Year-end tax planning strategies must take business turbulence into account
November 9, 2020
Election years often lead to uncertainty for businesses, but 2020 surely takes the cake when it comes to unpredictability. Amid the chaos of the COVID-19 pandemic, the resulting economic downturn and civil unrest, businesses are on their yearly search for ways to minimize their tax bills — and realizing that some of the typical approaches aren’t necessarily well-suited for this year. On the other hand, several new opportunities have arisen thanks to federal tax relief legislation.
Businesses facing cash flow crunches can take advantage of a provision in the CARES Act that accelerates the timeline for recovering unused alternative minimum tax (AMT) credits. The Tax Cuts and Jobs Act (TCJA) eliminated the corporate AMT but allowed businesses with unused credits to claim them incrementally in taxable years beginning in 2018 and through 2020.
Under the TCJA, for tax years beginning in 2018, 2019 and 2020, if AMT credit carryovers exceed regular tax liability, 50% of the excess is refundable, with any remaining credits fully refundable in 2021. But the CARES Act lets businesses claim all remaining credits in 2018 or 2019, opening the door to immediate 100% refunds for excess credits. Instead of amending a 2018 tax return to claim the credits, a business owner can file Form 1139, “Corporate Application for Tentative Refund,” by December 31, 2020.
The CARES Act also temporarily loosened the rules for net operating losses (NOLs). The TCJA limits the NOL deduction to 80% of taxable income and NOLs can’t be carried back. Now, NOLs arising in 2018, 2019 or 2020 can be carried back five years to claim refunds in previous tax years. No taxable income limitation applies for years beginning before 2021, meaning NOLs can completely offset income in those years.
Businesses can obtain even larger refunds by accelerating deductions into years when higher pre-TCJA tax rates were in effect (for example, a 35% corporate tax rate vs. 21% under the TCJA). Bear in mind, though, that carrying back NOLs can trigger a recalculation of other tax attributes and deductions, such as AMT credits and the research credit, often referred to as the “research and development,” “R&D,” or “research and experimentation” credit.
Capital assets purchases
Capital investments have long been a useful way to reduce income taxes, and the TCJA further juiced this technique by expanding bonus depreciation. And the CARES Act finally remedies a drafting error in the TCJA that left qualified improvement property (QIP), generally interior improvements to nonresidential real property, ineligible for bonus deprecation.
For qualified property purchased after September 27, 2017, and before January 1, 2023, businesses can deduct 100% of the cost of new and used (subject to certain conditions) qualified property in the first year the property is placed into service. Special rules apply to property with a longer production period.
Qualified property includes computer systems, purchased software, vehicles, machinery, equipment and office furniture. Beginning in 2023, the amount of the bonus depreciation deduction will fall 20% each year. Absent congressional action, the deduction will be eliminated in 2027.
Congress clearly intended for QIP that was placed in service after 2017 to qualify for 100% first-year bonus depreciation, but a drafting error prevented that favorable treatment. The CARES Act includes a technical correction to fix the problem. As a result, businesses that made qualified improvements in 2018 or 2019 can claim an immediate tax refund for the missed bonus depreciation.
Under the TCJA, Sec. 179 expensing (that is, deducting the entire cost) is available for several improvements to nonresidential real property, including roofs, HVAC, fire protection systems, alarm systems and security systems. The law also increases the maximum deduction for qualifying property. The 2020 limit is $1.04 million (the maximum deduction is limited to the amount of income from business activity). The expensing deduction begins phasing out on a dollar-for-dollar basis when qualifying property placed in service this year exceeds $2.59 million.
Business interest management
The TCJA generally has limited the deduction for business interest expense to 30% of adjusted taxable income (ATI). The CARES Act allows C- and S-corporations to deduct up to 50% of their ATI for the 2019 and 2020 tax years (special partnership rules apply for 2019).
It also permits businesses to elect to use their 2019 ATI, rather than 2020 ATI, for the calculation, which should increase the amount of the deduction for many businesses. Businesses should consider using accounting method changes to shift their business interest deductions from 2019 to 2020 to boost their 2019 ATI.
Income and expense timing
Businesses that haven’t expected to be in a higher tax bracket the following tax year have long deferred income and accelerated expenses to minimize taxable income. If the Democrats win the White House and the Senate, and retain the House of Representatives, tax rates could increase as soon as 2021. In that case, it could be advantageous to accelerate income into 2020, when it would be taxed at the lower current rates.
Even if tax rates don’t climb next year, companies of all kinds have seen downturns in business this year due to the far-reaching effects of the COVID-19 pandemic. Those that expect to be more profitable in 2021 may want to push their expense deductions past year-end to help offset profits.
Payroll tax deductions
A similar analysis applies to payroll tax deductions. The CARES Act allows businesses and self-employed individuals to delay their payments of the employer share (6.2% of wages) of the Social Security payroll tax. Such taxpayers can pay the tax over the next two years, with the first half due by December 31, 2021, and the second half due by December 31, 2022.
Sticking with those dates, however, will affect 2020 taxes. Businesses generally can’t deduct their share of payroll taxes until they actually make the payments. Certain businesses might find it more worthwhile to pay those taxes in 2020. This could, for example, increase the amount of NOLs they can carry back to higher tax-rate years.
Many of these taxing planning opportunities come with filing requirements, whether for amended tax returns, applications for changes in accounting method (IRS Form 3115) or applications for tentative refunds. In addition, some of these strategies could have a negative impact on taxpayers who claim the qualified business income deduction. We can help determine your best course forward and ensure you don’t miss any critical deadlines.