July 2022 - Ullrich Delevati

Sometimes, bigger isn’t better: Your small- or medium-sized business may be eligible for some tax breaks that aren’t available to larger businesses. Here are some examples.

1. QBI deduction

For 2018 through 2025, the qualified business income (QBI) deduction is available to eligible individuals, trusts and estates. But it’s not available to C corporations or their shareholders.

The QBI deduction can be up to 20% of:

QBI earned from a sole proprietorship or single-member limited liability company (LLC) that’s treated as a sole proprietorship for federal income tax purposes, plus
QBI passed through from a pass-through business entity, meaning a partnership, LLC classified as a partnership for federal income tax purposes or S corporation.

Pass-through business entities report tax items to their owners, who then take them into account on their owner-level returns. The QBI deduction rules are complicated, and the deduction can be phased out at higher income levels.

2. Eligibility for cash-method accounting

Businesses that are eligible to use the cash method of accounting for tax purposes have the ability to fine-tune annual taxable income. This is accomplished by timing the year in which you recognize taxable income and claim deductions.

Under the cash method, you generally don’t have to recognize taxable income until you’re paid in cash. And you can generally write off deductible expenses when you pay them in cash or with a credit card.

Only “small” businesses are potentially eligible for the cash method. For this purpose under current law, a small business includes one that has no more than $25 million of average annual gross receipts, based on the preceding three tax years. This limit is adjusted annually for inflation. For tax years beginning in 2022, the limit is $27 million.

3. Section 179 deduction

The Sec. 179 first-year depreciation deduction potentially allows you to write off some (or all) of your qualified asset additions in the first year they’re placed in service. It’s available for both new and used property.

For qualified property placed in service in tax years 2018 and beyond, the deduction rules are much more favorable than under prior law. Enhancements include:

Higher deduction. The Sec. 179 deduction has been permanently increased to $1 million with annual inflation adjustments. For qualified assets placed in service in 2022, the maximum is $1.08 million.

Liberalized phase-out. The threshold above which the maximum Sec. 179 deduction begins to be phased out is $2.5 million with annual inflation adjustments. For qualified assets placed in service in 2022, the phase-out begins at $2.7 million.

The phase-out rule kicks in only if your additions of assets that are eligible for the deduction for the year exceed the threshold for that year. If they exceed the threshold, your maximum deduction is reduced dollar-for-dollar by the excess. Sec. 179 deductions are also subject to other limitations.

Bonus depreciation

While Sec. 179 deductions may be limited, those limitations don’t apply to first-year bonus depreciation deductions. For qualified assets placed in service in 2022, 100% first-year bonus depreciation is available. After this year, the first-year bonus depreciation percentages are scheduled to start going down to 80% for qualified assets placed in service in 2023. They will continue to be reduced until they reach 0% for 2028 and later years.

Contact us to determine if you’re taking advantage of all available tax breaks, including those that are available to small and large businesses alike.

A business or individual might be able to dispose of appreciated real property without being taxed on the gain by exchanging it rather than selling it. You can defer tax on your gain through a “like-kind” or Section 1031 exchange.

A like-kind exchange is a swap of real property held for investment or for productive use in your trade or business for like-kind investment real property or business real property. For these purposes, “like-kind” is very broadly defined, and most real property is considered to be like-kind with other real property. However, neither the relinquished property nor the replacement property can be real property held primarily for sale. If you’re unsure whether the property involved in your exchange is eligible for a like-kind exchange, contact us to discuss the matter.

Here’s how the tax rules work

If it’s a straight asset-for-asset exchange, you won’t have to recognize any gain from the exchange. You’ll take the same “basis” (your cost for tax purposes) in the replacement property that you had in the relinquished property. Even if you don’t have to recognize any gain on the exchange, you still have to report the exchange on a form that is attached to your tax return.

However, the properties often aren’t equal in value, so some cash or other (non-like-kind) property is thrown into the deal. This cash or other property is known as “boot.” If boot is involved, you’ll have to recognize your gain, but only up to the amount of boot you receive in the exchange. In these situations, the basis you get in the like-kind replacement property you receive is equal to the basis you had in the relinquished property you gave up reduced by the amount of boot you received but increased by the amount of any gain recognized.

Here’s an example

Let’s say you exchange land (investment property) with a basis of $100,000 for a building (investment property) valued at $120,000 plus $15,000 in cash. Your realized gain on the exchange is $35,000: You received $135,000 in value for an asset with a basis of $100,000. However, since it’s a like-kind exchange, you only have to recognize $15,000 of your gain: the amount of cash (boot) you received. Your basis in the new building (the replacement property) will be $100,000, which is your original basis in the relinquished property you gave up ($100,000) plus the $15,000 gain recognized, minus the $15,000 boot received.

