2019 Business Year End Tax Planning Options
2019 Year End Tax Planning for Businesses
As the year draws to a close, it’s time for us to discuss whether there are any last- minute actions we can take to reduce your business-related tax liability. The actions necessary will depend on the year-end estimate of your business taxable income.
Section 179 Expensing and Bonus Depreciation Deductions
Generally, the two biggest deductions that can reduce a client's taxable income are the Code Sec. 179 expense deduction and the 100 percent bonus depreciation deduction. And, as a result of TCJA, bonus depreciation can now be taken on used property as well as new property. It's important to remember that bonus depreciation rules apply unless a taxpayer specifically elects out of those rules. A business may want to elect out of bonus depreciation if the business expects a tax loss for the year and the bonus depreciation would just increase that loss. By not taking bonus depreciation in the current year, a business can defer depreciation deductions into future years where it expects to have taxable income that can be offset by the depreciation deductions. Of course, where the business is operated through a flow-through entity, additional considerations must be given to the tax situation of the owner of the flow-through entity and whether the owner can benefit from the flow-through of the bonus depreciation deductions.
Since the Code Sec. 179 expense deduction can't reduce taxable income, this is a better option for clients with taxable income. This year, the maximum Code Sec. 179 expense deduction is $1,020,000. This amount is reduced dollar for dollar (but not below zero) by the amount by which the cost of the Section 179 property placed in service during the year exceeds $2,550,000.
If a client is looking for business-related property to purchase in order to reap the maximum benefit of the Code Sec. 179 expense deduction and/or the bonus depreciation deduction, a vehicle purchase could result in a substantial tax savings. By purchasing a sport utility vehicle weighing more than 6,000 pounds, a client can obtain a bigger deduction than if a smaller vehicle is purchased. Because vehicles that weigh 6,000 pounds or less are considered listed property, deductions are limited to $18,100 for cars, trucks and vans acquired and placed in service in 2019. However, if the vehicle weighs more than 6,000 pounds, up to $25,500 of the cost of the vehicle can be immediately expensed.
In October, the IRS issued final and proposed bonus depreciation regulations which clarify the implementation of the bonus depreciations rules. Under the proposed regulations, upon which taxpayers may rely immediately, a de minimis rule provides that a taxpayer is not deemed to have had a prior depreciable interest in a property - and thus that property is eligible for bonus depreciation in the taxpayer's hands - if the taxpayer previously disposed of that property within 90 days of the date on which that property was placed in service. In addition, the proposed rules provide for an election that taxpayers may make to treat certain components of self-constructed property as eligible for bonus depreciation.
Qualified Improvement Property Glitch Remains Unfixed
While practitioners had hoped that Congress would enact technical corrections legislation this year to fix certain glitches in the Tax Cuts and Jobs Act of 2017 (TCJA), that did not happen. Due to a drafting error, the 15-year recovery periods that were available for qualified leasehold improvements, qualified restaurant property, and qualified retail improvement property placed in service before 2018, no longer exist for such property placed in service after 2017. Instead, the depreciation period is 39 years. As a result, until legislation is enacted fixing this mistake, such property does not meet the bonus depreciation criteria specified in Code Sec. 168(k)(2)(A) (i.e., the recovery period is not 20 years or less) and it is thus not eligible for bonus depreciation.
Section 199A Qualified Business Income Deduction
The Code Sec. 199A qualified business income (QBI) deduction is another potentially big deduction for clients with a qualified trade or business. The deduction is available to sole proprietors, partners in a partnership, members of an LLC taxed as a partnership, S corporation shareholders, or trusts and estates. Whether a client is eligible for the deduction depends on whether the client has a qualified trade or business and the client's taxable income.
Qualified trades or businesses include trades or businesses for which the taxpayer is allowed a deduction for ordinary and necessary business expenses under Code Sec. 162. In general, to be engaged in a trade or business under Code Sec. 162, the taxpayer must conduct the activity with continuity and regularity and the primary purpose for engaging in the activity must be for income or profit. If a taxpayer owns an interest in a pass-through entity, the trade or business determination is made at that entity's level. Material participation under Code Sec. 469 isn't required for the QBI deduction. Qualified trades or businesses do not include activities conducted by C corporations and the performance of services as an employee.
Additionally, specified service trades or businesses (SSTB) aren't qualified trades or businesses if the taxpayer has taxable income above a certain threshold (before the QBI deduction). An SSTB is defined as any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, including investing and investment management, trading, or dealing in securities, partnership interests, or commodities, and any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. Engineering and architecture services are specifically excluded from the definition of a specified service trade or business. The thresholds above which an SSTB will not fully qualify for the QBI deduction are $160,725 if married filing separately; $321,400 if married filing jointly; $160,700 for all others. Above those thresholds a partial deduction may be available before the deduction is fully phased out.
