5 key points about bonus depreciation

You’re probably aware of the 100% bonus depreciation tax break that’s available for a wide range of qualifying property. Here are five important points to be aware of when it comes to this powerful tax-saving tool.

1. Bonus depreciation is scheduled to phase out

Under current law, 100% bonus depreciation will be phased out in steps for property placed in service in calendar years 2023 through 2027. Thus, an 80% rate will apply to property placed in service in 2023, 60% in 2024, 40% in 2025, and 20% in 2026, and a 0% rate will apply in 2027 and later years. Keep in mind, we are in an election year, and tax law can change with adminstriations and changes to budget.

For certain aircraft (generally, company planes) and for the pre-January 1, 2027 costs of certain property with a long production period, the phaseout is scheduled to take place a year later, from 2024 to 2028.

Of course, Congress could pass legislation to extend or revise the above rules.

2. Bonus depreciation is available for new and most used property

In the past, used property didn’t qualify. It currently qualifies unless: 

  • The taxpayer previously used the property and
  • The property was acquired in certain forbidden transactions (generally acquisitions that are tax free or from a related person or entity).

3. Taxpayers should sometimes make the election to turn down bonus depreciation 

Taxpayers can elect to reject bonus depreciation for one or more classes of property. The election out may be useful for sole proprietorships, and business entities taxed under the rules for partnerships and S corporations, that want to prevent “wasting” depreciation deductions by applying them against lower-bracket income in the year property was placed in service — instead of against anticipated higher bracket income in later years.

Note that business entities taxed as “regular” corporations (in other words, non-S corporations) are taxed at a flat rate.

4. Bonus depreciation is available for certain building improvements

Before the 2017 Tax Cuts and Jobs Act (TCJA), bonus depreciation was available for two types of real property: 

  • Land improvements other than buildings, for example fencing and parking lots, and
  • “Qualified improvement property,” a broad category of internal improvements made to non-residential buildings after the buildings are placed in service.

The TCJA inadvertently eliminated bonus depreciation for qualified improvement property.

However, the 2020 Coronavirus Aid, Relief and Economic Security Act (CARES Act) made a retroactive technical correction to the TCJA. The correction makes qualified improvement property placed in service after December 31, 2017, eligible for bonus depreciation.

5. 100% bonus depreciation has reduced the importance of “Section 179 expensing”

If you own a smaller business, you’ve likely benefited from Sec. 179 expensing. This is an elective benefit that — subject to dollar limits — allows an immediate deduction of the cost of equipment, machinery, off-the-shelf computer software and some building improvements. Sec. 179 has been enhanced by the TCJA, but the availability of 100% bonus depreciation is economically equivalent and has greatly reduced the cases in which Sec. 179 expensing is useful.

We can help

The above discussion touches only on some major aspects of bonus depreciation. This is a complex area with tax implications for transactions other than simple asset acquisitions. Please feel free to reach out if you have any questions on this topic.

3 Myths About Real Estate Taxation

As an active CPA, I often stumble across forums and blogs on the internet with a plethora of misinformation that makes me want to bang my head against the wall. While this blog isn’t intended to be a PSA, the tax code is complex and you should always consult with a tax professional before acting on advice of a friend, colleague, or stranger on the web.

I assembled a list of the top  3 myths about real estate taxation with the intention of setting the record straight. Here’s the top offenders:

Myth #1: You need a real estate license to be a real estate professional

While you may need a license to hold yourself out to the public as a “real estate professional”, to qualify for real estate professional tax status the IRS only requires that you meet certain annual time thresholds.

The rules are pretty simple, the IRS defines a real estate professional as a taxpayer that materially participates in real estate. Qualifications? Work 750 hours in a real estate capacity and spend more than half your time in a real estate trade or business.

So what is a real estate business or trade? The IRS lists the following: renting and leasing of realty, construction, development, buying, operating, and managing realty, as well as realty brokerage businesses.

Simple enough, right? The full text can be found in full under Code Sec. 469(c)(7)(B).

Myth #2: Flipping income qualifies as capital gain

The IRS says “real estate dealers”, individuals or business involved in the buying, improving, and selling real property (“flipping”), cannot qualify for capital gains – regardless of whether you hold the property for 1 year or longer!

Court cases have made this pretty clear – real estate dealers should treat the business of flipping property similar to any other inventory based business. Meaning, sole proprietors involved in flipping activities would also be subject to self-employment taxes. You should also be aware that “real estate dealer” status could also subject your rentals to “self-employment”.

There are several strategies a knowledgeable CPA can help employ to reduce exposure to some of the negative implications.

Don’t believe me? There are plenty of court cases that support this – email me for a list!

Myth #3: Passive losses disallowed in one year are lost forever

The IRS has rules related to “passive losses”. These rules often limit the amount of loss that can be taken in a given year for a rental property.

The good news is that if your rental shows a passive loss, no taxes are being paid on the rental income you received for the year! Hopefully, that loss being generated is just “tax loss” rather than a hard loss.

So what happens to the losses in excessive of your rents received? When you have a passive loss from your rental activities and cannot use the loss because of your income level or the passive loss rules, they become suspended until they can be used to offset future passive income or offset any gain in the year that property is disposed of in a sale.

While the key to effective tax strategy usually involves obtaining the largest benefit now, the passive loss rules can work out quite nicely in the future.

Oh, and you can and should always write off depreciation. If you don’t write off depreciation, you will run into quite a mess when you go to sell the property.

Any questions? Feel free to email me at paul@launchconsultinginc.com or leave a message in the comment section below.

