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

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

To be sure, tax deferral will be beneficial if you turn out to be in the same or lower tax brackets in future years. In that case, making moves that lower current-year taxable income will at least put off the tax day of reckoning and give you more cash to work with until the bill comes due. If tax rates turn out to be lower in future years, so much the better. Deferring taxable income into those years will cause deferred amounts to be taxed lower rates. Terrific! But is it reasonable to believe that lower tax rates are in the cards? Probably not. Let’s discuss.

Small business owner tax deferral opportunities

If you’re a small business owner who operates using a sole proprietorship, partnership, LLC treated as a sole proprietorship or partnership for tax purposes, or S corporation, you have multiple opportunities to defer taxable income. Usually, you do that by taking steps near yearend to reduce your business taxable income —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 do), you can prepay deductible expenses near yearend and send out invoices late enough that they are not paid until the following year.

You may also be able to claim big first-year depreciation write-offs for asset additions including vehicles, equipment, computer hardware, software, and even certain real property expenditures.

Taking advantage of these opportunities will lower your taxable income for the year at the cost of increasing 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’ve not yet sent in your return because you extended the filing deadline. For example, on your yet-to-be filed 2020 return, you can choose to take advantage of big first-year depreciation write-offs for assets that were placed in service last year. Or not.

As for 2021, the rest of the year remains to make tax-deferral moves, and you’ll have until well into 2022 to make decisions that can defer income on your 2021 return. Or not.

So, the question for the day is: should you take full advantage of all the federal-income-tax-deferral opportunities that you may still have available for an extended 2020 return and that you definitely still have available for your 2021 return? Answer: maybe not. Please keep reading for reasons why.

Future individual tax rates could be higher

Assuming no retroactive tax legislation, we know the individual federal income tax rates and brackets for 2021. If the current favorable Tax Cuts and Jobs Act (TCJA) regime is left in place for 2022 (possible), the tax bracket beginning and ending points for next year will probably be close to those for this year, with presumably modest adjustments for inflation. If so, 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, these assume no retroactive changes that take effect this year.

single

joint

HOH*

10% bracket

$0 – $9,950

$0 – $19,900

$0 – $14,200

beginning of 12% bracket

$9,951

$19,901

$14,201

beginning of 22% bracket

$40,526

$81,051

$54,201

beginning of 24% bracket

$86,376

$172,751

$86,351

beginning of 32% bracket

$164,926

$329,851

$164,901

beginning of 35% bracket

$209,426

$418,851

$209,401

beginning of 37% bracket

$523,601

$628,301

$523,601

*head of household

We don’t know whether the TCJA rate regime will be allowed to survive through 2025, as scheduled, or if it will be scrapped sooner due to political developments. If rates are increased, they could be increased by a lot for upper-income folks. Owners of profitable small businesses could be affected.

Beware of possible negative side-effects of claiming big first-year depreciation deductions

I explained these in an earlier column. See this Tax Guy. Take heed. The considerations I covered are now more valid than ever.

Potential negative impact on QBI deduction

The deduction for up to 20% of qualified business income (QBI) from pass-through entities (sole proprietorships, partnerships, LLCs treated as sole proprietorships or partnerships for tax purposes, and S corporations) is still on the books for 2020 and 2021. In fact, it’s scheduled to live through 2025 unless Congress kills it 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 gain (net long-term capital gains in excess of net short-term capital losses plus qualified dividends).

So, moves that reduce your taxable income, such as claiming 100% first-year bonus deprecation and making maximum deductible retirement plan contributions can potentially have the adverse side effect of reducing your allowable QBI deduction.

While most moves that defer taxable income just create timing differences for when taxable income is recognized, the QBI deduction creates permanent tax savings. And it’s a use-it-or-lose-it proposition, because it’s scheduled to expire at the end of 2025. As stated, it could disappear sooner. So, beware of over-indulging on tax deferral moves if they would significantly reduce your allowable QBI deduction. It’s a balancing act. Work with your tax pro to find the proper balance.

Tax-smart moves that don’t involve tax deferral

Thankfully, you can make tax-smart moves that do not involve tax deferral with its potentially negative side effects. Here are three ideas.

Contribute to Roth IRA

Because qualified withdrawals from Roth IRAs are federal-income-tax-free, Roth accounts offer the opportunity for outright tax avoidance, as opposed to tax deferral. So, making annual contributions to a Roth IRA (if your income permits) 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 into a Roth account effectively allows you to prepay the federal income tax bill on your current IRA account balance at today’s low rates instead of paying possibly higher future rates on the current balance and future account earnings.

Key point: 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’ll be age 50 or older as of 12/31/21), you have until 4/15/22 to do the deed.

For more on Roth IRAs, see here.

Contribute to a Health Savings Account (HSA)

Because withdrawals from HSAs are federal-income-tax-free when used to cover qualified medical expenses, HSAs offer the opportunity for outright tax avoidance, as opposed to tax deferral. You must have qualifying high-deductible health insurance coverage and no other general health coverage to be eligible for HSA contributions. Many small business owners are in that scenario.

For the 2021 tax year, you can make a deductible HSA contribution of up to $3,600 if you have qualifying self-only coverage or up to $7,200 if you have qualifying family coverage. For those who will be age 55 or older as of 12/31/21, the maximum contribution is $1,000 higher, or $2,000 higher if both you and your spouse will be 55 or older on that date.

The write-off for HSA contributions is an above-the-line deduction. That means you can claim it even if you don’t itemize. More good news: the HSA contribution privilege is not lost just because you happen to be a high earner. Even billionaires can make deductible contributions if they have qualifying high-deductible health coverage.

The bottom line

If you’ve not yet filed your 2020 return, work with your tax pro to find the proper balance between making tax deferral moves on that return and just recognizing income without any contortions. Take into account the distinct possibility of higher federal income tax rates in future years and the impact of tax deferral moves on your allowable QBI deduction for 2020. Ditto for your 2021 tax year. The current tax environment is unsettled, and you have to be willing to think outside the box.

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