As we continue to navigate a challenging environment, one certainty remains: year-end tax planning is upon us. Now is the time to look back on your business performance, successes and challenges to determine how you can use those to best optimize your tax position for 2021 — while keeping a close eye on new tax legislation potentially to come.
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.
In response to the COVID-19 pandemic, Congress passed the CARES Act to delay the impact of the TCJA provisions. As a result, 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- Repealed the 80% limitation of taxable income on the use of NOLs for losses arising in tax years beginning after December 31, 2017 and beginning before January 1, 2021. As a reminder, NOLs generated after December 31, 2017 are subject to the 80% income limitation going forward.
- Delayed the excess business loss limitation to tax years beginning after December 31, 2020.
Absent any legislative changes, the excess business loss rules and NOL limitations are back for the 2021 tax season. If you are a pass-through entity owner, you will need to plan carefully to fully understand your tax situation up front, so you are not caught by a surprise tax liability late in the process.
2. Accelerating Depreciation
For assets placed in service before year-end, businesses can potentially use 100% bonus or Section 179 expensing. Eligible assets include machinery and equipment, furniture and fixtures, software and qualified improvement property. The maximum Section 179 deduction for 2021 is $1.05 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 $2.62 million. It is important to note that absent Congressional action, the 100% bonus depreciation allowance begins to phase out in the 2023 tax year by 20% per year.
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 retroactively 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.
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 study 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 this approach whether or not the real property was purchased in the current tax year, and you could take any catch-up depreciation deduction in 2021.
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, prepaid expense 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 2021.
Also consider accounting method changes such as the method of accounting for inventory, 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.
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 2021.
5. Bad Debts and Worthless Investments
The past several years have been tough for many businesses and industries, affecting 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 as either a short-term capital loss or ordinary business expense, depending on the circumstance; 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 2021.
6. Section 199 – Qualified Business Income Deduction (QBID)
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.
7. Meal and Entertainment Expenses
Generally, entertainment expenses are no longer deductible even if you are entertaining customers, and 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.
In response to the COVID-19 pandemic and the distressed state of the restaurant industry, Congress passed the Consolidated Appropriations Act in 2021. This most recent act allows for the 100% deduction for business meal expenses incurred after December 31, 2020, through December 31, 2022, if the meals are provided by a restaurant. If meals are not provided by a restaurant, the deduction remains limited to 50%. Note that entertainment expenses are still not deductible, as stated in the TCJA.
8. Employee Retention Credit
The employee retention credit (ERC) was first introduced in the CARES Act and allowed eligible employers a payroll tax credit for wages paid to eligible employees during specified periods of time if either of the following tests were met:
- You fully or partially suspended operations in any calendar quarter due to a federal, state or local government order due to COVID-19; or
- Your business experienced a substantial decline in gross receipts during any calendar quarter beginning in the first calendar quarter of 2020.
The Consolidated Appropriations Act modified and expanded the ERC, with key changes applying retroactively to 2020, including:
- Making PPP loan recipients eligible for the credit in 2020 and 2021;
- Expanding the list of eligible businesses in 2021 to include colleges, universities, hospitals and medical care providers;
- Increasing the credit rate from 50% to 70% of qualified wages (maximum credit $7,000 per employee per quarter for 2021);
- Increasing the number of full-time employees from 100 to 500 for eligibility in 2021;
- Expanding the timeframe to claim the credit to June 30, 2021 — note, the American Rescue Plan Act, 2021 extended this timeframe to December 31, 2021; however, the Infrastructure Investment and Jobs Act created an early sunset of the Employee Retention Credit (ERC) as of September 30, 2021. Given that the ERC is no longer available for Q4 2021, many taxpayers may have to reset their planning for the end of 2021.
Take note: If your business has not taken advantage of the ERC at any point from the credit’s inception in March 2020 through Q3 2021, there is an opportunity to amend prior returns and still claim the credit.
9. Accelerate Deductions and Defer Income, or Vice Versa?
While accelerating deductions often makes sense for a company at year-end, it is very possible that doing so this year is not the best plan based on 2021 results. Pass-through entity owners may be in a situation where income is down enough compared to prior years 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 and/or accelerating income.
10. Potential Tax Changes on the Horizon
Watch for Congress to pass additional tax law changes before year-end. Such legislation could have varying degrees of impact, depending on your specific situation. Begin planning now with your tax advisers to take advantage of any opportunities currently available that make sense for your business — and be sure to discuss any pending legislation and its potential effects.
Contact Jeff McMichael at firstname.lastname@example.org or a member of your service team to discuss this topic further.
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.