Small Business Tax briefs
Exploring business entities: Is an S corporation the right choice?
Are you starting a business with partners and deciding on the right entity? An S corporation might be the best choice for your new venture.
One benefit of an S corporation
One major advantage of an S corporation over a partnership is that shareholders aren’t personally liable for corporate debts. To ensure this protection, it’s crucial to:
- Adequately finance the corporation,
- Maintain the corporation as a separate entity, and
- Follow state-required formalities (for example, by filing articles of incorporation, adopting bylaws, electing a board of directors and holding organizational meetings).
Handling losses
If you anticipate early losses, an S corporation is more favorable than a C corporation from a tax perspective. Shareholders in a C corporation generally don’t benefit from such losses. However, as an S corporation shareholder, you can deduct your share of losses on your personal tax return, up to your basis in the stock and any loans you made to the entity. Losses exceeding your basis can be carried forward and deducted in the future when there’s sufficient basis.
Profits and taxes
Once the S corporation starts earning profits, the income is taxed directly to you, whether or not it’s distributed. It will be reported on your individual tax return and combined with income from other sources. Your share of the S corporation’s income isn’t subject to self-employment tax, but your wages will be subject to Social Security taxes. If the income qualifies as qualified business income (QBI), you can take the 20% pass-through deduction, subject to various limitations.
Note: The QBI deduction is set to expire after 2025 unless extended by Congress. However, the deduction will likely be extended and maybe even made permanent under the Tax Cuts and Jobs Act extension being negotiated in Congress.
Fringe benefits
If you plan to offer fringe benefits like health and life insurance, be aware that the costs for a more than 2% shareholder are deductible by the entity but taxable to the recipient.
Protecting S status
Be cautious about transferring stock to ineligible shareholders (for example, another corporation, a partnership or a nonresident alien), as this could terminate the S election, making the corporation a taxable entity. To avoid this risk, have each shareholder sign an agreement not to make transfers that would jeopardize the S election. Also, be aware that an S corporation can’t have more than 100 shareholders.
Final steps
Before making your final decision on the entity type, consult with us. We can answer your questions and help you launch your new venture successfully.
Ways to manage the limit on the business interest expense deduction
Prior to the enactment of the Tax Cuts and Jobs Act (TCJA), businesses were able to claim a tax deduction for most business-related interest expense. The TCJA created Section 163(j), which generally limits deductions of business interest, with certain exceptions.
If your business has significant interest expense, it’s important to understand the impact of the deduction limit on your tax bill. The good news is there may be ways to soften the tax bite in 2025.
The nuts and bolts
Unless your company is exempt from Sec. 163(j), your maximum business interest deduction for the tax year equals the sum of:
- 30% of your company’s adjusted taxable income (ATI),
- Your company’s business interest income, if any, and
- Your company’s floor plan financing interest, if any.
Assuming your company doesn’t have significant business interest income or floor plan financing interest expense, the deduction limitation is roughly equal to 30% of ATI.
Your company’s ATI is its taxable income, excluding:
- Nonbusiness income, gain, deduction or loss,
- Business interest income or expense,
- Net operating loss deductions, and
- The 20% qualified business income deduction for pass-through entities.
When Sec. 163(j) first became law, ATI was computed without regard to depreciation, amortization or depletion. But for tax years beginning after 2021, those items are subtracted in calculating ATI, shrinking business interest deductions for companies with significant depreciable assets.
Deductions disallowed under Sec. 163(j) may be carried forward indefinitely and treated as business interest expense paid or accrued in future tax years. In subsequent tax years, the carryforward amount is applied as if it were incurred in that year, and the limitation for that year will determine how much of the disallowed interest can be deducted. There are special rules for applying the deduction limit to pass-through entities, such as partnerships, S corporations and limited liability companies that are treated as partnerships for tax purposes.
