The Biden administration recently announced plans to raise taxes on corporations and other businesses, including tax increases on some pass-through business owners. With these tax increases a possibility, it may be wise to start thinking about steps and strategies to lessen the impact of hikes of a tax rate. These options generally look to accelerate income and delay deductions, which is the opposite of conventional wisdom.
Changing Entity Type
Before we look at timing strategies, it is prudent to also consider that the C corporation form may not be the best option for your business. The 2017 tax reform law commonly known as the Tax Cuts and Jobs Act (TCJA) lowered and consolidated the corporate tax rates to a flat 21% rate. This put the total corporate tax burden (the total tax paid by the corporation and its shareholders) at a level that was close, but slightly higher than, the tax burden faced by owners of partnerships and S corporations (pass-through entities), especially if the pass-through entity is eligible for the qualified business income exclusion. This made tax rates less of a consideration for new and existing businesses that were either considering C corporation status or that were already C corporations. But with C corporation tax rates potentially rising to 28%, along with tax rates on corporate dividends potentially rising to 43.4%, this consideration will again rise in importance. A business may be able to find significant tax savings by changing its entity form to avoid being taxed as a C corporation, even if tax rates also rise for owners of pass-through entities.
The combination of the proposed increase to the base corporate tax rate, the proposed increased tax rate on dividends, and the net investment income tax would combine to push the effective corporate tax rate on distributed earnings to approximately 59%. That is nearly a 50% increase from the current level of 39%. By comparison, the Biden administration’s planned tax increases for owners of pass-through entities would raise the current level by just 2 percentage points to roughly 34%. A corporation making $5 million in pre-tax profit annually could save over $1.2 million per year in total income tax just by changing entity types (notwithstanding taxes that potentially apply to the conversion itself). Consider the following example to provide this point:
For many years the goal of most businesses was to accelerate deductions and delay recognizing income. This reduces a business’s current tax liability and allows a business to reinvest those dollars to generate future profits. This creates a cycle where the business can grow more and more profitable while minimizing its tax liability in the near term. However, rising tax rates potentially change that calculation. A business may want to accelerate taxable income in the near term to avoid higher tax rates. This can be accomplished using several different strategies.
One such strategy involves a change from the cash method of accounting to the accrual method of accounting. The TCJA permitted most businesses with less than $25 million in average gross receipts to use the cash method instead of the accrual method. Under the cash method, a taxpayer reports income when it is actually received and deducts expenses when they are paid. The accrual method differs in that a business generally recognizes income and expenses when incurred, rather than when any money changes hands. Thus, under the accrual method, a business will recognize income when sales take place, even if the business has not been paid. Likewise, a business that prepays an expense will generally not be able to deduct it until there is economic performance with respect to the expenditure. Although businesses on the accrual method also must deduct accrued expenses as they are economically performed (sooner than possible under the cash method), many businesses find that accrued sales outpace accrued expenses. The result is that a business on the accrual method will generally recognize overall taxable income sooner. This acceleration of income may be beneficial in the short term if tax rates increase, as a business may be able to shift that income to tax years with lower tax rates.
In a related move, a business already using the accrual method may consider a change to how it accounts for prepaid expenses. As with the recognition of income, businesses typically try to accelerate deductions when possible. An accrual-method business may generally deduct a prepaid expense if, among other requirements, the right or benefit associated with the prepaid expense does not extend beyond 12 months after the time the business first realizes a benefit (exceptions apply in the case of short years). Common examples of such items are state income taxes and insurance. But if tax rates rise, it may be beneficial to delay the deduction for these prepaid expenses to a year with higher tax rates (when the tax deduction is worth more). This can be accomplished by making a simple election when the tax return is filed.
Perhaps the most common situation involving the timing of deductions pertains to cost recovery for capital expenditures (fixed assets). Bonus depreciation and the Section 179 deduction both allow a taxpayer to deduct 100% of the cost of certain property, subject to some limitations. This provides a benefit to businesses in that it accelerates the deduction, while matching that deduction with the outflow of cash. If a business does not elect one of these two methods of accelerated depreciation, then it must generally spread the depreciation deduction out over a number of years. This can be anywhere from three years to 40 years depending on the property. As with the considerations for prepaid expenses, a decision to delay these deductions until years with higher tax rates will make the deductions more valuable. These decisions must be analyzed in light of other issues, such as the time value of money and the potential for different political regimes in the future.
Delaying deductions is not the only planning technique to prepare for a future tax increase. A taxpayer who sells property or an entire business may be able to accelerate recognition of income to ensure that the gain on the sale will be taxed at the current low rates. This is done by electing out of installment sale treatment. Typically, a taxpayer who sells property with payments to be received over time will choose the installment method to report the associated gain as payments are received. This delays the taxation of the gain, and it provides better matching because the gain is reported at the same time when cash is actually received. But if tax rates rise significantly, it may be better to elect out of installment reporting so that the tax on all of the gain is paid at a time when it is less costly.
The Biden administration’s plan for tax increases has not yet been formally introduced as legislation, so it remains to be seen what provisions come to fruition. Nevertheless, savvy business owners should start thinking about how your business may respond to tax law changes that would increase their tax liability in order to take advantage of lower tax rates that exist today. Many of the strategies discussed do not have to be implemented until the time that a tax return is filed, which gives business owners time to assess tax elections after the time that underlying business transactions occur. If you have would like to discuss any of these strategies further, please contact us.
Kevin Eagan is a Tax Managing Director in New England. He can be reached at 617. 761.0744 or email@example.com.
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