Income taxation and owner liability are the main factors that differentiate one business structure from another. Many businesses choose entities that combine pass-through taxation with limited liability, namely limited liability companies (LLCs) and S corporations. But TCJA changes warrant revisiting the tax consequences of business structure.
The now-flat corporate rate (21%) is significantly lower than the top individual rate (37%), providing significant tax benefits to C corporations and helping to mitigate the impact of double taxation for their owners. In addition, the corporate alternative minimum tax (AMT) has been repealed, while the individual AMT remains (though it will affect far fewer taxpayers). But, the TCJA also introduced a powerful deduction for owners of pass-through entities.
Depending on your situation, a structure change may sound like a good idea. But keep in mind that increases to both the corporate and the top individual rate have been proposed. Even if there are no tax increases, a change could have unwelcome tax consequences. Consult your tax advisor if you'd like to explore whether a structure change could benefit you.
199A Deduction for Pass-through Businesses
Through 2025, the TCJA provides the Section 199A deduction for sole proprietorships and owners of pass-through business entities, such as partnerships, S corporations, and LLCs that are treated as sole proprietorships, partnerships or S corporations for tax purposes. The 199A deduction isn’t allowed in calculating the owner’s adjusted gross income, but it reduces taxable income. In effect, it’s treated the same as an allowable itemized deduction (though you don’t have to itemize to claim it).
The deduction generally equals 20% of qualified business income (QBI), not to exceed 20% of taxable income. QBI is generally defined as the net amount of qualified items of income, gain, deduction and loss that are effectively connected with the conduct of a U.S. business. QBI doesn’t include certain investment items, reasonable compensation paid to an owner for services rendered to the business, or any guaranteed payments to a partner or LLC member treated as a partner for services rendered to the partnership or LLC.
Additional limits can begin to apply if 2023 taxable income exceeds the applicable threshold — $182,100 or, if married filing jointly, $362,400. The limits fully apply when 2023 taxable income exceeds $232,100 and $462,400, respectively. (For 2022, additional limits can begin to apply if taxable income exceeds the applicable threshold — $170,050 or, if married filing jointly, $340,100. The limits fully apply when 2022 taxable income exceeds $220,050 and $440,100, respectively.)
When the income-based limit applies, the 199A deduction generally can’t exceed the greater of the owner’s share of:
50% of the amount of W-2 wages paid to employees by the qualified business during the tax year, or
The sum of 25% of W-2 wages plus 2.5% of the cost of qualified property.
Qualified property is the depreciable tangible property (including real estate) owned by a qualified business as of year end and used by the business at any point during the tax year to produce qualified business income. Additional rules apply.
Another limitation for taxpayers subject to the income-based limit is that the 199A deduction generally isn’t available for income from “specified service businesses.” Examples include businesses that involve investment-type services and most professional practices (other than engineering and architecture).
The W-2 wage and property limitations and the service business limitation don’t apply if your taxable income is under the applicable threshold. In that case, you should qualify for the full 20% deduction.
Projecting Income
Projecting your business’s income for this year and next can allow you to time income and deductions to your advantage. It’s generally — but not always — better to defer tax, so consider:
Deferring income to next year. If your business uses the cash method of accounting, you can defer billing for products or services at year end. If you use the accrual method, you can delay shipping products or delivering services.
Accelerating deductible expenses into the current year. If you’re a cash-basis taxpayer, you may pay business expenses by Dec. 31, so you can deduct them this year rather than next. Both cash and accrual-basis taxpayers can charge expenses on a credit card and deduct them in the year charged, regardless of when the credit card bill is paid.
Warning: Don’t let tax considerations get in the way of sound business decisions. For example, the negative impact of these strategies on your cash flow or customers may not be worth the potential tax benefit.
Taking the opposite approach. If your business is a flow-through entity and it’s likely you’ll be in a higher tax bracket next year, accelerating income and deferring deductible expenses may save you more tax over the two-year period.
Depreciation
For assets with a useful life of more than one year, you generally must depreciate the cost over a period of years. In most cases the Modified Accelerated Cost Recovery System (MACRS) will be preferable to the straight-line method because you’ll get a larger deduction in the early years of an asset’s life.
But if you make more than 40% of the year’s asset purchases in the last quarter, you could be subject to the typically less favorable midquarter convention. When it comes to repairs and maintenance of tangible property, however, different rules may apply. Careful planning during the year can help you maximize depreciation deductions in the year of purchase.
Other depreciation-related breaks and strategies also are available, and in many cases have been enhanced by the TCJA:
Bonus depreciation.This additional first-year depreciation is available for qualified assets, which include new tangible property with a recovery period of 20 years or less (such as office furniture and equipment), off-the-shelf computer software and water utility property.