Small businesses are exempt from the business interest deduction limit. These are businesses whose average annual gross receipts for the preceding three tax years don’t exceed a certain threshold. (There’s an exception if the business is treated as a “tax shelter.”) To prevent larger businesses from splitting themselves into small entities to qualify for the exemption, certain related businesses must aggregate their gross receipts for purposes of the threshold.
Ways to avoid the limit
Some real estate and farming businesses can opt out of the business interest deduction limit and therefore avoid it or at least reduce its impact. Real estate businesses include those that engage in real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage.
Remember that opting out of the interest deduction limit comes at a cost. If you do so, you must reduce depreciation deductions for certain business property by using longer recovery periods. To determine whether opting out will benefit your business, you’ll need to weigh the tax benefit of unlimited interest deductions against the tax cost of lower depreciation deductions.
Another tax-reduction strategy is capitalizing interest expense. Capitalized interest isn’t treated as interest for purposes of the Sec. 163(j) deduction limit. The tax code allows businesses to capitalize certain overhead costs, including interest, related to the acquisition or production of property.
Interest capitalized to equipment or other fixed assets can be recovered over time through depreciation, while interest capitalized to inventory can be deducted as part of the cost of goods sold. We can crunch the numbers to determine which strategy would provide a better tax advantage for your business.
You also may be able to mitigate the impact of the deduction limit by reducing your interest expense. For example, you might rely more on equity than debt to finance your business or pay down debts when possible. Or you could generate interest income (for example, by extending credit to customers) to offset some interest expense.
Weigh your options
Unfortunately, the business interest deduction limitation isn’t one of the many provisions of the Tax Cuts and Jobs Act scheduled to expire at the end of 2025. But it’s possible Congress could act to repeal the limitation or alleviate its impact. If your company is affected by the business interest deduction limitation, contact us to discuss the impact on your tax bill. We can help assess what’s right for your situation.
How a business owner’s home office can result in tax deductions
As a business owner, you may be eligible to claim home office tax deductions that will reduce your taxable income. However, it’s crucial to understand the IRS rules to ensure compliance and avoid potential IRS audit risks. There are two methods for claiming this tax break: the actual expense method and the simplified method. Here are answers to frequently asked questions about the tax break.
Who qualifies?
In general, you qualify for home office deductions if part of your home is used “regularly and exclusively” as your principal place of business.
If your home isn’t your principal place of business, you may still be able to deduct home office expenses if:
- You physically meet with patients, clients or customers on your premises, or
- You use a storage area in your home (or a separate free-standing structure, such as a garage) exclusively and regularly for business.
What expenses can you deduct?
Many eligible taxpayers deduct actual expenses when they claim home office deductions. Deductible home office expenses may include:
- Direct expenses, such as the cost of painting and carpeting a room used exclusively for business,
- A proportionate share of indirect expenses, including mortgage interest, rent, property taxes, utilities, repairs, maintenance and insurance,
- Security system if applicable to your business, and
- Depreciation.
But keeping track of actual expenses can take time and requires organized recordkeeping.
How does the simplified method work?
Fortunately, there’s a simplified method: You can deduct $5 for each square foot of home office space, up to a maximum of $1,500.
The cap can make the simplified method less valuable for larger home office spaces. Even for small spaces, taxpayers may qualify for larger deductions using the actual expense method. So, tracking your actual expenses can be worth it.
Can you change methods?
You’re not stuck with a particular method when claiming home office deductions. For instance, you might choose the actual expense method on your 2024 return, use the simplified method when you file your 2025 return next year and then switch back to the actual expense method for 2026. The choice is yours.
What if you sell your home?
If you sell — at a profit — a home on which you claimed home office deductions, there may be tax implications. We can explain them to you.
Also, be aware that the amount of your home office deductions is subject to limitations based on the income attributable to your use of the office. Other rules and limits may apply. However, any home office expenses that you can’t deduct because of these limitations can be carried over and deducted in later years.
Do employees qualify?
