The 2020 election has left the future of tax policy uncertain. While Democrats maintained a slim majority in the House of Representatives, the final composition of the Senate will not be decided until two runoff elections are held in Georgia in January of 2021.
Of the 100 possible Senate seats, Democrats currently hold 48 for the coming term, with 50 held by Republicans. If Republicans win even one of the two seats at stake in January, that party will maintain control and a split Congress will remain for the foreseeable future; as a result, President-elect Joe Biden’s plans to overhaul the tax law will have to wait until at least the 2022 midterm elections. If both open Senate seats are won by Democrats, however, that party will have a 51-50 majority when including Vice President-elect Kamala Harris as the tie-breaking vote, opening the door for the Biden administration to potentially implement $3.3 trillion in proposed tax increases as early as January 1, 2021.
As a result, tax planning for the remaining days of 2020 poses unique challenges. With the Senate hanging in the balance until 2021, do you behave as if tax rates will remain the same in 2021, and thus stick to the tried-and-true approach of accelerating deductions and deferring income? Or with large tax increases potentially looming, do you turn conventional tax planning upside down, and accelerate income into the waning days of 2020 while deferring losses and deductions into 2021?
There is, of course, no great answer; but information is vital. Understanding what is being proposed will allow any taxpayer to make an informed decision, and choose a year-end planning strategy that balances the desire to minimize 2020 taxes with taking into consideration possible tax increases that may take hold as early as next month.
The below discussion identifies the key proposals of the Biden tax plan, before discussing two distinct types of year-end tax planning strategies: one that assumes the law will remain largely unchanged in 2021, and another that assumes the Biden proposals will immediately come to fruition.
Joe Biden’s Tax Plan
President-elect Joe Biden has proposed raising nearly $3.3 trillion in tax revenue, with those increases levied exclusively on corporations and individuals earning more than $400,000. Specifically, Biden has proposed to:
- Return the top ordinary individual income tax rate to 39.6% from 37%.
- Subject wages and self-employment income in excess of $400,000 to the 12.4% Social Security tax (currently only applies to the first $137,700).
- Tax capital gains and dividends at a 39.6% ordinary rate for individuals with income greater than $1 million.
- Reinstate the “Pease limitation,” which would reduce a taxpayer’s overall itemized deductions when income exceeds $400,000.
- Cap the total benefit of itemized deductions at a rate of 28%. Thus, for a high-earning taxpayer, the final dollar of income would be taxed at 39.6%, while the final dollar of expense would give rise to only a 28% deduction.
- Eliminate the 20% Qualified Business Income deduction for income over $400,000.
- Increase the corporate income tax rate from 21% to 28%.
- Eliminate the tax-free step-up in basis that occurs upon death under current law, reduce the estate tax exemption from $11.5 million to $3.5 million, and increase the estate tax rate from 40% to 45%.
Ten Planning Opportunities for 2020 If We Assume Tax Rates Remain Constant
If it’s assumed that Biden’s tax proposals will not become law in the foreseeable future, conventional methods to defer income and accelerate deductions for the last few weeks of 2020 are prudent. As you’ll note, several of the strategies are unique to 2020; thus, they may be new to you. For more information on any of the strategies discussed below, please contact your RubinBrown team member.
2020 Only Planning
1. You may be eligible to withdraw up to $100,000 of a Coronavirus‐related distribution from an eligible retirement plan before year‐end. These distributions are subject to special rules: the 10% additional tax for early withdrawals will not apply, and while they are still generally subject to income tax, the income may be spread over three years beginning with 2020. Alternatively, an individual has up to three years to repay the distribution, in which case no income will be recognized.
2. For this year only, even individuals who do not itemize their deduction – but instead claim the standard deduction – may nonetheless deduct up to $300 (regardless of filing status) for qualifying cash charitable contributions made to a public charity. Beware that noncash donations, or cash amounts made to donor advised funds or supporting organizations, will not qualify for this new deduction. These donations must be supported, so keep any records of the contribution.
3. If you’ve been contemplating a large cash contribution to a public charity, this is the year. For 2020 only, the 60% of adjusted gross income limitation that typically applies to such contributions is raised to 100%. Thus, you can completely wipe out your income with a cash donation. For corporations, the 10% of taxable income limitation is increased to 25%.
4. If you have been negotiating with your lender to forgive a portion of your mortgage on your primary residence, it could be hugely advantageous to complete the negotiations by year-end. In 2020, you can exclude up to $2 million in cancellation of debt income attributable to certain mortgages on your principal residence. That provision, however, expires on December 31, 2020.
