Businesses of all sizes, across all industries, have been impacted by the monumental changes to the federal tax code. To maximize tax savings and ensure compliance with the new rules, businesses need to engage in year-end planning conversations now. Certain tax savings opportunities may apply regardless of how your business is structured, while others may apply only to a particular type of business organization. No matter the type of business entity you operate, year-end tax planning should consider all possibilities to effectively lower your total tax liability.
Over the last several months, we’ve highlighted some of the new tax savings strategies for business owners. This article will touch on some of additional tactics, including marginal tax rates, advance payments, related-party transactions and unrelated party compensation.
2018 Versus 2019 Marginal Tax Rates
Whether you choose to accelerate taxable income into 2018 or defer it until 2019 depends, in part, on the marginal tax rate for each year projected for your business. Generally, unless your 2018 marginal tax rate will be significantly lower than your 2019 marginal tax rate, you should defer taxable income to 2019.
The marginal tax rate is the rate applied to your next dollar of income or deduction. Projections of your business’s 2018 and 2019 income and deductions are necessary to determine the marginal tax rate for each year.
Your advisor can be consulted to recommend how your business can recognize income and deductions between these years to minimize your tax liability.
In addition, the circumstances of an individual taxpayer may cause the marginal or effective tax rate to be higher in one year than in the other year. While the maximum marginal federal tax rate is 21 percent for C corporations, the maximum marginal federal tax rate for individuals is 37 percent. Moreover, the combined effect of certain phase-out provisions for high-income individuals and the additional 3.8 percent tax on net investment income could push the effective marginal tax rate on high-income individuals to nearly 41 percent. If the relevant tax rate is expected to be approximately the same for each of 2018 and 2019, consider taking advantage of various tax rules that allow taxable income or gain to be deferred, such as sales of stock to an employee stock ownership plan, like-kind exchanges, involuntary conversions, and tax-free merger and acquisition transactions.
Advance Payments
Cash-method taxpayers recognize revenue (including advance payments) when cash is actually or constructively received. Accrual-method taxpayers recognize revenue upon the earliest of when:
- Payment is earned through performance
- Payment is due
- Payment is received.
Read Also: Ready To Make The Switch: TCJA Creates Opportunity For Business Owners To Switch From Accrual To Cash Accounting
However, under Revenue Procedure 2004-34, payments received by an accrual-method taxpayer in advance of services being performed or goods being delivered can be deferred to the next succeeding taxable year if such payments are reported on the taxpayer’s “applicable” financial statements as deferred revenue, or if earned in a later taxable year in the absence of applicable financial statements. This so-called “one-year deferral method” is also available for advance payments received for the use of intellectual property, certain guaranty or warranty contracts, and the sale, lease, or license of computer software.
As part of tax reform, Congress codified the one-year deferral method. Under new Section 451(c), effective for taxable years beginning after December 31, 2017, advance payments shall either be included in gross income in the taxable year received, or deferred in accordance with books in the year received, with the remaining amounts to be included in the subsequent year. While Rev. Proc. 2004-34 may ultimately be replaced by Section 451(c), the IRS stated in a recent notice that taxpayers can continue to utilize Rev. Proc. 2004-34 and its procedural rules until further notice. If an accrual-method taxpayer wishes to change its present method of accounting for recognizing advance payments to a method consistent with the one-year deferral method described in Rev. Proc. 2004-34, generally such change can be made by filing an automatic consent Form 3115 with its timely-filed federal income tax return (including extensions). Similarly, a cash-method taxpayer desiring to change to an overall accrual method, as well as adopt the one-year deferral method for advance payments, may file a single combined automatic consent Form 3115.
Additionally, as a result of Section 451(c), the deferral techniques available to advance payments for goods under Section 1.451-5 of the Income Tax Regulations (such as the two-year deferral method for inventoriable goods) are overridden. Taxpayers that are deferring advance payments under Section 1.451-5 of the regulations would be required to file an automatic consent Form 3115 to change to either the full inclusion method or the one-year deferral method for tax years beginning after December 31, 2017.