Note: No matter how much boot is received, you’ll never recognize more than your actual (“realized”) gain on the exchange.

If the property you’re exchanging is subject to debt from which you’re being relieved, the amount of the debt is treated as boot. The theory is that if someone takes over your debt, it’s equivalent to him or her giving you cash. Of course, if the replacement property is also subject to debt, then you’re only treated as receiving boot to the extent of your “net debt relief” (the amount by which the debt you become free of exceeds the debt you pick up).

Like-kind exchanges can be complex but they’re a good tax-deferred way to dispose of investment or trade or business assets. We can answer any additional questions you have or assist with the transaction.

Sadly, many businesses have been forced to shut down recently due to the pandemic and the economy. If this is your situation, we can assist you, including taking care of the various tax responsibilities that must be met.

Of course, a business must file a final income tax return and some other related forms for the year it closes its doors. The type of return to be filed depends on the type of business you have. Here’s a rundown of the basic requirements.

Sole proprietorships. You’ll need to file the usual Schedule C, “Profit or Loss from Business,” with your individual return for the year you close the business. You may also need to report self-employment tax.

Partnerships. A partnership must file Form 1065, “U.S. Return of Partnership Income,” for the year it closes. You also must report capital gains and losses on Schedule D. Indicate that this is the final return and do the same on Schedule K-1, “Partner’s Share of Income, Deductions, Credits, etc.”

All corporations. Form 966, “Corporate Dissolution or Liquidation,” must be filed if you adopt a resolution or plan to dissolve a corporation or liquidate any of its stock.

C corporations. File Form 1120, “U.S. Corporation Income Tax Return,” for the year you close. Report capital gains and losses on Schedule D. Indicate this is the final return.

S corporations. File Form 1120-S, “U.S. Income Tax Return for an S Corporation,” for the year of closing. Report capital gains and losses on Schedule D. The “final return” box must be checked on Schedule K-1.

All businesses. Other forms may need to be filed to report sales of business property and asset acquisitions if you sell your business.

Employees and contract workers

If you have employees, you must pay them final wages and compensation owed, make final federal tax deposits and report employment taxes. Failure to withhold or deposit employee income, Social Security and Medicare taxes can result in full personal liability for what’s known as the Trust Fund Recovery Penalty.

If you’ve paid any contractors at least $600 during the calendar year in which you close your business, you must report those payments on Form 1099-NEC, “Nonemployee Compensation.”

Other tax issues

If your business has a retirement plan for employees, you’ll want to terminate the plan and distribute benefits to participants. There are detailed notice, funding, timing and filing requirements that must be met by a terminating plan. There are also complex requirements related to flexible spending accounts, Health Savings Accounts, and other programs for your employees.

We can assist you with many other complicated tax issues related to closing your business, including debt cancellation, use of net operating losses, freeing up any remaining passive activity losses, depreciation recapture, and possible bankruptcy issues.

We can advise you on the length of time you need to keep business records. You also must cancel your Employer Identification Number (EIN) and close your IRS business account.

If your business is unable to pay all the taxes it owes, we can explain the available payment options to you. Contact us to discuss these issues and get answers to any questions.

Although merger and acquisition activity has been down in 2022, according to various reports, there are still companies being bought and sold. If your business is considering merging with or acquiring another business, it’s important to understand how the transaction will be taxed under current law.

Stocks vs. assets

From a tax standpoint, a transaction can basically be structured in two ways:

1. Stock (or ownership interest). A buyer can directly purchase a seller’s ownership interest if the target business is operated as a C or S corporation, a partnership, or a limited liability company (LLC) that’s treated as a partnership for tax purposes.

The current 21% corporate federal income tax rate makes buying the stock of a C corporation somewhat more attractive. Reasons: The corporation will pay less tax and generate more after-tax income than it would have years ago. Plus, any built-in gains from appreciated corporate assets will be taxed at a lower rate when they’re eventually sold.

Under current law, individual federal tax rates are reduced from years ago and may also make ownership interests in S corporations, partnerships and LLCs more attractive. Reason: The passed-through income from these entities also will be taxed at lower rates on a buyer’s personal tax return. However, individual rate cuts are scheduled to expire at the end of 2025, and, depending on future changes in Washington, they could be eliminated earlier or extended.

2. Assets. A buyer can also purchase the assets of a business. This may happen if a buyer only wants specific assets or product lines. And it’s the only option if the target business is a sole proprietorship or a single-member LLC that’s treated as a sole proprietorship for tax purposes.

Note: In some circumstances, a corporate stock purchase can be treated as an asset purchase by making a “Section 338 election.” Ask your tax advisor for details.

