As the great Michael Scott once said, “It’s happening! Everybody stay calm!”.
The iconic “The Office” scene can be found here.
With the 2020 tax season almost in the rearview, the 2021 tax season is creeping up, closer than you think (or would want). Ever heard the phrase, “the sooner, the better?” You guessed it! That phrase directly applies to tax planning. What we mean is that the sooner you can begin this process, the better it will be for you later in the year. 2020 has provided the business community with enough challenges, do not let mismanaging the tax piece of your operation be the straw the broke the camel’s back in this challenging year.
Tax planning can help you avoid stress when the deadline comes around to file your taxes. Seriously… this is a year-round process and quite frankly, the absolute fastest and easiest way to increase your cash flow as an entrepreneur and business owner is to reduce your taxes!
Maximizing cash flow and enhancing balance sheets (we want more assets and less liabilities) has been the over-reaching operational goal for 2020. To this end, some of the most basic tax planning ideas warrant the attention of business owners. These are the tools in the tax planning tool shed that never fail and can make a significant difference in reducing income tax, thereby increasing cash flow.
Examine all business receivables to determine if a write-off can be taken
An accrual-basis business can take an ordinary deduction for the write-off of a business bad debt.
The worthlessness of a debt is determined by the particular facts surrounding each debt. The standard for this determination is more pragmatic than it is legal. Court cases often rely on what could be considered sound business judgment in determining worthlessness.
Use the lower-of-cost-or-market method for valuing inventory
The lower-of-cost-or-market (LCM) method of inventory valuation can result in current write-downs of inventory cost before the sale of the inventory.
Depreciate (or dispose) idle equipment
It is entirely possible that as a result of reduced demand in the current economy that manufacturers find themselves with property that becomes idle.
Depreciation is allowed on assets that are temporarily idle, provided the taxpayer can demonstrate an intention to devote them to active use as soon as conditions permit. Or, if the assets may be idle for an undeterminable period of time, consider disposing them to capture all remaining depreciation in the current ~ or if the asset has value, turning the idle asset into cash is certainly a way to bolster working capital.
An ordinary deduction for worthless stock of a subsidiary
An opportunity exists for a corporation to take an ordinary, not capital, loss when the stock of an “affiliated entity” becomes worthless.
There are certain requirements to obtain that beneficial tax deduction. First, for the worthless entity to be “affiliated,” the stockholder must own stock representing at least 80% of the voting power and at least 80% of the value of the entity’s stock. Second, 90% of the subsidiary’s aggregate gross receipts for all tax years during which the subsidiary has been in existence must be from sources other than royalties, rents, dividends, interest, annuities, or gains from sales or exchanges of stock and securities.
The business does not need to be disposed of to obtain the loss. However, there must be an identifiable event that occurs to take the loss.
Ensure adequate stock and debt basis in S corporations and partnerships
Much has been written about the provisions in the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, that can result in increased deductions and potential refunds of taxes paid. These include the technical correction to the depreciation provisions for qualified improvement property, the increased interest deduction under Sec. 163(j), and the net operating loss (NOL) carryback provisions. However, if these relief provisions are generated through a partnership or S corporation, the partner/shareholder must have an adequate tax basis to take any deduction or loss that flows through from the entity to benefit in the current year from these favorable provisions.
A basis calculation for shareholders and partners consists of a running computation from the point in time when the owner obtained an ownership interest in the entity and must be updated each year to reflect all of the relevant activity that affects the basis. It is important to have the calculation completed to the extent possible before year-end to determine if an additional basis needs to be created by making additional capital contributions or loans before the end of the year.
Consider an automatic change in accounting method to reduce taxable income
Automatic changes in accounting methods can be made by the due date of the tax return, including extensions. Note that while these changes may possibly only have a benefit in the year of change, those changes made on the 2020 tax return could result in significant tax savings on the 2020 tax return and possibly an NOL to be carried back or forward.
Rev. Proc. 2018-31 includes a list of automatic changes in accounting methods and should be reviewed to determine which changes can apply on a case-by-case basis. Some very common ones that are relevant to a wide range of businesses include:
- Changing the treatment of prepaid expenses — Deduct prepaid expenses when paid using the “12-month rule” (Regs. Sec. 1.263(a)-4(f));
- Changing the treatment of accrued compensation — Deduct the amounts that are fixed and determinable at year-end and are paid within 2½ months after year-end (Regs. Sec. 1.461-4);
- Changing the treatment of advanced payments received — Defer the receipt of those payments to the subsequent year (Rev. Proc. 2004-34, Sec. 451(c), Rev. Proc. 2019-37, Prop. Regs. Sec. 1.451-3);
- Reviewing the class lives used for depreciation — Often the class lives are simply incorrect and result in too long a depreciation period, which can be significantly shortened on review.
Have you acquired a commercial property in the last few years? Consider a cost segregation study
A Cost Segregation Study is a federal income tax tool that increases your near-term cash flow, in the form of a deferral, by utilizing shorter recovery periods to accelerate the return on capital from your investment in property. Whether newly constructed, purchased, or renovated, the components of your building may be properly classified through a cost segregation study into shorter recovery periods for computing depreciation. The study carves out (into 5, 7, and 15-year lives) certain qualifying portions of your building that are normally buried in 39 or 27.5-year categories.
Do you rely on the hard sciences or use technology in your business to create or improve products or processes? You might be able to reduce your taxes by deploying the Research and Development Tax Credit
The Research and Development Tax Credit is a permanent federal tax incentive meant to stimulate innovation, technical design and manufacturing within the U.S. Most states have a similar tax incentive as well. While the R&D Tax Credit was available since 1981, tax regulations that were finalized in December 2003 significantly increased the types of activities that qualify for the credit.
Companies no longer need to develop a product or process that was new to their industry, it only needed to be new to them. Companies of all sizes and in many different industries can now qualify for these dollar-for-dollar tax credits. Some of the industries that qualify for the credit include manufacturers, tool and die / job shops, plastic mold injection, software developers, architectural and engineering firms, construction contractors, food processors, chemical companies, agribusiness, and apparel/textile companies, among others.
Less than one-third of eligible companies realize they qualify for the R&D tax credit. Also, many of the companies that are taking the credit are not claiming all of the credits to which they are entitled.
In these challenging economic times, it is extremely worthwhile to review many of the classic tax-saving opportunities that have provided a significant reduction of taxes during a wide range of economic conditions. While the recently enacted CARES Act contains several significant tax-saving opportunities, a great deal of needed cash can be generated by applying the tried-and-true tax provisions that have been used by tax planners for many years. The possibilities are not limited to just the ones noted in this article. Therefore, it is essential to review all the circumstances of each business to determine “oldies but goodies” that are relevant in each set of circumstances.