Monetary awards and settlements are often provided for an array of reasons. For example, a person could receive compensatory and punitive damage payments for personal injury, discrimination or harassment. Some of this money is taxed by the federal government, and perhaps by state governments. Hopefully, you’ll never need to know how payments for personal injuries are taxed. But here are the basic rules — just in case you or a loved one does receive an award or settlement and needs to understand them.

Under tax law, individuals are permitted to exclude from gross income damages that are received on account of a personal physical injury or a physical sickness. It doesn’t matter if the compensation is from a court-ordered award or an out-of-court settlement, and it makes no difference if it’s paid in a lump sum or installments.

Emotional distress doesn’t count

For purposes of this exclusion, emotional distress is not considered a physical injury or physical sickness. So, for example, an award under state law that’s meant to compensate for emotional distress caused by age discrimination or harassment would have to be included in gross income. However, if you require medical care for treatment of the consequences of emotional distress, then the amount of damages not exceeding those expenses would be excludable from gross income.

Punitive damages for any personal injury claim, whether or not physical, aren’t excludable from gross income unless awarded under certain state wrongful death statutes that provide for only punitive damages.

The law doesn’t consider back pay and liquidated damages received under the Age Discrimination in Employment Act (ADEA) to be paid in compensation for personal injuries. Thus, an award for back pay and liquidated damages under the ADEA must be included in gross income.

Court cases

As you may suspect, the IRS and courts often decide that awards and settlements are taxable while many taxpayers feel they should be excluded from taxable income. For example, in one case, a taxpayer was injured while at a hospital. She sued for negligence but lost her case. She then sued her attorney for legal malpractice and was awarded $125,000. The IRS said the amount was taxable because it wasn’t for physical injuries. The U.S. Tax Court and the 9th Circuit Court of Appeals agreed. (Blum, 3/23/22)

In another case, the Tax Court ruled that married taxpayers weren’t entitled to income exclusion for a settlement the husband received from his former employer in connection with an employment discrimination / wrongful termination lawsuit. Although the settlement agreement provided for payment “for alleged personal injuries,” there was no evidence that it was paid on account of physical injuries or sickness. (TC Memo 2022-90)

Legal fees

You can’t deduct attorney fees incurred to collect a tax-free award or settlement for physical injury or sickness. However, to a limited extent, attorney’s fees (whether contingent or non-contingent) or court costs paid by, or on behalf of, a taxpayer in connection with an action involving certain employment-related claims, are currently deductible from gross income to determine adjusted gross income.

After-tax recovery

Keep in mind that, while you want the best tax result possible from any settlement, lawsuit or discrimination action you’re considering, non-tax legal factors, together with the tax factors, will determine the amount of your after-tax recovery. Consult with your attorney on the best way to proceed and we can provide any tax guidance that you may need.

You may have heard of the “nanny tax.” But if you don’t employ a nanny, you may think it doesn’t apply to you. Check again. Hiring a housekeeper, gardener or other household employee (who isn’t an independent contractor) may make you liable for federal income and other taxes. You may also have state tax obligations.

If you employ a household worker, you aren’t required to withhold federal income taxes from pay. However, you may choose to withhold if the worker requests it. In that case, ask the worker to fill out a Form W-4. However, you may be required to withhold Social Security and Medicare (FICA) taxes and to pay federal unemployment (FUTA) tax.

Threshold increasing in 2024

In 2023, you must withhold and pay FICA taxes if your household worker earns cash wages of $2,600 or more (excluding the value of food and lodging). If you reach the threshold, all the wages (not just the excess) are subject to FICA. In 2024, the threshold will increase to $2,700.

However, if a nanny is under age 18 and child care isn’t his or her principal occupation, you don’t have to withhold FICA taxes. So, if you have a part-time babysitter who is a student, there’s no FICA tax liability.

Both an employer and a household worker may have FICA tax obligations. As an employer, you’re responsible for withholding your worker’s FICA share. In addition, you must pay a matching amount. FICA tax is divided between Social Security and Medicare. The Social Security tax rate is 6.2% for the employer and 6.2% for the worker (12.4% total). Medicare tax is 1.45% each for both the employer and the worker (2.9% total).

