With 2020 only two weeks away, if you are a business owner and you have not reviewed your tax picture for the year (providing you use the calendar year tax-year), now is the time to sit down and do so. This year is the second tax year under the Tax Cuts and Jobs Act of 2017 (TCJA), which brought sweeping changes across the board for all taxpayers. Business owners, in particular, were the largest benefactors of this tax reform, benefiting from such changes as a reduced tax rate for corporations and the addition of a brand new deduction for qualified business income. In this small business tax strategies article, we go over the most notable changes made to the U.S. tax code for business owners and simple strategies you can implement here at the year-end.
Small Business Tax Strategies: The Notable Changes
Business owners benefited the most from the tax reform. Below we cover the most notable changes:
Flat 21% tax rate for corporations.
Before the TCJA, C corporations paid taxes according to the following graduated tax brackets:
- 15% on taxable income of $0-$50,000
- 25% on taxable income of $50,001-$75,000
- 34% on taxable income of $75,001-$10 million
- 35% on taxable income over $10 million
- 35% on taxable income for personal service corporations (PSCs) paid 35%.
However, the TCJA established a flat 21% corporate tax rate across the board for all corporations. If you are an owner of a corporation that’s in those higher tax brackets, this likely translated to substantial tax savings for you.
Elimination of the corporate AMT.
Before the TCJA, all corporations had to calculate their tax burdens under both the regular corporate income tax and the AMT and pay whichever was higher. Corporations with less than $7.5 million were exempt. Still, many medium-sized businesses Now, the TCJA repealed the corporate AMT completely, simplifying the tax filing process and reducing taxes across the board.
New qualified business income (QBI) deduction for pass-through entities.
The QBI deduction is an entirely new introduction to the U.S. tax code. Before the TCJA, net taxable income from “pass-through” business entities (sole proprietorships, partnerships, LLCs taxed as sole proprietorships or partnerships, and S corporations), passed-through to the business owner(s) personal tax return. Under the new law, that income qualifies for a deduction of up to 20%, subject to the restrictions that can apply for high earners. Visit the IRS’s Qualified Business Income Deduction webpage to learn more.
100% first-year bonus depreciation.
The TCJA increased the bonus depreciation from 50 percent to 100 percent for qualified property purchased and placed in service between September 27, 2017, and January 1, 2023. Qualified property refers to depreciable business assets with a recovery period of 20 years or less and certain other property. Common examples include machinery, equipment, computers, appliances, and furniture. The new tax law also added film, television, live theatrical productions, and specific types of used property as the types of property that may be eligible for the first-year bonus depreciation.
Section 179 first-year depreciation deductions.
Section 179 of the U.S. tax code allows taxpayers to deduct the cost of certain types of property on their income taxes as a one-time expense, rather than depreciating the value of the asset over time. Qualifying property is generally limited to depreciable tangible personal property used for business purposes, including expenditures for specific building improvements. The TCJA increased the first-year maximum depreciation deduction from $500,000 to $1 million. The TCJA also expanded the definition of qualifying assets to include property used mainly in the furnishing of lodging (e.g., furniture and appliances), and HVAC equipment, fire protection systems, alarm systems, and security systems for nonresidential real property. You can read more on the IRS website.
Depreciation Deductions for Company Vehicles.
Under prior law, passenger cars used more than 50% of the time for business had maximum annual depreciation deductions as such:
- $11,160 for Year 1 for a new car ($3,160 for used)
- $5,100 for Year 2
- $3,050 for Year 3
- $1,875 for Year 4 and all subsequent years.
Now, the TCJA made the deductions much more taxpayer-friendly and changed them to:
- $10,000 for Year 1 if placed in service after December 31, 2017. Or, $18,000 if you claim the first-year bonus depreciation.
- $16,000 for Year 2
- $9,600 for Year 3
- $5,760 for Year 4 and thereafter until fully depreciated.
Limitation on business interest expense deductions.
Before the TCJA, you could fully deduct the cost of interest incurred by your business. Under the new laws, however, you cannot deduct interest expense above 30% of your adjusted taxable income in tax years starting in 2018. The excess interest expense is then carried over to the following tax year. Business taxpayers with average annual gross receipts of $25 million or less are exempt from this limitation, and real property businesses and farming businesses that elect a slower depreciation method (10 years or more) are also exempt.
Reduced or eliminated business entertainment deductions.
Under prior law, you could deduct 50% of business-related entertainment expenses. Under the TCJA, however, that deduction no longer exists, except for meal expenses incurred in connection with business entertainment and meal expenses related to client and potential client meetings.
