Tax‐Planning Decisions

Some deductions are under your control because you can decide whether to incur the expenditure. Also, sometimes you are permitted to make tax elections on when to report income or when to claim write‐offs. Here are some pointers that can help you minimize your income and maximize your deductions. Or, you can follow the reverse strategy if you already have losses for the year and want to accelerate income to offset those losses (and defer deductions).

• Cash‐basis businesses. If you account for your expenses and income on a cash basis, you can influence when you receive income and claim deductions for year‐end items. For example, you can delay billing out for services or merchandise so that payment will be received in the following year. In deferring income for services or goods sold, do not delay billing so that collection may be in jeopardy. Also factor in your tax bracket for this year and the bracket you expect to be in next year. If you will be in a higher tax bracket next year because your income will be greater or because of tax law changes, you may not want to defer income. You may prefer to bill and collect as soon as possible to report the income in the lower‐tax year.

On the flip side, as a year‐end tax planning strategy you can accelerate deductions by paying outstanding bills and stocking up on supplies. Again, determine whether accelerating deductions makes sense for you.

However, in accelerating deductions, do not prepay expenses that relate to items extending beyond one year. For example, if you pay a 3‐year subscription to a trade magazine, you can deduct only the portion of the subscription (one‐third) that relates to the current year; the balance is deductible in future years as allocated.

• Accrual method businesses. The board of directors of an accrual‐basis C corporation can authorize a charitable contribution and make note of it in the corporate minutes. A current deduction can be claimed even if the contribution is paid after the end of the year (as long as it is paid no later than 2½ months after the close of the year). Charitable contributions are discussed in Chapter 22.

  Similarly, accrual method businesses can accrue bonuses and other payments to employees in the current year that are paid within 2½ months of the close of the year. However, this rule does not extend to payments to S corporation owner‐employees—payments are deductible only when received by the owner‐employees.

• Owner participation. If you own a business, be sure that your level of participation for 2022 is sufficient to allow you to deduct all your losses under the passive loss limitation rules and avoid the 3.8% tax on net investment income. Increase your level of participation, and keep records of how and when you participated in the business. Passive loss rules and the various participation tests under these rules are discussed in Chapter 4.
• Increase basis to fully utilize losses. If you are an owner in a pass‐through entity, your share of losses generally is deductible only to the extent of your basis in the business. Explore ways in which to increase your basis so that the losses can be fully utilized. For example, if you are an S corporation shareholder, you can increase basis by lending funds to your business. Alternatively, you can work with the corporation's lenders to restructure debt, making you primarily liable for the amount borrowed (which you then lend to the corporation and increase basis). Basis rules and their impact on deducting losses are discussed in Chapter 4.
• Minimize FICA. Owners who work for their corporations may be able to extract distributions on a FICA‐free basis by arranging loans or rentals to the business and taking payments in the form of interest or rents. Of course, these arrangements must be bona fide. However, S corporation shareholders who perform substantial services for their corporation should not erroneously characterize compensation as dividends. And W‐2 wages are important for optimizing the qualified business income deduction.
• Review qualified plan selection. If you are self‐employed and use an IRA, SEP, SIMPLE, or other qualified plan to save for retirement, review your choice of plan annually to see if it optimizes your benefits while keeping costs down.

  Similarly, corporations should review existing plans to see whether terminations or other courses of action are warranted as cost‐cutting measures. If you want to terminate one plan and begin another, do not do so without consulting a pension expert. You must be sure that your old plan is in full compliance with the tax laws before it is terminated.

• Carry medical coverage for yourself and employees. Buy the kind of coverage you can afford as long as it meets minimum essential coverage requirements. The business picks up the expense for your personal insurance protection. Even if you cannot receive this benefit on a tax‐free basis (if, for example, you are a partner or S corporation shareholder who must include business‐paid insurance in your income), you may deduct 100% of the coverage on your individual return.

  You can reduce the cost of coverage to the business by buying a high‐deductible plan that allows employees to contribute to health savings accounts (HSAs) on a tax‐deductible basis. Alternatively, you can make deductible contributions to an HSA on behalf of your employees. If you are not subject to the employer mandate under the Affordable Care Act, you can shift most of the cost of coverage to employees by adopting a premium‐only cafeteria plan. Or you may be able to use a type of health reimbursement arrangement to help employees pay for their individually‐obtained coverage.

  You may be able to use other reimbursement options, such as an Excepted Benefit Health Reimbursement Arrangement, to pay for certain costs not covered by insurance. Medical coverage strategies are discussed in Chapter 19.