Under the TCJA, through 2026, the definition has been expanded to include used property and qualified film, television and live theatrical productions. In addition, qualified improvement property is now eligible for bonus depreciation.
For qualified assets placed in service though Dec. 31, 2022, bonus depreciation is 100%. In later years, bonus depreciation is scheduled to be reduced as follows:
80% for 2023.
60% for 2024.
40% for 2025.
20% for 2026.
For certain property with longer production periods, these reductions are delayed by one year. For example, 80% bonus depreciation will apply to long-production-period property placed in service in 2024.
Warning: Under the TCJA, in some cases a business may not be eligible for bonus depreciation starting in 2018. Examples include real estate businesses that elect to deduct 100% of their business interest expense and dealerships with floor-plan financing, if they have average annual gross receipts of more than $25 million for the three previous tax years. Section 179 expensing election. This allows you to deduct (rather than depreciate over a number of years) the cost of purchasing eligible new or used assets, such as equipment, furniture, off-the-shelf computer software, and qualified improvement property. For qualifying property placed in service in 2023, the expensing limit is $1.16 million (up from $1.08 million for 2022). The break begins to phase out dollar for dollar when asset acquisitions for the year exceed $2.89 million (up from $2.7 million for 2022). You can claim the election only to offset net income, not to reduce it below zero to create a net operating loss.
Tangible property repair safe harbors. A business that has made repairs to tangible property, such as buildings, machinery, equipment and vehicles, can expense those costs and take an immediate deduction. But costs incurred to acquire, produce or improve tangible property must be depreciated. Distinguishing between repairs and improvements can be difficult. Fortunately, some IRS safe harbors can help: 1) the routine maintenance safe harbor, 2) the small business safe harbor, or 3) the de minimis safe harbor. The rules are complex, so contact your tax advisor for details.
Cost segregation study. If you’ve recently purchased or built a building or are remodeling existing space, consider a cost segregation study. It identifies property components and related costs that can be depreciated much faster and dramatically increase your current deductions. Typical assets that qualify include decorative fixtures, security equipment, parking lots, landscaping and architectural fees allocated to qualifying property. See the Case Study "Cost segregation study can accelerate depreciation."
The benefit of a cost segregation study may be limited in certain circumstances — for example, if the business is located in a state that doesn’t follow federal depreciation rules.
Vehicle-related Tax Breaks
Business-related vehicle expenses can be deducted using the mileage-rate method (58.5 cents per mile driven from January 1 to June 30, 2022, and 62.5 cents per mile from July 1 to December 31, 2022) or the actual-cost method (total out-of-pocket expenses for fuel, insurance and repairs, plus depreciation). For 2023, the mileage rate is 65.5 cents per mile driven.
Purchases of new or used vehicles may be eligible for Sec. 179 expensing. However, many rules and limits apply. For example, the normal Sec. 179 expensing limit generally applies to vehicles with a gross vehicle weight rating of more than 14,000 pounds. For 2022, a $27,000 limit (up from $26,200 for 2021) applies to vehicles (typically SUVs) rated at more than 6,000 pounds but no more than 14,000 pounds.
Vehicles rated at 6,000 pounds or less don’t satisfy the SUV definition and thus are subject to the passenger vehicle limits; contact your tax advisor for details.
Keep in mind that, if a vehicle is used for business and personal purposes, the associated expenses, including depreciation, must be allocated between deductible business use and nondeductible personal use. The depreciation limit is reduced if the business use is less than 100%. If business use is 50% or less, you can’t use Sec. 179 expensing or the accelerated regular MACRS; you must use the straightline method.
Entertainment, Meal and Transportation Deductions
Before the TCJA, businesses regularly claimed deductions for meal, entertainment, vehicle and travel expenses, as well as employee reimbursements of such expenses. But the TCJA eliminated some of these deductions. Here’s a look at what's deductible and what's not:
Entertainment. Under the TCJA, these expenses are no longer deductible.
Meals. Under the TCJA, business-related meal expenses, including those incurred while traveling on business, have remained 50% deductible. But, the TCJA expanded the 50% disallowance rule to meals provided via an on-premises cafeteria or otherwise on the employer’s premises for the convenience of the employer. The Consolidated Appropriations Act (CAA) generally increases the deduction to 100% for food and beverages provided by a restaurant in 2022 (in 2023 the deduction decreases to 50%).
Transportation. Employer deductions for the cost of providing commuting transportation to an employee (such as hiring a car service) aren’t allowed under the TCJA, unless the transportation is necessary for the employee’s safety. The TCJA also eliminated employer deductions for the cost of providing qualified employee transportation fringe benefits (for example, parking allowances, mass transit passes and van pooling). However, those benefits are still tax-free to recipient employees. Transportation expenses for business travel are still 100% deductible, provided they meet the applicable rules.