Limitation on excess business losses of individual taxpayers.
Net business losses that exceed $250,000 for individuals and $500,000 for married filing-jointly couples are no longer deductible and must be carried forward to later tax years.
Enhanced access to cash method accounting for inventory.
If your annual average gross receipts do not exceed $25 million for the last three tax years, you are no longer required to use the accrual method of accounting for inventories in most cases. You may use the more taxpayer-friendly cash method of accounting for inventories instead. In essence, the cash method recognizes revenues when cash is received and expenses when paid. The accrual method records revenues and expenses when earned, regardless of when money is received or paid. Using the cash method can result in significant tax savings for your business because you will generally have opportunities to postpone revenue recognition and accelerate payments at year-end.
Small Business Tax Strategies: The Strategies
Accelerate 2020 income or defer 2019 deductions.
If you own a corporation that is anticipating a small net operating loss (NOL) in 2019, but substantial net income next year, it may be worthwhile to accelerate just enough of next year’s income into the current tax year. Or, defer just enough of your current year deductions into next year with the goal of creating a small amount of net income for this year. Successful execution of this strategy will help you base your 2020 estimated tax installments on the relatively small amount of income tax shown on your 2019 return as opposed to having to pay estimated taxes on 100% of the much larger 2020 taxable income.
Take advantage of the Qualified Business Income (QBI) deduction.
If your business is a pass-through entity, you can now take advantage of the new QBI deduction, which generally allows you to deduct the lesser of:
- 20% of your QBI, plus 20% of qualified real estate investment trust (REIT) dividends, and qualified publicly traded partnership (PTP) income, or
- 20% of your taxable income minus net capital gain.
This deduction is available regardless of whether you itemize your deductions or not. QBI does not include the following:
- Business income earned outside the U.S.
- Capital gains and losses
- Commodities transactions or foreign currency gains or losses
- Dividends and any dividend income equivalent
- Guarantee payments to partners in partnerships or LLC members
- Income from annuities (unless received in connection with your trade or business)
- Income from wages
- Interest income that you can’t allocate to the trade or business
- W-2 wages paid to S-Corp shareholders
Additionally, there are limitations to the QBI deduction. Providing your income is less than $157,500 (or $315,000 if you are married filing jointly), you can claim the full 20% deduction. However, if your income exceeds those thresholds, the deduction is based on the type of business you have, and whether it is a specified service trade or business (SSTB). SSTB’s include:
- Actuarial science
- Any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners
- Dealing in certain assets such as securities or commodities
- Financial services
- Investing and investment management
- Performing arts
If your business is an SSTB and your taxable income is between $157,500 and $207,500 (or $315,000 and $415,000 for joint filers), a wage limit for the QBI deduction begins phasing in. Once you are over the income limits as an SSTB, you can no longer take the QBI deduction. Non-SSTB’s, however, can still take the deduction if they are over the income limits, but it will be limited to the greater of your share of:
- 50% of the W-2 wages paid to employees, or
- The sum of 25% of such W-2 wages plus 2.5% of the unadjusted basis immediately upon acquisition (UBIA) of the qualified property.
The opportunity to deduct up to 20% of your income is rather significant, but the QBI deduction calculation is, unfortunately, complicated. Make sure you work with your tax professional to help you achieve the most significant deduction available to you.
Separate your entertainment and meal expenses.
Under prior law, most business-related meals and entertainment expenses were eligible for a 50% deduction. Now, however, business-related entertainment expenses are no longer deductible, so it’s a good idea to separate your deductible expenses from your nondeductible expenses to help maximize your deductions. You can do this in your bookkeeping software or just pay for nondeductible from personal accounts. Also, there are still exceptions to the rule, including:
- Food and beverages for employees providing there’s a business purpose.
- Expenses treated as compensation.
- Reimbursed expenses.
- Recreational expenses for employees (e.g., office gym maintenance, company picnics)
- Business meetings of employees or shareholders.
- Business league meetings (must be qualified 501c(6) nonprofits).
- Food and beverages provided for the general public.
- Entertainment sold to customers.
- Expenses includible in the income nonemployees (e.g., 1099 contractors).
Consider buying and placing in service new or used machinery, equipment, and software.