  If you pay at least half the premiums for your employees and qualify as a small employer, you can claim a tax credit for a percentage of your payments (Chapter 19).

• Institute other employee benefit plans. If you have a C corporation that is profitable and you are a shareholder‐employee, you may be able to turn your nondeductible personal expenses into deductible business expenses. For example, you can have the corporation institute a group term life insurance plan for employees and obtain tax‐free coverage up to $50,000. Of course, in weighing the advantages and disadvantages of employee benefit plans, be sure to consider the cost of covering rank‐and‐file employees, since most benefit plans have strict nondiscrimination rules. Also, take into account the fact that employer‐paid educational assistance and adoption assistance plans cannot give more than 5% of benefits to shareholders owning more than 5% of the stock, usually making such plans undesirable for closely held corporations. Employee benefits are discussed in Chapter 7.
• Adopt expense reimbursement arrangements. If your corporation reimburses you for travel, work‐from‐home expenses (e.g., internet access fees), and other business costs, be sure that the arrangement is treated as an accountable plan. This will ensure that not only does the corporation save on employment taxes, but also that you are not taxed on reimbursements. With an accountable plan, the corporation deducts the expenses, and no income is reported to you. Reimbursement arrangements are discussed in Chapter 8.
• Abandon versus selling of property. If you have property that simply is of no value to the business, you may want to abandon it rather than sell it for a nominal amount. This will allow the business to take an ordinary loss deduction rather than a capital loss on a sale. A sale of Section 1231 property may result in a capital or ordinary loss, depending on other Section 1231 transactions for the current year and prior Section 1231 losses. Abandonment of property and Section 1231 property are discussed in Chapter 6.
• Take disaster losses in the prior year. If you suffer a disaster loss to business property in an area declared to be eligible for federal disaster assistance, consider claiming the deduction on an original or amended return for the year preceding the year of the loss if this will give you needed cash flow or result in a greater benefit from the deduction. Disaster losses are discussed in Chapter 17.
• Review the business structure. Changes in the business climate, in business goals, tax laws, and state laws may warrant a change in the form of business organization. For example, your business may start as a sole proprietorship; later you may want to incorporate in order to take advantage of certain employee benefit plans. Review the options that will afford tax reduction and other benefits. Business organization is discussed in Chapter 1.
• Do year‐end planning. Businesses have an opportunity to save on taxes with year‐end planning. Well‐timed expenditures for which tax credits or deductions are available may prove advantageous. Begin year‐end planning well before the end of the year in order to have time to implement your decisions.
• Stay abreast of tax law changes. New opportunities are continually being created—through Congressional action, court decisions, and IRS rulings. Download a free Supplement to this book (available in February 2023) on tax developments affecting small businesses from https://www.jklasser.com and https://www.BigIdeasForSmallBusiness.com.

Post‐Year Tax Elections to Cut Your Tax Bill

Even though the tax year is over, there are still certain decisions that you can make after the year has ended to favorably impact your tax liability. Here are some elections and actions that can be helpful when you file your tax return for the current year:

• Take optimum write‐offs for business equipment purchases. When the business can benefit from a larger deduction, instead of depreciating the cost of equipment over the life of the property, consider electing the Section 179 deduction or using bonus depreciation. Alternatively, when the business cannot benefit from a current deduction because it does not have sufficient income to offset it or you may be subject to the limit on excess noncorporate losses, consider other write‐off options. Time business equipment purchases carefully in view of the mid‐quarter convention. Depreciation, Section 179 expensing, bonus depreciation, and the de minimis safe harbor election are discussed in Chapter 14.
• Installment sale. If you sold property on an installment basis where at least one payment is due after the year of sale, you report the gain over the period in which payments are made. However, you may opt to report all of the gain in the year of sale, regardless of when payments are received. This is done simply by reporting the full amount of gain on the 2022 return. Reporting the full gain may be advisable if you have losses in the year of sale or loss carryovers to offset the gains. It may also make sense if you expect to be in a higher tax bracket when additional installment payments will be received.
• Real estate professionals. If you own multiple rental properties that produce a net loss, you can escape the passive activity loss limitation imposed on investors by aggregating the properties to qualify as a real estate professional. To do this, you must attach an election to your return. Without the election, a reported net loss may be disallowed. What's more, unless qualifying as a real estate professional, income from real estate activities cannot escape the additional Medicare tax on net investment income if you are a high‐income taxpayer.
• Retirement plans. If 2022 is a profitable year but you don't have a qualified retirement plan for your business, it may not be too late to create and fund one. You have until the extended due date of the return to set up a qualified retirement plan and add the deductible contribution for 2022, but watch pre‐year‐end deadlines for giving notice to employees where applicable.
• File for refunds. There are many situations in which you can obtain a tax refund from earlier years, which are discussed throughout the book.

