September 9, 2021
National Small Business Week will be celebrated September 13-15 this year to honor America’s small businesses and recognize their hard work. More than half of Americans either own or work for a small business, and they create about two out of every three new jobs in the U.S. each year. This month’s tax planning article focuses on certain planning considerations for small businesses unique to this year.
Strategically Evaluate your Choice of Entity
A small business has several options for its business structure. A small business owner can operate as a sole proprietor, partnership, limited liability company (LLC), S corporation or C corporation. The choice of entity impacts taxation on the business income and deductions.
If you started a new business, or own an established business, now is a good time to evaluate your current business structure to optimize tax savings. For example, choosing to be a C corporation used to be a sensible choice only in limited situations when the top corporate tax rate was 35%. However, beginning the tax year 2018 and beyond, the top corporate tax rate has reduced to 21%, making a C corporation a potentially better option for a wider range of business owners. An LLC is unique because it can elect to be taxed as a partnership (if owned by more than one person), an S corporation, or a C corporation.
Sole proprietorship vs. Pass-Through vs. Corporation
When you start a new business alone without incorporation, it is a sole proprietorship with no business structure. If you set up an LLC for your sole proprietorship with no other person doing the business together, it is disregarded for federal tax purposes and is reported on Schedule C as part of your individual income tax return. This is very common for start-ups and is often reasonable in the start-up phase of a business because it saves compliance costs and other legal and accounting expenses.
A business, including an LLC, can choose to be a partnership (if there is more than one owner), or incorporate itself to be an S corporation or a C corporation. A partnership and S corporation is also known as a “pass-through” entity for tax purposes. A pass-through entity does not pay federal income tax at the entity level. Instead, the company’s ordinary income “passes through” to the owner(s)’s individual tax return(s), where the highest tax bracket is 37% for federal income tax. Under current law, C corporations pay federal corporate income taxes levied at a 21 % rate plus state corporate taxes that range from zero to 11.5 %, resulting in a combined average top tax rate of 25.8 % in 2021. An LLC with its owner(s) in the top tax bracket, should consider changing its tax structure to a C corporation for significant tax savings. For example, if the LLC owner is subject to the highest tax bracket due to her spouse’s income, but the LLC elects to be a C corporation, it may result in significant tax savings for the owner. The C corporation could pay a moderate amount of salary to the LLC owner and issue dividends (which also could be qualified dividends subject to no more than 20% tax), while maxing out pre-tax benefits such as medical insurance, HSA (Health Savings Account) contributions, or retirement savings including profit sharing for the owner/shareholders.
Keep in mind that C corporations and those considering that business structure should not count on the corporate tax rate remaining at 21%. The Biden Administration signaled during the 2020 election that his tax plan would include increasing the corporate income tax rate from 21% to 28%. Though important, maximizing your tax savings is only one of the factors to consider in choosing the optimal business structure for your small business. It is important to consult with not only your tax advisor, but also your corporate attorney and others with knowledge and insights on your business operations when making the choice of entity.
Take Advantage of New Tax Rules
Businesses have a number of tax savings opportunities as a result of new laws enacted to support economy recovery during and after the COVID-19 pandemic. Every business owner should review these new rules to take advantage of all available opportunities.
New Temporary Exception for Meals Expense Deduction Limit in 2021 and 2022
Under current tax law, businesses can deduct 50% of the cost of business-related meals while deducting the full cost of “ordinary and necessary” expenses incurred for business. The new legislation (the Taxpayer Certainty and Disaster Relief Act of 2020) added a temporary exception to the 50% limit on the business expenses for food or beverages, allowing a 100% deduction for food or beverages from restaurants. For 2021 and 2022, businesses can claim 100% of their food or beverage expenses paid to restaurants if the expense is “ordinary and necessary,” the business owner (or an employee of the business) is present when food or beverages are provided to you or to a business associate (customers, employees, etc.), and the expense is not lavish or extravagant under the circumstances. More details on the exception are in IRS Notice 2021-25.
Relaxed NOL Limits
When a business’ deductible expense total exceeds its taxable income, it has a net operating loss (NOL). The new tax law enacted in 2017 (the Tax Cuts and Jobs Act of 2017, “TCJA”) removed an option to carry back NOLs two years, while adding a new rule limiting the NOL offset to 80% of the taxpayer’s taxable income before the Qualified Business Income deduction. These changes under the TCJA are generally less friendly to businesses because of the removal of carryback and more limitation on the offset amount.
