Much of what the Biden administration hopes to enact hangs in the balance as we await the run-off elections in Georgia. While there were rumblings of a full repeal of the Tax Cuts and Jobs Act, this is unlikely to occur. Democrats will retain a majority in the House and, with the potential of a split Senate with a tie-breaking vote from the Vice President-Elect in their favor, signs point to a status quo in terms of tax legislation for at least the next two years. There’s a higher likelihood of bipartisan economic stimulus along with modest tax increases before any wholesale tax law changes.
As we’ve seen from recent elections, outcomes have been notoriously hard to predict and most didn’t foresee the results in 2020, much like in 2016. Taking that into consideration at year-end, we feel it’s prudent to review President-Elect Joe Biden’s key tax proposals and how they may impact you next year.
- Restore the top individual ordinary income tax rate to 39.6% from 37%.
- Preference income (i.e. long-term capital gains & qualified dividends) would be taxed as ordinary income for taxpayers with over $1 million of income.
- All income from carried interests would be taxed at ordinary rates.
- Increase the Social Security earnings cap: Wages above $400,000 would be subject to the 12.4% payroll tax. The current taxable maximum, $142,800 in 2021, would continue to increase annually by cost-of-living adjustments while the $400,000 threshold would remain static.
This would eventually eliminate the cap on earned income subject to FICA. The maximum exemption would gradually increase as a result of inflation up to $400,000. At that point, all wages would be taxable.
- Cap the value of itemized deductions for high-income taxpayers (income above $400,000):
~ Cap the tax benefit of itemized deductions at 28%. For example, under current law, an individual in the top ordinary rate bracket of 37% who is itemizing should see a 37% tax benefit for each additional dollar spent on eligible tax deductions (assuming the taxpayer is not subject to the Alternative Minimum Tax). Under the Biden proposal, the tax benefit in the above scenario would be limited to 28% instead of 37%.
~ Restore the Pease Limitation on itemized deductions. The Pease Limitation reduced itemized deductions by 3% for every dollar spent once income went above certain levels.
- Phase-out of the Business Income Deduction under IRC section 199A for those earning above $400,000. The deduction is set to sunset at the end of 2025. There is already an income-based phaseout for Specified Service Trade or Business Income. This would expand phaseouts to all Qualified Business Income.
- Eliminate “unproductive tax cuts for high-income real estate investors.” While not specifically defined, many interpreted this as the limitation of:
~ Accelerated depreciation of rental housing; and
~ Deferral of capital gain taxes from like-kind exchanges.
- Expand the Child Tax Credit and the Child and Dependent Care Tax Credit. Each credit would be significantly expanded under the Biden administration.
~ The Child Tax Credit would become fully refundable to help mitigate the economic impact of the COVID-19 pandemic, with the maximum value increasing to $3,000 from $2,000 for children 17 or younger. A $600 bonus would also be provided for children under 6.
~ The Child and Dependent Care Tax Credit would become refundable, and the maximum allowable expenses for one child would increase to $8,000 and $16,000 for multiple children. The maximum reimbursement rate would increase to 50% from 35% for children younger than 13.
- Return the estate tax to 2009 levels. The estate tax in 2009 had a top rate of 45% with a base exclusion of $3.5 million per taxpayer, indexed annually for inflation.
- Eliminate “stepped-up” basis for capital gains at death for high-income taxpayers (income above $400,000). Details were not provided whether unrealized gains would become taxable upon death or if a carryover basis rule would be instituted.
- Increase the corporate income tax to 28%. The current top rate is 21%.
If you believe steps should be taken to accelerate income or deductions, update your estate plan or review your business entity structure. It’s best to act now before the new year when legislation could be made retroactive to January 1.
Strategically Plan the Timing of Additional Income or Deductions in 2020
The default tax planning strategies are to either accelerate deductions while deferring income or accelerate income and defer deductions. Accelerating both would typically offset the benefit of the other, however, this year could be different.
A. LOOK FOR SITUATIONS WHERE GENERATING INCOME IN 2020 WILL RESULT IN NO ADDITIONAL TAX OR WILL BE SUBJECTED TO A LOWER MARGINAL RATE THAN IT WOULD BE IN 2021.
- Realize capital gains:
~ If you have excess (non-deductible) capital losses;
~ If your long-term gains will be subject to the 0% rate;
~ If your long-term gains will be taxed at 15% this year and could be subject to the higher 20% rate in 2021;
~ If you’re concerned that your long-term gains may be subjected to the top ordinary rate starting in 2021 ($1 million or more in total income). The top marginal rate under the Biden proposal would be 43.4% (39.6% ordinary rate plus 3.8% Net Investment Income tax) vs. 23.8% under current law.
- Realizing passive income where you have blocked passive activity losses.
