How Businesses Can Maximize Their Tax Savings
In today’s economic landscape, businesses are navigating various challenges, such as supply chain disruptions, staffing shortages, and persistent high costs and interest rates. At the same time, many businesses are experiencing rapid growth. Regardless of your business’s current situation, it’s essential to fully capitalize on available tax breaks. Furthermore, the provisions under the Tax Cuts and Jobs Act (TCJA) still require attention.
If you own a business, itâs likely your most significant investment, making long-term considerationsâsuch as your exit strategyâcritical. For executives, it’s equally important to consider not just the company’s tax strategy, but also the tax implications of compensation beyond salary and bonuses, such as stock options. Executive compensation planning involves navigating various tax types, including ordinary income, capital gains, the Net Investment Income Tax (NIIT), and employment taxes.
Business Structure and Taxation
Income taxation and owner liability are the primary factors that distinguish different business structures. Many owners opt for entities that offer a blend of pass-through taxation and limited liability, such as limited liability companies (LLCs) and S corporations. However, the TCJA has significantly impacted the tax implications of business structure.
The now-flat corporate tax rate of 21% is substantially lower than the top individual rate of 37%, providing tax benefits to corporations and alleviating the impact of double taxation on their owners. The Inflation Reduction Act, effective after December 31, 2022, introduced a 15% corporate alternative minimum tax, which applies only to the largest C corporations. Despite this, double taxation can still be a costly drawback. In many cases, pass-through entities can be more tax-efficient for owners, and the TCJA introduced the valuable Section 199A deduction for owners of pass-through entities.
If you’re considering changing your business structure, itâs important to note that the top individual tax rate is expected to rise, and the Section 199A deduction will expire after 2025 unless Congress acts. Additionally, there have been proposals to adjust corporate tax rates. Even if tax rates don’t increase, a structural change could still have unintended tax consequences. Consult with your tax advisor to determine whether changing your business structure could provide benefits.
Section 199A Deduction for Pass-Through Businesses
The TCJA provides the Section 199A deduction for sole proprietorships and owners of pass-through business entities such as partnerships, S corporations, and LLCs treated as sole proprietorships, partnerships, or S corporations for tax purposes. This deduction is not included in the ownerâs adjusted gross income but reduces taxable income, similar to an itemized deduction (though you don’t have to itemize to claim it).
Generally, the 199A deduction equals 20% of qualified business income (QBI), but it cannot exceed 20% of taxable income. QBI includes the net amount of income, gain, deduction, and loss from U.S. business operations, excluding certain investment items, reasonable compensation paid to an owner for services, or guaranteed payments to a partner or LLC member for services.
There are additional limitations if the ownerâs taxable income exceeds certain thresholds. One such limitation is that the 199A deduction cannot exceed the greater of:
50% of the W-2 wages paid to employees by the business during the tax year, or
25% of W-2 wages plus 2.5% of the cost of qualified property.
Qualified property includes tangible depreciable property, including real estate, owned by the business and used in operations to generate qualified business income. Other rules may apply.
Moreover, the 199A deduction is generally unavailable for income from âspecified service businesses,â such as investment services or most professional practices (except for engineering and architecture). However, if your taxable income is below the applicable threshold, the W-2 wage, property limitations, and service business restrictions do not apply, and you may be eligible for the full 20% deduction.
Projecting Income to Optimize Tax Savings
Projecting your businessâs income for the current and upcoming year allows you to strategically time income and deductions for maximum tax advantage. In general, deferring taxes is beneficial, but this isnât always the case. Consider the following strategies:
Deferring Income to the Next Year: If your business uses the cash method of accounting, you can defer billing for products or services at the end of the year. For accrual-basis businesses, delaying product shipments or service delivery can achieve similar results.
Accelerating Deductible Expenses: If you’re a cash-basis taxpayer, paying business expenses by December 31 allows you to deduct them in the current year. Both cash and accrual-basis taxpayers can charge expenses to a credit card and deduct them in the year they are charged, regardless of when the credit card bill is paid.
