Build & Preserve your Business Value with Tax-smart Planning
Year-end tax planning for businesses looks very different this year for several reasons including disruptions to supply chains, inflation, rising interest rates and declining stock market. How do businesses thrive in uncertain times? By turning toward opportunity, which includes proactive tax planning. Tax planning is essential for businesses looking for ways to optimize cash flow while minimizing their total tax liability over the long term.
When you start planning and projecting what your taxes might look like at the end of the year, you have the ability to make changes and take actions to make your situation a more favorable one.
Several key factors are laid out here for year-end business tax planning in the final weeks of 2022. Tax planning often means determining whether to accelerate or delay income or deductions. There are many other factors to consider, and every business circumstance is unique. Make sure to set up a meeting with an Adams Brown tax advisor to discuss your situation.
Recent Legislative Changes
The Inflation Reduction Act (IRA) was enacted on August 16, 2022. Tax-related provisions in the IRA include:
- A 15% alternative minimum tax (AMT) on the adjusted financial statement income of certain large corporations (also referred to as the “book minimum tax” or “business minimum tax”), effective for tax years beginning after December 31, 2022.
- A 1% excise tax on corporate stock buybacks, which applies to repurchases made by public companies after December 31, 2022.
- Modification of many of the current energy-related tax credits and the introduction of significant new credits, including new monetization options.
- A two-year extension of the section 461(l) excess business loss limitation rules for noncorporate taxpayers, which are now set to expire for tax years beginning after 2028.
Treatment of R&E Expenses
Under the TCJA, research and experimental (R&E) expenditures incurred or paid for tax years beginning after December 31, 2021 will no longer be immediately deductible for tax purposes. Instead, businesses are required to capitalize and amortize R&E expenditures over a period of five or 15 years beginning in 2022. The mandatory capitalization rules also apply to software development costs, including software developed for internal use. The new rules present additional considerations for businesses that invest in R&E.
These strategies can help you engage in proactive planning and help grow your businesses.
Accounting Method Changes
Adopting or changing income tax accounting methods can provide taxpayers with valuable opportunities for timing the recognition of items of taxable income and expense, which determines when cash is needed to pay federal tax liabilities.
In general, accounting methods can either result in the acceleration or deferral of an item or items of taxable income or deductible expense, but they do not alter the total amount of income or expense that is recognized during the lifetime of a business. As interest rates continue to rise and debt becomes more expensive, many businesses want to preserve their cash, and one way to do this is to defer their tax liabilities through their choice of accounting methods.
Companies that want to reduce their 2022 tax liability should consider traditional tax accounting method changes, tax elections and other actions for 2022 to defer recognizing income to a later taxable year and accelerate tax deductions to an earlier taxable year, including the following:
- Changing from recognizing certain advance payments (e.g., upfront payments for goods, services, gift cards, use of intellectual property, sale or license of software) in the year of receipt to recognizing a portion in the following taxable year.
- Changing from the overall accrual to the overall cash method of accounting (i.e., where accounts receivable exceed accounts payable and accrued expenses).
- Changing from capitalizing certain prepaid expenses (e.g., insurance premiums, warranty service contracts, taxes, government permits and licenses, software maintenance) to deducting when paid using the “12-month rule.”
- Deducting eligible accrued compensation liabilities (such as bonuses and severance payments) that are fixed and determinable by the end of the year and paid within 2.5 months of year end.
- Accelerating deductions of liabilities such as warranty costs, rebates, allowances and product returns, state income and franchise taxes, and real and personal property taxes under the “recurring item exception.”
- Purchasing qualifying property and equipment before the end of 2022 to take advantage of the 100% bonus depreciation provisions (before bonus depreciation begins to gradually phase out starting in 2023) and the Section 179 expensing rules.
- Deducting “catch-up” depreciation (including bonus depreciation, if previously missed) of personal property by changing to shorter recovery periods or changing from non-depreciable to depreciable.
- Optimizing inventory valuation methods. For example, adopting, or making changes within, the last-in, first-out (LIFO) method of valuing inventory generally will result in higher cost of goods sold deductions as costs are increasing.
- Changing from amortizing commissions paid to employees to deducting in the year paid or incurred under the simplifying conventions.
- Electing to deduct 70% of success-based fees paid or incurred in 2022 in connection with certain acquisitive transactions under Rev. Proc. 2011-29. Other transaction costs that are not inherently facilitative may also be deductible. Taxpayers that incur transaction costs should consider undertaking a transaction cost study to maximize their tax deductions.
- Electing the de minimis safe harbor to deduct small-dollar expenses for the acquisition or production of property that would otherwise be capitalizable under general rules.
Depending on their facts and circumstances, some businesses may instead want to accelerate taxable income into 2022 if, for example, they believe tax rates will increase soon or they want to optimize use of NOLs. These businesses may want to consider “reverse” planning strategies, such as:
- Implementing a variety of “reverse” tax accounting method changes, such as changing to recognize advance payments in the year of receipt or changing to deduct certain tax liabilities (state income, state franchise, real and personal property taxes, payroll taxes) when paid.
