by Garrett Fisher
December 23, 2017
Tax reform has offered a small window of opportunity for select taxpayers to control deductibility of certain payments by doing so before December 31, 2017, as both deductibility and underlying rate classifications change in January 1. It is unlikely that Congress considered for or against this situation; it appears to be an unintended byproduct of a very large legislative package written quickly and passed just before it will take effect.
Before diving into some strategies, allow me to clarify one commonly held misconception. One of the most significant changes to the tax code is the lowering of the corporate tax rate from 35% to 21%. Many mistakenly presume that applies to all legal entities, when it applies solely to entities taxed as a corporation, otherwise known as “C Corporations.” These are most common in large companies, and found least amongst small business. LLCs, partnerships, and S Corporations, which are actually taxation elections and not necessarily juridical entity types, are considered “pass throughs” with regard to tax reform, and these receive different benefits.
I must put a standard proviso: review all strategies with your personal tax advisor. The reason this disclaimer appears here, and also in just about every public tax advise document is due to the myriad of regulations, revenue rulings, and Tax Court cases that offer additional clarification and restrictions on all levels of minutia. Your tax advisor is best suited to understand your individual picture, and if any applicable regulations exist that may change or negate the below strategies.
For Cash-Basis Pass Through Business Owners
Entities can elect to be taxed on a “cash” or “accrual” basis for tax reporting. “Cash” means that income and expenses are recognized upon payment as opposed to when recorded in the accounting ledger under more traditional accounting practices. The below strategy is effective for cash-basis businesses only.
In 2018, many pass-through entities will receive a 20% deduction on “K-1 income,” that being the income received as a shareholder and not an active participant in the business, subject to some restrictions. Also, all rate categories except the lowest will be taxed at a lower rate in 2018; thus, it is advantageous for entities that reasonably expect to make similar income in 2018 as 2017 to shift as much deductible expense into 2017 from 2018. For a cash basis entity, this can be done by paying as many invoices as possible by 12/31/2017. Payment, for cash-basis purposes, means the tendering of cash, mailing of the check, or swiping of the credit card. Writing a check and holding it doesn’t count, and when the credit card bill is actually paid has no relevance.
It is probably hard to control receipt of income, though to the extent large payments can be deferred until January 1 or later, that is worth considering if something anomalously large is due. Receiving a check and failing to deposit it is against regulation, and there are various rules that can cause income to be recorded constructively despite lack of actual receipt, so tread carefully on this one and talk with your tax advisor.
In either case, if the entity enjoys the 20% deduction in 2018, all related business expenses are 20% less effective in their deductibility in 2018 than 2017, so it makes sense to shift them into this year.
For Accrual and Cash Basis Business Owners
This strategy is one that I recommend be deployed on any given year, though I find its common practice to be lacking. IRS rules stipulate specific depreciation requirements for capital assets: method and service life are relatively pre-determined for capital expenditures, subject to the option of Section 179 expensing. Section 179 allows a limited dollar amount of assets to be written off entirely in the year purchased – even if the asset was financed and therefore not actually paid for. Most people elect Section 179 no matter what happens and spend all of the tax savings without thinking for a second about the future.
In any given year, I suggest businesses with regular fixed asset purchases review expected tax brackets for the current year compared to the future, and only opt for Section 179 in high income years. If the year is low income or a loss, opt for IRS specified service life, which pushes some of the deduction into future years, which makes sense if they are presumed to be higher income and therefore higher nominal tax rates.
For 2017 into 2018, the more deductions recorded in 2017, the better, so consider Section 179 to save more tax dollars on the same capital expenditure. If 2017 is very low income or a loss, and 2018 is anticipated to be superior, it is still recommended to elect a service life.
Note that these depreciation elections are available on a per asset purchased basis.
For Those That Itemize Deductions
Schedule A is the location where individuals itemize common deductions (charitable contributions, state and local taxes, mortgage interest, etc.). In 2017, Schedule A is only used when deductions of that nature exceed $6,350 for an individual or $12,700 for a married couple. This is due to the fact that the standard deduction (aforementioned amounts) kicks in if itemized deductions are not enough. In 2018, the standard deduction effectively doubles, so that creates some interesting dynamics for end of year planning.
- For those that itemize over the 2017 standard deduction, though less than the 2018 standard deduction. In this instance, all itemized payments in 2018 are irrelevant as they are absorbed by the standard deduction. Consider accelerating payments to 2017 for optional deductions, such as charitable contributions. Ensure that all real estate tax that pertains to 2017 is paid in 2017, even if an option to pay in 2018 is allowed. Note that the IRS has stated that prepayment of 2018 period real estate tax does not count. Make all 2017 estimated state income tax payments by 12/31/2017, instead of in 2018, applied to the 2017 calendar year. Note: overpayment may result in taxable income in 2018, so have estimates be accurate.
- For those that anticipate itemizing in 2018, despite the new higher standard deduction. In 2018, the state and local income tax deduction is capped at $10,000. This is combined for real estate and income tax. For those itemizing in 2018, it is likely that this will be a significant portion of the itemization, and consider paying in 2017 all permissible taxes over $10,000 per the prior paragraph. Note also that any deductions taken this year compared to 2018 have a higher income tax benefit due to tax rate changes, assuming that income remains similar.
For All Taxpayers
As rates will be going down for most, it is worth considering extra 401(k) or IRA contributions in 2017 in lieu of 2018, as the tax benefit will be higher. There is already strategy regarding who should use Roth vs Traditional products, and that should already be factored in retirement decision making. With lower marginal rates and the fact that individual rates go back to current legislated amounts in 2025, Roth products may make more sense for many beginning in 2018, reverting to Traditional retirement products if marginal income tax rates increase.
I must reiterate that a conversation with your tax specialist is a must, as the nuances of each situation are multitudinous, and advice given here may not work for each recipient based on those factors. That, and tax advisors are paid to effectively manage tax burden, so if you’re not talking with this person about taxes, that is a separate problem to be addressed.
