Small business owners still have time to make tax planning moves to lower their 2020 federal income tax bills — and possibly lay the groundwork to save taxes in future years. Here are 10 ideas for small businesses to consider.
1. Claim Bonus Depreciation for 2020 Asset Additions
Thanks to the Tax Cuts and Jobs Act (TCJA), 100% first-year bonus depreciation is available for qualified new and used property that's acquired and placed in service in calendar year 2020. That means your business might be able to write off the entire cost of some or all of your current-year asset additions on this year's return. Consider making additional acquisitions between now and December 31.
Important: It doesn't always make sense to claim 100% bonus depreciation in the first year that qualifying business property is placed in service. For example, if you think that tax rates will increase substantially in the future — either due to tax law changes or a change in your income level — it might be better to forgo bonus depreciation and, instead, depreciate your 2020 asset acquisitions over time. If you take advantage of bonus depreciation in 2020 and then federal income tax rates go up in future years, you'll have effectively traded more valuable future-year depreciation write-offs for less valuable first-year write-offs.
Your tax professional can explain the details of the bonus depreciation program, including what types of assets qualify and whether bonus depreciation is right for your business in 2020. You don't have to commit to taking 100% bonus depreciation until you file your tax return for the current year. By then, the outcome of the 2020 election — and the direction of future tax rates — will likely be clearer.
2. Claim Bonus Depreciation for 2020 QIP Expenditures
When drafting the TCJA, Congress intended to allow 100% first-year bonus depreciation for real estate qualified improvement property (QIP) placed in service in 2018 through 2022. Congress also intended to give you the option of claiming 15-year straight-line depreciation for QIP placed in service in 2018 and beyond.
QIP is defined as an improvement to an interior portion of a non-residential building that's placed in service after the date the building was first placed in service. However, QIP doesn't include expenditures:
- To enlarge a building,
- For any elevator or escalator,
- or For any internal structural framework of a building.
Due to an error in drafting the TCJA, the intended first-year bonus depreciation break for QIP never made it into the statutory language. The CARES Act included a retroactive technical correction to fix that oversight.
The correction causes QIP to be included in the tax code definition of 15-year property. That means QIP can be depreciated over 15 years for federal income tax purposes, which, in turn, gives real estate owners the option to claim 100% first-year bonus depreciation for QIP placed in service in the current tax year.
Again, there may be good reasons to forgo bonus depreciation. Your tax pro can help determine what makes the most sense for your business.
3. Claim Bonus Depreciation for a Heavy SUV, Pickup or Van
The 100% first-year bonus depreciation provision can have a sizable, beneficial impact on first-year depreciation deductions for new and used heavy vehicles used over 50% for business. For federal tax purposes, heavy SUVs, pickups and vans are treated as transportation equipment, so they qualify for 100% bonus depreciation.
This option is available only when the manufacturer's gross vehicle weight rating (GVWR) is above 6,000 pounds. You can verify a vehicle's GVWR by looking at the manufacturer's label, usually found on the inside edge of the driver's side door where the door hinges meet the frame.
If you're considering buying an eligible vehicle, doing so and placing it in service before the end of this tax year could deliver a big write-off on this year's return. Before signing the sales contract, contact your tax pro to help evaluate what's right for your business.
4. Cash in on More-Generous Section 179 Deduction Rules
The TCJA increased the maximum Section 179 deduction from only $510,000 for tax years beginning in 2017 to $1.04 million for qualifying property placed in service in tax years beginning in 2020.
Other beneficial TCJA changes to the Sec. 179 rules include:
Property used for lodging. For property placed in service in tax years beginning in 2018 and beyond, you can claim Sec. 179 deductions for personal property used in connection with furnishing lodging. Examples include furniture, kitchen appliances, lawnmowers and other equipment used in the living quarters of a lodging facility or in connection with a lodging facility, such as a hotel, motel, apartment house, or a rental condo or rental single-family home.
Qualifying equipment related to real property. For tax years beginning in 2018 and beyond, the TCJA expanded the definition of real property eligible for the Sec. 179 deduction to include qualified expenditures for roofs, HVAC equipment, fire protection and alarm systems, and security systems for nonresidential real property. To qualify, these items must be placed in service after 2017 and after the nonresidential building has been placed in service.
Important: Various limitations can apply to Sec. 179 deductions, especially if you conduct your business as a partnership, limited liability company (LLC) treated as a partnership for tax purposes, or an S corporation.
5. Time Income and Deductions for Tax Savings
If you conduct your business using a so-called "pass-through entity" — meaning a sole proprietorship, S corporation, LLC, or partnership — your shares of the business's income and deductions are passed through to you and taxed at your personal rates. Unless Congress passes legislation to increase taxes that takes effect next year, the 2021 individual federal income tax rate brackets will be the same as this year's, with modest bracket bumps for inflation.
So, the traditional strategy of deferring income into next year while accelerating deductible expenditures into this year makes sense if you expect to be in the same or lower tax bracket next year. Depending on the outcome of the 2020 election, it's unclear whether that expectation is realistic. In any case, deferring income and accelerating deductions will, at a minimum, postpone part of your tax bill from 2020 until 2021.
On the other hand, if you expect to be in a higher tax bracket in 2021, take the opposite approach: Accelerate income into this year (if possible) and postpone deductible expenditures until 2021. That way, more income will be taxed at this year's lower rate instead of next year's expected higher rate.