The Tax Cuts and Jobs Act suspended the business use of home office deductions through the end of 2025 for employees. Those who receive paychecks or Form W-2s aren’t eligible for deductions, even if they’re currently working from home because their employers require them to and don’t provide office space.
Home office tax deductions can provide valuable tax savings for business owners, but they must be claimed correctly. We can help you determine if you’re eligible and how to proceed.
Questions about taxes and tips? Here are some answers for employers
Businesses in certain industries employ service workers who receive tips as a large part of their compensation. These businesses include restaurants, hotels and salons. Compliance with federal and state tax regulations is vital if your business has employees who receive tips.
Are tips becoming tax-free?
During the campaign, President Trump promised to end taxes on tips. While the proposal created buzz among employees and some business owners, no legislation eliminating taxes on tips has been passed. For now, employers should continue to follow the existing IRS rules until the law changes — if it does. Unless legal changes are enacted, the status quo remains in effect.
With that in mind, here are answers to questions about the current rules.
How are tips defined?
Tips are optional and can be cash or noncash. Cash tips are received directly from customers. They can also be electronically paid tips distributed to employees by employers and tips received from other employees in tip-sharing arrangements. Workers must generally report cash tips to their employers. Noncash tips are items of value other than cash. They can include tickets, passes or other items that employees receive from customers. Workers don’t have to report noncash tips to employers.
Four factors determine whether a payment qualifies as a tip for tax purposes:
- The customer voluntarily makes a payment,
- The customer has an unrestricted right to determine the amount,
- The payment isn’t negotiated with, or dictated by, employer policy, and
- The customer generally has a right to determine who receives the payment.
There are more relevant definitions. A direct tip occurs when an employee receives it directly from a customer (even as part of a tip pool). Directly tipped employees include wait staff, bartenders and hairstylists. An indirect tip occurs when an employee who normally doesn’t receive tips receives one. Indirectly tipped employees can include bussers, service bartenders, cooks and salon shampooers.
What records need to be kept?
Tipped workers must keep daily records of the cash tips they receive. To do so, they can use Form 4070A, Employee’s Daily Record of Tips. It’s found in IRS Publication 1244.
Workers should also keep records of the dates and values of noncash tips. The IRS doesn’t require workers to report noncash tips to employers, but they must report them on their tax returns.
How must employees report tips to employers?
Employees must report tips to employers by the 10th of the month after the month they were received. The IRS doesn’t require workers to use a particular form to report tips. However, a worker’s tip report generally should include the:
- Employee’s name, address, Social Security number and signature,
- Employer’s name and address,
- Month or period covered, and
- Total tips received during the period.
Note: If an employee’s monthly tips are less than $20, there’s no requirement to report them to his or her employer. However, they must be included as income on his or her tax return.
Are there other employer requirements?
Yes. Send each employee a Form W-2 that includes reported tips. In addition, employers must:
- Keep employees’ tip reports.
- Withhold taxes, including income taxes and the employee’s share of Social Security and Medicare taxes, based on employees’ wages and reported tip income.
- Pay the employer share of Social Security and Medicare taxes based on the total wages paid to tipped employees as well as reported tip income.
- Report this information to the IRS on Form 941, Employer’s Quarterly Federal Tax Return.
- Deposit withheld taxes in accordance with federal tax deposit requirements.
In addition, “large” food or beverage establishments must file another annual report. Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips, discloses receipts and tips.
What’s the tip tax credit?
Suppose you’re an employer with tipped workers providing food and beverages. In that case, you may qualify for a valuable federal tax credit involving the Social Security and Medicare taxes you pay on employees’ tip income.
How should employers proceed?
Running a business with tipped employees involves more than just providing good service. It requires careful adherence to wage and hour laws, thorough recordkeeping, accurate reporting and an awareness of changing requirements. While President Trump’s pledge to end taxes on tips hasn’t yet materialized into law, stay alert for potential changes. In the meantime, continue meeting all current requirements to ensure compliance. Contact us for guidance about your situation.
