Dear Tax Constituent:
For nearly all California taxpayers, the 2023 tax season filing 2022 tax returns provided the most delayed filing deadlines this office has ever seen (November 15, 2023, for most deadlines)! At press time, we expect the 2024 tax season filing 2023 tax returns will be a return to a normal series of deadlines.
Currently, Congress does not appear set to propose major tax legislation affecting 2023, and we expect the provisions of the Tax Cuts and Jobs Act to remain through 2025: lower income tax rates, larger standard deductions, limited itemized deductions, elimination of personal exemptions, a reduced alternative minimum tax (AMT) for individuals, a major corporate tax rate reduction, limits on interest deductions, and generous expensing and depreciation rules for businesses. Non-corporate taxpayers with certain income from pass-through entities would still be entitled to a valuable Qualified Business Income (QBI) deduction, and eligible passthrough entities would still be able to take advantage of California’s Passthrough Entity Elective Tax (PEET) credit. These rules are scheduled to be in place through 2025, with the tax law reverting to generally higher tax obligations for most taxpayers in 2026 if Congress does not make affirmative tax law changes in the time ahead.
We have divided our commentary between business and individual considerations below:
BUSINESS
Consider Establishing a Tax-favored Retirement Plan
If your business doesn’t already have a retirement plan, now might be the time to take the plunge. Current rules allow for significant deductible contributions, and California requires most businesses with employees to establish a work-sponsored retirement plan or enroll in Calsavers..
For example, if you are self-employed and set up a SEP plan for yourself, you can contribute up to 20% of your net self-employment income, with a maximum contribution of $66,000 for 2023. If you are employed by your own corporation, up to 25% of your salary can be contributed, with a maximum contribution of $66,000 for 2023.
Other small business retirement plan options include the 401(k) plan, which can be set up for just one person; the defined benefit pension plan; and the SIMPLE-IRA, which can be a good choice if your business income is modest. Depending on your circumstances, non-SEP plans may allow bigger deductible contributions.
There May Still Be Time to Establish a Plan and Make a Deductible Contribution for Last Year. The general deadline for setting up a tax-favored retirement plan, such as a SEP or 401(k) plan, is the extended due date of the tax return for the year you or the plan sponsor want to make the initial deductible contribution. For instance, if your business is a sole proprietorship or a single-member LLC that is treated as a sole proprietorship for federal income tax purposes (Schedule C), you have until 10/15/24 to establish a plan and make the initial deductible contribution if you extend your 2023 Form 1040.
Evaluate Your Options. Contact us for more information on small business retirement plan alternatives, and be aware that if your business has employees, you may have to cover them too.
Take Advantage of Generous Depreciation Tax Breaks
Current federal income tax rules allow generous first-year depreciation write-offs for eligible assets.
Section 179 Deductions. For qualifying property placed in service in tax years beginning in 2023, the maximum allowable Section 179 deduction is $1.16 million. Most types of personal property used for business are eligible for Section 179 deductions, and off-the-shelf software costs are eligible too.
Section 179 deductions also can be claimed for certain real property expenditures called Qualified Improvement Property (QIP). QIP includes any improvement to an interior portion of a nonresidential building that is placed in service after the date the building is first placed in service, except for expenditures attributable to the enlargement of the building, any elevator or escalator, or the building’s internal structural framework.
Note that Section 179 deductions also can be claimed for qualified expenditures for roofs, HVAC equipment, fire protection and alarm systems, and security systems for nonresidential real property. To qualify, these items must be placed in service after the nonresidential building has been placed in service.
Section 179 deductions can’t cause an overall business tax loss, and deductions are phased out if too much qualifying property is placed in service in the tax year. The Section 179 deduction limitation rules can get tricky if you own an interest in a pass-through business entity (partnership, LLC treated as a partnership for tax purposes, or S corporation).
First-year Bonus Depreciation. 80% first-year bonus depreciation is available for qualified new and used property that is acquired and placed in service in calendar-year 2023. That means your business might be able to write off 80% of the cost of some or all of your 2023 asset additions on this year’s return.
De minimis Safe Harbor Election to Fully Deduct Purchases below a Threshold Amount. Taxpayers can elect to expense the costs of lower-cost assets provided the costs aren’t required to be capitalized under the UNICAP rules. Taxpayers that have an Applicable Financial Statement (AFS) can deduct units of property valued at up to $5,000. For taxpayers without an AFS, the de minimis safe harbor threshold is $2,500 per unit of property. An AFS is (1) a Form 10-K, (2) an audited financial statement used for obtaining credit, reporting to owners, or other substantial nontax purposes, or (3) a financial statement other than a tax return required to be provided a federal or state government or agency (other than the IRS or SEC).
