We’ve been talking tons about Covid 19 stuff over the last few weeks. Like the paycheck protection program. And employee retention credits. But a change in direction this week. Let’s talk about some killer small business tax breaks.
The revised tax deadline for most small businesses, July 15th, is barely more than a week away. And that should mean you and I think about how to dial down the upcoming tax bills. The very topic we’ve been able to ignore–maybe had to ignore–given the pandemic.
The interesting thing? Small businesses and entrepreneurs get some of the very best tax breaks available.
But let’s step through these “killer” small business tax breaks. And you’ll quickly see what I mean.
Section 199A Deduction
The Section 199A small business tax break works simply for really small businesses.
A business owner gets to add a tax deduction to her or his return equal to 20 percent of the profit shown for a sole proprietorship, a partnership, an S corporation or rental property.
Example 1: An entrepreneur makes $100,000 in some venture. She may be able to add a $20,000 tax deduction to her return.
The thing to keep in mind about Section 199A? If a taxpayer’s 2019 income rises into above $160,700 (above $321,400 if married), special rules kick in that may limit or reduce the deduction. (A taxpayer may need a business to pay W-2 wages or own depreciable property.)
Furthermore, a taxpayer may want to do things which boost the so-called “qualified business income” which the Section 199A applies to. Most types of small business profit count as “qualified business income” including sole proprietorship profits, partnership and S corporation distributive shares, net rental income, and so on. But some types of “business income” don’t including guaranteed payments from a partnership and wages from an S corporation.
I’m not going to dig into those rules here. This blog supplies a bunch of detailed posts about Section 199A. But if you are not absolutely confident you’re maximizing your Section 199A deductions, spend some time learning the ropes.
Though the Section 199A expires after 2025, some successful small business owners will use this small business tax break to avoid paying taxes on six and seven figures of income.
Note: To learn more about the Section 199A deduction, you might want to start here: Section 199A Deduction Rookie Mistakes
Subchapter S Election
Eligible entities, including traditional corporations and limited liability companies, can elect to use the tax accounting rules from Subchapter S of the Internal Revenue Code.
These accounting rules sort of work like partnership accounting in that a business’s profit get allocated to its owners—and then they pay the income taxes.
But this tax accounting method produces an unusual result. It typically saves a business owner a chunk of self-employment taxes.
Example 2: An entrepreneur makes $100,000 as a sole proprietor. Or makes $100,000 as a partner in a partnership. He pays income taxes on the $100,000. And he pays the 15.3% self-employment taxes on almost all of the $100,000.
Example 3: Another entrepreneur operates a business that also makes $100,000 but which has been structured as an S corporation. Assume the S corporation pays out half of the profit, or $50,000, to the owner as W-2 wages. The other $50,000 of profit? The business pays that out to the owner as a “shareholder distribution.” In this case, the business owner only pays the 15.3% self-employment taxes on $50,000 rather than on nearly all of $100,000 of income.
By the way? The few thousand dollars of tax savings someone experiences annually with an S corporation don’t seem like that much savings. But over time, the savings can compound massively. We’ve observed in our practice that many small business owners can accumulate an extra $1,000,000 of retirement savings by operating as an S corporation. (We step a reader through our math behind this observation here: The Million Dollar S Corporation Mistake.)
The recent tax law changes let businesses immediately write off most non-real-estate property used in a business or as real estate investments.
Giant depreciation deductions don’t at first blush seem like that big a break… but taxpayers may be able to use them to fund growth of a business or of an investment portfolio using pretax income.
Some taxpayers may even be able to use bonus depreciation to withdraw money from a retirement plan without paying income taxes.
Example 4: A small business owner wants to buy the $1,000,000 building her firm rents. To make the building purchase, she needs a $250,000 down payment and a $750,000 mortgage. Though she doesn’t have $250,000 of cash for a down payment, she does have $250,000 of funds available in a retirement account. Further, bonus deprecation rules allow her to immediately depreciate $250,000 of the building price at time of purchase. Accordingly, she can withdraw the $250,000 from the retirement account and shelter this withdrawal from income taxes by deducting $250,000 of bonus depreciation.
This caution: Using bonus depreciation to shelter great gobs of income may require extra efforts and of course requires careful planning. To use bonus depreciation on a building, a business owner would need to use a cost segregation study, something we’ve talked more about here: Vacation Rental Tax Shelters.
Note: If you’re interested in more information about the new depreciation rules, my colleague Christian Block did a recent post: Maximizing Depreciation Deductions Under the Tax Cuts and Jobs Act.
Qualified Opportunity Zones
Qualified opportunity zones allow an investor or entrepreneur to reinvest “capital gain” profits in an economically distressed area.
The small business tax break available here? Well, three small business tax breaks actually. First, the taxpayer delays paying any capital gains taxes until 2026.
Second, probably the taxpayer pays only 85% to 90% of the capital gains tax they owed in the first place.
And then, third, if the new investment in the qualified opportunity zone increases in value, that increase isn’t subject to any capital gains.
Example 5: An entrepreneur reinvests $1,000,000 of capital gains into a qualified opportunity zone. As a result, he delays paying any tax on the gain. Probably, when in 2026 he does need to “pay the piper,” he will only pay taxes on $850,000 to $900,000 of the gain. Finally, if that $1,000,000 investment grows by $2,000,000 to $3,000,000 of value, he probably won’t have to pay capital gains taxes on the $2,000,000.
How to make sense of qualified opportunity zones? Well, Congress wanted to heavily incent small business owners to invest in economically distressed areas.
We think you need to be cautious about trying to take this small business tax break. But if you’re “entrepreneur-ing” in some communities, you want to know about this gambit.
Note: Interested in more detail? See here: Sobering Up About Qualified Opportunity Zones.
Qualified Small Business Stock
Qualified small business stock, also known as Section 1202 stock, represents potentially the biggest small business tax break available.
If an investor invests in a regular “C” corporation and the business the corporation operates qualifies, the investor avoids paying capital gains taxes on the later sale of the “C” corporation stock.
A note: If you pursue the “Qualified Small Business Stock” small business tax break, you lose the opportunity to use Section 199A deductions. And you lose the ability to avoid payroll taxes with a Subchapter S election. But you can save a bundle of capital gains taxes.
Example 6: An entrepreneur invests time and money into a software company. Five years later she sells her shares for $10,000,000. Because the software company stock counts as Section 1202 “Qualified small business stock,” she pays zero capital gains taxes.
Note: Two recent blog posts we’ve published here dig into the details of the Section 1202 “Qualified Small Business Stock” exclusion. One post discusses how Section 1202 Qualified Small Business Stock works and the other identifies some of the Section 1202 Qualified Small Business Stock pitfalls people need to stay alert to.
Two Closing Comments
This blog post describes small business tax breaks available this year and in one or more future years.
But if your firm has been hit by the Covid 19 pandemic, you want to know about a couple of other items.
First, Congress earlier in the year changed the net operating loss carry back rules. If your firm lost money this year, therefore, be sure you understand how the new carry back rules work. (See this blog post, Covid 19 Small Business Tax Relief, for more information.)
Second, over the weekend, Mr. Trump signed the short, five week extension in the Paycheck Protection Program. If you missed getting a paycheck protection program loan earlier, you ought to look again at that program. (More information on that here: Paycheck Protection Program Explained and Illustrated.)