- Realizing investment income where you have blocked investment interest deductions.
- Roth IRA conversions. The CARES Act deferred 2020 Required Minimum Distributions which provides a planning opportunity for many taxpayers. Converting at sub 30% rates is recommended as we believe rates will only go up in future years.
- If you’re concerned that the top ordinary income rate will revert to 39.6% next year, it may be advisable to accelerate additional ordinary income this year at 37%. Don’t forget to consider whatever state income taxes you may be subject to.
B. DEVELOP STRATEGIES FOR TAKING 2020 ADDITIONAL DEDUCTIONS OR POSTPONING UNTIL 2021.
Know where additional deductions will produce little or no tax benefit.
- If your childcare expenses are already above the tax credit or salary reduction limits.
- If your rental losses are already blocked by the passive loss rules.
- If your losses or deductions will throw you into a 0%, 10%, or 12% tax bracket.
- If you won’t have enough deductions to itemize and instead will use the standard deduction (Single/Married Filing Separate = $12,400; Head of Household = $18,650; Married Filing Jointly = $24,800).
- Consider the possibility that the state and local tax cap of $10,000 might be repealed next year. There has been bipartisan support of this as there are Republicans who have constituents in high tax states. If you’re not receiving a tax benefit from state tax payments (i.e. income and real estate taxes) in 2020, consider postponing payment to 2021.
Consider accelerating deductions if they’ll provide a tax benefit.
- If your year-to-date realized gains exceed realized losses, consider realizing additional losses to reduce your overall gain.
~ A situation you want to avoid is paying tax on capital gains in 2020 but having non-deductible losses in 2021 because total losses exceed total gains and the allowable $3,000 capital loss deduction. Taking capital losses to offset capital gains can also avoid the surtax on investment income.
- Review how the CARES Act changed charitable giving in 2020.
~ The limitation on deductible cash contributions has been increased to 100% of Adjusted Gross Income. To qualify, the individual must itemize and:
1. Contributions must be to a qualified charitable organization;
2. Contributions must be in cash;
3. The taxpayer must elect the application of this section with respect to such contribution;
4. Contribution cannot be made to a “supporting organization” as defined In IRC sec. 509(a)(3);
5. Cannot be made to establish or maintain an existing donor-advised fund; and
6. Excess contributions can be carried forward for five years.
- Other charitable deduction limitations weren’t changed by the CARES Act.
1. Gifts of marketable securities are still limited to 20-50% depending on the recipient and holding period of the capital asset.
2. Donor-advised fund limitations fall under public charity rules, but the CARES Act specifically excluded contributions to donor-advised funds and the limitation maximum is still 60% of Adjusted Gross Income.
- It may make more sense to lump two years of charitable contributions into one year to take advantage of itemizing if you won’t see a tax benefit from your charitable giving in 2020 or 2021.
- If you’re concerned that your charitable contributions will be subject to a 28% tax benefit under the Biden administration, consider accelerating charitable giving this year if you’re receiving a tax benefit greater than 28%.
- If you’re concerned that charitable contributions will be limited to a 28% tax benefit and you will be in a marginal bracket higher than 28%, consider making charitable gifts directly from your IRA next year if you are over the age of 70 1/2. You will see a better tax benefit by making Qualified Charitable Distributions from your IRA than giving in cash. The charitable distributions will qualify against your Required Minimum Distributions and are limited annually to $100,000 per individual.
Please reach out to us to discuss if you have any questions.
C. REVIEW YOUR ESTATE, GIFT, AND GENERATION SKIPPING TAX PLAN
There is a very high likelihood that the current estate tax exemption (currently $11.58 million per individual with portability) will be reduced by the next administration. The IRS has issued a ruling that it will not clawback any large taxable gifts if the estate tax exemption reverts to prior lower thresholds. This is an instance where you may want to “use it before you lose it.”
It’s also worth noting that valuation discounts have been in the crosshairs for years leading up to the Trump administration. These could very well be on the chopping block again under the Biden administration. If eliminated, the gifting of noncontrolling interests in family owned businesses could become significantly more expensive from a gift tax perspective.
- We recommend that you review your estate plan with your counsel before year-end. Make sure appropriate changes are made before a potential change in the estate tax is made.
- Review gifting opportunities:
1. The present interest annual exclusion gift limitation for 2020 is $15,000 per donee. This limit remains unchanged for 2021.
2. Unlimited transfers directly to educational institutions for tuition: These amounts are not considered taxable gifts. If amounts are not paid directly to the educational institution, they are considered gifts.
3. Unlimited transfers directly to medical care providers for medical expenditures: These amounts are not considered taxable gifts. If amounts are not paid directly to the medical care provider, they are considered gifts.