If you want, you can pay your worker’s share of Social Security and Medicare taxes. If you do, your payments aren’t counted as additional cash wages for Social Security and Medicare purposes. However, your payments are treated as additional income to the worker for federal tax purposes, so you must include them as wages on the W-2 form that you provide.

You also must pay FUTA tax if you pay $1,000 or more in cash wages (excluding food and lodging) to your worker in any calendar quarter. FUTA tax applies to the first $7,000 of wages paid and is only paid by the employer.

Reporting and paying 

You pay household worker obligations by increasing your quarterly estimated tax payments or increasing withholding from wages, rather than making an annual lump-sum payment.

As a household worker employer, you don’t have to file employment tax returns, even if you’re required to withhold or pay tax (unless you own your own business). Instead, employment taxes are reported on your tax return on Schedule H.

When you report the taxes on your return, you include your employer identification number (EIN), which is not the same as your Social Security number. You must file Form SS-4 to get one.

However, if you own a business as a sole proprietor, you include the taxes for a household worker on the FUTA and FICA forms (940 and 941) that you file for your business. And you use your sole proprietorship EIN to report the taxes.

Keep meticulous records 

Keep related tax records for at least four years from the later of the due date of the return or the date the tax was paid. Records should include the worker’s name, address, Social Security number, employment dates, dates and amount of wages paid and taxes withheld, and copies of forms filed.

If you need assistance or have questions about how to comply with these employment tax requirements, contact us.

If you’re concerned about your 2023 tax bill, there may still be time to reduce it. Here are four quick strategies that may help you trim your taxes before year end.

1. Accelerate deductions and/or defer income. Certain tax deductions are claimed for the year of payment, such as the mortgage interest deduction. So, if you make your January 2024 payment in December, you can deduct the interest portion on your 2023 tax return (assuming you itemize).

Pushing income into the new year also will reduce your taxable income. If you’re expecting a bonus at work, for example, and you don’t want the income this year, ask if your employer can hold off on paying it until January. If you’re self-employed, you can delay sending invoices until late in December to postpone the revenue to 2024.

You shouldn’t follow this approach if you expect to be in a higher tax bracket next year. Also, if you’re eligible for the qualified business income deduction for pass-through entities, you might reduce the amount of that deduction if you reduce your income.

2. Take full advantage of retirement contributions. Federal tax law encourages individual taxpayers to make the allowable contributions for the year to their retirement accounts, including traditional IRAs and SEP plans, 401(k)s and deferred annuities.

For 2023, you generally can contribute as much as $22,500 to 401(k)s and $6,500 to traditional IRAs. Self-employed individuals can contribute up to 25% of net income (but no more than $66,000) to a SEP IRA.

3. Harvest your investment losses. Losing money on your investments has a bit of an upside — it gives you the opportunity to offset taxable gains. If you sell underperforming investments before the end of the year, you can offset gains realized this year on a dollar-for-dollar basis.

If you have more losses than gains, you generally can apply up to $3,000 of the excess to reduce your ordinary income. Any remaining losses are carried forward to future tax years.

4. Donate to charity using investments.If you itemize deductions and want to donate to IRS-approved public charities, you can simply write a check or use a credit card. Or you can use your taxable investment portfolio of stock and/or mutual funds. Consider making charitable contributions according to these tax-smart principles:

• Underperforming stocks. Sell taxable investments that are worth less than they cost and book the resulting tax-saving capital loss. Then, give the sales proceeds to a charity and claim the resulting tax-saving charitable write-off. This strategy delivers a double tax benefit: You receive tax-saving capital losses plus a tax-saving itemized deduction for your charitable donations.
• Appreciated stocks. For taxable investments that are currently worth more than they cost, you can donate the stock directly to a charity. Contributions of publicly traded shares that you’ve owned for over a year result in a charitable deduction equal to the current market value of the shares at the time of the gift. Plus, when you donate appreciated investments, you escape any capital gains taxes on those shares. This strategy also provides a double tax benefit: You avoid capital gains tax and you get a tax-saving itemized deduction for charitable contributions.