Warning: Be cautious of prioritizing tax strategies over sound business decisions. For example, the impact of deferring income or accelerating expenses on cash flow or customer relationships may outweigh the potential tax benefit.
Taking the Opposite Approach: If your business is a pass-through entity and expects to be in a higher tax bracket next year, accelerating income and deferring deductible expenses may reduce your overall tax burden across two years.
Depreciation Strategies
For assets with a useful life of more than one year, depreciation typically spreads the cost over several years. The Modified Accelerated Cost Recovery System (MACRS) is usually preferable to the straight-line method, as it provides larger deductions in the assetâs early years.
However, businesses that make over 40% of their asset purchases in the last quarter may be subject to the less favorable midquarter convention. When it comes to repairs and maintenance, different rules apply, so careful planning can help maximize depreciation deductions.
Depreciation-Related Breaks and Strategies Under TCJA
Section 179 Expensing Election: This allows businesses to immediately deduct the cost of qualifying assets, such as equipment, furniture, and off-the-shelf software, rather than depreciating them over several years. However, there is an annual limit, which begins to phase out dollar-for-dollar when asset acquisitions exceed a specific threshold. The Section 179 deduction can only offset net income, not create a net operating loss.
Bonus Depreciation: This allows for additional first-year depreciation on qualified assets, including new and used property, as well as certain qualified improvements. Under the TCJA, bonus depreciation applies through 2026, but the 100% deduction available in recent years expired in December 2022. Unless extended, it is scheduled to decrease by 20% annually until 2027.
Warning: Some businesses, like real estate firms or dealerships with floor-plan financing, may not qualify for bonus depreciation if their average annual gross receipts exceed certain thresholds.
Tangible Property Repair Safe Harbors: Businesses can immediately deduct repair costs for tangible property, such as buildings, machinery, and equipment. However, improvements to property must be depreciated. IRS safe harbors can simplify this distinction, including the routine maintenance, small business, and de minimis safe harbors.
Cost Segregation Study: If youâve purchased, built, or remodeled a property, a cost segregation study can accelerate depreciation deductions by identifying components of the property that can be depreciated more quickly. Typical assets include decorative fixtures, security systems, and parking lots.
Note: The benefit of a cost segregation study may be limited if your business is located in a state that doesnât follow federal depreciation rules.
Vehicle-Related Tax Breaks
Business vehicle expenses can be deducted using the mileage-rate method or the actual-cost method (fuel, insurance, repairs, and depreciation).
Purchases of new or used vehicles may qualify for Section 179 expensing, with specific rules applying to vehicles based on their weight. Vehicles weighing over 14,000 pounds typically qualify for the normal Section 179 expensing limit, while vehicles between 6,000 and 14,000 pounds (usually SUVs) have a reduced limit. Vehicles weighing 6,000 pounds or less are subject to passenger vehicle limits.
If a vehicle is used for both business and personal purposes, the expenses, including depreciation, must be split between deductible business use and non-deductible personal use. If business use is 50% or less, the vehicle cannot use Section 179 expensing or accelerated depreciation methods.
Entertainment, Meal, and Transportation Deductions
Under the TCJA, several deductions related to entertainment and travel expenses have been altered:
Entertainment: These expenses are no longer deductible.
Meals: Business-related meals, including those while traveling, remain 50% deductible. However, the TCJA now limits the 50% deduction to meals provided on the employerâs premises or in an on-site cafeteria.
Transportation: Employer deductions for commuting transportation (e.g., car services) are no longer allowed, except for transportation necessary for the employeeâs safety. Employer deductions for fringe benefits, like parking allowances and transit passes, were also eliminated, although they remain tax-free to employees within limits. Transportation expenses for business travel are still 100% deductible when meeting applicable rules.
Employee Benefits: Maximizing Tax Savings
Offering a variety of employee benefits can help attract and retain top talent while providing tax savings for your business. Typically, businesses can deduct their contributions to these plans:
Qualified Deferred Compensation Plans
These include pension plans, profit-sharing, SEP and 401(k) plans, and SIMPLE IRAs. Contributions to these plans are tax-deductible for the employer and provide tax-deferred savings for employees. Small employers may also be eligible for a tax credit when setting up such plans.
