By: Mark Mirsky, CPA & Paul Wilkin, CPA
As this year draws to a close, the advisors at KRD share tax updates and planning tips for 2022 and beyond.
We have included updates for small businesses and individuals. Click the links below to jump to the section of the article you’re interested in reading.
UPDATES FOR SMALL BUSINESSES
Pass-Through Entity Tax
Research and Development Costs
Depreciation
Tax Free Disaster Relief Payments?
Business Interest
Employee Retention Credit
Information Reporting Reminders
UPDATES FOR INDIVIDUALS
New Form 1099-K Requirements
Deducting Business Losses
New Tax Credit Opportunities
Capital Gains and Losses
Itemized or Standardized Deduction
UPDATES FOR SMALL BUSINESSES
Pass-Through Entity Tax
The Tax Cuts and Jobs Act of 2017 (TCJA) instituted a $10,000 cap on the amount of state and local taxes (SALT) that can be deducted as an itemized deduction on Schedule A of an individual’s federal income tax return. In response, many states have enacted workarounds to provide an additional federal tax benefit for state tax payments for those residents who own pass-through entities (PTE) such as S-corporations or partnerships. The PTE makes an election to pay the state-level tax, and then takes a deduction for the tax paid on its federal income tax return, as allowed by IRS Notice 2020-75. This has the effect of providing a greater federal tax deduction to the owners. For example, assume the entity makes a PTE Tax payment of $30,000, which it deducts on its federal income tax return. This reduces the income passed through to the owners in Box 1 of their K-1s. If the owners are in a 24% marginal tax bracket, they would realize a total federal income tax savings of $7,200. Higher marginal rates would mean greater tax savings. Rules do vary from state to state as to how the payment is treated on the entity’s state income tax return. In many states (such as Illinois for example), the payment is passed through to the owners as a credit on their personal state income tax returns.
Currently, 29 states and New York City have enacted a PTE Tax (with Connecticut being mandatory). If your business operates in only one state, it can often be an easy decision as to whether or not to elect the PTE Tax. If your business operates in multiple states, or you have owners that live in other states, some additional analysis may be required to determine if the PTE Tax election makes sense, and in which states. The payments generally need to be made by December 31st in order to qualify for deduction in the current year. Of course, payments are based on estimated income, which is then reconciled at the time the tax returns are filed.
If you would like KRD to analyze the PTE Tax for your business and compute your estimated payment(s) for 2022, you will need to provide year-to-date information to us no later than December 10, 2022.
Research and Development Costs
The TCJA also changed the treatment of research and development costs, effective for tax years beginning after December 31, 2021. Up until this year, companies were allowed to choose whether to deduct the costs as a current expense when incurred or to capitalize and amortize them over a 5-year period. Starting in 2022, research and development costs are required to be capitalized and amortized. For costs related to domestic activities, the amortization period is 5 years, while for costs related to activities outside the U.S., the amortization period is 15 years. The amortization period begins at the midpoint of the taxable year in which the costs were paid or incurred. Note that these costs must be capitalized whether or not the company claims the Credit for Increasing Research Activities (R&D Credit). This law change makes the R&D Credit even more valuable, because it provides a way to realize a current tax benefit from costs that will not be deductible until future years.
There is significant bipartisan support in Congress to either delay the changes in treatment of the R&D costs until 2026, or to eliminate the changes altogether. It is very possible that legislation to do one or the other will be passed prior to the end of 2022, or in 2023 but retroactive to 2022.
Depreciation
Another change from the TCJA has to do with bonus depreciation. Through the end of 2022, bonus depreciation will remain at 100% of the cost of the asset. Beginning in 2023, bonus depreciation will start to phase out as follows:
- 80% in 2023;
- 60% in 2024;
- 40% in 2025;
- 20% in 2026;
- No bonus depreciation for property placed in service in 2027 and later years.
Bonus depreciation is the default requirement unless an election out (by asset class) is made. As with any depreciation deduction, the property must be placed in service by the end of the year in order to qualify. This may be more complicated in 2022 due to supply chain issues, and so used equipment may be a good alternative for some businesses.
Section 179 expensing is still available. The 2022 limits are total asset purchases of $2,700,000, with an expensing limit of up to $1,080,000. These limits are indexed annually for inflation. A company can take advantage of both Section 179 and bonus depreciation. The Section 179 allowance must be applied first, and then bonus depreciation would apply to the remainder.
