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Watch out — too much tax deferral can backfire on small business owners

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According to common wisdom, postponing federal income bills “is always a good idea”. But common wisdom is not always right.

It is certain that tax deferral will be useful if you turn out to be in the same or lower tax brackets in future years. In that case, moves that reduce taxable income in the current year will at least delay the tax day of calculation and give you more money to work until the account matures. If it turns out that tax rates will be lower in the coming years, so much the better. Deferring taxable income in those years will cause lower rates to be taxed with deferred amounts. Great! But is it reasonable to believe that tax rates are lower on the cards? Probably not. Let’s talk.

Tax deferral options for small business owners

If you are the owner of a small business with a single owner, a partnership, LLC, which is treated for tax purposes as a single owner or partnership, or as an S corporation, you have multiple options to defer taxable income. You usually do this by taking steps near the year to reduce your taxable income from your business – which will be taxed on your personal Form 1040.

For example, if your small business uses the cash method of accounting for tax purposes (most use them), you can prepay deductible expenses near the year and send invoices late enough not to be paid by next year.

You may also be able to request a large depreciation charge in the first year to add assets, including vehicles, equipment, computer hardware, software, and even certain property costs.

By taking advantage of these opportunities, you will reduce your taxable income for the year at the cost of increasing your taxable income for the following year or years.

Even though 2020 is in your rearview mirror, you can still defer taxable income for that year if you haven’t submitted your refund yet because you’ve extended your application deadline. For example, on your return for 2020 that you want, you can choose to take advantage of a large depreciation write-off for the first year for an asset that was put into service last year. Or not.

As for 2021, the rest of the year remains for you to pull the tax deferral moves, and by 2022 you will have to make decisions that can delay income upon your return in 2021. Or not.

So the question today is: do you need to take full advantage of all the federal income tax and income tax deferral options that you may have available for an extended return in 2020 and that you definitely still have available for a return in 2021? Answer: maybe not. Please keep reading for a reason.

Future individual tax rates could be higher

Assuming there is no retroactive tax legislation, we know individual federal income tax rates and parentheses for 2021. If the current favorable Tax and Job Reduction Act (TCJA) regime is left in effect for 2022 (possible), the initial tax rate and the endpoints for next year are likely to be similar to those for this year, with probably modest adjustments for inflation. If that’s the case, the individual federal rates for 2021 and 2022 could be the lowest you’ll see for the rest of your life. Here are the individual rates and brackets for 2021. Again, they do not imply retroactive changes that would take effect this year.

single

joint

HOH *

10% brackets

0 – 9,950 USD

0 – 19,900 USD

0 – 14,200 USD

12% parentheses

9,951 USD

$ 19,901

14.201 USD

22% parentheses

$ 40,526

81,051 USD

54.201 USD

24% parentheses

$ 86,376

172,751 USD

86,351 USD

32% parentheses

$ 164,926

329,851 USD

$ 164,901

35% parentheses

$ 209,426

$ 418,851

$ 209,401

37% parentheses

$ 523,601

628,301 USD

$ 523,601

* head of household

We do not know whether the TCJA rate regime will be able to survive until 2025, as scheduled, or will be abolished sooner due to political developments. If rates increase, they could increase significantly for people with higher incomes. Owners of profitable small businesses can be affected.

Beware of the possible negative side effects of looking for large deductions for depreciation in the first year

I explained this in an earlier column. You see this tax type. Watch out. The considerations I have processed are now more valid than ever.

Potential negative impact on QBI deduction

A deduction of up to 20% of Qualified Operating Income (QBI) from transitional entities (individual ownership, partnerships, LLCs treated as individual ownership or partnerships for tax purposes and S corporations) is still in the 2020 and 2021 books. He is actually scheduled to live to see 2025, unless Congress kills him sooner. So far so good.

But the QBI deduction cannot exceed 20% of your taxable income calculated before any QBI deduction and before any net capital gains (net long-term capital gains greater than net short-term capital losses plus qualifying dividends).

Thus, moves that reduce your taxable income, such as requiring a 100% waiver of the first year bonus and giving maximum deductible contributions to the retirement plan, can potentially have the negative side effects of reducing your allowable QBI deduction.

Although most moves that defer taxable income create time differences when taxable income is recognized, the QBI deduction creates lasting tax savings. And that’s a “use it or lose it” proposal, because it should expire at the end of 2025. As said, it could disappear sooner. So, beware of over-indulging in tax deferral moves if they would significantly reduce your allowable QBI deduction. It’s a balance. Work with your tax professional to find the right balance.

Tax-smart moves that do not involve tax deferral

Fortunately, you can pull smart tax moves that don’t involve tax deferral with its potentially negative side effects. Here are three ideas.

Contributions to the Roth IRA

Because withdrawals from the Roth IRA are non-taxable, federal income taxes, Roth accounts offer an opportunity for complete tax avoidance, as opposed to tax deferrals. Thus, making annual contributions to the Roth IRA (if your income allows) is an attractive alternative to “too much” tax deferral for those who expect to pay higher tax rates during retirement.

Similarly, converting a traditional IRA to a Roth account effectively allows you to prepay a federal income tax bill on your current IRA account balance at today’s low rates, instead of paying possible higher future rates on your current balance and future earnings on the account.

Key thing: If your income allows you to make an annual Roth IRA contribution for your 2021 tax year (potentially up to $ 6,000 or $ 7,000 if you’re 50 or older on December 31, 21), you have until April 15, 22 to do the work.

For more information on Roth IRAs, see here.

Health Savings Account (HSA) Contribution

Because withdrawals from the HSA are not taxed with federal income when used to cover eligible medical expenses, the HSA provides the option of complete tax avoidance, as opposed to tax deferral. You must have qualified high-deductible health insurance and no other general health insurance to be eligible for HSA contributions. Many small business owners are in that scenario.

For the 2021 tax year, you can give a deductible HSA contribution of up to $ 3,600 if you have qualified self-coverage or up to $ 7,200 if you have family coverage. For those who will from 31.12.21. If you are 55 or older, the maximum contribution is $ 1,000 higher, or $ 2,000 higher if both you and your spouse are 55 or older on that day.

The write-off of the HSA contribution deduction is above the order. This means that you can file a claim even if you do not put the item in the file. More good news: the privilege of HSA contributions is not lost just because you happen to be earning high. Even billionaires can make deductible contributions if they have qualified health care with a high deduction.

Conclusion

If you haven’t filed for 2020 yet, work with your tax professional to find the right balance between withdrawing tax moves on that return and just recognizing income without any distortions. Consider the clear possibility of higher federal income tax rates in future years and the impact of tax deferral moves on your allowable QBI deduction for 2020. Also for your 2021 tax year. The current tax environment is not regulated and you need to be prepared to think outside the box.

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