Health Savings Accounts (HSAs) and Flexible Spending Accounts (FSAs)
If you provide a qualified high-deductible health plan (HDHP), you can offer employees Health Savings Accounts (HSAs). Regardless of the type of health insurance provided, you can also offer Flexible Spending Accounts (FSAs) for health care and dependent care expenses, such as daycare.
Health Reimbursement Accounts (HRAs)
An HRA reimburses employees for medical expenses up to a maximum amount. Unlike an HSA, no HDHP is required. Also, unused portions can be carried over to the following year. However, only the employer can contribute to an HRA.
Fringe Benefits
Certain fringe benefits are not included in employee income but can still be deducted by the employer, while avoiding payroll taxes. Examples include:
Employee discounts
Group term-life insurance (up to $50,000 per person)
Health insurance
Warning: Employers who donât offer health insurance may face penalties. Under the Affordable Care Act (ACA), âlargeâ employers must provide minimum essential coverage to full-time employees, or face penalties if the coverage is deemed “unaffordable” or doesnât meet the minimum value requirements.
Interest Expense Deduction
Under the Tax Cuts and Jobs Act (TCJA), businesses can deduct interest paid or accrued up to 30% of adjusted taxable income (ATI). However, businesses with average annual gross receipts below the threshold for the past three years are exempt from this limitation.
Real property businesses can also fully deduct interest expenses but must use the alternative depreciation system for real property.
Loss Deductions
A business incurs a loss when its expenses and other deductions exceed revenue:
Net Operating Losses (NOLs)
The TCJA limits the amount of taxable income offset by NOL deductions to 80% of taxable income. NOLs can no longer be carried back but can be carried forward indefinitely, unlike the previous 20-year limit. If your business anticipates a loss this year, consider accelerating income to reduce the loss amount.
Pass-Through Entity “Excess” Business Losses
Through 2025, non-corporate taxpayers are limited in how much of their business losses can offset income from other sources, such as salary or investment income. These âexcessâ losses can be carried forward to later years and deducted under NOL rules.
The CARES Act temporarily lifted this limit for 2018-2020, and the Inflation Reduction Act extends it through 2028.
Tax Credits: Reducing Tax Liability Dollar-for-Dollar
Tax credits can directly reduce your businessâs tax liability. Key credits include:
Research Credit
This credit incentivizes businesses to invest in research and development. Start-ups with under $5 million in gross receipts that havenât yet incurred income tax liability can use the credit against payroll taxes. The credit is complex but can provide significant tax savings.
Work Opportunity Credit
This credit encourages hiring from disadvantaged groups, such as certain veterans, ex-felons, and long-term unemployed individuals. The credit ranges from $2,400 to $9,600 per employee depending on the group and employment hours. The credit expires on December 31, 2025.
Warning: Certification from the appropriate State Workforce Agency must be obtained before claiming the credit.
New Markets Credit
This credit provides investors with a 39% tax credit over seven years for making investments in qualified low-income communities. The credit is available through Certified Community Development Entities (CDEs) and is set to expire on December 31, 2025.
Retirement Plan Credit
Small employers (with 100 or fewer employees) that set up a retirement plan may qualify for a $500 credit per year for three years. The credit covers 50% of qualified startup costs.
Small-Business Health Care Credit
Small employers who offer group health insurance can receive a 50% credit for premiums paid, provided they meet certain employee and wage criteria. This credit is available for two consecutive years and requires enrollment in the Small Business Health Options Program (SHOP). It is limited to employers with fewer than 25 full-time equivalent (FTE) employees and specific wage thresholds.
Warning: The credit applies only if the employer contributes at least 50% of premiums.
Family and Medical Leave Credit
This credit, created by the TCJA, is for employers who provide paid family and medical leave. It is equal to 12.5% to 25% of wages paid during leave (up to 12 weeks per year). This credit expires on December 31, 2025.
