As we approach the end of the year, it is crucial to reflect on the past 12 months to establish a sense of where your company’s taxable income numbers will land so you can optimize tax positions before the opportunity is lost. This is of the utmost importance for 2020, as Congress created new opportunities for businesses to reduce tax burdens and possibly recoup past taxes paid by passing the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) on March 27, 2020.
Whether or not the global pandemic has negatively affected your business’ income statement, there are many opportunities for year-end planning — created not only by the CARES Act but also through other legislation enacted in recent years, along with tried-and-true tax planning concepts. The following planning ideas will help keep more cash in your business instead of turning over a larger share to the U.S. government.
1. Net Operating Losses and Excess Business Losses
The Tax Cuts and Jobs Act (TCJA) of 2017 eliminated the carryback of net operating losses (NOLs) for individuals and corporations for tax years ending after December 31, 2017. The TCJA allowed taxpayers to indefinitely carry forward NOLs, but the amount that could be used in any given year was capped at 80% of taxable income. NOLs generated prior to tax years beginning January 1, 2018, were not subject to the 80% limitation. The TCJA also limited trade or businesses losses annually to $250,000 ($500,000 for a joint return). The excess business losses then carried forward to the next tax year as NOLs.
The CARES Act made the following changes to NOL and excess business loss rules:
- Allowed a five-year carryback of NOLs for tax years beginning in 2018, 2019 or 2020.
- Repealed the 80% limitation of taxable income on the use of NOLs for losses arising in tax years beginning after December 31, 2017, and beginning before January 1, 2021.
- Delayed the excess business loss limitation to tax years beginning after December 31, 2020.
These changes have created an opportunity for businesses and their owners to file carryback claims of current year NOLs to recoup taxes that were paid in the five prior years, starting with the oldest. Generally, the taxes that will be recouped are those paid at higher tax rates, as the TCJA lowered the corporate and individual income tax rates. Be sure to review prior year tax returns or consult your tax adviser to determine that carrying back a loss would be beneficial. There is also an option to carry the loss forward if a carryback is not beneficial.
A planning opportunity is to consider maximizing the benefit of an NOL carryback by creating a larger current year loss using the following planning ideas to increase your deductions.
2. Accelerating Depreciation
Businesses can fully depreciate the cost of current year additions of machinery and equipment, furniture and fixtures, software and qualified improvement property using either 100% bonus depreciation or Section 179 expensing. The maximum Section 179 deduction for 2020 is $1.4 million and can only be taken to the extent there is current taxable income. The deduction starts phasing out dollar for dollar if qualifying equipment purchases exceed $2.59 million.
Additionally, the CARES Act included the technical correction everyone was waiting for regarding qualified improvement property — clarifying that the recovery period is 15 years and, therefore, this property is eligible for bonus depreciation. This fix was made retroactive to the enactment of the TCJA, so to the extent your business had qualified improvement property additions after its enactment and prior to the current tax year, you still have the opportunity to take the additional depreciation this year.
A planning opportunity is to make sure any large purchases are placed into service by year-end to take advantage of the accelerated depreciation. Owners of real property could also consider having an engineer conduct a cost segregation on any buildings in which most of the cost is being depreciated over longer lives, with the goal of classifying the property into shorter depreciation lives that could then qualify for bonus depreciation. You can use approach whether or not the real property was purchased in the current tax year, and you could take any catch-up depreciation deduction in 2020.
3. Accounting Method Changes
The TCJA increased the gross receipts limitation under the cash basis method of accounting from an average of $5 million of gross receipts over the past three years to $26 million (adjusted annually for inflation). This has allowed more businesses to use the cash basis of accounting. Businesses that generally have accounts receivable, work in process, and prepaid expense that are greater than the sum of accounts payable, accrued expenses and unearned revenue should consider making the change from the accrual basis of accounting to the cash basis. The benefit of the change would be taken in 2020.
Other accounting method changes to consider are the method of accounting for inventory (especially if the value of your inventory has decreased in 2020), revenue recognition, advanced payments, prepaid expenses and UNICAP.
4. Timing of Expense Payments
Accrual basis taxpayers may be able to deduct payments incurred in the current tax year as long as they are paid within 2.5 months or within 8.5 months after year-end, if the expenses qualify under one of the recurring item exceptions. If your business is trying to increase its 2020 loss to carry back an NOL, you will want to examine your expenses related to 2020 and make sure they are paid withing 2.5 months or 8.5 months of year-end, depending on the recurring item exception under which the expenses qualify. Example of expenses that may qualify include bonuses, employee vacation, professional fees, real estate taxes, and state and local income taxes.
Cash basis taxpayers will want to manage cash payment of expenses, and it may even make sense to prepay expenses so the deduction will incur in 2020.
