By Megan Nelson, CPA
Business owners, whether a sole-proprietorship, partnership, S-Corporation or closely held C Corporation, should take the time before year end to assess their current financial situation. First and foremost, make sure the books and records are up to date, reconciled and properly categorized so you have an accurate view of your financial picture. No benefit is derived from tax planning based upon poor records. Next, take some time to reflect on the past year, anticipate the remainder of the year and project ahead to next year.
Most business owners are looking to minimize taxes, however avoiding taxes at all cost may not always result in keeping the most cash. For example, buying something before year end for the sake of getting a deduction does typically result in lower taxes, but it can also result in a negative impact on cash flows, meaning more dollars are spent than taxes saved and often doesn’t result in the best overall financial situation for the business. On the other hand, spending money on necessary expenses or equipment that will help the business grow and be more effective/efficient might justify that impact on cash flows. Or, if profits are up, it may make more sense to pay tax now and keep those after tax dollars to grow your business.
Keep in mind, tax planning shouldn’t be looked at based on a single year. Consider your tax situation this year, but how might it compare to next year and the year after? The Tax Cuts and Jobs Act (TCJA) became law in 2017 and lowered income taxes for almost everyone. Personal income tax rates in effect today are scheduled to sunset at the end of 2025 and increase to what they were in 2017. Under current law, the beginning of 2026 could find many taxpayers paying 3% to as much as 9% more in federal tax compared to the same income this year. Maybe saving cash and postponing that equipment purchase is a better financial decision.
If after looking at your current year income with consideration for few years, you decide it is beneficial to reduce current year income, here are some options to maximize deductions:
Set up a retirement account for tax deferral. If you are a sole proprietorship with no employees, this could be advantageous in two ways: a tax deduction plus saving for your retirement. A popular option for self-employed individuals with no employees is the Simplified Employee Pension (SEP) IRA that allows a contribution of just under 20% of net self-employment income (up to $66,000 for 2023). 401(k) plans or Savings Incentive Match Plan for Employees (SIMPLE) IRA are other popular options.
As mentioned above, buy that piece of equipment you have been wanting. If cash flow allows and the purchase makes sense, this may be a good time to buy equipment and write off a large portion this year. For 2023, the Section 179 deduction limit is $1,160,000 (reduced dollar for dollar when fixed asset purchases exceed $2,890,000). Note certain limitations apply to vehicles. Bonus depreciation is another accelerated asset write off method with an 80% deduction for 2023 on qualifying fixed asset purchases. Beware, not all states conform to bonus depreciation which can cause an addback to income on your state return. In order for any fixed asset purchase to be considered for depreciation, it must be placed in service (received and used) prior to year-end. Ordering a piece of equipment on December 31st and paying a down payment does not qualify.
Consider giving bonuses to employees. Payroll and related payroll taxes are a deductible business expense. Depending on the type of entity, you may want to give yourself a year-end bonus although you have to look at the tax situation. For example, the corporate tax rate is 21% as a result of the Tax Cuts and Jobs Act, therefore, paying a bonus to a shareholder of a closely held C Corporation might not be an overall tax savings if the taxpayer is in a higher tax bracket.
Prepay expenses if you are a cash basis taxpayer. If your business has expenses that you would normally pay in January and February, you may consider sending a check in December for these payments. If you deal with a vendor who is slow to invoice, consider giving them a call and asking them to send you that invoice sooner rather than later.
Lastly, see if you qualify for the qualified business income (QBI) deduction. In this case, having a higher profit results in a higher QBI deduction. The QBI deduction is up to 20% of qualified business income and is available to sole-proprietors, partners of a partnership and shareholders of an S-Corporation.
Tax planning can help a business owner keep more of the profits that you are working so hard to get. Analyze your financial position and consider several factors when deciding on year end moves. One of the smartest year end moves can be consulting with your tax advisor about how to keep more of those after-tax dollars!