The 2022 tax year has ended and tax professionals everywhere are encouraging their small business clients to close their books and start thinking about their tax returns. In a perfect world these clients have worked with their tax and accounting professionals throughout the year to optimize their small business taxes. Of course, we don’t live in a perfect world and clients are often surprised at how much their small business made (and how much tax they owe) come tax time. The good news is that there are a few tax optimization strategies that are available to small business owners after the tax year ends.
David Levi, CPA and Managing Director at CBIZ MHM, says that funding your (or your company’s) retirement plan is one of the best ways to “use Uncle Sam’s help to move money from your left pocket to your right pocket.” For example, sole proprietors (and others) have until the unextended due date of their tax return (April 17 this year) to fund their traditional IRA accounts. Of course, there are income thresholds that limit the deductibility of IRA contributions so it’s best to check with a tax professional before simply making the contribution and counting on it to be deductible. Simplified Employee Pension (SEP) IRAs offer higher contribution limits and can be set up and funded by the unextended due date of your tax return.
The second recommendation Levi has is to work with your tax professional to optimize your businesses depreciation and fixed assets both for the tax year that just ended and for the future. He notes that this is one area where a qualified professional “can really provide return on investment” (i.e., earn the money you’re paying them) because they know all of the rules and can use them to adjust the deductibility or capitalization of your specific purchases to your current and expected profit/loss situation. Clearly your business must have purchased fixed assets (equipment, furniture, etc.) to use this strategy.
Levi reminds taxpayers (and tax professionals) that “this is one of those times that constructive receipt isn’t a thing.” When it comes to depreciating equipment it’s the date the equipment was placed in service (think plugged in) not the date it was received or delivered that matters. Small businesses can actually move a deduction into the future by waiting to place a piece of equipment in service. This strategy can be helpful depending on the business’ current and projected profit.
Your tax pro can help you determine whether it’s best to “write it off” (to take the entire deduction in the current year using bonus depreciation, the Section 179 expensing election, or the $2500 per item de minimis safe harbor election) or to capitalize the expense (take the deduction over the property’s class life). Many tax professionals will use a combination of both capitalization and immediate write offs (of one or more types) to create a balance between current and future deductions. The choices can affect other items on the tax returns such as your Qualified Business Income Deduction (QBID) so it is important to use someone who is fully versed in all of the moving parts of the depreciation puzzle.
Levi’s third recommendation is for those with LLCs who file a Schedule C with their annual Form 1040 to consider making a late election to be taxed as a Subchapter S Corporation instead of as a sole proprietorship. This option won’t work for everyone but, depending on how profitable the business is and the owner’s threshold for administrative compliance (proper payroll is required), it provides owner-operators with the opportunity to separate profit from compensation. This strategy means that while all the income is subject to income tax, only the compensation component is subject to FICA taxes (Social Security and Medicare).
Making a late entity selection may also have state-level benefits. Specifically, 30 states are offering special pass-through entity taxation (PTET) that allows taxpayers with S-corporations (and partnerships) to deduct certain state income taxes as business expenses. States have implemented these new laws to provide taxpayers with a workaround to the federal $10,000 state and local tax (SALT) cap that was implemented as part of the Tax Cuts and Jobs Act back in 2017. Levi notes that there could be benefits even for taxpayers who take the standard deduction (the SALT cap only affects those who itemize deductions on Schedule A). Taxpayers considering this strategy should definitely consult a tax professional to run the numbers to determine if the additional costs associated with the strategy (payroll and payroll taxes, filing an additional entity-level tax return, etc.) are justified by the tax savings. Don’t let the tax tail wag the dog. Additionally, the rules for making the late S-corporation election are complex and failure to abide by them can result in the election being rejected by the IRS. The rules surrounding PTET/SALT benefits also are different for almost every state that offers them. In other words, there are many ways to make expensive mistakes with this strategy and money spent to hire a qualified professional to help will be well spent.
Levi counsels business owners to put some time and energy into organizing their financial information whether they are doing it themselves or using a professional helper. “The more promptly you are on top of this [your income and expenses] the more impactful your ability to use the information will be.” In other words, if you are wanting to use any of these strategies you need to gather the necessary accounting information yesterday! If you have an accounting professional who also prepares your tax returns, let them know that you are interested in exploring these options—yesterday! In the heat of tax season it is difficult for accounting and tax professionals to focus on anything other than closing client books, providing year end reports, and getting tax and information returns (W2s, 1099s) filed. If you want your tax pro to help you with after the fact planning it’s best to let them know and get them the information they need to prepare your returns and evaluate these tax planning options as early as possible.