016, the qualified improvement property doesn’t have to be leased.
Accelerated depreciation. The break allowing a shortened recovery period of 15 years — rather than 39 years — for qualified leasehold- improvement, restaurant and retail-improvement property expired Dec. 31, 2014. However, it has now been made permanent.
Tangible property repairs. A business that has made repairs to tangi- ble property, such as buildings, machinery, equipment and vehicles, can expense those costs and take an immediate deduction. But costs incurred to acquire, produce or improve tangible property must be depreciated. Final IRS regulations released in late 2013 distinguish between repairs and improvements and include safe harbors for small businesses and routine maintenance. The final regs are complex and are still being interpreted, so contact your tax advisor for details.
Cost segregation study. If you’ve recently purchased or built a building or are remodeling existing space, consider a cost segregation study. It identifies property components that can be depreciated much faster, increasing your current deductions. Typical assets that qualify include decorative fixtures, security equipment, parking lots and landscaping.
Business-related vehicle expenses can be deducted using the mileage-rate method (54 cents per mile driven in 2016) or the actual-cost method (total out-of-pocket expenses for fuel, insurance, repairs and other vehicle expenses, plus depreciation).
Purchases of new or used vehicles may be eligible for Sec. 179 expensing. However, many rules and limits apply. For example, the normal Sec. 179 expensing limit generally applies to vehicles with a gross vehicle weight rating of more than 14,000 pounds. A $25,000 limit applies to vehicles (typically SUVs) rated at more than 6,000 pounds.
Vehicles rated at 6,000 pounds or less are subject to the passenger automobile limits. For autos placed in service in 2016, the first-year depreciation limit is $3,160. The amount that may be deducted under the combination of MACRS depreciation and Sec. 179 for the first year is limited under the luxury auto rules to $11,160.
In addition, if a vehicle is used for business and personal purposes, the associated expenses, including depreciation, must be allocated between deductible business use and nondeductible personal use. The depreciation limit is reduced if the business use is less than 100%. If business use is 50% or less, you can’t use Sec. 179 expensing or the accelerated regular MACRS; you must use the straight-line method.
Section 199 deduction
The Section 199 deduction, also called the “manufacturers’ deduction” or “domestic production activities deduction,” is 9% of the lesser of qualified production activities income or taxable income. The deduction is also limited to 50% of W-2 wages paid by the taxpayer that are allocable to domestic production gross receipts.
The deduction is available to traditional manufacturers and to businesses engaged in activities such as construction, engineering, architecture, computer software production and agricultural processing. It isn’t allowed in determining net self-employment earnings and generally can’t reduce net income below zero. But it can be used against the AMT.
Offering a variety of benefits not only can help you attract and retain the best employees, but also may save tax:
Qualified deferred compensation plans. These include pension, profit-sharing, SEP and 401(k) plans, as well as SIMPLEs. You take a tax deduction for your contributions to employees’ accounts. (For information on the benefits to employees, see page 22.) Certain small employers may also be eligible for a credit when setting up a plan. (See page 19.)
HSAs and FSAs. If you provide employees with a qualified high- deductible health plan (HDHP), you can also offer them Health Savings Accounts. Regardless of the type of health insurance you provide, you can offer Flexible Spending Accounts for health care. (See our post on Income and Deductions.) If you have employees who incur day care expenses, consider offering FSAs for child and dependent care. (See our post on Family and Education.)
HRAs. A Health Reimbursement Account reimburses an employee for medical expenses up to a maximum dollar amount. Unlike an HSA, no HDHP is required. Unlike an FSA, any unused portion can be carried forward to the next year. But only the employer can contribute to an HRA.
Fringe benefits. Some fringe benefits — such as employee discounts, group term-life insurance (up to $50,000 annually per person), parking (up to $255 per month), mass transit / van pooling (also up to $255 per month for 2016, because Congress has made parity permanent) and health insurance — aren’t included in employee income. Yet the employer can still receive a deduction for the portion, if any, of the benefit it pays and typically avoid payroll tax as well.
Play-or-pay penalty risk. The play-or-pay provision of the Affordable Care Act (ACA) imposes a penalty on “large” employers if just one full-time employee receives a premium tax credit. Premium tax credits are available to employees who enroll in a qualified health plan through a government-run Health Insurance Marketplace and meet certain income requirements — but only if:
- They don’t have access to “minimum essential coverage” from their employer, or
- The employer coverage offered is “unaffordable” or doesn’t provide “minimum value.”
The IRS has issued detailed guidance on what these terms mean and how employers can determine whether they’re a “large” employer and, if so, whether they’re offering sufficient coverage to avoid the risk of penalties.
A net operating loss occurs when a C corporation’s operating expenses and other deductions for the year exceed its revenues. Generally, an NOL may be carried back two years to generate a refund. Any loss not absorbed is carried forward up to 20 years to offset income.
Carrying back an NOL may provide a needed influx of cash. But you can elect to forgo the carryback if carrying the entire loss forward may be more beneficial. This might be the case if you expect your income to increase substantially compared to the prior two years or tax rates to go up.
Tax credits reduce tax liability dollar-for-dollar, making them particularly beneficial. The PATH Act has made permanent the research credit (see “What’s New!” below) and extended but not made permanent other credits, including the Work Opportunity credit (see “What’s New!” at right) and the following:
Empowerment Zones. Empowerment Zones are certain urban and rural areas where employers and other taxpayers qualify for special tax incentives, including a 20% credit for “qualified zone wages” up to $15,000, for a maximum credit of $3,000. The tax incentive expired Dec. 31, 2014, but it has been extended through Dec. 31, 2016.
New Markets credit. This credit has been extended through 2019. It gives investors who make “qualified equity investments” in certain low-income communities a 39% tax credit over a seven-year period.