What buyers and sellers want

For several reasons, buyers usually prefer to purchase assets rather than ownership interests. Generally, a buyer’s main objective is to generate enough cash flow from an acquired business to pay any acquisition debt and provide an acceptable return on the investment. Therefore, buyers are concerned about limiting exposure to undisclosed and unknown liabilities and minimizing taxes after the deal closes.

A buyer can step up (increase) the tax basis of purchased assets to reflect the purchase price. Stepped-up basis lowers taxable gains when certain assets, such as receivables and inventory, are sold or converted into cash. It also increases depreciation and amortization deductions for qualifying assets.

Meanwhile, sellers generally prefer stock sales for tax and nontax reasons. One of their main objectives is to minimize the tax bill from a sale. That can usually be achieved by selling their ownership interests in a business (corporate stock or partnership or LLC interests) as opposed to selling business assets.

With a sale of stock or other ownership interest, liabilities generally transfer to the buyer and any gain on sale is generally treated as lower-taxed long-term capital gain (assuming the ownership interest has been held for more than one year).

Keep in mind that other issues, such as employee benefits, can also cause unexpected tax issues when merging with, or acquiring, a business.

Get professional advice

Buying or selling a business may be the most important transaction you make during your lifetime, so it’s important to seek professional tax advice as you negotiate. After a deal is done, it may be too late to get the best tax results. Contact us for the best way to proceed in your situation.

July 11, 2022

Employees – who work for tips. If you received $20 or more in tips during June, report them to your employer. You can use Form 4070.

July 15, 2022

Employers – Social Security, Medicare, and withheld income tax. If the monthly deposit rule applies, deposit the tax for payments in June.

Employers – Nonpayroll withholding. If the monthly deposit rule applies, deposit the tax for payments in June.

Here’s an interesting option if your small company or start-up business is planning to claim the research tax credit. Subject to limits, you can elect to apply all or some of any research tax credits that you earn against your payroll taxes instead of your income tax. This payroll tax election may influence some businesses to undertake or increase their research activities. On the other hand, if you’re engaged in or are planning to engage in research activities without regard to tax consequences, be aware that some tax relief could be in your future.

Here are some answers to questions about the option.

Why is the election important?

Many new businesses, even if they have some cash flow, or even net positive cash flow and/or a book profit, pay no income taxes and won’t for some time. Therefore, there’s no amount against which business credits, including the research credit, can be applied. On the other hand, a wage-paying business, even a new one, has payroll tax liabilities. The payroll tax election is thus an opportunity to get immediate use out of the research credits that a business earns. Because every dollar of credit-eligible expenditure can result in as much as a 10-cent tax credit, that’s a big help in the start-up phase of a business — the time when help is most needed.

Which businesses are eligible?

To qualify for the election a taxpayer:

Must have gross receipts for the election year of less than $5 million and
Be no more than five years past the period for which it had no receipts (the start-up period).

In making these determinations, the only gross receipts that an individual taxpayer takes into account are from his or her businesses. An individual’s salary, investment income or other income aren’t taken into account. Also, note that neither an entity nor an individual can make the election for more than six years in a row.

Are there limits on the election?

Research credits for which a taxpayer makes the payroll tax election can be applied only against the employer’s old-age, survivors and disability liability — the OASDI or Social Security portion of FICA taxes. So the election can’t be used to lower 1) the employer’s liability for the Medicare portion of FICA taxes or 2) any FICA taxes that the employer withholds and remits to the government on behalf of employees.

The amount of research credit for which the election can be made can’t annually exceed $250,000. Note too that an individual or C corporation can make the election only for those research credits which, in the absence of an election, would have to be carried forward. In other words, a C corporation can’t make the election for research credits that the taxpayer can use to reduce current or past income tax liabilities.

The above Q&As just cover the basics about the payroll tax election. And, as you may have already experienced, identifying and substantiating expenses eligible for the research credit itself is a complex area. Contact us for more information about the payroll tax election and the research credit.

If you’re a business owner and you’re getting a divorce, tax issues can complicate matters. Your business ownership interest is one of your biggest personal assets and in many cases, your marital property will include all or part of it.

Tax-free property transfers

You can generally divide most assets, including cash and business ownership interests, between you and your soon-to-be ex-spouse without any federal income or gift tax consequences. When an asset falls under this tax-free transfer rule, the spouse who receives the asset takes over its existing tax basis (for tax gain or loss purposes) and its existing holding period (for short-term or long-term holding period purposes).

Let’s say that under the terms of your divorce agreement, you give your house to your spouse in exchange for keeping 100% of the stock in your business. That asset swap would be tax-free. And the existing basis and holding periods for the home and the stock would carry over to the person who receives them.

