Year-End Tax Planning Considerations
Christmas music is back on the radio. If you’re a pointy-headed tax lawyer like me, that’s your reminder to start thinking about year-end tax planning considerations. Even if you’re not, you will want to start planning earlier than in years past to address all the changes brought by tax reform. We will hit the highlights here.
1. Think Twice Before Creating a Loss
Net operating losses (NOLs) are not as attractive as they used to be. New (post-2017) NOLs may only offset up to 80% of taxable income, and unless you’re a farmer, new NOLs may not be carried back to prior tax years. For example, if you generate a $100,000 loss in 2018 and have taxable income of $100,000 in 2019, you can only apply your 2018 NOL against $80,000. The remaining $20,000 of taxable income is subject to tax and the remaining $20,000 NOL is carried over into the next year.
For non-corporate taxpayers, an additional loss consideration is the Excess Business Loss limit. For married taxpayers filing jointly, this rule effectively limits the amount of deductible business losses to $500,000 in a single year. Any loss in excess of this amount becomes an NOL and is carried over to subsequent tax years. For example, a married taxpayer with wages of $1,000,000 and a pass-through loss of $750,000 from another business will be limited to deducting $500,000, resulting in taxable income of $500,000. The remaining $250,000 loss will become an NOL to be used in subsequent years.
The impact of these rules starts to become problematic when you start adding zeros. Paying taxes on 20% of $100,000 may be inconsequential, but what if taxable income is $1,000,000? What about $10,000,000? Now, only being able offset 80% of this income with NOLs doesn’t look so great. This loss utilization deferral is magnified by the excess business loss rule. A savvy taxpayer will notice that the NOL rules and the new excess business loss limit sunsets after 2025, so losses will be used eventually. That may be some consolation as long as you avoid a time value of money analysis on that deferred loss.
NOLs may be unavoidable in a bad year. Still, if you’re timing equipment purchases or deciding when to invoice a client, you should talk to your tax advisor about whether creating an NOL is a good idea.
2. Watch Out For Equipment Trades.
Code Section 1031 used to apply to equipment and real property, so equipment trades were a non-recognition event for tax purposes. Taxpayers would avoid gain and take carry-over basis on the new equipment plus any cash put toward the purchase. Tax reform revised Section 1031 to only apply to real property. As a result, an equipment trade is treated as a deemed sale of the old equipment for its trade-in value and a purchase of new equipment for the full purchase price. If Sections 179 or 168(k) were applied to the old equipment, this will trigger taxable gain.
The limited availability of Section 1031 means you not only need to be mindful of the taxation of equipment trades, but you also must be mindful of the type of gain generated from the deemed sale or exchange. If the gain is Section 1245 depreciation recapture, then the gain is ordinary income. If the amount of gain exceeds the amount previously taken in depreciation, the excess will be capital gain under Section 1231. This is especially relevant when you consider that Section 1245 gain is eligible for the new Section 199A deduction, but Section 1231 gain is not. Accordingly, taxpayers must track deemed gain on equipment trades and carefully determine the amount and type of that gain.
Changes to Section 1031 will also be problematic for C corporations that recently filed an election to be taxed as an S corporation. The deemed disposition of equipment on a trade-in will result in built-in gains tax. The good news is that tax reform lowered this rate from 35% to 21%. The bad news is that it will be easier than ever to trigger this 21%. Still, even if you trigger built-in gains tax, you don’t have to pay it if taxable income is zero. If you can keep taxable income to zero for the five year look-back that applies to built-in gains, you owe no taxes. Next, we’ll address a couple of tools available to minimize taxable income.
3. Managing Deemed Gain Is Easier Than It Used To Be.
The Section 1031 changes will create more taxable income and built-in gain tax than prior years, but changes to Sections 179 and 168(k) will make managing this additional income easier. Code Section 179 was made permanent – so no more year-end worries about whether congress will extend it. The limits were also increased, allowing taxpayers to deduct up to $1,000,000 of qualified property placed in service during the tax year. The phase out amount was also increased to $2,500,000. Both the deduction limit and the phase out amount are indexed for inflation.
Changes to bonus depreciation under Section 168(k) also makes managing taxable income an easier task. Tax reform extended bonus depreciation through 2026. For property acquired and placed in service between September 28, 2017 and December 31, 2022, bonus depreciation of 100% is available for qualified property. Better yet, qualified property means new and used property. Just watch out for the proposed anti-abuse regulations and avoid trying to buy your dad’s machinery to create a 168(k) deduction.
The question then becomes whether taxpayers should use Section 179 or Section 168(k). The answer depends on the amount of taxable income you need to eliminate. As a general rule, Section 179 provides more precision in arriving at a target amount of taxable income. This is because a taxpayer can select the amount to be deducted under Section 179 (up to $1,000,000 and subject to the phase-out limit). On the other hand, bonus depreciation is an all or nothing proposition. You may not want to take 100% bonus depreciation and generate an NOL when you can avoid the NOL and eliminate taxable income with Section 179. Every situation is different, which makes consulting your tax advisor important – especially if you’re planning a year-end equipment purchase or managing built-in gain triggered by an equipment trade.
4. The Section 199A Deduction Is Not Easy.
Unless you’re under the threshold amount, then it is easy. We have other articles that take a deep dive on the math, but here it will suffice to say there are multiple limits to the deduction. And those limits have additional limits if you’re in the phase-in range, but they go away after you make more than the phase in range. Sound complicated yet? But wait. There’s more.
The proposed regulations under Section 199A permit taxpayers to aggregate various pass-through trades or businesses to generate the best Section 199A deduction possible. Without getting into the math, aggregation is especially advantageous if you have multiple businesses, one of which has no wages and no basis of qualified property. If you have multiple entities for liability protection purposes, aggregating could mean the income generated in entities that don’t pay any wages will still qualify for the deduction.
Unless you’re on the naughty list. If you’re in a specified service trade or business (“SSTB”), the 199A deduction may not be available. Here, there are more limits. Are you above or below the threshold amount of taxable income? Could your amount of SSTB income be considered de minimis? This is not an area for DIY tax preparation. When in doubt, consult your advisor early and often.
Conclusion – Make Your List and Check It Twice.
The topics above are only a sampling of changes brought by tax reform. Other changes include deduction limits for state and local taxes, interest expense deduction limits, depreciable life changes, and limits to the deductibility of meals and expenses. Certain regulations are proposed but not finalized (e.g., Sections 168(k) and 199A), so more changes may be on the horizon.
Accordingly, your big take-away is to start consulting with your tax advisor now if you’re going to make any big year-end tax decisions. You should also plan on your tax return taking longer to prepare than in previous years, and an extension may be necessary if finalized regulations present more new changes before the end of the year.
To learn more about how tax reform will impact your business specifically, contact a Foster Swift tax attorney.
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