Time is running out

The ideas described above are only a few of the strategies that still may be available. Contact us if you have questions about these or other methods for minimizing your tax liability for 2023.

If you have a tax-saving flexible spending account (FSA) with your employer to help pay for health or dependent care expenses, there’s an important date coming up. You may have to use the money in the account by year-end or you’ll lose it (unless your employer has a grace period).

As the end of 2023 gets closer, here are some rules and reminders to keep in mind.

Health FSA 

A pre-tax contribution of $3,050 to a health FSA is permitted in 2023. This amount will be increasing to $3,200 in 2024. You save taxes in these accounts because you use pre-tax dollars to pay for medical expenses that might not be deductible. For example, expenses won’t be deductible if you don’t itemize deductions on your tax return. Even if you do itemize, medical expenses must exceed a certain percentage of your adjusted gross income in order to be deductible. Additionally, the amounts that you contribute to a health FSA aren’t subject to FICA taxes.

Your employer’s plan should have a list of qualifying items and any documentation from a medical provider that may be needed to get reimbursed for these expenses.

FSAs generally have a “use-it-or-lose-it” rule, which means you must incur qualifying medical expenditures by the last day of the plan year (December 31 for a calendar year plan) — unless the plan allows an optional grace period. A grace period can’t extend beyond the 15th day of the third month following the close of the plan year (March 15 for a calendar year plan).

What if you don’t spend the money before the last day allowed? You forfeit it.

Take a look at your year-to-date expenditures now. It will show you what you still need to spend. What are some ways to use up the money? Before year end (or the extended date, if permitted), schedule certain elective medical procedures, visit the dentist or buy new eyeglasses.

Dependent care FSA 

Some employers also allow employees to set aside funds on a pre-tax basis in dependent care FSAs. A $5,000 maximum annual contribution is permitted ($2,500 for a married couple filing separately).

FSAs are for:

• A child who qualifies as your dependent and who is under age 13, or
• A dependent or spouse who is physically or mentally incapable of self-care and who has the same principal place of abode as you for more than half of the tax year.

Like health FSAs, dependent care FSAs are subject to a use-it-or-lose-it rule, but the grace period relief may apply. Therefore, it’s a good time to review your expenses to date.

Other rules and exceptions may apply. Your HR department can answer any questions about your specific plan. Contact us with any questions you have about the tax implications.

The IRS recently announced various inflation-adjusted federal income tax amounts. Here’s a rundown of the amounts that are most likely to affect small businesses and their owners.

Rates and brackets

If you run your business as a sole proprietorship or pass-through business entity (LLC, partnership or S corporation), the business’s net ordinary income from operations is passed through to you and reported on your personal Form 1040. You then pay the individual federal income tax rates on that income.

Here are the 2024 inflation adjusted bracket thresholds.

• 10% tax bracket: $0 to $11,600 for singles, $0 to $23,200 for married joint filers, $0 to $16,550 for heads of household;
• Beginning of 12% bracket: $11,601 for singles, $23,201 for married joint filers, $16,551 for heads of household;
• Beginning of 22% bracket: $47,151 for singles, $94,301 for married joint filers, $63,101 for heads of household;
• Beginning of 24% bracket: $100,526 for singles, $201,051 for married joint filers, $100,501 for heads of household;
• Beginning of 32% bracket: $191,951 for singles, $383,901 for married joint filers, $191,951 for heads of household;
• Beginning of 35% bracket: $243,726 for singles, $487,451 for married joint filers and $243,701 for heads of household; and
• Beginning of 37% bracket: $609,351 for singles, $731,201 for married joint filers and $609,351 for heads of household.

Key Point: These thresholds are about 5.4% higher than for 2023. That means that, other things being equal, you can have about 5.4% more ordinary business income next year without owing more to Uncle Sam.

