It's that time of year again where we should consider meeting to discuss any year end strategies that might reduce your 2023 taxes. The following are some of the tax breaks from which you may benefit, as well as the strategies we can employ to help minimize your taxable income and resulting federal tax liability for 2023.
I have compiled a list of actions based on current tax rules that may help you save tax dollars if you act before year-end. Not all of them will apply to you, but you may benefit from many of them. We can narrow down specific actions when we meet to tailor a particular plan for you. In the meantime, please review the following list and contact me at your earliest convenience so that I can advise you on which tax-saving moves might be beneficial:
Qualified Business Income Deduction
- Taxpayers other than corporations may be entitled to a deduction of up to 20% of their qualified business income. For 2023, if taxable income exceeds $364,200 for a married couple filing jointly, (about half that for others), the deduction may be limited based on whether the taxpayer is engaged in a service-type trade or business (such as law, accounting, health, or consulting), the amount of W-2 wages paid by the business, and/or the unadjusted basis of qualified property (such as machinery and equipment) held by the business. The limitations are phased in; for example, the phase-in applies to joint filers with taxable income up to $100,000 above the threshold, and to other filers with taxable income up to $50,000 above their threshold.
Deferring Income & Accelerating Deductions
- Taxpayers may be able to salvage at least some of this deduction, by deferring income or accelerating deductions to keep income under the dollar thresholds (or be subject to a smaller deduction phaseout) for 2023. Depending on their business model, taxpayers also may be able increase the deduction by increasing W-2 wages before year-end. The rules are quite complex, so don't make a move in this area without consulting us.
Cash Basis and Accrual Basis
- More small businesses are able to use the cash (as opposed to accrual) method of accounting than were allowed to do so in earlier years. To qualify as a small business a taxpayer must, among other things, satisfy a gross receipts test, which is satisfied for 2023 if, during a three-year testing period, average annual gross receipts don't exceed $29 million (next year this dollar amount is estimated to increase to $30 million). Not that many years ago it was $1 million. Cash method taxpayers may find it a lot easier to shift income, for example by holding off billings till next year or by accelerating expenses, for example, paying bills early or by making certain prepayments.
Section 179 Deduction
- Businesses should consider making expenditures that qualify for the liberalized business property expensing option. For tax years beginning in 2023, the expensing limit is $1,160,000, and the investment ceiling limit is $2,890,000. Expensing is generally available for most depreciable property (other than buildings) and off-the-shelf computer software. It is also available for interior improvements to a building (but not for its enlargement), elevators or escalators, or the internal structural framework), for roofs, and for HVAC, fire protection, alarm, and security systems.
- Generous dollar ceilings mean that many small and medium sized businesses that make timely purchases will be able to currently deduct most if not all their outlays for machinery and equipment. What's more, the expensing deduction is not prorated for the time that the asset is in service during the year. So expensing eligible items acquired and placed in service in the last days of 2023, rather than at the beginning of 2024, can result in a full expensing deduction for 2023.
Bonus Depreciation (80% in 2023)
- Businesses also can claim bonus first year depreciation deduction for machinery and equipment bought used (with some exceptions) or new if purchased and placed in service this year, and for qualified improvement property, described above as related to the expensing deduction. The write-off is permitted without any proration based on the length of time that an asset is in service during the tax year. As a result, the bonus first-year write-off is available even if qualifying assets are in service for only a few days in 2023.
- Qualifying property includes tangible property depreciated under MACRS with a recovery period of 20 years or less, most computer software, qualified film, television, and live theatrical productions, and water utility property.
- For 2023, a first-year bonus depreciation deduction falls to 80% of the adjusted basis of depreciable property is allowed for qualified property acquired and placed in service during the year.
- Remember that under current law the bonus depreciation deduction falls to:
- 60% for property placed in service in 2024,
- 40% for property placed in service in 2025,
- 20% for property placed in service in 2026, and
- 0% for property placed in service in 2027.
De Minimis Safe Harbor
- Businesses may be able to take advantage of the de minimis safe harbor election (also known as the book- tax conformity election) to expense the costs of lower-cost assets and materials and supplies, assuming the costs aren’t required to be capitalized under the UNICAP rules. To qualify for the election, the cost of a unit of property can't exceed $5,000 if the taxpayer has an applicable financial statement (AFS, e.g., a certified audited financial statement along with an independent CPA's report). If there's no AFS, the cost of a unit of property can't exceed $2,500. Where the UNICAP rules aren't an issue, and where potentially increasing tax rates for 2024 aren’t a concern, consider purchasing qualifying items before the end of 2023.
- Year-end bonuses can be timed for maximum tax effect by both cash- and accrual-basis employers. Cash- basis employers deduct bonuses in the year paid, so they can time the payment for maximum tax effect. Accrual-basis employers deduct bonuses in the accrual year when all events related to them are established with reasonable certainty. However, the bonus must be paid within 21⁄2 months after the end of the employer’s tax year for the deduction to be allowed in the earlier accrual year. Accrual employers looking to defer deductions to a higher-taxed future year should consider changing their bonus plans before year-end to set the payment date later than the 2.5-month window or change the bonus plan’s terms to make the bonus amount not determinable at year end.
