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Also see: 2022 Year-End Tax Planning for Individuals.

2022 Year-End Tax Planning for Businesses

(Parker Tax Publishing November 2022)

The second installment of Parker's annual two-part series on year-end tax planning recaps 2022's major changes affecting businesses as well as some strategies clients can utilize to minimize their business's 2022 tax bill.

Practice Aid: Use Parker's Sample Client Letter as a template or just sign your name at the bottom. See Our Sample Client Letter (Businesses).

The following are some of the considerations to review when deciding what year-end actions may reap the biggest tax benefits for a client's business. The list includes several new or expanded green energy incentives that were enacted as part of the 2022 Inflation Reduction Act (Pub. L. 117-169), which was signed into law by President Biden in August.

Section 179 Expensing and Bonus Depreciation

Generally, the two most popular tax deductions for businesses are the Code Sec. 179 expense deduction and the 100 percent depreciation deduction (i.e., the bonus depreciation). The 100 percent bonus depreciation starts to phase out after 2022, and is replaced with an 80 percent bonus depreciation for years beginning in 2023, and less for the following years. Thus, businesses have a greater incentive to take advantage of the bonus depreciation in 2022 if they can.

The bonus depreciation rules apply unless a taxpayer elects out of those rules. An election out may be advisable where a business has a loss for the year and will get no benefit from the loss. Most businesses no longer have the option to carryback a net operating loss (NOL) and NOLs arising in tax years ending after 2020 can only be carried forward. Exceptions apply to certain farming losses and NOLs of insurance companies other than a life insurance company. Also, the NOL deduction for tax years beginning after December 31, 2020, is limited to 80 percent of the excess (if any) of taxable income (determined without regard to certain deductions) over the total NOL deduction from NOLs arising in tax years beginning before January 1, 2018.

By not taking bonus depreciation in the current year, a business can defer depreciation deductions into future years when it expects to have taxable income that can be offset by the depreciation deductions. Of course, where the business is operated through a flow-through entity, additional considerations must be given to the tax situation of the owner of the flow-through entity and whether the owner can benefit from the flow-through of the bonus depreciation deductions.

Since the Code Sec. 179 expense deduction can't reduce taxable income, this is a better option for clients with taxable income. For 2022, the maximum Code Sec. 179 expense deduction is $1,080,000. This amount is reduced dollar for dollar (but not below zero) by the amount by which the cost of the Section 179 property placed in service during the year exceeds $2,700,000.

If a client is looking for business-related property to purchase in order to reap the maximum benefit of the Code Sec. 179 expense deduction and/or the bonus depreciation deduction, a vehicle purchase could result in a substantial tax savings. By purchasing a sport utility vehicle weighing more than 6,000 pounds, a client can obtain a bigger deduction than if a smaller vehicle is purchased. Because vehicles that weigh 6,000 pounds or less are considered listed property, deductions are limited to $19,200 for cars, trucks and vans acquired and placed in service in 2022. However, if the vehicle weighs more than 6,000 pounds, up to $27,000 of the cost of the vehicle can be immediately expensed.

Retirement Plans and Employee Benefits

The COVID pandemic has had a significant effect on retirements. Many businesses are facing a worker shortage and are reevaluating what it will take to entice employees to apply for a job. A business may reap substantial tax benefits, as well as non-tax benefits, by offering a retirement plan and/or other fringe benefits to employees. Businesses that offer such benefits have a better chance of attracting and retaining talented workers which, in turn, reduces the costs of searching for and training new employees. Contributions made to retirement plans on behalf of employees are deductible and the business may be eligible for a tax credit for setting up a qualified plan.

In addition, business owners and spouses can take advantage of the retirement plan themselves. Where a spouse is not currently on the payroll of a business, consideration should be given to adding the spouse as an employee and paying a salary up to the maximum amount that can be deferred into a retirement plan. If the spouse of a business owner is 50 years old or over and receives a salary of $27,000, all of it could go into a 401(k), leaving him or her with a retirement account but no current year taxable income.