Whereas bonus depreciation applies to the entire amount of an asset class, Section 179 can be elected on an asset by asset basis, or for a portion of an asset. Bonus depreciation does not have an income limitation, but Section 179 cannot create or increase a loss. For PTEs, bonus depreciation is included in the income or loss figure in Box 1 of the K-1, while Section 179 flows through to the owners as a separately stated item. The wages or guaranteed payments of the owners are considered in determining the deductibility of Section 179 on the owners’ personal tax returns.
Many states have decoupled from federal bonus depreciation rules, so state tax law treatment is another consideration in deciding whether or not to take bonus depreciation or Section 179.
Tax Free Disaster Relief Payments?
Many employers like to give employees a bonus payment around holiday time, both to reward the employees for the past year of work, and also to assist with extra expenses that are incurred for gift giving, entertaining family, etc. The challenge is that a bonus payment is technically includible in the employee’s wages, so even with no federal or state income taxes withheld, it will still require FICA and Medicare withholding and the corresponding employer tax portion. The full amount of the intended payment does not make it into the employee’s hands. For example, a bonus of $1,000 with no income tax withheld would result in the employee receiving $923.50, and a total cost to the employer of $1,076.50. To avoid this result, many employers choose to give gift cards or simply cash. While these methods don’t necessarily show up in the payroll system, the payments still need to be documented in order to support a tax deduction. This leaves open the exposure for failure to withhold and remit appropriate payroll taxes. Almost anything employers pay employees is subject to income tax and withholding.
COVID-19 may have provided us with an opportunity to supplement these bonuses, providing more to employees for this year. Section 139 of the Internal Revenue Code allows employers to make non-taxable disaster relief payments to employees for reasonable and necessary expenses resulting from the pandemic. Code Section 139 has been around since shortly after the 9/11 terrorist attacks. Thankfully, it has not been widely used, because it only applies when there is a qualified disaster. On March 13, 2020, President Trump declared a national emergency pursuant to the Robert T. Stafford Disaster Relief and Emergency Assistance Act due to the pandemic, which triggered the availability of payments under Code Section 139.
Section 139 payments should be for reimbursable expenses that are reasonable, necessary and incurred as a result of COVID-19. Examples of such expenses would include (but not be limited to):
- Expenses associated with setting up or maintaining a home office, including internet connections, computer equipment and office supplies;
- Increased home expenses such as utilities associated with being quarantined or working from home;
- Unreimbursed medical expenses such as co-pays, deductibles and supplements;
- Housing and food costs for additional family members such as college students returning home;
- Increased childcare expenses;
- Expenses to enhance physical, psychological and emotional well-being from isolation and social distancing.
Provided the amount of the payments is reasonable, the employee is neither required to account for the actual expenses nor provide substantiation to the employer. Code Section 139 does not impose a dollar limit on payments, and there is no discrimination testing as would apply to fringe benefit plans. The payments are not subject to payroll taxes. The payments are fully deductible by the employer, not includible in income by the employee, and there is no reporting requirement on Forms W-2 or 1099. The employer is not required to adopt a formal written plan, but may wish to document the assumption that the employees were adversely financially impacted by COVID-19, and the provision of the Section 139 payments to the employees in response.
Although the 2020 disaster declaration is still in effect due to the fact that it did not specify an end date, the President has the authority to lift the disaster designation at any time. The IRS has made it clear that Section 139 payments may not be a substitute for compensation. However, they may be paid to employees to help cover the additional costs they have incurred during the pandemic. Employers may wish to take advantage of Section 139 payments should consider still paying a year-end bonus, potentially at a reduced amount, and paying Section 139 payments while the opportunity exists for 2022. Please contact a member of the KRD team to discuss prior to making any such payments.
Business Interest
Section 163(j) was enacted as part of the TCJA in order to limit the deductibility of business interest. With a rising interest rate environment, this may become more of an issue for companies with debt. The interest expense limitation is 30% of adjusted taxable income (ATI), and the definition of ATI changes significantly in 2022. Prior to this year, the definition of ATI was essentially EBITDA. For tax years beginning after December 31, 2021, the definition of ATI no longer contains the add-back for depreciation and amortization. This could potentially reduce ATI by a significant amount, thus reducing deductible interest as well. Any interest incurred that is nondeductible due to the limitations can be carried forward indefinitely. The good news for small businesses is that for 2022, companies with average annual gross receipts of $27 million over the three prior years are exempt, and that figure rises to $29 million in 2023. As with many of the provisions of the TCJA, Section 163(j) will sunset after 2025.
