As we head into the year-end, owners of pass-through businesses and other high-earning individuals should be made aware: It appears likely that your tax rates will be rising in 2022. Which ones and by how much, we can’t say just yet, but we have a basic idea from the Build Back Better framework that is still being negotiated. While not everything in there is guaranteed to be included in the final bill, you and your tax professional should start exploring planning alternatives for certain areas of your business before the end of the year.
Based on current highlights from the Build Back Better framework, owners of pass-through businesses and other high-earning individuals can potentially experience an approximate 12% tax rate increase in 2022 between surcharges and the expansion of income subject to net investment income tax. In view of that, owners of pass-through businesses with the ability to push deductions into the 2022 tax year could experience a 12% savings based on the differential in tax rates.
Below, we’ve compiled a list of operating expenses generally incurred in the ordinary course of business that are deductible based on timing of the payment and/or other criteria. Depending on the expense, you may be able to secure a tax deduction at a higher rate if you defer those expenses from 2021 into 2022.
- Employee bonuses: Consider deferring the payment of accrued, but unpaid 2021 employee bonuses until March 16, 2022. For accrual-basis companies, bonuses paid within 75 days of year-end are typically deductible in the preceding tax year. Accordingly, paying such bonuses on day 76 or thereafter would push the deduction into 2022 with no adverse consequences for your employees.
- Capital expenditures: In most cases, companies that claim bonus depreciation for machinery and equipment are able to deduct the full cost incurred when the corresponding asset is placed in service. For that reason, companies should consider holding off on year-end purchases of nonvital CAPEX and rather acquire and place such assets in service during January 2022.
- Bonus depreciation on three-, five- or seven-year assets: For eligible assets already purchased and placed into service during 2021, companies should consider opting out of bonus depreciation and, alternatively, depreciating such property under the modified accelerated cost recovery system (MACRS). This would ultimately defer much of the depreciation into later years at the higher tax rates.
- SALT workaround: Many states have recently implemented workarounds for individual owners of pass-through entities to effectively obtain federal deductions for their state income taxes, which were limited to $10,000 under the Tax Cuts and Jobs Act of 2017. IRS Notice 2020-75 clarifies that state and local taxes imposed on and paid by a partnership or an S corporation on its income are allowed as a deduction by the partnership or S corporation in computing its nonseparately stated taxable income or loss for the taxable year of payment. Accordingly, deferring the payment of such taxes to 2022 could secure the deduction at the higher tax rate.
- Office supplies, tools, maintenance/repairs, etc.: Wherever possible, businesses may want to hold off on restocking supplies or making minor repairs or betterments until the new year and all nonessential expenses should be deferred from December 2021 into January 2022.
- Charitable deductions and other discretionary spending: Most charitable donations are voluntary in nature and the timing is subject to the donor’s discretion. Again, waiting until January 2022 to make such charitable donations could result in additional tax savings, subject to annual limitations imposed on taxable income.
- Unused vacation payouts: Many businesses pay out unused vacation time to their employees after year-end. Similar to employee bonuses, the payout of vacation time is generally deductible in the preceding tax year if paid within 75 days of year-end. Fortunately, paying such vacation time on day 76 or thereafter would push the deduction into 2022 with no adverse consequences for your employees.
- Shareholder compensation: For accrual-basis companies, compensation paid to shareholders or other cash-basis related parties is generally deductible when paid. Paying such compensation in January 2022 as opposed to December 2021 would push the deduction into 2022.
- FIFO election: For businesses that are actively looking to convert from last-in, first-out (LIFO) inventory to first-in, first-out (FIFO) inventory or had intentions of doing so in the near term, consider accelerating the time frame and acting now. Making such a conversion before the end of the year could allow businesses to recognize income in 2021 at the lower tax rate.
- Shipments and revenue recognition: While the items above discuss the deferral of expenses into 2022, businesses should also consider the benefits of accelerating the recognition of income into 2021 to secure the lower tax rate. For manufacturing and distribution entities, revenue is typically recognized upon delivery of the related goods. As a result, make a coordinated effort to increase year-end sales and deliveries prior to Dec. 31, 2021.
Note: These are general topics for businesses to consider. Not every expense listed will be applicable to your business and the implementation of these techniques requires attention to detail and guidance from your tax professional. Furthermore, there may be additional applicable expenses not included in this list. We recommend discussing your specific set of facts and circumstances with your tax professional to help you maximize your tax savings and capitalize on these year-end planning opportunities.