To help employees with medical expenses, a business might consider setting up a high deductible health plan paired with a health savings account (HSA). The benefits to the business include savings on health insurance premiums that would otherwise be paid to traditional health insurance companies and having employee wage contributions to the plan not being counted as wages and thus neither the employer nor the employee is subject to FICA taxes on the payroll contributions. As for employees, they can reap a tax deduction for funds contributed to the HSA and the funds can grow tax free and be used in retirement.

Another employee benefit a business might consider is the establishment of a flexible spending arrangement (FSA). An FSA allows employees to be reimbursed for medical expenses or dependent care expenses and is usually funded through voluntary salary reduction agreements with the employer. The employer has the option of making or not making contributions to the FSA. Contributions made by the business are excludible from the employee's gross income and thus no employment or federal income taxes apply to the contributions. Reimbursements to the employee are tax free if used for qualified medical or dependent care expenses, and the FSA can be used to pay qualified expenses even if the employer or employee haven't yet placed the funds in the account.

Finally, Code Sec. 139 is a little-known or used provision that employers may be able to use to compensate employees tax-free for extra expenses incurred due to the COVID-19 pandemic, such as expenses incurred to set up a home office or to rent a place in which to quarantine. Under Code Sec. 139(a), gross income does not include any amount received by an individual as a qualified disaster relief payment. The term "qualified disaster relief payment" means any amount paid to or for the benefit of an individual:

(1) to reimburse or pay reasonable and necessary personal, family, living, or funeral expenses incurred as a result of a qualified disaster;

(2) to reimburse or pay reasonable and necessary expenses incurred for the repair or rehabilitation of a personal residence or repair or replacement of its contents to the extent that the need for such repair, rehabilitation, or replacement, is attributable to a qualified disaster; or

(3) by a federal, state, or local government, or agency or instrumentality thereof, in connection with a qualified disaster in order to promote the general welfare.

Code Sec. 139 codifies (but does not supplant) the administrative general welfare exclusion with respect to certain disaster relief payments to individuals. According to Rev. Rul. 2003-12, this exclusion from income applies only to the extent any expense compensated by such payment is not compensated for by insurance or otherwise. Additionally, qualified disaster relief payments do not include qualified wages paid by an employer, even those that are paid when an employee is not providing services.

The term "qualified disaster" includes a disaster determined by the President to warrant assistance by the federal government under the Robert T. Stafford Disaster Relief and Emergency Assistance Act. Because the COVID-19 pandemic was declared a national emergency under the Robert T. Stafford Disaster Relief and Emergency Assistance Act, the provisions of Code Sec. 139 should apply to payments made by employers to employees to compensate them for additional expenses incurred as a result of the pandemic. Likewise, in FS-2022-36, the IRS said that certain payments made by a state or local government to individuals in connection with the COVID-19 pandemic may be qualified disaster relief payments that are excluded from the recipient's gross income.

Qualified Business Income Deduction

For an individual operating as a sole proprietorship, a partner in a partnership, a member in an LLC taxed as a partnership, or as a shareholder in an S corporation, the qualified business income (QBI) deduction under Code Sec. 199A can significantly reduce taxable income. The QBI deduction allows eligible taxpayers to deduct up to 20 percent of their QBI, plus 20 percent of qualified real estate investment trust dividends and qualified publicly traded partnership income. A W-2 wage limitation amount may apply to limit the amount of the deduction. The W-2 wage limitation amount must be calculated for taxpayers with a taxable income that exceeds a statutorily-defined amount (i.e., the threshold amount). For any tax year beginning in 2022, the threshold amount is $340,100 for married filing joint returns, $170,050 for married filing separately, and $170,050 for all other returns.

Since the QBI deduction reduces taxable income, and is not used in computing adjusted gross income, it does not affect limitations based on adjusted gross income such as the medical expense deduction or the calculation of social security income that is includible in income. The QBI deduction does not apply to a "specified service trade or business," which is defined as any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, including investing and investment management, trading, or dealing in securities, partnership interests, or commodities, and any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. Engineering and architecture services are specifically excluded from the definition of a specified service trade or business.

