Tackle tax planning challenges head on
Running a profitable business these days isn’t easy. You have to operate efficiently, market aggressively and respond swiftly to competitive and financial challenges. But even when you do all of that, taxes may drag down your bottom line more than they should. This year, tax law uncertainty makes planning even more challenging: Lower rates for both corporations and flow-through entities have been proposed, along with replacement of the depreciation system with immediate deductions but elimination of many other breaks.
Also, if you own the business, it’s likely your biggest investment, so thinking about long-term considerations, such as your exit strategy, is critical as well. And if you’re an executive, you likely have to think about not only the company’s taxes, but also tax considerations related to compensation you receive beyond salary and bonuses, such as stock options. Planning for executive comp involves not only a variety of special rules but also several types of taxes — including ordinary income taxes, capital gains taxes, the NIIT and employment taxes. Keep in mind that proposed tax law changes such as changes to tax rates and repeal of the 0.9% additional Medicare tax, NIIT and AMT could affect the tax consequences — and associated planning strategies — related to exec comp.
Projecting your business’s income for this year and next will allow you to time income and deductions to your advantage. It’s generally — but not always — better to defer tax, so consider:
Deferring income to next year. If your business uses the cash method of accounting, you can defer billing for your products or services. Or, if you use the accrual method, you can delay shipping products or delivering services.
Accelerating deductions into the current year. This also will defer tax. If you’re a cash-basis taxpayer, you may pay business expenses before December 31, so you can deduct them this year rather than next. Both cash- and accrual-basis taxpayers can charge expenses on a credit card and deduct them in the year charged, regardless of when the credit card bill is paid.
Warning: Don’t let tax considerations get in the way of sound business decisions. For example, the negative impact of these strategies on your cash flow may not be worth the potential tax benefit.
Taking the opposite approach. If it’s likely you’ll be in a higher tax bracket next year, accelerating income and deferring deductible expenses may save you more tax.
For assets with a useful life of more than one year, you generally must depreciate the cost over a period of years. In most cases the Modified Accelerated Cost Recovery System (MACRS) will be preferable to the straight-line method because you’ll get a larger deduction in the early years of an asset’s life.
But if you make more than 40% of the year’s asset purchases in the last quarter, you could be subject to the typically less favorable midquarter convention. When it comes to repairs and maintenance of tangible property, however, different rules may apply. Careful planning during the year can help you maximize depreciation deductions in the year of purchase.
Other depreciation-related breaks and strategies also are available:
Section 179 expensing election. This allows you to deduct (rather than depreciate over a number of years) the cost of purchasing eligible new or used assets, such as equipment, furniture, off-the-shelf computer software, and leasehold-improvement, restaurant and retail-improvement property. The expensing limit for 2017 is $510,000 — and the break begins to phase out dollar-for-dollar when total asset acquisitions for the tax year exceed $2.03 million. (These amounts are annually adjusted for inflation.) You can claim the election only to offset net income, not to reduce it below zero to create an NOL.
50% bonus depreciation.This additional first-year depreciation for qualified assets has been extended through 2019. However, it’s scheduled to drop to 40% for 2018 and 30% for 2019.
Qualified assets include new tangible property with a recovery period of 20 years or less (such as office furniture and equipment), off-the-shelf computer software, water utility property and qualified improvement property.
Tangible property repair safe harbors. A business that has made repairs to tangible property, such as buildings, machinery, equipment and vehicles, can expense those costs and take an immediate deduction. But costs incurred to acquire, produce or improve tangible property must be depreciated. Distinguishing between repairs and improvements can be difficult. Fortunately, some IRS safe harbors can help: 1) the routine maintenance safe harbor, 2) the small business safe harbor, or 3) the de minimis safe harbor. The rules are complex, so contact your tax advisor for details.
Cost segregation study. If you’ve recently purchased or built a building or are remodeling existing space, consider a cost segregation study. It identifies property components and related costs that can be depreciated much faster and dramatically increase your current deductions. Typical assets that qualify include decorative fixtures, security equipment, parking lots, landscaping and architectural fees allocated to qualifying property. See the Case Study "Cost segregation study can accelerate depreciation."
The benefit of a cost segregation study may be limited in certain circumstances — for example, if the business is subject to the AMT or located in a state that doesn’t follow federal depreciation rules.
Business-related vehicle expenses can be deducted using the mileage-rate method (53.5 cents per mile driven in 2017, down from 54 cents per mile in 2016) or the actual-cost method (total out-of-pocket expenses for fuel, insurance and repairs, plus depreciation).