- Selling and leasing back appreciated property before the end of 2022, creating gain that is taxed currently offset by future deductions of lease expense, being careful that the transaction is not recharacterized as a financing transaction.
- Accelerating taxable capital gain into 2022.
- Electing out of the installment sale method for installment sales closing in 2022.
- Delaying payments of liabilities whose deduction is based on when the amount is paid, so that the payment is deductible in 2023 (e.g., paying year-end bonuses after the 2.5-month rule).
Write-off Bad Debts & Worthless Stock
While the economy attempts to recover from the challenges brought on by the pandemic, inflation and rising interest rates, businesses should evaluate whether losses may be claimed on their 2022 returns related to worthless assets such as receivables, property, 80% owned subsidiaries or other investments.
- Business bad debts can be wholly or partially written off for tax purposes. A partial write-off requires a conforming reduction of the debt on the books of the taxpayer; a complete write-off requires demonstration that the debt is wholly uncollectible as of the end of the year.
- Losses related to worthless, damaged or abandoned property can sometimes generate ordinary losses for specific assets.
- Businesses should consider claiming losses for investments in insolvent subsidiaries that are at least 80% owned and for certain investments in insolvent entities taxed as partnerships.
Maximize Interest Expense Deductions
The TCJA significantly expanded Section 163(j) to impose a limitation on business interest expense of many taxpayers, with exceptions for small businesses (those with three-year average annual gross receipts not exceeding $27 million for 2022), electing real property trades or businesses, electing farming businesses and certain utilities.
- The deduction limit is based on 30% of adjusted taxable income. The amount of interest expense that exceeds the limitation is carried over indefinitely.
- Beginning with 2022 taxable years, taxpayers will no longer be permitted to add back deductions for depreciation, amortization and depletion in arriving at adjusted taxable income (the principal component of the limitation).
Maximize Tax Benefits of NOLs
Net operating losses (NOLs) are valuable assets that can reduce taxes owed during profitable years, thus generating a positive cash flow impact for taxpayers. Businesses should make sure they maximize the tax benefits of their NOLs.
- For tax years beginning after 2020, NOL carryovers from tax years beginning after 2017 are limited to 80% of the excess of the corporation’s taxable income over the corporation’s NOL carryovers from tax years beginning before 2018 (which are not subject to this 80% limitation, but may be carried forward only 20 years). If the corporation does not have pre-2018 NOL carryovers, but does have post-2017 NOLs, the corporation’s NOL deduction can only negate up to 80% of the 2022 taxable income with the remaining subject to the 21% federal corporate income tax rate. Corporations should monitor their taxable income and submit appropriate quarterly estimated tax payments to avoid underpayment penalties.
- Corporations should monitor their equity movements to avoid a Section 382 ownership change that could limit annual NOL deductions.
- Losses from pass-throughs entities must meet certain requirements to be deductible at the partner or S corporation owner level.
Defer Tax on Capital Gains
Tax planning for capital gains should consider not only current and future tax rates, but also the potential deferral period, short and long-term cash needs, possible alternative uses of funds and other factors. Noncorporate shareholders are eligible for exclusion of gain on dispositions of Qualified Small Business Stock. For other sales, businesses should consider potential long-term deferral strategies, including:
- Reinvesting capital gains in Qualified Opportunity Zones.
- Reinvesting proceeds from sales of real property in other “like-kind” real property.
- Selling shares of a privately held company to an Employee Stock Ownership Plan.
Businesses engaging in reverse planning strategies may instead want to move capital gain income into 2022 by accelerating transactions (if feasible) or, for installment sales, electing out of the installment method.
Claim Available Tax Credits
Tax credits are extremely valuable breaks for taxpayers. Credits lead to a greater reduction in tax than deductions because they are directly applied to your tax bill in a dollar-for-dollar manner.
The U.S. offers a variety of tax credits and other incentives to encourage employment and investment, often in targeted industries or areas such as innovation and technology, renewable energy and low-income or distressed communities. Many states and localities also offer tax incentives. Businesses should make sure they are claiming all available tax credits.
- The Employee Retention Credit (ERC) is a refundable payroll tax credit for qualifying employers that were significantly impacted by COVID-19 in 2020 or 2021. For most employers, the compensation eligible for the credit had to be paid prior to October 1, 2021. However, the deadline for claiming the credit does not expire until the statute of limitations closes on Form 941. Therefore, employers generally have three years to claim the ERC for eligible quarters during 2020 and 2021 by filing an amended Form 941-X for the relevant quarter. Employers that received a Paycheck Protection Program (PPP) loan can claim the ERC, but the same wages cannot be used for both programs.
- Businesses that incur expenses related to qualified research and development (R&D) activities are eligible for the federal R&D credit.
- Small business start-ups are permitted to use up to $250,000 of their qualified R&D credits to offset the 6.2% employer portion of social security payroll tax. The IRA doubles this payroll tax offset limit to $500,000, providing an additional $250,000 that can be used to offset the 1.45% employer portion of Medicare payroll tax.