Additionally, the CARES Act allowed employers and self-employed taxpayers to defer their share of Social Security tax for deposits and payments due from March 27, 2020, through December 31, 2020. The deferred taxes must be paid over two years, with half due by December 31, 2021, and the remaining due by December 31, 2022. These payroll tax payments will not be deductible until paid. If cash flow is available, businesses may want to consider paying some or all of these taxes by the end of the year to increase an NOL.
5. Bad Debts and Worthless Investments
This year has been tough for many businesses and industries, which has affected collections from customers. Closely review your accounts receivable at year-end to ensure any uncollectable bad debts have been written off. Also, review any non-business loans and/or intercompany loans to ensure they are collectable. The IRS allows these loans to be written off; however, it needs to occur in the year the loan becomes uncollectable.
Worthless investments are also allowed to be written off in the year the investment became worthless. Review any security holdings or investments in other entities for worthlessness that occurred in 2020.
6. Section 199 – Qualified Business Income Deduction (QBID)
Business owners (individuals, estates and trusts) of partnerships, S Corporations and sole proprietorships can take a maximum deduction of 20% of qualified business income. However, limitations for wage and/or unadjusted basis of fixed assets may apply. Also, if you are an owner of a specified service business, you are ineligible for the deduction if your taxable income exceeds a threshold amount.
Businesses will want to plan to ensure this deduction is maximized for owners. Consider if multiple activities can be aggregated. If aggregation cannot be used, placement of wages and fixed assets becomes important when dealing with multiple businesses.
>> Read “IRS Finalizes Qualified Business Income Deduction Regs & Provides Guidance”
7. 163(j) – Interest Expense Limitation
The CARES Act provided some relief for businesses subject to the interest expense limitations enacted by the TCJA. Interest expense, for tax years beginning in 2019 and 2020 (2020 for partnerships), is limited to 50% of adjusted taxable income instead of the 30% of adjusted taxable income under the originally enacted law. Taxpayers are also able to elect to use the 2019 adjusted taxable income in the 2020 calculation instead of using the 2020 adjusted taxable income. This will benefit businesses whose income has decreased over the past year. Additional relief was provided to partners that were allocated excess business interest expense from a partnership in 2019. These partners can deduct 50% of that amount in 2020 without regard to the 163(j) limitations.
>> Read “CARES Act Offers 14 Areas of Potential Tax Relief for Taxpayers”
8. Meal and Entertainment Expenses
Generally, entertainment expenses are no longer deductible even if you are entertaining customers, and trade or business meal expenses are deductible at 50%. The IRS issued final regulations in 2020 that clarified charges incurred for food and beverages during an entertainment event that are separately stated on the invoice will be subject to the 50% limitation instead of being non-deductible. Businesses should have separate accounts on their general ledgers for entertainment and meals. Review your entertainment invoices to determine if there are separate charges for meals and that those amounts are properly reported in the meals account.
9. Employee Retention Credit
The CARES Act allows for a payroll tax credit for eligible employers equal to 50% of the qualified wages, limited to $10,000 per employee for all calendar quarters, paid by the employer after March 12, 2020, and before January 1, 2021, if:
- You fully or partially suspended operations in any calendar quarter by a federal, state or local government order due to the COVID-19 virus, or
- Your business experienced a substantial decline in gross receipts during any calendar quarter beginning in the first calendar quarter of 2020.
An eligible employer who receives a covered loan under SBA 7(A) is not eligible for this credit. Review your facts and circumstances to determine if you qualify for this credit.
10. Other Considerations, from Accelerating Income to PPP Guidance
It is very possible that accelerating deductions is not the best plan for your business based on 2020 results. Businesses could be in a situation where income is down enough compared to prior years that flow-through entity owners will be able to take advantage of lower income tax brackets, making it preferable to defer deductions into a future tax year. Effective planning in this situation would be to maximize the use of the lower tax brackets by deferring deductions or accelerating income.
Another consideration is the timing of possible forgiveness of Paycheck Protection Program (PPP) loans. While loan forgiveness may be tax-free, the IRS has said expenses paid with the funds — such as wages, rent, utilities and certain interest expense — are non-deductible, which can significantly impact an entity’s tax situation. While there is still hope Congress will pass legislation to reverse its stance on expense deductibility, for now, loan recipients may want to delay the application for forgiveness into 2021, because forgiveness triggers the deductibility issue. However, there are many factors to consider regarding timing of the forgiveness application, so it’s important to be aware of all the issues. Additionally, there are state taxability of PPP funds to consider, which will depend on whether or not your state has adopted the federal CARES Act.
>> Read “2020’s Top 10 Individual Tax Planning Strategies”
This year has been full of challenges and the unknown, and the final results of our presidential and congressional elections could bring more uncertainty. Only time will tell. However, it’s imperative to begin planning now with your tax advisers to take advantage of opportunities currently available — helping you keep more cash in the business.
Contact Jen Tapia at firstname.lastname@example.org or a member of your service team to discuss this topic further.
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Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.