With tax year 2020 coming to a close here are some tax planning ideas for Businesses & Individuals
Review your accounting method:
Businesses typically use either an accrual method of accounting or the cash basis. Under an accrual method, income and expense is recognized when: 1) All events have occurred to deduct the cost or recognize the income and 2) the amount can be determined with reasonable accuracy. Under the cash basis, income is recognized when actually or constructively received and expenses are generally deducted in the year paid. Many businesses were prohibited from using the cash basis of accounting due to restrictions on gross income levels or the required use of inventories. The Tax Cuts and Jobs Act of 2017 (TCJA) has expanded the definition of who qualifies to use the cash basis of accounting. Businesses with average annual gross receipts (3-year average) under $26 million can now qualify to use the cash method of accounting. Is the cash method right for your business?
Cost Segregation Analysis:
A Cost Segregation Analysis is a commonly used strategic tax planning tool that allows companies and individuals who have constructed, purchased, expanded or remodeled any kind of real estate to accelerate depreciation deductions. When a property is purchased, not only does it include a building structure, but it also includes all of its interior and exterior components. Many of those components fall into tax categories that can be written off much quicker than the building structure. A Cost Segregation Analysis dissects the construction cost or purchase price of the property that would otherwise be depreciated over 27 ½ or 39 years. The primary goal of a Cost Segregation Analysis is to identify all property-related costs that can be depreciated over 5, 7 and 15 years.
Qualified Improvement Property:
Qualified improvement property (QIP) is any improvement made to the interior of an existing nonresidential building (enlargements, elevators/escalators, or internal structural framework do not qualify). The Coronavirus Aid, Relief and Economic Security Act (CARES Act) shortened the depreciable life of QIP from 39 years to 15 years. This change is retroactive to property placed in service in 2018. QIP is also eligible for immediate deduction by electing to take 100% bonus depreciation or a section 179 deduction in the year the property is placed in service. However, New York (and many other states) have decoupled from the CARES Act, and the depreciable life for QIP in New York remains at 39 years.
Bonus depreciation allows for the accelerated depreciation of capitalized assets with depreciable lives of 20 years or less. The allowable bonus depreciation is typically 100% of the cost of the property, with the exception of certain passenger automobiles that are subject to dollar limits on a per vehicle basis. Placing bonus-eligible assets in service before year end can be an effective way to reduce your Federal tax liability. Caution: New York, and many other states, don’t accept bonus depreciation. Bonus depreciation claimed on the Federal return must be added back in full to NY taxable income, and the bonus eligible property is depreciated over the normal recovery period.
Net Operating Loss (NOL) Rules:
The CARES Act made significant changes to the NOL rules. Under the CARES Act, NOLs arising in tax years beginning after December 31, 2017, and before January 1, 2021 (e.g., NOLs incurred in 2018, 2019, or 2020 by a calendar-year taxpayer) may be carried back to each of the five tax years preceding the tax year of such loss. Since the enactment of the Tax Cuts and Jobs Act of 2017 (TCJA), NOLs generally could not be carried back but could be carried forward indefinitely. Further, the TCJA limited NOL absorption to 80% of taxable income. The CARES Act temporarily removes the 80% limitation, reinstating it for tax years beginning after 2020. Please note that many states are not following the CARES Act.
The Research and Development (R&D) Tax Credit remains one of the best opportunities for businesses to substantially reduce their tax liability. Large and small companies from a wide-range of industries can qualify for federal and state tax savings. The R&D Tax Credit may be claimed by taxpaying businesses that develop, design or improve products, processes, formulas or software. Research activities no longer have to be new to the industry; instead activities need to be new to the company – a standard that is much more favorable to taxpayers.
Planning with Year-End Bonuses:
If a business is having a successful year consider making bonuses to employees. An accrual basis taxpayer can accrue bonuses, and get a deduction in 2020 as long as they make the payments by March 15, 2021. Please note that bonuses accrued to owners do not qualify.
If an owner believes they are underpaid for estimated taxes, a year-end bonus paid by December 31, 2020 can be used to withhold additional federal and state taxes.
Another bonus strategy relates to an existing C corporation that is making an election to be treated as an S corporation. An existing C corporation that makes this election is subject to built-in-gains (BIG) tax for a 60-month period after electing S status. Any asset sold during the 60-month period that has a BIG attached is subject to C corporation tax rates. An accrued bonus to an owner that is paid in the following year is considered a built-in-loss that can be used to reduce BIG tax in the future.
Income/ Deduction Deferral or Acceleration:
With proposed tax rates looking to increase for tax year 2021, accelerating income into tax year 2020 means that income would be taxed at a lower rate. Consider the following to accelerate income into the current year:
- Consider converting an IRA to a ROTH IRA during 2020.
- Recognize capital gains earlier than planned. Considering selling investments that have capital gain potential this year vs 2021.
- If you took a coronavirus-related distribution (CRD) in 2020, for tax purposes, you can recognize the income over three years, or you can recognize 100% of the distribution this year. If you expect to be in a higher tax bracket in 2021 and 2022, you may want to recognize all the income in 2020.
