In the 17 years I’ve been in public accounting, very few “tax seasons” have been normal or easy. It’s not just the long hours but constant changes in tax law. As our world grows smaller, and the reach of the local business stretches out wide, we now have to be aware of tax issues in other states and even internationally. COVID threw plenty of twists and turns in the world of taxes, and the effects of the Tax Cut and Jobs Act (TCJA) of 2018 are still being felt today. I’m not sure if the world of taxes will ever be “easy,” but I wonder if the changes will ever slow down.
Tax Inside & Outside of the State
California is one of the most aggressive taxing states. It will find a way to tax any business it can, even if just to claim the $800 minimum tax. If a business is organized in California or operating in California, then there’s no benefit to fighting the fact that you have to file and pay taxes to California. But what about the other 49 states in the Union?
For service-based companies, in particular, this is a growing issue. Many states are moving to an economic-based approach to establishing nexus in their states. Even with no physical presence in the other state(s), if you have business relationships/revenues in another state, you may need to file a tax return in those states.
Each state addresses this differently, and there’s no one-size-fits-all. We are encouraging clients to be aware of its business’ reach into other states. If you hire employees in other states, especially remote employees, you may also trigger nexus. This will be a growing issue as our world becomes more connected.
Employee Retention Credit
After dealing with all the COVID-related tax matters for the last few years, we are finally starting to see those matters phase out of the returns. However, we aren’t quite done. The straggler that everyone is talking about is ERC – Employee Retention Credit. Many pop-up businesses are heavily marketing this “opportunity” to businesses. I get spam emails and text messages daily! If your business qualifies, it’s an incredible source of additional cash flow, once you get the cash. If you’re pursuing these credits now, be prepared for a few things.
- The vendor helping calculate the credits will take a sizable fee. I’ve seen anywhere from 15-35% of the total credit claimed.
- At this point, any new credit claims will be done by amending the applicable quarterly payroll form 941X. It will take the IRS a long time to process the amended return and refund. Some clients have received the refunds within 6 months, but I have other clients who have been waiting for over a year. In my experience, the larger the refund, the longer the wait seems to be.
- Unlike the reporting required for the PPP loans (both the applications and the forgiveness applications), the reporting filed with the amended 941X to claim the refund is minimal. I suspect there is a lot of fraud in this program, and therefore we should expect to see some IRS audits down the road. Be prepared with your documentation.
- This is a payroll tax credit, not an income tax credit. That’s why it’s filed on the 941X. However, it does impact the company tax returns. Here’s a quick summary and explanation.
- Federal return – the payroll tax credit (refund) reduces your payroll deductions. So, while it’s not technically taxable “income,” it does effectively increase your taxable income via the reduced deduction. This reduction should be recorded in the taxable year for which the credit was taken, not received. So, this means the 2020 and 2021 income tax returns may need to be amended. If it’s a passthrough company (S-corp or partnership), then the owner returns may also need to be amended and additional taxes paid.
- California return – up until recently, California’s position was: This is a federal credit and therefore does not reduce the payroll deduction. Earlier in February, the FTB suddenly changed its mind and now suggests these refunds may be taxable. We are waiting for further clarification.
Passthrough Entity Elective Tax
Another new-ish item in California this year is the Passthrough Entity Elective Tax (PTE). This new election only pertains to California passthrough entities, but it’s great news for owners of these businesses. When the TCJA capped deductible taxes on the schedule A to $10,000, it heavily punished the small business owners of these passthrough entities, because the owners pay income taxes on all of the business taxable income (unlike a corporation which pays its own tax). The new election allows the passthrough entity to pay a 9.3% tax at the entity level in order to reduce the federal taxable income. Then the tax is pushed through to the owners on the K-1s as a California state tax credit.
For many business owners, this will result in significant federal tax savings. However, it’s not for everyone. The 9.3% calculation is not flexible. If an owner isn’t a California resident, or the owner has significant losses and/or deductions from other sources to reduce taxable income, the owner may not be able to fully utilize the credit.
While any unused credits carry forward, it’s only for 5 years, after which the credits are lost. Careful tax planning is necessary each year to make sure participation in this election is a wise decision. There are strict deadlines to participate in this election, so it’s critical to have timely conversations with your CPA and to have your accounting current to run the necessary calculations.
Research & Development Expenditures
Finally, while the Research & Development (R&D) credits are not new, there are new tax regulations stemming back to the TCJA again that go into effect for tax years beginning in 2022. There are two different regulations that address R&D expenses and previously, all R&D expenses could be expensed as “incurred” regardless of the applicable section. Now, R&D expenses that are research and experimental (R&E) expenditures under IRC §174, are required to be capitalized onto the balance sheet and amortized over five years.
The IRS defines research and experimental expenditures as research and development costs in the experimental or laboratory sense, which include all costs that are incident to the development or improvement of a product. (Treas. Regs. §1.174-2(a)(1)). If you conduct R&D type activities, it may be necessary to reevaluate the expenditures to separate ordinary and necessary business expenses (deductible right away) from “research and experimental expenditures” under IRC §174.
Our profession has requested more IRS guidance because the existing guidance is insufficient. There are also rumblings that this may get postponed by the IRS but for now, we should at least be evaluating the activities in preparation for the change.
In Conclusion
As tax professionals, we do our best to assess these issues when working on client returns. However, the reality is we are working really fast during this time of year and may not always have time to slow down and ask about these questions. If any of these four new-ish matters pertain to your business, bring it up with your CPA. Don’t wait for him/her to bring it up because they may not know to inquire about it.
As always, this very summarized article is meant to help facilitate conversation and is in no way intended to be tax advice. We strongly encourage you to discuss all tax matters with your tax professional.