Consider tax accounting method changes and strategic tax elections
The 2017 Tax Cuts and Jobs Act (TCJA) lowered the regular corporate tax rate to 21% and eliminated the corporate alternative minimum tax beginning in 2018. The current version of the proposed Build Back Better Act would leave the 21% regular corporate tax rate unchanged but, beginning in 2023, would create a new 15% corporate alternative minimum tax on the adjusted financial statement income of corporations with such income over $1 billion. Companies with adjusted financial statement income over $1 billion, therefore, should take into account the proposed 15% corporate alternative minimum tax when considering 2021 tax planning actions that could affect future years.
Companies that want to reduce their 2021 tax liability should consider traditional tax accounting method changes, tax elections and other actions for 2021 to defer recognizing income to a later taxable year and accelerate tax deductions to an earlier taxable year, including the following:
- Changing from recognizing certain advance payments (e.g., upfront payments for goods, services, gift cards, use of intellectual property, sale or license of software) in the year of receipt to recognizing a portion in the following taxable year.
Tax accounting method changes – is a Form 3115 required and when?
Some of the opportunities listed above for changing the timing of income recognition and deductions require taxpayers to submit a request to change their method of tax accounting for the particular item of income or expense. Generally, tax accounting method change requests require taxpayers to file a Form 3115, Application for Change in Accounting Method, with the IRS under one of the following two procedures:
- The “automatic” change procedure, which requires the taxpayer to attach the Form 3115 to the timely filed (including extensions) federal tax return for the year of change and to file a separate copy of the Form 3115 with the IRS no later than the filing date of that return; or
- The “nonautomatic” change procedure, which applies when a change is not listed as automatic and requires the Form 3115 (including a more robust discussion of the legal authorities than an automatic Form 3115 would include) to be filed with the IRS National Office during the year of change along with an IRS user fee. Calendar year taxpayers that want to make a nonautomatic change for the 2021 taxable year should be cognizant of the accelerated December 31, 2021 due date for filing Form 3115.
Only certain changes may be implemented without a Form 3115.
Write-off bad debts and worthless stock
Given the economic challenges brought on by the COVID-19 pandemic, businesses should evaluate whether losses may be claimed on their 2021 returns related to worthless assets such as receivables, property, 80% owned subsidiaries or other investments.
- Bad debts can be wholly or partially written off for tax purposes. A partial write-off requires a conforming reduction of the debt on the books of the taxpayer; a complete write-off requires demonstration that the debt is wholly uncollectible as of the end of the year.
- Losses related to worthless, damaged or abandoned property can generate ordinary losses for specific assets.
- Businesses should consider claiming losses for investments in insolvent subsidiaries that are at least 80% owned and for certain investments in insolvent entities taxed as partnerships (also see Partnerships and S corporations, below).
- Certain losses attributable to COVID-19 may be eligible for an election under Section 165(i) to be claimed on the preceding taxable year’s return, possibly reducing income and tax in the earlier year or creating an NOL that may be carried back to a year with a higher tax rate.
Maximize interest expense deductions
The TCJA significantly expanded Section 163(j) to impose a limitation on business interest expense of many taxpayers, with exceptions for small businesses (those with three-year average annual gross receipts not exceeding $26 million ($27 million for 2022), electing real property trades or businesses, electing farming businesses and certain utilities.
- The deduction limit is based on 30% of adjusted taxable income. The amount of interest expense that exceeds the limitation is carried over indefinitely.
- Beginning with 2022 taxable years, taxpayers will no longer be permitted to add back deductions for depreciation, amortization and depletion in arriving at adjusted taxable income (the principal component of the limitation).
- The Build Back Better Act proposes to modify the rules with respect to business interest expense paid or incurred by partnerships and S corporations (see Partnerships and S corporations, below).
Maximize tax benefits of NOLs
Net operating losses (NOLs) are valuable assets that can reduce taxes owed during profitable years, thus generating a positive cash flow impact for taxpayers. Businesses should make sure they maximize the tax benefits of their NOLs.
