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Tax Planning for Small Business: 5 Strategies for 2021

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For most small businesses, every penny counts. Not only do you want to optimize revenue, but you also need to minimize your tax liability.

Fortunately, there’s still time to do some year-end tax planning to lower your 2020 federal income tax bill before filing your taxes in 2021. You might also be able to take advantage of new tax incentives put into place by the Coronavirus Aid, Relief and Economic Security (CARES) Act passed earlier this year as well as more recent legislation in the final days of 2020.

5 small business tax-planning strategies

Here are a few small business tax planning strategies you might implement.

Consider a tax status change

As a small business owner, you have several options for structuring your business. You can operate as a sole proprietor, partnership, limited liability company (LLC), S corporation or C corporation. The business structure impacts how to file taxes for small business owners.

If you’ve outgrown your current business structure in the past year, you may be able to change to one that’s a better fit. For example, LLCs can elect to be taxed like a C corporation by filing Form 8832 with the IRS.

Making such an election used to be rare, as the top corporate tax rate was 35%, but the Tax Cuts and Jobs Act of 2017 (TCJA) dropped the top corporate income tax rate from 35% to 21%.

Corporations vs. pass-through businesses

Pass-through businesses, such as sole proprietorships, partnerships, LLCs and S corporations, don’t pay a corporate income tax. Instead, the company’s net income “passes through” to the owner’s individual tax return, where the highest tax bracket is 37%. For LLC members in the top tax bracket, a tax status change can result in significant tax savings.

However, it remains to be seen if that 21% corporate tax rate will last under a new U.S. president. The tax plan released by President-elect Joe Biden prior to the November 2020 election includes increasing the corporate income tax rate from 21% to 28%.

Of course, tax savings aren’t the only factor that goes into selecting a structure for your small business. Before changing your tax status, consult with a tax pro who can help you crunch the numbers and run a cost-benefit analysis.

Continue to take advantage of tax reform

The TCJA also created the qualified business income (QBI) deduction, which provides pass-through business owners a deduction worth up to 20% of their share of the business’s income. But it does come with a lot of rules and limitations.

Owners of specified service trades or businesses (SSTBs) lose out on the deduction if their income is too high. SSTBs generally include any service-based business other than engineering and architecture firms, where the business depends on its employees’ or owners’ reputation or skill. Examples of these types of SSTBs include:

  • Law firms
  • Medical practices
  • Consulting firms
  • Professional athletes
  • Performing artists
  • Accountants
  • Financial advisers
  • Investment managers

If your business is an SSTB, your QBI deduction starts to phase out once your total taxable income exceeds a certain amount. For the 2020 tax year, those thresholds are $163,300 if single or $326,600 if married filing a joint return. You’ll need to use Part II of Form 8995-A to calculate your deduction. Once your income is over $213,300 for single filers ($426,600 for married filing jointly), you can’t take the deduction.

If your business is not an SSTB, but your total taxable income is above those upper limits, you can claim the deduction, but it’s limited to:

  • 50% of your share of W-2 wages paid by the business, or
  • 25% of those wages, plus 2.5% of your share of qualified property

Confused? You’re not alone. The QBI deduction can provide a generous deduction for small business owner taxes but figuring out who can claim it and then calculating the deduction is no easy task. Talk to your accountant if you think you might qualify.

Leverage the CARES Act

The Coronavirus Aid, Relief and Economic Security (CARES) Act included several new tax planning for small business opportunities.

Relaxed NOL limits

The CARES Act relaxed some of the restrictions on Net Operating Losses (NOL) that the TCJA put into place.

NOLs occur when a company’s tax deductions are higher than its taxable income. Prior to the TCJA, businesses could carry an NOL back up to two prior tax years to offset a previous year’s tax bill or carry it forward up to 20 years.

The TCJA ended the option to carry NOLs back two years. It also added a rule that allows taxpayers to offset only 80% of their taxable income with NOLs.

The CARES Act partially loosened these limitations by removing the 80% limit on carryovers from 2017 and earlier. It also allows taxpayers to carry NOLs from 2018, 2019 and 2020 back up to five years. If your business lost money due to the pandemic, talk to your accountant about carrying the loss back to a prior year. You may be able to recover some of the taxes paid when revenues were higher.

Employee retention credit

Businesses that help idle workers on payroll during the pandemic may qualify for a tax credit worth half of the employee’s wages and health plan costs. The credit initially applied to wages paid from March 13, 2020, through Dec. 31, 2020, and was worth up to $5,000 per employee.

The Coronavirus Response and Relief Supplemental Appropriation Act of 2021, passed in the final days of 2020, extended the credit to cover qualified wages through June 30, 2021. It also increased the credit amount to 70% of qualified wages for each of the first two quarters of 2021 (up to $14,000 per employee) including the cost of continuing to provide health benefits to employees.

