U.S. businesses are facing pressure to drive revenue, manage costs and increase shareholder value, all while surrounded by economic and political uncertainties. Disruptions to supply chains brought about by the pandemic have continued into 2022. Inflation and rising interest rates have made the cost of debt, goods, and services more expensive and cooled consumer spending. The stock market has declined sharply, and the prospect of a recession is on the rise.
This article provides a checklist of areas where, with proper planning, businesses may be able to reduce or defer taxes over time. Unless otherwise noted, the information contained in this article is based on enacted tax laws and policies as of the publication date and is subject to change based on future legislative or tax policy changes.
Companies that want to reduce their 2022 tax liability should consider traditional tax accounting method changes, tax elections, and other actions for 2022 to defer recognizing income to a later taxable year and accelerate tax deductions to an earlier taxable year, including the following:
Changing from recognizing certain advance payments (e.g., upfront payments for goods, services, gift cards, use of intellectual property, sale or license of software) in the year of receipt to recognizing a portion in the following taxable year.
Changing from the overall accrual to the overall cash method of accounting (i.e., where accounts receivable exceed accounts payable and accrued expenses).
Changing from capitalizing certain prepaid expenses (e.g., insurance premiums, warranty service contracts, taxes, government permits and licenses, software maintenance) to deducting when paid using the “12-month rule.”
Deducting eligible accrued compensation liabilities (such as bonuses and severance payments) that are fixed and determinable by the end of the year and paid within 2.5 months of year-end.
Accelerating deductions of liabilities such as warranty costs, rebates, allowances and product returns, state income and franchise taxes, and real and personal property taxes under the “recurring item exception.”
Purchasing qualifying property and equipment before the end of 2022 to take advantage of the 100% bonus depreciation provisions (before bonus depreciation begins to gradually phase out starting in 2023) and the Section 179 expensing rules.
Deducting “catch-up” depreciation (including bonus depreciation, if previously missed) of personal property by changing to shorter recovery periods or changing from non-depreciable to depreciable.
Optimizing inventory valuation methods. For example, adopting, or making changes within, the last-in, first-out (LIFO) method of valuing inventory generally will result in higher cost of goods sold deductions as costs are increasing.
Changing from amortizing commissions paid to employees to deducting in the year paid or incurred under the simplifying conventions.
Electing to deduct 70% of success-based fees paid or incurred in 2022 in connection with certain acquisitive transactions under Rev. Proc. 2011-29. Other transaction costs that are not inherently facilitative may also be deductible. Taxpayers that incur transaction costs should consider undertaking a transaction cost study to maximize their tax deductions.
Electing the de minimis safe harbor to deduct small-dollar expenses for the acquisition or production of property that would otherwise be capitalizable under general rules.
Is “reverse” planning better for your situation?
Depending on their facts and circumstances, some businesses may instead want to accelerate taxable income into 2022 if, for example, they believe tax rates will increase in the near future or they want to optimize use of NOLs. These businesses may want to consider “reverse” planning strategies, such as:
Implementing a variety of “reverse” tax accounting method changes, such as changing to recognize advance payments in the year of receipt or changing to deduct certain tax liabilities (state income, state franchise, real and personal property taxes, payroll taxes) when paid.
Selling and leasing back appreciated property before the end of 2022, creating gain that is taxed currently offset by future deductions of lease expense, being careful that the transaction is not recharacterized as a financing transaction.
Accelerating taxable capital gain into 2022.
Electing out of the installment sale method for installment sales closing in 2022.
Delaying payments of liabilities whose deduction is based on when the amount is paid, so that the payment is deductible in 2023 (e.g., paying year-end bonuses after the 2.5-month rule).
Treatment of R&E Expenses
Under the 2017 Tax Cuts and Jobs Act (TCJA), research and experimental (R&E) expenditures incurred or paid for tax years beginning after December 31, 2021 will no longer be immediately deductible for tax purposes. Instead, businesses are required to capitalize and amortize R&E expenditures over a period of five or 15 years beginning in 2022. The mandatory capitalization rules also apply to software development costs, including software developed for internal use. The new rules present additional considerations for businesses that invest in R&E.
Tax accounting method changes – is Form 3115 required and when?
Some of the opportunities listed above for changing the timing of income recognition and deductions require taxpayers to submit a request to change their method of tax accounting for the particular item of income or expense. Generally, tax accounting method change requests require taxpayers to file a Form 3115, Application for Change in Accounting Method, with the IRS under one of the following two procedures:
The “automatic” change procedure, requires the taxpayer to attach Form 3115 to the timely filed (including extensions) federal tax return for the year of change and to file a separate copy of the Form 3115 with the IRS no later than the filing date of that return; or
The “nonautomatic” change procedure, which applies when a change is not listed as automatic and requires Form 3115 (including a more robust discussion of the legal authorities than an automatic Form 3115 would include) to be filed with the IRS National Office during the year of change along with an IRS user fee. Calendar-year taxpayers that want to make a nonautomatic change for the 2022 taxable year should be cognizant of the accelerated December 31, 2022, the due date for filing Form 3115.
