Revenue recognition and timing of deductions
There are many options available to businesses to affect the timing of when revenue and deductions are factored into taxable income. Generally, taxpayers will prefer to adopt allowable accounting methods that will defer revenue and accelerate deductions. However, as described in earlier sections the BBBA as passed by House contains a surcharge provision on taxpayers with modified AGI in excess of $10 million and potentially expands the types of income subject to the net investment tax for taxpayers with modified AGI in excess of the “high threshold”. Currently, the BBBA has not been passed by the Senate, leaving uncertainty as to what ultimate legislation, if enacted, will look like. Taxpayers who believe they may be subject to increased tax burdens for 2022 and future years, may want to consider timing strategies that would accelerate revenue into 2021 and defer deductions into future years in the hopes of realizing a permanent tax savings.
Overall method of accounting: The broadest item to consider is the overall method of accounting – generally the cash or accrual methods. Consider whether your business is eligible for the expanded use of the cash method. The cash method is generally available to small businesses with average annual gross receipts of less than $26 million. The cash method is generally considered more tax-efficient than the accrual method when accounts receivable exceeds accounts payable and certain accrued expenses.
Accrual method taxpayers have many options available to affect the timing of deductions. Businesses should review their accrued expenses to identify the most advantageous method of accounting for these items.
Common items where opportunities exist to accelerate deductions include accrued compensation (including, bonuses, vacation, sick pay, severance, etc.), accrued services, accrued taxes, self-insured accrued employee medical expenses, accrued insurance, prepaid insurance and prepaid real property taxes among others.
Inventory and UNICAP
Inventory: Opportunities may exist to capture additional deductions through your inventory valuation accounting methods, such as Subnormal Goods and Lower of Cost or Market (LCM). “Subnormal goods” are generally inventory that cannot be sold in the normal way because of damage, imperfections, odd or broken lots, style changes or other similar causes. Meeting certain criteria, these items may be eligible for an inventory write-down, accelerating a tax deduction to 2021 that might otherwise not be realized until a later year. Have you experienced falling prices in the market value of inventory? Businesses on an LCM inventory method may have an opportunity to write down the carrying cost of the inventory to a lower cost or market value. The key is to identify inventory items with a market value less than the current carrying cost. Establishing the market value, however, is not arbitrary and requires establishing a value based on evidentiary market cost data.
Businesses that meet the fact patterns to claim an inventory write-down may be required to change their accounting method before claiming the deduction. Consult your tax adviser to discuss the process and your eligibility for changing your accounting methods to accelerate deductions for your inventories on hand.
UNICAP: Businesses are often required to capitalize additional costs into ending inventory on top of what is capitalized for financial accounting purposes. This is referred to as Uniform Capitalization – UNICAP for short – or 263A costs. Final IRS regulations, which were generally effective starting in 2019, introduced a broad range of modifications to how inventory costs are computed under UNICAP.
These regulations introduced a new allowable method of computing Section 263A costs on-hand: the modified simplified production method (MSPM). The MSPM allows manufacturers and manufacturer-resellers to derive tax benefits from a more favorable treatment of their raw materials and any resale inventories.
In addition to generating tax benefits, taxpayers may find that the MSPM offers a reduced administrative burden. By adopting the MSPM, taxpayers may avoid the regulations’ more stringent restrictions on taxpayers using the Simplified Production Method – including the requirement to compute book inventory costs on a tax basis and a restriction on using negative adjustments to remove costs not required to be capitalized.
Taxpayers may generally adopt the MSPM for tax years 2019 and forward. Businesses that have not determined the applicability or implemented these final regulations should consult with their tax advisor to determine if tax savings opportunities exist.
Fixed assets and depreciation
Businesses are permitted generous opportunities to immediately deduct the cost of investments in certain fixed assets. These deductions are claimed through “bonus depreciation” and Section 179.
Bonus Depreciation: Certain business assets eligible for immediate deduction generally include machinery, equipment, furniture and fixtures, land improvements, software, Qualified Improvement Property and other non-building assets. Eligible assets are not required to be new purchases – as in the past – but now must only be “new to you.” There is no limit on the amount of bonus depreciation deduction that may be claimed to reduce taxable income.