Rental Real Estate
- If you have any rental real estate activities, it's important to determine if the activity will be considered a passive activity by the IRS. Generally, losses from passive activities 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 you actively participates in the rental real estate activities. This deduction is subject to a phaseout for individuals with modified adjusted gross income above $100,000 (or $50,000 if married filing separately). Additionally, you may be eligible for a qualified business income deduction if certain criteria are met, such as the rental activity qualifying as a Section 162 trade or business.
Substantiation of Vehicle-Related Deductions
- In audits, the IRS tends to focus on deductions taken for vehicle expenses. If not properly substantiated, such deductions are disallowed. Thus, if vehicles are used in any part of your business or business-related activities, your tax records with respect to each vehicle should include the following:
- (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.
- The IRS will consider the following as adequate substantiation for 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 note that records are considered adequate to substantiate the element of a vehicle expense only if they are prepared or maintained in such a manner that each recording of an element of the expense is made at or near the time the expense is incurred.
Disposing of a Passive Activity
- Sometimes the disposition of a passive activity can be timed to make best use of its freed-up suspended losses. Where reduction of 2023 income is desired, consider disposing of a passive activity before year- end to take the suspended losses against 2023 income. If possible 2024 top rate increases are a concern, holding off on disposing of the activity until 2024 might save more in future taxes.
Pass-Thru Entity Considerations
- If you are operating a business through a pass-thru entity such as a partnership or S corporation, your basis in the entity must be high enough to allow for any loss deduction, if you have one for the year. In such a situation, we should consider the options available for increasing your basis in such entity.
- If you are an S corporation shareholder it's important to ensure that you and other shareholders involved in running the business are paid an amount that is commensurate with the work being done. 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 to tax deficiencies, interest, and penalties. The key to establishing reasonable compensation is showing that the compensation paid for the type of work an owner-employee does for the S corporation is similar to what other entities would pay for similar work. An S corporation needs to adequately document the factors that support the salary an S corporation owner is being paid.
- Also, because there are stringent requirements for who may be an S corporation shareholder, if the number of shareholders have changed or increased during the year, we should review the residency or citizenship status of the S corporation's shareholders and S corporation stock beneficiaries (including contingent and residuary beneficiaries).
Consider Pass-Through Entity Tax at the Entity Level
- The pass-through state income tax deduction allows business owners to deduct state income tax on their business income without limit. This deduction allows a pass-through entity to elect to pay the state income tax due on the business income that would otherwise pass through and get paid on the owner’s personal tax returns. The federal itemized deduction cap of $10,000 ($5,000 if MFS) for state and local taxes doesn’t apply when a pass-through entity pays state and local tax on its earnings at the entity level. As of 2023, 36 states and one locality have passed legislation allowing the pass-through tax deduction work- around, and some states have even passed retroactive legislation.
Net operating losses
- A corporation (other than a large corporation) that anticipates a small net operating loss (NOL) for 2023 (and substantial net income in 2024) may find it worthwhile to accelerate just enough of its 2024 income (or to defer just enough of its 2023 deductions) to create a small amount of net income for 2023. This allows the corporation to base its 2024 estimated tax installments on the relatively small amount of income shown on its 2023 return, rather than having to pay estimated taxes based on 100% of its much larger 2024 taxable income.
- NOLs from before 2018 could be carried back two years and carried forward only 20 years.
- 2018, 2019, and 2020 NOLs may be carried back five years and carried forward indefinitely; and
- Post-2020 NOLs may not be carried back (except for farm losses, which may be carried back two years), but may be carried forward indefinitely.
- Starting with the 2021 tax year, the NOL deduction is subject to an 80% of taxable income limitation (not counting the NOL or the qualified business income deduction)
- What this boils down to is that for earlier tax years, NOL carryovers and carrybacks could fully offset taxable income, but unused losses couldn’t be carried forward indefinitely. Starting with the 2021 tax year, deductions for NOLs generated after 2017 are limited by the 80% standard, but unused losses may be carried forward indefinitely.
Making the most of NOLs
- A taxpayer that may have difficulty taking advantage of the full amount of an NOL carryforward this year should consider shifting income into and deductions away from this year. By doing so, the taxpayer can avoid the intervening year modifications that would apply if the NOL is not fully absorbed in 2023. This may also avoid potentially higher tax rates next year on the accelerated income and increase the tax value of deferred deductions.
When to avoid an NOL
- A corporation (other than a large corporation) that anticipates a small NOL this year and substantial net income next year may find it worthwhile to accelerate just enough of its 2024 income (or to defer just enough of its 2023 deductions) to create a small amount of net income for this year. This will permit the corporation to base next year’s estimated tax payments on the lower income shown on its 2023 return, rather than having to pay estimated taxes based on its higher 2024 taxable income.
Please call me at your convenience so we can set up an appointment to discuss your 2023 tax return and determine if any estimated tax payment may be due before year end.
Ike Braden, CPA PLLC
NOTE: Ike Braden is a licensed CPA in both Arizona and Montana with over 15 years of public accounting experience. He provides tax services for Individuals, S Corporations and Partnerships, Locums along with business valuation, litigation support and forensic accounting.
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