2021 Year-End Tax Planning
Good tax planning is the identification of opportunities to minimize tax paid over a multi-year period while maintaining adequate cash for operations. This may be done at the business entity and/or individual level. For business, it is accomplished by the shifting of income and/or expenses, by the timing of acquisitions and disposal of assets like inventory or equipment among other things. For individuals, it is accomplished by the sale of investments, retirement contributions and the grouping of itemized deduction payments. The corner stone of tax planning is the ability to forecast taxable income, tax rates and available tax incentives. This is going to be much harder to do this year given the current administration’s agenda. As we always say, a good accounting system is a key to accomplishing accurate forecasting and tax planning. Most planning moves require cash like an equipment purchase. When one’s marginal tax bracket is only at 12%, a $10,000 equipment purchase only saves $1,200 in tax. Deferring a purchase until one’s marginal rate is closer to 38% (a $3,800 tax savings) may be advisable? Paying a little tax today that preserves cash flexibility might be the best answer.
Potential tax legislation for 2021 or early 2022
The end of the year usually brings some last-minute tax changes. This year it is especially true. New legislation to raise revenue to cover the “Build Back Better” plan may mean enacted by yearend resulting in major tax increases starting in 2022. This is especially true for large corporations and high net worth/income taxpayers. Increases in areas such as excise, estate, new capital gains and qualified dividend tax rates, may be passed that could impact many more taxpayers. More spending and revenue raisers are expected in 2022. These possibilities make it difficult to plan with certainty. Provisions originally under consideration are as follows:
Increasing the top ordinary income tax rate from 37% to 39.6%, which was the rate prior to the passage of the Tax Cuts and Jobs Act of 2017.
Increasing the long-term capital gains and qualified dividend rate from 20% to 39.6% for taxpayers with annual adjusted gross income of more than $1 million.
Tax appreciated assets when they are gifted or transferred to people at death at capital gains rates
Tax capital gains when assets are transferred to or from an irrevocable trust or partnership.
Tax capital gains on unrealized appreciation of assets held in trust if capital gains have not been paid on a property for 90 years (e.g., property in a generation-skipping trust).
Tax carried interests as ordinary income instead of capital gains.
If taxable income is greater than $400,000, subjecting pass-through income to either the 3.8% Medicare tax or the 15.3% self-employment tax.
Repealing the Section 1031 like-kind exchange rules for real estate so that investors cannot defer taxes by rolling profits from the sale of a property into their next purchased property.
Instead of an increase in the corporate income tax rate, there is a 15% corporate alternative minimum tax.
1% surcharge on corporate stock buybacks
a surcharge on high-net-worth individuals
a limit on excess business losses
Note that, if passed, some of these provisions are likely to be subject to certain exclusions and dollar limits:
Although we have not yet seen a final draft of this year’s proposed legislation at the time of writing this article, a 15% large corporate alternative minimum tax, a 1% surcharge on corporate stock buybacks, a surcharge on high-net-worth individuals, and a limit on excess business losses were included in the Build Back Better proposal. These items are projected to raise over $400 billion in revenue. More will be needed to balance the budget for the added expenditures in the proposal. In addition, at least two other tax topics still might be included in the final bill: (1) a change in the $10,000 state and local income tax limit and (2) an increase in the estate and gift tax rate. Debate around all these provisions is ongoing, but prudent taxpayers should become familiar with how they can change business and estate plans going forward to reduce the tax impact from these potential changes.
Things to Consider for 2021
Below are some proactive measures that could result in lower taxes should these changes in the tax code be enacted:
Transfer appreciated assets by the end of 2021. Waiting until 2022 may expose gifts to a capital gains tax. This should include planned transfers to a spouse, revocable trust, not for profit, small business or family farm. We do not yet know whether transfers to any or all of these entities will remain excluded from taxation in the future.
Review estate tax planning strategies involving irrevocable trusts or partnerships. Consider any potential capital gains tax that may be triggered under the proposed law on appreciated assets to be contributed or distributed in the future.
Consider selling investment real estate and buying new property before the law is changed. This may help avoid triggering taxes if the Section 1031 exchange rules change.