Employee Retention Credit
The Employee Retention Credit (ERC) continues to be a viable benefit for companies that experienced a significant decline in revenues due to the pandemic. Companies that qualify can file amended payroll tax returns for 2020 and 2021 to claim a refund of up to $5,000 per employee for 2020 and $7,000 per employee, per quarter for 2021. There is generally a three-year statute of limitations for filing amended returns, so there is still time to take advantage of the ERC. Keep in mind that amending the payroll tax returns will also require (per IRS) amending income tax returns for the year(s) affected, in order to pick up the ERC as income. If you believe your company may qualify, you should talk to your advisors to find out. KRD has already assisted companies in receiving millions of dollars in ERC, so we are available as a resource for you.
However, beware – there are many unscrupulous companies currently marketing ERC eligibility to take advantage of business owners who don’t know all the complicated rules. They will claim that your business qualifies for big refunds due to government shut-down orders or “supply chain” issues. What they don’t tell you is that the IRS already laid out in Notice 2021-20 that there had to have been at least a 10% reduction in hours or revenues and a decrease in profits. They don’t tell you that the wages of owners and their families don’t qualify. These promoters often require large up-front fees or percentages of the ERC claimed in order to submit the amended filings. The fraud around ERC is rampant in the marketplace. The IRS has started to attack these bogus ERC claims, and the promoters will be nowhere to be found when the audit comes (and it will). The outcomes for these business owners who believed the ERC promoters have been disastrous, with some even losing their businesses altogether. If your business has already filed for ERC based on these claims, you should talk to us immediately about correcting any errors.
ERC is a potentially lucrative benefit for companies that were affected by the pandemic. The calculations can have many wrinkles, such as coordinating with PPP, EIDL and other programs, and the rules are not always easy to interpret. It is definitely worthwhile to explore whether your company qualifies for ERC, but be certain you are dealing with a reputable provider who knows the intricacies of the calculations.
Finally, with respect to the PPP and EIDL programs, please note Congress has extended to 10 years the statute of limitations to audit eligibility and use of funds from these programs. We recommend that you retain all documentation substantiating the need for the funds and the use of the funds, as audits related to both programs have begun at the federal, state, and local level.
Information Reporting Reminders
It will soon be time to file W-2s and 1099s. Here are a few reminders as your business prepares for the filings.
- Review your payroll processor’s deadlines now so that you can prepare to timely provide them with necessary information for bonuses, year-end payroll and information return reporting.
- Be sure to report personal use of automobiles. If your company provides vehicles for employees’ use, the personal portion of the auto usage must be computed and reported as income to the employee in Boxes 1, 3, 5 and 14 of Form W-2. There are various methods that can be used to calculate the personal use value, such as the General Valuation Method, the Annual Lease Value Method, the Cents-Per-Mile Method, or the Commuting Value Method. Make sure that this information is given to your W-2 provider in time for inclusion on the form.
- If you have an S corporation, health insurance premiums paid for any 2% or greater shareholder (and family) must be reported in Box 1 of Form W-2. If the premiums are not properly reported as compensation, then the shareholder cannot deduct them. Make sure that this information is given to your W-2 provider in time for inclusion on the form. Be sure the 2% shareholder (and family) are participating in the plan at the same rate as employees, or the amounts are subject to Boxes 3 and 5 (FICA/Medicare). Also, 2% shareholders (and partners in a partnership) are NOT eligible to participate in pre-tax Section 125 plans. Please contact us to discuss.
- Make sure that you have W-9s on file for all of your vendors in order to facilitate proper 1099 reporting. Rents paid to an LLC typically require a 1099-MISC to be filed. Besides services, other 1099s could be required for interest paid, dividends paid, or other income payments >$600.
- Review and verify worker classification as employees or independent contractors, to ensure that the correct W-2 or 1099-NEC is filed for each worker.
- The Emergency Paid Sick Leave Act and the Emergency Family and Medical Leave Expansion Act both require that employers report the amount of qualified family leave wages and qualified sick leave wages paid to employees in Box 14 of Form W-2 or on a separate statement.
UPDATES FOR INDIVIDUALS
New Form 1099-K Requirements
This (relatively) new form actually applies to both small businesses and individuals. Businesses that processed payments of $20,000 or more last year through a third-party settlement organization (TPSO), such as a credit card processor, are used to seeing this form. What’s new this year is that many, many more businesses, and also individuals, will be receiving a 1099-K, because the reporting threshold has dropped from $20,000 to $600. But you don’t take any payments on credit cards, you say? Perhaps true, but the $750 you received from Etsy or OfferUp from selling all that vintage stuff will now be reported to the IRS. The definition of a TPSO also includes payment facilitators like Venmo or Zelle. The reporting requirement is supposed to be only for payments for goods or services, so in theory, when you put the monthly dinners with your friends on your credit card so you could get the points, and then they reimbursed you for their portions of the checks via Venmo, that activity should not generate a 1099-K. It’s a new reporting threshold, however, so it’s entirely possible some forms will be issued in error. There are protocols for dealing with erroneous forms. The main thing is to remember to include any 1099-K forms you receive with your tax information for the year, so that we can ensure everything is reported properly.
