Last December’s Tax Cuts and Jobs Act (TCJA) presents both a challenge because of its wide-ranging scope and an opportunity to reap a share of that law’s much-touted tax savings. Small businesses, especially car-care service businesses, should begin seeing the promised tax savings when the tax returns for the 2018 tax year are filed — but can benefit from the full potential of the TCJA only by planning now.
Owners of car wash businesses can plan their year-end tax strategies knowing the federal corporate tax rate has been streamlined to a flat 21 percent. A new 20 percent deduction for “qualified” business income may, however, have some thinking of changing the entity of their business as they could be hit with a tax rate as high as 29.6 percent. But more about that later.
PROFITS FROM CHANGE
Among the areas every car wash business owner and manager should be thinking about before the end of the tax year are:
A car wash is now allowed to fully write off the entire cost of new purchases utilizing 100 percent “bonus” depreciation. With bonus depreciation, the cost of equipment, computers, and vehicles can be written off in the year placed in service — in lieu of depreciating the cost over a number of years. There is also the increased Section 179, first-year expensing writeoff that has been doubled from $500,000 to $1,000,000. Section 179 now also includes fire protection, alarm systems, and security systems.
In 2013 the IRS issued new regulations that kicked in during the 2016 tax year and impacted every business in the car care industry with fixed assets. Today, the de minimis safe harbor deduction for materials and supplies has been increased from $500 to $2,500 for those operations that don’t have an applicable financial statement. It is also not too late to update the car care operation’s policy differentiating repairs from capital expenditures to comply with the updated regulation.
Abandon, Don’t Sell
If equipment or other business assets have no value to the car wash business, the benefits of abandoning it rather than selling it might be rewarding. This could generate an ordinary, fully deductible loss, rather than treating the loss as a capital loss, which is subject to limitations. Of course, abandonment must be documented and the property really abandoned.
Writing Off Entertainment
Business related entertainment, amusement, or recreational expenses are no longer deductible after the TCJA. Business meals, of course, remain 50-percent deductible.
Family and Medical Leave Tax Credits
As part of the TCJA, employers are now able to claim a tax credit (a reduction in the car wash operation’s tax bill as opposed to a deduction in the income that tax bill is based on) on wages paid to qualifying employees while they are on family or medical leave. In order to claim the credit, there must be a written policy that provides at least two weeks of paid leave annually to all qualifying employees who work full time. What’s more, the paid leave must be no less than 50% of the wages normally paid to the employee.
Limiting the Deduction for Business Interest
The TCJA placed new limits on the deduction for business interest, restricting the deduction to 30 percent of the operation’s adjusted gross income. Questions remain about what constitutes “investment” rather than business interest and how the limit should be applied to pass-through entities. Note: corporate debt is considered to be business interest rather than investment interest.
Fortunately, an exception exists for small businesses: those with gross receipts that have not exceeded a $25-million threshold for a three-year period, protecting their ability to write off the interest on loans that help them start or expand a business, hire workers, and increase paychecks.
What percentage of a vehicle used in or by the car wash or detailing business is attributable to the business? Whatever the percentage, the amount may qualify as an auto expense. The IRS allows two ways to calculate the deduction. First, there is the actual expense to which the percentage is applied to create the business auto expense deduction, or, second, tracking the actual mileage for business purposes and using the 54.5 cents per mile standard write-off.
Don’t Forget Those Carryovers
Deductions for capital losses, net operating losses, home-office deductions and even large charitable donations, if not fully used in one year may be carried forward to future years. Because these items have a way of slipping through the cracks, make sure to track these deductions and note carryovers from the current tax year’s return. NOL carrybacks, of course, are no longer permitted.
REASONABLE COMPENSATION AND YEAR-END BONUSES
Paying bonuses and ensuring the operation doesn’t overpay an owner, manager, or key employee can be complicated. Paying bonuses early or creating a separate bonus payroll might simplify things.
The owner of an incorporated car wash business who works in the operation might want to carefully consider his or her salary. S corporation owners benefit from a low salary because amounts that aren’t salary escape payroll taxes. Of course, a so-called “passive” owner will be subject to the Net Investment Income Tax.
On the other hand, owners of regular C corporations generally benefit from a higher salary and lower distributions. While employment taxes are paid on the salary, the earnings paid as salary are only taxed once. Earnings that are distributed as dividends are taxed twice, once at the corporate level and a second time at the individual level.
The IRS frequently challenges salaries they deem unreasonable. While factors used by the courts to determine reasonable compensation vary, the IRS typically looks at training and experience, duties and responsibilities, time and effort devoted to the business, dividend history, employee payments and bonuses, compensation agreements, the amount paid by comparable businesses for similar services, and the use of a bonus formula.
THE PASS-THROUGH CONUNDRUM
To even the playing field between pass-through car care businesses and the new 21 percent corporate tax rate, the TCJA created a 20 percent deduction for income earned from pass-through businesses such as sole proprietorships, partnerships, and S corporations. While eligible taxpayers may be entitled to the 20 percent deduction from qualified business income (QBI), for those with taxable income that exceeds $315,000 for a married couple filing a joint return, or $157,500 for all others, the deduction is subject to limitations based on the type of business, the taxpayer’s taxable income, and the amount of W-2 wages paid by the business.
The issues involve how the IRS defines “qualified business income (QBI),” and what constitutes a “specified service business,” both resulting in a limited deduction. Pass-through owners will also need to pay close attention to changes in the personal income tax rules, some removed deductions (including personal exemptions and the deduction for state and local income tax), and the increased standard deduction.
PLANNING BEFORE YEAR-END
As the end of the car care operation’s tax year approaches, several general rules might help guide it to real tax savings, savings that will be consistent, year-after-year:
• Don’t spend money simply to reduce that tax bill. After all, $1 spent does not equal $1 worth of tax saved nor create a $1 deduction. Also, keep in mind that if those accelerated deductions result in a net operating loss (NOL), it can now only be used to offset tax bills down the road — there is no longer a NOL carryback.
• Know thy accounting method. Most year-end tax strategies work best for cash-basis taxpayers. Accrual-basis car washes report all income in the year it is earned and all expenses in the year they are incurred. So, just because a car care business is paying for a 2019 expense in 2018 doesn’t always result in an immediate deduction on the 2018 tax return.
• Chart a “pro forma” analysis of the car wash operation’s tax liabilities for 2018 using the new rules, deductions and credits. By using estimated income and expense figures, this should not be too difficult. Otherwise, the true impact of “reform” will not be known until the tax return is prepared — when it may be too late to make any moves to reduce it.
• Don’t forget the car wash’s business entity. Depending on whether the car wash business files as a “pass-through” entity or as a regular C corporation, there might be a significant tax savings if the operation’s entity were changed. Obviously, this is not something that happens quickly, meaning the numbers should be run now.
Once the work is done and the alternatives tested, should you opt for a series of aggressive year-end tax strategies? Or, would another approach result in consistently low tax bills year-after-year? Above all, make sure the operation is actually spending money and not just moving it around. Otherwise, how can anyone hope to know how much the tax reform bill will affect them? If the car care operation’s tax professionals are not already involved in the planning process, now might be a good time to enlist their aid.
Mark E. Battersby is an Ardmore, PA-based freelance writer, specializing in finance and tax issues.