Related-Party Transactions
According to Section 267, accrual-method taxpayers may not deduct salaries, bonuses, interest, rent, or other expenses owed to cash-method related parties until payments are made.
Related parties include:
- An individual and his or her more than 50 percent-owned corporation;
- Partnerships and their partners;
- S corporations and their shareholders;
- Two corporations having more than 50 percent common ownership; and
- A corporation and a partnership, if the same persons own more than 50 percent of each entity.
If you are an accrual method taxpayer and have improperly deducted accrued expenses or payables prior to actual payment, consult your advisor regarding filing an automatic Form 3115 to request IRS consent to change its method of accounting to comply with the Section 267 rules.
Listen to episode 119, “tax cuts and jobs act: implications for c-corps & flow-through entities,” featuring Christopher Axene, CPA, on unsuitable on Rea Radio, for more tax planning strategies.
Unrelated Party Compensation
Accrued compensation, including bonuses and vacation pay, which are payable to unrelated employees, reduces an employer’s taxable income. However, these deductions are also subject to restrictions. For accrual-method employers, the fact of the liability to pay the compensation must be fixed and determinable by the end of the taxable year to generate a deduction for compensation accrued by the employer’s year-end. The Service issued additional guidance in recent years on the application of these requirements to bonus plans.
In addition to the foregoing requirements, for the accrual-method employer to obtain a current deduction for compensation, the 2018 accrued compensation must be paid to unrelated employees (and cash-method independent contractors) within 2½ months after the end of the taxable year. Otherwise, this compensation is treated as deferred compensation and is deductible only when paid.
Note: Vested deferred compensation, although not currently deductible, is considered “wages” for FICA (Federal Insurance Contributions Act) and FUTA (Federal Unemployment Tax Act) tax purposes. Note also that under the Section 409A deferred compensation rules discussed below, certain items with deferred payment dates will now be currently taxed to the employee (with a corresponding deduction to the employer).
If your taxable year ends in October, November or December, a planning suggestion might be to pay accrued compensation to unrelated employees in early 2019 (within 2 1/2 months of the employer’s year-end) to obtain:
- 2018 deduction for employers
- 2019 income for employees
Check out our Tax Reform Guidance Resource Center for answers to your frequently asked questions, articles, insight, access to past webinar recordings and more.
Nonqualified Deferred Compensation
Section 404(a)(5) dictates the employer’s deduction for deferred compensation is the taxable year that the employee is taxed on the compensation. For deferred compensation arrangements that comply with the Section 409A restrictions on the timing of distributions from, and contributions to, nonqualified deferred compensation plans the deduction will be recognized when paid. For noncompliant Section 409A taxation to the participant has deemed taxable income as the compensation vests and accordingly the employer’s deduction is accelerated. Failure to properly report taxable compensation and to withhold appropriate taxes exposes the employer to reporting and under-withholding penalties, as well as liability for any unpaid taxes that should have been withheld. However, the heavier penalty is on the participants in such plans who will be subject to immediate taxation of plan balances that have not previously been taxed, plus an additional 20 percent tax penalty and interest. Plans that may be affected by these rules include salary deferral plans, incentive bonus plans, severance plans, discounted stock options and stock appreciation rights, phantom stock plans, and restricted stock units.
Under an IRS correction program for operational errors, certain errors can be corrected penalty-free in the same taxable year as the failure (or by the end of the immediately following year for non-insiders – participants other than directors, officers and ten percent owners), and limited relief for certain errors corrected thereafter or failures involving small amounts. The Service issued an additional program that allowed taxpayers to correct certain plan-document failures with no penalties if corrected more than one year prior to the payment event (or limited penalties in which the 20 percent tax is applied to only half of the account balance if, in most instances, corrected within 12 months of the payment event). Corrective action for operational failures that occurred during 2018 (and 2017 for non-insiders) should be completed by December 31, 2018, to obtain penalty-free relief; and documentary failures should be corrected immediately and sufficiently in advance of the earliest payment event to obtain penalty-free relief.
Contact your Rea tax planning advisor to find out if you can reduce your tax liability.