Top 5 tax deferral strategies, plus whether there’s such a thing as too many deferrals
If you’re looking to put extra cash in play, you might decide to defer your federal income tax bill. By lowering your taxable income, you can postpone your tax bill to a later date.
But because of possible changes on the tax horizon, now is the time to ask, “Can you have too much deferral?” The answer, quite possibly, could be yes.
The tax rate game
Prior to 2018, the top corporate tax rate was 35%, but with the Tax Cuts and Jobs Act (TCJA) in effect, the current corporate tax rate is 21%. Even though it’s not scheduled to expire after 2025 like individual rates are, the corporate rate will likely face some scrutiny in 2020.
On the individual side, 2020 tax brackets are expected to stay the same or face marginal cost-of-living increases. However, we can expect individual tax rates to also come under intense scrutiny next fall. Rates will either be preserved through 2025 as originally intended, or they will be revised by Congress.
If you choose to defer income past 2020, you could be in for a big surprise if and when the rates go up.
The potential consequences of deferring taxes
When you defer tax, you could actually destroy your allowable qualified business income (QBI) deduction. The new deduction allows you to deduct from your taxable income up to 20% of QBI from pass-through entities before any QBI deduction and net capital gains.
In other words, when you use tax deferral strategies to reduce your current taxable income — like making a sizable deductible retirement plan contribution or claiming first-year depreciation — you also reduce your allowable QBI deduction.
QBI could win out over tax deferrals for two reasons. The first is because the QBI deduction creates permanent tax savings. The second is because it’s scheduled to last only through 2025.
The takeaway here is that you must carefully consider how and when to make tax deferral moves.
The benefits of deferring taxes
Tax deferrals make perfect sense if you have a better use for your cash. Capital investments, like a dealership acquisition or expansion, will usually net a significant return.
Some common tax deferral strategies include:
1. Cash method
Your dealership may be eligible for the cash method of accounting.
If your dealership’s average gross receipts are less than $25 million, you can prepay deductible expenses or send out invoices as close to year-end as possible.
To determine if you qualify or if it’s the right decision for your dealership, consult your tax advisor.
2. Bonus depreciation
The TCJA increased first-year bonus depreciation to 100% for certain long-term assets placed in service after September 27, 2017. This percentage will be in effect until January 1, 2023, but afterward, it will be phased out.
Under bonus depreciation, eligible assets are not subject to an annual dollar limit. Unless for listed property, assets do not need to be used 50% of the time for business, and any bonus depreciation deductions are not limited to annual business profit.
Please be sure to consider your state’s conformity to bonus depreciation. Some states do not allow bonus depreciation. Without proper planning, you could experience a significant difference between state and federal depreciation.
Because the write-off potential in this category is significant, work with your tax professional to determine what types of assets qualify.
3. Section 179 deduction
Under Section 179, qualifying property that is placed in service beginning in the 2018 tax year is eligible for a $1 million maximum deduction. In order to qualify, assets must be used 50% of the time. Listed property may be subject to further limitations based on the business use or the asset’s gross vehicle weight. Unlike bonus depreciation, Section 179 is subject to both an annual dollar limit and a company’s annual taxable income.
If you want to claim Section 179 and bonus depreciation for the same asset, you must use Section 179, bonus depreciation and regular depreciation in that order.
4. Inventory methods
Dealerships can take advantage of inventory methods. LIFO (last in, first-out) still offers significant tax deferral opportunity.
Also, deferring trade discounts for interest and advertising credits allows you to defer income until the vehicle is sold.
5. Prepaid and accrued expense recognition
There are numerous accounting method opportunities to accelerate expenses for tax purposes. Consult your tax advisor to determine if they benefit your dealership.
Putting your tax deferral strategies into action
Like the car business, timing is everything. On the one hand, deferring income during times of expansion or limited profitability will give you the cash boost you need to invest in your dealership.
On the other hand, if you expect to be in a higher tax bracket in a future year, it may a good idea to ensure more income will be taxed at today’s rate. It may be wise to accelerate income into the current year and postpone deductible expenditures to the following year.
It’s critical to know what your tax deferrals are now, what your current rate of return is on invested capital, and what are the future consequences when your deferrals reverse. Use this information to determine when it makes sense to accelerate rather than defer income.
It’s also a good idea to work with a tax professional. Walking through different scenarios is the first step of proper and effective tax planning.
At Wipfli, we can walk you through your options and advise you on the timing and balance of tax deferral strategies. Contact us to learn more, or continue reading on:
Commercial real estate assessments: Are you paying too much in real estate taxes?
Starting the conversation: 6 succession planning tips for dealership owners
The three “D”s of fixed asset accounting: Dos, don’ts, and details