The IRS can, and will, challenge salary amounts they deem to be “unreasonable.”
While the factors used by the IRS and 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 and more. The courts generally look at amounts paid by comparable businesses for similar services, the use of a bonus formula and the importance of the role played by the compensated individual.
Planning before year’s end
One basic fact that should be kept in mind with taxes in general is that the financial or operational strengths of a business transaction should always stand on their own, aside from the tax benefits that may be derived from them. In other words, the tax tail should never wag the tax dog.
Still, as the end of the tax year approaches, several general rules might help guide producers and contractors to real tax savings – savings that will be consistent, year after year:
• Don’t spend money simply to reduce that tax bill. After all, a dollar spent does not equal a dollar worth of tax saved or create a dollar deduction.
• Know thy accounting method. Most year-end tax strategies work best for cash-basis taxpayers. Accrual-basis businesses report all income in the year it is earned and all expenses in the year they are incurred. So, just because a construction materials producer or contractor prepays a 2023 expense in 2022 doesn’t always result in an immediate deduction on the 2022 tax return.
• Worker classification matters. Every producer and contractor must correctly determine whether workers are employees or independent contractors. Independent contractors are not, of course, subject to withholding, making them responsible for paying their own income taxes plus Social Security and Medicare taxes.
• Ensure that the operation will be taking every deduction available. Now is the time to keep abreast of the complex and fluid tax laws, along with compiling the records that will be necessary to document all transactions – incoming or outgoing.
Year-end planning isn’t just taxes
Many producers and contractors should be assessing their debt arrangements as inflation and interest rates rise. Unfortunately, restructuring debt can trigger significant tax consequences, and a recent rule change tightening the amount of interest deductions could affect plans.
Debt modifications can create cancellation-of-debt (COD) income. Modifications or changes to yield, security, recourse or timing of payments represent significant changes that can create COD income.
Deleting or altering customary financial covenants is generally not a significant modification, but any fees paid with a modification must be assessed to a change in the yield. Not only should businesses evaluating their debt arrangements consider the potential tax impact of any modification of existing debt, but they should consider whether they will be able to deduct the interest expense under the new, tighter rules.
The deduction for net interest expense is generally limited to 30 percent of an operation’s adjusted taxable income. Although, until this year, adjusted taxable income was generally equivalent to earnings before interest, taxes and depreciation, for tax years beginning in 2022, depreciation and amortization must be included, lowering the adjusted taxable income limit.
Every contractor and producer should evaluate whether their 2022 interest deduction will be limited and assess the potential impact on other items on the tax returns.
Lease accounting
Year-end planning isn’t, obviously, limited to taxes.
For example, a new lease accounting standard took effect Jan. 1 for all years beginning after Dec. 15, 2021. Under the new accounting standard, all long-term leased assets must be recorded on a balance sheet.
Under the former guidance, only so-called finance leases were required to be shown leases. Now, the only leases that can stay off the balance sheet are non-recurring leases with terms less than 12 months.
The bottom line is any business that has leases will be impacted by the new lease accounting standard. All leases longer than one year must now be recorded as an asset and corresponding liability on a balance sheet, meaning every producer and contractor will have to calculate the present value of their future lease payments to record this correctly.
Above all, remember the recently passed Inflation Reduction Act not only includes provisions impacting climate change and health care, but it provides significant funding for the IRS to increase enforcement, create revenue and close the tax gap. In other words, every construction materials business – large and small – could see more audits.
Planning to avoid – not evade – is legal
No less a body than the U.S. Supreme Court has ruled that striving for the lowest possible tax bill is perfectly legal. Thus, planning to produce the lowest possible tax bill possible should be the goal of every producer and contractor.
While it is almost always recommended, few producers or contractors get their tax professionals involved well before the end of the tax year. But, how can anyone hope to know whether income deferral or accelerated write-offs will be most helpful in reducing this year’s tax bill – and the tax bills in future years?
Mark E. Battersby is a freelance writer who specializes in taxes and finance.