Properly tracking vehicle expenses is critical, as is tracking other expenses related to transportation and travel, as well as meals and entertainment. See the Case Study "Be cautious when deducting meal, entertainment, auto and travel expenses."
Purchases of new or used vehicles may be eligible for Sec. 179 expensing. However, many rules and limits apply. For example, the normal Sec. 179 expensing limit generally applies to vehicles with a gross vehicle weight rating of more than 14,000 pounds. A $25,000 limit applies to vehicles (typically SUVs) rated at more than 6,000 pounds but no more than 14,000 pounds.
Vehicles rated at 6,000 pounds or less don’t satisfy the SUV definition and thus are subject to the passenger automobile limits. For autos placed in service in 2017, the depreciation limit is $3,160 (the same as for 2016). The amount that may be deducted under the combination of MACRS and Sec. 179 rules for the first year is limited under the luxury auto rules to $11,160 for 2017.
In addition, if a vehicle is used for business and personal purposes, the associated expenses, including depreciation, must be allocated between deductible business use and nondeductible personal use. The depreciation limit is reduced if the business use is less than 100%. If business use is 50% or less, you can’t use Sec. 179 expensing or the accelerated regular MACRS; you must use the straightline method.
The Section 199 deduction, also called the “manufacturers’ deduction” or “domestic production activities deduction,” is 9% of the lesser of qualified production activities income or taxable income. The deduction is also limited to 50% of W-2 wages paid by the taxpayer that are allocable to domestic production gross receipts.
The deduction is available to traditional manufacturers and to businesses engaged in activities such as construction, engineering, architecture, computer software production and agricultural processing. It isn’t allowed in determining net earnings from self-employment and generally can’t reduce net income below zero to create a net operating loss (NOL). But it can be used against the AMT.
Including a variety of benefits in your compensation package can help you not only attract and retain the best employees, but also manage your tax liability:
Qualified deferred compensation plans. These include pension, profit-sharing, SEP and 401(k) plans, as well as SIMPLEs. You can enjoy a tax deduction for your contributions to employees’ accounts, and the plans offer tax-deferred savings benefits for employees. Small employers (generally those with 100 or fewer employees) that create a retirement plan may be eligible for a $500 credit per year for three years. The credit is limited to 50% of qualified startup costs. (For more on the benefits to employees, see “401(k)s and other employer plans.”)
HSAs and FSAs. If you provide employees with a qualified high-deductible health plan (HDHP), you can also offer them Health Savings Accounts. Regardless of the type of health insurance you provide, you also can offer Flexible Spending Accounts for health care. If you have employees who incur day care expenses, consider offering FSAs for child and dependent care.
HRAs. A Health Reimbursement Account reimburses an employee for medical expenses up to a maximum dollar amount. Unlike an HSA, no HDHP is required. Unlike an FSA, any unused portion can be carried forward to the next year. But only the employer can contribute to an HRA.
Fringe benefits. Some fringe benefits, such as group term-life insurance (up to $50,000 annually per person), health insurance, parking ($255 per month in 2017, same as 2016), mass transit / van pooling (also $255 per month) and employee discounts, aren’t included in employee income. Yet the employer still receives a deduction for the portion, if any, of the benefit it pays and typically avoids payroll tax as well.
Certain small businesses providing health care coverage to their employees may be eligible for a tax credit.
On the other hand, you might be penalized for not offering health insurance. The play-or-pay provision of the Affordable Care Act (ACA) can in some cases impose a penalty on “large” employers if they don’t offer full-time employees “minimum essential coverage” or if the coverage offered is “unaffordable” or doesn’t provide “minimum value.”
The IRS has issued detailed guidance on what these terms mean and how employers can determine whether they’re a “large” employer and, if so, whether they’re offering sufficient coverage to avoid the risk of penalties. However, as of this writing, it's uncertain whether these penalties will be enforced, given the Executive Order issued earlier this year for federal agencies to “exercise all authority and discretion available to them” to minimize the ACA’s impact. Plus, ACA repeal and replace legislation might eliminate the provision.
NQDC. Nonqualified deferred compensation plans generally aren’t subject to nondiscrimination rules, so they can be used to provide substantial benefits to executives and other key employees. But the employer generally doesn’t get a deduction for NQDC plan contributions until the employee recognizes the income.