Employee Benefits
Including a variety of benefits in your compensation package can help you not only attract and retain the best employees, but also save tax because you generally can deduct your contributions:
Qualified deferred compensation plans. These include pension, profit-sharing, SEP and 401(k) plans, as well as SIMPLEs. You can enjoy a tax deduction for your contributions to employees’ accounts, and the plans offer tax-deferred savings benefits for employees. Certain small employers may also be eligible for a tax credit when setting up a plan.
HSAs and FSAs. If you provide employees with a qualified high-deductible health plan (HDHP), you can also offer them Health Savings Accounts. Regardless of the type of health insurance you provide, you also can offer Flexible Spending Accounts for health care. If you have employees who incur day care expenses, consider offering FSAs for child and dependent care.
HRAs. A Health Reimbursement Account reimburses an employee for medical expenses up to a maximum dollar amount. Unlike an HSA, no HDHP is required. Unlike an FSA, any unused portion can be carried forward to the next year. But only the employer can contribute to an HRA.
Fringe benefits. Certain fringe benefits aren’t included in employee income, yet the employer can still deduct the portion, if any, that it pays and typically also avoid payroll taxes. Examples are employee discounts, group term-life insurance (up to $50,000 per person) and health insurance.
Warning: You might be be penalized for not offering health insurance. The play-or-pay provision of the Affordable Care Act (ACA) can in some cases impose a penalty on “large” employers if they don’t offer full-time employees “minimum essential coverage” or if the coverage offered is “unaffordable” or doesn’t provide “minimum value.” The IRS has issued detailed guidance on what these terms mean and how employers can determine whether they’re a “large” employer and, if so, whether they’re offering sufficient coverage to avoid the risk of penalties.
Interest Expense Deduction
Generally, under the TCJA, interest paid or accrued by a business is deductible up to 30% of adjusted taxable income (ATI). Taxpayers (other than tax shelters) with average annual gross receipts of $25 million or less for the three previous tax years are exempt from the interest deduction limitation.
Some other taxpayers are also exempt. For example, real property businesses can elect to fully deduct their interest, but then would be required to use the alternative depreciation system for real property used in the business.
Loss Deduction
Net operating losses (NOLs). The TCJA generally reduces the maximum amount of taxable income that can be offset with NOL deductions from 100% to 80%. In addition, the TCJA generally prohibits NOLs from being carried back to an earlier tax year — but it allows them to be carried forward indefinitely (as opposed to the 20-year limit under pre-TCJA law).
Pass-through entity “excess” business losses.Through 2025, the TCJA applies a limit to deductions for current-year business losses incurred by noncorporate taxpayers: Such losses generally can’t offset more than $250,000 ($500,000 for married couples filing jointly) of income from other sources, such as salary, self-employment income, interest, dividends and capital gains. (The limit is annually adjusted for inflation.) “Excess” losses are carried forward to later tax years and can then be deducted under the NOL rules.
The CARES Act temporarily lifted the limit, allowing taxpayers to deduct 100% of business losses arising in 2018, 2019 and 2020. But the limit returned in 2021, and the Inflation Reduction Act of 2022 extends it through 2028.
Tax Credits
Tax credits can reduce tax liability dollar for dollar, making them particularly beneficial: Research credit. The research credit (often called the “research and development” credit) gives businesses an incentive to step up their investments in research.
Certain start-ups (in general, those with less than $5 million in gross receipts) that haven’t yet incurred any income tax liability can, alternatively, use the credit against their payroll tax. While the credit is complicated to compute, the tax savings can prove significant.
Work Opportunity credit. This credit is designed to encourage hiring from certain disadvantaged groups, such as certain veterans, ex-felons, individuals who’ve been unemployed for 27 weeks or more and food stamp recipients. The CAA extends the credit through Dec. 31, 2025.
The size of the tax credit depends on the hired person’s target group, the wages paid to that person and the number of hours that person worked during the first year of employment. The maximum tax credit that can be earned for each member of a target group is generally $2,400 per adult employee. But the credit can be higher for members of certain target groups, up to as much as $9,600 for certain veterans.
Employers aren’t subject to a limit on the number of eligible individuals they can hire. That is, if there are 10 individuals that qualify, the credit can be 10 times the listed amount. Note: You must obtain certification that an employee is a target group member from the appropriate State Workforce Agency before you can claim the credit. The certification generally must be requested within 28 days after the employee begins work.
New Markets credit. This credit gives investors who make “qualified equity investments” in certain low-income communities a 39% tax credit over a seven-year period. Certified Community Development Entities (CDEs) determine which projects get funded — often construction or rehabilitation real estate projects in “distressed” communities, using data from the 2006–2010 American Community Survey. Flexible financing is provided to the developers and business owners. The CAA extends the credit through Dec. 31, 2025.