The first step in determining the QBI deduction is to determine the QBI component, which is generally 20 percent of the taxpayer's QBI from the taxpayer's trades or businesses. Where the taxpayer's taxable income (before the QBI deduction) exceeds the applicable thresholds, a reduction to the QBI deduction is phased in until the deduction is entirely eliminated. In this case, the QBI for each of trade or business may be partially or fully reduced to the greater of 50 percent of W-2 wages paid by the qualified trade or business, or 25 percent of W-2 wages plus 2.5 percent of the unadjusted basis immediately after acquisition (UBIA) of qualified property from the qualified trade or business. The partial or full reduction to QBI is determined by the taxpayer's taxable income. If taxable income (before the QBI deduction) is: (1) at or below the threshold, there is no need to reduce QBI; (2) above the threshold but below the phase-in range (more than $160,725 but below $210,725 if married filing separately; $321,400 and $421,400 if married filing jointly; $160,700 and $210,700 for all others), the reduction is phased in; or (3) above the threshold and phase-in range, the full reduction applies.
If the taxpayer is a patron of an agricultural or horticultural cooperative, the taxpayer must reduce cooperative QBI by the lesser of: 9 percent of the QBI allocable to qualified payments, or 50 percent of W-2 wages from the trade or business allocable to the qualified payments.
With respect to S corporations and partnerships, QBI does not include any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer, or any guaranteed payment (or other payment) to a partner in a partnership for services rendered with respect to the trade or business. Qualified items do not include specified investment-related income, deductions, or losses, such as capital gains and losses, dividends and dividend equivalents, interest income other than that which is properly allocable to a trade or business, and similar items.
If the net amount of QBI from all qualified trades or businesses during the tax year is a loss, it is carried forward as a loss from a qualified trade or business to the next tax year (and reduces the QBI for that year).
In the case of a partnership or S corporation, the business income deduction applies at the partner or shareholder level. Each partner in a partnership takes into account the partner's allocable share of each qualified item of income, gain, deduction, and loss, and is treated as having W-2 wages for the tax year equal to the partner's allocable share of W-2 wages of the partnership. Similarly, each shareholder in an S corporation takes into account the shareholder's pro rata share of each qualified item and W-2 wages.
Compliance Tip: While there was no tax form to file last year with respect to the Code Sec. 199A deduction, there will be forms for 2019 tax returns. In October, the IRS released draft forms (Form 8995, Qualified business Income Deduction Simplified Computation, and Draft Form 8995-A, Qualified Business Income Deduction), as well as draft instructions for the forms.
Rental Real Estate and the QBI Deduction
If a client operates a rental real estate enterprise, whether individually or through a flow-through entity, the QBI deduction may apply to that client if certain criteria are met. For example, the rental activity must qualify as a Code Sec. 162 trade or business. While there are no strict guidelines as to what constitutes such a trade or business, the IRS has issued some safe harbor rules under which a taxpayer's business will qualify for the QBI deduction, assuming the required election is made and other applicable rules are met. For one, a client's rental activity must be considerable, regular, and continuous in scope. In determining whether a rental real estate activity meets this criteria, relevant factors include, but are not limited to, the following:
(1) the type of rented property (commercial real property versus residential property);
(2) the number of properties rented;
(3) the taxpayer's or taxpayer's agent's day-to-day involvement;
(4) the types and significance of any ancillary services provided under the lease; and
(5) the terms of the lease (for example, a net lease versus a traditional lease and a short-term lease versus a long-term lease).
An interest in mixed-use property may be treated as a single rental real estate enterprise or may be bifurcated into separate residential and commercial interests. Mixed-use property is defined as a single building that combines residential and commercial units. An interest in mixed-use property, if treated as a single rental real estate enterprise, may not be treated as part of the same enterprise as other residential, commercial, or mixed-use property.
Under the safe harbor rules, the following conditions must be met for a rental real estate enterprise to qualify for the QBI deduction:
(1) separate books and records are maintained to reflect the income and expenses for each rental real estate enterprise;
(2) for rental real estate enterprises that have been in existence less than four years, 250 or more hours of rental services are performed per year with respect to the rental real estate enterprise (with slightly less stringent requirements for rental real estate enterprises that have been in existence for at least four years);
(3) contemporaneous records have been maintained, including time reports, logs, or similar documents, regarding the following: (i) hours of all services performed; (ii) description of all services performed; (iii) dates on which such services were performed; and (iv) who performed the services; and
(4) certain compliance requirements are met.
Thus, to qualify for this deduction, it's important to determine if the safe harbor conditions are met and, if not, whether such conditions can be met by year end. Alternatively, even if the safe harbor requirements are not met, certain actions may be taken to ensure that a real estate enterprise falls within the "trade or business" guidelines for taking the QBI deduction.
Compliance Tip: At the end of October, the IRS issued Rev. Proc. 2019-38 which summarizes the rules necessary for meeting the rental real estate safe harbor and qualifying for the deduction under Code Sec. 199A. A rental real estate enterprise making the safe harbor election must file an election statement with its return. See ¶330,235.
