Acuity Advisors

When businesses may want to take a contrary approach with income and deductions

Businesses usually want to delay recognition of taxable income into future years and accelerate deductions into the current year. But when is it wise to do the opposite? And why would you want to?

One reason might be tax law changes that raise tax rates. The Biden administration has proposed raising the corporate federal income tax rate from its current flat 21% to 28%. Another reason may be because you expect your noncorporate pass-through entity business to pay taxes at higher rates in the future and the pass-through income will be taxed on your personal return. There have also been discussions in Washington about raising individual federal income tax rates.

If you believe your business income could be subject to tax rate increases, you might want to accelerate income recognition into the current tax year to benefit from the current lower tax rates. At the same time, you may want to postpone deductions into a later tax year, when rates are higher and the deductions will be more beneficial.

To fast-track income

Consider these options if you want to accelerate revenue recognition into the current tax year:

Sell appreciated assets that have capital gains in the current year, rather than waiting until a later year.
Review the company’s list of depreciable assets to determine if any fully depreciated assets are in need of replacement. If fully depreciated assets are sold, taxable gains will be triggered in the year of sale.
For installment sales of appreciated assets, elect out of installment sale treatment to recognize gain in the year of sale.
Instead of using a tax-deferred like-kind Section 1031 exchange, sell real property in a taxable transaction.
Consider converting your S corporation into a partnership or LLC treated as a partnership for tax purposes. That will trigger gains from the company’s appreciated assets because the conversion is treated as a taxable liquidation of the S corp. The partnership will have an increased tax basis in the assets.
For construction companies with long-term construction contracts previously exempt from the percentage-of-completion method of accounting for long-term contracts: Consider using the percentage-of-completion method to recognize income sooner as compared to the completed contract method, which defers recognition of income until the long-term construction is completed.

To postpone deductions

Consider the following actions to postpone deductions into a higher-rate tax year, which will maximize their value:

Delay purchasing capital equipment and fixed assets, which would give rise to depreciation deductions.
Forego claiming big first-year Section 179 deductions or bonus depreciation deductions on new depreciable assets and instead depreciate the assets over a number of years.
Determine whether professional fees and employee salaries associated with a long-term project could be capitalized, which would spread out the costs over time.
Buy bonds at a discount this year to increase interest income in future years.
If allowed, put off inventory shrinkage or other write-downs until a year with a higher tax rate.
Delay charitable contributions into a year with a higher tax rate.
If allowed, delay accounts receivable charge-offs to a year with a higher tax rate.
Delay payment of liabilities where the related deduction is based on when the amount is paid.

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Don’t have a tax-favored retirement plan? Set one up now

If your business doesn’t already have a retirement plan, it might be a good time to take the plunge. Current retirement plan rules allow for significant tax-deductible contributions.

For example, if you’re self-employed and set up a SEP-IRA, you can contribute up to 20% of your self-employment earnings, with a maximum contribution of $69,000 for 2024 (up from $66,000 for 2023). If you’re employed by your own corporation, up to 25% of your salary can be contributed to your account, with a maximum contribution of $69,000. If you’re in the 32% federal income tax bracket, making a maximum contribution could cut what you owe Uncle Sam for 2024 by a whopping $22,080 (32% × $69,000).

Other possibilities

There are more small business retirement plan options, including:

401(k) plans, which can even be set up for just one person (also called solo 401(k)s),
Defined benefit pension plans, and
SIMPLE-IRAs.

Depending on your situation, these plans may allow bigger or smaller deductible contributions than a SEP-IRA. For example, for 2024, a participant can contribute $23,000 to a 401(k) plan, plus a $7,500 “catch-up” contribution for those age 50 or older.

Watch the calendar

Thanks to a change made by the 2019 SECURE Act, tax-favored qualified employee retirement plans, except for SIMPLE-IRA plans, can now be adopted by the due date (including any extension) of the employer’s federal income tax return for the adoption year. The plan can then receive deductible employer contributions that are made by the due date (including any extension), and the employer can deduct those contributions on the return for the adoption year.

