by Scott Lewis, CPA, MSA
We finally know the results on most of the National general elections and it’s almost time to eat turkey, at an appropriate social distance of course. After that, there are still many decisions to be made as we finalize year-end tax planning, and we say goodbye to this year 2020, again, finally.
Regardless of who takes control of the Senate (after the Georgia run-off elections held in early January 2021), it is possible that some of President-elect Biden’s tax proposals can be passed into law, with potential compromise across party lines to get some legislation approved, such as additional COVID relief. We present a snapshot on some key items taken from President-elect Biden’s individual tax proposals, as well as some time sensitive actions for 2020 taxes. These are not all inclusive, and not all details on how to implement these have been stated in these plans. They are noted as a guide for you to make informed decisions for your own tax situation. Remember that changes in tax policy must originate in Congress, not in the White House. And all suggestions below assume that you as the taxpayer, are owners of pass-through entities and have some control over economic decisions within these businesses.
Change in Income Tax Proposals
Raise the top individual ordinary income tax rate back to 39.6%, from the current level of 37%, on earnings over $400,000.
Compared to “normal” tax planning, consider shifting income into 2020, whether it be additional wages at year-end, deferring expenses to 2021, or electing out of bonus depreciation on business property additions.
And if applicable to your situation, bring in all amounts from Paycheck Protection Program (PPP) loan forgiveness, even if you haven’t formally applied or are waiting final notice from your lenders, into taxable income. Revenue Ruling 2020-27 from the IRS, which was issued last week, assumes that if it is reasonably expected that all proceeds will be formally forgiven, whether this occurs in 2020 or 2021, these monies need to be taken into income, via expense reduction in 2020. This is the year that forgivable expenses such as salaries paid, have occurred.
The above does assume you are reasonably certain that the full loan amounts are eligible for full forgiveness based on the program criteria. The IRS also issued Revenue Procedure 2020-51 last week. This contains a safe harbor when a taxpayer is only deemed partial loan forgiveness. Those amounts, which must be taken into taxable income in 2020, can be deducted in 2021, or through increased expense deductions in 2021.
As of this writing, the expenses paid by the loans for such items as salaries and mortgage interest are not tax-deductible, based on IRS Notice 2020-32 issued late in April 2020. As an example, if your business income shows $2 million which includes $500,000 of salary expense, and your loan is $500,000, taxable income will now be $2.5 million. Late last week, members of the Senate Finance Committee issued a joint statement noting that they are working to pass legislation by the end of the year that will reverse the IRS guidance and that these expenses will be fully deductible.
Increase in payroll taxes, specifically social security on wages over $400,000. These are currently capped at $137,700 (in 2020 and inflation increased each year) at 12.4% (split in half between the employee and the employer). The plan is to keep this in place, there would be no social security tax on wages in between, and then taxes would be applied after wages reach $400,000. There hasn’t been any clear discussion on whether this would be imposed on both the employee and the employer.
Perform some economic analyses to determine if it is feasible to shift some wages now for yourself or other employees into 2020, if these wages amounts are close to the proposed cap. Other items to consider is that an increase in salary expense will lower the 20% Qualified Business Income (QBI) deduction on most pass-through entities, so these decisions should be weighted.
Increase on dividends and long term capital gains tax rates on taxable income over $1 million to the proposed ordinary income tax rate of 39.6%. These are currently at 20% plus the 3.8% Net Investment Income Tax (NIIT), if applicable.
Consider accelerating the timing and receipt on dividends from closely held corporations such as reinsurance companies into 2020. These would have to be initiated and completed before December 31, 2020 with limited exceptions. Consult with your financial advisors as well on your investment portfolios, to determine whether assets with high unrealized gains should be sold before year end.
Phaseout of 20% Qualified Business Income Deduction on income over $400,000. This deduction, commonly known as 199A, was enacted as part of the Tax Cuts and Jobs Act (TCJA) in 2017. It allows a 20% deduction on K-1 income from pass-throughs and other selected income calculated from some formulas at the 1040 individual tax return level.
Although it wouldn’t result in a dollar for dollar reduction, if income is accelerated as noted above for 2020, this deduction would go up as well. This 20% reduction may not apply on pass-through income pushed into 2021.
Change in Itemized Deductions Proposals
Restoration of the PEASE limitations on income over $400,000 (which prior to the TCJA capped the amount of itemized deductions. These include amounts paid for mortgage interest or charitable contributions to either 3% reductions based on every dollar over a certain income amount or up to 80% of all deductions). There would no longer be a corresponding reduction in taxable income for every dollar spent. The proposal also notes that the total amount of deductions capped would be 28% of income.
There is also discussion on either repealing or adjusting the limitations on State and Local tax (SALT) deductions, which are capped at $10,000. The removal of this limitation does favor states with high state and real estate taxes such as New York and California.
When reductions in tax benefits such as itemized deductions may be forthcoming, we encourage increased expenditures before the end of the year, such as cash charitable contributions, which were limited to 60% of adjusted gross income, and temporarily raised to 100% on contributions paid 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 the tax on capital gains 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. Keep in mind that these would have to be done before year-end.
If possible, defer payments on real estate taxes until January 2021, as well as estimated state and local tax payments which are generally due in January anyway. If receiving K-1 income from your closely held business, see if your state allows the entity to pay the applicable state taxes, rather than at the individual level. States such as New Jersey and Connecticut have adopted this methodology in the past few years, as a “workaround” on the SALT limitations of $10,000. The IRS approved this method in a Notice just released on November 9, 2020.
Change in Estate Tax Proposals
Reduce estate tax exemptions (amount of assets that can be shifted without estate or gift tax being paid) down to $3.5 million for an individual or $7 million for a married couple. Amounts are at $11.58 million, and $23.16 million in 2020, for an individual and a married couple, respectively. And they are not currently set to sunset back to $5 million and $10 million, until 2026.
Increase the top estate tax from 40% to 45%.
Eliminating the “tax-free” stepped up basis on inherited estate assets. The step up basis brings the assets inherited by beneficiaries to fair market value on the date of death or shortly thereafter. Without this step up to fair market value, the carried-over tax basis on assets to the beneficiaries maybe extremely low if these assets were held for long periods of time, as an example. Upon sale by a beneficiary, these would be subject to large capital gain taxes.
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, or if any of the above occur.
All the above have been presented with the assumptions that they will all be passed into law in 2021 and considered retroactive to January 1, 2021. Many factors, events, and compromises would have to be present for this all to occur. We are offering these to you to make the most informed decisions for your 2020 taxes with the fact patterns that exist.