Regardless of who wins the upcoming presidential election, as we enter the final three months of 2020, we are suggesting some topline tax planning ideas. We are noting the potential changes Biden has laid out in his tax proposals vs. the current tax code for information only. These are by no means comprehensive, or “one size fits all” strategies. We are proposing suggestions that may increase income or decrease income in 2020 depending on the individual situations and the character of income.
Top ordinary tax rates were lowered to 37% by the Tax Jobs and Cuts Act (TCJA) in 2017. The proposals outlined are to raise them back to 39.6%, which was the rate pre TCJA.
For taxpayers who own and can control pass through entities, such as S corporations and partnerships, there exists a Biden proposal to phase out the 20% Qualified Business Income (QBI) (199A) deduction (which was created in the TCJA) for taxpayers with income over $400,000. Although contra intuitive, in this case, it may be more advantageous to defer deductions until 2021, if possible. As a very top-line example, say income from a S corporation is $1 million and, assuming all qualifying factors are met, the QBI 20% deduction is $200,000 meaning the taxable income is now $800,000. If the QBI is eliminated, to stay “breakeven”, income would have to be $800,000 ($200,000 of deductions would have to be deferred till the subsequent year). Significant planning will be needed in the next couple of months.
Also, on the subject of pass-through and sole proprietorship ownership, and if applicable, Paycheck Protection Program (PPP) loan forgiveness must be taken into account for 2020. The position from IRS Notice 2020-32 published earlier this year has not changed. Expenses paid with PPP loan monies are not deductible. For example, let’s say the PPP loan is $1 million, and current recorded net income is $5 million, which includes $1 million of salary expense funded by the loan. Assuming full forgiveness of the loan, this $1 million is now non-deductible and taxable income is now $6 million. From our discussions with banks and other lending institutions, they have noted that combined with the sheer volume of loan forgiveness applications and frequent changes to the Small Business Administration (SBA) rules on loan forgiveness, some loans may not be forgiven until 2021. This would create a timing difference from our example where the $1 million of payroll expense is a tax deduction in 2020 and an addback to taxable income in 2021. Even without the uncertainty of the tax changes in the Biden proposals, significant planning still must be done within the next several months in order to address this situation.
Capital gains tax rates are currently at 20% plus the 3.8% Net Investment Income Tax or NIIT (lower rates if ordinary income is under certain levels, $496,601 for married filing joint in 2020, as an example). Biden’s position is to tax capital gains at ordinary income rates for taxpayers with income over $1 million. If rates do go up, taxpayers who can plan the timing on receiving investment income, such as dividends from a closely held corporation or a reinsurance company may want to consider accelerating these into 2020.
Itemized deductions changes include bringing back the Pease limitations (which capped itemized deductions depending on taxable income levels) on taxpayers over $400,000 and capping the tax benefit of itemized deductions at 28% for taxpayers with income tax rates higher than 28%.
As we have suggested in the past, when reductions in tax benefits such as itemized deductions are known, we encourage increased deductions before the end of the year, specifically in cash charitable contributions, which were limited to 60% of adjusted gross income, but temporarily raised to 100% to qualified organizations in 2020 as part of the CARES Act. Non-cash contributions such as appreciated stock or other investments are still subject to the 60% levels. If capital gains tax does increase in 2021, this could be a potential strategy to contribute highly appreciated stock to charitable causes, without paying any income tax, and getting a deduction. Taxpayers do have until the end of the year to make decisions such as these.
From the perspective of estate planning, now is the time to do so, if not already. Gifting or shifting business assets and other investments down to a lower generation in the family such as children and grandchildren is always a good idea, especially if taxable income producing assets are then owned by these individuals who maybe in a lower income tax bracket. The estate tax exemptions (amount of assets that can be shifted without estate or gift tax being paid) is $11.58 million for 2020 for an individual and $23.16 million for a married couple. These are currently set to return back to $5 million and $10 million, respectively in 2026.
Part of the Biden tax proposals includes accelerating the timeframe when the exemptions are set to roll back to the lower amounts. There is also discussion on eliminating the “tax-free” stepped up basis on inherited estate assets. The step up basis brings the assets of the deceased to the beneficiaries at fair market value on the date of death or shortly thereafter. Without this step up, this new tax basis, in the hands of the deceased, maybe extremely low if assets were held for long periods of time. Upon sale by the beneficiary, these would be subject to large capital gain taxes, as opposed to the outcome by utilizing the stepped up basis. Additionally, there is a proposal as noted above, to increase capital gains taxes on individuals making over $1 million to ordinary income plus the NIIT of 3.8%. Other commentary has suggested that this could be similarly accomplished by taxing on the unrealized gains of the estate at death even without the sale of the underlying assets.
Now is the time to start thinking about the above suggestions and how they may affect you. Many of the short items for 2020 as noted can still be accomplished after the election, such as accelerating and decelerating income.