Section 1231 gains and qualified dividends

If you run your business as a sole proprietorship or a pass-through entity, and the business sells assets, you may have Section 1231 gains that passed through to you to be included on your personal Form 1040. Sec. 1231 gains are long-term gains from selling business assets that were held for more than one year, and they’re generally taxed at the same lower federal rates that apply to garden-variety long-term capital gains (LTCGs), such as stock sale gains. Here are the 2024 inflation-adjusted bracket thresholds that will generally apply to Sec. 1231 gains recognized by individual taxpayers.

• 0% tax bracket: $0 to $47,025 for singles, $0 to $94,050 for married joint filers and $0 to $63,000 for heads of household;
• Beginning of 15% bracket: $47,026 for singles, $94,051 for joint filers, $63,001 for heads of household; and
• Beginning of 20% bracket: $518,901 for singles, $583,751 for married joint filers and $551,351 for heads of household.

If you run your business as a C corporation, and the company pays you qualified dividends, they’re taxed at the lower LTCG rates. So, the 2024 rate brackets for qualified dividends paid to individual taxpayers will be the same as above.

Self-employment tax

If you operate your business as a sole proprietorship or as a pass-through entity, you probably have net self-employment (SE) income that must be reported on your personal Form 1040 to calculate your SE tax liability. For 2024, the maximum 15.3% SE tax rate will apply to the first $166,800 of net SE income (up from $160,200 for 2023).

Section 179 deductions

For tax years beginning in 2024, small businesses can potentially write off up to $1,220,000 of qualified asset additions in year one (up from $1,160,000 for 2023). However, the maximum deduction amount begins to be phased out once qualified asset additions exceed $3,050,000 (up from $2,890,000 for 2023). Various limitations apply to Sec. 179 deductions.

Side Note: Under the first-year bonus depreciation break, you can deduct up to 60% of the cost of qualified asset additions placed in service in calendar year 2024. For 2023, you could deduct up to 80%.

Just the beginning

These are only the 2024 inflation-adjusted amounts that are most likely to affect small businesses and their owners. There are others that may potentially apply, including: limits on qualified business income deductions and business loss deductions, income limits on various favorable exceptions such as the right to use cash-method accounting, limits on how much you can contribute to your self-employed or company-sponsored tax-favored retirement account, limits on tax-free transportation allowances for employees, and limits on tax-free adoption assistance for employees. Contact us with questions about your situation.

If you’re facing a serious cash shortfall, one possible solution is to take an early withdrawal from your traditional IRA. That means one before you’ve reached age 59½. For this purpose, traditional IRAs include simplified employee pension (SEP-IRA) and SIMPLE-IRA accounts.

Here’s what you need to know about the tax implications, including when the 10% early withdrawal penalty tax might apply.

Penalty may be avoided 

In almost all cases, all or part of a withdrawal from a traditional IRA will constitute taxable income. The taxable percentage depends on whether you’ve made any nondeductible contributions to your traditional IRAs. If you have, each withdrawal from a traditional IRA consists of a proportionate amount of your total nondeductible contributions. That part is tax-free. The proportionate amount of each withdrawal that consists of deductible contributions and accumulated earnings is taxable. If you’ve never made any nondeductible contributions, 100% of a withdrawal is taxable.

Wide variety of exceptions 

Unless one of these 11 exceptions applies, there will be a 10% early withdrawal penalty tax on the taxable portion of a traditional IRA withdrawal taken before age 59½.

1. Substantially equal periodic payments (SEPPs). These are annual annuity-like withdrawals that must be taken for at least five years or until the you reach age 59½, whichever comes later. Because the SEPP rules are complicated, consult with us to avoid pitfalls.

2. Withdrawals for medical expenses. If you have qualified medical expenses in excess of 7.5% of your adjusted gross income, the excess is exempt from the penalty tax.

3. Higher education expense withdrawals. Early withdrawals are penalty-free to the extent of qualified higher education expenses paid during the same year.

4. Withdrawals for health insurance premiums while unemployed. This exception is available to an IRA owner who has received unemployment compensation payments for 12 consecutive weeks under any federal or state unemployment compensation law during the year in question or the preceding year.

5. Birth or adoption withdrawals. Penalty-free treatment is available for qualified birth or adoption withdrawals of up to $5,000 for each eligible event.

