New Course! Learn to correct depreciation errors using Form 3115

As the year ends, our thoughts turn to the holidays – faith, family, fun, and festivities.  The season’s joy and activity are invigorating.  And they provide a happy distraction from what arrives shortly after we pack up the decorations and kick the tree to the curb.  That's when another, far less enjoyable season has come - TAX season.

With this in mind, I have two wishes for you and your household.  The first is a blessed Christmas, Hanukkah, and Holiday Season and a happy, healthy, and prosperous New Year!

My second wish?  If you're a business owner, it's to distract you long enough (just a moment, promise) to remind you that tax cutting must happen before the year ends.  And - as you know - little is more festive than trimming one of your most significant expenses - TAXES!

To this end, I have composed a list of seven deductions designed to keep more of your hard-earned income where it belongs – in your pocket!  

  1. Section 179 Deduction: The title of this expense references the portion of the tax code allowing it.  Through the Section 179 expense, business owners can deduct a selected amount of qualified assets purchased (and placed in service) during the year.  In other words, owners can minimize tax and influence certain income-based credits by choosing the optimum Section 179 deduction amount.

    Qualified assets include most property used in a business, such as tools and equipment - pretty much any purchase not categorized as real estate.  Like many sections of the tax code, however, there is a special carveout for improvements made to the interior portions of leased commercial real estate that will qualify for Section 179.  This carveout is called Qualified Improvement Property.  There is also another, albeit riskier, way to bypass the real property restriction through a tool called the segregation analysis (I’m not going to elaborate – some players abuse it).

    Many Vehicles Have Limits: It’s worth noting that although vehicles qualify for the Section 179 deduction, many passenger vehicles have limits, so make sure you do a little research before making the purchase.

    Used Assets Qualify: Qualifying assets must be new to your business, but they do not have to be brand new.  Used tools, equipment, and vehicles can qualify. 

    Deduction & Purchase Limits: There are annual limits on the Section 179 deduction.  For 2023, this limit is $1,160,000.  There are also restrictions on the amount of Section 179-qualified assets placed in service during the year.  For 2023, this limit is $2,890,000.  Once a business exceeds this limit, the allowed Section 179 Deduction is reduced dollar-for-dollar.

    Section 179 & Losses: The Section 179 Deduction can reduce business income to zero but cannot generate a loss.  Any excess gets carried over to the following year.  This loss limitation is confusing because business income can include W2 wages, which may cause the deduction to create a business loss after all.

  2. Bonus Depreciation: Bonus Depreciation (also called the Special Depreciation Allowance) is similar to the Section 179 expense in that it allows businesses to depreciate a large portion of an asset’s cost in the year of purchase/placement-in-service.  For several years, this percentage was 100% asset cost.  However, for 2023, the bonus amount is 80%, and the rate decreases by 20% each consecutive year until it reaches zero in 2027 (or Congress changes the law, which is likely).

    Assets that qualify for bonus depreciation are very similar to those allowed for Section 179 (including used property).  Vehicles may also have limits, even when combined with the 179 Expense, so research before purchasing.  Here are a few other differences worth noting:

    Bonus is Mandatory (kind of): Bonus depreciation is mandatory for qualifying assets placed in service during the year.  The only way to avoid it is to opt-out by attaching a statement to your tax return.  When electing out of bonus depreciation, you must elect out for an entire class of assets for the year.  Assets sharing a class have the same depreciable life (number of years over which they get depreciated).

    Bonus Can Cause Losses: Unlike Section 179, Bonus Depreciation can and will generate a loss when depreciation plus other expenses exceed income.

    Warning: Although creating a loss to offset other nonbusiness income is tempting, it may not be in your best long-term interest.  Income rates are marginal (increase as income rises), and the self-employment tax (FICA for business owners) can be 15.3% of business income.  Because of these two variables, having the depreciation available in future years may save a lot more tax than taking it all at once.

  3. No Employees (except you)?  Consider a SEP: SEP stands for Simplified Employee Pension.  It allows employers to contribute and deduct up to 25% of employee W2 earnings toward retirement up to $66,000 for 2023.  The allowed contribution is a percentage of profit, not wages, for those self-employed (not employees of their own companies).  For these individuals, the calculation is more complex.  It’s still 25% after deducting 1/2 of the self-employment tax and the SEP contribution.  You need an IRS table or calculator to determine your exact percentage, but the maximum is 20% of profit instead of 25%.

    Another benefit, in addition to the high contribution limit, is that – for those who are self-employed - your contribution can be calculated after your income and tax is determined.  So, you can use it to influence the tax you end up paying for the year.  Also, contributions do not have to be made until the due date of your return, including extensions if one gets filed.  Plus, you can have a 401k at your W2 job and contribute to your SEP through your business!

    Having Other Employees: If you have employees other than yourself, consider whether a SEP is financially viable.  Why?  Because, once employed for a specific period (generally three years), you must contribute the same percentage of their earnings to all SEP accounts, yours and theirs. 

    Of course, this article provides only general information regarding the SEP (and there are many plans to choose from).  Be sure you talk with a retirement professional before establishing any retirement plan.