Deducting Business Losses
Losses flowing through to you from businesses may be limited as to the amount that is deductible. Assuming you can meet the hurdles of active participation, basis and at-risk basis (all beyond the scope of this letter), the TCJA throws one more hurdle to deducting your business loss on your personal return – “excess business losses”. This provision was suspended by the CARES Act for 2018-2020, but it reared its head again in 2021, and thanks to legislation passed earlier this year, it is now extended through 2028. The provision limits the dollar amount of losses that may be deducted by a noncorporate taxpayer against nonbusiness income. For 2022, this limitation is $540,000 for married individuals filing a joint return, and $270,000 for all others.
For example, assume that as a single individual, you know you will have $350,000 in nonbusiness income for the year. You did some planning with your s-corporation, using depreciation and other deductions to generate a loss of $350,000. So now you are breakeven for the year with no tax due, right? Not exactly. The excess business loss provision will limit the amount of deductible losses from your s-corporation to $270,000, and you will pay tax on $80,000 of income. The remaining $80,000 of losses will be carried forward as a net operating loss. It should be noted that NOL deductions are also limited for federal tax purposes to 80% of taxable income. So, in the example, if you had $60,000 of taxable income before NOL in the following year, you would only be able to offset $48,000 of it with the NOL deduction. You would pay tax on $12,000 of income, and carry forward an NOL of $32,000.
This is yet another illustration that planning around your entire tax situation, including business losses, should be accomplished with the experienced professionals at KRD, who can navigate the complexity of the tax laws.
New Tax Credit Opportunities
An assortment of tax credit provisions related to energy were included in the Inflation Reduction Act of 2022 (IRA22). For example, if you purchased an electric vehicle prior to August 17, 2022, you could be eligible for a credit ranging from $2,500 to $7,500, depending on various vehicle requirements. If you purchased an electric vehicle after August 16, 2022, or you are considering purchasing an electric vehicle prior to the end of 2022, a different set of vehicle eligibility criteria applies. It may also be worth waiting until next year to make the purchase, because yet another set of vehicle eligibility criteria goes into effect after December 31, 2022. All of the vehicle credits are limited to individuals with modified adjusted gross income below the following thresholds:
- $300,000 for joint filers,
- $225,000 for head-of-household filers, and
- $150,000 for single filers.
The Nonbusiness Energy Credit, which relates to installation of energy-efficient windows, doors, water heaters or furnaces in your home, had expired at the end of 2021. That credit was 10% of the cost of the improvements, with a lifetime cap of $500. IRA22 extended the credit under its existing rules through 2022. Beginning in 2023 and extending through 2032, the credit changes to a 30% credit with no lifetime cap and an annual limit of $1,200. Starting in 2024, taxpayers will have to include a product identification number with the tax return claiming the credit.
IRA22 also added or extended a number of other credits for new construction or commercial buildings.
Capital Gains and Losses
A gain on the sale of a capital asset (stocks, bonds, etc.) held one year or less is considered a short-term capital gain, and is taxed at ordinary income tax rates. If the asset is held for more than one year, the gain on sale is considered long-term. Long-term capital gains are taxed at either the rate of 0%, 15% or 20%, depending on your filing status and income level. Your capital gains and losses are all netted together to determine whether you are in a net gain or net loss position before they flow into your tax return. If you are in a net loss position, you are only able to deduct up to $3,000 of that capital loss in any given year, and the remainder will carry forward to subsequent years.
It may be possible to do some planning around capital gains and losses for your holdings. For example, if you are in a position where you have actually realized net capital losses through selling securities, you may want to review your portfolio for securities where you have an unrealized gain. You could sell those securities in an amount that would allow the capital gain realized to be sheltered by your capital losses, thus netting to close to zero or a slight loss. If the gain security happens to be one that you particularly like and want to hold, you can literally purchase it again the following day, thus locking in a higher basis for future sales due to the gain you recognize this year. If you are in the reverse position, where you have net capital gains, consider selling some additional securities that have declined in value, so that the losses realized can offset your capital gains. If the securities you sell at a loss are securities that you want to continue to hold for the future, you will have to wait 31 days to repurchase them due to the “wash sale” rules. If you repurchase the loss security within 30 days of sale, the loss on the sale will be disallowed.