6. Withdrawals for first-time home purchases. Penalty-free withdrawals are allowed to an account owner within 120 days to pay qualified principal residence acquisition costs, subject to a $10,000 lifetime limit.

7. Withdrawals by certain military reservists. Early withdrawals taken by military reserve members called to active duty for at least 180 days or for an indefinite period are exempt from the 10% penalty.

8. Withdrawals after disability. Early withdrawals taken by an IRA owner who is physically or mentally disabled to the extent that the owner cannot engage in his or her customary gainful activity or a comparable gainful activity are exempt from the penalty tax. The disability must be expected to lead to death or be of long or indefinite duration.

9. Withdrawals to satisfy certain IRS debts. This applies to early IRA withdrawals taken to pay IRS levies against the account.

10. Withdrawals after death. Withdrawals taken from an IRA after the account owner’s death are always exempt from the 10% penalty. However, this exemption isn’t available for funds rolled over into the surviving spouse’s IRA or if the surviving spouse elects to treat an IRA inherited from the deceased spouse as the spouse’s own account.

11. Penalty-free withdrawals for emergencies coming soon. The SECURE 2.0 law adds a new exception for certain distributions used for emergency expenses, which are defined as unforeseeable or immediate financial needs relating to personal or family emergencies. Only one distribution of up to $1,000 is permitted a year and a taxpayer has the option to repay it within three years. This provision is effective for distributions made after December 31, 2023.

Plan ahead 

Since most or all of an early traditional IRA withdrawal will probably be taxable, it could push you into a higher marginal federal income tax bracket. You may also owe the 10% early withdrawal penalty and possibly state income tax too. Note that the penalty tax exceptions generally have additional requirements that we haven’t covered here. Contact us for more details.

Restricted stock awards are a popular way for companies to offer equity-oriented executive compensation. Some businesses offer them instead of stock option awards. The reason: Options can lose most or all of their value if the price of the underlying stock takes a dive. But with restricted stock, if the stock price goes down, your company can issue you additional restricted shares to make up the difference.

Restricted stock basics

In a typical restricted stock deal, you receive company stock subject to one or more restrictions. The most common restriction is that you must continue working for the company until a certain date. If you leave before then, you forfeit the restricted shares, which are usually issued at minimal or no cost to you.

To be clear, the restricted shares are transferred to you, but you don’t actually own them without any restrictions until they become vested.

Tax rules for awards 

What are the tax implications? You don’t have any taxable income from a restricted share award until the shares become vested — meaning when your ownership is no longer restricted. At that time, you’re deemed to receive taxable compensation income equal to the difference between the value of the shares on the vesting date and the amount you paid for them, if anything. The current federal income tax rate on compensation income can be as high as 37%, and you’ll probably owe an additional 3.8% net investment income tax (NIIT). You may owe state income tax too.

Any appreciation after the shares vest is treated as capital gain. So, if you hold the stock for more than one year after the vesting date, you’ll have a lower-taxed long-term capital gain on any post-vesting-date appreciation. The current maximum federal rate on long-term capital gains is 20%, but you may also owe the 3.8% NIIT and possibly state income tax.

Special election to be currently taxed

If you make a special Section 83(b) election, you’ll be taxed at the time you receive your restricted stock award instead of later when the restricted shares vest. The income amount equals the difference between the value of the shares at the time of the restricted stock award and the amount you pay for them, if anything. The income is treated as compensation subject to federal income tax, federal employment taxes and state income tax, if applicable.

The benefit of making the election is that any subsequent appreciation in the value of the stock is treated as lower-taxed, long-term capital gain if you hold the stock for more than one year. Also, making the election can provide insurance against higher tax rates that might be in place when your restricted shares become vested.

The downside of making the election is that you recognize taxable income in the year you receive the restricted stock award, even though the shares may later be forfeited or decline in value. If you forfeit the shares back to your employer, you can claim a capital loss for the amount you paid for the shares, if anything.

If you opt to make the election, you must notify the IRS either before the restricted stock is transferred to you or within 30 days after that date. We can help you with election details.

Important decision 

The tax rules for restricted stock awards are pretty straightforward. The major tax planning consideration is deciding whether or not to make the Section 83(b) election. Consult with us before making that call.