- Make sure the business has filed carryback claims for all permitted NOL carrybacks. The CARES Act allows taxpayers with losses to carry those losses back up to five years when the tax rates were higher. Taxpayers can still file for “tentative” refunds of NOLs originating in 2020 within 12 months from the end of the taxable year (by December 31, 2021 for calendar year filers) and can file refund claims for 2018 or 2019 NOL carrybacks on timely filed amended returns.
- Corporations should monitor their equity movements to avoid a Section 382 ownership change that could limit annual NOL deductions.
- Losses of pass-throughs entities must meet certain requirements to be deductible at the partner or S corporation owner level (see Partnerships and S corporations, below).
Defer tax on capital gains
Tax planning for capital gains should consider not only current and future tax rates, but also the potential deferral period, short and long-term cash needs, possible alternative uses of funds and other factors.
Noncorporate shareholders are eligible for exclusion of gain on dispositions of Qualified Small Business Stock (QSBS). The Build Back Better Act would limit the gain exclusion to 50% for sales or exchanges of QSBS occurring after September 13, 2021 for high-income individuals, subject to a binding contract exception. For other sales, businesses should consider potential long-term deferral strategies, including:
- Reinvesting capital gains in Qualified Opportunity Zones.
- Reinvesting proceeds from sales of real property in other “like-kind” real property.
- Selling shares of a privately held company to an Employee Stock Ownership Plan.
Businesses engaging in reverse planning strategies (see Is “reverse” planning better for your situation? above) may instead want to move capital gain income into 2021 by accelerating transactions (if feasible) or, for installment sales, electing out of the installment method.
Claim available tax credits
The U.S. offers a variety of tax credits and other incentives to encourage employment and investment, often in targeted industries or areas such as innovation and technology, renewable energy and low-income or distressed communities. Many states and localities also offer tax incentives. Businesses should make sure they are claiming all available tax credits for 2021 and begin exploring new tax credit opportunities for 2022.
- The Employee Retention Credit (ERC) is a refundable payroll tax credit for qualifying employers that have been significantly impacted by COVID-19. Employers that received a Paycheck Protection Program (PPP) loan can claim the ERC but the same wages cannot be used for both programs. The Infrastructure Investment and Jobs Act signed by President Biden on November 15, 2021, retroactively ends the ERC on September 30, 2021, for most employers.
- Businesses that incur expenses related to qualified research and development (R&D) activities are eligible for the federal R&D credit.
- Taxpayers that reinvest capital gains in Qualified Opportunity Zones may be able to defer the federal tax due on the capital gains. An additional 10% gain exclusion also may apply if the investment is made by December 31, 2021. The investment must be made within a certain period after the disposition giving rise to the gain.
Partnerships and S corporations
The Build Back Better Act contains various tax proposals that would affect partnerships, S corporations and their owners. Planning opportunities and other considerations for these taxpayers include the following:
- Taxpayers with unused passive activity losses attributable to partnership or S corporation interests may want to consider disposing of the interest to utilize the loss in 2021.
- Taxpayers other than corporations may be entitled to a deduction of up to 20% of their qualified business income (within certain limitations based on the taxpayer’s taxable income, whether the taxpayer is engaged in a service-type trade or business, the amount of W-2 wages paid by the business and the unadjusted basis of certain property held by the business). Planning opportunities may be available to maximize this deduction.
- Certain requirements must be met for losses of pass-through entities to be deductible by a partner or S corporation shareholder. In addition, an individual’s excess business losses are subject to overall limitations. There may be steps that pass-through owners can take before the end of 2021 to maximize their loss deductions. The Build Back Better Act would make the excess business loss limitation permanent (the limitation is currently scheduled to expire for taxable years beginning on or after January 1, 2026) and change the manner in which the carryover of excess business losses may be used in subsequent years.
Planning for international operations
The Build Back Better Act proposes substantial changes to the existing U.S. international taxation of non-U.S. income beginning as early as 2022. These changes include, but are not limited to, the following:
- Imposing additional interest expense limitations on international financial reporting groups.