Important: This provision didn’t change the deadline to establish a SIMPLE-IRA plan. It remains October 1 of the year for which the plan is to take effect. Also, the SECURE Act change doesn’t override rules that require certain plan provisions to be in effect during the plan year, such as the provisions that cover employee elective deferral contributions (salary-reduction contributions) under a 401(k) plan. The plan must be in existence before such employee elective deferral contributions can be made.

For example, the deadline for the 2023 tax year for setting up a SEP-IRA for a sole proprietorship business that uses the calendar year for tax purposes is October 15, 2024, if you extend your 2023 tax return. The deadline for making a contribution for the 2023 tax year is also October 15, 2024. For the 2024 tax year, the deadline for setting up a SEP and making a contribution is October 15, 2025, if you extend your 2024 tax return. However, to make a SIMPLE-IRA contribution for the 2023 tax year, you must have set up the plan by October 1, 2023. So, it’s too late to set up a plan for last year.

While you can delay until next year establishing a tax-favored retirement plan for this year (except for a SIMPLE-IRA plan), why wait? Get it done this year as part of your tax planning and start saving for retirement. We can provide more information on small business retirement plan options. Be aware that, if your business has employees, you may have to make contributions for them, too.

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Scrupulous records and legitimate business expenses are the key to less painful IRS audits

If you operate a business, or you’re starting a new one, you know records of income and expenses need to be kept. Specifically, you should carefully record expenses to claim all the tax deductions to which you’re entitled. And you want to make sure you can defend the amounts reported on your tax returns in case you’re ever audited by the IRS.

Be aware that there’s no one way to keep business records. On its website, the IRS states: “You can choose any recordkeeping system suited to your business that clearly shows your income and expenses.” But there are strict rules when it comes to deducting legitimate expenses for tax purposes. And certain types of expenses, such as automobile, travel, meal and home office costs, require extra attention because they’re subject to special recordkeeping requirements or limitations on deductibility.

Ordinary and necessary

A business expense can be deducted if a taxpayer establishes that the primary objective of the activity is making a profit. To be deductible, a business expense must be “ordinary and necessary.” In one recent case, a married couple claimed business deductions that the IRS and the U.S. Tax Court mostly disallowed. The reasons: The expenses were found to be personal in nature and the taxpayers didn’t have adequate records for them.

In the case, the husband was a salaried executive. With his wife, he started a separate business as an S corporation. His sideline business identified new markets for chemical producers and connected them with potential customers. The couple’s two sons began working for the business when they were in high school.

The couple then formed a separate C corporation that engaged in marketing. For some of the years in question, the taxpayers reported the income and expenses of the businesses on their joint tax returns. The businesses conducted meetings at properties the family owned (and resided in) and paid the couple rent for the meetings.

The IRS selected the couple’s returns for audit. Among the deductions the IRS and the Tax Court disallowed:

Travel expenses. The couple submitted reconstructed travel logs to the court, rather than records kept contemporaneously. The court noted that the couple didn’t provide “any documentary evidence or other direct or circumstantial evidence of the time, location, and business purpose of each reported travel expense.”
Marketing fees paid by the S corporation to the C corporation. The court found that no marketing or promotion was done. Instead, the funds were used to pay several personal family expenses.
Rent paid to the couple for the business use of their homes. The court stated the amounts “were unreasonable and something other than rent.”

Retirement plan deductions allowed

The couple did prevail on deductions for contributions to 401(k) accounts for their sons. The IRS contended that the sons weren’t employees during one year in which contributions were made for them. However, the court found that 401(k) plan documents did mention the sons working in the business and the father “credibly recounted assigning them research tasks and overseeing their work while they were in school.” Thus, the court ruled the taxpayers were entitled to the retirement plan deductions. (TC Memo 2023-140)

Lessons learned

As this case illustrates, a business can’t deduct personal expenses, and scrupulous records are critical. Make sure to use your business bank account for business purposes only. In addition, maintain meticulous records to help prepare your tax returns and prove deductible business expenses in the event of an IRS audit.

