Capitalization and Depreciation
Several changes in federal tax law have taken effect recently that could affect the way many businesses plan for their 2023 taxes. This includes mandatory capitalization of certain expenses and limitations on a law that allowed accelerated depreciation of certain assets.
Section 174 Capitalization
Section 174 of the Internal Revenue Code (IRC) requires taxpayers to capitalize “specified research or experimental expenditures” (SRE). It defines SRE as “research or experimental expenditures…in connection with the taxpayer’s trade or business,” which the taxpayer incurs during a particular tax year. Congress made substantial changes to § 174 in the Tax Cuts and Jobs Act (TCJA) of 2017. Those changes took effect on January 1, 2022.
Under the TCJA’s changes to § 174, taxpayers cannot deduct SRE expenditures during the year they incur them. Instead, they must capitalize them and then amortize them over a period of five years. For SRE associated with foreign research, the amortization period is 15 years.
The section specifies that software development expenditures are considered SRE. Certain expenditures related to land acquisition and mineral exploration, on the other hand, are not included.
Bonus Depreciation
Bonus depreciation allows taxpayers to write off part or all of the cost of “qualified property” during the tax year that they put the assets into service. This provides an incentive for businesses and others to invest in those assets. Examples of “qualified property” include computer software, various entertainment properties and many types of assets with depreciation periods of no more than 20 years.
The TCJA amended § 168(k) of the IRC to allow bonus depreciation of 100% of the cost of qualified property, but it also included a schedule for phasing out bonus depreciation altogether. This process began on January 1, 2023, when the bonus depreciation percentage dropped to 80%. If a business paid $100,000 for qualified property and placed it into service in 2023, it can only deduct $80,000 of the cost on its 2023 taxes. The remainder will be subject to depreciation according to the standard depreciation schedule.
The phaseout will continue at the beginning of each year as follows:
January 1, 2024: 60%
January 1, 2025: 40%
January 1, 2026: 20%
January 1, 2027: No bonus depreciation
Pass-Through Entity Tax Elections
Pass-through entities may include business forms like general partnerships, limited liability partnerships, S corporations and limited liability companies. The details of how PTEs are structured may vary from one state to another. Generally speaking, both income and losses “pass through” the entity to the owners.
Taxpayers who must pay state and local income taxes may deduct those taxes on their federal income tax returns, but only up to $10,000. Many states allow pass-through entities to make elections that can help owners and other stakeholders save on their overall tax bills. The state laws regarding pass-through entity tax (PTET) elections can vary widely.
State PTET laws tend to fall into two categories:
1. Pass-through entities may give owners an income tax credit to owners based on state tax paid by the business, with each owner receiving a pro-rata share of the credit.
2. Owners of pass-through entities may deduct pro-rata shares of state and local income taxes paid by the business from their individual taxable income.
Either system can help pass-through entity owners by allowing them to account for their companies’ state and local tax payments without using up the $10,000 federal tax deduction limit.
Businesses with pass-through taxation can get a head start on their 2023 taxes by determining what state laws apply to them and start projecting how much PTET they will owe for the year. If possible, paying the PTET tax in 2023 can help owners maximize their deductions.
New and Expanded Tax Credits
Several statutes passed in 2022, particularly the Inflation Reduction Act (IRA), created new tax credits or expanded the availability of existing ones. Many of these credits are intended to promote energy efficiency and clean energy production. Others offer incentives to invest in manufacturing and other industries or to provide additional compensation to employees. The following are some tax credit programs that could benefit businesses on their 2023 taxes.
Clean Energy Tax Credits
The IRA established or expanded numerous tax credits that promote various “green” technologies. Examples include:
• Qualified commercial clean vehicle credit;
• Advanced energy project credit;
• Alternative fuel vehicle refueling property credit; and
• Clean electricity investment credit.
Some credits are refundable, meaning that businesses can get money back from the IRS in certain circumstances.
Work Opportunity Tax Credit
The work opportunity tax credit (WOTC) offers an incentive for businesses to hire workers from certain groups that have faced difficulties finding employment. Congress has authorized the credit to continue through the end of 2025.
The amount of the WOTC is typically 40% of eligible employees’ wages for their first year up to $6,000. This creates a tax credit of up to $2,400 per worker.
Qualified Retirement Plan Credits
In late 2022, the SECURE Act 2.0 made more tax credits available to businesses that create qualified retirement plans for their employees. Small employers who establish new plans could be eligible for tax credits of up to $5,000 for the cost of setup and $1,000 per employee for employer-matching contributions.
Tax Benefits for Compensation Planning
Businesses may want to consider various incentives for providing employee benefits in addition to retirement plans. These may include:
• Reimbursement of qualified student loan payments up to a maximum of $5,250 per year.
• Reimbursement of qualified dependent care expenses up to $5,000.
Tax Consequences of Purchases and Sales
If a business made major purchases or sales in 2023, they should evaluate the potential tax consequences as soon as possible. Purchases could be eligible for deductions or tax credits, or they could be subject to mandatory capitalization. Sales could trigger various tax liabilities.
Planning in advance for purchases and sales can also help businesses manage their tax obligations. Deferring sales until the following tax year and advancing purchases to the current year can help reduce their taxable income under some circumstances.
subject to annual limits, but the remainder can be carried forward to future years.
Contact Frankel to learn more about how we can support your business at frankel.cpa or call us at (402) 469-9100.