As usual, maximize contributions to retirement plans. Be aware that backdoor Roth IRAs may be eliminated in 2022.
Cash out any carried interest positions.
If you are thinking about selling a business in 2022, consider doing it before there is a change in the capital gains rate. The discussed proposed capital gains rate is nearly double the current rate.
The situation is changing rapidly, and the best advice is to keep in close contact with your tax advisor.
The Other Usual Businesses Tax Planning Opportunities
The Section 199A deduction for 2021 tax year should be in your tax planning. For non-corporate taxpayers, this deduction may reduce taxable income by as much as 20%. Calculate whether the 50% of W-2 wages limitation applies. Consider the impact of the Covid 19 credits. If it does, consider increasing 2021 W-2 income to owner-shareholders whose compensation is used in the 50% limitation calculation.
Year-end payroll bonuses can be timed for maximum tax effect by both cash and accrual basis employers. Cash based taxpayers deduct it when paid while accrual taxpayers may have to modify their plans before yearend to change the timing of the bonus deduction for the business.
When appropriate, businesses should also consider making expenditures that qualify for 100% bonus first year depreciation and Section 179 election. The bonus depreciation deduction is also permitted without any proration based on the length of time that an asset is in service during the tax year. For tax years beginning in 2021, the expensing limit is $1,050,000, and the investment ceiling limit is $2,620,000.
If you own an interest in a partnership or S corporation, consider whether you need to increase your inside basis in the entity so you can deduct a loss from it for this year.
Your business may make a 2021 deductible Simplified Employee Pension (“SEP”) contribution of up to 25% of wages limited at $58,000 by the extended due date of the tax return. That contribution could be as late as October 15, 2022 with the correct facts.
Potential Year-End Individuals’ Tax Planning Opportunities
You may be able to save overall taxes for this year and next by applying a bunching strategy to "miscellaneous" itemized deductions, medical expenses and other itemized deductions. Attention should be given to the timing of payments of non-business state taxes, property and sales in Florida, since they are currently limited to $10,000.
Higher-income earners must be wary of the 3.8% Net Investment Income Tax (surtax) on certain unearned income. The 3.8% surtax currently applies to the lesser of modified adjusted gross income in excess of $250,000 for joint filers or surviving spouses, half of that for a married individual filing a separate return, and $200,000 in any other case, or net investment income
In addition, for 2021 the 0.9% additional Medicare tax also may require year-end actions. Employers must withhold the additional Medicare tax from wages in excess of $200,000 regardless of the employee's filing status or other income. This could be an estimated payment trap if a high-income individual earns wages from more than one source. An example is individual has W-2 wages for $200,000 and also has earned income from his sole proprietorship. The combined total is used to calculate the additional tax due. On the other hand, over withholding is possible if the individual is married and the other spouse has less than $50,000 of wages subject to the Medicare tax.
If you are concerned about tax rates rising: taking some capital gains, or converting a portion of your traditional 401(k) or IRA savings to a Roth. If you did convert assets in a traditional IRA to a Roth IRA earlier in the year and the assets in the Roth IRA account declined in value, you can back out of the transaction by re-characterizing the conversion by transferring the converted amount (plus earnings, or minus losses) from the Roth IRA back to a traditional IRA via a timely trustee-to-trustee transfer. You can later reconvert to a Roth IRA with a lower income impact. Also, if RMD was taken earlier this year it may be returned before the end of the year to avoid 2020 tax.
Summary
Tax Planning must take into account each particular business and financial situation, and planning goals. Normally most businesses would come out ahead by following the time-honored approach of deferring income and accelerating deductions to minimize 2021 taxes. However, with the new administration, businesses that anticipate substantial net income in future years may find it worthwhile to accelerate some income into 2021. A significant amount of effort will be required to accomplish good tax planning this year. Review your current year’s facts and prior years to see if your operation benefited from last year’s law changes. It's always a good idea to take advantage of tax-preferred retirement savings opportunities, but that may be particularly true this year. The difficult conversation of succession planning should also be brought to the forefront and addressed. Plans in place should be reviewed, given the potential focus on tax increases. Nobody knows when or what new tax legislation might be enacted. Your tax adviser should be able to help you navigate these issues.