Qualified improvement property (QIP): QIP generally encompasses interior improvements made by the taxpayer to a building that does not include an enlargement, expansion or altering the building’s internal structural framework. Prior to 2020 and due to a drafting error in the TCJA, QIP was depreciated over 39 years and was not eligible for bonus depreciation. The CARES Act passed in early 2020 corrected this error, changing the depreciation period for QIP to 15 years, as well as making the assets eligible for bonus depreciation. The correction of this error was made retroactively to the beginning of 2018. Taxpayers may be able to catch up on missed deductions under the prior law by filing an accounting method change if they have not already filed amended returns or made the method change in the 2020 tax year.
If you are contemplating a purchase of business assets, consider doing so and placing them in service before December 31, 2021, to claim bonus depreciation. If you acquired, renovated or substantially improved a building, consider implementing a cost segregation analysis to maximize the cost eligible for QIP and bonus depreciation. A cost segregation analysis can be implemented retroactively through an accounting method change – without amending tax returns – to capture depreciation deductions missed on prior tax returns.
Section 179: This is another asset-expensing provision. It applies to similar types of property as bonus depreciation, generally non-building assets. The maximum deduction under this provision for 2021 is $1,050,000 and begins to phase out once a taxpayer’s annual investment in eligible assets exceeds $2,620,000. The TCJA also expanded the definition of eligible Section 179 property to include the following improvements installed in a building after initial construction (i.e., not new construction): qualified improvement property (same definition as above under bonus depreciation), and certain improvements to non-residential property, including roofs, HVAC property, fire protection and alarm systems and security systems.
Taxpayers seeking to defer deductions for 2021 may want to consider electing out of bonus depreciation, forgoing the available 179 deduction or possibly even delay acquiring and placing fixed assets into service until 2022.
Business interest expense
Under current law, interest expense generally may not exceed 30 percent of taxable business income before depreciation, amortization, depletion, and interest expense (also known as adjusted taxable income or ATI). In tax years beginning after 2022, this limitation becomes even more restrictive as the limitation will no longer be applied before the deduction for depreciation, amortization, and depletion.
In late 2020 and early 2021, the IRS provided additional guidance on the business interest expense limitation in the form of final regulations. The final regulations issued in late 2020 are generally applicable for tax years beginning after November 13, 2020, however taxpayers may choose to apply them to taxable years beginning after December 31, 2017, so long as the taxpayers and their related parties consistently apply them. The final regulations contained many revisions from the previously proposed regulations which might be considered taxpayer-friendly, including revisions to the types of expenditures considered to be interest subject to the limitation, changes in the computation of ATI for taxpayers subject to UNICAP and application of a singular qualification for the small business exemption at the entity level. Beyond this, potentially favorable changes were made with respect to multi-national businesses. Taxpayers whose business interest expense deductions for 2018, 2019, or 2020 were limited may want to evaluate their original filing positions against the guidance of the final regulations to identify whether there may be a potential benefit to file amended returns to take positions aligned with the final regulations.
Additionally, taxpayers may want to evaluate the potential impact of the final regulations as they apply the business interest expense limitation for 2021 and future years.
Under the final regulations taxpayers owning multiple pass-through entities with intercompany loans or who have made loans to their majority-owned S-corporations may find their tax liability significantly impacted by the business interest expense limitations. For example, if an S-corporation shareholder loaned money to the S-corporation itself, additional tax may arise due to the potential mismatching of the income (investment interest income recognized by the shareholder) compared to the expense (limited business interest expense recognized by the S-corporation). A similar issue existed with respect to related party loans and the passive loss limitations under Section 469. However, the IRS issued regulations to favorably address and resolve the Section 469 mismatch issue. In late 2019, the IRS indicated it was considering issuance of similar regulations to favorably resolve the mismatch issue with respect to the business interest expense limitation. However, the newly effective and final regulations provide relief solely with respect to loans made between a partner and partnership. Taxpayers with significant loans to their majority-owned S-corporations or between related businesses should consider discussing the potential tax implications and restructuring options for minimizing tax distortions with their tax advisor.