Note: Small taxpayers meeting the three-year average gross receipts test threshold of $29 million in 2023 are not required to apply the UNICAP rules.
Bottom Line: To take advantage of favorable federal income tax depreciation rules, consider making eligible asset acquisitions between now and year end. The bonus depreciation percentage decreases to 60% for assets placed in service in 2024. So, if you are thinking about acquiring qualifying assets, getting them placed in service in 2023 rather than 2024 means that the higher bonus depreciation rate will apply.
Time Business Income and Deductions for Tax Savings
If you conduct your business as a sole proprietorship or using a pass-through entity (S corporation, partnership, or LLC classified as such), your shares of the business’s income and deductions are taxed at your personal rates. Assuming no legislative changes, next year’s individual federal income tax rates will be the same as this year’s, with significant bumps in the rate bracket thresholds thanks to inflation adjustments.
The traditional strategy of deferring income into next year while accelerating deductible expenditures into this year makes sense if you expect to be in the same or lower tax bracket next year. Deferring income and accelerating deductions will, at a minimum, postpone part of your tax bill from 2023 until 2024. And, after the inflation adjustments to 2024 rate bracket thresholds, the deferred income might be taxed at a lower rate. That would be nice!
On the other hand, if you expect to be in a higher tax bracket in 2024, take the opposite approach. Accelerate income into this year (if possible) and postpone deductible expenditures until 2024. That way, more income will be taxed at this year’s lower rate instead of next year’s higher rate.
Timing of Year-end Bonuses. Year-end bonuses to employees other than passthrough entity owners can be timed for maximum tax effect by both cash and accrual basis employers. Cash basis taxpayers should pay bonuses before year end to maximize the deduction available in 2023 if they expect to be in the same or lower tax bracket next year. Cash basis taxpayers that expect to be in a higher tax bracket in 2024 because of significant revenue increases, should wait to pay 2023 year-end bonuses until January 2024. Accrual basis taxpayers deduct bonuses in the year when all events related to the bonuses are established with reasonable certainty. However, for accrual basis taxpayers, the bonus must be paid no later than 2 ½ months of the accrual year end for a current year deduction (by March 15 for calendar year- end taxpayers). Accrual method employers who want to defer deductions to a higher-taxed future year should consider changing their bonus plans before year-end to set the payment date later than the 2 ½ month window or consider changing the bonus plan’s terms to make the bonus amount indeterminable at year end.
For employee owners of passthrough S-corporations, there are additional considerations which impact the timing and extent of compensation. Contact our office for details.
State Income Tax Deduction Work-around
The pass-through state income tax deduction essentially allows business owners to deduct personal state income tax generated by their pass-through business income. This deduction allows a pass-through entity to elect to pay the state income tax due on the business income that would otherwise be paid on the owner’s personal tax returns. The federal itemized deduction cap of $10,000 ($5,000 if MFS) for state and local taxes doesn’t apply when a pass-through entity pays state and local tax on its earnings at the entity level. As of 2023, 36 states (including California) and one locality have passed legislation allowing the pass-through tax deduction work-around. Please review our earlier commentary on California’s Passthrough Entity Elective Tax (PEET) credit and consider getting our help to make a PEET payment for 2023 before year end to advance the related deduction.
Maximize the Qualified Business Income (QBI) Deduction
The QBI deduction remains in place for 2023. We discussed this deduction earlier at our linked commentary for pass-through businesses and real estate activities. For tax years through 2025, the deduction can be up to 20% of a pass-through entity owner’s QBI, subject to restrictions that can apply at higher income levels and another restriction based on the owner’s taxable income.
For QBI deduction purposes, pass-through entities are defined as sole proprietorships, single-member LLCs that are treated as sole proprietorships for tax purposes, partnerships, S corporations, and LLCs that are classified as partnerships or S corporations for tax purposes.
For 2023, if taxable income exceeds $364,200 for taxpayers that are married filing jointly ($182,100 for others), the QBI deduction is limited if the taxpayer is engaged in a Specified Service Trade or Business (SSTB) - such as law, accounting, health, or consulting. At that income level, the deduction may be limited to all pass-through entity owners by the amount of W-2 wages paid by the business, and/or the unadjusted basis of qualified property (such as machinery and equipment) held by the business. The limitations are phased in; for example, the limits start to apply to joint filers when taxable income exceeds $364,200 and are fully phased in when taxable income is $100,000 above the threshold. For other filers, the limits are fully phased in when taxable income is $50,000 above their threshold. The phase in range ends at $464,200 for married filing jointly filers and at about half that for all others.