4. Gifts to 529 plans: These are considered gifts that reduce your annual exclusion ($15,000 maximum per donee in 2020). However, there is an exception that allows 5 years of gifts in 1 year – a maximum of $75,000 in 2020.
2020 Year-End Tax Planning:
1. TAXPAYERS SHOULD MAKE SURE THAT WITHHOLDING AND/OR TAX DEPOSITS ARE ADEQUATE TO AVOID UNDERPAYMENT PENALTIES.
- Review tax estimates to make sure tax deposits (including withholding) are sufficient to avoid underpayment penalties. We recommend updating your estimate before year-end if income has changed materially during the year.
- Holders of mutual funds in non-tax deferred accounts should review year-end capital gain distributions. This could be an atypical year for some shareholders. Higher than normal distributions could result in sticker shock come next April. Distributions should begin sometime the week after Thanksgiving until year-end. Fund companies do provide distribution information on their website, so do give this a look over if you’re concerned.
2. WITH INTEREST RATES AT HISTORIC LOWS, IT’S TIME TO RESTRUCTURE YOUR DEBTS WHERE POSSIBLE TO ENSURE DEDUCTIBILITY AND REDUCE FINANCIAL RISK.
- Pay down nondeductible debt first.
- Consider paying down debt that produces deductions that are part of blocked passive activity losses.
- Lock in fixed rates.
- Caution: When refinancing grandfathered acquisition debt, you must meet several limitations if you want to keep the old $1,000,000 debt limit. Debt will not be recognized as grandfathered if:
1. it is an increase over the previous loan balance;
2. it is extended after the original term has completed,
3. it has principal that is not amortized over its term, and
4. it is extended longer than the current term remaining of the original long with a maximum of 30 years (i.e. If 25 years remain on a 30-year mortgage, the refinance cannot exceed 25 years. In the event you have a balance with a term longer than 30 years you cannot extend beyond 30 years to meet the requirements for refinancing grandfathered debt).
3. MAKE SURE THAT YOU ARE MAKING MAXIMUM USE OF THE FOLLOWING TAX BENEFITS:
- $3,000/year capital loss deduction allowance.
- $25,000 rental loss allowance for owners with active participation in the ownership and management of rental real estate. (Warning: This benefit is phased out as Adjusted Gross Income increases from $100,000 to $150,000.)
- The $2,000 per individual child (must be under the age of 17) tax credit, and $500 for other dependents (not children under age 17). Phase out begins at $400,000 of modified adjusted gross income for married filing joint filers ($200,000 for all other filers).
- $5,000 per year dependent care exclusion ($2,500 for single filers).
- Deductible IRA contributions (Maximum $6,000 per individual). Individuals over age 50 can make an additional “catch-up” contribution of $1,000. Non-working spouses may have deductible IRA’s available if Adjusted Gross Income tests are met.
Note that deduction phase-out ranges are increased annually for individuals who have pension coverage. The phase-out point begins for individuals with pension coverage at $65,000 of AGI for single and head of household filers, and $104,000 of AGI for joint filers with pension coverage. Individuals are completely phased out at AGI levels of $75,000 for single and head of household filers, and $125,000 for joint filers. The phase-out point for spouses without pension coverage starts at $196,000 of AGI when the other spouse has pension coverage.
- $100,000 per year exclusion of charitable distributions from IRA accounts by individuals aged 70 ½ or older.
- Review whether 100% bonus depreciation or IRC section 179 expensing is more beneficial for property used in a trade or business. To qualify for bonus depreciation the property categorization must meet the MACRS recovery period of 20 years or less.
The maximum deduction under Section 179 expensing is $1,040,000 and the phase-out-threshold begins at $2,590,000 million of asset additions. The expense allowance is completely phased out if $3,590,000 of purchases are made.
- The optional standard mileage reimbursement rate for 2020 is 57.5 cents per mile.
4. PAY ATTENTION TO FINANCIAL HOUSEKEEPING.
- Shareholders who have advanced money to their incorporated businesses should evidence the transaction with a note and should charge an adequate rate of interest. Failure to do so could cause the loan to be recharacterized as a capital contribution.
- Loans between family members should be evidenced with a note and an adequate rate of interest should be charged. The rate of interest should be at or above the applicable federal rate for the month the loan was made. Avoid any disguised gift tax issue by having a written debt instrument with appropriate interest, a repayment schedule, and an expectation that the amount will be repaid.
- If you are married to a foreign national, make sure your spouse has an ITIN (Individual Tax Identification Number). E-filing is not allowed without one.
- Apply for Social Security numbers for dependents.
- Change Social Security name records for name changes due to marriage or divorce. (Note: Names used on tax returns must agree exactly to the spelling used by the Social Security Administration, including the use of abbreviations and initials.)
- Obtain documentation for charitable contributions. Gifts of $250 or more must be substantiated by a written acknowledgment from the donee organization.