Track Carryovers

You may have tax write‐offs that you are unable to use because of a dollar, a percentage, or some other limit. Be sure to keep track of the carryovers so you can use them in future years to the extent allowed. Here are some common carryovers to keep records on:

• Capital losses. Unused capital losses for individuals have an unlimited carryforward. Unused capital losses of C corporations have a 5‐year carryover limit.
• Charitable contribution carryover. If charitable contributions are limited because of adjusted gross income (AGI) or taxable income, excess amounts can be carried forward for up to 5 years (15 years for contributions of conservation easements).
• General business credit carryover. If you have any unused general business credit, it can be carried forward for up to 20 years.
• Home office deduction carryover. If your home office deduction in 2022 (figured using the actual expense method) is limited because of your gross income from the home office activity, the excess deduction can be used on the 2023 return to the extent there is sufficient gross income from the home office activity. You do not have to be in the same home office in the carryover year in order to use the carryover. There is no time limit on the use of a home office deduction carryover. There is no carryover if your home office deduction for 2022 is figured using the simplified method.
• Investment interest. Unused investment interest by individuals has an unlimited carryover period. Investment interest may arise, for example, on borrowing to purchase stock in your incorporated business.
• Net operating loss carryover. If you have a pre‐2018 net operating loss (NOL) carryover that has not been used up, carry it forward for up to 20 years. NOLs arising in 2018 and later years have an indefinite carryover. Keep track of each separate NOL. The NOL is reported as a negative figure on the “other income” line on Schedule 1 of Form 1040 or 1040‐SR.

Planning Ahead

The ever‐changing tax laws make it challenging to devise long‐term tax strategies for your business. This is especially true at this time when political wrangling and historic budget deficits may result in the imposition of new or increased taxes and the elimination of some tax breaks; some changes could even be made retroactive. Still, it is important to be able to plan ahead so you can decide in which year it may be more favorable to purchase capital equipment, hire new workers, or take other actions that can affect your after‐tax profits.

Many of the tax changes that take place each year are the result of cost‐of‐living adjustments (COLA). Others are the product of phased‐in law changes, while still others are IRS devised. In Appendix D, you will find a listing of some common scheduled adjustments and law changes affecting small businesses over the next several years.

Salary of Corporate Officers

Some corporations have been claiming deductions for management or consulting fees paid to the corporation's owners. At the same time, these corporations have not claimed deductions for salary. This leads the IRS to conclude that the corporations are misclassifying payments to corporate officers as fees rather than compensation in order to avoid payroll taxes. Corporations may be liable for penalties for failing to withhold and deposit payroll taxes and for failing to file required payroll tax returns. Of course, sometimes payments to shareholders may very well be management or consulting fees for occasional outside assistance. But if these individuals conduct the actual business of the corporation—perform the services for which the corporation was organized or provide management services on a full‐time or consistent basis—the payments look more like compensation.

S corporations especially may also fail to deduct compensation paid to owner‐employees and instead call distributions to them dividends. The rationale for this strategy is to reduce the corporation's liability for payroll taxes. Again, the IRS has identified this strategy as a common error and has imposed penalties on S corporations that have followed it. If an owner‐employee performs substantial services for the S corporation, some reasonable amount of payment for services must be treated as deductible compensation subject to payroll taxes. And the impact of the W‐2 limitation for the qualified business income (QBI) deduction must be factored in when setting compensation to owner‐employees.

Below‐Market Loans

Loans from shareholders to their corporations that bear an interest rate lower than the applicable federal rate (a rate set monthly by the IRS, which varies with the term of the loan) result in phantom or imputed interest. Shareholders must report this interest income; corporations can deduct the imputed interest. Due to low interest rates in recent years, IRS attention to below‐market loans was minimal but could increase with interest rates on the rise. If the corporation fails to take an interest deduction, the IRS may conclude that the shareholder has not really made a loan but rather a contribution to the capital of the corporation, and no deduction for the corporation will be allowed.