Finally, whether a rental real estate enterprise is considered a passive activity with respect to a taxpayer is important in determining whether losses from the activity are deductible. Generally, passive activity losses are only deductible against passive activity income. However, a deduction of up to $25,000 ($12,500 if married filing separately) may be allowed against nonpassive income to the extent an individual actively participates in the rental real estate activities. However, the deduction is subject to a phaseout for individuals with modified adjusted gross income above $100,000 (or $50,000 if married filing separately).
Vehicle-Related Deductions and Substantiation Requirements
In an audit involving a business, the IRS is quick to focus on vehicle expense deductions and whether such deductions are adequately substantiated. Thus, practitioners should ensure that the following are part of any client's business tax records with respect to each vehicle used in a business:
(1) the amount of each separate expense with respect to the vehicle (e.g., the cost of purchase or lease, the cost of repairs and maintenance, etc.);
(2) the amount of mileage for each business or investment use and the total miles for the tax period;
(3) the date of the expenditure; and
(4) the business purpose for the expenditure.
For purposes of the above, the following are considered adequate for substantiating such expenses:
(1) records such as a notebook, diary, log, statement of expense, or trip sheets; and
(2) documentary evidence such as receipts, canceled checks, bills, or similar evidence.
It's important to impress upon clients that records are only considered adequate to substantiate vehicle expenses if they are prepared contemporaneously at the time the expense is incurred.
Fringe Benefit/Retirement Programs
There are substantial tax and other benefits available to a business that offers fringe benefits and retirement plans to employees. For example, an employer has a better chance of attracting and retaining talented workers by offering such benefits, which in turn reduces the costs of searching for and training new employees. Employers can deduct contributions made on behalf of their employees to qualified retirement plans and, under Code Sec. 45E, a tax credit of up to $500 is available for setting up a qualified plan.
In addition, business owners can take advantage of the retirement plan themselves, as can their spouse. Where a spouse is not currently on the payroll of a business, consideration should be given to adding him or her as an employee and paying a salary up to the maximum amount that can be deferred into a retirement plan. So, for example, if a business owner's spouse is 50 years old or over and receives a salary of $25,000, all of it could go into a 401(k), leaving the spouse with a retirement account but no taxable income.
To help employees with medical expenses, a business may want to consider setting up a high deductible health plan paired with a health savings account (HSA). The benefits to a business include savings on health insurance premiums that would otherwise be paid to traditional health insurance companies and having employee wage contributions to the plan not being counted as wages and thus neither the employer nor the employee is subject to FICA taxes on the payroll contributions. As for employees, they can reap a tax deduction for funds contributed to the HSA, they can invest the funds for future medical costs because there is no use-it-or-lose-it limit like there is for flexible spending accounts and thus the funds can grow tax free and be used in retirement.
A business might also consider establishing a flexible spending arrangement (FSA) which allows employees to be reimbursed for medical expenses and is usually funded through voluntary salary reduction agreements with the employer. The employer has the option of making or not making contributions to the FSA. Some of the benefits of an FSA include the fact that contributions made by the business can be excluded from the employee's gross income, there are no employment or federal income taxes deducted from the contributions, reimbursements to the employee are tax free if used for qualified medical expenses, and an FSA can be used to pay qualified medical expenses even if the employer or employee haven't yet placed the funds in the account.
Increasing Basis in Pass-thru Entities
If a client is a partner in a partnership or a shareholder in an S corporation, and the entity is expecting to pass through a loss for the year, it's important to determine if the partner or shareholder has enough basis to absorb the loss. If not, then actions should be taken before the end of the entity's tax year to increase basis. Generally, this is done by contributing or loaning money to the entity.
S Corporation Shareholder Salaries
For any business operating as an S corporation, it's important to ensure that shareholders involved in running the business are paid an amount that is commensurate with their workload. The IRS scrutinizes S corporations which distribute profits instead of paying compensation subject to employment taxes. Failing to pay arm's length salaries can lead not only to tax deficiencies, but penalties and interest on those deficiencies as well. The key to establishing reasonable compensation is being able to show that the compensation paid for the type of work an owner-employee does for the S corporation is similar to what other corporations would pay for similar work. Practitioners should document in their workpapers the factors that support the salary being paid to a shareholder.
Annual De Minimis Safe Harbor Election
Depending on a business's tax situation, it may be advantageous for a client to elect the annual de minimis safe harbor election in Reg. Sec. 1.263(a)-1(f) for amounts paid to acquire or produce tangible property that are not required to be capitalized under the uniform capitalization rules. By making this election, a business can deduct amounts that might otherwise have to be capitalized. The maximum deductible amount is $2,500 per invoice or item (or up to $5,000 if the business has an applicable financial statement).
(Clarification: A companion piece to this article, "2019 Year-End Tax Planning for Individuals", appearing in the October 23, 2019 issue of Parker's Federal Tax Bulletin, referred to a $10,000 limitation on the exclusion from income for distributions from a Code Sec. 529 qualified tuition program. The $10,000 limitation on the exclusion applies only to distributions used for elementary and/or secondary school expenses. The limitation does not apply to other qualified higher education expenses.)