Tax-free transfers can occur before a divorce or at the time it becomes final. Tax-free treatment also applies to post-divorce transfers as long as they’re made “incident to divorce.” This means transfers that occur within:

A year after the date the marriage ends, or
Six years after the date the marriage ends if the transfers are made pursuant to your divorce agreement.

More tax issues

Later on, there will be tax implications for assets received tax-free in a divorce settlement. The ex-spouse who winds up owning an appreciated asset — when the fair market value exceeds the tax basis — generally must recognize taxable gain when it’s sold (unless an exception applies).

What if your ex-spouse receives 49% of your highly appreciated small business stock? Thanks to the tax-free transfer rule, there’s no tax impact when the shares are transferred. Your ex will continue to apply the same tax rules as if you had continued to own the shares, including carryover basis and carryover holding period. When your ex-spouse ultimately sells the shares, he or she will owe any capital gains taxes. You will owe nothing.

Note that the person who winds up owning appreciated assets must pay the built-in tax liability that comes with them. From a net-of-tax perspective, appreciated assets are worth less than an equal amount of cash or other assets that haven’t appreciated. That’s why you should always take taxes into account when negotiating your divorce agreement.

In addition, the beneficial tax-free transfer rule is now extended to ordinary-income assets, not just to capital-gains assets. For example, if you transfer business receivables or inventory to your ex-spouse in a divorce, these types of ordinary-income assets can also be transferred tax-free. When the asset is later sold, converted to cash or exercised (in the case of nonqualified stock options), the person who owns the asset at that time must recognize the income and pay the tax liability.

Plan ahead to avoid surprises

Like many major life events, divorce can have major tax implications. For example, you may receive an unexpected tax bill if you don’t carefully handle the splitting up of qualified retirement plan accounts (such as a 401(k) plan) and IRAs. And if you own a business, the stakes are higher. We can help you minimize the adverse tax consequences of settling your divorce.

Are you a partner in a business? You may have come across a situation that’s puzzling. In a given year, you may be taxed on more partnership income than was distributed to you from the partnership in which you’re a partner.

Why does this happen? It’s due to the way partnerships and partners are taxed. Unlike C corporations, partnerships aren’t subject to income tax. Instead, each partner is taxed on the partnership’s earnings — whether or not they’re distributed. Similarly, if a partnership has a loss, the loss is passed through to the partners. (However, various rules may prevent a partner from currently using his or her share of a partnership’s loss to offset other income.)

Pass through your share

While a partnership isn’t subject to income tax, it’s treated as a separate entity for purposes of determining its income, gains, losses, deductions and credits. This makes it possible to pass through to partners their share of these items.

An information return must be filed by a partnership. On Schedule K of Form 1065, the partnership separately identifies income, deductions, credits and other items. This is so that each partner can properly treat items that are subject to limits or other rules that could affect their correct treatment at the partner’s level. Examples of such items include capital gains and losses, interest expense on investment debts and charitable contributions. Each partner gets a Schedule K-1 showing his or her share of partnership items.

Basis and distribution rules ensure that partners aren’t taxed twice. A partner’s initial basis in his or her partnership interest (the determination of which varies depending on how the interest was acquired) is increased by his or her share of partnership taxable income. When that income is paid out to partners in cash, they aren’t taxed on the cash if they have sufficient basis. Instead, partners just reduce their basis by the amount of the distribution. If a cash distribution exceeds a partner’s basis, then the excess is taxed to the partner as a gain, which often is a capital gain.

Illustrative example

Two people each contribute $10,000 to form a partnership. The partnership has $80,000 of taxable income in the first year, during which it makes no cash distributions to the two partners. Each of them reports $40,000 of taxable income from the partnership as shown on their K-1s. Each has a starting basis of $10,000, which is increased by $40,000 to $50,000. In the second year, the partnership breaks even (has zero taxable income) and distributes $40,000 to each of the two partners. The cash distributed to them is received tax-free. Each of them, however, must reduce the basis in his or her partnership interest from $50,000 to $10,000.

More rules and limits

The example and details above are an overview and, therefore, don’t cover all the rules. For example, many other events require basis adjustments and there are a host of special rules covering noncash distributions, distributions of securities, liquidating distributions and other matters. Contact us if you’d like to discuss how a partner is taxed.

Three Tax Breaks for Small Businesses

Important Considerations When Engaging in a Like-Kind Exchange

The Tax Obligations if Your Business Closes its Doors

How Do Taxes Factor into an M&A Transaction?

Tax Deadlines: July 2022

Fun Fact: How Much Do Americans Spend On Cooling Their Homes?

Infographic: These Benefits Enable Key Employees to Earn More and Defer Taxes

Help When Needed: Apply the Research Credit Against Payroll Taxes

Getting a Divorce? Be Aware of Tax Implications if You Own a Business

Partners May Have to Report More Income on Tax Returns Than They Receive in Cash

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