Rental Real Estate Considerations

For clients with real estate businesses that generated losses, it's important to determine whether such losses from the activity are deductible. Generally, passive activity losses are only deductible against passive activity income. However, a deduction of up to $25,000 ($12,500 if married filing separately) may be allowed against nonpassive income to the extent an individual actively participates in the rental real estate activities. However, the deduction is subject to a phaseout for individuals with modified adjusted gross income above $100,000 (or $50,000 if married filing separately).

Rental real estate enterprises operated by individuals and owners of passthrough entities may also qualify for the QBI deduction if certain criteria are met. For example, in order to qualify for the deduction, a taxpayer's rental activity must be considerable, regular, and continuous in scope. In determining whether a rental real estate activity meets this criteria, relevant factors include, but are not limited to, the following:

(1) the type of rented property (commercial real property versus residential property);

(2) the number of properties rented;

(3) the taxpayer's or taxpayer's agent's day-to-day involvement;

(4) the types and significance of any ancillary services provided under the lease; and

(5) the terms of the lease (for example, a net lease versus a traditional lease and a short-term lease versus a long-term lease).

A rental real estate activity will be treated as a business eligible for the QBI deduction if certain safe harbor requirements are satisfied, such as:

(1) separate books and records are maintained to reflect the income and expenses for each rental real estate enterprise;

(2) for rental real estate enterprises that have been in existence less than four years, 250 or more hours of rental services are performed per year with respect to the rental real estate enterprise (with slightly less stringent requirements for rental real estate enterprises that have been in existence for at least four years);

(3) contemporaneous records have been maintained, including time reports, logs, or similar documents, regarding the following: (i) hours of all services performed; (ii) description of all services performed; (iii) dates on which such services were performed; and (iv) who performed the services; and

(4) certain compliance requirements are met.

Thus, to qualify for the QBI deduction, it's essential to determine if the safe harbor conditions are met and, if not, whether such conditions can be met by year end. Alternatively, even if the safe harbor requirements are not met, certain actions may be taken to ensure that a taxpayer's real estate business falls within the "trade or business" guidelines for taking the deduction.

Meal and Entertainment Expenses

Generally, the business deduction allowable for food or beverage expenses is limited to 50 percent of the amount which would otherwise be allowable as a deduction. However, the Consolidated Appropriations Act of 2021 enacted a more lenient rule for expenses relating to food and beverages purchased from restaurants in 2021 and 2022. Under this rule, a 100 percent deduction is allowed, providing the expense is properly documented. As part of that documentation, the business purpose of the meal must be provided. The term "restaurant" in this case means a business that prepares and sells food or beverages to retail customers for immediate consumption, regardless of whether the food or beverages are consumed on the business's premises. However, a restaurant does not include a business that primarily sells pre-packaged food or beverages not for immediate consumption, such as a grocery store; specialty food store; beer, wine, or liquor store; drug store; convenience store; newsstand; or a vending machine or kiosk.

Vehicle-Related Deductions and Substantiation Requirements

Deductions relating to vehicles are generally part of any business tax return. Since the IRS tends to focus on vehicle expenses in an audit and disallow them if they are not properly substantiated, it's important to remind business clients that the following should be part of their business's tax records with respect to each vehicle used in the business:

(1) the amount of each separate expense with respect to the vehicle (e.g., the cost of purchase or lease, the cost of repairs and maintenance, etc.);

(2) the amount of mileage for each business or investment use and the total miles for the tax period;

(3) the date of the expenditure; and

(4) the business purpose for the expenditure.

The following are considered adequate for substantiating such expenses:

(1) records such as a notebook, diary, log, statement of expense, or trip sheets; and

(2) documentary evidence such as receipts, canceled checks, bills, or similar evidence.

Records are considered adequate to substantiate the element of a vehicle expense only if they are prepared or maintained in such a manner that each recording of an element of the expense is made at or near the time the expense is incurred.