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2024 Q2 tax calendar: Key deadlines for businesses and employers

Here are some of the key tax-related deadlines that apply to businesses and other employers during the second quarter of 2024. Keep in mind that this list isn’t all-inclusive, so there may be additional deadlines that apply to you. Contact us to ensure you’re meeting all applicable deadlines and to learn more about the filing requirements.

April 15

If you’re a calendar-year corporation, file a 2023 income tax return (Form 1120) or file for an automatic six-month extension (Form 7004) and pay any tax due.
For corporations, pay the first installment of 2024 estimated income taxes. Complete and retain Form 1120-W (worksheet) for your records.
For individuals, file a 2023 income tax return (Form 1040 or Form 1040-SR) or file for an automatic six-month extension (Form 4868) and pay any tax due.
For individuals, pay the first installment of 2024 estimated taxes, if you don’t pay income tax through withholding (Form 1040-ES).

April 30

Employers report income tax withholding and FICA taxes for the first quarter of 2024 (Form 941) and pay any tax due.

May 10

Employers report income tax withholding and FICA taxes for the first quarter of 2024 (Form 941), if they deposited on time, and fully paid, all of the associated taxes due.

May 15

Employers deposit Social Security, Medicare and withheld income taxes for April if the monthly deposit rule applies.

June 17

Corporations pay the second installment of 2024 estimated income taxes.

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Business owners, your financial statements are trying to tell you something

Business owners are commonly and rightfully urged to regularly generate financial statements in compliance with Generally Accepted Accounting Principles (GAAP). One reason why is external users of financial statements, such as lenders and investors, place greater trust in financial reporting done under the rigorous standards of GAAP.

But that’s not the only reason. GAAP-compliant financial statements can reveal details of your company’s financial performance that you and your leadership team may otherwise not notice until a major problem has developed.

Earnings are only the beginning

Let’s begin with the income statement (also known as the profit and loss statement). It provides an overview of revenue, expenses and earnings over a given period.

Many business owners focus only on earnings in the income statement, which is understandable. You presumably went into business to make money. However, though revenue and profit trends are certainly important, they aren’t the only metrics that matter.

For example, high-growth companies may report healthy top and bottom lines but not have enough cash on hand to pay their bills. So, be sure to look beyond your income statement.

A snapshot is just that

The second key part of GAAP-compliant financial statements is the balance sheet (also known as the statement of financial position). It provides a snapshot of your company’s financial health by tallying assets, liabilities and equity.

For instance, intangible assets — such as patents, customer lists and goodwill — can provide significant value to businesses. But internally developed intangibles aren’t reported on the balance sheet. Intangible assets are reported only when they’ve been acquired externally.

Similarly, owners’ equity (or net worth) is the extent to which the book value of assets exceeds liabilities. If liabilities exceed assets, net worth will be negative. However, book value may not necessarily reflect market value. Some companies provide the details of owners’ equity in a separate statement called the statement of retained earnings. It covers sales or repurchases of stock, dividend payments, and changes caused by reported profits or losses.

Ultimately, your balance sheet can tell you a lot about what you’ve got, what you owe and how much equity you truly have in your company. But it doesn’t tell you everything, so it’s important to read the balance sheet in the context of the other two parts of your financial statements.

Cash is (you guessed it) king

The third key part of GAAP-compliant financial statements is the statement of cash flows. True to the name, it shows all the cash flowing in and out of your business. Cash inflows aren’t necessarily limited to sales; they can also include loans and stock sales. Outflows typically result from paying expenses, investing in capital equipment and repaying debt.

Typically, statements of cash flow are organized in three categories: operating, investing and financing activities. The bottom of the statement shows the net change in cash during the period.

Read your statement of cash flows closely as soon it’s available. It’s essentially telling you how much liquidity your business had during the reporting period. A sudden slow down in cash flow can quickly lead to a crisis if you aren’t generating enough cash to pay creditors, vendors and employees.

Detailed picture

In the day-to-day commotion of running a company, it can be easy to think of your financial statements solely as paperwork for the purposes of obtaining loans or other capital infusions. But these documents paint a detailed picture of the financial performance of your business. Use them wisely. For help generating GAAP-compliant financial statements, or just understanding them better, contact us.

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