Another page has turned on the calendar of this eventful 2020 year. As we dive into the month of June, it is hard to ignore that we are quickly approaching the new July 15 tax deadline. This deadline not only applies to 2019 annual income tax filings, but also quarters 1 and 2 of the 2020 federal estimated income tax payments. Identified below are several considerations to take into account when planning for 2020 income tax liabilities amidst the vital need for cash flow management.
Pass-through structured entities, such as partnerships and S-Corporations, pass taxable income or loss from their business operations through to the owner’s personal tax returns. For 2020 estimated tax purposes, individuals have the option to pay estimated taxes based on 100 percent of their 2019 tax liability (110 percent for those above certain high income thresholds), referred to as “safe harbor,” or to pay estimated taxes based on 90 percent of their projected 2020 tax liability.
Given the COVID-19 shutdown of jobsites in March and April, many owners of construction contractors should give consideration as to whether it is more cash prudent to pay estimated taxes based on 90 percent of their current 2020 projected tax liability.
For large C-corporations (i.e., those that have had taxable income in excess of $1 million in any of the previous three tax years), 2020 estimated taxes are based on an annualized methodology. The annualized income methodology is typically based on annualizing the first three months of book income (used for quarter 1 and quarter 2 estimates), first six months (used for quarter 3 estimate), and first nine months (used for quarter 4 estimate), and applying the relevant tax adjustments to each calculation.
Contractors that fall into this category may feel that annualizing their book income through the first three months – a period before the negative impact of pandemic circumstances arose – will grossly overstate their anticipated full year book income. This could result in significantly overpaying quarters 1 and 2 estimated taxes.
An Alternative for All Entities
An alternative approach for C-corporations and pass-through entities may be to use forecasted book income for the year as a starting point when calculating estimated taxes. While this does carry a risk of estimated tax penalty (computed at the federal interest rate), being charged if underpaid at year-end is a much more cash conservative approach when book income is heavily focused on the first quarter of 2020.
Assuming the plan for a contractor’s 2020 estimated tax computation is to use projected book income for the year as a starting point, below are several recent tax measures to consider when converting the projected book income into projected taxable income:
- Were CARES Act payroll tax credits or Payroll Protection Program (PPP) funds utilized in 2020? If yes, these items may have an impact on 2020 taxable income. For example, under recent IRS guidance, a tax deduction will not be allowed for expenses paid with PPP funds for which loan forgiveness occurs. This could increase the level of taxable income reported compared with book income as well as the timing of profit recognition under the tax reporting version of the percentage of completion method of accounting. Such implications should be reviewed with your tax advisor.
- Recent legislation in the CARES Act allows for Net Operating Losses incurred in calendar years 2019 and 2020 to be carried back up to five years. This carryback opportunity is only applicable in tax years beginning before January 1, 2021, so if a contractor is projecting a loss for the current year it may be advantageous to maximize the loss to utilize the carryback to a previous year of taxable income, particularly if higher marginal tax rates applied in the carryback period.
- If planning to maximize losses, consider whether there are any capital expenditures planned for 2020 or 2021. If cash flows allow for capital expenditures to be placed in service in 2020, they could generate an immediate tax deductible write-off under bonus depreciation. Conversely, if the objective is to increase taxable income, then an election to forego accelerated depreciation may be appropriate.
- For contractors with significant interest expense on debts previously subject to a tax deduction limitation, the CARES Act has temporarily increased the allowable interest expense to 50 percent of modified taxable income for tax years beginning in 2019 or 2020. This increased percentage is a temporary increase from the 30 percent limitation imposed under the Tax Cuts and Jobs Act. Taxpayers may also elect to use 2019 income to measure the limitation for 2020 – a better outcome if profits are lower in 2020. The allowable percentage of modified taxable income will revert to 30 percent for tax years beginning in 2021.
The opportunities listed in this alert are just a few that should be considered for 2020 tax planning. With so much economic uncertainty at this point in time, planning cash flows is more critical than ever. If you have any questions on the above items or would like to discuss your 2020 tax planning in further detail, please contact your Kreischer Miller relationship professional or any member of our team.
Information contained in this alert should not be construed as the rendering of specific accounting, tax, or other advice. Material may become outdated and anyone using this should research and update to ensure accuracy. In no event will the publisher be liable for any damages, direct, indirect, or consequential, claimed to result from use of the material contained in this alert. Readers are encouraged to consult with their advisors before making any decisions.