If you’re fortunate to have an employer that offers a 401(k) plan, and you don’t contribute to it, you may wonder if you should participate. In general, it’s a great tax and retirement saving deal! These plans help an employee accumulate a retirement nest egg on a tax-advantaged basis. If you’re thinking about contributing to a plan at work, here are some of the advantages.

With a 401(k) plan, you can opt to set aside a certain amount of your wages in a qualified retirement plan. By electing to set cash aside in a 401(k) plan, you’ll reduce your gross income and defer tax on the amount until the cash (adjusted by earnings) is distributed to you in the future. It will either be distributed from the plan or from an IRA or other plan that you roll your proceeds into after leaving your job.

Tax benefits

Your wages or other compensation will be reduced by the pre-tax contributions that you make, which will save you current income taxes. But the amounts will still be subject to Social Security and Medicare taxes. If your employer’s plan allows, you may instead make all, or some, contributions on an after-tax basis. These are Roth 401(k) contributions. With Roth 401(k) contributions, the amounts will be subject to current income taxation, but if you leave these funds in the plan for a required time, distributions (including earnings) will be tax-free.

Your elective contributions — either pre-tax or after-tax — are subject to annual IRS limits. In 2023, the maximum amount permitted is $22,500. When you reach age 50, if your employer’s plan allows, you can make additional “catch-up” contributions. In 2023, that additional amount is up to $7,500. So if you’re 50 or older, the total that you can contribute to all 401(k) plans in 2023 is $30,000. Total employer contributions, including your elective deferrals (but not catch-up contributions), can’t exceed 100% of compensation or, for 2023, $66,000, whichever is less.

In a typical plan, you’re permitted to invest the amount of your contributions (and any employer matching or other contributions) among available investment options that your employer has selected. Periodically review your plan investment performance to determine that each investment remains appropriate for your retirement planning goals and your risk specifications.

Taking withdrawals

Another important characteristic of these plans is the limitation on withdrawals while you’re working. Amounts in the plan attributable to elective contributions aren’t available to you before one of the following events:

• Retirement (or other separation from service),
• Reaching age 59½,
• Disability,
• Plan termination, or
• Hardship.

Eligibility rules for a hardship withdrawal are strict. A hardship distribution must be necessary to help deal with an immediate and heavy financial need.

As an alternative to taking a hardship or other plan withdrawal while employed, your employer’s plan may allow you to receive a loan, which you pay back to your account with interest.

Matching contributions

Employers may opt to match 401(k) contributions up to a certain amount. Although matching is not required, surveys show that most employers offer some type of match. If your employer matches contributions, you should make sure to contribute enough to receive the full amount. Otherwise, you’ll lose out on free money!

These are just the basics of 401(k) plans for employees. For more information, contact your employer. Of course, we can answer any tax questions you may have.

Perhaps you’ve been in this situation before: You have a financial emergency and need to get your hands on some cash. You consider taking money out of a traditional IRA or 401(k) account but if you’re under age 59½, such distributions are not only taxable but also are generally subject to a 10% penalty tax.

There are exceptions to the 10% early withdrawal penalty, but they don’t cover many types of emergencies.

Good news: Beginning in 2024, there will be new relief for some taxpayers facing emergencies. The SECURE 2.0 law, which was enacted late last year, contains two different relevant provisions:

1. Pension-linked emergency savings accounts.Employers with 401(k), 403(b) and 457(b) plans can opt to offer these emergency savings accounts to non-highly compensated employees. For 2024, a participant who earned $150,000 or more in 2023 is a highly compensated employee. Here are some more details of these new type of accounts:

• Contributions to the accounts will be limited to up to $2,500 a year (or a lower amount determined by the plan sponsor).
• The accounts can’t have a minimum contribution or account balance requirement.
• Employers can offer to enroll eligible participants in these accounts beginning in 2024 or can automatically enroll participants in them.
• Participants can make a withdrawal at least once per calendar month and such withdrawals must be made “as soon as practicable.”
• For the first four withdrawals from an account in a plan year, participants can’t be subject to any fees or charges. Subsequent withdrawals may be subject to reasonable fees or charges.
• Contributions must be held as cash, in an interest-bearing deposit account or in an investment product.
• If an employee has a pension-linked emergency savings account and is not highly compensated, but becomes highly compensated as defined under tax law, he or she can’t make further contributions but retains the right to withdraw the balance.
• Contributions will be made on a Roth basis, meaning they are included in an employee’s taxable income but participants won’t have to pay tax when they make withdrawals.