 

What every founder should know about Equity Compensation

Equity Based Compensation – Influencing the Choice of Entity

One of the most important decisions you make when starting a business is entity selection. Many factors affect the choice of entity, from legal, to tax, to initial cost, complexity, and exit alternatives. While I am a big proponent of the lean startup, there are two moments in your business timeline where going lean will actually cost you more in the long run – forming and exiting your business. It is important to have a knowledgeable CPA and lawyer working together to maximize the legal and tax implications of your selection.

Among to the most common choices of entities include Limited Liability Companies (LLC’s) and Corporations. Both of these entities offer great legal protection and limit liability to their owners but from a taxation standpoint are fundamentally different. Since offering equity as a form of compensation has become all the norm in the start-up world, this article will explore the differences between these two type of entities and the tax implications of incentivizing employees with a share of your company.

Limited Liabilities Companies

Since LLC’s came into existence in the late 1970’s they have added quite a bit of complexity to the U.S. Internal Revenue Code. Since LLC’s are formed under state law and LLC statues vary by state, the Internal Revenue Service (IRS) has taken the position that LLC’s are “flow-through” entities by default. This means any LLC with two or more members automatically becomes a partnership for federal tax purposes, unless an election is made to treat it otherwise.

Flow through entities typically don’t pay any federal entity level tax. Instead, the members, or owners, of a flow-through entity report their share of the LLC’s income on their individual tax returns, paying tax at their personal marginal income tax rates. The LLC reports income to each member on Schedule K-1. This income is allocated based on the LLC’s operating agreement. Selecting an LLC can limit your choices on equity based compensation, but LLC’s still remain a popular choice for service based businesses. The most common types of equity based compensation are “capital interests” and “profits interest”. Capital interests in a LLC can be viewed similar to issuance of stock in a corporation, while a profit interest offers the opportunity to share in future profits of a business.

Grant of a Capital Interest in an LLC

Compensating an employee of your company with a capital interest allows the company to write-off the grant as a deduction similar to that of W-2 wages. This taxable event doesn’t occur until the interest is fully vested, at which point, the employee recognizes ordinary income equal to the Fair Market Value (FMV) on the vest date1. The amount of the deduction received by the LLC is equal to the amount of ordinary income the employee recognizes as a result of the equity award. If the LLC was liquated today, the members would receive a portion of the LLC assets based on their capital ownership.

Grant of a Profits Interest in an LLC

Granting an employee an interest in profits of your LLC is a more flexible incentive that allows the individual to share in the future success of the company. Unlike the transfer of a capital interest, generally there is no deduction allowed by the LLC for the transfer of a profits interest. This also means that no income is recognized by the employee receiving the grant as a result of the transfer. The employee receiving the grant will however be taxed on future profits of the company. An important distinction between a profits interest and a capital interest is this – if the company were to liquidate the same day the grant becomes fully vested, a profits sharing individual would not be entitled to any of the assets of the LLC, while an individual with a capital interest would be entitled to a proportionate share of the LLCs assets (or capital).

Corporations

Corporations are widely known in the start-up world as being the entity preferred by VC’s – mostly because of their ability to raise large amounts of capital, their flexibility from an equity standpoint, and as an added bonus, the investors don’t have any Schedule K-1s to wait on. While corporations do have their downfall – notoriously, double taxation, a tax at the entity level, and again at the individual level when profits are distributed to shareholders – they still are the preferred choice for businesses that plan to scale and want to offer compensation in the form of equity to their employees. There are quite a few ways to incentivize employees and offer the opportunity to participate in the financial success of your corporation through equity.

Below are the most popular types of equity compensation and a brief overview of the tax implications for individuals and the corporations.

Stock options – this includes Incentive Stock Options (ISOs) and non-qualified stock options (NQSOs). Stock options offer an employee or in the case of NQSOs, any person providing services to the corporation, the opportunity to purchase stock in the corporation at a future date for a price less than the current fair market value (FMV).

Incentive Stock Options are typically more favorable to employees, as a grant of ISO’s does not trigger a taxable event. When the options are exercised however, the difference between the FMV and the exercise price (“bargain element” or “spread price”) is an adjustment to the individual’s Alternative Minimum Tax (AMT) calculation. Corporation’s typically don’t net a deduction for offering this type of incentive, although there are exceptions.

Non-qualified Stock Options (NQSO) are similar to ISO’s, as there is no tax deduction for the corporation at the date of grant. With a NQSO, the taxable event occurs at the date of exercise, where the spread price is reported as ordinary income subject to FICA taxes. The corporation is entitled to a deduction for the amount of ordinary income recognized by the recipient.

Restricted Stock – Restricted Stock Units, or “RSUs” as they are commonly referred to as, are another common type of stock compensation utilized by corporation to incentive employees. Typically, RSUs are offered with a vesting period of 4-5 years, with the unvested portion forfeited if the employee resigns or is terminated. At the grant date, an employee can elect to pay tax on the current spread, or defer taxation until the RSUs are vested. The corporation is entitled to a tax deduction for RSUs issued and vested by an employee. In the eyes of the IRS, RSUs are viewed very similar to wages, as the corporation is required to pay FICA taxes, withhold federal taxes, and report the FMV of the vested portion in the employee’s W-2.

As always, every taxpayer’s situation is unique. If you have any questions about what entity would be the best solution for you, feel free to contact Paul Glantz, CPA at paul@launchconsultinginc.com

 

1 Since a grant of a capital interest in a LLC falls under the rules of IRC 83, an exception exists for the characterization and treatment of this transaction.