Exit Planning: Strategies for Transitioning Ownership
An exit strategy is a well-planned approach to transferring responsibility for running your company, passing ownership, and extracting value from the business. It’s crucial to plan well ahead of time for a smooth transition. Here are some of the most common exit options:
Buy-Sell Agreements
A buy-sell agreement is essential for businesses with more than one owner. This agreement governs the businessâs future when certain events occur, such as retirement, disability, or death of an owner. Key benefits include:
Provides a ready market for a departing ownerâs shares
Sets a price for the shares
Ensures business continuity by preventing disputes caused by new owners
A critical aspect of a buy-sell agreement is funding the purchase of the departing ownerâs shares. Often, life or disability insurance is used for this, which has both tax and non-tax implications. For instance, life insurance proceeds are generally excluded from taxable income, though there are exceptions, so it’s essential to consult your tax advisor.
Succession Within the Family
Passing your business to family members can be done through:
Gifting interests
Selling interests
A combination of both
It’s important to consider:
Your income needs
How family members will feel about your decision
The gift and estate tax consequences
With the higher gift tax exemption under the TCJA, this is a favorable time to transfer ownership interests. Additionally, valuation discounts can reduce the taxable value of the gift.
Management Buyout
If family members are not interested or able to take over, consider a management buyout (MBO). An MBO offers:
Smooth transition, as the management team already knows the business
Avoidance of the time and expense associated with finding an outside buyer
Employee Stock Ownership Plan (ESOP)
An ESOP is a retirement plan that allows employees to own shares in the company. It provides benefits for:
Business liquidity
Tax-favored loans
Employee benefit programs
Sale to an Outsider
If you can find the right buyer, selling the business may provide a premium price. Preparing your business for sale requires:
Transparent operations
Assets in good working condition
Minimal reliance on key individuals
Sale or Acquisition: Key Tax Considerations
When selling or acquiring a business, tax consequences can significantly impact the outcome. Here are some important considerations:
Asset vs. Stock Sale
Sellers typically prefer a stock sale to benefit from capital gains tax treatment and avoid double taxation.
Buyers generally prefer an asset sale to maximize future depreciation write-offs.
Taxable Sale vs. Tax-Deferred Transfer
Ownership transfers in a corporation can be tax-deferred if done in exchange for stock or securities of the recipient corporation during a qualifying reorganization. However, this method has strict rules. Advantages of a taxable sale include:
The seller doesn’t have to worry about the buyer’s stock quality or business risks
The buyer receives a stepped-up basis in the acquired assets
Both parties avoid the complexities of a tax-deferred transfer
Installment Sale
An installment sale allows the buyer to pay over time, which can benefit the seller by spreading the gain over multiple years. This approach may be particularly beneficial if it keeps the seller under the thresholds for the 3.8% Net Investment Income Tax (NIIT) or 20% long-term capital gains rate.
However, there are risks:
Depreciation recapture must be reported as income in the year of sale, even if payments are spread out.
If tax rates increase, the total tax liability could end up being higher.
Incentive Stock Options (ISOs)
Incentive Stock Options (ISOs) are granted to executives or key employees, offering tax benefits but subject to specific rules. With ISOs:
No tax is owed when the options are granted.
No regular tax is owed when the options are exercised.
Long-term capital gains tax is paid when the stock is sold after holding the stock for at least one year post-exercise.
Important points:
Disqualifying disposition (selling before meeting holding period requirements) results in ordinary income tax, but not FICA or Medicare taxes.
Exercising ISOs may trigger the Alternative Minimum Tax (AMT) on the bargain element (the difference between the stock’s market value and exercise price).
To minimize tax implications:
Exercise early to start the holding period for long-term capital gains treatment.
Exercise when the bargain element is small to reduce AMT risk.
Sell early if avoiding AMT takes precedence over achieving long-term capital gains.
The TCJA increased the AMT exemption and its phaseout, reducing the risk of AMT for many taxpayers. However, the NIIT could still apply, so careful planning is necessary.
Nonqualified Stock Options (NQSOs)
Tax Treatment of NQSOs:
When exercised, NQSOs create compensation income taxed at ordinary income rates on the bargain element (the difference between the exercise price and the market value of the stock).