Taxpayers near or above these thresholds may benefit from accelerating deductions, deferring discretionary income, or making deductible retirement plan contributions to stay below these thresholds. For non-SSTBs with income exceeding the thresholds, consider increasing W-2 compensation from the business before the end of the year to get the maximum QBI deduction.
The QBI deduction is only available to individuals, trusts, and estates.
Claim 100% Gain Exclusion for Qualified Small Business Stock
There is a 100% federal income tax gain exclusion for eligible sales of Qualified Small Business Corporation (QSBC) stock that was acquired after 9/27/10. QSBC shares must be held for more than five years to be eligible for the gain exclusion. Contact us if you think you own stock that could qualify for the break.
Also, contact us if you are considering establishing a new corporate business the stock of which might be eligible for the gain exclusion. Advance planning may be required to lock in the exclusion privilege.
Social Security Wage Base
To help gauge some of your tax planning moves, the Social Security wage base (the maximum earned income that Social Security tax of a combined 12.4% is assessed upon) will be $168,600 for 2024. The Social Security wage base was $160,200 for 2023.
INDIVIDUALS
Check Your Tax Withholding and Estimated Payments
If your income is likely to be much higher in 2023 than it was in 2022, you should consider adjusting your Federal income tax withholding from any paychecks and your estimated tax payments to account for the difference. Otherwise, you might have a much larger tax bill than expected and may be exposed to an underpayment penalty.
Note: You will avoid an underpayment finance charge for 2023 if your 2023 tax payments (estimated taxes and withholding) are at least equal to your 2022 tax liability [110% of that amount if your 2022 AGI is more than $150,000 ($75,000 if you file MFS)] or, if less than 90% of your 2023 tax.
Taxes that are withheld from wages are considered paid ratably over the year no mater when the withholdings are actually submitted. Conversely, making an estimated tax payment reduces the underpayment from the time the payment is made. So, if it turns out you had unexpected income or gains early this year, you can increase your withholding for the rest of the year to reduce or eliminate your underpayment from earlier quarters. The IRS’s “Tax Withholding Estimator,” available at www.irs.gov/individuals/tax-withholding-estimator can be used to see if you need to adjust your withholding, or you can contact our office for additional assistance.
Consider Bunching Itemized Deductions
You can deduct the greater of your itemized deductions (mortgage interest, charitable contributions, medical expenses, and taxes) or the standard deduction. The 2023 standard deduction is $13,850 for singles and individuals who are Married Filing Separately (MFS), $27,700 for couples Married Filing Jointly (MFJ), and $20,800 for Heads of Household (HOH). If your total itemizable deductions for 2023 will be close to your standard deduction, consider timing your itemized deduction items between now and year-end. The idea is to “bunch” your itemized deductions, so they exceed your standard deduction every other year. Paying enough itemizable deductions in 2023 to exceed your standard will lower this year’s tax bill, and next year you can claim the standard deduction, which will be increased to account for inflation.
For example, assume your filing status is MFJ and your itemized deductions are fairly steady at around $25,000 per year. In that case, you would end up claiming the standard deduction each year. But, if you can bunch expenditures so that you have itemized deductions of $30,000 in 2023 and $20,000 in 2024, you could itemize in 2023 and get a $30,000 deduction versus a $27,700 standard deduction. In 2024, your itemized deductions would be below the standard deduction (which adjusted for inflation will be at least $27,700), so for that year, you would claim the standard deduction. If you manage to exceed the standard deduction every other year, you’ll be better off than if you just settle for the standard deduction each year.
If you have a home mortgage, you can bunch itemized deductions into 2023 by making your house payment due on January 1, 2024, in 2023. Accelerating that payment into this year will give you 13 months’ worth of interest in 2023. There are limits on the amount of home mortgage interest you can deduct. Generally, in 2023, you can deduct interest expense on up to $375,000 [$750,000 if married filing jointly (MFJ)] of a mortgage loan used to acquire your home. More generous rules apply to mortgages (and home equity debt) incurred before December 15, 2017. Check with us if you are not sure how much home mortgage interest you can deduct.
Timing your charitable contributions is another simple way to get your itemized deductions into the year you want them.
