It may be the middle of the year, but it is never too early to start tax planning. In this post, I would like to lay out some common practices that will serve to help the smaller contractor save tax dollars or at the very least, defer the payment of those tax dollars until a later year.
You may recall in a previous post that I wrote about the different kinds of legal entities a contractor can choose. Many contractors choose to be a “C” corporation. If a contractor is a “C” corporation, the contractor might consider making a “S” election and thus eliminating the double taxation at the “C” corporation level. The difference in Federal tax rates that a contractor might pay can be significant (41% vs. 24%). As a “S” corporation, the contractor will pass all their contractor taxable income through to their personal returns and thus only pay one level of tax.
Another common practice of smaller contractors is to utilize the cash basis method of accounting to report their taxable income (revenue = income deposited and deductions = cash paid for expenses). The Tax Cuts and Jobs Act (TCJA) of 2017 drastically changed the definition of a small business taxpayer that can utilize the cash basis method of accounting. Prior to TCJA, a small taxpayer was required to utilize the accrual basis method of accounting once their gross receipts exceeded $5 million. Under the TCJA, that gross receipts threshold has increased to $25 million and is adjusted for inflation each year. Utilizing the cash basis method allows for smaller contractors to just pay tax on their cash activity and not on their billings that have not yet been received. This should serve to help smaller contractors better control their cash flow.
A third common practice of smaller contractors is to utilize accelerated depreciation on their fixed asset (equipment) purchases. There are two options to accelerate the deduction of fixed asset purchases available. A contractor can utilize section 179 and deduct the entire cost of qualified fixed asset purchases in the year those assets are placed in service. The maximum deduction under section 179 amounts to $1,050,000 for 2021 with a spending cap of $2,620,000. The second option is 100% bonus depreciation for certain qualified fixed asset purchases in the year those fixed assets are placed in service. Why does accelerated depreciation make sense? It allows a contractor to take a full deduction for a piece of equipment in the year of purchase even if that equipment was purchased utilizing debt and not cash on hand.
A final common practice (although not as common as the above) is the utilization of retirement plan options for both owners and non-union employees. There are several retirement plan options for smaller contractors that allow for a deduction of those retirement plan contributions in the current year, but that payment would not be due until the following year regardless of accounting method for tax purposes. This option is a desirable benefit for both the contractor owner and will serve to attract a more quality employee.
I would just issue a warning that all of the above common practices result in deferring the tax until a later date. I like to caution my clients that we are just kicking the bucket down the road to a later year and eventually that tax bucket will need to be emptied. Speaking with your CPA about tax planning options is important and should be a meeting that happens more than once a year to determine the best options for you and your business. Tax laws are changing faster and faster these days. You have all seen the speed at which the TCJA took effect and the same could happen under our current sitting President. The tax picture will continue to constantly evolve. If you have not spoken to your CPA yet this year about tax planning, do it now. It will save you a scramble in the later months of 2021.