Also, deductions will be more valuable if tax rates are higher in tax year 2021.
- As the standard deduction increases from year to year, more and more individuals are benefiting by the higher amounts and not itemizing their deductions on their return, thereby not taking advantage of any charitable contribution donations. However, individuals may consider “bunching charitable gifts” whereby gifts that would normally be made over a two or three year period instead were significantly made in one year, resulting in potential tax savings. With this concept, taxpayers may benefit by alternating between claiming the standard deduction in some years and itemizing deductions in other years. If possible, “lumping” as many as those deductions into those years when itemizing.
- Gift appreciated assets such as stock. Do not gift stock that has decreased in value since acquisition; in that situation it is better to sell the stock, claim a capital loss on your return and gift the cash proceeds to a charity.
- If you are bunching deductions, pay your January mortgage payment at the end of December to get an extra months interest on your mortgage.
Other ways to lower income in 2021 to minimize the tax impact from increased tax rates
- Consider increasing contributions to a health savings account (HSA) if you are covered by a high deductible health plan.
- Consider increasing your retirement plan contributions to reduce your taxable income.
Charitable Deductions – CARES Act:
New for Tax Year 2020 only – individuals who do not itemize deductions can claim a $300 above the line deduction for cash contributions made to a qualified organization.
Also new for 2020, the CARES ACT temporarily increased the individual AGI limit for cash contributions made to qualified public charities. Individuals will be able to deduct cash contributions up to 100% of their adjusted gross income (AGI). Note, the AGI limitations will be reinstated for 2021 and will revert back to the 60% of adjusted gross income limitation. Therefore, if an individual is considering a large cash donation with a possibility of being limited by AGI in tax year 2021, they may want to consider expediting the donation for this year.
Qualified Business Income Deduction (QBI):
The Tax Cuts and Job Act allowed certain taxpayers to deduct up to 20% of qualified business income from a pass through entity or sole proprietorship. The IRS placed certain thresholds on deductibility based upon the type of business, taxpayer’s taxable income, amount of W2 wages with respect to the business and unadjusted basis of the qualified property. One of the strategies to qualify for the QBI deduction is to keep taxable income under the thresholds. While losses from pass through entities are beneficial in reducing taxable income, these losses will also have a negative effect on the QBI thereby reducing the amount of the deduction. Therefore planning opportunities to limit the adverse tax effects of negative QBI should be reviewed.
The CARES Act suspended the required minimum distribution (RMD) for 2020. For those taxpayers that in years prior to 2020, took an RMD distribution with associated federal or state withholding taken out, and now has suspended that distribution, there may be a possibility of being under withheld at year end. As such, steps may need to be taken to increase or make year- end estimated payments.
For additional information on Retirement Plans, see Cares Act changes for Eligible Retirement Plans on the TBC Web page.
Many schools at this point are either remote learning or a hybrid of in class and remote learning. This maybe a good time to revisit a 529 plan strategy if you have a child in college. Parents may need to take steps to avoid penalty if you find yourself in a position of receiving a refund for college expenses, due to the COVID outbreak and these expenses were originally paid for with 529 money. If the school issues a refund for the expense that you used monies from a 529 account, the refund will need to be put back into the 529 plan within 60 days. If the amount is not recontributed to the 529 account within 60 days, the IRS could recharacterize the amount as taxable and deem the distribution as not being used for qualified expenses. As such, the earning portion of the distribution the amount will be subject to tax and a 10% penalty, but you won’t have to pay taxes on the principle.
Eligible educators may claim an above the line deduction for up to $250 for unreimbursed qualified expenses for items such as books, supplies, computer equipment and other supplementary equipment used in the classroom. The $250 is per individual, so if taxpayers are filing a joint return and are eligible educators, each can claim $250 for a maximum amount of $500.
Annual gift exclusion:
The annual gift exclusion remains at $15,000 per person for 2020. Married couples who elect to split gifts can give $30,000 per person, per year. There is no limit to how many donees can receive gifts in a calendar year, and there are no gift tax filing requirements as long as the $15,000 per person limit isn’t exceeded. There is also an unlimited gift exclusion for payments made on behalf of a donee as medical payments or tuition paid to an educational institution, as long as the payment is made directly to the medical care provider or educational institution.
There is talk that the Unified Gift & Estate Tax Exemption may be reduced by the incoming administration. Currently the exemption is $11,580,000 per individual (Pre-2018 exemption was $5,490,000); the Internal Revenue Service has said that it would not claw back lifetime gifts if the exemption was lowered. Now may be the time to review your estate plan.
Capital losses can offset capital gains:
Triggering capital loss harvesting from your investment portfolio can help offset any capital gains incurred in the same tax year. If capital gains are expected, it may be a good time to rid your portfolio of assets that are currently worth less than their initial purchase price. Capital gains and losses arising from the sale of business assets follow special tax rules, so it’s important to discuss expectations surrounding those gains and losses with an experienced tax advisor. The limit on deducting capital losses in excess of capital gains remains at $3,000 for tax year 2020.
These are just a few planning ideas to consider for 2020 or 2021 and are general in nature. If you have any questions or need further information please contact your TBC advisor.