To a certain extent, you can also choose the year you pay state and local income and property taxes. Taxes that are due in early 2024 (such as fourth quarter state estimated tax payments in many states) can be paid in 2023. Likewise, property tax bills are often sent out before year-end, but not due until the following year. Prepaying those taxes before year-end so that your itemized deductions exceed your standard deduction can decrease your 2023 federal income tax bill because your total itemized deductions will be that much higher. However, note that the deduction for state and local taxes is limited to $10,000 ($5,000 if you are married filing separately). So, if your state and local tax bill is close to or over that limit, prepaying taxes may not affect your total itemized deductions. A prepaid property tax will likely still give you a California tax benefit. California does not have the same $10,000/$5,000 tax deduction limit as federal.
Finally, consider accelerating elective medical procedures, dental work, and vision care in 2023. For 2023, medical expenses can be claimed as an itemized deduction to the extent they exceed 7.5% of your Adjusted Gross Income (AGI).
Note: If your itemized deductions exceed your standard deduction every year, the conventional wisdom of paying them before year-end, to get your deduction in 2023 rather than 2024 applies, especially if you think that interest rates will increase. The higher the interest rate, the more interest you can earn on the taxes you manage to defer.
Manage Investment Gains and Losses
It’s a good idea to look at your investment portfolio with an eye to selling before year-end to save taxes. But remember that selling investments to generate a tax gain or loss doesn’t apply to investments held in a retirement account or IRA where the gains and losses are not currently taxed.
Sometimes, it makes tax sense to sell appreciated securities that have been held for over 12 months. The federal income tax rate on the long-term capital gains recognized in 2023 is only 15% for most individuals, but it can reach the maximum 20% rate at higher income levels. The 3.8% Net Investment Income Tax (NIIT) can apply at higher income levels. Even so, the highest tax rate on long-term capital gains (23.8%) is still far less than the 37% maximum tax rate on ordinary income. And, to the extent you have capital losses that were recognized earlier this year or capital loss carryovers from earlier years, those losses may absorb any additional tax if you decide sell stocks at a gain this year.
You should also consider selling stocks that are worth less than your tax basis in them (typically, the amount you paid for them). Taking the resulting capital losses this year would shelter capital gains, including short-term capital gains, which are taxed at ordinary income tax rates, resulting from other sales this year. But consider the wash sale rules. If you sell a stock at a loss, and within the 30 day period before or the 30 day period after the sale date you acquire substantially identical securities, the loss is suspended until you sell the identical securities.
If you sell enough loss stock that capital losses exceed your capital gains, the resulting net capital loss for the year can be used to shelter up to $3,000 ($1,500 if MFS) of 2023 ordinary income from salaries, bonuses, self-employment income, interest, royalties, etc. Any excess net capital loss from this year is carried forward to next year and beyond.
Having a capital loss carryover into next year and beyond could be a tax advantage. The carryover can be used to shelter both short-term gains and long-term gains. This can give you some investing flexibility in those years because you won’t have to hold appreciated securities for over a year to get a lower tax rate on any gains you trigger by selling, since those gains will be sheltered by the capital loss carryforward.
Of course, nontax considerations must be considered when deciding to sell or hold a security. If you have stock that has fallen in value, but may recover, you might want to keep it rather than trigger the capital loss. Assume that after all factors are considered, you decide to take some capital gains and/or losses to minimize your 2023 taxes. Afterward, you should make sure your overall asset portfolio is still allocated to the types of investments you want based on your investment objectives. You may have to rebalance your portfolio. When you do, be sure to consider investment assets held in taxable brokerage accounts, as well as those held in tax-advantaged accounts like IRAs and 401(k) plans.
Make Your Charitable Giving Plans
Donor-advised funds - If you would like to reduce your 2023 taxable income by making charitable donations, but don’t have a specific charity or charities that you are comfortable making large donations to, you can make a contribution to a donor-advised fund instead. Donor-advised funds (also known as charitable gift funds or philanthropic funds) allow you to make a charitable contribution to a specific public charity or community foundation that uses the assets to establish a separate fund to receive grant requests from charities seeking distributions from the advised fund. Donors can suggest (but not dictate) which grant requests should be honored. You claim the charitable tax deduction in the year you contribute to the donor-advised fund but retain the ability to recommend which charities will benefit for several years. If you have questions or want more information on donor-advised funds, please give us a call.
Donating appreciated stock - Another tax-advantaged way to support your charitable causes is to donate appreciated assets that were held for over a year. If you give such assets to a public charity, you can deduct the full fair market value of the donated asset while avoiding the tax you would have paid had you sold the asset and donated the cash to the charity. Charitable gifts of appreciated property to a private nonoperating foundation are generally only deductible to the extent of your basis in the asset. But there’s an exception for qualified appreciated stock (generally, publicly traded stock), which can qualify for a deduction equal to its fair market value if it's donated to a private nonoperating foundation.