Retirement plan credit. Small employers (generally those with 100 or fewer employees) that create a retirement plan may be eligible for a $500 credit per year for three years. The credit is limited to 50% of qualified startup costs.
Small-business health care credit. The maximum credit is 50% of group health coverage premiums paid by the employer, provided it contributes at least 50% of the total premium or of a benchmark premium. Only employers with fewer that 25 full-time equivalent employees (FTEs) and average annual wages below certain thresholds are eligible. And the credit is reduced for employers with more than 10 FTEs or average wages exceeding certain amounts. Contact your tax advisor for details. Note: To qualify for the credit, online enrollment in the Small Business Health Options Program (SHOP) generally is required. In addition, the credit can be taken for only two years, and they must be consecutive. (Credits taken before 2014 don’t count, however.)
Family and Medical Leave Credit. For 2018 and 2019, the TCJA created a tax credit for qualifying employers that begin providing paid family and medical leave to their employees. (Under the CAA, the credit has been extended through 2025.) It is equal to a minimum of 12.5% of the employee’s wages paid during that leave (up to 12 weeks per year) and can be as much as 25% of wages paid. Ordinary paid leave that employees are already entitled to doesn’t qualify.
Exit Planning
An exit strategy is a plan for passing on responsibility for running the company, transferring ownership and extracting your money from the business. This requires planning well in advance of the transition. Here are the most common exit options:
Buy-sell Agreements. When a business has more than one owner, a buy-sell agreement can be a powerful tool. The agreement controls what happens to the business when a specified event occurs, such as an owner’s retirement, disability or death. Among other benefits, a well-drafted agreement:
Provides a ready market for the departing owner’s shares,
Sets a price for the shares, and
Allows business continuity by preventing disagreements caused by new owners.
A key issue with any buy-sell agreement is providing the buyer(s) with a means of funding the purchase. Life or disability insurance often helps fulfill this need and can give rise to several tax and nontax issues and opportunities.
One of the biggest advantages of life insurance as a funding method is that proceeds generally are excluded from the beneficiary’s taxable income. There are exceptions, however, so be sure to consult your tax advisor.
Succession within the family. You can pass your business on to family members by giving them interests, selling them interests or doing some of each. Be sure to consider your income needs, how family members will feel about your choice, and the gift and estate tax consequences. With the higher gift tax exemption in effect under the TCJA for the next few years, now may be a particularly good time to transfer ownership interests in your business. Valuation discounts may further reduce the taxable value of the gift.
Management buyout. If family members aren’t interested in or capable of taking over your business, one option is a management buyout. This may provide for a smooth transition because there may be little learning curve for the new owners. Plus you avoid the time and expense of finding an outside buyer.
ESOP. If you want rank and file employees to become owners as well, an employee stock ownership plan (ESOP) may be the ticket. An ESOP is a qualified retirement plan created primarily to own your company’s stock. Whether you’re planning for liquidity, looking for a tax-favored loan or wanting to supplement an employee benefit program, an ESOP can offer many advantages.
Sale to an outsider. If you can find the right buyer, you may be able to sell the business at a premium. Putting your business into a sale-ready state can help you get the best price. This generally means transparent operations, assets in good working condition and minimal reliance on key people.
Sale or Acquisition
Whether you’re selling your business as part of your exit strategy or acquiring another company to help grow it, the tax consequences can have a major impact on the transaction’s success or failure. Here are a few key tax considerations:
Asset vs. stock sale. With a corporation, sellers typically prefer a stock sale for the capital gains treatment and to avoid double taxation. Buyers generally want an asset sale to maximize future depreciation write-offs.
Taxable sale vs. tax-deferred transfer. A transfer of ownership of a corporation can be tax-deferred if made solely in exchange for stock or securities of the recipient corporation in a qualifying reorganization. But the transaction must comply with strict rules. Although it’s generally better to postpone tax, there are some advantages to a taxable sale:
The seller doesn’t have to worry about the quality of buyer stock or other business risks that might come with a tax-deferred transfer.
The buyer benefits by receiving a stepped-up basis in its acquisition’s assets.
The parties don’t have to meet the technical requirements of a tax-deferred transfer.
Installment sale. A taxable sale might be structured as an installment sale if the buyer lacks sufficient cash or pays a contingent amount based on the business’s performance. An installment sale also may make sense if the seller wishes to spread the gain over a number of years — which could be especially beneficial if it would allow the seller to stay under the thresholds for triggering the 3.8% NIIT or the 20% long-term capital gains rate.
Installment sales can backfire on the seller. For example, depreciation recapture must be reported as gain in the year of sale, no matter how much cash the seller receives. And, if tax rates increase, the overall tax could wind up being more. Of course, tax consequences are only one of many important considerations when planning a merger or acquisition.
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