Tax Cuts and Jobs Act: Understand Your Tax Break Profit Dispositions
Installing security contractors will have to decide whether to either plow tax breaks back into the business or to create a separate nest egg.
Despite the hoopla and promises, few electronic security professionals will see the results from last December’s Tax Cuts and Jobs Act (TCJA) until their tax returns are filed. If those anticipated profits are a reality, an important question needs an answer: what to do with those profits?
Today, thanks to the TCJA, answering the quesiton of whether to re-invest the operation’s profits in the installing security contractor business or to create a separate nest egg, must factor in taxes more than ever. First, re-investment usually involves profits before they are diluted by the annual tax bill. To create a separate nest egg usually involves profits after they have been reduced by taxes — but not always.
Today, there is the deduction from the income passed on by the business to sole proprietors, S corporation shareholders and partners. However, only income from some pass-through businesses and applying only to the first $315,000 of income (half that for single taxpayers) earned by pass-through electronic security businesses. Fortunately, the tax laws, before and after the TCJA, allow some tax breaks for investing or creating a nest egg.
Plowing Back the Profits
Many alarm industry professionals choose to re-invest their profits in business improvements. Infastructure, equipment and streamlining business processes or finding ways to improve operations and the customer experience are popular strategies. They are also strategies than can increase profits in the long run, allowing expanded operations — and tax deductions.
Re-investing profits in the electronic security business is considered a legitimate, tax deductible, business expense using pre-taxed profits. Business expenses can include short-term projects, advertising or buying long-term assets such as new equipment, computers or vehicles. While depreicating long-term assets could spread the write-offs over several years, the TCJA’s new rules permit write-offs for the entire expenditure for long-term assets.
Many electronic security professionals take as much from their business as they can through distributions. For S corporations, partnerships and limited liability companies (LLCs), these distributions are often in form of loan repayments that can usually be ignored for tax purposes.
Retaining cash in the business provides a “war chest” that allows good choices. Having equity capital can, for example, be an important consideration in whether a business will get a loan, or a supplier extend credit on favorable terms, etc.
Many business owners have a substantial and all-too-often, all of their net worth, tied up in their business. They’ve re-invested earnings in the business, they’ve added to that concentration by owning he building that houses the business and the business has a cash reserve for emergencies or to take advantage of deals that may crop up. But, what if the business turns sour?
Investing in Investments
Saving money should be a priority for every installing contractor and electronic security professional. Luckily there are a number of resources for saving, many that involve investing pre-tax dollars. One strategy might be a so-called “tax favored” plan. A Simplified Employee Pension (SEP) is for self-employed and small business owners with any number of employees. Contributions, of up to 25% of income, or $55,000 (2018) whichever is less, are made by the employer only and are tax deductible as a business expense.
A Self-Employed 401(k) plan is similar to the traditional 401(k) but only covers individuals and business owners with no employees other than their spouses. Contributions to these plans can, however, be made as both the employer and as an employee. Both employer contributions and salary deferrals work although having employees disqualifies usage of a self-employed 401(k).
Another option is provided with a SIMPLE IRA. SIMPLE stands for Savings Incentive Match Plan for Employees and mean setting up Individual Retirement Accounts (IRAs) for the installing security contractor business owner and the operation’s employees. While SIMPLE IRAs allow both the owner and employees to contribute amounts before taxes, they are only for businesses with 100 employees or fewer.
Overall, the SEP plan is often the better option for many small businesses because it allows larger contributions and greater flexibility.
Whether to create a source of income separate from the business, cash-in on a hobby or merely to plan for retirement, a secondary business can often be a good investment. Keeping in mind that starting a new venture will usually involve profits or other income after it has been reduced by taxes, special deductions for the cost of entering into a new venture may ease the pain.
Startup costs are expenditures made to start or open a business and include market research and analysis, marketing and advertising, employee training and professional fees associated with establishing that business. Up to $5,000 in startup costs can be deducted by any new venture with less than $50,000 in total startup costs.
Startup costs in excess of $5,000 can be amortized and written-off over a 15-year period. In fact, if profits are unlikely in the first-year, all startup costs can be amortized to create write-offs in later, hopefully more profitable, years. Or, recovering those startup costs could wait until the new business is sold.
The IRS treats general business startup costs and so-called “organizational” costs separately.
Organizational costs are amounts spent for forming a corporation, partnership or limited liability company (LLC), but not a sole proprietorship. In addition to the $5,000 deduction for startup expenses, an additional deduction of up to $5,000 for small business organizational expenses can be taken in the operation’s first year. If total startup costs are no more than $50,000, $5,000 may be deducted as startup costs and $5,000 deducted for organizational costs.
This deduction for organizational expenses must be claimed the year the business opens although, if needed, there is also a six-month window for filing an amendment. Of course, if the new business posts losses during its early years, there is always the option of amortizing these costs, deducting them over the course of several years instead.
Second Businesses and Hobbies
With more and more installing contractors and self-employed electronic security professionals looking at secondary activities as a nest egg, having multiple business activities is now quite common. A significant write-off is available if it can be argued that the new, money-losing operation, is really an extension of the original business.
For a new, unrelated business, however, losses can be a problem. Those operating a business that generates a loss for the year can usually deduct the full amount of that loss on their annual tax return — if the activity is conducted “with a profit intent.” The resulting loss can then be used to reduce income from other sources such as self-employment, wages, business income or investments.
The picture is somewhat bleaker if the money-losing activity must be treated as a not-for-profit “hobby.”
Prior to the TCJA, hobby-related expenses could be deducted up to the amount of income generated by that activity. However, those expenses were treated as miscellaneous itemized deductions and written-off only to the extent they exceeded two-percent of adjusted gross income. Those othewise allowable hobby deductions were completely disallowed for those subjected to the alternative minimum tax (AMT).
Proving that an activity is a business for tax purposes, means profit motive must be present and some type of economic activity must be conducted. With profits in three out of five consecutive tax years, it is up to the IRS to prove the activity is a hobby. In the case of an activity of breeding, training, showing, or racing horses, the three out of five rule is a two years out of seven. Without profits, it is the electronic security professional who must prove that the activity is a business — if asked — often employing a nine-point test created by the courts.
In a surprising number of cases, the IRS will accept the characterization of two or more undertakings as one activity unless, of course, the characterization is artificial or unreasonable. While the odds of running afoul of the hobby/loss rules remain long, one, extremely important potential pitfall involves both the basic business and secondary activities — so-called “passive” income.
A passive activity is one that involves the conduct of any trade or business in which the taxpayer does not materially participate. An individual materially participates in an activity if he or she is involved on a regular, continuous and substantial basis, or participates in the activity for more than 500 hours during the year. Generally, losses from passive activities may not be deducted from non-passive income (for example, wages, interest or dividends).
With two decisions, either plow the profits back into the business to improve or expand the operation or to create a separate nest egg, many installing contractors and electronic security professionals face a dilemma. A second source of income from a nest egg, be it dividend and interest income, investment income or income generated by a second business, can best be compared a “safety net” as you operate your electronic security business.
Fortunately, a legion of professional advisors stands ready to help every electronic security professional as they decide whether to re-invest in the business or create a separate nest egg.
Mark E. Battersby is a freelance journalist who reports on the news and developments within the ever-changing tax and financial arenas.
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