- Taxpayers that reinvest capital gains in Qualified Opportunity Zones may be able to temporarily defer the federal tax due on the capital gains. The investment must be made within a certain period after the disposition giving rise to the gain. Post-reinvestment appreciation is exempt from tax if the investment is held for at least 10 years but sold by December 31, 2047.
- The New Markets Tax Credit Program provides federally funded tax credits for approved investments in low-income communities that are made through certified “Community Development Entities.”
- Other incentives for employers include the Work Opportunity Tax Credit, the Federal Empowerment Zone Credit, the Indian Employment Credit and credits for paid family and medical leave (FMLA).
- There are several federal tax benefits available for investments to promote energy efficiency and sustainability initiatives. The IRA extends and enhances certain green energy credits as well as introduces a variety of new incentives. Projects that have historically been eligible for tax credits and that have been placed in service in 2022 may be eligible for credits at higher amounts. Additionally, projects that begin construction under the tax rules prior to 60 days after the Department of the Treasury releases guidance on these requirements are eligible for the credits at the higher rates. Certain other projects may be eligible for tax credits beginning in 2023. The IRA also introduces prevailing wage and apprenticeship requirements in the determination of certain credit amounts, as well as direct pay or transferability tax credit monetization options beginning with projects placed in service in 2023.
- Under the CHIPS Act, taxpayers that invest in semiconductor manufacturing or the manufacture of certain equipment required in the semiconductor manufacturing process may be entitled to a 25% advanced manufacturing investment credit beginning in 2023. The credit generally applies to qualified property placed in service after December 31, 2022 and for which construction begins before January 1, 2027. Where construction began prior to January 1, 2023, the credit applies only to the extent of the basis attributable to construction occurring after August 9, 2022.
- Review tax credits available in the state and local jurisdictions that you do business in that may apply to your business operations.
Considerations for Employers
Employers should consider the following issues as they close out 2022 and enter 2023:
- Employers have until the extended due date of their 2022 federal income tax return to retroactively establish a qualified retirement plan and to fund the new or an existing plan for 2022. However, employers cannot retroactively eliminate existing retirement plans (such as simplified employee pensions (SEPs) or SIMPLE plans) to make room for a retroactively adopted plan (such as an employee stock ownership plan (ESOP) or cash balance plan).
- Contributions made to a qualified retirement plan by the extended due date of the 2022 federal income tax return may be deductible for 2022; contributions made after this date are deductible for 2023.
- Employers can reimburse employees tax-free for up to $5,250 per year in student loan debt, through Dec. 31, 2025, if the employer sets up a broad-based IRC Section 127 educational assistance plan.
- Employers seeking to attract and retain employees may offer tuition assistance to future employees by providing forgivable loan agreements. When the loans are forgiven (typically after the student has become an employee for a specified period of time), the amount forgiven is taxable wages, subject to income and employment taxes (including the employer share of employment taxes).
- The CARES Act permitted employers to defer payment of the employer portion of Social Security (6.2%) payroll tax liabilities that would have been due from March 27 through December 31, 2020. Employers are reminded that the remaining balance of the deferred amount must be paid by December 31, 2022. Notice CP256-V is not required to make the required payment.
- Employers should ensure that common fringe benefits are properly included in employees’ and, if applicable, 2% S corporation shareholders’ taxable wages. Partners and LLC members (including owners of capital interests and profits interests) should not be issued W-2s.
- Generally, for calendar year accrual basis taxpayers, accrued bonuses must be fixed and determinable by year end and paid within 2.5 months of year end (by March 15, 2023) for the bonus to be deductible in 2022. However, the bonus compensation must be paid before the end of 2022 if it is paid by a Personal Service Corporation to an employee-owner, by an S corporation to any employee-shareholder, or by a C corporation to a direct or indirect majority owner.
- Businesses should assess the tax impacts of their mobile workforce. Potential impacts include the establishment of a corporate tax presence in the state or foreign country where the employee works; dual tax residency for the employee; additional taxable compensation for remote workers’ travel to a work location that is determined to be personal commuting expense; and payroll tax, benefits, and transfer pricing issues.
Begin Planning for the Future
Businesses should consider actions that will put them on the best path forward for 2022 and beyond. Business can begin now to:
- Reevaluate choice of entity decisions while considering alternative legal entity structures to minimize total tax liability and enterprise risk.
- Review available tax credits and incentives for relevancy to leverage within applicable business lines.
- Evaluate global value chain and cross border transactions to optimize transfer pricing and minimize global tax liabilities.
- Consider legal entity rationalization, which can reduce administrative costs and provide other benefits and efficiencies.
- Review your succession and exit planning. Are they structured correctly to provide tax benefits for both owners and the company?
- Perform a cost segregation study with respect to investments in buildings or renovation of real property to accelerate taxable deductions, claim qualifying bonus depreciation and identify other discretionary incentives to reduce or defer various taxes.
- Evaluate possible co-sourcing or outsourcing arrangements to assist with priority projects as part of an overall tax function transformation.
How can we help? Every year is unique, and your business is unique. If you have questions about the information outlined above or need assistance with another tax or accounting issue, contact an Adams Brown advisor.