  4. Pay Expenses in Advance: This may seem an obvious tip, but many owners fail to utilize it.   Paying future costs before the year’s end can create significant savings, at least for one year.  After that, maintaining the tax cut must become an annual tradition.  The process is as simple as it sounds.  As the year’s end approaches, stock up on supplies you know you will need over the following months – paper, folders, lightbulbs, etc.  Advance payments on contracts and services are also allowed – rent, advertising, cell phones, and utilities (as long as advance payment is allowed).  Remember – every $100 business deduction can save up to $40 in taxes!   

    But remember the twelve-month rule when doing so: The business must consume stockpiled supplies and pre-paid costs within twelve months or the end of the following year, whichever comes first.

  5. Don’t Forget the Kids!  If you have children old enough to perform light duties around the house (in the old days, these were called chores), consider hiring them in your business.  Hiring the kids is simple, especially if you already have employees.  

    Hiring your progenies creates several tax-cutting and saving opportunities.  First, the Standard Deduction increased substantially after the passage of 2017’s Tax Cut and Jobs Act.  For 2023, it’s $13,850.  Then it jumps to $14,600 in 2024.  That’s the amount your children can earn completely federal tax-free!  Here are a few pointers, highlights, and guidelines:

    Avoid FICA & Other Taxes: If your business is a sole proprietorship or a partnership, the wages are not subject to social security, Medicare, or federal unemployment (likely state as well).  Those who own C or S corporations cannot save these taxes, but the income tax savings will likely offset the cost.  

    Note - You cannot avoid FICA and unemployment by hiring your grandchildren, regardless of your business structure.  

    Income Not Subject to the Kiddie Tax:  This tax applies to unearned income (such as interest, dividends, and capital gains), not earned income from wages. 

    Allows Saving for a ROTH IRA: As soon as your child (or grandchild) has earned income, they can start saving for retirement.  If they have $20,000 to $25,000 in a ROTH in their early 20s, the magic of compound interest can transform that small nest egg into over a million dollars when it’s time for them to retire!

    Section 529 Savings: Your hardworking kiddos can even set aside some of their earnings to save for college in their own 529 plans and, if they owe state tax, maybe even get a deduction.

    Pay Must Be Reasonable: The IRS knows it’s tempting to shift $13,000 of taxable income to each child each year to cut the parent’s bill.  That’s why the pay must reflect the value of the work completed.   Use your state’s minimum wage laws as a baseline gauge and track each child’s hours and responsibilities.

    Follow Child Labor Laws:  Also, tasks performed must reflect the child’s age and skill.  Federal and state laws govern the hours young people can work and duties that may be off-limits.  Be sure to follow them. 

  6. Turn Donations into Advertising: Many business owners must support religious organizations and local charities.  They do not contribute to get a tax deduction, but it’s nice when it happens.  Unfortunately, the same standard deduction that allows tax-free earnings for our children makes such charitable tax savings increasingly rare.  But – there’s a tax-cutting alternative –you’re your contributions into deductible business expenses.

    When a business makes charitable donations, there is (and should be) an ulterior motive - establishing goodwill and promoting itself to the community.  That sounds a lot like advertising because it is.  But, as discussed in my book - The Real Estate Agent Tax-Cut Library - be sure to trade each donation for a tangible business benefit.  How?  Get your business in front of the public through an advertisement, banner, plaque, sign,  or something that turns the donation into public recognition and advertising.  It’s a Win-Win!

  7. Subtractions from Adjusted Gross Income: The last tip on our list is to remind you of tax savings many business owners overlook.   These deductions are not on your business return.  These adjustments appear on page two of Schedule One.  They reduce your Adjusted Gross Income and, therefore, federal (and often state) tax.  As you will see if you click the link above, quite a few adjustments exist.  Here are the ones most commonly overlooked by business owners:

    Health Savings Account Deduction – if you have a high deductible health insurance plan (many of us do, unfortunately), see if it qualifies and establish one.

    Deductible Part of Self-Employment Tax – if you’re a sole proprietor or in a partnership, you pay self-employment tax (social security and Medicare).  Half of it gets deducted here.

    Self-Employed SEP, Simple, and Other Qualified Retirement Plans – We discussed the SEP above, but there are other plans the self-employed may be able to contribute to.

    Self-Employed Health Insurance – Business owners can deduct the cost of health insurance paid through a business-owned/sponsored plan (which is broadly defined).

    IRA Contributions – If you don’t have a SEP or other retirement plan, you may qualify for a traditional IRA deduction.  Note - income limits and special rules exist if you (or your spouse) have another retirement plan.  If eligible, you can contribute up to $6,500 for 2023 ($7,500 if 50 or older) and $7,000 for 2024 ($8,000 if 50 or older).  Contributions are deductible up until your return’s non-extended due date.

Wrap’in It Up: So, there they are, seven tax-cutting business tips.  For most business owner, their most significant single expense is taxes.  Remember these tips as you develop a (legal) tax-cutting mindset.  They’ll help keep some of your hard-earned income in your pocket.  

Want to learn more about tax-cutting and growing your business?  Check out our courses at Overnight Accountant.   Need help with your taxes?  Reach out to us at Real Estate Tax Pros

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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