A net operating loss occurs when a C corporation's operating expenses and other deductions for the year exceed its revenues. Generally, an NOL may be carried back two years to generate a refund. Any loss not absorbed is carried forward up to 20 years.
Carrying back an NOL may provide a needed influx of cash. But you can elect to forgo the carryback if carrying the entire loss forward may be more beneficial, such as if you expect your income to increase substantially compared to the prior two years or tax rates to go up.
Tax credits reduce tax liability dollar-for-dollar, making them particularly
Research credit. The research credit (often called the “research and development” credit) gives businesses an incentive to step up their investments in research.
Businesses with $50 million or less in gross receipts may be able to claim the credit against AMT liability. And certain start-ups (in general, those with less than $5 million in gross receipts) that haven’t yet incurred any income tax liability can use the credit against their payroll tax.
While the credit is complicated to compute, the tax savings can prove significant.
Work Opportunity credit. This credit is designed to encourage hiring from certain disadvantaged groups, such as certain veterans, ex-felons, individuals who’ve been unemployed for 27 weeks or more and food stamp recipients.
The size of the tax credit depends on the hired person’s target group, the wages paid to that person and the number of hours that person worked during the first year of employment. The maximum tax credit that can be earned for each member of a target group is generally $2,400 per adult employee. But the credit can be higher for members of certain target groups, up to as much as $9,600 for certain veterans.
Employers aren’t subject to a limit on the number of eligible individuals they can hire. That is, if there are 10 individuals that qualify, the credit can be 10 times the listed amount.
Bear in mind that you must obtain certification that an employee is a target group member from the appropriate State Workforce Agency before you can claim the credit. The certification generally must be requested within 28 days after the employee begins work.
New Markets credit. This credit gives investors who make “qualified equity investments” in certain low-income communities a 39% tax credit over a seven-year period. Certified Community Development Entities (CDEs) determine which projects get funded — often construction or rehabilitation real estate projects in “distressed” communities, using data from the 2006–2010 American Community Survey. Flexible financing is provided to the developers and business owners. The credit is scheduled to expire Dec. 31, 2019.
Retirement plan credit. Small employers (generally those with 100 or fewer employees) that create a retirement plan may be eligible for a $500 credit per year for three years. The credit is limited to 50% of qualified startup costs.
Small-business health care credit. The maximum credit is 50% of group health coverage premiums paid by the employer, provided it contributes at least 50% of the total premium or of a benchmark premium. For 2017, the full credit is available for employers with 10 or fewer full-time equivalent employees (FTEs) and average annual wages of less than $26,200 per employee. Partial credits are available on a sliding scale to businesses with fewer than 25 FTEs and average annual wages of less than $52,400. Warning: To qualify for the credit, online enrollment in the Small Business Health Options Program (SHOP) generally is required. In addition, the credit can be taken for only two years, and they must be consecutive. (Credits taken before 2014 don’t count, however.)
Empowerment Zones. Empowerment Zones are certain urban and rural areas where employers and other taxpayers qualify for special tax incentives, including a 20% credit for “qualified zone wages” up to $15,000, for a maximum credit of $3,000. This tax incentive expired on Dec. 31, 2016, but Congress could extend it. Check with your tax advisor for the latest information.
Income taxation and owner liability are the main factors that differentiate one business structure from another. Many businesses choose entities that combine flow-through taxation with limited liability, namely limited liability companies (LLCs) and S corporations. (See the Chart “Income tax differences based on business structure” to compare the tax treatment for pass-through entities vs. C corporations.)
The top individual rate is higher (39.6%) than the top corporate rate (generally 35%), which might affect business structure decisions. For tax or other reasons, a structure change may be beneficial in certain situations, but there may be unwelcome tax consequences, so be sure to consult your tax advisor. And tax reform legislation could significantly reduce the tax differences between the various structure types.
Some current tax differences between structures may provide planning opportunities, such as those related to salary vs. distributions. (See “Employment taxes for owner-employees.”)
An exit strategy is a plan for passing on responsibility for running the company, transferring ownership and extracting your money from the business. This requires planning well in advance of the transition. Here are the most common exit options:
Buy-sell agreements. When a business has more than one owner, a buy-sell agreement can be a powerful tool. The agreement controls what happens to the business when a specified event occurs, such as an owner’s retirement, disability or death. Among other benefits, a well-drafted agreement:
- Provides a ready market for the departing owner’s shares,
- Sets a price for the shares, and
- Allows business continuity by preventing disagreements caused by
A key issue with any buy-sell agreement is providing the buyer(s) with a means of funding the purchase. Life or disability insurance often helps fulfill this need and can give rise to several tax and nontax issues and opportunities.
