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For Goodness Sake, Remember Your 1099s!

All businesses and organizations must file Form 1099s when required. The most common 1099 they must submit is Form 1099-MISC. Form 1099-MISC is necessary when a business or organization makes payments of $600 or more for services to a nonincorporated individual or business during the year. Form 1099-MISC is also compulsory for many types of rent payments.

Small business owners failing to follow Form 1099 rules is a long-time source of consternation for the US Treasury. This is not surprising since the Treasury investigators have determined that small business 1099 noncompliance is the primary cause of unpaid tax in the United States. After years of unsuccessfully trying to increase Form 1099-MISC reporting, Congress has resorted to the hammer. The result: Two powerful enforcement tools: 1) Business return questions owners must answer under penalty of perjury, and 2) Draconian penalties for late and non-filing of Form(s) 1099. The current penalty for not filing a single Form 1099-MISC: $1,060!

For more information on the 1099 return questions and penalties, please read my article on OvernightAccountant.com, The 1099 Perjury-Trap, and 1099 Noncompliance (Can Literally Destroy Your Business). If you need to learn the rules for Form 1099-MISC, check out a course I created called Form 1099-MISC Basics.

You (probably) Qualify for the GIANT 20% Qualified Business Income (QBI) Deduction

The Tax Cuts and Jobs Act of 2017 created a 20% income tax deduction for businesses, particularly small businesses. The deduction is called the Qualified Business Income Deduction. The deduction is equal to 20% of qualifying business income, which reduces federal income tax. Although it does not reduce federal self-employment tax, it will also cut the income tax owed to many states.

If your business earns a profit and your taxable income before the QBI deduction falls below $160,700 (single) and $321,400 (married filing jointly), guess what? You qualify for the deduction!

Once taxable income exceeds these thresholds, the QBI deduction starts to phase out. Services businesses in industries such as law, accounting, healthcare, consulting, and investing lose the deduction phase-out entirely. If your business is in one of these industries and close to losing the QBI deduction, do what you can (legally) to lower your taxable income.

For other businesses, the deduction remains available but gets restricted by two additional limits related to W2 wages and the cost of business property.

Real Estate Agents and the QBI deduction is the topic of our article; I’m a Real Estate Agent, Do I Qualify for the 20% Income Deduction. I also discuss the deduction in an article I wrote for OvernightAccountant.com, Will My Service Business Qualify for the 20% Income Deduction.

The Qualified Business Income (QBI) Deduction and Rental Properties

Only business income qualifies for the QBI deduction. To be considered a business, the taxpayer must have a profit motive and materially participate (work in/at) the activity. Whether rental properties rise to the level of a trade or business for purposes of the QBI deduction is a source of confusion and consternation for tax professionals and landlords alike.

On the one hand, there’s a handful of tax-related case law showing that rental properties can rise to the level of a business under specific circumstances. Income from Real Estate Investment Trusts (REITs) explicitly qualifies for the QBI deduction, even when investors have no involvement in operations. Additionally, self-rentals qualify for the 20% QBI deduction when the owner works in the business renting the property (as when an accountant owns her office, and her practice pays rent for the office).

On the other hand, rental income is considered passive to taxpayers who are not Real Estate Professionals (a high bar to achieve). In general terms, this means that rental activity is, by definition, not a business. Real Estate Professionals report income on Schedule C, Profit or Loss from Business, and pay self-employment tax on income. Non-real estate professionals report their rental income on Schedule E Supplemental Income and Loss (not for business income).

Further backing the position that a rental is not a business is the fact that, in 2012, congress rescinded a short-lived requirement that rental owners file Form 1099-MISC. The primary argument made by those lobbying for the change was that rentals were NOT a trade or business.

The recently released IRS safe harbor (Revenue Procedure 19-38) regarding rentals that qualify for the QBI deduction did little to ease the confusion. The safe harbor requirements are so high that very few landlords will meet it. The problem the safe harbor, however, is that it only makes those meeting their requirements safe from the IRS denying the QBI deduction. It does NOT establish who may or may not qualify for the QBI deduction.