- Modifying the rules for global intangible low-taxed income (GILTI), including calculating GILTI and the corresponding foreign tax credits (FTCs) on a country-by-country basis, allowing country specific NOL carryforwards for one taxable year and reducing the QBAI reduction to 5%.
- Modifying the existing FTC rules for all remaining categories to be calculated on a country-by-country basis.
- Modifying the rules for Subpart F, foreign derived intangible income (FDII) and the base erosion anti-abuse tax (BEAT).
- Imposing new limits on the applicability of the Section 245A dividends received deduction (DRD) by removing the application of the DRD rules to non-controlled foreign corporations (CFCs).
- Modifying the rules under Section 250 to remove the taxable income limitation as well as reduce the GILTI and FDII deductions to 28.5% and 24.8%, respectively.
Review transfer pricing compliance
Businesses with international operations should review their cross-border transactions among affiliates for compliance with relevant country transfer pricing rules and documentation requirements. They should also ensure that actual intercompany transactions and prices are consistent with internal transfer pricing policies and intercompany agreements, as well as make sure the transactions are properly reflected in each party’s books and records and year-end tax calculations. Businesses should be able to demonstrate to tax authorities that transactions are priced on an arm’s-length basis and that the pricing is properly supported and documented. Penalties may be imposed for non-compliance.
Considerations for employers
Employers should consider the following issues as they close out 2021 and head into 2022:
- Employers have until the extended due date of their 2021 federal income tax return to retroactively establish a qualified retirement plan and fund the plan for 2021.
- Contributions made to a qualified retirement plan by the extended due date of the 2021 federal income tax return may be deductible for 2021; contributions made after this date are deductible for 2022.
- The amount of any PPP loan forgiveness is excluded from the federal gross income of the business, and qualifying expenses for which the loan proceeds were received are deductible.
- The CARES Act permitted employers to defer payment of the employer portion of Social Security (6.2%) payroll tax liabilities that would have been due from March 27 through December 31, 2020. Employers are reminded that half of the deferred amount must be paid by December 31, 2021 (the other half must be paid by December 31, 2022). Notice CP256-V is not required to make the required payment.
State and local taxes
Businesses should monitor the tax rules in the states in which they operate or make sales. Taxpayers that cross state borders—even virtually—should review state nexus and other policies to understand their compliance obligations, identify ways to minimize their state tax liabilities and eliminate any state tax exposure. The following are some of the state-specific areas taxpayers should consider when planning for their tax liabilities in 2021 and 2022:
- Does the state conform to federal tax rules (including recent federal legislation) or decouple from them? Not all states follow federal tax rules. (Note that states do not necessarily follow the federal treatment of PPP loans. See Considerations for employers, above.)
Accounting for income taxes – ASC 740 considerations
The financial year-end close can present unique and challenging issues for tax departments. Further complicating matters is pending U.S. tax legislation that, if enacted by the end of the calendar year, will need to be accounted for in 2021. To avoid surprises, tax professionals can begin now to prepare for the year-end close:
- Evaluate the effectiveness of year-end tax accounting close processes and consider modifications to processes that are not ideal. Update work programs and train personnel, making sure all team members understand roles, responsibilities, deliverables and expected timing. Communication is especially critical in a virtual close.
- Know where there is pending tax legislation and be prepared to account for the tax effects of legislation that is “enacted” before year end. Whether legislation is considered enacted for purposes of ASC 740 depends on the legislative process in the particular jurisdiction.
Begin Planning for the Future
Future tax planning will depend on final passage of the proposed Build Back Better Act and precisely what tax changes the final legislation contains. Regardless of legislation, businesses should consider actions that will put them on the best path forward for 2022 and beyond. Business can begin now to:
- Reevaluate choice of entity decisions while considering alternative legal entity structures to minimize total tax liability and enterprise risk.
- Evaluate global value chain and cross-border transactions to optimize transfer pricing and minimize global tax liabilities.
- Review available tax credits and incentives for relevancy to leverage within applicable business lines.
GJC is an Independent Member of the BDO Alliance USA