Tax accounting method changes generally allow for the recognition of unfavorable changes over four years while allowing the full amount of any favorable changes in the year of the change.
Write off bad debts and worthless stock
While the economy attempts to recover from the challenges brought on by the COVID-19 pandemic, inflation, and rising interest rates, businesses should evaluate whether losses may be claimed on their 2022 returns related to worthless assets such as receivables, property, 80% owned subsidiaries, or other investments.
Business bad debts can be wholly or partially written off for tax purposes. A partial write-off requires a conforming reduction of the debt on the books of the taxpayer; a complete write-off requires a demonstration that the debt is wholly uncollectible as of the end of the year.
Losses related to worthless, damaged, or abandoned property can sometimes generate ordinary losses for specific assets.
Businesses should consider claiming losses for investments in insolvent subsidiaries that are at least 80% owned and for certain investments in insolvent entities taxed as partnerships (also see Partnerships and S corporations, below).
Maximize interest expense deductions
The TCJA significantly expanded Section 163(j) to impose a limitation on business interest expense of many taxpayers, with exceptions for small businesses (those with three-year average annual gross receipts not exceeding $27 million for 2022), electing real property trades or businesses, electing farming businesses and certain utilities.
The deduction limit is based on 30% of adjusted taxable income. The amount of interest expense that exceeds the limitation is carried over indefinitely.
Beginning with 2022 taxable years, taxpayers will no longer be permitted to add back deductions for depreciation, amortization, and depletion in arriving at adjusted taxable income (the principal component of the limitation).
Maximize tax benefits of NOLs
Net operating losses (NOLs) are valuable assets that can reduce taxes owed during profitable years, thus generating a positive cash flow impact for taxpayers. Businesses should make sure they maximize the tax benefits of their NOLs.
For tax years beginning after 2020, NOL carryovers from tax years beginning after 2017 are limited to 80% of the excess of the corporation’s taxable income over the corporation’s NOL carryovers from tax years beginning before 2018 (which are not subject to this 80% limitation but may be carried forward only 20 years). If the corporation does not have pre-2018 NOL carryovers but does have post-2017 NOLs, the corporation’s NOL deduction can only negate up to 80% of the 2022 taxable income with the remaining subject to the 21% federal corporate income tax rate. Corporations should monitor their taxable income and submit appropriate quarterly estimated tax payments to avoid underpayment penalties.
Corporations should monitor their equity movements to avoid a Section 382 ownership change that could limit annual NOL deductions.
Losses from pass-through entities must meet certain requirements to be deductible at the partner or S corporation owner level (also see Partnerships and S corporations, below).
Defer tax on capital gains
Tax planning for capital gains should consider not only current and future tax rates, but also the potential deferral period, short and long-term cash needs, possible alternative uses of funds, and other factors.
Noncorporate shareholders are eligible for exclusion of gain on dispositions of Qualified Small Business Stock. For other sales, businesses should consider potential long-term deferral strategies, including:
Reinvesting capital gains in Qualified Opportunity Zones.
Reinvesting real property sales proceeds in other “like-kind” real property.
Selling shares of a privately held co. to an Employee Stock Ownership Plan.
Businesses engaging in reverse planning strategies (see Is “reverse” planning better for your situation? above) may instead want to move capital gain income into 2022 by accelerating transactions (if feasible) or, for installment sales, electing out of the installment method.
Claim available tax credits
The U.S. offers a variety of tax credits and other incentives to encourage employment and investment, often in targeted industries or areas such as innovation and technology, renewable energy, and low-income or distressed communities. Many states and localities also offer tax incentives. Businesses should make sure they are claiming all available tax credits.
The Employee Retention Credit (ERC) is a refundable payroll tax credit for qualifying employers that were significantly impacted by COVID-19 in 2020 or 2021. For most employers, the compensation eligible for the credit had to be paid prior to October 1, 2021. However, the deadline for claiming the credit does not expire until the statute of limitations closes on Form 941. Therefore, employers generally have three years to claim the ERC for eligible quarters during 2020 and 2021 by filing an amended Form 941-X for the relevant quarter. Employers that received a Paycheck Protection Program (PPP) loan can claim the ERC but the same wages cannot be used for both programs.