Qualified Charitable Distribution from Retirement Accounts - If you are age 70½ or older, consider a direct transfer from your IRA to a qualified charity [known as a Qualified Charitable Distribution (QCD)]. While you will not be able to claim a charitable donation for the amount transferred to the charity, the QCD does count toward your Required Minimum Distribution (RMD). If you don’t itemize, that’s better than taking a fully taxable RMD and then donating the amount to charity with no corresponding deduction. Even if you do itemize and would be able to deduct the full amount transferred to the charity, the QCD does not increase your Adjusted Gross Income (AGI), while a RMD would. Keeping your AGI low can decrease the amount of your Social Security benefits that are taxable, as well as avoid or minimize the phaseout of other favorable tax provisions based on AGI.
Caution: If you are over age 70½ and you’re still working in 2023, you can contribute to a traditional IRA. However, if you’re considering a QCD for 2023 (or a later year), making a deductible IRA contribution for years you are age 70½ or older will affect your ability to exclude future QCDs from your income.
Planning Tip: To get a QCD completed by year-end, you should initiate the transfer before December 31. Talk to your IRA custodian, but making the transfer no later than mid-December is probably a good idea.
Convert Traditional IRAs into Roth Accounts
Because you must pay tax on the conversion as if the traditional IRA had been distributed to you, converting makes the most sense when you expect to be in the same or higher tax bracket during your retirement years. If that turns out to be true, the current tax hit from a conversion this year could be a relatively small price to pay for completely avoiding potentially higher future tax rates on the account’s post-conversion earnings. In effect, a Roth IRA can insure part or all of your retirement savings against future tax rate increases.
Planning Tip: If the conversion triggers a lot of income, it could push you into a higher tax bracket than expected. One way to avoid that is to convert smaller portions of the traditional IRA over several years. Of course, this delays getting funds into the Roth IRA where they can be potentially earning tax-free income. There is no one answer here. But keep in mind that you do not have to convert a traditional IRA into a Roth all at once.
Also consider that a ROTH IRA is a better asset for your heirs to inherit. Distributions from your regular IRA would be taxable to your heirs, and must be distributed subject to Required Minimum Distribution rules. ROTH IRA distributions will not be taxable to your heirs . Will your heirs be in a lower tax bracket than you are in today? Do you expect to have your retirement accounts last longer than you? Contact our office for help with tax planning if either asset is yes.
Take Advantage of the Annual Gift Tax Exclusion
The basic estate, gift, and generation skipping transfer tax exclusion is scheduled to fall from $12.06 million ($24.12 million for married couples) in 2022 to $5 million ($10 million for married couples) in 2026. Those amounts will be adjusted for inflation, but the long and short of it is that many estates that would escape taxation before 2026 will be subject to estate tax after 2025. If you think your estate may be taxable, annual exclusion gifts (perhaps to children or grandchildren) are an easy way to reduce your taxable estate. The annual gift exclusion allows for tax-free gifts that don’t count toward your lifetime gifting exemption. For 2023, you can make annual exclusion gifts up to $17,000 per donee, with no limit on the number of donees. If you are married, you and your spouse can elect to gift split, so that a gift that either one of you makes is considered to be made one half by each spouse.
In addition to potentially reducing your taxable estate, many individuals gift income producing assets to children (or other loved ones) to shift the income from the asset to someone in a lower tax bracket. But, if you give assets to someone who is under age 24, the Kiddie Tax rules could potentially cause some of the resulting capital gains and dividends to be taxed at your higher marginal federal income tax rate.
If you are gifting investment assets, avoid gifting assets currently worth less than what you paid for them. The donee’s basis for recognizing a loss is the lower of your basis or the property’s FMV at the date of the gift. So, in many cases, the loss that occurred while you held the asset may go unrecognized. Instead, you should sell the securities and take the resulting tax loss. Then, give the cash to your intended donee.
Planning Tip: If you think you will be exposed to estate tax in the future, we can work with you and an estate planning attorney on an estate plan. Estate planning involves a lot more than avoiding the Federal estate tax. Sound estate planning ensures that your assets go where you want them, considering your desires, family members’ needs, and charitable giving, among other things.
If you would like our assistance with your specific yearend tax planning, or more information on these or other tax topics of interest to you, please contact our office.
—McAvoy + Co, CPA