All information in this post is provided for illustrative and educational purposes only and should not be considered tax or investment advice. Consult a tax professional to see if any of these strategies may work for you.
As we approach the year-end and get ready for the holidays, consider doing some tax planning for 2021 and beyond. We cover typical business and self-employed tax planning tools in this post and will continue with individual tax planning in the next post.
If you are self-employed or own a business, some things to consider for tax planning purposes are:
- Making capital investments, including business vehicles
- Contributing to a retirement plan
- Hiring your children
As always, we challenge you to think beyond 2020 as good tax planning should take a long view. In some cases, it may be better to reduce future income rather than current income, as some of our examples illustrate.
Economics and taxes
A basic rule of tax planning is to pay only what’s due by using all available deductions. For example, if you are eligible for the home office deduction, you should take it. A less obvious rule comes from realizing that certain business choices can cause taxable income and deductions can be shifted from a year to the next or vice versa. For example, shifting a planned capital expenditure up to this year can lower your taxable income this year but will likely generate higher taxable income next year. The timing of when you realize income can also make a difference. With this in mind, the goal of tax planning isn’t simply to lower taxes this year, which could be of little use if it causes taxes to be even higher in the future. Generally, with a progressive tax system, you may be better off attempting to smooth your taxable income over time. The timing of some business decisions can help you do that.
Before we proceed, a warning. The tax code is complex and each situation is unique. Make sure you consult with a tax professional to see if and how any of these ideas apply to your situation and make a tax projection before you make a decision. The IRS has a good website with resources for small businesses.
Capital investments and taxes
As a business owner, you probably have plenty of ideas about big-ticket expenses (or capital investments) for your business, like new equipment, office furniture, vehicles, or improvements to an existing property. If you are considering making a capital investment in 2022, consider anticipating it to 2021. The tax code allows you to recover the cost of property used for business purposes that has a useful life of more than a year through depreciation, which is an allowance for the wear and tear, deterioration, or obsolescence of the property.
Section 179 deduction
Under Section 179 of the tax code, you can choose to deduct up to $1,050,000 of the cost of certain property placed into service in 2021 as a 2021 expense. The deduction applies to tangible personal property such as machinery and equipment. The Tax Cuts and Jobs Act of 2017 (TCJA) amended the definition of qualified property to include improvements to nonresidential real property, such as roofs, heating, air-conditioning, fire protection, and alarm and security systems. The deduction phases out after you reach $2,620,000.
Bonus depreciation
Assuming you have remaining depreciable property after you applied the Section 179 deduction, the tax code allows you to use an additional special deduction called bonus depreciation. For example, if you spend $1,250,000 on various equipment, you can use bonus depreciation on the remaining $200,000. The TCJA increased the bonus depreciation percentage temporarily to 100 percent for qualified property. You will be able to claim the 100% bonus depreciation for property purchased until the end of December 2022. After that, it will revert back to 50%.
There may be some other limits on Section 179 and bonus depreciation, depending on the type of property (see business vehicles below). If you are left with any depreciable amount after Section 179 and bonus depreciation are applied, you can use standard depreciation methods.
Business vehicles
Business vehicles qualify for Section 179 and bonus depreciation but have special limits. First, consider heavy SUVs. Heavy is defined as having a manufacturer weight rating (called GVWR) of more than 6,000 pounds. Check out the GVWR on full-size SUVs like the Audi Q7, BMW X5, Toyota Tacoma, Chevy Tahoe, etc. You’ll see that all of these are above 6,000 (coincidence?). For these vehicles, Section 179 is limited to $26,200. However, with the 100% bonus depreciation, you can deduct 100% of the cost in 2020. Bonus depreciation is scheduled to revert back to 50% for the 2023 tax year, so that’s a big incentive to accelerate the purchase of these expensive vehicles.
Passenger vehicles with a gross weight rating of less than 6,000 pounds have special depreciation limits, which extend over a number of years. The maximum allowable depreciation schedule is $10,200, $16,100, $9,700, $5,760, for years 1, 2, 3, 4 and after, respectively. For these vehicles, bonus depreciation is also subject to an $18,200 limit the first year. For example, If you buy a $40,000 vehicle, you can depreciate $18,200 the first year (claiming bonus depreciation), then $16,100 the second year, and so on.
Hiring children in your business
If you have children working in your business, remember they too have a $12,550 standard deduction for 2021, and they too can give earnings or property up to $15,000 per tax year. How do the do go together, you may ask. Suppose you have teenage, college-bound children that work in your business. They earn $17,550 for their work doing digital marketing campaigns for you or other job the may be good at. You deduct the employee expense in your business profit and loss statement. The children can put $5,000 in an IRA account, which reduces theyr taxable income to $12,550. This remaining amount is tax-free thanks to the standard deduction. One of the things they can do is to give the $12,550 as a gift to you, and you put that in their 529 plan. You have reduced your taxable income and made a tax-advantaged contribution to their college fund.
You can of course deviate from these numbers in any way you like. The point here is that you and your income-earning children have the option to contribute to an IRA (or Roth IRA), and the option to use the $12,550 deduction for tax planning purposes. Also, keep in mind that this may affect other dependent-related credits.
Solo 401(k)
This is a great time of the year to make contributions to your retirement savings. Consider establishing and contributing to a solo 401(k) or a SEP IRA. While the two have similar maximum limits, the solo 401(k) has the most flexibility in terms of how much you can contribute to it. In a SEP, you can contribute up to 20% of your net earnings from self-employment, up to $58,000. In the 401(k), the employee part of your contributions can be up to 100% of your compensation, up to $19,500. After that, the employer portion can be 20% of your net self-employment income, up to a total (employer + employee) of $58,000. In addition, in a solo 401(k), but not in a SEP, you are allowed a catch-up contribution to your employee portion of $6,500 if you are 50 or older. So the total can be $64,500 in a solo 401(k). The reason the SEP does not have the catch-up contribution is that only the employer portion can be contributed to a SEP. Check out our recent post on these plans.
If you think the solo 401(k) may be a good option for you, know that you have to establish it before the end of the year. The advantage of the SEP, on the other hand, is that you have time to make a contribution until the filing of the tax return, or April 15, 2021.
Business Use of Your Home
If you use part of your home exclusively and as a primary place of business, you may be able to use the home office deduction. This allows you to deduct certain expenses that are directly related to your business activity or use a simplified method based on the size of your home. You have to be self-employed to use this exemption, employees can’t use it. To qualify, the part of your home has to be used exclusively and regularly for the business, and it has to be either the primary location of your business or a place where you regularly meet customers.
Business meals deduction
Expenses on business meals can be deducted. A business meal is when you are traveling for business, you are at a business conference, or you are meeting with a client. Typically, business meals are deductible up to 50% of the amount. Under temporary Covid relief rules, the business meals deduction for 2021 is 100%.
Until next time!
Massi De Santis is an Austin, TX fee-only financial planner. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