Increasing Basis in Pass-thru Entities

If a client is a partner in a partnership or a shareholder in an S corporation, and the entity is expecting to pass through a loss for the year, it's important to determine if the partner or shareholder has enough basis to absorb the loss. If not, then actions should be taken before the end of the entity's tax year to increase basis, if possible. Generally, this is done by contributing or loaning money to the entity.

S Corporation Shareholder Salaries

For any business operating as an S corporation, it's important to ensure that shareholders involved in running the business are paid an amount that is commensurate with their workload. The IRS scrutinizes S corporations which distribute profits instead of paying compensation subject to employment taxes. Failing to pay arm's length salaries can lead not only to tax deficiencies, but penalties and interest on those deficiencies as well. The key to establishing reasonable compensation is being able to show that the compensation paid for the type of work an owner-employee does for the S corporation is similar to what other corporations would pay for similar work. Practitioners should document in their workpapers the factors that support the salary being paid to a shareholder.

Also, because there are stringent requirements for who may be an S corporation shareholder, it's prudent to check annually as to the residency or citizenship status of S corporation shareholders and S stock beneficiaries (including contingent and residuary beneficiaries).

Energy Efficient Building Deduction

The Consolidated Appropriations Act of 2021 made the Code Sec. 179D energy efficient building deduction permanent. Thus, if a business owner made certain energy-efficient improvements during the year, such as installing property that is part of (1) an interior lighting system, (2) heating, cooling, ventilation, and hot water systems, or (3) the building envelope, a deduction equal to $1.88 times the square footage of the building may be available. The basis of the property is reduced by the amount of the deduction allowed.

Beginning in 2023, (1) the 2022 Inflation Reduction Act (2022 IRA) increased the maximum value of the deduction to $5 per square foot, adjusted for inflation; and (2) an alternative deduction is available for energy efficient lighting, HVAC, and building envelope costs placed into service in connection with a qualified retrofit plan.

New Vehicle Credits

The 2022 IRA modified tax credits for electric vehicles (EVs) and fuel cell vehicles. The law also enacted new tax credits for used and commercial clean vehicles. Multiple factors determine whether an EV purchased in 2022 qualifies for federal tax credits. Many EVs purchased before August 16, 2022, qualify for a tax credit of up to $7,500 (with smaller amounts available for certain makes and models). Vehicles manufactured by Tesla or General Motors purchased in 2022 are not eligible for tax credits, as Tesla and GM have exceeded the 200,000 vehicle threshold that limits the number of tax credits that can be claimed for vehicles made by a manufacturer.

For vehicles purchased after August 16, 2022, only vehicles for which final assembly occurred in North America qualify. The U.S. Department of Energy has released a list of model year 2022 and 2023 vehicles with final assembly in North America.

EV purchasers who ordered a vehicle before August 16, 2022, and take delivery of their vehicle at a later date may be able to claim tax credits for vehicles not assembled in North America if they had a "written binding contract" to purchase the vehicle. In determining whether there is a written binding contract, the IRS has indicated that a nonrefundable deposit or down payment of 5 percent of the purchase price can be an indication of a binding contract.

The 2022 IRA also enacted two new tax credits for clean vehicles, both starting in 2023. The first is the new Code Sec. 25E credit for previously owned clean vehicles. This tax credit is 30 percent of a used EV's sales price, up to $4,000. It can be claimed by taxpayers with income of less than $150,000 (for joint filers; $75,000 for single filers) for used EVs with a purchase price of $25,000 or less. The second is the new Code Sec. 45W tax credit for commercial clean vehicles. This tax credit is 15 percent of a qualifying vehicle's cost (30 percent if the vehicle does not have a gas- or diesel-powered internal combustion engine), limited to the incremental cost of the vehicle relative to a solely gas or diesel powered vehicle. The credit for light-duty vehicles is limited to $7,500, while heavy-duty vehicles can qualify for tax credits of up to $40,000.