The Coronavirus Aid, Relief and Economic Security (CARES) Act temporarily lifted the TCJA limitations on NOLs. Under the CARES Act, an NOL from a tax year beginning in 2018, 2019 or 2020 can be carried back five years, which the taxpayer can also elect to forego and only carry forward the NOLs. This carryback option is not available after 2020. NOLs generated in 2018, 2019 and 2020 are still subject to the TCJA 80%-of-income limitation if they are carried forward to a year in which the limitation applies (generally, tax years beginning after 2020). However, NOLs generated in 2018, 2019 and 2020 are not subject to the 80%-of-income limitation if they are exhausted during the five-year carryback period or during 2018, 2019 or 2020. NOLs carried over from pre-TCJA years aren’t subject to the limitation.
Excess Business Losses
Non-corporate taxpayers can deduct a net trade or business loss up to a maximum of $262,000 ($524,000 for joint returns) in 2021. A “trade or business” can include, but is not limited to, Schedule F (Farming) and Schedule C (Business) activities and other business activities reported on Schedule E (Rents and Royalties). Business gains and losses reported on Form 4797 may be included in the loss calculation. However, W-2 wages are not considered business income in calculating the excess business loss. Any excess loss becomes an NOL and is carried forward to future tax years.
Employee Retention Credit
Businesses that maintained workers on their payroll during the pandemic may also qualify for a tax credit worth half of the employee’s wages and health plan costs. The Employee Retention Credit (“ERC”) initially applied to wages paid from March 13, 2020, through Dec. 31, 2020, and was worth up to $5,000 per employee. Subsequent laws (the Consolidated Appropriations Act, 2021 and American Rescue Plan Act of 2021) have expanded ERC.
For all of 2021, eligible employers can claim ERC against the employer share of Social Security tax equal to 70% of up to $10,000 in qualified wages paid per employee per quarter. The maximum ERC amount available is $7,000 per employee per calendar quarter, for a total of $28,000 in 2021 in general. Certain startup businesses started after Feb. 15, 2020, with an average of $1 million or less in gross receipts may be allowed a credit of up to $50,000 per quarter.
To qualify, your business must prove:
- It fully or partially suspended operations due to governmental orders limiting commerce, travel, or group meetings due to the pandemic, or
- In 2020, it had a 50% decline in gross receipts compared to the same quarter in 2019.
- In 2021, the business’s gross receipts were less than 80% of gross receipts for the same quarter in 2019.
A new business can use gross receipts for the quarter when the business started as a reference for any quarter in which the business does not have 2019 figures. Alternatively, a business has an option to determine eligibility based on gross receipts in the immediately preceding calendar quarter.
Effective January 1, 2021, qualified wages are defined as:
- For an employer that averaged more than 500 full-time employees in 2019 – wages paid to employees that are not providing services because operations were fully or partially suspended or due to the decline in gross receipts.
- For an employer that averaged 500 or fewer full-time employees in 2019 – wages paid to all employees during a period that operations were fully or partially suspended or during the quarter that the employer had a decline in gross receipts regardless of whether the employees are providing services.
The law allows employers who received Paycheck Protection Program (PPP) loans to claim the ERC for qualified wages – but remember, the credit can only be taken on wages that are not forgiven or expected to be forgiven under PPP. Small employers (i.e., employers with an average of 500 or fewer full-time employees in 2019) may request advance payment of the credit (subject to certain limits) on Form 7200, Advance of Employer Credits Due to Covid-19.
Higher Deductibility for Charitable Contributions (Cash)
The AGI limit for cash contributions also remains increased for corporate donors. In 2021, corporations can deduct up to 25 % of taxable income (formerly 10 % prior to the CARES Act).
For individual taxpayers, the adjusted gross income (AGI) limit for cash contributions to qualifying public charities remains increased to 100 %. For cash contributions made in 2021, an individual taxpayer can elect to deduct up to 100 % of his/her AGI (formerly 60 % prior to the CARES Act). Business owners whose business structure is a sole proprietorship, or a pass-through entity will benefit more from cash contributions from their businesses.
For more in-depth tax planning and advice for small businesses, contact your CPA or Jennifer Galstad-Lee CPA, Tax Manager, GRF CPAs & Advisors at firstname.lastname@example.org. Read additional articles from our 2021 Year-End Tax Planning Series for more tax planning strategies and helpful tips.
Jennifer Galstad-Lee, CPA, JD
GRF CPAs & Advisors
 The combined average top tax rate is according to the calculation by Tax Foundation. https://taxfoundation.org/25-%-corporate-income-tax-rate/