2. Penalty-free withdrawals for emergency expenses.This new provision is another way to get money for emergencies. As mentioned earlier, taking a distribution from an IRA or 401(k) before age 59½ generally results in a 10% penalty tax unless an exception exists. SECURE 2.0 adds a new exception for certain distributions used for emergency expenses, which are defined as “unforeseeable or immediate financial needs relating to personal or family” emergencies.

Only one distribution of up to $1,000 is permitted a year, and a taxpayer has the option to repay the distribution within three years. This provision is effective for distributions made beginning in 2024.

Guidance likely coming soon

These are just the basic details of the two new emergency-related provisions. Other rules apply and the IRS will need to issue guidance to address certain details. Contact us if you have questions or need cash and want to explore the most tax-efficient ways to tap one of your accounts.

Do you use an automobile in your trade or business? If so, you may question how depreciation tax deductions are determined. The rules are complicated, and special limitations that apply to vehicles classified as passenger autos (which include many pickups and SUVs) can result in it taking longer than expected to fully depreciate a vehicle.

Depreciation is built into the cents-per-mile rate

First, be aware that separate depreciation calculations for a passenger auto only come into play if you choose to use the actual expense method to calculate deductions. If, instead, you use the standard mileage rate (65.5 cents per business mile driven for 2023), a depreciation allowance is built into the rate.

If you use the actual expense method to determine your allowable deductions for a passenger auto, you must make a separate depreciation calculation for each year until the vehicle is fully depreciated. According to the general rule, you calculate depreciation over a six-year span as follows: Year 1, 20% of the cost; Year 2, 32%; Year 3, 19.2%; Years 4 and 5, 11.52%; and Year 6, 5.76%. If a vehicle is used 50% or less for business purposes, you must use the straight-line method to calculate depreciation deductions instead of the percentages listed above.

For a passenger auto that costs more than the applicable amount for the year the vehicle is placed in service, you’re limited to specified annual depreciation ceilings. These are indexed for inflation and may change annually. For example, for a passenger auto placed in service in 2023 that cost more than a certain amount, the Year 1 depreciation ceiling is $20,200 if you choose to deduct first-year bonus depreciation. The annual ceilings for later years are: Year 2, $19,500; Year 3, $11,700; and for all later years, $6,960 until the vehicle is fully depreciated.

These ceilings are proportionately reduced for any nonbusiness use. And if a vehicle is used 50% or less for business purposes, you must use the straight-line method to calculate depreciation deductions.

Reminder: Under the Tax Cuts and Jobs Act, bonus depreciation is being phased down to zero in 2027, unless Congress acts to extend it. For 2023, the deduction is 80% of eligible property and for 2024, it’s scheduled to go down to 60%.

Heavy SUVs, pickups and vans

Much more favorable depreciation rules apply to heavy SUVs, pickups, and vans used over 50% for business, because they’re treated as transportation equipment for depreciation purposes. This means a vehicle with a gross vehicle weight rating (GVWR) above 6,000 pounds. Quite a few SUVs and pickups pass this test. You can usually find the GVWR on a label on the inside edge of the driver-side door.

What matters is the after-tax cost

What’s the impact of these depreciation limits on your business vehicle decisions? They change the after-tax cost of passenger autos used for business. That is, the true cost of a business asset is reduced by the tax savings from related depreciation deductions. To the extent depreciation deductions are reduced, and thereby deferred to future years, the value of the related tax savings is also reduced due to time-value-of-money considerations, and the true cost of the asset is therefore that much higher.

The rules are different if you lease an expensive passenger auto used for business. Contact us if you have questions or want more information.