Loans to shareholders from their corporations may also present tax deduction problems. Shareholders are entitled to deduct imputed interest in this case (as business or investment interest), with the corporation picking up the imputed interest as interest income. Unfortunately, some corporations are failing to report the income, but they are still showing the loan on their balance sheets. This is an unnecessary error for corporations to make. If the shareholders are also employees of the corporation, then the corporation can claim a deduction for compensation to the shareholder‐employees to offset the imputed interest income. If, however, the shareholders are not employees of the corporation, the payments to them must be treated as dividends, which are not deductible by the corporation.

Meals Deductions

Some businesses claim a full deduction for the cost of business meals. While business meals provided at restaurants in 2022 are 100% deductible, other business meals are only 50% deductible. This problem commonly occurs for meals away from home, especially when using a per diem rate for meal costs that do not qualify for the 100% deduction in 2022 because they are not provided at restaurants.

Bad Debt Deductions

Some individuals are claiming bad debt deductions as ordinary losses rather than short‐term capital losses. In other words, they are classifying the bad debt as a business bad debt when, in fact, it may be a nonbusiness bad debt. For example, if a shareholder has a bad debt for a loan to the corporation, the loan should be treated as a nonbusiness bad debt because it is not incurred in a trade or business; rather, it is made to protect one's investment as a shareholder.

Casualty Losses

Some businesses fail to reduce deductions for casualty losses by any insurance reimbursements received. This results in an overstatement of casualty losses.

Claiming Losses in General

Some taxpayers claim losses in excess of amounts that are otherwise allowed. They fail to observe the passive loss limitation rules that limit loss deductions for activities in which there is no material participation. Just because someone owns stock in an S corporation, for example, does not mean that he or she is a material participant in the business. The shareholder must meet special material participation tests to deduct losses in excess of passive income.

Other taxpayers may be treating hobby losses as business losses. If the activity is really a hobby, no expenses can be deducted.

Also, some shareholders in S corporations claim losses in excess of their basis in the corporation. Losses are deductible only to the extent of a shareholder's basis in stock and loans to the corporation. Basis is adjusted annually for various transactions—shareholder's distributive share of S corporation income that is taxable to the shareholder, distributions by the corporation, and losses claimed. Losses in excess of basis are not lost. They can be carried forward and used in a subsequent year when there is sufficient basis to offset them.

Help from the IRS

The IRS has a website exclusively for small business and self‐employed individuals at https://www.irs.gov/businesses/small-businesses-self-employed. This site contains industry‐specific information so, for example, if you are in construction you will find the hot issues relating to the construction industry. You will also find audit guides that tell IRS agents what to look for when examining returns of businesses within your industry. And there is a Self‐Employed Individuals Tax Center at https://www.irs.gov/individuals/self-employed with help for Schedule C filers. You will also find links to other tax sites that may be helpful to you.

The IRS provides a number of publications, some of which have been mentioned throughout this book, that can give you important information on income and deductions. Table 24.2 lists some of these publications.

These publications are available directly from the IRS by calling (800) 829‐3676 or, in some locations, by visiting your local IRS office, post office, or library. You may also download them from the IRS at https://www.irs.gov.

The IRS also offers the Small Business Tax Workshop at https://www.irsvideos.gov/Business/SBTW, which is composed of 8 interactive lessons about tax rights and responsibilities for small business owners.

Another valuable source of assistance is the instructions for particular tax returns. For example, if your business is an S corporation, you can obtain guidance on claiming various tax deductions from the instructions for Form 1120‐S.

If you have questions, you may direct them to the IRS. There is a special telephone number to call for questions about your business return: (800) 829‐4933. However, do not simply rely on statements made to you by someone in your local IRS office or over the telephone. If you want to rely on IRS advice, be sure to get it in writing (note the IRS employee's ID number). The IRS is not bound by oral advice, but it is bound by any written advice it may give you. If you can't resolve a problem with the IRS, the Taxpayer Advocate Service may be able to help; call (877)‐777‐4778 or visit https://www.irs.gov/advocate/local-taxpayer-advocate to find a Local Taxpayer Advocate.

If you have a thorny tax issue involving substantial dollars and are not sure how the IRS will rule on the subject, you may want to obtain a special ruling. You may ask for a private letter ruling without the assistance of a tax professional, but this may not be the best course of action. You need to frame your question appropriately. Also, you need to supply a great deal of information to the IRS before it will take any action. A tax professional can ensure that your request will receive the attention you desire. The procedure entails the payment of a user fee that must accompany your ruling request.