What’s the Rental Property QBI Deduction Bottom Line? The answer remains unknown. We know that self-rentals, real estate investment trusts, real estate professionals, and rentals meeting the safe harbor qualify. We also believe that triple-net leased rentals (in which the tenant pays for taxes, insurance, and maintenance) do NOT qualify.

Until we receive more guidance or a dispute winds its way through the court system, one should tread lightly near rental properties and the QBI deduction. If you decide to claim the deduction, make sure your property meets as many of the safe harbor requirements as possible.

Remember the 179 Deduction and Bonus Depreciation

If your business needs tools and equipment to serve its customers profitably, you can deduct 100% of the purchase price using Bonus Depreciation or the Section 179 Expense. Here’s a quick overview of each.

Bonus Depreciation: Bonus Depreciation, also called the Special Depreciation Allowance, allows (actually requires) business owners to write off 100% (for 2019) of qualifying property the year it is placed in service. Qualifying property has a class life of 20 years or less and includes most tools and equipment as well as autos, although vehicle limits apply. Starting in late 2017, used property, as well as personal assets converted to business use, may also qualify for Bonus Depreciation.

Bonus Depreciation is mandatory unless the taxpayer elects out for the entire class (all assets with the same depreciable life) for the year. For a more thorough understanding of Bonus Depreciation, please read our article on Bonus Depreciation and Section 179 Expense.

Section 179 Expense: Section 179 of the US Tax Code allows businesses to deduct an elected amount of the cost, up to 100%, of qualifying assets the year it is placed in service. Unlike bonus depreciation, utilizing the Section 179 Expense is not mandatory. The business owner can expense an amount of asset-cost that provides the most significant over-all tax savings. To learn more about Section 179 Expense, please read our article on Bonus Depreciation and Section 179 Expense

BEWARE – Making Expensive Purchases to Get a Tax Deduction May Not be a Good Idea

Making a large purchase to cut an upcoming tax bill may seem like a good idea at the time. You’re saving a ton of tax! Instead of giving your hard-earned money to the government, it’s buying an asset for your business. Good idea, right? The correct answer to this question, like so many in finance and tax, is “it depends.” Before spending $10,000 to save $3,500 in tax, ask yourself two questions:

  1. Do you need the asset? Will the purchase add value to your business? Will it will generate enough additional revenue to cover its cost and generate a return on the investment?
  2. If you buying the assets means going into debt, will you have the cash flow to cover the payments in upcoming years? Completely expensing the asset will have tax consequences down the road. There is nothing left to expense to reduce taxes later, but you still have to make payments on the purchase. Additionally, if you sell the asset, you may have to repay much of the tax saved by writing it off.

Example: Here’s a scenario I have witnessed too many times, especially in construction-related businesses. A builder is facing a $20,000 tax bill. He does not have $20,000 to pay the bill. If he buys a $50,000 backhoe by year’s end, he can expense it via section 179 and wipe the liability out. So, he goes into debt to purchase the backhoe. The payment is $750 per month. The purchase and subsequent expense cut his tax liability to zero.

Great! But starting January 1st of the following year, he must make the $750 monthly payment.
As it turns out, he does not use the loader as often as he had hoped. Even though it sits idle three weeks of each month, the $750 payment must still be made. The next year he pays $9,000 on the backhoe debt (I am assuming no interest), nearly half what he saved in tax with its purchase. As the next December nears, the builder discovers he will owe likely another $20,000 in tax. Because the backhoe was written off on the previous year’s tax return, the $9,000 in payments are not deductible. Now, he’s $9,000 poorer because of the backhoe payments and he has even less money to pay his taxes.