- Obtain appraisals for non-cash contributions exceeding $5,000.
- Get auto usage records compiled. Businesses should make sure that the personal use value of company autos is included in the employee’s W-2.
- Make sure that documentation for meal expenses is adequate to withstand an IRS audit. Do not dispose of the year’s appointment book if you intend to rely on it to support business deductions. Entertainment expenses are no longer deductible.
- Get taxpayer ID numbers for 1099 and W-2 recipients (including daycare providers) by having them complete Form W-9.
- Document participation in business activities if you feel that this may be an issue in applying the passive loss rules (or if you are claiming exemption from the Net Investment Income tax on the sale of partnership interests or S-corporation stock). The general cutoff point for material participation is 500 hours per year. The cutoff for status as a Qualified Real Estate Professional is 750 hours.
- Update your tax basis records for investments, especially for mutual funds with dividend reinvestment. Also, update basis records for improvements done to real estate.
- If you have received any gifts of investment property during the year, ask the donor for the carryover basis information.
- Get business activities segregated into separate bank accounts for 2021.
- If your deductions will change radically in 2021, be sure to adjust your withholding accordingly using Form W-4.
5. REVIEW 2021 BENEFIT PLAN OPTIONS WITH YOUR EMPLOYER.
- 401(k) plan contribution rate and investment choices. (Don’t forget to elect the bonus contributions if you’re 50 or older.) The maximum elective deferral for 2021 is unchanged from 2020 ($19,500). The catch-up contribution for individuals 50 years or older is $6,500.
- Non-qualified deferred compensation plan elections.
- Dependent care assistance salary reductions.
- Compensation paid in the form of mass transit passes. (The Tax Cuts and Jobs Act eliminated the deduction for employers but retained the pre-tax benefit for employees.)
- Health savings account contributions
- Flex spending account contributions
Having health insurance coverage with a high deductible policy entitles you to make contributions to a Health Savings Account (HSA). Minimum qualifying policy deductibles are $1,400 for single coverage or $2,800 for family coverage. The maximum HSA contribution for 2021 is $3,600 for single coverage or $7,200 for family coverage. Bonus contributions of $1,000 will be allowed for those individuals age 55 or more. Individuals enrolled in Medicare cannot make HSA contributions.
The maximum annual contribution limit for a flex spending account for 2020 was $2,750. Participants can carry over up to $550 in unspent contributions if the plan has not adopted the 2 ½ month grace period rule. (This allows 2 ½ months after year-end to spend unused funds.) The $550 carryover will not reduce the current year’s FSA contribution. Caution: Taking advantage of the carryover rule will prevent HSA contributions.
Action: If you plan on making HSA contributions for 2021, clear out the flex spending account before year-end.
Looking to 2021
Much ink is spilled on tax planning and most ignore the impact of state-level changes. As state tax budgets begin to feel the impact of the COVID-19 pandemic, state and local legislators will need to find new, more aggressive ways to generate revenue. One of the easiest ways to generate revenue is by increasing consumption, income and real estate taxes.
As practitioners based in Chicago, we are seeing this firsthand. According to a Nov. 23 Bloomberg report, “the state faces a $3.9 billion budget deficit for the fiscal year 2021 and a $10.1 billion backlog of unpaid bills.” * The City of Chicago passed a budget that increased real estate taxes and fuel taxes to close the widening budget gap.
With the state’s Fair Tax failing on Election Day, and the Franchise Tax going into the second year of its four-year phase-out (it will be eliminated after-tax years beginning on Jan. 1, 2025), legislators will have to grapple with the prospect of cutting costs and finding new ways to generate revenue. Recall that “the largest income tax increase in state history occurred in 2011 during a lame-duck session of the legislature.”* History may very well repeat itself.
California, New York, and New Jersey are other states that have passed, or are in the process of trying to pass, income tax increases. Governor Phil Murphy of New Jersey was finally able to pass the millionaires tax which brings the top rate of 10.75%, once for income above $5 million, down to those taxpayers with income above $1 million. In California, AB 1253 would increase tax rates for high-income earners up to 15.3%, which could create a combined marginal rate of 58.7% of ordinary investment income. With Proposition 15 failing this election, some legislators are pushing a wealth tax. Governor Gavin Newsom has previously gone on record stating he doesn’t support the wealth tax proposals.
There is a common theme here: if you’re a high-income taxpayer the government wants to tax more of what you make. For those making $400,000+ a year, the odds are pretty good you’ll see an income tax increase soon.
As the federal, state, and local income tax landscape continues to evolve, we’ll continue to incorporate all three into our planning services.
*Illinois Fiscal Crisis Worsens, Leaving Tough, Taxing Choices, Michael J Bologna, www.bloomberglaw.com