Finally, there is an investment (we are not providing investment advice here), that you may be able to utilize called a Qualified Opportunity Fund (QOF) which may allow you to defer taxation of your capital gains (short-term, long-term, 1256, 1231) until 12/31/2026. You can choose how much of any gain you generate that you would like to defer and invest this into one of the QOFs. Generally, you have 180 days from the date the gain is generated to reinvest into one of these funds. (Example, 10/31/22 you sell stock for $100,000 gain, you decide to defer $20,000 so you invest $20,000 on 2/15/23 into a QOF. You can defer the $20,000 gain to 12/31/2026). Further, if you retain the investment for 10 years and a day, your federal tax on any gain on the appreciation of that investment would be 0%. (Example continued – the $20,000 you invested increased to $120,000 in 2033, and you sell after the required minimum holding period, your federal tax on the $100,000 gain would be 0%).
If you want to minimize taxable gains and take advantage of losses, you should work closely with your investment advisor and tax professional to do so before the end of the year.
Itemized or Standard Deduction
The standard deduction levels are currently fairly substantial — $12,950 for single filers and $25,900 for married individuals filing jointly. As a result, many people don’t have enough expense deductions to itemize. You should consider whether you are in a position to itemize deductions this year. The most common itemizable expenses are:
- Medical and dental expenses not covered by insurance, to the extent that they exceed 7.5% of your adjusted gross income.
- State and local taxes up to $10,000.
- Home mortgage interest (subject to limitations, such as proceeds must be used to buy, build, or improve a first or second residence).
- Gifts to charity (cash, check or other property given to a qualified charitable organization).
Charitable giving is the item that is most under your control, and is often the category that pushes taxpayers over the itemization thresholds. There are limitations to how much you can deduct annually, based on a percentage of your adjusted gross income; anything over that percentage limit carries forward for up to 5 years. Below are some ways you can increase donations to charity and help reduce your taxes.
- Accelerate your schedule. If you have charitable organizations to whom you give a set monthly or annual amount, consider whether you could accelerate next year’s donations into the current year. By “bunching” your donations, you increase the potential current year deduction. If you suspend your giving for the following year, you will be in the same overall donation position you would have been if you had stuck to the original schedule, and you will have increased your tax deductions. This is an effective strategy if you are close to the itemization threshold, to get a tax benefit from your donations. You would still be able to take the standard deduction in the following year.
- Take a Qualified Charitable Distribution (QCD) from your IRA. A QCD is a charitable contribution of up to $100,000 per year made directly from your IRA. This is an especially useful strategy if you are at the point of taking required minimum distributions from your IRA. The QCD satisfies your minimum distribution requirement, but it is not included in your income. Reducing income can be important in determining how much of your Social Security benefits are taxable, how much medical expense you can deduct (see above), and a number of other factors.
- Give appreciated securities. When you give appreciated securities to charity, you get to take a deduction for the fair market value of the security without having to recognize the capital gain inherent in the appreciated value. This winds up being a double benefit – you don’t pick up the capital gain income, and you get a deduction for the donation. The deductible amount for this type of donation is therefore based on a lower percentage of your adjusted gross income. It may take a few days for your brokerage to actually transfer the securities, so if you are contemplating this strategy, be sure to plan it well before December 31st to ensure it happens in time to get the deduction.
- Give other non-cash items. These transactions can be as simple as donating a couple of bags of clothing or some furniture to Goodwill or Salvation Army, or more involved like donating a vehicle, or as complex as donating real estate. However, you must itemize what you donated in those bags to us and value these items. A bag of clothing without itemization has $0 value. Also, you should always maintain receipts from the charity indicating value and good records of property donated (such as pictures). Keep in mind that if the value of the property for any category donated exceeds $5,000, you will need to get a formal, written appraisal to support the value claimed.
Typically, gifts paid to GoFundMe pages are non-deductible, as they are not paid to a registered charitable organization, but instead are paid to an individual in most cases. Also, some sheriff, police, and fire groups may not be considered 501(c)(3) entities. Be sure to confirm the deductibility of these donations should you wish to obtain a deduction.
If you are going to make any donation to charity, make sure you always receive an acknowledgement from the charitable organization listing the date of the donation, the value of the property or cash donated, and that you received nothing from them in return. You need to have this acknowledgement with your tax records in order to actually claim a deduction for the donation. The acknowledgement, if the donation is greater than $250, is required to state “no goods or services were received” on its face with the date of the contribution in order to be a valid receipt.
Questions? Contact KRD Today
Contact your KRD advisor to discuss your next steps in preparing for the upcoming tax season.