Certified Community Development Entities (CDEs) determine which projects get funded — often construction or rehabilitation real estate projects in “distressed” communities, using data from the 2006–2010 American Community Survey. Flexible financing is provided to the developers and business owners.
The now-permanent research credit can net significant tax savings
The research credit (often called the “research and development” or “research and experimentation” credit) gives businesses an incentive to step up their investments in research — and now it’s here to stay.
Businesses have long complained that the annual threat of extinction to the credit deterred them from pursuing critical research into new products and technologies. But the PATH Act permanently extends the credit.
Plus, beginning this year, businesses with $50 million or less in gross receipts can claim the credit against AMT liability. And certain start-ups (in general, those with less than $5 million
in gross receipts) that haven’t yet incurred any income tax liability can use the credit against their payroll tax.
While the credit is complicated to compute, the tax savings can prove significant.
Two potentially valuable credits that never expired are:
Retirement plan credit. Small employers (generally those with 100 or fewer employees) that create a retirement plan may be eligible for a $500 credit per year for three years. The credit is limited to 50% of qualified startup costs.
Small-business health care credit. The maximum credit is 50% of group health coverage premiums paid by the employer, provided it contributes at least 50% of the total premium or of a benchmark premium. For 2016, the full credit is available for employers with 10 or fewer full-time equivalent employees (FTEs) and average annual wages of less than $25,900 per employee. Partial credits are available on a sliding scale to businesses with fewer than 25 FTEs and average annual wages of less than $51,800. Warning: To qualify for the credit, online enrollment in the Small Business Health Options Program (SHOP) generally is required. In addition, the credit can be taken for only two years, and they must be consecutive. (Credits taken before 2014 don’t count, however.)
Work Opportunity credit reliable through 2019
The Work Opportunity credit for employers that hire from a “target group” has been extended through 2019, thanks to the PATH Act. Starting this year, the act also expands the target groups to include individuals who’ve been unemployed for 27 weeks or more.
The size of the tax credit depends on the hired person’s target group, the wages paid to that person and the number of hours that person worked during the first year of employment. The maximum tax credit that can be earned for each member of a target group is generally $2,400 per adult employee. But the credit can be higher for members of certain target groups, up to as much as $9,600 for certain veterans.
Employers aren’t subject to a limit on the number of eligible individuals they can hire. That is, if there are 10 individuals that qualify, the credit can be 10 times the listed amount.
Bear in mind that you must obtain certification that an employee is a target group member from the appropriate State Workforce Agency before you can claim the credit. The certification generally must be requested within 28 days after the employee begins work.
Income taxation and owner liability are the main factors that differentiate one business structure from another. (See Chart 3 to compare the tax treatments.) Many businesses choose entities that combine flow-through taxation with limited liability, namely limited liability companies (LLCs) and S corporations.
The top individual rate is higher (39.6%) than the top corporate rate (generally 35%), which might affect business structure decisions. For tax or other reasons, a structure change may be beneficial in certain situations, but there also may be unwelcome tax consequences.
Some tax differences between structures may provide tax planning oppor- tunities, such as differences related to salary vs. distributions/dividends:
S corporations. Only income that shareholder-employees receive as salary is subject to employment taxes and, if applicable, the additional 0.9% Medicare tax, which generally applies to taxpayers with earned income exceeding the same thresholds as those for the NIIT. (See our post on Investing.) To reduce these taxes, you may want to keep your salary ”relatively — but not unreasonably — low and increase your distributions of company income, because distributions generally aren’t taxed at the corporate level or subject to the 0.9% Medicare tax or the 3.8% NIIT.
C corporations. Only income that shareholder-employees receive as salary is subject to employment taxes and, if applicable, the 0.9% Medicare tax. Nevertheless, you may prefer to take more income as salary (which is deductible at the corporate level) as opposed to dividends (which aren’t deductible at the corporate level, yet are still taxed at the shareholder level and could be subject to the 3.8% NIIT) if the overall tax paid by both the corporation and you would be less.
Warning: The IRS is cracking down on misclassification of corporate payments to shareholder-employees, so tread carefully.
Income tax differences based on business structure
1 Stay tuned for our post on Tax Rates for exceptions.
Sale or acquisition
Whether you’re selling your business or acquiring another company, the tax consequences can have a major impact on the transaction’s success or failure.
Consider installment sales, for example. A taxable sale might be structured as an installment sale if the buyer lacks sufficient cash or pays a contingent amount based on the business’s performance.
An installment sale also may make sense if the seller wishes to spread the gain over a number of years — which could be especially beneficial if it would allow the seller to stay under the thresholds for triggering the 3.8% NIIT or the 20% long-term capital gains rate. But an installment sale can backfire on the seller. For example:
- Depreciation recapture must be reported as gain in the year of sale, no matter how much cash the seller receives.
- If tax rates increase, the overall tax could wind up being more.
With a corporation, a key consideration is whether the deal should be structured as an asset sale or a stock sale. If a stock sale is chosen, another important question is whether it should be a tax-deferred transfer or a taxable sale.
Of course, tax consequences are only one of many important consid- erations when planning a sale or acquisition.
If you’re self-employed, you can deduct 100% of health insurance costs for yourself, your spouse and your dependents. This above-the-line deduction is limited to your net self-employment income. You also can take an above-the-line deduction for contributions made to a retirement plan (stay tuned for our forthcoming post on Retirement) and, if you’re eligible, an HSA (see our post on Income and Deductions) for yourself.
You pay both the employee and employer portions of employment taxes on your self-employment income. The employer portion (6.2% for Social Security tax and 1.45% for Medicare tax) is deductible above the line.
And you may be able to deduct home office expenses (see our post on Income and Deductions for more) from your self-employment income. ❖