Businesses that incur expenses related to qualified research and development (R&D) activities are eligible for the federal R&D credit.
Small business start-ups are permitted to use up to $250,000 of their qualified R&D credits to offset the 6.2% employer portion of social security payroll tax. The IRA doubles this payroll tax offset limit to $500,000, providing an additional $250,000 that can be used to offset the 1.45% employer portion of Medicare payroll tax.
Taxpayers that reinvest capital gains in Qualified Opportunity Zones may be able to temporarily defer the federal tax due on the capital gains. The investment must be made within a certain period after the disposition giving rise to the gain. Post-reinvestment appreciation is exempt from tax if the investment is held for at least 10 years but sold by December 31, 2047.
The New Markets Tax Credit Program provides federally funded tax credits for approved investments in low-income communities that are made through certified “Community Development Entities.”
Other incentives for employers include the Work Opportunity Tax Credit, the Federal Empowerment Zone Credit, the Indian Employment Credit, and credits for paid family and medical leave (FMLA).
There are several federal tax benefits available for investments to promote energy efficiency and sustainability initiatives. The IRA extends and enhances certain green energy credits as well as introduces a variety of new incentives. Projects that have historically been eligible for tax credits and that have been placed in service in 2022 may be eligible for credits at higher amounts. Additionally, projects that begin construction under the tax rules prior to 60 days after the Department of the Treasury releases guidance on these requirements are eligible for the credits at higher rates. Certain other projects may be eligible for tax credits beginning in 2023. The IRA also introduces prevailing wage and apprenticeship requirements in the determination of certain credit amounts, as well as direct pay or transferability tax credit monetization options beginning with projects placed in service in 2023.
Under the CHIPS Act, taxpayers that invest in semiconductor manufacturing or the manufacture of certain equipment required in the semiconductor manufacturing process may be entitled to a 25% advanced manufacturing investment credit beginning in 2023. The credit generally applies to qualified property placed in service after December 31, 2022, and for which construction begins before January 1, 2027. Where construction began prior to January 1, 2023, the credit applies only to the extent of the basis attributable to construction occurring after August 9, 2022.
Partnerships and S Corporations
Partnerships, S corporations and their owners may want to consider the following tax planning opportunities:
Taxpayers with unused passive activity losses attributable to partnership or S corporation interests may want to consider disposing of the interest to utilize the loss in 2022.
Taxpayers other than corporations may be entitled to a deduction of up to 20% of their qualified business income (within certain limitations based on the taxpayer’s taxable income, whether the taxpayer is engaged in a service-type trade or business, the amount of W-2 wages paid by the business and the unadjusted basis of certain property held by the business). Planning opportunities may be available to maximize this deduction.
Certain tax basis, at-risk and active participation requirements must be met for losses of pass-through entities to be deductible by a partner or S corporation shareholder. In addition, an individual’s excess business losses are subject to overall limitations. There may be steps that pass-through owners can take before the end of 2022 to maximize their loss deductions. The Inflation Reduction Act extends the excess business loss limitation by two years (the limitation was scheduled to expire for taxable years beginning on or after January 1, 2027).
Under current rules, the abandonment or worthlessness of a partnership interest may generate an ordinary deduction (instead of a capital loss) in cases where no partnership liabilities are allocated to the interest. If business conditions are such that the interest does not have value or the partner is considering abandonment, important issues need to be considered.
Following enactment of the TCJA, deductibility of expenses incurred by investment funds are treated as “investment expenses”—and therefore are limited at the individual investor level— if the fund does not operate an active trade or business (i.e., if the fund’s only activities are investment activities). To avoid the investment expense limitation, consideration should be given as to whether a particular fund’s activities are so closely connected to the operations of its portfolio companies that the fund itself should be viewed as operating an active trade or business.
Under current rules, gains allocated to carried interests in investment funds are treated as long-term capital gains only if the investment property has been held for more than three years. Investment funds should consider holding the property for more than three years prior to sale to qualify for reduced long-term capital gains rates.
Various states have enacted PTE tax elections that seek a workaround to the federal personal income tax limitation on the deduction of state taxes for individual owners of pass-through entities. See State pass-through entity tax elections, below.
The transition rules in the 2019 final regulations that put an end to the use of bottom-dollar guarantees by partners to create a recourse tax basis in a partnership will expire on October 4, 2023. Taxpayers that currently rely on the transition rules should review their partnership liability allocations.
Cobalt PacWest | CPAs & Advisors
Natalie C. Papagni, CPA
Principal & Tax Strategist
3000 El Camino Real, Bld 4, Suite 200
Palo Alto, CA 94306
650.930.9562 | 877.223.5678