Bonus Depreciation and 179 Expense May Not Maximize Tax Savings: The marginal structure of the tax code has a quirky impact on deductions. The larger the deduction, the rate at which taxes are saved drops. The current tax brackets are 10%, 12%, 22%, 24%, 32%, 35%, and 37%. As taxable income goes up, the amount of tax paid increases as it enters and passes through each tax bracket. Conversely, as income drops by utilizing bonus depreciation or the Section 179 Expense, the amount of tax savings is reduced as the tax rates lessen. The result: Quite often, more tax can be saved by strategically utilizing the Section 179 Expense, opting out of Bonus Depreciation, and depreciating the asset of its normal class life. Maximizing tax savings is all the more reason to hire a tax professional.

Also, keep in mind that a more effective alternative to purchasing an unneeded asset may be prepaying expenses you already have.

Prepay Certain Expenses Using the Twelve-Month Rule

The Twelve-Month rule allows a cash-basis business to deduct advance payment of many operating expenses in the year of payment. The rule allows businesses to deduct amounts paid that create rights or benefits that do not extend beyond the EARLIER of:

1. Twelve months after the right or benefit begins, or
2. The end of the tax year after the tax year in which payment is made.

For example: In December 2019, you prepay ten months of billboard advertising rental. You can deduct the entire payment on 2019’s taxes. If, on the other hand, you prepay thirteen months of the billboard rental, you cannot deduct any of the prepayment on 2019’s taxes. The payments must be deducted in the year to which they apply; twelve months in 2020 and one month in 2021.

Note: The twelve-month rule does not allow for deductions on early payments for inventory items or interest expense. Also, business expenses paid to a related party are not deductible unless the amount is included in the related party’s income the same tax year.

Here are some expenses a business can prepay and deduct under the twelve-month rule (if the provider will accept early payment).

  • Utilities (Heat, water, sewer, electricity, gas)
  • Internet (Cable, fiber, phone)
  • Business Cell phone
  • Rent (only deduct if a related party includes as income in the same year)
  • Accounting and legal
  • Office supplies
  • Advertising
  • Dues and licenses
  • Continuing education
  • Equipment leases
  • Insurance

Sorry – The IRS Knows about the Holding-Money-Tax-Dodge

Most small businesses are cash basis taxpayers, meaning they count income when they RECEIVE it, not when it finds its way to the bank. The governing concept is called “constructive receipt,” which states that customer payments are income when received or accessible by the business, or the business’s agent.

For example, if a real estate broker is holding a commission check for an agent on December 30th. The agent has earned the income and merely needs to pick up the check. The check is income to the agent in December. Waiting until January 3rd to grab the check from the broker does not make the income taxable the following year.

If the IRS sees lower than average deposits in December and higher than average deposits in January, they may take a closer look at your business finances.

Tax-Cutting Retirement Plans

Don’t forget that saving for retirement can also reduce your tax liability. Here’s a brief list of retirement plans business owners can utilize to cut their taxes:

Traditional IRA:
Setup date for 2019: 4/15/20
Contribute by: 4/15/20
Maximum Contribution: $6,000
Maximum Contribution (over 49): $7,000

Simple IRA:
Setup date for 2019: 10/1/19
Contribute by: 4/15/20 or 10/15/20 with Extension
Maximum Contribution: $13,000 + 3% wages (can get complicated)
Additional Contribution (over 49): $3,000

Simplified Employee Pension (SEP):
Setup date for 2019: 4/15/20 or 10/15/20 with Extension
Contribute by: 4/15/20 or 10/15/20 with Extension
Maximum Contribution: $56,000 (can get complicated)

Solo 401-K
Setup date for 2019: 12/31/19
Contribute by: 4/15/20 or 10/15/20 with Extension
Maximum Contribution: $56,000 (can get complicated)
Additional Contribution (over 49): $3,000

Note: Retirement plans can be highly complex and influenced by many factors, including income and participation in other retirement plans. Always seek the assistance of a professional before making any retirement contributions.

All courses and articles are for informational purposes only and do not constitute tax advice. Taxes are complicated - do not act on course information without consulting a professional. Always refer to treasury regulation before making any tax decision. Read the full disclaimer.

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