5. If you’re a business owner, you can simultaneously create deductible expenses and goodwill among your staff by paying up to $5,250 of “educational assistance” payments on behalf of an employee. This includes tuition for education that maintains or improves their skills in their existing business and – for 2020 only – student loan principal and interest. Employers may also make disaster relief payments or reimbursements on a tax-free basis to their employees for COVID-related expenses not covered by insurance such as personal, family, living, or funeral expenses.
6. If you itemize your deductions, medical expenses are only deductible to the extent they exceed 7.5% of adjusted gross income. In 2021, that floor increases to 10%. As a result, if you’ve already incurred enough medical expenses in 2020 to exceed the 7.5% floor, don’t wait until 2021 to get that nagging knee taken care of; instead, accelerate as many medical expenses into 2020 as possible to take advantage of the lower floor. Traditional Planning
7. S corporation shareholders should optimize their compensation to minimize payroll taxes, while at the same time, maximizing their IRC Section 199A deduction. This requires careful consideration, as a lower salary will save payroll taxes and increase your Section 199A deduction – while a larger wage will help if your Section 199A deduction is limited to 50% of the W-2 wages paid by the business.
8. Harvest stock losses in taxable brokerage accounts before year-end to offset gains. Beware of the wash sale rules that disallow a loss deduction if the stock is repurchased within a 60-day window before or after the sale.
9. Maximize contributions to tax-advantaged accounts such as HSAs, IRAS, 401(k)s, and self-employed retirement plans. Note: for some plans, deductible contributions may be made after year end.
10. Consider charitable giving strategies such as deduction bunching to surpass the standard deduction threshold, donating appreciated property, creating a charitable trust, or giving directly to a charity from an IRA via the qualified charitable distribution if over age 70 ½.
Planning Ideas if Concerned About Tax Rates Increasing in 2021
If, however, you’re convinced or concerned tax rates will increase in 2021, here are a few tax planning ideas to consider. In this case, it may make sense to accelerate income and defer deduction.
1. If you’re currently in negotiations to sell a large asset, consider closing by December 31, 2020 and sell the asset using the installment method, if it qualifies. This method allows you to pay tax as the payments are received. If rates increase prior to filing your 2020 return, you can elect out of the installment method and report all of the gain on your 2020 return, subject to the lower rates. If rates do not increase, recognize the gain on the installment method and pay the tax as the cash is collected.
2. If you hold substantial vested but unexercised nonqualified stock options, consider exercising before December 31, 2020. This way, the compensation income – the difference between the FMV of the stock on the date of exercise and the exercise price – is included in your 2020 tax return and will not be subject to the potential increase in social security taxes and income taxes in 2021.
3. If stock has already been sold at a loss, perhaps during the downturn in early spring, harvest stock gains to offset those losses. Then, repurchase the stock sold at a gain to achieve a higher, stepped‐up basis to help insulate you against future capital gains rate increases. The wash sale rules do not apply to stock sold at a gain; as a result, you can repurchase the sold stock immediately.
4. If stock hasn’t already been sold at a loss, defer harvesting losses until 2021 to offset gains potentially taxed at a higher rate.
5. If you are a shareholder in an S corporation that has earnings & profits from previous C corporation years, consider making an election to purge the E&P at the 2020 dividend rates.
6. Contribute to a Roth IRA before tax rates increase. This can be done a few ways: a normal contribution if you are under the income threshold for making a contribution, a “back-door” Roth conversion if you are over the income threshold, or a normal conversion from a traditional account.
7. Get a second set of eyes on your estate plan. With the changes being proposed by President-elect Biden to the exemption, rate, and tax-free step-up of basis upon death, now is a great time to review your current strategy.
Consider the Entire Picture
It is never easy to implement tax savings strategies when the possibility of substantial law changes looms, but hopefully this discussion gives you food for thought. Of course, political or policy outcomes are just one factor in tax planning. Make sure to consider the entire picture, including your unique set of facts, including future developments in your personal or business life and your overall long-term non-tax goals. Tax is an important player in decision making, but not the only one.
For more information on any of the information provided, please reach out to your RubinBrown contact.
Readers should not act upon information presented without individual professional consultation.
Any federal tax advice contained in this communication (including any attachments): (i) is intended for your use only; (ii) is based on the accuracy and completeness of the facts you have provided us; and (iii) may not be relied upon to avoid penalties.
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