Unlike ISOs, NQSOs do not create an AMT preference item.
Taxes are triggered immediately upon exercise, regardless of whether the stock is held or sold.
You may need to increase your estimated tax payments or adjust your withholding to cover the tax liability.
Exercising NQSOs may push you into higher tax brackets, increasing exposure to the 0.9% additional Medicare tax and the Net Investment Income Tax (NIIT).
Restricted Stock
Tax Treatment of Restricted Stock:
Restricted stock is granted with a substantial risk of forfeiture, meaning it is not taxable until the stock is vested or sold.
Taxes are based on the fair market value (FMV) of the stock at the time the restrictions lapse (when the stock vests) and are taxed at ordinary-income rates. This FMV is also considered FICA income, potentially triggering the 0.9% additional Medicare tax.
Section 83(b) Election:
Under Section 83(b) of the tax code, you can choose to recognize income at the time the stock is granted, rather than when it vests. This allows you to:
Convert future appreciation from ordinary income into long-term capital gains income.
Defer tax on the appreciation until the stock is sold.
To make this election, it must be filed within 30 days of receiving the restricted stock.
Advantages of the Section 83(b) Election:
If the stockâs value at grant is low or if you expect the stock to appreciate significantly, this election could be beneficial.
The TCJA (Tax Cuts and Jobs Act) has low ordinary-income tax rates, making it an attractive time to recognize income under Section 83(b).
Disadvantages of the Section 83(b) Election:
You must prepay taxes on the stock at the time of the election, which could push you into a higher tax bracket and increase exposure to the additional 0.9% Medicare tax.
If you forfeit the stock or sell it at a loss, the taxes you paid due to the election cannot be refunded. However, you could claim a capital loss for tax purposes.
Upon sale of the stock, any gain will be subject to the 3.8% NIIT as net investment income.
Key Considerations:
The Section 83(b) election is ideal when the stockâs value is low at the grant date or if you expect significant appreciation.
If the stock forfeits or doesnât appreciate as expected, the tax paid is non-refundable, though you may be able to claim a loss.
Consult with a tax advisor to determine if making the 83(b) election is suitable for your situation.
Restricted Stock Units (RSUs)
Tax Treatment of RSUs:
RSUs are contractual rights to receive stock (or its cash equivalent) after vesting. Unlike restricted stock, RSUs are not eligible for the Section 83(b) election.
RSUs are typically taxed as ordinary income when the stock is delivered (i.e., when the RSUs vest and are converted into actual shares). This income is subject to FICA taxes, potentially triggering the 0.9% additional Medicare tax.
You may be able to defer taxes by negotiating with your employer to delay delivery of the RSUs until a later date, which will also defer taxes. However, this deferral must comply with IRC Section 409A.
Advantages and Considerations:
Unlike restricted stock, you cannot make a Section 83(b) election with RSUs.
The ability to delay delivery can help defer taxes and reduce exposure to the 0.9% Medicare tax.
However, it is essential to understand that any deferral must comply with strict regulations under IRC Section 409A.
Assessing the timing of tax recognition could be beneficial, particularly if tax rates remain low.
Nonqualified Deferred Compensation (NQDC) Plans
Tax Treatment of NQDC Plans:
NQDC plans allow executives to defer compensation until a later date. These plans differ from qualified plans (like 401(k)s) in that they:
Can favor highly compensated employees
Are not protected from the employerâs creditors.
Tax Issues:
Employment taxes (like FICA) are generally due when services are performed and there is no longer a substantial risk of forfeiture, even if compensation is not paid out immediately.
Your employer may withhold payroll taxes or ask you to pay your share directly, which could increase your taxable income.
The 0.9% additional Medicare tax could also apply to NQDC income.
Compliance and Penalties:
NQDC plans must meet strict regulatory requirements, and noncompliance can result in:
Immediate taxation of deferred amounts upon vesting.
A 20% penalty on the deferred amounts.
Potential interest charges.
Ensure that your employer is compliant with NQDC regulations to avoid these penalties.