One of the biggest advantages of life insurance as a funding method is that proceeds generally are excluded from the beneficiary’s taxable income. There are exceptions, however, so be sure to consult your tax advisor.
Succession within the family. You can pass your business on to family members by giving them interests, selling them interests or doing some of each. Be sure to consider your income needs, how family members will feel about your choice, and the gift and estate tax consequences.
Under the annual gift tax exclusion, you can gift up to $14,000 of ownership interests under your gift tax annual exclusion without using up any of your lifetime gift and estate tax exemption. Valuation discounts may further reduce the taxable value. (See “Gift interests in your business.”) But a gift and estate tax repeal has been proposed, so it’s possible that in the future you might be able to transfer your business to the next generation
free of federal tax.
Management buyout. If family members aren’t interested in or capable of taking over your business, one option is a management buyout. This may provide for a smooth transition because there may be little learning curve for the new owners. Plus you avoid the time and expense of finding an outside buyer.
ESOP. If you want rank and file employees to become owners as well, an employee stock ownership plan (ESOP) may be the ticket. An ESOP is a qualified retirement plan created primarily to purchase your company’s stock. Whether you’re planning for liquidity, looking for a tax-favored loan or wanting to supplement an employee benefit program, an ESOP can offer many advantages.
Selling to an outsider. If you can find the right buyer, you may be able to sell the business at a premium. Putting your business into a sale-ready state can help you get the best price. This generally means transparent operations, assets in good working condition and minimal reliance on key people.
Whether you’re selling your business as part of your exit strategy or acquiring another company to help grow it, the tax consequences can have a major impact on the transaction’s success or failure. Here are a few key tax considerations:
Asset vs. stock sale. With a corporation, sellers typically prefer a stock sale for the capital gains treatment and to avoid double taxation. Buyers generally want an asset sale to maximize future depreciation write-offs.
Taxable sale vs. tax-deferred transfer. A transfer of ownership of a corporation can be tax-deferred if made solely in exchange for stock or securities of the recipient corporation in a qualifying reorganization. But the transaction must comply with strict rules. Although it’s generally better to postpone tax, there are some advantages to a taxable sale:
- The seller doesn’t have to worry about the quality of buyer stock or other business
risks that might come with a tax-deferred transfer.
- The buyer benefits by receiving a stepped-up basis in its acquisition’s assets.
- The parties don’t have to meet the technical requirements of a tax-deferred transfer.
Installment sale. A taxable sale might be structured as an installment sale if the buyer lacks sufficient cash or pays a contingent amount based on the business’s performance. An installment sale also may make sense if the seller wishes to spread the gain over a number of years — which could be especially beneficial if it would allow the seller to stay under the thresholds for triggering the 3.8% NIIT or the 20% long-term capital gains rate.
But an installment sale can backfire on the seller. For example, depreciation recapture must be reported as gain in the year of sale, no matter how much cash the seller receives. And, if tax rates increase, the overall tax could wind up being more. Of course, tax consequences are only one of many important considerations when planning a merger or acquisition.
If you’re an executive with a larger company, you may receive incentive stock options (ISOs). ISOs receive tax-favored treatment but must comply with many rules. ISOs allow you to buy company stock in the future (but before a set expiration date) at a fixed price equal to or greater than the stock’s fair market value (FMV) at the date of the grant.
Therefore, ISOs don’t provide a benefit until the stock appreciates in value. If it does, you can buy shares at a price below what they’re then trading for, as long as you’ve satisfied the applicable ISO holding periods. Here are the key tax consequences:
- You owe no tax when the ISOs are granted.
- You owe no regular tax when you exercise the ISOs.
- If you sell the stock after holding the shares at least one year from the date of exercise and two years from the date the ISOs were granted, you pay tax on the sale at your long-term capital gains rate.
- If you sell the stock before long-term capital gains treatment applies, a “disqualifying disposition” occurs and any gain is taxed as compensation at ordinary-income rates.
If you’ve received ISOs, plan carefully when to exercise them and whether to immediately sell shares received from an exercise or hold them. Waiting to exercise ISOs until just before the expiration date (when the stock value may be the highest, assuming the stock is appreciating) and holding on to the stock long enough to garner long-term capital gains treatment often is beneficial. But there’s also market risk to consider.