Credit for Electricity Produced from Certain Renewable Resources

The 2022 IRA also extended the production tax credit (PTC) under Code Sec. 45 for five years, for facilities that begin construction before January 1, 2025. The PTC provides a tax credit for each kilowatt of electricity produced from qualifying facilities and sold to an unrelated party. Qualifying resources are generally sources of renewable electricity, including wind, biomass, municipal solid waste (including landfill gas and trash), geothermal, hydropower, and marine and hydrokinetic energy. The 2022 IRA provision also revived the PTC for solar energy (previously sunset in 2006) for facilities which begin construction before January 1, 2025.

For wind facilities, the credit reduction and phaseout scheduled to go into effect was eliminated by the 2022 IRA for any facility placed in service after December 31, 2021. Thus, such facilities are eligible to receive tax credits at full value.

The provision also modifies the rules governing projects that use both tax-exempt financing and claim the tax credits. Previously, the credits would be reduced by the lesser of 50 percent or the fraction of the basis of the facility that is financed with tax-exempt debt. However, for facilities that begin construction after August 16, 2022, and are financed with tax-exempt debt, the amount of credit is reduced by the lesser of 15 percent or the fraction of proceeds of a tax-exempt obligation used to finance the facility over the aggregate amount of additions to the capital account of the facility. The modified credit rates generally apply to facilities placed in service after December 31, 2021. The modifications related to the use of tax-exempt bonds apply to facilities that begin construction after August 16, 2022.

Energy Investment Tax Credit

The 2022 IRA also extended the Code Sec. 48 energy investment tax credit (ITC), which allows taxpayers to claim a tax credit for the cost of energy property. In most cases, the provision extends the credit for property for which begins construction before January 1, 2025. The provision provides a base credit rate of 2 or 6 percent of the basis of energy property or a bonus credit rate of 10 or 30 percent of the basis of energy property. These credit rates apply with respect to facilities placed into service after December 31, 2021. The 6 percent base and 30 percent bonus rate is provided for solar energy property, geothermal property, fiber-optic solar property, fuel cell property, microturbine property, small wind property, offshore wind property, combined heat and power property, and waste energy recovery property that begins construction before January 1, 2025.

Corporate Alternative Minimum Tax and Excise Tax on Stock Repurchases

While the 2022 IRA did enact a corporate alternative minimum tax of 15 percent on adjusted financial statement income for years after 2022, it only applies to corporations with such income in excess of $1 billion. Thus, it applies to very few businesses. Another new provision that only applies to very large businesses, and is also effective after 2022, imposes a 1 percent excise tax on stock repurchases by publicly traded corporations. The excise tax does not apply if repurchases are less than $1 million or if contributed to an employee pension plan, an employee stock ownership plan, or other similar plans. The excise tax also does not apply (1) where repurchases are treated as a dividend; (2) to repurchases made by regulated investment companies or real estate investment trusts; or (3) to purchases by a dealer in securities in the ordinary course of business.

Research and Development Expenditures

The deduction for research and development expenses previously allowed expired at the end of 2021 and such expenses must now be amortized over five years. However, a business that engages in certain types of research may qualify for an income tax credit based on its qualified research expenses. The credit is calculated as the amount of qualified research expenditures above a base amount that is meant to represent the amount of research expenditures in the absence of the credit. Because some small businesses may not have a large enough income tax liability to take advantage of their research credit, the law allows that small business (i.e., a business with less than $5 million in gross receipts and that is under five years old) to apply up to $250,000 of the research credit toward its social security payroll tax liability. The 2022 IRA expanded the amount available for the credit from $250,000 to $500,000 for tax years beginning after 2022.

Observation: There is a chance that the R&D expensing provision that terminated at the end of 2021 may be restored. There have been ongoing discussions between Republicans and Democrats about a potential last minute end-of-year tax deal regarding a reinstatement of the R&D deduction, which businesses are anxious to see reinstated, in exchange for an enhanced child tax credit that is similar to the 2021 enhanced child tax credit enacted as part of the American Rescue Plan Act of 2021.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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