To qualify, your business must prove:

  • It fully or partially suspended operations due to governmental orders limiting commerce, travel or group meetings due to the pandemic, or
  • In 2020, it had a 50% decline in gross receipts compared to the same quarter in 2019.
  • In 2021, the business’s gross receipts were less than 60% of gross receipts for the same quarter in 2019.

Businesses can claim the credit by reducing payroll tax deposits. If those deposits aren’t enough to cover the full credit, the business can request an advance from the IRS by filing Form 7200.

Charitable deductions for donated inventory

The CARES Act also temporarily modified the rules for businesses that deduct donations of unused inventory. Typically, businesses can deduct donations of food inventory up to 15% of the business’s taxable income. For 2020, that limit was increased to 25% of the business’s taxable income.

The deduction applies to corporations and non-corporate taxpayers, including cash basis small businesses that don’t keep inventories. This might be especially useful for restaurants hard-hit in the pandemic. The deduction is limited to the cost of the donated food inventory, plus half of the profit the business would have received if it had sold the donated food.

Defer income — or accelerate income

Many small businesses use the cash method of accounting on their books and tax return. Under the cash method, a company recognizes income when it’s received and expenses when paid — in other words, when cash actually changes hands.

That creates some interesting tax planning strategies. If you expect to be in a lower tax bracket next year, you might want to defer income to next year, when you’ll pay taxes at a lower rate.

When to defer income

For example, say you did some work for a client in December 2020, but you haven’t yet billed the client for your services. If you wait until January 2021 to invoice your client for the work you did in December, you could defer income to the next year and lower your 2020 tax bill.

When to accelerate income

On the other hand, it might make more sense to accelerate income to this year — especially if you think tax rates will increase under the new presidential administration. In that case, you might want to send your invoice and try to collect payment from your client in 2020 so more income will be taxed at your current tax rate.

The same concept works with expenses. If you are in a high tax bracket this year, you might want to accelerate expenses in 2020 to reduce your taxable income. Here’s a handy guide for when to accelerate or defer income and expenses.

Defer income, accelerate expenses when: Accelerate income, defer expenses when:
  • You had unusually high income in 2020, which is pushing you into a higher tax bracket
  • You expect tax rates to increase in 2021
  • You had unusually low income in 2020 and want to take advantage of paying taxes in a lower bracket
  • You expect tax rates to decrease next year

Set up — or contribute to — a retirement account

Setting up or contributing to a retirement account can reduce your taxable income. Business owners have several options for retirement savings, both for you and your employees.

  • If you set up a 401(k) plan before the end of the tax year, you can deduct any contributions made to the plan when you file your tax return. The plan’s terms dictate how much an employer can contribute. For 2020, total employee and employer contributions are limited to the lesser of an employee’s compensation or $57,000.
  • If you miss the cutoff to set up a 401(k) plan in 2020, you might still be able to set up a simplified employee pension plan, also known as a “SEP.” You have until the due date of your return (including extensions) to set up a SEP. The employer’s contribution to a SEP is limited to 25% of the employee’s compensation.

If you start up a 401(k) or SEP, not only can you deduct contributions to the plan, but you may qualify for the retirement plans startup costs tax credit is available to employers that:

  • Had 100 or fewer employees who received at least $5,000 in compensation during the year
  • Had at least one plan participant who was a non-highly compensated employee
  • Have not had another employer-sponsored retirement plan in the past three years

The credit is worth 50% of the plan’s startup costs, up to a maximum of $500.

Important 2021 tax filing deadlines

Tax day typically falls on April 15 for most people, but if that date falls on a weekend or holiday, the IRS pushes the deadline to the following business day. But tax day isn’t the only important date for small business owners. Here are a few other important dates to mark on your tax filing calendar in 2021:

January 15, 2021
  • Fourth-quarter 2020 estimated tax payments due
March 15, 2021
  • Partnership and S corporation tax returns due for the 2020 tax year
April 15, 2021
  • Individual and C corporation tax returns due for the 2020 tax year
  • First-quarter 2021 estimated tax payments due
  • Last date to make a 2020 IRA contribution
June 15, 2021
  • Second-quarter 2021 estimated tax payments due
September 15, 2021
  • Third-quarter 2021 estimated tax payments due
  • Extended partnership and S corporation tax returns due
October 15, 2021
  • Extended individual tax returns due
January 17, 2022
  • Fourth-quarter 2021 estimated tax payments due

Every business’s tax situation is unique, so it’s important to discuss these small business tax planning strategies with your tax professional before making any significant moves. Still, the strategies should help you prepare for your year-end tax planning meeting and understand more about how your small business can minimize taxes.

 

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