Plus, in several situations, acting earlier can be advantageous:
- Exercise early to start your holding period so you can sell and receive long-term capital gains treatment sooner.
- Exercise when the bargain element is small or when the market price is close to bottoming out to reduce or eliminate AMT liability.
- Exercise annually so you can buy only the number of shares that will achieve a breakeven point between the AMT and regular tax and thereby incur no additional tax.
- Sell in a disqualifying disposition and pay the higher ordinary-income rate to avoid the AMT on potentially disappearing appreciation.
On the negative side, exercising early accelerates the need for funds to buy the stock, exposes you to a loss if the shares’ value drops below your exercise cost, and may create a tax cost if the preference item from the exercise generates an AMT liability.
The timing of ISO exercises could also positively or negatively affect your liability for the higher ordinary-income tax rates, the 20% long-term capital gains rate or the NIIT. With your tax advisor, evaluate the risks and crunch the numbers using various assumptions to determine the best strategy for you.
The tax treatment of nonqualified stock options (NQSOs) is different from that of ISOs: NQSOs create compensation income (taxed at ordinary-income rates) on the bargain element when exercised (regardless of whether the stock is held or sold immediately), but they don’t create an AMT preference item.
You may need to make estimated tax payments or increase withholding to fully cover the tax on the exercise. Keep in mind that an exercise could trigger or increase exposure to top tax rates, the additional 0.9% Medicare tax and the NIIT.
Restricted stock is stock that’s granted subject to a substantial risk of forfeiture. Income recognition is normally deferred until the stock is no longer subject to that risk or you sell it. You then pay taxes based on the stock’s fair market value when the restriction lapses and at your ordinary-income rate.
But, under Section 83(b), you can elect to instead recognize ordinary income when you receive the stock. This election, which you must make within 30 days after receiving the stock, can be beneficial if the income at the grant date is negligible or the stock is likely to appreciate significantly before income would otherwise be recognized. Why? Because the election allows you to convert future appreciation from ordinary income to long-term capital gains income and defer it until the stock is sold.
There are some disadvantages of a Sec. 83(b) election: First, you must prepay tax in the current year — which also could push you into a higher income tax bracket and trigger or increase your exposure to the additional 0.9% Medicare tax. But if a company is in the earlier stages of development, the income recognized may be small. Second, any taxes you pay because of the election can’t be refunded if you eventually forfeit the stock or you sell it at a decreased value. But you’d have a capital loss when you forfeited or sold the stock.
Work with your tax advisor to map out whether the Sec. 83(b) election is appropriate for you in each particular situation. For an example of the Sec. 83(b) election in action, see the Case Study “Saving taxes on restricted stock with a Sec. 83(b) election.”
RSUs are contractual rights to receive stock (or its cash value) after the award has vested. Unlike restricted stock, RSUs aren’t eligible for the Sec. 83(b) election. So there’s no opportunity to convert ordinary income into capital gains.
But they do offer a limited ability to defer income taxes: Unlike restricted stock, which becomes taxable immediately upon vesting, RSUs aren’t taxable until the employee actually receives the stock. So rather than having the stock delivered immediately upon vesting, you may be able to arrange with your employer to delay delivery. This will defer income tax and may allow you to reduce or avoid exposure to the additional 0.9% Medicare tax (because the RSUs are treated as FICA income).
However, any income deferral must satisfy the strict requirements of Internal Revenue Code (IRC) Section 409A.
Nonqualified deferred compensation plans pay executives in the future for services to be currently performed. They differ from qualified plans, such as 401(k)s, in several ways. For example, unlike 401(k) plans, NQDC plans can favor highly compensated employees, but any NQDC plan funding isn’t protected from the employer’s creditors.
One important NQDC tax issue is that employment taxes are generally due once services have been performed and there’s no longer a substantial risk of forfeiture — even though compensation may not be paid or recognized for income tax purposes until much later. So your employer may withhold your portion of the payroll taxes from your salary or ask you to write a check for the liability. Or it may pay your portion, in which case you’ll have additional taxable income. Warning: The additional 0.9% Medicare tax could also apply.
Keep in mind that the rules for NQDC plans are tighter than they once were, and the penalties for noncompliance can be severe: You could be taxed on plan benefits at the time of vesting, and a 20% penalty and potential interest charges also could apply. So check with your employer to make sure it’s addressing any compliance issues.