Other issues addressed by the final regulations include interest tracing, particularly relating to debt-financed distribution interest, treatment of interest on loans to acquire ownership in flow-through entities and application of the business interest expense limitations in the case of tiered partnerships.
The BBBA as passed by the House includes changes that would apply the business interest expense limitation at the partner or S-corporation shareholder level instead of the entity level. This change if enacted as drafted would create new issues for which guidance would need to be provided and may render some provisions of the existing final regulations inapplicable.
Conversions to qualified small business stock
Holders of C-corporation stock which is qualified small business stock (QSBS – Section 1202 stock) may be able to exclude all or part of the gains from the sale or exchange of the stock if they have held the stock for more than five years.
Due to recent economic disruptions, private equity and other small business equity investors may now be looking at holding on to their ownership in various operating companies longer than originally intended. In some instances, it may make sense for controlling equity investors to consider restructuring an entity as a corporation in order to qualify the investment for treatment as qualified small business stock at a future date.
Equity investors considering this strategy will want to consider their anticipated exit date as well as the tax trade-offs associated with operating as a C-corporation going forward.
Navigating the rules governing qualified small business stock and the associated gain exclusions can be complicated. Investors interested in exploring conversion should work with their tax advisor to better understand the requirements and assess the potential in their specific situation.
Under the BBBA as passed by the House, taxpayers with an adjusted gross income of $400,000 or more the maximum gain exclusion percentage would be 50% even if the sale otherwise meets the 75% or 100% requirements. If enacted as drafted, this change would generally apply to sales or exchanges after September 13, 2021.
State and local tax
Most businesses have experienced a shift to a remote work from home environment fora significant portion of their workforce during 2020 and on into 2021. In some instances, employees working from home may now live in state and local jurisdictions where the business would not normally have a physical presence. Additionally, businesses may have seen shifts in their customer base as they have shifted to more of a virtual sales and delivery model. Physical presence in a jurisdiction can be sufficient to create a filing obligation. Furthermore, in many jurisdictions, simply exceeding a threshold of sales into the jurisdiction can create a filing obligation. Businesses impacted by these types of changes should work closely with their tax advisor to ensure they are in compliance with the various state and local jurisdictions for purposes of income tax, franchise tax, gross receipts and other taxes.
When filing state and local returns this year, businesses will also want to consult with their tax advisor to determine if there are any special apportionment elections available that might reduce their overall state tax burden. Businesses that have revenue from services and intangibles will also want to consider the proper revenue sourcing rules in each state. Since the laws vary state to state, possible scenarios can exist that the same revenue is attributable to multiple states or certain items of revenue might not be attributable to any state.
Related business groups, including groups filing consolidated federal returns, should also consider whether they are utilizing the appropriate statutory filing methodologies (combined, consolidated, separate, etc.) as well as whether there are any elective filing methodologies available that might yield tax savings.
State and local tax credits and incentives
As businesses continue to adapt and make changes to how they operate, it is important to continually consider what activities they may have in a jurisdiction that might create the opportunity for statutory or negotiated credits or incentives. Increased headcount, capital expenditures, research and development, training expenses, etc., are all items that have the potential to generate state and local tax credits. Some of these credits can offset tax types other than income tax (i.e., withholding).
Sales and use tax
Sales and use tax liabilities may also be impacted by the recent shifts to remote work and customer base. A physical presence or a threshold level of sales can create a filing obligation in virtually every jurisdiction. As a result, businesses should consider whether they are properly registered for sales and use tax in each jurisdiction and are collecting and remitting to the appropriate jurisdictions.
Most states’ economic nexus threshold is either $100,000 or $250,000. For more information, DHG has a complete list of economic nexus thresholds.
The sales and use tax area is an evolving landscape with many jurisdictions now subjecting digital products, SAAS, services, etc., to tax. In addition to registering and filing in the appropriate jurisdictions, businesses also need to consider the taxability of products and services sold. Businesses should also consider whether they are taking full advantage of all exemptions available to them on items purchased for use in their business. Identifying the available exemptions in each jurisdiction can reduce tax burdens going forward and generate potential refunds from prior years.