For qualifying assets placed in service between 09/28/2017 and 12/31/2022, the TCJA now allows you to deduct 100% of the cost in Year 1 (See “100% first-year bonus depreciation” above). If you have machinery, equipment, or software purchases to make, you might consider doing so before the end of the year to boost your tax savings for the year. As with accelerating or deferring any other deductions, the best timing requires careful consideration of your business’ entire financial picture, plans, and future expectations. Work with your financial planner and tax professional to choose the best course of action implementing your small business tax strategies.
Set up an employer-sponsored retirement plan.
With the proliferation of different options and providers, establishing an employer-sponsored retirement plan for your business – such as a 401(k), SEP IRA, or SIMPLE IRA – is easier than ever before. As a business owner, an employer-sponsored retirement plan can provide you with numerous tax benefits, including the ability to:
- Reduce your income with pre-tax contributions.
- Potentially create tax-free retirement income with after-tax contributions.
- Make tax-deductible matching contributions from the business to both you and any partners, and employees.
- Deduct any ongoing administrative costs as a business expense.
In general, 401(k)’s tend to be the best option in the employer-sponsored retirement plan space, even for single-member business owners. 401(k)’s tend to offer the most flexibility in design and more opportunities to maximize contributions. However, determining the best option for your business should involve comparing all the pros, cons, and costs of each plan against your current needs and capacity. Work with your financial adviser or schedule a call with us to help you determine the best small business tax strategies for your current situation. You can also read more about the different plan types and their features by visiting this small-business retirement plan comparison.
Consider eliminating a passive activity.
A passive activity is one in which you do not materially participate. Material participation refers to direct involvement in operations on a regular, continuous, and substantial basis. Material participation examples include:
- Participation in an activity for more than 500 hours in a taxable year.
- Your participation for the year was substantially all of the involvement in the passive activity.
- You participated for more than 100 hours during the year, and you participated at least as much as any other individual that year.
The most common type of passive activity is rental income from real estate holdings unless you perform more than 50 percent of your services in real property businesses, and you spend more than 750 hours during the taxable year in real property businesses.
As far as small business tax strategies are concerned, the caveat is that losses from passive activities are only deductible against passive income. In other words, passive losses cannot be used to reduce non-passive income, such as compensation, dividends, or interest. As a result, it’s generally a good idea to avoid investments producing passive losses unless the long-term economic benefits outweigh the short-term losses. However, if you already have a passive investment with losses, you might consider acquiring an investment that generates passive income so you can deduct the losses. Alternatively, you might consider eliminating the passive activity altogether. Work with your tax professional to determine the best course of action for you.
Review and analyze your current business legal structure.
As a business owner, you get to choose which legal structure you use for your business. Most small business owners will initially select a sole proprietorship, LLC, or partnership because they are the easiest and most cost-effective to set up, and they have the least amount of requirements to maintain.
However, the legal structure you start with may not always be the best option long-term. With an LLC, for example, all of your net business income passes-through to your tax return, upon which you must pay self-employment taxes in addition to federal and state/local (if applicable) income taxes. As you become highly profitable, those self-employment taxes can start to eat up a lot of your earnings, at which point switching to a more potentially tax-advantaged structure, such as an S-corp, could make sense. Your tax professional can help you determine the best small business tax strategies for you.
Small Business Tax Strategies: The Bottom Line
Business owners were the largest benefactors of the recent tax reform. However, with so many changes made, tax filing as a business owner is now a very different ball game than it used to be. We always recommend having a competent tax professional and financial planner on your side to help you navigate the inherent financial complexities that come with being a business owner. Not sure where to turn? Schedule a free consultation with us today to see how we can help.
Forefront Wealth Partners is an independent financial advisory firm that provides creative problem solving to our clients. In a world where change is accelerating and the future uncertain, we provide simplicity and confidence concerning financial, tax, and legal strategies. Our process involves a deep relationship, focusing on meaningful outcomes and dynamic planning.
The information given herein is taken from sources that IFP Advisors, LLC, dba Independent Financial Partners (IFP), IFP Securities LLC, dba Independent Financial Partners (IFP), and its advisors believe to be reliable, but it is not guaranteed by us as to accuracy or completeness.
This is for informational purposes only and in no event should be construed as an offer to sell or solicitation of an offer to buy any securities or products. Please consult your tax and/or legal advisor before implementing any tax and/or legal related strategies mentioned in this publication as IFP does not provide tax and/or legal advice. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors.
Securities offered through IFP Securities, LLC, dba Independent Financial Partners (IFP), member FINRA/SIPC. Investment advice offered through IFP Advisors, LLC, dba Independent Financial Partners (IFP), a Registered Investment Adviser.
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