6. Consider Taking Steps to Defer Taxable Income
Most small businesses are allowed to use cash-method accounting for tax purposes. Assuming your business is eligible, cash-method accounting allows you to manage your 2020 and 2021 business taxable income to minimize taxes over the two-year period. If you expect your business income will be taxed at the same or lower rate next year, here are specific cash-method moves that can defer some taxable income until 2021:
Charge recurring expenses that you would normally pay early next year on credit cards. You can claim 2020 deductions even though you won't pay the credit card bills until 2021.
Pay expenses with checks and mail them a few days before year-end. The tax rules allow you to deduct the expenses in the year you mail the checks, even though they won't be cashed or deposited until early next year. For big-ticket expenses, consider sending checks via registered or certified mail, so you can prove they were mailed before December 31.
Prepay some expenses before year-end. Prepaid expenses can be deducted in the year they're paid as long as the economic benefit from the prepayment doesn't extend beyond the earlier of 1) 12 months after the first date on which your business realizes the benefit of the expenditure, or 2) the end of the next tax year.
On the income side, the general rule for cash-basis businesses is that you don't have to report income until the year you receive cash or checks in hand or through the mail. To take advantage of this rule, consider waiting until near year-end to send out some invoices to customers. That will defer some income until 2021 because you won't collect the money until early next year. Of course, this should only be done for customers with solid payment histories.
On the other hand, if you expect to pay a significantly higher tax rate on next year's business income, it probably makes sense to do the opposite of those strategies. In other words, you'll want to accelerate income into 2020 and defer expenses into 2021. That way, you'll raise this year's taxable income and lower next year's taxable income.
7. Create or Increase an NOL
The economic fallout from the COVID-19 crisis will cause many small businesses to incur net operating losses (NOLs) this year. With the exception of the Sec. 179 deduction, the tax breaks and strategies discussed in this article can be used to create or increase a current-year net operating loss (NOL) if your business's expenses exceed its income.
If you incur an NOL in 2020, you can choose to carry it back for up to five years in order to recover taxes paid in those earlier years. Or you can choose to carry it forward to future years if you expect business tax rates to go up.
8. Reap a 0% Tax Rate on Gains from Selling QSBC Stock
For qualified small business corporation (QSBC) stock that was acquired after September 27, 2010, a 100% federal income tax gain exclusion break is potentially available when the stock is eventually sold. That equates to a 0% federal income tax rate if the shares are sold for a gain.
To benefit from this break, you must hold the shares for more than five years. Also, this deal isn't available to C corporations that own QSBC stock, and many companies don't meet the definition of a QSBC in the first place.
Important: Depending on the election results, this break could be gone after this year. So, it could be a limited time opportunity.
9. Maximize QBI Deduction for Pass-Through Business Income
The deduction based on qualified business income (QBI) from pass-through entities is a key element of the TCJA. For tax years beginning in 2018 through 2025, the deduction can be up to 20% of a pass-through entity owner's QBI. This break is subject to restrictions that can apply at higher income levels and another restriction based on the owner's taxable income.
For QBI deduction purposes, pass-through entities are defined as sole proprietorships, single-member LLCs that are treated as sole proprietorships for tax purposes, partnerships, LLCs that are treated as partnerships for tax purposes and S corporations.
The QBI deduction is available only to noncorporate taxpayers, meaning individuals, trusts and estates. For these taxpayers, the deduction can also be claimed for up to 20% of income from qualified real estate investment trust (REIT) dividends and 20% of qualified income from publicly traded partnerships. So, the deduction can potentially be a big tax saver for this year.
Because of various limitations on the QBI deduction, tax planning moves can unexpectedly increase or decrease your allowable QBI deduction. For example, strategies that reduce this year's taxable income can have the negative side-effect of reducing your QBI deduction. Work with your tax pro to optimize the overall results for your tax situation.
10. Establish a Tax-Favored Retirement Plan
If your business doesn't already have a retirement plan, now might be the time to take the plunge. Current retirement plan rules allow for significant deductible contributions.
For example, if you're self-employed and set up a SEP-IRA, you can contribute up to 20% of your self-employment earnings. If you're employed by your own corporation, up to 25% of your salary can be contributed to your SEP-IRA. The maximum 2020 contribution for these plans is $57,000.
Other small business retirement plan options include
- A 401(k) plan, which can even be set up for just one person (a solo 401(k))
- A defined benefit pension plan, and
- A SIMPLE-IRA.
Depending on your circumstances, these plans may allow bigger deductible contributions.
Important: The deadline for setting up a SEP-IRA for a sole proprietorship business and making the initial deductible contribution for the 2020 tax year is October 15, 2021, if you extend your 2020 federal income tax return to that date. Other types of plans generally must be established by December 31, 2020, if you want to make a deductible contribution for the 2020 tax year. But the contribution deadline is the extended due date for your 2020 return. However, to make a SIMPLE-IRA contribution for 2020, you must have set up the plan by October 1, 2020. So, you might have to wait until next year if the SIMPLE-IRA option is appealing.
Ready, Set, Plan
2020 has been a year of unprecedented uncertainty. Though you might not know what's going to happen after the dust clears from the November's election, the 2020 tax rules are a known commodity. Contact your HK tax advisor at 330-453-7633 to help evaluate your planning options as 2021 looms on the horizon.